Alarion Financial Services 10-Q 2012 Q1 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 March 31, 2012

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 May 14, 2012

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

INDEX

		Page
Part I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets -at March 31, 2012 (Unaudited) and at December  31, 2011			2
Condensed Consolidated Statements of Operations (Unaudited) - Three Months ended March  31, 2012 and 2011			3
Condensed Consolidated Statements of Comprehensive Income (Unaudited) - Three Months ended March 31, 2012 and 2011			4
Condensed Consolidated Statements of Stockholders’ Equity (Unaudited) - Three Months ended March 31, 2012 and 2011			5-6
Condensed Consolidated Statements of Cash Flows (Unaudited) - Three Months ended March  31, 2012 and 2011			7
Notes to Condensed Consolidated Financial Statements (Unaudited)			8-25
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		26-31
Item 3.	Quantitative and Qualitative Disclosures About Market Risk		32
Item 4.	Controls and Procedures		32
Part II. OTHER INFORMATION
Item 1.	Legal Proceedings		33
Item 1.A.	Risk Factors		33
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		33
Item 3.	Defaults upon Senior Securities		33
Item 4.	Mine Safety Disclosures		33
Item 5.	Other Information		33
Item 6.	Exhibits		34
SIGNATURES			35

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 March 31, 2012			At December 31, 2011
	(unaudited)
Assets
Cash and due from banks	$	4,367			4,853
Interest-earning deposits		248			224
Federal funds sold		460			—
Cash and cash equivalents		5,075			5,077
Securities available for sale		46,360			50,216
Loans, net of allowance for loan losses of $5,576 and $5,397		195,514			194,274
Loans held for sale		11,384			9,961
Accrued interest receivable		804			860
Premises and equipment, net		12,931			13,042
Other real estate owned, net		3,868			4,523
Federal Home Loan Bank stock, at cost		1,266			1,266
Deferred income taxes		4,337			4,511
Other assets		764			786
Total assets	$	282,303			284,516
Liabilities and Stockholders’ Equity
Liabilities:
Noninterest-bearing demand deposits		31,730			31,038
NOW, money-market and savings deposits		89,968			85,318
Time deposits less than $100,000		83,249			86,705
Time deposits greater than $100,000		35,054			38,167
Total deposits		240,001			241,228
Federal Home Loan Bank advances		13,000			16,000
Other borrowings		2,947			1,754
Accrued interest payable		329			342
Accrued expenses and other liabilities		1,486			935
Total liabilities		257,763			260,259
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		(118	)		(134	)
Common stock, $.01 par value; 4,000,000 shares authorized, 2,633,208 shares issued and outstanding		26			26
Additional paid-in capital, common		26,595			26,595
Accumulated deficit		(9,095	)		(9,271	)
Accumulated other comprehensive income		292			201
Total stockholders’ equity		24,540			24,257
Total liabilities and stockholders’ equity	$	282,303			284,516

See accompanying Notes to Condensed Consolidated Financial Statements.

2

ALARION FINANCIAL SERVICES, INC. AND SUBSIDARIES

Condensed Consolidated Statements of Operations (Unaudited)

($ in thousands, except per share amounts)

	Three Months Ended March 31,
	2012		2011
Interest income:
Loans	$	2,677		2,994
Securities		252		318
Other		3		4
Total interest income		2,932		3,316
Interest expense:
Deposits		593		858
Borrowings		149		168
Total interest expense		742		1,026
Net interest income		2,190		2,290
Provision for loan losses		300		525
Net interest income after provision for loan losses		1,890		1,765
Noninterest income:
Deposit account fees		87		93
Net gain on sale of securities		38		—
Net gain on sales of loans held for sale		582		234
Other		195		45
Total noninterest income		902		372
Noninterest expense:
Salaries and employee benefits		1,275		1,042
Occupancy and equipment		294		297
Data processing		185		136
Professional services		170		143
Advertising and promotion		50		40
Office supplies and printing		32		38
Other real estate owned expense		98		64
FDIC assessment		109		145
Other		269		253
Total noninterest expense		2,482		2,158
Earnings (loss) before income taxes (benefit)		310		(21	)
Income taxes (benefit)		118		(4	)
Net earnings (loss)		192		(17	)
Preferred stock dividend requirements and accretion of preferred stock to par		105		105
Net earnings (loss) available to common shareholders	$	87		(122	)
Earnings (loss) per share – basic and diluted	$	0.03		(0.05	)
Weighted-average number of common shares outstanding, basic and diluted		2,633,208		2,653,208
Dividends per common share	$	—		—

See accompanying Notes to Condensed Consolidated Financial Statements.

3

ALARION FINANCIAL SERVICES, INC. AND SUBSIDARIES

Condensed Consolidated Statements of Comprehensive Income (Unaudited)

(in thousands)

	Three Months Ended March 31,
	2012			2011
Net earnings (loss)	$	192			(17	)
Other comprehensive income:
Change in unrealized gain (loss) on investments:
Unrealized gain (loss) arising during the period		187			446
Reclassification adjustment for realized gains		(38	)		—
Net change in unrealized gain (loss)		149			446
Deferred income taxes on above change		(58	)		(167	)
Total other comprehensive income		91			279
Comprehensive income	$	283			262

See accompanying Notes to Condensed Consolidated Financial Statements.

