Park Sterling 10Q 2013 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D. C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2013

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

For the transition period from ________ to _________

Commission File Number 001-35032

PARK STERLING CORPORATION

(Exact name of registrant as specified in its charter)

North Carolina	27-4107242
(State or other jurisdiction of	(I.R.S. Employer
incorporation or organization)	Identification No.)

1043 E. Morehead Street, Suite 201
Charlotte, North Carolina	28204
(Address of principal executive offices)	(Zip Code)

(704) 716-2134

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ 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 ☒ No ☐

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

Large accelerated filer ☐	Accelerated Filer ☒	Non-accelerated filer ☐	Smaller reporting company ☐
		(Do not check if a smaller reporting company)

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

As of November 5, 2013, the registrant had outstanding 44,776,936 shares of common stock, $1.00 par value per share.

PARK STERLING CORPORATION

Table of Contents

			Page No.

Part I.	FINANCIAL INFORMATION

Item 1.	Financial Statements

		Condensed Consolidated Balance SheetsSeptember 30, 2013 and December 31, 2012	2

		Condensed Consolidated Statements of Income Three and Nine Months Ended September 30, 2013 and 2012	3

		Condensed Consolidated Statements of Comprehensive Income (Loss)Three and Nine Months Ended September 30, 2013 and 2012	4

		Condensed Consolidated Statements of Changes in Shareholders’ EquityNine Months Ended September 30, 2013 and 2012	5

		Condensed Consolidated Statements of Cash FlowsNine Months Ended September 30, 2013 and 2012	6

		Notes to Condensed Consolidated Financial Statements	7

Item 2.	Management’s Discussion and Analysis of Financial Condition andResults of Operations		48

Item 3.	Quantitative and Qualitative Disclosures about Market Risk		70

Item 4.	Controls and Procedures		70

Part II.	Other Information

Item 1.	Legal Proceedings		70

Item 1A.	Risk Factors		71

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		71

Item 3.	Defaults Upon Senior Securities		71

Item 4.	Mine Safety Disclosures		71

Item 5.	Other Information		71

Item 6.	Exhibits		72

PARK STERLING CORPORATION

Part I. Financial Information

Item 1. Financial Statements

CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)

(Dollars in thousands)

	September 30, 2013			December 31, 2012 *

ASSETS

Cash and due from banks	$	11,780		$	36,716
Interest-earning balances at banks		40,222			101,431
Federal funds sold		695			45,995
Investment securities available-for-sale, at fair value		328,396			245,571
Investment securities held-to-maturity(fair value of $26,680 and $0, respectively)		26,636			-
Nonmarketable equity securities		6,805			7,422
Loans held for sale		3,070			14,147
Loans:
Non-covered		1,240,307			1,254,954
Covered		76,035			101,753
Less allowance for loan losses		(8,652	)		(10,591	)
Net loans		1,307,690			1,346,116

Premises and equipment, net		56,670			57,222
Bank-owned life insurance		47,485			46,133
Deferred tax asset		38,528			41,025
Other real estate owned - non-covered		8,708			18,427
Other real estate owned - covered		6,173			6,646
Goodwill		26,589			26,589
FDIC indemnification asset		13,959			18,697
Core deposit intangible		8,886			9,658
Accrued interest receivable		4,006			3,821
Other assets		3,762			7,446

Total assets	$	1,940,060		$	2,033,062

LIABILITIES AND SHAREHOLDERS' EQUITY

Deposits:
Noninterest-bearing	$	262,114		$	243,495
Interest-bearing		1,293,849			1,388,509
Total deposits		1,555,963			1,632,004

Short-term borrowings		2,702			10,143
FHLB advances		75,000			70,000
Subordinated debt		21,932			21,573
Accrued interest payable		425			516
Accrued expenses and other liabilities		24,285			23,124
Total liabilities		1,680,307			1,757,360

Shareholders' equity:
Preferred stock, no par value5,000,000 shares authorized; 0 and 20,500 issued and outstanding at September 30, 2013 and December 31, 2012, respectively		-			20,500
Common stock, $1.00 par value200,000,000 shares authorized;44,761,384 and 44,575,853 shares issued and outstanding at September 30, 2013and December 31, 2012, respectively		44,761			44,576
Additional paid-in capital		222,559			220,996
Accumulated deficit		(3,549	)		(13,568	)
Accumulated other comprehensive income (loss)		(4,018	)		3,198
Total shareholders' equity		259,753			275,702

Total liabilities and shareholders' equity	$	1,940,060		$	2,033,062

* Derived from audited financial statements.

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

PARK STERLING CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

(Dollars in thousands, except per share data)

	Three Months Ended September 30					Nine Months Ended September 30
	2013			2012		2013			2012
Interest income
Loans, including fees	$	17,970		$	10,346	$	54,916		$	32,873
Federal funds sold		-			16		24			38
Taxable investment securities		1,494			826		3,429			2,814
Tax-exempt investment securities		187			187		571			559
Nonmarketable equity securities		37			22		109			114
Interest on deposits at banks		48			34		154			73
Total interest income		19,736			11,431		59,203			36,471

Interest expense
Money market, NOW and savings deposits		399			339		1,186			998
Time deposits		455			632		1,590			2,174
Short-term borrowings		-			-		7			3
FHLB advances		137			149		411			457
Subordinated debt		431			340		1,288			1,047
Total interest expense		1,422			1,460		4,482			4,679
Net interest income		18,314			9,971		54,721			31,792

Provision for loan losses		(419	)		7		(35	)		1,029
Net interest income after provision for loan losses		18,733			9,964		54,756			30,763

Noninterest income
Service charges on deposit accounts		637			324		2,016			935
Income from fiduciary activities		795			605		2,041			1,700
Commissions and fees from investment brokerage		115			61		308			226
Gain on sale of securities available for sale		-			989		104			1,478
Bankcard services income		639			174		1,818			560
Mortgage banking income		401			662		2,346			1,663
Income from bank-owned life insurance		537			294		1,447			813
Other noninterest income		133			209		603			328
Total noninterest income		3,257			3,318		10,683			7,703

Noninterest expense
Salaries and employee benefits		8,606			6,314		26,185			18,303
Occupancy and equipment		1,861			928		5,750			2,712
Advertising and promotion		186			144		556			413
Legal and professional fees		732			1,181		2,486			2,113
Deposit charges and FDIC insurance		372			261		1,268			777
Data processing and outside service fees		1,268			784		4,561			2,772
Communication fees		432			198		1,312			626
Core deposit intangible amortization		257			102		772			307
Net cost (earnings) of operation of other real estate owned		142			964		(323	)		2,295
Loan and collection expense		556			434		1,560			974
Postage and supplies		188			112		815			431
Other tax expense		128			70		431			208
Other noninterest expense		942			711		3,002			1,979
Total noninterest expense		15,670			12,203		48,375			33,910

Income before income taxes		6,320			1,079		17,064			4,556

Income tax expense		2,106			459		5,798			1,535

Net income		4,214			620		11,266			3,021

Preferred dividends		-			-		353			-

Net income to common shareholders	$	4,214		$	620	$	10,913		$	3,021

Basic earnings per common share	$	0.10		$	0.02	$	0.25		$	0.09

Diluted earnings per common share	$	0.10		$	0.02	$	0.25		$	0.09

Dividends per common share	$	0.02		$	-	$	0.02		$	-

Weighted-average common shares outstanding
Basic		44,170,964			32,138,367		44,098,417			32,111,466
Diluted		44,273,821			32,138,554		44,172,469			32,111,527

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

PARK STERLING CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (Unaudited)

(Dollars in thousands)

	Three Months Ended September 30						Nine Months Ended September 30
	2013			2012			2013			2012

