SmartFinancial (SMBK) 10-Q 2008 Q3 Quarterly report

United States Securities and Exchange Commission

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2008

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

For the transition period from __________to                             .

Commission File Number: 000-30497

(Exact name of small business issuer as specified in its charter)

Tennessee	62-1173944
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
835 Georgia Avenue Chattanooga, Tennessee	37402
(Address of principal executive offices)	(Zip Code)
423-385-3000	Not Applicable
(Registrant’s telephone number, including area code)	(Former name, former address and former fiscal
	year, if changes since last report)

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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.

Yes x No o

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

Large accelerated filer oAccelerated filer xNon-accelerated filer o Smaller reporting company o

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

Yes o No x

As of September 30, 2008 there were 6,319,718 shares of common stock, $1.00 par value per share, issued and outstanding.

TABLE OF CONTENTS

PART I – CONSOLIDATED FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements and Notes (Unaudited)	4
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	16
Item 3. Quantitative and Qualitative Disclosures about Market Risk	22
Item 4. Evaluation of Controls and Procedures	22
PART II – OTHER INFORMATION
Item 1. Legal Proceedings	23
Item 1A. Risk Factors	23
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	26
Item 3. Defaults Upon Senior Securities	26
Item 4. Submission of Matters to a Vote of Security Holders	26
Item 5. Other Information	26
Item 6. Exhibits and Reports on Form 8-K	26

2

FORWARD-LOOKING STATEMENTS

Cornerstone Bancshares, Inc. (“Cornerstone”) may from time to time make written or oral statements, including statements contained in this report which may constitute forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). The words “expect,” “anticipate,” “intend,” “consider,” “plan,” “believe,” “seek,” “should,” “estimate,” and similar expressions are intended to identify such forward-looking statements, but other statements may constitute forward-looking statements. These statements should be considered subject to various risks and uncertainties. Such forward-looking statements are made based upon management’s belief as well as assumptions made by, and information currently available to, management pursuant to “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. Cornerstone’s actual results may differ materially from the results anticipated in forward-looking statements due to a variety of factors. Such factors are described below and in Cornerstone’s Form 10-K, as updated by Item 1A of part II of this Form 10-Q and include, without limitation, (i) unanticipated deterioration in the financial condition of borrowers resulting in significant increases in loan losses and provisions for those losses, (ii) increased competition with other financial institutions, (iii) lack of sustained growth in the economy in the Chattanooga, Tennessee area, (iv) rapid fluctuations or unanticipated changes in interest rates, (v) the inability of our bank subsidiary, Cornerstone Community Bank, to satisfy regulatory requirements for its expansion plans, (vi) the inability of Cornerstone to achieve its targeted expansion goals in the Knoxville, Tennessee and Dalton, Georgia markets, (vii) the inability of Cornerstone to grow its loan portfolio at historic or planned rates (viii) changes in the legislative and regulatory environment, including compliance with the various provisions of the Sarbanes-Oxley Act of 2002 and (ix) general economic and market conditions. Many of such factors are beyond Cornerstone’s ability to control or predict, and readers are cautioned not to put undue reliance on such forward-looking statements. Cornerstone does not intend to update or reissue any forward-looking statements contained in this report as a result of new information or other circumstances that may become known to Cornerstone.

3

PART I. CONSOLIDATED FINANCIAL INFORMATION

CORNERSTONE BANCSHARES, INC. & SUBSIDIARIES

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS AND NOTES

CONSOLIDATED BALANCE SHEETS

	Unaudited
	September 30,			December 31,
		2008			2007
ASSETS
Cash and due from banks	$	9,908,901		$	14,933,349
Securities available for sale		41,107,053			34,751,985
Securities held to maturity		176,237			200,037
Federal Home Loan Bank stock, at cost		2,159,100			1,911,600
Loans, net of allowance for loan losses of $7,450,274 at September 30, 2008 and $13,710,109 at December 31, 2007		381,723,668			369,883,009
Bank premises and equipment, net		6,546,373			6,470,893
Accrued interest receivable		1,885,722			2,407,977
Goodwill and amortizable intangibles		2,869,988			2,941,798
Other assets		11,230,110			10,920,605
Total Assets	$	457,607,152		$	444,421,253
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits:
Noninterest-bearing demand deposits	$	41,621,651		$	45,284,518
Interest-bearing demand deposits		30,381,735			31,984,590
Savings deposits and money market accounts		43,254,761			49,970,489
Time deposits of $100,000 or more		64,293,061			71,505,272
Time deposits of less than $100,000		123,264,039			114,504,856
Total deposits		302,815,247			313,249,725
Federal funds purchased and securites sold under agreements to repurchase		43,451,974			41,560,355
Federal Home Loan Bank advances and line of credit		72,200,000			47,100,000
Accrued interest payable		246,862			216,086
Other liabilities		1,405,618			5,967,737
Total Liabilities		420,119,701			408,093,903
Stockholders' Equity
Preferred stock - no par value; 2,000,000 shares authorized; no shares issued		-			-
Common stock - $l.00 par value; 10,000,000 shares authorized;
6,522,718 and 6,522,718 issued in 2008 and 2007;
6,319,718 and 6,369,718 outstanding in 2008 and 2007		6,319,718			6,369,718
Additional paid-in capital		20,289,381			20,532,787
Retained earnings		10,935,367			9,317,878
Accumulated other comprehensive income		(57,015	)		106,967
Total Stockholders' Equity		37,487,451			36,327,350
Total Liabilities and Stockholders' Equity	$	457,607,152		$	444,421,253

The Notes to Consolidated Finanical Statements are an integral part of these statements.

4

CORNERSTONE BANCSHARES, INC. & SUBSIDIARIES

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS AND NOTES (continued)

CONSOLIDATED STATEMENTS OF INCOME

	Unaudited					Unaudited
	Three Months Ended					Nine Months Ended
	September 30					September 30,
	2008		2007			2008		2007
INTEREST INCOME
Loans, including fees	$	6,977,340	$	8,609,851		$	21,730,315	$	24,558,156
Investment securities		482,119		468,044			1,533,231		1,303,471
Federal funds sold		1,100		29,681			5,184		34,771
Other earning assets		1,914		2,248			10,711		9,645
Total interest income		7,462,473		9,109,824			23,279,441		25,906,043
INTEREST EXPENSE
Interest bearing demand accounts		56,513		122,197			180,030		385,008
Money market accounts		151,946		523,818			681,350		1,459,964
Savings accounts		15,717		19,409			46,903		57,278
Time deposits of more than $100,000		579,186		884,019			2,092,277		2,237,285
Time deposits of less than $100,000		1,322,111		1,351,423			4,150,336		3,847,285
Federal funds purchased and securities
sold under agreements to repurchase		157,141		181,122			501,927		674,680
Other borrowings		744,145		703,215			2,067,266		1,726,075
Total interest expense		3,026,759		3,785,203			9,720,089		10,387,575
Net interest income before provision for loan losses		4,435,714		5,324,621			13,559,352		15,518,468
Provision for loan losses		440,000		2,963,500			927,000		3,200,500
Net interest income after the provision for loan losses		3,995,714		2,361,121			12,632,352		12,317,968
NONINTEREST INCOME
Service charges and fees		439,664		368,771			1,278,485		1,045,572
Net gains / (losses) from sale of loans and other assets		18,107		(21,401	)		27,638		52,485
Other income		18,962		32,863			89,487		135,746
Total noninterest income		476,733		380,233			1,395,610		1,233,803
NONINTEREST EXPENSE
Salaries and employee benefits		1,856,162		1,356,769			5,531,873		4,911,759
Occupancy and equipment expense		371,943		309,020			1,134,996		995,731
Other operating expense		922,932		705,200			2,796,781		2,207,242
Total noninterest expense		3,151,037		2,370,989			9,463,650		8,114,732
Income before provision for income taxes		1,321,410		370,365			4,564,312		5,437,039
Provision for income taxes		461,194		(188,971	)		1,616,182		1,661,740
NET INCOME	$	860,216	$	559,336		$	2,948,130	$	3,775,299
EARNINGS PER COMMON SHARE
Basic net income per common share	$	0.14	$	0.09		$	0.47	$	0.58
Diluted net income per common share	$	0.13	$	0.08		$	0.45	$	0.55
DIVIDENDS DECLARED PER COMMON SHARE	$	0.07	$	0.05		$	0.21	$	0.15

The Notes to Consolidated Finanical Statements are an integral part of these statements.

