Penseco Financial Services (PFNS) 10-Q 2011 Q1 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended March 31, 2011

OR

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

Commission file number 000-23777

PENSECO FINANCIAL SERVICES CORPORATION

Incorporated pursuant to the laws of Pennsylvania

Internal Revenue Service — Employer Identification No. 23-2939222

150 North Washington Avenue, Scranton, Pennsylvania 18503-1848

(570) 346-7741

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for 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  ¨

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 (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     Yes  ¨    No  ¨

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

Large accelerated filer	¨	Accelerated filer	x
Non-accelerated filer	¨  (Do not check if a smaller reporting company)	Smaller reporting company	¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

The total number of shares of the registrant’s Common Stock, $0.01 par value, outstanding on May 1, 2011 was 3,276,079.

PENSECO FINANCIAL SERVICES CORPORATION

		Page
Part I — FINANCIAL INFORMATION
Item 1.	Unaudited Financial Statements - Consolidated
	Balance Sheets:
	March 31, 2011		3
	December 31, 2010		3
	Statements of Income:
	Three Months Ended March 31, 2011		4
	Three Months Ended March 31, 2010		4
	Statements of Changes in Stockholders’ Equity:
	Three Months Ended March 31, 2011		5
	Three Months Ended March 31, 2010		5
	Statements of Cash Flows:
	Three Months Ended March 31, 2011		6
	Three Months Ended March 31, 2010		6
	Notes to Unaudited Consolidated Financial Statements		7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		26
Item 3.	Quantitative and Qualitative Disclosures About Market Risk		40
Item 4.	Controls and Procedures		41
Part II — OTHER INFORMATION
Item 1.	Legal Proceedings		41
Item 1A.	Risk Factors		41
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		41
Item 3.	Defaults Upon Senior Securities		41
Item 4.	Removed and Reserved		41
Item 5.	Other Information		41
Item 6.	Exhibits		41
Signatures			42

2

PART I. FINANCIAL INFORMATION, Item 1 — Financial Statements

PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED BALANCE SHEETS

(unaudited)

(in thousands, except share and per share amounts)

	March 31,			December 31,
	2011			2010
ASSETS
Cash and due from banks	$	9,710		$	11,585
Interest bearing balances with banks		15,824			2,634
Federal funds sold		—			—
Cash and Cash Equivalents		25,534			14,219
Investment securities:
Available-for-sale, at fair value		169,844			173,297
Held-to-maturity (fair value of $40,036 and $45,218, respectively)		38,720			43,747
Total Investment Securities		208,564			217,044
Loans, net of unearned income		611,021			615,105
Less: Allowance for loan losses		6,800			6,500
Loans, Net		604,221			608,605
Bank premises and equipment		13,391			13,406
Other real estate owned		883			803
Accrued interest receivable		3,422			3,809
Goodwill		26,398			26,398
Cash surrender value of life insurance		15,500			15,380
Federal Home Loan Bank stock		5,778			6,082
Other assets		10,566			10,341
Total Assets	$	914,257		$	916,087
LIABILITIES
Deposits:
Non-interest bearing	$	113,551		$	113,391
Interest bearing		586,930			577,641
Total Deposits		700,481			691,032
Other borrowed funds:
Repurchase agreements		19,942			19,394
Short-term borrowings		508			8,688
Long-term borrowings		64,711			68,835
Accrued interest payable		1,106			1,128
Other liabilities		4,234			5,088
Total Liabilities		790,982			794,165
STOCKHOLDERS’ EQUITY
Common stock; $ .01 par value, 15,000,000 shares authorized, 3,276,079 shares issued and outstanding		33			33
Surplus		48,865			48,865
Retained earnings		75,697			74,304
Accumulated other comprehensive income		(1,320	)		(1,280	)
Total Stockholders’ Equity		123,275			121,922
Total Liabilities and Stockholders’ Equity	$	914,257		$	916,087

(See accompanying Notes to Unaudited Consolidated Financial Statements)

3

PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED STATEMENTS OF INCOME

(unaudited)

(in thousands, except share and per share amounts)

	Three Months Ended March 31, 2011		Three Months Ended March 31, 2010
INTEREST INCOME
Interest and fees on loans	$	8,342	$	8,686
Interest and dividends on investments:
U.S. Treasury securities and U.S. Agency obligations		815		719
States & political subdivisions		867		1,139
Other securities		14		11
Interest on Federal funds sold		—		—
Interest on balances with banks		2		2
Total Interest Income		10,040		10,557
INTEREST EXPENSE
Interest on time deposits of $100,000 or more		370		433
Interest on other deposits		892		974
Interest on other borrowed funds		635		699
Total Interest Expense		1,897		2,106
Net Interest Income		8,143		8,451
Provision for loan losses		369		328
Net Interest Income After Provision for Loan Losses		7,774		8,123
NON-INTEREST INCOME
Trust department income		398		380
Service charges on deposit accounts		472		532
Merchant transaction income		1,242		1,194
Brokerage fee income		56		70
Other fee income		378		350
Bank-owned life insurance income		120		122
Other operating income		630		61
Realized gains (losses) on securities, net		8		2
Total Non-Interest Income		3,304		2,711
NON-INTEREST EXPENSES
Salaries and employee benefits		3,525		3,173
Expense of premises and fixed assets		1,021		950
Merchant transaction expenses		833		811
FDIC insurance assessments		242		266
Other operating expenses		1,829		1,837
Total Non-Interest Expenses		7,450		7,037
Income before income taxes		3,628		3,797
Applicable income taxes		859		816
Net Income	$	2,769	$	2,981
Earnings per Common Share
(Based on weighted average shares outstanding of 3,276,079)	$	0.85	$	0.91
Cash Dividends Declared Per Common Share	$	0.42	$	0.42

(See accompanying Notes to Unaudited Consolidated Financial Statements)

4

PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

THREE MONTHS ENDED MARCH 31, 2011 AND 2010

(unaudited)

(in thousands, except per share amounts)

	Common Stock		Surplus		Retained Earnings			Accumulated Other Comprehensive Income			Total Stockholders’ Equity
Balance, December 31, 2009	$	33	$	48,865	$	68,086		$	413		$	117,397
Comprehensive income:
Net income		—		—		2,981			—			2,981
Other comprehensive income, net of tax
Unrealized gains on securities, net of reclassification adjustment		—		—		—			90			90
Other comprehensive income									90			90
Comprehensive income												3,071
Cash dividends declared ($0.42 per share)		—		—		(1,376	)		—			(1,376	)
Balance, March 31, 2010	$	33	$	48,865	$	69,691		$	503		$	119,092
Balance, December 31, 2010	$	33	$	48,865	$	74,304		$	(1,280	)	$	121,922
Comprehensive income:
Net income		—		—		2,769			—			2,769
Other comprehensive income, net of tax
Unrealized losses on securities, net of reclassification adjustment		—		—		—			(40	)		(40	)
Other comprehensive income									(40	)		(40	)
Comprehensive income												2,729
Cash dividends declared ($0.42 per share)		—		—		(1,376	)		—			(1,376	)
Balance, March 31, 2011	$	33	$	48,865	$	75,697		$	(1,320	)	$	123,275

(See accompanying Notes to Unaudited Consolidated Financial Statements)

5

PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

(in thousands)

	Three Months Ended			Three Months Ended
	March 31, 2011			March 31, 2010
OPERATING ACTIVITIES
Net Income	$	2,769		$	2,981
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		283			266
Provision for loan losses		369			328
Deferred income tax provision (benefit)		72			94
Amortization of securities, (net of accretion)		121			130
Net realized (gains) losses on securities		(8	)		(2	)
Loss (gain) on other real estate		—			13
Decrease (increase) in interest receivable		387			450
(Increase) decrease in cash surrender value of life insurance		(120	)		(134	)
(Increase) decrease in other assets		(297	)		(1,107	)
Increase (decrease) in income taxes payable		859			816
(Decrease) increase in interest payable		(22	)		(17	)
(Decrease) increase in other liabilities		(1,341	)		(907	)
Net cash provided (used) by operating activities		3,072			2,911
INVESTING ACTIVITIES
Purchase of investment securities available-for-sale		(5,255	)		(3,122	)
Purchase of investment securities to be held-to-maturity		—			—
Proceeds from sales and maturities of investment securities available-for-sale		7,541			3,102
Proceeds from sales and maturities of investment securities held-to-maturity		2,895			—
Proceeds from repayments of investment securities available-for-sale		1,015			649
Proceeds from repayments of investment securities held-to-maturity		2,109			3,621
Net loans repaid (originated)		3,889			(1,554	)
Proceeds from other real estate		—			33
Investment in premises and equipment		(268	)		(571	)
Net cash received (paid) in merger		—			—
Net cash provided (used) by investing activities		11,926			2,158
FINANCING ACTIVITIES
Net increase (decrease) in demand and savings deposits		9,376			(2,991	)
Net proceeds (payments) on time deposits		73			6,084
Increase (decrease) in repurchase agreements		548			1,027
Net (decrease) increase in short-term borrowings		(8,180	)		(1,442	)
Increase in long-term borrowings		—			—
Payments on long-term borrowings		(4,124	)		(4,803	)
Cash dividends paid		(1,376	)		(1,376	)
Net cash (used) provided by financing activities		(3,683	)		(3,501	)
Net increase (decrease) in cash and cash equivalents		11,315			1,568
Cash and cash equivalents at January 1		14,219			13,374
Cash and cash equivalents at March 31	$	25,534		$	14,942

The Company paid interest and income taxes of $1,919 and $200 and $2,123 and $0

for the three months ended March 31, 2011 and 2010, respectively.

(See accompanying Notes to Unaudited Consolidated Financial Statements)

6

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

For the Quarter Ended March 31, 2011

(unaudited)

These Notes to Unaudited Consolidated Financial Statements reflect events subsequent to December 31, 2010, the date of the most recent Report of Independent Registered Public Accounting Firm, through the date of this Quarterly Report on Form 10-Q. These Notes to Unaudited Consolidated Financial Statements should be read in conjunction with Parts I and II of this Report and the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, which was filed with the Securities and Exchange Commission (SEC) on March 14, 2011.

FORWARD LOOKING INFORMATION

This Quarterly Report on Form 10-Q contains forward-looking statements that are based on assumptions and may describe future plans, strategies and expectations of Penseco Financial Services Corporation. These forward-looking statements are generally identified by use of the words “believe,” “expect,” “intend,” “anticipate,” “estimate,” “project” or similar expressions. Penseco Financial Services Corporation’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations of Penseco Financial Services Corporation and its subsidiary include, but are not limited to, changes in interest rates, national and regional economic conditions, legislative and regulatory changes, monetary and fiscal policies of the U.S. government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality and composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in Penseco Financial Services Corporation’s market area, changes in real estate market values in Penseco Financial Services Corporation’s market area, changes in relevant accounting principles and guidelines and inability of third party service providers to perform. Additional factors that may affect our results are discussed in Part II, Item 1A to this Quarterly Report on Form 10-Q titled “Risk Factors”.

These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Except as required by applicable law or regulation, Penseco Financial Services Corporation does not undertake, and specifically disclaims any obligation, to release publicly the result of any revisions that may be made to any forward-looking statements to reflect events or circumstances after the date of the statements or to reflect the occurrence of anticipated or unanticipated events.

Unless the context indicates otherwise, all references in this Quarterly Report to “Company,” “we,” “us” and “our” refer to Penseco Financial Services Corporation and its direct and indirect subsidiaries.

NOTE 1 — Principles of Consolidation

Penseco Financial Services Corporation is a financial holding company incorporated under the laws of Pennsylvania. It is the parent company of Penn Security Bank and Trust Company (Bank), a Pennsylvania state chartered bank.

The Financial Statements of the Company have been consolidated with those of its wholly-owned subsidiary, Penn Security Bank and Trust Company, eliminating all intercompany items and transactions.

The accounting policies of the Company conform with accounting principles generally accepted in the United States of America (GAAP) and with general practices within the banking industry.

On April 1, 2009, the Company completed its acquisition of Old Forge Bank (the “Merger”) in a cash and stock transaction valued at approximately $55.5 million. The Merger was accounted for using the acquisition method of accounting and, accordingly, the assets and liabilities of Old Forge Bank have been recorded at their respective fair values on the date the Merger was completed.

NOTE 2 — Basis of Presentation

The unaudited consolidated financial statements have been prepared in accordance with the instructions to SEC Form 10-Q and GAAP for interim financial information. In the opinion of management, all adjustments that are of a normal recurring nature and are considered necessary for a fair presentation have been included. They are not, however, necessarily indicative of the results of consolidated operations for a full year or any other period.

All information is presented in thousands of dollars, except share and per share amounts.