Net income	$	4,214		$	620		$	11,266		$	3,021

Unrealized holding gains (losses) onavailable-for-sale securities		(1,286	)		1,773			(11,403	)		3,366
Income tax effect		478			(665	)		4,242			(1,173	)
Reclassification of gains recognized in net income,reported as gain on sale of securities available for sale on the condensed consolidated statement of income		-			(989	)		(104	)		(1,478	)
Income tax effect		-			371			49			515

Total other comprehensive income (loss)		(808	)		490			(7,216	)		1,230
					.						.
Total comprehensive income	$	3,406		$	1,110		$	4,050		$	4,251

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

PARK STERLING CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (Unaudited)

Nine Months Ended September 30, 2013 and 2012

(Dollars in thousands)

	Preferred Stock						Common Stock						Additional Paid-In			Accumulated			Accumulated Other Comprehensive			Total Shareholders'
	Shares			Amount			Shares			Amount			Capital			Deficit			Income (Loss)			Equity

Balance at December 31, 2011		-		$	-			32,643,627		$	32,644		$	172,390		$	(17,860	)	$	2,880		$	190,054

Issuance of restricted stockgrants		-			-			63,000			63			(63	)		-			-			-

Share-based compensation expense		-			-			-			-			1,499			-			-			1,499

Comprehensive income:
Net income		-			-			-			-			-			3,021			-			3,021

Unrealized holding gains onavailable-for-sale securities,net of taxes		-			-			-			-			-			-			1,230			1,230

Balance at September 30, 2012		-		$	-			32,706,627		$	32,707		$	173,826		$	(14,839	)	$	4,110		$	195,804

Balance at December 31, 2012		20,500		$	20,500			44,575,853		$	44,576		$	220,996		$	(13,568	)	$	3,198		$	275,702

Redemption of preferred stock		(20,500	)		(20,500	)		-			-			-			-			-			(20,500	)

Issuance of restricted stockgrants		-			-			151,500			151			(151	)		-			-			-

Forfeitures of restricted stockgrants		-			-			(21,360	)		(21	)		21			-			-			-

Exercise of stock options		-			-			55,391			55			225			-			-			280

Share-based compensation expense		-			-			-			-			1,468			-			-			1,468

Dividends on preferred stock		-			-			-			-			-			(353	)		-			(353	)

Dividends on common stock		-			-			-			-			-			(894	)		-			(894	)

Comprehensive income:
Net income		-			-			-			-			-			11,266			-			11,266

Unrealized holding losses onavailable-for-sale securities,net of taxes		-			-			-			-			-			-			(7,216	)		(7,216	)

Balance at September 30, 2013		-		$	-			44,761,384		$	44,761		$	222,559		$	(3,549	)	$	(4,018	)	$	259,753

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

PARK STERLING CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(Dollars in thousands)

	Nine Months Ended September 30,
	2013			2012
Cash flows from operating activities
Net income	$	11,266		$	3,021
Adjustments to reconcile net income to netcash provided by operating activities:
Accretion on acquired loans		(6,314	)		(4,549	)
Net amortization on investments		1,350			895
Other depreciation and amortization		5,848			1,309
Provision for (release of provision for) loan losses		(35	)		1,029
Share-based compensation expense		1,468			1,499
Deferred income taxes		6,787			1,405
Amortization of FDIC indemnification asset		209			-
Net gains on sales of investment securities available-for-sale		(104	)		(1,478	)
Net gains on sales of loans held for sale		(1,293	)		(742	)
Net (gains) losses on sales of premises and equipment		(18	)		78
Net gains on sales of other real estate owned		(1,664	)		(109	)
Writedowns on other real estate owned		1,152			1,797
Income from bank-owned life insurance		(1,447	)		(813	)
Proceeds from loans held for sale		93,800			48,151
Disbursements for loans held for sale		(81,430	)		(47,250	)
Change in assets and liabilities:
Increase in FDIC indemnification asset		(1,576	)		-
(Increase) decrease in accrued interest receivable		(185	)		1,193
Decrease in other assets		2,388			2,604
Decrease in accrued interest payable		(91	)		(1,341	)
Increase in accrued expenses and other liabilities		1,520			1,149
Net cash provided by operating activities		31,631			7,848

Cash flows from investing activities
Net decrease in loans		35,245			45,156
Purchases of premises and equipment		(1,988	)		(3,414	)
Proceeds from sales of premises and equipment		73			120
Purchases of investment securities available-for-sale		(154,459	)		(51,719	)
Purchases of investment securities held-to-maturity		(27,284	)		-
Proceeds from sales of investment securities available-for-sale		22,815			46,367
Proceeds from maturities and call of investment securities available-for-sale		37,936			31,167
Proceeds from maturities of investment securities held-to-maturity		171			-
FDIC reimbursement of recoverable covered asset losses		6,104			-
Proceeds from sale of other real estate owned		17,642			7,151
Net redemptions of nonmarketable equity securities		617			3,911
Net cash provided (used) by investing activities		(63,128	)		78,739

Cash flows from financing activities
Net decrease in deposits		(76,040	)		(14,962	)
Advances of long-term borrowings		5,000			15,000
Decrease in short-term borrowings		(7,441	)		(8,630	)
Redemption of preferred stock		(20,500	)		-
Exercise of stock options		280			-
Payment of preferred dividends		(353	)		-
Payment of common dividends		(894	)		-
Net cash used by financing activities		(99,948	)		(8,592	)

Net increase (decrease) in cash and cash equivalents		(131,445	)		77,995

Cash and cash equivalents, beginning		184,142			28,541

Cash and cash equivalents, ending	$	52,697		$	106,536

Supplemental disclosures of cash flow information:
Cash paid for interest	$	4,573		$	6,020
Cash paid for income taxes		74			94

Supplemental disclosure of noncash investing and financing activities:
Change in unrealized gain on available-for-sale securities, net of tax	$	(7,216	)	$	1,230
Transfer from other assets to investment securities available-for-sale		1,393			-
Loans transferred to other real estate owned		6,938			7,464

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

Note 1 – Basis of Presentation

Park Sterling Corporation (the “Company”) was formed on October 6, 2010 to serve as the holding company for Park Sterling Bank (the “Bank”) and is a bank holding company registered with the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). At September 30, 2013 and December 31, 2012, the Company’s primary operations and business were that of owning the Bank.

The accompanying unaudited condensed consolidated financial statements and notes have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information or footnotes necessary for a complete presentation of financial position, results of operations and cash flows in conformity with GAAP. Because the accompanying unaudited condensed consolidated financial statements do not include all of the information and footnotes required by GAAP, they should be read in conjunction with the Company’s audited consolidated financial statements and accompanying footnotes (the “2012 Audited Financial Statements”) included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012 filed with the Securities and Exchange Commission (“SEC”) on March 15, 2013 (the “2012 Form 10-K”).

In management’s opinion, the accompanying unaudited condensed consolidated financial statements reflect all normal, recurring adjustments necessary to present fairly the financial position of the Company as of September 30, 2013 and December 31, 2012, and the results of its operations and cash flows for the three- and nine-months ended September 30, 2013 and 2012. Operating results for the three- and nine-month periods ended September 30, 2013 are not necessarily indicative of the results that may be expected for the year or for other interim periods.

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the unaudited condensed consolidated financial statements and accompanying notes. Actual results could differ from those estimates. Material estimates that are susceptible to significant change in the near term are the valuation of purchased credit-impaired (“PCI”) loans, the valuation of the allowance for loan losses, the determination of the need for a deferred tax asset valuation allowance and the fair value of financial instruments and other accounts.

Tabular information, other than share and per share data, is presented in thousands of dollars. Certain amounts reported in prior periods have been reclassified to conform to the current period presentation.