5

CORNERSTONE BANCSHARES, INC. & SUBSIDIARIES

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS AND NOTES (continued)

CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY - Unaudited

For the Nine Months Ended September 30, 2008

							Additional						Other			Total
	Comprehensive			Common			Paid-in			Retained			Comprehensive			Stockholders'
	Income			Stock			Capital			Earnings			Income			Equity
BALANCE, December 31, 2007				$	6,369,718		$	20,532,787		$	9,317,878		$	106,967		$	36,327,350
Employee compensation stock					-			209,600			-			-			209,600
option expense
Dividend - $0.21 per share					-			-			(1,330,641	)		-			(1,330,641	)
Purchase of common stock					(50,000	)		(453,006	)		-			-			(503,006	)
Comprehensive income:
Net income	$	2,948,130			-			-			2,948,130			-			2,948,130
Other comprehensive income, net of tax:
Unrealized holding gains (losses) on securities available for sale, net of reclassification adjustment		(163,982	)		-			-			-			(163,982	)		(163,982	)
Total comprehensive income	$	2,784,148
BALANCE, September 30, 2008				$	6,319,718		$	20,289,381		$	10,935,367		$	(57,015	)	$	37,487,451

The Notes to Consolidated Financial Statements are an integral part of these statements.

6

CORNERSTONE BANCSHARES, INC. & SUBSIDIARIES

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS AND NOTES (continued)

CONSOLIDATED STATEMENTS OF CASH FLOWS

	Unaudited
	Nine Months Ended September 30,
	2008			2007
CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	2,948,130		$	3,775,299
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		422,877			323,783
Provision for loan losses		927,000			3,200,500
Stock compensation expense		209,600			165,012
Net (Gains) / Losses on sales of loans and other assets		(27,638	)		(52,485	)
Changes in other operating assets and liabilities:
Net change in loans held for sale		205,600			510,850
Accrued interest receivable		522,255			(313,064	)
Deferred income taxes		3,202,078			68,633
Accrued interest payable		30,776			173,979
Other assets and liabilities		(6,850,146	)		(1,572,639	)
Net cash provided by operating activities		1,590,532			6,279,868
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from security transactions:
Securities available for sale		21,722,393			6,093,544
Securities held to maturity		24,087			27,001
Purchase of securities available for sale		(28,320,718	)		(7,134,291	)
Purchase of Federal Home Loan Bank stock		(247,500	)		(579,500	)
Loan originations and principal collections, net		(15,947,942	)		(66,040,065	)
Purchase of bank premises and equipment		(450,096	)		(683,456	)
Proceeds from sale of other real estate and other assets		2,142,594			1,021,191
Net cash used in investing activities		(21,077,182	)		(67,295,576	)
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase / (decrease) in deposits		(10,434,478	)		58,810,577
Net increase / (decrease) in federal funds purchased and securities sold under agreements to repurchase		1,891,619			(3,331,149	)
Net proceeds from Federal Home Loan Bank advances and other borrowings		25,100,000			2,500,000
Purchase of common stock		(503,006	)		(42,699	)
Issuance of common stock		-			72,925
Payment of dividends		(1,591,933	)		(978,024	)
Net cash provided by financing activities		14,462,202			57,031,630
NET (DECREASE) IN CASH AND CASH EQUIVALENTS		(5,024,448	)		(3,984,078	)
CASH AND CASH EQUIVALENTS, beginning of period		14,933,349			17,635,956
CASH AND CASH EQUIVALENTS, end of period	$	9,908,901		$	13,651,878
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for interest	$	9,689,313		$	10,213,596
Cash paid during the period for taxes		738,886			2,041,300

The Notes to Consolidated Financial Statements are an integral part of these statements.

7

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Note 1. Presentation of Financial Information

Nature of Business-Cornerstone Bancshares, Inc. (“Cornerstone”) is a bank holding company whose primary business is performed by its wholly-owned subsidiaries, Cornerstone Community Bank (“Bank”) and Eagle Financial, Inc. (“Eagle”). The Bank provides a full range of banking services to the Chattanooga, Tennessee market. The Bank has also established a loan production office (“LPO”) in Dalton, Georgia and an LPO in Knoxville, Tennessee to further enhance the Bank’s lending markets. The Bank specializes in asset based lending, commercial lending and payment processing. Eagle is a commercial factoring company that provides financing to businesses that are relatively new or experiencing significant growth.

Interim Financial Information (Unaudited)-The financial information in this report for September 30, 2008 and September 30, 2007 has not been audited. The information included herein should be read in conjunction with the annual consolidated financial statements and footnotes thereto included in the 2007 Annual Report to Shareholders which was furnished to each shareholder of Cornerstone in March of 2008. The consolidated financial statements presented herein conform to generally accepted accounting principles and to general industry practices. In the opinion of Cornerstone’s management, the accompanying interim financial statements contain all material adjustments, consisting only of normal recurring adjustments necessary to present fairly the financial condition, the results of operations, and cash flows for the interim period. Results for interim periods are not necessarily indicative of the results to be expected for a full year.

Use of Estimates-The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities as of the balance sheet date and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term include the determination of the allowance for loan losses.

Consolidation-The accompanying consolidated financial statements include the accounts of Cornerstone and its subsidiaries Bank and Eagle. Substantially all intercompany transactions, profits and balances have been eliminated.

Reclassification-Certain amounts in the prior consolidated financial statements have been reclassified to conform to the current period presentation. The reclassifications had no effect on net income or stockholder’s equity as previously reported.

Accounting Policies-During interim periods, Cornerstone follows the accounting policies set forth in its 10-K for the year ended December 31, 2007 as filed with the Securities and Exchange Commission. Except as discussed in Note 7, since December 31, 2007 there have been no significant changes in any accounting principles or practices, or in the method of applying any such principles or practices.

Earnings per Common Share- Basic earnings per share (“EPS”) is computed by dividing income available to common shareholders (numerator) by the weighted average number of common shares outstanding during the period (denominator). Diluted EPS is computed by dividing income available to common shareholders (numerator) by the adjusted weighted average number of shares outstanding (denominator). The adjusted weighted average number of shares outstanding reflects the potential dilution occurring if securities or other contracts to issue common stock were exercised or converted into common stock resulting in the issuance of common stock that share in the earnings of the entity.

8

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The following is a summary of the basic and diluted earnings per share for the three month periods ended September 30, 2008 and 2007.

	Three Months Ended September 30,
Basic earnings per share calculation:		2008		2007
Numerator: Net income available to common shareholders	$	860,216	$	559,336
Denominator: Weighted avg. common shares outstanding		6,319,718		6,520,081
Effect of dilutive stock options		57,375		305,627
Diluted shares		6,377,093		6,825,708
Basic earnings per share	$	0.14	$	0.09
Diluted earnings per share	$	0.13	$	0.08

The following is a summary of the basic and diluted earnings per share for the nine month periods ended September 30, 2008 and 2007.

	Nine Months Ended September 30,
Basic earnings per share calculation:		2008		2007
Numerator: Net income available to common shareholders	$	2,948,130	$	3,775,299
Denominator: Weighted avg. common shares outstanding		6,325,375		6,517,236
Effect of dilutive stock options		161,459		357,971
Diluted shares		6,486,834		6,875,207
Basic earnings per share	$	0.47	$	0.58
Diluted earnings per share	$	0.45	$	0.55

Note 2. Stock Based Compensation

Accounting Policies- Cornerstone, as required by FASB, applies the fair value recognition provisions of SFAS No. 123(R) Share-Based Payment. As a result, for the nine month period ended September 30, 2008, the compensation cost charged to earnings related to the vested incentive stock options was approximately $210,000, which reduced basic earnings per share by $0.03 per share.