4

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Stockholders’ Equity (Unaudited)

Three Months Ended March 31, 2012 and 2011

($ in thousands)

	Preferred Stock													Common Stock									Accumulated
	Series A				Series B				Additional Paid-in									Additional Paid-In		Accumulated			Other Comprehensive			Total Stockholders’
	Shares		Amount		Shares		Amount		Capital		Discount			Shares		Amount		Capital		Deficit			(Loss)			Equity
Balance at December 31, 2010		6,514	$	—		326	$	—		6,840		(200	)		2,653,208	$	27		26,693		(6,111	)		(615	)		26,634
Net loss (unaudited)		—		—		—		—		—		—			—		—		—		(17	)		—			(17	)
Net change in unrealized loss on securities available for sale, net of taxes of $(167) (unaudited)		—		—		—		—		—		—			—		—		—		—			279			279
Share-based compensation (unaudited)		—		—		—		—		—		—			—		—		1		—			—			1
Preferred stock dividend requirements and Series B preferred stock accretion (unaudited)		—		—		—		—		—		16			—		—		—		(105	)		—			(89	)
Balance at March 31, 2011 (unaudited)		6,514	$	—		326	$	—		6,840		(184	)		2,653,208	$	27		26,694		(6,233	)		(336	)		26,808

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

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

Three Months Ended March 31, 2012 and 2011

($ in thousands)

	Preferred Stock													Common Stock									Accumulated
	Series A				Series B				Additional Paid-in									Additional Paid-In		Accumulated			Other Comprehensive		Total Stockholders’
	Shares		Amount		Shares		Amount		Capital		Discount			Shares		Amount		Capital		Deficit			Income		Equity
Balance at December 31, 2011		6,514	$	—		326	$	—		6,840		(134	)		2,633,208	$	26		26,595		(9,271	)		201		24,257
Net earnings (unaudited)		—		—		—		—		—		—			—		—		—		192			—		192
Net change in unrealized gain on securities available for sale, net of taxes of $58 (unaudited)		—		—		—		—		—		—			—		—		—		—			91		91
Series B preferred stock accretion of discount (unaudited)		—		—		—		—		—		16			—		—		—		(16	)		—		—
Balance at March 31, 2012 (unaudited)		6,514	$	—		326	$	—		6,840		(118	)		2,633,208	$	26		26,595		(9,095	)		292		24,540

See accompanying Notes to Condensed Consolidated Financial Statements.

6

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows (Unaudited)

(In thousands)

	Three Months Ended March 31,
	2012			2011
Cash flows from operating activities:
Net earnings (loss)	$	192			(17	)
Adjustments to reconcile net earnings (loss) to net cash provided by operating activities:
Provision for loan losses		300			525
Share-based compensation		—			1
Depreciation and amortization		141			141
Gain on sale of loans held for sale		(582	)		(234	)
Loans originated for sale		(24,091	)		(12,302	)
Proceeds from loans sold		23,250			16,080
Deferred income tax benefit		116			(4	)
Net amortization of deferred loan fees and costs		34			30
(Gain) loss on sale of other real estate owned		(33	)		40
Provision for other real estate owned losses		99			—
Net (decrease) increase in accrued interest payable		(13	)		11
Net decrease (increase) in accrued interest receivable		56			(13	)
Net decrease in other assets		22			107
Net gain on sale of securities		(38	)		—
Net increase in accrued expenses and other liabilities		551			520
Net amortization of premiums and discounts on securities available for sale		283			200
Net cash provided by operating activities		287			5,085
Cash flows from investing activities:
Purchase of securities available for sale		(8,741	)		(2,115	)
Proceeds from sales, principal repayments and maturities on securities available for sale		12,501			2,951
Net (increase) decrease in loans		(1,382	)		1,268
Purchase of premises and equipment		(30	)		(123	)
Proceeds from sale of other real estate owned		397			570
Redemption of Federal Home Loan Bank stock		—			(135	)
Net cash provided by investing activities		2,745			2,416
Cash flows from financing activities:
Net (decrease) increase in deposits		(1,227	)		11,362
Net increase in other borrowings		1,193			1,400
Net (decrease) increase in Federal Home Loan Bank advances		(3,000	)		1,000
Preferred stock dividend requirements and Series B stock accretion		—			(89	)
Net cash (used in) provided by financing activities		(3,034	)		13,673
Net (decrease) increase in cash and cash equivalents		(2	)		21,174
Cash and cash equivalents at beginning of period		5,077			6,404
Cash and cash equivalents at end of period	$	5,075			27,578
Supplemental disclosure of cash flow information:
Cash paid during the period for:
Interest	$	755			1,015
Income taxes	$	—			—
Noncash transactions:
Accumulated other comprehensive income, net change in unrealized gain on securities available for sale, net of taxes	$	91			279
Transfer of loans to other real estate owned	$	126			91
Transfer of other real estate owned to loans	$	318			—

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 March 31, 2012 and the results of operations and cash flows for the three-month periods ended March 31, 2012 and 2011. The results of operations for the three-month period ended March 31, 2012, are not necessarily indicative of results that may be expected for the year ending December 31, 2012.

