Alarion Financial Services 10-Q 2011 Q3 Quarterly report

U.S. SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2011

OR

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

For the transition period from              to             

Commission file number000-51843

ALARION FINANCIAL SERVICES, INC.

(Exact Name of Small Business Issuer as Specified in Its Charter)

Florida	20-3851373
(State or Other Jurisdiction of Incorporation or Organization)	(I.R.S. Employer Identification No.)
One Northeast First Avenue, Ocala, Florida	34470
(Address of Principal Executive Offices)	(Zip Code)

Registrant’s Telephone Number, Including Area Code(352) 237-4500

Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report.

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days:    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). *    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 definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (Check one):

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

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

Common stock, par value $.01 per share 2,633,208 shares outstanding at November 14, 2011

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

INDEX

		Page
Item 1. Financial Statements
Condensed Consolidated Balance Sheets - at September  30, 2011 (Unaudited) and at December 31, 2010			2
Condensed Consolidated Statements of Operations (Unaudited) - Three and Nine Months ended September 30, 2011 and 2010			3
Condensed Consolidated Statements of Changes in Stockholders’ Equity (Unaudited) - Nine Months ended September 30, 2011 and 2010			4-5
Condensed Consolidated Statements of Cash Flows (Unaudited) - Nine Months ended September  30, 2011 and 2010			6-7
Notes to Condensed Consolidated Financial Statements (Unaudited)			8-22
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		23-30
Item 3.	Quantitative and Qualitative Disclosures About Market Risk		31
Item 4.	Controls and Procedures		31
Part II. OTHER INFORMATION
Item 1.	Legal Proceedings		32
Item 1.A.	Risk Factors		32
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		32
Item 3.	Defaults upon Senior Securities		32
Item 4.	(Removed and Reserved)		32
Item 5.	Other Information		32
Item 6.	Exhibits		33
SIGNATURES			34

1

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Part I. FINANCIAL INFORMATION

Item 1. Financial Statements

Condensed Consolidated Balance Sheets

($ in thousands, except per share amounts)

	At			At
	September 30,			December 31,
	2011			2010
	(unaudited)
Assets
Cash and due from banks	$	4,496			3,127
Interest-earning deposits		233			262
Federal funds sold		18,769			3,015
Cash and cash equivalents		23,498			6,404
Securities available for sale		47,519			49,304
Loans, net of allowance for loan losses of $5,405 and $4,115		194,770			213,069
Loans held for sale		7,293			7,395
Accrued interest receivable		843			903
Premises and equipment, net		13,197			13,418
Other real estate owned, net		7,762			6,359
Federal Home Loan Bank stock, at cost		1,402			1,409
Deferred income taxes		3,790			3,347
Other assets		843			1,382
Total assets	$	300,917			302,990
Liabilities and Stockholders’ Equity
Liabilities:
Noninterest-bearing demand deposits		29,752			26,778
NOW, money-market and savings deposits		89,951			76,476
Time deposits less than $100,000		95,371			89,016
Time deposits greater than $100,000		42,504			59,074
Total deposits		257,578			251,344
Federal Home Loan Bank advances		13,000			21,000
Other borrowings		3,032			3,054
Accrued interest payable		345			436
Accrued expenses and other liabilities		1,454			522
Total liabilities		275,409			276,356
Stockholders’ equity:
Preferred stock, $.01 par value; 1,000,000 shares authorized:
Preferred stock, Series A, $.01 par value; $1,000 liquidation value; 6,514 shares outstanding		—			—
Preferred stock, Series B, $.01 par value; $1,000 liquidation value; 326 shares outstanding		—			—
Additional paid-in capital, preferred		6,840			6,840
Preferred stock discount		(151	)		(200	)
Common stock, $.01 par value; 4,000,000 shares authorized, 2,633,208 and 2,653,208 shares issued and outstanding at September 30, 2011 and December 31, 2010		26			27
Additional paid-in capital, common		26,595			26,693
Accumulated deficit		(8,068	)		(6,111	)
Accumulated other comprehensive loss (income)		266			(615	)
Total stockholders’ equity		25,508			26,634
Total liabilities and stockholders’ equity	$	300,917			302,990

See accompanying Notes to Condensed Consolidated Financial Statements.

2

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Operations (Unaudited)

($ in thousands, except per share amounts)

	Three Months Ended					Nine Months Ended
	September 30,					September 30,
	2011			2010		2011			2010
Interest income:
Loans	$	2,759			3,185		8,488			9,646
Securities		314			258		995			909
Other		7			13		17			55
Total interest income		3,080			3,456		9,500			10,610
Interest expense:
Deposits		738			1,066		2,386			3,390
Borrowings		160			174		491			524
Total interest expense		898			1,240		2,877			3,914
Net interest income		2,182			2,216		6,623			6,696
Provision for loan losses		525			600		3,450			5,894
Net interest income after provision for loan losses		1,657			1,616		3,173			802
Noninterest income:
Deposit account fees		90			86		277			284
Net gain on sales of loans held for sale		511			324		1,144			968
Net gain on sale of securities		—			478		—			478
Other		106			61		225			192
Total noninterest income		707			949		1,646			1,922
Noninterest expense:
Salaries and employee benefits		1,149			943		3,318			3,011
Occupancy and equipment		345			309		952			899
Data processing		148			151		431			446
Professional services		169			128		487			333
Advertising and promotion		57			51		145			124
Office supplies and printing		37			38		109			101
OREO expense		248			219		762			477
FDIC assessment		79			128		382			337
Other		308			159		847			895
Total noninterest expense		2,540			2,126		7,433			6,623
(Loss) earnings before income tax (benefit) expense		(176	)		439		(2,614	)		(3,899	)
Income tax (benefit) expense		(64	)		169		(972	)		(1,438	)
Net (loss) earnings		(112	)		270		(1,642	)		(2,461	)
Preferred stock dividend requirements and accretion of preferred stock to par		105			105		315			315
Net (loss) earnings available to common shareholders	$	(217	)		165		(1,957	)		(2,776	)
(Loss) earnings per share – basic	$	(.08	)		0.06		(.74	)		(1.05	)
(Loss) earnings per share – diluted	$	(.08	)		0.06		(.74	)		(1.05	)
Weighted-average number of common shares outstanding, basic		2,633,208			2,653,208		2,644,270			2,653,208
Weighted-average number of common shares outstanding, diluted		2,633,208			2,653,208		2,644,270			2,653,208
Dividends per common share	$	—			—		—			—

See accompanying Notes to Condensed Consolidated Financial Statements.