Officer and Employee Plans-Cornerstone has two stock option plans under which officers and employees can be granted incentive stock options or non-qualified stock options to purchase a total of up to 1,420,000 shares of Cornerstone’s common stock. The option price for incentive stock options shall be not less than 100 percent of the fair market value of the common stock on the date of the grant. The exercise price of the non-qualified stock options may be equal to or more or less than the fair market value of the common stock on the date of the grant. The stock options vest at 30 percent on the second and third anniversaries of the grant date and 40 percent on the fourth anniversary. The options expire ten years from the grant date. At September 30, 2008, the total remaining compensation cost to be recognized on non-vested options is approximately $624,000. A summary of the status of this stock option plan is presented in the following table:

9

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

						Weighted-
						Average
				Weighted		Contractual
				Average		Remaining		Aggregate
				Exercisable		Term		Intrinsic
	Number			Price		(in years)		Value
Outstanding at December 31, 2007		715,075		$	6.52		5.5 Years	$	5,177,118
Granted		71,500			7.99
Exercised		-			-
Forfeited		(9,150	)		13.34
Outstanding at September 30, 2008		777,425		$	6.06		5.2 Years	$	1,921,089
Options exercisable at September 30, 2008		571,360		$	4.72

The weighted average grant-date fair value of share options granted during the nine months ended September 30, 2008 was $2.23. This was determined using the Black-Scholes option pricing model with the following weighted -average assumptions. Dividend Yield: 1.470%, Expected Life: 8.0 years, Expected Volatility: 20.27%, Risk-free Interest Rate: 4.220%

Board of Directors Plan-Cornerstone has a stock option plan under which members of the Board of Directors, at the formation of the Bank, were granted options to purchase a total of up to 600,000 shares of the Bank's common stock. On October 15, 1997, the Bank stock options were converted to Cornerstone stock options. Only non-qualified stock options may be granted under the Plan. The exercise price of each option equals the market price of Cornerstone’s stock on the date of grant and the option’s maximum term is ten years. Vesting for options granted during 2008, are 50% on the first and second anniversary of the grant date. At September 30, 2008, the total remaining compensation cost to be recognized on non-vested options is approximately $62,000. A summary of the status of this stock option plan is presented in the following table:

					Weighted-
					Average
			Weighted		Contractual
			Average		Remaining		Aggregate
			Exercisable		Term		Intrinsic
	Number		Price		(in years)		Value
Outstanding at December 31, 2007		69,000	$	11.23		7.7 Years	$	164,214
Granted		12,800		7.99
Exercised		-		-
Forfeited		-		-
Outstanding at September 30, 2008		81,800	$	10.73		8.1 Years	$	38,694
Options exercisable at September 30, 2008		64,500	$	10.95

The weighted average grant-date fair value of share options granted during the nine months ended September 30, 2008 was $2.23. This was determined using the Black-Scholes option pricing model with the following weighted -average assumptions. Dividend Yield: 1.470%, Expected Life: 8.0 years, Expected Volatility: 20.27%, Risk-free Interest Rate: 4.220%

10

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Note 3. Stockholder’s Equity

During 2008, Cornerstone’s Board of Directors has declared the following dividends:

Dividend Rate	Declaration Date		Record Date		Payment Date
(per share)
$0.07		February 29, 2008		March 14, 2008		April 4, 2008
$0.07		May 23, 2008		June 15, 2008		July 3, 2008
$0.07		August 22, 2008		September 19, 2008		October 3, 2008

Any determinations relating to future dividends will be made at the discretion of Cornerstone’s Board of Directors and will depend on a number of factors, including our earnings, capital requirements, financial conditions, future prospects, regulatory restrictions and other factors that Cornerstone’s Board of Directors may deem relevant.

Note 4. Securities

The amortized cost and fair value of securities available-for-sale and held-to-maturity at September 30, 2008 and December 31, 2007 are summarized as follows:

	September 30, 2008
			Gross		Gross
	Amortized		Unrealized		Unrealized			Market
	Cost		Gains		Losses			Value
Securities Available-for-Sale:	$	8,974,711	$	136,147	$	-		$	9,110,858
U.S. Government Securities
State and municipal securities		3,307,425		43,935		(79,159	)		3,272,201
Mortgage-backed securities		28,911,305		34,975		(222,286	)		28,723,994
	$	41,193,441	$	215,057	$	(301,445	)	$	41,107,053
Securities Held-to-Maturity:
Mortgage-backed securities	$	176,237	$	636	$	(694	)	$	176,179

	December 31, 2007
			Gross		Gross
	Amortized		Unrealized		Unrealized			Market
	Cost		Gains		Losses			Value
Securities Available-for-Sale:	$	27,335,992	$	116,624	$	(38,942	)	$	27,413,674
U.S. Government Securities
State and municipal securities		3,436,399		66,369		(3	)		3,502,765
Mortgage-backed securities		3,817,522		20,427		(2,403	)		3,835,546
	$	34,589,913	$	203,420	$	(41,348	)	$	34,751,985
Securities Held-to-Maturity:
Mortgage-backed securities	$	200,037	$	424	$	(783	)	$	199,678

11

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

At September 30, 2008 approximately $41 million of Cornerstone’s investment portfolio was pledged to secure public funds and other deposits and securities sold under agreements to repurchase.

Note 5. Loans and Allowance for Loan Losses

At September 30, 2008 and December 31, 2007 loans are summarized as follows (in thousands):

	September 30, 2008					December 31, 2007
	Amount		Percent			Amount		Percent
Commercial, financial and agricultural	$	86,005		22.1	%	$	98,065		25.6	%
Real estate-construction		76,490		19.7	%		76,832		20.0	%
Real estate-mortgage		70,713		18.2	%		64,585		16.8	%
Real estate-commercial		149,976		38.5	%		138,074		36.0	%
Consumer loans		5,990		1.5	%		6,037		1.6	%
Total loans	$	389,174		100.0	%	$	383,593		100.0	%

A summary of transactions in the allowance for loan losses for the nine months ended September 30, 2008 and year ended December 31, 2007 is as follows:

	September 30,			December 31,
	2008			2007
Balance, beginning of period	$	13,710		$	4,258
Loans charged-off		(7,515	)		(1,075	)
Recoveries of loans previously charged-off		328			118
Provision for loan losses		927			10,409
Balance, end of period	$	7,450		$	13,710

Note 6. Commitments and Contingent Liabilities

In the normal course of business, the Bank has entered into off-balance sheet financial instruments which include commitments to extend credit (i.e., including unfunded lines of credit) and standby letters of credit. Commitments to extend credit are usually the result of lines of credit granted to existing borrowers under agreements that the total outstanding indebtedness will not exceed a specific amount during the term of the indebtedness. Typical borrowers are commercial concerns that use lines of credit to supplement their treasury management functions, thus their total outstanding indebtedness may fluctuate during any time period based on the seasonality of their business and the resultant timing of their cash flows. Other typical lines of credit are related to home equity loans granted to consumers. Commitments to extend credit generally have fixed expiration dates or other termination clauses and may require payment of a fee.

Standby letters of credit are generally issued on behalf of an applicant (our customer) to a specifically named beneficiary and are the result of a particular business arrangement that exists between the applicant and the beneficiary. Standby letters of credit have fixed expiration dates and are usually for terms of two years or less unless terminated beforehand due to criteria specified in the standby letter of credit. A typical arrangement involves the applicant routinely being indebted to the beneficiary for such items as inventory purchases, insurance, utilities, lease guarantees or other third party commercial transactions. The standby letter of credit would permit the beneficiary to obtain payment from the Bank under certain prescribed circumstances. Subsequently, the Bank would then seek reimbursement from the applicant pursuant to the terms of the standby letter of credit.

