UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

(Mark One)

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

For the fiscal year endedDecember 31, 20102012

OR

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

For the transition period from                    to                    

Commission file number 000-26481

FINANCIAL INSTITUTIONS, INC.

(Exact name of registrant as specified in its charter)

NEW YORK 
NEW YORK16-0816610

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

220 LIBERTY STREET,

WARSAW, NEW YORK

 14569
220 LIBERTY STREET, WARSAW, NEW YORK14569
(Address of principal executive offices) (ZIP Code)

Registrant’s telephone number, including area code:(585) 786-1100

Securities registered under Section 12(b) of the Exchange Act:

Title of each class

 

Name of exchange on which registered

Common stock, par value $.01 per share NASDAQ Global Select Market

Securities registered under Section 12(g) of the Exchange Act:NONE

Indicate by check mark if the regsitrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yeso¨    Noþx

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yeso¨    Noþx

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 past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yesþx    Noo¨

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).    Yesox    Noo¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this form 10-K or any amendment to this Form 10-K.o¨

Indicate by check mark whether the regsitrant 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 filero¨  Accelerated filerþ x
Non-accelerated filero¨    Smaller reporting companyo¨

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

The aggregate market value of the registrant’s common equitystock, par value $0.01 per share, held by non-affiliates of the registrant, as computed by reference to the June 30, 20102012 closing price reported by NASDAQ, was approximately $177,182,000.

$216,222,000.

As of March 1, 2011,2013, there were issued and outstanding, exclusive of treasury shares, 10,979,71513,803,158 shares of the registrant’s common stock.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s proxy statement for the 2013 Annual Meeting of Shareholders are incorporated by reference in Part III of this Annual Report on Form 10-K.

 

 


TABLE OF CONTENTS

PAGE
     PAGE 
Item 1.Business   5  
Item 1A. 
4
   18  
Item 1B. 
   25  
Item 2. 
   25  
Item 3. 
   25  
Item 4. 
   25  
PART II  
Item 5. 
   26  
Item 6. 
   28  
Item 7. 
   3132  
Item 7A. 
   5556  
Item 8. 
   5759  
Item 9. 
   106115  
Item 9A.Controls and Procedures   115  
Item 9A. Controls and Procedures9B.Other Information   106115  
PART III  
Item 10. 
106
   107116  
Item 11.Executive Compensation   116  
Item 11. Executive Compensation12. 109
   131116  
Item 13. 
   132116  
Item 14. 
   133116  
PART IV  
Item 15. 
   134117  
Signatures   120  
136
Exhibit 12
Exhibit 21
Exhibit 23
Exhibit 31.1
Exhibit 31.2
Exhibit 32
Exhibit 99.1
Exhibit 99.2


PART I

FORWARD LOOKING INFORMATION

Statements in this Annual Report on Form 10-K that are based on other than historical data are forward-looking within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements provide current expectations or forecasts of future events and include, among others:

statements with respect to the beliefs, plans, objectives, goals, guidelines, expectations, anticipations, and future financial condition, results of operations and performance of Financial Institutions, Inc. (“the parent” or “FII”) and its subsidiaries (collectively “the Company,” “we,” “our,” “us”); and

statements preceded by, followed by or that include the words “may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “intend,” “plan,” “projects,” or similar expressions.

These forward-looking statements are not guarantees of future performance, nor should they be relied upon as representing management’s views as of any subsequent date. Forward-looking statements involve significant risks and uncertainties and actual results may differ materially from those presented, either expressed or implied, in this Annual Report on Form 10-K, including, but not limited to, those presented in the Management’s Discussion and Analysis of Financial Condition and Results of Operation.Operations. Factors that might cause such differences include, but are not limited to:

If we experience greater credit losses than anticipated, earnings may be adversely impacted;

Geographic concentration may unfavorably impact our operations;

We depend on the accuracy and completeness of information about or from customers and counterparties;

We are subject to environmental liability risk associated with our lending activities;

Our indirect lending involves risk elements in addition to normal credit risk;

We are highly regulated and may be adversely affected by changes in banking laws, regulations and regulatory practices;

Recently enactedOngoing financial reform legislation will, among other things, tighten capital standards, create a new Consumer Financial Protection Bureau andmay result in new regulations that are expectedcould require us to maintain higher capital levels and/or increase our costs of operations;
As a participant in the Troubled Asset Relief Program (“TARP”), we are subject tooperations or limit certain restrictions on dividends, repurchasesactivities or lines of common stock and executive compensation;business;

New or changing tax, accounting, and regulatory rules and interpretations could significantly impact our strategic initiatives, results of operations, cash flows, and financial condition;

If our security systems, or those of merchants, merchant acquirers or other third parties containing information about customers, are compromised, we may be subject to liability and damage to our reputation;

We could be subject to losses if we fail to properly safeguard sensitive and confidential information;

Our information systems may experience an interruption or breach in security;

We rely on other companies to provide key components of our business infrastructure;

We may not be able to attract and retain skilled people;people and our ongoing leadership transition may be unsuccessful;

The potential for business interruption exists throughout our organization;

Acquisitions may disrupt our business and dilute shareholder value;

We are subject to interest rate risk;

Our business may be adversely affected by conditions in the financial markets and economic conditions generally;

Our earnings are significantly affected by the fiscal and monetary policies of the federal government and its agencies;

The soundness of other financial institutions could adversely affect us;

We may be required to recognize an impairment of goodwill:

We operate in a highly competitive industry and market area;

Our market valueSevere weather, natural disasters, acts of war or terrorism, and other external events could result in an impairment of goodwill;significantly impact our business;

Liquidity is essential to our businesses;

We may need to raise additional capital in the future and such capital may not be available when neededon acceptable terms or at all;

We rely on dividends from our subsidiaries for most of our revenue;

The market price for our common stock varies;varies, and you should purchase common stock for long-term investment only;

ThereWe may issue debt and equity securities or securities convertible into equity securities, any of which may be future sales or other dilution ofsenior to our equity,common stock as to distributions and in liquidation, which may adverselycould negatively affect the market pricevalue of our common stock;
Our shares of common stock are equity and are subordinate to our existing and future indebtedness and our preferred stock, and are effectively subordinated to all the indebtedness and other non-common equity claims against our subsidiaries;

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We may not pay dividends on our common stock; and

Our certificate of incorporation, our bylaws, and certain banking laws may have ancontain anti-takeover effect.provisions.

We caution readers not to place undue reliance on any forward-looking statements, which speak only as of the date made, and advisesadvise readers that various factors, including those described above, could affect our financial performance and could cause our actual results or circumstances for future periods to differ materially from those anticipated or projected. See also Item 1A, Risk Factors, in this Form 10-K.

10-K for further information. Except as required by law, we do not undertake, and specifically disclaim any obligation to publicly release any revisions to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.

 

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ITEM 1.
BUSINESS

GENERAL

Financial Institutions, Inc. is a financial holding company organized in 1931 under the laws of New York State (“New York” or “NYS”). Through its subsidiaries, including its wholly-owned, New York State chartered banking subsidiary, Five Star Bank, Financial Institutions, Inc. provides a broad array of deposit, lending and other financial services to retail, commercial, and municipal customers in Western and Central New York. All references in this Annual Report on Form 10-K to the parent company are to Financial Institutions, Inc. (“FII”). Unless otherwise indicated, or unless the context requires otherwise, all references in this Annual Report on Form 10-K to “the Company,” “we,” “our” or “us” means Financial Institutions, Inc. and its subsidiaries on a consolidated basis. Five Star Bank is referred to as Five Star Bank, “FSB” or “the Bank”. The parent companyFII is a legal entity separate and distinct from its subsidiaries, assisting those subsidiaries by providing financial resources and management.oversight. Our executive offices are located at 220 Liberty Street, Warsaw, New York.

We conduct business primarily through our banking subsidiary, Five Star Bank, which adopted its current name in 2005 when we merged three of our bank subsidiaries, Wyoming County Bank, National Bank of Geneva and Bath National Bank into our New York chartered bank subsidiary, First Tier Bank & Trust, which was renamed Five Star Bank. In addition, our business operations include a wholly-owned broker-dealer and investment adviser subsidiary, Five Star Investment Services, Inc. (“FSIS”).

OTHER INFORMATION
This Annual Report

Our Business Strategy

Our business strategy has been to maintain a community bank philosophy, which consists of focusing on Form 10-K, includingand understanding the exhibitsindividualized banking needs of the businesses, professionals and schedules filedother residents of the local communities surrounding our banking centers. We believe this focus allows us to be more responsive to our customers’ needs and provide a high level of personal service that differentiates us from larger competitors, resulting in long-standing and broad based banking relationships. Our core customers are primarily comprised of small- to medium-sized businesses, individuals and community organizations who prefer to build a banking relationship with a community bank that offers and combines high quality, competitively-priced banking products and services with personalized service. Because of our identity and origin as a locally operated bank, we believe that our level of personal service provides a competitive advantage over larger banks, which tend to consolidate decision-making authority outside local communities.

A key aspect of our current business strategy is to foster a community-oriented culture where our customers and employees establish long-standing and mutually beneficial relationships. We believe that we are well-positioned to be a strong competitor within our market area because of our focus on community banking needs and customer service, our comprehensive suite of deposit and loan products typically found at larger banks, our highly experienced management team and our strategically located banking centers. A central part of the Annual Report on Form 10-K, may be inspected at the public reference facility maintained by the SEC at its public reference room at 100 F. Street, N.E., Room 1580, Washington, DC 20549 and copies of all or any part thereof may be obtained from that office upon payment of the prescribed fees. You may call the SEC at 1-800-SEC-0330 for further information on the operation of the public reference room and you can request copies of the documents upon paymentour strategy is generating core deposits to support growth of a duplicating fee, by writing to the SEC. In addition, the SEC maintains a website that contains reports, proxydiversified and information statements and other information regarding registrants, including us, that file electronically with the SEC which can be accessed at www.sec.gov.

We also make available, free of charge through our website at www.fiiwarsaw.com, all reports filed with the SEC, including our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, as well as any amendments to those reports, as soon as reasonably practicable after those documents are filed with, or furnished to, the SEC. Information available on our website is not a part of, and is not incorporated into, this Annual Report on Form 10-K.
high-quality loan portfolio.

MARKET AREAS AND COMPETITION

We provide a wide range of consumer and commercial banking and financial services to individuals, municipalities and businesses through a network of over 50 offices and more than 70 ATMsan extensive ATM network in fourteenfifteen contiguous counties of Western and Central New York: Allegany, Cattaraugus, Cayuga, Chautauqua, Chemung, Erie, Genesee, Livingston, Monroe, Ontario, Orleans, Seneca, Steuben, Wyoming and Yates Counties.

counties. Our banking activities, though concentrated in the communities where we maintain branches, also extend into neighboring counties. In addition, we have expanded our consumer indirect lending presence to the Capital District of New York and Northern Pennsylvania.

Our market area is economically diversified in that we serve both rural markets and the larger more affluent markets of suburban Rochester and suburban Buffalo. Rochester and Buffalo are the two largest metropolitan areas in New York outside of New York City, with a combined metropolitan area populations of over two million people. We anticipate increasingcontinuing to increase our presence in and around these metropolitan statistical areas in the coming years.

We face significant competition in both making loans and attracting deposits, as both Western and Central New York have a high density of financial institutions. Our competition for loans comes principally from commercial banks, savings banks, savings and loan associations, mortgage banking companies, credit unions, insurance companies and other financial service companies. Our most direct competition for deposits has historically come from commercial banks, savings banks and credit unions. We face additional competition for deposits from non-depository competitors such as the mutual fund industry, securities and brokerage firms and insurance companies. We generally compete with other financial service providers on factors such as;as: level of customer service, responsiveness to customer needs, availability and pricing of products, and geographic location.

 

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The following table presents the Bank’s market share percentage for total deposits as of June 30, 2012, in each county where we have operations. The table also indicates the ranking by deposit size in each market. All information in the table was obtained from SNL Financial of Charlottesville, Virginia, which compiles deposit data published by the FDIC as of June 30, 2012 and updates the information for any bank mergers and acquisitions completed subsequent to the reporting date.

County

  Market
Share
  Market
Rank
   Number of
Branches
 

Allegany

   6.6  4     1  

Cattaraugus

   24.0  2     5  

Cayuga

   3.6  11     1  

Chautauqua

   1.2  9     1  

Chemung

   17.1  3     3  

Erie

   0.4  12     3  

Genesee

   20.4  3     5  

Livingston

   30.7  1     5  

Monroe

   1.6  9     5  

Ontario

   13.9  3     5  

Orleans

   23.7  2     2  

Seneca

   20.7  2     2  

Steuben

   28.6  1     7  

Wyoming

   46.8  1     5  

Yates

   38.6  1     2  

INVESTMENT ACTIVITIES

Our investment policy is contained within our overall Asset-Liability Management and Investment Policy. This policy dictates that investment decisions will be made based on the safety of the investment, liquidity requirements, potential returns, cash flow targets, need for collateral and desired risk parameters. In pursuing these objectives, we consider the ability of an investment to provide earnings consistent with factors of quality, maturity, marketability, pledgeable nature and risk diversification. Our Treasurer, guided by our Asset-Liability Committee (“ALCO”), is responsible for investment portfolio decisions within the established policies.

Our investment securities strategy centers on providing liquidity to meet loan demand and redeeming liabilities, meeting pledging requirements, managing credit risks, managing overall interest rate risks and maximizing portfolio yield. Our current policy generally limits security purchases to the following:

U.S. treasury securities;

U.S. government agency securities, which are securities issued by official Federal government bodies (e.g. the Government National Mortgage Association (“GNMA”) and U.S. government-sponsored enterprise (“GSE”) securities, which are securities issued by independent organizations that are in part sponsored by the federal government (e.g., the Federal Home Loan Bank (“FHLB”) system, the Federal National Mortgage Association (“FNMA”), the Federal Home Loan Mortgage Corporation (“FHLMC”), the Small Business Administration (“SBA”) and the Federal Farm Credit Bureau);

Mortgage-backed securities (“MBS”) include mortgage-backed pass-through securities (“pass-throughs”) and collateralized mortgage obligations (“CMO”) issued by GNMA, FNMA and FHLMC;

Investment grade municipal securities, including revenue, tax and bond anticipation notes, statutory installment notes and general obligation bonds;

Certain creditworthy un-rated securities issued by municipalities;

Certificates of deposit;

Equity securities at the holding company level; and

Limited partnership investments in Small Business Investment Companies.


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LENDING ACTIVITIES

General

We offer a broad range of loans including commercial business and revolving lines of credit, commercial mortgages, equipment loans, residential mortgage loans and home equity loans and lines of credit, home improvement loans, automobile loans and personal loans. Newly originated and refinanced fixed rate residential mortgage loans are either retained in our portfolio or sold to the secondary market with servicing rights retained.

We continually evaluate and update our lending policy. The key elements of our lending philosophy include the following:

To ensure consistent underwriting, employees must share a common view of the risks inherent in lending activities as well as the standards to be applied in underwriting and managing credit risk;

Pricing of credit products should be risk-based;

The loan portfolio must be diversified to limit the potential impact of negative events; and

Careful, timely exposure monitoring through dynamic use of our risk rating system is required to provide early warning and assure proactive management of potential problems.

Commercial Business and Commercial Mortgage Lending

We originate commercial business loans in our primary market areas and underwrite them based on the borrower’s ability to service the loan from operating income. We offer a broad range of commercial lending products, including term loans and lines of credit. Short and medium-term commercial loans, primarily collateralized, are made available to businesses for working capital (including inventory and receivables), business expansion (including acquisition of real estate, expansion and improvements) and the purchase of equipment. Commercial business loans are offered to the agricultural industry for short-term crop production, farm equipment and livestock financing. As a general practice, where possible, a collateral lien is placed on any available real estate, equipment or other assets owned by the borrower and a personal guarantee of the owner is obtained. As of December 31, 2010, $70.02012, $84.3 million, or 33%, of theour aggregate commercial business loan portfolio were at fixed rates, while $141.0$174.4 million, or 67%, were at variable rates.

We also offer commercial mortgage loans to finance the purchase of real property, which generally consists of real estate with completed structures and, to a smaller extent, agricultural real estate financing. Commercial mortgage loans are secured by first liens on the real estate and are typically amortized over a 10 to 20 year period. The underwriting analysis includes credit verification, appraisals and a review of the borrower’s financial condition and repayment capacity. As of December 31, 2010, $100.02012, $142.4 million, or 28%34%, of theour aggregate commercial mortgage portfolio were at fixed rates, while $252.9$270.9 million, or 72%66%, were at variable rates.

We utilize government loan guarantee programs where available and appropriate. See “Government Guarantee Programs” below.

Government Guarantee Programs

We participate in government loan guarantee programs offered by the Small Business Administration (“SBA”),SBA, U.S. Department of Agriculture, Rural Economic and Community Development and Farm Service Agency, among others. As of December 31, 2010,2012, we had loans with an aggregate principal balance of $55.1$62.8 million that were covered by guarantees under these programs. The guarantees typically only cover a certain percentage of these loans. By participating in these programs, we are able to broaden our base of borrowers while minimizing credit risk.

Residential Mortgage Lending

We originate fixed and variable rate one-to-four family residential mortgages collateralized by owner-occupied properties located in our market areas. We offer a variety of real estate loan products, which are generally amortized over periods of up to 30 years. Loans collateralized by one-to-four family residential real estate generally have been originated in amounts of no more than 80% of appraised value or have mortgage insurance. Mortgage title insurance and hazard insurance are normally required. We sell certain one-to-four family residential mortgages to the secondary mortgage market and typically retain the right to service the mortgages. To assure maximum salability of the residential loan products for possible resale, we have formally adopted the underwriting, appraisal, and servicing guidelines of the Federal Home Loan Mortgage Corporation (“FHLMC”)FHLMC as part of our standard loan policy. As of December 31, 2010, the2012, our residential mortgage servicing portfolio totaled $328.9$273.3 million, the majority of which havehas been sold to FHLMC. As of December 31, 2010,2012, our residential mortgage loan portfolio totaled $129.6$133.5 million, or 10%8% of our total loan portfolio. We do not engage in sub-prime or other high-risk residential mortgage lending as a line-of-business.

 

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Consumer Lending

We offer a variety of loan products to our consumer customers, including home equity loans and lines of credit, automobile loans, secured installment loans and various other types of secured and unsecured personal loans. At December 31, 2010,2012, outstanding consumer loan balances were concentrated in indirect automobile loans and home equity products.

We indirectly originate indirect consumer loans for a mix of new and used vehicles through franchised new car dealers, indirect consumer loans.dealers. The consumer indirect loan portfolio is primarily comprised of new and used automobile loans with terms that typically range from 36 to 84 months. We have expanded our relationships with franchised new car dealers in Western, Central and most recently, into the Capital District of New York, and have selectively originated a mix of new and used automobile loans from those dealers. In the latter part of 2010, we began efforts to expand our dealer network into Northern Pennsylvania and anticipate indirectly originating loans there in the first half of 2011.Pennsylvania. As of December 31, 2010, the2012, our consumer indirect portfolio totaled $418.0$586.8 million, or 31%34% of our total loan portfolio.

The consumer indirect loan portfolio is primarily fixed rate loans with relatively short durations.

We also originate, independently of the indirect loans described above, consumer automobile loans, recreational vehicle loans, boat loans, home improvement loans, closed-end home equity loans, home equity lines of credit, personal loans (collateralized and uncollateralized) and deposit account collateralized loans. The terms of these loans typically range from 12 to 180 months and vary based upon the nature of the collateral and the size of loan. The majority of the consumer lending program is underwritten on a secured basis using the customer’s home or the financed automobile, mobile home, boat or recreational vehicle as collateral. As of December 31, 2010, $97.22012, $152.9 million, or 47%53%, of theour home equity portfolio was at fixed rates, while $111.2$133.7 million, or 53%47%, was at variable rates. Approximately 69% of the loans in our home equity portfolio are first lien positions at December 31, 2012. The other consumer portfolio totaled $26.1$26.8 million as of December 31, 2010,2012, all but $1.3 million of which were fixed rate loans.

Credit Administration

Our loan policy establishes standardized underwriting guidelines, as well as the loan approval process and the committee structures necessary to facilitate and ensure the highest possible loan quality decision-making in a timely and businesslike manner. The policy establishes requirements for extending credit based on the size, risk rating and type of credit involved. The policy also sets limits on individual loan officer lending authority and various forms of joint lending authority, while designating which loans are required to be approved at the committee level.

Our credit objectives are as follows:

Compete effectively and service the legitimate credit needs of our target market;

Enhance our reputation for superior quality and timely delivery of products and services;

Provide pricing that reflects the entire relationship and is commensurate with the risk profiles of our borrowers;

Retain, develop and acquire profitable, multi-product, value added relationships with high quality borrowers;

Focus on government guaranteed lending and establish a specialization in this area to meet the needs of the small businesses in our communities; and

Comply with the relevant laws and regulations.

Our policy includes loan reviews, under the supervision of the Audit and Risk Oversight committees of the Board of Directors and directed by theour Chief Risk Officer, in order to render an independent and objective evaluation of our asset quality and credit administration process.

Risk ratings are assigned to loans in the commercial business and commercial mortgage portfolios. The risk ratings are specifically used as follows:

Profile the risk and exposure in the loan portfolio and identify developing trends and relative levels of risk;

Identify deteriorating credits; and

Reflect the probability that a given customer may default on its obligations.obligations; and

Assist with risk-based pricing.

Through the loan approval process, loan administration and loan review program, management seeks to continuously monitor our credit risk profile and assesses the overall quality of the loan portfolio and adequacy of the allowance for loan losses.

We have several procedures in place to assist in maintaining the overall quality of our loan portfolio. Delinquent loan reports are monitored by credit administration to identify adverse levels and trends. Loans, including impaired loans, are generally classified as non-accruing if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-collateralized and in the process of collection. Loans that are on a current payment status or past due less than 90 days may also be classified as non-accruing if repayment in full of principal and/or interest is uncertain.

 

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Allowance for Loan Losses

The allowance for loan losses is established through charges to earnings in the form of a provision for loan losses. The allowance reflects management’s estimate of the amount of probable loan losses in the portfolio, based on factors such as:

Specific allocations for individually analyzed credits;

Risk assessment process;

Historical net charge-off experience;

Evaluation of the loan portfolio with loan reviews;

Levels and trends in delinquent and non-accruing loans;

Trends in volume and terms;terms of loans;

Effects of changes in lending policy;

Experience, ability and depth of management;

National and local economic trends and conditions;

Concentrations of credit;

Interest rate environment;

Customer leverage;

Information (availability of timely financial information); and

Collateral values.

Our methodology in the estimation of the allowance for loan losses includes the following broad areas:

following:

1.Impaired commercial business and commercial mortgage loans, generally in excess of $50 thousand are reviewed individually and assigned a specific loss allowance, if considered necessary, in accordance with U.S. generally accepted accounting principles (“GAAP”).

2.The remaining portfolios of commercial business and commercial mortgage loans are segmented by risk rating into the following loan classification categories: uncriticized or pass, special mention, substandard and doubtful. Uncriticized loans, special mention loans, substandard loans and all doubtful loans not assigned a specific loss allowance are assigned allowance allocations based on historical net loan charge-off experience for each of the respective loan categories, supplemented with additional reserve amounts, if considered necessary, based upon qualitative factors. These qualitative factors include the levels and trends in delinquenciesdelinquent and non-accruing loans;loans, trends in volume and terms of loans;loans, effects of changes in lending policy;policy, experience, ability, and depth of management;management, national and local economic conditions;trends and conditions, concentrations of credit, interest rate environment;environment, customer leverage;leverage, information (availability of timely financial information);, and collateral values, among others.

3.The retail loan portfolio is segmented into the following types of loans: residential real estate, home equity (home equity loans and lines of credit), consumer indirect and other consumer. Allowance allocations for the real estate related loan portfolios (residential and home equity) are based on the average loss experience for the previous eight quarters, supplemented with qualitative factors similar to the elements described above. Allowance allocations for the consumer indirect and other consumer portfolios are based on vintage analyses performed with historical loss experience at 36 months and 24 months aging, respectively. The allocations on these portfolios are also supplemented with qualitative factors.

Management presents a quarterly review of the adequacy of the allowance for loan losses to our Board of Directors based on the methodology described above. See also the section titled “Allowance for Loan Losses” Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

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INVESTMENT ACTIVITIES
Our investment policy is contained within our overall Asset-Liability Management and Investment Policy. This policy dictates that investment decisions will be made based on the safety of the investment, liquidity requirements, potential returns, cash flow targets, need for collateral and desired risk parameters. In pursuing these objectives, we consider the ability of an investment to provide earnings consistent with factors of quality, maturity, marketability, pledgeable nature and risk diversification. Our Treasurer, guided by the Asset-Liability Committee (“ALCO”), is responsible for investment portfolio decisions within the established policies.
Our investment securities strategy centers on providing liquidity to meet loan demand and redeeming liabilities, meeting pledging requirements, managing credit risks, managing overall interest rate risks and maximizing portfolio yield. Our current policy generally limits security purchases to the following:
U.S. treasury securities;
U.S. government agency securities, which are securities issued by official Federal government bodies (e.g. the Government National Mortgage Association (“GNMA”)) and U.S. government-sponsored enterprise (“GSE”) securities, which are securities issued by independent organizations that are in part sponsored by the federal government (e.g., the Federal Home Loan Bank (“FHLB”) system, the Federal National Mortgage Association (“FNMA”), FHLMC, SBA and the Federal Farm Credit Bureau );
Mortgage-backed securities (“MBS”) include mortgage-backed pass-through securities (“pass-throughs”) and collateralized mortgage obligations (“CMO”) issued by GNMA, FNMA and FHLMC. See also the section titled “Investing Activities” in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations;”
Investment grade municipal securities, including revenue, tax and bond anticipation notes, statutory installment notes and general obligation bonds;
Certain creditworthy un-rated securities issued by municipalities;
CertificatesOperations” of deposit;
Equity securities at the holding company level; and
Limited partnership investments in Small Business Investment Companies.
this Annual Report on Form 10-K.

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SOURCES OF FUNDS

Our primary sources of funds are deposits, borrowed funds, and repurchase agreements, scheduled amortization and prepayments of principal from loans and mortgage-backed securities, maturities and calls of investment securities and funds provided by operations.

Deposits

We offermaintain a varietyfull range of deposit products and accounts to meet the needs of the residents and businesses in our primary service area. Products include an array of checking and savings account products with a range of interest ratesprograms for individuals and terms. The deposit accounts consist of noninterest-bearing demand, interest-bearing demand, savings,businesses, including money market club accounts, and certificates of deposit. We also offer certificates of deposit, with balances in excess of $100,000 to local municipalities, businesses, and individualssweep investment capabilities as well as Individual Retirement Accounts and other qualified plan accounts. The flow of deposits is influenced significantly by general economic conditions, prevailing interest rates and competition. Our deposits are obtained predominantly from the areas in which our branch offices are located. We rely primarily on competitive pricing of our deposit products, customer service and long-standing relationships with customers to attract and retain these deposits.deposits and seek to make our services convenient to the community by offering 24-hour ATM access at some of our facilities, access to other ATM networks available at other local financial institutions and retail establishments, and telephone banking services including account inquiry and balance transfers. We have also utilized certificatetake advantage of deposit sales in the national brokered market (“brokered deposits”) as a wholesale funding source; however, weuse of technology by allowing our customers banking access via the Internet and various advanced systems for cash management for our business customers.

We had no traditional brokered deposits at December 31, 2010. Our2012; however, we do participate in the Certificate of Deposit Account Registry Service (“CDARS”) and Insured Cash Sweep (“ICS”) programs, which enable depositors to receive FDIC insurance coverage for deposits otherwise exceeding the maximum insurable amount. Through these programs, deposits in excess of the maximum insurable amount are placed with multiple participating financial institutions. Reciprocal CDARS deposits and ICS deposits totaled $61.0 million and $18.1 million, respectively, at December 31, 2012.

Borrowings

We have access to a variety of borrowing sources and use both short-term and long-term borrowings consist mainly of advances entered into with the FHLB,to support our asset base. Borrowings from time-to-time include federal funds purchased, and securities sold under agreements to repurchase and FHLB advances. We also offer customers a deposit account that sweeps balances in excess of an agreed upon target amount into overnight repurchase agreements.

OPERATING SEGMENTS

Our primary operating segment is our subsidiary bank, FSB. Our brokerage subsidiary, FSIS, is also deemed an operating segment; however, it does not meet the applicable thresholds for separation.

separate disclosure requirements.

OTHER INFORMATION

All of the reports we file with the SEC, including this Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, as well as any amendments thereto may be read at the public reference facility maintained by the SEC at its public reference room at 100 F. Street, N.E., Room 1580, Washington, DC 20549 and copies of all or any part thereof may be obtained from that office upon payment of the prescribed fees. You may call the SEC at 1-800-SEC-0330 for further information on the operation of the public reference room and you can request copies of the documents upon payment of a duplicating fee, by writing to the SEC. In addition, the SEC maintains a website that contains reports, proxy and information statements and other information regarding registrants, including us, that file electronically with the SEC which can be accessed at www.sec.gov.

We also make available, free of charge, through our website, all reports filed with the SEC, including our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, as well as any amendments to those reports, as soon as reasonably practicable after those documents are filed with, or furnished to, the SEC. These filings may be viewed by accessing theCompany Filingssubsection of theSEC Filings section under theInvestor Relations tab on our website (www.fiiwarsaw.com). Information available on our website is not a part of, and is not incorporated into, this Annual Report on Form 10-K.

 

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SUPERVISION AND REGULATION

The Company and our subsidiaries are subject to an extensive system of laws and regulations that are intended primarily for the protection of customers and depositors and not for the protection of our security holders. These laws and regulations govern such areas as capital, permissible activities, allowance for loan losses, loans and investments, and rates of interest that can be charged on loans. Described below are elements of selected laws and regulations. The descriptions are not intended to be complete and are qualified in their entirety by reference to the full text of the statutes and regulations described.

Holding Company Regulation. As a bank holding company and financial holding company, we are subject to comprehensive regulation by the Board of Governors of the Federal Reserve System, frequently referred to as the Federal Reserve Board (“FRB”), under the Bank Holding Company Act, as amended by, among other laws, the Gramm-Leach-Bliley Act of 1999 (the “Gramm-Leach-Bliley Act”), and by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), enacted on July 21,in 2010. We must file reports with the FRB and such additional information as the FRB may require, and our holding company and non-banking affiliates are subject to examination by the FRB. Under FRB policy, a bank holding company must serve as a source of strength for its subsidiary banks. Under this policy, the FRB may require, and has required in the past, a holding company to contribute additional capital to an undercapitalized subsidiary bank. The Bank Holding Company Act provides that a bank holding company must obtain FRB approval before:

Acquiring, directly or indirectly, ownership or control of any voting shares of another bank or bank holding company if, after such acquisition, it would own or control more than 5% of such shares (unless it already owns or controls the majority of such shares);

Acquiring all or substantially all of the assets of another bank or bank holding company, or

Merging or consolidating with another bank holding company.

The Bank Holding Company Act generally prohibits a bank holding company from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank or bank holding company, or from engaging directly or indirectly in activities other than those of banking, managing or controlling banks, or providing services for its subsidiaries. The principal exceptions to these prohibitions involve certain non-bank activities which, by statute or by FRB regulation or order, have been identified as activities closely related to the business of banking or managing or controlling banks. The list of activities permitted by the FRB includes, among other things: lending; operating a savings institution, mortgage company, finance company, credit card company or factoring company; performing certain data processing operations; providing certain investment and financial advice; underwriting and acting as an insurance agent for certain types of credit related insurance; leasing property on a full-payout, non-operating basis; selling money orders, travelers’ checks and United States Savings Bonds; real estate and personal property appraising; providing tax planning and preparation services; and, subject to certain limitations, providing securities brokerage services for customers. These activities may also be affected by federal legislation.

The Gramm-Leach-Bliley Act amended portions of the Bank Holding Company Act to authorize bank holding companies, such as us, directly or through non-bank subsidiaries to engage in securities, insurance and other activities that are financial in nature or incidental to a financial activity. In order to undertake these activities, a bank holding company must become a “financial holding company” by submitting to the appropriate Federal Reserve Bank a declaration that the company elects to be a financial holding company and a certification that all of the depository institutions controlled by the company are well capitalized and well managed. During

Broker-Dealer and Related Regulatory Supervision. FSIS is a member of, and is subject to the second quarterregulatory supervision of, 2008, we received FRB approvalthe Financial Industry Regulatory Authority. Areas subject to this regulatory review include compliance with trading rules, financial reporting, investment suitability for an electionclients, and compliance with stock exchange rules and regulations. FSIS is also subject to reinstate our status as a financial holding company under the Gramm-Leach-Bliley Act.

supervision of the Investor Protection Bureau of the New York Attorney General’s Office for its investment advisory business.

Depository Institution Regulation.Our bank subsidiary is subject to regulation by the Federal Deposit Insurance Corporation (“FDIC”). This regulatory structure includes:

Real estate lending standards, which provide guidelines concerning loan-to-value ratios for various types of real estate loans;

Risk-based capital rules, including accounting for interest rate risk, concentration of credit risk and the risks posed by non-traditional activities;

Rules requiring depository institutions to develop and implement internal procedures to evaluate and control credit and settlement exposure to their correspondent banks;

Rules restricting types and amounts of equity investments; and

Rules addressing various safety and soundness issues, including operations and managerial standards, standards for asset quality, earnings and compensation standards.

 

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The Dodd-Frank Act.The Dodd-Frank Act, enacted in July 2010, significantly changed the bank regulatory structure and affected the lending, investment, trading and operating activities of financial institutions and their holding companies. The Dodd-Frank Act (as amended) implements far-reaching changes across the financial regulatory landscape, including provisions that, among other things, has or will:


Centralized responsibility for consumer financial protection by creating a new agency, the Bureau of Consumer Financial Protection, with broad rulemaking, supervision and enforcement authority for a wide range of consumer protection laws that apply to all banks and certain others, including the examination and enforcement powers with respect to any bank with more than $10 billion in assets.

Require new capital rules and apply the same leverage and risk-based capital requirements that apply to insured depository institutions to most bank holding companies.

Changed the assessment base for federal deposit insurance from the amount of insured deposits to consolidated average assets less tangible capital. As a result, this change generally imposes more deposit insurance cost on institutions with assets of $10 billion or more.

Increase the minimum ratio of net worth to insured deposits of the Deposit Insurance Fund from 1.15% to 1.35% and require the FDIC, in setting assessments, to offset the effect of the increase on institutions with assets of less than $10 billion.

Provide for new disclosure and other requirements relating to executive compensation and corporate governance, including guidelines or regulations on incentive-based compensation and a prohibition on compensation arrangements that encourage inappropriate risks or that could provide excessive compensation.

Repealed the federal prohibitions on the payment of interest on commercial demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts.

Allow de novo interstate branching by banks.

Increased the authority of the FRB to examine us and our non-bank subsidiary.

Required all bank holding companies to serve as a source of financial strength to their depository institution subsidiaries in the event such subsidiaries suffer from financial distress.

Many aspects of the Dodd-Frank Act are subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on us and the financial services industry more generally. Provisions in the legislation may require us to maintain higher capital levels and/or increase our cost of operations and limit certain activities or lines of business.

Capital Adequacy Requirements.The FRB and FDIC have issued substantially similar risk-based and leverage capital guidelines applicable to bank holding companies and banks. In addition, these regulatory agencies may from time to time require that a bank holding company or bank maintain capital above the minimum levels, based on its financial condition or actual or anticipated growth.

The FRB’s risk-based guidelines establish a two-tier capital framework. Tier 1 capital generally consists of common shareholders’ equity, retained earnings, a limited amount of qualifying perpetual preferred stock, qualifying trust preferred securities and non-controlling interests in the equity accounts of consolidated subsidiaries, less goodwill and certain intangibles. Tier 2 capital generally consists of certain hybrid capital instruments and perpetual debt, mandatory convertible debt securities and a limited amount of subordinated debt, qualifying preferred stock, loan loss allowance, and unrealized holding gains on certain equity securities. The sum of Tier 1 and Tier 2 capital represents qualifying total capital, at least 50% of which must consist of Tier 1 capital.

Risk-based capital ratios are calculated by dividing Tier 1 and total capital by risk-weighted assets. Assets and off-balance sheet exposures are assigned to one of four categories of risk-weights, based primarily on relative credit risk. For bank holding companies, generally the minimum Tier 1 risk-based capital ratio is 4% and the minimum total risk-based capital ratio is 8%. Our Tier 1 and total risk-based capital ratios under these guidelines at December 31, 20102012 were 12.34%10.70% and 13.60%11.96%, respectively.

The FRB’s leverage capital guidelines establish a minimum leverage ratio determined by dividing Tier 1 capital by adjusted average total assets. The minimum leverage ratio is 3% for bank holding companies that meet certain specified criteria, including having the highest regulatory rating. All other bank holding companies generally are required to maintain a leverage ratio of at least 4%. At December 31, 2010,2012, we had a leverage ratio of 8.31%7.70%. See also the section titled “Capital Resources” in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 10,11, Regulatory Matters, of the notes to consolidated financial statements.

statements, included in this Annual Report on Form 10-K.

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In June 2012, the U.S. federal banking agencies issued three notices of proposed rulemaking that would revise and replace the current regulatory capital rules. The federal regulatory authorities’ risk-basedproposals were initially intended to be effective on January 1, 2013, but the agencies have deferred implementation due to the volume of comments related to the proposed rules. In the Basel III notice of proposed rulemaking, the agencies proposal included the implementation of a new common equity Tier 1 minimum capital guidelines are based uponrequirement and a higher minimum Tier 1 capital requirement. Common equity is the 1988highest quality equity and most loss absorbing form of capital accord (“and establishes the base of Tier 1 common equity as adjusted for minority interests and various deductions. The minimum Tier 1 common equity ratio under Basel I”)III is 4.5%. Depending on the final form of the Basel Committee on Banking Supervision (the “Basel Committee”). The Basel Committee is a committee of central banks and bank supervisors/regulators from the major industrialized countries that develops broad policy guidelines for use by each country’s supervisors in determining the supervisory policies and regulations to which they apply. Actions of the Committee have no direct effect on banks in participating countries. In 2004, the Basel Committee published a new capital accord (“Basel II”) to replace Basel I. Basel II provides two approaches for settingIII capital standards, for credit risk — an internal ratings-based approach tailored to individual institutions’ circumstancesthe outcome will likely result in a higher capital requirement, greater volatility in regulatory capital and a standardized approachthe elimination of trust preferred instruments in regulatory capital. It is expected that bases risk weightingsfinal rules will be issued in 2013.

Future rulemaking and regulatory changes on external credit assessments to a much greater extent than permitted in existing risk-based capital guidelines. Basel II also would set capital requirements for operational riskmay impact the Company as it continues to grow and refine the existing capital requirements for market risk exposures.

A final rule implementing the advanced approaches of Basel II in the United States would apply only to certain large or internationally active banking organizations, or “core banks” — defined as those with consolidated total assets of $250 billion or more or consolidated on-balance sheet foreign exposures of $10 billion or more, became effective as of April 1, 2008. Certain other U.S. banking organizations would have the option to adopt the requirements of this rule. We are not required to comply with the advanced approaches of Basel II.
In July 2008, the agencies issued a proposed rule that would give banking organizations that do not use the advanced approaches the option to implement a new risk-based capital framework that generally parallels the relevant approaches under Basel II, but recognizes that U.S. markets have unique characteristics and risk profiles, most notably with respect to risk weighting residential mortgage exposures. To date, no final rule has been adopted.
In 2009, the United States Department of Treasury (the “Treasury”) issued a policy statement (the “Treasury Policy Statement”) entitled “Principles for Reforming the U.S. and International Regulatory Capital Framework for Banking Firms,” which contemplates changes to the existing regulatory capital regime involving substantial revisions to major parts of the Basel I and Basel II capital frameworks and affecting all regulated banking organizations and other systemically important institutions. The Treasury Policy Statement calls for, among other things, higher and stronger capital requirements for all banking firms, with changes to the regulatory capital framework to be phased in over a period of several years.
On December 17, 2009, the Basel Committee issued a set of proposals (the “2009 Capital Proposals”) that would significantly revise the definitions of Tier 1 capital and Tier 2 capital. Among other things, the 2009 Capital Proposals would re-emphasize that common equity is the predominant component of Tier 1 capital. Concurrently with the release of the 2009 Capital Proposals, the Basel Committee also released a set of proposals related to liquidity risk exposure (the “2009 Liquidity Proposals”). The 2009 Liquidity Proposals include the implementation of (i) a “liquidity coverage ratio” or LCR, designed to ensure that a bank maintains an adequate level of unencumbered, high-quality assets sufficient to meet the bank’s liquidity needs over a 30-day time horizon under an acute liquidity stress scenario and (ii) a “net stable funding ratio” or NSFR, designed to promote more medium and long-term funding of the assets and activities of banks over a one-year time horizon.

evaluate M&A activity.

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The Dodd-Frank Act includes certain provisions concerning the capital regulations of the U.S. banking regulators, which are often referred to as the “Collins Amendment.” These provisions are intended to subject bank holding companies to the same capital requirements as their bank subsidiaries and to eliminate or significantly reduce the use of hybrid capital instruments, especially trust preferred securities, as regulatory capital. Under the Collins Amendment, trust preferred securities issued by a company, such as our company, with total consolidated assets of less than $15 billion before May 19, 2010 and treated as regulatory capital are grandfathered, but any such securities issued later are not eligible as regulatory capital. The banking regulators must develop regulations setting minimum risk-based and leverage capital requirements for holding companies and banks on a consolidated basis that are no less stringent than the generally applicable requirements in effect for depository institutions under the prompt corrective action regulations discussed below. The banking regulators also must seek to make capital standards countercyclical so that the required levels of capital increase in times of economic expansion and decrease in times of economic contraction. The Dodd-Frank Act requires these new capital regulations to be adopted by the FRB in final form 18 months after its date of enactment (July 21, 2010). To date, no proposed regulations have been issued.
In December 2010 and January 2011, the Basel Committee published the final texts of reforms on capital and liquidity generally referred to as “Basel III.” Although Basel III is intended to be implemented by participating countries for large, internationally active banks, its provisions are likely to be considered by U.S. banking regulators in developing new regulations applicable to other banks in the United States, including Five Star Bank.
For banks in the United States, among the most significant provisions of Basel III concerning capital are the following:
A minimum ratio of common equity to risk-weighted assets reaching 4.5%, plus an additional 2.5% as a capital conservation buffer, by 2019 after a phase-in period.
A minimum ratio of Tier 1 capital to risk-weighted assets reaching 6.0% by 2019 after a phase-in period.
A minimum ratio of total capital to risk-weighted assets, plus the additional 2.5% capital conservation buffer, reaching 10.5% by 2019 after a phase -in period.
An additional countercyclical capital buffer to be imposed by applicable national banking regulators periodically at their discretion, with advance notice.
Restrictions on capital distributions and discretionary bonuses applicable when capital ratios fall within the buffer zone.
Deduction from common equity of deferred tax assets that depend on future profitability to be realized.
Increased capital requirements for counterparty credit risk relating to OTC derivatives, repos and securities financing activities.
For capital instruments issued on or after January 13, 2013 (other than common equity), a loss-absorbency requirement such that the instrument must be written off or converted to common equity if a trigger event occurs, either pursuant to applicable law or at the direction of the banking regulator. A trigger event is an event under which the banking entity would become nonviable without the write-off or conversion, or without an injection of capital from the public sector. The issuer must maintain authorization to issue the requisite shares of common equity if conversion were required.
The Basel III provisions on liquidity include complex criteria establishing the LCR and NSFR. The purpose of the LCR is to ensure that a bank maintains adequate unencumbered, high quality liquid assets to meet its liquidity needs for 30 days under a severe liquidity stress scenario. The purpose of the NSFR is to promote more medium and long-term funding of assets and activities, using a one-year horizon. Although Basel III is described as a “final text,” it is subject to the resolution of certain issues and to further guidance and modification, as well as to adoption by U.S. banking regulators, including decisions as to whether and to what extent it will apply to U.S. banks that are not large, internationally active banks.
Prompt Corrective Action.The Federal Deposit Insurance Corporation Improvement Act of 1991, among other things, identifies five capital categories for insured depository institutions (well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized) and requires the respective federal bank regulatory agencies to implement systems for “prompt corrective action” for insured depository institutions that do not meet minimum capital requirements within these categories. This act imposes progressively more restrictive constraints on operations, management and capital distributions, depending on the category in which an institution is classified. Failure to meet the capital guidelines could also subject a banking institution to capital raising requirements. An “undercapitalized” bank must develop a capital restoration plan and its parent holding company must guarantee that bank’s compliance with the plan. The liability of the parent holding company under any such guarantee is limited to the lesser of five percent of the bank’s assets at the time it became “undercapitalized” or the amount needed to comply with the plan. Furthermore, in the event of the bankruptcy of the parent holding company, such guarantee would take priority over the parent’s general unsecured creditors. In addition, the Federal Deposit Insurance Corporation Improvement Act requires the various regulatory agencies to prescribe certain non-capital standards for safety and soundness relating generally to operations and management, asset quality and executive compensation and permits regulatory action against a financial institution that does not meet these standards.

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The various federal bank regulatory agencies have adopted substantially similar regulations that define the five capital categories identified by the Federal Deposit Insurance Corporation Improvement Act, using the total risk-based capital, Tier 1 risk-based capital and leverage capital ratios as the relevant capital measures. These regulations establish various degrees of corrective action to be taken when an institution is considered undercapitalized. Under the regulations, a “well capitalized” institution must have a Tier 1 risk-based capital ratio of at least 6%, a total risk-based capital ratio of at least 10% and a leverage ratio of at least 5% and not be subject to a capital directive or order. An institution is “adequately capitalized” if it has a Tier 1 risk-based capital ratio of at least 4%, a total risk-based capital ratio of at least 8% and a leverage ratio of at least 4% (3% in certain circumstances). An institution is “undercapitalized” if it has a Tier 1 risk-based capital ratio of less than 4%, a total risk-based capital ratio of less than 8% or a leverage ratio of less than 4% (3% in certain circumstances). An institution is “significantly undercapitalized” if it has a Tier 1 risk-based capital ratio of less than 3%, a total risk-based capital ratio of less than 6% or a leverage ratio of less than 3%. An institution is “critically undercapitalized” if its tangible equity is equal to or less than 2% of total assets. Generally, an institution may be reclassified in a lower capitalization category if it is determined that the institution is in an unsafe or unsound condition or engaged in an unsafe or unsound practice.

As of December 31, 2010,2012, our subsidiary bank met the requirements to be classified as “well-capitalized.”

“well-capitalized”.

Dividends.The FRB policy is that a bank holding company should pay cash dividends only to the extent that its net income for the past year is sufficient to cover both the cash dividends and a rate of earnings retention that is consistent with the holding company’s capital needs, asset quality and overall financial condition, and that it is inappropriate for a bank holding company experiencing serious financial problems to borrow funds to pay dividends. Furthermore, a bank that is classified under the prompt corrective action regulations as “undercapitalized” will be prohibited from paying any dividends.

On December 23, 2008, as part of the TARP Capital Purchase Program of the Treasury, we sold to the Treasury 7,503 shares of our fixed rate cumulative perpetual preferred stock, Series A preferred stock (“Series A”), having a liquidation preference amount of $5,000 per share, for a purchase price of $37.5 million in cash and issued to Treasury a ten-year warrant to purchase 378,175 shares of the Company’s common stock at an exercise price of $14.88 per share (the “Warrant”).
We may redeem the Series A preferred stock at any time by repaying the Treasury, without penalty, subject to Treasury’s consultation with our appropriate regulatory agency and approval. Additionally, upon redemption of the Series A preferred stock, the Warrant generally may be repurchased from the Treasury at its fair market value as agreed-upon by us and the Treasury. In February 2011, the Company repaid one-third or $12.5 million of its obligation.
The securities purchase agreement between us and the Treasury provides that prior to the earlier of (i) December 23, 2011 and (ii) the date on which all of the shares of the Series A preferred stock have been redeemed by us or transferred by the Treasury to third parties, we may not, without the consent of the Treasury, (a) pay a quarterly cash dividend on our common stock of more than $0.10 per share or (b) subject to limited exceptions, redeem, repurchase or otherwise acquire shares of our common stock, preferred stock (other than the Series A preferred stock) or trust preferred securities. In addition, under the terms of the Series A preferred stock, we may not pay dividends on our common stock at any time we are in arrears on the dividends payable on the Series A preferred stock. Dividends on the Series A preferred stock are payable quarterly at a rate of 5% per annum for the first five years and a rate of 9% per annum thereafter if not redeemed prior to that time.

Our primary source for cash dividends is the dividends we receive from our subsidiary bank. Our bank is subject to various regulatory policies and requirements relating to the payment of dividends, including requirements to maintain capital above regulatory minimums. Approval of the New York State Banking Department of Financial Services is required prior to paying a dividend if the dividendsdividend declared by the Bank exceedexceeds the sum of the Bank’s net profits for that year and its retained net profits for the preceding two calendar years.

Federal Deposit Insurance Assessments.The Bank’sBank is a member of the FDIC and pays an insurance premium to the FDIC based upon its assessable deposits on a quarterly basis. Deposits are insured up to the maximum extent permittedapplicable limits by the FDIC and such insurance is backed by the full faith and credit of the United States Government.

Under the Dodd-Frank Act, a permanent increase in deposit insurance was authorized to $250,000. The coverage limit is per depositor, per insured depository institution for each account ownership category.

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The Dodd-Frank Act also set a new minimum Deposit Insurance Fund (“DIF”). Upon enactment reserve ratio at 1.35% of the Emergency Economic Stabilization Act of 2008 on October 3, 2008, federal deposit insurance coverage levels under the DIF temporarily increased from $100,000estimated insured deposits. The FDIC is required to $250,000 per deposit category, per depositor, per institution, through December 31, 2009. On May 20, 2009, the Helping Families Save Their Homes Act extended the temporary increase through December 31, 2013.attain this ratio by September 30, 2020. The Dodd-Frank Act permanently increasesalso required the maximum amount ofFDIC to define the deposit insurance assessment base for an insured depository institution as an amount equal to $250,000 per deposit category, per depositor, per institution retroactivethe institution’s average consolidated total assets during the assessment period minus average tangible equity. Premiums for the Bank are now calculated based upon the average balance of total assets minus average tangible equity as of the close of business for each day during the calendar quarter.

The FDIC has the flexibility to January 1, 2008,adopt actual rates that are higher or lower than the total base assessment rates adopted without notice and noninterest-bearing transaction accounts have unlimited deposit insurance through December 31, 2013.

Ascomment, if certain conditions are met.

DIF-insured institutions pay a Financing Corporation (“FICO”) assessment in order to fund the insurer,interest on bonds issued in the 1980s in connection with the failures in the thrift industry. For the fourth quarter of 2012, the FICO assessment was equal to 0.64 basis points computed on assets as required by the Dodd-Frank Act. These assessments will continue until the bonds mature in 2019.

The FDIC is authorized to conduct examinations of and to require reporting by FDIC-insured institutions. The FDICIt is also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or orderauthorized to poseterminate a serious threat to the DIF. The FDIC also has the authority to initiate enforcement actions against banks. Insurance of deposits may be terminateddepository bank’s deposit insurance upon a finding by the FDIC upon a findingthat the bank’s financial condition is unsafe or unsound or that the institution has engaged or is engaging in unsafe and unsound practices, is in an unsafe or unsound condition to continue operationspractices or has violated any applicable law,rule, regulation, rule, order or condition enacted or imposed by the FDIC or written agreement entered into with the FDIC.bank’s regulatory agency. The management of the Bank does not know of any practice, condition or violation that might lead to termination of deposit insurance.

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The FDIC maintains the DIF by assessing depository institutions an insurance premium on a quarterly basis under a risk-based assessment system. The amount of the assessment is a function of the institution’s risk category, of which there are four, and assessment base. An institution’s risk category is determined according to its supervisory ratings and capital levels and is used to determine the institution’s assessment rate. The assessment rate for risk categories are calculated according to a formula, which relies on supervisory ratings and either certain financial ratios or long-term debt ratings. An insured bank’s assessment base is currently determined by its level of deposits. Because the system is risk-based, it allows banks to pay lower assessments to the FDIC as their capital level and supervisory ratings improve. By the same token, if these indicators deteriorate, the institution will have to pay higher assessments to the FDIC.
Under the Federal Deposit Insurance Act, the FDIC Board has the authority to set the annual assessment rate range for the various risk categories within certain regulatory limitsBank would have a material adverse effect on our earnings, operations and to impose special assessments upon insured depository institutions when deemed necessary by the FDIC’s Board. As part of the Deposit Insurance Fund Restoration Plan adopted by the FDIC in October 2008, on February 27, 2009, the FDIC adopted the final rule modifying the risk-based assessment system, which set initial base assessment rates between 12 and 45 basis points, beginning April 1, 2009. The FDIC imposed an emergency special assessment on June 30, 2009, which totaled $923 thousand for our Bank. In addition, in September 2009, the FDIC extended the Restoration Plan period to eight years. In November 2009, the FDIC adopted a final rule requiring prepayment of 13 quarters of FDIC premiums. The Bank’s required prepayment amounted to $9.9 million and was collected in December 2009.
In October 2010, the FDIC adopted a new Restoration Plan for the DIF to ensure that the fund reserve ratio reaches 1.35% by September 30, 2020, as required by the Dodd-Frank Act. Under the Restoration Plan, the FDIC did not institute the uniform three-basis point increase in assessment rates scheduled to take place on January 1, 2011 and maintained the current schedule of assessment rates for all depository institutions. At least semi-annually, the FDIC will update its loss and income projections for the DIF and, if needed, will increase or decrease assessment rates, following notice-and-comment rulemaking, if required.
In November 2010, the FDIC issued a notice of proposed rulemaking to change the deposit insurance assessment base from total domestic deposits to average total assets minus average tangible equity, as required by the Dodd-Frank Act, effective April 1, 2011. The FDIC also issued a notice of proposed rulemaking to revise the deposit insurance assessment system for large institutions. The FDIC proposed to create a two tier system — one for most large institutions that have more than $10 billion in assets, and another for “highly complex” institutions that have over $50 billion in assets and are fully owned by a parent with over $500 billion in assets. These proposals did not apply to us or the Bank.
On February 9, 2011, the FDIC adopted a final rule which redefines the deposit insurance assessment base as required by the Dodd-Frank Act. The final rule sets the deposit insurance assessment base as average consolidated total assets minus average tangible equity. It also sets a new assessment rate schedule which reflects assessment rate adjustments including potentially reduced rates tied to unsecured debt and potentially increased rates for brokered deposits. The final rule generally becomes effective on April 1, 2011. Under the new rule, our FDIC insurance premiums are expected to decline in 2011. However, there can be no assurances that such premium reductions will be realized in 2011.
financial condition.

Transactions with Affiliates.FII and FSB are affiliates within the meaning of the Federal Reserve Act. The Federal Reserve Act imposes limitations on a bank with respect to extensions of credit to, investments in, and certain other transactions with, its parent bank holding company and the holding company’s other subsidiaries. Furthermore, bank loans and extensions of credit to affiliates also are subject to various collateral requirements.

Community Reinvestment Act.Under the Community Reinvestment Act, every FDIC-insured institution is obligated, consistent with safe and sound banking practices, to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The Community Reinvestment Act requires the appropriate federal banking regulator, in connection with the examination of an insured institution, to assess the institution’s record of meeting the credit needs of its community and to consider this record in its evaluation of certain applications, such as a merger or the establishment of a branch. An unsatisfactory rating may be used as the basis for the denial of an application and will prevent a bank holding company of the institution from making an election to become a financial holding company.

As of its last Community Reinvestment Act examination, Five Starthe Bank received a rating of “outstanding.”

Interstate BankingBranching.Pursuant to the Dodd-Frank Act, national and Branching.The FRBstate-chartered banks may approveopen an application of a bank holding company to acquire control of, or acquire all or substantially all of the assets of, a bank locatedinitial branch in a state other than the bank holding company’sits home state without regard to whether the transaction is prohibited(e.g., a host state) by the laws ofestablishing a de novo branch at any state. The FRB may not approve the acquisition oflocation in such host state at which a bank that has not beenchartered in existence for the minimum time period (not exceeding five years) specified by the law of the target bank’s home state. The FRB also may not approve an application if the bank holding company (and its bank affiliates) controls or would control more than ten percent of the insured deposits in the U.S. or, generally, 30% or more of the deposits in the target bank’s homesuch host state or in any state in which the target bank maintainscould establish a branch. Individual states may waiveApplications to establish such branches must still be filed with the 30% statewide concentration limit. Each state may limit the percentage of total insured deposits in the state that may be held or controlled by a bank or bank holding company to the extent the limitation does not discriminate against out-of-state banks or bank holding companies.

appropriate primary federal regulator.

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The federal banking agencies are authorized to approve interstate bank merger transactions without regard to whether these transactions are prohibited by the law of any state, unless the home state of one of the banks opted out of interstate mergers prior to June 1, 1997. Interstate acquisitions of branches are permitted only if the law of the state in which the branch is located permits these acquisitions. Interstate mergers and branch acquisitions are subject to the nationwide and statewide-insured deposit concentration limits described above.
Privacy Rules.Federal banking regulators, as required under the Gramm-Leach-Bliley Act, have adopted rules limiting the ability of banks and other financial institutions to disclose nonpublic information about consumers to non-affiliated third parties. The rules require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to non-affiliated third parties. The privacy provisions of the Gramm-Leach-Bliley Act affect how consumer information is transmitted through diversified financial services companies and conveyed to outside vendors.

International Money Laundering AbatementAnti-Terrorism Legislation.The Uniting and Financial Anti-TerrorismStrengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001.(“USA Patriot Act”), enacted in 2001:

prohibits banks from providing correspondent accounts directly to foreign shell banks;

imposes due diligence requirements on banks opening or holding accounts for foreign financial institutions or wealthy foreign individuals;

requires financial institutions to establish an anti-money-laundering (“AML”) compliance program; and

generally eliminates civil liability for persons who file suspicious activity reports.

The President signed the USA Patriot Act of 2001 into law in October 2001. This act contains the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001 (the “IMLAFA”).also increases governmental powers to investigate terrorism, including expanded government access to account records. The IMLAFA substantially broadens existing anti-money laundering legislation and the extraterritorial jurisdictionDepartment of the U.S., imposes newTreasury is empowered to administer and make rules to implement the Act, which to some degree, affects our record-keeping and reporting expenses. Should the Bank’s AML compliance and due diligence obligations, creates new crimes and penalties, compels the production of documents located both inside and outside the U.S., including those of foreignprogram be deemed insufficient by federal regulators, we would not be able to grow through acquiring other institutions that have a correspondent relationship in the U.S., and clarifies the safe harbor from civil liability to customers. The Treasury Department has issued a number of regulations implementing the USA Patriot Act that apply certain of its requirements to financial institutions such as our banking and broker-dealer subsidiaries. The regulations impose obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing. The increased obligations of financial institutions, including us, to identify their customers, watch for and report suspicious transactions, respond to requests for information by regulatory authorities and law enforcement agencies, and share information with other financial institutions, requires the implementation and maintenance of internal procedures, practices and controls which have increased, and may continue to increase, our costs and may subject us to liability.

As noted above, enforcement and compliance-related activity by government agencies has increased. Money laundering and anti-terrorism compliance is among the areas receiving a high level of focus in the present environment.
Regulatory Reform.On July 21 2010, the Dodd-Frank Act was signed into law. The Dodd-Frank Act (as amended) implements far-reaching changes across the financial regulatory landscape, including provisions that, among other things, will:
Centralize responsibility for consumer financial protection by creating a new agency, the Bureau of Consumer Financial Protection, with broad rulemaking, supervision and enforcement authority for a wide range of consumer protection laws that would apply to all banks and certain others, including the examination and enforcement powers with respect to any bank with more than $10 billion in assets.
Require new capital rules and apply the same leverage and risk-based capital requirements that apply to insured depository institutions to most bank holding companies.
Change the assessment base for federal deposit insurance from the amount of insured deposits to consolidated average assets less tangible capital.
Increase the minimum ratio of net worth to insured deposits of the Deposit Insurance Fund from 1.15% to 1.35% and require the FDIC, in setting assessments, to offset the effect of the increase on institutions with assets of less than $10 billion. As a result, this increase is generally expected to impose more deposit insurance cost on institutions with assets of $10 billion or more.
Provide for new disclosure and other requirements relating to executive compensation and corporate governance, including guidelines or regulations on incentive-based compensation and a prohibition on compensation arrangements that encourage inappropriate risks or that could provide excessive compensation.
Make permanent the $250 thousand limit for federal deposit insurance and provide unlimited federal deposit insurance until January 1, 2013 for non-interest bearing demand transaction accounts and IOLTA accounts at all insured depository institutions.
Repeal the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts.
Allow de novo interstate branching by banks.
Increase the authority of the FRB to examine the Company and its non-bank subsidiary.
Require all bank holding companies to serve as a source of financial strength to their depository institution subsidiaries in the event such subsidiaries suffer from financial distress.
opening de novo branches.

 

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Restrict proprietary trading by banks, bank holding companies and others, and their acquisition and retention of ownership interests in and sponsorship of hedge funds and private equity funds. This restriction is commonly referred to as the “Volcker Rule.” There is an exception in the Volcker Rule to allow a bank to organize and offer hedge funds and private equity funds to customers if certain conditions are met. These conditions include, among others, requirements that the bank providesbona fideinvestment advisory services; the funds are organized only in connectionVolcker Rule.The Dodd-Frank Act prohibits insured depository institutions and their holding companies from engaging in proprietary trading except in limited circumstances, and prohibits them from owning equity interests in excess of three percent (3%) of Tier 1 Capital in private equity and hedge funds (known as the “Volcker Rule”). The Federal Reserve released a final rule on February 9, 2011 (effective on April 1, 2011) which requires a “banking entity,” a term that is defined to include bank holding companies like the parent, to bring its proprietary trading activities and investments into compliance with such services and to customers of such services; the bank does not have more than ade minimisinterest in the funds, limited to a 3% ownership interest in any single fund and an aggregated investment in all funds of 3% of Tier 1 capital; the bank does not guarantee the obligations or performance of the funds; and no director or employee of the bank has an ownership interest in the fund unless he or she provides services directly to the funds. Further details on the scope of the Volcker Rule and its exceptions are expected to be defined in regulations due to be issued later in 2011.
Many aspects of the Dodd-Frank Act restrictions no later than two years after the earlier of: (1) July 21, 2012, or (2) 12 months after the date on which interagency final rules are subjectadopted. Pursuant to rulemakingthe compliance date final rule, banking entities are permitted to request an extension of this timeframe from the Federal Reserve. On October 11, 2011, the federal banking agencies released for comment proposed regulations implementing the Volcker Rule. The public comment period closed on February 13, 2012 and a final rule has not yet been published. The parent will be reviewing the implications of the interagency rules on its investments once those rules are issued and will take effect over several years, making it difficultplan for any adjustments of its activities or its holdings in order to anticipatebe in compliance by the overall financial impact on usannounced compliance date.

Ability-to-Repay and the financial services industry more generally. Provisions in the legislation that affect deposit insurance assessments, and payment of interest on demand deposits could increase the costs associated with deposits. Provisions in the legislation that require revisionsQualified Mortgage Rule.Pursuant to the capital requirements ofDodd Frank Act, the Company and Five Star Bank could require the Company and the Bank to seek additional sources of capital in the future.

TARP-Related Compensation and Corporate Governance Requirements.The Emergency Economic Stabilization Act of 2008 (“EESA”) was signed into lawCFPB issued a final rule on October 3, 2008 and authorized the Treasury to provide funds to be used to restore liquidity and stability to the U.S. financial system pursuant to the TARP. Under the authority of EESA, Treasury instituted the TARP Capital Purchase Program to encourage U.S. financial institutions to build capital to increase the flow of financing to U.S. businesses and consumers and to support the U.S. economy. As noted above,January 10, 2013 (effective on December 23, 2008, we participated in this program by issuing 7,503 shares of our Series A preferred stock to the Treasury for a purchase price of $37.5 million in cash and issued the Warrant to the Treasury. In February 2011, the Company repaid one-third or $12.5 million of its obligation.
In addition to the restrictions on the Company’s ability to pay dividends on and repurchase its stock, as described above under “Dividends,” participation in the TARP Capital Purchase Program also includes certain requirements and restrictions regarding compensation that were expanded significantly by the American Recovery and Reinvestment Act of 2009 (“ARRA”)January 10, 2014), amending Regulation Z as implemented by the Treasury’s Interim Final RuleTruth in Lending Act, requiring mortgage lenders to make a reasonable and good faith determination based on TARP Standardsverified and documented information that a consumer applying for Compensationa mortgage loan has a reasonable ability to repay the loan according to its terms. Mortgage lenders are required to determine consumers’ ability to repay in one of two ways. The first alternative requires the mortgage lender to consider the following eight underwriting factors when making the credit decision: (1) current or reasonably expected income or assets; (2) current employment status; (3) the monthly payment on the covered transaction; (4) the monthly payment on any simultaneous loan; (5) the monthly payment for mortgage-related obligations; (6) current debt obligations, alimony, and Corporate Governance. These requirementschild support; (7) the monthly debt-to-income ratio or residual income; and restrictions include, among others,(8) credit history. Alternatively, the following: (i) a prohibition on paying or accruing bonuses, retention awards and incentive compensation, other than qualifying long-term restricted stock or pursuant to certain preexisting employment contracts, to our five most highly-compensated employees; (ii) a general prohibition on providing severance benefits, or other benefits duemortgage lender can originate “qualified mortgages,” which are entitled to a change in controlpresumption that the creditor making the loan satisfied the ability-to-repay requirements. In general, a “qualified mortgage” is a mortgage loan without negative amortization, interest-only payments, balloon payments, or terms exceeding 30 years. In addition, to be a qualified mortgage the points and fees paid by a consumer cannot exceed 3% of the total loan amount. Qualified mortgages that are “higher-priced” (e.g. subprime loans) garner a rebuttable presumption of compliance with the ability-to-repay rules, while qualified mortgages that are not “higher-priced” (e.g. prime loans) are given a safe harbor of compliance.

Incentive Compensation Policies and Restrictions. In July 2010, the federal banking agencies issued guidance that applies to all banking organizations supervised by the agencies (thereby including both the Parent Company to our senior executive officers (“SEOs”) and next five most highly compensated employees; (iii) a requirement to make subject to clawback any bonus, retention award, or incentive compensation paid to any of the SEOs and any of the next twenty most highly compensated employees if such compensation was based on materially inaccurate financial statements or any other materially inaccurate performance metric criteria; (iv) a requirement to establish a policy on luxury or excessive expenditures; (v) a requirement to annually provide shareholders with a non-binding advisory “say on pay” vote on executive compensation; (vi) a prohibition on deducting more than $500,000 in annual compensation, including performance-based compensation,Bank). Pursuant to the executives covered under Internal Revenue Code Section 162(m); (vii) a requirement that the compensation committee of the board of directors evaluate and review on a semi-annual basis the risks involved in employee compensation plans; and (viii) a prohibition on providing tax “gross-ups”guidance, to our SEOs and the next 20 most highly compensated employees. These requirements and restrictions will remain applicable to us until we have redeemed the Series A preferred stock in full.

Incentive Compensation.On October 22, 2009, the Federal Reserve issued a comprehensive proposal on incentive compensation policies (the “Incentive Compensation Proposal”) intended to ensure that the incentive compensation policies of banking organizations do not undermine thebe consistent with safety and soundness of such organizations by encouraging excessive risk-taking. The Incentive Compensation Proposal, which covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon the key principles, that a banking organization’s incentive compensation arrangements should (i)should: (1) provide employees with incentives that do not encourage risk-taking beyond the organization’s ability to effectively identifyappropriately balance risk and manage risks, (ii)reward; (2) be compatible with effective internal controls and risk management,management; and (iii)(3) be supported by strong corporate governance including active and effective oversight by the banking organization’s board of directors. Banking organizations are instructed to begin an immediate review of their incentive compensation policies to ensure that they do not encourage excessive risk-takingMonitoring methods and implement corrective programs as needed. Where there are deficiencies inprocesses used by a banking organization should be commensurate with the incentive compensation arrangements, they must be immediately addressed.
Additionally, the Incentive Compensation Proposal will require the Federal Reserve to review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as us, that are not “large, complex banking organizations.” These reviews will be tailored to each organization based on the scopesize and complexity of the organization’s activitiesorganization and its use of incentive compensation.

In addition, in March 2011, the federal banking agencies, along with the Federal Housing Finance Agency, and the prevalence of incentive compensation arrangements. The findings of the supervisory initiatives will be included in reports of examination. Deficiencies will be incorporated into the organization’s supervisory ratings, which can affect the organization’s abilitySEC, released a proposed rule intended to make acquisitions and take other actions. Enforcement actions may be taken against a banking organization if itsensure that regulated financial institutions design their incentive compensation arrangements to account for risk. Specifically, the proposed rule would require compensation practices at the Parent Company and at the Bank to be consistent with the following principles: (1) compensation arrangements appropriately balance risk and financial reward; (2) such arrangements are compatible with effective controls and risk management; and (3) such arrangements are supported by strong corporate governance. In addition, financial institutions with $1 billion or related risk-management control or governance processes, pose a riskmore in assets would be required to the organization’s safetyhave policies and soundness and the organization is not taking prompt and effective measuresprocedures to correct the deficiencies.

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The scope and content of the U.S. banking regulators’ policies on executive compensation are continuing to develop and are likely to continue evolving in the near future. It cannot be determined at this time whetherensure compliance with such policies will adversely affect our abilitythe rule and would be required to hire, retain and motivate its key employees.
submit annual reports to their primary federal regulator. The comment period has closed but a final rule has not yet been published.

Sarbanes-Oxley Act of 2002.The Sarbanes-Oxley Act of 2002 implemented a broad range of corporate governance, accounting and reporting measures for companies that have securities registered under the Exchange Act, including publicly-held bank holding companies such as Financial Institutions. Specifically, the Sarbanes-Oxley Act of 2002 and the various regulations promulgated thereunder, established, among other things: (i) requirements for audit committees, including independence, expertise, and responsibilities; (ii) responsibilities regarding financial statements for the Chief Executive Officer and Chief Financial Officer of the reporting company; (iii) the forfeiture of bonuses or other incentive-based compensation and profits from the sale of the reporting company’s securities by the Chief Executive Officer and Chief Financial Officer in the twelve-month period following the initial publication of any financial statements that later require restatement; (iv) the creation of an independent accounting oversight board; (v) standards for auditors and regulation of audits, including independence provisions that restrict non-audit services that accountants may provide to their audit clients; (vi) disclosure and reporting obligations for the reporting company and their directors and executive officers, including accelerated reporting of stock transactions and a prohibition on trading during pension blackout periods; (vii) a prohibition on personal loans to directors and officers, except certain loans made by insured financial institutions on non-preferential terms and in compliance with other bank regulatory requirements; and (viii) a range of civil and criminal penalties for fraud and other violations of the securities laws.

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Consumer Laws and Regulations.In addition to the laws and regulations discussed herein, the Bank is also subject to certain consumer laws and regulations that are designed to protect consumers in transactions with banks. While the list set forth herein is not exhaustive, these laws and regulations include, among others, the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, the Fair Housing Act, the Home Mortgage Disclosure Act and the Real Estate Settlement Procedures Act. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must deal with customers when taking deposits or making loans to such customers. The Bank must comply with the applicable provisions of these consumer protection laws and regulations as part of its ongoing customer relations. The Check Clearing for the 21st Century Act (the “Check 21 Act”), which became effective on October 28, 2004, creates a new negotiable instrument, called a “substitute check”, which banks are required to accept as the legal equivalent of a paper check if it meets the requirements of the Check 21 Act. The Check 21 Act is designed to facilitate check truncation, to foster innovation in the check payment system, and to improve the payment system by shortening processing times and reducing the volume of paper checks.

Other Future Legislation and Changes in Regulations.In addition to the specific proposals described above, from time to time, various legislative and regulatory initiatives are introduced in Congress and state legislatures, as well as by regulatory agencies. Such initiatives may include proposals to expand or contract the powers of bank holding companies and depository institutions or proposals to substantially change the financial institution regulatory system. Such legislation could change banking statutes and theour operating environment of the Company in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. We cannot predict whether any such legislation will be enacted, and, if enacted, the effect that it, or any implementing regulations, would have on theour financial condition or results of operations of the Company.operations. A change in statutes, regulations or regulatory policies applicable to the Companyus or any itsour subsidiaries could have a material effect on our business.

Impact of Inflation and Changing Prices

Our financial statements included herein have been prepared in accordance with GAAP, which requires us to measure financial position and operating results principally using historic dollars. Changes in the relative value of money due to inflation or recession are generally not considered. The primary effect of inflation on our operations is reflected in increased operating costs. In our view, changes in interest rates affect the financial condition of a financial institution to a far greater degree than changes in the inflation rate. While interest rates are generally influenced by changes in the inflation rate, they do not necessarily change at the same rate or in the same magnitude. Interest rates are sensitive to many factors that are beyond our control, including changes in the expected rate of inflation, general and local economic conditions and the monetary and fiscal policies of the United States government, its agencies and various other governmental regulatory authorities.

Regulatory and Economic Policies

Our business and earnings are affected by general and local economic conditions and by the monetary and fiscal policies of the U.S. government, its agencies and various other governmental regulatory authorities. The FRB regulates the supply of money in order to influence general economic conditions. Among the instruments of monetary policy available to the FRB are (i) conducting open market operations in U.S. government obligations, (ii) changing the discount rate on financial institution borrowings, (iii) imposing or changing reserve requirements against financial institution deposits, and (iv) restricting certain borrowings and imposing or changing reserve requirements against certain borrowings by financial institutions and their affiliates. These methods are used in varying degrees and combinations to directly affect the availability of bank loans and deposits, as well as the interest rates charged on loans and paid on deposits. For that reason, the policies of the FRB could have a material effect on our earnings.

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EMPLOYEES


EMPLOYEES
At December 31, 2010,2012, we had 616662 employees. None of the employees are subject to a collective bargaining agreement and management believes its relations with employees are good.

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EXECUTIVE OFFICERS OF REGISTRANT

The following table sets forth current information regarding our executive officers and certain other significant employees (ages are as of May 4, 2011,8, 2013, the date of the 20112013 Annual Meeting of Shareholders).

           
      Started   
Name Age  In  Positions/Offices
Peter G. Humphrey 56  1977  President and Chief Executive Officer of the Company and the Bank since 1994.
           
Karl F. Krebs 55  2009  Executive Vice President and Chief Financial Officer of the Company and the Bank since 2009. Senior Financial Specialist at West Valley Environmental Services, LLC prior to joining FII in 2009. President of Robar General Funding Corp. from 2006 to 2008. Senior Vice President and Line-of-Business Finance Director at Five Star Bank from 2005 to 2006 and Senior Vice President at Wyoming County Bank from 2004 to 2005.
           
Rita M. Bartol 50  2010  Senior Vice President and Director of Human Resources of the Company and the Bank since late 2010. Senior Vice President and Director of Human Resources at Cardinal Financial Corporation in 2010 and Vice President and Director of Human Resources at Union Bankshares Corporation from 2006 to 2010. Vice President and Human Resources and Organizational Development Manager at M & T Bank Corporation from 1998 to 2005.
           
Martin K. Birmingham 44  2005  Executive Vice President and Regional President / Commercial Banking Executive Officer of the Bank since 2009. Senior Vice President and Regional President of the Bank since 2005. Senior Team Leader and Regional President of the Rochester Market at Bank of America (formally Fleet Boston Financial) from 2000 to 2005.
           
