Penseco Financial Services (PFNS) 10-Q 2011 Q3 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 September 30, 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  x    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 November 1, 2011 was 3,276,079.

PENSECO FINANCIAL SERVICES CORPORATION

	Page
Part I — FINANCIAL INFORMATION
Item 1. Unaudited Financial Statements - Consolidated
Balance Sheets:
September 30, 2011		3
December 31, 2010		3
Statements of Income:
Three Months Ended September 30, 2011		4
Three Months Ended September 30, 2010		4
Nine Months Ended September 30, 2011		5
Nine Months Ended September 30, 2010		5
Statements of Changes in Stockholders’ Equity:
Three Months Ended September 30, 2011		6
Three Months Ended September 30, 2010		6
Nine Months Ended September 30, 2011		7
Nine Months Ended September 30, 2010		7
Statements of Cash Flows:
Nine Months Ended September 30, 2011		8
Nine Months Ended September 30, 2010		8
Notes to Unaudited Consolidated Financial Statements		9
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		30
Item 3. Quantitative and Qualitative Disclosures About Market Risk		51
Item 4. Controls and Procedures		52
Part II — OTHER INFORMATION
Item 1. Legal Proceedings		52
Item 1A. Risk Factors		52
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		52
Item 3. Defaults Upon Senior Securities		52
Item 4. Removed and Reserved		52
Item 5. Other Information		52
Item 6. Exhibits		52
Signatures		53

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)

	September 30, 2011		December 31, 2010
ASSETS
Cash and due from banks	$	60,565	$	11,585
Interest bearing balances with banks		3,450		2,634
Federal funds sold		—		—
Cash and Cash Equivalents		64,015		14,219
Investment securities:
Available-for-sale, at fair value		149,156		173,297
Held-to-maturity (fair value of $29,616 and $45,218, respectively)		28,207		43,747
Total Investment Securities		177,363		217,044
Loans, net of unearned income		637,841		615,105
Less: Allowance for loan and lease losses		6,711		6,500
Loans, Net		631,130		608,605
Bank premises and equipment		13,192		13,406
Other real estate owned		2,109		803
Accrued interest receivable		3,145		3,809
Goodwill		26,398		26,398
Bank owned life insurance		15,749		15,380
Federal Home Loan Bank stock		5,214		6,082
Other assets		11,216		10,341
Total Assets	$	949,531	$	916,087
LIABILITIES
Deposits:
Non-interest bearing	$	131,189	$	113,391
Interest bearing		600,495		577,641
Total Deposits		731,684		691,032
Other borrowed funds:
Securities sold under agreements to repurchase		22,640		19,394
Short-term borrowings		863		8,688
Long-term borrowings		60,403		68,835
Accrued interest payable		1,041		1,128
Other liabilities		4,404		5,088
Total Liabilities		821,035		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		78,369		74,304
Accumulated other comprehensive income		1,229		(1,280	)
Total Stockholders’ Equity		128,496		121,922
Total Liabilities and Stockholders’ Equity	$	949,531	$	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 September 30, 2011		Three Months Ended September 30, 2010
INTEREST INCOME
Interest and fees on loans	$	8,463	$	8,690
Interest and dividends on investments:
U.S. Treasury securities and U.S. Agency obligations		597		706
States & political subdivisions		803		999
Other securities		16		15
Interest on Federal funds sold		2		—
Interest on balances with banks		3		2
Total Interest Income		9,884		10,412
INTEREST EXPENSE
Interest on time deposits of $100,000 or more		367		621
Interest on other deposits		833		818
Interest on other borrowed funds		585		676
Total Interest Expense		1,785		2,115
Net Interest Income		8,099		8,297
Provision for loan and lease losses		445		858
Net Interest Income After Provision for Loan and Lease Losses		7,654		7,439
NON-INTEREST INCOME
Trust department income		431		400
Service charges on deposit accounts		540		537
Merchant transaction income		1,680		1,597
Brokerage fee income		52		98
Other fee income		450		378
Bank-owned life insurance income		124		132
Other operating income		135		248
Realized gains (losses) on securities, net		159		248
Total Non-Interest Income		3,571		3,638
NON-INTEREST EXPENSES
Salaries and employee benefits		3,397		3,177
Expense of premises and fixed assets		887		888
Merchant transaction expenses		1,110		1,089
FDIC insurance assessments		14		256
Other operating expenses		2,048		1,791
Total Non-Interest Expenses		7,456		7,201
Income before income taxes		3,769		3,876
Applicable income taxes		951		832
Net Income	$	2,818	$	3,044
Earnings per Common Share
(Based on weighted average shares outstanding of 3,276,079)	$	0.86	$	0.93
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 INCOME

(unaudited)

(in thousands, except share and per share amounts)

	Nine Months Ended September 30, 2011		Nine Months Ended September 30, 2010
INTEREST INCOME
Interest and fees on loans	$	25,133	$	25,984
Interest and dividends on investments:
U.S. Treasury securities and U.S. Agency obligations		2,157		2,129
States & political subdivisions		2,527		3,232
Other securities		45		38
Interest on Federal funds sold		2		—
Interest on balances with banks		9		6
Total Interest Income		29,873		31,389
INTEREST EXPENSE
Interest on time deposits of $100,000 or more		1,100		1,586
Interest on other deposits		2,680		2,678
Interest on other borrowed funds		1,824		2,054
Total Interest Expense		5,604		6,318
Net Interest Income		24,269		25,071
Provision for loan and lease losses		1,713		1,723
Net Interest Income After Provision for Loan and Lease Losses		22,556		23,348
NON-INTEREST INCOME
Trust department income		1,214		1,117
Service charges on deposit accounts		1,531		1,632
Merchant transaction income		3,853		3,666
Brokerage fee income		185		260
Other fee income		1,259		1,141
Bank-owned life insurance income		369		384
Other operating income		1,080		481
Realized gains (losses) on securities, net		439		541
Total Non-Interest Income		9,930		9,222
NON-INTEREST EXPENSES
Salaries and employee benefits		10,168		9,442
Expense of premises and fixed assets		2,714		2,673
Merchant transaction expenses		2,609		2,539
FDIC insurance assessments		436		892
Other operating expenses		5,848		5,497
Total Non-Interest Expenses		21,775		21,043
Income before income taxes		10,711		11,527
Applicable income taxes		2,518		2,486
Net Income	$	8,193	$	9,041
Earnings per Common Share
(Based on weighted average shares outstanding of 3,276,079)	$	2.50	$	2.76
Cash Dividends Declared Per Common Share	$	1.26	$	1.26

(See accompanying Notes to Unaudited Consolidated Financial Statements)

5

PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

THREE MONTHS ENDED SEPTEMBER 30, 2011 AND 2010

(unaudited)

(in thousands, except per share amounts)

	Common Stock		Surplus		Retained Earnings			Accumulated Other Comprehensive Income		Total Stockholders’ Equity
Balance, June 30, 2010	$	33	$	48,865	$	71,330		$	880	$	121,108
Comprehensive income:
Net income		—		—		3,044			—		3,044
Other comprehensive income, net of tax
Unrealized gains on securities, net of reclassification adjustment		—		—		—			996		996
Other comprehensive income									996		996
Comprehensive income											4,040
Cash dividends declared ($0.42 per share)		—		—		(1,375	)		—		(1,375	)
Balance, September 30, 2010	$	33	$	48,865	$	72,999		$	1,876	$	123,773
Balance, June 30, 2011	$	33	$	48,865	$	76,927		$	118	$	125,943
Comprehensive income:
Net income		—		—		2,818			—		2,818
Other comprehensive income, net of tax
Unrealized gains on securities, net of reclassification adjustment		—		—		—			1,111		1,111
Other comprehensive income									1,111		1,111
Comprehensive income											3,929
Cash dividends declared ($0.42 per share)		—		—		(1,376	)		—		(1,376	)
Balance, September 30, 2011	$	33	$	48,865	$	78,369		$	1,229	$	128,496

(See accompanying Notes to Unaudited Consolidated Financial Statements)

6

PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

NINE MONTHS ENDED SEPTEMBER 30, 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		—		—		9,041			—			9,041
Other comprehensive income, net of tax
Unrealized gains on securities, net of reclassification adjustment		—		—		—			1,463			1,463
Other comprehensive income									1,463			1,463
Comprehensive income												10,504
Cash dividends declared ($1.26 per share)		—		—		(4,128	)		—			(4,128	)
Balance, September 30, 2010	$	33	$	48,865	$	72,999		$	1,876		$	123,773
Balance, December 31, 2010	$	33	$	48,865	$	74,304		$	(1,280	)	$	121,922
Comprehensive income:
Net income		—		—		8,193			—			8,193
Other comprehensive income, net of tax
Unrealized gains on securities, net of reclassification adjustment		—		—		—			2,509			2,509
Other comprehensive income									2,509			2,509
Comprehensive income												10,702
Cash dividends declared ($1.26 per share)		—		—		(4,128	)		—			(4,128	)
Balance, September 30, 2011	$	33	$	48,865	$	78,369		$	1,229		$	128,496

(See accompanying Notes to Unaudited Consolidated Financial Statements)

7

PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

(in thousands)