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 holding period to realize reasonable or full economic value.

Recent Accounting Standards Update.In April 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2011-03 Transfers and Servicing: “Reconsideration of Effective Control for Repurchase Agreements,” which applies to all public 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 from 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. ASU 2011-03 became effective January 1, 2012 and is to be applied prospectively to transactions or modifications of existing transactions that occur on or after such date. We adopted ASU 2011-03 on January 1, 2012 and it had no impact on our condensed consolidated financial statements.

(continued)

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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 May 2011, the FASB issued ASU 2011-04 Fair Value Measurement: “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 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. 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 became effective for interim and annual periods beginning after December 15, 2011 and is to be applied prospectively. We adopted ASU 2011-04 on January 1, 2012 and it had no impact on our condensed consolidated financial statements other than to increase financial disclosures already provided.

In June 2011, the FASB issued ASU No. 2011-05, “Presentation of Comprehensive Income.” ASU No. 2011-05 allows an entity the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. The statement(s) are required to be presented with equal prominence as the other primary financial statements. ASU No. 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of stockholders’ equity but does not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. The provisions of ASU No. 2011-05 became effective for interim reporting period beginning on or after December 15, 2011, with retrospective application required. We adopted ASU No. 2011-05 on January 1, 2012 and it had no financial impact on our condensed consolidated financial statements.

In September 2011, the FASB issued ASU No. 2011-08, “Testing Goodwill for Impairment.” 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. ASU No. 2011-08 became effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. We adopted ASU No. 2011-08 on January 1, 2012 and it had no impact on our condensed consolidated financial statements.

(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 December 2011, ASU No. 2011-12 “Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in ASU No. 2011-05” was issued. In order to defer only those changes in ASU 2011-05 that relate to the presentation of reclassification adjustments, the paragraphs in this ASU supersede certain pending paragraphs in ASU 2011-05. The amendments were made to allow the FASB time to re-deliberate whether to present on the face of the financial statements the effects of reclassifications out of accumulated other comprehensive income on the components of net income and other comprehensive income for all periods presented. While the Board is considering the operational concerns about the presentation requirements for reclassification adjustments and the needs of financial statement users for additional information about reclassification adjustments, entities are required to continue to report reclassifications out of accumulated other comprehensive income consistent with the presentation requirements in effect before ASU 2011-05. All other requirements in ASU 2011-05 are not affected by this ASU, including the requirement to report comprehensive income either in a single continuous financial statement or in two separate but consecutive financial statements. The provisions of ASU 2011-12 have no impact on our condensed consolidated financial statements.

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):

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
At March 31, 2012:
U.S. Government agency securities	$	1,044		4		—			1,048
Mortgage-backed securities		37,915		569		(2	)		38,482
Municipal bonds		4,839		3		(105	)		4,737
Corporate bonds		2,092		6		(5	)		2,093
	$	45,890		582		(112	)		46,360
At December 31, 2011:
U.S. Government agency securities		1,064		—		(5	)		1,059
Mortgage-backed securities		46,734		482		(52	)		47,164
Corporate bonds		2,097		—		(104	)		1,993
	$	49,895		482		(161	)		50,216

At March 31, 2012 and December 31, 2011, securities with a carrying value of approximately $12.3 million and $12.6 million, respectively, were pledged for other borrowings and public funds.

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

2. Securities, Continued.There were no sales of securities during the three months ended March 31, 2011. Securities sold during the three months ended March 31, 2012 are as follows (in thousands):

Proceeds received from sales	$	8,821
Gross gains		52
Gross losses		(14	)
Net gain	$	38

Securities with gross unrealized losses at March 31, 2012, 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 Losses			Fair Value
Securities Available for Sale:
U.S. Government agency securities	$	—			—
Mortgage-backed securities		(2	)		1,815
Municipal bonds		(105	)		4,031
Corporate bonds		(5	)		531
Total securities available for sale	$	(112	)		6,377

The unrealized losses on ten 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.

At March 31, 2012, management believed that we will not be required to sell any securities before recovery of their amortized losses.

(continued)

11

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

3. Loans. The loan portfolio segments and classes are as follows (in thousands):

	At March 31, 2012			At December 31, 2011
Real estate mortgage loans:
Office/retail/other	$	58,157			59,006
Multi-family		16,333			16,421
Land		16,338			16,118
Commercial real estate		13,311			13,384
Residential nonowner		14,007			14,315
Residential owner		33,831			32,252
Construction and development		7,120			6,520
Home equity and line of credit		14,242			14,522
Commercial		20,239			19,489
Consumer		7,145			7,284
Total loans		200,723			199,311
Allowance for loan losses		(5,576	)		(5,397	)
Net deferred loan costs		367			360
Loans, net	$	195,514			194,274

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

Real Estate Mortgage Loans.Real estate mortgage loans are divided into eight classes: Office/Retail/Other, Multi-Family, Land, Commercial Real Estate, Residential Nonowner, Residential Owner, Construction and Development and Home Equity & Line of Credit. All loans are underwritten in accordance with policies set forth and approved by the Board of Directors.