George D. Hagi 58  2006  Executive Vice President and Chief Risk Officer of the Company and the Bank since 2006. Senior Vice President and Director of Risk Management at First National Bankshares of Florida and FNB Corp. from 1997 to 2005.
           
Richard J. Harrison 65  2003  Executive Vice President and Senior Retail Lending Administrator of the Bank since 2009. Senior Vice President and Senior Retail Lending Administrator of the Bank since 2003. Executive Vice President and Chief Credit Officer at Savings Bank of the Finger Lakes from 2000 to 2003.
           
Kevin B. Klotzbach 58  2001  Senior Vice President and Treasurer of the Bank since 2001.
           
R. Mitchell McLaughlin 53  1981  Executive Vice President and Chief Information Officer of the Bank since 2009. Senior Vice President and Chief Information Officer of the Bank since 2006.
           
John L. Rizzo 61  2010  Senior Vice President and Corporate Secretary of the Company and the Bank since 2010. Counsel (in-house) for the Company and the Bank since 2007. Genesee County (New York) Attorney from 1976 to 2010.
           
John J. Witkowski 48  2005  Executive Vice President and Regional President / Retail Banking Executive Officer of the Bank since 2009. Senior Vice President and Regional President of the Bank since 2005. Senior Vice President and Director of Sales for Business Banking / Client Development Group at Bank of America from 1993 to 2005.

Name

      Age          Started    
In
  

Positions/Offices

Martin K. Birmingham  46  2005  President and Chief Executive Officer since March 2013. Previously, President and Chief of Community Banking of the Company and the Bank from August 2012. Executive Vice President and Regional President/ Commercial Banking Executive Officer of the Bank since 2009. Senior Vice President and Regional President of the Bank since 2005. Senior Team Leader and Regional President of the Rochester Market at Bank of America (formally Fleet Boston Financial) from 2000 to 2005.
Richard J. Harrison  67  2003  Executive Vice President and Chief Operating Officer of the Company and the Bank since August 2012. Executive Vice President and Senior Retail Lending Administrator of the Bank since 2009. Senior Vice President and Senior Retail Lending Administrator of the Bank since 2005.
Kevin B. Klotzbach  60  2001  Senior Vice President and Treasurer of the Bank since 2005.
Karl F. Krebs  57  2009  Executive Vice President and Chief Financial Officer of the Company and the Bank since 2009. Senior Financial Specialist at West Valley Environmental Services, LLC, an environmental remediation services firm, prior to joining the Company in 2009. President of Robar General Funding Corp., a mortgage and construction loan broker, from 2006 to 2008. Senior Vice President and Line-of-Business Finance Director at Five Star Bank from 2005 to 2006.
R. Mitchell McLaughlin              55  1981  Executive Vice President and Chief Information Officer of the Bank since 2009. Senior Vice President and Chief Information Officer of the Bank since 2006.
John L. Rizzo  63  2007  Senior Vice President and Corporate Secretary of the Company and the Bank since 2010. General counsel for the Company and the Bank since 2007. Genesee County (New York) Attorney from 1976 to 2010.
Kenneth V. Winn  55  2004  Executive Vice President and Chief Risk Officer of the Company and the Bank since July 2012. Senior Vice President and Senior Credit Compliance Administrator since 2006.

 

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ITEM 1A.
RISK FACTORS

An investment in our common stock is subject to risks inherent to our business. The material risks and uncertainties that management believes affect us are described below. Before making an investment decision, you should carefully consider the risks and uncertainties described below, together with all of the other information included or incorporated by reference herein. The risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair our business operations. This Annual Report on Form 10-K is qualified in its entirety by these risk factors. Further, to the extent that any of the information contained in this Annual Report on Form 10-K constitutes forward-looking statements, the risk factors set forth below also are cautionary statements identifying important factors that could cause our actual results to differ materially from those expressed in any forward-looking statements made by or on behalf of us.

If any of the following risks actually occur, our financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of our common stock could decline significantly, and you could lose all or part of your investment.

CREDIT RISKS

If we experience greater credit losses than anticipated, earnings may be adversely impacted.

As a lender, we are exposed to the risk that customers will be unable to repay their loans according to their terms and that any collateral securing the payment of their loans may not be sufficient to assure repayment. Credit losses are inherent in the business of making loans and could have a material adverse impact on our results of operations.

We make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral, and we provide an allowance for estimated loan losses based on a number of factors. We believe that the allowance for loan losses is adequate. However, if our assumptions or judgments are wrong, the allowance for loan losses may not be sufficient to cover the actual credit losses. We may have to increase the allowance in the future in response to the request of one of our primary banking regulators, to adjust for changing conditions and assumptions, or as a result of any deterioration in the quality of our loan portfolio. The actual amount of future provisions for credit losses may vary from the amount of past provisions.

Geographic concentration may unfavorably impact our operations.

Substantially all of our business and operations are concentrated in the Western and Central New York region. As a result of this geographic concentration, our results depend largely on economic conditions in these and surrounding areas. Deterioration in economic conditions in our market could:

increase loan delinquencies;

increase problem assets and foreclosures;

increase claims and lawsuits;

decrease the demand for our products and services; and

decrease the value of collateral for loans, especially real estate, in turn reducing customers’ borrowing power, the value of assets associated with non-performing loans and collateral coverage.

Generally, we make loans to small to mid-sized businesses whose success depends on the regional economy. These businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities. Adverse economic and business conditions in our market areas could reduce our growth rate, affect our borrowers’ ability to repay their loans and, consequently, adversely affect our business, financial condition and performance. For example, we place substantial reliance on real estate as collateral for our loan portfolio. A sharp downturn in real estate values in our market area could leave many of these loans inadequately collateralized. If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, the impact on our results of operations could be materially adverse.

We depend on the accuracy and completeness of information about or from customers and counterparties.

In deciding whether to extend credit or enter into other transactions, we may rely on information furnished by or on behalf of customers and counterparties, including financial statements, credit reports, and other financial information. We may also rely on representations of those customers, counterparties, or other third parties, such as independent auditors, as to the accuracy and completeness of that information. Reliance on inaccurate or misleading financial statements, credit reports, or other financial information could cause us to enter into unfavorable transactions, which could have a material adverse effect on our financial condition and results of operations.

 

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We are subject to environmental liability risk associated with our lending activities.

A significant portion of our loan portfolio is secured by real property. During the ordinary course of business, we may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, we may be liable for remediation costs, as well as for personal injury and property damage.damage regardless of whether we knew, had reason to know of, or caused the release of such substance. Environmental laws may require us to incur substantial expenses and may materially reduce the affected property’s value or limit our ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability. Although we have policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on our financial condition and results of operations.

Our indirect lending involves risk elements in addition to normal credit risk.

A portion of our current lending involves the purchase of consumer automobile installment sales contracts from automobile dealers located in Western, Central and the Capital District of New York, and Northern Pennsylvania. These loans are for the purchase of new or used automobiles. We serve customers that cover a range of creditworthiness, and the required terms and rates are reflective of those risk profiles. While these loans have higher yields than many of our other loans, such loans involve risks elements in addition to normal credit risk. Potential risk elements associated with indirect lending include the limited personal contact with the borrower as a result of indirect lending through dealers, the absence of assured continued employment of the borrower, the varying general creditworthiness of the borrower, changes in the local economy, and difficulty in monitoring collateral. While indirect automobile loans are secured, such loans are secured by depreciating assets and characterized by LTV ratios that could result in us not recovering the full value of an outstanding loan upon default by the borrower. If the economic environment in our primary market area contracts, we may experience higher levels of delinquencies, charge-offs and repossessions.

REGULATORY/LEGAL/COMPLIANCE RISKS

We are highly regulated and may be adversely affected by changes in banking laws, regulations and regulatory practices.

We are subject to extensive supervision, regulation and examination. This regulatory structure gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies to address not only compliance with applicable laws and regulations (including laws and regulations governing consumer credit, and anti-money laundering and anti-terrorism laws), but also capital adequacy, asset quality and risk, management ability and performance, earnings, liquidity, and various other factors. As part of this regulatory structure, we are subject to policies and other guidance developed by the regulatory agencies with respect to capital levels, the timing and amount of dividend payments, the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Under this structure the regulatory agencies have broad discretion to impose restrictions and limitations on our operations if they determine, among other things, that our operations are unsafe or unsound, fail to comply with applicable law or are otherwise inconsistent with laws and regulations or with the supervisory policies of these agencies.

This supervisory framework could materially impact the conduct, growth and profitability of our operations. Any failure on our part to comply with current laws, regulations, other regulatory requirements or safe and sound banking practices or concerns about our financial condition, or any related regulatory sanctions or adverse actions against us, could increase our costs or restrict our ability to expand our business and result in damage to our reputation.

Recently enacted

Ongoing financial reform legislation will, among other things, tighten capital standards, create a new Consumer Financial Protection Bureau andmay result in new regulations that are expectedcould require us to maintain higher capital levels and/or increase our costs of operations.

On July 21, 2010, President Obama signed theoperations or limit certain activities or lines of business.

The Dodd-Frank Act into law. This new law willhas significantly changechanged the current bank regulatory structure and affectaffects the lending, deposit, investment, trading and operating activities of financial institutions and their holding companies. The Dodd-Frank Act requires various federal agencies to adopt a broad range of new implementing rules and regulations, and to prepare numerous studies and reports for Congress. The federal agencies are given significant discretion in drafting the implementing rules and regulations, and consequently, many of the details and much of the impactrulemaking of the Dodd-Frank Act maywill not be known for many months or years.

Among the many requirements in the Dodd-Frank Act for new banking regulations is a requirement for new capital regulations to be adopted within 18 months. These regulations must be at least as stringent as, and may call for higher levels of capital, than current regulations. Generally, trust preferred securities will no longer be eligible as Tier 1 capital, but our currently outstanding trust preferred securities will be grandfathered and our currently outstanding TARP preferred securities will continue to qualify as Tier 1 capital.
Certain provisions of the Dodd-Frank Act are expected to have a near-term impact on us. For example, one year after the date of its enactment, the Dodd-Frank Act eliminates the federal prohibitions on paying interest on demand deposits, thus allowing businesses to have interest bearing checking accounts. Depending on competitive responses, this significant change to existing law could have an adverse impact on our interest expense.
The Dodd-Frank Act also permanently increases the maximum amount of deposit insurance for banks, savings institutions and credit unions to $250,000 per depositor, retroactive to January 1, 2008, and non-interest bearing transaction accounts and interest on lawyers trust accounts have unlimited deposit insurance through December 31, 2013.
The Dodd-Frank Act creates a new Bureau of Consumer Financial Protection with broad powers to supervise and enforce consumer protection laws. The Bureau will have broad rule-making authority for a wide range of consumer protection laws that apply to all banks, including the authority to prohibit “unfair, deceptive or abusive” acts and practices.
Many aspects of the Dodd-Frank Act are subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on us. However, compliance with this new law and its implementing regulations willare expected to result in additional operating costs that could have a material adverse effect on our financial condition and results of operations.

The federal banking agencies have proposed rules that would substantially amend the regulatory risk-based capital rules. The proposed rules implement the Basel III regulatory capital reforms and changes required by the Dodd-Frank Act. The proposed rules include new minimum risk-based capital and leverage ratios, which would be phased in over the next several years and would refine the definition of what constitutes “capital” for purposes of calculating those ratios. While the proposed Basel III changes and other regulatory capital requirements will likely result in generally higher regulatory capital standards, it is difficult at this time to predict when or how any new standards will ultimately be applied to the Company and the Bank.

 

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As a participant in TARP, we are subject to certain restrictions on dividends, repurchases of common stock and executive compensation.
We are subject to restrictions on dividends, repurchases of common stock, and executive compensation as a TARP participant. Compliance with these restrictions and other restrictions may increase our costs, impact our ability to retain executive officers and limit our ability to pursue business opportunities. Additionally, any reduction of, or the elimination of, our common stock dividend in the future could adversely affect the market price of our common stock. The current restrictions, as well as any possible future restrictions, associated with participation in TARP could have a material adverse impact on our business, financial condition, or results of operations.
New or changing tax, accounting, and regulatory rules and interpretations could significantly impact our strategic initiatives, results of operations, cash flows, and financial condition.

The financial services industry is extensively regulated. Federal and state banking regulations are designed primarily to protect the deposit insurance funds and consumers, not to benefit a company’s stockholders. These regulations may sometimes impose significant limitations on operations. The significant federal and state banking regulations that affect us are described in the section captioned “Supervision and Regulation” included in Part I, Item 1, “Business”. These regulations, along with the currently existing tax, accounting, securities, insurance, and monetary laws, regulations, rules, standards, policies, and interpretations control the methods by which financial institutions conduct business, implement strategic initiatives and tax compliance, and govern financial reporting and disclosures. These laws, regulations, rules, standards, policies, and interpretations are constantly evolving and may change significantly over time.

Proposed changes in New York State banking regulations could adversely affect us.
New York Governor Andrew Cuomo proposed merging the State Departments of Banking, Insurance and Consumer Protection into a single Department of Financial Regulation, or DFR. The bill provides that the Superintendent of the DFR may, beginning April 1, 2012, assess expenses in such proportion as he or she deems just and reasonable against banks and insurers. The bill also establishes a special account called the “consumer protection account,” which will consist of fees and penalties received by the department of state and DFR, as well as other monies received in the form of penalties. These monies will be available to the DFR to pay for costs related to its consumer and investor protection activities. If the consumer protection account is insufficient to cover those costs, the balance would be recoverable through assessments against the industry.
The bill makes New York’s “wild card” authority (that was set to expire September 10, 2011) permanent. Under this authority, the Banking Board has the power to grant to New York chartered banking organizations, as well as licensed foreign bank branches and agencies, powers possessed by a counterpart federally-chartered banking institution.
If this bill is adopted as proposed, it could adversely affect us.

OPERATIONAL RISKS

If our security systems, or those of merchants, merchant acquirers or other third parties containing information about customers, are compromised, we may be subject to liability and damage to our reputation.

As part of our business, we collect, process and retain sensitive and confidential client and customer information on our behalf and on behalf of other third parties. Customer data also may be stored on systems of third-party service providers and merchants that may have inadequate security systems. Third-party carriers regularly transport customer data, and may lose sensitive customer information. Unauthorized access to our networks or any of our other information systems potentially could jeopardize the security of confidential information stored in our computer systems or transmitted by our customers or others. If our security systems or those of merchants, processors or other third-party service providers are compromised such that this confidential information is disclosed to unauthorized parties, we may be subject to liability. For example, in the event of a security breach, we may incur losses related to fraudulent use of debit cards issued by us as well as the operational costs associated with reissuing cards. Although we take preventive measures to address these factors, such measures are costly and may become more costly in the future. Moreover, these measures may not protect us from liability, which may not be adequately covered by insurance, or from damage to our reputation.

We could be subject to losses if we fail to properly safeguard sensitive and confidential information.

As part of our normal operations, we maintain and transmit confidential information about our clients as well as proprietary information relating to our business operations. We maintain a system of internal controls designed to provide reasonable assurance that fraudulent activity, including misappropriation of assets, fraudulent financial reporting, and unauthorized access to sensitive or confidential data is either prevented or timely detected. Our systems or our third-party service providers’ systems could be victimized by unauthorized users or corrupted by computer viruses or other malicious software code, or authorized persons could inadvertently or intentionally release confidential or proprietary information. Such disclosure could, among other things:

seriously damage our reputation,

allow competitors access to our proprietary business information,

subject us to liability for a failure to safeguard client data,

result in the loss of our existing customers,

subject us to regulatory action, and

require significant capital and operating expenditures to investigate and remediate the breach.

Our information systems may experience an interruption or breach in security.

We rely heavily on communications and information systems to conduct our business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan and other systems. While we have policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.

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We rely on other companies to provide key components of our business infrastructure.

Third party vendors provide key components of our business infrastructure such as internet connections, network access and core application processing. While we have selected these third party vendors carefully, we do not control their actions. Any problems caused by these third parties, including as a result of their not providing us their services for any reason or their performing their services poorly, could adversely affect our ability to deliver products and services to our customers or otherwise conduct our business efficiently and effectively. Replacing these third party vendors could also entail significant delay and expense.

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We may not be able to attract and retain skilled people.
people and our ongoing leadership transition may be unsuccessful.

Our success depends, in large part, on our ability to attract and retain skilled people. Competition for the best people in most activities engaged in by us can be intense, and we may not be able to hire sufficiently skilled people or to retain them. Further, the rural location of our principal executive offices and many of our bank branches make it difficult for us to attract skilled people to such locations. The unexpected loss of services of one or more of our key personnel could have a material adverse impact on our business because of their skills, knowledge of our markets, years of industry experience, and the difficulty of promptly finding qualified replacement personnel.

On January 30, 2012, we eliminated the position of Retail Banking Executive previously held by John J. Witkowski, our former Executive Vice President and on June 30, 2012, George D. Hagi, our Executive Vice President and Chief Risk Officer retired and was replaced by Kenneth V. Winn. In August 2012, Peter G. Humphrey retired as our President and Chief Executive Officer. Following Mr. Humphrey’s retirement, our Board of Directors appointed John E. Benjamin to serve as Interim Chief Executive Officer in August 2012. At the same time, we also announced the promotion of Richard Harrison as Chief Operating Officer and Martin Birmingham as President and Chief of Community Banking. In March 2013, Mr. Birmingham was appointed to the position of President and Chief Executive Officer. These changes in key management could create uncertainty among our employees, customers, and other third parties with whom we do business and could result in changes to the strategic direction of our business, which could negatively affect our business, financial condition and results of operations. Any failure of our management to work together to effectively manage our operations, our inability to hire other key management, and any failure to effectively integrate new management into our controls, systems and procedures could adversely affect our business, financial condition and results of operations.

The potential for business interruption exists throughout our organization.

Integral to our performance is the continued efficacy of our technical systems, operational infrastructure, relationships with third parties and the vast array of associates and key executives in our day-to-day and ongoing operations. Failure by any or all of these resources subjects us to risks that may vary in size, scale and scope. This includes, but is not limited to, operational or technical failures, ineffectiveness or exposure due to interruption in third party support as expected, as well as the loss of key individuals or failure on the part of key individuals to perform properly. Although management has established policies and procedures, including implementation and testing of a comprehensive contingency plan, to address such failures, the occurrence of any such event could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations.

Acquisitions may disrupt our business and dilute shareholder value.

A key component of our strategy to grow and improve profitability is to expand our branch network into communities within or adjacent to markets where we currently conduct business. We intend to continue to pursue a growth strategy for our business. As a result, negotiations may take place and future mergers or acquisitions involving cash, debt, or equity securities may occur at any time. We seek merger or acquisition partners that are culturally similar, have experienced management, and possess either significant market presence or have potential for improved profitability through financial management, economies of scale, or expanded services.

Acquiring other banks, businesses, or branches involves potential adverse impact to our financial results and various other risks commonly associated with acquisitions, including, among other things:

difficulty in estimating the value of the target company;

payment of a premium over book and market values that may dilute our tangible book value and earnings per share in the short and long term;

potential exposure to unknown or contingent liabilities of the target company;

exposure to potential asset quality issues of the target company;

there may be volatility in reported income as goodwill impairment losses could occur irregularly and in varying amounts;

challenge and expense of integrating the operations and personnel of the target company;

inability to realize the expected revenue increases, cost savings, increases in geographic or product presence, and / or other projected benefits;

potential disruption to our business;

potential diversion of our management’s time and attention;

the possible loss of key employees and customers of the target company; and

potential changes in banking or tax laws or regulations that may affect the target company.

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EXTERNAL RISKS

We are subject to interest rate risk.

Our earnings and cash flows are largely dependent upon our net interest income. Interest rates are highly sensitive to many factors that are beyond our control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Federal Reserve. Changes in monetary policy, including changes in interest rates, could influence not only the interest we receive on loans and investments and the amount of interest we pay on deposits and borrowings, but such changes could also affect (i) our ability to originate loans and obtain deposits; (ii) the fair value of our financial assets and liabilities; and (iii) the average duration of our mortgage-backed securities portfolio and other interest-earning assets. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, our net interest income, and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings.

Although management believes it has implemented effective asset and liability management strategies to reduce the potential effects of changes in interest rates on our results of operations, any substantial, unexpected or prolonged change in market interest rates could have a material adverse effect on our financial condition and results of operations. Also, our interest rate risk modeling techniques and assumptions likely may not fully predict or capture the impact of actual interest rate changes on our balance sheet.

Our business may be adversely affected by conditions in the financial markets and economic conditions generally.

From December 2007 through June 2009, the U.S. economy was in recession. Business activity across a wide range of industries and regions in the U. S.U.S. was greatly reduced. Although economic conditions have begun to improve, certain sectors, such as real estate, remain weak and unemployment remains high. Local governments and many businesses are still in serious difficulty due to lower consumer spending and reduced tax collections.

Market conditions also led to the failure or merger of several prominent financial institutions and numerous regional and community-based financial institutions. These failures as well as projected future failures, have had a significant negative impact on the capitalization level of the deposit insurance fund of the FDIC, which, in turn, has led to past increases in deposit insurance premiums paid by financial institutions.

Our financial performance generally, and in particular the ability of borrowers to pay interest on and repay principal of outstanding loans and the value of collateral securing those loans, as well as demand for loans and other products and services we offer, is highly dependent on the business environment in the markets where we operate, in the State of New York and in the United States as a whole. A favorable business environment is generally characterized by, among other factors, economic growth, efficient capital markets, low inflation, low unemployment, high business and investor confidence, and strong business earnings. Unfavorable or uncertain economic and market conditions can be caused by declines in economic growth, business activity or investor or business confidence; limitations on the availability or increases in the cost of credit and capital; increases in inflation or interest rates; high unemployment, natural disasters; or a combination of these or other factors.

Approximately 20% of our investment securities portfolio at December 31, 2010 is comprised of municipal securities issued by or on behalf of New York and its political subdivisions, agencies or instrumentalities, the interest on which is exempt from regular federal income tax. Risks associated with investing in municipal securities include political, economic and regulatory factors which may affect the issuers. The concerns facing the State of New York may lead nationally recognized rating agencies to downgrade its debt obligations. It is uncertain how the financial markets may react to any potential future ratings downgrade in New York’s debt obligations. However, the fallout from continued budgetary concerns and a possible ratings downgrade could adversely affect the value of New York’s obligations and those of its political subdivisions, agencies and instrumentalities.

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Overall, during 2010, the business environment has been adverse for many households and businesses in the United States and worldwide. While economic conditions in the State of New York, the United States and worldwide have begun to improve, there can be no assurance that this improvement will continue. Such conditions could adversely affect our financial condition and results of operations.
Our earnings are significantly affected by the fiscal and monetary policies of the federal government and its agencies.

The policies of the Federal Reserve impact us significantly. The Federal Reserve regulates the supply of money and credit in the United States. Its policies directly and indirectly influence the rate of interest earned on loans and paid on borrowings and interest-bearing deposits and can also affect the value of financial instruments we hold. Those policies determine to a significant extent our cost of funds for lending and investing. Changes in those policies are beyond our control and are difficult to predict. Federal Reserve policies can also affect our borrowers, potentially increasing the risk that they may fail to repay their loans. For example, a tightening of the money supply by the Federal Reserve could reduce the demand for a borrower’s products and services. This could adversely affect the borrower’s earnings and ability to repay its loan, which could have a material adverse effect on our financial condition and results of operation.

operations.

The soundness of other financial institutions could adversely affect us.

Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. We have exposure to many different industries and counterparties, and we routinely execute transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks, and other institutional clients. Many of these transactions expose us to credit risk in the event of a default by our counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized or is liquidated at prices not sufficient to recover the full amount of the credit or derivative exposure due us. Any such losses could have a material adverse effect on our financial condition and results of operations.

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We may be required to recognize an impairment of goodwill.

Under current accounting standards, goodwill is not amortized but, instead, is subject to impairment tests on at least an annual basis or more frequently if an event occurs or circumstances change that reduce the fair value of a reporting unit below its carrying amount. Significant and sustained declines in our stock price and market capitalization, significant declines in our expected future cash flows, significant adverse changes in the business climate or slower growth rates could result in impairment of goodwill. During 2012, the annual impairment test performed as of September 30 indicated that the fair value of our single reporting unit exceeded the fair value of its assets and liabilities. In the event that we conclude that all or a portion of our goodwill may be impaired, a non-cash charge for the amount of such impairment would be recorded to earnings, which could have a material adverse impact on our results of operations or financial condition. Such a charge would have no impact on tangible capital. At December 31, 2012, we had goodwill of $49.0 million, representing approximately 19% of shareholders’ equity. For further discussion, see Note 1, Summary of Significant Accounting Policies, and Note 7, Goodwill and Other Intangible Assets, to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.

We operate in a highly competitive industry and market area.

We face substantial competition in all areas of our operations from a variety of different competitors, many of which are larger and may have more financial resources. Such competitors primarily include national, regional and internet banks within the various markets in which we operate. We also face competition from many other types of financial institutions, including, without limitation, savings and loans,loan associations, credit unions, finance companies, brokerage firms, insurance companies and other financial intermediaries. The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. Banks, securities firms and insurance companies can merge under the umbrella of a financial holding company, which can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting), and merchant banking. Also, technology has lowered barriers to entry and made it possible for nonbanks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems. Many of our competitors have fewer regulatory constraints and may have lower cost structures. Additionally, due to their size, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services as well as better pricing for those products and services than we can.

Our ability to compete successfully depends on a number of factors, including, among other things:

the ability to develop, maintain and build upon long-term customer relationships based on top quality service, high ethical standards and safe, sound assets;

the ability to develop, maintain and build upon long-term customer relationships based on top quality service, high ethical standards and safe, sound assets;
the ability to expand our market position;
the scope, relevance and pricing of products and services offered to meet customer needs and demands;
the rate at which we introduce new products and services relative to our competitors;
customer satisfaction with our level of service; and
industry and general economic trends.

the ability to expand our market position;

the scope, relevance and pricing of products and services offered to meet customer needs and demands;

the rate at which we introduce new products and services relative to our competitors;

customer satisfaction with our level of service; and

industry and general economic trends.

Failure to perform in any of these areas could significantly weaken our competitive position, which could adversely affect our growth and profitability, which, in turn, could have a material adverse effect on our financial condition and results of operations.

Our market

Severe weather, natural disasters, acts of war or terrorism, and other external events could significantly impact our business.

Severe weather, natural disasters, acts of war or terrorism, and other adverse external events could have a significant impact on our ability to conduct business. Such events could affect the stability of our deposit base, impair the ability of borrowers to repay outstanding loans, impair the value couldof collateral securing loans, cause significant property damage, result in an impairmentloss of goodwill.

Our goodwill is evaluated for impairment on an annual basis revenue, and/or when triggering events or circumstances indicate impairment may exist. Significantcause us to incur additional expenses. Although management has established disaster recovery policies and sustained declines in our stock price and market capitalization, significant declines in our expected future cash flows, significant adverse changes inprocedures, the business climate or slower growth rates could result in impairmentoccurrence of goodwill. At December 31, 2010, we had goodwill of $37.4 million, representing approximately 18% of shareholders’ equity. If impairment of goodwill was determined to exist, we would be required to write down our goodwill as a charge to earnings, whichany such event could have a material adverse impacteffect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations or financial condition. For further discussion, see Note 1, Summary of Significant Accounting Policies, and Note 6, Goodwill and Other Intangible Assets, to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.

operations.

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LIQUIDITY RISKS

Liquidity is essential to our businesses.

Our liquidity could be impaired by an inability to access the capital markets or unforeseen outflows of cash. This situation may arise due to circumstances that we may be unable to control, such as a general market disruption or an operational problem that affects third parties or us. Our efforts to monitor and manage liquidity risk may not be successful or sufficient to deal with dramatic or unanticipated reductions in our liquidity. In such events, our cost of funds may increase, thereby reducing our net interest revenue,income, or we may need to sell a portion of our investment and/or loan portfolio, which, depending upon market conditions, could result in ourus realizing a loss.

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We may need to raise additional capital in the future and such capital may not be available when neededon acceptable terms or at all.

We may need to raise additional capital in the future to provide sufficient capital resources and liquidity to meet our commitments and business needs. Our ability to raise additional capital, if needed, will depend on, among other things, conditions in the capital markets at that time, which are outside of our control, and our financial performance.

In addition, we are highly regulated, and our regulators could require us to raise additional common equity in the future. Both weWe and our regulators perform a variety of analyses of our assets, including the preparation of stress case scenarios, and as a result of those assessments we could determine, or our regulators could require us, to raise additional capital.

We cannot assure that such capital will be available on acceptable terms or at all. Any occurrence that may limit our access to the capital markets, such as a decline in the confidence of debt purchasers, depositors of the Bank or counterparties participating in the capital markets, or a downgrade of our debt rating, may adversely affect our capital costs and ability to raise capital and, in turn, our liquidity. An inability to raise additional capital on acceptable terms when needed could have a material adverse impact on our business, financial condition, results of operations or liquidity.

We rely on dividends from our subsidiaries for most of our revenue.

We are a separate and distinct legal entity from our subsidiaries. A substantial portion of our revenue comes from dividends from our Bank subsidiary. These dividends are the principal source of funds we use to pay dividends on our common and preferred stock, and to pay interest and principal on our debt. Various federal and/or state laws and regulations limit the amount of dividends that our Bank subsidiary and nonbank subsidiary may pay to us. Also, our right to participate in a distribution of assets upon a subsidiary’s liquidation or reorganization is subject to the prior claims of the subsidiary’s creditors. In the event our bank subsidiary is unable to pay dividends to us, we may not be able to service debt, pay obligations, or pay dividends on our common and preferred stock. The inability to receive dividends from our bank subsidiary could have a material adverse effect on our business, financial condition, and results of operations.

RISKS RELATED TO AN INVESTMENT IN OUR COMMON STOCK

The market price for our common stock varies, and you should purchase common stock for long-term investment only.

Although our common stock is currently traded on the NASDAQ Global Select Market, we cannot assure you that there will, at any time in the future, be an active trading market for our common stock. Even if there is an active trading market for our common stock, we cannot assure you that you will be able to sell all of your shares of common stock at one time or at a favorable price, if at all. As a result, you should purchase shares of common stock described herein only if you are capable of, and seeking, to make a long-term investment in our common stock.

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ThereWe may issue debt and equity securities or securities convertible into equity securities, any of which may be future sales or other dilution ofsenior to our equity,common stock as to distributions and in liquidation, which may adverselycould negatively affect the market pricevalue of our common stock.
We are not restricted from

In the future, we may attempt to increase our capital resources by entering into debt or debt-like financing that is unsecured or secured by all or up to all of our assets, or by issuing additional sharesdebt or equity securities, which could include issuances of commonsecured or unsecured commercial paper, medium-term notes, senior notes, subordinated notes, preferred stock including anyor securities that are convertible into or exchangeable for or that representequity securities. In the right to receive, common stock. We are currently authorized to issue up to 50,000,000 shares of common stock and up to 210,000 shares of preferred stock, par value $100 per share, which is designated into two classes, Class A of which 10,000 shares are authorized, and Class B of which 200,000 shares are authorized.

As of December 31, 2010, 10,937,506 shares of common stock and 183,259 sharesevent of our preferred stock were issuedliquidation, our lenders and outstanding including (i) 7,503 sharesholders of our fixed rate cumulative perpetual Series Adebt and preferred stock, par value $100 per share, havingsecurities would receive a liquidation preference of $5,000 per share, which we refer to as the TARP preferred stock, (ii) 1,533 sharesdistribution of our Series A 3% cumulative preferred stock, which we referavailable assets before distributions to as the 3% preferred stock, and (iii) 174,223 shares of Series B-1 8.48% cumulative preferred stock, which we refer to as the 8.48% preferred stock. We refer to our TARP preferred stock, our 3% preferred stock and our 8.48% preferred stock collectively as the preferred stock. Our Board of Directors has authority, without action or vote of the shareholders, to issue all or part of the authorized but unissued shares. These authorized but unissued shares could be issued on terms or in circumstances that could dilute the interests of the holders of our common stock.
Pursuant Because our decision to incur debt and issue securities in our future offerings will depend on market conditions and other factors beyond our control, we cannot predict or estimate the Letter Agreement, dated December 23, 2008, and the Securities Purchase Agreement - Standard Terms attached thereto, which we refer to collectively as the Securities Purchase Agreement, that we entered into with the Treasury, in connection with our participation in TARP, the Treasury received a warrant to purchase up to 378,175 sharesamount, timing or nature of our common stock, which we referfuture offerings and debt financings. Further, market conditions could require us to as the warrant, at an exercise price of $14.88 per share, and we have provided the Treasury with registration rights covering the warrant and the underlying shares of common stock. We may seek the approval of our regulators to repurchase the warrant with the proceeds from any offering. The issuance of additional shares of common stock as a result of exercise of the warrant or otherwise oraccept less favorable terms for the issuance of securities convertible or exercisable into shares of common stock would dilute the ownership interest of existing holders of our common stock. Although the Treasury has agreed to not vote any of the shares of common stock it receives upon exercise of the warrant, a transferee of any portion of the warrant or of any shares of common stock acquired upon exercise of the warrant is not bound by this restriction. The market price of our common stock could decline as a result of any offering as well as other sales of a large block of common stocksecurities in the market after an offering, or the perception that such sales could occur.
The terms of the warrant include an anti-dilution adjustment, which provides that (except in certain permitted transactions, including registered offerings), if we issue shares of common stock at a price that is less than 90% of the market price of such shares on the last trading day preceding the date of the agreement to sell such shares, the number of shares of common stock to be issued under the warrant would increase and the per share price of common stock to be purchased pursuant to the warrant would decrease.
Our shares of common stock are equity and are subordinate to our existing and future indebtedness and our preferred stock, and are effectively subordinated to all the indebtedness and other non-common equity claims against our subsidiaries.
Our shares of common stock are equity interests in us and do not constitute indebtedness. Accordingly, our common stock will rank junior to all of our indebtedness and to other non-equity claims on us with respect to assets available to satisfy claims on us. Additionally, holders of our common stock are subject to the prior dividend and liquidation rights of holders of our outstanding preferred stock. See Note 11, Shareholders’ Equity, in the accompanying consolidated financial statements. The terms of our preferred stock currently prohibit us from paying dividends with respect to our common stock unless all accrued and unpaid dividends for all completed dividend periods with respect to the preferred stock have been paid with our TARP preferred stock and 3% preferred stock receiving payments first.
In addition, our right to participate in any distribution of assets of any of our subsidiaries upon the subsidiary’s liquidation or otherwise, and thus your ability as a holder of our common stock to benefit indirectly from such distribution, will be subject to the prior claims of creditors of that subsidiary and holders of any of that subsidiary’s preferred stock, except to the extent that any of our claims as a creditor of such subsidiary may be recognized. As a result, our common stock will effectively be subordinated to all existing and future liabilities and obligations of our subsidiaries.
future.

We may not pay dividends on our common stock.

Holders of our common stock are only entitled to receive such dividends as our Board of Directors may declare out of funds legally available for such payments. Although we have historically declared cash dividends on our common stock, we are not required to do so and may reduce or eliminate our common stock dividend in the future. This could adversely affect the market price of our common stock. Also, participation in TARP limits our ability to increase our dividend or to repurchase our common stock, for so long as any securities issued under such program remain outstanding, as discussed in greater detail below.

Our certificate of incorporation, our bylaws, and certain banking laws may have an anti-takeover effect.

Provisions of our certificate of incorporation, our bylaws, and federal and state banking laws, including regulatory approval requirements, could make it more difficult for a third party to acquire us, even if doing so would be perceived to be beneficial to our shareholders. The combination of these provisions may discourage others from initiating a potential merger, takeover or other change of control transaction, which, in turn, could adversely affect the market price of our common stock.

 

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ITEM 1B.
UNRESOLVED STAFF COMMENTS
Not applicable.

None.

ITEM 2.
PROPERTIES

We own a 27,400 square foot building in Warsaw, New York that serves as our headquarters, and principal executive and administrative offices. Additionally, we are obligated under a lease commitment through 2017 for a 17,750 square foot regional administrative facility in Pittsford, New York.

We are engaged in the banking business through 5052 branch offices, of which 3436 are owned and 16 are leased, in fourteenfifteen contiguous counties of Western and Central New York: Allegany, Cattaraugus, Cayuga, Chautauqua, Chemung, Erie, Genesee, Livingston, Monroe, Ontario, Orleans, Seneca, Steuben, Wyoming and Yates Counties. The operating leases for our branch offices expire at various dates through the year 20232036 and generally include options to renew.

We believe that our properties have been adequately maintained, are in good operating condition and are suitable for our business as presently conducted, including meeting the prescribed security requirements. For additional information, see Note 5,6, Premises and Equipment, Net, and Note 9,10, Commitments and Contingencies, in the accompanying financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data”, all of which are included elsewhere in this report and incorporated herein by reference thereto.

Annual Report on Form 10-K.

ITEM 3.
LEGAL PROCEEDINGS

From time to time we are a party to or otherwise involved in legal proceedings arising in the normal course of business. Management does not believe that there is any pending or threatened proceeding against us, which, if determined adversely, would have a material adverse effect on our business, results of operations or financial condition.

ITEM 4.
RESERVED
MINE SAFETY DISCLOSURES

Not applicable.

 

- 25 -


PART II

ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Our common stock is traded on the NASDAQ Global Select Market under the ticker symbol “FISI.” At December 31, 2010, 10,937,5062012, 13,787,709 shares of our common stock were outstanding and held by approximately 1,3001,400 shareholders of record. During 2010,2012, the high sales price of our common stock was $20.74$19.52 and the low sales price was $10.91.$15.22. The closing price per share of common stock on December 31, 2010,2012, the last trading day of the Company’sour fiscal year, was $18.97.$18.63. We declared dividends of $0.40$0.57 per common share during the year ended December 31, 2010.2012. See additional information regarding the market price and dividends paid in Part II, Item 6, “Selected Financial Data.”

Data”.

We have paid regular quarterly cash dividends on our common stock and our Board of Directors presently intends to continue this practice, subject to our results of operations and the need for those funds for debt service and other purposes. However, the payment of dividends is subject to continued compliance with minimum regulatory capital requirements and TARP restrictions. See the discussions in the section captioned “Supervision and Regulation” included in Part I, Item 1, “Business”, in the section captioned “Liquidity and Capital Resources” included in Part II, Item 7, in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in Note 10,11, Regulatory Matters, in the accompanying financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data”, all of which are included elsewhere in this report and incorporated herein by reference thereto.

Equity Compensation Plan Information

The following table sets forth, as of December 31, 2010,2012, information about our equity compensation plans that have been approved by our shareholders, including the number of shares of our common stock exercisable under all outstanding options, warrants and rights, the weighted average exercise price of all outstanding options, warrants and rights and the number of shares available for future issuance under our equity compensation plans. We have no equity compensation plans that have not been approved by our shareholders.

             
          Number of securities 
      Weighted average  remaining for future 
  Number of securities to  exercise price  issuance under equity 
  be issued upon exercise  of outstanding  compensation plans 
  of outstanding options,  options, warrants  (excluding securities 
  warrants and rights  and rights  reflected in column (a)) 
Plan Category (a)  (b)  (c) 
             
Equity compensation plans approved by shareholders  560,689(1) $20.64(1)  748,101(2)
             
Equity compensation plans not approved by shareholders    $    

    
(1) Number of securities
Weighted averageremaining for future
Number of securities toexercise priceissuance under equity
be issued upon exerciseof outstandingcompensation plans
of outstanding options,options, warrants(excluding securities
warrants and rightsand rightsreflected in column (a))

Plan Category

(a)(b)(c)

Equity compensation plans
approved by shareholders

398,855(1)$20.22(1)651,464(2)

Equity compensation plans
not approved by shareholders

—  $—  —  

(1)

Includes 150,79679,580 shares of unvested restricted stock awards outstanding as of December 31, 2010.2012. The weighted average exercise price excludes such awards.

(2)

Represents the 940,000 aggregate shares approved for issuance under our two active equity compensation plans, reduced by 191,899373,297 shares, which are the 117,012227,623 restricted stock awards issued under these plans to date plus an adjustment of 74,887145,674 shares. Pursuant to the terms of the plans, for purposes of calculating the number of shares available for issuance, each share of common stock granted pursuant to a restricted stock award shall count as 1.64 shares of common stock.

Sales of Unregistered Securities
2009 Management Incentive Plan
On May 6, 2009, our shareholders approved our 2009 Management Stock Incentive Plan. Pursuant to the terms of the 2009 Management Stock Incentive Plan, we have the ability to grant incentive stock options, non-qualified stock options and restricted stock to members of our management team. Between May 6, 2009 and December 31, 2010, we granted shares of restricted stock to members of our management team under the 2009 Management Stock Incentive Plan as described in the table below.
         
      Number of 
  Number of  individuals 
  shares  receiving 
Date issued  awards 
October 1, 2009  1,972   1 
January 13, 2010  40,188   5 
February 23, 2010  59,152   23 
December 15, 2010  500   1 

 

- 26 -


These shares of restricted stock were issued without registration under the Securities Act of 1933, as amended (the “Securities Act”) in reliance on the exemption from registration in Section 4(2) of the Securities Act. These shares of restricted stock are subject to the resale prohibitions under the Securities Act and may not be sold or transferred without registration except in accordance with Rule 144 of the Securities Act.
2009 Directors’ Stock Incentive Plan
On May 6, 2009, our shareholders approved our 2009 Directors’ Stock Incentive Plan. Pursuant to the terms of the 2009 Directors’ Stock Incentive Plan, we have the ability to grant non-qualified stock options and restricted stock to our non-employee directors. On May 6, 2009, we granted a total of 8,000 shares of restricted stock to ten of our non-employee directors and on May 6, 2010, we granted a total of 7,200 shares of restricted stock to nine of our non-employee directors.
These shares of restricted stock were issued without registration under the Securities Act in reliance on the exemption from registration in Section 4(2) of the Securities Act. These shares of restricted stock are subject to the resale prohibitions under the Securities Act and may not be sold or transferred without registration except in accordance with Rule 144 of the Securities Act.
Stock Performance Graph

The stock performance graph below compares (a) the cumulative total return on our common stock for the period beginning December 31, 20052007 as reported by the NASDAQ Global Select Market, through December 31, 2010,2012, (b) the cumulative total return on stocks included in the NASDAQ Composite Index over the same period, and (c) the cumulative total return, as compiled by SNL Financial L.C., of Major Exchange (NYSE, AMEX and NASDAQ) Banks with $1 billion to $5 billion in assets over the same period. Cumulative return assumes the reinvestment of dividends. The graph was prepared by SNL Financial, LC and is expressed in dollars based on an assumed investment of $100.

Total Return Performance
                         
  Period Ending 
Index 12/31/05  12/31/06  12/31/07  12/31/08  12/31/09  12/31/10 
Financial Institutions, Inc.  100.00   119.37   94.50   78.59   67.41   111.16 
NASDAQ Composite  100.00   110.39   122.15   73.32   106.57   125.91 
SNL Bank $1B-$5B Index  100.00   115.72   84.29   69.91   50.11   56.81 

   Period Ending 

Index

  12/31/07   12/31/08   12/31/09   12/31/10   12/31/11   12/31/12 

Financial Institutions, Inc.

   100.00     83.16     71.33     117.63     103.06     122.99  

NASDAQ Composite

   100.00     60.02     87.24     103.08     102.26     120.42  

SNL Bank $1B-$5B Index

   100.00     82.94     59.45     67.39     61.46     75.75  

 

- 27 -


ITEM 6.
SELECTED FINANCIAL DATA
                     
  At or for the year ended December 31, 
(Dollars in thousands, except selected ratios and per share data) 2010  2009  2008  2007  2006 
Selected financial condition data:
                    
Total assets $2,214,307  $2,062,389  $1,916,919  $1,857,876  $1,907,552 
Loans, net  1,325,524   1,243,265   1,102,330   948,652   909,434 
Investment securities  694,530   620,074   606,038   754,720   775,536 
Deposits  1,882,890   1,742,955   1,633,263   1,575,971   1,617,695 
Borrowings  103,877   106,390   70,820   68,210   87,199 
Shareholders’ equity  212,144   198,294   190,300   195,322   182,388 
Common shareholders’ equity(1)
  158,359   144,876   137,226   177,741   164,765 
Tangible common shareholders’ equity(2)
  120,990   107,507   99,577   139,786   126,502 
                     
Selected operations data:
                    
Interest income $96,509  $94,482  $98,948  $105,212  $103,070 
Interest expense  17,720   22,217   33,617   47,139   43,604 
                
Net interest income  78,789   72,265   65,331   58,073   59,466 
Provision (credit) for loan losses  6,687   7,702   6,551   116   (1,842)
                
Net interest income after provision (credit) for loan losses  72,102   64,563   58,780   57,957   61,308 
Noninterest income (loss)(3)
  19,454   18,795   (48,778)  20,680   21,911 
Noninterest expense  60,917   62,777   57,461   57,428   59,612 
                
Income (loss) before income taxes  30,639   20,581   (47,459)  21,209   23,607 
Income tax expense (benefit)  9,352   6,140   (21,301)  4,800   6,245 
                
Net income (loss) $21,287  $14,441  $(26,158) $16,409  $17,362 
                
Preferred stock dividends and accretion  3,725   3,697   1,538   1,483   1,486 
                
Net income (loss) applicable to common shareholders $17,562  $10,744  $(27,696) $14,926  $15,876 
                
                     
Stock and related per share data:
                    
Earnings (loss) per common share:                    
Basic $1.62  $0.99  $(2.54) $1.34  $1.40 
Diluted  1.61   0.99   (2.54)  1.33   1.40 
Cash dividends declared on common stock  0.40   0.40   0.54   0.46   0.34 
Common book value per share(1)
  14.48   13.39   12.71   16.14   14.53 
Tangible common book value per share(2)
  11.06   9.94   9.22   12.69   11.15 
Market price (NASDAQ: FISI):                    
High  20.74   15.99   22.50   23.71   25.38 
Low  10.91   3.27   10.06   16.18   17.43 
Close  18.97   11.78   14.35   17.82   23.05 

   At or for the year ended December 31, 
(Dollars in thousands, except selected ratios and per share data)  2012  2011  2010  2009  2008 

Selected financial condition data:

      

Total assets

  $2,764,034   $2,336,353   $2,214,307   $2,062,389   $1,916,919  

Loans, net

   1,681,012    1,461,516    1,325,524    1,243,265    1,102,330  

Investment securities

   841,701    650,815    694,530    620,074    606,038  

Deposits

   2,261,794    1,931,599    1,882,890    1,742,955    1,633,263  

Borrowings

   179,806    150,698    103,877    106,390    70,820  

Shareholders’ equity

   253,897    237,194    212,144    198,294    190,300  

Common shareholders’ equity(1)

   236,426    219,721    158,359    144,876    137,226  

Tangible common shareholders’ equity(2)

   185,606    182,352    120,990    107,507    99,577  

Selected operations data:

      

Interest income

  $97,567   $95,118   $96,509   $94,482   $98,948  

Interest expense

   9,051    13,255    17,720    22,217    33,617  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Net interest income

   88,516    81,863    78,789    72,265    65,331  

Provision for loan losses

   7,128    7,780    6,687    7,702    6,551  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Net interest income after provision for loan losses

   81,388    74,083    72,102    64,563    58,780  

Noninterest income (loss)(3)

   24,777    23,925    19,454    18,795    (48,778

Noninterest expense

   71,397    63,794    60,917    62,777    57,461  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Income (loss) before income taxes

   34,768    34,214    30,639    20,581    (47,459

Income tax expense (benefit)

   11,319    11,415    9,352    6,140    (21,301
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Net income (loss)

  $23,449   $22,799   $21,287   $14,441   $(26,158
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Preferred stock dividends and accretion

   1,474    3,182    3,725    3,697    1,538  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Net income (loss) applicable to common shareholders

  $21,975   $19,617   $17,562   $10,744   $(27,696
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Stock and related per share data:

      

Earnings (loss) per common share:

      

Basic

  $1.60   $1.50   $1.62   $0.99   $(2.54

Diluted

   1.60    1.49    1.61    0.99    (2.54

Cash dividends declared on common stock

   0.57    0.47    0.40    0.40    0.54  

Common book value per share(1)

   17.15    15.92    14.48    13.39    12.71  

Tangible common book value per share(2)

   13.46    13.21    11.06    9.94    9.22  

Market price (NASDAQ: FISI):

      

High

   19.52    20.36    20.74    15.99    22.50  

Low

   15.22    12.18    10.91    3.27    10.06  

Close

   18.63    16.14    18.97    11.78    14.35  

Performance ratios:

      

Net income (loss), returns on:

      

Average assets

   0.93  1.00  0.98  0.71  -1.37

Average equity

   9.46    9.82    10.07    7.43    -14.30  

Average common equity(1)

   9.53    9.47    11.14    7.61    -16.84  

Average tangible common equity(2)

   11.74    11.55    14.59    10.37    -21.87  

Common dividend payout ratio(4)

   35.63    31.33    24.69    40.40    NA  

Net interest margin (fully tax-equivalent)

   3.95    4.04    4.07    4.04    3.93  

Efficiency ratio(5)

   62.87  60.55  60.36  65.52  64.07

(1)

Excludes preferred shareholders’ equity.

(2)

Excludes preferred shareholders’ equity, goodwill and other intangible assets.

(3)

The 2012, 2011, 2010, 2009 and 2008 figures include other-than-temporary impairment (“OTTI”) charges of $91 thousand, $18 thousand, $594 thousand, $4.7 million and $68.2 million, respectively. There were no OTTI charges in the other years presented.

- 28 -


                     
  At or for the year ended December 31, 
(Dollars in thousands, except per share data) 2010  2009  2008  2007  2006 
Selected financial ratios and other data:
                    
Performance ratios:
                    
Net income (loss), returns on:                    
Average assets  0.98%  0.71%  -1.37%  0.86%  0.90%
Average equity  10.07   7.43   -14.30   8.84   9.86 
Average common equity(1)
  11.14   7.61   -16.84   8.89   10.02 
Average tangible common equity(2)
  14.59   10.37   -21.87   11.50   13.23 
Common dividend payout ratio(3)
  24.69   40.40  NA   34.33   24.29 
Net interest margin (fully tax-equivalent)  4.07   4.04   3.93   3.53   3.55 
Efficiency ratio(4)
  60.36%  65.52%  64.07%  68.77%  69.78%
                     
Capital ratios:
                    
Leverage ratio  8.31%  7.96%  8.05%  9.35%  8.91%
Tier 1 risk-based capital  12.34   11.95   11.83   15.74   15.85 
Total risk-based capital  13.60   13.21   13.08   16.99   17.10 
Equity to assets (5)
  9.75   9.55   9.60   9.73   9.08 
Common equity to assets(1) (5)
  7.28   6.94   8.63   8.81   8.17 
Tangible common equity to tangible assets(2)(5)
  5.65%  5.19%  6.78%  6.95%  6.32%
                     
Asset quality:
                    
Non-performing loans $7,582  $8,681  $8,196  $8,077  $15,840 
Non-performing assets  8,895   10,442   9,252   9,498   17,043 
Allowance for loan losses  20,466   20,741   18,749   15,521   17,048 
Net loan charge-offs $6,962  $5,710  $3,323  $1,643  $1,341 
Total non-performing loans to total loans  0.56%  0.69%  0.73%  0.84%  1.71%
Total non-performing assets to total assets  0.40   0.51   0.48   0.51   0.89 
Net charge-offs to average loans  0.54   0.47   0.32   0.18   0.14 
Allowance for loan losses to total loans  1.52   1.64   1.67   1.61   1.84 
Allowance for loan losses to non-performing loans  270%  239%  229%  192%  108%
                     
Other data:
                    
Number of branches  50   50   51   50   50 
Full time equivalent employees  577   572   600   621   640 
(4)
(1)Excludes preferred shareholders’ equity.
(2)Excludes preferred shareholders’ equity, goodwill and other intangible assets.
(3)

Common dividend payout ratio equals dividends declared during the year divided by earnings per share for the year. There is no ratio shown for years where we both declared a dividend and incurred a loss because the ratio would result in a negative payout since the dividend declared (paid out) will always be greater than 100% of earnings.

(4)(5)

Efficiency ratio equals noninterest expense less other real estate expense and amortization of intangible assets as a percentage of net revenue, defined as the sum of tax-equivalent net interest income and noninterest income before net gains and impairment charges on investment securities and proceeds from company owned life insurance included in income and net gains from the sale of trust relationships (all from continuing operations).

- 28 -


   At or for the year ended December 31, 
(Dollars in thousands, except per share data)  2012  2011  2010  2009  2008 

Capital ratios:

      

Leverage ratio

   7.70  8.63  8.31  7.96  8.05

Tier 1 capital ratio

   10.70    12.20    12.34    11.95    11.83  

Total risk-based capital ratio

   11.96    13.45    13.60    13.21    13.08  

Equity to assets(3)

   9.84    10.20    9.75    9.55    9.60  

Common equity to assets(1) (3)

   9.15    9.10    7.28    6.94    8.63  

Tangible common equity to tangible assets(2)(3)

   7.56  7.58  5.65  5.19  6.78

Asset quality:

      

Non-performing loans

  $9,125   $7,076   $7,582   $8,681   $8,196  

Non-performing assets

   10,062    9,187    8,895    10,442    9,252  

Allowance for loan losses

   24,714    23,260    20,466    20,741    18,749  

Net loan charge-offs

  $5,674   $4,986   $6,962   $5,710   $3,323  

Non-performing loans to total loans

   0.53  0.48  0.56  0.69  0.73

Non-performing assets to total assets

   0.36    0.39    0.40    0.51    0.48  

Net charge-offs to average loans

   0.36    0.36    0.54    0.47    0.32  

Allowance for loan losses to total loans

   1.45    1.57    1.52    1.64    1.67  

Allowance for loan losses to non-performing loans

   271  329  270  239  229

Other data:

      

Number of branches

   52    50    50    50    51  

Full time equivalent employees

   628    575    577    572    600  

(1)

Excludes preferred shareholders’ equity.

(5)(2)

Excludes preferred shareholders’ equity, goodwill and other intangible assets. Ratios calculated using average balances for the periods shown.

 

- 29 -


SELECTED QUARTERLY DATA
                 
  2010 
  Fourth  Third  Second  First 
(Dollars in thousands, except per share data) Quarter  Quarter  Quarter  Quarter 
Interest income $24,297  $24,186  $24,202  $23,824 
Interest expense  4,229   4,393   4,526   4,572 
             
Net interest income  20,068   19,793   19,676   19,252 
Provision for loan losses  1,980   2,184   2,105   418 
             
Net interest income, after provision for loan losses  18,088   17,609   17,571   18,834 
Noninterest income  5,274   5,131   4,966   4,083 
Noninterest expense  16,373   14,936   14,870   14,738 
             
Income before income taxes  6,989   7,804   7,667   8,179 
Income tax expense  1,891   2,141   2,469   2,851 
             
Net income $5,098  $5,663  $5,198  $5,328 
             
Preferred stock dividends  933   932   931   929 
             
Net income applicable to common shareholders $4,165  $4,731  $4,267  $4,399 
             
                 
Earnings per common share(1):
                
Basic $0.38  $0.44  $0.39  $0.41 
Diluted  0.38   0.43   0.39   0.40 
Market price (NASDAQ: FISI):                
High $20.74  $19.94  $19.48  $15.40 
Low  16.80   14.14   14.07   10.91 
Close  18.97   17.66   17.76   14.62 
Dividends declared $0.10  $0.10  $0.10  $0.10 
                 
  2009 
  Fourth  Third  Second  First 
(Dollars in thousands, except per share data) Quarter  Quarter  Quarter  Quarter 
Interest income $24,390  $23,697  $23,302  $23,093 
Interest expense  5,175   5,619   5,657   5,766 
             
Net interest income  19,215   18,078   17,645   17,327 
Provision for loan losses  1,088   2,620   2,088   1,906 
             
Net interest income, after provision for loan losses  18,127   15,458   15,557   15,421 
Noninterest income  5,183   4,406   4,515   4,691 
Noninterest expense  15,117   15,142   16,440   16,078 
             
Income before income taxes  8,193   4,722   3,632   4,034 
Income tax expense  2,756   1,313   1,004   1,067 
             
Net income $5,437  $3,409  $2,628  $2,967 
             
Preferred stock dividends  927   927   925   918 
             
Net income applicable to common shareholders $4,510  $2,482  $1,703  $2,049 
             
                 
Earnings per common share(1):
                
Basic $0.42  $0.23  $0.16  $0.19 
Diluted  0.42   0.23   0.16   0.19 
Market price (NASDAQ: FISI):                
High $12.25  $15.00  $15.99  $14.95 
Low  9.71   9.90   6.98   3.27 
Close  11.78   9.97   13.66   7.62 
Dividends declared $0.10  $0.10  $0.10  $0.10 

   Fourth   Third   Second   First 
(Dollars in thousands, except per share data)  Quarter   Quarter   Quarter   Quarter 

2012

        

Interest income

  $25,087    $25,299    $23,731    $23,450  

Interest expense

   1,999     2,200     2,343     2,509  
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income

   23,088     23,099     21,388     20,941  

Provision for loan losses

   2,520     1,764     1,459     1,385  
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income, after provision for loan losses

   20,568     21,335     19,929     19,556  

Noninterest income

   6,283     6,353     6,690     5,451  

Noninterest expense

   17,541     21,618     16,581     15,657  
  

 

 

   

 

 

   

 

 

   

 

 

 

Income before income taxes

   9,310     6,070     10,038     9,350  

Income tax expense

   2,978     1,805     3,382     3,154  
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income

  $6,332    $4,265    $6,656    $6,196  
  

 

 

   

 

 

   

 

 

   

 

 

 

Preferred stock dividends

   369     368     368     369  
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income applicable to common shareholders

  $5,963    $3,897    $6,288    $5,827  
  

 

 

   

 

 

   

 

 

   

 

 

 

Earnings per common share(1):

        

Basic

  $0.44    $0.28    $0.46    $0.43  

Diluted

   0.43     0.28     0.46     0.42  

Market price (NASDAQ: FISI):

        

High

  $19.39    $19.52    $17.66    $17.99  

Low

   17.61     16.50     15.51     15.22  

Close

   18.63     18.64     16.88     16.17  

Dividends declared

  $0.16    $0.14    $0.14    $0.13  

2011

        

Interest income

  $23,875    $23,774    $23,830    $23,639  

Interest expense

   2,721     3,156     3,577     3,801  
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income

   21,154     20,618     20,253     19,838  

Provision for loan losses

   2,162     3,480     1,328     810  
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income, after provision for loan losses

   18,992     17,138     18,925     19,028  

Noninterest income

   5,767     8,036     4,974     5,148  

Noninterest expense

   16,279     17,012     15,153     15,350  
  

 

 

   

 

 

   

 

 

   

 

 

 

Income before income taxes

   8,480     8,162     8,746     8,826  

Income tax expense

   2,718     2,664     3,027     3,006  
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income

  $5,762    $5,498    $5,719    $5,820  
  

 

 

   

 

 

   

 

 

   

 

 

 

Preferred stock dividends

   369     368     370     2,075  
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income applicable to common shareholders

  $5,393    $5,130    $5,349    $3,745  
  

 

 

   

 

 

   

 

 

   

 

 

 

Earnings per common share(1):

        

Basic

  $0.39    $0.38    $0.39    $0.33  

Diluted

   0.39     0.37     0.39     0.33  

Market price (NASDAQ: FISI):

        

High

  $17.26    $17.98    $17.93    $20.36  

Low

   12.18     13.63     15.20     16.40  

Close

   16.14     14.26     16.42     17.52  

Dividends declared

  $0.13    $0.12    $0.12    $0.10  

(1)

Earnings per share data is computed independently for each of the quarters presented. Therefore, the sum of the quarterly earnings or loss per common share amounts may not equal the total for the year.

 

- 30 -


2012 FOURTH QUARTER RESULTS

Net income was $6.3 million for the fourth quarter of 2012 compared with $5.8 million for the fourth quarter of 2011. After preferred dividends, fourth quarter diluted earnings per share for 2012 was $0.43 compared with $0.39 per share for the fourth quarter of 2011.

Net interest income totaled $23.1 million for the three months ended December 31, 2012, an increase of $1.9 million or 9% over the fourth quarter of 2011. Average earning assets increased $293.1 million during the fourth quarter 2012 compared to the same quarter last year, the result of a $219.6 million increase in average loans combined with a $73.5 million increase in investment securities.

The net interest margin on a tax-equivalent basis was 3.92% in the fourth quarter of 2012, compared with 4.07% in the fourth quarter of 2011. Our yield on earning-assets decreased 33 basis points in the fourth quarter of 2012 compared with the same quarter last year, a result of cash flows being reinvested in the current low interest rate environment, which includes the impact of investing the cash from the branch acquisitions into lower yielding securities. The cost of interest-bearing liabilities decreased 22 basis points compared with the fourth quarter of 2011, primarily a result of the continued downward re-pricing of our certificates of deposit.

The provision for loan losses was $2.5 million for the fourth quarter of 2012 compared with $2.2 million for the fourth quarter of 2011. Net charge-offs for the fourth quarter of 2012 were $2.1 million, or 0.50% annualized, of average loans, compared to $1.9 million, or 0.51% annualized, of average loans in the fourth quarter of 2011. See the sections “Allowance for Loan Losses” and “Non-performing Assets and Potential Problem Loans” for additional information on net charge-offs and non-performing loans.

Noninterest income totaled $6.3 million for the fourth quarter of 2012, a 9% increase over the fourth quarter of 2011. The majority of the increase related to a $452 thousand increase in income from service charges on deposit accounts when comparing the fourth quarter 2012 compared with the same quarter last year.

Noninterest expense was $17.5 million for the fourth quarter of 2012, an increase of $1.3 million or 8% from the fourth quarter of 2011. The increases in expenses across all categories for the fourth quarter of 2012 compared to the fourth quarter of 2011 reflect higher infrastructure costs to support the increased number of branches and employees.

Income tax expense for the fourth quarter of 2012 was $3.0 million compared to $2.7 million for the fourth quarter of 2011. The change in income tax expense was primarily due to an $830 thousand increase in pretax income between the periods.

- 31 -


ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following is a discussion and analysis of our financial position and results of operations and should be read in conjunction with the information set forth under Part I, Item 1A, “Risks Factors,”Factors”, and our consolidated financial statements and notes thereto appearing under Part II, Item 8, “Financial Statements and Supplementary Data” of this report.Annual Report on Form 10-K.

OVERVIEW AND OUTLOOK

Business Overview

Financial Institutions, Inc. is a financial holding company headquartered in New York State, providing banking and nonbanking financial services to individuals and businesses primarily in our Western and Central New York footprint. We have also expanded our indirect lending network to include relationships with franchised automobile dealers in the Capital District of New York and Northern Pennsylvania. Through our wholly-owned banking subsidiary, Five Star Bank, we provide a wide range of services, including business and consumer loan and depository services, as well as other traditional banking services. Through our nonbanking subsidiary, Five Star Investment Services, we provide brokerage and investment advisory services to supplement our banking business.

Our primary sources of revenue are net interest income (predominantly from interest(interest earned on our loans and securities, net of interest paid on deposits and other funding sources), and noninterest income, particularly fees and other revenue from financial services provided to customers or ancillary services tied to loans and deposits. Business volumes and pricing drive revenue potential, and tend to be influenced by overall economic factors, including market interest rates, business spending, consumer confidence, economic growth, and competitive conditions within the marketplace. We are not able to predict market interest rate fluctuations with certainty and our asset/liability management strategy may not prevent interest rate changes from having a material adverse effect on our results of operations and financial condition.

2012 Significant Events

OutlookBranch Acquisitions.

During 2012, we successfully completed the acquisition of eight retail bank branch locations in Upstate New York. Former HSBC Bank USA, N.A. branches located in Albion, Elmira, Elmira Heights, and Horseheads were acquired in August, complementing the former First Niagara Bank, N.A. locations in Batavia, Brockport, Medina, and Seneca Falls acquired in June. Through the acquisition we assumed deposits of $286.8 million and acquired in-market performing loans of $75.6 million. The general stateacquisition of these branch offices was a marked success. We were able to integrate the offices and customer accounts seamlessly. Through detailed planning, we ensured that our sales and support staff members were ready to assist customers with any questions or issues. The feedback we received from our customers was positive and executing on our detailed planning process ultimately resulted in deposit retention rates that were better than expected. We incurred approximately $3.0 million in pre-tax expense during 2012 related to the branch acquisitions.

The combined assets acquired and deposits assumed in the two transactions were recorded at their estimated fair values as follows:

Cash

  $195,778  

Loans

   75,635  

Bank premises and equipment

   1,938  

Goodwill

   11,599  

Core deposit intangible asset

   2,042  

Other assets

   339  
  

 

 

 

Total assets acquired

  $287,331  
  

 

 

 

Deposits assumed

  $286,819  

Other liabilities

   512  
  

 

 

 

Total liabilities assumed

  $287,331  
  

 

 

 

In anticipation of the U.S. economybranch acquisitions, we leveraged our balance sheet through the execution of short-term FHLB advances in order to “pre-acquire” investment securities. This strategy allowed us to purchase securities over time and in particular, economic and market conditions in Western and Central New York havecarry out a significant impact on loan demand, the abilitydollar cost averaging strategy. Our purchase of borrowers to repay loans and the value of any collateral securing loans and may also affect deposit levels. Accordingly, future general economic conditions and the impact on credit risk are key uncertainties that may materially affect our results of operations.

Approximately 20% of our investment securities portfolio at December 31, 2010 iswas comprised of mortgage-backed securities, U.S. Government agencies and sponsored enterprise bonds and tax-exempt municipal securities issued by or on behalfbonds. The cash received at the time of New York and its political subdivisions, agencies or instrumentalities,closing the interest on which is exempt from federal income tax. Risks associated with investing in municipal securities include political, economic and regulatory factors which may affecttransactions was used to pay down the issuers. The concerns facingshort-term FHLB advances used to fund the State of New York may lead nationally recognized rating agencies to downgrade its debt obligations. It is uncertain how the financial markets may react to any potential future ratings downgrade in New York’s debt obligations. However, the fallout from continued budgetary concerns and a possible ratings downgrade could adversely affect the value of New York’s obligations.
Our interest rate spread affects our profitability. Our interest rate spread is the difference between the interest rate we receive on interest-earning assets, such as loans and investment securities, and the interest rate we pay on deposits and other borrowings. If the interest rates we pay on our deposits and other borrowings were to increase at a faster rate than the interest rates we receive on our loans and investments securities, our interest rate spread will decline, which could adversely affect our profitability.
Legislative and regulatory reforms continue to be adopted which impose additional restrictions on current business practices including passagepurchase of the Dodd-Frank Act. The Dodd-Frank Act is complex and we continue to assess how this legislation and subsequent rule-making will affect us. As hundreds of regulations are promulgated, we will continue to evaluate impacts such as changes in regulatory costs and fees, modifications to consumer products or disclosures required byinvestment securities.

For detailed information on the Consumer Financial Protection Bureau andaccounting for the requirementsbranch acquisitions, see Note 2, Branch Acquisitions, of the enhanced supervision provisions, among others.

Recent Developments
On February 23, 2011, the Company was granted approval from the Treasury and redeemed $12.5 million of the $37.5 million in Series A preferred stock issued by the Company in December 2008. The redemption will result in a reduction of the associated Series A preferred stock dividends and Tier 1 Capital in future periods. Upon issuance in December 2008, the discount associated with the Series A preferred stock was $2.0 million, which is being accretednotes to retained earnings as an adjustment to dividends using the effective yield method. At December 31, 2010, the Series A preferred stock discount totaled $1.3 million. As a result of the redemption, the Company will accelerate the accretion of the remaining discount in proportion to the Series A preferred stock redeemed in the first quarter of 2011. This transaction has no effect on the outstanding warrant to purchase common stock issued to the Treasury as part of the original issuance of the Series A preferred stock. The Company may apply for approval to repay the remaining balance of the Series A preferred stock in future periods.
consolidated financial statements.

 

- 3132 -


MANAGEMENT’S DISCUSSION AND ANALYSIS

Leadership Transition.

2010In August 2012, Peter G. Humphrey our former President and Chief Executive Officer retired. Mr. Humphrey continues to serve as a member of our Board of Directors. Following Mr. Humphrey’s retirement, our Board of Directors appointed John E. Benjamin to serve as our Interim Chief Executive Officer in August 2012. At the same time, we also announced the promotion of Richard Harrison as Chief Operating Officer and Martin Birmingham as President and Chief of Community Banking. Mr. Harrison and Mr. Birmingham were instrumental in the structuring, negotiating and integrating the branch office acquisitions. We incurred approximately $2.6 million in pre-tax expense during 2012 related to the retirement of Mr. Humphrey.

The Board of Directors subsequently appointed Mr. Birmingham as President and Chief Executive Officer, effective March 1, 2013.

2012 Performance Summary

Our reported net income was $21.3$23.4 million for the year ended December 31, 2010,2012, compared to a net income of $14.4$22.8 million for the year ended December 31, 2009.2011. For 2010,2012, net income available to common shareholders was $17.6$22.0 million, or $1.61$1.60 per diluted common share. Netshare, compared to 2011 net income available to common shareholders was $10.7of $19.6 million, for 2009, or $0.99$1.49 per diluted common share. Cash dividends of $0.40$0.57 and $0.47 per common share were paiddeclared in 20102012 and 2009.

2011, respectively.

We had total assets of $2.214$2.764 billion at December 31, 20102012 compared to $2.062$2.336 billion at December 31, 2009.2011. At December 31, 2010,2012, shareholders’ equity totaled $212.1$253.9 million with book value per common share at $14.48,$17.15, compared to $198.3$237.2 million with book value per common share at $13.39$15.92 at the end of 2009. Tangible common equity to tangible common assets improved to 5.65% during 2010 from 5.19% in 2009.2011. The Tier 1 capital ratio was 12.34%10.70% as of December 31, 20102012 compared to 11.95%12.20% at December 31, 2009.

2011.

Key factors behind these results are discussed below.

At December 31, 2010,2012, total gross loans (includes loans held for sale) were $1.349$1.706 billion, up 7%$220.9 million or 15% from year-end 2009, primarily2011. At December 31, 2012, total loans included $64.5 million in commercial mortgage and consumer indirect loans as we have focused our business development effortsobtained in these areas in accordance with our strategic objectives.the branch acquisitions. Total deposits at December 31, 2010,2012, were $1.883$2.262 billion, up 8%$330.2 million or 17% from year-end 2009,2011, primarily attributable to a $113.6$286.8 million increase in retail deposits.deposits assumed from the branch acquisitions. Our deposit mix remains favorably weighted in lower cost demand, savings and money market accounts, which comprised 60.7%71% of total deposits at the end of 2010.2012 compared to 64% of total deposits at the end of 2011.

Nonperforming loans were $7.6$9.1 million or 0.53% of total loans at December 31, 2010,2012, compared to $8.7$7.1 million or 0.48% of total loans at December 31, 2009, as our loan portfolio continues to benefit from responsible underwriting and lending practices.2011.
Net charge-offs were $7.0 million in 2010 (or 0.54% of average loans) compared to $5.7 million in 2009 (or 0.47% of average loans). We had a $5.0 million participation interest in one commercial business loan, which was sold during the third quarter of 2010 for $1.9 million, resulting in a charge-off of $3.1 million.

The provision for loan losses was $6.7$7.1 million and $7.7$7.8 million, respectively, for 20102012 and 2009. 2011. Net charge-offs were $5.7 million in 2012 (or 0.36% of average loans) compared to $5.0 million in 2011 (or 0.36% of average loans).

At year-end 2010,2012, the allowance for loan losses of $20.5$24.7 million represented 1.52%1.45% of total loans (covering 270%271% of non-performing loans), compared to $20.7$23.3 million or 1.64%1.57% (covering 239%329% of non-performing loans) at year-end 2009. See also sections, “Allowance2011. Excluding loans acquired in the branch acquisitions during 2012, the allowance for Loan Losses” and “Non-performing Assets and Potential Problem Loans” for additional information on net charge-offs and non-performing loans.loan losses was 1.51% of total loans at year-end 2012.

Taxable equivalent net interest income was $80.7$90.8 million for 20102012 or 8% higher than $75.0$83.9 million in 2009.2011. Taxable equivalent interest income increased $1.2$2.7 million, while interest expense decreased by $4.5$4.2 million. The increase in taxable equivalent net interest income was a function of a favorable volume variance (increasing taxable equivalent net interest income by $6.3$11.7 million), partially offset by an unfavorable rate variance (decreasing taxable equivalent net interest income by $573 thousand)$4.8 million). See also section, “Net Interest Income and Net Interest Margin” for additional information on taxable equivalent net interest income and net interest margin.

The net interest margin for 20102012 was 4.07%3.95%, 39 basis points higherlower than 4.04% in 2009. The increase in net interest margin was attributable to a 10 basis point increase in interest rate spread (the net of a 36 basis point decrease in the cost of interest-bearing liabilities and a 26 basis decrease in the yield on earning assets), partially offset by a 7 basis point lower contribution from net free funds (primarily attributable to lower rates on interest-bearing liabilities reducing the value of noninterest-bearing deposits and other net free funds). See also section, “Net Interest Income and Net Interest Margin” for additional information on taxable equivalent net interest income and net interest margin.2011.

Noninterest income was $19.5$24.8 million for 20102012 compared to $18.8$23.9 million for 2009.2011. Core fee-based revenues (defined as service charges on deposit accounts, ATM and debit fees, and broker-dealer fees and commissions) totaled $15.4 million for 2012, a $580 thousand or 4% increase from $14.9 million for 2010, up $166 thousand from $14.7 million for 2009.in 2011. Net mortgage banking income was $1.8$2.0 million for 2010, compared to $2.02012, an increase of $323 thousand or 19% from $1.7 million in 2009, a decrease of $233 thousand from 2009, primarily attributable to lower secondary mortgage production experienced during 2010 and a decrease in our loan serviced for others portfolio. For additional discussion concerning noninterest income see section, “Noninterest Income.”2011.

Net investment securities lossesgains (defined as net gain on sales and calls of investment securities and impairment charges on investment securities and net gain on disposal of investment securities) were $425 thousand$2.6 million for 2010,2012 compared to net investment securities losses of $1.2$3.0 million for 2009, primarily attributable to other-than-temporary write-downs on investment securities.2011.

Noninterest expense for 20102012 was $60.9$71.4 million, a decreasean increase of $1.9$7.6 million or 3%12% over 2009. FDIC assessments decreased $1.1 million, salaries and employee benefits decreased $823 thousand, and collectively all remaining noninterest expense categories were up $107 thousand or less than half a percent compared to 2009. Other2011. As previously mentioned, noninterest expense for 20102012 includes $1.0pre-tax expenses of approximately $3.0 million related to the branch acquisitions and $2.6 million incurred in association with the retirement of losses relatingour former CEO. Noninterest expense for 2011 includes a loss on extinguishment of debt of $1.1 million, recognized as a result of redeeming our 10.20% junior subordinated debentures. Excluding these expenses, which we consider to irregular instance of fraudulent debit card activity. The efficiency ratio (as defined under Part II, Item 6, “Selected Financial Data”) was 60.36% for 2010 and 65.52% for 2009. For additional discussion regardingbe non-recurring in nature, noninterest expense see section, “Noninterest Expense.”
Income tax expense for 2010 was $9.4increased $3.1 million comparedor 5% when comparing 2012 to $6.1 million for 2009. The change in income tax expense was primarily due to a $10.1 million increase in pretax income between the years. For additional discussion concerning income tax see section, “Income Taxes.”2011.