	Nine Months Ended September 30, 2011			Nine Months Ended September 30, 2010
OPERATING ACTIVITIES
Net Income	$	8,193		$	9,041
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		797			803
Provision for loan and lease losses		1,713			1,723
Deferred income tax provision (benefit)		190			222
Amortization of securities, (net of accretion)		361			365
Net realized (gains) losses on securities		(439	)		(541	)
(Gain) loss on other real estate		(245	)		(11	)
Decrease (increase) in interest receivable		664			644
(Increase) decrease in bank owned life insurance		(369	)		(396	)
(Increase) decrease in other assets		(1,065	)		1,561
Increase (decrease) in income taxes payable		2,433			1,238
(Decrease) increase in interest payable		(87	)		(174	)
(Decrease) increase in other liabilities		(4,035	)		(3,692	)
Net cash provided (used) by operating activities		8,111			10,783
INVESTING ACTIVITIES
Purchase of investment securities available-for-sale		(5,281	)		(26,773	)
Purchase of investment securities to be held-to-maturity		—			—
Proceeds from investment securities available-for-sale		30,446			18,245
Proceeds from repayments of investment securities available-for-sale		2,916			3,157
Proceeds from repayments of investment securities held-to-maturity		15,478			8,831
Net loans (originated) repaid		(26,536	)		(17,766	)
Proceeds from other real estate		864			589
Investment in premises and equipment		(583	)		(1,721	)
Purchase of bank owned life insurance		—			(450	)
Proceeds from FHLB share buy back		868			—
Net cash provided (used) by investing activities		18,172			(15,888	)
FINANCING ACTIVITIES
Net increase (decrease) in demand and savings deposits		46,578			2,323
Net (payments) proceeds on time deposits		(5,926	)		29,754
Increase (decrease) in securities sold under agreements to repurchase		3,246			3,804
Net (decrease) increase in short-term borrowings		(7,825	)		(27,287	)
Increase in long-term borrowings		—			12,800
Payments on long-term borrowings		(8,432	)		(9,954	)
Cash dividends paid		(4,128	)		(4,128	)
Net cash provided (used) by financing activities		23,513			7,312
Net increase (decrease) in cash and cash equivalents		49,796			2,207
Cash and cash equivalents at January 1		14,219			13,374
Cash and cash equivalents at September 30	$	64,015		$	15,581
The Company paid interest and income taxes of $5,691 and $2,315 and $6,492 and $1,800 for the nine months ended September 30, 2011 and 2010, respectively.

(See accompanying Notes to Unaudited Consolidated Financial Statements)

8

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

For the Three and Nine Months Ended September 30, 2011

(unaudited)

These Notes to Unaudited Consolidated Financial Statements reflect events subsequent to December 31, 2010, 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.

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 and trust company.

The financial statements of the Company have been consolidated with those of its wholly-owned subsidiary, Penn Security Bank and Trust Company and its subsidiaries, 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 applicable rules and regulations of the Securities and Exchange Commission (SEC), 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.

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 and lease 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 and lease 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.

9

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.

Investment securities 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 security. 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 September 30, 2011 and December 31, 2010 are as follows:

Available-for-Sale

		00000000		00000000		00000000		00000000
September 30, 2011	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
U.S. Agency securities	$	54,150	$	912	$	—	$	55,062
Mortgage-backed securities		22,700		983		—		23,683
States & political subdivisions		62,035		3,371		21		65,385
Corporate securities		4,018		7		—		4,025
Total Debt Securities		142,903		5,273		21		148,155
Equity securities		786		387		172		1,001
Total Available-for-Sale	$	143,689	$	5,660	$	193	$	149,156

Available-for-Sale

		00000000		00000000		00000000		00000000
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

		00000000		00000000		00000000		00000000
September 30, 2011	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Mortgage-backed securities	$	23,893	$	1,347	$	—	$	25,240
States & political subdivisions		4,314		62		—		4,376
Total Held-to-Maturity	$	28,207	$	1,409	$	—	$	29,616

10

Held-to-Maturity

		00000000		00000000		00000000		00000000
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 September 30, 2011 and December 31, 2010 consisted solely of other financial institutions’ stock.

A summary of transactions involving available-for-sale debt securities for the nine months ended September 30, 2011 and 2010 are as follows:

	September 30,		September 30,
	2011		2010
Proceeds from sales	$	15,318	$	8,897
Gross realized gains		145		65
Gross realized losses		—		(4	)

The amortized cost and fair value of debt securities at September 30, 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.

September 30, 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	$	8,030	$	8,140	$	—	$	—
Corporate securities		4,018		4,025		—		—
After one year through five years:
U.S. Agency securities		46,120		46,922		—		—
States & political subdivisions		194		199		—		—
After five years through ten years:
States & political subdivisions		4,603		4,730		4,314		4,376
After ten years:
States & political subdivisions		57,238		60,456		—		—
Subtotal		120,203		124,472		4,314		4,376
Mortgage-backed securities		22,700		23,683		23,893		25,240
Total Debt Securities	$	142,903	$	148,155	$	28,207	$	29,616

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 September 30, 2011 and December 31, 2010 are as follows:

		0000000		0000000		0000000		0000000		0000000		0000000
	Less than twelve months				Twelve months or more				Totals
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
September 30, 2011	Value		Losses		Value		Losses		Value		Losses
States & political subdivisions	$	472	$	21	$	—	$	—	$	472	$	21
Equities		201		40		217		132		418		172
Total	$	673	$	61	$	217	$	132	$	890	$	193

11

		0000000		0000000		0000000		0000000		0000000		0000000
	Less than twelve months				Twelve months or more				Totals
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
December 31, 2010	Value		Losses		Value		Losses		Value		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 September 30, 2011, includes six (6) securities that have unrealized losses for less than twelve months and seven (7) 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 September 30, 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 September 30, 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 September 30, 2011.

Marketable Equity Securities

The unrealized losses on the Company’s investments in marketable equity securities were caused by interest rate fluctuations and general 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 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 September 30, 2011.

12

NOTE 6 — Loan Portfolio

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

	September 30,		December 31,
As of:	2011		2010
Loans secured by real estate:
Construction and land development
Residential real estate	$	5,694	$	7,799
Commercial real estate		21,770		28,345
Secured by 1-4 family residential properties:
Revolving, open-end loans		32,097		33,102
Secured by first liens		223,388		225,105
Secured by junior liens		22,136		21,233
Secured by multi-family properties		9,725		8,062
Secured by non-farm, non-residential properties		187,789		179,619
Commercial and industrial loans to U.S. addressees		50,474		36,190
Loans to individuals for household, family and other personal expenditures:
Credit card and related plans		3,087		3,327
Other (installment and student loans, etc.)		50,588		52,536
Obligations of states & political subdivisions		21,257		9,882
All other loans		9,837		9,906
Gross Loans		637,842		615,106
Less: Unearned income on loans		1		1
Loans, net of unearned income	$	637,841	$	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 what the Company believes are conservative underwriting standards.

Age Analysis of Past Due Loans

As of September 30, 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	$	3	$	44	$	443	$	490	$	81,078	$	81,568	$	—
Commercial real estate:
Commercial real estate - construction		—		—		579		579		21,191		21,770		—
Commercial real estate - other		260		399		29		688		187,101		187,789		—
Consumer:
Consumer - credit card		10		2		24		36		3,051		3,087		24
Consumer - other		38		—		10		48		8,033		8,081		—
Consumer - auto		93		19		25		137		29,706		29,843		5
Student loans - TERI		33		27		40		100		5,958		6,058		—
Student loans - other		52		121		240		413		6,192		6,605		240
Residential:
Residential - prime		745		938		2,828		4,511		288,529		293,040		496
Total	$	1,234	$	1,550	$	4,218	$	7,002	$	630,839	$	637,841	$	765

13

Age Analysis of Past Due Loans

As of December 31, 2010

	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	$	90	$	—	$	1,077	$	1,167	$	54,811	$	55,978	$	100
Commercial real estate:
Commercial real estate - construction		—		516		1,040		1,556		26,789		28,345		—
Commercial real estate - other		229		102		345		676		178,943		179,619		—
Consumer:
Consumer - credit card		—		36		20		56		3,271		3,327		20
Consumer - other		—		9		5		14		5,914		5,928		—
Consumer - auto		261		18		34		313		29,801		30,114		6
Student loans - TERI		21		89		60		170		7,233		7,403		—
Student loans - other		150		21		268		439		8,651		9,090		268
Residential:
Residential - prime		2,204		985		2,815		6,004		289,297		295,301		1,236
Total	$	2,955	$	1,776	$	5,664	$	10,395	$	604,710	$	615,105	$	1,630

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

The Bank 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, undercapitalized, 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.

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.

14

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 September 30, 2011

Corporate Credit Exposure

Credit Risk Profile by Credit Worthiness Category

	Commercial		Commercial Real Estate - Construction		Commercial Real Estate - Other
Pass / Watch	$	78,501	$	19,255	$	164,886
Criticized		1,054		2,515		13,772
Substandard		2,013		—		9,131
Total	$	81,568	$	21,770	$	187,789

Consumer Credit Exposure

Credit Risk Profile by Payment Activity

	Residential Real Estate
Performing	$	290,708
Non-performing		2,332
Total	$	293,040

Credit Risk Profile by Payment Activity

	Consumer - Credit Card		Consumer - Other		Consumer - Auto		Student Loans - TERI		Student Loans - Other
Performing	$	3,087	$	8,071	$	29,823	$	6,018	$	6,605
Non-performing		—		10		20		40		—
Total	$	3,087	$	8,081	$	29,843	$	6,058	$	6,605

15

Credit Quality Indicators as of December 31, 2010

Corporate Credit Exposure

Credit Risk Profile by Credit worthiness Category

	Commercial		Commercial Real Estate - Construction		Commercial Real Estate - Other
Pass / Watch	$	54,189	$	25,860	$	160,583
Criticized		896		1,436		10,416
Substandard		893		1,049		8,620
Total	$	55,978	$	28,345	$	179,619

Consumer Credit Exposure

Credit Risk Profile by Payment Activity

	Residential Real Estate
Performing	$	292,486
Non-performing		2,815
Total	$	295,301

Credit Risk Profile by Payment Activity

	Consumer - Credit Card		Consumer - Other		Consumer - Auto		Student Loans - TERI		Student Loans - Other
Performing	$	3,307	$	5,923	$	30,080	$	7,343	$	8,822
Non-performing		20		5		34		60		268
Total	$	3,327	$	5,928	$	30,114	$	7,403	$	9,090

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. 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.