3

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Changes in Stockholders’ Equity (Unaudited)

Nine Months Ended September 30, 2011 and 2010

($ in thousands)

	Preferred Stock													Common Stock						Accumulated			Accumulated Other Comprehensive			Total Stockholders’
	Series A				Series B				Additional Paid-in		Discount			Shares		Amount		Additional Paid-In
	Shares		Amount		Shares		Amount		Capital									Capital		Deficit			Loss			Equity
Balance at December 31, 2009		6,514	$	—		326	$	—		6,840		(265	)		2,653,208	$	27		26,680		(2,531	)		(45	)		30,706
Comprehensive loss:
Net loss (unaudited)		—		—		—		—		—		—			—		—		—		(2,461	)		—			(2,461	)
Net change in unrealized loss on securities available for sale, net of taxes of $(25) (unaudited)		—		—		—		—		—		��			—		—		—		—			(43	)		(43	)
Comprehensive loss (unaudited)																											(2,504	)
Share-based compensation (unaudited)		—		—		—		—		—		—			—		—		9		—			—			9
Preferred stock dividend requirements and Series B preferred stock accretion (unaudited)		—		—		—		—		—		49			—		—		—		(315	)		—			(266	)
Balance at September 30, 2010 (unaudited)		6,514	$	—		326	$	—		6,840		(216	)		2,653,208	$	27		26,689		(5,307	)		(88	)		27,945

(continued)

4

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Changes in Stockholders’ Equity (Unaudited), Continued

Nine Months Ended September 30, 2011 and 2010

($ in thousands)

	Preferred Stock													Common Stock									Accumulated			Accumulated Other			Total Stockholders’ Equity
	Series A				Series B				Additional Paid-in											Additional Paid-In						Comprehensive Income
	Shares		Amount		Shares		Amount		Capital		Discount			Shares			Amount			Capital			Deficit			(Loss)
Balance at December 31, 2010		6,514	$	—		326	$	—		6,840		(200	)		2,653,208		$	27			26,693			(6,111	)		(615	)		26,634
Comprehensive loss:
Net loss (unaudited)		—		—		—		—		—		—			—			—			—			(1,642	)		—			(1,642	)
Net change in unrealized loss on securities available for sale, net of taxes of $530 (unaudited)		—		—		—		—		—		—			—			—			—			—			881			881
Comprehensive loss (unaudited)																														(761	)
Share-based compensation (unaudited)		—		—		—		—		—		—			—			—			1			—			—			1
Retirement of stock (unaudited)		—		—		—		—		—		—			(20,000	)		(1	)		(99	)		—			—			(100	)
Preferred stock dividend requirements and Series B preferred stock accretion (unaudited)		—		—		—		—		—		49			—			—			—			(315	)		—			(266	)
Balance at September 30, 2011 (unaudited)		6,514	$	—		326	$	—		6,840		(151	)		2,633,208		$	26			26,595			(8,068	)		266			25,508

See accompanying Notes to Condensed Consolidated Financial Statements.

5

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows (Unaudited)

(In thousands)

	Nine Months Ended
	September 30,
	2011			2010
Cash flows from operating activities:
Net loss	$	(1,642	)		(2,461	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Provision for loan losses		3,450			5,894
Share-based compensation		1			9
Depreciation and amortization		424			437
Gain on sale of loans held for sale		(1,144	)		(968	)
Loans originated for sale		(49,450	)		(49,887	)
Proceeds from loans sold		50,696			51,691
Net amortization of premiums and discounts on securities available for sale		516			321
Deferred income tax benefit		(973	)		(1,438	)
Net amortization of deferred loan fees and costs		83			74
Loss on sale of other real estate owned		72			5
Provision for other real estate loan losses		662			247
Gain on sale of securities available for sale		—			(478	)
Net decrease in accrued interest payable		(91	)		(203	)
Net decrease (increase) in accrued interest receivable		60			(57	)
Net decrease in other assets		439			289
Net increase in accrued expenses and other liabilities		932			1,158
Net cash provided by operating activities		4,035			4,633
Cash flows from investing activities:
Proceeds from sales, principal repayments and maturities on securities available for sale		7,486			30,035
Purchase of securities available for sale		(4,806	)		(52,310	)
Net decrease in time deposits		—			2,287
Net decrease in loans		11,479			2,108
Purchases of premises and equipment		(203	)		(545	)
Proceeds from sale of other real estate owned		1,150			11
Redemption of Federal Home Loan Bank stock		7			90
Net cash provided by (used in) investing activities		15,113			(18,324	)
Cash flows from financing activities:
Net increase in deposits		6,234			10,761
Net decrease in other borrowings		(22	)		(3,318	)
Net decrease in advances from Federal Home Loan Bank		(8,000	)		—
Preferred stock dividend requirements and Series B stock accretion		(266	)		(266	)
Net cash (used in) provided by financing activities		(2,054	)		7,177
Net increase (decrease) in cash and cash equivalents		17,094			(6,514	)
Cash and cash equivalents at beginning of period		6,404			22,098
Cash and cash equivalents at end of period	$	23,498			15,584

(continued)

6

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows (Unaudited), Continued

(In thousands)

	Nine Months Ended
	September 30,
	2011		2010
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest	$	2,968		4,117
Income taxes	$	—		—
Noncash transactions:
Accumulated other comprehensive (loss) income, net change in unrealized (loss) gain on securities available for sale, net of taxes	$	881		(43	)
Transfer of loans to other real estate owned	$	3,287		3,354
Transfer of other real estate owned to loans	$	—		189
Retirement of common stock from other assets	$	100		—

See accompanying Notes to Condensed Consolidated Financial Statements.

7

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited)

1.Basis of Presentation. In the opinion of the management of Alarion Financial Services, Inc. (the “Holding Company”), the accompanying condensed consolidated financial statements contain all adjustments (consisting of normal recurring accruals) necessary to present fairly the financial position at September 30, 2011 and the results of operations for the three- and nine-month periods ended September 30, 2011 and 2010 and cash flows for the nine-month periods ended September 30, 2011 and 2010. The results of operations for the three- and nine-month periods ended September 30, 2011, are not necessarily indicative of results that may be expected for the year ending December 31, 2011.

The Holding Company owns 100% of the common stock of Alarion Bank (the “Bank”) and North Central Florida Developers Corporation (“NCFDC”) (together the “Company”). The Holding Company’s primary activity is the operation of the Bank and NCFDC. The Bank is a state (Florida)-chartered commercial bank. The Bank offers a variety of banking and financial services to individual and corporate customers through its six banking offices located in Ocala and Gainesville, Florida. The deposit accounts of the Bank are insured up to the applicable limits by the Federal Deposit Insurance Corporation. NCFDC holds loans or assets that might require a longer than desirable term hold to realize reasonable or full economic value.

Recent Accounting Standards Update.In January 2011, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2011-01,Receivables (Topic 310) Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20.The amendments in this Update delayed the effective date of the disclosures about troubled debt restructurings in Update 2010-20 for public entities. For public entities, the amendments are effective for the first interim or annual period beginning on or after June 15, 2011 and should be applied retrospectively to the beginning of the annual period of adoption. The adoption of the ASU did not have a material impact on the Company’s consolidated financial statements.

In April 2011, the FASB issued ASU No. 2011-02,Receivables (Topic 310) A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring. This amends the guidance for troubled debt restructurings. The guidance clarifies the guidance on a creditor’s evaluation of whether it has granted a concession and whether a debtor is experiencing financial difficulties. For public entities, the amendments are effective for the first interim or annual period beginning on or after June 15, 2011 and should be applied retrospectively to the beginning of the annual period of adoption. The adoption of the ASU did not have a material impact on the Company’s consolidated financial statements.

(continued)

8

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

1.Basis of Presentation, Continued.

Recent Accounting Standards Update, Continued.In April 2011, the FASB issued ASU 2011-03,Transfers and Servicing (Topic 860): Reconsideration of Effective Control for Repurchase Agreement, which applies to all public entities. It affects all entities that enter into agreements to transfer financial assets that both entitle and obligate the transferor to repurchase or redeem the financial assets before their maturity. The amendments do not affect other transfers of financial assets. ASU 2011-03 removes the assessment of effective control the criterion relating to the transferor’s ability to repurchase or redeem financial assets on substantially the agreed terms, even in the event of default by the transferee. Consequently, it also eliminates the requirement to demonstrate that the transferor possesses adequate collateral to fund substantially all the cost of purchasing replacement financial assets. Eliminating the transferor’s ability criterion and related implementation guidance from an entity’s assessment of effective control should improve the accounting for repos and other similar transactions. ASU 2011-03 is effective for the first interim or annual period beginning on or after December 15, 2011 and is to be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. Early adoption is not permitted. We do not expect the adoption of ASU 2011-03 to have a material impact on our consolidated financial statements.