 

- 3233 -


MANAGEMENT’S DISCUSSION AND ANALYSIS

RESULTS OF OPERATIONS FOR THE YEARS ENDED

DECEMBER 31, 20102012 AND DECEMBER 31, 20092011

Net Interest Income and Net Interest Margin

Net interest income is the primary source of our revenue. Net interest income is the difference between interest income on interest-earning assets, such as loans and investment securities, and the interest expense on interest-bearing deposits and other borrowings used to fund interest-earning and other assets or activities. Net interest income is affected by changes in interest rates and by the amount and composition of earning assets and interest-bearing liabilities, as well as the sensitivity of the balance sheet to changes in interest rates, including characteristics such as the fixed or variable nature of the financial instruments, contractual maturities and repricing frequencies.

Interest rate spread and net interest margin are utilized to measure and explain changes in net interest income. Interest rate spread is the difference between the yield on earning assets and the rate paid for interest-bearing liabilities that fund those assets. The net interest margin is expressed as the percentage of net interest income to average earning assets. The net interest margin exceeds the interest rate spread because noninterest-bearing sources of funds (“net free funds”), principally noninterest-bearing demand deposits and stockholders’ equity, also support earning assets. To compare tax-exempt asset yields to taxable yields, the yield on tax-exempt investment securities is computed on a taxable equivalent basis. Net interest income, interest rate spread, and net interest margin are discussed on a taxable equivalent basis.

The following table reconciles interest income per the consolidated statements of operationsincome to interest income adjusted to a fully taxable equivalent basis for the years ended December 31 (in thousands):

             
  2010  2009  2008 
Interest income per consolidated statements of operations $96,509  $94,482  $98,948 
Adjustment to fully taxable equivalent basis  1,895   2,692   4,292 
          
Interest income adjusted to a fully taxable equivalent basis  98,404   97,174   103,240 
Interest expense per consolidated statement of operations  17,720   22,217   33,617 
          
Net interest income on a taxable equivalent basis $80,684  $74,957  $69,623 
          

   2012   2011   2010 

Interest income per consolidated statements of income

  $97,567    $95,118    $96,509  

Adjustment to fully taxable equivalent basis

   2,284     2,062     1,895  
  

 

 

   

 

 

   

 

 

 

Interest income adjusted to a fully taxable equivalent basis

   99,851     97,180     98,404  

Interest expense per consolidated statement of income

   9,051     13,255     17,720  
  

 

 

   

 

 

   

 

 

 

Net interest income on a taxable equivalent basis

  $90,800    $83,925    $80,684  
  

 

 

   

 

 

   

 

 

 

Taxable equivalent net interest income of $80.7$90.8 million for 20102012 was $5.7$6.9 million or 8% higher than 2009. While the2011. The impact of a decline in average yields on our loans and assets declined, the impact was far exceededdiminished by the benefit of substantial loan production and asset growth.a $217.4 million or 10% increase in interest-earning assets. The average balance of loans rose $85.4$199.6 million or 14% to $1.295$1.593 billion, reflecting growth in the commercial and consumer indirectevery loan portfolios, ascategory. Consistent with our strategic plan, we have focused business development efforts in those areas, and the average balance of interest-earning assets rose $124.3 million to $1.981 billion, both increases of 7%. We will continue to pursue loan development efforts in the commercial and consumer indirect lending portfolios in accordance with our prudent underwriting standards.

The increase in taxable equivalent net interest income was a function of a favorable volume variance (asas balance sheet changes in both volume and mix increased taxable equivalent net interest income by $6.3 million),$11.7 million, partially offset by an unfavorable rate variance (decreasingthat decreased taxable equivalent net interest income by $573 thousand).$4.8 million. The change in mix and volume of earning assets increased taxable equivalent interest income by $6.8$11.2 million, while the change in volume and composition of interest-bearing liabilities increaseddecreased interest expense by $499$474 thousand, for a net favorable volume impact of $6.3$11.7 million on taxable equivalent net interest income. Rate changes on earning assets reduced interest income by $5.6$8.5 million, while changes in rates on interest-bearing liabilities lowered interest expense by $5.0$3.7 million, for a net unfavorable rate impact of $573 thousand.

$4.8 million.

The net interest margin for 20102012 was 4.07%3.95% compared to 4.04% in 2009. 2011.

The 3 basis point improvementdecrease in net interest margin was attributable to a 10 basis point increase in interest rate spread (the net of a 36 basis point decrease in the cost of interest-bearing liabilities and a 26 basis decrease in the yield on earning assets), partially offset by a 7 basis point lower contribution from net free funds (primarily attributable to lower rates on interest-bearing liabilities reducing the relative value of noninterest-bearing deposits and other net free funds).

The interest rate spread decreased by 2 basis points to 3.85% for the year ended December 31, 2012, as a 32 basis point decrease in the yield on earning assets more than offset the 30 basis point decrease in the cost of interest-bearing liabilities.

The Federal Reserve left the Federal funds rate unchanged at 0.25% during 2010 through 2012. During 2011, the Federal Reserve disclosed that short-term interest rates would be held near zero through at least the middle of 2013, in anticipation of low growth and 2009.

little risk of inflation. In April 2012, the Federal Reserve further announced that interest rates will likely remain at exceptionally low levels through late 2014. As a result of the Federal Reserve’s policy, we expect net interest margin and interest rate spread to continue to tighten.

- 34 -


MANAGEMENT’S DISCUSSION AND ANALYSIS

For 2010,2012, the yield on average earning assets of 4.97%4.35% was 2632 basis points lower than 2009.2011. Loan yields decreased 1544 basis points to 5.86%5.09%. Commercial mortgage and consumer indirect loans in particular, down 2628 and 3484 basis points, respectively, experiencedcontinued to experience lower yields given the competitive pricing pressures and re-pricing of loans in a low interest rate environment. The yield on investment securities dropped 6927 basis points to 3.31%2.66%, also impacted by the lower interest rate environment, and prepayments of mortgage-related investment securities and the impact of investing the excess cash related to our branch acquisitions into low yielding securities. Overall, earning asset rate changes reduced interest income by $5.6$8.5 million.

The cost of average interest-bearing liabilities of 1.10%0.50% in 20102012 was 3630 basis points lower than 2009.2011. The average cost of interest-bearing deposits was 0.97%0.50% in 2010, 362012, 24 basis points lower than 2009,2011, reflecting the lower rate environment, mitigated by a focus on product pricing to retain balances.sustained low-rate environment. The cost of wholesale funding (comprised of short-term borrowings and long-term borrowings) decreased 14110 basis points to 3.33%0.48% for 2010.2012, primarily a result of the redemption of the Company’s 10.20% junior subordinated debentures during the third quarter of 2011. The interest-bearing liability rate changes resulted in $5.0reduced interest expense by $3.7 million lower interest expense.

during 2012.

- 33 -


MANAGEMENT’S DISCUSSION AND ANALYSIS
Average interest-earning assets of $1.981$2.297 billion in 20102012 were $124.3$217.4 million or 7%10% higher than 2009.2011. Average investment securities increased $71.2$17.9 million mostly in high quality U.S. Government agency securities. Averagewhile average loans increased $85.4$199.6 million or 7%,14%. The growth in average loans was comprised of increases in all loan categories, with a $33.3consumer loans up $130.5 million, increase in commercial loans and a $74.2up $63.4 million increase in consumer loans, offset by a $22.1 million decrease inand residential mortgage loans.
loans up $5.6 million.

Average interest-bearing liabilities of $1.610$1.825 billion in 20102012 were up $85.1$162.9 million or 6%10% versus 2009, mainly attributable to higher average retail deposit balances.2011. The impacts of the recent recession have had a positivecontinue to positively impact on our deposit balances, as consumers tend to save more conservatively when consumer confidence is low. On average, interest-bearing deposits grew $89.0$156.2 million, while average noninterest-bearing demand deposits (a principal component of net free funds) increased by $36.0$62.0 million. Average wholesale funding decreased $3.9borrowings increased $6.7 million, net of the $6.0representing a $22.6 million increase and $9.9$15.9 million decrease in short-term and long-term borrowings, respectively.

The recently enacted Dodd-Frank Act repealed the federal prohibitions on the payment of interest on demand deposits for commercial accounts, thereby permitting depository institutions to pay interest on business transaction and other accounts beginning July 21, 2011. Although the ultimate impact of this legislation on us has not yet been determined, we expect interest costs associated with demand deposits to increase as a result of competitor responses to this change. See Part I, Item 1, Section “Supervision and Regulation” for a detailed discussion of this legislation.

 

- 3435 -


MANAGEMENT’S DISCUSSION AND ANALYSIS

The following tables present, for the periods indicated, information regarding: (i) the average balance sheet; (ii) the amount of interest income from interest-earning assets and the resulting annualized yields (tax-exempt yields have been adjusted to a tax-equivalent basis using the applicable Federal tax rate in each year); (iii) the amount of interest expense on interest-bearing liabilities and the resulting annualized rates; (iv) net interest income; (v) net interest rate spread; (vi) net interest income as a percentage of average interest-earning assets (“net interest margin”); and (vii) the ratio of average interest-earning assets to average interest-bearing liabilities. Investment securities are at amortized cost for both held to maturity and available for sale securities. Loans include net unearned income, net deferred loan fees and costs and non-accruing loans. Dollar amounts are shown in thousands.

                                     
  Years ended December 31, 
  2010  2009  2008 
  Average      Average  Average      Average  Average      Average 
  Balance  Interest  Rate  Balance  Interest  Rate  Balance  Interest  Rate 
Interest-earning assets:
                                    
Federal funds sold and other interest-earning deposits $5,034  $10   0.21% $37,214  $82   0.22% $26,568  $619   2.33%
Investment securities:                                    
Taxable  571,856   17,101   2.99   454,552   16,466   3.62   487,687   21,882   4.49 
Tax-exempt  108,900   5,416   4.97   155,054   7,920   5.11   233,864   13,065   5.59 
                            
Total investment securities  680,756   22,517   3.31   609,606   24,386   4.00   721,551   34,947   4.84 
Loans:                                    
Commercial business  206,167   9,939   4.82   204,235   9,612   4.71   167,760   10,476   6.24 
Commercial mortgage  338,149   20,389   6.03   306,763   19,309   6.29   274,677   18,877   6.87 
Residential mortgage  138,954   8,157   5.87   161,055   9,701   6.02   172,083   10,761   6.25 
Home equity  202,189   9,224   4.56   193,929   9,121   4.70   189,448   11,041   5.83 
Consumer indirect  382,977   25,379   6.63   313,239   21,838   6.97   185,197   13,098   7.07 
Other consumer  26,950   2,789   10.35   30,791   3,125   10.15   34,895   3,421   9.80 
                            
Total loans  1,295,386   75,877   5.86   1,210,012   72,706   6.01   1,024,060   67,674   6.61 
                            
Total interest-earning assets  1,981,176   98,404   4.97   1,856,832   97,174   5.23   1,772,179   103,240   5.83 
                               
Less: Allowance for loan losses  20,883           20,355           16,287         
Other noninterest-earning assets  206,303           197,439           149,453         
                                  
Total assets $2,166,596          $2,033,916          $1,905,345         
                                  
                                     
Interest-bearing liabilities:
                                    
Deposits:                                    
Interest-bearing demand $382,517   705   0.18  $365,873   772   0.21  $347,702   3,246   0.93 
Savings and money market  414,953   1,133   0.27   383,697   1,090   0.28   369,926   3,773   1.02 
Certificates of deposit  726,330   13,015   1.79   685,259   17,228   2.51   617,381   22,330   3.62 
                            
Total interest-bearing deposits  1,523,800   14,853   0.97   1,434,829   19,090   1.33   1,335,009   29,349   2.20 
Short-term borrowings  49,104   365   0.74   43,092   270   0.63   38,028   721   1.90 
Long-term borrowings  37,043   2,502   6.75   46,913   2,857   6.09   53,687   3,547   6.61 
                            
Total borrowings  86,147   2,867   3.33   90,005   3,127   3.47   91,715 �� 4,268   4.65 
                            
Total interest-bearing liabilities  1,609,947   17,720   1.10   1,524,834   22,217   1.46   1,426,724   33,617   2.36 
                               
Noninterest-bearing deposits  329,853           293,852           280,467         
Other liabilities  15,485           20,890           15,249         
Shareholders’ equity  211,311           194,340           182,905         
                                  
Total liabilities and shareholders’ equity $2,166,596          $2,033,916          $1,905,345         
                                  
Net interest income (tax-equivalent)     $80,684          $74,957          $69,623     
                                  
Interest rate spread          3.87%          3.77%          3.47%
                                  
Net earning assets $371,229          $331,998          $345,455         
                                  
Net interest margin (tax-equivalent)          4.07%          4.04%          3.93%
                                  
Ratio of average interest-earning assets to average interest-bearing liabilities  123.06%          121.77%          124.21%        
                                  

  Years ended December 31, 
  2012  2011  2010 
  Average     Average  Average     Average  Average     Average 
  Balance  Interest  Rate  Balance  Interest  Rate  Balance  Interest  Rate 

Interest-earning assets:

         

Federal funds sold and other interest-earning deposits

 $113   $—      0.29 $140   $—      0.20 $5,034   $10    0.21

Investment securities:

         

Taxable

  525,912    12,202    2.32    545,112    14,185    2.60    571,856    17,101    2.99  

Tax-exempt

  177,731    6,526    3.67    140,657    5,890    4.19    108,900    5,416    4.97  
 

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Total investment securities

  703,643    18,728    2.66    685,769    20,075    2.93    680,756    22,517    3.31  

Loans:

         

Commercial business

  242,100    11,263    4.65    215,598    10,311    4.78    206,167    9,939    4.82  

Commercial mortgage

  407,737    22,182    5.44    370,843    21,216    5.72    338,149    20,389    6.03  

Residential mortgage

  127,363    6,637    5.21    121,742    6,868    5.64    138,954    8,157    5.87  

Home equity

  257,537    10,984    4.27    216,428    9,572    4.42    202,189    9,224    4.56  

Consumer indirect

  533,589    27,371    5.13    444,527    26,549    5.97    382,977    25,379    6.63  

Other consumer

  25,058    2,686    10.72    24,686    2,589    10.49    26,950    2,789    10.35  
 

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Total loans

  1,593,384    81,123    5.09    1,393,824    77,105    5.53    1,295,386    75,877    5.86  
 

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Total interest-earning assets

  2,297,140    99,851    4.35    2,079,733    97,180    4.67    1,981,176    98,404    4.97  
  

 

 

  

 

 

   

 

 

  

 

 

   

 

 

  

 

 

 

Less: Allowance for loan losses

  24,305      21,567      20,883    

Other noninterest-earning assets

  246,423      218,983      206,303    
 

 

 

    

 

 

    

 

 

   

Total assets

 $2,519,258     $2,277,149     $2,166,596    
 

 

 

    

 

 

    

 

 

   

Interest-bearing liabilities:

         

Deposits:

         

Interest-bearing demand

 $423,096    598    0.14   $383,122    614    0.16   $382,517    705    0.18  

Savings and money market

  586,329    998    0.17    451,030    1,056    0.23    414,953    1,133    0.27  

Certificates of deposit

  693,353    6,866    0.99    712,411    9,764    1.37    726,330    13,015    1.79  
 

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Total interest-bearing deposits

  1,702,778    8,462    0.50    1,546,563    11,434    0.74    1,523,800    14,853    0.97  

Short-term borrowings

  121,735    589    0.48    99,122    500    0.50    49,104    365    0.74  

Long-term borrowings

  —      —      —      15,905    1,321    8.31    37,043    2,502    6.75  
 

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Total borrowings

  121,735    589    0.48    115,027    1,821    1.58    86,147    2,867    3.33  
 

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Total interest-bearing liabilities

  1,824,513    9,051    0.50    1,661,590    13,255    0.80    1,609,947    17,720    1.10  
  

 

 

  

 

 

   

 

 

  

 

 

   

 

 

  

 

 

 

Noninterest-bearing deposits

  430,240      368,268      329,853    

Other liabilities

  16,506      15,041      15,485    

Shareholders’ equity

  247,999      232,250      211,311    
 

 

 

    

 

 

    

 

 

   

Total liabilities and shareholders’ equity

 $2,519,258     $2,277,149     $2,166,596    
 

 

 

    

 

 

    

 

 

   

Net interest income (tax-equivalent)

  $90,800     $83,925     $80,684   
  

 

 

    

 

 

    

 

 

  

Interest rate spread

    3.85    3.87    3.87
   

 

 

    

 

 

    

 

 

 

Net earning assets

 $472,627     $418,143     $371,229    
 

 

 

    

 

 

    

 

 

   

Net interest margin (tax-equivalent)

    3.95    4.04    4.07
   

 

 

    

 

 

    

 

 

 

Ratio of average interest-earning assets to average interest-bearing liabilities

  125.90    125.17    123.06  
 

 

 

    

 

 

    

 

 

   

 

- 3536 -


MANAGEMENT’S DISCUSSION AND ANALYSIS
Rate /Volume

Rate/Volume Analysis

The following table presents, on a tax equivalenttax-equivalent basis, the relative contribution of changes in volumes and changes in rates to changes in net interest income for the periods indicated. The change in interest not solely due to changes in volume or rate has been allocated in proportion to the absolute dollar amounts of the change in each (in thousands):

                         
  Change from 2010 to 2009  Change from 2009 to 2008 
Increase (decrease) in: Volume  Rate  Total  Volume  Rate  Total 
Interest income:
                        
Federal funds sold and other interest-earning deposits $(65) $(7) $(72) $179  $(716) $(537)
Investment securities:                        
Taxable  3,807   (3,172)  635   (1,412)  (4,004)  (5,416)
Tax-exempt  (2,300)  (204)  (2,504)  (4,102)  (1,043)  (5,145)
                   
Total investment securities  1,507   (3,376)  (1,869)  (5,514)  (5,047)  (10,561)
Loans:                        
Commercial business  92   235   327   2,015   (2,879)  (864)
Commercial mortgage  1,916   (836)  1,080   2,097   (1,665)  432 
Residential mortgage  (1,302)  (242)  (1,544)  (673)  (387)  (1,060)
Home equity  382   (279)  103   256   (2,176)  (1,920)
Consumer indirect  4,665   (1,124)  3,541   8,930   (190)  8,740 
Other consumer  (396)  60   (336)  (414)  118   (296)
                   
Total loans  5,357   (2,186)  3,171   12,211   (7,179)  5,032 
                   
Total interest income
  6,799   (5,569)  1,230   6,876   (12,942)  (6,066)
                   
Interest expense:
                        
Deposits:                        
Interest-bearing demand  34   (101)  (67)  162   (2,636)  (2,474)
Savings and money market  86   (43)  43   135   (2,818)  (2,683)
Certificates of deposit  982   (5,195)  (4,213)  2,257   (7,359)  (5,102)
                   
Total interest-bearing deposits  1,102   (5,339)  (4,237)  2,554   (12,813)  (10,259)
Short-term borrowings  41   54   95   85   (536)  (451)
Long-term borrowings  (644)  289   (355)  (426)  (264)  (690)
                   
Total borrowings  (603)  343   (260)  (341)  (800)  (1,141)
                   
Total interest expense
  499   (4,996)  (4,497)  2,213   (13,613)  (11,400)
                   
 
Net interest income
 $6,300  $(573) $5,727  $4,663  $671  $5,334 
                   

 

   Change from 2012 to 2011  Change from 2011 to 2010 
Increase (decrease) in:  Volume  Rate  Total  Volume  Rate  Total 

Interest income:

       

Federal funds sold and other interest-earning deposits

  $—     $—     $—     $(5 $(5 $(10

Investment securities:

    

Taxable

   (487  (1,496  (1,983  (772  (2,144  (2,916

Tax-exempt

   1,422    (786  636    1,418    (944  474  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Total investment securities

   935    (2,282  (1,347  646    (3,088  (2,442

Loans:

    

Commercial business

   1,239    (287  952    452    (80  372  

Commercial mortgage

   2,041    (1,075  966    1,905    (1,078  827  

Residential mortgage

   308    (539  (231  (980  (309  (1,289

Home equity

   1,763    (351  1,412    636    (288  348  

Consumer indirect

   4,879    (4,057  822    3,829    (2,659  1,170  

Other consumer

   39    58    97    (237  37    (200
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Total loans

   10,269    (6,251  4,018    5,605    (4,377  1,228  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Total interest income

   11,204    (8,533  2,671    6,246    (7,470  (1,224
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Interest expense:

       

Deposits:

       

Interest-bearing demand

   60    (76  (16  1    (92  (91

Savings and money market

   271    (329  (58  93    (170  (77

Certificates of deposit

   (255  (2,643  (2,898  (245  (3,006  (3,251
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Total interest-bearing deposits

   76    (3,048  (2,972  (151  (3,268  (3,419

Short-term borrowings

   110    (21  89    281    (146  135  

Long-term borrowings

   (660  (661  (1,321  (1,662  481    (1,181
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Total borrowings

   (550  (682  (1,232  (1,381  335    (1,046
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Total interest expense

   (474  (3,730  (4,204  (1,532  (2,933  (4,465
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Net interest income

  $11,678   $(4,803 $6,875   $7,778   $(4,537 $3,241  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

- 36 -


MANAGEMENT’S DISCUSSION AND ANALYSIS
Provision for Loan Losses

The provision for loan losses is based upon credit loss experience, growth or contraction of specific segments of the loan portfolio, and the estimate of losses inherent in the current loan portfolio. The provision for loan losses was $6.7$7.1 million for the year ended December 31, 20102012 compared with $7.7$7.8 million for 2009.2011. See the “Allowance for Loan Losses” section of this Management’s Discussion and Analysis for further discussion.

- 37 -


MANAGEMENT’S DISCUSSION AND ANALYSIS

Noninterest Income (Loss)

The following table summarizes our noninterest income (loss) for the years ended December 31 (in thousands):

             
  2010  2009  2008 
Service charges on deposits $9,585  $10,065  $10,497 
ATM and debit card  3,995   3,610   3,313 
Broker-dealer fees and commissions  1,283   1,022   1,458 
Company owned life insurance  1,107   1,096   563 
Loan servicing  1,124   1,308   664 
Net gain on sale of loans held for sale  650   699   339 
Net gain on disposal of investment securities  169   3,429   288 
Impairment charges on investment securities  (594)  (4,666)  (68,215)
Net (loss) gain on sale and disposal of other assets  (203)  180   305 
Other  2,338   2,052   2,010 
          
Total noninterest income (loss) $19,454  $18,795  $(48,778)
          

   2012  2011  2010 

Service charges on deposits

  $8,627   $8,679   $9,585  

ATM and debit card

   4,716    4,359    3,995  

Broker-dealer fees and commissions

   2,104    1,829    1,283  

Company owned life insurance

   1,751    1,424    1,107  

Loan servicing

   617    835    1,124  

Net gain on sale of loans held for sale

   1,421    880    650  

Net gain on disposal of investment securities

   2,651    3,003    169  

Impairment charges on investment securities

   (91  (18  (594

Net (loss) gain on sale and disposal of other assets

   (381  67    (203

Other

   3,362    2,867    2,338  
  

 

 

  

 

 

  

 

 

 

Total noninterest income

  $24,777   $23,925   $19,454  
  

 

 

  

 

 

  

 

 

 

The components of noninterest income fluctuated as discussed below.

Service charges on deposits were $9.6 milliondecreased slightly during 2012 compared to 2011. An increase in 2010, which was $480 thousand or 5% lower than 2009. The decrease was primarily attributable to lower nonsufficient funds fees in 2010, which were down $407 thousand to $7.9 million. In November 2009, the FRB issued a final rule that, effective July 1, 2010, prohibits financial institutions from charging consumers fees for paying overdrafts on automated teller machine and one-time debit card transactions, unless a consumer consents, or opts in, to the overdraft service for those types of transactions, commonly referred to as “Reg.-E”. Consumers must be provided a notice that explains the financial institution’s overdraft services, including the fees associated with the service, and the consumer’s choices. We implemented the provisions of Reg.-E in the third quarter of 2010 and the number of customers that have chosen to opt-in has exceeded our original expectations; howevercustomer accounts, including those added from the extentbranch acquisitions in June and August of the adverse impacts of Reg.-E on our future2012, helped offset decreases in service charge revenue is uncertain.

income related to changes in customer behavior and regulatory changes that included the requirement that customers opt-in for overdraft coverage for certain types of electronic banking activities.

ATM and debit card income was $4.0$4.7 million for 2010,2012, an increase of $385$357 thousand or 11%8%, compared to 2009, due to2011. The increased popularity of electronic banking and transaction processing has resulted in higher interchange fees resulting from an increase in the number of cardholdersATM and an increase in customer transactions.

debit card point-of-sale usage income.

Broker-dealer fees and commissions were up $261$275 thousand or 26%15%, compared to 2009.2011. Broker-dealer fees and commissions fluctuate mainly due to sales volume, which increasedcontinued to increase during 20102012 as a result of improving market and economic conditions.

conditions and our renewed focus on this line of business.

During the third quarter of 2011 we purchased an additional $18.0 million of company owned life insurance. The increased amount of insurance was largely responsible for the $327 thousand increase in company owned life insurance income for 2012.

Loan servicing income represents fees earned for servicing mortgage and indirect auto loans sold to third parties, net of amortization expense and impairment losses, if any, associated with capitalized mortgageloan servicing assets. Loan servicing income decreased $184was down $218 thousand or 26% for the year ended December 31, 20102012 compared to 2009, mainly2011. Loan servicing income decreased as a result of more rapid amortization of servicing rights due to loans paying off, prior to maturity and lower fees collected due to a decrease in the sold and serviced portfolio.

We recognized $425portfolio and write-downs on capitalized mortgage servicing assets.

Net gain on loans held for sale was $1.4 million in 2012, an increase of $541 thousand in net losses onor 61%, compared to 2011, mainly due to increased origination volume related primarily to refinancing activity, a result of low interest rates.

Net gains from the sales of investment securities duringwere $2.7 million for the year ended December 31, 2010 as2012, compared to $1.2$3.0 million for the year ended December 31, 2011. During 2012, we recognized gains totaling $2.6 million from the sale of net losses duringfive pooled trust-preferred securities. Net gains for 2011 included $2.3 million from the same period in 2009.sale of four pooled trust-preferred securities and $730 thousand from the sale of eight mortgage-backed securities. The investment security net losses for 2010 resulted from other-than-temporary impairment chargesamount and timing of $594 thousand, partly offset by $169 thousandour sale of investments securities is dependent on a number of factors, including our prudent efforts to realize gains while managing duration, premium and credit risk.

Due to their proximity to our existing locations, we consolidated four branches as part of the branch acquisitions. The majority of the loss on the disposal of securities. The 2010 OTTI charges primarily relateother assets for 2012 was due to pooled trust preferred securitieswrite-off of leasehold improvements and other fixed assets for these branches that were designated as impairedclosed.

Other noninterest income increased $495 thousand or 17% for the year ended December 31, 2012, compared to 2011. Income from our investment in several limited partnerships and dividends from FHLB stock comprised the first quarter due to credit quality. The $1.2 millionmajority of investment security losses for 2009 are a result of $4.7 million of other-than-temporary impairment charges, partly offset by $3.4 million of gains on the sale of securities.

year-over-year increase.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

Noninterest Expense

The following table summarizes our noninterest expense for the years ended December 31 (in thousands):

             
  2010  2009  2008 
Salaries and employee benefits $32,811  $33,634  $31,437 
Occupancy and equipment  10,818   11,062   10,502 
FDIC assessments  2,507   3,651   674 
Computer and data processing  2,487   2,340   2,433 
Professional services  2,197   2,524   2,141 
Supplies and postage  1,772   1,846   1,800 
Advertising and promotions  1,121   949   1,453 
Other  7,204   6,771   7,021 
          
Total noninterest expense $60,917  $62,777  $57,461 
          

   2012   2011   2010 

Salaries and employee benefits

  $40,127    $35,743    $32,844  

Occupancy and equipment

   11,419     10,868     10,818  

Professional services

   4,133     2,617     2,197  

Computer and data processing

   3,271     2,437     2,487  

Supplies and postage

   2,497     1,778     1,772  

FDIC assessments

   1,300     1,513     2,507  

Advertising and promotions

   929     1,259     1,121  

Loss on extinguishment of debt

   —       1,083     —    

Other

   7,721     6,496     7,171  
  

 

 

   

 

 

   

 

 

 

Total noninterest expense

  $71,397    $63,794    $60,917  
  

 

 

   

 

 

   

 

 

 

The components of noninterest expense fluctuated as discussed below.

Salaries and employee benefits (which includes salary-related expenses and fringe benefit expenses) was $32.8$40.1 million for 2010, down $8232012, up $4.4 million or 12% from 2011. As discussed earlier, salaries and employee benefits for 2012 included pre-tax costs of approximately $2.6 million that were incurred in association with the retirement of our former CEO. After adjusting for these expenses, the increase in salaries and employee benefits for 2012 when compared to the prior year is attributable to higher pension costs along with increased staffing levels. Full time equivalent employees increased by 9% to 628 at December 31, 2012 from 575 at December 31, 2011, primarily due to the branch acquisitions.

Occupancy and equipment increased by $551 thousand or 2%5% when comparing 2012 to 2011. The increase was primarily related to the growth in the branch network related to the branch acquisitions.

Professional services expense of $4.1 million in 2012 increased $1.5 million or 58% from 2009. Average full-time equivalent employees (“FTEs”) were 577 for 2010, down 2% from 586 for 2009. Salary-related2011. Professional fees increased primarily due to legal expenses were relatively unchanged at $25.3related to the branch acquisitions. The management transition described earlier also contributed to the increase in professional fees.

Computer and data processing and supplies and postage expense increased, collectively, by $1.6 million for 2010 and $25.2 million for 2009. Fringe benefitwhen comparing 2012 to 2011. The year-over-year increase was due to expenses decreased $876 thousand or 10%, primarily attributablerelated to lower pension costs.

the branch acquisition transactions.

FDIC assessments comprised mostly of deposit insurance paid to the FDIC, decreased $1.1 million$213 thousand for the year ended December 31, 2010, due2012, compared to 2011, primarily toa result of changes implemented by the one-time specialFDIC in the method of calculating assessment of $923 thousand incurredrates which became effective in the second quarter of 2009. FDIC assessment rates have also declined as2011.

Advertising and promotions costs were $330 thousand or 26% lower in 2012 compared to 2011 due to the timing of marketing campaigns and promotions, coupled with cost management strategies.

We redeemed all of our 10.20% junior subordinated debentures during the third quarter of 2011. As a result of our improved financial ratios, upon which the assessment rate is based

Professional services expenseredemption, we recognized a loss on extinguishment of $2.2debt of $1.1 million, consisting of a redemption premium of $852 thousand and a write-off of the remaining unamortized issuance costs of $231 thousand in 2010 decreased $327 thousand or 13% from 2009, primarily due to lower legal costs associated with loan workouts and other corporate activities.
Advertising and promotions expenses were $172 thousand or 18% higher in 2010 compared to 2009 due to increases in business development expenses.
2011.

Other noninterest expense increased $433 thousand$1.2 million or 6%19% during 20102012 compared to 2009. This increase was2011. The increases in other noninterest expenses were primarily duerelated to a loss of approximately $1.0 million relating to irregular instances of fraudulent debit card activity that we recorded in the fourth quarter of 2010. We have taken actions to limit our exposure to such fraudulent activity and we are reviewing the remedies that may by available. Any recoveries or other remedies received will be separate from the $1.0 million loss recorded in 2010 and will be recorded if and when received.

branch acquisition transactions.

The efficiency ratio for the year ended December 31, 2010 improved to 60.36%2012 was 62.87% compared with 65.52%60.55% for 2009.2011. The higher efficiency ratio is a supplemental financial measure utilized in management’s internal evaluationsattributable to the additional expenses related to the branch acquisitions and is not defined under generally accepted accounting principles.retirement of our former CEO, as previously discussed. The efficiency ratio is calculated by dividing total noninterest expense, excluding other real estate expense and amortization of intangible assets, by net revenue, defined as the sum of tax-equivalent net interest income and noninterest income before net gains and impairment charges on investment securities. Taxes are not part of this calculation. An increase in the efficiency ratio indicates that more resources are being utilized to generate the same volume of income, while a decrease would indicate a more efficient allocation of resources.

Income Taxes

We recognized income tax expense of $9.4$11.3 million for 20102012 compared to $6.1$11.4 million for 2009.2011. The lower tax provision was primarily attributable to a decrease in our effective tax rate to 32.6% for 2012 compared to 33.4% for 2011. The lower effective tax rate in 2012 was a result of the greater impact of tax-exempt income on lower taxable income. Effective tax rates are impacted by items of income and expense that are not subject to federal or state taxation. Our effective tax rates reflect the impact of these items, which include, but are not limited to, interest income from tax-exempt securities and earnings on company owned life insurance.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

RESULTS OF OPERATIONS FOR THE YEARS ENDED

DECEMBER 31, 2011 AND DECEMBER 31, 2010

Net Interest Income and Net Interest Margin

Net interest income in the consolidated statements of income (which excludes the taxable equivalent adjustment) was $81.9 million in 2011, compared to $78.8 million in 2010. The taxable equivalent adjustments (the adjustments to bring tax-exempt interest to a level that would yield the same after-tax income had that income been subject to a taxation using a tax rate of 35%) of $2.1 million and $1.9 million for 2011 and 2010, respectively, resulted in fully taxable equivalent net interest income of $83.9 million in 2011 and $80.7 million in 2010.

Taxable equivalent net interest income of $83.9 million for 2011 was $3.2 million or 4% higher than 2010. The impact of a decline in average yields on our assets was diminished by a 5% increase in interest-earning assets. The average balance of loans rose $98.4 million or 8% to $1.394 billion, reflecting growth in the commercial and consumer indirect loan portfolios, and the average balance of interest-earning assets rose $98.6 million to $2.080 billion.

The increase in taxable equivalent net interest income was a function of a favorable volume variance (as balance sheet changes in both volume and mix increased taxable equivalent net interest income by $7.8 million), partially offset by an unfavorable rate variance (decreasing taxable equivalent net interest income by $4.5 million). The change in mix and volume of earning assets increased taxable equivalent interest income taxby $6.3 million, while the change in volume and composition of interest-bearing liabilities decreased interest expense by $1.5 million, for a net favorable volume impact of $7.8 million on taxable equivalent net interest income. Rate changes on earning assets reduced interest income by $7.4 million, while changes in rates on interest-bearing liabilities lowered interest expense by $2.9 million, for a net unfavorable rate impact of $4.5 million.

The net interest margin for 2011 was 4.04% compared to 4.07% in 2010. The slight decrease in net interest margin was attributable to a 3 basis point lower contribution from net free funds (primarily attributable to lower rates on interest-bearing liabilities reducing the value of noninterest-bearing deposits and other net free funds). The interest rate spread remained unchanged from the year ended December 31, 2010 at 3.87%, as a 30 basis point decrease in the yield on earning assets offset the 30 basis point decrease in the cost of interest-bearing liabilities.

The Federal Reserve left the Federal funds rate unchanged at 0.25% during 2011 and 2010.

For 2011, the yield on average earning assets of 4.67% was 30 basis points lower than 2010. Loan yields decreased 33 basis points to 5.53%. Commercial mortgage and consumer indirect loans in particular, down 31 and 66 basis points, respectively, experienced lower yields given the competitive pricing pressures and re-pricing of loans in a low interest rate environment. The yield on investment securities dropped 38 basis points to 2.93%, also impacted by the lower interest rate environment and prepayments of mortgage-related investment securities. Overall, earning asset rate changes reduced interest income by $7.5 million.

The cost of average interest-bearing liabilities of 0.80% in 2011 was 30 basis points lower than 2010. The average cost of interest-bearing deposits was 0.74% in 2011, 23 basis points lower than 2010, reflecting the low-rate environment, mitigated by a focus on product pricing to retain balances. The cost of borrowings decreased 175 basis points to 1.58% for 2011, primarily a result of the redemption of the 10.20% junior subordinated debentures. The interest-bearing liability rate changes reduced interest expense by $2.9 million.

Average interest-earning assets of $2.080 billion in 2011 were $98.6 million or 5% higher than 2010. Average investment securities increased $5.0 million while average loans increased $98.4 million or 8%. Commercial loans increased $42.1 million and consumer loans increased $73.5 million, offset by a $17.2 million decrease in residential mortgage loans.

Average interest-bearing liabilities of $1.662 billion in 2011 were up $51.6 million or 3% versus 2010. On average, interest-bearing deposits grew $22.8 million, while average noninterest-bearing demand deposits (a principal component of net free funds) increased by $38.4 million. Average borrowings increased $28.9 million, representing a $50.0 million increase and $21.1 million decrease in short-term and long-term borrowings, respectively.

Provision for Loan Losses

The provision for loan losses was $7.8 million for the year ended December 31, 2011 compared with $6.7 million for 2010.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

Noninterest Income

Service charges on deposits were $8.7 million in 2011, which was $906 thousand or 9% lower than 2010. The decrease was primarily due to changes in customer behavior and regulatory changes that included requirements for customers to opt-in for overdraft coverage for certain types of electronic banking activities.

ATM and debit card income was $4.4 million for 2011, an increase of $364 thousand or 9%, compared to 2010. The increased popularity of electronic banking and transaction processing has resulted in higher ATM and debit card point-of-sale usage income.

Broker-dealer fees and commissions were up $546 thousand or 43%, compared to 2010, as a $10.1result of improving market and economic conditions and our renewed focus on this line of business.

Company owned life insurance income was up $317 thousand or 29% for the year ended December 31, 2011 compared to the same period in 2010. The increase was the result of an additional $18.0 million investment in company owned life insurance during the third quarter of 2011.

Loan servicing income was down $289 thousand or 26% for the year ended December 31, 2011 compared to 2010. Loan servicing income decreased as a result of more rapid amortization of servicing rights due to loans paying off, lower fees collected due to a decrease in the sold and serviced portfolio and write-downs on capitalized mortgage servicing assets.

Net gain on loans held for sale was $880 thousand in 2011, an increase of $230 thousand or 35%, compared to 2010, mainly due to the $153 thousand gain relating to the servicing retained sale of $13.0 million of indirect auto loans during the third quarter of 2011.

Net gains from the sales of investment securities were $3.0 million for the year ended December 31, 2011, compared to $169 thousand in 2010. Net gains from the sales of investment securities in 2011 included net gains of $2.3 million from the sale of four pooled trust-preferred securities that had been written down in prior periods and included in non-performing assets. Net gains of $730 thousand from the sale of eight mortgage-backed securities were also recognized during 2011.

Other noninterest income increased $529 thousand or 23% for the year ended December 31, 2011, compared to 2010. Other noninterest income for 2011 includes $152 thousand related to insurance proceeds received for losses relating to an irregular instance of fraudulent debit card activity recorded in the fourth quarter of 2010. Merchant services fees paid by customers for account management and electronic processing of transactions and income from our capital investment in several limited partnerships also contributed to the 2011 increases.

Noninterest Expense

Salaries and employee benefits (which includes salary-related expenses and fringe benefit expenses) was $35.7 million for 2011, up $2.9 million or 9% from 2010. Average full-time equivalent employees (“FTEs”) were 576 for 2011, about the same as 577 for 2010. Salary-related expenses increased $2.0 million for the year ended December 31, 2011, compared to 2010, reflecting an increase in estimated incentive compensation, which was previously limited under the TARP Capital Purchase Program. Fringe benefit expenses increased $672 thousand or 9%, primarily attributable to higher medical expenses.

Professional services expense of $2.6 million in 2011 increased $420 thousand or 19% from 2010, primarily due to legal and shareholder expenses related to our common stock offering and redemption of our Series A preferred stock and 10.20% junior subordinated debentures. We also recognized a loss on extinguishment of debt of $1.1 million in connection with the redemption of the 10.20% junior subordinated debentures during 2011.

FDIC assessments decreased $1.0 million for the year ended December 31, 2011, compared to 2010, primarily a result of changes implemented by the FDIC in the method of calculating assessment rates which became effective in the second quarter of 2011.

Advertising and promotions expenses were $138 thousand or 12% higher in 2011 compared to 2010 due to increases in business development expenses and the opening of a new branch in suburban Rochester in the third quarter of 2011.

Other noninterest expense decreased $404 thousand or 6% during 2011 compared to 2010. The 2010 expense includes a loss of approximately $1.0 million relating to irregular instances of fraudulent debit card activity.

The efficiency ratio for the year ended December 31, 2011 was 60.55% compared with 60.36% for 2010.

Income Taxes

We recognized income tax expense of $11.4 million for 2011 compared to $9.4 million for 2010. The change was due in part to a $3.6 million increase in pretax income between the years. We alsoIn addition, during 2010, we recorded non-recurring tax benefits during 2010 of $1.2 million related to valuation of our deferred tax assets as a result of the NYS repeal of the experience method for determining bad debts and re-valuing at the highest Federal statutory rate of 35%. Our effective tax rates were 33.4% in 2011 and 30.5% in 2010 and 29.8% in 2009. Effective tax rates are affected by income and expense items that are not subject to Federal or state taxation. Our income tax provision reflects the impact of such items, including tax-exempt interest income from municipal securities, tax-exempt earnings on bank-owned life insurance and the effect of certain state tax credits.

2010.

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MANAGEMENT’S DISCUSSION AND ANALYSIS
RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2009 AND DECEMBER 31, 2008
Net Interest Income and Net Interest Margin
Net interest income in the consolidated statements of operations (which excludes the taxable equivalent adjustment) was $72.3 million in 2009 compared to $65.3 million in 2008. The taxable equivalent adjustments (the adjustments to bring tax-exempt interest to a level that would yield the same after-tax income had that income been subject to a taxation using a 34% tax rate) of $2.7 million and $4.3 million for 2009 and 2008, respectively, resulted in fully taxable equivalent net interest income of $75.0 million in 2009 and $69.6 million in 2008.
Taxable equivalent net interest income of $75.0 million for 2009 was $5.3 million or 8% higher than 2008. The increase in taxable equivalent net interest income was a combination of favorable volume variances (as balance sheet changes in both volume and mix increased taxable equivalent net interest income by $4.7 million) and favorable interest rate changes (as the impact of changes in the interest rate environment and product pricing increased taxable equivalent net interest income by $671 thousand). The change in mix and volume of earning assets increased taxable equivalent interest income by $6.9 million, while the change in volume and composition of interest-bearing liabilities decreased interest expense by $2.2 million, for a net favorable volume impact of $4.7 million on taxable equivalent net interest income. Rate changes on earning assets reduced interest income by $12.9 million, while changes in rates on interest-bearing liabilities lowered interest expense by $13.6 million, for a net favorable rate impact of $671 thousand.
The net interest margin for 2009 was 4.04%, compared to 3.93% in 2008. The 11 basis point improvement in net interest margin was attributable to a 30 basis point increase in interest rate spread (the net of a 90 basis point decrease in the cost of interest-bearing liabilities and a 60 basis decrease in the yield on earning assets), partially offset by a 19 basis point lower contribution from net free funds (primarily attributable to lower rates on interest-bearing liabilities reducing the relative value of noninterest-bearing deposits and other net free funds).
For 2009, the yield on average earning assets of 5.23% was 60 basis points lower than 2008. Loan yields also decreased 60 basis points (to 6.01%). Commercial loans in particular, down 97 basis points, experienced lower yields given the repricing of adjustable rate loans and competitive pricing pressures in a low interest rate environment. The yield on securities and short-term investments was down 84 basis points to 4.00%, also impacted by the lower interest rate environment and prepayment speeds of mortgage-related investment securities purchased at a premium. Overall, earning asset rate changes reduced interest income by $12.9 million.
The cost of average interest-bearing liabilities of 1.46% in 2009 was 90 basis points lower than 2008. The average cost of interest-bearing deposits was 1.33% in 2009, 87 basis points lower than 2008, reflecting the lower rate environment, mitigated by a focus on product pricing to retain balances. The cost of wholesale funding (comprised of short-term borrowings and long-term borrowings) decreased 118 basis points to 3.47% for 2009, with short-term borrowings down 127 basis points and long-term borrowings down 52 basis points. The interest-bearing liability rate changes resulted in $13.6 million lower interest expense.
Average interest-earning assets of $1.857 billion in 2009 were $84.7 million or 5% higher than 2008. Average investment securities decreased $111.9 million as a result of mortgage-related investment securities sales and maturities. Average loans increased $186.0 million or 18%, with a $68.6 million increase in commercial loans and a $128.4 million increase in consumer loans, offset by a $11.0 million decrease in residential real-estate loans.
Average interest-bearing liabilities of $1.525 billion in 2009 were up $98.1 million or 7% versus 2008, attributable to higher average deposit balances. On average, interest-bearing deposits grew $99.8 million, while average noninterest-bearing demand deposits (a principal component of net free funds) increased by $13.4 million. Average wholesale funding decreased $1.7 million, the net of $5.1 million increase and $6.8 million decrease in short-term and long-term borrowings, respectively.
Provision for Loan Losses
The provision for loan losses totaled $7.7 million for the year ended December 31, 2009, versus $6.6 million for 2008. The increase in the provision was due to increased net charge-offs and increases in loan portfolio outstandings during 2009. See the “Allowance for Loan Losses” section for further discussion.
Noninterest Income
Service charges on deposits were $10.1 million in 2009, which was $432 thousand or 4% lower than 2008. The decrease was primarily attributable to lower nonsufficient fund fees in 2009, which were down $505 thousand to $8.3 million, offset by an increase in other service charges, which increased by $73 thousand to $1.8 million in 2009.
ATM and debit card income was $3.6 million for 2009, an increase of $297 thousand or 9%, compared to 2008, as the increased popularity of electronic banking and transaction processing has resulted in higher ATM and debit card point-of-sale usage fees.

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MANAGEMENT’S DISCUSSION AND ANALYSIS
Loan servicing income represents fees earned for servicing mortgage loans sold to third parties, net of amortization expense and impairment losses, if any, associated with capitalized mortgage servicing assets. Loan servicing income increased $644 thousand for the year ended December 31, 2009 compared to 2008, mainly from an increase in the sold and serviced residential real estate portfolio and a recovery in the fair value of capitalized mortgage servicing assets.
We invested $20.0 million in company owned life insurance during the third quarter of 2008, resulting in the $533 thousand increase when comparing company owned life insurance income for the year ended December 31, 2009 to 2008.
Broker-dealer fees and commissions were down $436 thousand or 30%, compared to 2008. Broker-dealer fees and commissions fluctuate mainly due to sales volume, which has declined during 2009 as a result of current market and economic conditions.
Net gain on sale of loans held for sale increased $360 thousand compared to the prior year, due primarily to higher gains on sales and related income resulting from increased volumes. Secondary mortgage production was $89.0 million for 2009, compared to $28.5 million for 2008. In addition, the 2008 income includes $104 thousand in net gains from the sale of student loans. We exited the student loan business in 2008.
The $3.4 million net gain on disposal of investment securities for 2009 is comprised of $6.8 million in gross gains, primarily from securities issued by U.S. government sponsored agencies, and $3.4 million in gross losses on sales of privately issued whole loan CMOs and auction rate securities. The $288 thousand net gain on disposal of investment securities for 2008 is comprised of $291 thousand in gross gains and $3 thousand in gross losses.
The $4.7 million of impairment charges on investment securities for 2009 is comprised of valuation write-downs of $2.4 million on pooled trust preferred securities and $2.3 million on privately issued whole loan CMOs. The $68.2 million of impairment charges on investment securities for 2008 is comprised of valuation write-downs of $30.0 million on pooled TPS, $5.9 million on privately issued whole loan CMOs and $32.3 million on auction-rate securities.
Noninterest Expense
Salaries and employee benefits (which includes salary-related expenses and fringe benefit expenses) was $33.6 million for 2009, up $2.2 million or 7% from 2008. Average FTEs were 586 for 2009, down 4% from 610 for 2008. Salary-related expenses were relatively unchanged at $25.2 million for 2009 and $25.1 million for 2008, a result of fewer FTEs offset by higher incentives and commissions. Fringe benefit expenses increased $2.1 million or 34%, primarily from higher pension and post-retirement benefit costs.
Compared to 2008, occupancy and equipment expenses of $11.1 million were up $560 thousand or 5%, primarily a result of additional expenses related to the opening of two new branches at the end of 2008, combined with increased software maintenance costs.
FDIC assessments, comprised mostly of deposit insurance paid to the FDIC, increased $3.0 million for the year ended December 31, 2009. The increases resulted from a combination of an increase in deposit levels subject to insurance premiums, higher FDIC insurance premium rates during 2009 and a $923 thousand special assessment during the second quarter of 2009, coupled with utilization of approximately $451 thousand in carryforward credits that reduced expense during the first nine months of 2008.
Professional services expense of $2.5 million in 2009 increased $383 thousand or 18% from 2008, primarily due to higher legal and other professional consultant costs associated with loan workouts and other corporate activities and projects.
Advertising and promotions expense of $949 thousand and other noninterest expense of $6.8 million, collectively, were down $754 thousand or 9%, reflecting efforts to control selected discretionary expenses.
The efficiency ratio for the year ended December 31, 2009 was 65.52% compared with 64.07% for 2008. The diminished efficiency ratio is reflective of noninterest expense increasing by larger margin than the higher level of net interest income. The efficiency ratio equals noninterest expense less other real estate expense and amortization of intangible assets as a percentage of net revenue, defined as the sum of tax-equivalent net interest income and noninterest income before net gains and impairment charges on investment securities and proceeds from company owned life insurance included in income.
Income Taxes
We recognized income tax expense of $6.1 million for 2009 compared to an income tax benefit of $21.3 million for 2008. The change in income tax was primarily due to us having pre-tax income for 2009 versus a pre-tax loss for 2008. Our effective tax rates were 29.8% in 2009 and (44.9%) in 2008. Effective tax rates are affected by income and expense items that are not subject to Federal or state taxation. Our income tax provision reflects the impact of such items, including tax-exempt interest income from municipal securities, tax-exempt earnings on bank-owned life insurance and the effect of certain state tax credits. The unusual 2008 effective tax benefit rate results from the relationship between the size of the favorable permanent differences and pre-tax loss.

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MANAGEMENT’S DISCUSSION AND ANALYSIS
2010 FOURTH QUARTER RESULTS
Net income was $5.1 million for the fourth quarter of 2010 compared with $5.4 million for the fourth quarter of 2009. After preferred dividends, fourth quarter diluted earnings per share for 2010 was $0.38 compared with $0.42 per share for the fourth quarter of 2009.
Net interest income totaled $20.1 million for the three months ended December 31, 2010, an increase of $853 thousand or 4% over the fourth quarter of 2009. The increase in net interest income compared to the fourth quarter of 2009 resulted primarily from lower funding costs, a result of continued re-pricing of our certificates of deposit in the low rate environment. Average earning assets increased $102.2 million or 5% in the fourth quarter of 2010 compared with the fourth quarter last year, with most of the growth in the investment securities portfolio, and the indirect consumer and commercial mortgage loan portfolios. The increase in average indirect consumer loans reflected our continued expansion, including expansion of our dealer network into the Capital District of New York State.
The net interest margin on a tax-equivalent basis was 4.01% in the fourth quarter of 2010, compared with 4.06% in the fourth quarter of 2009. Our yield on earning-assets decreased 29 basis points in the fourth quarter of 2010 compared with the same quarter last year. This was due to the effect of reinvesting cash flows in the low interest rate environment and a substantial portion of earning asset growth being concentrated in lower yielding mortgage-backed securities. The cost of interest-bearing liabilities decreased 27 basis points compared with the fourth quarter of 2009 due to continued downward changes in our interest-bearing deposit rates, a result of the continued re-pricing of certificates of deposit.
Noninterest income totaled $5.3 million for the fourth quarter of 2010, a 2% increase over the fourth quarter of 2009. Noninterest expense was $16.4 million for the fourth quarter of 2010, an increase of $1.3 million or 8% from the fourth quarter of 2009. This increase was primarily due to a loss of approximately $1.0 million relating to irregular instances of fraudulent debit card activity that we recorded in the fourth quarter of 2010.
Total assets at December 31, 2010 were $2.214 billion, down $35.2 million from $2.250 billion at September 30, 2010. Total gross loans (includes loans held for sale) were $1.349 billion and represented 61% of total assets at December 31, 2010, compared to $1.326 billion and 59% of total assets at September 30, 2010. Total investment securities were $694.5 million at December 31, 2010, down $25.1 million or 3% from September 30, 2010. Total deposits decreased $63.5 million to $1.883 billion at December 31, 2010, compared to $1.946 billion at September 30, 2010, due to seasonal reductions in public deposits. Lower cost demand, savings and money market accounts comprised 60.7% of total deposits at the end of 2010.
Total shareholders’ equity was $212.1 million at December 31, 2010, a $4.0 million decrease from September 30, 2010, due to a $7.5 million decrease in accumulated other comprehensive income, partially offset by a net increase of $3.1 million in our retained earnings. The decrease in accumulated comprehensive income was primarily related to a decrease in unrealized gains on investment securities from $13.0 million to $3.1 million driven by an increase in interest rates. Our tangible common equity as a percent of tangible assets was 5.56% as of December 31, 2010, with a tangible common book value per share of $11.06.
Non-performing assets were $8.9 million or 0.40% of total assets at December 31, 2010, up from $8.5 million at September 30, 2010. The ratio of non-performing loans to total loans was 0.56% at the end of the third and fourth quarters of 2010. The provision for loan losses was $2.0 million for the fourth quarter of 2010, compared to $2.2 million for the third quarter of 2010. Net charge-offs were $1.2 million, or 0.37% annualized, of average loans, down from $4.3 million, or 1.30% annualized, of average loans in the third quarter of 2010. The third quarter of 2010 included a $3.1 million charge-off related to one commercial business loan.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

ANALYSIS OF FINANCIAL CONDITION

OVERVIEW

At December 31, 2010,2012, we had total assets of $2.214$2.764 billion, an increase of 7%18% from $2.062$2.336 billion as of December 31, 2009, primarily a result of2011, largely attributable to the branch acquisitions combined with our continued core business growth in both loans and deposits. Total grossNet loans (includes loans held for sale) were $1.349$1.681 billion as of December 31, 2010,2012, up $84.7$219.5 million, or 7%15%, when compared to $1.264$1.462 billion as of December 31, 2009.2011. The increase in net loans was primarily attributed to the continued expansion of the indirect lending program, in existing and new markets and commercial business development efforts.efforts and loans acquired in the branch acquisition. At December 31, 2012, total loans included $64.5 million in loans obtained in the branch acquisitions. Non-performing assets totaled $8.9$10.1 million as of December 31, 2010, down $1.5 million2012, up $875 thousand from a year ago, due to decreases in both non-performing loans and investment securities for which we have stopped accruing interest.ago. Total deposits amounted to $1.883$2.262 billion and $1.743$1.932 billion as of December 31, 20102012 and 2009,2011, respectively. The impacts of the recent recession have had a positive impact on our deposit balances, as consumers tend to save more conservatively when consumer confidence is low. As of December 31, 2010, total2012, borrowed funds were $103.9totaled $179.8 million, compared to $106.4$150.7 million as of December 31, 2009.2011. Book value per common share was $14.48$17.15 and $13.39$15.92 as of December 31, 20102012 and 2009,2011, respectively. As of December 31, 20102012 our total shareholders’ equity was $212.1$253.9 million compared to $198.3$237.2 million a year earlier.

INVESTING ACTIVITIES

The following table summarizes the composition of the available for sale and held to maturity security portfolios (in thousands).

                         
  Investment Securities Portfolio Composition 
  At December 31, 
  2010  2009  2008 
  Amortized  Fair  Amortized  Fair  Amortized  Fair 
  Cost  Value  Cost  Value  Cost  Value 
Securities available for sale:
                        
U.S. Government agency and government-sponsored enterprise securities $141,591  $140,784  $134,564  $134,105  $67,871  $68,173 
State and political subdivisions  105,622   105,666   80,812   83,659   129,572   131,711 
Mortgage-backed securities:                        
Agency mortgage-backed securities  414,502   417,709   356,044   356,355   297,278   303,105 
Non-Agency mortgage-backed securities  981   1,572   5,087   5,160   42,296   39,447 
Asset-backed securities  564   637   1,295   1,222   3,918   3,918 
Equity securities              923   1,152 
                   
Total available for sale securities  663,260   666,368   577,802   580,501   541,858   547,506 
Securities held to maturity:
                        
State and political subdivisions  28,162   28,849   39,573   40,629   58,532   59,147 
                   
Total investment securities $691,422  $695,217  $617,375  $621,130  $600,390  $606,653 
                   

   Investment Securities Portfolio Composition 
   At December 31, 
   2012   2011   2010 
   Amortized   Fair   Amortized   Fair   Amortized   Fair 
   Cost   Value   Cost   Value   Cost   Value 

Securities available for sale:

            

U.S. Government agency and government-sponsored enterprise securities

  $128,097    $131,695    $94,947    $97,712    $141,591    $140,784  

State and political subdivisions

   188,997     195,210     119,099     124,424     105,622     105,666  

Mortgage-backed securities:

            

Agency mortgage-backed securities

   479,913     494,770     390,375     401,596     414,502     417,709  

Non-Agency mortgage-backed securities

   73     1,098     327     2,089     981     1,572  

Asset-backed securities

   121     1,023     297     1,697     564     637  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total available for sale securities

   797,201     823,796     605,045     627,518     663,260     666,368  

Securities held to maturity:

            

State and political subdivisions

   17,905     18,478     23,297     23,964     28,162     28,849  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total investment securities

  $815,106    $842,274    $628,342    $651,482    $691,422    $695,217  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Our investment policy is contained within our overall Asset-Liability Management and Investment Policy. This policy dictates that investment decisions will be made based on the safety of the investment, liquidity requirements, potential returns, cash flow targets, need for collateral and desired risk parameters. In pursuing these objectives, we consider the ability of an investment to provide earnings consistent with factors of quality, maturity, marketability, pledgeable nature and risk diversification. Our Treasurer, guided by ALCO, is responsible for investment portfolio decisions within the established policies.

Impairment Assessment

We review investment securities on an ongoing basis for the presence of OTTI with formal reviews performed quarterly. Declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses or the security is intended to be sold or will be required to be sold. The amount of the impairment related to non-credit related factors is recognized in other comprehensive income. Evaluating whether the impairment of a debt security is other than temporary involves assessing i.) the intent to sell the debt security or ii.) the likelihood of being required to sell the security before the recovery of its amortized cost basis. In determining whether the other-than-temporary impairment includes a credit loss, we use our best estimate of the present value of cash flows expected to be collected from the debt security considering factors such as: a.) the length of time and the extent to which the fair value has been less than the amortized cost basis, b.) adverse conditions specifically related to the security, an industry, or a geographic area, c.) the historical and implied volatility of the fair value of the security, d.) the payment structure of the debt security and the likelihood of the issuer being able to make payments that increase in the future, e.) failure of the issuer of the security to make scheduled interest or principal payments, f.) any changes to the rating of the security by a rating agency, and g.) recoveries or additional declines in fair value subsequent to the balance sheet date.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

As of December 31, 2010,2012, management does not have the intent to sell any of the securities in a loss position and believes that it is not likely that it will not be required to sell any such securities before the anticipated recovery of amortized cost. The unrealized losses are largely due to increases in market interest rates over the yields available at the time the underlying securities were purchased. The fair value is expected to recover as the bonds approach their maturity date, repricing date or if market yields for such investments decline. Management does not believe any of the securities in a loss position are impaired due to reasons of credit quality. Accordingly, as of December 31, 2010,2012, management has concluded that unrealized losses on its investment securities are temporary and no further impairment loss has been realized in our consolidated statements of operations.income. The following discussion provides further details of our assessment of the securities portfolio by investment category.

The table below summarizes unrealized losses in each category of the securities portfolio at the end of the periods indicated (in thousands).
                         
  Unrealized Losses on Investment Securities 
  At December 31, 
  2010  2009  2008 
  Unrealized  % of  Unrealized  % of  Unrealized  % of 
  Losses  Total  Losses  Total  Losses  Total 
Securities available for sale:
                        
U.S. Government agency and government-sponsored enterprise securities $1,965   31.6% $545   19.8% $307   7.3%
State and political subdivisions  1,472   23.6   3   0.1   42   1.0 
Mortgage-backed securities:                        
Agency mortgage-backed securities  2,655   42.7   1,638   59.3   981   23.1 
Non-Agency mortgage-backed securities        330   12.0   2,854   67.3 
Asset-backed securities  131   2.1   244   8.8       
Equity securities              52   1.2 
                   
Total available for sale securities  6,223   100.0   2,760   100.0   4,236   99.9 
Securities held to maturity:
                        
State and political subdivisions              4   0.1 
                   
Total investment securities $6,223   100.0% $2,760   100.0% $4,240   100.0%
                   

U.S. Government Agencies and Government Sponsored Enterprises (“GSE”).As of December 31, 2010,2012, there were 14six securities in an unrealized loss position in the U.S. Government agencies and GSE portfolio that were in anwith unrealized loss position.losses totaling $69 thousand. Of these, 7three were in an unrealized loss position for 12 months or longer and had an aggregate amortized cost of $8.9$3.0 million and unrealized losses of $54$2 thousand. Because theThe decline in fair value is attributable to changes in interest rates, and not credit quality, and because we do not have the intent to sell these securities and it is likely that we will not be required to sell the securities before their anticipated recovery, we do not consider these securities to be other-than-temporarily impaired at December 31, 2010.

2012.

State and Political Subdivisions.As of December 31, 2010,2012, the state and political subdivisions portfolio (“municipals”) portfolio totaled $133.9$213.1 million, of which $105.7$195.2 million was classified as available for sale. As of that date, $28.2$17.9 million was classified as held to maturity with a fair value of $28.8$18.5 million. As of December 31, 2010,2012, there were 9536 municipals in an unrealized loss position, all of which were available for sale. Thesesale and in an unrealized loss position for less than 12 months. Those 36 securities had an aggregate amortized cost of $39.9$8.5 million and unrealized losses of $1.5 million. There were no municipals in an unrealized loss position for 12 months or longer as of December 31, 2010. totaling $72 thousand.

Because the decline in fair value is attributable to changes in interest rates, and not credit quality, and because we do not have the intent to sell these securities and it is not likely that we will not be required to sell the securities before their anticipated recovery, we do not consider these securities to be other-than-temporarily impaired at December 31, 2010.

2012.

Agency Mortgage-backed Securities.With the exception of the non-Agency mortgage-backed securities (“non-Agency MBS”) discussed below, all of the mortgage-backed securities held by us as of December 31, 2010,2012, were issued by U.S. Government sponsored entities and agencies (“Agency MBS”), primarily GNMA.FNMA. The contractual cash flows of our Agency MBS are guaranteed by FNMA, FHLMC or GNMA. The GNMA mortgage-backed securities are backed by the full faith and credit of the U.S. Government.

As of December 31, 2010,2012, there were 36ten securities in the U.S. Government agencies and GSEAgency MBS portfolio that were in an unrealized loss position. Of these, only 4three were in an unrealized loss position for 12 months or longer and had an aggregate amortized cost of $2.3$1.2 million and unrealized losses of $11$2 thousand. Given the high credit quality inherent in Agency MBS, we do not consider any of the unrealized losses as of December 31, 2010,2012 on such MBS to be credit related or other-than-temporary. As of December 31, 2010,2012, we did not intend to sell any of Agency MBS that were in an unrealized loss position, all of which were performing in accordance with their terms.

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MANAGEMENT’S DISCUSSION AND ANALYSIS
Non-Agency Mortgage-backed Securities.Our non-Agency MBS portfolio consists of positions in threetwo privately issued whole loan collateralized mortgage obligations with a fair value of $1.6$1.1 million and net unrealized gains of $591 thousand$1.0 million as of December 31, 2010.2012. As of that date, each of the 3two non-Agency MBS were rated below investment grade. None of these securities were in an unrealized loss position. To date, we have recognized aggregate OTTI charges of $6.0 million due to reasons of credit quality against these securities, all of which was recorded prior to 2010.

Asset-backed Securities (“ABS”).As of December 31, 2010,2012, the fair value of theour ABS portfolio totaled $637 thousand$1.0 million and consisted of positions in 15six securities, the majority of which are pooled trust preferred securities (“TPS”) issued primarily by financial institutionsinsurance companies and, to a lesser extent, insurance companiesfinancial institutions located throughout the United States. As a result of some issuers defaulting and others electing to defer interest payments, we considered the TPS to be non-performing and stopped accruing interest on thethese investments during 2009.

During 2010, we recognized OTTI charges totaling $594 thousand against 5 ABSs. Since the second quarter of 2008, we have written down each of the securities in the ABS portfolio, resulting in aggregate OTTI charges of $32.9 million through December 31, 2010. We expect to recover the remaining amortized cost of $564 thousand on the securities. As of December 31, 2010,2012, each of the securities in the ABS portfolio was rated below investment grade. There were 8 ABS in a loss position with an aggregate amortized costNone of $338 thousand and unrealized losses totaling $131 thousand as of December 31, 2010. Of these 6securities were in an unrealized loss position for 12 months or longer andposition.

During 2012, we recognized gains totaling $2.6 million from the sale of five TPS. The five securities had an aggregate amortized costa fair value of $166 thousand and unrealized losses of $70 thousand. We determined$1.1 million at December 31, 2010 that2011. We continue to monitor the unrealized losses inmarket for these securities and evaluate the ABS portfolio are temporary.

potential for future dispositions.

Other Investments.As a member of the FHLB the Bank is required to hold FHLB stock. The amount of required FHLB stock is based on the Bank’s asset size and the amount of borrowings from the FHLB. We have assessed the ultimate recoverability of our FHLB stock and believe that no impairment currently exists. Our ownership of FHLB stock, which totaled $2.5 million at December 31, 2010, is included in other assets and recorded at cost.

As a member of the FRB system, we are required to maintain a specified investment in FRB stock based on a ratio relative to our capital. At December 31, 2012, our ownership of FHLB and FRB stock totaled $8.4 million and $3.9 million, at December 31, 2010,respectively and is included in other assets and recorded at cost.
cost, which approximates fair value.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

LENDING ACTIVITIES

Total loans were $1.346$1.706 billion at December 31, 2010,2012, an increase $82.0of $220.9 million or 6%15% from December 31, 2009.2011. Commercial loans increased $26.9$44.9 million or 5%7% and represented 41.9%39.4% of total loans at the end of 2010, compared to 42.5% at December 31, 2009.2012. Residential mortgage loans were $129.6$133.5 million, down $14.6up $19.6 million or 10%17% and represented 9.6% of total loans compared to 11.4% at December 31, 2009, while consumer loans increased $69.8 million to represent 48.5%7.8% of total loans at December 31, 2010 and 46.1%2012, while consumer loans increased $156.4 million to represent 52.8% of total loans at December 31, 2009.2012 compared to 50.1% at December 31, 2011. The composition of our loan portfolio, excluding loans held for sale and including net unearned income and net deferred fees and costs, is summarized as follows (in thousands):

                                         
  Loan Portfolio Composition 
  At December 31, 
  2010  2009  2008  2007  2006 
  Amount  Percent  Amount  Percent  Amount  Percent  Amount  Percent  Amount  Percent 
Commercial business $211,031   15.7% $206,383   16.3% $180,100   16.1% $157,550   16.3% $130,695   14.1%
Commercial mortgage  352,930   26.2   330,748   26.2   285,383   25.5   272,394   28.3   275,884   29.8 
                               
Total commercial  563,961   41.9   537,131   42.5   465,483   41.6   429,944   44.6   406,579   43.9 
                                         
Residential mortgage  129,580   9.6   144,215   11.4   177,683   15.8   166,863   17.3   163,244   17.6 
                                         
Home equity  208,327   15.5   200,684   15.9   189,794   16.9   194,144   20.1   203,426   22.0 
Consumer indirect  418,016   31.1   352,611   27.9   255,054   22.8   134,977   14.0   106,445   11.5 
Other consumer  26,106   1.9   29,365   2.3   33,065   2.9   38,245   4.0   46,788   5.0 
                               
Total consumer  652,449   48.5   582,660   46.1   477,913   42.6   367,366   38.1   356,659   38.5 
                               
Total loans  1,345,990   100.0%  1,264,006   100.0%  1,121,079   100.0%  964,173   100.0%  926,482   100.0%
Allowance for loan losses  20,466       20,741       18,749       15,521       17,048     
                                    
Total loans, net $1,325,524      $1,243,265      $1,102,330      $948,652      $909,434     
                                    

  Loan Portfolio Composition 
  At December 31, 
  2012  2011  2010  2009  2008 
  Amount  Percent  Amount  Percent  Amount  Percent  Amount  Percent  Amount  Percent 

Commercial business

 $258,675    15.2 $233,836    15.7 $211,031    15.7 $206,383    16.3 $180,100    16.1

Commercial mortgage

  413,324    24.2    393,244    26.5    352,930    26.2    330,748    26.2    285,383    25.5  
 

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Total commercial

  671,999    39.4    627,080    42.2    563,961    41.9    537,131    42.5    465,483    41.6  

Residential mortgage

  133,520    7.8    113,911    7.7    129,580    9.6    144,215    11.4    177,683    15.8  

Home equity

  286,649    16.8    231,766    15.6    208,327    15.5    200,684    15.9    189,794    16.9  

Consumer indirect

  586,794    34.4    487,713    32.9    418,016    31.1    352,611    27.9    255,054    22.8  

Other consumer

  26,764    1.6    24,306    1.6    26,106    1.9    29,365    2.3    33,065    2.9  
 

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Total consumer

  900,207    52.8    743,785    50.1    652,449    48.5    582,660    46.1    477,913    42.6  
 

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Total loans

  1,705,726    100.0  1,484,776    100.0  1,345,990    100.0  1,264,006    100.0  1,121,079    100.0

Allowance for loan losses

  24,714     23,260     20,466     20,741     18,749   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

  

Total loans, net

 $1,681,012    $1,461,516    $1,325,524    $1,243,265    $1,102,330   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

  

As of December 31, 2012, the residential mortgage portfolio consisted of $28.2 million of loans acquired with the branch acquisitions and $105.3 million of organic loans. The decrease in organic residential mortgage loans from $177.7$129.6 million to $144.2$113.9 million to $129.6$105.3 million for the periods ending December 31, 2008, 20092010, 2011 and 2010,2012, respectively, and the increase in consumer indirect loans from $255.1$418.0 million to $352.6$487.7 million to $418.0$586.8 million for the same periods reflects a strategic shift to increase our consumer indirect loan portfolio, while placing less emphasis on expanding our residential mortgage loan portfolio, coupled with our practice of selling the majority of our fixed-rate residential mortgages in the secondary market with servicing rights retained.

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MANAGEMENT’S DISCUSSION AND ANALYSIS
Commercial loans are generally viewed as having more inherent risk of default than residential mortgage or consumer loans. Also, the commercial loan balance per borrower is typically larger than that for residential mortgage and consumer loans, inferring higher potential losses on an individual customer basis. Commercial loans increased during 20102012 as we continued our commercial business development efforts. The credit risk related to commercial loans is largely influenced by general economic conditions and the resulting impact on a borrower’s operations or on the value of underlying collateral, if any.

The Company participates in various lending programs in which guarantees are supplied by U.S. government agencies, such as the SBA, U.S. Department of Agriculture, Rural Economic and Community Development and Farm Service Agency, among others. As of December 31, 2012, the principal balance of such loans (included in commercial loans) was $62.5 million and the guaranteed portion amounted to $43.1 million. Most of these loans were guaranteed by the SBA.

Commercial business loans were $211.0$258.7 million at the end of 2010,2012, up $4.6$24.8 million or 2%11% since year-end 2009,2011, and comprised 15.7%15.2% of total loans outstanding at December 31, 2010 compared to 16.3% at December 31, 2009.2012. We typically originate business loans of up to $15.0 million for small to mid-sized businesses in our market area for working capital, equipment financing, inventory financing, accounts receivable financing, or other general business purposes. Loans of this type are in a diverse range of industries. Within the commercial business classification, loans to finance agricultural production totaled approximately 1% of totalcommercial business loans as of December 31, 2010.

2012. As of December 31, 2012, commercial business SBA loans accounted for a total of $38.9 million or 15% of our commercial business loan portfolio.

Commercial mortgage loans totaled $352.9$413.3 million at December 31, 2010,2012, up $22.2$20.1 million or 7%5% from December 31, 2009,2011, and comprised 26.2%24.2% of total loans, unchanged from year-end 2009.compared to 26.5% at December 31, 2011. Commercial mortgage includes both owner occupied and non-owner occupied commercial real estate loans. Approximately 51%46% and 45% of the commercial mortgage portfolio at December 31, 20102012 and 2011, respectively, was owner occupied commercial real estate. The majority of our commercial real estate loans are secured by office buildings, manufacturing facilities, distribution/warehouse facilities, and retail centers, which are generally located in our local market area.

As of December 31, 2012, commercial mortgage SBA loans accounted for a total of $18.1 million or 4% of our commercial mortgage loan portfolio.

Our current lending standards for commercial real estate and real estate construction lending are determined by property type and specifically address many criteria, including: maximum loan amounts, maximum loan-to-value (“LTV”), requirements for pre-leasing and / or pre-sales, minimum debt-service coverage ratios, minimum borrower equity, and maximum loan to cost. Currently, the maximum standard for LTV is 80%85%, with lower limits established for certain higher risk types, such as raw land which has a 65% LTV maximum. Our LTV guidelines are in compliance with regulatory supervisory limits.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

Residential mortgage loans totaled $129.6$133.5 million at the end of 2010, down $14.62012, up $19.6 million or 10%17% from the prior year and comprised 9.6%7.8% of total loans outstanding at December 31, 20102012 and 11.4%7.7% at December 31, 2009.2011. Residential mortgage loans include conventional first lien home mortgages and we generally limit the maximum loan to 85% of collateral value without credit enhancement (e.g. PMI insurance). As part of management’s historical practice of originating and servicing residential mortgage loans, the majority of our fixed-rate residential mortgage loans are sold in the secondary market with servicing rights retained.

Our underwriting and risk-based pricing guidelines for consumer-related real estate loans consist of a combination of borrower FICO (credit score) and the LTV of the property securing the loan. Currently, for home equity products, the maximum acceptable LTV is 90%. The average FICO score for new home equity production in 2010 was 759 compared to 763 in 2009. Residential mortgage products continue to be underwritten using FHLMC and FNMA secondary marketing guidelines.

Consumer loans totaled $652.4$900.2 million at December 31, 2010,2012, up $69.8$156.4 million or 12%21% compared to 2009,2011, and represented 48.5%52.8% of the 20102012 year-end loan portfolio versus 46.1%50.1% at year-end 2009.2011. Loans in this classification include indirect consumer, home equity and other consumer installment loans. Credit risk for these types of loans is generally influenced by general economic conditions, the characteristics of individual borrowers, and the nature of the loan collateral. Risks of loss are generally on smaller average balances per loan spread over many borrowers. Once charged off, there is usually less opportunity for recovery on these smaller retail loans. Credit risk is primarily controlled by reviewing the creditworthiness of the borrowers, monitoring payment histories, and taking appropriate collateral and guaranty positions.

Consumer indirect loans amounted to $418.0$586.8 million at December 31, 20102012 up $65.4$99.1 million or 19%20% compared to 2009,2011, and represented 31.1%34.4% of the 20102012 year-end loan portfolio versus 27.9%32.9% at year-end 2009.2011. The loans are primarily for the purchase of automobiles (both new and used) and light duty trucks primarily to individuals, but also to corporations and other organizations. The loans are originated through dealerships and assigned to us with terms that typically range from 36 to 84 months. During the year ended December 31, 2010,2012, we originated $204.4$324.6 million in indirect loans with a mix of approximately 33%49% new auto and 67%51% used vehicles. This compares with $199.1$266.7 million in indirect loans with a mix of approximately 32%46% new auto and 68%54% used vehicles for the same period in 2009.2011. The increase in loans for new autos reflects changes in market conditions in 2012. We do business with over 300400 franchised auto dealers primarilylocated in Western, and Central, New York. During 2010, we continued to grow our indirect lending network by establishing relationships with dealerships inand the Capital District of New York. In the latter part of 2010, we began efforts to expand our dealer network intoYork, and Northern Pennsylvania and anticipate indirectly originating loans there in the first half of 2011.