16

Impaired Loans

September 30, 2011

	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:
Commercial real estate	$	390	$	390	$	—	$	431	$	—
Commercial		—		—		—		—		—
Consumer - TERI		40		40		—		58		—
Consumer - other		10		10		—		10		—
Consumer - auto		20		20		—		30		—
Residential real estate		1,355		1,355		—		1,300		—
With an allowance recorded:
Commercial real estate - construction		—		—		—		—		—
Commercial real estate - other		218		218		50		218		—
Commercial		820		820		427		1,120		—
Residential real estate		977		977		185		1,277		—
Total:	$	3,830	$	3,830	$	662	$	4,444	$	—
Commercial real estate	$	608	$	608	$	50	$	649	$	—
Commercial	$	820	$	820	$	427	$	1,120	$	—
Consumer	$	70	$	70	$	—	$	98	$	—
Residential real estate	$	2,332	$	2,332	$	185	$	2,577	$	—

Impaired Loans

December 31, 2010

	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		60		60		—		100		—
Consumer - other		5		5		—		67		—
Consumer - auto		28		28		—		30		—
Residential real estate		467		467		—		500		—
With an allowance recorded:
Commercial real estate - construction		1,040		1,040		200		1,300		—
Commercial real estate - other		150		150		25		155		—
Commercial		1,178		1,178		921		427		17
Residential real estate		1,370		1,370		269		700		14
Total:	$	4,493	$	4,493	$	1,415	$	3,474	$	31
Commercial real estate	$	1,385	$	1,385	$	225	$	1,650	$	—
Commercial	$	1,178	$	1,178	$	921	$	427	$	17
Consumer	$	93	$	93	$	—	$	197	$	—
Residential real estate	$	1,837	$	1,837	$	269	$	1,200	$	14

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 such loans are considered past due. When interest accrual is discontinued, all unpaid accrued interest income is reversed.

17

Interest income is subsequently recognized only to the extent cash payments are received in excess of total 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.

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

	September 30, 2011		December 31, 2010
Commercial	$	443	$	977
Commercial real estate:
Commercial real estate - construction		579		1,040
Commercial real estate - other		29		345
Consumer:
Student loans - TERI		40		60
Student loans - other		—		—
Consumer - other		10		5
Consumer - auto		20		28
Residential:
Residential real estate		2,332		1,579
Total	$	3,453	$	4,034

The Allowance for Loan and Lease Losses and Recorded Investment in Loans for the nine month period ended September 30, 2011 is as follows:

	Commercial			Commercial Real Estate			Consumer			Residential			Credit Card			Unallocated		Total
Allowance for Loan and Lease Losses:
Beginning balance 12/31/10	$	1,957		$	2,067		$	1,380		$	753		$	343		$	—	$	6,500
Charge-offs		(62	)		(494	)		(127	)		(812	)		(81	)		—		(1,576	)
Recoveries		2			1			39			26			6			—		74
Provision		67			537			139			882			88			—		1,713
Ending balance 09/30/11	$	1,964		$	2,111		$	1,431		$	849		$	356		$	—	$	6,711
Ending balance: Individually evaluated for impairment		427			50			—			185			—			—		662
Ending balance: Collectively evaluated for impairment	$	1,537			2,061		$	1,431		$	664		$	356		$	—	$	6,049
Ending balance: Loans acquired with deteriorated credit quality	$	—		$	—		$	—		$	—		$	—		$	—	$	—
Loans:
Ending balance	$	81,568		$	209,559		$	50,587		$	293,040		$	3,087		$	—	$	637,841
Ending balance: Individually evaluated for impairment		5,919			6,232			—			1,594			—			—		13,745
Ending balance: Collectively evaluated for impairment	$	75,649		$	203,327		$	50,587		$	291,446		$	3,087		$	—	$	624,096
Ending balance: Loans acquired with deteriorated credit quality	$	—		$	—		$	—		$	—		$	—		$	—	$	—

18

The Allowance for Loan and Lease Losses and Recorded Investment in Loans for the year ended December 31, 2010 is as follows:

	Commercial		Commercial Real Estate		Consumer		Residential		Credit Card		Unallocated		Total
Allowance for Loan and Lease Losses:
Ending balance	$	1,957	$	2,067	$	1,380	$	753	$	343	$	—	$	6,500
Ending balance: Individually evaluated for impairment		921		225		—		269		—		—		1,415
Ending balance: collectively evaluated for impairment	$	1,036	$	1,842	$	1,380	$	484	$	343	$	—	$	5,085
Ending balance: loans acquired with deteriorated credit quality	$	—	$	—	$	—	$	—	$	—	$	—	$	—
Loans:
Ending balance	$	55,978	$	207,964	$	52,535	$	295,301	$	3,327	$	—	$	615,105
Ending balance: Individually evaluated for impairment		1,178		1,385		93		1,837		—		—		4,493
Ending balance: collectively evaluated for impairment	$	54,800	$	206,579	$	52,442	$	293,464	$	3,327	$	—	$	610,612
Ending balance: loans acquired with deteriorated credit quality	$	—	$	—	$	—	$	—	$	—	$	—	$	—

The Company had one commercial loan whose terms had been modified in a troubled debt restructuring as of September 30, 2011 and December 31, 2010; monthly payments were lowered to accommodate the borrower’s financial needs for a period of time.

Modification

September 30, 2011

	Number of Contracts		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Troubled Debt Restructurings Commercial		1	$	808	$	377

There were no troubled debt restructurings that subsequently defaulted during the nine months ended September 30, 2011.

Modification

December 31, 2010

	Number of Contracts		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Troubled Debt Restructurings Commercial		1	$	808	$	401

19

The loan above, classified as a Troubled Debt Restructuring (TDR), was charged down during 2010 to a balance of $401 and the entire pre-modification balance was split into two notes. The customer is currently paying principal and interest on one note and interest only on the other note. Nonetheless, the loan is fully reserved based on management’s evaluation of both the customer’s ability to maintain their cash flow and the value of the underlying collateral.

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 within other assets 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.

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:

September 30,
2012	$	276
2013		239
2014		203
2015		166
2016		129
Thereafter		166
	$	1,179

20

NOTE 10 — Long-Term Debt

The loans from the Federal Home Loan Bank of Pittsburgh are secured by all 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 September 30, 2011 is as follows:

Monthly Installment	Fixed Rate			Maturity Date		Balance
Amortizing loans
$  29		1.84	%		08/28/12	$	311
90		3.10	%		02/28/13		1,496
430		3.74	%		03/13/13		7,517
18		2.66	%		08/28/14		599
67		3.44	%		03/02/15		2,591
13		3.48	%		03/31/15		530
10		3.83	%		04/02/18		700
186		4.69	%		03/13/23		19,859
Total amortizing							33,603
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						$	60,403

Aggregate maturities of long-term debt at September 30, 2011 are as follows:

September 30,	Principal
2012	$	10,827
2013		12,605
2014		2,696
2015		10,355
2016		4,720
Thereafter		19,200
	$	60,403

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
Nine months ended September 30,	2011			2010			2011		2010
Service cost	$	—		$	—		$	6	$	3
Interest cost		525			532			18		15
Expected return on plan assets		(678	)		(660	)		—		—
Amortization of prior service cost		—			—			6		6
Amortization of net loss (gain)		63			43			—		—
Net periodic pension cost	$	(90	)	$	(85	)	$	30	$	24

21

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 nine months ended September 30, 2011 and 2010 was $362 and $390 respectively.

The Company granted restricted stock awards during the nine months ended September 30, 2011 valued at $56. There were no awards during the nine months ended September 30, 2010.

NOTE 12 — Regulatory Matters

The Company and the Bank are subject to various regulatory capital requirements administered by the Federal Deposit Insurance Corporation (FDIC) and the Board of Governors of the Federal Reserve System (Federal Reserve Board). 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 September 30, 2011, that the Company and the Bank meet all capital adequacy requirements to which they are subject.

As of September 30, 2011, 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. As of September 30, 2011, the Company and Bank have capital levels that 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. Dividends from the Bank are the Company’s primary source of funds.

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 Board has interpreted “capital stock and surplus” to include undivided profits.

22

Actual							Regulatory Requirements
							For Capital Adequacy Purposes							To Be “Well Capitalized”
As of September 30, 2011	Amount		Ratio				Amount			Ratio				Amount			Ratio
Total Capital (to Risk Weighted Assets)
PFSC (Company)	$	103,823		16.75	%	³	$	49,576	³		8.0	%	³		N/A	³		N/A
PSB (Bank)	$	100,213		16.19	%	³	$	49,528	³		8.0	%	³	$	61,909	³		10.0	%
Tier 1 Capital (to Risk Weighted Assets)
PFSC (Company)	$	97,015		15.66	%	³	$	24,788	³		4.0	%	³		N/A	³		N/A
PSB (Bank)	$	93,502		15.10	%	³	$	24,764	³		4.0	%	³	$	37,145	³		6.0	%
Tier 1 Capital (to Average Assets)
PFSC (Company)	$	97,015		10.82	%	³	$	*	³		*		³		N/A	³		N/A
PSB (Bank)	$	93,502		10.47	%	³	$	*	³		*		³	$	44,632	³		5.0	%

PFSC - *3.0% ($26,668), 4.0% ($35,557) or 5.0% ($44,447) depending on the bank’s CAMELS Rating and other regulatory risk factors.

PSB - *3.0% ($26,536), 4.0% ($35,381) or 5.0% ($44,227) depending on the bank’s CAMELS Rating and other regulatory risk factors.

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	%	³	$	47,852	³		8.0	%	³		N/A	³		N/A
PSB (Bank)	$	94,455		15.81	%	³	$	47,808	³		8.0	%	³	$	59,760	³		10.0	%
Tier 1 Capital (to Risk Weighted Assets)
PFSC (Company)	$	91,499		15.30	%	³	$	23,926	³		4.0	%	³		N/A	³		N/A
PSB (Bank)	$	87,955		14.72	%	³	$	23,904	³		4.0	%	³	$	35,856	³		6.0	%
Tier 1 Capital (to Average Assets)
PFSC (Company)	$	91,499		10.68	%	³	$	*	³		*		³		N/A	³		N/A
PSB (Bank)	$	87,955		10.32	%	³	$	*	³		*		³	$	42,607	³		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.