Office/Retail/Other Loans. Office/retail/other loans are typically secured by the subject property, such as a church, motel/hotel, restaurant, retail store, warehouse, or an office. These loans are secured by first liens on properties located within the Company’s market area. The Company’s underwriting analysis includes credit verification, independent appraisals, a review of the borrower’s financial condition, and a detailed analysis of the borrower’s underlying cash flows.

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

3. Loans, Continued.

Multi-Family Loans.Multi-family loans are typically secured by properties such as apartments, duplexes and others that are constructed for use by multiple family groups. These loans are secured by first liens on properties located within the Company’s market area. The Company’s underwriting analysis typically utilizes the same standards and criteria used on commercial real estate loans and include credit verification, independent appraisals, a review of the borrower’s financial condition, and a detailed analysis of the borrower’s underlying cash flows. These loan types also are considered a higher degree of credit risk due to the underlying management assumptions that need to be considered when dealing with these types of real estate investments.

Land Loans.Land loans are typically secured by raw land, farm land, improved land such as a lot, or land to be used for development. 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. Additionally, these loans have a higher degree of risk associated with overall budget and project costs, evaluating and monitoring construction progress, and overall market saturations which may affect values negatively during an economic downturn.

Commercial Real Estate Loans.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. Such standards include, among other factors, loan to value limits, cash flow coverage and general creditworthiness of the obligors. These loan types also are considered a higher degree of credit risks due to the underlying management assumptions that need to be considered when dealing with these types of real estate investments.

Residential Nonowner and Residential Owner Real Estate Loans.The Company’s underwriting analysis includes reviewing the borrower’s repayment capacity and source, value of the underlying property, credit history and stability. The Company originates mostly adjustable-rate mortgage loans for the purchase or refinance of residential properties. These loans are collateralized by first or second mortgages on owner-occupied, second homes or investment residential properties located in the Company’s market area. The primary risk associated with these loan types is the construction phase of a home and the borrower’s accuracy of projected costs associated to complete a home. In addition, market conditions could fluctuate negatively and affect the home’s final value.

(continued)

13

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

3. Loans, Continued.

Construction and Development Loans.Construction and development loans 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, cost estimates and pre-construction sale information. The primary risk associated with these loan types is the construction phase of owner occupied and lease properties and the borrower’s accuracy of projected costs associated to complete a property. In addition, market conditions could fluctuate negatively and affect the property’s final value, and overall market saturations may affect values negatively during an economic downturn.

Home Equity and Line of Credit Loans.Home equity and line of credit loans are secured by a recorded lien position against the equity in the secured real property and mainly consist of variable-rate and fixed-rate personal loans and lines of credit. The risks inherent with these types of loans are economic conditions affecting the borrower’s future employment or their spouse’s loss of job affecting their ability to continue servicing debt repayments.

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, the Company takes 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. These loans are also affected by adverse economic conditions should they prevail within the Company’s local market.

(continued)

14

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

3. Loans, Continued.

Consumer Loans.Consumer loans are extended for various purposes, including purchases of automobiles, recreational vehicles, and boats. The Company also offers 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. The Company’s underwriting analysis includes a determination of the borrower’s payment history on other debts and an assessment of ability to meet existing obligations and payments on the proposed loan. The risks inherent with these types of loans are the borrower’s continuing financial stability, which can be negatively affected by job loss, divorce, illness or personal bankruptcy.

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

	Office/ Retail/ Other			Multi- Family			Land			Commercial Real Estate			Resid. Non- Owner			Resid. Owner			Construction and Development			Home Equity and Line of Credit			Commercial			Consumer			Total
Three Months Ended March 31, 2012:
Beginning balance	$	1,625			16			1,420			146			191			378			611			245			437			328			5,397
Provision for loan losses		179			—			57			(3	)		(11	)		158			(4	)		141			(189	)		(28	)		300
Recoveries		1			—			1			—			1			2			—			4			—			13			22
Charge-offs		(109	)		—			(3	)		—			(20	)		—			—			—			—			(11	)		(143	)
Ending balance	$	1,696			16			1,475			143			161			538			607			390			248			302			5,576
Individually evaluated for impairment:
Recorded investment	$	3,363			—			4,333			—			2,269			397			2,154			377			65			247			13,205
Balance in allowance for loan losses	$	1,208			—			1,262			—			—			55			600			127			—			165			3,417
Collectively evaluated for impairment:
Recorded investment	$	54,794			16,333			12,005			13,311			11,738			33,434			4,966			13,865			20,174			6,898			187,518
Balance in allowance for loan losses	$	488			16			213			143			161			483			7			263			248			137			2,159
Three Months Ended March 31, 2011:
Beginning balance		1,075			10			582			259			441			350			23			744			427			204			4,115
Provision for loan losses		207			(1	)		39			52			(19	)		119			(17	)		(28	)		130			43			525
Recoveries		—			—			—			—			—			—			—			—			—			1			1
Charge-offs		—			—			(5	)		—			—			(15	)		—			—			(25	)		(3	)		(48	)
Ending balance	$	1,282			9			616			311			422			454			6			716			532			245			4,593
Individually evaluated for impairment:
Recorded investment	$	2,885			—			8,029			1,059			290			651			898			912			70			83			14,877
Balance in allowance for loan losses	$	668			—			337			166			26			173			—			476			84			178			2,108
Collectively evaluated for impairment:
Recorded investment	$	61,375			9,482			14,792			15,528			18,183			31,982			4,409			18,825			18,632			7,302			200,510
Balance in allowance for loan losses	$	614			9			279			145			396			281			6			240			448			67			2,485