In May 2011, the FASB issued ASU 2011-04,Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. ASU 2011-04 applies to all reporting entities that are required or permitted to measure or disclose the fair value of an asset, a liability, or an instrument classified in a reporting entity’s shareholders’ equity in the financial statements. ASU 2011-04 is expected to result in common fair value measurement and disclosure requirements in U.S. GAAP and International Financial Reporting Standards (“IFRSs”). Consequently, it changes the wording used to describe many of the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements. For many of the requirements of ASU 2011-04, it is not intended for the amendments to result in a change in the application of the requirements in Topic 820. Some of the amendments clarify the application of existing fair value measurement requirements. Other amendments change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements, including the following: (1) measuring the fair value of financial instruments that are managed within a portfolio; (2) application of premiums and discounts in a fair value measurement; and (3) additional disclosures about fair value measurements.

ASU 2011-04 is effective during interim and annual periods beginning after December 15, 2011 and is to be applied prospectively. Early application is not permitted. We are currently evaluating the impact of ASU 2011-04 on our consolidated financial statements, but we do not expect its adoption to have a material impact on our consolidated statements, other than to further increase the amount of financial disclosures already provided.

(continued)

9

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

1.Basis of Presentation, Continued.

Recent Accounting Standards Update, Continued.In June 2011, the FASB issued ASU No. 2011-05,Comprehensive Income (Topic 220). The amendments in this update remove the option to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity. The effective date of this update is for fiscal years, and interim periods within those years, beginning after December 15, 2011. We do not expect its adoption to have a material impact on our consolidated financial statements, other than to further increase the amount of financial disclosures already provided.

In September 2011, the FASB issued ASU No. 2011-08, “Testing Goodwill for Impairment.” The provisions of ASU No. 2011-08 permits an entity an option to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If an entity believes, as a result of its qualitative assessment, that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, the quantitative impairment test is required. Otherwise, no further impairment testing is required. ASU No. 2011-08 includes examples of events and circumstances that may indicate that a reporting unit’s fair value is less than its carrying amount. The provisions of ASU No. 2011-08 are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted provided that the entity has not yet performed its annual impairment test for goodwill. The adoption of ASU No. 2011-08 will not have any impact on our financial statements since we do not have any goodwill.

2.Securities.Securities have been classified according to management’s intent. The carrying amount of securities available for sale and their approximate fair values are as follows (in thousands):

			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value
At September 30, 2011:
U.S. Government agency securities	$	1,089		—		(5	)		1,084
Mortgage-backed securities		44,401		498		(4	)		44,895
Corporate bonds		1,602		—		(62	)		1,540
	$	47,092		498		(71	)		47,519
At December 31, 2010-
Mortgage-backed securities	$	50,288		77		(1,061	)		49,304

At September 30, 2011 and December 31, 2010, securities with a carrying value of approximately $13.5 million and $10.5 million, respectively, were pledged for other borrowings and public funds.

There were no sales of securities during the nine months ended September 30, 2011.

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

2.Securities, Continued.Securities sold during the nine months ended September 30, 2010 are summarized as follows (in thousands):

Principal received from sales	$	22,600
Gross gains		478
Gross losses		—
Net gain	$	478

Securities with gross unrealized losses at September 30, 2011, aggregated by investment category and length of time that individual securities have been in a continuous loss position, is as follows (in thousands):

	Less Than Twelve Months
	Gross
	Unrealized			Fair
	Losses			Value
Securities Available for Sale:
U.S. government agency securities	$	(5	)		528
Mortgage-backed securities		(4	)		2,433
Corporate bonds		(62	)		1,540
Total securities available for sale	$	(71	)		4,501

The unrealized losses on four investment securities were caused by interest rate changes. It is expected that the securities would not be settled at a price less than the par value of the investments. Because the decline in fair value is attributable to changes in interest rates and not credit quality, and because the Company has the ability and intent to hold these investments until a market price recovery or maturity, these investments are not considered other-than-temporarily impaired.

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

3.Loans.The components of loans are as follows (in thousands):

	At			At
	September 30,			December 31,
	2011			2010
Real estate loans:
Office/retail/other	$	62,043			63,357
Multi-family		9,777			9,518
Land		16,032			23,345
Commercial real estate		14,515			16,927
Residential non-owner		15,748			18,356
Residential owner		32,404			32,667
Construction		4,776			4,819
Home equity & line of credit		17,240			19,764
Commercial		19,660			20,587
Consumer		7,625			7,471
Total loans		199,820			216,811
Allowance for loan losses		(5,405	)		(4,115	)
Deferred loan costs, net		355			373
Loans, net	$	194,770			213,069

The Company has divided the loan portfolio into three portfolio segments, each with different risk characteristics and methodologies for assessing risk. The portfolio segments identified by the Company are as follows:

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

3.Loans, Continued.

Real Estate Mortgage Loans.Real estate mortgage loans are typically segmented into eight classes: Office/Retail/Other, Multi-Family, Land, Commercial Real Estate, Residential Non-Owner, Residential Owner, Construction and Home Equity & Line of Credit. Commercial real estate loans are secured by the subject property and are underwritten based upon standards set forth in the policies approved by the Company’s board of directors (the “Board”). Such standards include, among other factors, loan to value limits, cash flow coverage and general creditworthiness of the obligors. Residential real estate loans are underwritten in accordance with policies set forth and approved by the Board, including repayment capacity and source, value of the underlying property, credit history and stability. Construction loans to borrowers are to finance the construction of owner occupied and lease properties. These loans are categorized as construction loans during the construction period, later converting to commercial or residential real estate loans after the construction is complete and amortization of the loan begins. Real estate development and construction loans are approved based on an analysis of the borrower and guarantor, the viability of the project and on an acceptable percentage of the appraised value of the property securing the loan. Real estate development and construction loan funds are disbursed periodically based on the percentage of construction completed. The Company carefully monitors these loans with on-site inspections and requires the receipt of lien waivers on funds advanced. Development and construction loans are typically secured by the properties under development or construction, and personal guarantees are typically obtained. Further, to assure that reliance is not placed solely on the value of the underlying property, the Company considers the market conditions and feasibility of proposed projects, the financial condition and reputation of the borrower and guarantors, the amount of the borrower’s equity in the project, independent appraisals, costs estimates and pre-construction sale information. The Company also makes loans on occasion for the purchase of land for future development by the borrower. Land loans are extended for the future development for either commercial or residential use by the borrower. The Company carefully analyzes the intended use of the property and the viability thereof.

Commercial Loans.Commercial loans are primarily underwritten on the basis of the borrowers’ ability to service such debt from income. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. As a general practice, we take as collateral a security interest in any available real estate, equipment, or other chattel, although loans may also be made on an unsecured basis. Collateralized working capital loans typically are secured by short-term assets whereas long-term loans are primarily secured by long-term assets.

(continued)

13

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

3.Loans, Continued.