7

For further information, refer to the consolidated financial statements and accompanying notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

NOTE 3 — Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements 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 relate to the determination of the allowance for loan losses and the valuation of other real estate owned acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the allowances for loan losses and other real estate owned, management obtains independent appraisals for significant properties.

NOTE 4 — Reclassifications

Certain prior year amounts have been reclassified to conform to the current year presentation.

NOTE 5 — Investment Securities

Investments in securities are classified in two categories and accounted for as follows:

Securities Held-to-Maturity Bonds, notes, debentures and mortgage-backed securities for which the Company has the positive intent and ability to hold to maturity are reported at cost, adjusted for amortization of premiums and accretion of discounts computed on the straight-line basis, which approximates the interest method, over the remaining period to maturity.

Securities Available-for-Sale Bonds, notes, debentures, mortgage-backed securities and certain equity securities not classified as securities to be held to maturity are carried at fair value with unrealized holding gains and losses, net of tax, reported as a net amount in a separate component of stockholders’ equity until realized.

The amortization of premiums on mortgage-backed securities is done based on management’s estimate of the lives of the securities, adjusted, when necessary, for advanced prepayments in excess of those estimates.

Realized gains and losses on the sale of securities available-for-sale are determined using the specific identification method and are reported as a separate component of other income in the Statements of Income. Unrealized gains and losses are included as a separate item in computing comprehensive income.

Investments are evaluated periodically to determine whether a decline in their value is other than temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other than temporary. The term “other than temporary” is not intended to indicate that the decline is permanent. It indicates that the prospects for a near term recovery of value are not necessarily favorable, or that there is a lack of evidence to support fair values equal to, or greater than, the carrying value of the investment. Once a decline in value is determined to be other than temporary, the value of the security is reduced and a corresponding charge to earnings is recognized.

The amortized cost and fair value of investment securities at March 31, 2011 and December 31, 2010 are as follows:

Available-for-Sale
			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
March 31, 2011	Cost		Gains		Losses		Value
U.S. Agency securities	$	76,409	$	469	$	451	$	76,427
Mortgage-backed securities		24,657		660		85		25,232
States & political subdivisions		62,355		1,039		585		62,809
Corporate securities		4,057		14		—		4,071
Total Debt Securities		167,478		2,182		1,121		168,539
Equity securities		760		586		41		1,305
Total Available-for-Sale	$	168,238	$	2,768	$	1,162	$	169,844

8

Available-for-Sale

December 31, 2010	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
U.S. Agency securities	$	78,993	$	620	$	319	$	79,294
Mortgage-backed securities		25,686		709		25		26,370
States & political subdivisions		62,381		839		662		62,558
Corporate securities		4,077		13		—		4,090
Total Debt Securities		171,137		2,181		1,006		172,312
Equity securities		494		540		49		985
Total Available-for-Sale	$	171,631	$	2,721	$	1,055	$	173,297
Held-to-Maturity
March 31, 2011	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Mortgage-backed securities	$	26,741	$	1,153	$	80	$	27,814
States & political subdivisions		11,979		243		—		12,222
Total Held-to-Maturity	$	38,720	$	1,396	$	80	$	40,036
Held-to-Maturity
December 31, 2010	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Mortgage-backed securities	$	28,877	$	1,161	$	24	$	30,014
States & political subdivisions		14,870		334		—		15,204
Total Held-to-Maturity	$	43,747	$	1,495	$	24	$	45,218

Equity securities at March 31, 2011 and December 31, 2010 consisted primarily of other financial institutions’ stock.

The amortized cost and fair value of debt securities at March 31, 2011 by contractual maturity are shown in the following table. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

March 31, 2011	Available-for-Sale				Held-to-Maturity
	Amortized		Fair		Amortized		Fair
	Cost		Value		Cost		Value
Due in one year or less:
U.S. Agency securities	$	16,165	$	16,296	$	—	$	—
Corporate securities		4,057		4,071		—		—
After one year through five years:
U.S. Agency securities		60,244		60,131		—		—
States & political subdivisions		65		70		—		—
Corporate securities		—		—		—		—
After five years through ten years:
States & political subdivisions		3,561		3,687		6,628		6,780
After ten years:
States & political subdivisions		58,729		59,052		5,351		5,442
Subtotal		142,821		143,307		11,979		12,222
Mortgage-backed securities		24,657		25,232		26,741		27,814
Total Debt Securities	$	167,478	$	168,539	$	38,720	$	40,036

9

The gross fair value and unrealized losses of the Company’s investments aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at March 31, 2011 and December 31, 2010 are as follows:

	Less than twelve months				Twelve months or more				Totals
March 31, 2011	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
U.S. Agency securities	$	33,514	$	451	$	—	$	—	$	33,514	$	451
Mortgage-backed securities		24,657		165		—		—		24,657		165
States & political subdivisions		20,595		501		716		84		21,311		585
Equities		149		2		311		39		460		41
Total	$	78,915	$	1,119	$	1,027	$	123	$	79,942	$	1,242
	Less than twelve months				Twelve months or more				Totals
December 31, 2010	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
U.S. Agency securities	$	28,662	$	319	$	—	$	—	$	28,662	$	319
Mortgage-backed securities		25,554		49		—		—		25,554		49
States & political subdivisions		23,627		582		721		80		24,348		662
Equities		186		49		—		—		186		49
Total	$	78,029	$	999	$	721	$	80	$	78,750	$	1,079

The table at March 31, 2011, includes forty-one (41) securities that have unrealized losses for less than twelve months and nine (9) securities that have been in an unrealized loss position for twelve or more months. The table at December 31, 2010, includes fifty-one (51) securities that have unrealized losses for less than twelve months and two (2) securities that have been in an unrealized loss position for twelve or more months.

U.S. Agency Securities

The unrealized losses on the Company’s investments in U.S. Agency securities were caused by interest rate fluctuations. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the par value of the investment. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at March 31, 2011.

Mortgage-backed Securities

The unrealized losses on the Company’s investments in mortgage-backed securities were caused by interest rate fluctuations. The contractual cash flows of these investments are guaranteed by an agency of the U.S. Government. Accordingly, it is expected that these securities would not be settled at a price less than the amortized cost of the Company’s investment. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at March 31, 2011.

States and Political Subdivisions

The unrealized losses on the Company’s investments in states and political subdivisions were caused by interest rate fluctuations and not credit quality. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the par value of the investment. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at March 31, 2011.

10

Marketable Equity Securities

The unrealized losses on the Company’s investments in marketable equity securities were caused primarily by interest rate fluctuations and other market conditions. The Company’s investments in marketable equity securities consist primarily of investments in common stock of companies in the financial services industry. The Company has analyzed its equity portfolio and determined that the market value fluctuation in these equity securities is consistent with the broader market and not a cause for recognition of a current loss. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their cost bases, the Company does not consider those investments to be other-than-temporarily impaired at March 31, 2011.

NOTE 6 — Loan Portfolio

Details regarding the Company’s loan portfolio during the periods indicated are as follows:

As of:	March 31, 2011		December 31, 2010
Loans secured by real estate:
Construction and land development
Residential real estate	$	8,122	$	7,799
Commercial real estate		21,662		28,345
Secured by 1-4 family residential properties:
Revolving, open-end loans		32,701		33,102
Secured by first liens		226,383		225,105
Secured by junior liens		21,312		21,233
Secured by multi-family properties		9,823		8,062
Secured by non-farm, non-residential properties		170,976		179,619
Commercial and industrial loans to U.S. addressees		38,969		36,190
Loans to individuals for household, family and other personal expenditures:
Credit card and related plans		3,159		3,327
Other (installment and student loans, etc.)		50,935		52,536
Obligations of states & political subdivisions		16,882		9,882
All other loans		10,098		9,906
Gross Loans		611,022		615,106
Less: Unearned income on loans		1		1
Loans, net of unearned income	$	611,021	$	615,105

The Company has not engaged in any sub-prime residential mortgage lending. Therefore, the Company is not subject to any credit risks associated with such loans. The Company’s loan portfolio consists primarily of residential and commercial mortgage loans secured by properties located in Northeastern Pennsylvania and subject to conservative underwriting standards.

11

Age Analysis of Past Due Loans

As of March 31, 2011

	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Loans		Recorded Investment > 90 Days and Accruing
Commercial	$	49	$	86	$	1,154	$	1,289	$	64,660	$	65,949	$	—
Commercial real estate:
Commercial real estate construction		—		—	$	1,040		1,040		20,622		21,662		—
Commercial real estate - other		634		—	$	280		914		170,062		170,976		85
Consumer:
Consumer - credit card		12		13	$	26		51		3,108		3,159		26
Consumer - other		15		5	$	—		20		8,690		8,710		—
Consumer - auto		125		18	$	40		183		28,871		29,054		34
Student loans - TERI		109		33	$	61		203		6,090		6,293		—
Student loans - other		260		56	$	60		376		6,501		6,877		60
Residential:
Residential - prime		3,790		48	$	3,380		7,218		291,123		298,341		903
Total	$	4,994	$	259	$	6,041	$	11,294	$	599,727	$	611,021	$	1,108

Credit Quality Indicators. As part of the on-going monitoring of the credit quality of the Company’s loan portfolio, management tracks certain credit quality indicators including trends related to (i) loan delinquency, (ii) the level of classified commercial loans, (iii) net charge-offs, (iv) non-performing loans (see details above) and (v) the general economic conditions in the Company’s market area.

The Company utilizes a risk grading matrix to assign a risk grade to each of its commercial loans. Loans are graded on a scale of 1 to 8. A description of the general characteristics of the 8 risk grades is as follows:

Pass 1 (Minimal Risk)

This classification includes loans which are fully secured by liquid collateral or loans to very high quality borrowers who demonstrate exceptional credit fundamentals, including stable and predictable profit margins and cash flows, strong liquidity, a conservative balance sheet, superior asset quality and good management with an excellent track record.

Pass 2 (Average Risk)

This classification includes loans which have no identifiable risk of collection and conform in all aspects to the Bank’s policies and procedures as well as federal and state regulations. Documentation exceptions are minimal and in the process of correction and not of a type that could subsequently introduce loan loss risk.

Pass 3 (Acceptable Risk)

This classification includes loans to borrowers of acceptable credit quality and risk. Such borrowers are differentiated from Pass 2 in terms of secondary sources of repayment or they are of lesser stature in other key credit metrics in that they may be over-leveraged, under capitalized, inconsistent in performance or in an industry that is known to have a higher level of risk, volatility, or susceptibility to weaknesses in the economy.

Pass 4 (Watch List)

This classification is intended to be utilized on a temporary basis for pass grade borrowers where a significant risk-modifying action is anticipated in the near term. It is assigned to loans where, for example, the financial condition of the company has taken a negative turn and may be temporarily strained; borrowers may exhibit excessive growth, declining earnings, strained cash flow, increasing leverage and/or weakening market position that indicate above average risk. Interim losses and/or adverse trends may occur, but not to the level that would affect the Bank’s position and cash flow may be weak but minimally acceptable.

12

Criticized 5 (Other Assets Especially Mentioned)

This classification is also intended to be temporary and includes loans to borrowers whose credit quality has clearly deteriorated and are at risk of further decline unless active measures are taken to correct the situation.

Classified 6 (Substandard)

This classification includes loans with well-defined weaknesses which are inadequately protected by current net worth, repayment capacity or pledged collateral of the borrower. Loans are substandard when they have one or more weaknesses that could jeopardize debt repayment and/or liquidation, primarily resulting in the possibility that the Bank may sustain some loss if the deficiencies are not corrected.

Classified 7 (Doubtful)

This classification includes loans that have all weaknesses inherent in the substandard category and where collection or liquidation in full is highly improbable. The possibility of loss is high, but because of certain important and reasonably specific pending factors, its classification as an estimated loss is deferred until its more exact status may be determined.

Classified 8 (Loss)

This classification includes loans considered uncollectible and of such little value that continuance as bankable assets is not warranted and, therefore, should be charged-off. This classification does not mean that the loans have absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off these assets even though partial recovery may be affected in the future.

Credit Quality Indicators as of March 31, 2011

Corporate Credit Exposure

Credit Risk Profile by Credit Worthiness Category

	Commercial		Commercial Real Estate Construction		Commercial Real Estate - Other
Pass / Watch	$	63,704	$	19,201	$	148,356
Criticized		781		1,412		13,665
Substandard		1,464		1,049		8,955
Total	$	65,949	$	21,662	$	170,976

Consumer Credit Exposure

Credit Risk Profile by Payment Activity

	Residential - Real Estate
Performing	$	294,961
Non Performing		3,380
Total	$	298,341

Credit Risk Profile by Payment Activity

	Consumer - Credit Card		Consumer - Other		Consumer - Auto		Student Loans - TERI		Student Loans - Other
Performing	$	3,133	$	8,710	$	29,014	$	6,232	$	6,817
Nonperforming		26		—		40		61		60
Total	$	3,159	$	8,710	$	29,054	$	6,293	$	6,877

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Impaired Loans. Loans are considered impaired when, based on current information and events, it is probable the Company will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. Impairment is evaluated in total for smaller-balance loans of a similar nature and on an individual loan basis for other loans. If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. 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.