(continued)

15

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

3. Loans, Continued. Management believes that the allowance for loan losses at March 31, 2012 appropriately reflects the risk inherent in the portfolio. The methodologies used in the calculation are in compliance with regulatory policy, with Financial Accounting Standards Board (“FASB”) Accounting Standard Codification (“ASC”) 310 and 450 and on other requirements of US GAAP.

The following summarizes the loan credit quality (in thousands):

	Real Estate Mortgage
Credit Risk Profile by Internally Assigned Grade	Office/ Retail/ Other		Multi- Family		Land		Commercial Real Estate		Resid. Non- Owner		Resid. Owner		Construction and Development		Home Equity and Line of Credit		Commercial		Consumer		Total
March 31, 2012:
Grade:
Pass	$	49,149		16,333		9,716		13,124		8,939		32,765		4,854		13,312		19,426		6,576		174,194
Special mention		5,248		—		2,289		187		2,341		669		112		353		748		297		12,244
Substandard		3,760		—		4,333		—		2,727		397		2,154		577		65		272		14,285
Total	$	58,157		16,333		16,338		13,311		14,007		33,831		7,120		14,242		20,239		7,145		200,723
December 31, 2011:
Grade:
Pass		49,338		16,421		9,207		12,749		10,475		31,467		4,255		14,142		18,541		6,862		173,457
Special mention		4,756		—		2,211		635		1,009		664		112		179		303		133		10,002
Substandard		4,912		—		4,700		—		2,831		121		2,153		201		645		289		15,852
Total	$	59,006		16,421		16,118		13,384		14,315		32,252		6,520		14,522		19,489		7,284		199,311

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:

(continued)

16

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

3. Loans, Continued. 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.

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.

(continued)

17

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

3. Loans, Continued. 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 March 31, 2012:
Real estate mortgage loans:
Office/retail/other	$	2,718		128		—		2,846		55,311		—		58,157
Multi-family		—		—		—		—		16,333		—		16,333
Land		299		—		—		299		14,362		1,677		16,338
Commercial real estate		—		—		—		—		13,311		—		13,311
Residential nonowner		1,350		133		—		1,483		10,255		2,269		14,007
Residential owner		337		—		—		337		33,097		397		33,831
Construction and development		—		—		—		—		5,752		1,368		7,120
Home equity and line of credit		—		—		—		—		14,115		127		14,242
Commercial		178		—		—		178		19,996		65		20,239
Consumer		455		1		—		456		6,689		—		7,145
Total	$	5,337		262		—		5,599		189,221		5,903		200,723
At December 31, 2011:
Real estate mortgage loans:
Office/retail/other		—		2,718		—		2,718		55,537		751		59,006
Multi-family		—		—		—		—		16,421		—		16,421
Land		1,480		—		—		1,480		12,864		1,774		16,118
Commercial real estate		—		—		—		—		13,384		—		13,384
Residential nonowner		—		—		—		—		11,953		2,362		14,315
Residential owner		516		—		—		516		31,615		121		32,252
Construction and development		—		—		—		—		5,152		1,368		6,520
Home equity and line of credit		—		—		—		—		14,522		—		14,522
Commercial		179		—		—		179		19,245		65		19,489
Consumer		58		—		—		58		7,199		27		7,284
Total	$	2,233		2,718		—		4,951		187,892		6,468		199,311

(continued)

18

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

3. Loans, Continued. 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		Recorded Investment		Unpaid Principal Balance		Related Allowance		Recorded Investment		Unpaid Principal Balance		Related Allowance
March 31, 2012:
Real estate mortgage loans:
Office/retail/other	$	—		—		3,363		3,737		1,208		3,363		3,737		1,208
Multi-family		—		—		—		—		—		—		—		—
Land		—		—		4,333		5,908		1,262		4,333		5,908		1,262
Commercial real estate		—		—		—		—		—		—		—		—
Residential nonowner		2,269		2,269		—		—		—		2,269		2,269		—
Residential owner		121		141		276		297		55		397		438		55
Construction and development		—		—		2,154		2,154		600		2,154		2,154		600
Home equity and line of credit		250		250		127		127		127		377		377		127
Commercial		65		70		—		—		—		65		70		—
Consumer		—		—		247		258		165		247		258		165
	$	2,705		2,730		10,500		12,481		3,417		13,205		15,211		3,417
December 31, 2011:
Real estate mortgage loans:
Office/retail/other		750		1,016		3,364		3,629		1,208		4,114		4,645		1,208
Multi-family		—		—		—		—		—		—		—		—
Land		82		144		4,618		6,184		1,234		4,700		6,328		1,234
Commercial real estate		—		—		—		—		—		—		—		—
Residential nonowner		2,269		2,269		93		111		2		2,362		2,380		2
Residential owner		121		141		—		20		—		121		161		—
Construction and development		—		—		2,153		2,153		600		2,153		2,153		600
Home equity and line of credit		—		—		—		—		—		—		—		—
Commercial		65		70		—		—		—		65		70		—
Consumer		—		—		275		275		179		275		275		179
	$	3,287		3,640		10,503		12,372		3,223		13,790		16,012		3,223