Consumer and Other Loans.Consumer and other loans are extended for various purposes, including purchases of automobiles, recreational vehicles, and boats. We also offer home improvement loans, lines of credit, personal loans, and deposit account collateralized loans. Repayment of these loans is primarily dependent on the personal income of the borrowers, which can be impacted by economic conditions in their market areas such as unemployment levels. Loans to consumers are extended after a credit evaluation, including the creditworthiness of the borrower(s), the purpose of the credit, and the secondary source of repayment. Consumer loans are made at fixed and variable interest rates and may be made on terms of up to ten years. Risk is mitigated by the fact that the loans are of smaller individual amounts and spread over a large number of borrowers.

An analysis of the change in the allowance for loan losses follows (in thousands):

		0000000		0000000		0000000			0000000			0000000		0000000			0000000		0000000		0000000		0000000			0000000			0000000
	Three Months Ended September 30,
	2011
	Office/ Retail/ Other		Multi- Family		Land			Commercial Real Estate			Resid. Non- Owner		Resid. Owner			Construction		Home Equity & LOC		Commercial		Consumer			Total			2010
Beginning balance	$	1,818		10		1,146			284			281		550			52		423		465		251			5,280			4,452
Provision for loan losses		255		—		(149	)		(30	)		5		217			2		161		—		64			525			600
Recoveries		—		—		—			—			4		2			—		—		—		—			6			6
Charge-offs		—		—		(119	)		(159	)		—		(33	)		—		—		—		(95	)		(406	)		(91	)
Ending balance	$	2,073		10		878			95			290		736			54		584		465		220			5,405			4,967

		0000000			0000000		0000000			0000000			0000000			0000000			0000000		0000000			0000000			0000000			0000000			0000000
	Nine Months Ended September 30,
	2011
	Office/ Retail/ Other			Multi- Family		Land			Commercial Real Estate			Resid. Non- Owner			Resid. Owner			Construction		Home Equity & LOC			Commercial			Consumer			Total			2010
Beginning balance	$	1,075			9		583			259			441			350			23		744			427			204			4,115			3,035
Provision for loan losses		1,196			1		555			(5	)		(158	)		792			31		557			147			334			3,450			5,894
Recoveries		—			—		—			—			7			7			—		—			—			2			16			60
Charge-offs		(198	)		—		(260	)		(159	)		—			(413	)		—		(717	)		(109	)		(320	)		(2,176	)		(4,022	)
Ending balance	$	2,073			10		878			95			290			736			54		584			465			220			5,405			4,967
Individually evaluated for impairment:
Recorded investment	$	3,734			—		5,056			1,020			2,571			1,369			831		1,369			135			91			16,176
Balance in allowance for loan losses	$	1,160			—		719			—			99			371			47		293			20			91			2,800
Collectively evaluated for impairment:
Recorded investment	$	58,309			9,777		10,976			13,495			13,177			31,035			3,945		15,871			19,525			7,534			183,644
Balance in allowance for loan losses	$	913			10		159			95			191			365			7		291			445			129			2,605

(continued)

14

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

3.Loans, Continued.The following summarizes the loan credit quality (in thousands):

Credit Risk Profile by Internally Assigned Grade:	Office/ Retail/ Other		Multi- Family		Land		Commercial Real Estate		Resid. Non- Owner		Resid. Owner		Construction		Home Equity & Line of Credit		Commercial		Consumer		Total
September 30, 2011:
Grade:
Pass	$	52,072		9,777		9,314		13,303		11,678		30,476		3,946		15,013		18,177		7,179		170,935
Special mention		4,982		—		1,662		150		1,223		559		—		859		377		104		9,916
Substandard		4,989		—		5,056		1,062		2,847		1,369		830		1,368		1,106		342		18,969
Doubtful		—		—		—		—		—		—		—		—		—		—		—
Loss		—		—		—		—		—		—		—		—		—		—		—
Total	$	62,043		9,777		16,032		14,515		15,748		32,404		4,776		17,240		19,660		7,625		199,820
December 31, 2010:
Grade:
Pass		57,974		9,518		13,812		15,699		14,492		30,908		3,895		15,992		18,450		6,769		187,509
Special mention		408		—		1,371		—		3,277		594		—		2,060		897		352		8,959
Substandard		4,975		—		8,162		1,228		587		1,165		924		1,712		1,240		350		20,343
Doubtful		—		—		—		—		—		—		—		—		—		—		—
Loss		—		—		—		—		—		—		—		—		—		—		—
Total	$	63,357		9,518		23,345		16,927		18,356		32,667		4,819		19,764		20,587		7,471		216,811

The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors.

The Company analyzes loans individually by classifying the loans as to credit risk. Loans classified as substandard or special mention are reviewed quarterly by the Company for further deterioration or improvement to determine if they are appropriately classified and whether there is any impairment. All loans are graded upon initial issuance. Further, commercial loans are typically reviewed at least annually to determine the appropriate loan grading. In addition, during the renewal process of any loan, as well as if a loan becomes past due, the Company will determine the appropriate loan grade.

Loans excluded from the review process above are generally classified as pass credits until: (a) they become past due; (b) management becomes aware of a deterioration in the credit worthiness of the borrower; or (c) the customer contacts the Company for a modification. In these circumstances, the loan is specifically evaluated for potential classification as to special mention, substandard or even charged off. The Company uses the following definitions for risk ratings:

Internally assigned loan grades are defined as follows:

Pass – A Pass loan’s primary source of loan repayment is satisfactory, with secondary sources very likely to be realized if necessary.

(continued)

15

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

3.Loans, Continued.

Special Mention – A Special Mention loan has potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in the deterioration of the repayment prospects for the asset or the Company’s credit position at some future date. Special Mention loans are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification.

Substandard – A Substandard loan is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.

Doubtful – A loan classified Doubtful has all the weaknesses inherent in one classified Substandard with the added characteristics that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Loss – A loan classified Loss is considered uncollectible and of such little value that continuance as a bankable asset is not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be affected in the future.

Age analysis of past-due loans is as follows (in thousands):

	Accruing Loans
	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days Past Due		Total Past Due		Current		Nonaccrual Loans		Total Loans
At September 30, 2011:
Real estate loans:
Office/retail/other	$	—		3,115		—		3,115		57,912		1,016		62,043
Multi-family		—		—		—		—		9,777		—		9,777
Land		56		—		—		56		13,846		2,130		16,032
Commercial real estate		—		—		—		—		13,495		1,020		14,515
Residential non-owner		—		—		—		—		15,445		303		15,748
Residential owner		—		322		—		322		30,713		1,369		32,404
Construction		113		—		—		113		4,663		—		4,776
Home equity & line of credit		250		—		—		250		15,622		1,368		17,240
Commercial		—		65		—		65		19,525		70		19,660
Consumer		153		166		—		319		7,306		—		7,625
Total	$	572		3,668		—		4,240		188,304		7,276		199,820

(continued)

16

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

3.Loans, Continued.