Note 2 - Recent Accounting Pronouncements

In February 2013, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2013-02, "Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income" ("ASU 2013-02"). This guidance is the culmination of the FASB's deliberation on reporting reclassification adjustments from accumulated other comprehensive income ("AOCI"). The amendments in ASU 2013-02 do not change the current requirements for reporting net income or other comprehensive income. However, the amendments require disclosure of amounts reclassified out of AOCI in its entirety, by component, on the face of the statement of income or in the notes thereto. Amounts that are not required to be reclassified in their entirety to net income must be cross-referenced to other disclosures that provide additional detail. This standard is effective prospectively for annual and interim reporting periods beginning after December 15, 2012. The Company has adopted this standard and the required disclosures are presented in the condensed consolidated financial statements.

In July 2013, the FASB issued ASU No. 2013-11, “Income Taxes (Topic 740): Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists” (a consensus of the FASB Emerging Issues Task Force), to eliminate the diversity in practice regarding presentation of unrecognized tax benefits in the statement of financial position. Under the provisions of the ASU, an unrecognized tax benefit, or a portion of an unrecognized tax benefit, should be presented in the financial statements as a reduction to a deferred tax asset unless certain criteria are met. The standard is effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. Early adoption is permitted. The amendments should be applied prospectively to all unrecognized tax benefits that exist at the effective date. Retrospective application is permitted. Management does not expect this standard to have a material impact on the Company’s consolidated financial statements.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

In July 2013, the FASB issued ASU No. 2013-10, “Derivatives and Hedging (Topic 815): Inclusion of the Fed Funds Effective Swap Rate (or Overnight Index Swap Rate) as a Benchmark Interest Rate for Hedge Accounting Purposes” (a consensus of the FASB Emerging Issues Task Force). The ASU permits the Fed Funds Effective Swap Rate to be used as a U.S. benchmark interest rate for hedge accounting purposes, in addition to United States Treasury rates and the London InterBank Offered Rate (“LIBOR”). The amendments also remove the restriction on using different benchmark rates for similar hedges. The standard is effective prospectively for qualifying new or redesignated hedging relationships entered into on or after July 17, 2013. Management does not expect this standard to have a material impact on the Company’s consolidated financial statements.

Note 3– Business Combinations and Goodwill

Business Combinations

Generally, acquisitions are accounted for under the acquisition method of accounting in accordance with FASB Accounting Standards Codification (“ASC”) 805,Business Combinations. Both the purchased assets and liabilities assumed are recorded at their respective acquisition date fair values. Determining the fair value of assets and liabilities, especially the loan portfolio, is a complicated process involving significant judgment regarding methods and assumptions used to calculate estimatedfair values. Fair values are preliminary and subject to refinement for up to one year after the closing date of the acquisition as additional information regarding the closing date fair values becomes available.

Citizens South

On October 1, 2012, Citizens South Banking Corporation (“Citizens South”) was merged with and into the Company, with the Company as the surviving legal entity, in accordance with an Agreement and Plan of Merger dated as of May 13, 2012. Under the terms of the Citizens South merger agreement, Citizens South stockholders received either $7.00 in cash or 1.4799 shares of the Company’s Common Stock for each Citizens South share they owned immediately prior to the merger, subject to the limitation that the total consideration paid in the merger would consist of 30% in cash and 70% in Common Stock. The Citizens South merger was structured to be tax-free to Citizens South stockholders with respect to the shares of Common Stock received in the merger and taxable with respect to the cash received in the merger. Cash was paid in lieu of fractional shares. The aggregate merger consideration consisted of 11,857,226 shares of Common Stock and $24.3 million in cash. Based on the $4.94 per share closing price of the Common Stock on September 28, 2012, the last trading date prior to consummation of the merger, the transaction value was $82.9 million. In addition, in connection with the merger, the preferred stock previously issued by Citizens South to the United States Department of the Treasury (the “Treasury”) in connection with Citizens South’s participation in the Small Business Lending Fund (“SBLF”) program was converted to 20,500 shares of a substantially identical newly created series of the Company’s preferred stock. See Note 10 – Preferred Stock for further discussion.

Citizens South operated 21 full service branches in North Carolina, South Carolina and Georgia at the date of acquisition. The acquisition of Citizens South was part of the Company’sbusiness plan seeking accelerated organic growth and to acquire regional and community banks in the Carolinas and Virginia.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

The assets and liabilities assumed from Citizens South were recorded at their fair value as of the closing date of the merger. Goodwill of $22.5 million was initially recorded at the time of acquisition. As a result of refinements to the fair value mark on loans, bank-owned life insurance, other real estate owned (“OREO”), the FDIC indemnification asset, deferred tax assets (“DTAs”), other assets, and other liabilities, goodwill as indicated below is $3.5 million greater than the goodwill estimated in the Company’s 2012 Audited Financial Statements. Goodwill as of December 31, 2012 has been retrospectively adjusted. The following table summarizes the consideration paid by the Company in the merger with Citizens South and the amounts of the assets acquired and liabilities assumed recognized at the acquisition date:

	As Recorded by Citizens South		Fair Value and Other Merger Related Adjustments			As Recorded by the Company
Consideration Paid
Cash						$	24,283
Common shares issued (11,857,226 shares)							58,575
Fair value of noncontrolling interest							20,500

Fair Value of Total Consideration Transferred						$	103,358

Recognized amounts of identifiable assets acquired and liabilities assumed:

Cash and cash equivalents	$	48,661	$	-		$	48,661
Securities		88,068		2,275			90,343
Nonmarketable equity securities		5,390		-			5,390
Loans held for sale		1,695		-			1,695
Loans, net of allowance		694,016		(12,340	)		681,676
Premises and equipment		25,443		4,326			29,769
Core deposit intangibles		1,032		5,168			6,200
Other real estate owned		18,957		(3,169	)		15,788
Bank owned life insurance		18,879		(79	)		18,800
Deferred tax asset		3,560		(728	)		2,832
FDIC indemnification asset		20,652		1,846			22,498
Other assets		4,338		(238	)		4,100

Total assets acquired	$	930,691	$	(2,939	)	$	927,752

Deposits	$	826,134	$	2,166		$	828,300
Short term borrowings		7,678		-			7,678
Junior subordinated debt		15,464		(6,627	)		8,837
Other liabilities		418		5,128			5,546

Total liabilities assumed	$	849,694	$	667		$	850,361

Total identifiable assets	$	80,997	$	(3,606	)	$	77,391

Goodwill resulting from acquisition						$	25,967

Goodwill

Goodwill represents the excess of the purchase price over the sum of the estimated fair values of the tangible and identifiable intangible assets acquired less the estimated fair value of the liabilities assumed. Goodwill has an indefinite useful life and is evaluated for impairment annually or more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value.

The goodwill impairment analysis is a two-step test. The first step, used to identify potential impairment, involves comparing the reporting unit’s estimated fair value to its carrying value, including goodwill. If the estimated fair value of a reporting unit exceeds its carrying value, there is an indication of potential impairment and the second step is performed to measure the amount of impairment of goodwill assigned to that reporting unit.

If required, the second step involves calculating an implied fair value of goodwill for each reporting unit for which the first step indicated impairment. The implied fair value of goodwill is determined in a manner similar to the amount of goodwill calculated in a business combination, by measuring the excess of the estimated fair value of the reporting unit, as determined in the first step, over the aggregate estimated fair values of the individual assets, liabilities and identifiable intangibles as if the reporting unit was being acquired in a business combination. If the implied fair value of goodwill exceeds the carrying value of the goodwill assigned to the reporting unit, there is no impairment. If the carrying value of goodwill assigned to a reporting unit exceeds the implied fair value of the goodwill, an impairment charge is recorded for the excess. An impairment loss cannot exceed the carrying value of goodwill assigned to a reporting unit, and the loss establishes a new basis of goodwill.

In September 2011, the FASB issued ASU 2011-08, which gives entities the option of first performing a qualitative assessment to test goodwill for impairment on a reporting-unit-by reporting-unit basis. If, after performing the qualitative assessment, an entity concludes that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, the entity would perform the two-step goodwill impairment test described in ASC 350. However, if, after applying the qualitative assessment, the entity concludes that it is not more likely than not that the fair value is less than the carrying amount, the two-step goodwill impairment test is not required.