Pennsylvania.

Home equity consists of home equity lines, as well as home equity loans, some of which are first lien positions. Home equities amounted to $208.3$286.6 million at December 31, 20102012 up $7.6$54.9 million or 4%24% compared to 2009,2011, and represented 15.5%16.8% of the 20102012 year-end loan portfolio versus 15.9%15.6% at year-end 2009.2011. The increase included home equities acquired in the branch acquisitions, which totaled $26.8 million at December 31, 2012. The portfolio had a weighted average LTV at origination of approximately 52%54% and 53% at December 31, 2010.2012 and 2011, respectively. Approximately 37%69% of the loans in the home equity portfolio are secondwere first lien positions at December 31, 2010.

2012 and 2011.

Our underwriting guidelines for home equity products includes a combination of borrower FICO (credit score), the LTV of the property securing the loan and evidence of the borrower having sufficient income to repay the loan. Currently, for home equity products, the maximum acceptable LTV is 90%. The average FICO score for new home equity production was 758 in 2012 compared to 755 in 2011.

Other consumer loans totaled $26.1$26.8 million at December 31, 2010, down $3.32012, up $2.5 million or 11%10% compared to 2009,2011, and represented 1.9%1.6% of the 2010 year-end loan portfolio versus 2.3% at year-end 2009.December 31, 2012 and 2011. The increase in other consumer loans is attributed to loans acquired in the branch acquisitions, which totaled $3.4 million at December 31, 2012. Other consumer consists of personal loans (collateralized and uncollateralized) and deposit account collateralized loans.

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MANAGEMENT’S DISCUSSION AND ANALYSIS
Factors that are important to managing overall credit quality are sound loan underwriting and administration, systematic monitoring of existing loans and commitments, effective loan review on an ongoing basis, early identification of potential problems, an appropriate allowance for loan losses, and sound nonaccrual and charge off policies.

An active credit risk management process is used for commercial loans to further ensure that sound and consistent credit decisions are made. Credit risk is controlled by detailed underwriting procedures, comprehensive loan administration, and periodic review of borrowers’ outstanding loans and commitments. Borrower relationships are formally reviewed and graded on an ongoing basis for early identification of potential problems. Further analyses by customer, industry, and geographic location are performed to monitor trends, financial performance, and concentrations.

The loan portfolio is widely diversified by types of borrowers, industry groups, and market areas within our core footprint. Significant loan concentrations are considered to exist for a financial institution when there are amounts loaned to numerous borrowers engaged in similar activities that would cause them to be similarly impacted by economic or other conditions. At December 31, 2010,2012, no significant concentrations, as defined above, existed in the Company’sour portfolio in excess of 10% of total loans.

- 45 -


MANAGEMENT’S DISCUSSION AND ANALYSIS

Loans Held for Sale and MortgageLoan Servicing Rights.Loans held for sale (not included in the loan portfolio composition table) were entirely comprised of residential real estate mortgages and totaled $3.1$1.5 million and $421 thousand$2.4 million as of December 31, 20102012 and 2009, respectively, all of which were residential real estate loans.

2011, respectively.

We sell certain qualifying newly originated andor refinanced residential real estate mortgages on the secondary market. The sold and serviced residentialResidential real estate loan portfolio decreasedmortgages serviced for others, which are not included in the consolidated statements of financial condition, amounted to $328.9$273.3 million and $297.8 million as of December 31, 20102012 and 2011, respectively.

During 2011, we sold $13.0 million of indirect auto loans, which were reclassified from $349.8 millionportfolio to loans held for sale during the second quarter of 2011. The loan servicing asset for the sold and serviced indirect auto loans, included in other assets in the consolidated statements of financial condition, was $250 thousand and $574 thousand as of December 31, 2009. The decrease in the sold2012 and serviced portfolio resulted from a decrease in residential loan origination and refinancing volumes associated with the interest rate environment during 2010 compared to 2009.

2011, respectively.

Allowance for Loan Losses

The following table summarizes the activity in the allowance for loan losses (in thousands).

                     
  Loan Loss Analysis 
  Year Ended December 31, 
  2010  2009  2008  2007  2006 
Allowance for loan losses, beginning of year $20,741  $18,749  $15,521  $17,048  $20,231 
Charge-offs:                    
Commercial business  3,426   2,360   720   618   1,472 
Commercial mortgage  263   355   1,192   439   603 
Residential mortgage  290   225   320   319   278 
Home equity  259   195   110   255   108 
Consumer indirect  4,669   3,637   2,011   988   532 
Other consumer  909   1,058   1,106   1,276   1,206 
                
Total charge-offs  9,816   7,830   5,459   3,895   4,199 
Recoveries:                    
Commercial business  326   428   684   1,140   1,777 
Commercial mortgage  501   150   315   216   161 
Residential mortgage  21   12   26   50   71 
Home equity  36   20   19   12   22 
Consumer indirect  1,485   1,030   548   235   224 
Other consumer  485   480   544   599   603 
                
Total recoveries  2,854   2,120   2,136   2,252   2,858 
                
Net charge-offs  6,962   5,710   3,323   1,643   1,341 
Provision (credit) for loan losses  6,687   7,702   6,551   116   (1,842)
                
Allowance for loan losses, end of year $20,466  $20,741  $18,749  $15,521  $17,048 
                
                     
Net charge-offs to average loans  0.54%  0.47%  0.32%  0.18%  0.14%
Allowance to end of period loans  1.52%  1.64%  1.67%  1.61%  1.84%
Allowance to end of period non-performing loans  270%  239%  229%  192%  108%

   Loan Loss Analysis 
   Year Ended December 31, 
   2012  2011  2010  2009  2008 

Allowance for loan losses, beginning of year

  $23,260   $20,466   $20,741   $18,749   $15,521  

Charge-offs:

      

Commercial business

   729    1,346    3,426    2,360    720  

Commercial mortgage

   745    751    263    355    1,192  

Residential mortgage

   326    152    290    225    320  

Home equity

   305    449    259    195    110  

Consumer indirect

   6,589    4,713    4,669    3,637    2,011  

Other consumer

   874    877    909    1,058    1,106  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Total charge-offs

   9,568    8,288    9,816    7,830    5,459  

Recoveries:

      

Commercial business

   336    401    326    428    684  

Commercial mortgage

   261    245    501    150    315  

Residential mortgage

   130    90    21    12    26  

Home equity

   44    44    36    20    19  

Consumer indirect

   2,769    2,066    1,485    1,030    548  

Other consumer

   354    456    485    480    544  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Total recoveries

   3,894    3,302    2,854    2,120    2,136  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Net charge-offs

   5,674    4,986    6,962    5,710    3,323  

Provision for loan losses

   7,128    7,780    6,687    7,702    6,551  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Allowance for loan losses, end of year

  $24,714   $23,260   $20,466   $20,741   $18,749  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Net charge-offs to average loans

   0.36  0.36  0.54  0.47  0.32

Allowance to end of period loans

   1.45  1.57  1.52  1.64  1.67

Allowance to end of period non-performing loans

   271  329  270  239  229

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

The following table sets forth the allocation of the allowance for loan losses by loan category as of the dates indicated. The allocation is made for analytical purposes and is not necessarily indicative of the categories in which actual losses may occur. The total allowance is available to absorb losses from any segment of the loan portfolio (in thousands).

                                         
  Allowance for Loan Losses by Loan Category 
  At December 31, 
  2010  2009  2008  2007  2006 
      Percentage      Percentage      Percentage      Percentage      Percentage 
  Loan  of loans by  Loan  of loans by  Loan  of loans by  Loan  of loans by  Loan  of loans by 
  Loss  category to  Loss  category to  Loss  category to  Loss  category to  Loss  category to 
  Allowance  total loans  Allowance  total loans  Allowance  total loans  Allowance  total loans  Allowance  total loans 
Commercial business $3,712   15.7% $4,407   16.3% $3,300   16.1% $2,505   16.3% $3,294   14.1%
Commercial mortgage  6,431   26.2   6,638   26.2   4,635   25.5   4,640   28.3   5,494   29.8 
Residential mortgage  1,013   9.6   1,251   11.4   2,516   15.8   1,763   17.3   1,748   17.6 
Home equity  972   15.5   1,043   15.9   2,374   16.9   1,869   20.1   2,082   22.0 
Consumer indirect  7,754   31.1   6,837   27.9   5,152   22.8   2,284   14.0   1,749   11.5 
Other consumer  584   1.9   565   2.3   772   2.9   798   4.0   751   5.0 
Unallocated(1)
                    1,662      1,930    
                               
Total $20,466   100.0% $20,741   100.0% $18,749   100.0% $15,521   100.0% $17,048   100.0%
                               
(1)During 2008 management revised estimation techniques related to allocation of the allowance to specific loan segments. The result was the elimination of the unallocated portion of the allowance for loan losses and allocation of the entire balance to specific loan segments.

  Allowance for Loan Losses by Loan Category 
  At December 31, 
  2012  2011  2010  2009  2008 
     Percentage     Percentage     Percentage     Percentage     Percentage 
  Loan  of loans by  Loan  of loans by  Loan  of loans by  Loan  of loans by  Loan  of loans by 
  Loss  category to  Loss  category to  Loss  category to  Loss  category to  Loss  category to 
  Allowance  total loans  Allowance  total loans  Allowance  total loans  Allowance  total loans  Allowance  total loans 

Commercial business

 $4,884    15.2 $4,036    15.7 $3,712    15.7 $4,407    16.3 $3,300    16.1

Commercial mortgage

  6,581    24.2    6,418    26.5    6,431    26.2    6,638    26.2    4,635    25.5  

Residential mortgage

  740    7.8    858    7.7    1,013    9.6    1,251    11.4    2,516    15.8  

Home equity

  1,282    16.8    1,242    15.6    972    15.5    1,043    15.9    2,374    16.9  

Consumer indirect

  10,715    34.4    10,189    32.9    7,754    31.1    6,837    27.9    5,152    22.8  

Other consumer

  512    1.6    517    1.6    584    1.9    565    2.3    772    2.9  
 

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Total

 $24,714    100.0 $23,260    100.0 $20,466    100.0 $20,741    100.0 $18,749    100.0
 

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Management believes that the allowance for loan losses at December 31, 20102012 is adequate to cover probable losses in the loan portfolio at that date. Factors beyond our control, however, such as general national and local economic conditions, can adversely impact the adequacy of the allowance for loan losses. As a result, no assurance can be given that adverse economic conditions or other circumstances will not result in increased losses in the portfolio or that the allowance for loan losses will be sufficient to meet actual loan losses. See Part I, Item 1A “Risk Factors” for the risks impacting this estimate. Management presents a quarterly review of the adequacy of the allowance for loan losses to our Board of Directors based on the methodology that is described in further detail in Part I, Item I “Business” under the section titled “Lending Activities”. See also “Critical Accounting Estimates” for additional information on the allowance for loan losses.

Non-performing Assets and Potential Problem Loans

The following table sets forth information regarding non-performing assets (in thousands):

                     
  Non-performing Assets 
  At December 31, 
  2010  2009  2008  2007  2006 
Non-accruing loans:                    
Commercial business $947  $650  $510  $839  $4,031 
Commercial mortgage  3,100   2,288   2,670   3,294   7,671 
Residential mortgage  2,102   2,376   3,365   2,987   3,127 
Home equity  875   880   1,143   661   712 
Consumer indirect  514   621   445   278   166 
Other consumer  41   7   56   16   130 
                
Total non-accruing loans  7,579   6,822   8,189   8,075   15,837 
Restructured accruing loans               
Accruing loans contractually past due over 90 days  3   1,859   7   2   3 
                
Total non-performing loans  7,582   8,681   8,196   8,077   15,840 
Foreclosed assets  741   746   1,007   1,421   1,203 
Non-performing investment securities  572   1,015   49       
                
Total non-performing assets $8,895  $10,442  $9,252  $9,498  $17,043 
                
                     
Non-performing loans to total loans  0.56%  0.69%  0.73%  0.84%  1.71%
Non-performing assets to total assets  0.40%  0.51%  0.48%  0.51%  0.89%

   Non-performing Assets 
   At December 31, 
   2012  2011  2010  2009  2008 

Non-accruing loans:

      

Commercial business

  $3,413   $1,259   $947   $650   $510  

Commercial mortgage

   1,799    2,928    3,100    2,288    2,670  

Residential mortgage

   2,040    1,644    2,102    2,376    3,365  

Home equity

   939    682    875    880    1,143  

Consumer indirect

   891    558    514    621    445  

Other consumer

   25    —      41    7    56  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Total non-accruing loans

   9,107    7,071    7,579    6,822    8,189  

Restructured accruing loans

   —      —      —      —      —    

Accruing loans contractually past due over 90 days

   18    5    3    1,859    7  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Total non-performing loans

   9,125    7,076    7,582    8,681    8,196  

Foreclosed assets

   184    475    741    746    1,007  

Non-performing investment securities

   753    1,636    572    1,015    49  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Total non-performing assets

  $10,062   $9,187   $8,895   $10,442   $9,252  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Non-performing loans to total loans

   0.53  0.48  0.56  0.69  0.73

Non-performing assets to total assets

   0.36  0.39  0.40  0.51  0.48

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

Non-performing assets include non-performing loans, foreclosed assets and non-performing investment securities. Non-performing assets at December 31, 20102012 were $8.9$10.1 million, a decreasean increase of $1.5 million$875 thousand from the $10.4$9.2 million balance at December 31, 2009.2011. The primary component of non-performing assets is non-performing loans, which were $7.6$9.1 million or 0.53% of total loans at December 31, 2010, a decrease2012, an increase of $1.1$2.0 million from the $8.7$7.1 million balanceor 0.48% of total loans at December 31, 2009.2011. The decrease in non-performing loans was attributable to a commercial relationship included in accruing loans past due 90 days or more at December 31, 2009 on which we collected substantially all of the $1.9 million balance during the first quarter of 2010, partially offset by a $757 thousand increase in non-accruing loans.

TheCompany’s ratio of non-performing loans to total loans was 0.56% at December 31, 2010, compared to 0.69% at December 31, 2009. This ratio continues to compare favorably to the average of ourits peer group average, which was 3.53%2.48% of total loans at December 31, 2010,September 30, 2012, the most recent period for which information is available (Source: Federal Financial Institutions Examination Council — Bank Holding Company Performance Report as of December 31, 2010September 30, 2012 — Top-tier bank holding companies having consolidated assets between $1 billion and $3 billion).
Non-accruing loans at December 31, 2010 were $7.6 million compared to $6.8 million at December 31, 2009.

Approximately $3.3$4.2 million, or 43%46%, of the $7.6$9.1 million in non-accruingnon-performing loans as of December 31, 20102012 were current with respect to payment of principal and interest, but were classified as non-accruing because repayment in full of principal and/or interest was uncertain. For non-accruing loans outstanding as of December 31, 2010,2012, the amount of interest income forgone totaled $474$555 thousand. Included in nonaccrual loans are troubled debt restructurings (“TDRs”) of $534$636 thousand at December 31, 2010.2012. We had no TDRs whichthat were accruing interest as of December 31, 2010.

2012.

Foreclosed assets consist of real property formerly pledged as collateral to loans, which we have acquired through foreclosure proceedings or acceptance of a deed in lieu of foreclosure. Foreclosed asset holdings represented 135 properties totaling $741$184 thousand at December 31, 20102012 and 148 properties totaling $746$475 thousand at December 31, 2009.

2011.

Non-performing investment securities for which we have stopped accruing interest were $572$753 thousand at December 31, 2010, a decrease of $443 thousand from the $1.02012, compared to $1.6 million balance at December 31, 2009. The decrease2011. Non-performing investment securities are included in non-performing investmentassets at fair value and are comprised of pooled trust preferred securities. There have been no securities reflects net losses, both realizedtransferred to non-performing status since the first quarter of 2009. During 2012, we recognized gains totaling $2.6 million from the sale of five ABS securities. The five securities had a fair value of $1.1 million at December 31, 2011. We continue to monitor the market for these securities and unrealized, in our asset backed securities portfolio.

evaluate the potential for future dispositions.

Potential problem loans are loans that are currently performing, but information known about possible credit problems of the borrowers causes management to have concern as to the ability of such borrowers to comply with the present loan payment terms and may result in disclosure of such loans as nonperforming at some time in the future. These loans remain in a performing status due to a variety of factors, including payment history, the value of collateral supporting the credits, and/or personal or government guarantees. Management considers loans classified as substandard, which continue to accrue interest, to be potential problem loans. We identified $11.5$13.8 million and $18.4$8.6 million in loans that continued to accrue interest which were classified as substandard as of December 31, 20102012 and 2009,2011, respectively.

Included in potential problem loans at December 31, 2012 is one credit relationship which we internally downgraded to substandard status from special mention during the fourth quarter 2012. The relationship consists of commercial business and commercial mortgage loans with unpaid principal balances totaling $3.4 million. The downgrade necessitated a provision and increase in our allowance for losses of approximately $400 thousand. These loans were performing in accordance with their contractual terms as of December 31, 2012, however, we continue to monitor this relationship closely.

In addition, we currently have a large commercial relationship with an Industrial Development Agency project in our market area. The relationship consists of a $14.1 million first lien mortgage position and $3.5 million second lien mortgage on a manufacturing facility. Recent events with the underlying third party tenant of the project has resulted in our monitoring the credit relationship more closely and including the first mortgage loan as “uncriticized—watch” and the second mortgage loan as “special mention” in our loan rating system. The loans are current as of December 31, 2012.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

FUNDING ACTIVITIES

Deposits

The following table summarizes the composition of our deposits (dollars in thousands).

                         
  At December 31, 
  2010  2009  2008 
  Amount  Percent  Amount  Percent  Amount  Percent 
Noninterest-bearing demand $350,877   18.6% $324,303   18.6% $292,586   17.9%
Interest-bearing demand  374,900   19.9   363,698   20.9   344,616   21.1 
Savings and money market  417,359   22.2   368,603   21.1   348,594   21.3 
Certificates of deposit < $100,000  555,840   29.5   512,969   29.5   482,863   29.6 
Certificates of deposit of $100,000 or more  183,914   9.8   173,382   9.9   164,604   10.1 
                   
Total deposits $1,882,890   100.0% $1,742,955   100.0% $1,633,263   100.0%
                   

   At December 31, 
   2012  2011  2010 
   Amount   Percent  Amount   Percent  Amount   Percent 

Noninterest-bearing demand

  $501,514     22.2 $393,421     20.3 $350,877     18.6

Interest-bearing demand

   449,744     19.9    362,555     18.8    374,900     19.9  

Savings and money market

   655,598     28.9    474,947     24.6    417,359     22.2  

Certificates of deposit < $100,000

   432,506     19.2    486,496     25.2    555,840     29.5  

Certificates of deposit of $100,000 or more

   222,432     9.8    214,180     11.1    183,914     9.8  
  

 

 

   

 

 

  

 

 

   

 

 

  

 

 

   

 

 

 

Total deposits

  $2,261,794     100.0 $1,931,599     100.0 $1,882,890     100.0
  

 

 

   

 

 

  

 

 

   

 

 

  

 

 

   

 

 

 

We offer a variety of deposit products designed to attract and retain customers, with the primary focus on building and expanding long-term relationships. At December 31, 2010,2012, total deposits were $1.883$2.262 billion, representing an increase of $139.9$330.2 million for the year. The increase is largely attributable to $286.8 million in nonpublic (retail) deposits assumed from the branch acquisitions. Certificates of deposit were approximately 39%29% and 36% of total deposits at both December 31, 20102012 and 2009.

2011, respectively. Depositors remain hesitant to invest in certificates of deposit for long periods due to the low interest rate environment. This has resulted in lower amounts being placed in time deposits for generally shorter terms.

Nonpublic deposits, the largest component of our funding sources, represented 80% of total deposits and totaled $1.501$1.789 billion and $1.387$1.541 billion as of December 31, 20102012 and 2009,2011, respectively. We have managed this segment of funding through a strategy of competitive pricing that minimizes the number of customer relationships that have only a single service high cost deposit account. Nonpublic deposit levels continue to be positively impacted by the 2008 de novo branch expansion as our Henrietta and Greece branches have grown to $51.0 million and $34.6 million in deposits, respectively as of December 31, 2010.

We had no traditional brokered deposits at December 31, 2012 or 2011, however, we do participate in the Certificate of Deposit Account Registry Service (“CDARS”) and Insured Cash Sweep (“ICS”) programs, which enables depositors to receive FDIC insurance coverage for deposits otherwise exceeding the maximum insurable amount. Through these programs, deposits in excess of the maximum insurable amount are placed with multiple participating financial institutions. Reciprocal CDARS deposits totaled $61.0 million and $46.5 million at December 31, 2012 and 2011, respectively. ICS deposits totaled $18.1 million at December 31, 2012. There were non ICS deposits outstanding at December 31, 2010 or 2009.

2011.

- 48 -


MANAGEMENT’S DISCUSSION AND ANALYSIS
As an additional source of funding, we offer a variety of public (municipal) deposit products to the many towns, villages, counties and school districts within our market. Public deposits generally range from 20% to 25% of our total deposits. There is a high degree of seasonality in this component of funding, asbecause the level of deposits varies with the seasonal cash flows for these public customers. We maintain the necessary levels of short-term liquid assets to accommodate the seasonality associated with public deposits. AsTotal public deposits were $454.2 million and $390.2 million, as of December 31, 2010, total public deposits were $382.2 million or 20% of total deposits, compared to $355.9 million or2012 and 2011, respectively, and represented 20% of total deposits as of December 31, 2009.the end of each period. In general, the number of public relationships remained stable in comparison to the prior year.
Short-term

Borrowings

Short-term

There were no long-term borrowings fromoutstanding as of December 31, 2012 and 2011. Outstanding short-term borrowings are summarized as follows as of December 31 (in thousands):

   2012   2011 

Short-term borrowings:

    

Federal funds purchased

  $—      $11,597  

Repurchase agreements

   40,806     36,301  

Short-term FHLB borrowings

   139,000     102,800  
  

 

 

   

 

 

 

Total short-term borrowings

  $179,806    $150,698  
  

 

 

   

 

 

 

We classify borrowings as short-term or long-term in accordance with the original terms of the agreement.

We have credit capacity with the FHLB are used to satisfy funding requirements resulting from daily fluctuationsand can borrow through facilities that include amortizing and term advances or repurchase agreements. We had approximately $5 million of immediate credit capacity with FHLB as of December 31, 2012. We had approximately $452 million in deposit, loansecured borrowing capacity at the Federal Reserve Bank (“FRB”) Discount Window, none of which was outstanding at December 31, 2012. The FHLB and investment activities. FHLB borrowingsFRB credit capacity are collateralized by certainsecurities from our investment securities, FHLB stock owned by usportfolio and certain qualifying loans. AtWe had approximately $120 million of credit available under unsecured federal funds purchased lines with various banks as of December 31, 2010, short-term borrowings consisted2012. Additionally, we had approximately $150 million of unencumbered liquid securities available for pledging.

- 49 -


MANAGEMENT’S DISCUSSION AND ANALYSIS

Federal funds purchased are short-term borrowings that typically mature within one to ninety days. Short-term repurchase agreements are secured overnight borrowings with customers. Short-term FHLB borrowings have original maturities of $38.2 millionless than one year and $38.9 million ofinclude overnight repurchase agreements. Atborrowings which the Company typically utilizes to address short term funding needs as they arise. Short-term FHLB borrowings at December 31, 2009, short-term borrowings2012 consisted of Federal funds purchased$99.0 million in overnight borrowings and $40.0 million in short-term advances. Short-term FHLB borrowings at December 31, 2011 consisted of $9.4$65.0 million $35.1in overnight borrowings and $37.8 million of overnight repurchase agreements and a $15.0 million advance from the Federal Reserve’s Term Auction Facility.

in short-term advances.

The following table summarizes information relating to our short-term borrowings (dollars in thousands).

             
  At or for the Year Ended December 31, 
  2010  2009  2008 
Year-end balance $77,110  $59,543  $23,465 
Year-end weighted average interest rate  0.21%  0.59%  0.48%
Maximum outstanding at any month-end $77,110  $85,912  $56,861 
Average balance during the year $49,104  $43,092  $38,028 
Average interest rate for the year  0.74%  0.63%  1.90%
Long-term Borrowings
Long-term

   At or for the Year Ended December 31, 
   2012  2011  2010 

Year-end balance

  $179,806   $150,698   $77,110  

Year-end weighted average interest rate

   0.54  0.39  0.21

Maximum outstanding at any month-end

  $229,598   $188,355   $77,110  

Average balance during the year

  $121,735   $99,122   $49,104  

Average interest rate for the year

   0.48  0.50  0.74

There were no long-term borrowings totaled $26.8outstanding at December 31, 2012 and 2011. In August 2011, the Company redeemed all of the 10.20% junior subordinated debentures at a redemption price equaling 105.1% of the principal amount redeemed, plus all accrued and unpaid interest. As a result of the redemption, the Company recognized a loss on extinguishment of debt of $1.1 million, consisting of the redemption premium of $852 thousand and the write-off of the remaining unamortized issuance costs of $231 thousand.

Shareholders’ Equity

Total shareholders’ equity was $253.9 million at December 31, 2010 and consisted2012, an increase of $10.0 million in FHLB repurchase agreements, $65 thousand of FHLB amortizing advances and $16.7 million in junior subordinated debentures. At December 31, 2009, long-term borrowings totaled $46.8 million and consisted of $30.0 million in FHLB repurchase agreements, $145 thousand of FHLB amortizing advances and $16.7 million in junior subordinated debentures.

In February 2001, we established FISI Statutory Trust I (the “Trust”), which issued 16,200 fixed rate pooled trust preferred securities with a liquidation preference of $1,000 per security. The trust preferred securities represent an interest in our related junior subordinated debentures, which were purchased by the Trust and have substantially the same payment terms as these trust preferred securities. The subordinated debentures mature in 2031 and are the only assets of the Trust and interest payments from the debentures finance the distributions paid on the trust preferred securities. Distributions on the debentures are payable quarterly at a fixed interest rate equal to 10.20%. We incurred $487 thousand in costs related to the issuance that are being amortized over 20 years using the straight-line method. The Trust is accounted for as an unconsolidated subsidiary.
Shareholders’ Equity
Shareholders’ equity increased by $13.9 million in 2010 to $212.1$237.2 million at December 31, 2010, primarily due to net2011. Net income of $21.3for the year increased shareholders’ equity by $23.4 million, which was partially offset by common and preferred stock dividends declared of $8.1$9.3 million. Accumulated other comprehensive income included in shareholders’ equity increased $2.3 million during the year due primarily to higher net unrealized gains on securities available for sale. For detailed information on shareholders’ equity, see Note 11,12, Shareholders’ Equity, of the notes to consolidated financial statements.

The Company and Bank are subject to various regulatory capital requirements. At December 31, 2010,2012, both the Company and the Bank exceeded all regulatory requirements. For detailed information on regulatory capital, see Note 10,11, Regulatory Matters, of the notes to consolidated financial statements.

GOODWILL

AND OTHER INTANGIBLE ASSETS

The carrying amountvalue of goodwill totaled $49.0 million and $37.4 million as of December 31, 20102012 and 2009. The2011, respectively. We performed a qualitative assessment of goodwill relates to our primary subsidiary andat the reporting unit level, Five Star Bank. We perform a goodwill impairment test on an annual basis or more frequentlyBank, to determine if events and circumstances warrant. On September 30, 2010, the Company performed the annual goodwill impairment test and determined the estimated fair value of our reporting unit to be in excess of its carrying amount. Accordingly, as of the annual impairment test date, thereit was no indication of goodwill impairment. We test goodwill for impairment between annual tests if an event occurs or circumstances change that would more likely than not reducethat the fair value of ourthe reporting unit belowis less than its carrying amount.

value. In performing a qualitative analysis, factors considered include, but are not limited to, business strategy, financial performance and market and regulatory dynamics. The results of the qualitative assessment for 2012 indicated that it was not more likely than not that the fair value of the reporting unit is less than its carrying value. Consequently, no additional quantitative two-step impairment test was required, and no impairment was recorded in 2012.

The change in the balance for goodwill during the years ended December 31 was as follows (in thousands):

   2012   2011 

Goodwill, beginning of year

  $37,369    $37,369  

Branch acquisitions

   11,599     —    

Impairment

   —       —    
  

 

 

   

 

 

 

Goodwill, end of year

  $48,968    $37,369  
  

 

 

   

 

 

 

Declines in the market value of our publicly traded stock price or declines in our ability to generate future cash flows may increase the potential that goodwill recorded on our consolidated statementstatements of financial condition be designated as impaired and that we may incur a goodwill write-down in the future.

The Company’s other intangible assets consisted entirely of a core deposit intangible asset. The gross carrying amount and accumulated amortization for the core deposit intangible asset was $2.0 million and $190 thousand, respectively, at December 31, 2012. The Company had no other intangible assets as of December 31, 2011. Core deposit intangible amortization expense, included in other noninterest expense on the consolidated statements of income, was $190 thousand for the year ended December 31, 2012. There was no core deposit intangible amortization expense for the years ended December 31, 2011 and 2010. For further discussion, see Note 1, Summary of Significant Accounting Policies, and Note 7, Goodwill and Other Intangible Assets, to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.

 

- 4950 -


MANAGEMENT’S DISCUSSION AND ANALYSIS

LIQUIDITY AND CAPITAL RESOURCES

The objective of maintaining adequate liquidity is to assure that we meet our financial obligations. These obligations include the withdrawal of deposits on demand or at their contractual maturity, the repayment of matured borrowings, the ability to fund new and existing loan commitments and the ability to take advantage of new business opportunities. We achieve liquidity by maintaining a strong base of core customer funds, maturing short-term assets, our ability to sell or pledge securities, lines-of-credit, and access to the financial and capital markets. In addition, we currently have an effective shelf registration that allows for the ability to issue up to $50 million in common stock.

Liquidity for the Bank is managed through the monitoring of anticipated changes in loans, the investment portfolio, core deposits and wholesale funds. The strength of the Bank’s liquidity position is a result of its base of core customer deposits. These core deposits are supplemented by wholesale funding sources that include credit lines with the other banking institutions, the FHLB and the FRB.

The primary sources of liquidity for FII are dividends from the Bank and access to financial and capital markets. Dividends from the Bank are limited by various regulatory requirements related to capital adequacy and earnings trends. The Bank relies on cash flows from operations, core deposits, borrowings and short-term liquid assets. FSIS relies on cash flows from operations and funds from FII when necessary.

Our cash and cash equivalents were $39.1$60.4 million as of December 31, 2010, down2012, up $2.8 million from $43.0$57.6 million as of December 31, 2009.2011. Our net cash provided by operating activities totaled $35.4$38.7 million and the principal source of operating activity cash flow was net income adjusted for noncash income and expense items. Net cash used in investing activities totaled $169.2$99.1 million, which included outflows of $151.3 million for net loan origination funding of $89.5originations and $138.4 million andfrom net investment securities transactions, of $77.8 million.substantially offset by $195.8 million in cash received through the branch acquisitions. Net cash provided by financing activities of $129.9$63.2 million was attributed to the $139.9 million and $17.6a $43.4 million increase in deposits and a $29.1 million increase in short-term borrowings, respectively, partiallypartly offset by $20.1 million repayments of long-term debt and $7.7$8.9 million in cash paid for dividends.

dividend payments.

Contractual Obligations and Other Commitments

The following table summarizes the maturities of various contractual obligations and other commitments (in thousands):

                     
  At December 31, 2010 
  Within 1  Over 1 to 3  Over 3 to 5  Over 5    
  year  years  Years  years  Total 
On-Balance sheet:
                    
Certificates of deposit (1)
 $554,104  $141,608  $43,888  $154  $739,754 
Long-term borrowings  10,065         16,702   26,767 
Supplemental executive retirement plans  155   318   318   708   1,499 
                     
Off-Balance sheet:
                    
Limited partnership investments(2)
 $695  $1,391  $695  $  $2,781 
Commitments to extend credit(3)
  357,240            357,240 
Standby letters of credit(3)
  4,075   1,216   1,233      6,524 
Operating leases  1,218   2,188   1,933   5,868   11,207 

   At December 31, 2012 
   Within 1   Over 1 to 3   Over 3 to 5   Over 5     
   year   years   Years   years   Total 

On-Balance sheet:

          

Certificates of deposit (1)

  $495,423    $127,045    $31,721    $749    $654,938  

Supplemental executive retirement plans

   159     506     618     1,402     2,685  

Off-Balance sheet:

          

Limited partnership investments(2)

  $402    $804    $402    $—      $1,608  

Commitments to extend credit(3)

   435,948     —       —       —       435,948  

Standby letters of credit(3)

   4,161     4,996     66     —       9,223  

Operating leases

   1,433     2,689     2,023     4,347     10,492  

(1)

Includes the maturity of certificates of deposit amounting to $100 thousand or more as follows: $68.1$58.7 million in three months or less; $27.0$39.5 million between three months and six months; $58.5$79.5 million between six months and one year; and $30.3$44.7 million over one year.

(2)

We have committed to capital investments in several limited partnerships of up to $6.1 million. As$6.3 million, of which we have contributed $4.7 million as of December 31, 2010, we have contributed $3.3 million to the partnerships,2012, including $806$951 thousand during 2010.2012.

(3)

We do not expect all of the commitments to extend credit and standby letters of credit to be funded. Thus, the total commitment amounts do not necessarily represent our future cash requirements.

Off-Balance Sheet Arrangements

With the exception of obligations in connection with our trust preferred securities and in connection with our irrevocable loan commitments, operating leases and limited partnership investments, we had no other off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors. For additional information on off-balance sheet arrangements, see Note 1, Summary of Significant Accounting Policies and Note 9,10, Commitments and Contingencies, in the notes to the accompanying consolidated financial statements.

 

- 5051 -


MANAGEMENT’S DISCUSSION AND ANALYSIS

Security Yields and Maturities Schedule

The following table sets forth certain information regarding the amortized cost (“Cost”), weighted average yields (“Yield”) and contractual maturities of our debt securities portfolio as of December 31, 2010.2012. Mortgage-backed securities are included in maturity categories based on their stated maturity date. Actual maturities may differ from the contractual maturities presented because borrowers may have the right to call or prepay certain investments. We have stopped accruing interest on our asset-backed securities. No tax-equivalent adjustments were made to the weighted average yields (in thousands).

                                         
                  Due after five       
  Due in one year  Due from one to  years through  Due after ten    
  or less  five years  ten years  years  Total 
  Cost  Yield  Cost  Yield  Cost  Yield  Cost  Yield  Cost  Yield 
Available for sale debt securities:
                                        
U.S. Government agencies and government-sponsored enterprises $   % $59,324   2.25% $60,113   2.48% $22,154   1.40% $141,591   2.21%
State and political subdivisions  17,186   3.53   43,177   3.10   45,259   2.19         105,622   2.78 
Mortgage-backed securities  8,503   4.02   12,423   3.96   118,320   1.96   276,237   3.57   415,483   3.13 
Asset-backed securities                    564      564    
                                    
   25,689   3.69   114,924   2.75   223,692   2.15   298,955   3.41   663,260   2.88 
Held to maturity debt securities:
                                        
State and political subdivisions  21,439   2.43   5,490   4.13   1,055   5.08   178   5.53   28,162   2.88 
                                    
  $47,128   3.12% $120,414   2.82% $224,747   2.16% $299,133   3.41% $691,422   2.88%
                                    

  Due in one year
or less
  Due from one
to five years
  Due after five
years through
ten years
  Due after ten
years
  Total 
  Cost  Yield  Cost  Yield  Cost  Yield  Cost  Yield  Cost  Yield 

Available for sale debt securities:

          

U.S. Government agencies and government-sponsored enterprises

 $18,557    1.89 $23,973    2.20 $72,633    1.77 $12,934    0.87 $128,097    1.78

State and political subdivisions

  10,064    3.64    68,677    2.21    110,256    2.06    —      —      188,997    2.20  

Mortgage-backed securities

  346    3.76    1,829    3.65    135,235    1.82    342,576    2.33    479,986    2.19  

Asset-backed securities

  —      —      —      —      —      —      121    —      121    —    
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

  
  28,967    2.52    94,479    2.24    318,124    1.89    355,631    2.27    797,201    2.13  

Held to maturity debt securities:

          

State and political subdivisions

  12,886    2.24    4,164    3.69    768    4.78    87    5.53    17,905    2.70  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

  
 $41,853    2.43 $98,643    2.30 $318,892    1.90 $355,718    2.28 $815,106    2.14
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

  

Contractual Loan Maturity Schedule

The following table summarizes the contractual maturities of our loan portfolio at December 31, 2010.2012. Loans, net of deferred loan origination costs, include principal amortization and non-accruing loans. Demand loans having no stated schedule of repayment or maturity and overdrafts are reported as due in one year or less (in thousands).

                 
  Due in less  Due from one  Due after five    
  than one year  to five years  years  Total 
Commercial business $130,990  $71,730  $8,311  $211,031 
Commercial mortgage  80,096   161,978   110,856   352,930 
Residential mortgage  25,556   57,534   46,490   129,580 
Home equity  35,208   91,464   81,655   208,327 
Consumer indirect  136,355   269,061   12,600   418,016 
Other consumer  11,772   13,006   1,328   26,106 
             
Total loans $419,977  $664,773  $261,240  $1,345,990 
             
                 
Loans maturing after one year:                
With a predetermined interest rate     $205,867  $166,360  $372,227 
With a floating or adjustable rate      458,906   94,880   553,786 
              
Total loans maturing after one year     $664,773  $261,240  $926,013 
              

   Due in less
than one year
   Due from one
to five years
   Due after five
years
   Total 

Commercial business

  $158,620    $87,051    $13,004    $258,675  

Commercial mortgage

   134,797     212,004     66,523     413,324  

Residential mortgage

   28,496     64,013     41,011     133,520  

Home equity

   49,190     129,284     108,175     286,649  

Consumer indirect

   204,831     362,478     19,485     586,794  

Other consumer

   10,647     13,874     2,243     26,764  
  

 

 

   

 

 

   

 

 

   

 

 

 

Total loans

  $586,581    $868,704    $250,441    $1,705,726  
  

 

 

   

 

 

   

 

 

   

 

 

 

Loans maturing after one year:

        

With a predetermined interest rate

    $249,428    $131,385    $380,813  

With a floating or adjustable rate

     619,276     119,056     738,332  
    

 

 

   

 

 

   

 

 

 

Total loans maturing after one year

    $868,704    $250,441    $1,119,145  
    

 

 

   

 

 

   

 

 

 

 

- 5152 -


MANAGEMENT’S DISCUSSION AND ANALYSIS

Capital Resources

The FRB has adopted a system using risk-based capital guidelines to evaluate the capital adequacy of bank holding companies on a consolidated basis. The guidelines require a minimum Tier 1 leverage ratio of 4.00%, a minimum Tier 1 capital ratio of 4.00% and a minimum total risk-based capital ratio of 8.00%. The following table reflects the ratios and their components (in thousands):

         
  2010  2009 
Total shareholders’ equity $212,144  $198,294 
Less: Unrealized gain on securities available for sale, net of tax  1,877   1,655 
Unrecognized net periodic pension & postretirement benefits (costs), net of tax  (6,599)  (5,357)
Disallowed goodwill and other intangible assets  37,369   37,369 
Disallowed deferred tax assets  14,608   17,214 
Plus: Qualifying trust preferred securities  16,200   16,200 
       
Tier 1 capital $181,089  $163,613 
       
Adjusted average total assets (for leverage capital purposes) $2,177,911  $2,054,699 
       
Tier 1 leverage ratio (Tier 1 capital to adjusted average total assets)  8.31%  7.96%
         
Total Tier 1 capital $181,089  $163,613 
Plus: Qualifying allowance for loan losses  18,363   17,153 
       
Total risk-based capital $199,452  $180,766 
       
Net risk-weighted assets $1,466,957  $1,368,653 
       
Tier 1 capital ratio (Tier 1 capital to net risk-weighted assets)  12.34%  11.95%
Total risk-based capital ratio (Total risk-based capital to net risk-weighted assets)  13.60%  13.21%

   2012  2011 

Total shareholders’ equity

  $253,897   $237,194  

Less: Unrealized gain on securities available for sale, net of tax

   16,060    13,570  

Unrecognized net periodic pension & postretirement benefits (costs), net of tax

   (12,807  (12,625

Disallowed goodwill and other intangible assets

   50,820    37,369  

Disallowed deferred tax assets

   —      1,794  
  

 

 

  

 

 

 

Tier 1 capital

  $199,824   $197,086  
  

 

 

  

 

 

 

Adjusted average total assets (for leverage capital purposes)

  $2,595,691   $2,282,755  
  

 

 

  

 

 

 

Tier 1 leverage ratio (Tier 1 capital to adjusted average total assets)

   7.70  8.63

Total Tier 1 capital

  $199,824   $197,086  

Plus: Qualifying allowance for loan losses

   23,352    20,239  
  

 

 

  

 

 

 

Total risk-based capital

  $223,176   $217,325  
  

 

 

  

 

 

 

Net risk-weighted assets

  $1,866,764   $1,616,119  
  

 

 

  

 

 

 

Tier 1 capital ratio (Tier 1 capital to net risk-weighted assets)

   10.70  12.20

Total risk-based capital ratio (Total risk-based capital to net risk-weighted assets)

   11.96  13.45

CRITICAL ACCOUNTING ESTIMATES

Our consolidated financial statements are prepared in accordance with GAAP and are consistent with predominant practices in the financial services industry. Application of critical accounting policies, which are those policies that management believes are the most important to our financial position and results, requires management to make estimates, assumptions, and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes and are based on information available as of the date of the financial statements. Future changes in information may affect these estimates, assumptions and judgments, which, in turn, may affect amounts reported in the financial statements.

We have numerous accounting policies, of which the most significant are presented in Note 1, Summary of Significant Accounting Policies, of the notes to consolidated financial statements. These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets, liabilities, revenues and expenses are reported in the consolidated financial statements and how those reported amounts are determined. Based on the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has determined that the accounting policies with respect to the allowance for loan losses, valuation of goodwill and deferred tax assets, the valuation of securities and determination of OTTI, and accounting for defined benefit plans require particularly subjective or complex judgments important to our financial position and results of operations, and, as such, are considered to be critical accounting policies as discussed below. These estimates and assumptions are based on management’s best estimates and judgment and are evaluated on an ongoing basis using historical experience and other factors, including the current economic environment. We adjust these estimates and assumptions when facts and circumstances dictate. Illiquid credit markets and volatile equity have combined with declines in consumer spending to increase the uncertainty inherent in these estimates and assumptions. As future events cannot be determined with precision, actual results could differ significantly from our estimates.

 

- 5253 -


MANAGEMENT’S DISCUSSION AND ANALYSIS

Adequacy of the Allowance for Loan Losses

The allowance for loan losses represents management’s estimate of probable credit losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of subjective measurements including management’s assessment of the internal risk classifications of loans, changes in the nature of the loan portfolio, industry concentrations, existing economic conditions, the fair value of underlying collateral, and other qualitative and quantitative factors which could affect probable credit losses. Because current economic conditions can change and future events are inherently difficult to predict, the anticipated amount of estimated loan losses, and therefore the appropriateness of the allowance for loan losses, could change significantly. As an integral part of their examination process, various regulatory agencies also review the allowance for loan losses. Such agencies may require additions to the allowance for loan losses or may require that certain loan balances be charged off or downgraded into criticized loan categories when their credit evaluations differ from those of management, based on their judgments about information available to them at the time of their examination. We believe the level of the allowance for loan losses is appropriate as recorded in the consolidated financial statements.

For additional discussion related to our accounting policies for the allowance for loan losses, see the sections titled “Allowance for Loan Losses” in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 1, Summary of Significant Accounting Policies, of the notes to consolidated financial statements.

Valuation of Goodwill

Goodwill represents the excess of the purchase price over the fair value of net assets acquired in accordance with the purchase method of accounting for business combinations. Goodwill has an indefinite useful life and is not amortized, but instead, is subjecttested for impairment. GAAP requires goodwill to be tested for impairment testsat our reporting unit level on at least an annual basis, orwhich for us is September 30th, and more frequently if an event occursevents or circumstances changeindicate that reduce the fair value of a reporting unit below its carrying amount. The Company completes the annual goodwill impairment test as of September 30 of each year. The impairment testing process is conducted by assigning net assets and goodwill to each reporting unit.there may be impairment. Currently, the Company’sour goodwill is evaluated at the entity level as there is only one reporting unit. The

Impairment exists when a reporting unit’s carrying value of goodwill exceeds its implied fair value. In testing goodwill for impairment, GAAP permits us to first assess qualitative factors to determine whether it is more likely than not that the fair value of eacha reporting unit is comparedless than its carrying value. If, after assessing the totality of events and circumstances, we determine it is not more likely than not that the fair value of a reporting unit is less than its carrying value, then performing the two-step impairment test would be unnecessary. However, if we conclude otherwise, we would then be required to perform the first step (Step 1) of the goodwill impairment test, and continue to the recorded booksecond step (Step 2), if necessary. Step 1 compares the fair value “step one”.of a reporting unit with its carrying value, including goodwill. If the faircarrying value of the reporting unit exceeds its carryingfair value, Step 2 of the goodwill impairment test is not considered impaired and “step two” is not considered necessary. Ifperformed to measure the carrying value of a reporting unit exceeds its fair value, the impairment test continues (“step two”) by comparing the carrying value of the reporting unit’s goodwill to the implied fair value of goodwill. The implied fair value is computed by adjusting all assets and liabilities of the reporting unit to current fair value with the offset adjustment to goodwill. The adjusted goodwill balance is the implied fair value of the goodwill. An impairment charge is recognizedloss, if the carrying fair value of goodwill exceeds the implied fair value of goodwill.

any.

Valuation of Deferred Tax Assets

The determination of deferred tax expense or benefit is based on changes in the carrying amounts of assets and liabilities that generate temporary differences. The carrying value of our net deferred tax assets assumes that we will be able to generate sufficient future taxable income based on estimates and assumptions (after consideration of historical taxable income as well as tax planning strategies). If these estimates and related assumptions change, we may be required to record valuation allowances against our deferred tax assets resulting in additional income tax expense in the consolidated statements of operations.income. Management evaluates deferred tax assets on a quarterly basis and assesses the need for a valuation allowance, if any. A valuation allowance is established when management believes that it is more likely than not that some portion of its deferred tax assets will not be realized. Changes in valuation allowance from period to period are included in the Company’sour tax provision in the period of change. For additional discussion related to our accounting policy for income taxes see Note 14,15, Income Taxes, of the notes to consolidated financial statements.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

Valuation and Other Than Temporary Impairment of Securities

We record all of our securities that are classified as available for sale at fair value. The fair value of equity securities are determined using public quotations, when available. Where quoted market prices are not available, fair values are estimated based on dealer quotes, pricing models, discounted cash flow methodologies, or similar techniques for which the determination of fair value may require significant judgment or estimation. Fair values of public bonds and those private securities that are actively traded in the secondary market have been determined through the use of third-party pricing services using market observable inputs. Private placement securities and other corporate fixed maturities wherefor which we do not receive a public quotation are valued using a variety of acceptable valuation methods. Market rates used are applicable to the yield, credit quality and average maturity of each security. Private equity securities may also utilize internal valuation methodologies appropriate for the specific asset. Fair values might also be determined using broker quotes or through the use of internal models or analysis.

Securities are evaluated quarterly to determine whether a decline in their fair value is other than temporary. Management utilizes criteria such as, the current intent or requirement to hold or sell the security, the magnitude and duration of the decline and, when appropriate, consideration of negative changes in expected cash flows, creditworthiness, near term prospects of issuers, the level of credit subordination, estimated loss severity, and delinquencies, to determine whether a loss in value is other than temporary. The term “other than temporary” is not intended to indicate that the decline is permanent, but indicates that the prospect for a near-term recovery of value is not necessarily favorable. Declines in the fair value of investment securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses to the extent the impairment is related to credit issues or concerns, or the security is intended to be sold. The amount of impairment related to non-credit related factors on securities not intended to be sold is recognized in other comprehensive income.

Defined Benefit Pension Plan

Management is required to make various assumptions in valuing its defined benefit pension plan assets and liabilities. These assumptions include, but are not limited to, the expected long-term rate of return on plan assets, the weighted average discount rate used to value certain liabilities and the rate of compensation increase. We use a third-party specialist to assist in making these estimates and assumptions. Changes in these estimates and assumptions are reasonably possible and may have a material impact on our consolidated financial statements, results of operationsincome or liquidity.

RECENT ACCOUNTING PRONOUNCEMENTS

See Note 1, Summary of Significant Accounting Policies — Policies—Recent Accounting Pronouncements, in the notes to consolidated financial statements for a discussion of recent accounting pronouncements.

 

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ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Asset-Liability Management

The principal objective of our interest rate risk management is to evaluate the interest rate risk inherent in assets and liabilities, determine the appropriate level of risk to us given our business strategy, operating environment, capital and liquidity requirements and performance objectives, and manage the risk consistent with the guidelines approved by our Board of Directors. Management is responsible for reviewing with the Board of Directors our activities and strategies, the effect of those strategies on the net interest margin,income, the fair value of the portfolio and the effect that changes in interest rates will have on the portfolio and exposure limits. Management has developed an Asset-Liability Policy that meets the strategic objectives and regularly reviews the activities of the Bank.

Portfolio Composition

Our balance sheet assets are a mix of fixed and variable rate assets with consumer indirect loans, commercial loans, and MBSs comprising a significant portion of our assets. Our consumer indirect loan portfolio comprised 21% of assets and is primarily fixed rate loans with relatively short durations. Our commercial loan portfolio totaled 24% of assets and is a combination of fixed and variable rate loans, lines and mortgages. The MBS portfolio, including collateralized mortgages obligations, totaled 18% of assets with durations averaging three to five years.

Our liabilities are made up primarily of deposits, which account for approximately 90% of total liabilities. Of these deposits, the majority, or 53%, is in nonpublic variable rate and noninterest bearing products including demand (both noninterest and interest- bearing), savings and money market accounts. In addition, fixed rate nonpublic certificate of deposit products make up 27% of total deposits. The bank also has a significant amount of public deposits, which represented 20% of total deposits as of December 31, 2012.

Net Interest Income at Risk Analysis

The

A primary tool we useused to manage interest rate risk is a “rate shock” simulation to measure the rate sensitivity of the statement of financial condition.sensitivity. Rate shock simulation is a modeling technique used to estimate the impact of changes in rates on net interest income andas well as economic value of equity. At December 31, 2012, the Company is generally asset sensitive, meaning that, in most cases, net interest income tends to rise as interest rates rise and decline as interest rates fall. The following table sets forth the results of the modeling analysis as of December 31, 20102012 (dollars in thousands):

                         
Changes in Net Interest Income  Economic Value of Equity 
interest rate Amount  Change  Amount  Change 
                         
+ 300 basis points $80,089  $(655)  (0.81)% $409,884  $(45,722)  (10.04)%
+ 200 basis points  80,387   (357)  (0.44)  428,304   (27,303)  (5.99)
+ 100 basis points  80,342   (402)  (0.50)  443,028   (12,578)  (2.76)
- 100 basis points  76,204   (4,540)  (5.62)  438,274   (17,332)  (3.80)
We measure net

   Changes in Interest Rate 
   -100 bp  +100 bp  +200 bp  +300 bp 

Change in net interest income

  $(106 $2,611   $5,492   $6,565  

% Change

   (0.12)%   2.85  5.99  7.16

Net interest income at risk is measured by estimating the changes in net interest income resulting from instantaneous and sustained parallel shifts in interest rates of different magnitudes over a period of 12 months. As of December 31, 2010,2012, a 100300 basis point increase in rates would decreaseincrease net interest income by $402 thousand,$6.6 million, or 0.5%7.2%, over the nextfollowing twelve-month period. A 100 basis point decrease in rates would decrease net interest income by $4.5 million,$106 thousand, or 5.6%, over a twelve-month period. As of December 31, 2010, a 100 basis point increase in rates would decrease the economic value of equity by $12.6 million, or 2.8%0.1%, over the nextfollowing twelve-month period. A 100 basis point decrease

In addition to the changes in rates would decreaseinterest rate scenarios listed above, other scenarios are typically modeled to measure interest rate risk. These scenarios vary depending on the economic value of equity by $17.3 million, or 3.8%, over a twelve-month period. This simulation isand interest rate environment.

The simulations referenced above are based on management’s assumption as to the effect of interest rate changes on assets and liabilities and assumes a parallel shift of the yield curve. It also includes certain assumptions about the future pricing of loans and deposits in response to changes in interest rates. Further, it assumes that delinquency rates would not change as a result of changes in interest rates, although there can be no assurance that this will be the case. While this simulation is a useful measure as to net interest income at risk due to a change in interest rates, it is not a forecast of the future results and is based on many assumptions that, if changed, could cause a different outcome.

In addition to

Economic Value of Equity At Risk

The economic (or “fair”) value of financial instruments on our balance sheet will also vary under the changes in interest rate scenarios listed above, we typically run other scenariospreviously discussed. This is measured by simulating changes in our economic value of equity (“EVE”), which is calculated by subtracting the estimated fair value of liabilities from the estimated fair value of assets. Fair values for financial instruments are estimated by discounting projected cash flows (principal and interest) at current replacement rates for each account type, while fair values of non-financial assets and liabilities are assumed to measureequal book value and do not vary with interest rate risk, which vary depending onfluctuations. An economic value simulation is a static measure for balance sheet accounts at a given point in time, but this measurement can change substantially over time as the economiccharacteristics of our balance sheet evolve and as interest rate environments.

and yield curve assumptions are updated.

 

- 5556 -


The amount of change in economic value under different interest rate scenarios depends on the characteristics of each class of financial instrument, including the stated interest rate or spread relative to current market rates or spreads, the likelihood of prepayment, whether the rate is fixed or floating, and the maturity date of the instrument. As a general rule, fixed-rate financial assets become more valuable in declining rate scenarios and less valuable in rising rate scenarios, while fixed-rate financial liabilities gain in value as interest rates rise and lose value as interest rates decline. The longer the duration of the financial instrument, the greater the impact a rate change will have on its value. In our economic value simulations, estimated prepayments are factored in for financial instruments with stated maturity dates, and decay rates for non-maturity deposits are projected based historical data (back-testing).

The table below shows estimated changes in our EVE under different interest rate scenarios relative to a base case of current interest rates.

   Changes in Interest Rate 
   -100 bp  +100 bp  +200 bp  +300 bp 

Change in EVE

  $27,739   $3,684   $172   $(15,721

% Change

   7.06  0.94  0.04  (4.00)% 

As of December 31, 2012, a 300 basis point increase in rates would decrease the economic value of equity by $15.7 million, or 4.0%. A 100 basis point decrease in rates would increase the economic value of equity by $27.7 million, or 7.0%. Embedded options within the current balance sheet such as caps, floors, and calls as well as changes in prepayment speeds and a decompression of deposit rates in rising interest rate scenarios are affecting the results, particularly as market rates begin to rise with rates increasing 100 and 200 basis points. Embedded optionality sometimes outweighs impacts of the movement in the direction of interest rates. This is evidenced in the results under the plus 100 and plus 200 basis point scenarios.

- 57 -


Interest Rate Sensitivity Gap

The following table presents an analysis of our interest rate sensitivity gap position at December 31, 2010.2012. All interest-earning assets and interest-bearing liabilities are shown based on the earlier of their contractual maturity or re-pricing date. The expected maturities are presented on a contractual basis or, if more relevant, based on projected call dates. Investment securities are at amortized cost for both securities available for sale and securities held to maturity. Loans, net of deferred loan origination costs, include principal amortization adjusted for estimated prepayments (principal payments in excess of contractual amounts) and non-accruing loans. Borrowings include junior subordinated debentures. Because the interest rate sensitivity levels shown in the table could be changed by external factors such as loan prepayments and liability decay rates or by factors controllable by us, such as asset sales, it is not an absolute reflection of our potential interest rate risk profile (in thousands).
                     
  At December 31, 2010 
      Over Three  Over       
  Three  Months  One Year       
  Months  Through  Through  Over    
  or Less  One Year  Five Years  Five Years  Total 
INTEREST-EARNING ASSETS:                    
Federal funds sold and interest-earning deposits in other banks $  $94  $  $  $94 
Investment securities  99,649   137,148   262,173   192,452   691,422 
Loans  420,507   211,128   604,736   112,757   1,349,128 
                
Total interest-earning assets $520,156  $348,370  $866,909  $305,209   2,040,644 
                 
Cash and due from banks                  38,964 
Other assets(1)
                  134,699 
                    
Total assets                 $2,214,307 
                    
                     
INTEREST-BEARING LIABILITIES:                    
Interest-bearing demand, savings and money market $792,259  $  $  $  $792,259 
Certificates of deposit  180,581   373,523   185,496   154   739.754 
Borrowings  77,175   10,000      16,702   103,877 
                
Total interest-bearing liabilities $1,050,015  $383,523   185,496   16,856   1,635,890 
                 
Noninterest-bearing deposits                  350,877 
Other liabilities                  15,396 
                    
Total liabilities                  2,002,163 
Shareholders’ equity                  212,144 
                    
Total liabilities and shareholders’ equity                 $2,214,307 
                    
Interest sensitivity gap $(529,859) $(35,153) $681,413  $288,353  $404,754 
                
Cumulative gap $(529,859) $(565,012) $116,401  $404,754     
                 
Cumulative gap ratio(2)
  49.5%  60.6%  107.2%  124.7%    
Cumulative gap as a percentage of total assets  (23.9)%  (25.5)%  5.3%  18.3%    

   At December 31, 2012 
   Over Three  Over       
   Three  Months  One Year       
   Months  Through  Through  Over    
   or Less  One Year  Five Years  Five Years  Total 

INTEREST-EARNING ASSETS:

      

Federal funds sold and interest-earning deposits in other banks

  $—     $94   $—     $—     $94  

Investment securities

   98,857    137,633    344,016    234,600    815,106  

Loans

   521,041    306,079    749,167    130,957    1,707,244  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Total interest-earning assets

  $619,898   $443,806   $1,093,183   $365,557    2,522,444  
  

 

 

  

 

 

  

 

 

  

 

 

  

Cash and due from banks

       60,342  

Other assets(1)

       181,248  
      

 

 

 

Total assets

      $2,764,034  
      

 

 

 

INTEREST-BEARING LIABILITIES:

      

Interest-bearing demand, savings and money market

  $1,105,342   $—     $—     $—     $1,105,342  

Certificates of deposit

   154,826    340,379    158,984    749    654,938  

Borrowings

   139,806    40,000    —      —      179,806  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Total interest-bearing liabilities

  $1,399,974   $380,379   $158,984   $749    1,940,086  
  

 

 

  

 

 

  

 

 

  

 

 

  

Noninterest-bearing deposits

       501,514  

Other liabilities

       68,537  
      

 

 

 

Total liabilities

       2,510,137  

Shareholders’ equity

       253,897  
      

 

 

 

Total liabilities and shareholders’ equity

      $2,764,034  
      

 

 

 

Interest sensitivity gap

  $(780,076 $63,427   $934,199   $364,808   $582,358  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Cumulative gap

  $(780,076 $(716,649 $217,550   $582,358   
  

 

 

  

 

 

  

 

 

  

 

 

  

Cumulative gap ratio(2)

   44.3  59.7  111.2  130.0 

Cumulative gap as a percentage of total assets

   (28.2)%   (25.9)%   7.9  21.1 

(1)

Includes net unrealized gain on securities available for sale and allowance for loan losses.

(2)

Cumulative total interest-earning assets divided by cumulative total interest-bearing liabilities.

For purposes of interest rate risk management, we direct more attention on simulation modeling, such as “net interest income at risk” as previously discussed, rather than gap analysis. The net interest income at risk simulation modeling is considered by management to be more informative in forecasting future income at risk.

 

- 5658 -



Management’s Report on Internal Control over Financial Reporting

Management is responsible for establishing and maintaining adequate internal control over financial reporting for Financial Institutions, Inc. and its subsidiaries (the “Company”), as such term is defined in Exchange Act Rules 13a-15(f). The Company’s system of internal control over financial reporting has been designed to provide reasonable assurance to the Company’s management and board of directors regarding the reliability of financial reporting and the preparation and fair presentation of financial statements for external purposes in accordance with accounting principlesU.S. generally accepted in the United States of America.

accounting principles.

Any system of internal control over financial reporting, no matter how well designed, has inherent limitations, including the possibility that a control can be circumvented or overridden and misstatements due to error or fraud may occur and not be detected. Also, because of changes in conditions, internal control effectiveness may vary over time. Accordingly, even an effective system of internal control will provide only reasonable assurance with respect to financial statement preparation and presentation.

The Company’s management has assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2010.2012. To make this assessment, we used the criteria for effective internal control over financial reporting described inInternal Control Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our assessment and based on such criteria, we believe that, as of December 31, 2010,2012, the Company’s internal control over financial reporting was effective.

The Company’s independent registered public accounting firm that audited the Company’s consolidated financial statements has issued an attestation report on internal control over financial reporting as of December 31, 2010.2012. That report appears herein.

/s/ Martin K. Birmingham  
/s/ Peter G. Humphrey
/s/ Karl F. Krebs
President and Chief Executive Officer  Executive Vice President and Chief Financial Officer
March 7, 201118, 2013  March 7, 201118, 2013

 

- 5860 -


Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders

Financial Institutions, Inc.:

We have audited Financial Institutions, Inc. and subsidiaries’ (the Company) internal control over financial reporting as of December 31, 2010,2012, based on criteria established inInternal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also includes performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the CompanyFinancial Institutions, Inc. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010,2012, based on criteria established inInternal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statements of financial condition of the CompanyFinancial Institutions, Inc. and subsidiaries as of December 31, 20102012 and 2009,2011, and the related consolidated statements of operations,income, comprehensive income, changes in shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2010,2012, and our report dated March 7, 201118, 2013 expressed an unqualified opinion on those consolidated financial statements.

/s/ KPMG LLP

Rochester, New York

March 7, 2011

18, 2013

 

- 5961 -


Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders

Financial Institutions, Inc.:

We have audited the accompanying consolidated statements of financial condition of Financial Institutions, Inc. and subsidiaries (the Company) as of December 31, 20102012 and 2009,2011, and the related consolidated statements of operations,income, comprehensive income, changes in shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2010.2012. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the CompanyFinancial Institutions, Inc. and subsidiaries as of December 31, 20102012 and 2009,2011, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2010,2012, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2010,2012, based on criteria established inInternal Control — Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 7, 201118, 2013 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

/s/ KPMG LLP

Rochester, New York

March 7, 2011

18, 2013

 

- 6062 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Financial Condition
         
  December 31, 
(Dollars in thousands, except share and per share data) 2010  2009 
ASSETS
        
Cash and cash equivalents:        
Cash and due from banks $38,964  $42,874 
Federal funds sold and interest-bearing deposits in other banks  94   85 
       
Total cash and cash equivalents  39,058   42,959 
Securities available for sale, at fair value  666,368   580,501 
Securities held to maturity, at amortized cost (fair value of $28,849 and $40,629, respectively)  28,162   39,573 
Loans held for sale  3,138   421 
Loans (net of allowance for loan losses of $20,466 and $20,741, respectively)  1,325,524   1,243,265 
Company owned life insurance  26,053   24,867 
Premises and equipment, net  33,263   34,783 
Goodwill  37,369   37,369 
Other assets  55,372   58,651 
       
Total assets $2,214,307  $2,062,389 
       
         
LIABILITIES AND SHAREHOLDERS’ EQUITY
        
Deposits:        
Noninterest-bearing demand $350,877  $324,303 
Interest-bearing demand  374,900   363,698 
Savings and money market  417,359   368,603 
Certificates of deposit  739,754   686,351 
       
Total deposits  1,882,890   1,742,955 
Short-term borrowings  77,110   59,543 
Long-term borrowings  26,767   46,847 
Other liabilities  15,396   14,750 
       
Total liabilities  2,002,163   1,864,095 
       
Commitments and contingencies (Note 9)        
Shareholders’ equity:        
Series A 3% preferred stock, $100 par value; 1,533 shares authorized and issued  153   153 
Series A preferred stock, $100 par value, 7,503 shares authorized and issued, aggregate liquidation preference of $37,515; net of $1,305 and $1,672 discount, respectively  36,210   35,843 
Series B-1 8.48% preferred stock, $100 par value, 200,000 shares authorized, 174,223 shares issued  17,422   17,422 
       
Total preferred equity  53,785   53,418 
Common stock, $0.01 par value, 50,000,000 shares authorized, 11,348,122 shares issued  113   113 
Additional paid-in capital  26,029   26,940 
Retained earnings  144,599   131,371 
Accumulated other comprehensive loss  (4,722)  (3,702)
Treasury stock, at cost410,616 and 527,854 shares, respectively
  (7,660)  (9,846)
       
Total shareholders’ equity  212,144   198,294 
       
Total liabilities and shareholders’ equity $2,214,307  $2,062,389 
       

    December 31, 
(Dollars in thousands, except share and per share data)  2012  2011 
ASSETS   

Cash and cash equivalents:

   

Cash and due from banks

  $60,342   $57,489  

Federal funds sold and interest-bearing deposits in other banks

   94    94  
  

 

 

  

 

 

 

Total cash and cash equivalents

   60,436    57,583  

Securities available for sale, at fair value

   823,796    627,518  

Securities held to maturity, at amortized cost (fair value of $18,478 and $23,964, respectively)

   17,905    23,297  

Loans held for sale

   1,518    2,410  

Loans (net of allowance for loan losses of $24,714 and $23,260, respectively)

   1,681,012    1,461,516  

Company owned life insurance

   47,386    45,556  

Premises and equipment, net

   36,618    33,085  

Goodwill and other intangible assets, net

   50,820    37,369  

Other assets

   44,543    48,019  
  

 

 

  

 

 

 

Total assets

  $2,764,034   $2,336,353  
  

 

 

  

 

 

 
LIABILITIES AND SHAREHOLDERS’ EQUITY   

Deposits:

   

Noninterest-bearing demand

  $501,514   $393,421  

Interest-bearing demand

   449,744    362,555  

Savings and money market

   655,598    474,947  

Certificates of deposit

   654,938    700,676  
  

 

 

  

 

 

 

Total deposits

   2,261,794    1,931,599  

Short-term borrowings

   179,806    150,698  

Other liabilities

   68,537    16,862  
  

 

 

  

 

 

 

Total liabilities

   2,510,137    2,099,159  
  

 

 

  

 

 

 

Commitments and contingencies (Note 10)

   

Shareholders’ equity:

   

Series A 3% preferred stock, $100 par value; 1,533 shares authorized; 1,499 and 1,500 shares issued, respectively

   150    150  

Series B-1 8.48% preferred stock, $100 par value, 200,000 shares authorized; 173,210 and 173,235 shares issued, respectively

   17,321    17,323  
  

 

 

  

 

 

 

Total preferred equity

   17,471    17,473  

Common stock, $0.01 par value, 50,000,000 shares authorized and 14,161,597 shares issued

   142    142  

Additional paid-in capital

   67,710    67,247  

Retained earnings

   172,244    158,079  

Accumulated other comprehensive income

   3,253    945  

Treasury stock, at cost – 373,888 and 358,481 shares, respectively

   (6,923  (6,692
  

 

 

  

 

 

 

Total shareholders’ equity

   253,897    237,194  
  

 

 

  

 

 

 

Total liabilities and shareholders’ equity

  $2,764,034   $2,336,353  
  

 

 

  

 

 

 

See accompanying notes to the consolidated financial statements.

 

- 6163 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of OperationsIncome
             
  Years ended December 31, 
(Dollars in thousands, except per share amounts) 2010  2009  2008 
Interest income:            
Interest and fees on loans $75,877  $72,706  $67,674 
Interest and dividends on investment securities  20,622   21,694   30,655 
Other interest income  10   82   619 
          
Total interest income  96,509   94,482   98,948 
          
Interest expense:            
Deposits  14,853   19,090   29,349 
Short-term borrowings  365   270   721 
Long-term borrowings  2,502   2,857   3,547 
          
Total interest expense  17,720   22,217   33,617 
          
Net interest income  78,789   72,265   65,331 
Provision for loan losses  6,687   7,702   6,551 
          
Net interest income after provision for loan losses  72,102   64,563   58,780 
          
Noninterest income (loss):            
Service charges on deposits  9,585   10,065   10,497 
ATM and debit card  3,995   3,610   3,313 
Broker-dealer fees and commissions  1,283   1,022   1,458 
Company owned life insurance  1,107   1,096   563 
Loan servicing  1,124   1,308   664 
Net gain on sale of loans held for sale  650   699   339 
Net gain on disposal of investment securities  169   3,429   288 
Impairment charges on investment securities  (594)  (4,666)  (68,215)
Net (loss) gain on sale and disposal of other assets  (203)  180   305 
Other  2,338   2,052   2,010 
          
Total noninterest income (loss)  19,454   18,795   (48,778)
          
Noninterest expense:            
Salaries and employee benefits  32,811   33,634   31,437 
Occupancy and equipment  10,818   11,062   10,502 
FDIC assessments  2,507   3,651   674 
Computer and data processing  2,487   2,340   2,433 
Professional services  2,197   2,524   2,141 
Supplies and postage  1,772   1,846   1,800 
Advertising and promotions  1,121   949   1,453 
Other  7,204   6,771   7,021 
          
Total noninterest expense  60,917   62,777   57,461 
          
Income (loss) before income taxes  30,639   20,581   (47,459)
Income tax expense (benefit)  9,352   6,140   (21,301)
          
Net income (loss) $21,287  $14,441  $(26,158)
          
             
Preferred stock dividends, net of accretion  3,725   3,697   1,538 
          
Net income (loss) available to common shareholders $17,562  $10,744  $(27,696)
          
             
Earnings (loss) per common share (Note 15):            
Basic $1.62  $0.99  $(2.54)
Diluted $1.61  $0.99  $(2.54)

    Years ended December 31, 
(Dollars in thousands, except per share amounts)  2012  2011  2010 

Interest income:

    

Interest and fees on loans

  $81,123   $77,105   $75,877  

Interest and dividends on investment securities

   16,444    18,013    20,622  

Other interest income

   —      —      10  
  

 

 

  

 

 

  

 

 

 

Total interest income

   97,567    95,118    96,509  
  

 

 

  

 

 

  

 

 

 

Interest expense:

    

Deposits

   8,462    11,434    14,853  

Short-term borrowings

   589    500    365  

Long-term borrowings

   —      1,321    2,502  
  

 

 

  

 

 

  

 

 

 

Total interest expense

   9,051    13,255    17,720  
  

 

 

  

 

 

  

 

 

 

Net interest income

   88,516    81,863    78,789  

Provision for loan losses

   7,128    7,780    6,687  
  

 

 

  

 

 

  

 

 

 

Net interest income after provision for loan losses

   81,388    74,083    72,102  
  

 

 

  

 

 

  

 

 

 

Noninterest income:

    

Service charges on deposits

   8,627    8,679    9,585  

ATM and debit card

   4,716    4,359    3,995  

Broker-dealer fees and commissions

   2,104    1,829    1,283  

Company owned life insurance

   1,751    1,424    1,107  

Loan servicing

   617    835    1,124  

Net gain on sale of loans held for sale

   1,421    880    650  

Net gain on disposal of investment securities

   2,651    3,003    169  

Impairment charges on investment securities

   (91  (18  (594

Net (loss) gain on sale and disposal of other assets

   (381  67    (203

Other

   3,362    2,867    2,338  
  

 

 

  

 

 

  

 

 

 

Total noninterest income

   24,777    23,925    19,454  
  

 

 

  

 

 

  

 

 

 

Noninterest expense:

    

Salaries and employee benefits

   40,127    35,743    32,844  

Occupancy and equipment

   11,419    10,868    10,818  

Professional services

   4,133    2,617    2,197  

Computer and data processing

   3,271    2,437    2,487  

Supplies and postage

   2,497    1,778    1,772  

FDIC assessments

   1,300    1,513    2,507  

Advertising and promotions

   929    1,259    1,121  

Loss on extinguishment of debt

   —      1,083    —    

Other

   7,721    6,496    7,171  
  

 

 

  

 

 

  

 

 

 

Total noninterest expense

   71,397    63,794    60,917  
  

 

 

  

 

 

  

 

 

 

Income before income taxes

   34,768    34,214    30,639  

Income tax expense

   11,319    11,415    9,352  
  

 

 

  

 

 

  

 

 

 

Net income

  $23,449   $22,799   $21,287  
  

 

 

  

 

 

  

 

 

 

Preferred stock dividends

   1,474    1,877    3,358  

Accretion of discount on Series A preferred stock

   —      1,305    367  
  

 

 

  

 

 

  

 

 

 

Net income available to common shareholders

  $21,975   $19,617   $17,562  
  

 

 

  

 

 

  

 

 

 

Earnings per common share (Note 16):

    

Basic

  $1.60   $1.50   $1.62  

Diluted

  $1.60   $1.49   $1.61  

Cash dividends declared per common share

  $0.57   $0.47   $0.40  

Weighted average common shares outstanding:

    

Basic

   13,696    13,067    10,767  

Diluted

   13,751    13,157    10,845  

See accompanying notes to the consolidated financial statements.

 

- 6264 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Changes in Shareholders’ EquityComprehensive Income
Years ended December 31, 2010, 2009 and 2008
                             
                  Accumulated        
          Additional      Other      Total 
(Dollars in thousands, Preferred  Common  Paid-in  Retained  Comprehensive  Treasury  Shareholders’ 
except per share data) Equity  Stock  Capital  Earnings  Income (Loss)  Stock  Equity 
Balance at January 1, 2008
 $17,581  $113  $24,778  $158,744  $667  $(6,561) $195,322 
Comprehensive income:                            
Net loss           (26,158)        (26,158)
Other comprehensive loss, net of tax              (4,680)     (4,680)
                            
Total comprehensive loss                          (30,838)
Cumulative effect of adoption of new accounting pronouncements           (241)        (241)
Repurchase of common shares                 (4,818)  (4,818)
Repurchase of Series A 3% preferred stock  (6)     3            (3)
Warrant issued in connection with Series A preferred stock        2,025            2,025 
Issue shares of Series A preferred stock  37,515                  37,515 
Discount on Series A preferred stock  (2,025)                 (2,025)
Share-based compensation plans:                            
Share-based compensation        603   30         633 
Stock options exercised        (12)        44   32 
Restricted stock awards issued        (998)        998    
Directors’ retainer        (2)        114   112 
Accrued undeclared cumulative dividend on Series A preferred stock, net of accretion  9         (56)        (47)
Cash dividends declared:                            
Series A 3% preferred-$3.00 per share           (5)        (5)
Series B-1 8.48% preferred-$8.48 per share           (1,477)        (1,477)
Common-$0.54 per share           (5,885)        (5,885)
                      
                             
Balance at December 31, 2008
 $53,074  $113  $26,397  $124,952  $(4,013) $(10,223) $190,300 
Comprehensive income:                            
Net income           14,441         14,441 
Other comprehensive income, net of tax              311      311 
                            
Total comprehensive income                          14,752 
Issuance costs of Series A preferred stock        (68)           (68)
Share-based compensation plans:                            
Share-based compensation        852   2         854 
Stock options exercised        (4)        19   15 
Restricted stock awards issued, net        (207)        207    
Directors’ retainer          (30)          151   121 
Accrued undeclared cumulative dividend on Series A preferred stock, net of accretion  344         (537)        (193)
Cash dividends declared:                            
Series A 3% preferred-$3.00 per share           (5)        (5)
Series A preferred-$223.61 per share           (1,678)        (1,678)
Series B-1 8.48% preferred-$8.48 per share           (1,477)        (1,477)
Common-$0.40 per share           (4,327)        (4,327)
                      
 
Balance at December 31, 2009
 $53,418  $113  $26,940  $131,371  $(3,702) $(9,846) $198,294 
                      
Continued on next page

    Years ended December 31, 
(Dollars in thousands)  2012  2011  2010 

Net income

  $23,449   $22,799   $21,287  

Other comprehensive income:

    

Unrealized gains on securities:

    

Change in net unrealized securities gains arising during period

   6,682    22,350    (16

Deferred tax expense

   (2,646  (8,855  (19

Reclassification adjustment for gains included in income before income taxes

   (2,560  (2,985  425  

Related tax expense (benefit)

   1,014    1,183    (168
  

 

 

  

 

 

  

 

 

 

Change in net unrealized gains on securities, net of tax

   2,490    11,693    222  

Change in pension and post-retirement obligations:

    

Change in net actuarial gain\loss

   (300  (9,979  (2,192

Related tax expense

   118    3,953    950  
  

 

 

  

 

 

  

 

 

 

Change in pension and post-retirement obligations, net of tax

   (182  (6,026  (1,242
  

 

 

  

 

 

  

 

 

 

Other comprehensive income (loss)

   2,308    5,667    (1,020
  

 

 

  

 

 

  

 

 

 

Comprehensive income

  $25,757   $28,466   $20,267  
  

 

 

  

 

 

  

 

 

 

See accompanying notes to the consolidated financial statements.