	Accruing Loans
	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days Past Due		Total Past Due		Current		Nonaccrual Loans		Total Loans
At December 31, 2010:
Real estate loans:
Office/retail/other	$	392		2,620		—		3,012		59,876		469		63,357
Multi-family		—		—		—		—		9,518		—		9,518
Land		3,109		5		—		3,114		17,533		2,698		23,345
Commercial real estate		—		—		—		—		15,699		1,228		16,927
Residential non-owner		—		—		—		—		18,048		308		18,356
Residential owner		496		358		—		854		31,031		782		32,667
Construction		—		—		—		—		4,819		—		4,819
Home equity & line of credit		—		—		—		—		19,764		—		19,764
Commercial		91		—		—		91		20,338		158		20,587
Consumer		144		194		—		338		6,944		189		7,471
Total	$	4,232		3,177		—		7,409		203,570		5,832		216,811

The following summarizes the amount of impaired loans (in thousands):

	With No Related Allowance Recorded						With an Allowance Recorded						Total
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Recorded Investment		Unpaid Principal Balance		Related Allowance		Recorded Investment		Unpaid Principal Balance		Related Allowance
September 30, 2011:
Real estate loans:
Office/retail/other	$	—		—		—		3,734		3,734		1,160		3,734		3,734		1,160
Multi-family		—		—		—		—		—		—		—		—		—
Land		761		761		—		4,295		5,592		719		5,056		6,353		719
Commercial real estate		1,020		1,020		—		—		—		—		1,020		1,020		—
Residential non-owner		2,269		2,269		—		302		302		99		2,571		2,571		99
Residential owner		381		381		—		988		988		371		1,369		1,369		371
Construction		—		—		—		831		831		47		831		831		47
Home equity & line of credit		—		—		—		1,369		1,369		293		1,369		1,369		293
Commercial		70		70		—		65		65		20		135		135		20
Consumer		—		—		—		91		91		91		91		91		91
	$	4,501		4,501		—		11,675		12,972		2,800		16,176		17,473		2,800

(continued)

17

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

3.Loans, Continued.

	With No Related Allowance Recorded						With an Allowance Recorded						Total
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Recorded Investment		Unpaid Principal Balance		Related Allowance		Recorded Investment		Unpaid Principal Balance		Related Allowance
December 31, 2010:
Real estate loans:
Office/retail/other	$	—		—		—		2,858		3,681		667		2,858		3,681		667
Multi-family		—		—		—		—		—		—		—		—		—
Land		4,625		5,936		—		3,200		3,652		337		7,825		9,588		337
Commercial real estate		1,020		1,020		—		42		277		166		1,062		1,297		166
Residential non-owner		208		208		—		74		100		26		282		308		26
Residential owner		621		707		—		127		161		34		748		868		34
Construction		923		923		—		—		—		—		923		923		—
Home equity & line of credit		—		—		—		912		1,388		476		912		1,388		476
Commercial		—		—		—		164		240		76		164		240		76
Consumer		92		146		—		116		260		145		208		406		145
	$	7,489		8,940		—		7,493		9,759		1,927		14,982		18,699		1,927

The average net investment in impaired loans and interest income recognized and received on impaired loans are as follows (in thousands):

	For the Three Months Ended September 30,						For the Nine Months Ended September 30,
	2011						2011
	Average Recorded Investment		Interest Income Recognized		Interest Income Received		Average Recorded Investment		Interest Income Recognized		Interest Income Received
Real estate loans:
Office/retail/other	$	3,964		49		49		3,752		148		148
Multi-family		—		—		—		—		—		—
Land		6,239		45		45		7,251		143		143
Commercial real estate		1,122		—		—		1,174		—		—
Residential non-owner		2,578		17		17		1,445		28		28
Residential owner		1,110		—		—		934		1		1
Construction		842		8		8		876		25		25
Home equity & line of credit		1,368		—		—		1,378		15		15
	$	17,223		119		119		16,810		360		360
Comparative totals for September 30, 2010	$	17,193		64		64		13,397		180		180

(continued)

18

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

3.Loans, Continued.Troubled debt restructurings entered during the period are as follows (dollars in thousands):

	Three Months Ended September 30, 2011						Nine Months Ended September 30, 2011
	Outstanding Recorded Investment						Outstanding Recorded Investment						At
	Number of Contracts		Pre- Modification		Post- Modification		Number of Contracts		Pre- Modification		Post- Modification		September 30, 2011 Nonaccrual
Troubled Debt Restructurings:
Real estate mortgage loans:
Office/retail/other:
Modified interest rate and amortization		—	$	—		—		1		2,718		2,718		—
Land:
Modified interest rate and amortization		—		—		—		3		3,078		3,078		1,632
Residential non-owner:
Modified interest rate and amortization		—		—		—		1		2,269		2,269		—
Residential owner:
Modified interest rates		1		135		135		1		135		135		135
Modified interest rate and amortization		1		191		191		2		346		346		346
Construction:
Modified interest rates		—		—		—		1		830		830		—
		2	$	326		326		9		9,376		9,376		2,113

The allowance for loan losses on commercial real estate and residential real estate loans that have been restructured and are considered trouble debt restructurings (“TDR”) is included in the Company’s specific reserve. The specific reserve is determined on a loan by loan basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate, or the fair value of the collateral if the loan is collateral dependent. TDR’s that have subsequently defaulted are considered collateral-dependent.

The allowance for loan losses on commercial and consumer loans that have been restructured and are considered TDR’s is included in the Company’s specific reserve. The specific reserve is determined on a loan by loan basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate, or the fair value of the collateral if the loan is collateral-dependent. TDR’s that have subsequently defaulted are considered collateral-dependent. There were no TDR’s that subsequently defaulted during the three- and nine-month periods ended September 30, 2011, which were restructured during the last twelve months.

(continued)

19

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

4.Loss Per Share.Basic loss per share has been computed on the basis of the weighted-average number of shares of common stock outstanding during the periods, which was 2,644,270 and 2,653,208 shares during the nine-month periods ended September 30, 2011 and 2010, respectively and 2,633,208 and 2,653,208 during the three-month periods ended September 30, 2011 and 2010, respectively. All outstanding stock options are not dilutive securities for the three month periods ended September 30, 2011 and for the nine month periods ended September 30, 2011 and 2010 due to the net losses of the Company. All outstanding stock options and warrants are not considered dilutive securities for the three month periods ended September 30, 2010 due to the exercise price exceeding the average market price for the purposes of calculating diluted EPS, which is computed using the treasury stock method.

5.Share-Based Compensation. The Company adopted a stock option plan for its employees and directors (the “Plan”). Fifteen percent of the total amount of common shares outstanding, up to 450,000 shares (currently 394,981 shares), have been reserved under the Plan. Stock options are granted at an exercise price equal to or greater than the fair market value of the common stock on the date of grant. Options granted to directors vest immediately and for employees, the options primarily vest over two years starting with the date of grant and ending on the second anniversary thereof. At September 30, 2011, there were 125,462 options available for future grants under the Plan. A summary of stock option transactions under the Plan for the nine-month period ended September 30, 2011, follows:

	Number of Options			Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Term		Aggregate Intrinsic Value
Options outstanding at December 31, 2010		246,203		$	10.12
Options forfeited		(200	)		10.00
Options outstanding at September 30, 2011		246,003		$	10.12		5.11 years	$	—
Options exercisable at September 30, 2011		246,003		$	10.12		5.11 years	$	—

There were no options exercised during the nine month periods ended September 30, 2011 and 2010. At September 30, 2011, there was no unrecognized compensation expense related to the nonvested share-based compensation arrangement granted under the plan. The total fair value of shares vesting and recognized as compensation was approximately $1,000 and $9,000 for the nine month periods ended September 30, 2011 and 2010, respectively.

(continued)

20

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

6.Fair Value Measurements. Our listing of financial assets subject to fair value measurements on a recurring basis are as follows (in thousands):

			Fair Value Measurements at Reporting Date Using
	Fair Value		Quoted Prices In Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
As of September 30, 2011:
U.S. government agency securities	$	1,084		—		1,084		—
Mortgage-backed securities		44,895		—		44,895		—
Corporate bonds		1,540		—		1,540		—
	$	47,519		—		47,519		—
As of December 31, 2010-
Mortgage-backed securities	$	49,304		—		49,304		—

There were no transfers of securities between levels of inputs during the nine months ended September 30, 2011.