The Bank follows the same credit policies and underwriting practices when making these commitments as it does for on-balance sheet instruments. Each customer’s creditworthiness is evaluated on a case-by-case basis, and the amount of collateral obtained, if any, is based on management’s credit evaluation of the customer. Collateral held varies but may include cash, real estate and improvements, marketable securities, accounts receivable, inventory, equipment, and personal property.

12

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The contractual amounts of these commitments are not reflected in the consolidated financial statements and would only be reflected if drawn upon. Since many of the commitments are expected to expire without being drawn upon, the contractual amounts do not necessarily represent future cash requirements. However, should the commitments be drawn upon and should our customers default on their resulting obligation to us, the Bank’s maximum exposure to credit loss, without consideration of collateral, is represented by the contractual amount of those instruments.

A summary of the Bank’s total contractual amount for all off-balance sheet commitments at September 30, 2008 is as follows:

Commitments to extend credit	$	61.4 million
Standby letters of credit	$	5.0 million

Various legal claims also arise from time to time in the normal course of business. In the opinion of management, the resolution of claims outstanding at September 30, 2008 will not have a material effect on Cornerstone’s consolidated financial statements.

Note 7. Recent Relevant Accounting Pronouncements

Cornerstone adopted FASB Statement No. 157 (SFAS 157), “Fair Value Measurements” in January 2008. SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances. The adoption of SFAS 157 did not have a material impact on Cornerstone’s consolidated financial statements in 2008.

Cornerstone adopted FASB Statement No. 159 (SFAS 159), “The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of FASB Statement No. 115” in January 2008. This Statement permits entities to choose to measure many financial instruments and certain other items at fair value. Unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. This Statement is expected to expand the use of fair value measurement, which is consistent with the FASB’s long-term measurement objectives for accounting for financial instruments. Cornerstone has not elected the fair value option for any financial assets or liabilities at September 30, 2008.

13

CORNERSTONE BANCSHARES, INC.

CONSOLIDATED AVERAGE BALANCE

INTEREST INCOME/EXPENSE AND

YIELD/RATES

Taxable Equivalent Basis

(in thousands)

	Three months ended
	September 30
Assets	2008								2007
	Average			Income/		Yield/			Average			Income/		Yield/
Earning assets:	Balance			Expense		Rate			Balance			Expense		Rate
Loans, net of unearned income	$	381,342		$	6,977		7.26	%	$	367,056		$	8,610		9.31	%
Investment securities		48,508			482		4.06	%		39,390			468		4.83	%
Other earning assets		70			3		2.39	%		2,372			32		5.34	%
Total earning assets		429,920		$	7,462		6.90	%		408,818		$	9,110		8.85	%
Allowance for loan losses		(7,409	)							(4,916	)
Cash and other assets		26,542								28,317
TOTAL ASSETS	$	449,053							$	432,218
Liabilities and Shareholder's Equity
Interest bearing liabilities:
Interest bearing demand deposits	$	29,581		$	57		0.76	%	$	36,530		$	122		1.33	%
Savings deposits		8,313			16		0.75	%		7,635			20		1.02	%
MMDA's		40,683			152		1.48	%		49,814			524		4.17	%
Time deposits of $100,000 or less		128,591			1,322		4.08	%		106,377			1,351		5.04	%
Time deposits of $100,000 or more		57,486			579		4.00	%		67,396			884		5.20	%
Federal funds purchased and securities sold under agreements to repurchase		33,712			157		1.85	%		16,294			181		4.41	%
Other borrowings		72,329			744		4.08	%		59,331			703		4.70	%
Total interest bearing liabilities		370,695			3,027		3.24	%		343,377			3,785		4.37	%
Net interest spread				$	4,436		3.66	%				$	5,325		4.48	%
Noninterest bearing demand deposits		41,204								44,873
Accrued expenses and other liabilities		(587	)							2,239
Shareholder's equity		37,741								41,729
TOTAL LIABILITIES AND
SHAREHOLDERS' EQUITY	$	449,053							$	432,218
Net yield on earning assets							4.11	%							5.18	%
Taxable equivalent adjustment:
Loans					0								0
Investment securities					14								11
Total adjustment					14								11

14

CORNERSTONE BANCSHARES, INC.

CONSOLIDATED AVERAGE BALANCE

INTEREST INCOME/EXPENSE AND

YIELD/RATES

Taxable Equivalent Basis

(in thousands)

	Year-to-Date
	September 30
Assets	2008								2007
	Average			Income/		Yield/			Average			Income/		Yield/
Earning assets:	Balance			Expense		Rate			Balance			Expense		Rate
Loans, net of unearned income	$	383,966		$	21,730		7.57	%	$	344,890		$	24,558		9.52	%
Investment securities		46,439			1,533		4.54	%		37,739			1,303		4.74	%
Other earning assets		285			16		2.72	%		914			44		6.49	%
Total earning assets		430,690		$	23,279		7.24	%		383,543		$	25,906		9.04	%
Allowance for loan losses		(8,733	)							(4,396	)
Cash and other assets		27,300								26,498
TOTAL ASSETS	$	449,257							$	405,645
Liabilities and Shareholder's Equity
Interest bearing liabilities:
Interest bearing demand deposits	$	31,069		$	179		0.77	%	$	37,889		$	385		1.36	%
Savings deposits		7,938			47		0.80	%		7,651			58		1.01	%
MMDA's		46,865			682		1.94	%		45,723			1,460		4.27	%
Time deposits of $100,000 or less		123,277			4,150		4.50	%		102,983			3,847		4.99	%
Time deposits of $100,000 or more		60,240			2,092		4.64	%		58,747			2,237		5.09	%
Federal funds purchased and securities
sold under agreements to repurchase		32,050			502		2.09	%		19,316			675		4.67	%
Other borrowings		67,297			2,067		4.11	%		49,661			1,726		4.65	%
Total interest bearing liabilities		368,736			9,720		3.52	%		321,970			10,388		4.31	%
Net interest spread				$	13,559		3.72	%				$	15,518		4.73	%
Noninterest bearing demand deposits		42,687								40,741
Accrued expenses and other liabilities		426								2,373
Shareholder's equity		37,408								40,561
TOTAL LIABILITIES AND
SHAREHOLDERS' EQUITY	$	449,257							$	405,645
Net yield on earning assets							4.22	%							5.42	%
Taxable equivalent adjustment:
Loans					0								0
Investment securities					43								35
Total adjustment					43								35

15

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

Cornerstone Bancshares, Inc. (“Cornerstone”) is a bank holding company and the parent of Cornerstone Community Bank, (the “Bank”) a Tennessee banking corporation, and Eagle Financial, Inc., (“Eagle”), an accounts receivable financing company that operate primarily in and around Hamilton County, Tennessee. The Bank has also established loan production offices in Knoxville, Tennessee and Dalton, Georgia. The Bank’s business consists primarily of attracting deposits from the general public and, with these and other funds, originating real estate loans, consumer loans, business loans, and residential and commercial construction loans. The principal sources of income for the Bank are interest and fees collected on loans, fees collected on deposit accounts, and interest and dividends collected on other investments. The principal expenses of the Bank are interest paid on deposits, employee compensation and benefits, office expenses, and other overhead expenses. Eagle’s principal source of income is revenue received from the purchase of receivables. Expenses are related to employee compensation and benefits, office and overhead expenses.

The following is a discussion of our financial condition at September 30, 2008 and December 31, 2007 and our results of operations for the three and nine months ended September 30, 2008 and 2007. The purpose of this discussion is to focus on information about our financial condition and results of operations which is not otherwise apparent from the consolidated financial statements. The following discussion and analysis should be read along with our consolidated financial statements and the related notes included elsewhere herein.

Review of Financial Performance

As of September 30, 2008 Cornerstone had total consolidated assets of $457.6 million, total loans of $389.2 million, total deposits of $302.8 million and stockholders equity of $37.5 million. Net income for the three and nine month period ended September 30, 2008 was $860,216 and $2,948,130, respectively.

Results of Operations

Net income for the three months ended September 30, 2008 was $860,216 or $0.14 basic earnings per share, compared to $559,336 or $0.09 basic earnings per share, for the same period in 2007.