The Company performed the first step as outlined in ASU 2011-08 in assessing the carrying value of goodwill related to the mergers with Community Capital and Citizens South as of September 30, 2013, its annual test date, and determined that it was unlikely that the fair value was less than the carrying amount and that no further testing or impairment charge was necessary. Additionally, should the Company’s future earnings and cash flows decline and/or discount rates increase, an impairment charge to goodwill and other intangible assets may be required. There have been no events subsequent to the September 30, 2013 evaluation that caused the Company to perform an interim review of the carrying value of goodwill related to either the merger with Community Capital or the merger with Citizens South.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

Note 4 - Investment Securities

The amortized cost, unrealized gains and losses, and estimated fair value of securities available-for-sale and securities held-to-maturity at September 30, 2013 and December 31, 2012 are as follows:

Amortized Cost and Fair Value of Investment Portfolio

	Amortized Cost			Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(Dollars in thousands)
September 30, 2013
Securities available-for-sale:
U.S. Government agencies	$	514		$	49	$	-		$	563
Municipal securities		15,830			784		-			16,614
Residential agency mortgage-backed securities (MBS)		93,744			1,265		(349	)		94,660
Commercial MBS		66,739			-		(4,678	)		62,061
All other debt securities		156,562			324		(4,227	)		152,659
All other equity securities		1,393			446		-			1,839
	$	334,782		$	2,868	$	(9,254	)	$	328,396

Securities held-to-maturity:
Residential agency MBS	$	15,748		$	143	$	-		$	15,891
All other debt securities		10,888			78		(177	)		10,789
	$	26,636	��	$	221	$	(177	)	$	26,680

December 31, 2012
Securities available-for-sale:
U.S. Government agencies	$	518		$	65	$	-		$	583
Municipal securities		16,258			1,727		-			17,986
Residential agency MBS		156,492			3,188		(567	)		159,113
All other debt securities		67,181			1,017		(309	)		67,889
	$	240,450		$	5,997	$	(876	)	$	245,571

At September 30, 2013 and December 31, 2012, investment securities with a fair market value of $94.1 million and $102.5 million, respectively, were pledged to secure public and trust deposits and for other purposes as required and permitted by law.

At September 30, 2013, commercial MBS include $56.3 million of delegated underwriting and servicing (“DUS”) bonds collateralized by multi-family properties and backed by an agency of the U.S. government, and $5.7 million of private-label securities collateralized by commercial properties. There were no commercial MBS at December 31, 2012.

At September 30, 2013, all other debt securities include $5.7 million of asset-backed securities which are equally collateralized by the Federal family education loan program and private student loan program. There were no private-label asset-backed securities at December 31, 2012.

The amortized cost and fair value of investment securities at September 30, 2013 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. All of the Company’s residential MBS are backed by an agency of the U.S. government. None of our residential MBS are private-label securities.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

Maturities of Investment Portfolio

	Securities Available-for-Sale				Securities Held-to-Maturity
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	(Dollars in thousands)				(Dollars in thousands)

U.S. Government agencies
Due after one year through five years	$	514	$	563	$	-	$	-
Municipal securities
Due under one year		450		455		-		-
Due after ten years		15,380		16,159		-		-
Residential agency MBS
Due after five years through ten years		21,880		22,013		-		-
Due after ten years		71,864		72,647		15,748		15,891
Commercial MBS
Due after five years through ten years		66,739		62,061		-		-
All other debt securities
Due after five years through ten years		8,317		8,193		-		-
Due after ten years		148,245		144,466		10,888		10,789
All other equity securities		1,393		1,839		-		-
	$	334,782	$	328,396	$	26,636	$	26,680

Securities available-for-sale of $22.8 million were sold in the nine months ended September 30, 2013 resulting in a gross gain of $0.1 million. There were no sales of securities available-for-sale during the three months ended September 30, 2013. During the nine months ended September 30, 2012, the Company sold $46.4 million of securities available-for-sale, resulting in a gross gain of $1.5 million. During the three months ended September 30, 2012, the Company sold $23.9 million of securities available-for-sale, resulting in a gross gain of $1.0 million.

Management periodically evaluates each investment security for other than temporary impairment, relying primarily on industry analyst reports, observation of market conditions and interest rate fluctuations. The following table shows gross unrealized losses and fair value, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position, for investment securities with unrealized losses at September 30, 2013 and December 31, 2012. Since none of the unrealized losses relate to the marketability of the securities or the issuer’s ability to honor redemption obligations, and it is more likely than not that the Company will not have to sell the investments before recovery of their amortized cost basis, none of the securities are deemed to be other than temporarily impaired. At September 30, 2013 and December 31, 2012, one corporate debt security has been in a continuous loss position for twelve months or more. This unrealized loss is due to market volatility and uncertainty since the security was purchased. Management believes that the unrealized losses are temporary and fully expects to collect all cash flows.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

Investment Portfolio Gross Unrealized Losses and Fair Value

	Less Than 12 Months					12 Months or More					Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
	(Dollars in thousands)
September 30, 2013
Securities available-for-sale:
Residential agency MBS	$	22,670	$	(349	)	$	-	$	-		$	22,670	$	(349	)
Commercial MBS		62,061		(4,678	)		-		-			62,061		(4,678	)
All other debt securities		113,309		(4,137	)		410		(90	)		113,719		(4,227	)
	$	198,040	$	(9,164	)	$	410	$	(90	)	$	198,450	$	(9,254	)

Securities held-to-maturity:
All other debt securities	$	5,658	$	(177	)	$	-	$	-		$	5,658	$	(177	)
	$	5,658	$	(177	)	$	-	$	-		$	5,658	$	(177	)

December 31, 2012
Securities available-for-sale:
Residential agency MBS	$	40,041	$	(567	)	$	-	$	-		$	40,041	$	(567	)
All other debt securities		30,931		(224	)		415		(85	)		31,346		(309	)
	$	70,972	$	(791	)	$	415	$	(85	)	$	71,387	$	(876	)

The Company has nonmarketable equity securities consisting of investments in several financial institutions and the investments in CSBC Statutory Trust I and Community Capital Corporation Statutory Trust I. These investments totaled $6.8 million at September 30, 2013 and $7.4 million at December 31, 2012. Included in these amounts at September 30, 2013 and December 31, 2012 was $5.8 million and $6.3 million, respectively, of Federal Home Loan Bank (“FHLB”) stock. All nonmarketable equity securities were evaluated for impairment as of September 30, 2013 and December 31, 2012. The following factors have been considered in determining the carrying amount of FHLB stock: (1) management’s current belief that the Company has sufficient liquidity to meet all operational needs in the foreseeable future and would not need to dispose of the stock below recorded amounts, (2) management’s belief that the FHLB has the ability to absorb economic losses given the expectation that the FHLB has a high degree of government support and (3) redemptions and purchases of the stock are at the discretion of the FHLB. At September 30, 2013 and December 31, 2012, the Company estimated that the fair values of nonmarketable equity securities equaled or exceeded the cost of each of these investments, and, therefore, the investments were not impaired.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

Note 5 – Loans and Allowance for Loan Losses

The Company’s loan portfolio was comprised of the following at:

	September 30, 2013						December 31, 2012
	PCI loans		All other loans		Total		PCI loans		All other loans			Total
	(dollars in thousands)
Commercial:
Commercial and industrial	$	6,488	$	125,035	$	131,523	$	7,323	$	111,809		$	119,132
Commercial real estate (CRE) - owner-occupied		39,545		233,795		273,340		44,925		254,491			299,416
CRE - investor income producing		64,087		307,816		371,903		85,959		285,998			371,957
Acquisition, construction and development (AC&D)		29,165		113,619		142,784		39,541		101,120			140,661
Other commercial		142		3,799		3,941		742		4,886			5,628
Total commercial loans		139,427		784,064		923,491		178,490		758,304			936,794