Impaired Loans

For the Period Ended March 31, 2011

	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:
Commercial Real Estate	$	195	$	195	$	—	$	195	$	—
Commercial		—		—		—		—		—
Consumer - TERI		61		61		—		61		—
Consumer - other		—		—		—		—		—
Consumer - auto		6		6		—		6		—
Residential - Real Estate		269		269		—		369		—
With an allowance recorded:
Commercial real estate construction		1,040		1,040		200		1,040		—
Commercial real estate - other		—		—		—		—		—
Commercial		1,617		1,617		932		1,398		4
Residential Real Estate		2,208		2,208		294		1,800		—
Total:	$	5,396	$	5,396	$	1,426	$	4,869	$	4
Commercial Real Estate	$	1,235	$	1,235	$	200	$	1,235	$	—
Commercial	$	1,617	$	1,617	$	932	$	1,398	$	4
Consumer	$	67	$	67	$	—	$	67	$	—
Residential Real Estate	$	2,477	$	2,477	$	294	$	2,169	$	—

Non-Accrual and Past Due Loans. Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on non-accrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. Loans may be placed on non-accrual status regardless of whether or not such loans are considered past due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal due. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured with the minimum of a six month positive payment history.

14

Period-end non-accrual loans, segregated by class of loans, is as follows:

March 31,	2011
Commercial	$	1,154
Commercial real estate:
Commercial real estate construction		1,040
Commercial real estate - other		195
Consumer:
Student loans - TERI		61
Student loans - other		—
Consumer - other		—
Consumer - auto		6
Residential:
Residential real estate		2,477
Total	$	4,933

The Allowance for Credit Losses and Recorded Investment in Loans for the period ended March 31, 2011 is as follows:

	Commercial		Commercial Real Estate		Consumer			Residential			Credit Card			Unallocated		Total
Allowance for credit losses:
Beginning balance 12/31/10	$	1,957	$	2,067	$	1,380		$	753		$	343		$	—	$	6,500
Charge-offs		—		—		(34	)		(61	)		(20	)		—		(115	)
Recoveries		—		1		26			18			1			—		46
Provision		90		94		72			78			35			—		369
Ending balance 03/31/11	$	2,047	$	2,162	$	1,444		$	788		$	359		$	—	$	6,800
Ending balance: Individually evaluated for impairment		932		200		—			294			—					1,426
Ending balance: Collectively evaluated for impairment	$	1,115	$	1,962	$	1,444		$	494		$	359		$	—	$	5,374
Ending balance: Loans acquired with deteriorated credit quality	$	—	$	—	$	—		$	—		$	—		$	—	$	—
Loans:
Ending balance	$	65,949	$	192,638	$	50,934		$	298,341		$	3,159		$	—	$	611,021
Ending balance: Individually evaluated for impairment		1,617		1,235		67			2,477			—			—		5,396
Ending balance: Collectively evaluated for impairment	$	64,332	$	191,403	$	50,867		$	295,864		$	3,159		$	—	$	605,625
Ending balance: Loans acquired with deteriorated credit quality	$	—	$	—	$	—		$	—		$	—		$	—	$	—

NOTE 7 — Loan Servicing

The Company generally retains the right to service mortgage loans sold to third parties. The cost allocated to the mortgage servicing rights retained has been recognized as a separate asset and is amortized in proportion to and over the period of estimated net servicing income.

Mortgage servicing rights are evaluated for impairment based on the fair value of those rights. Fair values are estimated using discounted cash flows based on current market rates of interest and expected future prepayment rates. For purposes of measuring impairment, the rights must be stratified by one or more predominant risk characteristics of the underlying loans. The Company stratifies its capitalized mortgage servicing rights based on the product type, interest rate and term of the underlying loans. The amount of impairment recognized is the amount, if any, by which the amortized cost of the rights for each stratum exceed the fair value.

15

NOTE 8 — Goodwill

Goodwill represents the excess of the purchase price over the underlying fair value of merged entities. Goodwill is assessed for impairment at least annually and as triggering events occur. In making this assessment, management considers a number of factors including, but not limited to, operating results, business plans, economic projections, anticipated future cash flows, and current market data. There are inherent uncertainties related to these factors and management’s judgment in applying them to the analysis of Goodwill impairment. Changes in economic and operating conditions, as well as other factors, could result in Goodwill impairment in future periods.

NOTE 9 — Other Intangible Assets

Intangible assets include the premium assigned to the core deposit relationships acquired in the Merger. The core deposit intangible is being amortized over ten years on a sum-of-the-years-digits basis. Amortization expense is expected to be as follows:

March 31,
2012	$	295
2013		258
2014		221
2015		184
2016		148
2017 and thereafter		221
	$	1,327

NOTE 10 — Long-Term Debt

The loans from the Federal Home Loan Bank of Pittsburgh are secured by a general collateral pledge of the Company’s assets. The Company has agreed to maintain sufficient qualifying collateral to fully secure the borrowings below.

A summary of long-term debt, including amortizing principal and interest payments, at March 31, 2011 is as follows:

Monthly Installment	Fixed Rate			Maturity Date		Balance
Amortizing loans
$    29		1.84	%		08/28/12	$	479
90		3.10	%		02/28/13		2,009
430		3.74	%		03/13/13		9,930
18		2.66	%		08/28/14		697
67		3.44	%		03/02/15		2,945
13		3.48	%		03/31/15		601
10		3.83	%		04/02/18		747
186		4.69	%		03/13/23		20,503
Total amortizing							37,911
Non-amortizing loans
		3.27	%		02/29/12		2,000
		3.49	%		02/28/13		7,000
		2.89	%		11/28/14		2,000
		2.58	%		05/18/15		6,300
		3.32	%		11/27/15		3,000
		2.36	%		09/22/17		6,500
Total non-amortizing							26,800
Total long-term debt						$	64,711

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Aggregate maturities of long-term debt at March 31, 2011 are as follows:

March 31,	Principal
2012	$	10,695
2013		15,729
2014		2,659
2015		4,577
2016		10,981
Thereafter		20,070
	$	64,711

NOTE 11 — Employee Benefit Plans

The Company provides, among other benefits, a defined benefit pension plan, currently under curtailment, a 401(k) profit sharing plan for all eligible employees, a post-retirement benefit plan for eligible employees and a Long-Term Incentive Plan.

The components of the net periodic benefit cost are as follows:

	Pension Benefits						Other Benefits
Three months ended March 31,	2011			2010			2011		2010
Service cost	$	—		$	—		$	2	$	1
Interest cost		175			178			6		5
Expected return on plan assets		(226	)		(220	)		—		—
Amortization of prior service cost		—			—			2		2
Amortization of net loss (gain)		21			15			—		—
Net periodic pension cost	$	(30	)	$	(27	)	$	10	$	8

The Company previously disclosed in its financial statements for the year ended December 31, 2010 that it did not expect to contribute to its pension plan but expected to contribute $40 to its post-retirement plan during 2011. Readers should refer to the Company’s Annual Report on Form 10-K for 2010 for further details on the Company’s defined benefit pension plan.

The Company sponsors a 401(k) profit sharing plan for all eligible employees. The Company’s profit sharing expense for the three months ended March 31, 2011 and 2010 was $108 and $132 respectively.

The Company granted restricted stock awards during the three months ended March 31, 2011 valued at $56. There were no awards during the three months ended March 31, 2010.

NOTE 12 — Regulatory Matters

The Company and the Bank are subject to various regulatory capital requirements administered by the 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 effect on the Company and the Bank’s Consolidated Financial Statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Company and the Bank’s capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the Capital Adequacy table on the following page) of Tier 1 and Total Capital to risk-weighted assets and of Tier 1 Capital to average assets (Leverage ratio). The table also presents the Company’s actual capital amounts and ratios. Management believes, as of March 31, 2011, that the Company and the Bank meet all capital adequacy requirements to which they are subject.

17

As of June 30, 2010, the most recent regulatory notifications categorized the Bank as “well capitalized” under the regulatory framework for prompt corrective action. To be categorized as “well capitalized”, the Bank must maintain minimum Tier 1 Capital, Total Capital and Leverage ratios as set forth in the Capital Adequacy table. There are no conditions or events since that notification that management believes have changed the Company’s categorization by the FDIC.

The Company and Bank are also subject to minimum capital levels, which could limit the payment of dividends, although the Company and Bank currently have capital levels which are in excess of minimum capital level ratios required.

The Pennsylvania Banking Code restricts capital funds available for payment of dividends to the retained earnings of the Bank. The balances in the capital stock and surplus accounts are unavailable for dividends.

In addition, the Bank is subject to restrictions imposed by Federal law on certain transactions with the Company’s affiliates. These transactions include extensions of credit, purchases of or investments in stock issued by the affiliate, purchases of assets subject to certain exceptions, acceptance of securities issued by an affiliate as collateral for loans, and the issuance of guarantees, acceptances, and letters of credit on behalf of affiliates. These restrictions prevent the Company’s affiliates from borrowing from the Bank unless the loans are secured by obligations of designated amounts. Further, the aggregate of such transactions by the Bank with a single affiliate is limited in amount to 10 percent of the Bank’s Capital Stock and Surplus, and the aggregate of such transactions with all affiliates is limited to 20 percent of the Bank’s capital stock and surplus. The Federal Reserve System has interpreted “capital stock and surplus” to include undivided profits.

Actual							Regulatory Requirements
							For Capital Adequacy Purposes								To Be “Well Capitalized”
As of March 31, 2011	Amount		Ratio				Amount				Ratio				Amount			Ratio
Total Capital (to Risk Weighted Assets)
PFSC (Company)	$	100,691		16.88	%	>	$	47,726		>		8.0	%	>		N/A	>		N/A
PSB (Bank)	$	96,985		16.28	%	>	$	47,674		>		8.0	%	>	$	59,592	>		10.0	%
Tier 1 Capital (to Risk Weighted Assets)
PFSC (Company)	$	93,645		15.70	%	>	$	23,863		>		4.0	%	>		N/A	>		N/A
PSB (Bank)	$	90,185		15.13	%	>	$	23,837		>		4.0	%	>	$	35,755	>		6.0	%
Tier 1 Capital (to Average Assets)
PFSC (Company)	$	93,645		10.59	%	>	$		*	>		*		>		N/A	>		N/A
PSB (Bank)	$	90,185		10.25	%	>	$		*	>		*		>	$	43,974	>		5.0	%

PFSC - *3.0% ($26,517), 4.0% ($35,356) or 5.0% ($44,195) depending on the bank’s CAMELS Rating and other regulatory risk factors.

PSB - *3.0% ($26,384), 4.0% ($35,179) or 5.0% ($43,974) depending on the bank’s CAMELS Rating and other regulatory risk factors.

18

Actual							Regulatory Requirements
							For Capital Adequacy Purposes							To Be “Well Capitalized”
As of December 31, 2010	Amount		Ratio				Amount			Ratio				Amount			Ratio
Total Capital (to Risk Weighted Assets)
PFSC (Company)	$	98,220		16.42	%	>	$	47,852	>		8.0	%	>		N/A	>		N/A
PSB (Bank)	$	94,455		15.81	%	>	$	47,808	>		8.0	%	>	$	59,760	>		10.0	%
Tier 1 Capital (to Risk Weighted Assets)
PFSC (Company)	$	91,499		15.30	%	>	$	23,926	>		4.0	%	>		N/A	>		N/A
PSB (Bank)	$	87,955		14.72	%	>	$	23,904	>		4.0	%	>	$	35,856	>		6.0	%
Tier 1 Capital (to Average Assets)
PFSC (Company)	$	91,499		10.68	%	>	$	*	>		*		>		N/A	>		N/A
PSB (Bank)	$	87,955		10.32	%	>	$	*	>		*		>	$	42,607	>		5.0	%

PFSC - *3.0% ($25,696), 4.0% ($34,261) or 5.0% ($42,826) depending on the bank’s CAMELS Rating and other regulatory risk factors.

PSB - *3.0% ($25,564), 4.0% ($34,086) or 5.0% ($42,607) depending on the bank’s CAMELS Rating and other regulatory risk factors.