The following table presents our results for the three and nine months ended September 30, 2008 and 2007 (amounts in thousands).

						2008-2007										2008-2007
	Three months					Percent			Dollar			Nine months				Percent			Dollar
	ended September 30,					Increase			Amount			ended September 30,				Increase			Amount
	2008		2007			(Decrease)			Change			2008		2007		(Decrease)			Change
Interest income	$	7,462	$	9,110			(18.1	)%		(1,648	)	$	23,279	$	25,906		(10.1	)%		(2,627	)
Interest expense		3,026		3,785			(20.1	)%		(759	)		9,720		10,388		(6.4	)%		(668	)
Net interest income
before provision for loss		4,436		5,325			(16.7	)%		(889	)		13,559		15,518		(12.6	)%		(1,959	)
Provision for loan loss		440		2,964			(85.2	)%		(2,524	)		927		3,201		(71.0	)%		(2,274	)
Net interest income after
provision for loan loss		3,996		2,361			69.3	%		1,635			12,632		12,318		2.6	%		314
Total noninterest income		476		380			25.2	%		96			1,396		1,234		13.1	%		162
Total noninterest expense		3,151		2,371			32.9	%		780			9,464		8,115		16.6	%		1,349
Income before income taxes		1,321		370			256.8	%		951			4,564		5,437		(16.1	)%		(873	)
Provision for income taxes		461		(189	)		(344.1	)%		650			1,616		1,662		(2.7	)%		(46	)
Net income	$	860	$	559			53.8	%		301		$	2,948	$	3,775		(21.9	)%		(827	)

16

Net Interest Income-Net interest income represents the amount by which interest earned on various earning assets exceeds interest paid on deposits and other interest bearing liabilities. Net interest income is also the most significant component of our earnings. For the three months ended September 30, 2008, net interest income before the provision for loan loss, decreased $889 thousand or (16.7)% over the same period of 2007. For the nine months ended September 30, 2008, net interest income before the provision for loan loss, decreased $1,959 thousand or (12.6)% over the same time of 2007. Cornerstone’s interest rate spread on a tax equivalent basis (which is the difference between the average yield on earning assets and the average rate paid on interest bearing liabilities) was 3.72% for the nine month period ended September 30, 2008 compared to 4.73% for the same period in 2007. The net interest margin on a tax equivalent basis was 4.22% for the nine month period ended September 30, 2008 compared to 5.42% for the same period in 2007. Significant items related to the changes in net interest income, net interest yields and rates, and net interest margin are presented below:

· Future changes in the net interest margin will be impacted due to increased competition for funding. An example would include large investment banks entering into the certificate of deposit market to obtain funding. The inclusion of these banks has resulted in interest rate increases on certificates of deposit in recent months.

· The Bank has been able to maintain a loan portfolio yield of 7.57% for the nine months ended September 30, 2008. The loan yield is due primarily to the Bank’s interest rate floors and attempt to price loan rates to be commensurate with risk associated with the loan. Management expects downward pressure to continue to be exerted on the net interest margin for the remainder of 2008 and into 2009. However, management has seen a decrease in the rate of decline of the net interest margin in recent months.

· For the nine month period ended September 30, 2008, the Bank’s investment portfolio resulted in a yield of 4.54% compared to 4.74% for the same time period in 2007. When compared to December 31, 2007 management has materially adjusted the interest rate sensitivity of the investment portfolio from primarily a fixed rate position to a variable rate position. The Bank continues its bias towards loans and is currently purchasing securities primarily for pledging requirements.

Provision for Loan Losses-The provision for loan losses represents a charge to earnings necessary to establish an allowance for loan losses that, in management’s evaluation, should be adequate to provide coverage for the inherent losses on outstanding loans. The provision for loan losses amounted to $440 thousand and $927 thousand for the three and nine months ended September 30, 2008.

Non Interest Income-Items reported as non interest income include service charges on checking accounts, insufficient funds charges, automated clearing house (“ACH”) processing fees and the Bank’s secondary mortgage department earnings. Increases in income derived from service charges and ACH fees are primarily a function of the Bank’s growth while fees from the origination of mortgage loans will often reflect market conditions and fluctuate from period to period.

The following table presents the components of non interest income for the three and nine months ended September 30, 2008 and 2007 (dollars in thousands).

						2008-2007							2008-2007
	Three months ended					Percent			Nine months ended				Percent
	September 30,					Increase			September 30,				Increase
	2008		2007			(Decrease)			2008		2007		(Decrease)
Service charges on deposit accounts	$	440	$	369			19.2	%	$	1,278	$	1,046		22.3	%
Net gains / (losses) on sale of loans and other assets		18		(22	)		184.6	%		28		52		(47.3	)%
Other fee income		18		33			(45.2	)%		90		136		(34.1	)%
Total noninterest income	$	476	$	380			25.1	%	$	1,396	$	1,234		13.1	%

Significant matters relating to the changes in non interest income are presented below:

· The increase in the amount of depository accounts is primarily attributable to the addition of the Bank’s payroll processor clients. Currently, the Bank has nine payroll processors processing ACH transactions and expects to add approximately five more during the remainder of 2008. This line of business has the ability to produce a material amount of non-interest income with a relatively low amount of credit and transaction risk.

17

Non Interest Expense-Items reported as non interest expense include salaries and employee benefits, occupancy and equipment expense and other operating expense.

The following table presents the components of non interest expense for the three and nine months ended September 30, 2008 and 2007 (dollars in thousands).

	Three months ended				2008-2007			Nine months ended				2008-2007
	September 30,				Percent			September 30,				Percent
	2008		2007		Increase			2008		2007		Increase
Salaries and employee benefits	$	1,856	$	1,357		36.8	%	$	5,532	$	4,912		12.6	%
Occupancy and equipment expense		372		309		20.4	%		1,135		996		14.0	%
Other operating expense		923		705		30.9	%		2,797		2,207		26.7	%
Total noninterest expense	$	3,151	$	2,371		32.9	%	$	9,464	$	8,115		16.6	%

Significant matters relating to the changes to non interest expense are presented below:

· During the third quarter of 2007, Cornerstone substantially eliminated employee incentive compensation accrued year to date. This decision was based upon the Bank’s lower than anticipated earnings. Therefore, the three months ended September 30, 2008 compared to September 30, 2007 calculates to a 36.8% increase. However, for the nine months ended September 30, 2008 compared to the nine months ended September 20, 2007 the 12.6% increase is primarily attributable to the increase in staff at the Bank’s operations center, annual salary and compensation increases.

· A significant item included in the increase in occupancy and equipment expense occurred during the first quarter of 2008 when Cornerstone’s expanded its operational center to accommodate the additional staff hired in the risk management department.

· During 2008 Cornerstone has incurred additional expense related to other real estate loan foreclosures. These expenses include legal, insurance, maintenance, and sales cost. Management expects these costs to continue throughout 2008 and into the first half of 2009.

· Cornerstone has incurred additional noninterest expense charges as a result of the Federal Deposit Insurance Corporation’s (“FDIC”) increase in deposit insurance premiums. As of September 30, 2008 the Bank had incurred approximately $189 thousand compared to $25 thousand for the nine months ended September 30, 2007. Management anticipates that these charges will increase significantly, perhaps as much as doubling, in 2009.

· Significant items included in Cornerstone’s other operating expense include data processing fees and other professional services such as accounting and legal fees. Compliance with legal and regulatory requirements resulted in a significant increase in accounting and audit fees that were incurred by Cornerstone during 2008 to perform appropriate level of testing of internal controls over financial statement reporting.