(continued)

19

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

3. Loans, Continued. 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 March 31,
	2012						2011
	Average Recorded Investment		Interest Income Recognized		Interest Income Received		Average Recorded Investment		Interest Income Recognized		Interest Income Received
Real estate mortgage loans:
Office/retail/other	$	3,739		29		29		3,539		51		51
Multi-family		—		—		—		—		—		—
Land		4,517		21		21		8,262		49		49
Commercial real estate		—		—		—		1,227		—		—
Residential nonowner		2,315		—		—		312		—		—
Residential owner		259		—		—		757		—		—
Construction and development		2,154		7		7		911		8		8
Home equity and line of credit		188		2		2		1,388		15		15
Commercial		65		—		—		156		—		—
Consumer		261		2		2		261		1		1
	$	13,498		61		61		16,813		124		124

Troubled debt restructurings entered during the period are as follows (dollars in thousands):

	Three Months Ended March 31, 2012
	Outstanding Recorded Investment
	Number of Contracts		Pre- Modification		Post- Modification		At March 31, 2012 Nonaccrual
Troubled Debt Restructurings:
Real estate mortgage loans:
Office/retail/other:
Modified interest rate		1	$	646		646		—
Modified interest rate and amortization		1		2,718		2,718		—
Land-
Modified interest rate and amortization		3		3,072		3,072		1,595
Residential nonowner-
Modified interest rate and amortization		1		2,269		2,269		2,269
Residential owner-
Modified interest rate		1		121		121		121
Construction-
Modified interest rate		1		785		785		—
Consumer-
Modified interest rate and amortization		1		90		90		—
		9	$	9,701		9,701		3,985

(continued)

20

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

3. Loans, Continued. The allowance for loan losses on all 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.

TDR’s that subsequently defaulted during the three-month period ended March 31, 2012, which were restructured during the last twelve months are as follows (dollars in thousands):

	Number of Contracts		Recorded Investment
Troubled Debt Restructurings:
Real estate mortgage loans:
Residential owner		2	$	246
Land		1		2,325
		3	$	2,571

Loans Held for Sale - As shown in the Statement of Cash Flows, all loans sold were originated for sale, with none reclassified from the portfolio.

4. Earnings (Loss) Per Share. Basic earnings (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 2,633,208 shares and 2,653,208 shares during the three-month periods ended March 31, 2012 and 2011, respectively. All outstanding stock options are not dilutive due to the net losses of the Company during the three month period ended March 31, 2011. All outstanding stock options are not considered dilutive for the three month period ended March 31, 2012 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.

(continued)

21

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

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 March 31, 2012, there were 132,012 options available for future grants under the Plan. A summary of stock option transactions under the Plan for the three-month period ended March 31, 2012, follows:

	Number of Options			Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Term		Aggregate Intrinsic Value
Options outstanding at December 31, 2011		243,953		$	10.12
Options forfeited		(4,500	)		10.17
Options outstanding at March 31, 2012		239,453		$	10.12		4.60 years	$	—
Options exercisable at March 31, 2012		239,453		$	10.12		4.60 years	$	—

There were no options exercised during the three month periods ended March 31, 2012 and 2011. At March 31, 2012, 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 for the three month period ended March 31, 2011.

(continued)

22

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 March 31, 2012:
U.S. Government agency securities	$	1,048		—		1,048		—	��
Mortgage-backed securities		38,482		—		38,482		—
Municipal bonds		4,737		—		4,737		—
Corporate bonds		2,093		—		2,093		—
	$	46,360		—		46,360		—
As of December 31, 2011:
U.S. Government agency securities		1,059		—		1,059		—
Mortgage-backed securities		47,164		—		47,164		—
Corporate bonds		1,993		—		1,993		—
	$	50,216		—		50,216		—

There were no transfers of securities between levels of inputs during the three months ended March 31, 2012 and during the year ended December 31, 2011.