 

- 6365 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Changes in Shareholders’ Equity

Years ended December 31, 2012, 2011 and 2010

(Dollars in thousands,

except per share data)

  Preferred
Equity
  Common
Stock
   Additional
Paid-in
Capital
  Retained
Earnings
  Accumulated
Other
Comprehensive
Income (Loss)
  Treasury
Stock
  Total
Shareholders’
Equity
 

Balance at January 1, 2010

  $53,418   $113    $26,940   $131,371   $(3,702 $(9,846 $198,294  

Comprehensive income:

         

Net income

   —      —       —      21,287    —      —      21,287  

Other comprehensive loss, net of tax

   —      —       —      —      (1,020  —      (1,020
         

 

 

 

Total comprehensive income

          20,267  

Purchases of common stock for treasury

   —      —       —      —      —      (69  (69

Share-based compensation plans:

         

Share-based compensation

   —      —       1,031    —      —      —      1,031  

Stock options exercised

   —      —       (74  —      —      290    216  

Restricted stock awards issued, net

   —      —       (1,853  —      —      1,853    —    

Directors’ retainer

   —      —       (15  —      —      112    97  

Accrued undeclared cumulative dividend on Series A preferred stock, net of accretion

   367    —       —      (367  —      —      —    

Cash dividends declared:

         

Series A 3% preferred-$3.00 per share

   —      —       —      (5  —      —      (5

Series A preferred-$250.00 per share

   —      —       —      (1,876  —      —      (1,876

Series B-1 8.48% preferred-$8.48 per share

   —      —       —      (1,477  —      —      (1,477

Common-$0.40 per share

   —      —       —      (4,334  —      —      (4,334
  

 

 

  

 

 

   

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Balance at December 31, 2010

  $53,785   $113    $26,029   $144,599   $(4,722 $(7,660 $212,144  

Comprehensive income:

         

Net income

   —      —       —      22,799    —      —      22,799  

Other comprehensive income, net of tax

   —      —       —      —      5,667    —      5,667  
         

 

 

 

Total comprehensive income

          28,466  

Issuance of common stock

   —      29     43,098    —      —      —      43,127  

Purchases of common stock for treasury

   —      —       —      —      —      (215  (215

Repurchase of Series A 3% preferred stock

   (3  —       —      —      —      —      (3

Repurchase of warrant issued to U.S. Treasury

   —      —       (2,080  —      —      —      (2,080

Redemption of Series A preferred stock

   (37,515  —       68    —      —      —      (37,447

Repurchase of Series B-1 8.48% preferred stock

   (99  —       —      —      —      —      (99

Share-based compensation plans:

         

Share-based compensation

   —      —       1,105    —      —      —      1,105  

Stock options exercised

   —      —       (28  —      —      119    91  

Restricted stock awards issued, net

   —      —       (954  —      —      954    —    

Excess tax benefit on share-based compensation

   —      —       21    —      —      —      21  

Directors’ retainer

   —      —       (12    110    98  

Accretion of discount on Series A preferred stock

   1,305    —       —      (1,305  —      —      —    

Cash dividends declared:

         

Series A 3% preferred-$3.00 per share

   —      —       —      (5  —      —      (5

Series A preferred-$53.24 per share

   —      —       —      (399  —      —      (399

Series B-1 8.48% preferred-$8.48 per share

   —      —       —      (1,473  —      —      (1,473

Common-$0.47 per share

   —      —       —      (6,137  —      —      (6,137
  

 

 

  

 

 

   

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Balance at December 31, 2011

  $17,473   $142    $67,247   $158,079   $945   $(6,692 $237,194  
  

 

 

  

 

 

   

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Continued on next page

See accompanying notes to the consolidated financial statements.

- 66 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Changes in Shareholders’ Equity (Continued)

Years ended December 31, 2010, 20092012, 2011 and 2008

                             
                  Accumulated        
          Additional      Other      Total 
(Dollars in thousands, Preferred  Common  Paid-in  Retained  Comprehensive  Treasury  Shareholders’ 
except per share data) Equity  Stock  Capital  Earnings  Income (Loss)  Stock  Equity 
                             
Balance at December 31, 2009
 $53,418  $113  $26,940  $131,371  $(3,702) $(9,846) $198,294 
Balance carried forward
                            
                             
Comprehensive income:                            
Net income           21,287         21,287 
Other comprehensive loss, net of tax              (1,020)     (1,020)
                      
Total comprehensive income                          20,267 
Purchases of treasury stock                 (69)  (69)
Share-based compensation plans:                            
Share-based compensation        1,031            1,031 
Stock options exercised        (74)        290   216 
Restricted stock awards issued, net        (1,853)        1,853    
Directors’ retainer          (15)          112   97 
Accrued undeclared cumulative dividend on Series A preferred stock, net of accretion  367         (367)         
Cash dividends declared:                            
Series A 3% preferred-$3.00 per share           (5)        (5)
Series A preferred-$250.00 per share           (1,876)        (1,876)
Series B-1 8.48% preferred-$8.48 per share           (1,477)        (1,477)
Common-$0.40 per share           (4,334)        (4,334)
                      
 
Balance at December 31, 2010
 $53,785  $113  $26,029  $144,599  $(4,722) $(7,660) $212,144 
                      
2010

(Dollars in thousands,

except per share data)

  Preferred
Equity
  Common
Stock
   Additional
Paid-in
Capital
  Retained
Earnings
  Accumulated
Other
Comprehensive
Income (Loss)
   Treasury
Stock
  Total
Shareholders’
Equity
 

Balance at December 31, 2011

  $17,473   $142    $67,247   $158,079   $945    $(6,692 $237,194  

Balance carried forward

          

Comprehensive income:

          

Net income

   —      —       —      23,449    —       —      23,449  

Other comprehensive income, net of tax

   —      —       —      —      2,308     —      2,308  
          

 

 

 

Total comprehensive income

           25,757  

Purchases of common stock for treasury

   —      —       —      —      —       (557  (557

Repurchase of Series B-1 8.48% preferred stock

   (2  —       —      —      —       —      (2

Share-based compensation plans:

          

Share-based compensation

   —      —       526    —      —       —      526  

Stock options exercised

   —      —       (10  —      —       79    69  

Restricted stock awards issued, net

   —      —       (140  —      —       140    —    

Excess tax benefit on share-based compensation

   —      —       97    —      —       —      97  

Directors’ retainer

   —      —       (10     107    97  

Cash dividends declared:

          

Series A 3% Preferred-$3.00 per share

   —      —       —      (5  —       —      (5

Series B-1 8.48% Preferred-$8.48 per share

   —      —       —      (1,469  —       —      (1,469

Common-$0.57 per share

   —      —       —      (7,810  —       —      (7,810
  

 

 

  

 

 

   

 

 

  

 

 

  

 

 

   

 

 

  

 

 

 

Balance at December 31, 2012

  $17,471   $142    $67,710   $172,244   $3,253    $(6,923 $253,897  
  

 

 

  

 

 

   

 

 

  

 

 

  

 

 

   

 

 

  

 

 

 

See accompanying notes to the consolidated financial statements.

 

- 6467 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows
             
  Years ended December 31, 
(Dollars in thousands) 2010  2009  2008 
Cash flows from operating activities:            
Net income (loss) $21,287  $14,441  $(26,158)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:            
Depreciation and amortization  3,537   4,067   3,959 
Net amortization of premiums on securities  3,005   2,587   390 
Provision for loan losses  6,687   7,702   6,551 
Share-based compensation  1,031   854   633 
Deferred income tax expense (benefit)  2,468   7,470   (23,848)
Proceeds from sale of loans held for sale  42,195   90,290   28,685 
Originations of loans held for sale  (44,262)  (88,999)  (28,453)
Increase in company owned life insurance  (1,107)  (1,096)  (563)
Net gain on sale of loans held for sale  (650)  (699)  (339)
Net gain on disposal of investment securities  (169)  (3,429)  (288)
Impairment charges on investment securities  594   4,666   68,215 
Net loss (gain) on sale and disposal of other assets  203   (180)  (305)
Increase in other assets  (353)  (8,773)  (1,322)
Increase (decrease) in other liabilities  961   (6,633)  (5,866)
          
Net cash provided by operating activities  35,427   22,268   21,291 
          
             
Cash flows from investing activities:            
Purchases of investment securities:            
Available for sale  (430,952)  (602,259)  (310,191)
Held to maturity  (19,791)  (29,280)  (54,925)
Proceeds from principal payments, maturities and calls on investment securities:            
Available for sale  219,974   353,545   337,704 
Held to maturity  30,885   46,891   57,325 
Proceeds from sales and calls of securities available for sale  122,090   224,928   58,368 
Net loan originations  (89,507)  (165,716)  (161,414)
Purchases of company owned life insurance  (79)  (79)  (20,112)
Proceeds from sales of other assets  611   1,709   1,783 
Purchases of premises and equipment  (2,438)  (1,959)  (6,333)
          
Net cash used in investing activities  (169,207)  (172,220)  (97,795)
          
             
Cash flows from financing activities:            
Net increase in deposits  139,935   109,692   57,292 
Net increase (decrease) in short-term borrowings  17,567   36,078   (2,178)
Proceeds from long-term borrowings        30,000 
Repayments of long-term borrowings  (20,080)  (508)  (25,212)
Purchases of preferred and common shares  (69)     (4,821)
Proceeds from issuance of preferred and common shares, net of issuance costs     (68)  35,602 
Proceeds from issuance of common stock warrant  ��     2,025 
Proceeds from stock options exercised  216   15   32 
Cash dividends paid to preferred shareholders  (3,358)  (3,160)  (1,482)
Cash dividends paid to common shareholders  (4,332)  (4,325)  (6,240)
          
Net cash provided by financing activities  129,879   137,724   85,018 
          
             
Net (decrease) increase in cash and cash equivalents  (3,901)  (12,228)  8,514 
Cash and cash equivalents, beginning of period  42,959   55,187   46,673 
          
Cash and cash equivalents, end of period $39,058  $42,959  $55,187 
          

    Years ended December 31, 
(Dollars in thousands)  2012  2011  2010 

Cash flows from operating activities:

    

Net income

  $23,449   $22,799   $21,287  

Adjustments to reconcile net income to net cash provided by operating activities:

    

Depreciation and amortization

   3,828    3,466    3,537  

Net amortization of premiums on securities

   5,284    5,722    3,005  

Provision for loan losses

   7,128    7,780    6,687  

Share-based compensation

   526    1,105    1,031  

Deferred income tax expense

   6,343    6,510    2,468  

Proceeds from sale of loans held for sale

   55,067    32,839    42,195  

Originations of loans held for sale

   (52,754  (31,231  (44,262

Increase in company owned life insurance

   (1,751  (1,424  (1,107

Net gain on sale of loans held for sale

   (1,421  (880  (650

Net gain on disposal of investment securities

   (2,651  (3,003  (169

Impairment charges on investment securities

   91    18    594  

Net loss (gain) on sale and disposal of other assets

   381    (67  203  

Contributions to defined benefit pension plan

   (8,000  (10,000  (4,300

Loss on extinguishment of debt

   —      1,083    —    

Increase in other assets

   (4,249  (7,756  (353

Increase in other liabilities

   7,429    5,057    5,261  
  

 

 

  

 

 

  

 

 

 

Net cash provided by operating activities

   38,700    32,018    35,427  
  

 

 

  

 

 

  

 

 

 

Cash flows from investing activities:

    

Purchases of investment securities:

    

Available for sale

   (322,191  (158,013  (430,952

Held to maturity

   (15,484  (17,188  (19,791

Proceeds from principal payments, maturities and calls on investment securities:

    

Available for sale

   175,679    168,976    219,974  

Held to maturity

   20,819    21,986    30,885  

Proceeds from sales of securities available for sale

   2,823    44,514    122,090  

Net increase in loans, excluding sales

   (151,311  (157,110  (89,507

Loans sold or participated to others

   —      13,033    —    

Purchases of company owned life insurance

   (79  (18,079  (79

Proceeds from sales of other assets

   734    705    611  

Purchases of premises and equipment

   (5,840  (3,678  (2,438

Net cash received in branch acquisitions

   195,778    —      —    
  

 

 

  

 

 

  

 

 

 

Net cash used in investing activities

   (99,072  (104,854  (169,207
  

 

 

  

 

 

  

 

 

 

Cash flows from financing activities:

    

Net increase in deposits

   43,376    48,709    139,935  

Net increase in short-term borrowings

   29,108    73,588    17,567  

Repayments of long-term borrowings

   —      (26,767  (20,080

Proceeds from issuance of common stock, net of issuance costs

   —      43,127    —    

Purchases of common stock for treasury

   (557  (215  (69

Repurchase of preferred stock

   (2  (37,549  —    

Repurchase of warrant issued to U.S. Treasury

   —      (2,080  —    

Proceeds from stock options exercised

   69    91    216  

Excess tax benefit on share-based compensation

   97    21    —    

Cash dividends paid to preferred shareholders

   (1,474  (2,118  (3,358

Cash dividends paid to common shareholders

   (7,392  (5,446  (4,332
  

 

 

  

 

 

  

 

 

 

Net cash provided by financing activities

   63,225    91,361    129,879  
  

 

 

  

 

 

  

 

 

 

Net increase (decrease) in cash and cash equivalents

   2,853    18,525    (3,901

Cash and cash equivalents, beginning of period

   57,583    39,058    42,959  
  

 

 

  

 

 

  

 

 

 

Cash and cash equivalents, end of period

  $60,436   $57,583   $39,058  
  

 

 

  

 

 

  

 

 

 

See accompanying notes to the consolidated financial statements.

 

- 6568 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2010, 20092012, 2011 and 2008

2010

(1.) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Financial Institutions, Inc., a financial holding company organized under the laws of New York State (“New York” or “NYS”), and its subsidiaries provide deposit, lending and other financial services to individuals and businesses in WesternCentral and CentralWestern New York. The Company has also expanded its indirect lending network to include relationships with franchised automobile dealers in the Capital District of New York and Northern Pennsylvania. Financial Institutions, Inc. owns 100%all of the capital stock of Five Star Bank, a New York State chartered bank, and Five Star Investment Services, Inc., a broker-dealerfinancial services subsidiary offering noninsured investment products. The Company also owns 100% of FISI Statutory Trust I (the “Trust”), which was formed in February 2001 for the purpose of issuing trust preferred securities.products and investment advisory services. References to “the Company” mean the consolidated reporting entities and references to “the Bank” mean Five Star Bank.

The accounting and reporting policies conform to general practices within the banking industry and to U.S. generally accepted accounting principles (“GAAP”). Prior years’ consolidated financial statements are re-classified whenever necessary to conform to the current year’s presentation.

The Company has evaluated events and transactions for potential recognition or disclosure through the day the financial statements were issued.

The following is a description of the Company’s significant accounting policies.

(a.) Principles of Consolidation

The consolidated financial statements include the accounts of the Company and its subsidiaries. The Trust is not included in the consolidated financial statements of the Company. All significant intercompany accounts and transactions have been eliminated in consolidation.

The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.

(b.) Use of Estimates

In preparing the consolidated financial statements in conformity with GAAP, management is required to make estimates and assumptions that affect the reported amount of assets and liabilities as of the date of the statement of financial condition and reported amounts of revenue and expenses during the reporting period. Material estimates relate to the determination of the allowance for loan losses, assumptions used in the defined benefit pension plan accounting, the carrying value of goodwill and deferred tax assets, and the valuation and other than temporary impairment (“OTTI”) considerations related to the securities portfolio. These estimates and assumptions are based on management’s best estimates and judgment and are evaluated on an ongoing basis using historical experience and other factors, including the current economic environment. The Company adjusts these estimates and assumptions when facts and circumstances dictate. As future events cannot be determined with precision, actual results could differ significantly from the Company’s estimates.

In preparing the consolidated financial statements in conformity with GAAP, management is required to make estimates and assumptions that affect the reported amount of assets and liabilities as of the date of the statement of financial condition and reported amounts of revenue and expenses during the reporting period. Material estimates relate to the determination of the allowance for loan losses, the carrying value of goodwill and deferred tax assets, the valuation and other than temporary impairment (“OTTI”) considerations related to the securities portfolio, and assumptions used in the defined benefit pension plan accounting. These estimates and assumptions are based on management’s best estimates and judgment and are evaluated on an ongoing basis using historical experience and other factors, including the current economic environment. The Company adjusts these estimates and assumptions when facts and circumstances dictate. As future events cannot be determined with precision, actual results could differ significantly from the Company’s estimates.

(c.) Cash Flow Reporting

Cash and cash equivalents include cash and due from banks, federal funds sold and interest-bearing deposits in other banks. Net cash flows are reported for loans, deposit transactions and short-term borrowings.

Supplemental cash flow information is summarized as follows for the years ended December 31 (in thousands):

   2012   2011  2010 

Cash payments:

     

Interest expense

  $10,438    $15,668   $17,676  

Income taxes

   4,014     5,191    6,923  

Noncash investing and financing activities:

     

Real estate and other assets acquired in settlement of loans

  $322    $305   $561  

Accrued and declared unpaid dividends

   2,562     2,144    1,694  

Accretion of preferred stock discount

   —       1,305    367  

Increase (decrease) in net unsettled security purchases

   51,135     (67  (317

Net transfer of portfolio loans to held for sale

   —       13,576    —    

Assets acquired and liabilities assumed in branch acquisition:

     

Loans and other non-cash assets, excluding goodwill and core deposit intangible asset

   77,912     —      —    

Deposits and other liabilities

   287,331     —      —    

- 69 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(1.)Cash and cash equivalents include cash and due from banks, federal funds sold and interest-bearing deposits in other banks. Net cash flows are reported for loans, deposit transactions and short-term borrowings.SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Supplemental cash flow information is summarized as follows for the years ended December 31 (in thousands):
             
  2010  2009  2008 
Cash paid during the year for:            
Interest expense $17,676  $21,682  $37,160 
Income taxes, net of income tax refunds  6,923   (1,312)  3,797 
Non-cash activity:            
Real estate and other assets acquired in settlement of loans $561  $1,096  $1,185 
Dividends declared and unpaid  1,694   1,692   1,497 
(Decrease) increase in net unsettled security purchases  (317)  (1,348)  1,453 
Loans securitized and sold     15,983    

(d.) Investment Securities

Investment securities are classified as either available for sale or held to maturity. Debt securities that management has the positive intent and ability to hold to maturity are classified as held to maturity and are recorded at amortized cost. Other investment securities are classified as available for sale and recorded at fair value, with unrealized gains and losses excluded from earnings and reported as a component of shareholders’ equity.

- 66 -

Investment securities are classified as either available for sale or held to maturity. Debt securities that management has the positive intent and ability to hold to maturity are classified as held to maturity and are recorded at amortized cost. Other investment securities are classified as available for sale and recorded at fair value, with unrealized gains and losses excluded from earnings and reported as a component of comprehensive income and shareholders’ equity.


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
(1.) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Securities are evaluated periodically to determine whether a decline in their fair value is other than temporary. Management utilizes criteria such as, the current intent to hold or sell the security, the magnitude and duration of the decline and, when appropriate, consideration of negative changes in expected cash flows, creditworthiness, near term prospects of issuers, the level of credit subordination, estimated loss severity, and delinquencies, to determine whether a loss in value is other than temporary. The term “other than temporary” is not intended to indicate that the decline is permanent, but indicates that the prospect for a near-term recovery of value is not necessarily favorable. Declines in the fair value of investment securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses to the extent the impairment is related to credit issues or concerns, or the security is intended to be sold. The amount of impairment related to non-credit related factors is recognized in other comprehensive income. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.
(e.) Loans Held for Sale and Mortgage Servicing Rights
The Company generally makes the determination of whether or not to identify a mortgage loan as held for sale at the time the loan is closed based on the Company’s intent and ability to hold the loan. Loans held for sale are recorded at the lower of cost or market computed on the aggregate portfolio basis. The amount, by which cost exceeds market value, if any, is accounted for as a valuation allowance with changes included in the determination of results of operations for the period in which the change occurs. The amount of loan origination cost and fees are deferred at origination of the loans and recognized as part of the gain and loss on sale of the loans, determined using the specific identification method, in the consolidated statement of operations.
The Company originates and sells certain residential real estate loans in the secondary market. The Company typically retains the right to service the mortgages upon sale. Mortgage-servicing rights (“MSRs”) represent the cost of acquiring the contractual rights to service loans for others. MSRs are recorded at their fair value at the time a loan is sold and servicing rights are retained. MSRs are reported in other assets in the consolidated statements of financial position and are amortized to noninterest income in the consolidated statements of operations in proportion to and over the period of estimated net servicing income. The Company uses a valuation model that calculates the present value of future cash flows to determine the fair value of servicing rights. In using this valuation method, the Company incorporates assumptions to estimate future net servicing income, which include estimates of the cost to service the loan, the discount rate, an inflation rate and prepayment speeds. On a quarterly basis the Company evaluates its MSRs for impairment and charges any such impairment to current period earnings. In order to evaluate its MSRs the Company stratifies the related mortgage loans on the basis of their predominant risk characteristics, such as interest rates, year of origination and term, using discounted cash flows and market-based assumptions. Impairment of MSRs is recognized through a valuation allowance, determined by estimating the fair value of each stratum and comparing it to its carrying value. Subsequent increases in fair value are adjusted through the valuation allowance, but only to the extent of the valuation allowance. No impairment loss was recognized during the years ended December 31, 2010 or 2009. The Company recognized an impairment loss of $343 thousand during the year ended December 31, 2008.
Mortgage loan servicing includes collecting monthly mortgagor payments, forwarding payments and related accounting reports to investors, collecting escrow deposits for the payment of mortgagor property taxes and insurance, and paying taxes and insurance from escrow funds when due. Loan servicing income (a component of noninterest income in the consolidated statements of operations) consists of fees earned for servicing mortgage loans sold to third parties, net of amortization expense and impairment losses associated with capitalized mortgage servicing assets.

- 67 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
(1.) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
(f.) Loans
Loans are classified as held for investment when management has both the intent and ability to hold the loan for the foreseeable future, or until maturity or payoff. Loans are carried at the principal amount outstanding, net of any unearned income and unamortized deferred fees and costs on originated loans. Loan origination fees and certain direct loan origination costs are deferred, and the net amount is amortized into net interest income over the contractual life of the related loans or over the commitment period as an adjustment of yield. Interest income on loans is based on the principal balance outstanding computed using the effective interest method.
A loan is considered delinquent when a payment has not been received in accordance with the contractual terms. The accrual of interest income for commercial loans is discontinued when there is a clear indication that the borrower’s cash flow may not be sufficient to meet payments as they become due, while the accrual of interest income for retail loans is discontinued when loans reach specific delinquency levels. Loans are generally placed on nonaccrual status when contractually past due 90 days or more as to interest or principal payments, unless the loan is well secured and in the process of collection. Additionally, whenever management becomes aware of facts or circumstances that may adversely impact the collectability of principal or interest on loans, it is management’s practice to place such loans on a nonaccrual status immediately, rather than delaying such action until the loans become 90 days past due. When a loan is placed on nonaccrual status, previously accrued and uncollected interest is reversed, amortization of related deferred loan fees or costs is suspended, and income is recorded only to the extent that interest payments are subsequently received in cash and a determination has been made that the principal balance of the loan is collectible. If collectability of the principal is in doubt, payments received are applied to loan principal. A nonaccrual loan is returned to accrual status when all delinquent principal and interest payments become current in accordance with the terms of the loan agreement, the borrower has demonstrated a period of sustained performance (generally a minimum of six months) and the ultimate collectability of the total contractual principal and interest is no longer in doubt.
The Company’s loan policy dictates the guidelines to be followed in determining when a loan is charged-off. All charge offs are approved by the Bank’s senior loan officers or loan committees, depending on the amount of the charge off, and are reported in aggregate to the Bank’s Board of Directors. Commercial business and commercial mortgage loans are charged-off when a determination is made that the financial condition of the borrower indicates that the loan will not be collectible in the ordinary course of business. Residential mortgage loans and home equities are generally charged-off or written down when the credit becomes severely delinquent and the balance exceeds the fair value of the property less costs to sell. Indirect and other consumer loans, both secured and unsecured, are generally charged-off in full during the month in which the loan becomes 120 days past due, unless the collateral is in the process of repossession in accordance with the Company’s policy.
A loan is accounted for as a troubled debt restructuring if the Company, for economic or legal reasons related to the borrower’s financial condition, grants a significant concession to the borrower that it would not otherwise consider. A troubled debt restructuring may involve the receipt of assets from the debtor in partial or full satisfaction of the loan, or a modification of terms such as a reduction of the stated interest rate or face amount of the loan, a reduction of accrued interest, an extension of the maturity date at a stated interest rate lower than the current market rate for a new loan with similar risk, or some combination of these concessions. Troubled debt restructurings generally remain on nonaccrual status until there is a sustained period of payment performance (usually six months or longer) and there is a reasonable assurance that the payments will continue. See Allowance for Loan Losses below for further policy discussion and see Note 4 for additional information on loans.
(g.) Off-Balance Sheet Financial Instruments
In the ordinary course of business, the Company enters into off-balance sheet financial instruments consisting of commitments to extend credit, stand by letters of credit and financial guarantees. Such financial instruments are recorded in the consolidated financial statements when they are funded or when related fees are incurred or received. The Company periodically evaluates the credit risks inherent in these commitments and establishes loss allowances for such risks if and when these are deemed necessary.
The Company recognizes as liabilities the fair value of the obligations undertaken in issuing the guarantees under the standby letters of credit, net of the related amortization at inception. The fair value approximates the unamortized fees received from the customers for issuing the standby letters of credit. The fees are deferred and recognized on a straight-line basis over the commitment period. Standby letters of credit outstanding at December 31, 2010 had terms ranging from one to five years.
Fees received for providing loan commitments and letters of credit that result in loans are typically deferred and amortized to interest income over the life of the related loan, beginning with the initial borrowing. Fees on commitments and letters of credit are amortized to other income as banking fees and commissions over the commitment period when funding is not expected.

- 68 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
(1.) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
(h.) Allowance for Loan Losses
The allowance for loan losses is established through charges to earnings in the form of a provision for loan losses. When a loan or portion of a loan is determined to be uncollectible, the portion deemed uncollectible is charged against the allowance and subsequent recoveries, if any, are credited to the allowance.
The allowance for loan losses is evaluated on a regular basis and is based upon periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
The allowance consists of specific and general components. Specific allowances are established for impaired loans. Commercial business and commercial mortgage loans are individually evaluated and measured for impairment based on the present value of expected future cash flows discounted at the loan’s effective interest rate, a loan’s observable market price, or the fair value of the collateral if the loan is collateral dependent. Regardless of the measurement method, impairment is based on the fair value of the collateral when foreclosure is probable. If the recorded investment in impaired loans exceeds the measure of estimated fair value, a specific allowance is established as a component of the allowance for loan losses. Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Impaired loans, or portions thereof, are charged off when deemed uncollectible.
A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered in determining impairment include payment status and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. The Company determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loans obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Large groups of homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment disclosures unless the loan has been subject to a troubled debt restructure.
General allowances are established for loan losses on a portfolio basis for loans that do not meet the definition of impaired. The portfolio is grouped into similar risk characteristics, primarily loan type. The Company applies an estimated loss rate to each loan group. The loss rate is based on historical experience and as a result can differ from actual losses incurred in the future. The historical loss rate is adjusted for qualitative factors such as levels and trends of delinquent and non-accruing loans, trends in volume and terms, effects of changes in lending policy, the experience, ability and depth of management, national and local economic trends and conditions, and concentrations of credit risk, interest rates, highly leveraged borrowers, information risk and collateral risk. The qualitative factors are reviewed at least quarterly and adjustments are made as needed.
While management evaluates currently available information in establishing the allowance for loan losses, future adjustments to the allowance may be necessary if conditions differ substantially from the assumptions used in making the evaluations. In addition, various regulatory agencies, as an integral part of their examination process, periodically review a financial institution’s allowance for loan losses. Such agencies may require the financial institution to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.
(i.) Other Real Estate Owned
Other real estate owned consists of properties acquired through foreclosure or by acceptance of a deed in lieu of foreclosure. These assets are recorded at the lower of fair value of the asset acquired less estimated costs to sell or “cost” (defined as the fair value at initial foreclosure). At the time of foreclosure, or when foreclosure occurs in-substance, the excess, if any, of the loan over the fair market value of the assets received, less estimated selling costs, is charged to the allowance for loan losses and any subsequent valuation write-downs are charged to other expense. In connection with the determination of the allowance for loan losses and the valuation of other real estate owned, management obtains appraisals for properties. Operating costs associated with the properties are charged to expense as incurred. Gains on the sale of other real estate owned are included in income when title has passed and the sale has met the minimum down payment requirements prescribed by GAAP. The balance of other real estate owned at December 31, 2010 was $741 thousand.

- 69 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
(1.) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
(j.) Company Owned Life Insurance
The Company holds life insurance policies on certain current and former employees. The Company is the owner and beneficiary of the policies. The cash surrender value of these policies is included as an asset on the consolidated statements of financial condition, and any increase in cash surrender value is recorded as noninterest income on the consolidated statements of operations. In the event of the death of an insured individual under these policies, the Company would receive a death benefit which would be recorded as noninterest income.
(k.) Premises and Equipment
Premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation is computed on the straight-line method over the estimated useful lives of the assets. The Company generally amortizes buildings and building improvements over a period of 15 to 39 years and furniture and equipment over a period of 3 to 10 years. Leasehold improvements are amortized over the shorter of the lease term or the useful life of the improvements. Premises and equipment are periodically reviewed for impairment or when circumstances present indicators of impairment.
(l.) Goodwill and Other Intangible Assets
Goodwill represents the excess of the purchase price over the fair value of net assets acquired in accordance with the purchase method of accounting for business combinations. Goodwill is not amortized but, instead, is subject to impairment tests on at least an annual basis or more frequently if an event occurs or circumstances change that reduce the fair value of a reporting unit below its carrying amount. The Company completes the annual goodwill impairment test as of September 30 of each year. The impairment testing process is conducted by assigning net assets and goodwill to each reporting unit. Currently, the Company’s goodwill is evaluated at the entity level as there is only one reporting unit. The fair value of each reporting unit is compared to the recorded book value “step one”. If the fair value of the reporting unit exceeds its carrying value, goodwill is not considered impaired and “step two” is not considered necessary. If the carrying value of a reporting unit exceeds its fair value, the impairment test continues (“step two”) by comparing the carrying value of the reporting unit’s goodwill to the implied fair value of goodwill. The implied fair value is computed by adjusting all assets and liabilities of the reporting unit to current fair value with the offset adjustment to goodwill. The adjusted goodwill balance is the implied fair value of the goodwill. An impairment charge is recognized if the carrying fair value of goodwill exceeds the implied fair value of goodwill.
The company had other intangible assets, consisting entirely of core deposit intangibles, which were fully amortized as of December 31, 2009. Amortization expense for these other intangible assets for the years ended December 31, 2009 and 2008 was $280 thousand and $307 thousand, respectively. Amortization of other intangible assets was computed using the straight-line method over the estimated lives of the respective assets (primarily 5 and 7 years).
(m.) Federal Home Loan Bank (“FHLB”) and Federal Reserve Bank (“FRB”) Stock
The non-marketable investments in FHLB and FRB stock are included in other assets in the consolidated statements of financial condition at par value or cost and are periodically reviewed for impairment. The dividends received relative to these investments are included in other noninterest income in the consolidated statements of operations.
As a member of the FHLB system, the Company is required to maintain a specified investment in FHLB of New York (“FHLBNY”) stock in proportion to its volume of certain transactions with the FHLB. FHLBNY stock totaled $2.5 million and $3.3 million as of December 31, 2010 and 2009, respectively.
As a member of the FRB system, the Company is required to maintain a specified investment in FRB stock based on a ratio relative to the Company’s capital. FRB stock totaled $3.9 million as of December 31, 2010 and 2009.
(n.) Equity Method Investments
The Company has investments in limited partnerships and accounts for these investments under the equity method. These investments are included in other assets in the consolidated statements of financial condition and totaled $3.6 million and $2.7 million as of December 31, 2010 and 2009, respectively.
(o.) Treasury Stock
Acquisitions of treasury stock are recorded at cost. The reissuance of shares in treasury is recorded at weighted-average cost.

- 70 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
(1.) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
(p.) Employee Benefits
The Company participates in a non-contributory defined benefit pension plan for certain employees who previously met participation requirements. The Company also provides post-retirement benefits, principally health and dental care, to employees of a previously acquired entity. The Company has closed the pension and post-retirement plans to new participants. The actuarially determined pension benefit is based on years of service and the employee’s highest average compensation during five consecutive years of employment. The Company’s policy is to at least fund the minimum amount required by the Employment Retirement Income Security Act of 1974. The cost of the pension and post-retirement plans are based on actuarial computations of current and future benefits for employees, and is charged to noninterest expense in the consolidated statements of operations.
The Company recognizes an asset or a liability for a plans’ overfunded status or underfunded status, respectively, in the consolidated financial statements and reports changes in the funded status as a component of other comprehensive income, net of applicable taxes, in the year in which changes occur. Prior to 2008, the assets and obligations that determine future funded status were measured as of September 30 of each year. Beginning in 2008, the measurement date was changed to December 31 to coincide with the end of the Company’s fiscal year. The effect of changing the measurement date resulted in a $43 thousand increase to retained earnings.
(q.) Share-Based Compensation Plans
Compensation expense for stock options and restricted stock awards is based on the fair value of the award on the measurement date, which, for the Company, is the date of grant and is recognized ratably over the service period of the award. The fair value of stock options is estimated using the Black-Scholes option-pricing model. The fair value of restricted stock awards is generally the market price of the Company’s stock on the date of grant.
Share-based compensation expense is included in the consolidated statements of operations under salaries and employee benefits for awards granted to management and in other noninterest expense for awards granted to directors.
(r.) Income Taxes
Income taxes are accounted for using the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date. A valuation allowance is recognized on deferred tax assets if, based upon the weight of available evidence, it is more likely than not that some or all of the assets may not be realized. The Company recognizes interest and/or penalties related to income tax matters in income tax expense.
(s.) Earnings (Loss) Per Share
Effective January 1, 2009, the Company adopted new authoritative accounting guidance under Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 260, “Earnings Per Share,” which provides that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of earnings per share pursuant to the two-class method. The Company has determined that its outstanding non-vested stock awards are participating securities. Accordingly, effective January 1, 2009, earnings per common share is computed using the two-class method prescribed under FASB ASC Topic 260. All previously reported earnings per common share data has been retrospectively adjusted to conform to the new computation method. The adoption and resulting adjustments to conform to the new guidance did not have a material impact on the Company’s consolidated financial statements.
Under the two-class method, basic earnings per common share is computed by dividing net earnings allocated to common stock by the weighted-average number of common shares outstanding during the applicable period, excluding outstanding participating securities. Diluted earnings per common share is computed using the weighted-average number of shares determined for the basic earnings per common share computation plus the dilutive effect of stock compensation using the treasury stock method. A reconciliation of the weighted-average shares used in calculating basic earnings per common share and the weighted average common shares used in calculating diluted earnings per common share for the reported periods is provided in Note 15 - Earnings (Loss) Per Share.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
(1.) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
(t.) Recent Accounting Pronouncements
FASB ASC 810 Consolidation(“ASC 810”) was amended to change how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a company is required to consolidate an entity is based on, among other things, an entity’s purpose and design and a company’s ability to direct the activities of the entity that most significantly impact the entity’s economic performance. The new authoritative accounting guidance requires additional disclosures about the reporting entity’s involvement with variable-interest entities and any significant changes in risk exposure due to that involvement as well as its affect on the entity’s financial statements. The new authoritative accounting guidance under ASC 810 was adopted effective January 1, 2010 and did not have a significant impact on the Company’s consolidated financial statements.
FASB ASC 860 Transfers and Servicing(“ASC 860”) was amended to enhance reporting about transfers of financial assets, including securitizations, and where companies have continuing exposure to the risks related to transferred financial assets. The new authoritative accounting guidance eliminates the concept of a “qualifying special-purpose entity” and changes the requirements for derecognizing financial assets. The new authoritative accounting guidance also requires additional disclosures about all continuing involvements with transferred financial assets including information about gains and losses resulting from transfers during the period. The new authoritative accounting guidance under ASC 860 was adopted effective January 1, 2010 and did not have a significant impact on the Company’s consolidated financial statements.
FASB ASC 820 Fair Value Measurements and Disclosures(“ASC 820”) was amended to require some new disclosures and clarify some existing disclosure requirements about fair value measurement. It requires separate presentation of significant transfers into and out of Levels 1 and 2 of the fair value hierarchy and disclosure of the reasons for such transfers. It will also require the presentation of purchases, sales, issuances and settlements within Level 3 on a gross basis rather than a net basis. The amendments also clarify that disclosures should be disaggregated by class of asset or liability and that disclosures about inputs and valuation techniques should be provided for both recurring and non-recurring fair value measurements. These new disclosure requirements were adopted by the Company during the current year, with the exception of the requirement concerning gross presentation of Level 3 activity, which is effective for fiscal years beginning after December 15, 2010. With respect to the portions of this amendment that were adopted during the current period, the adoption of this standard did not have a significant impact on the Company’s consolidated financial statements. The Company believes that the adoption of the remaining portion of this amendment will not have a significant impact on the Company’s consolidated financial statements.
FASB ASC 310 Receivables(“ASC 310”) was amended to require an entity to provide a greater level of disaggregated information about the credit quality of its financing receivables and its allowance for credit losses. The requirements are intended to enhance transparency regarding credit losses and the credit quality of loan and lease receivables. Under this statement, allowance for credit losses and fair value are to be disclosed by portfolio segment, while credit quality information, impaired financing receivables and nonaccrual status are to be presented by class of financing receivable. Disclosure of the nature and extent, the financial impact and segment information of troubled debt restructurings will also be required. These new disclosure requirements were adopted by the Company during the current year and are presented in Note 4 — Loans.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
(2.) INVESTMENT SECURITIES
The amortized cost and estimated fair value of investment securities are summarized below (in thousands).
                 
  December 31, 2010 
  Amortized  Unrealized  Unrealized  Fair 
  Cost  Gains  Losses  Value 
Securities available for sale:
                
U.S. Government agencies and government sponsored enterprises $141,591  $1,158  $1,965  $140,784 
State and political subdivisions  105,622   1,516   1,472   105,666 
Mortgage-backed securities:                
Federal National Mortgage Association  96,300   798   1,030   96,068 
Federal Home Loan Mortgage Corporation  83,745   321   1,317   82,749 
Government National Mortgage Association  102,633   2,422   7   105,048 
Collateralized mortgage obligations:                
Federal National Mortgage Association  8,938   231   11   9,158 
Federal Home Loan Mortgage Corporation  15,917   329   1   16,245 
Government National Mortgage Association  106,969   1,761   289   108,441 
Privately issued  981   591      1,572 
             
Total collateralized mortgage obligations  132,805   2,912   301   135,416 
             
Total mortgage-backed securities  415,483   6,453   2,655   419,281 
Asset-backed securities  564   204   131   637 
             
Total available for sale securities $663,260  $9,331  $6,223  $666,368 
             
                 
Securities held to maturity:
                
State and political subdivisions $28,162  $687  $  $28,849 
             
                 
  December 31, 2009 
  Amortized  Unrealized  Unrealized  Fair 
  Cost  Gains  Losses  Value 
Securities available for sale:
                
U.S. Government agencies and government sponsored enterprises $134,564  $86  $545  $134,105 
State and political subdivisions  80,812   2,850   3   83,659 
Mortgage-backed securities:                
Federal National Mortgage Association  75,108   629   259   75,478 
Federal Home Loan Mortgage Corporation  37,321   413   56   37,678 
Government National Mortgage Association  110,576   97   342   110,331 
Collateralized mortgage obligations:                
Federal National Mortgage Association  16,274   250   94   16,430 
Federal Home Loan Mortgage Corporation  20,879   504   14   21,369 
Government National Mortgage Association  95,886   56   873   95,069 
Privately issued  5,087   403   330   5,160 
             
Total collateralized mortgage obligations  138,126   1,213   1,311   138,028 
             
Total mortgage-backed securities  361,131   2,352   1,968   361,515 
Asset-backed securities  1,295   171   244   1,222 
             
Total available for sale securities $577,802  $5,459  $2,760  $580,501 
             
                 
Securities held to maturity:
                
State and political subdivisions $39,573  $1,056  $  $40,629 
             

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
(2.) INVESTMENT SECURITIES (Continued)
Interest and dividends on securities for the years ended December 31 are summarized as follows (in thousands):
             
  2010  2009  2008 
Taxable interest and dividends $17,101  $16,466  $21,882 
Tax-exempt interest and dividends  3,521   5,228   8,773 
          
Total interest and dividends on securities $20,622  $21,694  $30,655 
          
Sales of securities available for sale for the years ended December 31 were as follows (in thousands):
             
  2010  2009  2008 
Proceeds from sales and calls $122,090  $224,928  $58,368 
Gross realized gains  173   6,826   291 
Gross realized losses  4   3,397   3 
The scheduled maturities of securities available for sale and securities held to maturity at December 31, 2010 are shown below. Actual expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations (in thousands).
         
  Amortized  Fair 
  Cost  Value 
Debt securities available for sale:
        
Due in one year or less $25,689  $25,952 
Due from one to five years  114,924   117,338 
Due after five years through ten years  223,692   218,640 
Due after ten years  298,955   304,438 
       
  $663,260  $666,368 
       
Debt securities held to maturity:
        
Due in one year or less $21,439  $21,583 
Due from one to five years  5,490   5,856 
Due after five years through ten years  1,055   1,205 
Due after ten years  178   205 
       
  $28,162  $28,849 
       

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
(2.)
INVESTMENT SECURITIES (Continued)
The following tables show the investments’ gross unrealized losses (excluding unrealized losses that have been written down through the consolidated statements of operations) and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position as of December 31 (in thousands).
                         
  December 31, 2010 
  Less than 12 months  12 months or longer  Total 
  Fair  Unrealized  Fair  Unrealized  Fair  Unrealized 
  Value  Losses  Value  Losses  Value  Losses 
Securities available for sale:
                        
U.S. Government agencies and government sponsored enterprises $47,752  $1,911  $8,821  $54  $56,573  $1,965 
State and political subdivisions  38,398   1,472         38,398   1,472 
Mortgage-backed securities:                        
Federal National Mortgage Association  46,777   1,030         46,777   1,030 
Federal Home Loan Mortgage Corporation  60,707   1,317         60,707   1,317 
Government National Mortgage Association  5,135   7         5,135   7 
Collateralized mortgage obligations:                        
Federal National Mortgage Association        2,332   11   2,332   11 
Federal Home Loan Mortgage Corporation  612   1         612   1 
Government National Mortgage Association  17,798   289         17,798   289 
                   
Total collateralized mortgage obligations  18,410   290   2,332   11   20,742   301 
                   
Total mortgage-backed securities  131,029   2,644   2,332   11   133,361   2,655 
Asset-backed securities  111   61   96   70   207   131 
                   
Total temporarily impaired securities
 $217,290  $6,088  $11,249  $135  $228,539  $6,223 
                   
                         
  December 31, 2009 
  Less than 12 months  12 months or longer  Total 
  Fair  Unrealized  Fair  Unrealized  Fair  Unrealized 
  Value  Losses  Value  Losses  Value  Losses 
Securities available for sale:
                        
U.S. Government agencies and government sponsored enterprises $83,480  $360  $10,003  $185  $93,483  $545 
State and political subdivisions        150   3   150   3 
Mortgage-backed securities:                        
Federal National Mortgage Association  24,964   258   643   1   25,607   259 
Federal Home Loan Mortgage Corporation  5,627   56         5,627   56 
Government National Mortgage Association  55,304   342         55,304   342 
Collateralized mortgage obligations:                        
Federal National Mortgage Association  353   2   5,384   92   5,737   94 
Federal Home Loan Mortgage Corporation  490   1   814   13   1,304   14 
Government National Mortgage Association  79,645   873         79,645   873 
Privately issued        2,985   330   2,985   330 
                   
Total collateralized mortgage obligations  80,488   876   9,183   435   89,671   1,311 
                   
Total mortgage-backed securities  166,383   1,532   9,826   436   176,209   1,968 
Asset-backed securities  278   244         278   244 
                   
Total temporarily impaired securities
 $250,141  $2,136  $19,979  $624  $270,120  $2,760 
                   
There were no unrealized losses in held to maturity securities at December 31, 2010 or December 31, 2009.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
(2.) INVESTMENT SECURITIES (Continued)
The Company reviews investment securities on an ongoing basis for the presence of OTTI with formal reviews performed quarterly. Declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses to the extent the impairment is related to credit issues or concerns, or the security is intended to be sold. The amount of the impairment related to non-credit related factors is recognized in other comprehensive income. EvaluatingGains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.

(e.) Loans Held for Sale and Loan Servicing Rights

The Company generally makes the determination of whether to identify a mortgage as held for sale at the impairmenttime the loan is closed based on the Company’s intent and ability to hold the loan. Loans held for sale are recorded at the lower of cost or market computed on the aggregate portfolio basis. The amount, by which cost exceeds market value, if any, is accounted for as a debt securityvaluation allowance with changes included in the determination of results of operations for the period in which the change occurs. The amount of loan origination cost and fees are deferred at origination of the loans and recognized as part of the gain or loss on sale of the loans, determined using the specific identification method, in the consolidated statements of income.

The Company originates and sells certain residential real estate loans in the secondary market. The Company typically retains the right to service the mortgages upon sale. Mortgage-servicing rights (“MSRs”) represent the cost of acquiring the contractual rights to service loans for others. MSRs are recorded at their fair value at the time a loan is sold and servicing rights are retained. MSRs are reported in other than temporary involves assessing i.)assets in the intentconsolidated statements of financial position and are amortized to sellnoninterest income in the debt security or ii.)consolidated statements of income in proportion to and over the likelihoodperiod of being required to sell the security before the recovery of its amortized cost basis. In determining whether the OTTI includes a credit loss, theestimated net servicing income. The Company uses its best estimate ofa valuation model that calculates the present value of future cash flows to determine the fair value of servicing rights. In using this valuation method, the Company incorporates assumptions to estimate future net servicing income, which include estimates of the cost to service the loan, the discount rate, an inflation rate and prepayment speeds. On a quarterly basis, the Company evaluates its MSRs for impairment and charges any such impairment to current period earnings. In order to evaluate its MSRs the Company stratifies the related mortgage loans on the basis of their predominant risk characteristics, such as interest rates, year of origination and term, using discounted cash flows and market-based assumptions. Impairment of MSRs is recognized through a valuation allowance, determined by estimating the fair value of each stratum and comparing it to its carrying value. Subsequent increases in fair value are adjusted through the valuation allowance, but only to the extent of the valuation allowance. No impairment loss related to the MSRs was recognized during the years ended December 31, 2012 or 2010. The Company recognized an impairment loss related to the MSRs of $35 thousand during the year ended December 31, 2011.

Mortgage loan servicing includes collecting monthly mortgagor payments, forwarding payments and related accounting reports to investors, collecting escrow deposits for the payment of mortgagor property taxes and insurance, and paying taxes and insurance from escrow funds when due. Loan servicing income (a component of noninterest income in the consolidated statements of income) consists of fees earned for servicing mortgage loans sold to third parties, net of amortization expense and impairment losses associated with capitalized mortgage servicing assets.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(1.)SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Automobile loan servicing rights are accounted for using the amortization method. A servicing asset is established at fair value at the time of the sale. The servicing asset is reported in other assets in the consolidated statements of financial position and amortized to noninterest income in the consolidated statements of income in proportion to and over the period of estimated net servicing income. Impairment, if any, is recognized when carrying value exceeds the fair value as determined by calculating the present value of expected net future cash flows. The primary risk characteristic for measuring servicing assets is payoff rates of the underlying loan pools. Valuation calculations rely on the predicted payoff assumption and, if actual payoff is quicker than expected, then future value would be impaired. Management reviewed the servicing asset related to the automobile loan servicing rights for impairment as of December 31, 2012 and determined that no valuation allowance was necessary.

(f.) Loans

Loans are classified as held for investment when management has both the intent and ability to hold the loan for the foreseeable future, or until maturity or payoff. Loans are carried at the principal amount outstanding, net of any unearned income and unamortized deferred fees and costs on originated loans. Loan origination fees and certain direct loan origination costs are deferred, and the net amount is amortized into net interest income over the contractual life of the related loans or over the commitment period as an adjustment of yield. Interest income on loans is based on the principal balance outstanding computed using the effective interest method.

A loan is considered delinquent when a payment has not been received in accordance with the contractual terms. The accrual of interest income for commercial loans is discontinued when there is a clear indication that the borrower’s cash flow may not be sufficient to meet payments as they become due, while the accrual of interest income for retail loans is discontinued when loans reach specific delinquency levels. Loans are generally placed on nonaccrual status when contractually past due 90 days or more as to interest or principal payments, unless the loan is well secured and in the process of collection. Additionally, if management becomes aware of facts or circumstances that may adversely impact the collectability of principal or interest on loans, it is management’s practice to place such loans on a nonaccrual status immediately, rather than delaying such action until the loans become 90 days past due. When a loan is placed on nonaccrual status, previously accrued and uncollected interest is reversed, amortization of related deferred loan fees or costs is suspended, and income is recorded only to the extent that interest payments are subsequently received in cash and a determination has been made that the principal balance of the loan is collectible. If collectability of the principal is in doubt, payments received are applied to loan principal. A nonaccrual loan may be returned to accrual status when all delinquent principal and interest payments become current in accordance with the terms of the loan agreement, the borrower has demonstrated a period of sustained performance (generally a minimum of six months) and the ultimate collectability of the total contractual principal and interest is no longer in doubt.

The Company’s loan policy dictates the guidelines to be followed in determining when a loan is charged-off. All charge offs are approved by the Bank’s senior loan officers or loan committees, depending on the amount of the charge off, and are reported in aggregate to the Bank’s Board of Directors. Commercial business and commercial mortgage loans are charged-off when a determination is made that the financial condition of the borrower indicates that the loan will not be collectible in the ordinary course of business. Residential mortgage loans and home equities are generally charged-off or written down when the credit becomes severely delinquent and the balance exceeds the fair value of the property less costs to sell. Indirect and other consumer loans, both secured and unsecured, are generally charged-off in full during the month in which the loan becomes 120 days past due, unless the collateral is in the process of repossession in accordance with the Company’s policy.

A loan is accounted for as a troubled debt restructuring if the Company, for economic or legal reasons related to the borrower’s financial condition, grants a significant concession to the borrower that it would not otherwise consider. A troubled debt restructuring may involve the receipt of assets from the debtor in partial or full satisfaction of the loan, or a modification of terms such as a reduction of the stated interest rate or face amount of the loan, a reduction of accrued interest, an extension of the maturity date at a stated interest rate lower than the current market rate for a new loan with similar risk, or some combination of these concessions. Troubled debt restructurings generally remain on nonaccrual status until there is a sustained period of payment performance (usually six months or longer) and there is a reasonable assurance that the payments will continue. See Allowance for Loan Losses below for further policy discussion and see Note 5 – Loans for additional information.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(1.)SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

(g.) Off-Balance Sheet Financial Instruments

In the ordinary course of business, the Company enters into off-balance sheet financial instruments consisting of commitments to extend credit, standby letters of credit and financial guarantees. Such financial instruments are recorded in the consolidated financial statements when they are funded or when related fees are incurred or received. The Company periodically evaluates the credit risks inherent in these commitments and establishes loss allowances for such risks if and when these are deemed necessary.

The Company recognizes as liabilities the fair value of the obligations undertaken in issuing the guarantees under the standby letters of credit, net of the related amortization at inception. The fair value approximates the unamortized fees received from the customers for issuing the standby letters of credit. The fees are deferred and recognized on a straight-line basis over the commitment period. Standby letters of credit outstanding at December 31, 2012 had original terms ranging from one to five years.

Fees received for providing loan commitments and letters of credit that result in loans are typically deferred and amortized to interest income over the life of the related loan, beginning with the initial borrowing. Fees on commitments and letters of credit are amortized to other income as banking fees and commissions over the commitment period when funding is not expected.

(h.) Allowance for Loan Losses

The allowance for loan losses is established through charges to earnings in the form of a provision for loan losses. When a loan or portion of a loan is determined to be uncollectible, the portion deemed uncollectible is charged against the allowance and subsequent recoveries, if any, are credited to the allowance.

The allowance for loan losses is evaluated on a regular basis and is based upon periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

The allowance consists of specific and general components. Specific allowances are established for impaired loans. Impaired commercial business and commercial mortgage loans are individually evaluated and measured for impairment based on the present value of expected future cash flows discounted at the loan’s effective interest rate, a loan’s observable market price, or the fair value of the collateral if the loan is collateral dependent. Regardless of the measurement method, impairment is based on the fair value of the collateral when foreclosure is probable. If the recorded investment in impaired loans exceeds the measure of estimated fair value, a specific allowance is established as a component of the allowance for loan losses. Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Impaired loans, or portions thereof, are charged-off when deemed uncollectible.

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered in determining impairment include payment status and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. The Company determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loans obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Large groups of homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment disclosures unless the loan has been subject to a troubled debt restructure. At December 31, 2012, there were no commitments to lend additional funds to those borrowers whose loans were classified as impaired.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(1.)SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

General allowances are established for loan losses on a portfolio basis for loans that do not meet the definition of impaired. The portfolio is grouped into similar risk characteristics, primarily loan type. The Company applies an estimated loss rate to each loan group. The loss rate is based on historical experience and as a result can differ from actual losses incurred in the future. The historical loss rate is adjusted for qualitative factors such as levels and trends of delinquent and non-accruing loans, trends in volume and terms, effects of changes in lending policy, the experience, ability and depth of management, national and local economic trends and conditions, concentrations of credit risk, interest rates, highly leveraged borrowers, information risk and collateral risk. The qualitative factors are reviewed at least quarterly and adjustments are made as needed.

While management evaluates currently available information in establishing the allowance for loan losses, future adjustments to the allowance may be necessary if conditions differ substantially from the assumptions used in making the evaluations. In addition, various regulatory agencies, as an integral part of their examination process, periodically review a financial institution’s allowance for loan losses. Such agencies may require the financial institution to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.

(i.) Other Real Estate Owned

Other real estate owned consists of properties acquired through foreclosure or by acceptance of a deed in lieu of foreclosure. These assets are recorded at the lower of fair value of the asset acquired less estimated costs to sell or “cost” (defined as the fair value at initial foreclosure). At the time of foreclosure, or when foreclosure occurs in-substance, the excess, if any, of the loan over the fair market value of the assets received, less estimated selling costs, is charged to the allowance for loan losses and any subsequent valuation write-downs are charged to other expense. In connection with the determination of the allowance for loan losses and the valuation of other real estate owned, management obtains appraisals for properties. Operating costs associated with the properties are charged to expense as incurred. Gains on the sale of other real estate owned are included in income when title has passed and the sale has met the minimum down payment requirements prescribed by GAAP. The balance of other real estate owned was $184 thousand and $475 thousand at December 31, 2012 and 2011, respectively.

(j.) Company Owned Life Insurance

The Company holds life insurance policies on certain current and former employees. The Company is the owner and beneficiary of the policies. The cash surrender value of these policies is included as an asset on the consolidated statements of financial condition, and any increase in cash surrender value is recorded as noninterest income on the consolidated statements of income. In the event of the death of an insured individual under these policies, the Company would receive a death benefit which would be recorded as noninterest income.

(k.) Premises and Equipment

Premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation is computed on the straight-line method over the estimated useful lives of the assets. The Company generally amortizes buildings and building improvements over a period of 15 to 39 years and software, furniture and equipment over a period of 3 to 10 years. Leasehold improvements are amortized over the shorter of the lease term or the useful life of the improvements. Premises and equipment are periodically reviewed for impairment or when circumstances present indicators of impairment.

(l.) Goodwill and Other Intangible Assets

Goodwill represents the excess of the purchase price over the fair value of net assets acquired in accordance with the purchase method of accounting for business combinations. Goodwill has an indefinite useful life and is not amortized, but is tested for impairment. GAAP requires goodwill to be tested for impairment at the Company’s reporting unit level on an annual basis, which for the Company is September 30th, and more frequently if events or circumstances indicate that there may be impairment. Currently, the Company’s goodwill is evaluated at the entity level as there is only one reporting unit.

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(1.)SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Impairment exists when a reporting unit’s carrying value of goodwill exceeds its implied fair value. In testing goodwill for impairment, GAAP permits the Company to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. If, after assessing the totality of events and circumstances, the Company determines it is not more likely than not that the fair value of a reporting unit is less than its carrying value, then performing the two-step impairment test would be unnecessary. However, if the Company concludes otherwise, it would then be required to perform the first step (Step 1) of the goodwill impairment test, and continue to the second step (Step 2), if necessary. Step 1 compares the fair value of a reporting unit with its carrying value, including goodwill. If the carrying value of the reporting unit exceeds its fair value, Step 2 of the goodwill impairment test is performed to measure the amount of impairment loss, if any.

Intangible assets are acquired assets that lack physical substance but can be distinguished from goodwill because of contractual or other legal rights or because the asset is capable of being sold or exchanged either on its own or in combination with a related contract, asset, or liability. The Company’s intangible assets relate to core deposits. Intangible assets with definite useful lives are amortized on an accelerated basis over their estimated life of approximately nine and a half years. Intangible assets with indefinite useful lives are not amortized until their lives are determined to be definite. Intangible assets are tested for impairment whenever events or changes in circumstances indicate the carrying amount of the assets may not be recoverable from future undiscounted cash flows. If impaired, the assets are recorded at fair value. See Note 7—Goodwill and Other Intangible Assets.

(m.) Federal Home Loan Bank (“FHLB”) and Federal Reserve Bank (“FRB”) Stock

The non-marketable investments in FHLB and FRB stock are included in other assets in the consolidated statements of financial condition at par value or cost and are periodically reviewed for impairment. The dividends received relative to these investments are included in other noninterest income in the consolidated statements of income.

As a member of the FHLB system, the Company is required to maintain a specified investment in FHLB of New York (“FHLBNY”) stock in proportion to its volume of certain transactions with the FHLB. FHLBNY stock totaled $8.4 million and $6.8 million as of December 31, 2012 and 2011, respectively.

As a member of the FRB system, the Company is required to maintain a specified investment in FRB stock based on a ratio relative to the Company’s capital. FRB stock totaled $3.9 million as of December 31, 2012 and 2011.

(n.) Equity Method Investments

The Company has investments in limited partnerships and accounts for these investments under the equity method. These investments are included in other assets in the consolidated statements of financial condition and totaled $4.7 million and $4.0 million as of December 31, 2012 and 2011, respectively.

(o.) Treasury Stock

Acquisitions of treasury stock are recorded at cost. The reissuance of shares in treasury is recorded at weighted-average cost.

(p.) Employee Benefits

The Company participates in a non-contributory defined benefit pension plan for certain employees who previously met participation requirements. The Company also provides post-retirement benefits, principally health and dental care, to employees of a previously acquired entity. The Company has closed the pension and post-retirement plans to new participants. The actuarially determined pension benefit is based on years of service and the employee’s highest average compensation during five consecutive years of employment. The Company’s policy is to at least fund the minimum amount required by the Employment Retirement Income Security Act of 1974. The cost of the pension and post-retirement plans are based on actuarial computations of current and future benefits for employees, and is charged to noninterest expense in the consolidated statements of income.

The Company recognizes an asset or a liability for a plans’ overfunded status or underfunded status, respectively, in the consolidated financial statements and reports changes in the funded status as a component of other comprehensive income, net of applicable taxes, in the year in which changes occur.

- 74 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(1.)SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

(q.) Share-Based Compensation Plans

Compensation expense for stock options and restricted stock awards is based on the fair value of the award on the measurement date, which, for the Company, is the date of grant and is recognized ratably over the service period of the award. The fair value of stock options is estimated using the Black-Scholes option-pricing model. The fair value of restricted stock awards is generally the market price of the Company’s stock on the date of grant.

Share-based compensation expense is included in the consolidated statements of income under salaries and employee benefits for awards granted to management and in other noninterest expense for awards granted to directors.

(r.) Income Taxes

Income taxes are accounted for using the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be collectedrecovered or settled. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date. A valuation allowance is recognized on deferred tax assets if, based upon the weight of available evidence, it is more likely than not that some or all of the assets may not be realized. The Company recognizes interest and/or penalties related to income tax matters in income tax expense.

(s.) Earnings Per Common Share

The Company calculates earnings per common share (“EPS”) using the two-class method in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 260, “Earnings Per Share”. The two-class method requires the Company to present EPS as if all of the earnings for the period are distributed to common shareholders and any participating securities, regardless of whether any actual dividends or distributions are made. All outstanding unvested share-based payment awards that contain rights to nonforfeitable dividends are considered participating securities. Certain of the restricted shares issued under the Company’s share-based compensation plan are entitled to dividends at the same rate as common stock. The Company has determined that these outstanding non-vested stock awards qualify as participating securities.

Basic EPS is computed by dividing distributed and undistributed earnings available to common shareholders by the weighted average number of common shares outstanding for the period. Distributed and undistributed earnings available to common shareholders represent net income reduced by preferred stock dividends and distributed and undistributed earnings available to participating securities. Common shares outstanding include common stock and vested restricted stock awards. Diluted EPS reflects the assumed conversion of all potential dilutive securities. A reconciliation of the weighted-average shares used in calculating basic earnings per common share and the weighted average common shares used in calculating diluted earnings per common share for the reported periods is provided in Note 16—Earnings Per Common Share.

- 75 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(1.)SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

(t.) Recent Accounting Pronouncements

In May 2011, the FASB issued Accounting Standards Update (“ASU”) No. 2011-04,“Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” The provisions of ASU No. 2011-04 provide a consistent definition of fair value and common requirements for the measurement of and disclosure about fair value between U.S. GAAP and International Financial Reporting Standards (“IFRS”). The changes to U.S. GAAP as a result of ASU No. 2011-04 are as follows: (1) the concepts of highest and best use and valuation premise are only relevant when measuring the fair value of nonfinancial assets (that is, it does not apply to financial assets or any liabilities); (2) extends the prohibition on applying a blockage factor in valuing financial instruments with quoted prices in active markets; (3) creates an exception to the basic fair value measurement principles for an entity that holds a group of financial assets and financial liabilities with offsetting positions in market risks or counterparty credit risk that are managed on the basis of the entity’s net exposure to either of those risks by allowing the entity, if certain criteria are met, to measure the fair value of the net asset or liability position in a manner consistent with how market participants would price the net risk position; (4) aligns the fair value measurement of instruments classified within an entity’s shareholders’ equity with the guidance for liabilities; and (5) enhances disclosure requirements for Level 3 fair value measurements to disclose quantitative information about unobservable inputs and assumptions used, to describe the valuation processes used by the entity, and to qualitatively describe the sensitivity of fair value measurements to changes in unobservable inputs and the interrelationships between those inputs. In addition, entities must report the level in the fair value hierarchy of items that are not measured at fair value in the statement of condition but whose fair value must be disclosed. The Company adopted the provisions of ASU No. 2011-04 effective January 1, 2012. The fair value measurement provisions of ASU No. 2011-04 had no material impact on the Company’s consolidated financial statements. See Note 18 – Fair Value Measurements to the consolidated financial statements for the enhanced disclosures required by ASU No. 2011-04.In June 2011, the FASB issued ASU No. 2011-05, “Presentation of Comprehensive Income.” The provisions of ASU No. 2011-05 allow an entity the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both options, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. Under either method, entities are required to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statement(s) where the components of net income and the components of other comprehensive income are presented. ASU No. 2011-05 also eliminates the option to present the components of other comprehensive income as part of the statement of changes in shareholders’ equity but does not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. ASU No. 2011-05 was effective for the Company’s interim reporting period beginning on or after January 1, 2012, with retrospective application required. In December 2011, the FASB issued ASU No. 2011-12,“Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05.” The provisions of ASU No. 2011-12 defer indefinitely the requirement for entities to present reclassification adjustments out of accumulated other comprehensive income by component in both the statement in which net income is presented and the statement in which other comprehensive income is presented. ASU No. 2011-12, which shares the same effective date as ASU No. 2011-05, does not defer the requirement for entities to present components of comprehensive income in either a single continuous statement of comprehensive income or in two separate but consecutive statements. The Company adopted the provisions of ASU No. 2011-05 and ASU No. 2011-12 which resulted in a new statement of comprehensive income beginning with the interim period ended March 31, 2012. The adoption of ASU No. 2011-05 and ASU No. 2011-12 had no material impact on the Company’s statements of income and financial condition.

In September 2011, the FASB issued ASU No. 2011-08“Testing Goodwill for Impairment.” The provisions of ASU 2011-08 permit an entity the option to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If an entity believes, as a result of its qualitative assessment, that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, the quantitative impairment test is required. Otherwise, no further impairment testing is required. ASU No. 2011-08 includes examples of events and circumstances that may indicate that a reporting unit’s fair value is less than its carrying amount. The provisions of ASU No. 2011-08 are effective for annual and interim goodwill impairment tests performed beginning in 2012. The adoption of ASU No. 2011-08 did not have a material impact on the Company’s consolidated financial statements.

- 76 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(1.)SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

In July 2012, the FASB issued ASU No. 2012-02,“Testing Indefinite-Lived Intangible Assets for Impairment.” The provisions of ASU No. 2012-02 permit an entity to first assess qualitative factors to determine whether it is more likely than not that an indefinite-lived intangible asset is impaired as a basis for determining whether it is necessary to perform a quantitative impairment test, as is currently required by GAAP. ASU No. 2012-02 is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. The Company does not have any indefinite-lived intangible assets other than goodwill, therefore the adoption of ASU No. 2012-02 is expected to have no material impact on the Company’s consolidated financial statements.

In February 2013, the FASB issued ASU No. 2013-02,Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. The Update requires an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component and to present either on the face of the statement where net income is presented, or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income, but only if the amount reclassified is required to be reclassified to net income in its entirety in the same reporting period. The amendments are effective for annual and interim reporting periods beginning on or after December 15, 2012. The Company is currently in the process of evaluating the ASU but does not expect it will have a material impact on the Company’s consolidated financial statements.

- 77 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(2.) BRANCH ACQUISITIONS

On January 19, 2012, the Bank entered into agreements with First Niagara Bank, National Association (“First Niagara”) to acquire four First Niagara retail bank branches in Medina, Brockport, Batavia and Waterloo, New York (the “First Niagara Branches”) and four retail bank branches previously owned by HSBC Bank USA, National Association (“HSBC”) in Elmira, Elmira Heights, Horseheads and Albion, New York (the “HSBC Branches”). First Niagara assigned its rights to the HSBC branches in connection with its acquisition of HSBC’s Upstate New York banking franchise. Under the terms of the agreements, the Bank assumed all related deposits and purchased the related branch premises and certain performing loans. The transaction to acquire the First Niagara Branches was completed on June 22, 2012 and the transaction to acquire the HSBC Branches was completed on August 17, 2012. The combined assets acquired and deposits assumed in the two transactions were recorded at their estimated fair values as follows:

Cash

  $195,778  

Loans

   75,635  

Bank premises and equipment

   1,938  

Goodwill

   11,599  

Core deposit intangible asset

   2,042  

Other assets

   339  
  

 

 

 

Total assets acquired

  $287,331  
  

 

 

 

Deposits assumed

  $286,819  

Other liabilities

   512  
  

 

 

 

Total liabilities assumed

  $287,331  
  

 

 

 

The transactions were accounted for using the acquisition method of accounting and accordingly, assets acquired, liabilities assumed and consideration exchanged were recorded at their estimated fair values on the acquisition dates. Fair values are preliminary and in certain cases are subject to refinement for up to one year after the closing date of the acquisition as additional information relative to fair values becomes available.

The operating results of the acquired branches included in the Company’s consolidated statement of income for the year ended December 31, 2012 reflect only amounts from the acquisition dates through December 31, 2012. The operating results of the acquired branches prior to the acquisition dates were not material for purposes of supplemental disclosure under the FASB guidance on business combinations.

The Company acquired the loan portfolios at a fair value discount of $824 thousand. The discount represents expected credit losses, net of market interest rate adjustments. The discount on loans receivable will be amortized to interest income over the estimated remaining life of the acquired loans using the level yield method. The core deposit intangible asset will be amortized on an accelerated basis over a period of approximately nine and a half years. The time deposit premium of $335 thousand will be accreted over the estimated remaining life of the related deposits as a reduction of interest expense.

Preliminary goodwill of $11.6 million is calculated as the purchase premium after adjusting for the fair value of net assets acquired and represents the value expected from the synergies created and the economies of scale expected from combining the operations of the acquired branches with those of the Bank. All goodwill and core deposit intangible assets arising from this acquisition are expected to be deductible for tax purposes.

- 78 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(3.) INVESTMENT SECURITIES

The amortized cost and estimated fair value of investment securities are summarized below (in thousands).

   Amortized
Cost
   Unrealized
Gains
   Unrealized
Losses
   Fair
Value
 

December 31, 2012

        

Securities available for sale:

        

U.S. Government agencies and government sponsored enterprises

  $128,097    $3,667    $69    $131,695  

State and political subdivisions

   188,997     6,285     72     195,210  

Mortgage-backed securities:

        

Federal National Mortgage Association

   147,946     4,394     188     152,152  

Federal Home Loan Mortgage Corporation

   65,426     1,430     —       66,856  

Government National Mortgage Association

   56,166     3,279     —       59,445  

Collateralized mortgage obligations:

        

Federal National Mortgage Association

   60,805     1,865     2     62,668  

Federal Home Loan Mortgage Corporation

   78,581     1,911     —       80,492  

Government National Mortgage Association

   70,989     2,168     —       73,157  

Privately issued

   73     1,025     —       1,098  
  

 

 

   

 

 

   

 

 

   

 

 

 

Total collateralized mortgage obligations

   210,448     6,969     2     217,415  
  

 

 

   

 

 

   

 

 

   

 

 

 

Total mortgage-backed securities

   479,986     16,072     190     495,868  

Asset-backed securities

   121     902     —       1,023  
  

 

 

   

 

 

   

 

 

   

 

 

 

Total available for sale securities

  $797,201    $26,926    $331    $823,796  
  

 

 

   

 

 

   

 

 

   

 

 

 

Securities held to maturity:

        

State and political subdivisions

  $17,905    $573    $—      $18,478  
  

 

 

   

 

 

   

 

 

   

 

 

 

December 31, 2011

        

Securities available for sale:

        

U.S. Government agencies and government sponsored enterprises

  $94,947    $2,770    $5    $97,712  

State and political subdivisions

   119,099     5,336     11     124,424  

Mortgage-backed securities:

        

Federal National Mortgage Association

   98,679     2,944     —       101,623  

Federal Home Loan Mortgage Corporation

   63,838     1,017     —       64,855  

Government National Mortgage Association

   73,226     3,376     —       76,602  

Collateralized mortgage obligations:

        

Federal National Mortgage Association

   28,339     581     7     28,913  

Federal Home Loan Mortgage Corporation

   22,318     675     1     22,992  

Government National Mortgage Association

   103,975     2,654     18     106,611  

Privately issued

   327     1,762     —       2,089  
  

 

 

   

 

 

   

 

 

   

 

 

 

Total collateralized mortgage obligations

   154,959     5,672     26     160,605  
  

 

 

   

 

 

   

 

 

   

 

 

 

Total mortgage-backed securities

   390,702     13,009     26     403,685  

Asset-backed securities

   297     1,400     —       1,697  
  

 

 

   

 

 

   

 

 

   

 

 

 

Total available for sale securities

  $605,045    $22,515    $42    $627,518  
  

 

 

   

 

 

   

 

 

   

 

 

 

Securities held to maturity:

        

State and political subdivisions

  $23,297    $667    $—      $23,964  
  

 

 

   

 

 

   

 

 

   

 

 

 

- 79 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(3.) INVESTMENT SECURITIES (Continued)

Interest and dividends on securities for the years ended December 31 are summarized as follows (in thousands):

   2012   2011   2010 

Taxable interest and dividends

  $12,202    $14,185    $17,101  

Tax-exempt interest and dividends

   4,242     3,828     3,521  
  

 

 

   

 

 

   

 

 

 

Total interest and dividends on securities

  $16,444    $18,013    $20,622  
  

 

 

   

 

 

   

 

 

 

Sales and calls of securities available for sale for the years ended December 31 were as follows (in thousands):

   2012   2011   2010 

Proceeds from sales

  $2,823    $44,514    $122,090  

Gross realized gains

   2,651     3,051     173  

Gross realized losses

   —       48     4  

The scheduled maturities of securities available for sale and securities held to maturity at December 31, 2012 are shown below. Actual expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations (in thousands).

   Amortized
Cost
   Fair
Value
 

Debt securities available for sale:

    

Due in one year or less

  $28,967    $29,165  

Due from one to five years

   94,479     98,341  

Due after five years through ten years

   318,124     326,802  

Due after ten years

   355,631     369,488  
  

 

 

   

 

 

 
  $797,201    $823,796  
  

 

 

   

 

 

 

Debt securities held to maturity:

    

Due in one year or less

  $12,886    $12,974  

Due from one to five years

   4,164     4,455  

Due after five years through ten years

   768     931  

Due after ten years

   87     118  
  

 

 

   

 

 

 
  $17,905    $18,478  
  

 

 

   

 

 

 

- 80 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(3.) INVESTMENT SECURITIES (Continued)

There were no unrealized losses in held to maturity securities at December 31, 2012 or December 31, 2011. Unrealized losses on investment securities available for sale and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position as of December 31 are summarized as follows (in thousands):

   Less than 12 months   12 months or longer   Total 
   Fair   Unrealized   Fair   Unrealized   Fair   Unrealized 
   Value   Losses   Value   Losses   Value   Losses 

December 31, 2012

            

U.S. Government agencies and government sponsored enterprises

  $13,265    $67    $2,967    $2    $16,232    $69  

State and political subdivisions

   8,471     72     —       —       8,471     72  

Mortgage-backed securities:

            

Federal National Mortgage Association

   25,200     188     —       —       25,200     188  

Collateralized mortgage obligations:

            

Federal National Mortgage Association

   —       —       1,173     2     1,173     2  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total collateralized mortgage obligations

   —       —       1,173     2     1,173     2  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total mortgage-backed securities

   25,200     188     1,173     2     26,373     190  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total temporarily impaired securities

  $46,936    $327    $4,140    $4    $51,076    $331  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

December 31, 2011

            

U.S. Government agencies and government sponsored enterprises

  $2,177    $1    $5,246    $4    $7,423    $5  

State and political subdivisions

   452     2     646     9     1,098     11  

Mortgage-backed securities:

            

Collateralized mortgage obligations:

            

Federal National Mortgage Association

   —       —       1,817     7     1,817     7  

Federal Home Loan Mortgage Corporation

   —       —       388     1     388     1  

Government National Mortgage Association

   6,138     18     —       —       6,138     18  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total collateralized mortgage obligations

   6,138     18     2,205     8     8,343     26  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total mortgage-backed securities

   6,138     18     2,205     8     8,343     26  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total temporarily impaired securities

  $8,767    $21    $8,097    $21    $16,864    $42  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The total number of security positions in the investment portfolio in an unrealized loss position at December 31, 2012 was 52 compared to 14 at December 31, 2011. At December 31, 2012, the Company had positions in six investment securities with an amortized cost of $4.1 million and an unrealized loss of $4 thousand that have been in a continuous unrealized loss position for more than 12 months. There were a total of 46 securities positions in the Company’s investment portfolio, with an amortized cost of $47.3 million and a total unrealized loss of $327 thousand at December 31, 2012, that have been in a continuous unrealized loss position for less than 12 months. The unrealized loss on these investment securities was predominantly caused by changes in market interest rates, average life or credit spreads subsequent to purchase. The fair value of most of the investment securities in the Company’s portfolio fluctuates as market interest rates change.