Consumer:
Residential mortgage		34,784		139,996		174,780		40,483		148,049			188,532
Home equity lines of credit (HELOC)		1,736		144,748		146,484		1,949		161,676			163,625
Residential construction		7,459		39,040		46,499		11,265		41,547			52,812
Other loans to individuals		1,356		23,369		24,725		2,095		13,458			15,553
Total consumer loans		45,335		347,153		392,488		55,792		364,730			420,522
Total loans		184,762		1,131,217		1,315,979		234,282		1,123,034			1,357,316
Deferred costs (fees)		-		363		363		-		(609	)		(609	)
Total loans, net of deferred costs (fees)	$	184,762	$	1,131,580	$	1,316,342	$	234,282	$	1,122,425		$	1,356,707

Included in the September 30, 2013 and December 31, 2012 loan totals are $76.0 million and $101.7 million, respectively, of covered loans pursuant to FDIC loss share agreements assumed by the Bank in connection with the Citizens South merger. At September 30, 2013, approximately $72.7 million of the covered loans are included in PCI loans and $3.3 million is included in all other loans. At December 31, 2012, $96.9 million of the covered loans are included in PCI loans and $4.8 million is included in all other loans.

At September 30, 2013 and December 31, 2012, the Company had sold participations in loans aggregating $6.0 million and $10.8 million, respectively, to other financial institutions on a nonrecourse basis. Collections on loan participations and remittances to participating institutions conform to customary banking practices.

The Bank accepts residential mortgage loan applications and funds loans of qualified borrowers. Funded loans are sold with limited recourse to investors under the terms of pre-existing commitments. The Bank executes all of its loan sales agreements under best efforts contracts with investors. The Company does not service residential mortgage loans for the benefit of others.

Loans sold with limited recourse are 1-4 family residential mortgages originated by the Company and sold to various other financial institutions. Various recourse agreements exist, but generally range from thirty days to twelve months. The Company’s exposure to credit loss in the event of nonperformance by the other party to the loan is represented by the contractual notional amount of the loan. Since none of the loans have ever been returned to the Company, the amount of total loans sold with limited recourse does not necessarily represent future cash requirements. The Company uses the same credit policies in making loans held for sale as it does for on-balance sheet instruments. Total loans sold with limited recourse in the nine months ended September 30, 2013 were $92.5 million. Total loans sold with limited recourse in the nine months ended September 30, 2012 were $47.4 million.

At September 30, 2013 and December 31, 2012, the carrying value of loans pledged as collateral on FHLB borrowings totaled $318.8 million and $144.2 million, respectively. At September 30, 2013 and December 31, 2012, the carrying value of loans pledged as collateral on the Federal Reserve Discount Window totaled $157.4 million and $83.1 million, respectively.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

Concentrations of Credit-Loans are primarily made within the Company’s operating footprint of North Carolina, South Carolina and Georgia. Real estate loans can be affected by the condition of the local real estate market. Commercial and industrial loans can be affected by the local economic conditions. The commercial loan portfolio has concentrations in business loans secured by real estate including construction loans and real estate development loans. Primary concentrations in the consumer loan portfolio include home equity lines of credit and residential mortgages. At September 30, 2013 and December 31, 2012, the Company had no loans outstanding with non-U.S. entities.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

Allowance for Loan Losses-The following tables present, by portfolio segment, the activity in the allowance for loan losses for the three and nine months ended September 30, 2013 and September 30, 2012.

	Commercial and industrial			CRE - owner- occupied			CRE - investor income producing			AC&D			Other commercial			Residential mortgage			Home equity lines of credit			Residential construction			Other loans to individuals			Total

For the three months ended September 30, 2013	(dollars in thousands)
Allowance for Loan Losses, excluding PCI:
Balance, beginning of period	$	1,585		$	343		$	1,419		$	3,930		$	4		$	267		$	1,311		$	518		$	86		$	9,463
Provision for loan losses		539			57			26			(1,240	)		1			284			357			(44	)		20			-
Charge-offs		(634	)		(12	)		(9	)		(88	)		-			(125	)		(68	)		-			(22	)		(958	)
Recoveries		52			1			26			-			1			32			16			2			11			141
Net charge-offs		(582	)		(11	)		17			(88	)		1			(93	)		(52	)		2			(11	)		(817	)
Balance, end of period	$	1,542		$	389		$	1,462		$	2,602		$	6		$	458		$	1,616		$	476		$	95		$	8,646

PCI Impairment Allowance for Loan Losses:
Balance, beginning of period	$	216		$	-		$	1		$	445		$	-		$	394		$	3		$	289		$	36		$	1,384
PCI impairment charge-offs		(216	)		-			-			(163	)		-			(311	)		-			(233	)		(36	)		(959	)
PCI impairment recoveries		-			-			-			-			-			-			-			-			-			-
Net PCI impairment charge-offs		(216	)		-			-			(163	)		-			(311	)		-			(233	)		(36	)		(959	)

PCI release of provision for loan losses		-			-			(1	)		(282	)		-			(77	)		(3	)		(56	)		-			(419	)
Benefit attributable to FDIC loss shareagreements		-			-			-			-			-			-			-			-			-			-
Total provision for loan losses charged to operations		-			-			(1	)		(282	)		-			(77	)		(3	)		(56	)		-			(419	)

Provision for loan losses recorded through FDIC lossshare receivable		-			-			-			-			-			-			-			-			-			-
Balance, end of period	$	-		$	-		$	-		$	-		$	-		$	6		$	-		$	-		$	-		$	6

Total Allowance for Loan Losses	$	1,542		$	389		$	1,462		$	2,602		$	6		$	464		$	1,616		$	476		$	95		$	8,652

For the nine months ended September 30, 2013
Allowance for Loan Losses, excluding PCI:
Balance, beginning of period	$	849		$	496		$	1,102		$	4,157		$	8		$	454		$	1,463		$	1,046		$	49		$	9,624
Provision for loan losses		1,740			(64	)		131			(2,206	)		(3	)		69			756			(616	)		66			(127	)
Charge-offs		(1,190	)		(52	)		(230	)		(94	)		-			(128	)		(660	)		(49	)		(52	)		(2,455	)
Recoveries		143			9			459			745			1			63			57			95			32			1,604
Net charge-offs		(1,047	)		(43	)		229			651			1			(65	)		(603	)		46			(20	)		(851	)
Balance, end of period	$	1,542		$	389		$	1,462		$	2,602		$	6		$	458		$	1,616		$	476		$	95		$	8,646

PCI Impairment Allowance for Loan Losses:
Balance, beginning of period	$	225		$	-		$	-		$	542		$	-		$	200		$	-		$	-		$	-		$	967
PCI impairment charge-offs		(216	)		-			(16	)		(177	)		(386	)		(311	)		-			(233	)		(36	)		(1,375	)
PCI impairment recoveries		-			-			-			25			-			-			-			-			-			25
Net PCI impairment charge-offs		(216	)		-			(16	)		(152	)		(386	)		(311	)		-			(233	)		(36	)		(1,350	)

PCI provision for loan losses		(9	)		-			16			(390	)		386			117			-			233			36			389
Benefit attributable to FDIC loss shareagreements		(104	)		-			(1	)		(192	)		-			-			-			-			-			(297	)
Total provision for loan losses charged to operations		(113	)		-			15			(582	)		386			117			-			233			36			92

Provision for loan losses recorded through FDIC lossshare receivable		104			-			1			192			-			-			-			-			-			297
Balance, end of period	$	-		$	-		$	-		$	-		$	-		$	6		$	-		$	-		$	-		$	6