(continued)

23

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

6. Fair Value Measurements, Continued. Impaired collateral-dependent loans are carried at fair value when the current collateral value is lower than the carrying value of the loan. Impaired collateral-dependent loans are evaluated individually according to an appraised value obtained at least annually. Those impaired collateral-dependent loans which are measured at fair value or a nonrecurring basis are as follows (in thousands):

		00000000		00000000		00000000		00000000		00000000		00000000
	Fair Value		Level 1		Level 2		Level 3		Total Losses		Losses Recorded  in Operations for the Three-Month Period Ended March 31, 2012
At March 31, 2012:
Real estate mortgage:
Office/retail/other	$	2,155		—		—		2,155		1,582		109
Multi-family		—		—		—		—		—		—
Land		3,072		—		—		3,072		2,836		36
Commercial real estate		—		—		—		—		—		—
Residential nonowner		—		—		—		—		—		—
Residential owner		342		—		—		342		75		55
Construction and development		1,554		—		—		1,554		600		—
Home equity and line of credit		—		—		—		—		127		127
Commercial		65		—		—		65		5		—
Consumer		82		—		—		82		176		(3	)
Total	$	7,270		—		—		7,270		5,401		324

		00000000		00000000		00000000		00000000		00000000		00000000
	Fair Value		Level 1		Level 2		Level 3		Total Losses		Losses Recorded  in Operations for the Year Ended December 31, 2011
At December 31, 2011:
Real estate mortgage:
Office/retail/other		2,906		—		—		2,906		1,473		1,213
Multi-family		—		—		—		—		—		—
Land		3,466		—		—		3,466		2,801		1,422
Commercial real estate		—		—		—		—		—		—
Residential nonowner		91		—		—		91		20		(6	)
Residential owner		121		—		—		121		40		20
Construction and development		1,554		—		—		1,554		600		600
Home equity and line of credit		—		—		—		—		—		—
Commercial		65		—		—		65		5		5
Consumer		96		—		—		96		179		84
Total	$	8,299		—		—		8,299		5,118		3,338

In addition, loans with a carrying value of $2,519,000 at March 31, 2012 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 $2,269,000 at December 31, 2011 were measured for impairment using Level 3 inputs and had a fair value in excess of carrying value.

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

6. Fair Value Measurements, Continued. Other real estate owned is recorded at fair value less estimated costs to sell. Other real estate owned which is measured at fair value on a nonrecurring basis is as follows (in thousands):

		000000		000000		000000		000000		000000		000000
	Fair Value		Level 1		Level 2		Level 3		Total Losses		Losses Recorded in Operations for the Three-Month Period  Ended March 31, 2012
At March 31, 2012	$	3,868		—		—		3,868		1,039		99

		000000		000000		000000		000000		000000		000000
	Fair Value		Level 1		Level 2		Level 3		Total Losses		Losses Recorded in Operations for the Year Ended December  31, 2011
At December 31, 2011	$	4,523		—		—		4,523		2,128		1,522

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

	At March 31, 2012				At December 31, 2011
	Carrying Amount		Fair Value		Carrying Amount		Fair Value
Financial assets:
Cash and cash equivalents	$	5,075		5,075		5,077		5,077
Securities available for sale		46,360		46,360		50,216		50,216
Loans, net		195,514		194,506		194,274		193,445
Loans held for sale		11,384		11,384		9,961		9,961
Accrued interest receivable		804		804		860		860
Federal Home Loan Bank stock		1,266		1,266		1,266		1,266
Financial liabilities:
Deposits		240,001		241,112		241,228		242,748
Federal Home Loan Bank advances		13,000		14,893		16,000		17,975
Other borrowings		2,947		2,947		1,754		1,754
Accrued interest payable		329		329		342		342
Off-balance-sheet financial instruments		—		—		—		—

25

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 (“NCFDC”) (collectively 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 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. NCFDC holds loans or assets that might require a longer than desirable holding period 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.

26

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Capital Resources, Commitments and Capital Requirements

The Bank’s principal source of funds includes 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 March 31, 2012 (in thousands):

Contractual Obligations	Total
Time deposit maturities	$	118,303
Advances from Federal Home Loan Bank		13,000
Other borrowings		2,947
Commitments to extend credit		735
Unused lines of credit		11,083
Standby letters of credit		80
Total	$	146,148

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 March 31, 2012, 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.

27

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 March 31, 2012, 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 March 31, 2012 and December 31, 2011, and the minimum required amounts and percentages ($ in thousands).

	Actual					For Capital Adequacy Purposes					For Well Capitalized Purposes
	Amount		Percent			Amount		Percent			Amount		Percent
As of March 31, 2012:
Total capital to Risk-
Weighted Assets	$	21,920		10.39	%	$	16,878		8.00	%	$	21,097		10.00	%
Tier I Capital to Risk-
Weighted Assets		19,246		9.12			8,441		4.00			12,662		6.00
Tier I Capital to Average Assets		19,246		6.87			11,206		4.00			14,007		5.00
As of December 31, 2011:
Total capital to Risk-
Weighted Assets		21,482		10.16			16,915		8.00			21,144		10.00
Tier I Capital to Risk-
Weighted Assets		18,805		8.89			8,461		4.00			12,692		6.00
Tier I Capital
to Average Assets		18,805		6.49			11,590		4.00			14,488		5.00

28

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Results of Operations

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

	Three Months Ended March 31, 2012			Year Ended December 31, 2011			Three Months Ended March 31, 2011
Average equity as a percentage of average assets		8.52	%		8.59	%		8.90	%
Total equity to total assets at end of period		8.69	%		8.53	%		8.44	%
Return on average assets (1)		0.27	%		(0.92	)%		(.02	)%
Return on average equity (1)		3.18	%		(10.70	)%		(.25	)%
Noninterest expense to average assets (1)		3.51	%		3.70	%		2.86	%
Nonperforming loans to total loans at end of period (2)		3.02	%		3.33	%		2.87	%

(1) Annualized for the three-months ended March 31, 2012 and 2011.