NOTE 13 — Merger

An Agreement and Plan of Merger (the “Agreement”) by and between the Company, the Bank and Old Forge Bank, was entered into on December 5, 2008. The Agreement provided for, among other things, the Company to acquire 100% of the outstanding common shares of Old Forge Bank through a two-step merger transaction. The Company consummated the acquisition of Old Forge Bank on April 1, 2009, at which time Old Forge Bank was merged with and into the Bank. Following the Merger, the Bank continues to operate as a banking subsidiary of the Company.

There was approximately $26.4 million of goodwill created in the Merger, largely based on the Company’s evaluation of the business growth opportunities inherent in the Old Forge Bank customer base, as well as operating synergies and economy of scale resulting from the Merger. None of the goodwill is expected to be deductible for income tax purposes.

The table below illustrates the fair value adjustments made to the amortized cost basis in order to present the fair value of the loans acquired.

Gross amortized cost basis at April 1, 2009	$	166,348
Market rate adjustment		640
Credit fair value adjustment in pools of homogeneous loans		(5,648	)
Credit fair value adjustment on distressed loans		(1,391	)
Fair value of purchased loans at April 1, 2009	$	159,949

In connection with its acquisition of Old Forge Bank, the Company acquired loans with evidence of credit deterioration that have been accounted for under ASC 310-30. As part of the Company’s acquisition of Old Forge Bank, the acquired loan portfolio of Old Forge Bank was evaluated based on risk characteristics and other credit and market criteria to determine a credit adjustment to the fair value of the loans acquired. The acquired loan balance was reduced by the aggregate amount of the credit fair value adjustment for both homogeneous pools and specific loans in determining the fair value of the loans. The credit fair value adjustment accounted for acquired loans deemed to require a specific allocation in accordance with Accounting Standard Codification 310-30-30, previously known as Statement of Position (SOP) 03-3, “Accounting for Certain Loans Acquired in a Transfer.” These loans are accounted for in the credit fair value adjustment considering the portion of the loan balance that has been deemed uncollectible based on management’s expectations of future cash flows for each respective loan. Based on management’s evaluation of the acquired loan portfolio of Old Forge Bank, six loans with a carrying value of $2,151 exhibited credit quality deterioration resulting in a credit fair value adjustment of $1,391. As of March 31, 2011, there were a total of two loans remaining with a carrying value of $228 with a credit fair value adjustment of $228. As of December 31, 2010, there were a total of two loans remaining with a carrying value of $229 with a credit fair value adjustment of $229. As of March 31, 2010, there were a total of four loans remaining with a carrying value of $1,936 with a credit fair value adjustment of $1,305. There is no accretable yield for the specific loans accounted for under Accounting Standard Codification 310-30-30. There were no significant prepayment estimates by Management in the determination of contractual cash flows and cash flows expected to be collected.

19

Changes in the credit fair value adjustment on specific loans purchased are as follows:

Three Months Ended March 31, 2011
	Carrying Value			Credit Fair Value Adjustment			Net Amount
Balance, December 31, 2010
Residential Mortgages	$	—		$	—		$	—
Commercial		229			229			—
Consumer / Other		—			—			—
		229			229			—
Charge-offs
Residential Mortgages		—			—			—
Commercial		—			—			—
Consumer / Other		—			—			—
Total Charge-offs		—			—			—
Loans transferred to other real estate owned
Residential Mortgages		—			—			—
Commercial		—			—			—
Consumer / Other		—			—			—
Total loans transferred to other real estate owned		—			—			—
Payments
Residential Mortgages		—			—			—
Commercial		(1	)		(1	)		—
Consumer / Other		—			—			—
Total Payments		(1	)		(1	)		—
								��
Balance, March 31, 2011	$	228		$	228		$	—

Three Months Ended March 31, 2010
	Carrying Value			Credit Fair Value Adjustment			Net Amount
Balance, December 31, 2009
Residential Mortgages	$	—		$	—		$	—
Commercial		1,966			1,307			659
Consumer / Other		—			—			—
		1,966			1,307			659
Charge-offs
Residential Mortgages		—			—			—
Commercial		—			—			—
Consumer / Other		—			—			—
Total Charge-offs		—			—			—
Loans transferred to other real estate owned
Residential Mortgages		—			—			—
Commercial		—			—			—
Consumer / Other		—			—			—
Total loans transferred to other real estate owned		—			—			—
Payments
Residential Mortgages		—			—			—
Commercial		(30	)		(2	)		(28	)
Consumer / Other		—			—			—
Total Payments		(30	)		(2	)		(28	)
Balance, March 31, 2010	$	1,936		$	1,305		$	631

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Note 14 – Fair Value Measurements

The following table sets forth the Company’s financial assets that were accounted for at fair value and are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

Level I - Quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access at the measurement date.

Level II - Observable inputs other than Level I prices, such as quoted prices for similar assets or liabilities in active markets; quoted prices in markets that are not active for identical or similar assets or liabilities; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level III - Unobservable inputs that are supported by little or no market activity and significant to the fair value of the assets or liabilities that are developed using the reporting entities’ estimates and assumptions, which reflect those that market participants would use.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

A description of the valuation methodologies used for financial assets measured at fair value on a recurring basis, as well as the classification of the assets pursuant to the valuation hierarchy, are as follows:

Securities Available-for-Sale

Securities classified as available-for-sale are reported using Level I, Level II and Level III inputs. Level I instruments generally include equity securities valued in accordance with quoted market prices in active markets. Level II instruments include U.S. government agency obligations, state and municipal bonds, mortgage-backed securities and corporate bonds. 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. Level III instruments include certain non-public equity securities and real estate sold under contract. See Note 5 – Investment Securities for additional information.

Assets and liabilities measured at fair value on a recurring basis are summarized as follows:

		March 31, 2011
		Level I		Level II		Level III		Total
Assets:
Securities available-for-sale
U.S. Agency securities		$	—	$	76,427	$	—	$	76,427
Mortgage-backed securities:	��
Residential			—		25,232		—		25,232
States & political subdivisions:
Bank qualified tax exempt			—		62,809		—		62,809
Corporate securities:
Aaa credit rating			—		4,071		—		4,071
Equity securities:
Financial services industry			1,305		—		—		1,305
Total securities available-for-sale		$	1,305	$	168,539	$	—	$	169,844

21

	December 31, 2010
	Level I		Level II		Level III		Total
Assets:
Securities available-for-sale
U.S. Agency securities	$	—	$	79,294	$	—	$	79,294
Mortgage-backed securities:
Residential		—		26,370		—		26,370
States & political subdivisions:
Bank qualified tax exempt		—		62,558		—		62,558
Corporate securities:
Aaa credit rating		—		4,090		—		4,090
Equity securities:
Financial services industry		985		—		—		985
Total securities available-for-sale	$	985	$	172,312	$	—	$	173,297

Assets Measured at Fair Value on a Nonrecurring Basis

Certain non-financial assets and non-financial liabilities, measured at fair value on a non-recurring basis, include foreclosed and non-performing assets, goodwill and other intangible assets.

A description of the valuation methodologies and classification levels used for non-financial assets and non-financial liabilities measured at fair value on a nonrecurring basis are listed as follows:

Goodwill and Other Identifiable Intangibles

The Company employs general industry practices in evaluating the fair value of its goodwill and other identifiable intangibles. The Company calculates the fair value, with the assistance of a third party specialist, using a combination of the following valuation methods: dividend discount analysis under the income approach, which calculates the present value of all excess cash flows plus the present value of a terminal value and market multiples (pricing ratios) under the market approach. Management performed a review of goodwill and other identifiable intangibles as of December 31, 2010. Goodwill and other identifiable intangibles were not evaluated during the three months ended March 31, 2011 as a result of management’s determination that no evidence of impairment was present during the period.

Impaired Loans

At March 31, 2011 certain impaired loans were remeasured and reported at fair value through a specific valuation allowance allocation of the allowance for loan losses based upon the fair value of the underlying collateral and the evaluation of expected future cash flows. Impaired loans with a carrying value of $5,396 were reduced by a specific valuation allowance allocation totaling $1,426, to a total reported fair value of $3,970 based on collateral valuations utilizing Level III valuation inputs.

Federal Home Loan Bank Stock

Federal Home Loan Bank of Pittsburgh (FHLB) stock is a required investment in order for the Company to participate in a FHLB line of credit program. The FHLB stock is stated at par value as it is restricted to purchases and sales with the FHLB. The FHLB had indefinitely suspended its stock repurchase and dividend payments during December 2008. During the first quarter of 2011, the FHLB repurchased $304 of capital stock which represented 5.0% of the Bank’s $6,082 investment. Based on current financial information available, management does not believe the FHLB stock value is impaired as of March 31, 2011.

Other Real Estate Owned

Foreclosed real estate, which is considered to be a non-financial asset, has been valued using a market approach. The values were determined using market prices of similar real estate assets, which the Company considered to be Level II inputs.

22

Certain assets measured at fair value on a non-recurring basis as of March 31, 2011 is as follows:

	Fair Value Measurement Using
	Quoted Prices in Active Markets for Identical Assets/Liabilities		Significant Other Observable Inputs		��	Significant Unobservable Inputs		Balance March 31, 2011
	Level I		Level II			Level III		Total
Assets
Core deposit intangible	$	—	$	—		$	1,327	$	1,327
Goodwill		—		—			26,398		26,398
Impaired loans		—		—			5,396		5,396
Federal Home Loan Bank stock		—		—			5,778		5,778
Other real-estate owned		—		883			—		883
Total non-financial assets	$	—	$	883		$	38,899	$	39,782

Certain assets measured at fair value on a non-recurring basis as of December 31, 2010 is as follows:

	Fair Value Measurement Using
	Quoted Prices in Active Markets for Identical Assets/Liabilities		Significant Other Observable Inputs		Significant Unobservable Inputs		Balance December 31, 2010
	Level I		Level II		Level III		Total
Assets
Core deposit intangible	$	—	$	—	$	1,410	$	1,410
Goodwill		—		—		26,398		26,398
Impaired loans		—		—		4,493		4,493
Federal Home Loan Bank stock		—		—		6,082		6,082
Other real-estate owned		—		803		—		803
Total non-financial assets	$	—	$	803	$	38,383	$	39,186

A reconciliation of items in Level III for the period ended March 31, 2011 is as follows:

	Core deposit intangible			Goodwill		Impaired Loans			Federal Home Loan Bank Stock			Total
Balance December 31, 2010	$	1,410		$	26,398	$	4,493		$	6,082		$	38,383
Amortization of core deposit intangible		(83	)		—		—			—			(83	)
Increase in impaired loans		—			—		1,043			—			1,043
Decrease in impaired loans		—			—		(102	)		—			(102	)
Payments received		—			—		(38	)		(304	)		(342	)
Balance March 31, 2011	$	1,327		$	26,398	$	5,396		$	5,778		$	38,899

A reconciliation of items in Level III for the year ended December 31, 2010 is as follows:

	Core deposit intangible			Goodwill		Impaired Loans			Federal Home Loan Bank Stock			Real estate sold under contract			Total
Balance December 31, 2009	$	1,751		$	26,398	$	—		$	6,402		$	123		$	34,674
Amortization of core deposit intangible		(341	)		—		—			—			—			(341	)
Increase in impaired loans		—			—		5,073			—			—			5,073
Decrease in impaired loans		—			—		(580	)		—			—			(580	)
Payments received		—			—		—			(320	)		(123	)		(443	)
Balance December 31, 2010	$	1,410		$	26,398	$	4,493		$	6,082		$	—		$	38,383

23

Disclosures about Fair Value of Financial Instruments

General Accepted Accounting Principles require disclosure of the estimated fair value of an entity’s assets and liabilities considered to be financial instruments. For the Company, as for most financial institutions, the majority of its assets and liabilities are considered financial instruments. However, many such instruments lack an available trading market, as characterized by a willing buyer and seller engaging in an exchange transaction. Also, it is the Company’s general practice and intent to hold its financial instruments to maturity and not to engage in trading or sales activities, except for certain loans and investments. Therefore, the Company had to use significant estimates and present value calculations to prepare this disclosure.

Changes in the assumptions or methodologies used to estimate fair values may materially affect the estimated amounts. Also, management is concerned that there may not be reasonable comparability between institutions due to the wide range of permitted assumptions and methodologies in the absence of active markets. This lack of uniformity gives rise to a high degree of subjectivity in estimating financial instrument fair values.