Financial Condition

Overview-Cornerstone’s consolidated assets totaled $444.4 million as of December 31, 2007. As of September 30, 2008 total consolidated assets had increased $13.2 million or 3.0% to $457.6 million. The Bank’s loan portfolio totaled $389.2 million as of September 30, 2008. Secondly, the Bank’s investment portfolio increased by approximately $6.3 million to a total of $41.3 million as of September 30, 2008 compared to a total of $35.0 million as of December 31, 2007. The increase in the security portfolio was needed to provide additional liquidity and for pledging requirements. Increases in liabilities are primarily attributable to an increase in Bank and Cornerstone borrowings. The Bank’s Federal Home Loan Bank (“FHLB”) borrowing as of September 30, 2008 totaled $67 million. As of December 31, 2007 the Bank had borrowed $47 million from the FHLB. Management elected to increase FHLB borrowings to establish a defined maturity structure and obtain funds at a lower cost when compared to other sources available to the Bank. Additionally, Cornerstone increased its outstanding loan with Silverton Bank from $100 thousand at December 31, 2007 to $5.2 million as of September 30, 2008. The increase in Cornerstone’s borrowing has allowed Bancshares to fund additional advances required by Eagle, operating requirements for the parent company and provide for a $2.5million capital injection into the Bank.

18

Securities-The Bank’s investment portfolio, primarily consisting of Federal Agency, mortgage-backed securities and municipal securities, amounted to $41.3 million as of September 30, 2008 compared to $35.0 million as of December 31, 2007. The primary purpose of the Bank’s investment portfolio is to satisfy pledging requirements to collateralize the Bank’s repurchase accounts.

Loans-The composition of loans at September 30, 2008 and at December 31, 2007 and the percentage (%) of each classification to total loans are summarized in the following table (dollars in thousands):

	September 30, 2008					December 31, 2007
	Amount		Percent			Amount		Percent
Commercial, financial and agricultural	$	86,005		22.1	%	$	98,065		25.6	%
Real estate-construction		76,490		19.7	%		76,832		20.0	%
Real estate-mortgage		70,713		18.2	%		64,585		16.8	%
Real estate-commercial		149,976		38.5	%		138,074		36.0	%
Consumer loans		5,990		1.5	%		6,037		1.6	%
Total loans	$	389,174		100.0	%	$	383,593		100.0	%

Allowance for Loan Losses-The allowance for loan losses represents Cornerstone’s assessment of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. Management analyzes the loan portfolio to determine the adequacy of the allowance for loan losses and the appropriate provisions required to maintain a level considered adequate to absorb anticipated loan losses. The Bank uses a risk based approach to calculate the appropriate loan loss allowance in accordance with guidance issued by the Federal Financial Institutions Examination Council. Although the Bank performs prudent credit underwriting, no assurances can be given, however, that adverse economic circumstances will not result in increased losses in the loan portfolio and require greater provisions for possible loan losses in the future.

· During the first quarter of 2008, the Bank charged off $6 million on one commercial loan relationship. The provision was taken at the end of 2007 as announced in Cornerstone’s Form 10-K, and after an investigation in 2008 the loan was considered a loss. The remaining $1.6 million, of the total $7.6 million relationship, has been paid off with no further loss to the Bank. Management expects minimal recovery from the initial loss recognized.

· The Bank has a loan relationship of $8.0 million with $2.5 million reserved under the Bank’s allowance for loan losses. The borrower is presently operating and current on its debt service obligation. Management believes that the current allocation of loan loss allowance, based on its SFAS 114 estimation, is appropriate.

The following is a summary of changes in the allowance for loan losses for the nine months ended September 30, 2008 and for the year ended December 31, 2007 and the ratio of the allowance for loan losses to total loans as of the end of each period (dollars in thousands):

	September 30,			December 31,
	2008			2007
Balance, beginning of period	$	13,710		$	4,258
Loans charged-off		(7,515	)		(1,075	)
Recoveries of loans previously charged-off		328			118
Provision for loan losses		927			10,409
Balance, end of period	$	7,450		$	13,710
Total loans	$	389,174		$	383,593
Ratio of allowance for loan losses to loans outstanding at the end of the period		1.91	%		3.57	%
Ratio of net charge-offs to total loans outstanding for the period		1.85	%		0.25	%

19

Non-Performing Assets-The specific economic and credit risks associated with the Bank’s loan portfolio include, but are not limited to, a general downturn in the economy which could affect employment rates in our market area, general real estate market deterioration, interest rate fluctuations, deteriorated or non-existent collateral, title defects, inaccurate appraisals, financial deterioration of borrowers, fraud, and violation of laws and regulations.

The Bank attempts to reduce these economic and credit risks by adherence to a lending policy approved by the Bank’s board of directors. The Bank’s lending policy establishes loan to value limits, collateral perfection, credit underwriting criteria and other acceptable lending standards. The Bank classifies loans that are ninety (90) days past due and still accruing interest, renegotiated, non-accrual loans, foreclosures and repossessed property as non-performing assets. The Bank’s policy is to categorize a loan on non-accrual status when payment of principal or interest is contractually ninety (90) or more days past due. At the time the loan is categorized as non-accrual the interest previously accrued but not collected may be reversed and charged against current earnings.

The following is a summary of changes in Cornerstone’s impaired loans for the nine months ended September 30, 2008 and for the year ended December 31, 2007 (dollars in thousands):

	September 30,		December 31,
	2008		2007
Impaired loans without a valuation allowance	$	1,058,667	$	17,075
Impaired loans with a valuation allowance	$	9,618,031	$	13,176,547
Total impaired loans	$	10,676,698	$	13,193,622
Valuation allowance related to impaired loans	$	3,337,466	$	9,789,748
Total non-accrual loans	$	2,043,975	$	684,903
Total loans past-due ninety days or more and still accruing	$	-	$	-

· The September 30, 2008 impaired loans without a valuation allowance increased primarily due to one loan relationship. After performing its FAS 114 analysis management has concluded that the relationship represents no risk of loss to the Bank’s loan loss allowance.

· The September 30, 2008 impaired loan amount was significantly reduced by the aforementioned $6 million charge-off that occurred during the first quarter of 2008.

· As of September 30, 2008 the Bank’s non-accrual loans consisted of ten relationships with only one relationship of a material amount. The material relationship represents a loan totaling $1.2 million for which the Bank has fully provided its estimated loss based on its FAS 114 analysis.

20

The following table summarizes Cornerstone’s non-performing assets for the nine months ended September 30, 2008 and for the year ended December 31, 2007 (dollars in thousands):

	September 30,			December 31,
	2008			2007
Non-accrual loans	$	2,044		$	685
Repossessed assets		192			-
Foreclosed properties		1,901			1,038
Total non-performing assets	$	4,137		$	1,723
Total loans outstanding	$	389,174		$	383,593
Ratio of nonperforming assets to total loans outstanding at the end of the period		1.06	%		0.45	%
Ratio of nonperforming assets to total allowance for loan losses at the end of the period		55.53	%		12.57	%

· As of September 30, 2008 the Bank had fourteen foreclosed properties comprising the $1.9 million in other real estate.

Deposits and Other Borrowings-The Bank’s deposits consist of non-interest bearing demand deposits, interest bearing demand accounts, savings and money market accounts, and time deposits. The Bank has agreements with some customers to sell certain of its securities under agreements to repurchase the security the following day. The Bank has also obtained advances from the Federal Home Loan Bank.

The following table presents the Bank’s deposits and other borrowings as either core funding or non-core funding. Core funding consists of all deposits except for time deposits issued in denominations of $100,000 or greater. All other funding is classified as non-core.

	September 30, 2008					December 31, 2007
	Amount		Percent			Amount		Percent
Core funding:
Non interest bearing demand deposits	$	41,622		10.1	%	$	45,285		11.3	%
Interest-bearing demand deposits		30,382		7.4	%		31,985		8.0	%
Savings & money market accounts		43,255		10.5	%		49,970		12.4	%
Time deposits under $100,000		123,264		29.8	%		114,505		28.5	%
Total core funding		238,523		57.7	%		241,745		60.2	%
Non-core funding:
Time deposit accounts greater than $100,000
Brokered deposits		11,712		2.8	%		13,255		3.3	%
Other time deposits		52,581		12.7	%		58,250		14.5	%
Federal funds purchased		22,600		5.5	%		28,450		7.1	%
Securities sold under agreements to repurchase		20,852		5.0	%		13,110		3.3	%
Federal Home Loan Bank advances		67,000		16.2	%		47,000		11.7	%
Total non-core funding		174,745		42.3	%		160,065		39.8	%
Total	$	413,268		100.0	%	$	401,810		100.0	%

· Federal funds purchased are lines of credit established with other financial institutions that allow the Bank to meet short term funding requirements. These lines can be used as frequently as daily with large variations in balances depending upon the Bank’s immediate funding requirements. As of September 30, 2008 the Bank had established $40 million in available federal funds lines.