(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 $284 million at December 31, 2011 to $282 million at March 31, 2012, primarily as a result of a $4 million decrease in securities available for sale, somewhat offset by an increase in net loans of $1.2 million. Deposits decreased $1.2 million from $241 million at December 31, 2011 to $240 million at March 31, 2012.

29

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 March 31,
	2012							2011
	Average Balance		Interest and Dividends		Average Yield/ Rate			Average Balance		Interest and Dividends		Average Yield/ Rate
	($ in thousands)
Interest-earning assets:
Loans	$	199,540		2,677		5.40	%	$	215,166		2,994		5.64	%
Securities		48,275		252		2.10			48,720		318		2.65
Other (1)		4,763		3		0.25			10,657		4		0.15
Total interest-earning assets		252,578		2,932		4.67			274,543		3,316		4.90
Noninterest-earning assets		31,346							31,106
Total assets	$	283,924						$	305,649
Interest-bearing liabilities:
Deposits		210,983		593		1.13			224,266		858		1.55
Federal Home Loan Bank advances and other borrowings		16,828		149		3.56			25,175		168		2.71
Total interest-bearing liabilities		227,811		742		1.31			249,441		1,026		1.67
Noninterest-bearing deposits		31,000							28,562
Noninterest-bearing liabilities		920							439
Stockholders’ equity		24,193							27,207
Total liabilities and stockholders’ equity	$	283,924						$	305,649
Net interest income			$	2,190						$	2,290
Interest-rate spread						3.36	%						3.23	%
Net interest margin (2)						3.49	%						3.38	%
Ratio of interest-earning assets to interest-bearing liabilities		1.11							1.10

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

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

30

ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Comparison of the Three-Month Periods Ended March 31, 2012 and 2011

General Operating Results.Net earnings available to common shareholders for the three-month period ended March 31, 2012 was $87,000, or $.03 per basic and diluted common share, compared to a net loss of $122,000, or $(0.05) per basic and diluted common share, for the comparable period in 2011. The $209,000 increase in net earnings available to common shareholders resulted primarily from a $530,000 increase in noninterest income and a $225,000 decrease in provision for loan losses, partially offset by a $324,000 increase in noninterest expense and a $122,000 increase in income tax expense.

Interest Income.Interest income decreased $384,000 to $2.9 million for the three-month period ended March 31, 2012, compared to the three-month period ended March 31, 2011. The decrease was due to a $22,000 decrease in average interest-earning assets outstanding for the three months ended March 31, 2012 compared to the 2011 period and a decrease in the average yield earned on interest-earning assets from 4.90% for the three months ended March 31, 2011 to 4.67% for the three months ended March 31, 2012.

Interest Expense.Interest expense decreased $284,000 for the three-month period ended March 31, 2012 compared to the same 2011 period. The decrease was primarily due to decrease in the average cost of interest-bearing liabilities from 1.67% for the three months ended March 31, 2011 to 1.31% for the comparable 2012 period. Average interest-bearing liabilities decreased from $249.4 million outstanding during the three months ended March 31, 2011 to $227.8 million outstanding during the comparable period for 2012.

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 March 31, 2012 and 2011 of $300,000 and $525,000, respectively. Management believes that the allowance for loan losses, which was $5.6 million or 2.78% of gross loans at March 31, 2012 is adequate.

Noninterest Income.Noninterest income increased $530,000 during the 2012 period. The increase was primarily due to a $348,000 increase in gain on sale of loans held for sale compared to the three-month period ended March 31, 2011.

Noninterest Expense.Noninterest expense increased by $324,000 from $2.2 million for the three-month period ended March 31, 2011 to $2.5 million for the three-month period ended March 31, 2012. The increase was primarily due to increases of $233,000 in salaries and employee benefits, $49,000 in data processing expense, and $16,000 in other noninterest expense, all related to the overall growth of the Company.

Income Taxes.The income tax benefit was $4,000 for the three-month period ended March 31, 2011. The income taxes were $118,000 for the corresponding period in 2012.

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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 March 31, 2012, 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 March 31, 2012 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.

32

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

Not applicable

Item 3. Defaults upon Senior Securities

We are currently prohibited from paying dividends without the approval of the Federal Reserve Bank of Atlanta. As a result, we did not pay $88,760 in dividends due on our Series A or Series B preferred stock in February 2012.

Item 4. Mine Safety Disclosures

Not applicable

Item 5. Other Information

Not applicable

33

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
	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.

34

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: May 14, 2012

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

35