23

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 September 30, 2011, there were a total of two loans remaining with a carrying value of $217 with a credit fair value adjustment of $217. 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 September 30, 2010, there were a total of three loans remaining with a carrying value of $714 with a credit fair value adjustment of $370. 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.

24

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

Nine Months Ended September 30, 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		(12	)		(12	)		—
Consumer / Other		—			—			—
Total Payments		(12	)		(12	)		—
Balance, September 30, 2011	$	217		$	217		$	—

Nine Months Ended September 30, 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		(1,240	)		(925	)		(315	)
Consumer / Other		—			—			—
Total loans transferred to other real estate owned		(1,240	)		(925	)		(315	)
Payments
Residential Mortgages		—			—			—
Commercial		(12	)		(12	)		—
Consumer / Other		—			—			—
Total Payments		(12	)		(12	)		—
Balance, September 30, 2010	$	714		$	370		$	344

25

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:

	September 30, 2011
	Level I		Level II		Level III		Total
Assets:
Securities available-for-sale
U.S. Agency securities	$	—	$	55,062	$	—	$	55,062
Mortgage-backed securities:
Residential		—		23,683		—		23,683
States & political subdivisions:
Bank qualified tax exempt		—		65,385		—		65,385
Corporate securities:
Aaa credit rating		—		4,025		—		4,025
Equity securities:
Financial services industry		1,001		—		—		1,001
Total securities available-for-sale	$	1,001	$	148,155	$	—	$	149,156

26

	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 nine months ended September 30, 2011 as a result of management’s determination that no evidence of impairment was present during the period.

Impaired Loans

At September 30, 2011 certain impaired loans were re-measured and reported at fair value through a specific valuation allowance allocation of the allowance for loan and lease 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 $3,830 were reduced by a specific valuation allowance allocation totaling $662, to a total reported fair value of $3,168 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. During the first nine months of 2011, the FHLB repurchased $868 of capital stock which represented 14.27% of the Bank’s $6,082 investment as of December 31, 2010. Based on current financial information available, management does not believe the FHLB stock value is impaired as of September 30, 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.

27

Certain assets measured at fair value on a non-recurring basis as of September 30, 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 September 30, 2011
	Level I		Level II		Level III		Total
Assets
Core deposit intangible	$	—	$	—	$	1,179	$	1,179
Goodwill		—		—		26,398		26,398
Impaired loans		—		—		3,168		3,168
Federal Home Loan Bank stock		—		—		5,214		5,214
Other real-estate owned		—		2,109		—		2,109
Total non-financial assets	$	—	$	2,109	$	35,959	$	38,068

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		—		—		3,078		3,078
Federal Home Loan Bank stock		—		—		6,082		6,082
Other real-estate owned		—		803		—		803
Total non-financial assets	$	—	$	803	$	36,968	$	37,771

A reconciliation of items in Level III for the nine month period ended September 30, 2011 is as follows:

	Core deposit intangible			Goodwill		Impaired Loans			Federal Home Loan Bank Stock			Total
Balance, December 31, 2010	$	1,410		$	26,398	$	3,078		$	6,082		$	36,968
Amortization of core deposit intangible		(231	)		—		—			—			(231	)
Increase in impaired loans		—			—		2,742			—			2,742
Decrease in impaired loans		—			—		(2,652	)		—			(2,652	)
Payments received		—			—		—			(868	)		(868	)
Balance, September 30, 2011	$	1,179		$	26,398	$	3,168		$	5,214		$	35,959

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		—			—		3,658			—			—			3,658
Decrease in impaired loans		—			—		(580	)		—			—			(580	)
Payments received		—			—		—			(320	)		(123	)		(443	)
Balance, December 31, 2010	$	1,410		$	26,398	$	3,078		$	6,082		$	—		$	36,968

28

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 September 30, 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 bank owned 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 (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 (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.

29

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

	September 30, 2011						December 31, 2010
	Carrying Amount			Fair Value			Carrying Amount			Fair Value
Cash and cash equivalents	$	64,015		$	64,015		$	14,219		$	14,219
Investment securities held-to-maturity		28,207			29,616			43,747			45,218
Loans, net		631,130			647,602			608,605			620,040
Bank owned life insurance		15,749			15,749			15,380			15,380
Demand deposits		488,546			488,546			441,968			441,968
Time deposits		243,138			246,761			249,064			251,779
Short-term borrowings		23,503			23,503			28,082			28,082
Long-term borrowings		60,403			64,306			68,835			71,309
Standby Letters of Credit	$	(192	)	$	(192	)	$	(164	)	$	(164	)

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

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 and its direct and indirect subsidiaries. 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 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. Department of Treasury and the Federal Reserve System, 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 the values of real estate and other collateral, particularly in our market area, changes in relevant accounting principles and guidelines, and inability of third party service providers to perform.

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.

The following commentary provides an overview of the financial condition at September 30, 2011, including any significant changes from December 31, 2010, and significant changes in the results of our operations for the three and nine month periods ended September 30, 2011 and September 30, 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 and Allowance for loan and lease losses - The allowance for loan and lease 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 and lease losses charged to operating expense represents the adjustment that, in management’s judgement, is necessary to the allowance for loan and lease losses such that the allowance can absorb probable losses.

30

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 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.

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 Company’s 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.

31

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 exceed 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.

Securities sold under agreements to repurchase - The Company also offers securities sold under agreements to repurchase as an alternative to conventional savings deposits for its customers. The securities sold under agreements to repurchase 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 professionally prepared Step One goodwill impairment test as of December 31, 2010. As a result of such impairment test, goodwill was determined to be not impaired at December 31, 2010.

Comparison of Operating Results

	Three Months Ended September 30,						Nine Months Ended September 30,
	2011			2010			2011			2010
Interest Income	$	9,884		$	10,412		$	29,873		$	31,389
Interest Expense		1,785			2,115			5,604			6,318
Net Interest Income		8,099			8,297			24,269			25,071
Non-Interest Income		3,571			3,638			9,930			9,222
Non-Interest Expenses		7,456			7,201			21,775			21,043
Net Income	$	2,818		$	3,044		$	8,193		$	9,041
Total Revenue(1)	$	13,455		$	14,050		$	39,803		$	40,611
Net Interest Margin		3.88	%		4.08	%		3.84	%		4.13	%
Return on Assets (ROA)		1.20	%		1.37	%		1.20	%		1.36	%
Return on Equity (ROE)		8.88	%		9.94	%		8.76	%		9.99	%

(1) Total revenue is the sum of interest income and non-interest income.

The Company reported net income for the three months ended September 30, 2011 of $2,818 or $0.86 per weighted average share compared with $3,044 or $0.93 per weighted average share from the year ago period, a decrease of $226 or 7.4%. Pre-provision net interest income decreased $198 or 2.4%. Net interest income, after provision for loan and lease losses, increased $215 or 2.9% during the 2011 period, a reduction in interest expense of $330 or 15.6% from lower funding costs and a $413 decrease in the provision for loan and lease losses offset by a decrease in interest income of $528 or 5.1%. The decrease in interest income was primarily attributable to investment and

32

loan cash flows being reinvested at historically low yields, including excess reserve deposits held at the Federal Reserve Bank of Philadelphia. Non-interest income decreased $67 or 1.8%. Non-interest expenses increased $255 or 3.5% due to increases in salaries and benefits and other operating expenses.

The Company reported net income for the nine months ended September 30, 2011 of $8,193 or $2.50 per weighted average share compared with $9,041 or $2.76 per weighted average share from the year ago period, a decrease of $848 or 9.4%. Pre-provision net interest income decreased $802 or 3.2%. Net interest income, after provision for loan and lease losses, decreased $792 or 3.4% during the 2011 period, due to a decrease in interest income of $1,516 or 4.8%, reduced interest expense of $714 or 11.3% from lower funding costs and an essentially unchanged provision for loan and lease losses at $1,713. The decrease in interest income was primarily attributable to investment and loan cash flows being reinvested at historically low yields. Non-interest income increased $708 or 7.7% primarily as a result of the reversal in the first quarter of a $500 contingent liability recorded in connection with the Merger. Non-interest expenses increased $732 or 3.5% due to increases in salaries and employee benefits and other operating expenses offset by reduced FDIC insurance expense.

Net income from core operations, which excludes the reversal of a contingent liability recorded in connection with the Merger, decreased $1,178 for the nine months ended September 30, 2011 to $7,863 compared to $9,041 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 the acquisition date fair value adjustments relating to the Merger, included in the Company’s financial results during the periods indicated:

	Three Months Ended
	September 30, 2011			September 30, 2010
Homogeneous loan pools	$	124		$	152
Time deposits		22			41
Core deposit intangible expense		(48	)		(55	)
Net income from acquisition fair value adjustment	$	98		$	138

	Nine Months Ended
	September 30, 2011			September 30, 2010
Homogeneous loan pools	$	403		$	481
Time deposits		77			148
Core deposit intangible expense		(152	)		(170	)
Net income from acquisition fair value adjustment	$	328		$	459

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.

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.

33

Net interest income before applying the provision for loan and lease losses decreased $198 or 2.4% to $8,099 for the three months ended September 30, 2011 compared to $8,297 for the three months ended September 30, 2010. The average yield on interest earning assets decreased 45 basis points or 8.4%.

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. For the three months ended September 30, 2011, net interest margin decreased 20 basis points to 3.88% from 4.08% in the same period of 2010.

Total average interest earning assets and average interest bearing liabilities increased from the three months ended September 30, 2010. Average interest earning assets increased $21.1 million or 2.6%, from $814.1 million in 2010 to $835.2 million in 2011 and average interest bearing liabilities increased $36.6 million or 5.7%, from $646.6 million to $683.2 million for the same period. As a percentage of average assets, average earning assets, including bank-owned life insurance (BOLI) decreased for the three months ended September 30, 2011 and 2010, respectively, to 90.3% from 93.2%. The decrease is primarily due to management’s decision to currently maintain excess deposits with the Federal Reserve Bank of Philadelphia (FRB) which are highly liquid, albeit low-yield, investment which the Company can quickly liquidate and reinvest as more attractive investment opportunities become available.