- 81 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(3.) INVESTMENT SECURITIES (Continued)

The Company reviews investment securities on an ongoing basis for the presence of other-than-temporary impairment (“OTTI”) with formal reviews performed quarterly. When evaluating debt security consideringsecurities for OTTI, management considers many factors, such as: a.)including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the amortized cost basis, b.) adverse conditions specifically related to the security, an industry, or a geographic area, c.) the historicalfinancial condition and implied volatilitynear-term prospects of the fair value ofissuer, (3) whether the security, d.)market decline was affected by macroeconomic conditions, and (4) whether the payment structure ofCompany has the intention to sell the debt security or whether it is more likely than not that it will be required to sell the debt security before its anticipated recovery. The assessment of whether OTTI exists involves a high degree of subjectivity and judgment and is based on the likelihood of the issuer being ableinformation available to make payments that increase in the future, e.) failure of the issuer of the security to make scheduled interest or principal payments, f.) any changes to the rating of the security by a rating agency, and g.) recoveries or additional declines in fair value subsequent to the balance sheet date.

management.

The following summarizes the amounts of OTTI recognized during the years ended December 31 by investment category (in thousands).

             
  2010  2009  2008 
Mortgage-backed securities — Privately issued whole loan CMOs $  $2,353  $5,918 
Asset-backed securities — Trust preferred securities  526   1,787   23,443 
Asset-backed securities — Other  68   526   6,531 
Equity securities — Auction rate securities        32,323 
          
  $594  $4,666  $68,215 
          
At

   2012   2011   2010 

Mortgage-backed securities—Privately issued whole loan CMOs

  $91    $18    $—    

Asset-backed securities—Trust preferred securities

   —       —       526  

Asset-backed securities—Other

   —       —       68  
  

 

 

   

 

 

   

 

 

 

Total OTTI

  $91    $18    $594  
  

 

 

   

 

 

   

 

 

 

Based on management’s review and evaluation of the Company’s debt securities as of December 31, 2010,2012, the number of investmentdebt securities in anwith unrealized loss position totaled 156.losses were not considered to be OTTI. As of December 31, 2010, management2012, the Company does not have the intentintend to sell any of thedebt securities in awhich have an unrealized loss, position and believes that it is likely that itunlikely the Company will not be required to sell any suchthese securities before the anticipated recovery of amortized cost. The unrealized losses are largely due to increases in market interest rates and terms over the yields and terms available at the time the underlying securities were purchased or, for securities determined to have been other-than-temporarily impaired, from the time impairment charges were last recognized and the securities were written down. The fair value is expectedCompany expects to recover as the bonds approach their maturity date or repricing date or if market yields for such investments decline. Management does not believe anyentire amortized cost of the securities in a loss position arethese impaired due to reasons of credit quality.securities. Accordingly, as of December 31, 2010,2012, management has concluded that unrealized losses on its investment securities are temporary and no further impairment loss has been realized in the Company’s consolidated statements of income.

- 76 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
(3.(4.) LOANS HELD FOR SALE AND MORTGAGELOAN SERVICING RIGHTS

Loans held for sale were entirely comprised of residential real estate mortgages and totaled $3.1$1.5 million and $421 thousand$2.4 million as of December 31, 20102012 and 2009,2011, respectively.

The Company sells certain qualifying newly originated or refinanced residential real estate mortgages on the secondary market. Residential real estate mortgages serviced for others, which are not included in the consolidated statements of financial condition, amounted to $328.9$273.3 million and $349.8$297.8 million as of December 31, 20102012 and 2009,2011, respectively. In connection with these mortgage-servicing activities, the Company administered escrow and other custodial funds which amounted to approximately $6.2$5.6 million atand $5.9 million as of December 31, 2010. 2012 and 2011, respectively.

The activity in capitalized mortgage servicing assets included in other assets in the consolidated statements of financial condition, is summarized as follows for the years ended December 31 (in thousands):

             
  2010  2009  2008 
Mortgage servicing assets, beginning of year $1,534  $925  $1,000 
Originations  408   952   230 
Amortization  (300)  (343)  (305)
          
Mortgage servicing assets, end of year  1,642   1,534   925 
Valuation allowance  (175)  (185)  (362)
          
Mortgage servicing assets, net, end of year $1,467  $1,349  $563 
          
The Company did not securitize any loans in 2010 or 2008.

   2012  2011  2010 

Mortgage servicing assets, beginning of year

  $1,609   $1,642   $1,534  

Originations

   554    319    408  

Amortization

   (526  (352  (300
  

 

 

  

 

 

  

 

 

 

Mortgage servicing assets, end of year

   1,637    1,609    1,642  

Valuation allowance

   (168  (210  (175
  

 

 

  

 

 

  

 

 

 

Mortgage servicing assets, net, end of year

  $1,469   $1,399   $1,467  
  

 

 

  

 

 

  

 

 

 

During 2009,2011, the Company pooled $16.0sold $13.0 million of one-to-four family residential mortgageindirect auto loans and converted the loans to FHLMC securities.under a 90%/10% participation agreement, recognizing a gain of $153 thousand. The Company retained servicing responsibilities for this securitization. The mortgage-backed securities received in exchange for the loans were classified as available-for-sale and subsequently sold.reclassified from portfolio to loans held for sale during the second quarter of 2011. The $564 thousand gain recognized on the sale of the securities isloan servicing asset for these loans, included in other assets in the consolidated statements of operations under net gain on disposalfinancial condition, was $250 thousand and $574 thousand as of investment securities.

(4.December 31, 2012 and 2011, respectively. The Company will continue to service the loans for a fee in accordance with the participation agreement.

- 82 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(5.) LOANS

The Company’s loan portfolio consisted of the following at December 31 (in thousands):

             
      Net Deferred    
      Loan (Fees)    
  Loans, Gross  Costs  Loans, Net 
2010
            
Commercial business $210,948  $83  $211,031 
Commercial mortgage  353,537   (607)  352,930 
Residential mortgage  129,553   27   129,580 
Home equity  205,070   3,257   208,327 
Consumer indirect  400,221   17,795   418,016 
Other consumer  25,937   169   26,106 
          
Total $1,325,266  $20,724   1,345,990 
           
Allowance for loan losses          (20,466)
            
Total loans, net         $1,325,524 
            
             
2009
            
Commercial business $206,512  $(129) $206,383 
Commercial mortgage  331,268   (520)  330,748 
Residential mortgage  144,286   (71)  144,215 
Home equity  197,795   2,889   200,684 
Consumer indirect  338,495   14,116   352,611 
Other consumer  29,192   173   29,365 
          
Total $1,247,548  $16,458   1,264,006 
           
Allowance for loan losses          (20,741)
            
Total loans, net         $1,243,265 
            

 

   Principal
Amount
Outstanding
   Net Deferred
Loan (Fees)
Costs
  Loans, Net 

2012

     

Commercial business

  $258,706    $(31 $258,675  

Commercial mortgage

   414,282     (958  413,324  

Residential mortgage

   133,341     179    133,520  

Home equity

   282,503     4,146    286,649  

Consumer indirect

   559,964     26,830    586,794  

Other consumer

   26,657     107    26,764  
  

 

 

   

 

 

  

 

 

 

Total

  $1,675,453    $30,273    1,705,726  
  

 

 

   

 

 

  

Allowance for loan losses

      (24,714
     

 

 

 

Total loans, net

     $1,681,012  
     

 

 

 

2011

     

Commercial business

  $233,727    $109   $233,836  

Commercial mortgage

   394,034     (790  393,244  

Residential mortgage

   113,865     46    113,911  

Home equity

   227,853     3,913    231,766  

Consumer indirect

   465,807     21,906    487,713  

Other consumer

   24,138     168    24,306  
  

 

 

   

 

 

  

 

 

 

Total

  $1,459,424    $25,352    1,484,776  
  

 

 

   

 

 

  

Allowance for loan losses

      (23,260
     

 

 

 

Total loans, net

     $1,461,516  
     

 

 

 

- 77 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
(4.) LOANS (Continued)
The Company’s significant concentrations of credit risk in the loan portfolio relate to a geographic concentration in the communities that the Company serves.

Certain executive officers, directors and their business interests are customers of the Company. Transactions with these parties are based on substantially the same terms as similar transactions with unrelated third parties and do not carry more than normal credit risk. Borrowings by these related parties amounted to $609$292 thousand and $555$378 thousand at December 31, 20102012 and 2009,2011, respectively. During 2010,2012, new borrowings amounted to $144$50 thousand (including borrowings of executive officers and directors that were outstanding at the time of their election), and repayments and other reductions were $90$136 thousand.

- 83 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(5.) LOANS (Continued)

Past Due Loans Aging

The following table provides an analysis,Company’s recorded investment, by loan class, of the Company’s delinquentin current and nonaccrual loans, as well as an analysis of accruing delinquent loans is set forth as of December 31 (in thousands):

                             
          Greater               
  30-59 Days  60-89 Days  Than 90  Total Past          Total 
  Past Due  Past Due  Days  Due  Nonaccrual  Current  Loans 
2010
                            
Commercial business $172  $92  $  $264  $947  $209,737  $210,948 
Commercial mortgage  163         163   3,100   350,274   353,537 
Residential mortgage  492   6      498   2,102   126,953   129,553 
Home equity  428   47      475   875   203,720   205,070 
Consumer indirect  656   107      763   514   398,944   400,221 
Other consumer  82   1   3   86   41   25,810   25,937 
                      
Total loans, gross $1,993  $253  $3  $2,249  $7,579  $1,315,438  $1,325,266 
                      
                             
2009
                            
Commercial business $141  $3  $76  $220  $650  $205,642  $206,512 
Commercial mortgage  212   319   1,783   2,314   2,288   326,666   331,268 
Residential mortgage  1,039         1,039   2,376   140,871   144,286 
Home equity  388   54      442   880   196,473   197,795 
Consumer indirect  1,304   110      1,414   621   336,460   338,495 
Other consumer  105   8      113   7   29,072   29,192 
                      
Total loans, gross $3,189  $494  $1,859  $5,542  $6,822  $1,235,184  $1,247,548 
                      
The table above includes certain

   30-59 Days
Past Due
   60-89 Days
Past Due
   Greater
Than 90
Days
   Total Past
Due
   Nonaccrual   Current   Total
Loans
 

2012

              

Commercial business

  $160    $—      $—      $160    $3,413    $255,133    $258,706  

Commercial mortgage

   331     —       —       331     1,799     412,152     414,282  

Residential mortgage

   376     —       —       376     2,040     130,925     133,341  

Home equity

   675     10     —       685     939     280,879     282,503  

Consumer indirect

   1,661     163     —       1,824     891     557,249     559,964  

Other consumer

   127     35     18     180     25     26,452     26,657  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total loans, gross

  $3,330    $208    $18    $3,556    $9,107    $1,662,790    $1,675,453  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

2011

              

Commercial business

  $35    $—      $—      $35    $1,259    $232,433    $233,727  

Commercial mortgage

   165     —       —       165     2,928     390,941     394,034  

Residential mortgage

   517     —       —       517     1,644     111,704     113,865  

Home equity

   749     68     —       817     682     226,354     227,853  

Consumer indirect

   984     92     —       1,076     558     464,173     465,807  

Other consumer

   106     10     5     121     —       24,017     24,138  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total loans, gross

  $2,556    $170    $5    $2,731    $7,071    $1,449,622    $1,459,424  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

There were no loans which were past due greater than 90 days and still accruing interest. Asinterest as of December 31, 2010, there2012 and December 31, 2011. There were $3$18 thousand and $5 thousand in consumer overdrafts which were past due greater than 90 days. Asdays as of December 31, 2009, there were $76 thousand in commercial business2012 and December 31, 2011, respectively. Consumer overdrafts are overdrawn deposit accounts which have been reclassified as loans and $1.8 million in commercial mortgage loans which were past due greater than 90 days and still accruingbut by their terms do not accrue interest.

Interest income on nonaccrual loans, if recognized, is recorded using the cash basis method of accounting. There was no interest income recognized on nonaccrual loans during the years ended December 31, 2010, 20092012, 2011 and 2008.2010. For the years ended December 31, 2010, 20092012, 2011 and 2008,2010, estimated interest income of $474$555 thousand, $388$438 thousand, and $546$474 thousand, respectively, would have been recorded if all such loans had been accruing interest according to their original contractual terms.

- 84 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(5.) LOANS (Continued)

Troubled Debt Restructured Loans

TroubledRestructurings

A modification of a loan constitutes a troubled debt restructuring (“TDR”) when a borrower is experiencing financial difficulty and the modification constitutes a concession. The Company offers various types of concessions when modifying loans, however, forgiveness of principal is rarely granted. Commercial loans modified in a TDR may involve temporary interest-only payments, term extensions, reducing the interest rate for the remaining term of the loan, extending the maturity date at an interest rate lower than the current market rate for new debt with similar risk, requesting additional collateral, releasing collateral for consideration, or substituting or adding a new borrower or guarantor.

The following presents, by loan class, information related to loans modified in a TDR during the years ended December 31 (in thousands).

   Number of
Contracts
   Pre-
Modification
Outstanding
Recorded
Investment
   Post-
Modification
Outstanding
Recorded
Investment
 

2012

      

Commercial business

   3    $536    $536  

Commercial mortgage

   4     648     648  
  

 

 

   

 

 

   

 

 

 

Total

   7    $1,184    $1,184  
  

 

 

   

 

 

   

 

 

 

2011

      

Commercial business

   6    $142    $142  

Commercial mortgage

   1     280     280  
  

 

 

   

 

 

   

 

 

 

Total

   7    $422    $422  
  

 

 

   

 

 

   

 

 

 

All of the loans identified as TDRs by the Company were previously on nonaccrual status and reported as impaired loans prior to restructuring. The modifications primarily related to extending the amortization periods of the loans and releasing collateral in consideration of payment. All loans restructured loans (“TDRs”) areduring the years ended December 31, 2012 and 2011 were on nonaccrual status at the end of those respective years. Nonaccrual loans that the Company, for economic or legal reasons relatedare restructured remain on nonaccrual status, but may move to accrual status after they have performed according to the borrower’s financial condition, has grantedrestructured terms for a significant concessionperiod of time. The TDR classification did not have a material impact on the Company’s determination of the allowance for loan losses because the modified loans were impaired and evaluated for a specific reserve both before and after restructuring.

For purposes of this disclosure, a loan modified as a TDR is considered to have defaulted when the borrower that it would not otherwise consider. TDRs can be classified as either accrual or nonaccrual loans. Included in nonaccrual loans arebecomes 90 days past due. One commercial TDRsbusiness loan restructured during 2012 with a balance of $534$52 thousand at December 31, 2010. The Company had no TDRs on which it continued to accrue interest2012 was in default. One commercial real estate loan restructured during 2011 with a balance of $261 thousand at December 31, 2010. There were no TDRs outstanding at December 31, 2009.

2011 was in default. These defaults did not significantly impact the Company’s determination of the allowance for loan losses.

 

- 7885 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2010, 20092012, 2011 and 2008

(4.2010

(5.) LOANS (Continued)

Impaired Loans

Management has determined that specific commercial loans on nonaccrual status and all loans that have had their terms restructured in a troubled debt restructuring are impaired loans. The following table presents data on impaired loans at December 31 (in thousands):

                     
      Unpaid      Average  Interest 
  Recorded  Principal  Related  Recorded  Income 
  Investment  Balance  Allowance  Investment  Recognized 
2010
                    
With no related allowance recorded:                    
Commercial business $372  $524  $  $275  $ 
Commercial mortgage  187   187      481    
                
   559   711      756    
With an allowance recorded:                    
Commercial business  576   576   149   1,828    
Commercial mortgage  2,913   2,921   883   1,897    
                
   3,489   3,497   1,032   3,725    
                
  $4,048  $4,208  $1,032  $4,481  $ 
                
                     
2009
                    
With no related allowance recorded:                    
Commercial business $292  $414  $  $1,200  $ 
Commercial mortgage  714   716      1,222    
                
   1,006   1,130      2,422    
With an allowance recorded:                    
Commercial business  358   386   155   605    
Commercial mortgage  1,574   1,574   699   758   69 
                
   1,932   1,960   854   1,363   69 
                
  $2,938  $3,090  $854  $3,785  $69 
                

   Recorded
Investment(1)
   Unpaid
Principal
Balance(1)
   Related
Allowance
   Average
Recorded
Investment
   Interest
Income
Recognized
 

2012

          

With no related allowance recorded:

          

Commercial business

  $963    $1,425    $—      $755    $—    

Commercial mortgage

   911     1,002     —       1,310     —    
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
   1,874     2,427     —       2,065     —    

With an allowance recorded:

          

Commercial business

   2,450     2,450     664     2,114     —    

Commercial mortgage

   888     888     310     1,858     —    
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
   3,338     3,338     974     3,972     —    
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
  $5,212    $5,765    $974    $6,037    $—    
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

2011

          

With no related allowance recorded:

          

Commercial business

  $342    $1,266    $—      $361    $—    

Commercial mortgage

   605     696     —       583     —    
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
   947     1,962     —       944     —    

With an allowance recorded:

          

Commercial business

   917     917     436     1,033     —    

Commercial mortgage

   2,323     2,323     644     2,172     —    
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
   3,240     3,240     1,080     3,205     —    
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
  $4,187    $5,202    $1,080    $4,149    $—    
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

(1)

Difference between recorded investment and unpaid principal balance represents partial charge-offs.

During the year ended December 31, 2008,2010, the Company’s average investment in impaired loans was $3.1$4.5 million. There was no interest income recognized on impaired loans during the year ended December 31, 2008. At December 31, 2010, there were no commitments2010.

Credit Quality Indicators

The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to lend additional fundsservice their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors such as the fair value of collateral. The Company analyzes commercial business and commercial mortgage loans individually by classifying the loans as to those borrowers whose loans werecredit risk. Risk ratings are updated any time the situation warrants. The Company uses the following definitions for risk ratings:

Special Mention:Loans classified as impaired.

Credit Quality Indicators
The Company utilizes an internal asset classification system asspecial mention have a meanspotential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of identifying and reporting problem and potential problem commercial loans. Underthe repayment prospects for the loan or of the Company’s risk rating system,credit position at some future date.

Substandard:Loans classified as substandard are inadequately protected by the Company classifies problemcurrent net worth and potential problem loans as “Special Mention,” “Substandard,” and “Doubtful”. Substandard loans include thosepaying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Company will sustain some loss will be sustained if the deficiencies are not corrected.

- 86 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(5.) LOANS (Continued)

Doubtful:Loans classified as Doubtfuldoubtful have all the weaknesses inherent in those classified as Substandard, with the added characteristic that the weaknesses present make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Loans not meeting the criteria above that do not currently expose the Company to sufficient risk to warrant classification in oneare analyzed individually as part of the aforementioned categories, but possess weaknesses that deserve management’s close attention are deemed to be Special Mention. Risk ratings are updated any time the situation warrants. Loans that do not currently possess a sufficient degree of risk to warrant classification in one of the aforementioned categoriesprocess described above are considered “Uncriticized” or pass-rated loans and are included in groups of homogeneous loans with similar risk and loss characteristics.

- 79 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
(4.) LOANS (Continued)
The following table sets forth the Company’s commercial loan portfolio, categorized by internally assigned asset classification, as of December 31 (in thousands):
         
  Commercial  Commercial 
  Business  Mortgage 
2010
        
Uncriticized $194,510  $338,061 
Special mention  11,479   4,931 
Substandard  4,959   10,545 
       
Total $210,948  $353,537 
       
         
2009
        
Uncriticized $185,256  $305,129 
Special mention  12,737   13,339 
Substandard  8,519   12,800 
       
Total $206,512  $331,268 
       

   Commercial
Business
   Commercial
Mortgage
 

2012

    

Uncriticized

  $240,291    $400,576  

Special mention

   6,591     6,495  

Substandard

   11,824     7,211  

Doubtful

   —       —    
  

 

 

   

 

 

 

Total

  $258,706    $414,282  
  

 

 

   

 

 

 

2011

    

Uncriticized

  $221,477    $383,700  

Special mention

   7,445     2,388  

Substandard

   4,805     7,946  

Doubtful

   —       —    
  

 

 

   

 

 

 

Total

  $233,727    $394,034  
  

 

 

   

 

 

 

The Company utilizes payment status as a means of identifying and reporting problem and potential problem retail loans. The Company considers nonaccrual loans and loans past due greater than 90 days and still accruing interest to be non-performing. The following table sets forth the Company’s retail loan portfolio, categorized by payment status, as of December 31 (in thousands):

                 
  Residential  Home  Consumer  Other 
  Mortgage  Equity  Indirect  Consumer 
2010
                
Performing $127,451  $204,195  $399,707  $25,896 
Non-performing  2,102   875   514   41 
             
Total $129,553  $205,070  $400,221  $25,937 
             
                 
2009
                
Performing $141,910  $196,915  $337,874  $29,185 
Non-performing  2,376   880   621   7 
             
Total $144,286  $197,795  $338,495  $29,192 
             

   Residential
Mortgage
   Home
Equity
   Consumer
Indirect
   Other
Consumer
 

2012

        

Performing

  $131,301    $281,564    $559,073    $26,632  

Non-performing

   2,040     939     891     25  
  

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $133,341    $282,503    $559,964    $26,657  
  

 

 

   

 

 

   

 

 

   

 

 

 

2011

        

Performing

  $112,221    $227,171    $465,249    $24,138  

Non-performing

   1,644     682     558     —    
  

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $113,865    $227,853    $465,807    $24,138  
  

 

 

   

 

 

   

 

 

   

 

 

 

 

- 8087 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2010, 20092012, 2011 and 2008

(4.2010

(5.) LOANS (Continued)

Allowance for Loan Losses

The following table setstables set forth the changes in the allowance for loan losses for the years ended December 31 (in thousands):

                             
      Commercial  Residential  Home  Consumer  Other    
  Commercial  Mortgage  Mortgage  Equity  Indirect  Consumer  Total 
2010
                            
Allowance for loan losses:
                            
Beginning balance $4,407  $6,638  $1,251  $1,043  $6,837  $565  $20,741 
Charge-offs  3,426   263   290   259   4,669   909   9,816 
Recoveries  326   501   21   36   1,485   485   2,854 
Provision (credit)  2,405   (445)  31   152   4,101   443   6,687 
                      
Ending balance $3,712  $6,431  $1,013  $972  $7,754  $584  $20,466 
                      
Evaluated for impairment:                            
Individually $149  $883  $  $  $  $  $1,032 
                      
Collectively $3,563  $5,548  $1,013  $972  $7,754  $584  $19,434 
                      
                             
Loans:
                            
Ending balance $210,948  $353,537  $129,553  $205,070  $400,221  $25,937  $1,325,266 
                      
Evaluated for impairment:                            
Individually $948  $3,100  $  $  $  $  $4,048 
                      
Collectively $210,000  $350,437  $129,553  $205,070  $400,221  $25,937  $1,321,218 
                      
         
  2009  2008 
Beginning balance $18,749  $15,521 
Charge-offs  7,830   5,459 
Recoveries  2,120   2,136 
Provision (credit)  7,702   6,551 
       
Ending balance $20,741  $18,749 
       

   Commercial  Commercial
Mortgage
  Residential
Mortgage
  Home
Equity
  Consumer
Indirect
  Other
Consumer
  Total 

2012

        

Allowance for loan losses:

        

Beginning balance

  $4,036   $6,418   $858   $1,242   $10,189   $517   $23,260  

Charge-offs

   (729  (745  (326  (305  (6,589  (874  (9,568

Recoveries

   336    261    130    44    2,769    354    3,894  

Provision

   1,241    647    78    301    4,346    515    7,128  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Ending balance

  $4,884   $6,581   $740   $1,282   $10,715   $512   $24,714  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Evaluated for impairment:

        

Individually

  $664   $310   $—     $—     $—     $—     $974  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Collectively

  $4,220   $6,271   $740   $1,282   $10,715   $512   $23,740  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Loans:

        

Ending balance

  $258,706   $414,282   $133,341   $282,503   $559,964   $26,657   $1,675,453  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Evaluated for impairment:

        

Individually

  $3,413   $1,799   $—     $—     $—     $—     $5,212  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Collectively

  $255,293   $412,483   $133,341   $282,503   $559,964   $26,657   $1,670,241  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

2011

        

Allowance for loan losses:

        

Beginning balance

  $3,712   $6,431   $1,013   $972   $7,754   $584   $20,466  

Charge-offs

   (1,346  (751  (152  (449  (4,713  (877  (8,288

Recoveries

   401    245    90    44    2,066    456    3,302  

Provision (credit)

   1,269    493    (93  675    5,082    354    7,780  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Ending balance

  $4,036   $6,418   $858   $1,242   $10,189   $517   $23,260  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Evaluated for impairment:

        

Individually

  $436   $644   $—     $—     $—     $—     $1,080  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Collectively

  $3,600   $5,774   $858   $1,242   $10,189   $517   $22,180  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Loans:

        

Ending balance

  $233,727   $394,034   $113,865   $227,853   $465,807   $24,138   $1,459,424  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Evaluated for impairment:

        

Individually

  $1,259   $2,928   $—     $—     $—     $—     $4,187  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Collectively

  $232,468   $391,106   $113,865   $227,853   $465,807   $24,138   $1,455,237  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

- 88 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(5.) LOANS (Continued)

   Commercial  Commercial
Mortgage
  Residential
Mortgage
  Home
Equity
  Consumer
Indirect
  Other
Consumer
  Total 

2010

        

Allowance for loan losses:

        

Beginning balance

  $4,407   $6,638   $1,251   $1,043   $6,837   $565   $20,741  

Charge-offs

   (3,426  (263  (290  (259  (4,669  (909  (9,816

Recoveries

   326    501    21    36    1,485    485    2,854  

Provision (credit)

   2,405    (445  31    152    4,101    443    6,687  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Ending balance

  $3,712   $6,431   $1,013   $972   $7,754   $584   $20,466  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Evaluated for impairment:

        

Individually

  $149   $883   $—     $—     $—     $—     $1,032  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Collectively

  $3,563   $5,548   $1,013   $972   $7,754   $584   $19,434  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Loans:

        

Ending balance

  $210,948   $353,537   $129,553   $205,070   $400,221   $25,937   $1,325,266  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Evaluated for impairment:

        

Individually

  $948   $3,100   $—     $—     $—     $—     $4,048  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Collectively

  $210,000   $350,437   $129,553   $205,070   $400,221   $25,937   $1,321,218  
  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

  

 

 

 

Risk Characteristics

Commercial business loans primarily consist of loans to small to mid-sized businesses in our market area in a diverse range of industries. These loans are of higher risk and typically are made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business. Further, the collateral securing the loans may depreciate over time, may be difficult to appraise and may fluctuate in value. The credit risk related to commercial loans is largely influenced by general economic conditions and the resulting impact on a borrower’s operations or on the value of underlying collateral, if any.

Commercial mortgage loans generally have larger balances and involve a greater degree of risk than residential mortgage loans, inferring higher potential losses on an individual customer basis. Loan repayment is often dependent on the successful operation and management of the properties, as well as on the collateral securing the loan. Economic events or conditions in the real estate market could have an adverse impact on the cash flows generated by properties securing the Company’s commercial real estate loans and on the value of such properties.

Residential mortgage loans and home equities (comprised of home equity loans and home equity lines) are generally made on the basis of the borrower’s ability to make repayment from his or her employment and other income, but are secured by real property whose value tends to be more easily ascertainable. Credit risk for these types of loans is generally influenced by general economic conditions, the characteristics of individual borrowers, and the nature of the loan collateral.

Consumer indirect and other consumer loans may entail greater credit risk than residential mortgage loans and home equities, particularly in the case of other consumer loans which are unsecured or, in the case of indirect consumer loans, secured by depreciable assets, such as automobiles or boats. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be affected by adverse personal circumstances such as job loss, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.

 

- 8189 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2010, 20092012, 2011 and 2008

(5.2010

(6.) PREMISES AND EQUIPMENT, NET

Major classes of premises and equipment at December 31 are summarized as follows (in thousands):

         
  2010  2009 
Land and land improvements $4,335  $4,334 
Buildings and leasehold improvements  39,215   39,553 
Furniture, fixtures, equipment and vehicles  23,645   23,771 
       
Premises and equipment  67,195   67,658 
Accumulated depreciation and amortization  (33,932)  (32,875)
       
Premises and equipment, net $33,263  $34,783 
       

   2012  2011 

Land and land improvements

  $4,883   $4,330  

Buildings and leasehold improvements

   43,402    40,590  

Furniture, fixtures, equipment and vehicles

   24,440    23,414  
  

 

 

  

 

 

 

Premises and equipment

   72,725    68,334  

Accumulated depreciation and amortization

   (36,107  (35,249
  

 

 

  

 

 

 

Premises and equipment, net

  $36,618   $33,085  
  

 

 

  

 

 

 

Depreciation and amortization expense relating to premises and equipment, included in occupancy and equipment expense in the consolidated statements of operations,income, amounted to $3.5$3.6 million for the year ended December 31, 2010, $3.82012 and $3.5 million for the yearyears ended December 31, 20092011 and $3.7 million for the year ended December 31, 2008.

(6.2010.

(7.) GOODWILL AND OTHER INTANGIBLE ASSETS

The carrying amountchange in the balance for goodwill during the years ended December 31, 2012 and 2011 was as follows (in thousands):

   2012   2011 

Goodwill, beginning of year

  $37,369    $37,369  

Branch acquisitions

   11,599     —    

Impairment

   —       —    
  

 

 

   

 

 

 

Goodwill, end of year

  $48,968    $37,369  
  

 

 

   

 

 

 

Pursuant to the adoption of ASU 2011-08 in 2012, the Company first performed a qualitative assessment of goodwill totaled $37.4 million as of December 31, 2010 and 2009. The goodwill relates toat the Company’s primary subsidiary and reporting unit Five Star Bank. The Company performs a goodwill impairment test on an annual basis or more frequentlylevel, the Bank, to determine if events and circumstances warrant. On September 30, 2010, the Company performed the annual goodwill impairment test and determined the estimated fair value of our reporting unit to be in excess of its carrying amount. Accordingly, as of the Company’s annual impairment test date, thereit was no indication of goodwill impairment. The Company tests its goodwill for impairment between annual tests if an event occurs or circumstances change that would more likely than not reducethat the fair value of ourthe reporting unit belowis less than its carrying amount.

value. In performing a qualitative analysis, factors considered include, but are not limited to, business strategy, financial performance and market and regulatory dynamics. The results of the qualitative assessment for 2012 indicated that it was not more likely than not that the fair value of the reporting unit is less than its carrying value. Consequently, no additional quantitative two-step impairment test was required, and no impairment was recorded in 2012. In 2011 and 2010, prior to the adoption of ASU 2011-08, the Company performed a quantitative impairment test that did not result in any impairment.

Declines in the market value of the Company’s publicly traded stock price or declines in the Company’s ability to generate future cash flows may increase the potential that goodwill recorded on the Company’s consolidated statement of financial condition be designated as impaired and that the Company may incur a goodwill write-down in the future.

The amount of goodwill to be deducted for tax purposes was $11.3 million at December 31, 2012.

The Company’s other intangible assets consisted entirely of a core deposit intangible asset. The gross carrying amount and accumulated amortization for the core deposit intangible asset was $2.0 million and $190 thousand, respectively, at December 31, 2012. The Company had no other intangible assets as of December 31, 2011. Core deposit intangible amortization expense, included in other noninterest expense on the consolidated statements of income, was $190 thousand for the year ended December 31, 2012. There was no core deposit intangible amortization expense for the years ended December 31, 2011 and 2010.

Estimated core deposit intangible amortization expense for each of the next five years is as follows:

2013

  $386  

2014

   341  

2015

   296  

2016

   251  

2017

   205  

 

- 8290 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2010, 20092012, 2011 and 2008

(7.2010

(8.) DEPOSITS

A summary of deposits as of December 31 are as follows (dollars in(in thousands):

         
  2010  2009 
Noninterest-bearing demand $350,877  $324,303 
Interest-bearing demand  374,900   363,698 
Savings and money market  417,359   368,603 
Certificates of deposit, due:        
Within one year  554,104   526,549 
One to two years  126,955   132,289 
Two to three years  14,653   8,200 
Three to five years  43,888   18,968 
Thereafter  154   345 
       
Total certificates of deposits  739,754   686,351 
       
Total deposits $1,882,890  $1,742,955 
       

   2012   2011 

Noninterest-bearing demand

  $501,514    $393,421  

Interest-bearing demand

   449,744     362,555  

Savings and money market

   655,598     474,947  

Certificates of deposit, due:

    

Within one year

   495,423     547,874  

One to two years

   91,052     84,687  

Two to three years

   35,993     17,974  

Three to five years

   31,721     50,000  

Thereafter

   749     141  
  

 

 

   

 

 

 

Total certificates of deposit

   654,938     700,676  
  

 

 

   

 

 

 

Total deposits

  $2,261,794    $1,931,599  
  

 

 

   

 

 

 

Certificates of deposit in denominations of $100,000 or more at December 31, 2010, 20092012 and 20082011 amounted to $183.9 million, $173.4$222.4 million and $164.6$214.2 million, respectively. Interest expense on those certificates totaled $2.4 million, $3.2 million and $5.7 million in 2010, 2009 and 2008, respectively.

Interest expense by deposit type for the years ended December 31 is summarized as follows (in thousands):

             
  2010  2009  2008 
Interest-bearing demand $705  $772  $3,246 
Savings and money market  1,133   1,090   3,773 
Certificates of deposit  13,015   17,228   22,330 
          
Total interest expense on deposits $14,853  $19,090  $29,349 
          
(8.

   2012   2011   2010 

Interest-bearing demand

  $598    $614    $705  

Savings and money market

   998     1,056     1,133  

Certificates of deposit

   6,866     9,764     13,015  
  

 

 

   

 

 

   

 

 

 

Total interest expense on deposits

  $8,462    $11,434    $14,853  
  

 

 

   

 

 

   

 

 

 

(9.) BORROWINGS

There were no long-term borrowings outstanding as of December 31, 2012 and 2011. Outstanding short-term borrowings are summarized as follows as of December 31 (in thousands):

         
  2010  2009 
Short-term borrowings:        
Federal funds purchased $38,200  $9,419 
Repurchase agreements  38,910   35,124 
Other short-term borrowings     15,000 
       
Total short-term borrowings  77,110   59,543 
       
         
Long-term borrowings:        
FHLB advances and repurchase agreements  10,065   30,145 
Junior subordinated debentures  16,702   16,702 
       
Total long-term borrowings  26,767   46,847 
       
Total borrowings $103,877  $106,390 
       

   2012   2011 

Short-term borrowings:

    

Federal funds purchased

  $—      $11,597  

Repurchase agreements

   40,806     36,301  

Short-term FHLB borrowings

   139,000     102,800  
  

 

 

   

 

 

 

Total short-term borrowings

  $179,806    $150,698  
  

 

 

   

 

 

 

The Company classifies borrowings as short-term or long-term in accordance with the original terms of the agreement. At December 31, 2010,2012, the Company’s short-term and long-term borrowings had a weighted average ratesrate of 0.21% and 7.87%, respectively.

0.54%.

Short-term Borrowings

Federal funds purchased are short-term borrowings that typically mature within one to ninety days. Federal funds purchased totaled $38.2 million and $9.4 million at December 31, 2010 and 2009, respectively. RepurchaseShort-term repurchase agreements are secured overnight borrowings with customers. These short-term repurchase agreements amountedShort-term FHLB borrowings have original maturities of less than one year and include overnight borrowings which the Company typically utilizes to $38.9 million and $35.1 millionaddress short term funding needs as ofthey arise. Short-term FHLB borrowings at December 31, 20102012 consisted of $99.0 million in overnight borrowings and 2009, respectively.

$40.0 million in short-term advances. Short-term FHLB borrowings at December 31, 2011 consisted of $65.0 million in overnight borrowings and $37.8 million in short-term advances.

 

- 8391 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2010, 20092012, 2011 and 2008

(8.2010

(9.) BORROWINGS (Continued)

Long-term Borrowings

The Company has credit capacity with the FHLB and can borrow through facilities that include an overnight line of credit, amortizing and term advances, and repurchase agreements. The FHLB credit capacity is collateralized by securities from the Company’s investment portfolio and certain qualifying loans. FHLB advances totaled $65 thousand and $145 thousand as of December 31, 2010 and 2009, respectively. The advances mature on various dates in 2011 and had a weighted average rate of 5.89% at December 31, 2010. FHLB repurchase agreements are stated at the amount of cash received in connection with the transaction. The Company may be required to provide additional collateral based on the fair value of the underlying securities. There were no FHLB repurchase agreements totaled $10.0 million and $30.0 millionborrowings outstanding as of December 31, 20102012 and 2009, respectively. The FHLB repurchase agreements mature during 2011 and bear a fixed interest rate of 3.98% at December 31, 2010. The $10.1 million of outstanding FHLB advances and repurchase agreements at December 31, 2010 is scheduled to be paid during 2011.

In February 2001, the Company formed Financial Institutions Statutory Trust I (the “Trust”) for the sole purpose of issuing trust preferred securities. The Company’s $502 thousand investment in the common equity of the Trust iswas classified in the consolidated statements of financial condition as other assets and $16.7 million of related 10.20% junior subordinated debentures arewere classified as long-term borrowings. In 2001, the Company incurred costs relating to the issuance of the debentures totaling $487 thousand. These costs, which arewere included in other assets on the consolidated statements of financial condition, were deferred and arewere being amortized to interest expense using the straight-line method over a twenty year period.

The

In August 2011, the Company through the Trust, issued 16,200 fixed rate pooled trust preferred securities with a liquidation preference of $1,000 per security. The trust preferred securities represent an interest in the related subordinated debenturesredeemed all of the Company, which were purchased by the Trust and have substantially the same payment terms as these trust preferred securities. The subordinated debentures are the only assets of the Trust and interest payments from the debentures finance the distributions paid on the trust preferred securities. Distributions on the debentures are payable semi-annually at a fixed interest rate of 10.20%. The trust preferred securities are subject to mandatory redemption at the liquidation preference, in whole or in part, upon repayment of the junior subordinated debentures at maturity or their earlier redemption. The subordinated debentures are redeemable prior to the maturity date of February 22, 2031, at the optiona redemption price equaling 105.1% of the Company on or after February 22, 2011, in whole or in part on semi-annual payment dates (February 22 or August 22) in periods thereafter. The subordinated debentures are also redeemable at any time, in whole, but not in part, uponprincipal amount redeemed, plus all accrued and unpaid interest. As a result of the occurrence of specific events defined within the trust indenture. The Company has the option to defer distributions on the subordinated debentures from time to time for a period not to exceed 20 consecutive quarters; howeverredemption, the Company has not opted to defer any payments to date.

Interest expenserecognized a loss on borrowings forextinguishment of debt of $1.1 million, consisting of the years ended December 31 is summarized as follows (in thousands):
             
  2010  2009  2008 
Short-term borrowings $365  $270  $721 
Long-term borrowings  2,502   2,857   3,547 
          
Total interest expense on borrowings $2,867  $3,127  $4,268 
          

redemption premium of $852 thousand and the write-off of the remaining unamortized issuance costs of $231 thousand.

- 84 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
(9.(10.) COMMITMENTS AND CONTINGENCIES

Financial Instruments with Off-Balance Sheet Risk

The Company has financial instruments with off-balance sheet risk established in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk extending beyond amounts recognized in the financial statements.

The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is essentially the same as that involved with extending loans to customers. The Company uses the same credit underwriting policies in making commitments and conditional obligations as for on-balance sheet instruments.

Off-balance sheet commitments as of December 31 consist of the following (in thousands):

         
  2010  2009 
Commitments to extend credit $357,240  $316,688 
Standby letters of credit  6,524   6,887 

   2012   2011 

Commitments to extend credit

  $435,948    $374,266  

Standby letters of credit

   9,223     8,855  

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.agreement. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Commitments may expire without being drawn upon; therefore the total commitment amounts do not necessarily represent future cash requirements. Each customer’s creditworthiness is evaluated on a case-by-case basis. The amount of collateral obtained, if any, is based on management’s credit evaluation of the borrower. Standby letters of credit are conditional lending commitments issued by the Company to guarantee the performance of a customer to a third party. These standby letters of credit are primarily issued to support private borrowing arrangements. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loan facilities to customers.

The Company also extends rate lock agreements to borrowers related to the origination of residential mortgage loans. To mitigate the interest rate risk inherent in these rate lock agreements when the Company intends to sell the related loan, once originated, as well as closed residential mortgage loans held for sale, the Company enters into forward commitments to sell individual residential mortgages. Rate lock agreements and forward commitments are considered derivatives and are recorded at fair value. Forward sales commitments totaled $8.0$1.8 million and $2.9 million at December 31, 2010. At December 31, 2010, forward sales commitments had positive fair values, included with other assets in the consolidated statements of financial condition, totaling $187 thousand2012 and negative fair values, included within other liabilities in the consolidated statements of financial condition, totaling $13 thousand. At December 31, 2009, forward sales commitments totaled $4.5 million. At December 31, 2009, these forward sales commitments had positive fair values, included with other assets in the consolidated statements of financial condition, totaling $63 thousand.2011, respectively. In addition, the net change in the fair values of these derivatives was recognized as other noninterest income or other noninterest expense in the consolidated statements of operations.

income.

- 92 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(10.) COMMITMENTS AND CONTINGENCIES (Continued)

Lease Obligations

The Company is obligated under a number of noncancellable operating lease agreements for land, buildings and equipment. Certain of these leases provide for escalation clauses and contain renewal options calling for increased rentals if the lease is renewed. Future minimum payments by year and in the aggregate, under the noncancellable leases with initial or remaining terms of one year or more, are as follows at December 31, 20102012 (in thousands):

     
2011 $1,218 
2012  1,164 
2013  1,024 
2014  993 
2015  940 
Thereafter  5,868 
    
  $11,207 
    

2013

  $1,433  

2014

   1,384  

2015

   1,305  

2016

   1,197  

2017

   826  

Thereafter

   4,347  
  

 

 

 
  $10,492  
  

 

 

 

Rent expense relating to these operating leases, included in occupancy and equipment expense in the statements of operations,income, was $1.4$1.6 million, $1.5 million and $1.1$1.4 million in 2012, 2011 and 2010, 2009 and 2008, respectively.

Contingent Liabilities

In the ordinary course of business there are various threatened and pending legal proceedings against the Company. Based on consultation with outside legal counsel, management believes that the aggregate liability, if any, arising from such litigation would not have a material adverse effect on the Company’s consolidated financial statements.

- 85 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
(10.(11.) REGULATORY MATTERS

General

The supervision and regulation of financial and bank holding companies and their subsidiaries is intended primarily for the protection of depositors, the deposit insurance funds regulated by the FDIC and the banking system as a whole, and not for the protection of shareholders or creditors of bank holding companies. The various bank regulatory agencies have broad enforcement power over financial holding companies and banks, including the power to impose substantial fines, operational restrictions and other penalties for violations of laws and regulations and for safety and soundness considerations.

Capital

Banks and financial holding companies are subject to various regulatory capital requirements administered by state and federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material impact on the Company’s consolidated financial statements. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weighting and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios of Total and Tier 1 capital to risk-weighted assets and of Tier 1 capital to average assets (all as defined in the regulations). These minimum amounts and ratios are included in the table below.

The Company’s and the Bank’s Tier 1 capital consists of shareholders’ equity excluding unrealized gains and losses on securities available for sale (except for unrealized losses which have been determined to be other than temporary and recognized as expense in the consolidated statements of operations)income), goodwill and other intangible assets and disallowed portions of deferred tax assets. Tier 1 capital for the Company also includes, subject to limitation, $16.7 million of trust preferred securities issued by FISI Statutory Trust I and $37.5$17.5 million of preferred stock issued to the U.S. Department of Treasury (the “Treasury”) through the Treasury’s Troubled Asset Relief Program (“TARP”) (see Note 11, Shareholders’ Equity).stock. The Company and the Bank’s total capital are comprised of Tier 1 capital for each entity plus a permissible portion of the allowance for loan losses.

- 93 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(11.) REGULATORY MATTERS (Continued)

The Tier 1 and total risk-based capital ratios are calculated by dividing the respective capital amounts by risk-weighted assets. Risk-weighted assets are calculated based on regulatory requirements and include total assets, excluding goodwill and other intangible assets and disallowed portions of deferred tax assets, allocated by risk weight category and certain off-balance sheetoff-balance-sheet items (primarily loan commitments and securities more than one level below investment grade that are subject to the low level exposure rule)commitments). The leverage ratio is calculated by dividing Tier 1 capital by adjusted quarterly average total assets, which exclude goodwill and other intangible assets and disallowed portions of deferred tax assets.

The Company’s and the Bank’s actual and required regulatory capital ratios were as follows as of December 31 (in thousands):

                           
            For Capital    
    Actual  Adequacy Purposes  Well Capitalized 
    Amount  Ratio  Amount  Ratio  Amount  Ratio 
December 31, 2010:
                          
                           
Tier 1 leverage: Company $181,089   8.31% $87,116   4.00% $108,896   5.00%
  Bank  156,957   7.22   86,958   4.00   108,697   5.00 
                           
Tier 1 capital: Company  181,089   12.34   58,678   4.00   88,017   6.00 
  Bank  156,957   10.74   58,450   4.00   87,674   6.00 
                           
Total risk-based capital: Company  199,452   13.60   117,357   8.00   146,696   10.00 
  Bank  175,250   11.99   116,899   8.00   146,124   10.00 
                           
December 31, 2009:
                          
                           
Tier 1 leverage: Company $163,613   7.96% $82,188   4.00% $102,735   5.00%
  Bank  154,316   7.53   82,018   4.00   102,522   5.00 
                           
Tier 1 capital: Company  163,613   11.95   54,746   4.00   82,119   6.00 
  Bank  154,316   11.33   54,475   4.00   81,712   6.00 
                           
Total risk-based capital: Company  180,766   13.21   109,492   8.00   136,865   10.00 
  Bank  171,385   12.58   108,949   8.00   136,186   10.00 

 

             For Capital        
      Actual  Adequacy
Purposes
  Well Capitalized 
      Amount   Ratio  Amount   Ratio  Amount   Ratio 

2012

            

Tier 1 leverage:

  Company  $199,824     7.70 $103,828     4.00 $129,785     5.00
  Bank   191,704     7.40    103,664     4.00    129,580     5.00  

Tier 1 capital:

  Company   199,824     10.70    74,671     4.00    112,006     6.00  
  Bank   191,704     10.29    74,515     4.00    111,773     6.00  

Total risk-based capital:

  Company   223,176     11.96    149,341     8.00    186,677     10.00  
  Bank   215,008     11.54    149,031     8.00    186,289     10.00  

2011

            

Tier 1 leverage:

  Company  $197,086     8.63 $91,310     4.00 $114,138     5.00
  Bank   184,639     8.10    91,192     4.00    113,990     5.00  

Tier 1 capital:

  Company   197,086     12.20    64,645     4.00    96,967     6.00  
  Bank   184,639     11.46    64,445     4.00    96,667     6.00  

Total risk-based capital:

  Company   217,325     13.45    129,290     8.00    161,612     10.00  
  Bank   204,817     12.71    128,890     8.00    161,112     10.00  

- 86 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
As of December 31, 2010, 20092012, the Company and 2008
(10.) REGULATORY MATTERS (Continued)
Five Star Bank has been notified by its regulator that, as of its most recentwere considered “well capitalized” under all regulatory examination, it is regarded as well capitalized under the regulatory framework for prompt corrective action.capital guidelines. Such determination has been made based on the Bank’sTier 1 leverage, Tier 1 capital and total risk-based capital and leverage ratios. There have been no conditions or events since this notification that management believes would change the Bank’s categorization as well capitalized under the aforementioned ratios.

Federal Reserve Requirements

The Bank is required to maintain a reserve balance at the FRB of New York. The reserve requirement for the Bank totaled $1.0 million as of December 31, 20102012 and 2009.

2011.

Dividend Restrictions

In the ordinary course of business, the Company is dependent upon dividends from Five Star Bank to provide funds for the payment of interest expense on the junior subordinated debentures, dividends to shareholders and to provide for other cash requirements. Banking regulations may limit the amount of dividends that may be paid. Approval by regulatory authorities is required if the effect of dividends declared would cause the regulatory capital of the Bank to fall below specified minimum levels. Approval is also required if dividends declared exceed the net profits for that year combined with the retained net profits for the preceding two years.

In addition, pursuant The Company is no longer subject to the limitations prescribed by the terms of the Treasury’s TARP Capital Purchase Program (seeProgram. See Note 11, 12—Shareholders’ Equity), the Company may not declare or pay any cash dividends on its common stock other than regular quarterly cash dividends of not more than $0.10 without the consent of the Treasury.
(11.Equity.

- 94 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(12.) SHAREHOLDERS’ EQUITY

The Company’s authorized capital stock consists of 50,210,000 shares of capital stock, 50,000,000 of which are common stock, par value $0.01 per share, and 210,000 of which are preferred stock, par value $100 per share, which is designated into two classes, Class A of which 10,000 shares are authorized, and Class B of which 200,000 shares are authorized. There are two series of Class A preferred stock: Series A 3% preferred stock and the Series A preferred stock. There is one series of Class B preferred stock: Series B-1 8.48% preferred stock. As of December 31, 2010, thereThere were 183,259174,709 shares and 174,735 shares of preferred stock issued and outstanding.

In addition,outstanding as of December 31, 2012 and 2011, respectively.

Common Stock

The following table sets forth the Company currently has an effective shelf registration which allows forchanges in the ability to issue up to $50 million in common stock.

Common Stock
The changes innumber of shares of common stock outstanding were as follows for the years ended December 31:
         
  2010  2009 
Shares outstanding at beginning of period  10,820,268   10,798,019 
Restricted stock awards issued, net  99,324   13,172 
Stock options exercised  15,563   1,010 
Directors’ retainer  6,009   8,067 
Treasury stock purchases  (3,658)   
       
Shares outstanding at end of period  10,937,506   10,820,268 
       
Treasury

   Outstanding  Treasury  Issued 

2012

    

Shares outstanding at beginning of year

   13,803,116    358,481    14,161,597  

Restricted stock awards issued, net of forfeitures

   7,857    (7,857  —    

Stock options exercised

   4,250    (4,250  —    

Treasury stock purchases

   (33,330  33,330    —    

Directors’ retainer

   5,816    (5,816  —    
  

 

 

  

 

 

  

 

 

 

Shares outstanding at end of year

   13,787,709    373,888    14,161,597  
  

 

 

  

 

 

  

 

 

 

2011

    

Shares outstanding at beginning of year

   10,937,506    410,616    11,348,122  

Shares issued in common stock offering

   2,813,475    —      2,813,475  

Restricted stock awards issued, net of forfeitures

   51,070    (51,070  —    

Stock options exercised

   6,357    (6,357  —    

Treasury stock purchases

   (11,181  11,181    —    

Directors’ retainer

   5,889    (5,889  —    
  

 

 

  

 

 

  

 

 

 

Shares outstanding at end of year

   13,803,116    358,481    14,161,597  
  

 

 

  

 

 

  

 

 

 

Issuance of Common Stock

The

In March 2011, the Company had 410,616 shares and 527,854 sharescompleted the sale of treasury stock at December 31, 2010 and 2009, respectively. The Company repurchased 3,6582,813,475 shares of its common stock from employees in order to facilitate the paymentthrough an underwritten public offering at a price of withholding taxes on restricted shares granted. There were no open market transactions during the year ended December 31, 2010. There were no repurchases$16.35 per share. The net proceeds of the offering, after deducting underwriting discounts and commissions and offering expenses, were $43.1 million. A portion of the proceeds from this offering was used to redeem the Company’s Series A preferred stock during 2009.

and the 10.20% junior subordinated debentures.

- 87 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
(11.) SHAREHOLDERS’ EQUITY (Continued)
Preferred Stock and Warrant

Series A 3% Preferred Stock.As of December 31, 2010, thereThere were 1,5331,499 shares and 1,500 shares of Series A 3% preferred stock issued and outstanding.outstanding as of December 31, 2012 and 2011, respectively. Holders of Series A 3% preferred stock are entitled to receive an annual dividend of $3.00 per share, which is cumulative and payable quarterly. Holders of Series A 3% preferred stock have no pre-emptive right in, or right to purchase or subscribe for, any additional shares of the Company’s capital stock and have no voting rights. Dividend or dissolution payments to the Class A shareholders must be declared and paid, or set apart for payment, before any dividends or dissolution payments can be declared and paid, or set apart for payment, to the holders of Class B preferred stock or common stock. The Series A 3% preferred stock is not convertible into any other of the Company’s securities.

Series A Preferred Stock and Warrant.In December 2008, under the Treasury’s TARP Capital Purchase Program, the Company entered into a Securities Purchase Agreement — Standard Terms with the U.S. Treasury pursuant to which, among other things, the Company sold to the Treasury for an aggregate purchase price of $37.5 million, 7,503 shares of fixed rate cumulative perpetual preferred stock, Series A (“Series A” preferred stock) and a warrant to purchase up to 378,175 shares of common stock, par value $0.01 per share at an exercise price of $14.88 per share (subject to certain anti-dilution adjustments) (the “Warrant”), of the Company. The Company’s Series A preferred stock qualifies as Tier 1 capital in accordance with regulatory capital requirements (see Note 10, Regulatory Matters).
The Series A preferred stock ranks senior to the Company’s common shares andpari passu, which is at an equal level in the capital structure, with existing preferred shares (“Series A 3%” preferred stock), other than preferred shares which by their terms rank junior to any other existing preferred shares (“Series B-1 8.48%” preferred stock). The Series A preferred stock pays a compounding cumulative dividend, in cash, at a rate of 5% per annum through February 15, 2014, and 9% per annum thereafter on the liquidation preference of $5,000 per share. The Company is prohibited from paying any dividend with respect to shares of common stock, other junior securities or preferred stock rankingpari passuwith the Series A preferred stock or repurchasing or redeeming any shares of the Company’s common shares, other junior securities or preferred stock rankingpari passuwith the Series A preferred stock in any quarter unless all accrued and unpaid dividends are paid on the Series A preferred stock for all past dividend periods (including the latest completed dividend period), subject to certain limited exceptions. The Series A preferred stock is non-voting, other than class voting rights on matters that could adversely affect the Series A preferred stock. The Treasury may also transfer the Series A preferred stock to a third party at any time.
Under the terms of TARP, as amended by the American Recovery and Reinvestment Act of 2009 (“ARRA”), the Company is permitted, subject to consultation with its appropriate Federal banking agency, to repay such assistance without regard to whether the recipient has replaced such funds from any other source or to any waiting period. ARRA further provides that when the recipient repays such assistance in full, the Secretary of Treasury shall liquidate the warrants associated with the assistance at the current market price. The Company is subject to existing supervisory procedures for approving redemption requests for capital instruments if it elects to repay the TARP funds. The FRB will weigh the Company’s desire to redeem the Series A preferred stock against the contribution of Treasury capital to the Company’s overall soundness, capital adequacy and ability to lend.
The Warrant has a term of 10 years and is exercisable at any time, in whole or in part, at an exercise price of $14.88 per share (subject to certain anti-dilution adjustments). The $37.5 million in proceeds was allocated to the Series A preferred stock and the Warrant based on their relative fair values at issuance ($35.5 million was allocated to the Series A preferred stock and $2.0 million to the Warrant). The $2.0 million allocated to the Warrant is being charged to retained earnings as an adjustment to the dividend yield using the effective yield method. The amount charged to retained earnings is deducted from the numerator in calculating basic and diluted earnings per share during the related reporting period (see Note 15, Earnings (Loss) per Share).

Series B-1 8.48% Preferred Stock.As of December 31, 2010, thereThere were 174,223173,210 shares and 173,235 shares of Series B-1 8.48% preferred stock issued and outstanding.outstanding as of December 31, 2012 and 2011, respectively. Holders of Series B-1 8.48% preferred stock are entitled to receive an annual dividend of $8.48 per share, which is cumulative and payable quarterly. Holders of Series B-1 8.48% preferred stock have no pre-emptive right in, or right to purchase or subscribe for, any additional shares of the Company’s common stock and have no voting rights. Accumulated dividends on the Series B-1 8.48% preferred stock do not bear interest, and the Series B-1 8.48% preferred stock is not subject to redemption. Dividend or dissolution payments to the Class B shareholders must be declared and paid, or set apart for payment, before any dividends or dissolution payments are declared and paid, or set apart for payment, to the holders of common stock. The Series B-1 8.48% preferred stock is not convertible into any other of the Company’s securities.

 

- 8895 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2010, 20092012, 2011 and 2008

2010

(12.) SHAREHOLDERS’ EQUITY (Continued)

Redemption of Series A Preferred Stock and Warrant

In December 2008, under the Treasury’s TARP Capital Purchase Program, the Company entered into a Securities Purchase Agreement—Standard Terms with the Treasury pursuant to which, among other things, the Company sold to the Treasury for an aggregate purchase price of $37.5 million, 7,503 shares of fixed rate cumulative perpetual preferred stock, Series A (“Series A” preferred stock) and a warrant to purchase up to 378,175 shares of the Company’s common stock, par value $0.01 per share, at an exercise price of $14.88 per share (the “Warrant”), of the Company.

Pursuant to the terms of the Purchase Agreement, the Company’s ability to declare or pay dividends on any of its shares was limited. Specifically, the Company was prohibited from paying any dividend with respect to shares of common stock, other junior securities or preferred stock rankingpari passu with the Series A preferred stock or repurchasing or redeeming any shares of the Company’s common stock, other junior securities or preferred stock rankingpari passu with the Series A preferred stock in any quarter unless all accrued and unpaid dividends were paid on the Series A preferred stock for all past dividend periods (including the latest completed dividend period), subject to certain limited exceptions.

The $37.5 million in proceeds was allocated to the Series A preferred stock and the Warrant based on their relative fair values at issuance ($35.5 million was allocated to the Series A preferred stock and $2.0 million to the Warrant). The resulting discount for the Series A preferred stock was to be accreted over five years through retained earnings as a preferred stock dividend. The Warrant was to remain in additional paid-in-capital at its initial book value until it was exercised or expired.

In February 2011, the Company redeemed one-third, or $12.5 million, of the Series A preferred stock. In March 2011, the remaining $25.0 million of the Series A preferred stock was redeemed. The unamortized discount related to the Series A preferred stock was charged to retained earnings upon redemption. The complete redemption of the Series A preferred stock removed the TARP restrictions pertaining to the Company’s ability to declare and pay dividends and repurchase its common stock, as well as certain restrictions associated with executive compensation.

In May 2011, the Company repurchased the Warrant issued to the Treasury. The repurchase price of $2.1 million was recorded as a reduction of additional paid-in capital.

- 96 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(13.) OTHER COMPREHENSIVE INCOME (LOSS)

Total

Other comprehensive income (loss) is reported in the accompanying consolidated statements of comprehensive income and changes in shareholders’ equity. Information related to other comprehensive income (loss) for the years ended December 31 was as follows (in thousands):

             
  Pre-tax  Tax Expense  Net-of-tax 
  Amount  (Benefit)  Amount 
2010
            
Securities available for sale:            
Change in net unrealized gain/loss during the period $(16) $19  $(35)
Reclassification adjustment for gains included in income  (169)  (67)  (102)
Reclassification adjustment for impairment charges included in income  594   235   359 
          
   409   187   222 
             
Change in net actuarial gain/loss and prior service benefit (cost) on defined benefit pension and post-retirement plans  (2,192)  (950)  (1,242)
          
Other comprehensive loss $(1,783) $(763)  (1,020)
           
Net income          21,287 
            
Comprehensive income         $20,267 
            
             
2009
            
Securities available for sale:            
Change in net unrealized gain/loss during the period $(4,186) $(1,619) $(2,567)
Reclassification adjustment for gains included in income  (3,429)  (1,327)  (2,102)
Reclassification adjustment for impairment charges included in income  4,666   1,805   2,861 
          
   (2,949)  (1,141)  (1,808)
             
Change in net actuarial gain/loss and prior service benefit (cost) on defined benefit pension and post-retirement plans  3,457   1,338   2,119 
          
Other comprehensive income $508  $197   311 
           
Net income          14,441 
            
Comprehensive income         $14,752 
            
             
2008
            
Securities available for sale:            
Change in net unrealized gain/loss during the period $(61,464) $(23,778) $(37,686)
Reclassification adjustment for gains included in income  (288)  (111)  (177)
Reclassification adjustment for impairment charges included in income  68,215   26,389   41,826 
          
   6,463   2,500   3,963 
             
Change in net actuarial gain/loss and prior service benefit (cost) on defined benefit pension and post-retirement plans  (14,098)  (5,455)  (8,643)
          
Other comprehensive loss $(7,635) $(2,955)  (4,680)
           
Net loss          (26,158)
            
Comprehensive loss         $(30,838)
            

   

Pre-tax

Amount

  

Tax Expense

(Benefit)

  

Net-of-tax

Amount

 

2012

    

Securities available for sale:

    

Change in net unrealized gain/loss during the period

  $6,682   $2,646   $4,036  

Reclassification adjustment for gains included in income

   (2,651  (1,050  (1,601

Reclassification adjustment for impairment charges included in income

   91    36    55  
  

 

 

  

 

 

  

 

 

 
   4,122    1,632    2,490  

Change in net actuarial gain/loss and prior service cost on defined benefit pension and post-retirement plans

   (300  (118  (182
  

 

 

  

 

 

  

 

 

 

Other comprehensive income

  $3,822   $1,514   $2,308  
  

 

 

  

 

 

  

 

 

 

2011

    

Securities available for sale:

    

Change in net unrealized gain/loss during the period

  $22,350   $8,855   $13,495  

Reclassification adjustment for gains included in income

   (3,003  (1,190  (1,813

Reclassification adjustment for impairment charges included in income

   18    7    11  
  

 

 

  

 

 

  

 

 

 
   19,365    7,672    11,693  

Change in net actuarial gain/loss and prior service cost on defined benefit pension and post-retirement plans

   (9,979  (3,953  (6,026
  

 

 

  

 

 

  

 

 

 

Other comprehensive income

  $9,386   $3,719   $5,667  
  

 

 

  

 

 

  

 

 

 

2010

    

Securities available for sale:

    

Change in net unrealized gain/loss during the period

  $(16 $19   $(35

Reclassification adjustment for gains included in income

   (169  (67  (102

Reclassification adjustment for impairment charges included in income

   594    235    359  
  

 

 

  

 

 

  

 

 

 
   409    187    222  

Change in net actuarial gain/loss and prior service cost on defined benefit pension and post-retirement plans

   (2,192  (950  (1,242
  

 

 

  

 

 

  

 

 

 

Other comprehensive loss

  $(1,783 $(763 $(1,020
  

 

 

  

 

 

  

 

 

 

The components of accumulated other comprehensive income (loss), net of tax, as of December 31 were as follows (in thousands):

         
  2010  2009 
Net actuarial loss and prior service cost on defined benefit pension and post-retirement plans $(6,599) $(5,357)
Net unrealized gain on securities available for sale  1,877   1,655 
       
  $(4,722) $(3,702)
       

   2012  2011 

Net actuarial loss and prior service cost on defined benefit pension and post-retirement plans

  $(12,807 $(12,625

Net unrealized gain on securities available for sale

   16,060    13,570  
  

 

 

  

 

 

 
  $3,253   $945  
  

 

 

  

 

 

 

 

- 8997 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2010, 20092012, 2011 and 2008

(13.2010

(14.) SHARE-BASED COMPENSATION

The Company maintains certain stock-based compensation plans, approved by the Company’s shareholders that are administered by the Board, or the Management Development and Compensation Committee (the “Compensation Committee”) of the Board. OnIn May 6, 2009, the shareholders of the Company approved two share-based compensation plans, the 2009 Management Stock Incentive Plan (“Management Plan”) and the 2009 Directors’ Stock Incentive Plan (“Director’s Plan”), and collectively with the Management Plan, “the Plans”. An aggregate of 690,000 shares hasof the Company’s common stock have been reserved for issuance by the Company under the terms of the Management Plan pursuant to the grant of incentive stock options (not to exceed 500,000 shares), non-qualified stock options and restricted stock grants, all which are defined in the plan. An aggregate of 250,000 shares hasof the Company’s common stock have been reserved for issuance by the Company under the terms of the Director’s Plan pursuant to the grant of non-qualified stock options and restricted stock grants, all which are defined in the plan. Under both plans, for purposes of calculating the number of shares of common stock available for issuance, each share of common stock granted pursuant to a restricted stock grant shall count as 1.64 shares of common stock. As of December 31, 2010,2012, there were approximately 225,000200,000 and 523,000451,000 shares available for grant under the Director’s Plan and Management Plan, respectively, of which 61% were available for issuance as restricted stock grants.

Under the Plans, the Board, in the case of the Director’s Plan, or the Compensation Committee, in the case of the Management Plan, and the Director’s Plan (the “Plans”), the Board (or the Compensation Committee) may establish and prescribe grant guidelines including various terms and conditions for the granting of stock-based compensation. For stock options, the exercise price of each option equals the market price of the Company’s stock on the date of the grant. All options expire after a period of ten years from the date of grant and generally become fully exercisable over a period of 3 to 5 years from the grant date. When option recipients exercise their options, the Company issues shares from treasury stock and records the proceeds as additions to capital. ForShares of restricted stock sharesgranted to employees generally vestsvest over 2 to 3 years from the grant date. Fifty percent of the shares of restricted stock granted to non-employee directors generally vests on the date of grant and the remaining fifty percent generally vests one year from the grant date. Vesting of the shares may be based on years of service, established performance measures or both. If restricted stock grants are forfeited before they vest, the shares are reacquired into treasury stock.

The share-based compensation plans were established to allow for the granting of compensation awards to attract, motivate and retain employees, executive officers and non-employee directors who contribute to the success and profitability of the Company and to give such persons a proprietary interest in the Company, thereby enhancing their personal interest in the Company’s success.

The share-based compensation expense for the years ended December 31 was as follows (in thousands):

             
  2010  2009  2008 
Stock options:            
Management Stock Incentive Plan $110  $222  $378 
Director Stock Incentive Plan  43   46   40 
          
Total stock option expense  153   268   418 
Restricted stock awards:            
Management Stock Incentive Plan  761   488   215 
Director Stock Incentive Plan  117   98    
          
Total restricted stock award expense  878   586   215 
          
Total share-based compensation $1,031  $854  $633 
          

   2012   2011   2010 

Stock options:

      

Management Stock Incentive Plan

  $12    $55    $110  

Director Stock Incentive Plan

   —       14     43  
  

 

 

   

 

 

   

 

 

 

Total stock options

   12     69     153  

Restricted stock awards:

      

Management Stock Incentive Plan

   382     917     761  

Director Stock Incentive Plan

   132     119     117  
  

 

 

   

 

 

   

 

 

 

Total restricted stock awards

   514     1,036     878  
  

 

 

   

 

 

   

 

 

 

Total share-based compensation

  $526    $1,105    $1,031  
  

 

 

   

 

 

   

 

 

 

- 98 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(14.) SHARE-BASED COMPENSATION (Continued)

The Company uses the Black-Scholes valuation method to estimate the fair value of its stock option awards. There were no stock options awarded during 2012, 2011 or 2010. There was no unrecognized compensation expense related to unvested stock options as of December 31, 2012. The following is a summary of stock option activity for the year ended December 31, 20102012 (dollars in thousands, except per share amounts):

                 
          Weighted    
      Weighted  Average    
      Average  Remaining  Aggregate 
  Number of  Exercise  Contractual  Intrinsic 
  Options  Price  Term  Value 
Outstanding at beginning of year  458,734  $20.30         
Granted              
Exercised  (15,563)  13.88         
Forfeited  (2,317)  17.94         
Expired  (30,961)  19.25         
                
Outstanding at end of year  409,893   20.64   4.49 years  $155 
Exercisable at end of year  374,290   20.92   4.23 years  $104 

 

          Weighted     
      Weighted   Average     
      Average   Remaining   Aggregate 
   Number of  Exercise   Contractual   Intrinsic 
   Options  Price   Term   Value 

Outstanding at beginning of year

   368,058   $20.70      

Granted

   —      —        

Exercised

   (4,250  15.85      

Forfeited

   —      —        

Expired

   (44,533  24.55      
  

 

 

      

Outstanding at end of period

   319,275   $20.22     2.6 years    $71  

Exercisable at end of period

   319,275   $20.22     2.6 years    $71  

- 90 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
(13.) SHARE-BASED COMPENSATION (Continued)
As of December 31, 2010, there was $62 thousand of unrecognized compensation expense related to unvested stock options, all of which is expected to be recognized during 2011.
The aggregate intrinsic value (the amount by which the market price of the stock on the date of exercise exceeded the market price of the stock on the date of grant) of option exercises for the years ended December 31, 2012, 2011 and 2010 2009 and 2008 was $59$10 thousand, $1$31 thousand, and $10$59 thousand, respectively. The total cash received as a result of option exercises under stock compensation plans for the years ended December 31, 2012, 2011 and 2010 2009 and 2008 was $216$69 thousand, $14$91 thousand, and $32$216 thousand, respectively. The tax benefits realized in connection with these stock option exercises were not significant.
The Company uses the Black-Scholes valuation method to estimate the fair value of its stock option awards. This method is dependent on certain assumptions. There were no stock options awarded during 2010 or 2009. The following is a summary of the stock options granted during the year ended December 31, 2008 as well as the weighted average assumptions used to compute their fair value.
     
Options granted  61,100 
Grant date weighted average fair value per share $5.09 
Grant date weighted average share price $16.98 
Risk-free interest rate  3.40%
Expected dividend yield  3.48%
Expected stock price volatility  38.60%
Expected life (in years)  6.19 
In the table above the risk-free interest rate is the U.S. Treasury rate commensurate with the expected life of option on the date of their grant. The expected stock price volatility is based upon historical activity of the Company’s stock over a span of time equal to the expected life of the options. The expected life for options granted is based upon based on historical experience for the Plans.

The following is a summary of restricted stock award activity for the year ended December 31, 2010:

         
      Weighted 
      Average 
      Market 
  Number of  Price at 
  Shares  Grant Date 
Outstanding at beginning of year  77,772  $15.05 
Granted  107,040   12.51 
Vested  (26,300)  18.24 
Forfeited  (7,716)  13.64 
        
Outstanding at end of year  150,796  $12.76 
        
2012:

      Weighted 
      Average 
      Market 
   Number of  Price at 
   Shares  Grant Date 

Outstanding at beginning of year

   166,654   $14.34  

Granted

   57,541    17.32  

Vested

   (94,931  12.79  

Forfeited

   (49,684  16.67  
  

 

 

  

Outstanding at end of period

   79,580   $16.89  
  

 

 

  

As of December 31, 2010,2012, there was $869$458 thousand of unrecognized compensation expense related to unvested restricted stock awards that is expected to be recognized over a weighted average period of 1.661.31 years.

 

- 9199 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2010, 20092012, 2011 and 2008

(14.2010

(15.) INCOME TAXES

Total income tax expense (benefit) was allocated as follows for the years ended December 31 (in thousands):
             
  2010  2009  2008 
Income tax expense (benefit) $9,352  $6,140  $(21,301)
Shareholder’s equity  (763)  197   (2,955)

The income tax expense (benefit) for the years ended December 31 consisted of the following (in thousands):

             
  2010  2009  2008 
Current tax expense (benefit):            
Federal $5,781  $(1,355) $2,043 
State  1,103   25   504 
          
Total current tax expense (benefit)  6,884   (1,330)  2,547 
          
Deferred tax expense (benefit):            
Federal  2,852   6,189   (19,640)
State  (384)  1,281   (4,208)
          
Total deferred tax expense (benefit)  2,468   7,470   (23,848)
          
Total income tax expense (benefit) $9,352  $6,140  $(21,301)
          

   2012   2011   2010 

Current tax expense:

      

Federal

  $4,021    $3,747    $5,781  

State

   955     1,158     1,103  
  

 

 

   

 

 

   

 

 

 

Total current tax expense

   4,976     4,905     6,884  
  

 

 

   

 

 

   

 

 

 

Deferred tax expense (benefit):

      

Federal

   5,262     5,584     2,852  

State

   1,081     926     (384
  

 

 

   

 

 

   

 

 

 

Total deferred tax expense

   6,343     6,510     2,468  
  

 

 

   

 

 

   

 

 

 

Total income tax expense

  $11,319    $11,415    $9,352  
  

 

 

   

 

 

   

 

 

 

Income tax expense (benefit) differed from the statutory federal income tax rate for the years ended December 31 as follows:

             
  2010  2009  2008 
Statutory federal tax rate  35.0%  34.0%  (34.0)%
Increase (decrease) resulting from:            
Tax exempt interest income  (4.2)  (8.6)  (5.2)
Non-taxable earnings on company owned life insurance  (1.3)  (1.8)  (0.4)
Dividend received deduction  (0.1)  (0.1)  (0.8)
State taxes, net of federal tax benefit  1.5   4.2   (5.2)
Nondeductible expenses  0.6   1.0   0.2 
Disallowed interest expense  0.2   0.5   0.5 
Other, net  (1.2)  0.6    
          
Effective tax rate  30.5%  29.8%  (44.9)%
          

 

   2012  2011  2010 

Statutory federal tax rate

   35.0  35.0  35.0

Increase (decrease) resulting from:

    

Tax exempt interest income

   (4.6  (4.3  (4.2

Non-taxable earnings on company owned life insurance

   (1.8  (1.5  (1.3

State taxes, net of federal tax benefit

   3.8    4.0    1.5  

Nondeductible expenses

   0.3    0.4    0.6  

Other, net

   (0.1  (0.2  (1.1
  

 

 

  

 

 

  

 

 

 

Effective tax rate

   32.6  33.4  30.5
  

 

 

  

 

 

  

 

 

 

- 92 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Total income tax expense was allocated as follows for the years ended December 31 2010, 2009 and 2008
(14.) INCOME TAXES (Continued)
(in thousands):

   2012   2011   2010 

Income tax expense

  $11,319    $11,415      $9,352  

Shareholder’s equity

   1,514     3,718       (763

The Company’s net deferred tax asset is included in other assets in the Consolidated Statementsconsolidated statements of Condition.condition. The tax effects of temporary differences that give rise to the deferred tax assets and deferred tax liabilities are as follows at December 31 (in thousands):

         
  2010  2009 
Deferred tax assets:        
Other than temporary impairment of investment securities $15,418  $14,827 
Allowance for loan losses  8,108   7,418 
Tax attribute carryforward benefits  2,033   5,559 
Share-based compensation  1,250   1,033 
Interest on non-accruing loans  781   788 
Core deposit intangible  158   258 
Accrued pension costs     92 
Other  665   580 
       
Gross deferred tax assets  28,413   30,555 
Deferred tax liabilities:        
Deferred loan origination costs  2,263   3,290 
Depreciation and amortization  1,489   1,283 
Net unrealized gain on securities available for sale  1,231   1,044 
Loan servicing assets  581   522 
Prepaid pension costs  139    
Other     1 
       
Gross deferred tax liabilities  5,703   6,140 
       
Net deferred tax asset $22,710  $24,415 
       

   2012   2011 

Deferred tax assets:

    

Other than temporary impairment of investment securities

  $5,283    $11,326  

Allowance for loan losses

   9,791     9,106  

Share-based compensation

   1,111     1,437  

SERP agreements

   734     285  

Deferred compensation

   868     499  

Interest on nonaccrual loans

   732     716  

Accrued pension costs

   —       538  

Tax attribute carryforward benefits

   —       463  

Other

   798     467  
  

 

 

   

 

 

 

Gross deferred tax assets

   19,317     24,837  

Deferred tax liabilities:

    

Net unrealized gain on securities available for sale

   10,536     8,903  

Depreciation and amortization

   1,827     1,741  

Prepaid pension costs

   1,648     —    

Loan servicing assets

   681     781  

Deferred loan origination costs

   —       930  
  

 

 

   

 

 

 

Gross deferred tax liabilities

   14,692     12,355  
  

 

 

   

 

 

 

Net deferred tax asset

  $4,625    $12,482  
  

 

 

   

 

 

 

- 100 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(15.) INCOME TAXES (Continued)

The Company recognizes deferred income taxes for the estimated future tax effects of differences between the tax and financial statement bases of assets and liabilities considering enacted tax laws. These differences result in deferred tax assets and liabilities, which are included in other assets in the Company’s consolidated statements of condition. The Company also assesses the likelihood that deferred tax assets will be realizable based on, among other considerations, future taxable income and establishes, if necessary, a valuation allowance for those deferred tax assets determined to not likely be realizable. A deferred tax asset valuation allowance is recognized if, based on the weight of available evidence (both positive and negative), it is more likely than not that some portion or all of the deferred tax assets will not be realized. The future realization of deferred tax benefits depends upon the existence of sufficient taxable income within the carry-back and carry-forward periods. ManagementManagement’s judgment is required in determining the appropriate recognition of deferred tax assets and liabilities, including projections of future taxable income.