21

· Federal Home Loan Bank of Cincinnati (the “FHLB”) borrowings are secured by certain qualifying residential mortgage loans and, pursuant to a blanket lien, all qualifying commercial mortgage loans as collateral. Management believes that FHLB borrowings provide an additional source of funding at lower interest rates than alternative sources. The borrowings are structured as either term loans with call and put options after a stated conversion date and an overnight borrowing arrangement. As of September 30, 2008 the Bank had borrowed a total of $67 million from the FHLB consisting of structured term loans.

Capital Resources-At September 30, 2008 and December 31, 2007 Cornerstone’s stockholders’ equity amounted to $37.5 million and $36.3 million, respectively.

· Cornerstone had total outstanding borrowings of $5.2 million from Silverton Bank as of September 30, 2008. The proceeds from the advance were used to repurchase 200 thousand shares of Cornerstone’s stock during 2007 and in 2008 provide for a $2.5 million capital injection into the Bank. This capital injection resulted in a change in the Bank’s regulatory capital classification from an adequately capitalized position to a well capitalized position. Cornerstone’s line of credit with Silverton Bank consists of an $8.5 million line of credit with an interest rate of prime minus one and a half.

Market and Liquidity Risk Management

Interest Rate Sensitivity

The Bank’s Asset Liability Management Committee (“ALCO”) is responsible for making decision regarding liquidity and funding solutions based upon approved liquidity, loan, capital and investment policies. The ALCO committee must consider interest rate sensitivity and liquidity risk management when rendering a decision on funding solutions and loan pricing. The following is a brief discussion of one of the primary tools used by the ALCO committee to perform its responsibilities:

· Gap Analysis is a technique of asset-liability management that can be used to assess interest rate risk or liquidity risk. The Bank has developed a gap analysis to assist the ALCO committee in its decision making. The analysis provides the committee information regarding the interest rate-sensitivity of the Bank. The interest rate-sensitivity is the difference between the interest-earning assets and interest-bearing liabilities scheduled to mature or reprice within a stated time period. The gap is considered positive when the amount of interest rate-sensitive assets exceeds the amount of interest rate-sensitive liabilities. Conversely, the gap is considered negative when the amount of interest rate-sensitive liabilities exceeds the amount of interest rate-sensitive assets. The gap position coupled with interest rate movements will result in either an increase or decrease in net interest income depending upon the Bank’s position and the nature of the movement.

Liquidity Risk Management

Liquidity is measured by the Bank's ability to raise cash at a reasonable cost or with a minimum of loss. These funds are used primarily to fund loans and satisfy deposit withdrawals. Several factors must be considered by management when attempting to minimize liquidity risk. Examples include changes in interest rates, competition, loan demand, and general economic conditions. Minimizing liquidity risk is a responsibility of the ALCO committee and is reviewed by the Bank’s regulatory agencies on a regular basis.

Item 3.Quantitative and Qualitative Disclosures About Market Risk

A comprehensive qualitative and quantitative analysis regarding market risk was disclosed in Cornerstone’s Form 10-K for the year ended December 31, 2007. No material changes in the assumptions used in preparing, or results obtained from, the model have occurred since December 31, 2007.

Item 4. Evaluation of Controls and Procedures

Cornerstone’s Chief Executive Officer and Treasurer have evaluated the effectiveness of Cornerstone’s disclosure controls and procedures (as such term is defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”). Based on such evaluation, such officers have concluded that, as of the Evaluation Date, Cornerstone’s disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to Cornerstone (including its consolidated subsidiaries) required to be included in Cornerstone’s periodic filings under the Exchange Act. Since the Evaluation Date, there have not been any significant changes in Cornerstone’s internal controls or in other factors that could significantly affect such controls.

22

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

There are various claims and lawsuits in which the Bank is periodically involved incidental to the Bank’s business. In the opinion of Management, no material loss is expected from any of such pending claims or lawsuits.

Item 1A. Risk Factors

Growth Strategy-Cornerstone intends to continue pursuing a growth strategy for its business through acquisitions and de novo branching. Cornerstone’s prospects must be considered in light of the risks, expenses and difficulties occasionally encountered by financial services companies in growth stages, including maintaining loan quality, maintaining adequate management personnel and information systems to oversee such growth while maintaining adequate controls and compliance functions. Failure to successfully address the growth effectively and efficiently could have a material adverse effect on Cornerstone’s business, future prospects, financial condition or results of operations and could adversely affect Cornerstone’s ability to successfully implement its business strategy.

Cornerstone may also consider and enter into new lines of business or offer new products or services. Acquisitions and mergers involve a number of risks, including;

· The time and costs associated with identifying and evaluating potential acquisitions and merger partners;

· Inaccuracies in the estimates and judgments used to evaluate credit, operations, and management and market risks with respect to the target institution;

· The time and costs of evaluating new markets, hiring experienced local management and opening new offices, and the time lags between these activities and the generation of sufficient assets and deposits to support the costs of the expansion;

· Cornerstone’s ability to finance an acquisition and possible dilution to its existing shareholders;

· The diversion of Cornerstone’s management’s attention to the negotiation of a transaction, and the integration of the operations and personnel of the combining businesses;

· Entry into new markets where Cornerstone lacks experience;

· The introduction of new products and services into Cornerstone’s business;

· The incurrence and possible impairment of goodwill associated with an acquisition and possible adverse short- term effects on Cornerstone’s results of operations; and

· The risk of loss of key employees and customers.

In the case of acquisitions or mergers, the success of integrating the separate operations depends on the ability to consolidate systems, procedures, operations and controls while eliminating redundant costs. Integration difficulties may have an adverse affect on any economic benefits Cornerstone expects to achieve.

23

Competition-Much of Cornerstone’s recent growth has been focused in the highly competitive Chattanooga metropolitan markets. We compete with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds, and other mutual funds, as well as other community banks and super-regional and national financial institutions that operate offices in Cornerstone’s primary market areas. Cornerstone’s continued expansion into this market may be impacted if it is unable to meet customer demands or compete effectively with the financial institutions operating in these markets. Cornerstone’s historical accomplishments may not be indicative of future results. There is no assurance that existing offices or future offices will maintain or achieve deposit levels, loan balances or other operating results necessary to avoid losses or produce profits.

Economic Conditions-Cornerstone’s success significantly depends upon the growth in population, income levels, deposits and housing starts in its market areas. If the communities in which Cornerstone operates do not grow or prevailing economic conditions locally or nationally are unfavorable, Cornerstone’s business may not succeed. Adverse economic conditions in Cornerstone’s specific market areas could reduce its growth rate, affect the ability of its customers to repay their loans to the Bank and generally affect its financial condition and results of operations.

In addition, the market value of the real estate securing loans as collateral could be adversely affected by unfavorable changes in market and economic conditions. Any sustained period of increased payment delinquencies, foreclosures or losses caused by adverse market or economic conditions in the state of Tennessee could adversely affect the value of Cornerstone’s assets, revenues, results of operations and financial condition.