Changes in the mix of both interest earning assets and funding sources also impacted net interest income in the three months ended September 30, 2011 and 2010. Average loans as a percentage of average interest earning assets decreased from 75.1% in 2010 to 75.0% in 2011. Average investment securities decreased $11.3 million or 5.9% year over year as a percentage of interest earning assets to 21.5% at September 30, 2011 from 23.4% at September 30, 2010. Average short-term investments, federal funds sold, FHLB stock and interest bearing balances with banks, increased as a percentage of average assets to 3.5% at September 30, 2011 from 1.5% at September 30, 2010. Average time deposits increased $22.6 million or 10.1% from $224.7 million or 34.7% of interest bearing liabilities in 2010 to $247.3 million or 36.2% of interest bearing liabilities for the 2011 period. In addition, during the three months ended September 30, 2011, securities sold under agreements to repurchase increased $0.4 million or 1.8% and average short-term borrowings decreased $4.4 million or 91.7%.

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 64 basis points from 4.69% for the three months ended September 30, 2010 to 4.05% for the three months ended September 30, 2011. Also, average loan yields decreased 29 basis points from 5.69% for the three months ended September 30, 2010 to 5.40% for the three months ended September 30, 2011.

The average time deposit costs decreased 48 basis points from 1.92% for the three months ended September 30, 2010 to 1.44% for the three months ended September 30, 2011. In addition, the average cost of money market accounts decreased 12 basis points from 0.60% for the three months ended September 30, 2010 to 0.48% for the three months ended September 30, 2011.

Interest expense for the three months ended September 30, 2011 totaled $1,785, compared to $2,115 in 2010, a decrease of $330 or 15.6%. The average rate paid on interest-bearing liabilities for the three months ended September 30, 2011 decreased to 1.08%, compared to 1.31% in 2010. Average interest-bearing liabilities increased $36.6 or 5.7% to $683.2 from $646.6 in 2010. Average savings deposits increased $3.4 or 2.9%. Average time deposits increased $22.6 or 10.1% for the three months ended September 30, 2011 due primarily to the issuance of brokered certificates of deposit which had favorable terms compared to other funding sources. Average time deposits represented 36.2% of average interest-bearing liabilities for the three months ended September 30, 2011, compared to 34.7% in 2010. Average demand non-interest bearing deposits increased $11.6 or 10.2%.

The historically low interest rates have begun to stress our margin as funding costs have reached a low point and asset yields continue to price downward. The Dodd-Frank Act, which was enacted in July 2010, and the regulations that have been and will be promulgated under the Act, are expected to reduce our non-interest income, such as overdraft fees, and increase compliance and regulatory costs.

34

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

The table below presents average balances, interest income on a 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 September 30, 2011 and September 30, 2010.

	September 30, 2011							September 30, 2010
ASSETS	Average Balance		Revenue/ Expense		Yield/ Rate			Average Balance		Revenue/ Expense		Yield/ Rate
Investment Securities
Available-for-sale:
U.S. Agency obligations	$	78,800	$	361		1.80	%	$	80,720	$	472		2.34	%
States & political subdivisions		64,144		721		6.73	%		65,539		739		6.83	%
Other		5,253		16		1.20	%		5,235		15		1.15	%
Held-to-maturity:
U.S. Agency obligations		24,713		236		3.84	%		19,272		234		4.86	%
States & political subdivisions		6,399		82		7.82	%		19,810		260		7.95	%
Loans, net of unearned income:
Real estate mortgages		315,109		4,040		5.16	%		326,985		4,302		5.26	%
Commercial real estate		185,664		2,292		4.92	%		182,574		2,361		5.17	%
Commercial		41,198		610		5.88	%		30,817		482		6.26	%
Consumer and other		84,493		1,521		7.20	%		71,025		1,545		8.70	%
Federal funds sold		10,109		2		0.12	%		—		—		—
Federal Home Loan Bank stock		5,298		—		—			6,402		—		—
Interest on balances with banks		14,010		3		0.12	%		5,712		2		0.14	%
Total Interest Earning Assets/
Total Interest Income		835,190	$	9,884		4.92	%		814,091	$	10,412		5.37	%
Cash and due from banks		42,669							10,871
Bank premises and equipment		13,214							13,152
Accrued interest receivable		3,128							3,602
Goodwill		26,398							26,398
Bank owned life insurance		15,676							15,005
Other assets		12,135							12,658
Less: Allowance for loan and lease losses		6,553							6,003
Total Assets	$	941,857						$	889,774
LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits:
Demand-Interest bearing	$	68,680	$	51		0.24	%	$	68,607	$	69		0.40	%
Savings		118,937		78		0.24	%		115,549		82		0.28	%
Money markets		163,339		186		0.48	%		143,520		217		0.60	%
Time - Over $100		84,542		367		1.68	%		107,896		621		2.30	%
Time - Other		162,767		518		1.32	%		116,786		450		1.54	%
Federal funds purchased		—		—		—			—		—		—
Securities sold under agreements to repurchase		23,027		21		0.36	%		22,633		42		0.74	%
Short-term borrowings		385		—		—			4,832		8		0.66	%
Long-term borrowings		61,527		564		3.72	%		66,802		626		3.75	%
Total Interest Bearing Liabilities/
Total Interest Expense		683,204	$	1,785		1.08	%		646,625	$	2,115		1.31	%
Demand - Non-interest bearing		124,831							113,213
All other liabilities		6,641							7,420
Stockholders’ equity		127,181							122,516
Total Liabilities and Stockholders’ Equity	$	941,857						$	889,774
Interest Spread						3.84	%						4.06	%
Net Interest Income			$	8,099						$	8,297
FINANCIAL RATIOS
Net interest margin						3.88	%						4.08	%
Return on average assets						1.20	%						1.37	%
Return on average equity						8.88	%						9.94	%
Average equity to average assets						13.50	%						13.77	%
Dividend payout ratio						48.84	%						45.16	%

35

(1) The net interest margin is equal to tax equivalent net interest income divided by average interest earning assets. In order to make pre-tax income on tax-exempt investments comparable to taxable investments, a tax equivalent adjustment is made to interest income. This adjustment increased interest income by $401 and $513 for the three months ended September 30, 2011 and 2010, respectively. Although the Company believes that these financial measures enhance investors’ understanding of our business and performance, these measures should not be considered an alternative to GAAP.

Net interest income before provision for loan and lease losses decreased $802 or 3.2% to $24,269 for the nine months ended September 30, 2011 compared to $25,071 for the nine months ended September 30, 2010. The average yield on interest earning assets decreased 53 basis points or 9.7%.

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 nine months ended September 30, 2011, net interest margin decreased 29 basis points to 3.84% from 4.13% in the same period of 2010.

Total average interest earning assets and average interest bearing funds increased from the nine months ended September 30, 2010. Average interest earning assets increased $33.7 million or 4.2%, from $808.8 million in 2010 to $842.5 million in 2011 and average interest bearing funds increased $31.6 million or 4.9%, from $644.9 million to $676.5 million for the same period. As a percentage of average assets, average interest-earning assets, including bank-owned life insurance (BOLI) remained relatively unchanged for the nine months ended September 30, 2011 and 2010, respectively.

Changes in the mix of both interest earning assets and funding sources also impacted net interest income in the nine months ended September 30, 2011 and 2010. Average loans as a percentage of average interest earning assets decreased from 75.2% in 2010 to 73.5% in 2011. Average investment securities increased $8.2 million but as a percentage of interest earning assets investments remained relatively unchanged at 23.6% for the nine months ended September 30, 2011 and 2010, respectively. Average short-term investments, federal funds sold, FHLB stock and interest bearing balances with banks, increased as a percentage of average assets to 2.9% at September 30, 2011 from 1.3% at September 30, 2010. Average time deposits increased $31.4 million or 14.5% from $216.6 million or 33.6% of interest bearing liabilities in 2010 to $248.0 million or 36.7% of interest bearing liabilities for the 2011 period. In addition, during the nine months ended September 30, 2011, average federal funds purchased decreased $5.2 million or 100.0%, average securities sold under agreements to repurchase increased $1.5 million or 7.6% and average short-term borrowings decreased $9.5 million or 90.5%.

Shifts in the interest rate environment and local competition for loans and deposits affected the rates paid for funds as well as the yields earned on assets. The investment securities tax equivalent yield decreased 90 basis points from 4.94% for the nine months ended September 30, 2010 to 4.04% for the nine months ended September 30, 2011. Also, average loan yields decreased 29 basis points from 5.70% for the nine months ended September 30, 2010 to 5.41% for the nine months ended September 30, 2011.

The average time deposit costs decreased 40 basis points from 1.91% for the nine months ended September 30, 2010 to 1.51% for the nine months ended September 30, 2011. In addition, the average cost of money market accounts decreased 14 basis points from 0.62% for the nine months ended September 30, 2010 to 0.48% for the nine months ended September 30, 2011.

Interest expense for the nine months ended September 30, 2011 totaled $5,604, compared to $6,318 in 2010, a decrease of $714 or 11.3%. The average rate paid on interest-bearing liabilities for the nine months ended September 30, 2011 decreased to 1.08%, compared to 1.31% in 2010. Average interest-bearing liabilities increased $31.6 or 4.9% to $676.5 from $644.9 in 2010. Average savings deposits increased $3.0 or 2.6%. Average time deposits increased $31.4 or 14.5% for the nine months ended September 30, 2011 due primarily to the issuance of brokered certificates of deposit. Average time deposits represented 36.7% of average interest-bearing liabilities for the nine months ended September 30, 2011, compared to 33.6% in 2010. Average demand non-interest bearing deposits increased $8.7 or 7.9%.

36

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

The table below presents average balances, interest income on a 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 nine months ended September 30, 2011 and September 30, 2010.