Assets measured at fair value on a nonrecurring basis are summarized below (in thousands):

											Total Losses Recorded in Operations for the Nine-Month
	Net Carrying Value at September 30, 2011										Period Ended
									Total		September 30,
	Total		Level 1		Level 2		Level 3		Losses		2011
As of September 30, 2011:
Impaired loans	$	10,508		—		—		10,508		4,097		2,336
Other real estate owned	$	7,762		—		—		7,762		1,352		663

											Total Losses Recorded in Operations for
	Net Carrying Value at December 31, 2010										the Year Ended
									Total		December 31,
	Total		Level 1		Level 2		Level 3		Losses		2010
As of December 31, 2010:
Impaired loans	$	9,088		—		—		9,088		3,717		3,493
Other real estate owned	$	6,359		—		—		6,359		1,134		1,107

(continued)

21

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

6.Fair Value Measurements, Continued. In addition, loans with a carrying value of $2,868,000 at September 30, 2011 were measured for impairment using Level 3 inputs and had a fair value in excess of carrying value.

In addition, loans with a carrying value of $5,894,000 at December 31, 2010 were measured for impairment using Level 3 inputs and had a fair value in excess of carrying value.

7.Fair Value of Financial Instruments.The estimated fair values of the Company’s financial instruments are as follows (in thousands):

	At September 30, 2011				At December 31, 2010
	Carrying Amount		Fair Value		Carrying Amount		Fair Value
Financial assets:
Cash and cash equivalents	$	23,498		23,498		6,404		6,404
Securities available for sale		47,519		47,519		49,304		49,304
Loans, net		194,770		194,421		213,069		214,080
Loans held for sale		7,293		7,293		7,395		7,395
Accrued interest receivable		843		843		903		903
Federal Home Loan Bank stock		1,402		1,402		1,409		1,409
Financial liabilities:
Deposits		257,578		259,448		251,344		253,656
Federal Home Loan Bank advances		13,000		10,970		21,000		19,404
Other borrowings		3,032		3,032		3,054		3,054
Accrued interest payable		345		345		436		436
Off-balance-sheet financial instruments		—		—		—		—

22

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

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

General

Alarion Financial Services, Inc. (the “Holding Company”) owns 100% of the common stock of Alarion Bank (the “Bank”) and North Central Florida Developers Corporation (collectively the “Company”). The Holding Company’s primary activity is the operation of the Bank and North Central Florida Developers Corporation. The Bank is a state (Florida)-chartered commercial bank. The Company offers a variety of banking and financial services to individual and corporate customers through its six banking offices located in Ocala and Gainesville, Florida. North Central Florida Developers Corporation (“NCFDC”) holds loans or assets that might require a longer than desirable term hold to realize full or reasonable economic value.

The Bank’s deposits are insured by the Deposit Insurance Fund of the Federal Deposit Insurance Corporation (“FDIC”) up to applicable limits. The Holding Company’s and NCFDC operations are subject to supervision and regulation of the Federal Reserve Board. The operations of the Bank are subject to the supervision and regulation of the FDIC and the Florida Office of Financial Regulation.

The Bank provides a variety of consumer and commercial banking services to individuals, businesses and industries. The basic services offered by the Bank include: demand interest-bearing and noninterest-bearing accounts, money-market deposit accounts, NOW accounts, time deposits, credit cards, cash management, direct deposits, notary services, money orders, night depository, travelers’ checks, cashier’s checks, domestic collections, savings bonds, bank drafts, automated teller services, drive-in tellers, and banking by mail. In addition, the Bank makes secured and unsecured commercial, consumer, and real estate loans and issues stand-by letters of credit. The Bank provides automated teller machine (ATM) cards and is a member of the Star ATM network, thereby permitting customers to utilize the convenience of larger ATM networks. In addition to the foregoing services, the offices of the Company provide customers with extended banking hours. The Company does not have trust powers and, accordingly, no trust services are provided.

The revenues of the Bank are primarily derived from interest on, and fees received in connection with real estate and other loans, and from interest and dividends from investment and mortgage-backed securities, and short-term investments. The principal sources of funds for the Bank’s lending activities are its deposits and borrowings, repayment of loans, and the sale and maturity of investment securities. The principal expenses of the Bank are the interest paid on deposits, and operating and general administrative expenses.

As is the case with banking institutions generally, the Company’s operations are materially and significantly influenced by general economic conditions and by related monetary and fiscal policies of financial institution regulatory agencies, including the Board of Governors of the Federal Reserve System (the “Federal Reserve”) and the FDIC. Deposit flows and costs of funds are influenced by interest rates on competing investments and general market rates of interest. Lending activities are affected by the demand for financing of real estate and other types of loans, which in turn is affected by the interest rates at which such financing may be offered and other factors affecting local demand and availability of funds. The Company faces strong competition in the attraction of deposits (its primary source of lendable funds) and in the origination of loans.

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Capital Resources, Commitments and Capital Requirements

The Bank’s principal sources of funds are those generated by the Bank, including net increases in deposits and borrowings, principal and interest payments on loans, and proceeds from maturities and sales of investment securities.

The Bank uses its capital resources principally to fund existing and continuing loan commitments and to purchase investment securities. Off-balance-sheet commitments to extend credit represent legally binding agreements to lend to customers with fixed expiration dates or other termination clauses. Since many commitments are expected to expire without being funded, committed amounts do not necessarily represent future cash requirements.

The following table summarizes the Bank’s contractual obligations, including certain on-balance sheet and off-balance sheet obligations, at September 30, 2011 (in thousands):

Contractual Obligations	Total
Time deposit maturities	$	137,875
Advances from Federal Home Loan Bank		13,000
Other borrowings		3,032
Commitments to extend credit		871
Unused lines of credit		13,458
Standby letters of credit		97
Total	$	168,333

Management believes that the Bank has adequate resources to fund all its commitments, that a majority of all of its existing commitments will be funded within 12 months and, if so desired, that the Bank can adjust the rates and terms on time deposits and other deposit accounts to retain or obtain new deposits in a changing interest rate environment.

The Bank has agreed with its regulators to undertake a program of corrective and proactive actions as contained in a memorandum of understanding. The memorandum of understanding imposes no penalties on the Bank and as of September 30, 2011, the Bank was in compliance with all of its provisions. Specifically, the Bank has agreed to maintain its “well capitalized” position, to establish and maintain an adequate allowance for loan and lease losses, to reduce adversely classified assets, to submit to the regulators a strategic plan and a commercial real estate loan risk monitoring and reduction plan, to ensure compliance with laws, regulations and policy statements, to not pay dividends, to notify the regulators of any changes in directors or executive officers and to provide periodic reports as to the Bank’s compliance with the memorandum. We believe we are in substantive compliance at this time.

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Regulatory Capital Requirements

The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory - and possibly additional discretionary - actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification 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 Bank to maintain minimum amounts and percentages of total and Tier 1 capital to risk-weighted assets, and of Tier 1 capital to average assets. If such minimum amounts and percentages are met, the Bank is considered “adequately capitalized.” If the actual amounts exceed the requirements of “adequately capitalized,” and meet even more stringent minimum standards, they are considered “well capitalized.” Management believes as of September 30, 2011, the Bank meets the capital requirements for a “well capitalized” financial institution.

The table below shows the total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios of the Bank at September 30, 2011 and December 31, 2010, and the minimum required amounts and percentages ($ in thousands).