Liquidity-Cornerstone relies on dividends from the Bank as its primary source of funds. The Bank’s primary sources of funds are customer deposits and loan repayments. While scheduled loan repayments are a relatively stable source of funds, they are subject to the ability of borrowers to repay the loans. The borrowers’ resources can be adversely affected by changes in economic conditions, adverse trends or events affecting business industry group, reductions in real estate values or markets, natural disasters or international instability. Accordingly, Cornerstone may be required from time to time to rely on secondary sources of liquidity to accommodate any funding needs. Such sources include Federal Home Loan Bank advances and federal funds lines of credit from correspondent banks. While Cornerstone believes that these sources are currently adequate, there can be no assurance they will be sufficient to meet future liquidity demands. Cornerstone may be required to slow or discontinue loan growth, capital expenditures or other investments or liquidate assets should such sources not be adequate.

Credit Risks-The risk of credit losses varies with, among other things, general economic conditions, the type of loan being made, the creditworthiness of the borrower over the term of the loan and, in the case of a collateralized loan, the value and marketability of the collateral for the loan. Management maintains an allowance for credit losses based upon historical experience and regular analysis of the ultimate collectibility of the loan portfolio. Capital could be significantly adversely affected if these assumptions and adjustments in the allowance for loan losses prove to be inadequate to absorb unforeseen losses.

Regulatory-Cornerstone’s growth and expansion plans may be adversely affected by a number of regulatory developments or events. Failure to obtain required regulatory approvals, changes in laws and regulations may prevent or adversely affect Cornerstone’s continued growth and expansion. Cornerstone operates in a highly regulated industry and is subject to examination, supervision, and comprehensive regulation by various federal and state agencies including the Board of Governors of the Federal Reserve Bank (FRB), the FDIC and the Tennessee Department of Financial Institutions. Cornerstone’s regulatory compliance is costly and restricts certain of its activities, including payment of dividends, mergers and acquisitions, investments, loans, and interest rates charged, interest rates paid on deposits and locations of offices. Cornerstone is also subject to capitalization guidelines established by its regulators, which require it to maintain adequate capital to support its growth.

Loss of Key Employees-Cornerstone depends on the strategies and management services of Gregory B. Jones, its Chairman of the Board and Chief Executive Officer. Although Cornerstone has entered into an employment agreement with him, the loss of Mr. Jones’ services could have a material adverse effect on Cornerstone’s business, results of operations and financial condition. Cornerstone is also dependent on certain other key officers who have important customer relationships or are instrumental to its daily operations. Changes in key personnel and their responsibilities may be disruptive to Cornerstone’s business and could have a material adverse effect on Cornerstone’s business, financial condition and results of operations. Cornerstone believes that its future results will also depend in part upon its attracting and retaining highly skilled and qualified management, sales and marketing personnel.

24

Interest Rate Fluctuations-Changes in interest rates may affect Cornerstone’s level of interest income, the primary component of its gross revenue, as well as the level of its interest expense. Interest rates are highly sensitive to many factors that are beyond Cornerstone’s control, including general economic conditions and the policies of various governmental and regulatory authorities. Accordingly, changes in interest rates up or down could ultimately affect Cornerstone’s earnings. Changes in the level of interest rates also may negatively affect the Bank’s ability to originate real estate loans and may lower the value of Cornerstone’s assets.

Risks of Corporate Buyout-As a Tennessee corporation, Cornerstone is subject to various legislative acts which impose restrictions on and require compliance with procedures designed to protect shareholders against unfair or coercive mergers and acquisitions. These statutes may delay or prevent offers to acquire Cornerstone and increase the difficulty of consummating any such offers, even if the acquisition of Cornerstone would be in its shareholders’ best interests.

The amount of common stock owned by, and other compensation arrangements with, Cornerstone’s officers and directors may make it more difficult to obtain shareholder approval of potential takeovers that they oppose. Also, these arrangements with Cornerstone’s senior management provide for significant payments under certain circumstances following a change in control.

Capital Adequacy and Market Fluctuations-Cornerstone is required by federal and state regulatory authorities to maintain adequate levels of capital to support its operations. While Cornerstone’s capital resources will satisfy its capital requirements for the foreseeable future, Cornerstone may at some point, however, need to raise additional capital to support its continued growth. Cornerstone’s ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time and on its financial performance. We cannot assure you of our ability to raise additional capital if needed on terms acceptable to us.

In order to maintain its capital at desired levels or required regulatory levels, or to fund future growth, Cornerstone’s board of directors may decide from time to time to issue additional shares of common stock or securities convertible into, exchangeable for or representing rights to acquire shares of its common stock. The sale of these shares may significantly dilute Cornerstone’s shareholders’ ownership interest as a shareholder and the per share book value of its common stock. New investors may also have rights, preferences and privileges senior to its current shareholders which may adversely impact its current shareholders.

Cornerstone cannot predict the effect, if any, that future sales of its common stock in the market, or availability of shares of its common stock for sale in the market, will have on the market price of Cornerstone’s common stock. The market price of Cornerstone’s common stock may fluctuate in the future, and these fluctuations may be unrelated to its performance. General market price declines or overall market volatility in the future could adversely affect the price of our common stock, and the current market price may not be indicative of future market prices. Cornerstone cannot say with any certainty when a more active and liquid trading market for its common stock will develop or be sustained. Because of this, Cornerstone’s shareholders may not be able to sell their shares at the volumes, prices, or times that they desire.

Ability to Pay Dividends-Cornerstone derives its income solely from dividends on the shares of common stock of the Bank. The Bank’s ability to declare and pay dividends is limited by its obligations to maintain sufficient capital and by other general restrictions on its dividends that are applicable to banks that are regulated by the FDIC and the Tennessee Department of Financial Institutions. In addition, the FRB may impose restrictions on Cornerstone’s ability to pay dividends on its common stock. As a result, Cornerstone cannot assure its shareholders that it will declare or pay dividends on shares of its common stock in the future.

25

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

ISSUER PURCHASES OF EQUITY SECURITIES

					(c) Total Number of Shares		(d) Maximum Number of
	(a) Total Number of		(b) Average Price		Purchased as Part of		Shares that May Yet be
Period	Shares Purchased		Paid Per Share		Publically Announced Plans		Purchased Under the Plan
Prior to 2008		153,000		11.47		150,000
Jan. 2008		50,000		10.00		50,000		-
Total		203,000		11.11		200,000

Item 3. Defaults Upon Senior Securities

None

Item 4. Submission of Matters to a Vote of Security Holders

None

Item 5. Other Information

None

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits

Exhibit Number	Description
31	Certifications under Section 302 of the Sarbanes-Oxley Act of 2002.
32	Certifications under Section 906 of the Sarbanes-Oxley Act of 2002.

(b) Reports on Form 8-K

(1)	Form 8-K dated January 23, 2008 reporting earnings results for the fiscal quarter ended December 31, 2007.
(2)	Form 8-K dated February 13, 2008 reporting a revision of unaudited earnings results for the 4th fiscal quarter and fiscal year-ending December 31, 2007.
(3)	Form 8-K dated February 29, 2008 reporting the declaration of a cash dividend.
(4)	Form 8-K dated April 18, 2008 reporting earnings results for the fiscal quarter ended March 31, 2008.
(5)	Form 8-K dated May 23, 2008 reporting the declaration of a cash dividend.
(6)	Form 8-K dated July 22, 2008 reporting earnings results for the fiscal quarter ended June 30, 2008.
(7)	Form 8-K dated August 22, 2008 reporting the declaration of a cash dividend.
(8)	Form 8-K dated October 24, 2008 reporting earnings results for the fiscal quarter ended September 30, 2008.

26

SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	Cornerstone Bancshares, Inc.
Date: November 7, 2008	/s/ Gregory B. Jones
	Gregory B. Jones,
	Chairman and Chief Executive Officer
Date: November 7, 2008	/s/ Nathaniel F. Hughes
	Nathaniel F. Hughes
	President and Treasurer

EXHIBIT INDEX

Exhibit Number	Description
3	First Amendment to Amended and Restated Charter of Cornerstone Bancshares, Inc. (1)
31	Certifications under Section 302 of the Sarbanes-Oxley Act of 2002.
32	Certifications under Section 906 of the Sarbanes-Oxley Act of 2002.

(1) Incorporated by reference from Exhibit 3 of the registrant’s Form 10-QSB filed on  May 14, 2004.

27