Based upon the Company’s historical and projected future levels of pre-tax and taxable income, the scheduled reversals of taxable temporary differences to offset future deductible amounts, and prudent and feasible tax planning strategies, management believes it is more likely than not that the deferred tax assets will be realized. As such, no valuation allowance has been recorded as of December 31, 20102012 or 2009.

2011.

The Company and its subsidiaries are subject to federal and New York State (“NYS”) income taxes. The federal income tax years currently open for audits are 2007 through 2010.2012. The NYS income tax years currently open for audits are 2009 and 2010.

through 2012.

At December 31, 2010,2012, the Company had no federal or NYS net operating loss carryforwards. The Company has federalor tax credits of approximately $2.0 million which have an unlimited carryforward period.

credit carryforwards.

The Company’s unrecognized tax benefits and changes in unrecognized tax benefits were not significant as of or for the years ended December 31, 20102012 and 2009.2011. There were no interest or penalties recorded in the income statement in income tax expense for the year ended December 31, 2010.2012. As of December 31, 2010,2012, there were no amounts accrued for interest or penalties related to uncertain tax positions.

- 93 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
(15.(16.) EARNINGS (LOSS) PER COMMON SHARE

The following table presents a reconciliation of the earnings and shares used in calculating basic and diluted EPS for each of the years ended December 31 (in thousands, except per share amounts).

             
  2010  2009  2008 
Net income (loss) available to common shareholders $17,562  $10,744  $(27,696)
Less: Earnings (loss) allocated to participating securities  105   87   (230)
          
Earnings (loss) allocated to common shares outstanding $17,457  $10,657  $(27,466)
          
             
Weighted average common shares used to calculate basic EPS  10,767   10,730   10,818 
Add: Effect of common stock equivalents  78   39    
          
Weighted average common shares used to calculate diluted EPS  10,845   10,769   10,818 
          
 
Earnings (loss) per common share:            
Basic $1.62  $0.99  $(2.54)
Diluted $1.61  $0.99  $(2.54)
             
Shares subject to the following securities, outstanding as of December 31 of the respective year, were excluded from the computation of diluted EPS because the effect would be antidilutive:
             
Stock options  353   459   583 
Restricted stock awards        82 
Warrant     378   378 
          
   353   837   1,043 
          
(16.

   2012  2011  2010 

Net income available to common shareholders

  $21,975   $19,617   $17,562  

Less: Earnings allocated to participating securities

   2    38    105  
  

 

 

  

 

 

  

 

 

 

Net income available to common shareholders for EPS

  $21,973   $19,579   $17,457  
  

 

 

  

 

 

  

 

 

 

Weighted average common shares outstanding:

    

Total shares issued

   14,162    13,599    11,348  

Unvested restricted stock awards

   (107  (166  (154

Treasury shares

   (359  (366  (427
  

 

 

  

 

 

  

 

 

 

Total basic weighted average common shares outstanding

   13,696    13,067    10,767  

Incremental shares from assumed:

    

Exercise of stock options

   4    3    6  

Vesting of restricted stock awards

   51    65    27  

Exercise of warrant

   —      22    45  
  

 

 

  

 

 

  

 

 

 

Total diluted weighted average common shares outstanding

   13,751    13,157    10,845  

Basic earnings per common share

  $1.60   $1.50   $1.62  
  

 

 

  

 

 

  

 

 

 

Diluted earnings per common share

  $1.60   $1.49   $1.61  
  

 

 

  

 

 

  

 

 

 

For each of the periods presented, average shares subject to the following instruments were excluded from the computation of diluted EPS because the effect would be antidilutive:

                              

Stock options

   303     339     353  

Restricted stock awards

   1     —       —    
  

 

 

   

 

 

   

 

 

 
   304     339     353  
  

 

 

   

 

 

   

 

 

 

- 101 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(17.) EMPLOYEE BENEFIT PLANS

Defined Benefit Pension Plan

The Company participates in The New York State Bankers Retirement System (the “Plan”), a defined benefit pension plan covering substantially all employees, subject to the limitations related to the plan closure effective December 31, 2006. The benefits are based on years of service and the employee’s highest average compensation during five consecutive years of employment. The defined benefit plan was closed to new participants effective December 31, 2006. Only employees hired on or before December 31, 2006 and who met participation requirements on or before January 1, 2008 are eligible to receive benefits.

The following table provides a reconciliation of the Company’s changes in the plan’s benefit obligations, fair value of assets and a statement of the funded status as of and for the year ended December 31 (in thousands):

         
  2010  2009 
Change in projected benefit obligation:        
Projected benefit obligation at beginning of period $(33,441) $(30,878)
Service cost  (1,633)  (1,689)
Interest cost  (1,933)  (1,826)
Actuarial loss  (2,969)  (489)
Benefits paid and plan expenses  1,595   1,441 
       
Projected benefit obligation at end of period  (38,381)  (33,441)
       
         
Change in plan assets:        
Fair value of plan assets at beginning of period  33,203   24,431 
Actual return on plan assets  2,823   5,132 
Employer contributions  4,300   5,081 
Benefits paid and plan expenses  (1,595)  (1,441)
       
Fair value of plan assets at end of period  38,731   33,203 
       
Funded (unfunded) status at end of period $350  $(238)
       

   2012  2011 

Change in projected benefit obligation:

   

Projected benefit obligation at beginning of period

  $48,303   $38,381  

Service cost

   2,037    1,756  

Interest cost

   2,017    2,027  

Actuarial loss

   3,291    7,939  

Benefits paid and plan expenses

   (2,023  (1,800
  

 

 

  

 

 

 

Projected benefit obligation at end of period

   53,625    48,303  
  

 

 

  

 

 

 

Change in plan assets:

   

Fair value of plan assets at beginning of period

   46,943    38,731  

Actual return on plan assets

   4,865    12  

Employer contributions

   8,000    10,000  

Benefits paid and plan expenses

   (2,023  (1,800
  

 

 

  

 

 

 

Fair value of plan assets at end of period

   57,785    46,943  
  

 

 

  

 

 

 

Funded (unfunded) status at end of period

  $4,160   $(1,360
  

 

 

  

 

 

 

The accumulated benefit obligation was $34.3$48.0 million and $29.5$43.3 million at December 31, 20102012 and 2009,2011, respectively.

- 94 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
(16.) EMPLOYEE BENEFIT PLANS (Continued)
The Company’s funding policy is to contribute, at a minimum, an actuarially determined amount that will satisfy the minimum funding requirements determined under the appropriate sections of Internal Revenue Code. The Company satisfied thehad no minimum required contribution for the 2013 fiscal year, but for tax purposes chose to contribute $8.0 million to its pension plan of $4.3 million for the 2011 fiscal year prior to December 31, 2010.
2012.

Estimated benefit payments under the pension plan over the next ten years at December 31, 20102012 are as follows (in thousands):

     
2011 $1,415 
2012  1,504 
2013  1,561 
2014  1,682 
2015  1,795 
2016 - 2020  11,669 

2013

  $1,637  

2014

   1,724  

2015

   1,882  

2016

   2,106  

2017

   2,284  

2018 – 2022

   13,128  

Net periodic pension cost consists of the following components for the years ended December 31 (in thousands):

             
  2010  2009  2008 
Service cost $1,633  $1,689  $1,456 
Interest cost on projected benefit obligation  1,933   1,826   1,562 
Expected return on plan assets  (2,444)  (1,848)  (2,094)
Amortization of unrecognized loss  458   728    
Amortization of unrecognized prior service cost  11   11   11 
          
Net periodic pension cost $1,591  $2,406  $935 
          

   2012  2011  2010 

Service cost

  $2,037   $1,756   $1,633  

Interest cost on projected benefit obligation

   2,017    2,027    1,933  

Expected return on plan assets

   (3,211  (2,653  (2,444

Amortization of unrecognized loss

   1,370    608    458  

Amortization of unrecognized prior service cost

   20    19    11  
  

 

 

  

 

 

  

 

 

 

Net periodic pension cost

  $2,233   $1,757   $1,591  
  

 

 

  

 

 

  

 

 

 

- 102 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(17.) EMPLOYEE BENEFIT PLANS (Continued)

The actuarial assumptions used to determine the net periodic pension cost were as follows:

             
  2010  2009  2008 
Weighted average discount rate  5.89%  6.03%  6.35%
Rate of compensation increase  3.50%  3.50%  3.50%
Expected long-term rate of return  7.50%  7.50%  7.50%

   2012  2011  2010 

Weighted average discount rate

   4.27  5.38  5.89

Rate of compensation increase

   3.00  3.00  3.50

Expected long-term rate of return

   7.00  7.00  7.50

The actuarial assumptions used to determine the projected benefit obligation were as follows:

             
  2010  2009  2008 
Weighted average discount rate  5.38%  5.89%  6.03%
Rate of compensation increase  3.00%  3.50%  3.50%

   2012  2011  2010 

Weighted average discount rate

   3.84  4.27  5.38

Rate of compensation increase

   3.00  3.00  3.00

The weighted average discount rate was based upon the projected benefit cash flows and the market yields of high grade corporate bonds that are available to pay such cash flows.

- 95 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
(16.) EMPLOYEE BENEFIT PLANS (Continued)
The weighted average expected long-term rate of return is estimated based on current trends in the Plan’s assets as well as projected future rates of return on those assets and reasonable actuarial assumptions based on the guidance provided by Actuarial Standard of Practice No. 27, “Selection of Economic Assumptions for Measuring Pension Obligations”, for long term inflation, and the real and nominal rate of investment return for a specific mix of asset classes. The following assumptions were used in determining the long-term rate of return:

Equity securities

  Dividend discount model, the smoothed earnings yield model and the equity risk premium model

Fixed income securities

  Current yield-to-maturity and forecasts of future yields

Other financial instruments

  Comparison of the specific investment’s risk to that of fixed income and equity instruments and using judgment

The long term rate of return considers historical returns. Adjustments were made to historical returns in order to reflect expectations of future returns. These adjustments were due to factor forecasts by economists and long-term U.S. Treasury yields to forecast long-term inflation. In addition forecasts by economists and others for long-term GDP growth were factored into the development of assumptions for earnings growth and per capital income.

The Plan’s overall investment strategy is to achieve a mix of approximately 97% of investments for long-term growth and 3% for near-term benefit payments with a wide diversification of asset types, fund strategies, and fund managers. The target allocations for Plan assets are shown in the table below. Cash equivalents consist primarily of short term investment funds. Equity securities primarily include investments in common stock and depository receipts. Fixed income securities include corporate bonds, government issues and mortgage backed securities. Other financial instruments primarily include rights and warrants.

- 103 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(17.) EMPLOYEE BENEFIT PLANS (Continued)

Effective March 2009,September 2011, the Plan revised its investment guidelines. The Plan currently prohibits its investment managers from purchasing any security greater than 5% of the portfolio at the time of purchase or greater than 8% at market value in any one issuer. In addition, the following investments;

are prohibited:

Equity securities

  

Short sales

Unregistered securities

Margin purchases

Equity

Fixed income securities

  Securities in emerging market countries as defined by the Morgan Stanley Emerging Markets Index, Short sales, Unregistered securities and Margin purchases
Fixed income securitiesSecurities of BBB quality or less, CMOs

Mortgage backed derivatives that have an inverse floating rate and whose payments don’t include principal, Commercial MBSscoupon or commercial property mortgages which aren’t certified and guaranteedthat are interest only securities

Any ABS that is not issued by the U.S. Government ABSs that aren’t issued or guaranteed by the U.S., or its agencies or its instrumentalities Non-agency residential subprime or ALT-A MBSs and Structured Notes

Generally securities of less than Baa2/BBB quality may not be purchased

Securities of less than A-quality may not in the aggregate exceed 10% of the investment manager’s portfolio

Other financial instruments

  Unhedged currency exposure in countries not defined as “high income economies” by the World Bank

Prior to September 2011 investments in emerging countries as defined by the Morgan Stanley Emerging Markets Index and structured notes were prohibited.

- 96 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
(16.) EMPLOYEE BENEFIT PLANS (Continued)
All other investments not prohibited by the Plan are permitted. At December 31, 20102012 and 2011, the Plan holdsheld certain investments which are no longer deemed acceptable to acquire. These positions will be liquidated when the investment managers deem that such liquidation is in the best interest of the Plan.
                 
              Weighted 
              Average 
  2011  Percentage of Plan Assets  Expected 
  Target  at December 31,  Long-term 
  Allocation  2010  2009  Rate of Return 
Asset category:                
Cash equivalents  0 — 20%   11.2%  13.8%   
Equity securities  40 — 60   48.2   45.7   4.60%
Fixed income securities  40 — 60   40.6   40.5   1.90%
Other financial instruments  0 — 5          
The major categories of assets in the Plan as of year-end are presented in the following table.

            Weighted 
            Average 
   2013  Percentage of Plan Assets  Expected 
   Target  at December 31,  Long-term 
   Allocation  2012  2011  Rate of Return 

Asset category:

     

Cash equivalents

   0 – 20  12.8  10.6  0.38

Equity securities

   40 – 60    45.5    47.9    3.95  

Fixed income securities

   40 – 60    41.7    41.5    1.90  

Other financial instruments

   0 – 5    —      —      —    

- 104 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(17.) EMPLOYEE BENEFIT PLANS (Continued)

Assets are segregated by the level of the valuation inputs within the fair value hierarchy established by ASC Topic 820 utilized to measure fair value (see Note 17 — 18—Fair Value Measurements).

                 
  Level 1  Level 2  Level 3  Total 
  Inputs  Inputs  Inputs  Fair Value 
December 31, 2010:
                
Cash equivalents:                
Foreign currencies $84  $  $  $84 
Short term investment funds     4,266      4,266 
             
Total cash equivalents  84   4,266      4,350 
Equity securities:                
U.S. Large Cap  10,800         10,800 
U.S. Mid Cap  1,103         1,103 
U.S. Small Cap  82         82 
International  6,698         6,698 
             
Total equities  18,683         18,683 
Fixed income securities:                
Corporate bonds                
Rated single A or higher by S&P     2,113      2,113 
Rate below single A by S&P     1,483      1,483 
Government issues     11,259      11,259 
Collateralized mortgage obligations:               
Rated single A or higher by S&P     582      582 
Rate below single A by S&P     261      261 
             
Total fixed income securities     15,698      15,698 
             
Total Plan investments $18,767  $19,964  $  $38,731 
             

- 97 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
(16.) EMPLOYEE BENEFIT PLANS (Continued)
                 
  Level 1  Level 2  Level 3  Total 
  Inputs  Inputs  Inputs  Fair Value 
December 31, 2009:
                
Cash equivalents:                
Foreign currencies $114  $  $  $114 
Short term investment funds     4,486      4,486 
             
Total cash equivalents  114   4,486      4,600 
Equity securities:                
U.S. Large Cap  8,094         8,094 
U.S. Mid Cap  289         289 
U.S. Small Cap  83         83 
International  6,712         6,712 
             
Total equities  15,178         15,178 
Fixed income securities:                
Corporate bonds                
Rated single A or higher by S&P     1,722      1,722 
Rate below single A by S&P     1,433      1,433 
Government issues     9,281      9,281 
Collateralized mortgage obligations:                
Rated single A or higher by S&P     617      617 
Rate below single A by S&P     185      185 
Other fixed income securities     187      187 
             
Total fixed income securities     13,425      13,425 
             
Total Plan investments $15,292  $17,911  $  $33,203 
             
There were no assets classified as Level 3 assets during the yearyears ended December 31, 2010.2012 and 2011. The following is a reconciliationmajor categories of Level 3Plan assets for which significant unobservable inputs were used to determinemeasured at fair value for the year endedon a recurring basis as of December 31 2009are presented in the following table (in thousands):
     
Balance at beginning of year $130 
Change in unrealized appreciation  53 
Realized loss  (57)
Sale proceeds  (126)
    
Balance at end of year $ 
    
.

   Level 1   Level 2   Level 3   Total 
   Inputs   Inputs   Inputs   Fair Value 

2012

        

Cash equivalents:

        

Foreign currencies

   60     —       —       60  

Government issues

   —       314     —       314  

Short term investment funds

   —       7,083     —       7,083  
  

 

 

   

 

 

   

 

 

   

 

 

 

Total cash equivalents

   60     7,397     —       7,457  

Equity securities:

        

Common stock

   25,447     —       —       25,447  

Depository receipts

   569     —       —       569  

Preferred stock

   113     —       —       113  

Real estate investment fund

   113     —       —       113  
  

 

 

   

 

 

   

 

 

   

 

 

 

Total equity securities

   26,242     —       —       26,242  

Fixed income securities:

        

Auto loan receivable

   —       313     —       313  

Collateralized mortgage obligations

   —       6,262     —       6,262  

Corporate Bonds

   —       5,456     —       5,456  

FHLMC

   —       717     —       717  

FNMA

   —       2,867     —       2,867  

GNMA I

   —       31     —       31  

GNMA II

   —       133     —       133  

Government Issues

   —       8,231     —       8,231  

Municipals

   —       63     —       63  

Other Asset Backed

   —       14     —       14  
  

 

 

   

 

 

   

 

 

   

 

 

 

Total fixed income securities

   —       24,087     —       24,087  
  

 

 

   

 

 

   

 

 

   

 

 

 

Total Plan investments

  $26,302     31,484     —       57,786  
  

 

 

   

 

 

   

 

 

   

 

 

 

- 105 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(17.) EMPLOYEE BENEFIT PLANS (Continued)

   Level 1
Inputs
   Level 2
Inputs
   Level 3
Inputs
   Total
Fair Value
 

2011

        

Cash equivalents:

        

Foreign currencies

   81     —       —       81  

Short term investment funds

   —       4,901     —       4,901  
  

 

 

   

 

 

   

 

 

   

 

 

 

Total cash equivalents

   81     4,901     —       4,982  

Equity securities:

        

Common stock

   21,951     —       —       21,951  

Depository receipts

   473     —       —       473  

Preferred stock

   69     —       —       69  
  

 

 

   

 

 

   

 

 

   

 

 

 

Total equity securities

   22,493     —       —       22,493  

Fixed income securities:

        

Auto loan receivable

   —       6     —       6  

Collateralized mortgage obligations

   —       4,587     —       4,587  

Corporate Bonds

   —       4,171     —       4,171  

FHLMC

   —       809     —       809  

FNMA

   —       2,500     —       2,500  

GNMA I

   —       34     —       34  

GNMA II

   —       175     —       175  

Government Issues

   —       7,078     —       7,078  

Municipals

   —       55     —       55  

Other Asset Backed

   —       53     —       53  
  

 

 

   

 

 

   

 

 

   

 

 

 

Total fixed income securities

   —       19,468     —       19,468  
  

 

 

   

 

 

   

 

 

   

 

 

 

Total Plan investments

  $22,574     24,369     —       46,943  
  

 

 

   

 

 

   

 

 

   

 

 

 

At December 31, 2012 the portfolio was managed by two investment firms, with control of the portfolio split approximately 49% and 43% under the control of the investment managers with the remaining 8% under the direct control of the Plan. A portfolio concentration in the State Street Bank & Trust Co. Short Term Investment Fund of 12% and 10% existed at December 31, 2012 and 2011, respectively.

Postretirement Benefit Plan

Prior to December 31, 2001, an

An entity acquired by the Company provided health and dental care benefits to retired employees who met specified age and service requirements through a postretirement health and dental care plan in which both the acquired entity and the retirees shared the cost. The plan provided for substantially the same medical insurance coverage as for active employees until their death and was integrated with Medicare for those retirees aged 65 or older. In 2001, the plan’s eligibility requirements were amended to curtail eligible benefit payments to only retired employees and active participantsemployees who were fully vestedhad already met the then-applicable age and service requirements under the Plan. In 2003, retirees under age 65 began contributing to health coverage at the same cost-sharing level as that of active employees. The retirees agedRetirees ages 65 or older were offered new Medicare supplemental plans as alternatives to the plan historically offered. The cost sharing of medical coverage was standardized throughout the group of retirees aged 65 or older. In addition, to be consistent with the administration of the Company’s dental plan for active employees, all retirees who continued dental coverage began paying the full monthly premium. The accrued liability included in other liabilities in the consolidated statements of financial condition related to this plan amounted to $162$118 thousand and $155$122 thousand as of December 31, 20102012 and 2009,2011, respectively. The postretirement expense for the plan that was included in salaries and employee benefits in the consolidated statements of operationsincome was not significant for the years ended December 31, 2010, 20092012, 2011 and 2008.2010. The plan is not funded.

 

- 98106 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2010, 20092012, 2011 and 2008

(16.2010

(17.) EMPLOYEE BENEFIT PLANS (Continued)

The components of accumulated other comprehensive loss related to the defined benefit plan and postretirement benefit plan, on a pre-tax basis as of December 31 are summarized below (in thousands):

         
  2010  2009 
Defined benefit plan:
        
Net actuarial loss $(11,188) $(9,056)
Prior service cost  (132)  (143)
       
   (11,320)  (9,199)
       
         
Postretirement benefit plan:
        
Net actuarial loss  (252)  (248)
Prior service credit  643   710 
       
   391   462 
       
Total recognized in accumulated other comprehensive loss $(10,929) $(8,737)
       

   2012  2011 

Defined benefit plan:

   

Net actuarial loss

  $(21,428 $(21,160

Prior service cost

   (93  (113
  

 

 

  

 

 

 
   (21,521  (21,273
  

 

 

  

 

 

 

Postretirement benefit plan:

   

Net actuarial loss

   (195  (210

Prior service credit

   508    575  
  

 

 

  

 

 

 
   313    365  
  

 

 

  

 

 

 

Total recognized in accumulated other comprehensive loss

  $(21,208 $(20,908
  

 

 

  

 

 

 

Changes in plan assets and benefit obligations recognized in other comprehensive income (loss)loss on a pre-tax basis during the years ended December 31 are as follows (in thousands):

         
  2010  2009 
Defined benefit plan:
        
Net actuarial (loss) gain $(2,590) $2,795 
Amortization of net loss  458   728 
Amortization of prior service cost  11   12 
       
   (2,121)  3,535 
       
         
Postretirement benefit plan:
        
Net actuarial loss  (4)  (10)
Amortization of prior service credit  (67)  (68)
       
   (71)  (78)
       
Total recognized in other comprehensive income (loss) $(2,192) $3,457 
       

   2012  2011 

Defined benefit plan:

   

Net actuarial loss

  $(1,638 $(10,580

Amortization of net loss

   1,370    608  

Amortization of prior service cost

   20    19  
  

 

 

  

 

 

 
   (248  (9,953
  

 

 

  

 

 

 

Postretirement benefit plan:

   

Net actuarial gain

   15    42  

Amortization of prior service credit

   (67  (68
  

 

 

  

 

 

 
   (52  (26
  

 

 

  

 

 

 

Total recognized in other comprehensive loss

  $(300 $(9,979
  

 

 

  

 

 

 

For the year ending December 31, 2011,2013, the estimated net loss and prior service cost for the plan that will be amortized from accumulated other comprehensive income into net periodic benefit cost is $608$1.3 million and $20 thousand, and $19 thousand, respectively.

Defined Contribution Plan

Employees that meet certain age and service requirementsspecified eligibility conditions are eligible to participate in the Company sponsored 401(k) plan. Under the plan, participants may make contributions, in the form of salary deferrals, up to the maximum Internal Revenue Code limit. The Company matches a participant’s contributions up to 4.5% of compensation, calculated as 100% of the first 3% of compensation and 50% of the next 3% of compensation deferred by the participant. The Company may also make additional discretionary matching contributions, although no such additional discretionary contributions were made in 2010, 20092012, 2011 or 2008.2010. The expense included in salaries and employee benefits in the consolidated statements of operationsincome for this plan amounted to $1.0 million in 2012 and 2011 and $936 thousand $914 thousand and $993 thousand in 2010, 2009 and 2008, respectively.

2010.

Supplemental Executive Retirement Plans

The Company has a non-qualified Supplemental Executive Retirement PlanPlans (“SERP”SERPs”) covering threefour former executives. At December 31, 2010, there was a $1.1 millionThe unfunded pension liability related to the SERP. PensionSERPs was $2.2 million and $1.0 million at December 31, 2012 and 2011, respectively. SERP expense was $1.3 million, $67 thousand, and $262 thousand $648 thousand,for 2012, 2011 and $309 thousand for 2010, 2009 and 2008, respectively.

 

- 99107 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2010, 20092012, 2011 and 2008

(17.2010

(18.) FAIR VALUE MEASUREMENTS

Determination of Fair Value Assets Measured at Fair Value on a Recurring and Nonrecurring Basis

Valuation Hierarchy

The fair value of an asset or liability is the price that would be received to sell that asset or paid to transfer that liability in an orderly transaction occurring in the principal market (or most advantageous market in the absence of a principal market) for such asset or liability. ASC Topic 820, “Fair Value Measurements and Disclosures,” establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:

Level 1—Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

Level 1- Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.
Level 2- Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, volatilities, prepayment speeds, credit risks, etc.) or inputs that are derived principally from or corroborated by market data by correlation or other means.
Level 3- Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

Level 2—Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, volatilities, prepayment speeds, credit risks, etc.) or inputs that are derived principally from or corroborated by market data by correlation or other means.

Level 3—Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, fair value is based upon internally developed models that primarily use, as inputs, observable market-based parameters. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality and the company’s creditworthiness, among other things, as well as unobservable parameters. Any such valuation adjustments are applied consistently over time. The Company’s valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. Furthermore, the reported fair value amounts have not been comprehensively revalued since the presentation dates, and therefore, estimates of fair value after the balance sheet date may differ significantly from the amounts presented herein. A more detailed description of the valuation methodologies used for assets and liabilities measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.

Investment securitiesSecurities available for sale:Publicly traded equity securities (stocks) are reported at fair value utilizing Level 1 inputs. Pooled trust preferred securities are reported at fair value utilizing Level 3 inputs. Fair values for these securities are determined through the use of internal valuation methodologies appropriate for the specific asset, which may include the use of a discounted expected cash flow analysis or the use of broker quotes. Other securitiesSecurities classified as available for sale are reported at fair value utilizing Level 2 inputs. For these securities, the Company obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things.

Loans held for sale: The fair value of loans held for sale is determined using quoted secondary market prices and investor commitments. Loans held for sale are classified as Level 2 in the fair value hierarchy.

Collateral dependent impaired loans:The fair Fair value of impaired loans with specific allocations of the allowance for loan losses is generallymeasured based on recentthe value of the collateral securing these loans and is classified as Level 3 in the fair value hierarchy. Collateral may be real estate appraisals.and/or business assets including equipment, inventory and/or accounts receivable and collateral value is determined based on appraisals performed by qualified licensed appraisers hired by the Company. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely madeAppraised and reported values may be discounted based on management’s historical knowledge, changes in market conditions from the appraisal process bytime of valuation, and/or management’s expertise and knowledge of the appraisers to adjust for differences betweenclient and the comparable sales and income data available.client’s business. Such adjustmentsdiscounts are typically significant and result in a Level 3 classification of the inputs for determining fair value.

Other real estate owned (Foreclosed assets):Nonrecurring adjustments to certain commercial Impaired loans are reviewed and residential real estate properties classified as other real estate owned are measuredevaluated on at the lower of carrying amount or fair value, less costs to sell. Fair values are generallyleast a quarterly basis for additional impairment and adjusted accordingly, based on third party appraisals of the property, resulting in a Level 3 classification. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized.
same factors identified above.

 

- 100108 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2010, 20092012, 2011 and 2008

(17.2010

(18.) FAIR VALUE MEASUREMENTS (Continued)

MortgageLoan servicing rights:MortgageLoan servicing rights do not trade in an active market with readily observable market data. As a result, the Company estimates the fair value of mortgageloan servicing rights by using a discounted cash flow model to calculate the present value of estimated future net servicing income. The assumptions used in the discounted cash flow model are those that we believe market participants would use in estimating future net servicing income, including estimates of loan prepayment rates, servicing costs, ancillary income, impound account balances, and discount rates. Significant assumptionsThe significant unobservable inputs used in the valuationfair value measurement of mortgagethe Company’s loan servicing rights include changes in interest rates, estimated loan repaymentare the constant prepayment rates and weighted average discount rate. Significant increases (decreases) in any of those inputs in isolation could result in a significantly lower (higher) fair value measurement. Although the timing of cash flows, among other factors. Mortgageconstant prepayment rate and the discount rate are not directly interrelated, they will generally move in opposite directions. Loan servicing rights are classified as Level 3 measurements due to the use of significant unobservable inputs, as well as significant management judgment and estimation.

Other real estate owned (Foreclosed assets): Nonrecurring adjustments to certain commercial and residential real estate properties classified as other real estate owned are measured at the lower of carrying amount or fair value, less costs to sell. Fair values are generally based on third party appraisals of the property, resulting in a Level 3 classification. The appraisals are sometimes further discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the client and client’s business. Such discounts are typically significant and result in a Level 3 classification of the inputs for determining fair value. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized.

- 109 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(18.) FAIR VALUE MEASUREMENTS (Continued)

Assets Measured at Fair Value

The following table presents for each of the fair-value hierarchy levels the Company’s assets that are measured at fair value on a recurring and non-recurring basis as of December 31 2010 (in thousands).

                 
  Level 1  Level 2  Level 3  Total 
  Inputs  Inputs  Inputs  Fair Value 
Measured on a recurring basis:
                
Securities available for sale:                
U.S. Government agencies and government sponsored enterprises $  $140,784  $  $140,784 
State and political subdivisions     105,666      105,666 
Mortgage-backed securities     419,281      419,281 
Asset-backed securities:                
Trust preferred securities        572   572 
Other     65      65 
             
  $  $665,796  $572  $666,368 
             
Measured on a nonrecurring basis:
                
Loans:                
Loans held for sale $  $3,138  $  $3,138 
Collateral dependent impaired loans        2,457   2,457 
Other assets:                
Mortgage servicing rights        1,467   1,467 
Other real estate owned        741   741 
             
  $  $3,138  $4,665  $7,803 
             

 

   Quoted Prices in
Active Markets
for Identical
Assets or
Liabilities
(Level 1)
   Significant
Other
Observable
Inputs
(Level 2)
   Significant
Unobservable
Inputs

(Level 3)
   Total 

2012

        

Measured on a recurring basis:

        

Securities available for sale:

        

U.S. Government agencies and government sponsored enterprises

  $—      $131,695    $—      $131,695  

State and political subdivisions

   —       195,210     —       195,210  

Mortgage-backed securities

   —       495,868     —       495,868  

Asset-backed securities:

        

Trust preferred securities

   —       754     —       754  

Other

   —       269     —       269  
  

 

 

   

 

 

   

 

 

   

 

 

 
  $—      $823,796    $—      $823,796  
  

 

 

   

 

 

   

 

 

   

 

 

 

Measured on a nonrecurring basis:

        

Loans:

        

Loans held for sale

  $—      $1,518    $—      $1,518  

Collateral dependent impaired loans

   —       —       2,364     2,364  

Other assets:

        

Loan servicing rights

   —       —       1,719     1,719  

Other real estate owned

   —       —       184     184  
  

 

 

   

 

 

   

 

 

   

 

 

 
  $—      $1,518    $4,267    $5,785  
  

 

 

   

 

 

   

 

 

   

 

 

 

2011

        

Measured on a recurring basis:

        

Securities available for sale:

        

U.S. Government agencies and government sponsored enterprises

  $—      $97,712    $—      $97,712  

State and political subdivisions

   —       124,424     —       124,424  

Mortgage-backed securities

   —       403,685     —       403,685  

Asset-backed securities:

        

Trust preferred securities

   —       —       1,636     1,636  

Other

   —       61     —       61  
  

 

 

   

 

 

   

 

 

   

 

 

 
  $—      $625,882    $1,636    $627,518  
  

 

 

   

 

 

   

 

 

   

 

 

 

Measured on a nonrecurring basis:

        

Loans:

        

Loans held for sale

  $—      $2,410    $—      $2,410  

Collateral dependent impaired loans

   —       —       2,160     2,160  

Other assets:

        

Loan servicing rights

   —       —       1,973     1,973  

Other real estate owned

   —       —       475     475  
  

 

 

   

 

 

   

 

 

   

 

 

 
  $—      $2,410    $4,608    $7,018  
  

 

 

   

 

 

   

 

 

   

 

 

 

- 101 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
There were no transfers between level 1 and 2 during the years ended December 31, 2010, 20092012 and 2008
(17.) FAIR VALUE MEASUREMENTS (Continued)
The following table presents for each of the fair-value hierarchy levels the Company’s assets that are measured at fair value on a recurring and non-recurring basis as of December 31, 2009 (in thousands).
                 
  Level 1  Level 2  Level 3  Total 
  Inputs  Inputs  Inputs  Fair Value 
Measured on a recurring basis:
                
Securities available for sale:                
U.S. Government agencies and government sponsored enterprises $  $134,105  $  $134,105 
State and political subdivisions     83,659      83,659 
Mortgage-backed securities     361,515      361,515 
Asset-backed securities:                
Trust preferred securities        1,015   1,015 
Other     207      207 
             
  $  $579,486  $1,015  $580,501 
             
Measured on a nonrecurring basis:
                
Loans:                
Loans held for sale $  $421  $  $421 
Collateral dependent impaired loans        1,078   1,078 
Other assets:                
Mortgage servicing rights        1,349   1,349 
Other real estate owned         746   746 
             
  $  $421  $3,173  $3,594 
             
2011. There were no liabilities measured at fair value on a recurring or nonrecurring basis during the years ended December 31, 20102012 and 2009.
2011.

- 110 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(18.) FAIR VALUE MEASUREMENTS (Continued)

The following table presents additional quantitative information about assets measured at fair value on a recurring and nonrecurring basis for which the Company has utilized Level 3 inputs to determine fair value (dollars in thousands).

Asset

  Fair
Value
   Valuation Technique Unobservable Input Unobservable Input
Value or Range

Collateral dependent impaired loans

  $2,364    Appraisal of collateral (1) Appraisal adjustments (2) 16% – 100% discount
    Discounted cash flow Discount rate 4.9%(3)
     Risk premium rate 10.1%(3)

Loan servicing rights

   1,719    Discounted cash flow Discount rate 4.1%(3)
     Constant prepayment rate 28.9%(3)

Other real estate owned

   184    Appraisal of collateral (1) Appraisal adjustments(2) 20% – 55% discount

(1)

Fair value is generally determined through independent appraisals of the underlying collateral, which generally include various Level 3 inputs which are not identifiable.

(2)

Appraisals may be adjusted by management for qualitative factors such as economic conditions and estimated liquidation expenses.

(3)

Weighted averages.

Changes in Level 3 Fair Value Measurements

There were no assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) as of December 31, 2012. The Company transferred all of the assets classified as Level 3 assets at December 31, 2011 to Level 2 during the three months ended March 31, 2012. The transfers of the $1.5 million of pooled trust preferred securities out of Level 3 was primarily the result of using observable pricing information or a third party pricing quote that appropriately reflects the fair value of those securities, without the need for adjustment based on our own assumptions regarding the characteristics of a specific security or the current liquidity in the market.

The reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the years ended December 31 is as follows (in thousands):

         
  2010  2009 
Securities available for sale (Level 3), beginning of year $1,015  $3,772 
Transfers into Level 3      
Capitalized interest  399   296 
Principal paydowns and amortization of premiums     (9)
Coupon payments applied to principal  (136)  (273)
Total losses (realized/unrealized):        
Included in earnings  (526)  (2,263)
Included in other comprehensive income  (180)  (508)
       
Securities available for sale (Level 3), end of year $572  $1,015 
       

   2012  2011 

Securities available for sale, beginning of period

  $1,636   $572  

Sales

   (360  (2,478

Principal paydowns and other

   —      (53

Total gains (losses) realized/unrealized:

   

Included in earnings

   331    2,263  

Included in other comprehensive income

   (102  1,332  

Transfers from Level 3 to Level 2

   (1,505  —    
  

 

 

  

 

 

 

Securities available for sale, end of period

  $—     $1,636  
  

 

 

  

 

 

 

- 111 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011 and 2010

(18.) FAIR VALUE MEASUREMENTS (Continued)

Disclosures about Fair Value of Financial Instruments

The Fair Value of Financial Instruments Subsection of the ASC requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring basis or non-recurring basis.

The following discussion describes the valuation methodologies used for assets and liabilities measured or disclosed at fair value. The techniques utilized in estimating the fair values of financial instruments are reliant on the assumptions used including discount rates and estimates of the amount and timing of future cash flows. Care should be exercisedbelow are expected to approximate those that market participants would use in deriving conclusions about our business, its value orvaluing these financial position based on the fair value information of financial instruments presented below.
instruments.

Fair value estimates are made at a specific point in time, based on available market information and judgments about the financial instrument, including estimates of timing, amount of expected future cash flows and the credit standing of the issuer. Such estimates do not consider the tax impact of the realization of unrealized gains or losses. In some cases, the fair value estimates cannot be substantiated by comparison to independent markets. In addition, the disclosed fair value may not be realized in the immediate settlement of the financial instrument.

Care should be exercised in deriving conclusions about our business, its value or financial position based on the fair value information of financial instruments presented below.

- 102 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2010, 2009 and 2008
(17.) FAIR VALUE MEASUREMENTS (Continued)
The estimated fair value approximates carrying value for cash and cash equivalents, FHLB and FRB stock, company owned life insurance, accrued interest receivable, non-maturity deposits, short-term borrowings and accrued interest payable. Fair value estimates for other financial instruments not included elsewhere in this disclosure are discussed below.

LoansSecurities held for sale.to maturity:The fair value of the Company’s investment securities held to maturity is based on estimates, quoted market prices and investor commitments.

Loans.For variable rate loans that re-price frequently, fair value approximates carrying amount.primarily measured using information from a third-party pricing service. The fair value for fixed rate loans is estimated through discountedmeasurements consider observable data that may include dealer quotes, market spreads, cash flow analysis using interest rates currently being offered on loans with similarflows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and credit quality. For criticized and classified loans,conditions, among other things.

Loans:The fair value isof the Company’s loans was estimated by discounting the expected future cash flows using the current interest rates at awhich similar loans would be made for the same remaining maturities. Loans were first segregated by type such as commercial, residential mortgage, and consumer, and were then further segmented into fixed and variable rate commensurate with the risk associated with the estimatedand loan quality categories. Expected future cash flows or estimates ofwere projected based on contractual cash flows, adjusted for estimated prepayments.

Time deposits:The fair value discounts based on observable market information.

Deposits.The fair values for demand accounts, money market and savingsof time deposits are equal to their carrying amounts. The fair values of certificates of deposit arewas estimated using a discounted cash flow approach that applies prevailing market interest rates for similar maturity instruments.
Long-term borrowings (excluding junior subordinated debentures).The fair values of the Company’s time deposit liabilities do not take into consideration the value forof the Company’s long-term borrowings isrelationships with depositors, which may have significant value.

The following presents the carrying amount, estimated using a discounted cash flow approach that applies prevailing market interest rates for similar maturity instruments.

Junior subordinated debentures.The fair value, for the junior subordinated debentures is estimated using a discounted cash flow approach that applies prevailing market interest rates for similar maturity instruments.
The fair value of a financial instrument is the current amount that would be exchanged between willing parties, other thanand placement in a forced liquidation. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company’s various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlementmeasurement hierarchy of the instrument. The accounting guidelines exclude certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented at December 31, 2010 and December 31, 2009 may not necessarily represent the underlying fair value of the Company.
The carrying values and fair values ofCompany’s financial instruments as of December 31 are as follows (in31(in thousands):
                 
  December 31, 2010  December 31, 2009 
      Estimated      Estimated 
  Carrying  Fair  Carrying  Fair 
  Amount  Value  Amount  Value 
Financial assets:
                
Cash and cash equivalents $39,058  $39,058  $42,959  $42,959 
Securities available for sale  666,368   666,368   580,501   580,501 
Securities held to maturity  28,162   28,849   39,573   40,629 
Loans held for sale  3,138   3,138   421   421 
Loans  1,325,524   1,388,787   1,243,265   1,290,136 
Accrued interest receivable  7,613   7,613   7,386   7,386 
FHLB and FRB stock  6,353   6,353   7,185   7,185 
                 
Financial liabilities:
                
Demand, savings and money market deposits  1,143,136   1,143,136   1,056,604   1,056,604 
Certificate of deposit  739,754   740,440   686,351   692,429 
Short-term borrowings  77,110   77,110   59,543   59,543 
Long-term borrowings (excluding junior subordinated debentures)  10,065   10,244   30,145   30,886 
Junior subordinated debentures  16,702   10,564   16,702   10,741 
Accrued interest payable  7,620   7,620   7,576   7,576 

   Level in  2012   2011 
   Fair Value      Estimated       Estimated 
   Measurement  Carrying   Fair   Carrying   Fair 
   Hierarchy  Amount   Value   Amount   Value 

Financial assets:

          

Cash and cash equivalents

  Level 1  $60,436    $60,436    $57,583    $57,583  

Securities available for sale

  Level 2   823,796     823,796     625,882     625,882  

Securities available for sale(1)

  Level 3   —       —       1,636     1,636  

Securities held to maturity

  Level 2   17,905     18,478     23,297     23,964  

Loans held for sale

  Level 2   1,518     1,547     2,410     2,442  

Loans

  Level 2   1,678,648     1,701,419     1,459,356     1,490,999  

Loans(2)

  Level 3   2,364     2,364     2,160     2,160  

Accrued interest receivable

  Level 1   7,843     7,843     7,655     7,655  

FHLB and FRB stock

  Level 2   12,321     12,321     10,674     10,674  

Financial liabilities:

          

Non-maturity deposits

  Level 1   1,606,856     1,606,856     1,230,923     1,230,923  

Time deposits

  Level 2   654,938     658,342     700,676     702,720  

Short-term borrowings

  Level 1   179,806     179,806     150,698     150,698  

Accrued interest payable

  Level 1   3,819     3,819     5,207     5,207  

(1)

Comprised of trust preferred asset-backed securities.

(2)

Comprised of collateral dependent impaired loans.

 

- 103112 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2010, 20092012, 2011 and 2008

(18.2010

(19.) PARENT COMPANY FINANCIAL INFORMATION

Condensed financial statements pertaining only to the Parent are presented below (in thousands).

Condensed Statements of Condition
         
  December 31, 
  2010  2009 
Assets:        
Cash and due from subsidiary $23,894  $7,727 
Investment in and receivables due from subsidiary  202,754   203,986 
Other assets  4,623   5,698 
       
Total assets $231,271  $217,411 
       
Liabilities and shareholders’ equity:        
Junior subordinated debentures $16,702  $16,702 
Other liabilities  2,425   2,415 
Shareholders’ equity  212,144   198,294 
       
Total liabilities and shareholders’ equity $231,271  $217,411 
       
Condensed Statements of Operations
             
  Years ended December 31, 
  2010  2009  2008 
Dividends from subsidiary and associated companies $23,151  $5,051  $11,251 
Management and service fees from subsidiary  1,163   603   418 
Other (loss) income  (134)  182   74 
          
Total income  24,180   5,836   11,743 
Operating expenses  4,005   4,436   4,363 
          
Income before income tax benefit and equity in (excess distributions) undistributed earnings of subsidiary  20,175   1,400   7,380 
Income tax benefit  1,323   1,286   1,499 
          
Income before equity in (excess distributions) undistributed earnings of subsidiary  21,498   2,686   8,879 
Equity in (excess distributions) undistributed earnings of subsidiary  (211)  11,755   (35,037)
          
Net income (loss) $21,287  $14,441  $(26,158)
          

Condensed Statements of Condition  December 31, 
   2012   2011 

Assets:

    

Cash and due from subsidiary

  $6,602    $11,621  

Investment in and receivables due from subsidiary

   246,535     223,577  

Other assets

   3,563     4,337  
  

 

 

   

 

 

 

Total assets

  $256,700    $239,535  
  

 

 

   

 

 

 

Liabilities and shareholders’ equity:

    

Other liabilities

  $2,803    $2,341  

Shareholders’ equity

   253,897     237,194  
  

 

 

   

 

 

 

Total liabilities and shareholders’ equity

  $256,700    $239,535  
  

 

 

   

 

 

 

Condensed Statements of Income  Years ended December 31, 
   2012   2011   2010 

Dividends from subsidiary and associated companies

  $4,000    $9,233    $23,151  

Management and service fees from subsidiary

   517     1,161     1,163  

Other income (loss)

   24     78     (134
  

 

 

   

 

 

   

 

 

 

Total income

   4,541     10,472     24,180  
  

 

 

   

 

 

   

 

 

 

Operating expenses

   2,732     3,787     4,005  

Loss on extinguishment of debt

   —       1,083     —    
  

 

 

   

 

 

   

 

 

 

Total expenses

   2,732     4,870     4,005  
  

 

 

   

 

 

   

 

 

 

Income before income tax benefit and equity in undistributed earnings of subsidiary

   1,809     5,602     20,175  

Income tax benefit

   991     1,539     1,323  
  

 

 

   

 

 

   

 

 

 

Income before equity in undistributed earnings of subsidiary

   2,800     7,141     21,498  

Equity in undistributed earnings (excess distributions) of subsidiary

   20,649     15,658     (211
  

 

 

   

 

 

   

 

 

 

Net income

  $23,449    $22,799    $21,287  
  

 

 

   

 

 

   

 

 

 

 

- 104113 -


FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2010, 20092012, 2011 and 2008

(18.2010

(19.) PARENT COMPANY FINANCIAL INFORMATION (Continued)

Condensed Statements of Cash Flows
             
  Years ended December 31, 
  2010  2009  2008 
Cash flows from operating activities:            
Net income (loss) $21,287  $14,441  $(26,158)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:            
Equity in excess distributions (undistributed earnings) of subsidiary  211   (11,755)  35,037 
Depreciation and amortization  193   318   427 
Share-based compensation  1,031   854   633 
Decrease (increase) in other assets  980   797   (763)
Increase (decrease) in other liabilities  8   (230)  (258)
          
Net cash provided by operating activities  23,710   4,425   8,918 
Cash flows from investing activities:            
Purchase of investment assets, net of disposals     (1,323)  (99)
Capital investment in subsidiary     (15,000)  (20,000)
          
Net cash used in investing activities     (16,323)  (20,099)
Cash flows from financing activities:            
Purchase of preferred and common shares  (69)     (4,821)
Proceeds from issuance of preferred and common shares, net of issuance costs     (68)  35,602 
Proceeds from issuance of common stock warrant        2,025 
Proceeds from stock options exercised  216   15   32 
Dividends paid  (7,690)  (7,485)  (7,722)
          
Net cash (used in) provided by financing activities  (7,543)  (7,538)  25,116 
          
Net increase (decrease) in cash and cash equivalents  16,167   (19,436)  13,935 
Cash and cash equivalents as of beginning of year  7,727   27,163   13,228 
          
Cash and cash equivalents as of end of the year $23,894  $7,727  $27,163 
          
(19.) SUBSEQUENT EVENT
On February 23, 2011, the Company was granted approval by the Treasury and redeemed $12.5 million of the $37.5 million in Series A preferred stock issued by the Company in December 2008. The redemption will result in a reduction of the associated Series A preferred stock dividends and Tier 1 capital in future periods. Upon issuance in December 2008, the discount associated with the Series A preferred stock was $2.0 million, which is being accreted to retained earnings as an adjustment to dividends using the effective yield method. At December 31, 2010, the Series A preferred stock discount totaled $1.3 million. As a result of the redemption, the Company will accelerate the accretion of the remaining discount in proportion to the Series A preferred stock redeemed in the first quarter of 2011. This transaction has no effect on the outstanding warrant to purchase common stock issued to the Treasury as part of the original issuance of the Series A preferred stock. The Company may apply for approval to repay the remaining balance of the Series A preferred stock in future periods.

Condensed Statements of Cash Flows  Years ended December 31, 
   2012  2011  2010 

Cash flows from operating activities:

    

Net income

  $23,449   $22,799   $21,287  

Adjustments to reconcile net income to net cash provided by operating activities:

    

Equity in (undistributed earnings) excess distributions of subsidiary

   (20,649  (15,658  211  

Depreciation and amortization

   65    116    193  

Share-based compensation

   526    1,105    1,031  

Decrease in other assets

   805    771    980  

Increase (decrease) in other liabilities

   44    (534  8  
  

 

 

  

 

 

  

 

 

 

Net cash provided by operating activities

   4,240    8,599    23,710  

Cash flows from financing activities:

    

Redemption of junior subordinated debentures

   —      (16,702  —    

Proceeds from issuance of preferred and common shares, net of issuance costs

   —      43,127    —    

Purchase of preferred and common shares

   (559  (37,764  (69

Repurchase of warrant issued to U.S. Treasury

   —      (2,080  —    

Proceeds from stock options exercised

   69    91    216  

Dividends paid

   (8,866  (7,564  (7,690

Other

   97    20    —    
  

 

 

  

 

 

  

 

 

 

Net cash used in financing activities

   (9,259  (20,872  (7,543
  

 

 

  

 

 

  

 

 

 

Net (decrease) increase in cash and cash equivalents

   (5,019  (12,273  16,167  

Cash and cash equivalents as of beginning of year

   11,621    23,894    7,727  
  

 

 

  

 

 

  

 

 

 

Cash and cash equivalents as of end of the year

  $6,602   $11,621   $23,894  
  

 

 

  

 

 

  

 

 

 

 

- 105114 -


ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

ITEM 9A.
CONTROLS AND PROCEDURES

Effectiveness of Controls and Procedures

As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer (Principal Executive Officer) and Chief Financial Officer (Principal Accounting Officer), of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Rule 13a-15(b), as adopted by the Securities and Exchange Commission (“SEC”) under the Securities Exchange Act of 1934 (“Exchange Act”). Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of the end of the period covered by this Annual Report on Form 10-K.

Disclosure controls and procedures are the controls and other procedures that are designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Exchange Act is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined effective can provide only reasonable assurance with respect to financial statement preparation and presentation.

Management Report on Internal Control over Financial Reporting and Attestation Report of Independent Registered Public Accounting Firm

Management of Financial Institutions, Inc. (the Company)the Company is responsible for establishing and maintaining adequate internal control over financial reporting. Management assessed the Company’s internal control over financial reporting based on criteria established in the Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this assessment, management has concluded that, as of December 31, 2010,2012, the Company maintained effective internal control over financial reporting. Management’s Report on Internal Control over Financial Reporting is included under Item 8 “Financial Statements and Supplementary Data” in Part II of this Form 10-K.

KPMG LLP, aan independent registered public accounting firm, has audited the consolidated financial statements included in this Annual Report on Form 10-K, and has issued an attestation report on the effectiveness of the Company’s internal control over financial reporting. The Report of Independent Registered Public Accounting Firm that attests the effectiveness of internal control over financial reporting is included under Item 8 “Financial Statements and Supplementary Data” in Part II of this Form 10-K.

Changes in Internal Control over Financial Reporting

There were no changes in the Company’s internal control over financial reporting that occurred during the quarter ended December 31, 20102012 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

ITEM 9B.
OTHER INFORMATION

Not applicable.

 

- 106115 -


PART III

ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Our Board of Directors is divided into three classes, one of which is elected at each annual meeting of shareholders for a term of three years and until their successors have been elected and qualified. The Board believes that

In response to this Item, the many years of service that our Directors have at the Company and Five Star Bank (the “Bank”) is one of the Directors’ most important qualifications for service on our Board. This service has given them extensive knowledge of the banking business and our Company. Each outside Director also brings special skills, experience and expertise to the Board as a result of their other business activities and associations. The business experience of each Director of the Company for at least the past five years and the experience, qualifications, attributes, skills and areas of expertise of each Director that supports his or her service as a Director areinformation set forth below. Unless otherwise specified, each Director ofin the Company has also been a Director of the Bank since 2005. Age shownCompany’s Proxy Statement for each Director is as of May 4, 2011, the date of the 2011its 2013 Annual Meeting of Shareholders.

               
Name Age Position(s) Held Director Since Term Expires
Karl V. Anderson, Jr.  64  Director  2006   2012 
John E. Benjamin  69  Chairman of the Board  2002   2011 
Barton P. Dambra  69  Director  1993   2011 
Samuel M. Gullo  62  Director  2000   2013 
Susan R. Holliday  55  Director  2002   2011 
Peter G. Humphrey  56  President and Chief Executive Officer  1983   2011 
Erland E. Kailbourne  69  Director  2005   2012 
Robert N. Latella  68  Director  2005   2012 
James L. Robinson  68  Director  2007   2013 
James H. Wyckoff  59  Director  1985   2013 
BusinessShareholders (the “2013 Proxy Statement”) to be filed within 120 days following the end of the Company’s fiscal year, under the headings “Election of Directors,” “Business Experience and Qualification of Directors,
Karl V. Anderson, Jr.has had a Practice of Law since 1972 and also held the position of President and CEO of Bank of Avoca from 1981 to 2002. Has been a Director of the Company and Bank since 2006. He previously served as Director of National Bank of Geneva and Bath National Bank until their merger with and into the Bank in 2005. Mr. Anderson’s 30 years of experience in the banking industry provides him with valuable insight and perspective into our operations, which greatly enriches the decision making of the board of directors. In addition, Mr. Anderson’s extensive financial and risk assessment experience are utilized in his committee assignments.
John E. Benjaminhas been President of Three Rivers Development Corporation, a not-for-profit business for the public and private economic development of businesses and government in the greater Corning, New York area, since 1981. He was appointed Chairman of the Board in May 2010, served as Vice Chairman of the Board since May 2009 and served as a Director of Bath National Bank until its merger with the Bank in 2005. Mr. Benjamin’s three decades of experience in economic development in the geographic region in which we compete provides our board of directors with valuable insight into the economic environment in the markets we serve. In addition, Mr. Benjamin’s perspective into the corporate governance practices at a broad range of companies“Section 16(a) Beneficial Ownership Reporting Compliance” is valuable to us in his role as Chairman of the Board.
Barton P. Dambrahas been the President of Markin Tubing LP, a manufacturer of steel tubing with worldwide sales since 1978. He previously served as a Director of National Bank of Geneva until its merger with the Bank in 2005. The board of directors benefits from Mr. Dambra’s business acumen gleaned from over three decades of business leadership as President of Markin Tubing. Mr. Dambra’s experience leading a manufacturing company in our geographic region provides insight into the banking needs of the businesses in the geographic areas we serve. Mr. Dambra’s extensive financial and accounting expertise is utilized in his role as one of our audit committee financial experts.
Samuel M. Gullohas owned and operated a retail furniture sales business, Family Furniture, since 1976. He previously served as Director of Wyoming County Bank until its merger into the Bank in 2005. He was the CEO of American Classic Outfitters, Inc., an apparel manufacturer, from 2002 to 2009. The board of directors benefits from Mr. Gullo’s extensive business experience in the retail and real estate development industries in the geographic markets we serve. Mr. Gullo’s experience leading retail and real estate development companies in our geographic region provides the board of directors with a unique perspective that assists us in our marketing initiatives.

incorporated herein by reference.

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Susan R. Hollidayhas been the President and Publisher of the Rochester Business Journal, Inc., a business newspaper in the western New York area since 1988. Mrs. Holliday’s business experiences and relationships in the Rochester, New York area serve the Company well in the markets it serves. Ms. Holliday’s decades of experience leading a business newspaper gives her insight into new and emerging business practices that are valuable to the board of directors. In particular, her exposure to corporate governance and executive compensation best practices across different industries are valuable to us in her role as Chair of our Management Development and Compensation Committee.
Peter G. Humphreyhas been President and Chief Executive Officer of the Company since 1994 and the Bank since 2005. He previously served as the Company’s Chairman of the Board from 2001 until 2006. He has been a Director of Five Star Investment Services, Inc., the Company’s broker-dealer subsidiary, since 1999, serving as its Chairman from 1999 until 2006. He previously served as Chairman of the Board and Director of Wyoming County Bank, National Bank of Geneva and Bath National Bank until their merger with and into the Bank in 2005. From 2002 to 2005 he also served as a Director of Burke Group, Inc., an employee benefits and compensation consulting firm subsidiary sold by the Bank in 2005. He currently serves as a Director on the Board’s of the New York Bankers Association and the New York State Banking Department. He was also a Director of the Buffalo Branch of the Federal Reserve Bank of New York from 2001 to 2006. The attributes, skills and qualifications Mr. Humphrey has developed through his banking background, professional experiences as a business leader, as well as his knowledge and experience as director of the Bank and the Company, enable him to provide continued banking and business expertise to the Board. Mr. Humphrey’s 16 years of experience as our President and Chief Executive Officer, his 27 years of service on the board of directors, and his deep knowledge of the banking industry provides valuable insight to our board of directors.
Erland E. Kailbourneserved as Chairman and interim Chief Executive Officer of Adelphia Communications Corp. from May 2002 until March 2003 (Adelphia filed a petition under Chapter 11 of the United States Bankruptcy Code in 2002.) He retired as Chairman and Chief Executive Officer (New York Region) of Fleet National Bank, a banking subsidiary of Fleet Financial Group, Inc., in 1998. He was Chairman and Chief Executive Officer of Fleet Bank, also a banking subsidiary of Fleet Financial Group, Inc., from 1993 until its merger into Fleet National Bank in 1997. Mr. Kailbourne was also a member of New York State Banking Department Board from 1999 to 2006. Mr. Kailbourne served as Chairman of the Board of the Company and the Bank from 2006 until May 2010. He currently serves as Chairman of the Board of Albany International, Corp., a global advanced textiles and materials processing company. He is a Director of the New York ISO, Rand Capital Corporation, Allegany Co-op Insurance Company, and the Farash Corporation. Mr. Kailbourne’s extensive knowledge and experience of business strategy, business development, corporate governance and leadership development gained from years of service as a director of multiple public and private companies and governmental entities greatly benefits the board of directors and enables him to make valuable contributions in his role as Chairman of the Executive, Nominating and Governance Committee.
Robert N. Latellahas been Counsel and attorney with the law firm of Hiscock & Barclay, LLP since 2009 and was previously a partner with the law firm of Hiscock & Barclay, LLP from 2004 to 2009. Since 2009 Mr. Latella has served as the Chief Operating Officer of Integrated Nano-Technologies, LLC, a developer of field portable diagnostic systems to identify virus and bacterial pathogens. Mr. Latella’s extensive legal and operational experience, and his expertise in corporate governance and strategic planning, provides him with a depth and breadth of experience that enhances our ability to navigate legal and strategic issues. Mr. Latella’s exposure to corporate governance and executive compensation best practices as an expert advising a wide variety of companies across different industries also enables him to make valuable contributions to our board of directors with respect to these matters.
James L. Robinsonserved as President, CEO and Treasurer of Olean Wholesale Grocery Cooperative, Inc., and its subsidiaries from 1977 to 2005. Has been a Director of the Company and the Bank since 2007, and previously served as Director of First Tier Bank & Trust until its merger with the Bank in 2005. The board of directors’ benefits from Mr. Robinson’s financial and management expertise gained from nearly three decades as President, Chief Executive Officer and Treasurer of Olean Wholesale Grocery Cooperative, Inc. Mr. Robinson’s extensive financial and accounting expertise is utilized in his role as one of our audit committee financial experts.
James H. Wyckoffhas been a faculty member of the Curry School of Education at the University of Virginia since 2008 and a Director of the Center on Educational Policy and Workforce Competitiveness at the University of Virginia since 2010. Dr. Wyckoff was previously University Professor with the Departments of Public Administration and Economics at State University of New York Albany from 1986 through 2007. He previously served as Director of National Bank of Geneva until its merger with the Bank in 2005. Dr. Wyckoff has extensive economic and public policy expertise gained from over two decades of researching, writing and teaching on such subjects that provides him with a perspective that is valuable to our board of directors.
The information under the heading “Executive Officers of the Registrant” in Part I, Item 1 of this Form 10-K is also incorporated herein by reference.

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SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Securities Exchange Act of 1934 requiresInformation concerning the Company’s DirectorsAudit Committee and executive officersthe Audit Committee’s financial expert is set forth under the caption “Corporate Governance Information” in the 2013 Proxy Statement and persons who own more than 10% of a registered class of FII’s equity securities to file with the U.S. Securities and Exchange Commission reports of transactions in and ownership of Financial Institutions, Inc. common stock. Officers, Directors and greater than 10% shareholders are requiredis incorporated herein by SEC regulations to furnish us with copies of all Section 16(a) forms they file. Based solely on review of the copies of such reports and representations that no other reports are required, all Section 16(a) filing requirements applicable to its officers, Directors and greater than 10% beneficial owners were complied with during the fiscal year ended December 31, 2010 except that John J. Witkowski filed one late Form 4 report with respect to one transaction.
CODE OF ETHICS
reference.

The Company has adopted a Code of Business Conduct and Ethics that applies to its principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions. The Code of Business Conduct and Ethics is posted on the Company’s internet website at www.fiiwarsaw.com.www.fiiwarsaw.com under the Corporate Overview/Governance Documents tabs of the Investor Relations drop down menu. In addition, the Company will provide a copy of the Code of Business Conduct and Ethics to anyone, without charge, upon request addressed to Director of Human Resources at Financial Institutions, Inc., 220 Liberty Street, Warsaw, NY 14569. The Company intends to disclose any amendment to, or waiver from, a provision of its Code of Business Conduct and Ethics that applies to the Company’s principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions, and that relates to any element of the Code of Business Conduct and Ethics, by posting such information on the Company’s website.

AUDIT COMMITTEE
The Board of Directors has established a standing Audit Committee. Mr. Robinson and Mr. Dambra are the committee’s “audit committee financial experts” as defined by Securities and Exchange Commission rules.
The Audit Committee engages and reviews the general scope of the audit conducted by our independent auditors and matters relating to our financial reporting, internal control systems and credit quality. In performing its function, the Audit Committee meets separately with representatives of the independent auditors, internal auditors and senior management. In 2010, the Audit Committee held eight meetings. The Audit Committee members are Chairman James L. Robinson, Karl V. Anderson, Jr., Barton P. Dambra, and Samuel M. Gullo. Mr. Robinson and Mr. Dambra are the committee’s “audit committee financial experts” as defined by Securities and Exchange Commission rules. All committee members are “independent” as defined in Securities and Exchange Commission and NASDAQ rules applicable to audit committees.

ITEM 11.
EXECUTIVE COMPENSATION
COMPENSATION DISCUSSION AND ANALYSIS
Introduction
This Compensation Discussion and Analysis, which we refer to as CD&A, provides detail about the compensation programs for our executive officers named in the 2011 Summary Compensation Table and referred to in this CD&A and in the subsequent tables as our named executive officers. These named executive officers are: Peter G. Humphrey, our President and Chief Executive Officer; Karl F. Krebs, our Executive Vice President and Chief Financial Officer; Richard J. Harrison, our Executive Vice President and Senior Retail Lending Administrator, John J. Witkowski, our Executive Vice President and Retail Banking Executive; George D. Hagi, our Executive Vice President and Chief Risk Officer and Martin K. Birmingham, our Executive Vice President and Commercial Banking Executive. We elected to include six, instead of five, named executive officers because Mr. Harrison, Mr. Witkowski, Mr. Hagi and Mr. Birmingham have similar total compensation and similar job responsibilities as Executive Vice Presidents.
This CD&A includes the philosophy and objectives of the Management, Development & Compensation Committee of our Board of Directors, which we refer to as the MD&C Committee, descriptions of each of the elements of our executive compensation programs and the basis for the compensation earned by our named executive officers during 2010.

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Executive Summary
Despite the economic crisis that dramatically impacted the profitability and overall performance of financial institutions during 2008 and 2009, we entered 2010 well positioned to exploit an improved economic environment. Through the skillful efforts of our Board, executive team and dedicated employees, we unlocked the potential of and grew our community banking franchise. We experienced significant improvements in our profitability and financial performance during 2010:
Stock price growth of 61% to $18.97 per share at the close of business December 31, 2010, as compared to $11.78 per share at the close of business December 31, 2009;
Diluted earnings per share (EPS) growth in 2010 of 63% over 2009, to $1.61 per share from $.99 per share in 2009;
Improved our efficiency ratio by approximately 8%, to 60.36% in 2010 from 65.52% in 2009;
Increased our Tier 1 leverage ratio and Tier 1 risk based capital ratio over 3% to 8.31% and 12.34%, respectively, as compared to 2009;
Improved our ratio of non-performing assets/total assets by 22% to 0.40% at December 31, 2010, from 0.51% at December 31, 2009.
Our improved profitability and financial performance influenced our compensation decisions during 2010. During 2010, the long-term incentive awards for Mr. Humphrey and our other named executive officers, were determined by the results of certain financial performance measures selected by our MD&C Committee, which were earnings per share, which we refer to as EPS, non-performing assets/total assets and efficiency ratio. Mr. Humphrey’s annual cash incentive award and 75% of the annual cash incentive awards for our other named executive officers were also determined by these performance measures. Such performance-based compensation accounted for nearly 33% of our named executive officers’ 2010 total compensation and would have accounted for more if we were not subject to the executive compensation restrictions imposed on participants in the Treasury Department’s Troubled Asset Relief Program, which we refer to as TARP. If we were not subject to TARP restrictions, performance-based compensation would have accounted for, on average, 62.39% of our named executive officers’ 2010 total compensation.
During 2010, we implemented or revised the following executive compensation policies and practices that impacted all of our executive officers:
Approved new stock ownership requirements for all our executive officers and directors;
In addition to EPS, we added two new performance measures, non-performing assets/total assets and efficiency ratio, to our annual cash incentive plan and long-term equity-based incentive plan; and
Established a new peer group used for executive compensation plan analysis.
In January 2011, we approved a clawback provision which requires our named executive officers and certain employees to return compensation they received from us in the event that the amount was determined based on materially inaccurate financial information. This provision has been incorporated into all of our incentive compensation plan documents and award agreements.
In December 2008, we issued preferred shares to the Treasury Department pursuant to the Treasury Department’s Capital Purchase Program, which we refer to as the CPP. As a participant in the CPP, we are subject to the Emergency Economic Stabilization Act of 2008, which we refer to as EESA, and the Interim Final Rule on TARP Standards for Compensation and Corporate Governance, which we refer to as the Interim Final Rule, issued by the U.S. Treasury Department in June 2009 under the American Recovery and Reinvestment Act of 2009, which we refer to as the ARRA.
For our senior executive officers, who are also the same persons as our named executive officers, the Interim Final Rule prohibits or limits certain components of our executive compensation program, including:
Payment or accrual of annual and long-term incentive compensation, other than long-term restricted shares subject to certain limitations;
Granting of stock options;
Certain retirement benefits; and
Potential payments upon termination of employment or change of control (severance payments) that the executive officers or covered employees might otherwise have been eligible to receive.
As a result, the primary means remaining available to us for compensating our named executive officers covered by the Interim Final Rule are limited to cash salary and, on a limited basis, ARRA-compliant grants of restricted stock. The MD&C Committee made significant efforts in 2010 to determine how best to continue to meet the objectives of our executive compensation program within the context of these limitations.

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In July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which we refer to as Dodd-Frank, was passed into law. Certain provisions of Dodd-Frank will be phased in over time, while other provisions are effective immediately. These provisions will impact both our operations and our executive compensation programs. Our Board of Directors and management are committed to compliance with Dodd-Frank and the ARRA. We have taken the appropriate actions to conform our compensation programs to such regulatory provisions including say-on-pay, compensation committee independence, implementation of clawback agreements and improvements to our incentive compensation structure. Our compensation philosophy remains focused on rewarding our employees for continued performance excellence, while never losing sight of the relationship and alignment of compensation with the interests of our shareholders.
Compensation Philosophy and Objectives
The MD&C Committee believes that executive compensation should be directly linked to continuous improvements in corporate performance. The primary objective of our executive compensation program is to maintain a program that will fairly compensate our executives, attract and retain qualified executives who are able to contribute to our long-term success, encourage performance consistent with clearly defined corporate goals, and align our executives’ long-term interests with those of our shareholders. To this end, our executive compensation program is designed to:
Drive performance relative to our financial goals, balancing short-term operational objectives with long-term strategic goals;
Align executives’ long-term interests with those of our shareholders by placing a portion of total compensation at risk, contingent on our performance;
Attract and retain the highly-qualified executives needed to achieve our financial goals, and maintain a stable executive management group;
Deliver compensation to our executive officers in an effective and cost-effective manner; and
Allow flexibility in responding to changing laws, accounting standards, and business needs and the constraints and dynamic conditions in the markets in which we do business.
The MD&C Committee
We have a standing MD&C Committee which operates pursuant to a charter that has been approved by our Board of Directors. Each member of the MD&C Committee is independent as defined under applicable NASDAQ rules.
The MD&C Committee performs the following duties pursuant to its charter:
Establishes the performance goals and objectives of our President and Chief Executive Officer, which we refer to as our CEO, and evaluates our CEO’s performance in light of these goals and objectives;
Reviews and approves compensation of our named executive officers and certain senior executives who report directly to our CEO;
Approves equity awards to all officers, including our CEO;
Approves our executive and senior management compensation programs, which include our annual cash incentive plan and our long-term equity-based incentive plan, and approves the corporate performance objectives in such plans each year;
Reviews and monitors development and succession plans for our executive officers;
Approves employment conditions, change of control, severance and termination arrangements with our executive officers;
Evaluates competitive compensation levels for Directors, including our Chairman of the Board, and makes recommendations for director compensation to the full Board for approval;
Evaluates the risks associated with our compensation philosophy and all compensation programs, including those of our named executive officers;
Makes recommendations to the Board with respect to major modifications to our benefit programs including our 401(k) and defined benefit plans;
Selects and engages independent compensation consultants, legal counsel, and other committee advisors;
Reviews and discusses with management our CD&A and, based on such review and discussion, recommends to the Board that CD&A be included in our Annual Report on Form 10-K and proxy statement; and
Produces the MD&C Committee’s report on executive officer compensation as required by the SEC and the ARRA.

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The MD&C Committee has not delegated any of its authority, as described above, to other persons. During 2010, the MD&C Committee completed the following key initiatives:
Approved the peer group used for executive compensation plan analysis;
Approved design changes to our annual cash incentive plan and our long-term equity-based incentive plan;
Approved the 2010 financial performance goals used in the annual cash incentive plan and the long-term equity-based incentive plan;
With the assistance of our senior risk officer, reviewed named executive officer compensation, all of our incentives plans and all other employee compensation plans for unnecessary and excessive risk;
Approved new stock ownership requirements for our executive officers and Directors; and
Approved the 2011 engagement of McLagan (formerly Amalfi Consulting LLC) as our outside compensation consultant.
Role of Executive Officers in Compensation Decisions
Our Chairman and our CEO annually review the performance of our executive vice presidents, which includes our named executive officers, other than Mr. Humphrey whose performance is reviewed by the MD&C Committee. The conclusions reached and recommendations made with respect to salary adjustments and annual cash incentive amounts, based on these reviews, are presented to the MD&C Committee. The MD&C Committee has final discretion over all compensation decisions regarding our CEO and each of our executive vice presidents. Decisions regarding the non-equity compensation of our non-executive senior officers, which includes our senior vice presidents, are made by our CEO. Our named executive officers, including our CEO, are not present when the MD&C Committee votes on compensation matters.
Role of Compensation Consultant
Pursuant to its charter, the MD&C Committee has the sole and direct authority to retain, at our expense, legal counsel, advisors, and compensation consultants and to approve the fees and retention terms of such consultants and advisors. In December 2009, the MD&C Committee retained Amalfi Consulting, LLC, an independent compensation consulting firm focused exclusively on providing compensation services to banks throughout the country, including TARP recipient banks. In December 2010, Amalfi Consulting joined McLagan, an AonHewitt Company. McLagan reports directly to the Chair of the MD&C Committee. McLagan has no personal or business relationship with any member of the MD&C Committee. McLagan is retained solely by the MD&C Committee and provides no other services to us.
During 2010, the MD&C Committee requested McLagan to provide it with the following assistance:
Establish a new peer group based on parameters determined by the MD&C Committee;
Analyze competitive market data specific to executive compensation considering base pay, annual cash incentive awards and long-term equity-based incentive awards;
Advise the MD&C Committee with respect to TARP requirements and regulatory guidance on incentive compensation practices with respect to our executive compensation program;
Review plan designs of our annual cash incentive plan and the long-term equity-based incentive plan; and
Review our Director compensation plan.
McLagan met with the MD&C Committee to review its findings relative to its compensation study of market compensation practices. The study evaluated the competitiveness of our compensation plan relative to market with respect to base salary, cash incentives and long term incentive opportunities for our executive officers. While McLagan provides reports and recommendations to the MD&C Committee regarding our executive compensation programs, the MD&C Committee is solely responsible for determining the form of compensation, the final amount, and the level of performance targets used in our executive compensation plans.
While the core incentive plans were preserved, the MD&C Committee approved design changes to our annual cash incentive plan and long-term equity-based incentive plan that reflect industry best practices and the requirements imposed upon us by our participation in TARP and the Federal Reserve’s guidance on incentive compensation practices.
The MD&C Committee concluded that our executive compensation program is meeting our objectives and is competitive within the newly established peer group, reinforces a pay-for-performance philosophy, and will allow us to attract and retain key executives, while complying with regulatory requirements. Other than revisions to the incentive plans, no additional changes to our executive compensation program were approved.