Estimated fair values have been determined by the Company using the best available data and an estimation methodology suitable for each category of financial instruments. The estimation methodologies used at March 31, 2011 and December 31, 2010 are outlined below. The methodologies for estimating the fair value of financial assets and financial liabilities that are measured at fair value on a recurring or non-recurring basis are discussed in the fair value measurements section above. The estimated fair value approximates carrying value for cash and cash equivalents, accrued interest and the cash surrender value of life insurance policies. The methodologies for other financial assets and financial liabilities are discussed below:

Short-term financial instruments

The carrying value of short-term financial instruments including cash and due from banks, federal funds sold, interest-bearing deposits in banks and other short-term investments and borrowings, approximates the fair value of these instruments. These financial instruments generally expose the Company to limited credit risk and have no stated maturities or have short-term maturities with interest rates that approximate market rates.

Investment securities held-to-maturity

The estimated fair values of investment securities held-to-maturity are based on quoted market prices provided by independent third parties that specialize in those investment sectors. If quoted market prices are not available, estimated fair values are based on quoted market prices of comparable instruments.

Loans

The loan portfolio, net of unearned income, has been valued by a third party specialist using quoted market prices, if available. When market prices were not available, a credit risk based present value discounted cash flow analysis was utilized. The primary assumptions utilized in this analysis are the discount rate based on the LIBOR curve, adjusted for credit risk, and prepayment estimates based on factors such as refinancing incentives, age of the loan and seasonality. These assumptions were applied by loan category and different spreads were applied based upon prevailing market rates by category.

Deposits

The estimated fair values of demand deposits (i.e., interest and non-interest bearing checking accounts, savings and money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). The fair value for certificates of deposit was calculated by an independent third party by discounting contractual cash flows using current market rates for instruments with similar maturities, using a credit based risk model. The carrying amount of accrued interest receivable and payable approximates fair value.

Long-term borrowings

The amounts assigned to long-term borrowings were based on quoted market prices, when available, or based on discounted cash flow calculations using prevailing market interest rates for debt of similar terms.

24

The carrying and fair values of certain financial instruments are as follows:

	March 31, 2011						December 31, 2010
	Carrying Amount			Fair Value			Carrying Amount			Fair Value
Cash and cash equivalents	$	25,534		$	25,534		$	14,219		$	14,219
Investment securities held-to-maturity		38,720			40,036			43,747			45,218
Loans, net		604,221			613,966			608,605			620,040
Cash surrender value of life insurance		15,500			15,500			15,380			15,380
Demand deposits		451,344			451,344			441,968			441,968
Time deposits		249,137			251,570			249,064			251,779
Short-term borrowings		20,450			20,450			28,082			28,082
Long-term borrowings		64,711			66,965			68,835			71,309
Standby Letters of Credit	$	(169	)	$	(169	)	$	(164	)	$	(164	)

25

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following commentary provides an overview of the financial condition and significant changes in the results of operations of Penseco Financial Services Corporation (the “Company”) and its subsidiary, Penn Security Bank and Trust Company (the “Bank”), at March 31, 2011 and for the three month periods ended March 31, 2011 and March 31, 2010. All information is presented in thousands of dollars, except as indicated.

Critical Accounting Policies

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Provision (allowance) for loan losses - The allowance for loan losses is based on past loan loss experience, management’s evaluation of the probable loss in the current loan portfolio under current economic conditions and such other factors as, in management’s best judgment, merit recognition in estimating loan losses. The provision for loan losses charged to operating expense is that amount which is sufficient to bring the balance of the allowance for loan losses to an adequate level to absorb probable losses.

Actuarial assumptions associated with pension, post-retirement and other employee benefit plans - These assumptions include discount rate, rate of future compensation increases and expected return on plan assets.

Income taxes - The calculation of the provision for federal income taxes is complex and requires the use of estimates and judgments. Deferred federal income tax assets or liabilities represent the estimated impact of temporary differences between the recognition of assets and liabilities under GAAP, and how such assets and liabilities are recognized under the federal tax code. The Company uses an estimate of future earnings to support management’s position that the benefit of the deferred tax assets will be realized. If projected income is not recognized, at all or in the amounts predicted, the amount of the deferred tax assets within the tax years to which they may be applied, the asset may not be realized and net income will be reduced. Deferred tax assets are described further in Note 18 of the “Notes to Consolidated Financial Statements” in the Company’s most recent Annual Report on Form 10-K.

Management evaluated the Company’s tax positions and concluded that the aggregate liabilities related to taxes are appropriately reflected in the consolidated financial statements. With few exceptions, the Company is no longer subject to income tax examinations by the U.S. Federal, state or local tax authorities for years before 2007.

Fair Value Measurements – Fair values of financial instruments are estimated using relevant market information and other assumptions. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayment speeds and other factors. Changes in assumptions or in market conditions could significantly affect the estimates. Fair value measurements are classified within one of three levels within a valuation hierarchy based on the transparency of inputs to each valuation as of the fair value measurement date. The three levels are defined as follows:

Level I – quoted prices (unadjusted) for identical assets or liabilities in active markets.

Level II – inputs include quoted prices for similar assets and liabilities in active markets, quoted prices of identical or similar assets or liabilities in markets that are not active, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

Level III – inputs that are unobservable and significant to the fair value measurement. Financial instruments are considered Level III when values are determined using pricing models, discounted cash flow methodologies, or similar techniques, and at least one significant model assumption or input is unobservable.

Other-than-temporary impairment of investments - Investments are evaluated periodically to determine whether a decline in their value is other-than-temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other-than-temporary. The term “other-than-temporary” is not intended to indicate that the decline is permanent. It indicates that the prospects for a near term recovery of value are not necessarily favorable, or that there is a lack of evidence to support fair values equal to, or greater than, the carrying value of the investment. Once a decline in value is determined to be other-than-temporary, the value of the security is reduced and a corresponding charge to earnings is recognized.

26

Premium amortization - The amortization of premiums on mortgage-backed securities is done based on management’s estimate of the lives of the securities, adjusted, when necessary, for advanced prepayments in excess of those estimates.

Loans purchased – Loans purchased in the Merger were recorded at the acquisition date fair value. Management made three different types of fair value adjustments in order to record the loans at fair value. An interest rate fair value adjustment was made comparing current weighted average rates of the acquired loans to stated market rates of similar loan types. A general credit fair value adjustment was made on similar loan types based on historical loss projections plus a discount for the weak economic environment. A specific credit fair value adjustment was made to loans identified by management as being problematic. The specific loans have been discounted by management based on collateral values and expected cash flows. The interest rate and general credit fair value adjustments are being accreted over an eight year period based on a sum-of-the-years-digits basis. The specific credit fair value adjustment is reduced only when cash flows are received or loans are charged-off or transferred to other real estate owned.

Loan servicing rights – Mortgage servicing rights are evaluated for impairment based on the fair value of those rights. Fair values are estimated using discounted cash flows based on current market rates of interest and current expected future prepayment rates. For purposes of measuring impairment, the rights must be stratified by one or more predominant risk characteristics of the underlying loans. The Company stratifies its capitalized mortgage servicing rights based on the product type, interest rate and term of the underlying loans. The amount of impairment recognized is the amount, if any, by which the amortized cost of the rights for each stratum exceeds the fair value.

Time deposits – Time deposits acquired through the Merger have been recorded at their acquisition date fair value. The fair value of time deposits represents the present value of the time deposits’ expected contractual payments discounted by market rates for similar deposits. The fair value adjustment is amortized monthly based on a level yield methodology.

Repurchase agreements - The Company also offers repurchase agreements as an alternative to conventional savings deposits for its customers. The repurchase agreements are accounted for as a collateralized borrowing with a one day maturity and are collateralized by U.S. Agency securities.

Core deposit intangible – The fair value assigned to the core deposit intangible asset represents the future economic benefit of the potential cost savings from acquiring core deposits in the Merger compared to the cost of obtaining alternative funding, such as brokered deposits, from market sources. Management utilized an income approach to present value the expected after tax cash flow benefits of the acquired core deposits. The core deposit intangible is being amortized over ten years on a sum-of-the-years-digits basis.

Goodwill – Goodwill is reviewed by management for possible impairment at least annually or more frequently upon the occurrence of an event or when circumstances indicate that its carrying amount exceeds fair value. Management has obtained a professional valuation of the Company value as of December 31, 2010. As a result of such valuation, goodwill was determined to be not impaired at December 31, 2010. Market conditions that could negatively impact the value of goodwill in the future are essentially those Risk Factors discussed in Part 1A of the Company’s most recent Annual Report on Form 10-K.

Comparison of Operating Results

	Three Months Ended March 31,
	2011			2010
Interest Income	$	10,040		$	10,557
Interest Expense		1,897			2,106
Net Interest Income		8,143			8,451
Non-Interest Income		3,304			2,711
Total Revenue	$	13,344		$	13,268
Non-Interest Expense		7,450			7,037
Net Income	$	2,769		$	2,981
Net Interest Margin		3.87	%		4.19	%
ROA		1.21	%		1.35	%
ROE		8.96	%		10.04	%

27

The Company reported net income for the three months ended March 31, 2011 of $2,769 or $0.85 per weighted average share compared with $2,981 or $0.91 per weighted average share from the year ago period, a decrease of $212 or 7.1%. Pre-provision net interest income decreased $308 or 3.6%. Net interest income, after provision for loan losses, decreased $349 or 4.3% during the 2011 period, due to a decrease in total interest income of $517 or 4.9% and a $41 increase in the provision for loan losses, partially offset by reduced interest expense of $209 or 9.9% from lower funding costs. The decrease in total interest income was primarily attributable to decreases in interest and fees on loans and interest and dividends on investments, due to weak loan demand and investment cash flows being reinvested into historically low short-term yields. Non-interest income increased $593 or 21.9% primarily as a result of the reversal of a contingent liability recorded in connection with the Merger. Non-interest expenses increased $413 or 5.9%, mainly due to increased salaries and employee benefits of $352 reflecting merit increases in salaries of existing personnel and increased staffing for loan production and monitoring asset quality.

Net income from core operations, which excludes the reversal of a contingent liability recorded in connection with the Merger, decreased $542 for the three months ended March 31, 2011 to $2,439 compared to $2,981 for the same period in 2010. Net income from core operations is a non-GAAP measure of net income. A reconciliation of the net income from core operations and disclosure of the non-GAAP return on assets, return on equity and dividend payout ratio derived from that measure are described in the non-GAAP reconciliation included in this Quarterly Report on Form 10-Q.

The following table reflects net income from accretion and amortization, net of taxes, of acquisition date fair value adjustments relating to the Merger included in the Company’s financial results during the periods indicated are as follows:

	Three Months Ended
	March 31, 2011			March 31, 2010
Homogeneous loan pools	$	151		$	175
Time deposits		30			58
Core deposit intangible expense		(55	)		(61	)
Net income from acquisition fair value adjustment	$	126		$	172

Accretion of the loan pools credit fair value adjustment and market rate fair value adjustment is calculated on a sum-of-the-years-digits basis over an eight year period. The fair value market rate adjustment of the time deposits is amortized monthly based on a level yield methodology over five years. The core deposit intangible is being amortized over ten years on a sum-of-the-years-digits basis.

28

Net Interest Income and Net Interest Margin

Net interest income, the principal component of the Company’s earnings, is defined as the difference between interest and fees earned on interest-earning assets and interest paid on deposits and other borrowings. Average earning assets are composed primarily of loans and investments while deposits, short-term and long-term borrowings represent interest-bearing liabilities. Variations in the volume and mix of these assets and liabilities, as well as changes in the yields earned and rates paid, are determinants of changes in net interest income.

Net interest income before provision for loan losses decreased $308 or 3.6% to $8,143 for the three months ended March 31, 2011 compared to $8,451 for the three months ended March 31, 2010. The average yield on interest earning assets decreased 53 basis points or 9.6%.

The net interest margin represents the Company’s net yield on its average interest earning assets and is calculated as net interest income divided by average interest earning assets. In the three months ended March 31, 2011, net interest margin decreased 32 basis points to 3.87% from 4.19% in the same period of 2010.

Total average interest earning assets and average interest bearing funds increased from the three months ended March 31, 2010. Average interest earning assets increased $32.9 million or 4.1%, from $807.7 million in 2010 to $840.6 million in 2011 and average interest bearing funds increased $21.5 million, or 3.3%, from $647.9 million to $669.4 million for the same period. As a percentage of average assets, average earning assets, including bank-owned life insurance (BOLI) remained relatively unchanged for the three months ended March 31, 2011 and 2010, respectively.