	September 30, 2011							September 30, 2010
ASSETS	Average Balance		Revenue/ Expense		Yield/ Rate			Average Balance		Revenue/ Expense		Yield/ Rate
Investment Securities
Available-for-sale:
U.S. Agency obligations	$	94,345	$	1,377		1.92	%	$	74,265	$	1,378		2.47	%
States & political subdivisions		63,195		2,153		6.91	%		71,048		2,399		6.82	%
Other		5,219		45		1.20	%		3,280		38		1.54	%
Held-to-maturity:
U.S. Agency obligations		26,197		780		3.96	%		20,910		751		4.79	%
States & political subdivisions		9,903		374		7.64	%		21,200		833		7.94	%
Loans, net of unearned income:
Real estate mortgages		317,262		12,205		5.16	%		329,255		13,051		5.29	%
Commercial real estate		179,380		6,642		4.92	%		176,961		6,813		5.13	%
Commercial		39,782		1,735		5.76	%		30,354		1,512		6.64	%
Consumer and other		82,707		4,551		7.32	%		71,365		4,608		8.61	%
Federal funds sold		3,992		2		0.12	%		—		—		—
Federal Home Loan Bank stock		5,611		—		—			6,402		—		—
Interest on balances with banks		14,873		9		0.12	%		3,753		6		0.21	%
Total Interest Earning Assets/
Total Interest Income		842,466	$	29,873		4.92	%		808,793	$	31,389		5.45	%
Cash and due from banks		21,148							10,550
Bank premises and equipment		13,336							12,769
Accrued interest receivable		3,291							3,757
Goodwill		26,398							26,398
Bank owned life insurance		15,551							14,667
Other assets		11,627							13,020
Less: Allowance for loan and lease losses		6,566							6,219
Total Assets	$	927,251						$	883,735
LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits:
Demand-Interest bearing	$	69,653	$	185		0.36	%	$	69,329	$	247		0.48	%
Savings		117,185		235		0.24	%		114,217		245		0.29	%
Money markets		155,223		555		0.48	%		143,088		666		0.62	%
Time - Over $100		83,907		1,100		1.80	%		95,142		1,586		2.22	%
Time - Other		164,139		1,705		1.44	%		121,474		1,520		1.67	%
Federal funds purchased		—		—		—			5,248		22		0.56	%
Securities sold under agreements to repurchase		21,288		67		0.36	%		19,842		124		0.83	%
Short-term borrowings		1,039		3		0.36	%		10,525		35		0.44	%
Long-term borrowings		64,099		1,754		3.60	%		66,066		1,873		3.78	%
Total Interest Bearing Liabilities/
Total Interest Expense		676,533	$	5,604		1.08	%		644,931	$	6,318		1.31	%
Demand - Non-interest bearing		119,191							110,473
All other liabilities		6,450							7,717
Stockholders’ equity		125,077							120,614
Total Liabilities and Stockholders’ Equity	$	927,251						$	883,735
Interest Spread						3.84	%						4.14	%
Net Interest Income			$	24,269						$	25,071
FINANCIAL RATIOS
Net interest margin						3.84	%						4.13	%
Return on average assets						1.20	%						1.36	%
Return on average equity						8.76	%						9.99	%
Average equity to average assets						13.49	%						13.65	%
Dividend payout ratio						50.40	%						45.65	%

37

(1) The net interest margin is equal to tax equivalent net interest income divided by average interest earning assets. In order to make pre-tax income on tax-exempt investments comparable to taxable investments, a tax equivalent adjustment is made to interest income. This adjustment increased interest income by $1,301 and $1,664 for the nine months ended September 30, 2011 and 2010, respectively. The Company believes that the tax equivalent presentation is consistent with industry practice. Although the Company believes that these financial measures enhance investors’ understanding of our business and performance, these measures should not be considered an alternative to GAAP.

Provision for Loan and Lease Losses

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

As a full service community bank operating twelve branch offices throughout Northeastern Pennsylvania, the Bank’s facilities, employees, customers and the collateral securing many of its loans is located in Northeastern Pennsylvania. Accordingly, trends in the local economy have a significant impact on the Bank’s and the Company’s financial condition.

During the three months ended September 30, 2011, 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 the Scranton/Wilkes-Barre metropolitan area was 9.8% in August 2011. The Company continues to proactively evaluate probable loan losses and address delinquent loans by, among other things, obtaining current appraisals of collateral, increasing communication with clients and placing loans on non-accrual status when collection is in doubt and the loan is moving toward foreclosure.

The Bank’s methodology for determining the allowance for loan and lease losses (ALLL) is based on a 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 allowance methodology in accordance with the FFIEC Interagency Policy Statements, as amended, and GAAP in assessing the adequacy of its allowance for loan and lease losses. Under GAAP, the adequacy of the allowance for loan and lease 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. The provision for loan and lease losses for the three months ended September 30, 2011 was $413 less than the provision for loan and lease losses for the three months ended September 30, 2010 due to lower net charge-offs.

The Bank’s 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 calculated by dollar amount. 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 drop in real estate values within the market area. The Bank’s provision for loan and lease losses for the quarter ended September 30, 2011 was allocated primarily to commercial real estate and residential real estate portfolios. Reference should be made to the information about the Company’s provision for loan and lease losses under the heading “General Notes to Financial Statements - Note 6 - Loan Portfolio”.

38

Based on this methodology, management made a provision for loan and lease losses of $1,713 for the nine month period ended September 30, 2011, compared to a $1,723 provision for the comparable prior year period, resulting in an allowance for loan and lease losses of $6,711 at September 30, 2011 compared to $6,500 at December 31, 2010. The provision for the three months ended September 30, 2011 was $445 compared to $858 for the three months ended September 30, 2010 due to lower net charge offs this quarter. The amount and number of charge-offs and foreclosures during the periods indicated are as follows:

	At and For The Nine Months Ended September  30, 2011			At and For The Twelve  Months Ended December 31, 2010			At and For The Nine  Months Ended September 30, 2010
Provision for loan and lease losses	$	1,713		$	1,999		$	1,723
Allowance for loan and lease losses to non-performing loans		194.35	%		161.13	%		133.44	%
Non-performing loans to period end loans		0.54	%		0.66	%		0.78	%
Ratio of charged-off loans to average loans		0.25	%		0.30	%		0.25	%
Ratio of foreclosed loans to average loans		0.38	%		0.19	%		0.19	%

	At and For The Nine  Months Ended September 30, 2011				At and For The Twelve  Months Ended December 31, 2010				At and For The Nine  Months Ended September 30, 2010
	Amount		(#)		Amount		(#)		Amount		(#)
Charge-offs	$	1,576		66	$	1,838		102	$	1,537		80
Foreclosures completed		2,370		14		1,183		6		1,183		6
Non-performing loans		3,453		82		4,034		70		4,871		76

The Company had one commercial loan whose terms had been modified in a troubled debt restructuring as of September 30, 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:

	September 30, 2011		December 31, 2010
Restructured Loans on Accrual Status and Not Past Due 90 Days or More	$	377	$	—
Restructured Loans Included in Non-Accrual Loans or Accruing Loans
Past Due 90 Days or More		—		401
Total Restructured Loans	$	377	$	401

The Company believes that the judgments used in determining the allowance for loan and lease losses are based on reliable information. In assessing the adequacy of the allowance for loan and lease 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 determining the allowance on a periodic basis. Based on this ongoing evaluation, a provision for loan and lease losses is made in the amount necessary to maintain an appropriate allowance.

The methodology for 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 and lease 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 and lease 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 and lease losses. Discussions with these regulatory agencies may result in adjustments to the Company’s allowance based on judgments about information available to the agencies at the time of their examination.

Other than the risks associated with the geographic concentration of our customers, facilities and the collateral securing some of our loans, there are no particular risk elements in the local economy that put a group or category of

39

loans at increased risk. However, the Company has increased its portfolio of commercial loans over the last five years, which typically bear a higher risk. These loans are typically secured by real estate to minimize this risk. At September 30, 2011, management believes the allowance for loan and lease 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 September 30, 2011 and September 30, 2010, respectively:

Three Months Ended:	September 30, 2011		September 30, 2010
Trust department income	$	431	$	400
Service charges on deposit accounts		540		537
Merchant transaction income		1,680		1,597
Brokerage fee income		52		98
Other fee income		450		378
Bank-owned life insurance income		124		132
Other operating income		135		248
Realized gains (losses) on securities, net		159		248
Total Non-Interest Income	$	3,571	$	3,638

Total non-interest income decreased $67 or 1.8%, to $3,571 for the three months ended September 30, 2011, compared with $3,638 for the same period in 2010. Trust department income increased $31 or 7.8% due to an increase in the market value of trust assets and new business. Merchant transaction income increased $83 or 5.2%, due primarily to the increased volume of merchant transactions and new business. Brokerage fee income decreased $46 or 46.9%, mostly due to a lower volume of investor activity. Other fee income increased $72 or 19.0% mainly from increased debit card discounts related to the increased number of accounts. Other operating income decreased $113 largely due to net gains on the sale of other real estate owned property in 2010 and lower gains on mortgage loans sold. Realized gains (losses) on securities, net, decreased $89.

The following table sets forth information by category of non-interest income for the Company for the nine months ended September 30, 2011 and September 30, 2010, respectively:

Nine Months Ended:	September 30, 2011		September 30, 2010
Trust department income	$	1,214	$	1,117
Service charges on deposit accounts		1,531		1,632
Merchant transaction income		3,853		3,666
Brokerage fee income		185		260
Other fee income		1,259		1,141
Bank-owned life insurance income		369		384
Other operating income		1,080		481
Realized gains (losses) on securities, net		439		541
Total Non-Interest Income	$	9,930	$	9,222

Total non-interest income increased $708 or 7.7% to $9,930 for the nine months ended September 30, 2011, compared with $9,222 for the same period in 2010. Trust department income increased $97 or 8.7% due to an increase in the market value of trust assets and new business. Service charges on deposit accounts decreased $101 or 6.2%, primarily due to decreased overdraft activity. Merchant transaction income increased $187 or 5.1%, due to the increased volume of merchant transactions primarily from new business. Brokerage fee income decreased $75 or 28.8% mostly due to a lower volume of investor activity. Other fee income increased $118 or 10.3% mainly from increased debit card discounts related to the increased number of accounts. Other operating income increased $599 largely due to the reversal of a contingent liability of $500 recorded in connection with the Old Forge Bank acquisition. Realized gains (losses) on securities, net, decreased $102.