Total Allowance for Loan Losses	$	1,542		$	389		$	1,462		$	2,602		$	6		$	464		$	1,616		$	476		$	95		$	8,652

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

	Commercial and industrial			CRE - owner- occupied			CRE - investor income producing			AC&D			Other commercial			Residential mortgage			Home equity lines of credit			Residential construction			Other loans to individuals			Total

For the three months ended September 30, 2012	(dollars in thousands)
Allowance for Loan Losses:
Balance, beginning of period	$	1,180		$	397		$	1,326		$	3,710		$	10		$	792		$	1,370		$	606		$	40		$	9,431
Provision for loan losses		153			(14	)		412			(524	)		1			(22	)		(21	)		(12	)		(3	)		(30	)
PCI provision for loan losses		67			-			-			-			-			(30	)		-			-			-			37
Charge-offs		(146	)		(56	)		(500	)		(383	)		-			(5	)		(8	)		-			(4	)		(1,102	)
Recoveries		19			-			48			658			-			10			5			124			7			871
Net charge-offs		(127	)		(56	)		(452	)		275			-			5			(3	)		124			3			(231	)
Ending balance	$	1,206		$	327		$	1,286		$	3,461		$	11		$	745		$	1,346		$	718		$	40		$	9,207


For the nine months ended September 30, 2012
Allowance for Loan Losses:
Balance, beginning of period	$	703		$	740		$	2,106		$	3,883		$	17		$	309		$	1,898		$	455		$	43		$	10,154
Provision for loan losses		1,009			(283	)		199			(616	)		88			304			(412	)		467			(18	)		738
PCI provision for loan losses		67			-			-			-			-			224			-			-			-			291
Charge-offs		(543	)		(130	)		(1,075	)		(740	)		(94	)		(104	)		(173	)		(328	)		(5	)		(3,192	)
Recoveries		37			-			56			934			-			12			33			124			20			1,216
Net charge-offs		(506	)		(130	)		(1,019	)		194			(94	)		(92	)		(140	)		(204	)		15			(1,976	)
Ending balance	$	1,206		$	327		$	1,286		$	3,461		$	11		$	745		$	1,346		$	718		$	40		$	9,207

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

The following table presents, by portfolio segment, the balance in the allowance for loan losses disaggregated on the basis of the Company’s impairment measurement method and the related recorded investment in loans at September 30, 2013 and December 31, 2012.

	Commercial and industrial		CRE - owner- occupied		CRE - investor income producing		AC&D		Other commercial		Residential mortgage		Home equity lines of credit		Residential construction		Other loans to individuals		Total

At September 30, 2013	(dollars in thousands)
Allowance for Loan Losses:
Individually evaluated for impairment	$	16	$	24	$	202	$	-	$	-	$	182	$	509	$	13	$	-	$	946
Collectively evaluated for impairment		1,526		365		1,260		2,602		6		276		1,107		463		95		7,700
		1,542		389		1,462		2,602		6		458		1,616		476		95		8,646
Purchased credit-impaired		-		-		-		-		-		6		-		-		-		6
Total	$	1,542	$	389	$	1,462	$	2,602	$	6	$	464	$	1,616	$	476	$	95	$	8,652

Recorded Investment in Loans:
Individually evaluated for impairment	$	326	$	2,266	$	3,850	$	2,275	$	153	$	4,951	$	3,287	$	79	$	62	$	17,249
Collectively evaluated for impairment		124,709		231,529		303,966		111,344		3,646		135,045		141,461		38,961		23,307		1,113,968
		125,035		233,795		307,816		113,619		3,799		139,996		144,748		39,040		23,369		1,131,217
Purchased credit-impaired		6,488		39,545		64,087		29,165		142		34,784		1,736		7,459		1,356		184,762
Total	$	131,523	$	273,340	$	371,903	$	142,784	$	3,941	$	174,780	$	146,484	$	46,499	$	24,725	$	1,315,979

At December 31, 2012
Allowance for Loan Losses:
Individually evaluated for impairment	$	115	$	-	$	-	$	-	$	-	$	249	$	351	$	-	$	-	$	715
Collectively evaluated for impairment		734		496		1,102		4,157		8		205		1,112		1,046		49		8,909
		849		496		1,102		4,157		8		454		1,463		1,046		49		9,624
Purchased credit-impaired		225		-		-		542		-		200		-		-		-		967
Total	$	1,074	$	496	$	1,102	$	4,699	$	8	$	654	$	1,463	$	1,046	$	49	$	10,591

Recorded Investment in Loans:
Individually evaluated for impairment	$	607	$	2,337	$	4,243	$	4,855	$	168	$	3,463	$	1,925	$	71	$	73	$	17,742
Collectively evaluated for impairment		111,202		252,154		281,755		96,265		4,718		144,586		159,751		41,476		13,385		1,105,292
		111,809		254,491		285,998		101,120		4,886		148,049		161,676		41,547		13,458		1,123,034
Purchased credit-impaired		7,323		44,925		85,959		39,541		742		40,483		1,949		11,265		2,095		234,282
Total	$	119,132	$	299,416	$	371,957	$	140,661	$	5,628	$	188,532	$	163,625	$	52,812	$	15,553	$	1,357,316

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

The Company’s allowance for loan loss methodology includes four components, as described below:

1) Specific Reserve Component. Specific reserves represent the current impairment estimate on specific loans, for which it is probable that the Company will be unable to collect all amounts due according to contractual terms based on current information and events. Impairment measurement reflects only a deterioration of credit quality and not changes in market rates that may cause a change in the fair value of the impaired loan. The amount of impairment may be measured in one of three ways, including (i) calculating the present value of expected future cash flows, discounted at the loan’s interest rate implicit in the original document and deducting estimated selling costs, if any; (ii) observing quoted market prices for identical or similar instruments traded in active markets, or employing model-based valuation techniques for which all significant assumptions are observable in the market; and (iii) determining the fair value of collateral, which is utilized for both collateral dependent loans and for loans when foreclosure is probable.

Impaired loans with a balance less than or equal to $150 thousand are viewed in two groups: those which have experienced charge-offs and those recorded at legal balance. Those loans which have experienced charge-offs have no additional reserve applied unless specifically calculated at a point in time when the loan balance exceeded $150 thousand. Those loans recorded at their legal balance are based on a pooled probability of default and loss given default calculation.

2) Quantitative Reserve Component. Quantitative reserves represent the current loss contingency estimate on pools of loans, which is an estimate of the amount for which it is probable that the Company will be unable to collect all amounts due on homogeneous groups of loans according to contractual terms should one or more events occur, excluding those loans specifically identified above. During the fourth quarter of 2011, the Company introduced two enhancements to this component of the allowance. First, management completed its previously disclosed project to collect and evaluate internal loan loss data and now incorporates the Company’s historical loss experience in this component. Previously, given the Company’s limited operating history, this component of the allowance for loan losses was based on the historical loss experience of comparable institutions. Second, the methodology now segregates loans by product.

This component of the allowance for loan losses is based on the historical loss experience of the Company. This loss experience is collected quarterly by evaluating internal loss data. The estimated historical loss rates are grouped by loan product type. The Company utilizes average historical losses to represent management’s estimate of losses inherent in that portfolio. The historical look back period is estimated by loan type and the Company applies the appropriate historical loss period which best reflects the inherent loss in the portfolio considering prevailing market conditions. A minimum reserve is utilized when the Company has insufficient internal loss history. Minimums are determined by analyzing Federal Reserve Bank charge-off data for all insured federal- and state-chartered commercial banks.

During the third quarter of 2013, the Company further segregated the AC&D portfolio into three collateral types: (i) CRE construction, (ii) 1-4 family construction and (iii) development (lots and land). These enhancements strengthen the granularity of the allowance methodology and better align with the Company’s present origination activities, which are focused on construction rather than development activities.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

In determining the quantitative reserve component at September 30, 2013, management utilized the following look back periods:

15 quarter – Commercial & industrial, CRE-investor income producing, AC&D-1-4 family construction, and AC&D-development (lots and land)

ii.