Changes in the mix of both interest earning assets and funding sources also impacted net interest income in the three months ended March 31, 2011 and 2010. Average loans as a percentage of average interest earning assets decreased slightly from 74.9% in 2010 to 73.2% in 2011. Average investments increased $19.3 million year over year as well as a percentage of interest earning assets to 25.4% at March 31, 2011 from 24.0% at March 31, 2010. Average short-term investments, federal funds sold, FHLB stock and interest bearing balances with banks, increased as a percentage of average assets to 1.4% at March 31, 2011 from 1.1% at March 31, 2010. Average time deposits increased $39.7 million or 19.0% from $208.9 million or 32.2% of interest bearing liabilities in 2010 to $248.6 million or 37.1% of interest bearing liabilities for the 2011 period. In addition, during the three months ended March 31, 2011, average federal funds purchased decreased $8.7 million and average short-term borrowings decreased $18.0 million.

Shifts in the interest rate environment and competitive factors affected the rates paid for funds as well as the yields earned on assets. The investment securities tax equivalent yield decreased 104 basis points from 5.06% for the three months ended March 31, 2010 to 4.02% for the three months ended March 31, 2011. Also, average loan yields decreased 33 basis points from 5.75% for the three months ended March 31, 2010 to 5.42% for the three months ended March 31, 2011.

The average time deposit costs decreased 41 basis points from 1.90% for the three months ended March 31, 2010 to 1.49% for the three months ended March 31, 2011. In addition, the average cost of money market accounts decreased 15 basis points from 0.66% for the three months ended March 31, 2010 to 0.51% for the three months ended March 31, 2011.

Interest expense in for the three months ended March 31, 2011 totaled $1,897, compared to $2,106 in 2010, a decrease of $209 or 9.9%. The average rate paid on interest-bearing liabilities for the three months ended March 31, 2011 decreased to 1.13%, compared to 1.30% in 2010. Average interest-bearing liabilities increased $21.5 or 3.3% to $669.4 from $647.9 in 2010. Average savings deposits increased $2.5 or 2.2%. Average time deposits increased $39.7 or 19.0% for the three months ended March 31, 2011 due primarily to the issuance of brokered certificates of deposit. Average time deposits represented 37.1% of average interest-bearing liabilities at March 31, 2011, compared to 32.2% at March 31, 2010. Average demand non-interest bearing deposits increased $7.4 or 6.9%.

Historically low interest rates will begin to stress our margin as funding costs have reached a low point and asset yields continue to price downward. The Dodd-Frank financial reform bill passed in 2010 will reduce revenue and increase compliance and regulatory costs.

29

Distribution of Assets, Liabilities and Stockholders’ Equity / Interest Rates and Interest Differential

The table below presents average balances, interest income on a fully taxable equivalent basis and interest expense, as well as average rates earned and paid on the Company’s major asset and liability items for the three months ended March 31, 2011 and March 31, 2010.

	March 31, 2011							March 31, 2010
ASSETS	Average		Revenue/		Yield/			Average		Revenue/		Yield/
	Balance		Expense		Rate			Balance		Expense		Rate
Investment Securities
Available-for-sale:
U.S. Agency obligations	$	105,401	$	533		2.02	%	$	71,333	$	456		2.56	%
States & political subdivisions		62,637		712		6.89	%		75,442		844		6.78	%
Other		5,038		14		1.11	%		1,925		11		2.29	%
Held-to-maturity:
U.S. Agency obligations		27,790		282		4.06	%		22,683		263		4.64	%
States & political subdivisions		12,443		155		7.55	%		22,584		295		7.92	%
Loans, net of unearned income:
Real estate mortgages		318,396		4,110		5.16	%		331,684		4,444		5.36	%
Commercial real estate		174,345		2,134		4.90	%		172,271		2,193		5.09	%
Commercial		38,559		571		5.92	%		28,577		513		7.18	%
Consumer and other		84,185		1,527		7.26	%		72,032		1,536		8.53	%
Federal funds sold		—		—		—			—		—		—
Federal Home Loan Bank stock		5,957		—		—			6,402		—		—
Interest on balances with banks		5,893		2		0.14	%		2,760		2		0.29	%
Total Interest Earning Assets/Total Interest Income		840,644	$	10,040		4.99	%		807,693	$	10,557		5.52	%
Cash and due from banks		10,381							10,535
Bank premises and equipment		13,438							12,395
Accrued interest receivable		3,395							3,888
Goodwill		26,398							26,397
Cash surrender value of life insurance		15,427							14,428
Other assets		11,652							12,772
Less: Allowance for loan losses		6,479							6,243
Total Assets	$	914,856						$	881,865
LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits:
Demand-Interest bearing	$	70,154	$	72		0.41	%	$	69,393	$	94		0.54	%
Savings		114,726		77		0.27	%		112,197		82		0.29	%
Money markets		147,306		186		0.51	%		143,846		237		0.66	%
Time - Over $100		84,077		370		1.76	%		83,187		433		2.08	%
Time - Other		164,555		557		1.35	%		125,705		561		1.79	%
Federal funds purchased		—		—		—			8,718		12		0.55	%
Repurchase agreements		19,228		24		0.50	%		18,575		42		0.90	%
Short-term borrowings		2,212		3		0.54	%		20,208		18		0.36	%
Long-term borrowings		67,101		608		3.62	%		66,063		627		3.80	%
Total Interest Bearing Liabilities/Total Interest Expense		669,359	$	1,897		1.13	%		647,892	$	2,106		1.30	%
Demand - Non-interest bearing		114,873							107,460
All other liabilities		7,008							7,782
Stockholders’ equity		123,616							118,731
Total Liabilities and Stockholders’ Equity	$	914,856						$	881,865
Interest Spread						3.86	%						4.22	%
Net Interest Income			$	8,143						$	8,451
FINANCIAL RATIOS
Net interest margin						3.87	%						4.19	%
Return on average assets						1.21	%						1.35	%
Return on average equity						8.96	%						10.04	%
Average equity to average assets						13.51	%						13.46	%
Dividend payout ratio						49.41	%						46.15	%

30

Provision for Loan Losses

The provision for loan losses represents the charge to operating expense necessary to maintain the allowance for loan losses at a level which management determines is adequate to absorb probable losses inherent in the Company’s loan portfolio.

The local economy continued to experience the effects of our nation’s economic downturn. The local housing market remained weak and the unemployment rate in Scranton/Wilkes-Barre metropolitan area was 9.4% at March 31, 2011. The Company continues to proactively evaluate probable loan losses and address delinquent loans by, among other things, obtaining current appraisals of collateral and increasing communication with clients.

The Bank’s process for determining the allowance for loan and lease losses (ALLL) is based on a comprehensive, well documented and consistently applied analysis of its loan portfolio. This analysis considers all significant factors that affect the collectability of the loans within our portfolio and supports the credit losses estimated by this process. Our ALLL methodology includes procedures for a review by a party who is independent of the Bank’s credit approval and ALLL estimation processes.

The Bank follows its systematic methodology in accordance with the FFIEC Interagency Policy Statements, as amended, and GAAP in assessing the adequacy of its allowance for loan losses. Under GAAP, the adequacy of the allowance for loan losses is determined based on the provisions of FASB ASC 310 for loans specifically identified to be individually evaluated for impairment and the requirements of FASB ASC 450 for large groups of smaller balance homogeneous loans to be collectively evaluated for impairment. Loans are identified by the Bank’s rating system, past due reports, watch list and sensitivity to economic factors and are then collectively evaluated for impairment compared to other loans utilizing standard criteria. Consideration is given to current local economic conditions which the Company continues to classify as recessionary.

Our historical analysis of loss factors, which utilizes a rolling twenty quarters, was refined in the third quarter of 2010 to assign greater weight to the four quarters of the previous five years that reflected the greatest loan loss allowances. This change in our methodology is designed to better address deterioration in local economic conditions. In addition, and in view of the concentration of the Bank’s loan portfolio in real estate - over 80% of the portfolio is secured by real estate mainly in the counties in which the Bank operates - the Bank also took into account the decline in real estate sales and new construction in our market area and the drop in real estate values within the market area. Our provision for loan losses for the quarter ended March 31, 2011 was allocated somewhat evenly to the commercial and industrial, commercial real estate, residential real estate and consumer portfolio. Reference should be made to the information about the Company’s provision for loan losses under the heading “General Notes to Financial Statements – Note 6 – Loan Portfolio”.

Based on this methodology, management made a provision of $369 for loan losses for the period ended March 31, 2011, compared to a $328 provision for the comparable prior year period. The amount and number of charge-offs and foreclosures during the periods indicated below are as follows:

At:	March 31, 2011			December 31, 2010			March 31, 2010
Provision for loan losses	$	369		$	1,999		$	328
Allowance for loan losses to non-performing loans		137.84	%		161.13	%		286.47	%
Non-performing loans to period end loans		0.81	%		0.66	%		0.38	%
Ratio of charged-off loans to average loans		0.02	%		0.30	%		0.02	%
Ratio of foreclosed loans to average loans		0.01	%		0.19	%		0.10	%

At:	March 31, 2011				December 31, 2010				March 31, 2010
	Amount		(#)		Amount		(#)		Amount		(#)
Charge-offs	$	115		15	$	1,838		102	$	131		19
Foreclosures completed		80		3		1,183		6		578		3
Non-performing loans		4,933		79		4,034		70		2,269		45

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The Company had one commercial loan whose terms had been modified in a troubled debt restructuring as of March 31, 2011 and December 31, 2010; monthly payments were lowered to accommodate the borrower’s financial needs for a period of time.

The following table presents loans whose terms were modified in a TDR at the dates indicated below:

	March 31, 2011		December 31, 2010
Restructured Loans on Accrual Status and Not Past Due 90 Days or More	$	—	$	—
Restructured Loans Included in Non-Accrual Loans or Accruing Loans Past Due 90 Days or More		394		401
Total Restructured Loans	$	394	$	401

The Company believes that the judgments used in establishing the allowance for loan losses are based on reliable information. In assessing the adequacy of the allowance for loan losses, management considers how well prior estimates have related to actual experience. The Company continually monitors the risk elements, historical rates and other data used in establishing the allowance on a periodic basis. Based on this ongoing evaluation, management determines the provision necessary to maintain an appropriate allowance.

The methodology of determining the adequacy of the allowance is necessarily judgmental and subject to changes in external conditions. Accordingly, there can be no assurance that existing levels of the allowance will ultimately prove adequate to cover actual loan losses. Although management uses available information to establish the appropriate level of the allowance for loan losses, future additions or reductions to the allowance may be necessary, based on estimates that are susceptible to change, as a result of changes in economic conditions and other factors. As a result, our allowance for loan losses may not be sufficient to cover actual loan losses, and future provisions for loan losses could materially adversely affect the Company’s operating results. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to recognize adjustments to the allowance based on their judgments about information available to them at the time of their examination.

There are also no particular risk elements in the local economy that put a group or category of loans at increased risk, however, the Company has increased its portfolio of commercial loans, which typically bear a higher risk. These loans are typically secured by real estate to minimize this risk. At March 31, 2011, management believes the allowance for loan losses is adequate to absorb probable loan losses inherent in the loan portfolio.

Non-Interest Income

The following table sets forth information by category of non-interest income for the Company for the three months ended March 31, 2011 and March 31, 2010, respectively:

Three Months Ended:	March 31, 2011		March 31, 2010
Trust department income	$	398	$	380
Service charges on deposit accounts		472		532
Merchant transaction income		1,242		1,194
Brokerage fee income		56		70
Other fee income		378		350
Bank-owned life insurance income		120		122
Other operating income		630		61
Realized gains (losses) on securities, net		8		2
Total Non-Interest Income	$	3,304	$	2,711

Total non-interest income increased $593 or 21.9%, to $3,304 for the three months ended March 31, 2011, compared with $2,711 for the same period in 2010. Service charges on deposit accounts decreased $60 or 11.3%, primarily due to decreased overdraft activity. Merchant transaction income increased $48 or 4.0%, due to the increased volume of merchant transactions primarily from new business. Brokerage fee income decreased $14 or 20.0%, mostly due to a lower volume of investor activity. Other fee income increased $28 or 8.0%, mainly due to increased debit card discounts of $27 related to the increased number of new accounts and organic growth. Other operating income increased $569 largely due to the reversal of a contingent liability of $500 recorded in connection with the Old Forge Bank acquisition and gains on the sale of low-yielding long-term fixed rate real estate loans of $48. Realized gains (losses) on securities, net, increased $6 as a result of investment securities being called.

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Non-Interest Expenses

The following table sets forth information by category of non-interest expenses for the Company for the three months ended March 31, 2011 and March 31, 2010, respectively:

Three Months Ended:	March 31, 2011		March 31, 2010
Salaries and employee benefits	$	3,525	$	3,173
Expense of premises and fixed assets		1,021		950
Merchant transaction expenses		833		811
FDIC insurance assessments		242		266
Other operating expenses		1,829		1,837
Total Non-Interest Expenses	$	7,450	$	7,037

Total non-interest expenses increased $413 or 5.9%, to $7,450 for the three months ended March 31, 2011 compared with $7,037 for the same period in 2010. Salaries and employee benefits expense increased $352 or 11.1%, due primarily to merit increases in salaries of existing personnel and increased staffing for loan production and monitoring asset quality. Expense of premises and fixed assets increased $71 or 7.5% largely due to increased occupancy expenses and additional depreciation from branch renovations. Merchant transaction expenses increased $22 or 2.7% due to the increased volume of merchant transactions. FDIC insurance assessments decreased $24 or 9.0% in 2011.