40

Non-Interest Expenses

The following table sets forth information by category of non-interest expenses for the Company for the three months ended September 30, 2011 and September 30, 2010, respectively:

Three Months Ended:	September 30, 2011		September 30, 2010
Salaries and employee benefits	$	3,397	$	3,177
Expense of premises and fixed assets		887		888
Merchant transaction expenses		1,110		1,089
FDIC insurance assessments		14		256
Other operating expenses		2,048		1,791
Total Non-Interest Expenses	$	7,456	$	7,201

Total non-interest expenses increased $255 or 3.5%, to $7,456 for the three months ended September 30, 2011 compared with $7,201 for the same period in 2010. Salaries and employee benefits increased $220 or 6.9%, due primarily to merit-based increases in salaries for existing personnel and increased staffing for loan production and monitoring asset quality. Merchant transaction expenses increased $21 or 1.9% due to the increased volume of merchant transactions. FDIC insurance assessments decreased $242 or 94.5%, resulting from recently passed banking legislation along with the new FDIC bank pricing methodology which affected the three months ended September 30, 2011. Other operating expenses increased $257 or 14.3% due to a severance payment of $90, an increase of $30 in consulting and advisory expenses, contributions of $30, other real estate owned expense of $20, merchant cardholder expense of $16, along with increased general operating expenses.

The following table sets forth information by category of non-interest expenses for the Company for the nine months ended September 30, 2011 and September 30, 2010, respectively:

Nine Months Ended:	September 30, 2011		September 30, 2010
Salaries and employee benefits	$	10,168	$	9,442
Expense of premises and fixed assets		2,714		2,673
Merchant transaction expenses		2,609		2,539
FDIC insurance assessments		436		892
Other operating expenses		5,848		5,497
Total Non-Interest Expenses	$	21,775	$	21,043

Total non-interest expenses increased $732 or 3.5% to $21,775 for the nine months ended September 30, 2011 compared with $21,043 for the same period of 2010. Salaries and employee benefits increased $726 or 7.7%, due primarily to merit-based increases in salaries for existing personnel and increased staffing for loan production and monitoring asset quality. Expense of premises and fixed assets increased $41 or 1.5% largely due to increased occupancy expenses and additional depreciation from branch renovations. Merchant transaction expenses increased $70 or 2.8% due to the increased volume of merchant transactions. FDIC insurance assessments decreased $456 or 51.1%, resulting from recently passed banking legislation along with the new FDIC bank pricing methodology which affected the nine months ended September 30, 2011. Other operating expenses increased $351 or 6.4% due to a severance payment of $90, an increase of $74 in consulting and advisory expenses, contributions of $73, merchant cardholder expense of $52, other real estate owned expense of $29, along with increased general operating expenses.

Income Taxes

Applicable income taxes increased $119 or 14.3% and $32 or 1.3% primarily due to higher taxable income for the three months and nine months ended September 30, 2011, respectively.

41

Cash Equivalents and 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 and interest bearing deposits with banks, which are classified as cash equivalents, as well as, U.S. Treasury securities and U.S. Agency securities 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:

	September 30, 2011		December 31, 2010
U.S. Agency obligations	$	102,638	$	134,541
States & political subdivisions		69,699		77,428
Corporate securities		4,025		4,090
Total Debt Securities		176,362		216,059
Equity Securities		1,001		985
Total Investment Securities	$	177,363	$	217,044

Federal Home Loan Bank Stock Impairment Evaluation

The Company’s banking subsidiary, Penn Security Bank and Trust Company, is required to maintain certain amounts of stock of the Federal Home Loan Bank of Pittsburgh, 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.

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 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 stock 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 nine months of 2011, the FHLB repurchased $868 of capital stock which represented 14.3% of the Bank’s $6,082 investment as of December 31, 2010. Also, during 2010, the Company received $320 in respect of FHLB stock, which represented 5.0% of the Bank’s $6,402 investment as of December 31, 2009. Based on current financial information available, management does not believe the FHLB stock is impaired as of September 30, 2011.

42

Loan Portfolio

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

As of:	September 30, 2011		December 31, 2010
Commercial secured by real estate	$	209,559	$	207,964
Residential real estate		293,040		295,301
Commercial loans		50,474		36,190
Credit card and related plans		3,087		3,327
Installment and other		60,424		62,441
Obligations of states & political subdivisions		21,257		9,882
Loans, net of unearned income		637,841		615,105
Less: Allowance for loan and lease losses		6,711		6,500
Loans, net	$	631,130	$	608,605

There were no purchased loans during the three and nine months ended September 30, 2011, other than loan participations with local banks. Originations of new loans in 2011 were primarily commercial and municipal 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 what we believe are conservative underwriting standards.

Loans secured by real estate continue to be the largest component of the loan portfolio, representing 79% and 82% of total loans at September 30, 2011 and December 31, 2010, respectively. Recent economic conditions and recessionary concerns have resulted in lower levels of loan demand. The decline ratio on loan applications has remained at normal levels. As we expect these conditions and concerns to continue for the near term, we expect that loan growth may be slower than historically expected.

Recent loan growth has been in commercial and industrial loans and loans to local municipalities where management believes there is manageable and acceptable risk.

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. Our loan quality has remained strong during the current general economic downturn, which we believe is due to the consistent application of our conservative underwriting standards.

Regardless of credit standards, there is risk of loss inherent in every loan portfolio. The allowance for loan and lease losses is an amount that management believes will be adequate to absorb probable losses on existing 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 and lease losses was adequate as of September 30, 2011. Management uses available information to estimate probable losses on loans, while future additions to the allowance may be necessary based on changes in economic conditions and other factors. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan and lease 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.

The allowance for loan and lease losses is increased by periodic charges against earnings as a provision for loan and lease 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 and lease losses as a percentage of loans was 1.05% at September 30, 2011, compared to 1.06% at December 31, 2010 and 1.05% at September 30, 2010.

43

Market Area

The Northeastern Pennsylvania economy in which we operate 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 9.8% during August 2011. This unemployment rate increased 1.1% from May to August and is the highest unemployment rate among Pennsylvania’s 14 metro areas according to the data released recently by the State Department of Labor and Industry. 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. Many economists in the country are concerned the economy may be headed for a double dip recession.

The foreclosure rate for the Scranton/Wilkes-Barre metropolitan area remained relatively stable despite an increase in unemployment during the quarter ended September 30, 2011. In July 2011, foreclosure actions were pending for 3.2% of all mortgaged properties. The Case-Shiller House Price Index which is a leading measure for the U.S. residential housing market, showed four consecutive months of increases income prices. 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 maintain their debt service 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:	September 30, 2011		December 31, 2010		September 30, 2010
Non-accrual loans
Residential real estate	$	2,332	$	1,579	$	2,108
Commercial real estate		608		1,385		1,648
Commercial loans		443		977		1,044
Consumer loans		70		93		71
Total non-performing loans	$	3,453	$	4,034	$	4,871
Other real estate owned		2,109		803		925
Total non-performing assets	$	5,562	$	4,837	$	5,796
Loans past due 90 days or more and accruing:
Residential real estate	$	496	$	1,236	$	834
Commercial real estate		—		—		—
Guaranteed student loans		240		268		194
Credit card loans		24		20		17
Commercial loans		—		100		2
Consumer loans		5		6		48
Total loans past due 90 days or more and accruing	$	765	$	1,630	$	1,095

Loans are generally placed on non-accrual status when principal or interest is past due 90 days and when payment in full is not anticipated. For commercial loans, an appraisal is obtained if the loan has been downgraded and the appraisal on file is at least one year old. 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 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.

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 United States Bankruptcy Code. As of September 30, 2011, the Company had $6,951 of TERI-guaranteed loans out of a

44

total student loan portfolio of $15,143. 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 September 30, 2011, $40 of such loans was on non-accrual status.

Loans on which the accrual of interest has been discontinued or reduced amounted to $3,453 or 0.54% of loans at September 30, 2011, representing a decrease of $1,418 from $4,871 or 0.78% of loans at September 30, 2010 and a decrease of $581 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 local unemployment rate, the effects of the slow economy on customers’ ability to repay loans and delays at the county level in acquiring properties through foreclosure. In accordance with management’s focused efforts to proactively address delinquent accounts, the increase in non-accrual loans and corresponding decrease in loans that are 90 days or more and accruing reflects, in part, the decision to place more loans on non-accrual status when there is a likelihood that such loans will proceed to foreclosure.

The 2010 increase in non-accrual loans 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 $192 and $175 for the nine months ended September 30, 2011 and September 30, 2010, respectively. Interest income on those loans, which is recorded only when received, amounted to $0 for the three months ended September 30, 2011 and September 30, 2010. There are no commitments to lend additional funds to borrowers whose loans are in non-accrual status. Non-accrual loans decreased to $3,453 at September 30, 2011 from $4,034 at December 31, 2010 due in part to the completion of certain foreclosure actions that increased the level of other real estate owned to $2,109 at September 30, 2011 compared to $803 at December 31, 2010.

Real estate loans of $496 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 that are in the process of collection.

Management’s process for evaluating the adequacy of the allowance for loan and lease 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 and overall credit risk. These reports also address the current status and actions in process on each listed loan. This information is used in our ALLL methodology and resulting adjustments are made to the allowance for loan and lease 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.

Estimated “low” and “high” allowances for loan loss amounts are derived by accumulating the loss estimates for specific loans and general pools. The actual allowance for loan losses, situated within the estimated low-to-high range, is approved on a quarterly basis by the Board of Directors.

Due to residential loan charge-offs taken in the first nine months of 2011, the specific reserve portion of the allowance for loan and lease losses decreased. Therefore the allowance for loan and lease losses of $6,711 provides an even greater degree of risk coverage for loans collectively evaluated.