12 quarter – residential mortgage and HELOCs

iii.

11 quarter – residential construction

iv.

Minimum – CRE-owner-occupied, AC&D-CRE construction, other commercial and other consumer

At December 31, 2012, management utilized the following look back periods:

12 quarter – AC&D, residential mortgage and residential construction

ii.

8 quarter – Commercial & industrial, CRE-owner-occupied, CRE-investor income producing, and HELOCs

iii.

Minimum –Other commercial and other consumer

The changes in the look back periods noted above were made to provide a better estimate of the loss inherent in the portfolio for each loan category and to reflect the availability of loss history.

3) Qualitative Reserve Component. Qualitative reserves represent an estimate of the amount for which it is probable that environmental or other relevant factors will cause the aforementioned loss contingency estimate to differ from the Company’s historical loss experience or other assumptions. During the second quarter of 2012, the Company refined its allowance methodology to eliminate the use of traditional risk grade factors as a single forward-looking qualitative indicator, which had been introduced during the fourth quarter of 2011, and instead focuses directly on five specific environmental factors. These five factors include portfolio trends, portfolio concentrations, economic and market conditions, changes in lending practices and other factors. Management believes these refinements simplify application of the qualitative component of the allowance methodology. Each of the factors, except other factors, can range from 0.00% (not applicable) to 0.15% (very high). Other factors are reviewed on a situational basis and are adjusted in 5 basis point increments, up or down, with a maximum of 0.50%. Details of the five environmental factors for inclusion in the allowance methodology are as follows:

Portfolio trends, which may relate to such factors as type or level of loan origination activity, changes in asset quality (i.e., past due, special mention, non-performing) and/or changes in collateral values;

ii.

Portfolio concentrations, which may relate to individual borrowers and/or guarantors, geographic regions, industry sectors, and/or loan types;

iii.

Economic and market trends, which may relate to trends and/or levels of gross domestic production, unemployment, bankruptcies, foreclosures, housing starts, housing prices, equity prices, and/or competitor activities;

iv.

Changes in lending practices, which may relate to changes in credit policies, procedures, systems or staff; and

Other factors, which is intended to capture environmental factors not specifically identified above.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

In addition, qualitative reserves on purchased performing loans are based on the Company’s judgment around the timing difference expected to occur between accretion of the fair market value credit adjustment and realization of actual loan losses.

During the third quarter of 2013, the Company applied the qualitative other factors against CRE-investor income producing loans and residential mortgage loans to adjust for inherent risks that, in management’s judgment, are not adequately reflected in historical loss rates.

4) Reserve on PCI Loans.In determining the acquisition date fair value of PCI loans, and in subsequent accounting, the Company generally aggregates purchased loans into pools of loans with common risk characteristics. Expected cash flows at the acquisition date in excess of the fair value of loans are recorded as interest income over the life of the loans using a level yield method if the timing and amount of the future cash flows of the pool is reasonably estimable. Subsequent to the acquisition date, significant increases in cash flows over those expected at the acquisition date are recognized as interest income prospectively. Decreases in expected cash flows after the acquisition date are recognized by recording an allowance for loan losses. In pools where impairment has already been recognized, an increase in cash flows will result in a reversal of prior impairment. Management analyzes these acquired loan pools using various assessments of risk to determine and calculate an expected loss. The expected loss is derived using an estimate of a loss given default based upon the collateral type and/or specific review by loan officers of loans generally greater than $1.0 million, and the probability of default that was determined based upon management’s review of the loan portfolio. Trends are reviewed in terms of traditional credit metrics such as accrual status, past due status, and weighted-average risk grade of the loans within each of the accounting pools. In addition, the relationship between the change in the unpaid principal balance and change in the fair value mark is assessed to correlate the directional consistency of the expected loss for each pool.

This analysis resulted in net (recovery) impairment for the three- and nine-months ended September 30, 2013 of ($419) thousand and $389 thousand, respectively. Additionally, in the nine-month period, approximately $297 thousand is attributable to covered loans under FDIC loss share agreements. These covered loan impairments were a function of an increase in expected losses and as a result, the FDIC indemnification asset was increased. See Note 6 – FDIC Loss Share Agreements for further discussion. These impairments are spread among several pools and reporting segments. A full breakdown of the net impairment or recovery is detailed in the allowance by segment table above for the three- and nine-months ended September 30, 2013.

The changes to the quantitative and qualitative reserve components of the non-PCI allowance for loan losses, in aggregate, did not have a material impact on the estimated allowance at September 30. 2013. The further segregation of the AC&D portfolio described above resulted in a decrease in the AC&D quantitative reserve of approximately $1.2 million from June 30, 2013 and $1.8 million from December 31, 2012. Offsetting this decrease were quantitative increases in the other loan portfolios as a result of extending look back periods which now contain sufficient build up in loss history. These increases were approximately $800 thousand from June 30, 2013 and $1.6 million from December 31, 2012. The growth in the loan portfolio coupled with the other qualitative factors referenced above resulted in a net $530 thousand increase in the qualitative factor from June 30, 2013 and $313 thousand from December 31, 2012. These changes, in management's judgment, produce a non-PCI allowance for loan losses that reflects the estimate of inherent losses in the loan portfolio at September 30, 2013.

The Company evaluates and estimates off-balance sheet credit exposure at the same time it estimates credit losses for loans by a similar process. These estimated credit losses are not recorded as part of the allowance for loan losses, but are recorded to a separate liability account by a charge to income, if material. Loan commitments, unused lines of credit and standby letters of credit make up the off-balance sheet items reviewed for potential credit losses. At September 30, 2013 and December 31, 2012, $125 thousand was recorded as an other liability for off-balance sheet credit exposure.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

Credit Quality Indicators-The Company uses several credit quality indicators to manage credit risk in an ongoing manner. The Company's primary credit quality indicator is an internal credit risk rating system that categorizes loans into pass, special mention, or classified categories. Credit risk ratings are applied individually to those classes of loans that have significant or unique credit characteristics that benefit from a case-by-case evaluation. These are typically loans to businesses or individuals in the classes that comprise the commercial portfolio segment. Groups of loans that are underwritten and structured using standardized criteria and characteristics, such as statistical models (e.g., credit scoring or payment performance), are typically risk rated and monitored collectively. These are typically loans to individuals in the classes that comprise the consumer portfolio segment.

The following are the definitions of the Company's credit quality indicators:

Pass:			Loans in classes that comprise the commercial and consumer portfolio segments that are not adversely rated, are contractually current as to principal and interest, and are otherwise in compliance with the contractual terms of the loan agreement. PCI loans that were recorded at estimated fair value on the acquisition date are generally assigned a “pass” loan grade because their net financial statement value is based on the present value of expected cash flows. Management believes there is a low likelihood of loss related to those loans that are considered pass.

Special Mention:			Loans in classes that comprise the commercial and consumer portfolio segments that have potential weaknesses that deserve management's close attention. If not addressed, these potential weaknesses may result in deterioration of the repayment prospects for the loan. Management believes there is a moderate likelihood of some loss related to those loans that are considered special mention.

Classified:			Loans in the classes that comprise the commercial and consumer portfolio segments that are inadequately protected by the sound worth and paying capacity of the borrower or of the collateral pledged, if any. Management believes that there is a distinct possibility that the Company will sustain some loss if the deficiencies related to classified loans are not corrected in a timely manner.