Income Taxes

Applicable income taxes increased $43 or 5.3% due to higher taxable income for the three months ended March 31, 2011.

Investments

The Company’s investment portfolio has two primary functions: to provide liquidity and to contribute to earnings. To provide liquidity, the Company may invest in short-term securities such as Federal funds sold, interest bearing deposits with banks, U.S. Treasury securities and U.S. Agency securities all with maturities of one year or less. These funds are invested short-term to ensure the availability of funds to meet customer demand for credit needs. The Company enhances interest income by securing long-term investments within its investment portfolio, by means of U.S. Treasury securities, U.S. Agency securities, municipal securities and mortgage-backed securities, generally with maturities greater than one year. The Company’s mortgage-backed securities portfolio does not contain any sub-prime or Alt-A credits.

The following table presents the carrying value, by security type and by maturity, for the Company’s investment portfolio during the periods indicated:

	March 31, 2011		December 31, 2010
U.S. Agency obligations	$	128,400	$	134,541
States & political subdivisions		74,788		77,428
Corporate securities		4,071		4,090
Total Debt Securities		207,259		216,059
Equity Securities		1,305		985
Total Investment Securities	$	208,564	$	217,044

Federal Home Loan Bank Stock Impairment Evaluation

The Company’s banking subsidiary, Penn Security Bank, is required to maintain certain amounts of Federal Home Loan Bank, or FHLB, stock in order to participate in a FHLB line of credit program. The FHLB stock is stated at par value as it is restricted to purchases and sales with the FHLB. FHLB stock is less liquid than other tradable equity securities and the fair value is equal to cost. No impairment write-downs have been recorded on FHLB stock during 2011 or 2010.

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The FHLB had suspended its stock repurchase and dividend payments during December 2008. A reduction in the level of core earnings resulting from lower short-term interest rates, the increased cost of maintaining liquidity and constrained access to the debt markets at attractive rates and maturities are the main reasons the FHLB cited as significant for the decision to suspend dividends and the repurchase of excess capital stock. Accounting guidance indicates that investors should recognize impairment in FHLB Pittsburgh capital stock if it is determined that it is not probable that the Bank will ultimately recover the par value of its shares. An investor in FHLB Pittsburgh must determine whether impairment exists based on its long-term performance, the severity and duration of declines in the market value of its net assets related to its capital stock amount, its commitment to make payments required by law or regulation and the level of such payments in relation to its operating performance, the impact of legislation and regulatory changes and its liquidity. During the first quarter of 2011, the FHLB repurchased $304 of capital stock which represented 5.0% of the Bank’s $6,082 investment. Also, during 2010, the Company received $320 of capital stock which represented 5.0% of the Bank’s $6,402 investment at that time. Based on current financial information available, management does not believe the FHLB stock value is impaired as of March 31, 2011.

Loan Portfolio

Details regarding the Company’s loan portfolio at the dates indicated are as follows:

	March 31, 2011		December 31, 2010
Commercial Secured by Real Estate	$	192,638	$	207,964
Residential Real Estate		298,341		295,301
Commercial and Industrial		38,969		36,190
Consumer		54,093		55,862
State & Political Subdivisions		16,882		9,882
All Other		10,098		9,906
Loans net of Unearned Income	$	611,021	$	615,105

There were no purchased loans as of March 31, 2011 other than loan participations with local banks. Originations of new loans are primarily in loans secured by real estate with an emphasis on commercial loans.

The Company has not engaged in any sub-prime residential mortgage lending. Therefore, the Company is not subject to any credit risks associated with such loans. The Company’s loan portfolio consists primarily of residential and commercial mortgage loans secured by properties located in Northeastern Pennsylvania and subject to conservative underwriting standards.

Loans secured by real estate continue to be the largest component of the loan portfolio, representing 80% and 82% of total loans at March 31, 2011 and December 31, 2010, respectively. Recent economic conditions and recessionary concerns have resulted in lower levels of loan demand. Accordingly, we expect that loan growth may be slower than historically expected.

Loan Quality

The lending activities of the Company are guided by the comprehensive lending policy established by the Board of Directors. Loans must meet certain criteria relating to the character, capacity and capital of the borrower, collateral provided for the loan, and prevailing economic conditions. Due to the consistent application of conservative underwriting standards, the Company’s loan quality has remained strong during the current general economic downturn.

Regardless of credit standards, there is risk of loss inherent in every loan portfolio. The allowance for loan losses is an amount that management believes will be adequate to absorb probable losses on existing loans that may become uncollectible, based on evaluations of the collectability of the loans. The evaluations take into consideration such factors as change in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, industry experience, collateral value and current economic conditions that may affect the borrower’s ability to pay. Management believes that the allowance for loan losses was adequate as of March 31, 2011. While management uses available information to estimate probable losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to recognize additions to the allowance based on their judgment of information available to them at the time of their examination.

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The allowance for loan losses is increased by periodic charges against earnings as a provision for loan losses, and decreased periodically by charge-offs of loans (or parts of loans) management has determined to be uncollectible, net of actual recoveries on loans previously charged-off.

The allowance for loan loss as a percentage of loans was 1.11% at March 31, 2011, compared to 1.06% at December 31, 2010 and 1.07% at March 31, 2010.

Market Area

Our market area has been affected by the economic decline that has affected the U.S. economy as a whole. The unemployment rate for the Scranton/Wilkes-Barre metropolitan area was 9.4% at March 31, 2011. Although this unemployment rate reflected a modest improvement compared to the regional unemployment rate at December 31, 2010, it is still the highest unemployment rate among Pennsylvania’s 14 metro areas and remains above the national unemployment rate of 8.8%. The high unemployment rate can be attributed to a gradual decline in manufacturing in Northeastern Pennsylvania, and much like the rest of the country, a slowdown in construction of residential and commercial property.

Improved labor conditions and a drop in unemployment did little to affect the foreclosure rate for the Scranton/Wilkes-Barre metropolitan area. In January 2011, foreclosure actions hit a new high, rising to 3.3% of all mortgaged properties. Although the pace of foreclosures has decreased, one of the strengths of the Northeastern Pennsylvania housing market is that it was not impacted by the loss of home equity that has affected the rest of the country. The Case-Shiller House Price Index for Northeastern Pennsylvania has not changed from December 2010. High unemployment in Northeastern Pennsylvania will continue to put pressure on the local economy and on our loan portfolio. We believe that our focus on identifying borrowers who are facing cash flow problems before they are unable to make their payments will significantly improve our ability to help these borrowers through difficult times.

Non-Performing Assets

Non-performing assets consist of non-accrual loans and other real estate owned. The following table sets forth information regarding non-performing assets and loans past due 90 days or more and still accruing interest as of the dates indicated:

As of:	March 31, 2011		December 31, 2010		March 31, 2010
Non-accrual loans
Residential real estate	$	2,477	$	1,579	$	1,506
Commercial real estate		1,235		1,385		416
Commercial loans		1,154		977		167
Consumer loans		67		93		180
Total non-performing loans	$	4,933	$	4,034	$	2,269
Other real estate owned		883		803		937
Total non-performing assets	$	5,816	$	4,837	$	3,206
Loans past due 90 days or more and accruing:
Secured by real estate	$	988	$	1,236	$	1,362
Guaranteed student loans		60		268		117
Credit card loans		26		20		12
Commercial loans		—		100		—
Consumer loans		34		6		2
Total loans past due 90 days or more and accruing	$	1,108	$	1,630	$	1,493

Loans are generally placed on a non-accrual status when principal or interest is past due 90 days and when payment in full is not anticipated. When a loan is placed on non-accrual status, all interest previously accrued but not collected is charged against current income. Loans are returned to accrual status when past due interest is collected and the collection of future principal and interest is probable.

During the second quarter of 2008, the Company was notified that The Education Resources Institute, Inc. (TERI), a guarantor of a portion of our student loan portfolio, had filed for reorganization under Chapter 11 of the Federal Bankruptcy Act. As of March 31, 2011, the Company had $7,279 of TERI loans out of a total student loan portfolio of $16,011. The Company does not anticipate that TERI’s bankruptcy filing will significantly impact the Company’s financial statements. These loans are placed on non-accrual status when they become more than 90 days past due. As of March 31, 2011 there was $61 of such loans placed on non-accrual status.

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Loans on which the accrual of interest has been discontinued or reduced amounted to $4,933 or 0.81% of loans at March 31, 2011, representing an increase of $2,664 from $2,269 or 0.38% of loans at March 31, 2010 and an increase of $899 from $4,034 or 0.66% of loans at December 31, 2010. The 2011 increase in non-accrual residential real estate loans is due to the continued high unemployment rate, both locally and nationally, and the effects of the slow economy on customers’ ability to repay loans, and delays at the county level in acquiring properties through foreclosure. The Company applies a conservative valuation of the property in assessing collectability, and historically has had a low charge-off ratio. Therefore, the Company believes adequate allowances have been provided. The 2010 increase can be attributed primarily to three commercial borrowers which are well secured and under continuous monitoring by Management. In each case the Bank has taken a charge-off or provided a specific reserve as reflected in the current recorded loan balance in the applicable financial statements. If interest on those loans had been accrued, such income would have been $91 and $43 for the three months ended March 31, 2011 and March 31, 2010, respectively. Interest income on those loans, which is recorded only when received, amounted to $0 for the three months ended March 31, 2011 and March 31, 2010. There are no commitments to lend additional funds to individuals whose loans are in non-accrual status.

Real estate loans of $988 that are past due 90 days or more and still accruing are primarily 1-4 family residential loans with favorable loan-to-value ratios and in the process of collection.

Management’s process for evaluating the adequacy of the allowance for loan losses includes reviewing each month’s loan committee reports which list all loans that do not meet certain internally developed criteria as to collateral adequacy, payment performance, economic conditions and overall credit risk. These reports also address the current status and actions in process on each listed loan. From this information, adjustments are made to the allowance for loan losses. Such adjustments include both specific loss allocation amounts and general provisions by loan category based on present and past collection experience, nature and volume of the loan portfolio, overall portfolio quality, and current economic conditions that may affect the borrower’s ability to pay.

As of March 31, 2011, the Company had total impaired loans of $5,396. Management performed an evaluation of expected future cash flows, including the anticipated cash flow from the sale of collateral, and compared that to the carrying amount of the impaired loans. Based on these evaluations, the Company determined that a reserve of $1,426, included in the allowance for loan losses, was required against impaired loans at March 31, 2011.

Most of the Company’s lending activity is with customers located in the Company’s geographic market area and repayment thereof is affected by economic conditions in this market area.

Loan Loss Experience

The following table presents the Company’s loan loss experience during the periods indicated:

Three Months Ended:	March 31, 2011			March 31, 2010
Balance at beginning of period	$	6,500		$	6,300
Charge-offs:
Residential real estate mortgages		61			4
Commercial real estate and all others		—			—
Credit card and related plans		20			11
Installment loans		34			116
Total charge-offs		115			131
Recoveries:
Residential real estate mortgages		18			—
Commercial real estate and all others		1			—
Credit card and related plans		1			—
Installment loans		26			3
Total recoveries		46			3
Net charge-offs (recoveries)		69			128
Provision charged to operations		369			328
Balance at End of Period	$	6,800		$	6,500
Ratio of net charge-offs (recoveries) to average loans outstanding		0.01	%		0.02	%

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The allowance for loan losses at March 31, 2011 was $6,800 or 1.11% of total loans compared to $6,500 or 1.06% of total loans at December 31, 2010 and $6,500 or 1.07% of total loans at March 31, 2010.