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Use of Peer Group Compensation Data
To attract and retain qualified executives, we seek to offer a total compensation package competitive with a peer group of similar companies. For compensation benchmark purposes, we believe that external comparisons should be made against a peer group of comparable institutions whose executives manage similarly-sized balance sheets and constituencies. In addition, we believe that our peer group should fairly represent the market for executive talent and should include institutions that share in the business and market challenges we face. Accordingly, the MD&C Committee retained McLagan to create a new peer group for 2010 based on the following criteria:
United States publicly traded financial institutions;
Headquartered in the northeast states of Connecticut, Massachusetts, Maine, New Hampshire, New Jersey, upstate New York, Ohio, western Pennsylvania, Rhode Island and Vermont; and
$1.0 billion to $5.5 billion in assets.
The following peer group was approved by the MD&C Committee as appropriate for the compensation analysis of our named executive officers. The peer group included banks headquartered in the northeastern U.S. that ranged from $1.0 billion to $5.5 billion in assets with a median of $2.0 billion in assets and remained unchanged from fiscal year 2010. Nine of the twenty-one peer banks have participated in the TARP program. A list of banks in the peer group follows.
Alliance Financial CorporationCitizens & Northern CorporationMerchants Bancshares, Inc.
Arrow Financial CorporationCommunity Bank System, Inc.NBT Bancorp Inc.
Bancorp Rhode Island, Inc.Enterprise Bancorp, Inc.Peoples Bancorp Inc.
Camco Financial CorporationFirst Bancorp, Inc.S&T Bancorp, Inc.
Camden National CorporationFirst National Community Bancorp, Inc.Sun Bancorp, Inc.
Canandaigua National CorporationIndependent Bank Corp.Tompkins Financial Corporation
Century Bancorp, Inc.Lakeland Bancorp, Inc.Washington Trust Bancorp, Inc.
The following table details our performance relative to the median of the peer group during 2010.
         
      Financial 
      Institutions, Inc. 
Measure Peer Median  Rank(1) 
Asset Size $2.0 Billion  51%
Return on Equity  9.13%  63%
Return on Assets  0.83%  59%
Net Interest Margin  3.7%  87%
Efficiency Ratio  61.2%  56%
Non-Performing Assets/Total Assets  1.41%  88%
Earnings Per Share Growth  11.7%  95%
(1)Rank represents relative standing within the peer group (e.g., 5% is low and 95% is high)

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Elements of Executive Compensation
Overview
A mix of compensation components has been designedIn response to reward achievement of our annual performance goals and motivate long-term performance of our named executive officers through a combination of cash and equity incentive awards. Our executive compensation program consists of three primary elements:
Base Salary;
Performance-based Annual Cash Incentive Awards; and
Performance-based Long-Term Equity Incentive Awards.
Rationale for Providing Each Primary Element of Executive Compensation
Pay ElementWhat the Pay Element RewardsObjectives of the Pay Element
Base SalaryIndividual ongoing performance and overall contribution to us.Attract and retain talented executives. Recognizes experience level required, scope and complexity of position and market value of the position.
Annual Cash Incentive PlanAchievement of our performance targets and measurable individual/department annual performance goals.Focuses attention on meeting our annual performance targets and near-term success and recognizes individual contributions.

Mandatory deferral of a portion of the executives’ awards ensures our performance is sustained.
Long-Term Incentive PlanAchieving performance targets that maximize shareholder value.

Retention during the vesting periods.
Focuses attention on longer-term success and provides a strong alignment between shareholders and executive officers.
Base Salary
It isthis Item, the MD&C Committee’s philosophy to compensate our named executive officers competitively, taking into account compensation paid for similar positions by financial institutions within our peer group. Base salary should compensate our named executive officers in a manner that encourages individual performance consistent with our expectations and those of our shareholders. Base salary is determined annually based on the scope and performance of the named executive officer’s responsibilities and the experience, skills and knowledge required for the position.
Generally, the MD&C Committee believes that executive officer base salaries should be targeted near the median levels within the peer group. The MD&C Committee also recognizes that, in some circumstances, it may be necessary to provide compensation at above-market levels. These circumstances include the need to retain or attract key individuals, reward outstanding performance, or to recognize roles that were larger in scope or accountability than comparable market positions. The median base salary of our peer group by position and the 2010 base salary for our named executive officers can be found in the following table.
         
  Median Peer    
  Group Base  Actual 2010 
  Salary  Base Salary 
Position ($000)  ($000) 
President and Chief Executive Officer  365.5   406.1 
Chief Financial Officer  197.0   180.0 
Senior Retail Lending Administrator  194.2   200.0 
Retail Banking Executive/Regional President  245.2   226.6 
Commercial Banking Executive/Regional President  201.2   205.6 
Chief Risk Officer  172.4   198.2 

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When considering base salary increases for each of our named executive officers, the MD&C Committee considers our financial performance and the named executive officer’s leadership effectiveness in achieving the strategic and financial performance goals for the executive’s area of operational responsibility. The MD&C Committee reviews peer group data with respect to base salaries for executives in similar positions and approves merit increases and salary range adjustments that may be required to bring our named executive officer’s base salary to the median levels within our peer group. Base salary increases are a reflection of individual performance and the salary of each of our named executive officers compared to the salary of similarly situated executives in our peer group.
Each of our named executive officers received an increase in their 2010 base salary. The MD&C Committee increased base salaries to reward the achievement of 2009 individual performance goals and to reflect cost of living adjustments. Mr. Krebs received a larger 2010 base salary increase to bring his base salary more in line with the median base salary of chief financial officers within our peer group. The table below shows the base salary increases for each of our named executive officers in 2010.
For 2010, we significantly exceeded each of our performance measures. Mr. Humphrey’s success in building a strong leadership team capable of leading such significant improvements in our profitability and overall financial performance was noted by the MD&C Committee. The extraordinary contributions our executive officers made to the achievement of these results were also noted by the MD&C Committee. Based on the exceptional individual performance of each of our named executive officers during 2010, the MD&C approved increases to base salaries as shown in the following table, effective January 1, 2011, as compared to 2010.
                 
  2010  2011 
  Salary      Salary    
  Increase  Base Salary  Increase  Base Salary 
Executive Name (%)  ($)  (%)  ($) 
Peter G. Humphrey  2.00   406,132   3.50   420,347 
Karl F. Krebs  5.90   180,000   15.39   207,710 
Richard J. Harrison  2.10   200,000   11.34   222,670 
John J. Witkowski  1.70   226,644   6.59   241,580 
Martin K. Birmingham  2.30   205,641   8.16   222,424 
George D. Hagi  2.80   198,221   9.19   216,441 
Incentive Compensation Plans
Our executive incentive compensation is based on a pay-for-performance philosophy, which emphasizes performance targets that correlate with our financial performance. We believe that as an executive’s level of responsibility increases, a greater portion of their compensation should be at risk and linked to both quantitative and qualitative expectations, including key operational and strategic goals. This provides additional upside potential and downside risk for our named executive officers, recognizing that these executives have greater influence on our performance.
Our incentive plans are designed to reward and retain high performers and drive both our annual and long-term financial success. The plans encourage teamwork and create an environment where executives are rewarded if we achieve or exceed pre-determined performance criteria.
Annual Cash Incentive Plan
Our annual incentive plan is a performance-based cash plan designed to reward eligible employees, including our named executive officers, who do not participate in a direct sales incentive plan. The primary objective of the annual incentive plan is to provide a cash payment based upon attainment of specified goals and objectives that align the interests of our named executive officers with our interest in obtaining superior financial results. Based on its review of our annual cash incentive plan, McLagan proposed revisions which were based on market data from our peer group and regulatory requirements. After consideration of McLagan’s proposals, the MD&C Committee approved the following revisions to our annual cash incentive plan for 2010:
EPS was retained as a corporate measure and two additional corporate measures, non-performing assets/total assets and efficiency ratio, were added;
To promote prudent and sound behavior consistent with our long-term objectives, a long-term component was added to our annual cash incentive plan, which requires 30% of the award to be deferred for two years for selected participants;
The weighting of financial performance and individual goals for our named executive officers, other than our CEO, was revised from 100% financial performance goals to 75% financial performance and 25% individual goals; and
Inclusion of threshold goals that must be attained before any annual cash incentive plan awards can be made to our named executive officers.

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As a TARP recipient, we are subject to the executive compensation restrictions of the ARRA. The ARRA prohibits us from making our annual incentive awards to our named executive officers in the form of cash. Instead, annual incentive awards must be made in the form of ARRA-compliant restricted stock. During 2010, our annual incentive awards to our named executive officers were made in the form of ARRA-compliant restricted stock in lieu of cash.
Structure of 2010 Awards
This table outlines the basic approved framework used to determine the 2010 annual cash incentive plan awards for our named executive officers.
                     
              Performance 
  Incentive as a % of Salary  Goal Weighting 
Position Threshold  Target  Max  Financial  Individual 
President and Chief Executive Officer  25%  50%  80%  100%   
Other Named Executive Officers  20%  40%  60%  75%  25%
2010 Performance Goals & Triggers
No named executive officer will receive an annual cash incentive plan award unless we have achieved a CAMEL rating that equals or exceeds the target CAMEL rating determined by the MD&C Committee at the beginning of the year. A CAMEL rating is a composite rating assigned to a bank by the Uniform Financial Institutions Rating System. The CAMEL rating is based on performance in six areas: the adequacy of capital, the quality of assets, the capability of management, the quality and level of earnings, the adequacy of liquidity, and sensitivity to market risk. We are prohibited by applicable banking regulations from publicly disclosing our CAMEL rating. The MD&C Committee anticipates that our named executive officers will routinely meet or exceed the target CAMEL rating.
In addition, our named executive officers, whose performance is evaluated by our Chairman and Chief Executive Officer at their discretion (except for our CEO, whose performance is evaluated by the MD&C Committee), must receive a minimum performance evaluation rating of satisfactory or better to be eligible for any payout. The MD&C Committee anticipates that our named executive officers will routinely achieve a satisfactory or better performance evaluation. For 2010, we satisfied the CAMEL threshold and each of our named executives received a performance rating of satisfactory or better, therefore, all of our named executive officers were eligible to receive annual cash incentive plan awards.
Our Chief Executive Officer’s annual cash incentive plan award and 75% of our other named executive officers’ annual cash incentive plan awards were determined based on the achievement of certain Company financial performance goals. For 2010, these measures of financial performance were earnings per share, non-performing assets/total assets and our efficiency ratio. The MD&C Committee selected these measures because they most accurately reflect our financial performance and each measure can be effectively tracked and communicated to all participants. The MD&C Committee met with our Chief Executive Officer and our Chief Financial Officer to review our approved budget and financial projections for 2010. Target performance was determined to be our operating budget for 2010. Threshold performance was determined to be the minimum level of performance the MD&C Committee deemed acceptable to warrant an incentive award and was established asinformation set forth in the table below. The maximum level of performance was determined to be the absolute maximum performance for which annual incentives would be awarded and was established as set forth in the table below.
The following table summarizes the specific financial performance goals and trigger requirements of our annual cash incentive plan for 2010.
                     
  Weighting             
Financial within             
Performance Goals Category  Threshold  Target  Max  Triggers
Earnings Per Share  60% $0.99  $1.10  $1.375  Each corporate goal has a threshold
Non-Performing Assets/Total Assets  20%  0.75%  0.50%  0.45% level of performance that must be achieved 
Efficiency Ratio(1)
  20%  64.5%  63.0%  61.5% before awards are paid for such measure. 
(1)Efficiency ratio equals noninterest expense less other real estate expense and amortization of intangible assets as a percentage of net revenue, defined as the sum of tax-equivalent net interest income and non-interest income before net gains and impairment charges on investment securities, and proceeds from company-owned life insurance included in income.

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The individual performance goals and their respective weighting by category of our named executive officers’ annual cash incentive plan, other than our Chief Executive Officer, vary by individual and may include achievement of our confidential retail and commercial sales goals, financial results, risk management, and credit administration.
No individually based incentive awards are paid unless the following two conditions are first met:
1.We achieve 80% of our annual earnings per share goal; and
2.Each participant achieves 70% of their individual goals.
The MD&C Committee believes that the individual performance goals are challenging and will require the concerted efforts of each of our named executive officers to achieve.
The table below shows the 2010 financial and individual performance annual cash incentive awards, at target, of our named executive officers.
             
  Annual Cash Incentive Targets 
  Financial  Individual  Total 
Executive Name ($)  ($)  ($) 
Peter G. Humphrey  203,066   n/a   203,066 
Karl F. Krebs  54,000   18,000   72,000 
Richard J. Harrison  60,000   20,000   80,000 
John J. Witkowski  67,994   22,664   90,658 
Martin K. Birmingham  61,692   20,564   82,256 
George D. Hagi  59,466   19,822   79,288 
For 2010, we reported earnings per share of $1.61 per common share, 0.40% non-performing assets/total assets and an efficiency ratio of 60.36%. As a result, our named executive officers exceeded the maximum for each financial performance measure.
After reviewing our 2010 financial performance and the attainment of individual performance goals established for our named executive officers, other than our Chief Executive Officer whose incentive is based entirely on our financial performance, the MD&C Committee approved the annual cash incentive plan awards. As a TARP recipient, limitations have been placed on our ability to pay cash incentives to our five most highly compensated employees, which includes our named executive officers. Therefore, to remain in compliance with TARP, the MD&C Committee elected to pay the annual cash incentives to the named executive officers in the form of restricted stock. The MD&C Committee believes the use of restricted stock focuses the executives on our longer-term performance and is consistent with awards used in our long term incentive plan.
Until we have repaid our TARP obligation, grants of restricted stock to our five most-highly compensated employees, all of whom are named executive officers, may not exceed one-third of their total compensation for the current year. Therefore, the MD&C Committee approved the value of the named executive officers’ annual cash incentive awards, paid in restricted stock, in amounts that met the one-third limitation imposed by the ARRA, after considering all other restricted stock granted in 2010. The number of shares of restricted stock granted to each named executive officer was determined by dividing the value of their annual incentive award by the closing price of our common stock on February 16, 2011. Since the one-third limitation required a significant reduction in the amount of restricted stock granted to our named executive officers, the MD&C Committee concluded that no deferral of the annual incentive award was required in 2010. The restricted stock awards were granted under our 2009 Management Stock Incentive Plan. To comply with the provisions of the ARRA, we obtained clawback agreements from each of our named executive officers.
The restricted stock awards vest on February 16, 2013 subject to the named executive officers’ continued employment and subject to accelerated vesting upon the death or disability of the participant. Unvested restricted stock awards are not entitled to receive dividends. Additionally, as long as we remain a TARP recipient, the restricted stock awards may be transferred only in 25% increments at the time of our repayment of 25%, 50%, 75%, and 100%, respectively, of the financial assistance we received under TARP, or as may be required to satisfy tax obligations incurred in connection with the vesting of the restricted shares.

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The table below shows the 2010 annual cash incentive award that was earned by each of our named executive officers, based on December 31, 2010 financial and individual results, and the value of the annual cash incentives awarded in the form of restricted stock after the one-third limitation imposed by the ARRA.
                         
          Total          Equivalent 
          Annual  Reduction  Adjusted  Restricted 
          Incentive  to Annual  Annual  Stock 
          Earned (in  Incentive  Incentive  Awards 
  Financial  Individual  accordance  Award(1)  Award  Granted(2) 
Executive Name ($)  ($)  with Plan) ($)  ($)  ($)  (#) 
Peter G. Humphrey  324,096   n/a   324,096   241,517   82,579   4,283 
Karl F. Krebs  81,000   26,190   107,190   89,471   17,719   919 
Richard J. Harrison  90,000   30,000   120,000   89,851   30,149   1,563 
John J. Witkowski  101,990   29,917   131,907   95,030   36,877   1,912 
Martin K. Birmingham  92,538   27,145   119,683   87,604   32,079   1,663 
George D. Hagi  89,199   28,246   117,445   90,116   27,329   1,417 
(1)Due to one-third limitation imposed by the ARRA.
(2)The number of shares of restricted stock granted to each named executive officer was determined by dividing the value of their adjusted annual incentive award by the closing price of our common stock on the date of grant (February 16, 2011).
Restricted stock awards made to each of our named executive officers pursuant to the annual cash incentive award for 2010 are shown in the Grants of Plan-Based Awards Table.
Long-Term Equity-Based Incentive Plan
Long-term equity-based incentive awards are a key component of our executive compensation plan. We are committed to rewarding key executives if we achieve or exceed annual financial performance criteria through the use of a performance-based equity incentive plan awards. This plan is designed to retain our named executive officers, align our named executive officers’ financial interests with the interests of our shareholders, and to drive our long-term financial success. 2010 awards were paid in the form of ARRA-compliant restricted stock. No stock options were granted in 2010 as we are currently prohibitedProxy Statement under the ARRA from utilizing stock options as a componentheading “Elements of our long-term equity incentive compensation.
Based on its review of our long-term equity incentive compensation plan, McLagan suggested revisions which were based on market data within our peer group and regulatory requirements. After consideration of McLagan’s proposals, the MD&C Committee approved the following revisions to our long-term equity incentive compensation plan for 2010:
Executive Compensation” is incorporated herein by reference.

Retain the general group of eligible participants; however, tier executives based on different levels of potential awards;
Express potential award opportunity levels as ranges for each participant tier group, rather than a fixed percentage;
Replace net charge-offs with non-performing assets/total assets as a performance measure, which will align the goals in the long-term equity incentive plan with those in the annual cash incentive plan; and
Set the minimum performance requirement at 90% of the target level and allow for awards for incremental performance between 100% and 125% of the target goal.
The approved long-term equity incentive compensation plan includes our named executive officers, executive management and select senior vice presidents. The MD&C Committee approves plan participants each year, and the basic plan design must be approved by the MD&C Committee on an annual basis.

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Structure of 2010 Awards
The long-term equity incentive plan awards are based entirely on the financial performance goals utilized under our annual cash incentive plan as described above. The table below outlines the basic framework approved for the 2010 long-term equity incentive compensation plan awards for our named executive officers. The MD&C Committee uses the same process to determine threshold, target and maximum levels in the long-term incentive plan as it uses in determining the annual cash incentive plan awards previously described in the “Annual Cash Incentive Plan” section above. The threshold, target and maximum awards for our named executive officers are shown as ranges because the MD&C Committee has the discretion to adjust each of the measures based on our stock price.
Incentive as a % of Salary
PositionThresholdTargetMax
President and Chief Executive Officer10 - 25%20 - 30%25 - 38%
Other Named Executive Officers7.5 - 12.5%15 - 25%19 - 32%
Restricted stock is granted annually at the beginning of each year at the maximum performance level for each participant. After our year-end financial results are determined, the portion of the shares eligible to vest based on the achievement of our established financial performance goals are not forfeited. Once the performance conditions are satisfied, the award vests in equal installments over a two year period.
2010 Performance Goals & Triggers
Consistent with our Annual Incentive Plan, no named executive officer will receive an annual long-term equity incentive compensation plan award unless we have achieved a CAMEL rating that equals or exceeds the target CAMEL rating determined by the MD&C Committee at the beginning of the year. In addition, each named executive officer must receive a performance review rating of satisfactory or better to be eligible for any payout. For 2010, we satisfied the CAMEL rating threshold and each of our named executive officers received a performance rating of satisfactory or better. Therefore, all of our named executive officers were eligible to receive a long-term equity-based incentive award.
The following table summarizes the specific performance goals and trigger requirements of our long-term incentive plan awards for 2010 and the actual results for 2010.
                             
  Weighting                  Result as  Restricted 
  within              2010  a % of  Stock 
Performance Goals Category  Threshold  Target  Max  Results  Target  Awarded 
Earnings Per Share  60% $0.99  $1.10  $1.375  $1.61   146.4%  100%
Non-Performing Assets/Total Assets  20%  0.75%  0.50%  0.45%  0.40%  125.0%  100%
Efficiency Ratio(1)
  20%  64.5%  63.0%  61.5%  60.36%  104.4%  100%
(1)Efficiency ratio equals noninterest expense less other real estate expense and amortization of intangible assets as a percentage of net revenue, defined as the sum of tax-equivalent net interest income and non-interest income before net gains and impairment charges on investment securities, and proceeds from company-owned life insurance included in income.
Each of our 2010 financial performance targets were surpassed. As a result, stock awards were made as shown in the table below.
             
      Maximum  Actual 
  Target Award  Award  Award 
Executive Name (#)  (#)  (#) 
Peter G. Humphrey  7,729   9,661   9,661 
Karl F. Krebs  2,790   3,488   3,488 
Richard J. Harrison  3,100   3,875   3,875 
John J. Witkowski  3,514   4,392   4,392 
Martin K. Birmingham  3,188   3,985   3,985 
George D. Hagi  3,073   3,841   3,841 
Restricted stock awards made to our named executive officers in 2010 are shown in the Grants of Plan-Based Awards Table.
While we remain a TARP recipient, these restricted stock awards cannot vest until January 2013, subject to the named executive officers’ continued employment and subject to accelerated vesting upon the death or disability of the participant. Unvested restricted stock awards are not entitled to receive dividends. Additionally, as long as we are a TARP recipient, the restricted stock awards may be transferred only in 25% increments at the time of our repayment of 25%, 50%, 75%, and 100%, respectively, of the financial assistance we received under TARP, or as may be required to satisfy tax obligations incurred in connection with the vesting of the restricted shares.

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2010 One-Time Restricted Stock Awards
On February 23, 2010, the MD&C Committee approved a special, one-time restricted stock award of 2,500 shares to each of our named executive officers. The restricted stock awards were granted under our 2009 Management Stock Incentive Plan. These restricted stock awards will vest on February 23, 2014, unless the named executive officer was age 62 or older on the date of grant, in which case they will vest on February 23, 2012. The unvested restricted stock is not entitled to receive dividends. As long as we are a TARP recipient, the restricted stock awards may be transferred only in 25% increments at the time of our repayment of 25%, 50%, 75%, and 100%, respectively, of the financial assistance we received under TARP, or as may be required to satisfy tax obligations incurred in connection with the vesting of the restricted shares.
The MD&C Committee elected to make these one-time restricted stock awards in 2010 as a method to help retain our named executive officers, while aligning their interests with those of our shareholders in our long-term success.
Stock Ownership Requirements
Our stock ownership requirements align the interests of our executive officers and directors with the interests of our shareholders and further promote our commitment to sound corporate governance.
The MD&C Committee proposed revisions to our stock ownership requirements, which were approved at the meeting of our Board of Directors held on October 27, 2010. Shares that count toward satisfaction of the stock ownership requirements include: shares owned outright by such person or his or her immediate family members residing in the same household, 401(k) funds invested in shares of the Company’s stock, shares acquired upon stock option exercises, shares held in trust for the benefit of such person and shares of unvested restricted stock.
Executive officer and director stock ownership guidelines have been adopted as follows:
PositionRequired Ownership
President and CEO2x annual base salary
Executive Officers1x annual base salary
Non-employee DirectorsShares in an amount equal to $100,000
All covered executive officers and directors are required to achieve their stock ownership requirement within five years (current named executive officers have until October 31, 2015 to meet this requirement) and must retain at least 75% of shares issued through the Company’s Management and Directors’ Stock Incentive Plans until the threshold holding requirement is met. Once achieved, ownership of the required amount must be maintained for as long as the individual holds an executive officer position or serves as a director.
Clawback Provision
In January 2011, we approved a clawback provision which has been incorporated into all of our incentive compensation plan documents and award agreements. The provision states that if the MD&C Committee determines that a covered individual received a payment, bonus, override, retention award, or incentive compensation award that was based on materially inaccurate criteria used in determining or setting such compensation, then the amount that was paid as a result of such materially inaccurate criteria shall be repaid by the employee.
Due to the our participation in TARP, we are required to establish specified standards for incentive compensation to employees eligible for such incentive compensation and to make changes to our compensation arrangements. To comply with these requirements, affected employees must agree that any bonus and incentive compensation paid to them during a TARP covered period is subject to recovery or clawback by us if the payments were based on materially inaccurate financial statements or any other materially inaccurate performance metric criteria.
2010 “Say-on-Pay” Proxy Vote
At our Annual Shareholders Meeting held May 6, 2010, an overwhelming number of our shareholders approved the advisory, non-binding shareholder vote regarding the compensation of our named executive officers. The MD&C Committee believes this vote supported its decisions with respect to the design of the executive compensation plan for our named executive officers as well as the potential compensation levels provided in each compensation component. The MD&C Committee will continue to reinforce its pay for performance philosophy using various elements of executive compensation subject to the restrictions of the ARRA. Providing a competitive executive compensation plan that aligns executive and shareholder interests will remain the MD&C Committee’s primary objective. Below are the results of our advisory, non-binding shareholder vote regarding the compensation of our named executive officers.
         
For Against  Abstain 
8,878,917  629,823   116,275 

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401(k) Retirement Savings Plan
We maintain a 401(k) Retirement Savings Plan, which we refer to as the 401(k) Plan, which is available to all eligible employees. We match 100% of employee deferrals up to 3%, plus 50% of deferral amounts in excess of 3% but not more than 6%. Participants may authorize up to 25% of their account balance to be invested in our common stock under the 401(k) Plan. In addition, the 401(k) Plan provides for catch-up contributions for eligible employees. We do not match catch-up contributions. Each of our named executive officers participates in the 401(k) Plan. Our matching contributions to our named executive officers are included in other compensation in the Summary Compensation Table.
Other Benefits
Eligible employees, including our named executive officers, may participate in our health and welfare benefit programs, including medical, dental, vision coverage, disability and life insurance. Eligible employees, including our named executive officers, may participate in a Health Savings Account plan which became effective January 1, 2011.
Perquisites and other Personal Benefits
We provide our named executive officers with limited perquisites that we and the MD&C Committee believe are reasonable and consistent with our overall compensation program, and allow our named executive officers to more effectively discharge their responsibilities to us. Each of our named executive officers is provided use of a company owned vehicle. We have fifty-three retail and commercial banking offices located in a 10,000 square mile footprint throughout western and central New York. We believe the regular presence of our named executive officers in the markets we serve is best accomplished by providing them with the use of a company owned vehicle. We also reimburse our named executive officers for membership costs for various clubs and organizations. We and the MD&C Committee believe such memberships provide opportunities for business development activities and demonstrate our philosophy of community involvement in the markets in which we do business. The dollar value of the use of a company owned vehicle and membership reimbursements for each of our named executive officers are included in other compensation in the Summary Compensation Table.
Pension Plan
We maintain a Defined Benefit Pension Plan in which each of our named executive officers participates. The plan was closed to new participants as of December 31, 2006. Because Mr. Krebs had previously worked for us, his prior years’ service allowed him to participate in the plan effective with his re-hire date. For additional information refer to the Pension Benefits Table.
Tax and Accounting Implications
The financial reporting and income tax consequences of individual compensation elements are important considerations for the MD&C Committee when analyzing the overall level of executive compensation and the individual components of executive compensation. Overall, the MD&C Committee seeks to balance its objective of ensuring an effective compensation package for our named executive officers with the need to maximize the immediate deductibility of compensation, while ensuring an appropriate (and transparent) impact on reported earnings and other closely followed financial measures.
Our executive compensation program has historically been structured to allow us to comply with Section 162(m) of the Internal Revenue Code. Section 162(m) of the Code generally provides that we may not deduct compensation that is paid to certain individuals each year of more than $1,000,000 per individual. As a result of our participation in the TARP Capital Purchase Program, however, for as long as the Treasury holds our preferred stock, the Section 162(m) compensation deduction limit is reduced to $500,000 annually and the exception for qualified performance based compensation will not be available to us. Currently, the MD&C Committee does not intend to limit compensation to certain covered executives to the $500,000 deduction limit, although we will not be able to claim a deduction for such excess payments. The MD&C Committee believes that amounts paid in excess of $500,000, including amounts attributable to stock compensation, and the cost of the lost tax deduction, are justifiable in order for us to effectively motivate, retain, and remain competitive with peer financial institutions
Under Financial Accounting Standards Board Accounting Codification Standards Topic 718 we are required to recognize compensation expense on our income statement over the requisite service period or performance period based on the grant date fair value of stock options and restricted stock.

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MANAGEMENT DEVELOPMENT & COMPENSATION COMMITTEE REPORT
The MD&C Committee of the Company’s Board of Directors has reviewed and discussed the Compensation Discussion and Analysis with management and, based on such review and discussions, the MD&C Committee recommended to the Board that the Compensation Discussion and Analysis be included in the Company’s Annual Report on Form 10-K and in the Company’s Proxy Statement for its 2011 Annual Meeting.
The MD&C Committee certifies that:
1)It has reviewed with the Senior Risk Officer the Senior Executive Officers (“SEO”) compensation plans and has made all reasonable efforts to ensure that these plans do not encourage SEO’s to take unnecessary and excessive risks that threaten the value of the Company;
2)It has reviewed with the Senior Risk Officer the employee compensation plans and has made all reasonable efforts to limit any unnecessary risks these plans pose to the Company; and
3)It has reviewed the employee compensation plans to eliminate any features of these plans that would encourage the manipulation of reported earnings of the Company to enhance the compensation of any employee.
At its February 23, 2010 meeting, the Senior Risk Officer provided the MD&C Committee an evaluation of the Annual Incentive Plan and Long-Term Incentive Plan designs proposed by the compensation consulting firm, McLagan. The evaluation outlined the fundamental aspects of the proposed plans and highlighted the risk management process and risk mitigation practices that maintained the Company’s risk profile within acceptable limits to ensure that management was not incented to take excessive risk positions.
Based on the structure of the Company’s Annual Incentive Plan and the Long-Term Incentive Plan, the triggers that drive the awards, the business planning and budgeting processes, the risk management processes that ensure accurate reporting of actual results, and the risk mitigating features that ensure management operates within established risk tolerance guidelines, it was determined that neither of the plans, as proposed, lead to excessive risk taking pursuant to TARP guidelines and industry standards. Additionally, the plans, as proposed, lead to long term value creation for the Company and were in compliance with TARP requirements and regulatory guidance on incentive compensation practices.
On August 30, 2010, the Senior Risk Officer presented a review of all employee compensation plans to the MD&C Committee. The Annual Incentive Plan and Long-Term Incentive Plan, which were reviewed at the February 23, 2010 meeting, were again determined not to encourage unnecessary and excessive risk. A review of the remaining employee compensation plans revealed that the Company employs fifteen distinct incentive/commission plans that consist of incentives, recognition, referral and commission payments. A review of each of the plans included a list of eligible employees covered under each of the plans, a description of each plan, the frequency of pay under the plan, a risk assessment of each of the plans, and 2010 year to date payouts.
Based on the structure of the Company’s employee compensation plans, it was determined that the Senior Executive Officer and employee compensation plans do not lead to excessive risk taking pursuant to TARP guidelines and industry standards and do promote long term value creation for the Company.
THE MANAGEMENT DEVELOPMENT & COMPENSATION COMMITTEE

Susan R. Holliday, Chair
Samuel M. Gullo
Erland E. Kailbourne
Robert N. Latella

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SUMMARY COMPENSATION TABLE
The following table contains information concerning the compensation earned by our named executive officers in the fiscal years ended December 31, 2010, 2009, and 2008.
                             
                  Change in       
              Stock  Pension  All Other    
      Salary  Bonus  Awards  Value  Compensation  Total 
Name & Principal Position Year  ($)(2)  ($)  ($)(3)  ($)(4)  ($)(5)  ($) 
Peter G. Humphrey
  2010   406,132      355,959   179,930   73,037   1,015,058 
President & Chief Executive Officer  2009   413,483      79,260   138,264   72,912   703,919 
of the Company and the Bank  2008   398,169      115,320   159,816   74,183   747,488 
                             
Karl F. Krebs(1)
  2010   180,000      77,245   28,212   26,671   312,128 
EVP & Chief Financial Officer  2009   40,539      19,996   9,316   13,084   82,935 
of the Company and the Bank                            
                             
Richard J. Harrison
  2010   200,000      138,384   60,414   28,045   426,843 
EVP & Senior Retail Lending Administrator of the Bank                            
                             
John J. Witkowski
  2010   226,644      152,421   24,100   23,592   426,757 
EVP & Retail Banking Executive/  2009   231,089      66,050   15,734   25,176   338,049 
Regional President of the Bank  2008   218,484   27,857   96,100   16,899   24,010   383,350 
                             
George D. Hagi
  2010   198,221      155,073   35,247   20,169   408,710 
EVP & Chief Risk Officer  2009   200,237      72,655   24,052   20,258   317,202 
of the Company and the Bank  2008   192,821      105,710   27,198   21,988   347,717 
                             
Martin K. Birmingham
  2010   205,641      140,943   20,654   27,169   394,407 
EVP & Commercial Banking Executive/  2009   208,484      66,050   12,387   26,053   312,974 
Regional President of the Bank  2008   195,732   24,369   96,100   14,085   26,365   356,651 
(1)Mr. Krebs was appointed to his position effective October 1, 2009. Mr. Krebs’ 2009 annualized base salary was $170,000.
(2)Salaries reflect twenty-seven pay periods in 2009 versus the normal twenty-six pay periods in a calendar year.
(3)The value of restricted stock awards is based on the market price of Financial Institutions, Inc. stock on the date of grant. The 2010 amount includes awards of restricted stock earned under the annual cash incentive plan for 2009 services, awards under the long-term equity incentive plan for 2009 service and a one-time restricted stock award granted during 2010 as shown in the Grants of Plan-Based Awards Table.
(4)The value represents the aggregate change in actuarial present value of each named executive officer’s accumulated defined benefit pension.
(5)Please see the table below for more information on the other compensation paid to our named executive officers in the year ended December 31, 2010.
All Other Compensation.The following table sets forth details of “All Other Compensation”, as presented above in the Summary Compensation Table.
                         
  Use of      401(k)  Split Dollar       
  Company  Club  Matching  Insurance       
  Vehicle  Memberships  Contribution  Premium  Other  Total 
Executive Name ($)  ($)  ($)  ($)  ($)(1)  ($) 
Peter G. Humphrey  1,900   3,150   11,025   50,830   6,132   73,037 
Karl F. Krebs  7,701   9,434   8,110      1,426   26,671 
Richard J. Harrison  4,354   8,177   9,010      6,504   28,045 
John J. Witkowski  4,077   6,168   10,203      3,144   23,592 
George D. Hagi  7,059      8,901      4,209   20,169 
Martin K. Birmingham  1,877   13,039   9,259      2,994   27,169 
(1)For Mr. Humphrey, represents the taxable portion of his split dollar policy of $2,149; dividends paid on restricted stock of $2,693; and the taxable portion of group term life insurance (“GTL”) of $1,290. For all others, represents dividends paid on restricted stock of $789 for Mr. Krebs; of $2,694 for Messrs. Harrison, Witkowski and Birmingham and of $2,918 for Mr. Hagi; and the taxable portion of GTL for Messrs. Krebs, Harrison, Witkowski, Hagi and Birmingham, in the amounts of $637, $3,810, $450, $1,290 and $300, respectively.

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2010 GRANTS OF PLAN-BASED AWARDS
The following table sets forth certain information with respect to options and restricted stock granted during the fiscal year ended December 31, 2010 to each of the named executive officers.
                         
                  All other    
                  stock awards:  Grant date 
      Estimated future payouts under equity incentive  Number of  fair value of 
      plan awards(1)(2)  shares of  stock and 
  Grant  Threshold          stock or units  option awards 
Executive Name Date  (#)  Target (#)  Maximum (#)  (#)  ($)(3) 
Peter G. Humphrey  01/13/10      17,807         199,082 
   02/23/10            2,500   32,250 
   02/23/10   3,864   7,729   9,661      124,627 
                         
Karl F. Krebs  02/23/10            2,500   32,250 
   02/23/10   1,395   2,790   3,488      44,995 
                         
Richard J. Harrison  01/13/10      5,022         56,146 
   02/23/10            2,500   32,250 
   02/23/10   1,550   3,100   3,875      49,988 
                         
John J. Witkowski  01/13/10      5,681         63,514 
   02/23/10            2,500   32,250 
   02/23/10   1,757   3,514   4,392      56,657 
                         
George D. Hagi  01/13/10      6,554         73,274 
   02/23/10            2,500   32,250 
   02/23/10   1,536   3,073   3,841      49,549 
                         
Martin K. Birmingham  01/13/10      5,124         57,286 
   02/23/10            2,500   32,250 
   02/23/10   1,594   3,188   3,985      51,407 
(1)These columns show the potential number of shares to be paid out for our named executive officers under our annual cash incentive plan and long-term equity incentive plan at threshold, target or maximum performance. The measures and potential payouts are described in more detail in the CD&A under the caption “Annual Cash Incentive Plan” and “Long-Term Equity-Based Incentive Plan”.
(2)Due to the restriction of TARP, our annual cash incentive plan granted on 1/13/10 was paid in the form of ARRA-compliant restricted stock.
(3)This column includes the full grant date fair value of stock awards for each of the years reported. The amounts reported in this column have been calculated in accordance with FASB ASC 718. For equity awards that are subject to performance conditions, the value reported is based upon the probable outcome of such conditions, excluding the effect of estimated forfeitures.

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OUTSTANDING EQUITY AWARDS AT DECEMBER 31, 2010
The following table includes certain information with respect to the value of all unexercised options and non-vested restricted stock awards granted under the 1999 and 2009 Management Stock Incentive Plans.
                                 
  Option awards  Stock awards 
                              Equity 
                              incentive 
                          Equity  plan 
                          incentive  awards: 
                          plan  market or 
                          awards:  payout 
         Market  number of  value of 
  Number of  Number of          Number of  value of  unearned  unearned 
  securities  securities          shares or  shares or  shares, units  shares, units 
  underlying  underlying          units of  units of  or other  or other 
  unexercised  unexercised  Option      stock that  stock that  rights that  rights that 
  options  options  exercise  Option  have not  have not  have not  have not 
  Exercisable  Unexercisable  price  expiration  vested  vested  vested  vested 
Executive Name (#)  (#)  ($)  date  (#)  ($)  (#)  ($) 
Peter G. Humphrey  14,083      23.80   02/04/14   2,500(2)  47,425   34,044(3)  645,815 
   16,659      21.05   02/23/15                 
   8,500      19.75   07/26/16                 
   6,375   2,125(1)  19.41   07/25/17                 
                                 
Karl F. Krebs              2,500(2)  47,425   5,460(4)  103,576 
                                 
Richard J. Harrison  1,345      23.80   02/04/14   2,500(2)  47,425   14,377(5)  272,732 
   1,773      21.05   02/23/15                 
   1,650      19.75   07/26/16                 
                                 
John J. Witkowski  7,450      17.80   09/07/15   2,500(2)  47,425   15,553(6)  295,040 
   1,650      19.75   07/26/16                 
   1,125   375(1)  19.41   07/25/17                 
                                 
George D. Hagi  6,047      19.59   01/18/16   2,500(2)  47,425   16,423(7)  311,544 
   1,650      19.75   07/26/16                 
   1,125   375(1)  19.41   07/25/17                 
                                 
Martin K. Birmingham  4,596      20.39   03/16/15   2,500(2)  47,425   14,589(8)  276,753 
   1,650      19.75   07/26/16                 
   1,125   375(1)  19.41   07/25/17               �� 
(1)Options vest on July 25, 2011.
(2)Restricted stock awards vest on February 23, 2014.
(3)600 awards vest on January 16, 2011; 5,976 awards vest in approximately equal parts on January 14, 2011 and January 14, 2012; 17,807 awards vest on January 13, 2012; and, subject to achievement of performance criteria 9,661 awards vest in equal parts on February 23, 2012 and February 23, 2013.
(4)1,972 awards vest on October 1, 2011 and, subject to achievement of performance criteria 3,488 awards vest in equal parts on February 23, 2012 and February 23, 2013.
(5)500 awards vest on January 16, 2011; 4,980 awards vest in approximately equal parts on January 14, 2011 and January 14, 2012; 5,022 awards vest on January 13, 2012; and, subject to achievement of performance criteria 3,875 awards vest in equal parts on February 23, 2012 and February 23, 2013.
(6)500 awards vest on January 16, 2011; 4,980 awards vest in approximately equal parts on January 14, 2011 and January 14, 2012; 5,681 awards vest on January 13, 2012; and, subject to achievement of performance criteria 4,392 awards vest in equal parts on February 23, 2012 and February 23, 2013.
(7)550 awards vest on January 16, 2011; 5,478 awards vest in approximately equal parts on January 14, 2011 and January 14, 2012; 6,554 awards vest on January 13, 2012; and, subject to achievement of performance criteria 3,841 awards vest in equal parts on February 23, 2012 and February 23, 2013.
(8)500 awards vest on January 16, 2011; 4,980 awards vest in approximately equal parts on January 14, 2011 and January 14, 2012; 5,124 awards vest on January 13, 2012; and, subject to achievement of performance criteria 3,985 awards vest in equal parts on February 23, 2012 and February 23, 2013.

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STOCK VESTED FOR 2010
Shares of restricted stock held by our named executive officers that vested in 2010 are shown in the table below. No stock options were exercised by our named executive officers in 2010.
         
  Number of    
  Shares  Value 
  Acquired on  Realized on 
  Vesting  Vesting(1) 
Executive Name (#)  ($) 
Peter G. Humphrey  4,800   85,938 
Karl F. Krebs      
Richard J. Harrison  2,000   33,975 
John J. Witkowski  2,000   33,975 
George D. Hagi  2,050   34,550 
Martin K. Birmingham  2,000   33,975 
(1)The amounts shown are calculated based on the closing market price of our common stock on the date of vesting, multiplied by the number of vested shares.
PENSION BENEFITS
The following Pension Benefits table provides information regarding the present value of the accumulated benefit and years of credited service for our named executive officers under the New York Bankers Retirement System Volume Submitter Plan as adopted by Financial Institutions, Inc. (the “New York Bankers Retirement Plan”). The present value of accumulated benefits was determined using the same assumptions used for financial reporting purposes under generally accepted accounting principles for 2010.
               
    Number of  Present    
    Years  Value of  Payments 
    Credited  Accumulated  During 
    Service  Benefit(1)  2010 
Executive Name Plan Name (#)  ($)  ($) 
Peter G. Humphrey New York Bankers Retirement Plan  31.417   1,044,980    
Karl F. Krebs New York Bankers Retirement Plan  2.250   37,528    
Richard J. Harrison New York Bankers Retirement Plan  6.417   202,600    
John J. Witkowski New York Bankers Retirement Plan  4.333   66,121    
George D. Hagi New York Bankers Retirement Plan  3.917   97,230    
Martin K. Birmingham New York Bankers Retirement Plan  4.750   56,923    
(1)The Present Value of Accumulated Benefits was determined using the same assumptions used for financial reporting purposes under GAAP. For a discussion of the valuation method and all material assumptions applied in quantifying the present value of the accumulated benefits, refer to Note 16 to our consolidated financial statements included in the Annual Report on Form 10-K for the year ended December 31, 2010.

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We maintain a defined benefit pension plan in which each of our named executive officers participates. The plan was closed to new participants as of December 31, 2006. Because Mr. Krebs had previously worked for us, his prior years’ service allowed him to participate in the plan effective with his re-hire date.
Material Terms and Conditions:
Benefits under the defined benefit pension plan are based on years of service and the named executive officer’s highest average compensation during five consecutive years of employment. Compensation used to determine benefits is all wages, tips, and other compensation as reported on the named executive officer’s form W-2. Normal retirement age for named executive officers who first participated in our plan prior to January 1, 2004 is age 62 with ten years of vesting service, as defined in the plan. Normal retirement age is age 65 for any named executive officer who first participated in the plan on or after January 1, 2004. The normal retirement benefit is an annual pension benefit commencing on the named executive officer’s normal retirement date payable in the normal benefit form in an amount equal to:
Basic Benefit
For Benefit Service accrued prior to January 1, 2004:
1.75 % of average annual compensation multiplied by creditable service accrued prior to January 1, 2004 up to 35 years; plus
For Benefit Service accrued on or after January 1, 2004:
1.50% of average annual compensation, multiplied by creditable service accrued on or after January 1, 2004 provided that such service shall not exceed the difference between (i) 35 and (ii) the participant’s years of benefit earned prior to January 1, 2004; plus
1.25% of average annual compensation multiplied by creditable service in excess of 35 years up to 5 years; minus
Offset Benefit
0.49% of final average compensation, up to covered compensation, multiplied by creditable service up to 35 years.
The normal benefit form is payable as a single life pension with sixty payments guaranteed. There are a number of optional forms of benefit available to participants, all of which are adjusted actuarially.
Named executive officers participating in the plan are eligible for early retirement upon attaining age 55. Early retirement benefits are determined as described below.
Benefits for named executive officers who first participated in the plan prior to January 1, 2004 and who are 100% vested as of December 31, 2003, and who remain in our employment until they reach the age of 55 are reduced 3% for the basic benefit and 6% for the offset benefit. Benefits for named executive officers who first participated in the plan prior to January 1, 2004 and who were not 100% vested as of December 31, 2003, and who do not remain in our employment until they reach the age of 55, are reduced 3% for the basic benefit and 6% for the offset benefit for the accrued benefit attributable to service earned as of December 31, 2003, and for service earned on or after January 1, 2004 the accrued benefit is determined as of the early retirement date, reduced by 1/180 for each of the first sixty months and by 1/360 for each of the next sixty months that the early retirement date precedes the normal retirement date.
Named executive officers who first participate in the plan on or after January 1, 2004 shall have their accrued benefit determined as of the early retirement date, reduced by 1/180 for each of the first sixty months and by 1/360 for each of the next sixty months that the early retirement date precedes the normal retirement date.
Mr. Hagi and Mr. Humphrey are eligible for early retirement.

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CHANGE IN CONTROL AGREEMENTS
We have entered into change of control agreements with Messrs. Humphrey, Witkowski, Hagi, and Birmingham. The change of control agreements are designed to promote stability and continuity of our senior management. Under the agreements, a change of control is defined as occurring when (1) any person (as such term is used in Sections 13(d) and 14(d) of the Securities Exchange Act of 1934 (“Act”) (other than us or a subsidiary of ours) becomes the beneficial owner (within the meaning of Rule 13d-3 under the Act) of our securities possessing twenty percent (20%) or more of the voting power for the election of our directors; (2) there is consummated (i) any consolidation, share exchange or merger of us in which we are not the continuing or surviving corporation or pursuant to which any shares or our common stock are to be converted into cash, securities or other property, provided that the transaction is not with a corporation which was a subsidiary of ours immediately before the transaction; or (ii) any sale, lease, exchange or other transfer (in one transaction or a series of related transactions) of all, or substantially all, of our assets; or (3) “approved directors” constitute less than a majority of the entire Board of Directors, with “approved directors” defined to mean the members of our Board of Directors as of the date of the agreement and any subsequently elected members who are nominated or approved by at least three quarters of the approved directors on the Board prior to such election. If a change of control, as defined in the agreement occurs during the executive officer’s employment, and if within the twelve-month period following such change of control, either we terminate the executive officer, other than for cause, or the executive officer terminates his employment for good reason, meaning (1) there has been a material diminution, compared to those existing as of the date the change of control occurs, in the executive officer’s responsibilities, duties, title, reporting responsibilities within the business organization, status, role, authority or aggregate compensation which is not restored within 15 days after written notice is provided to us by the executive officer; or (2) removal of the executive officer from his current position, other than (i) elevation to a higher ranking executive officer position with us or (ii) with the written consent of the executive officer; or (3) relocation of the executive officer’s principal place of employment by more than 75 miles from its location immediately prior to the change of control other than with the written consent of the executive officer, the executive officer will be entitled to benefits as provided in the agreement. Each change of control agreement includes covenants by the executive not to solicit employees of ours and not to compete during the term of the agreement and during any period for which the executive is entitled to receive compensation and six months thereafter, and not to disclose or use confidential information of the company.
The following summary sets forth potential cash payments and benefits in the event that a named executive officer’s employment terminates as a result of an involuntary termination or the executive terminates his employment because of good reason at any time within twelve months after a change of control:
1.All stock options and restricted stock held by the named executive officer will become fully vested and exercisable;
2.Medical and dental benefits will continue for a period not to exceed 18 months;
3.
Monthly cash payments equal to 1/12th the sum of the base salary amount for the most recent calendar year ending before the date on which the change of control occurred plus the average of the annual incentive compensation earned by the Executive for the two most recent calendar years ending before the date on which the change of control occurred will be made;
4.Mr. Humphrey is entitled to receive these cash payments over a thirty-six month period; Mr. Hagi is entitled to receive cash payments for twenty-four months; and Messrs. Witkowski and Birmingham are entitled to receive cash payments for twelve months.
We participated in the U.S. Treasury’s CPP. As a result, we are prohibited from making any “golden parachute” payments to our named executive officers and certain other employees during the period the Treasury holds any of our securities issued under the CPP. Our named executive officers have agreed to executive compensation waivers and agreements which specify the limitations on their compensation arrangements required by the CPP.
Potential Payments Following a Change in Control
Based on the terms of the Change in Control agreement, a share price of $18.97 as of December 31, 2010, and the number of options and restricted stock held by each of the named executive officers that were unearned and unvested as of December 31, 2010, the estimated values of cash payments and acceleration of stock options and restricted stock grants held by each named executive officer in the event of a change in control (assuming we were not subject to the CPP “golden parachute” restrictions described above) are as follows:
                         
      Salary plus  Stock  Restricted  Medical &  Gross 
  Continuation  Incentives  Options  Stock  Dental  Value 
Executive Name Period  ($)  ($)  ($)  ($)  ($) 
Peter G. Humphrey 36 months  1,539,075      693,240   14,961   2,247,276 
John J. Witkowski 12 months  262,846      342,465   9,974   615,285 
George D. Hagi 24 months  473,746      358,969   14,961   847,676 
Martin K. Birmingham 12 months  237,129      324,178   9,974   571,281 

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DIRECTOR COMPENSATION
We use a combination of cash and stock-based compensation to attract and retain qualified candidates to serve on our Board of Directors. In setting director compensation, we consider the significant amount of time that Directors expend in fulfilling their duties to us, as well as the skill levels required of members of the Board. Directors are subject to a minimum stock ownership requirement. Under the new stock ownership requirements, approved by the Board of Directors on October 27, 2010, each director is required to own shares of our common stock with a value of $100,000, based on the trailing 365-day average closing common stock price, within five years after joining the Board. The following table sets forth certain information regarding 2010 total director compensation.
                 
  Fees Earned or  Stock  All Other    
  Paid in Cash  Awards(2)(3)(4)  Compensation(5)  Total 
Director Name ($)  ($)  ($)  ($) 
Karl V. Anderson, Jr.  32,166   20,444   160   52,770 
John E. Benjamin  73,724   47,936   160   121,820 
Thomas P. Connolly(1)
  8,300      80   8,380 
Barton P. Dambra  30,966   20,444   160   51,570 
Samuel M. Gullo  32,916   13,964   80   46,960 
Susan R. Holliday  38,416   20,444   160   59,020 
Erland E. Kailbourne  37,666   20,444   160   58,270 
Robert N. Latella  37,616   13,964   80   51,660 
James L. Robinson  40,921   22,939   160   64,020 
James H. Wyckoff  26,916   20,444   160   47,520 
(1)Mr. Connolly did not stand for re-election due to his retirement from the Board effective with the Annual Shareholders meeting on May 6, 2010. Consequently, Mr. Connolly did not receive an annual retainer or restricted stock awards for 2010.
(2)The amount shown for each Director includes $12,960, representing the aggregate grant date fair value, calculated in accordance with FASB ASC 718, of the 800 shares of restricted stock granted under the 2009 Directors Stock Incentive Plan.
(3)The amount shown for each Director includes the portion of their annual retainer paid in common stock. For 2010, the number of shares was determined by dividing the applicable portion of their annual retainer by the closing price of the Company’s common stock on the date of grant, which was $16.20. For 2010 these amounts were $34,976 and $9,979 for Messrs. Benjamin and Robinson, respectively, and $7,484 for each of the other Directors.
(4)
With the exception of Mr. Connolly,who had no unvested restricted stock awards as of December 31, 2010, each of the Directors had 400 shares of unvested restricted stock awards as of December 31, 2010.
(5)Includes dividends on unvested restricted stock treated as compensation for directors who did not elect the IRS 83-b treatment of their restricted stock grants.

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Compensation Paid to Board Members
For the fiscal year ended December 31, 2010, members of the Board who were not employees of ours received annual cash retainers for serving on our Board of Directors and for serving on the Board of our wholly-owned subsidiary, Five Star Bank, as shown in the tables which follow. Half of the retainer is paid in shares of our common stock on the date of our annual organizational meeting and half is paid in cash six months thereafter. Directors may elect to receive cash instead of stock. Board service fees are specified in the table which follows. The meetings of our Board and the Board of Five Star Bank are normally scheduled on the same day therefore only one meeting fee is paid. In the event that such meetings are held on different days, fees are paid in accordance with the schedule for our Board meetings. Directors are paid two-thirds of the normal Board or Committee fee when the applicable meetings are scheduled as teleconference meetings. Board members are reimbursed for reasonable travel expenses to attend meetings.
Set forth below is the fee schedule for non-executive director.
         
      Five Star 
  Company  Bank 
Annual Retainer Fees        
Chair $40,000  $30,000 
Vice Chair(1)
  30,000   15,000 
Director  10,000   5,000 
         
Committee Chair:        
Audit  15,000     
Management Development and Compensation  10,000     
Executive, Nominating and Governance  10,000     
Risk Oversight Committee  10,000     
         
Board Meeting Fees        
Chair  3,000     
Vice Chair  1,500     
Director  1,200     
         
Committee Fees        
Chair  1,550     
Member  750     
(1)Effective May 6, 2010, Vice Chairman John E. Benjamin was named Chairman of the Board. The Board Vice Chairman position is currently not filled.
Non-Qualified Stock Options and Restricted Stock
Under the terms of the 2009 Director Stock Incentive Plan, which we refer to as the Plan, for 2010 each of our Directors was granted 400 shares of restricted stock and each Director serving as a Director of Five Star Bank was granted 400 additional shares of restricted stock at a price of $16.20 on the date of grant. These grants were made at the Board’s 2010 annual organizational meeting. The restricted stock agreement entered into with each of the Directors provides that fifty percent (50%) of the shares shall vest immediately upon the date of the grant, and if the Director remains in continuous service as our director until the first anniversary of the date of grant, the remaining fifty percent (50%) of the shares will vest. If the Director ceases to serve as our director the shares vest, the shares will be immediately forfeited, subject to the terms of the Plan. Directors will be entitled to receive any dividends paid with respect to the unvested shares of restricted stock. No non-qualified stock options were granted to Directors in 2010.

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ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

In response to this Item, the information set forth in the 2013 Proxy Statement under the heading “Beneficial Ownership of Common Stock” is incorporated herein by reference. The information under the heading “Equity Compensation Plan Information” in Part II, Item 5 of this Form 10-K is also incorporated herein by reference.

BENEFICIAL OWNERSHIP OF COMMON STOCK
The following table shows, as of March 7, 2011, the beneficial ownership of shares of Financial Institutions, Inc. common stock by (a) each stockholder known to the Company to beneficially own more than 5% of Financial Institutions, Inc. common stock, (b) all present directors, continuing and nominees, (c) the six named executive officers, and (d) all present directors and executive officers of the Company as a group. Beneficial ownership means that the individual has or shares voting power or investment power with respect to the shares of common stock or the individual has the right to acquire the shares of common stock within 60 days of March 7, 2011.
             
      Number of shares    
      included in previous    
      column which the    
      individual or group    
      has/have the right to  Percent of 
  Number of shares  acquire within 60 days  outstanding 
Name beneficially owned  of March 7, 2011  common stock(1) 
Canandaigua National Bank & Trust Co. (held in various trust / fiduciary capacities)  993,643(2)     9.05%
BlackRock, Inc.  818,473(3)     7.46%
Dimensional Fund Advisors LP  555,951(4)     5.06%
JPMorgan Chase and Co., Gail C. Humphrey and David G. Humphrey, as co-trustees  549,360(5)     5.00%
Directors(6):
            
Karl V. Anderson, Jr.  11,063   6,133   * 
John E. Benjamin  18,263   10,133   * 
Barton P. Dambra  23,920(7)  11,133   * 
Samuel M. Gullo  19,136   11,133   * 
Susan R. Holliday  19,887   9,333   * 
Peter G. Humphrey  405,152(8)  45,617   3.69%
Erland E. Kailbourne  32,457   5,700   * 
Robert N. Latella  12,473   6,481   * 
James L. Robinson  12,035   3,933   * 
James H. Wyckoff  424,340(9)  10,533   3.86%
Named Executive Officers(10):
            
Richard J. Harrison  35,993 �� 5,893   * 
Karl F. Krebs  11,579      * 
John J. Witkowski  36,266   10,225   * 
George D. Hagi  34,604   8,822   * 
Martin K. Birmingham  31,703   7,371   * 
Directors and executive officers as a group (19 persons)  1,172,762   169,523   10.68%

*Denotes less than 1%
(1)Calculated based on Rule 13d-3(d)(i) using the number of outstanding shares of common stock as of March 7, 2011.
(2)Share and percentage information obtained from NASDAQ Global Market Ownership holder position reported as of December 31, 2010 in Form 13F filings. The address of Canandaigua National Bank & Trust Co. is 1150 Pittsford-Victor Road, Pittsford, New York 14534.
(3)Based on information set forth in Amendment number 1 to Schedule 13G filed with the SEC on February 4, 2011 by BlackRock, Inc. reporting sole power to vote or direct the vote and to dispose or direct the disposition of 818,473 shares of Financial Institutions, Inc. common stock. The address of BlackRock, Inc. is 40 East 52nd Street, New York, New York 10022.

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(4)Based on information set forth in a Schedule 13G filed with the SEC on February 11, 2011 by Dimensional Fund Advisors LP reporting sole power to vote or direct the vote of 549,673 shares of Financial Institutions, Inc. common stock and sole power to dispose or direct the disposition of 555,951 shares of Financial Institutions, Inc. common stock. Dimensional Fund Advisors LP, an investment adviser registered under Section 203 of the Investment Advisors Act of 1940, furnishes investment advice to four investment companies registered under the Investment Company Act of 1940, and serves as investment manager to certain other commingled group trusts and separate accounts (such investment companies, trusts and accounts, collectively referred to as the “Funds”). In certain cases, subsidiaries of Dimensional Fund Advisors LP may act as an adviser or sub-adviser to certain Funds. In its role as investment advisor, sub-adviser and/or manager, neither Dimensional Fund Advisors LP or its subsidiaries (collectively, “Dimensional”) possess voting and/or investment power over the securities of the Issuer that are owned by the Funds, and may be deemed to be the beneficial owner of our shares held by the Funds. However, all shares beneficially owned are owned by the Funds. The address of Dimensional Fund Advisors LP is Palisades West, Building One, 6300 Bee Cave Road, Austin, Texas 78746.
(5)Share and percentage information obtained from NASDAQ Global Market Ownership holder position reported as of December 31, 2010 in Form 13F filings. The address of JPMorgan Chase and Co. is 1 Chase Square, Rochester, New York 14643.
(6)Except as set forth in the footnotes below, each person has sole investment and voting power with respect to the common stock beneficially owned by such person. Includes only those stock options that are exercisable or become exercisable within 60 days of March 1, 2011.
(7)Includes 1,000 shares held by Mr. Dambra’s spouse.
(8)Includes 10,000 shares held by trusts over which, Mr. Humphrey, as trustee, exercises voting and dispositive powers, 20,400 shares owned by Mr. Humphrey’s spouse, and 54,600 shares held in trust for Mr. Humphrey’s son.
(9)Includes 66,995 shares held by Mr. Wyckoff’s spouse.
(10)In addition to Mr. Humphrey, who also serves as a director.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS
Peter G. Humphrey, our President and Chief Executive Officer, and a member of our Board of Directors, James H. Wyckoff, are first cousins.
We last approved a Related Party Transaction Policy in 2010 that provides for

In response to this Item, the oversight of related party transactions by our Chief Risk Officer. Pursuant to such policy, our Chief Risk Officer is notified whenever a potential related party transaction is being contemplated. Our Chief Risk Officer refers any potential transactions, with appropriate supporting detail, to the Audit Committee of our Board of Directors. The Audit Committee determines whether the transaction is a related party transaction as such term is defined under Item 404(a) of Regulation S-K. If the Audit Committee determines that the potential transaction would be a related party transaction, then the Audit Committee determines whether to approve or decline the proposed transaction. The Audit Committee has not established a written policy regarding the factors it considers in deciding whether to approve a potential related party transaction. Instead, the Audit Committee considers all factors that it considers appropriate and then decides whether to approve the transaction using its business judgment.

During 2010, neither the Company nor any of our subsidiaries was a party to any transaction or series of transactions in which the amount involved exceeded $120,000 and which any director, executive officer, or related interests had or will have a direct or indirect material interest other than:
Compensation arrangements described within this document; and
The transactions described below.
Our directors, executive officers and many of our substantial shareholders and their affiliates are also our customers. On December 31, 2010, the aggregate principal amount of loans to our directors, executive officers, 5% or greater shareholders and their affiliates was $609,215 certain of which were in excess of $120,000. Loans made by Five Star Bank to officers, directors, 5% or greater shareholders or their affiliates were madeinformation set forth in the ordinary course of business on substantially2013 Proxy Statement under the same terms, including interest rate and collateral, as comparable transactions with other customers and did not involve more than the normal risk of collectability or present other unfavorable features.
Loans to directors, executive officers and substantial shareholders are subject to limitations contained in the Federal Reserve Act, which requires that such loans satisfy certain criteria. We expect to have such transactions or transactions on a similar basis with our directors, executive officers, substantial shareholders and their affiliates in the future.

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Board Independence
Based on recommendations made by the Executive, Nominating and Governance Committee, the Board of Directors has determined that all current directors are “independent” under NASDAQ rules, except Peter G. Humphrey, the President and Chief Executive Officer. Relationships described in the section titledheadings “Certain Relationships and Related Party Transactions” were taken into consideration when determiningand “Corporate Governance Information” is incorporated herein by reference.

ITEM 14.PRINCIPAL ACCOUNTANT FEES AND SERVICES

In response to this status.

Item, the information set forth in the 2013 Proxy Statement under the headings “Audit Committee Report” and “Independent Registered Public Accounting Firm” is incorporated herein by reference.

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PART IV

ITEM 15.EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(a)FINANCIAL STATEMENTS

Reference is made to the Index to Consolidated Financial Statements of Financial Institutions, Inc. and subsidiaries under Item 8 “Financial Statements and Supplementary Data” in Part II of this Annual Report on Form 10-K.

(b)EXHIBITS

The following is a list of all exhibits filed or incorporated by reference as part of this Report.

Exhibit
Number

Description

Location

ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
KPMG LLP has served as our independent registered public accounting firm since 1995. Representatives of KPMG LLP are expected to be present at the Company’s 2011 Annual Meeting. They will be given an opportunity to make a statement if they desire to do so and will be available to respond to appropriate questions.
Audit Fees
Fees paid or payable to KPMG for professional services rendered in connection with (i) the audit of our consolidated financial statements included in Form 10-K, (ii) the audit of the effectiveness of our internal controls over financial reporting, and (iii) the limited reviews of the interim consolidated financial statements included in Forms 10-Qs were $331,000 for each of the fiscal years ended December 31, 2010 and December 31, 2009.
Audit Related Fees
Audit related fees consist of services rendered in connection with the audits of our broker-dealer subsidiary’s financial statements and regulatory compliance procedures. These fees were $18,000 for the fiscal year ended December 31, 2010 and $45,400 for the fiscal year ended December 31, 2009.
Tax Fees
Aggregate fees for tax compliance and advisory services for the fiscal year ended December 31, 2010 were $53,440 and $44,800 for the fiscal year ended December 31, 2009.
All Other Fees
No additional fees other than those reported as audit fees, audit related fees and tax fees were paid or payable to KPMG for the fiscal years ended December 31, 2010 and December 31, 2009.
Pre-Approval Policy
Procedures have been adopted that require Audit Committee pre-approval of all permissible services to be performed by the independent accountant, including the fees and other compensation to be paid to the independent accountant, with the exception of certain routine additional professional services that may be performed at the request of management without pre-approval. The additional professional services include tax assistance, research and compliance, assistance researching accounting literature, and assistance in due diligence activities. The engagement letter entered into with the independent accountants for tax compliance services and tax consulting services stated such services would not exceed $10,000 per quarter and that a listing of the additional services would be provided to the Audit Committee at their next meeting.

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PART IV
ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a)
FINANCIAL STATEMENTS
Reference is made to the Index to Consolidated Financial Statements of Financial Institutions, Inc. and Subsidiaries under Item 8 “Financial Statements and Supplementary Data” in Part II of this Form 10-K.
(b)
EXHIBITS
The following is a list of all exhibits filed or incorporated by reference as part of this Report.
Exhibit
NumberDescriptionLocation
3.1  Amended and Restated Certificate of Incorporation of the Company  Incorporated by reference to Exhibits 3.1, 3.2 and 3.3 of the Form 10-K for the year ended December 31, 2008, dated March 12, 2009
3.2  Amended and Restated Bylaws of the Company  Incorporated by reference to Exhibit 3.4 of the Form 10-K for the year ended December 31, 2008, dated March 12, 2009
4.1Warrant to Purchase Common Stock, dated December 23, 2008 issued by the Registrant to the United States Department of the TreasuryIncorporated by reference to Exhibit 4.2 of the Form 8-K, dated December 24, 2008
10.1  1999 Management Stock Incentive Plan  Incorporated by reference to Exhibit 10.1 of the S-1 Registration Statement
10.2  Amendment Number One to the FII 1999 Management Stock Incentive Plan  Incorporated by reference to Exhibit 10.1of10.1 of the Form 8-K, dated July 28, 2006
10.3  Form of Non-Qualified Stock Option Agreement Pursuant to the FII 1999 Management Stock Incentive Plan  Incorporated by reference to Exhibit 10.2 of the Form 8-K, dated July 28, 2006
10.4  Form of Restricted Stock Award Agreement Pursuant to the FII 1999 Management Stock Incentive Plan  Incorporated by reference to Exhibit 10.3 of the Form 8-K, dated July 28, 2006
10.5  Form of Restricted Stock Award Agreement Pursuant to the FII 1999 Management Stock Incentive Plan  Incorporated by reference to Exhibit 10.1 of the Form 8-K, dated January 23, 2008
10.6  1999 Directors Stock Incentive Plan  Incorporated by reference to Exhibit 10.2 of the S-1 Registration Statement
10.7  Amendment to the 1999 Director Stock Incentive Plan  Incorporated by reference to Exhibit 10.7 of the Form 10-K for the year ended December 31, 2008, dated March 12, 2009
10.8  2009 Management Stock Incentive Plan  Incorporated by reference to Exhibit 10.8 of the Form 10-Q for the quarterly period ended June 30, 2009, dated August 5, 2009
10.9  2009 Directors’ Stock Incentive Plan  Incorporated by reference to Exhibit 10.9 of the Form 10-Q for the quarterly period ended June 30, 2009, dated August 5, 2009
10.10  Form of Restricted Stock Award Agreement Pursuant to the FII2009 Directors’ Stock Incentive PlanFiled Herewith
10.11Form of Restricted Stock Award Agreement Pursuant to the 2009 Management Stock Incentive Plan (Special, one-time Award)  Incorporated by reference to Exhibit 10.1 of the Form 8-K, dated January 19, 2010
10.1110.12  Form of Restricted Stock Award Agreement Pursuant to the FII 2009 Management Stock Incentive PlanIncorporated by reference to Exhibit 10.1 of the Form 8-K, dated March 1, 2010
10.12Form of Restricted Stock Award Agreement Pursuant to the FII 2009 Management Stock Incentive Plan (LTIP Award)  Incorporated by reference to Exhibit 10.2 of the Form 8-K, dated March 1, 2010

 

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Exhibit
Number

  

Description

  

Location

Exhibit
NumberDescriptionLocation
10.13  AmendedForm of “Service Based” Restricted Stock Ownership Requirements, dated December 14, 2005Award Agreement Pursuant to the 2009 Management Stock Incentive Plan  Incorporated by reference to Exhibit 10.1910.12 of the Form 10-K for the year ended December 31, 2005,2011, dated March 15, 20069, 2012
10.14  Form of 2012 Performance Program Master AgreementIncorporated by reference to Exhibit 10.13 of the Form 10-K for the year ended December 31, 2011, dated March 9, 2012
10.15Form of 2012 Performance Program Award CertificateIncorporated by reference to Exhibit 10.14 of the Form 10-K for the year ended December 31, 2011, dated March 9, 2012
10.16Form of 2013 Performance Program Master AgreementFiled Herewith
10.17Form of 2013 Performance Program Award CertificateFiled Herewith
10.18Amended and Restated Executive Agreement withbetween Financial Institutions, Inc. and Peter G. Humphrey  Incorporated by reference to Exhibit 10.1 of the Form 8-K, dated June 30, 2005July 5, 2012
10.19  
10.15Amended and Restated Executive Agreement with James T. Rudgersbetween Financial Institutions, Inc. and Martin K. Birmingham  Incorporated by reference to Exhibit 10.2 of the Form 8-K, dated June 30, 2005July 5, 2012
10.1610.20  Executive Agreement with Ronald A. Millerbetween Financial Institutions, Inc. and Karl F. Krebs  Incorporated by reference to Exhibit 10.3 of the Form 8-K, dated June 30, 2005July 5, 2012
10.1710.21  Executive Agreement with Martin K. Birminghambetween Financial Institutions, Inc. and Ronald Mitchell McLaughlin  Incorporated by reference to Exhibit 10.4 of the Form 8-K, dated June 30, 2005July 5, 2012
10.1810.22  Executive Agreement with John J. Witkowskibetween Financial Institutions, Inc. and Kenneth V. Winn  Incorporated by reference to Exhibit 10.710.5 of the Form 8-K, dated September 14, 2005July 5, 2012
10.23  
10.19Executive Agreement withSeparation and release agreement between Five Star Bank and George D. Hagi  Incorporated by reference to Exhibit 10.7 of the Form 8-K, dated February 2, 2006
10.20Voluntary Retirement Agreement with James T. RudgersIncorporated by reference to Exhibit 10.1 of the Form 8-K, dated September 26, 2008
10.21Amendment to Voluntary Retirement Agreement with James T. RudgersIncorporated by reference to Exhibit 10.110.6 of the Form 8-K, dated July 1, 20095, 2012
10.2210.24  Voluntary Retirement Agreement with Ronald A. Miller  Incorporated by reference to Exhibit 10.2 of the Form 8-K, dated September 26, 2008
10.2310.25  Amendment to Voluntary Retirement Agreement with Ronald A. Miller  Incorporated by reference to Exhibit 10.1 of the Form 8-K, dated March 3, 2010
10.26  Separation and release agreement between Financial Institutions, Inc. and Peter G. Humphrey  Incorporated by reference to Exhibit 10.2 of the Form 10-Q for the quarterly period ended September 30, 2012, dated November 6, 2012
10.27  
10.24Supplemental Executive Retirement Agreement between Financial Institutions, Inc. and Peter G. Humphrey  Incorporated by reference to Exhibit 10.3 of the Form 10-Q for the quarterly period ended September 30, 2012, dated November 6, 2012
Letter
10.28Assignment, Purchase and Assumption Agreement dated January 19, 2012 between First Niagara Bank, National Association and Five Star BankIncorporated by reference to Exhibit 10.24 of the Form 10-K for the year ended December 23, 2008, including the Securities31, 2011, dated March 9, 2012
10.29Amendment No. 1 to Assignment, Purchase Agreement-Standard Terms attached thereto,and Assumption Agreement, effective as of August 16, 2012, by and between the CompanyFive Star Bank and the United States DepartmentFirst Niagara Bank, National AssociationIncorporated by reference to Exhibit 10.1 of the TreasuryForm 10-Q for the quarterly period ended September 30, 2012, dated November 6, 2012
10.30Purchase and Assumption Agreement dated January 19, 2012 between First Niagara Bank, National Association and Five Star BankIncorporated by reference to Exhibit 10.25 of the Form 10-K for the year ended December 31, 2011, dated March 9, 2012
10.31Amendment No. 1 to Purchase and Assumption Agreement, effective as of June 21, 2012, by and between Five Star Bank and First Niagara Bank, National Association.  Incorporated by reference to Exhibit 10.1 of the Form 8-K, dated December 24, 2008June 28, 2012

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Exhibit
Number

  

Description

  

Location

10.32  
11.1StatementUnderwriting Agreement dated March 9, 2011 between Financial Institutions, Inc. and Keefe, Bruyette & Woods, Inc., as representative of Computation of Per Share Earningsthe underwriters  Incorporated by reference to Note 15Exhibit 1.1 of the Registrant’s audited consolidated financial statements under Item 8 filed herewith.Form 8-K, dated March 9, 2011
12Ratio of Earnings to Fixed Charges and Preferred DividendsFiled Herewith
21  Subsidiaries of Financial Institutions, Inc.  Filed Herewith
23  Consent of Independent Registered Public Accounting Firm  Filed Herewith
31.1  Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 — 2002—Principal Executive Officer  Filed Herewith
31.2  Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 — 2002—Principal Financial Officer  Filed Herewith
32  Certification pursuant to18to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002  Filed Herewith
*101.INS  XBRL Instance Document  
*101.SCH  
99.1XBRL Taxonomy Extension Schema Document  
Certification
*101.CALXBRL Taxonomy Extension Calculation Linkbase Document
*101.LABXBRL Taxonomy Extension Label Linkbase Document
*101.PREXBRL Taxonomy Extension Presentation Linkbase Document
*101.DEFXBRL Taxonomy Extension Definition Linkbase Document

*Pursuant to Rule 406T of Chief Executive Officer pursuantRegulation S-T, the information in this exhibit shall not be deemed to be “filed” for purposes of Section 111(b)(4)18 of the Emergency Economic StabilizationSecurities Exchange ActFiled Herewith
99.2Certification of Chief Financial Officer pursuant1934, or otherwise subject to Section 111(b)(4)the liability of that section, and shall not be incorporated by reference into any registration statement, prospectus or other document filed under the Emergency Economic StabilizationSecurities ActFiled Herewith of 1933, or the Securities Exchange Act of 1934, except as shall be expressly set forth by specific reference in such filings.

 

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SIGNATURES


SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

    
FINANCIAL INSTITUTIONS, INC.
March 7, 2011 18, 2013By:

/s/ Peter G. HumphreyMartin K. Birmingham

  
  Peter G. Humphrey Martin K. Birmingham
  
  President &and Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

Signatures

  

Title

  Date
Signatures

/s/ Martin K. Birmingham

  TitleDate
/s/ Peter G. Humphrey
Peter G. Humphrey
Director, President and Chief Executive Officer
March 18, 2013
Martin K. Birmingham(Principal Executive Officer)  March 7, 2011

/s/ Karl F. Krebs

Karl F. Krebs

  Executive Vice President and Chief Financial Officer
March 18, 2013
Karl F. Krebs(Principal Financial and Accounting Officer)  March 7, 2011

/s/ Karl V. Anderson, Jr.

DirectorMarch 18, 2013
Karl V. Anderson, Jr.  Director   March 7, 2011

/s/ John E. Benjamin

John E. Benjamin

  Director, Chairman  March 7, 201118, 2013
John E. Benjamin    

/s/ Barton P. Dambra

Barton P. Dambra

  Director  March 7, 201118, 2013
Barton P. Dambra    

/s/ Samuel M. Gullo

Samuel M. Gullo

  Director  March 7, 201118, 2013
Samuel M. Gullo    

/s/ Susan R. Holliday

Susan R. Holliday

  Director  March 7, 201118, 2013
Susan R. Holliday    

/s/ Peter G. Humphrey

DirectorMarch 18, 2013
Peter G. Humphrey

/s/ Erland E. Kailbourne

Erland E. Kailbourne

  Director  March 7, 201118, 2013
Erland E. Kailbourne    

/s/ Robert N. Latella

Robert N. Latella

  Director, Vice Chairman  March 7, 201118, 2013
Robert N. Latella    

/s/ James L. Robinson

James L. Robinson

  Director  March 7, 201118, 2013
James L. Robinson    

/s/ James H. Wyckoff

James H. Wyckoff

  Director  March 7, 201118, 2013
James H. Wyckoff

 

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