There were no changes in the methodology of determining the allowance for loan losses at September 30, 2011. Management continues to focus on trends in real estate delinquencies related to the poor labor and housing markets locally, in determining the allowance for loan losses. Management also continually evaluates the reliability of the allowance for loan loss methodology.

As of September 30, 2011, the Company had total impaired loans of $3,830. Of the total allowance for loan and lease losses $662 is specifically related to these impaired loans at September 30, 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.

45

Loan Loss Experience

The following table presents the Company’s allowance for loan and lease losses during the periods indicated:

Three Months Ended:	September 30, 2011			September 30, 2010
Balance at beginning of period	$	6,711		$	6,500
Charge-offs:
Residential real estate mortgages		307			49
Commercial real estate and all others		66			676
Credit card and related plans		29			29
Installment loans		67			110
Total charge-offs		469			864
Recoveries:
Residential real estate mortgages		8			—
Commercial real estate and all others		—			1
Credit card and related plans		5			—
Installment loans		11			5
Total recoveries		24			6
Net charge-offs (recoveries)		445			858
Provision charged to operations		445			858
Balance at End of Period	$	6,711		$	6,500
Ratio of net charge-offs (recoveries) to average loans outstanding		0.07	%		0.14	%

Nine Months Ended:	September 30, 2011			September 30, 2010
Balance at beginning of period	$	6,500		$	6,300
Charge-offs:
Residential real estate mortgages		1,032			61
Commercial real estate and all others		336			1,092
Credit card and related plans		81			67
Installment loans		127			317
Total charge-offs		1,576			1,537
Recoveries:
Residential real estate mortgages		26			1
Commercial real estate and all others		3			1
Credit card and related plans		6			1
Installment loans		39			11
Total recoveries		74			14
Net charge-offs (recoveries)		1,502			1,523
Provision charged to operations		1,713			1,723
Balance at End of Period	$	6,711		$	6,500
Ratio of net charge-offs (recoveries) to average loans outstanding		0.24	%		0.25	%

The allowance for loan and lease losses at September 30, 2011 was $6,711 or 1.05% of total loans compared to $6,500 or 1.06% of total loans at December 31, 2010 and $6,500 or 1.05% of total loans at September 30, 2010.

46

The allowance for loan and lease losses was allocated as follows:

As of:	September 30, 2011					December 31, 2010					September 30, 2010
	Amount		% *			Amount		% *			Amount		% *
Residential real estate	$	2,368		46	%	$	800		48	%	$	1,200		53	%
Commercial real estate and all others		3,458		45	%		4,000		40	%		4,200		35	%
Credit card and related plans		345		1	%		350		1	%		350		1	%
Personal installment loans		540		8	%		1,350		11	%		750		11	%
Total	$	6,711		100	%	$	6,500		100	%	$	6,500		100	%

* Percent of loans in each category to total loans

The entire ALLL is available for losses in any loan category, notwithstanding the allocation above.

Our non-performing loans decreased from $4,871 at September 30, 2010 to $3,453 at September 30, 2011. As of September 30, 2011, our non-performing loans were comprised of forty-nine (49) loans of which twelve (12) 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 September 30, 2010, our non-performing loans were comprised of forty (40) loans, of which sixteen (16) loans were in excess of one hundred thousand dollars in size and the remainder of which were less than one hundred thousand dollars each. The decrease in the non-performing loans can be attributed, to a large extent, to a large land development credit, which was transferred to OREO in the third quarter of 2011.

As of September 30, 2011, the total of the allowance for loan and lease losses was $6,711. Through the application of our ALLL methodology, the allowance reflects management’s conservative view of the local economic conditions. As a result of the economic conditions in our market area and the level of non-performing loans, management has previously undertaken the following actions:

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

• Hired a former bank examiner to perform loan reviews on a full time basis and to enhance our allowance for loan and lease loss methodology for implementation, which did not have any appreciable impact on the amount of the allowance in the period adopted; and

• Contracted with a credit professional 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 and lease losses.

As a result of the local and national weakness in the residential real estate industry, and to evaluate a potential 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. An appraisal is ordered in the case of commercial loans, if a loan has been downgraded and the current appraisal on file is at least one year old. Both residential and commercial appraisals continue to be discounted appropriately, by the Bank, in view of the weak real estate market.

Other Real Estate Owned

The Bank has eleven (11) properties in foreclosure, including one townhouse development project at a carrying value of $1,040, acquired in the third quarter of 2011. Management will be working with a real estate professional to attract a single purchaser for the property, either through listing or an auction. The development includes four townhouses which are substantially complete and additional acreage for development.

There are also ten (10) other properties in foreclosure with a range of values from $20 to $285. Most of these properties have been held less than nine months and are actively being marketed.

47

Deposits

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

	September 30, 2011		December 31, 2010
Demand - Non-interest bearing	$	131,189	$	113,391
Demand - Interest bearing		74,089		70,989
Savings		119,116		113,382
Money markets		164,152		144,206
Time - Over $100,000		82,049		85,404
Time - Other		161,089		163,660
Total	$	731,684	$	691,032

As of September 30, 2011, the Company had Certificate of Deposit Account Registry Service (“CDARS”) reciprocal deposits in the amount of $21.8 million. The Bank also currently issues brokered certificates of deposit as an alternative to wholesale funding due to their favorable terms. As of September 30, 2011, the dollar amount of brokered deposits, exclusive of CDARS reciprocal deposits, was $49.4 million or 6.7% 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 of checking and savings accounts 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.

In general, as interest rates in the economy change, some deposits migrate towards investments with higher anticipated yields. Historically, the Bank’s core deposits have been stable.

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 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 securities sold under agreements to repurchase, which have a one day maturity, as an alternative deposit option for its customers. The securities sold under agreements to repurchase 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 September 30, 2011 the Company had $194,008 of available borrowing capacity with the FHLB, a Borrower-In-Custody (BIC) line of credit of $23,607 with the FRB, available borrowing capacity at the Discount Window of $16,505, 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 funds is dividends received from the Bank.

Commitments and Contingent Liabilities

In the normal course of business, the Bank has 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.

48

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. However, the Bank has yet to receive municipal approval for a required variance. Without this approval, the Bank would not be required to close under the purchase agreement.

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 are retained earnings from the operations of the Company and proceeds 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 16.75% at September 30, 2011. The Bank’s total risk-based capital ratio was 16.19% at September 30, 2011, which 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 Bank’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 Bank could significantly increase its assets and still comply with these capital requirements without the necessity of increasing its equity capital.

49

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 September 30,
	2011			2010			Change
Net interest income after provision for loan and lease losses	$	7,654		$	7,439		$	215
Non-interest income		3,571			3,638			(67	)
Non-interest expense		(7,456	)		(7,201	)		(255	)
Income tax (provision) benefit		(951	)		(832	)		(119	)
Net income		2,818			3,044			(226	)
Adjustments
Non-interest income
Reversal of a contingent liability recorded in the Merger		—			—			—
Total adjustments pre-tax		—			—			—
Income tax provision (benefit)		—			—			—
After tax adjustments to GAAP		—			—			—
Adjusted “net income from core operations”	$	2,818		$	3,044		$	(226	)
Adjusted Return on Average Assets		1.20	%		1.37	%
Adjusted Return on Average Equity		8.88	%		9.94	%
Adjusted Dividend Payout Ratio		48.84	%		45.16	%

Return on average equity (ROE) and return on average assets (ROA) for the three months ended September 30, 2011 was 8.88% and 1.20%, respectively. ROE was 9.94% and ROA was 1.37% for the same period last year. The dividend payout ratio was 48.84% for the three months ended September 30, 2011 and 45.16% for the same period last year.

	Nine Months Ended September 30,
	2011			2010			Change
Net interest income after provision for loan and lease losses	$	22,556		$	23,348		$	(792	)
Non-interest income		9,930			9,222			708
Non-interest expense		(21,775	)		(21,043	)		(732	)
Income tax benefit (provision)		(2,518	)		(2,486	)		(32	)
Net income		8,193			9,041			(848	)
Adjustments
Non-interest income
Reversal of a contingent liability recorded in the Merger		(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”	$	7,863		$	9,041		$	(1,178	)
Adjusted Return on Average Assets		1.08	%		1.36	%
Adjusted Return on Average Equity		8.40	%		9.99	%
Adjusted Dividend Payout Ratio		52.50	%		45.65	%

50

Return on average equity (ROE) and return on average assets (ROA) for the nine months ended September 30, 2011 was 8.76% (8.40% excluding the reversal of a contingent liability) and 1.20% (1.08% excluding the reversal of a contingent liability), respectively. ROE was 9.99% and ROA was 1.36% for the same period last year. The dividend payout ratio was 50.40% (52.50% excluding the reversal of a contingent liability) for the nine months ended September 30, 2011 and 45.65% for the same period last year.

Allowance for Loan and Lease Losses and Credit Fair Value Adjustment

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

		0000000000		0000000000		0000000000
	September 30, 2011		December 31, 2010		September 30, 2010
Loans, net of unearned income	$	637,841	$	615,105	$	620,553
Credit fair value adjustment on purchased loans		2,623		3,579		3,997
Total adjusted loans	$	640,464	$	618,684	$	624,550

		0000000000			0000000000			0000000000
	September 30, 2011			December 31, 2010			September 30, 2010
Allowance for loan and lease losses	$	6,711		$	6,500		$	6,500
Credit fair value adjustment on purchased loans		2,623			3,579			3,997
Total adjusted allowance	$	9,334		$	10,079		$	10,497
Total adjusted allowance to adjusted loans		1.46	%		1.63	%		1.68	%

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 Bank’s board of directors. 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. The Company’s market risk is reasonable at this time.

51

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.

Item 4. Controls and Procedures

Under the supervision and with the participation of the Company’s management, including our Chief Executive Officer (our principal executive officer) and Finance Division Head (our principal financial officer), 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 September 30, 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

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

32 Section 1350 Certifications

101 Interactive Data File (Quarterly Report on Form 10-Q, for the quarter ended September 30, 2011, furnished in XBRL (eXtensible Business Reporting Language)).

52

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

53