The allowance for loan losses is allocated as follows:

As of:	March 31, 2011						December 31, 2010						March 31, 2010
	Amount		%			*	Amount		%			*	Amount		%			*
Residential real estate	$	788		49	%		$	800		48	%		$	800		51	%
Commercial real estate and all others		4,209		42	%			4,000		40	%			4,000		39	%
Credit card and related plans		359		1	%			350		1	%			350		1	%
Personal installment loans		1,444		8	%			1,350		11	%			1,350		9	%
Total	$	6,800		100	%		$	6,500		100	%		$	6,500		100	%

* Percent of loans in each category to total loans

Our non-performing loans increased from $2,269 at March 31, 2010 to $4,933 at March 31, 2011. As of March 31, 2011, our non-performing loans were comprised of seventy-nine loans of which sixteen loans were in excess of one hundred thousand dollars in size and the remainder of which were less than one hundred thousand dollars each. As of March 31, 2010, our non-performing loans were comprised of forty-five loans of which six loans are in excess of one hundred thousand dollars and the remainder of which are less than one hundred thousand dollars. The increase in the non-performing loans can be attributed, to a large extent, to the following factors: (1) the addition of a large land development credit and two commercial loans, (2) the continuing deterioration in the economic conditions both locally and regionally, and (3) the widely depressed housing and real estate construction market.

The decrease in asset quality has been addressed by maintaining an adequate loss allowance. As of March 31, 2011, the total of the allowance for loan losses was $6,800. The level of loan loss coverage reflects management’s conservative view of the local economic conditions and an appropriate increase in the allowance for loan losses. As a result of the economic conditions in our market area and the increase in non-performing loans, management has undertaken the following actions beginning in 2009:

• Adjusted the credit policy in 2009 to lower the maximum loan-to-value ratios on commercial real estate loans and certain consumer loans;

• Hired a former bank examiner in February 2010 to perform loan reviews on a full time basis and to enhance our allowance for loan loss methodology for implementation in the third quarter of 2010 which did not have any appreciable impact on the required level on loan loss allowance;

• Contracted with a credit professional in March 2010 to assess the soundness of the small business underwriting function as well as the appropriateness of the Company’s established methodology for determining the allowance for loan losses;

• As a result of the local and national weakness in the real estate industry, and to mitigate or prevent loan loss, the Bank orders a current appraisal of the collateral securing such loan after it is 90 days delinquent to assess the current loan to value ratio.

Deposits

Details regarding the Company’s deposit portfolio at the dates indicated are as follows:

	March 31, 2011		December 31, 2010
Demand - Non-interest bearing	$	113,551	$	113,391
Demand - Interest bearing		68,382		70,989
Savings		118,168		113,382
Money markets		151,243		144,206
Time - Over $100,000		83,776		85,404
Time - Other		165,361		163,660
Total	$	700,481	$	691,032

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As of March 31, 2011, the Company had Certificate of Deposit Account Registry Service (“CDARS”) reciprocal deposits in the amount of $19.7 million. The Company also issues brokered certificates of deposit from time to time as an alternative to wholesale funding. As of March 31, 2011, the dollar amount of brokered deposits, exclusive of CDARS reciprocal deposits, was $49.5 million or 7.1% of total deposits, compared to $51.3 million or 7.4% at December 31, 2010.

The Company is largely dependent on its core deposit base to fund operations. Management has competitively priced its deposit products in checking, savings, money market and time deposits to provide a stable source of funding.

As general interest rates in the economy change, some deposits migrate towards investment with higher anticipated yields.

Liquidity

The objective of liquidity management is to maintain a balance between sources and uses of funds in such a way that the cash requirements of customers for loans and deposit withdrawals are met in the most economical manner. Management monitors its liquidity position continuously in relation to trends of loans and deposits for short-term as well as long-term requirements. Liquid assets are monitored on a daily basis to assure maximum utilization. Management also manages its liquidity requirements by maintaining an adequate level of readily marketable assets and access to short-term funding sources. Management does not foresee any adverse trends in liquidity.

The Company remains in a highly liquid condition both in the short and long term. Sources of liquidity include the Company’s U.S. Agency bond portfolios, additional deposits, earnings, overnight loans to and from other companies (Federal Funds) and lines of credit at the Federal Reserve Bank and the Federal Home Loan Bank (FHLB). The Company is not a party to any commitments, guarantees or obligations that could materially affect its liquidity.

The Company offers collateralized repurchase agreements, which have a one day maturity, as an alternative deposit option for its customers. The repurchase agreements are accounted for as a collateralized borrowing with a one day maturity and are collateralized by U.S. Agency securities. The Company also has long-term debt outstanding to the FHLB, which was used to purchase a Freddie Mac pool of residential mortgages. At March 31, 2011 the Company had $237,819 of available borrowing capacity with the FHLB, a Borrower-In-Custody (BIC) line of credit of $23,863 with the Federal Reserve Bank of Philadelphia, available borrowing capacity at the Discount Window of $30,389, an overnight Federal funds line of credit of $19,000 with PNC Bank and an overnight Federal funds line of credit of $5,000 with Wells Fargo.

The Company is a separate legal entity from the Bank and must provide for its own liquidity. In addition to its operating expenses, the Company is responsible for paying any dividends declared to its shareholders. The Company’s primary source of income is dividends received from the Bank. The amount of dividends that the Bank may declare and pay to the Company is generally restricted under Pennsylvania law to the retained earnings of the Bank.

Commitments and Contingent Liabilities

In the normal course of business, there are outstanding commitments and contingent liabilities, created under prevailing terms and collateral requirements such as commitments to extend credit, financial guarantees and letters of credit, which are not reflected in the accompanying Financial Statements. The Company does not anticipate any losses as a result of these transactions. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the Balance Sheets.

The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.

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. Commitments generally have expiration dates of one year or less or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.

Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.

During 2010 the Bank had executed purchase agreements in the amount of one million dollars for land in Scranton, Pennsylvania, to be used for construction of a new branch facility. The Bank has received regulatory approval for the establishment of this new branch office.

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Related Parties

The Company does not have any material transactions involving related persons or entities, other than traditional banking transactions, which are made on the same terms and conditions as those prevailing at the time for comparable transactions with unrelated parties. At March 31, 2011, the Bank has issued standby letters of credit for the accounts of related parties in the amount of $7,785.

Capital Resources

A strong capital position is important to the continued profitability of the Company and promotes depositor and investor confidence. The Company’s capital provides a basis for future growth and expansion and also provides additional protection against unexpected losses.

Additional sources of capital would come from retained earnings from the operations of the Company and from the sale of additional shares of common stock. Management has no plans to offer additional shares of common stock at this time.

The Company’s total risk-based capital ratio was 16.88% at March 31, 2011. The Company’s risk-based capital ratio is more than the 10.00% ratio that Federal regulators use as the “well capitalized” threshold under the Federal prompt corrective action regulations. This is the current criteria which the FDIC uses in determining the lowest insurance rate for deposit insurance. The Company’s risk-based capital ratio is more than double the 8.00% minimum threshold, which determines whether a company is “adequately capitalized”. Under these rules, the Company could significantly increase its assets and still comply with these capital requirements without the necessity of increasing its equity capital.

Non-GAAP Financial Measures

Core Earnings Calculation

Certain financial measures reported herein exclude the effect of the reversal of a contingent liability recorded in the Merger. Management of the Company believes that investors’ understanding of the Company’s performance is enhanced by disclosing these non-GAAP financial measures as a reasonable basis for comparison of the Company’s ongoing results of operations. These non-GAAP measures should not be considered a substitute for GAAP-basis measures and results. Our non-GAAP measures may not be comparable to non-GAAP measures of other companies. The Non-GAAP Reconciliation Schedule provides a disclosure of these non-GAAP financial measures to the most closely analogous measure determined in accordance with GAAP.

The following table presents the reconciliation of non-GAAP financial measures to reported GAAP financial measures.

	Three Months Ended March 31,
	2011			2010			Change
Net interest income after provision for loan losses	$	7,774		$	8,123		$	(349	)
Non-interest income		3,304			2,711			593
Non-interest expense		(7,450	)		(7,037	)		(413	)
Income tax (provision) benefit		(859	)		(816	)		(43	)
Net income		2,769			2,981			(212	)
Adjustments
Non-interest income
Reversal of a contingent liability		(500	)		—			(500	)
Total adjustments pre-tax		(500	)		—			(500	)
Income tax provision (benefit)		170			—			170
After tax adjustments to GAAP		(330	)		—			(330	)
Adjusted “net income from core operations”	$	2,439		$	2,981		$	(542	)
Adjusted Return on Average Assets		1.07	%		1.35	%
Adjusted Return on Average Equity		7.89	%		10.04	%
Adjusted Dividend Payout Ratio		56.76	%		46.15	%

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Return on average equity (ROE) and return on average assets (ROA) for the three months ended March 31, 2011 was 8.96% (7.89% excluding the reversal of a contingent liability) and 1.21% (1.07% excluding the reversal of a contingent liability), respectively. ROE was 10.04% and ROA was 1.35% for the same period last year. The dividend payout ratio was 49.41% (56.76% excluding the reversal of a contingent liability) for the three months ended March 31, 2011 and 46.15% for the same period last year.

Allowance for Loan Losses and Credit Fair Value Adjustment

The Company has provided for anticipated loan losses through the allowance for loan losses and a credit fair value adjustment on loans acquired, as shown below:

	March 31,			December 31,			March 31,
	2011			2010			2010
Loans, net of unearned income	$	611,021		$	615,105		$	604,815
Credit fair value adjustment on purchased loans		3,290			3,579			5,483
Total adjusted loans	$	614,311		$	618,684		$	610,298
	March 31,			December 31,			March 31,
	2011			2010			2010
Allowance for loan losses	$	6,800		$	6,500		$	6,500
Credit fair value adjustment on purchased loans		3,290			3,579			5,483
Total allowance	$	10,090		$	10,079		$	11,983
Total allowance to adjusted loans		1.64	%		1.63	%		1.96	%

Management believes that the above information, as to the Company’s evaluation of probable credit losses and its effect on results of operations and financial condition, is useful to investors.

Item 3. Quantitative and Qualitative Disclosure About Market Risk

The Company currently does not enter into derivative financial instruments, which include futures, forwards, interest rate swaps, option contracts and other financial instruments with similar characteristics. However, the Company is party to traditional financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, financial guarantees and letters of credit. These traditional instruments involve to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the Consolidated Balance Sheets.

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. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party up to a stipulated amount and with specified terms and conditions.

Commitments to extend credit and standby letters of credit are not recorded as an asset or liability by the Company until the instrument is exercised.

The Company’s exposure to market risk is reviewed on a regular basis by the Asset/Liability Committee. Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income. Management realizes certain risks are inherent and that the goal is to identify and minimize the risks. Tools used by management include the standard GAP report and an interest rate shock simulation report. The Company has no market risk sensitive instruments held for trading purposes. It appears the Company’s market risk is reasonable at this time.

For a discussion of the Company’s asset and liability management policies, as well as the potential impact of interest rate changes upon the market value of the Company’s financial instruments, see Item 7A in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010. Management, as part of its regular practices, performs periodic reviews of the impact of interest rate changes upon net interest income and market value of the Company’s portfolio equity. Based on, among other factors, such reviews, management believes that there have been no material changes in the market risk of the Company’s asset and liability position since December 31, 2010.

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Item 4. Controls and Procedures

Under the supervision and with the participation of the Company’s management, including our Chief Executive Officer and Finance Division Head, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) under the Securities Exchange Act of 1934. Based upon this evaluation, the Company’s Chief Executive Officer and the Company’s Finance Division Head concluded that our disclosure controls and procedures were effective as of the end of the period covered by this quarterly report.

No changes in our internal control over financial reporting occurred during the quarter ended March 31, 2011 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1 — Legal Proceedings

None.

Item 1A — Risk Factors

There are no material changes to the risk factors set forth in Part I, Item 1A, “Risk Factors,” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, which was filed with the Securities and Exchange Commission (SEC) on March 14, 2011. Please refer to that section for disclosures regarding the risks and uncertainties related to the company’s business.

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

None.

Item 3 — Defaults Upon Senior Securities

None.

Item  4 — Removed and Reserved

Item 5 — Other Information

None.

Item 6 — Exhibits

3.1.1 Amendment to Articles of Incorporation of Penseco Financial Services Corporation, dated March 10, 2011 (incorporated by reference to Exhibit 3.1.2 of the Registrant’s annual report on Form 10-K filed with the SEC on March 14, 2011)

10.1 Employment Agreement, dated January 3, 2011, among Penseco Financial Services Corporation, Penn Security Bank & Trust, and Craig W. Best (incorporated by reference to Exhibit 10.1 of the Registrant’s current report on Form 8-K filed with the SEC on January 7, 2011)

31 Rule 13a-14(a) / 15-d-4(a) Certifications

32 Section 1350 Certifications

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SIGNATURES

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

PENSECO FINANCIAL SERVICES CORPORATION

By	/s/ CRAIG W. BEST
	Craig W. Best
	President and CEO
	(Principal Executive Officer)

Dated: May 9, 2011
By	/s/ PATRICK SCANLON
	Patrick Scanlon
	Senior Vice President, Finance Division Head
	(Principal Financial Officer)
Dated: May 9, 2011

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