											For Well
						For Capital					Capitalized
	Actual					Adequacy Purposes					Purposes
	Amount		Percent			Amount		Percent			Amount		Percent
As of September 30, 2011:
Total capital to Risk- Weighted Assets	$	23,328		10.77	%	$	17,328		8.00	%	$	21,660		10.00	%
Tier I Capital to Risk- Weighted Assets		20,586		9.50			8,668		4.00			13,002		6.00
Tier I Capital to Average Assets		20,586		6.83			12,056		4.00			15,070		5.00
As of December 31, 2010:
Total capital to Risk- Weighted Assets		26,170		11.47			18,253		8.00			22,816		10.00
Tier I Capital to Risk- Weighted Assets		23,303		10.22			9,121		4.00			13,681		6.00
Tier I Capital to Average Assets		23,303		7.62			12,233		4.00			15,291		5.00

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Results of Operations

The following table shows selected ratios for the periods ended or at the dates indicated:

	Nine Months						Nine Months
	Ended			Year Ended			Ended
	September 30,			December 31,			September 30,
	2011			2010			2010
Average equity as a percentage of average assets		8.63	%		9.16	%		9.21	%
Total equity to total assets at end of period		8.48	%		8.79	%		8.84	%
Return on average assets (1)		(0.72	)%		(1.01	)%		(1.04	)%
Return on average equity (1)		(8.31	)%		(10.98	)%		(11.26	)%
Noninterest expense to average assets (1)		3.24	%		3.12	%		2.80	%
Nonperforming loans to total loans at end of period (2)		3.74	%		2.74	%		2.42	%

(1) Annualized for the nine-months ended September 30, 2011 and 2010.

(2) Nonperforming loans consist of nonaccrual loans and accruing loans contractually past due ninety days or more.

Changes in Financial Condition

Total assets decreased $2 million or 1%, from $303 million at December 31, 2010 to $301 million at September 30, 2011, primarily as a result of a $17 million increase in cash and cash equivalents somewhat offset by a decrease in net loans of $18 million. Deposits increased $6 million from $251.3 million at December 31, 2010 to $257.5 million at September 30, 2011.

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Net Interest Margin and Interest-Rate Spread

The following tables set forth, for the periods indicated, information regarding (i) the total dollar amount of interest and dividend income of the Company from interest-earning assets and the resultant average yields; (ii) the total dollar amount of interest expense on interest-bearing liabilities and the resultant average costs; (iii) net interest/dividend income; (iv) interest-rate spread; and (v) net interest margin. Yields and costs were derived by dividing annualized income or expense by the average balance of assets or liabilities, respectively, for the periods shown. The yields and costs include certain fees which are considered to constitute adjustments to yields.

	Three Months Ended September 30,
	2011							2010
	Average Balance		Interest and Dividends		Average Yield/ Rate			Average Balance		Interest and Dividends		Average Yield/ Rate
	($ in thousands)
Interest-earning assets:
Loans	$	203,441		2,759		5.38	%	$	223,451		3,185		5.65	%
Securities		46,641		314		2.67			34,670		258		2.95
Other (1)		24,612		7		0.11			32,530		13		0.16
Total interest-earning assets		274,694		3,080		4.45			290,651		3,456		4.72
Noninterest-earning assets		30,127							26,363
Total assets	$	304,821						$	317,014
Interest-bearing liabilities:
Deposits		230,155		738		1.27			238,063		1,066		1.78
FHLB advances and other borrowings		19,474		160		3.26			24,787		174		2.79
Total interest-bearing liabilities		249,629		898		1.43			262,850		1,240		1.87
Noninterest-bearing deposits		28,658							24,236
Noninterest-bearing liabilities		1,190							1,956
Stockholders’ equity		25,344							27,972
Total liabilities and stockholders’ equity	$	304,821						$	317,014
Net interest income			$	2,182						$	2,216
Interest-rate spread						3.02	%						2.85	%
Net interest margin (2)						3.15	%						3.02	%
Ratio of interest-earning assets to interest-bearing liabilities		1.10							1.11

(1) Includes interest-earning deposits, federal funds sold, time deposits and Federal Home Loan Bank stock.

(2) Net interest margin is annualized net interest income divided by average interest-earning assets.

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

	Nine Months Ended September 30,
	2011							2010
	Average Balance		Interest and Dividends		Average Yield/ Rate			Average Balance		Interest and Dividends		Average Yield/ Rate
	($ in thousands)
Interest-earning assets:
Loans	$	209,425		8,488		5.42	%	$	228,663		9,646		5.64	%
Securities		47,804		995		2.78			36,990		909		3.29
Other (1)		18,625		17		0.12			24,673		55		0.30
Total interest-earning assets		275,854		9,500		4.60			290,326		10,610		4.89
Noninterest-earning assets		30,411							25,936
Total assets	$	306,265						$	316,262
Interest-bearing liabilities:
Deposits		228,252		2,386		1.40			237,574		3,390		1.91
FHLB advances and other borrowings		22,215		491		2.96			25,597		524		2.74
Total interest-bearing liabilities		250,467		2,877		1.54			263,171		3,914		1.99
Noninterest-bearing deposits		28,509							22,302
Noninterest-bearing liabilities		864							1,652
Stockholders’ equity		26,425							29,137
Total liabilities and stockholders’ equity	$	306,265						$	316,262
Net interest income			$	6,623						$	6,696
Interest-rate spread						3.07	%						2.90	%
Net interest margin (2)						3.21	%						3.08	%
Ratio of interest-earning assets to interest-bearing liabilities		1.10							1.10

(1) Includes interest-earning deposits, federal funds sold, time deposits and Federal Home Loan Bank stock.

(2) Net interest margin is annualized net interest income divided by average interest-earning assets.

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Comparison of the Three-Month Periods Ended September 30, 2011 and 2010

General Operating Results.Net loss available to common shareholders for the three-month period ended September 30, 2011 was $217,000, or $(0.08) per basic and diluted common share, compared to a net earnings of $165,000, or $0.06 per basic and diluted share, for the comparable period in 2010. The $382,000 change resulted primarily from a $414,000 increase in noninterest expense and a $242,000 decrease in noninterest income, partially offset by a $75,000 decrease in provision for loan losses.

Interest Income.Interest income decreased $376,000 to $3.1 million for the three-month period ended September 30, 2011, compared to the three-month period ended September 30, 2010. The decrease was due to a decrease in the average yield earned on interest-earning assets from 4.72% for the three months ended September 30, 2010 to 4.45% for the three months ended September 30, 2011 and a $15.9 million decrease in average interest-earning assets outstanding for the three months ended September 30, 2011 compared to the 2010 period.

Interest Expense.Interest expense decreased $342,000 from $1.2 million for the three-month period ended September 30, 2010 to $898,000 for the three-month period ended September 30, 2011. The decrease was primarily due to a decrease in the average cost of interest-bearing liabilities from 1.87% for the three months ended September 30, 2010 to 1.43% for the comparable 2011 period and decrease of $13.2 million in average interest-bearing liabilities outstanding.

Provision for Loan Losses.The provision for loan losses is charged to operations to increase the total loan loss allowance to a level deemed appropriate by management. The provision is based upon the volume and type of lending conducted by the Company, industry standards, general economic conditions, particularly as they relate to the Company’s market area, and other factors related to the collectability of the Company’s loan portfolio. The Company recorded provisions for loan losses for the three-month periods ended September 30, 2011 and 2010 of $525,000 and $600,000, respectively. Management believes that the allowance for loan losses, which was $5.4 million or 2.70% of gross loans at September 30, 2011 is adequate.

Noninterest Income.Noninterest income decreased $242,000 during the 2011 period. The decrease was primarily due to a $478,000 decrease in gain on sale of securities, partially offset with an $187,000 increase in net gain on sale of loans and a $45,000 increase in other income compared to the three month period ended September 30, 2010.

Noninterest Expense.Noninterest expense increased by $414,000 from $2.1 million for the three-month period ended September 30, 2010 to $2.5 million for the three-month period ended September 30, 2011. The increase was primarily due to increases of $206,000 in salaries and employee benefits, $36,000 in occupancy and equipment expense, $41,000 in professional services, $29,000 in OREO expense, $149,000 in other expenses, all related to the overall growth of the Company.

Income Taxes.The income tax benefit was $64,000 for the three-month period ended September 30, 2011, compared to an income tax expense of $169,000 for the corresponding period in 2010.

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Comparison of the Nine-Month Periods Ended September 30, 2011 and 2010

General Operating Results.Net loss available to common shareholders for the nine month period ended September 30, 2011 was $1.9 million, or $(.74) per basic and diluted common share, compared to $2.8 million, or $(1.05) per basic and diluted share, for the comparable period in 2010. The $819,000 change resulted primarily from a $2.4 million decrease in provision for loan losses, partially offset by a $276,000 decrease in noninterest income and an increase of $810,000 in noninterest expense.

Interest Income.Interest income decreased $1.1 million to $9.5 million for the nine-month period ended September 30, 2011, compared to the nine-month period ended September 30, 2010. The decrease was due to a $14.5 million decrease in average interest earning assets outstanding for the nine months ended September 30, 2011 compared to the 2010 period and a decrease in the average yield earned on interest earning assets from 4.89% for the nine months ended September 30, 2010 to 4.60% for the nine months ended September 30, 2011.

Interest Expense.Interest expense decreased $1 million from $3.9 million for the nine-month period ended September 30, 2010 to $2.9 million for the nine-month period ended September 30, 2011. The decrease was primarily due to a decrease in the average cost of interest-bearing liabilities from 1.99% for the nine months ended September 30, 2010 to 1.54% for the comparable 2011 period and a decrease of $12.7 million in average interest-bearing liabilities.

Provision for Loan Losses.The provision for loan losses is charged to operations to increase the total loan loss allowance to a level deemed appropriate by management. The provision is based upon the volume and type of lending conducted by the Company, industry standards, general economic conditions, particularly as they relate to the Company’s market area, and other factors related to the collectability of the Company’s loan portfolio. The Company recorded provisions for loan losses for the nine-month periods ended September 30, 2011 and 2010 of $3.5 million and $5.9 million, respectively. Management believes that the allowance for loan losses, which was $5.4 million or 2.70% of gross loans at September 30, 2011 is adequate.

Noninterest Income.Noninterest income decreased $276,000 during the 2011 period. The decrease was primarily due to a $478,000 decrease in net gain on sale of securities and $7,000 in deposit account fees, partially offset by increases of $176,000 in gain on sale of loans and $33,000 in other income when compared to the nine-month period ended September 30, 2010.

Noninterest Expense.Noninterest expense increased by $810,000 from $6.6 million for the nine-month period ended September 30, 2010 to $7.4 million for the nine-month period ended September 30, 2011. The increase was primarily due to increases of $307,000 in salaries and employee benefits, $53,000 in occupancy and equipment expense, $154,000 in professional services, and $285,000 in OREO expense, all related to the overall growth of the Company.

Income Taxes.The income tax benefit was $972,000 for the nine-month period ended September 30, 2011, compared to an income tax benefit of $1.4 million for the corresponding period in 2010.

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Not applicable

Item 4. Controls and Procedures

a. Evaluation of disclosure controls and procedures. The Company maintains controls and procedures designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. Based upon their evaluation of those controls and procedures performed as of September 30, 2011, the Principal Executive and Principal Financial Officer of the Company concluded that the Company’s disclosure controls and procedures were adequate.

b. Changes in internal controls. The Company made no significant changes in its internal controls over financial reporting during the quarter ended September 30, 2011 that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.

c. Limitations on Effectiveness of Controls. The Company, including its Principal Executive Officer and Principal Financial Officer, does not expect that our disclosure controls and internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Part II - OTHER INFORMATION

Item 1. Legal Proceedings

There are no material pending legal proceedings to which Alarion Financial Services, Inc. or its subsidiaries is a party or to which any of their property is subject.

Item 1.A. Risk Factors

Not applicable

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

During the quarter ended June 30, 2011, the Company repurchased 20,000 shares of its common stock from the Bank. The Bank had taken title to the shares when it foreclosed on a lien on such shares which secured a loan made by the Bank.

Period	Total Number of Shares Purchased		Average Price Paid Per Share		Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs		Maximum Number of Shares That May Yet Be Purchased Under the Plans or Programs
April 30, 2011		0		N/A		N/A		N/A
May 31, 2011		0		N/A		N/A		N/A
June 30, 2011		20,000	$	5.00		N/A		N/A
Total		20,000	$	5.00		N/A		N/A

Item 3. Defaults upon Senior Securities

Not applicable

Item 4. (Removed and Reserved)

Item 5. Other Information

Not applicable

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Item 6. Exhibits

Exhibits marked with an (a) were filed with the Form 10-K filed with the Securities and Exchange Commission on March 15, 2006. Exhibits marked with a (b) were filed with the Form 8-K filed with the Securities and Exchange Commission on January 27, 2009. Exhibit (c) was filed in the Annual Report on Form 10-KSB/A filed with the Commission on July 17, 2006. The Exhibits marked with a (d) were filed in Form 8-K filed with the Commission on January 27, 2009.

Exhibit No.		Description of Exhibit
(a)	3.1	Articles of Incorporation
(a)	3.2	Bylaws
(b)	3.3	Articles of Amendment to the Articles of Incorporation authorizing the Series A Preferred Shares
(b)	3.4	Articles of Amendment to the Articles of Incorporation authorizing the Series B Preferred Shares
(a)	4.1	Specimen Common Stock Certificate
(a)	4.2	Warrant Plan and Specimen Warrant Plan
(b)	4.3	Form of Certificate for Series A Preferred Stock
(b)	4.4	Form of Certificate for Series B Preferred Stock
(c)	4.5	2005 Stock Plan
(a)	10.1	Employment Agreement with Jon M. Kurtz
(a)	10.2	Lease for Main Office
(b)	10.3	Letter Agreement, dated January 23, 2009 between AFSI and the United States Department of the Treasury
(b)	10.4	Form of Waiver
(b)	10.5	Form of Compliance Agreement
(b)	10.6	Securities Purchase Agreement – Standard Terms between the Company and the United States Department of the Treasury
(d)	10.8	Employment Agreement with Robert L. Page
(a)	14.1	Code of Ethics
(a)	21.1	Schedule of Subsidiaries
31.1		Certification of Chief Executive Officer required by Rule 13a-14(a)/15d-14(a) under the Exchange Act
31.2		Certification of Principal Financial Officer required by Rule 13a-14(a)/15d-14(a) under the Exchange Act
32.1		Certification of Chief Executive Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2		Certification of Principal Financial Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

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 hereunto duly authorized.

Date: November 14, 2011

Alarion Financial Services, Inc.
By:	/s/ Jon M. Kurtz
Name:	Jon M. Kurtz, President and
	Principal Executive Officer
By:	/s/ Matthew Ivers
Name:	Matthew Ivers, Senior Vice President
	and Principal Financial and Accounting
	Officer

34