The Company's credit quality indicators are periodically updated on a case-by-case basis. The following tables present the recorded investment in the Company's loans as of September 30, 2013 and December 31, 2012, by loan class and by credit quality indicator.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

	As of September 30, 2013
(dollars in thousands)	Commercial and Industrial		CRE-Owner Occupied		CRE-Investor Income Producing		AC&D		Other Commercial		Total Commercial
Pass	$	130,891	$	266,152	$	363,597	$	134,773	$	3,677	$	899,090
Special mention		351		4,092		3,584		5,855		111		13,993
Classified		281		3,095		4,722		2,156		154		10,408
Total	$	131,523	$	273,339	$	371,903	$	142,784	$	3,942	$	923,491

	Residential Mortgage		Home Equity Lines of Credit		Residential Construction		Other Loans to Individuals		Total Consumer
Pass	$	170,624	$	140,263	$	45,717	$	24,244	$	380,848
Special mention		1,433		2,710		539		369		5,051
Classified		2,723		3,511		243		112		6,589
Total	$	174,780	$	146,484	$	46,499	$	24,725	$	392,488

Total Loans									$	1,315,979

	As of December 31, 2012
(dollars in thousands)	Commercial and Industrial		CRE-Owner Occupied		CRE-Investor Income Producing		AC&D		Other Commercial		Total Commercial
Pass	$	115,907	$	292,418	$	361,212	$	126,167	$	5,460	$	901,164
Special mention		173		3,804		5,564		9,252		-		18,793
Classified		3,052		3,194		5,181		5,242		168		16,837
Total	$	119,132	$	299,416	$	371,957	$	140,661	$	5,628	$	936,794

	Residential Mortgage		Home Equity Lines of Credit		Residential Construction		Other Loans to Individuals		Total Consumer
Pass	$	185,686	$	158,335	$	52,612	$	15,444	$	412,077
Special mention		1,115		2,599		-		78		3,792
Classified		1,731		2,691		200		31		4,653
Total	$	188,532	$	163,625	$	52,812	$	15,553	$	420,522

Total Loans									$	1,357,316

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

Aging Analysis of Accruing and Non-Accruing Loans -The Company considers a loan to be past due or delinquent when the terms of the contractual obligation are not met by the borrower. PCI loans are included as a single category in the table below as management believes, regardless of their age, there is a lower likelihood of aggregate loss related to these loan pools. Additionally, PCI loans are discounted to allow for the accretion of income on a level yield basis over the life of the loan based on expected cash flows. Regardless of accruing status, the associated discount on these loan pools results in income recognition. The following table presents, by class, an aging analysis of the Company’s accruing and non-accruing loans as of September 30, 2013 and December 31, 2012.

	30-59 Days Past Due		60-89 Days Past Due		Past Due 90 Days or More		PCI Loans		Current		Total Loans
	(dollars in thousands)
As of September 30, 2013
Commercial:
Commercial and industrial	$	340	$	221	$	37	$	6,488	$	124,437	$	131,523
CRE - owner-occupied		-		-		674		39,545		233,121		273,340
CRE - investor income producing		15		41		180		64,087		307,580		371,903
AC&D		-		-		542		29,165		113,077		142,784
Other commercial		-		-		-		142		3,799		3,941
Total commercial loans		355		262		1,433		139,427		782,014		923,491

Consumer:
Residential mortgage		-		33		1,926		34,784		138,037		174,780
Home equity lines of credit		311		263		2,143		1,736		142,031		146,484
Residential construction		-		38		40		7,459		38,962		46,499
Other loans to individuals		20		2		2		1,356		23,345		24,725
Total consumer loans		331		336		4,111		45,335		342,375		392,488
Total loans	$	686	$	598	$	5,544	$	184,762	$	1,124,389	$	1,315,979

As of December 31, 2012
Commercial:
Commercial and industrial	$	1,316	$	83	$	230	$	7,323	$	110,180	$	119,132
CRE - owner-occupied		48		1,903		113		44,925		252,427		299,416
CRE - investor income producing		224		27		366		85,959		285,381		371,957
AC&D		-		699		1,428		39,541		98,993		140,661
Other commercial		-		-		168		742		4,718		5,628
Total commercial loans		1,588		2,712		2,305		178,490		751,699		936,794

Consumer:
Residential mortgage		18		196		499		40,483		147,336		188,532
Home equity lines of credit		590		-		1,094		1,949		159,992		163,625
Residential construction		-		-		71		11,265		41,476		52,812
Other loans to individuals		36		4		-		2,095		13,418		15,553
Total consumer loans		644		200		1,664		55,792		362,222		420,522
Total loans	$	2,232	$	2,912	$	3,969	$	234,282	$	1,113,921	$	1,357,316

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

Impaired Loans - All classes of loans are considered impaired when, based on current information and events, it is probable the Company will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. Impaired loans may include all classes of nonaccrual loans and loans modified in a troubled debt restructuring (“TDR”). If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the rate implicit in the original loan agreement or at the fair value of collateral if repayment is expected solely from the collateral. Additionally, a portion of the Company’s qualitative factors accounts for potential impairment on loans generally less than $150 thousand. Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Impaired loans, or portions thereof, are charged off when deemed uncollectible.

During the three- and nine-months ended September 30, 2013, the Company’s quarterly cash flow analyses indicated that net (release) impairment of $(419) thousand and $389 thousand was present in several of the Company’s PCI loan pools. This net (release) impairment is spread among almost all the loan segments presented in the table above and is the result of changes in cash flows, increases and decreases.

The following tables do not include information regarding impairment of the Company’s PCI loans. At December 31, 2012, the Company’s quarterly cash flow analyses indicated that three of fourteen PCI loan pools were impaired. This analysis resulted in $225 thousand net impairment in a commercial pool, $542 thousand net impairment in an AC&D pool and $200 thousand net impairment of a residential mortgage pool at December 31, 2012.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

The table below presents impaired loans, by class, and the corresponding allowance for loan losses atSeptember30, 2013 and December 31, 2012:

	September 30, 2013						December 31, 2012
	Recorded Investment		Unpaid Principal Balance		Related Allowance For Loan Losses		Recorded Investment		Unpaid Principal Balance		Related Allowance For Loan Losses
	(dollars in thousands)
Impaired Loans with No Related Allowance Recorded:
Commercial:
Commercial and industrial	$	226	$	2,125	$	-	$	377	$	1,170	$	-
CRE - owner-occupied		2,117		3,426		-		2,337		2,675		-
CRE - investor income producing		180		5,245		-		4,243		4,424		-
AC&D		2,275		9,775		-		4,855		9,306		-
Other commercial		153		196		-		168		172		-
Total commercial loans		4,951		20,767		-		11,980		17,747		-
Consumer:
Residential mortgage		3,616		4,384		-		2,252		2,363		-
Home equity lines of credit		1,035		3,481		-		1,419		2,439		-
Residential construction		-		1,441		-		71		551		-
Other loans to individuals		60		104		-		73		75		-
Total consumer loans		4,711		9,410		-		3,815		5,428		-
Total impaired loans with no related allowance recorded	$	9,662	$	30,177	$	-	$	15,795	$	23,175	$	-

Impaired Loans with an Allowance Recorded:
Commercial:
Commercial and industrial	$	100	$	110	$	16	$	230	$	230	$	115
CRE - owner-occupied		149		164		24		-		-		-
CRE - investor income producing		3,670		3,674		202		-		-		-
AC&D		-		-		-		-		-		-
Other commercial		-		-		-		-		-		-
Total commercial loans		3,919		3,948		242		230		230		115
Consumer:
Residential mortgage		1,335		1,398		182		1,211		1,250		249
Home equity lines of credit		2,252		2,309		509		506		707		351
Residential construction		79		81		13		-		-		-
Other loans to individuals		2		4		-		-		-		-
Total consumer loans		3,668		3,792		704		1,717		1,957		600
Total impaired loans with an allowance recorded	$	7,587	$	7,740	$	946	$	1,947	$	2,187	$	715

Total Impaired Loans:
Commercial:
Commercial and industrial	$	326	$	2,235	$	16	$	607	$	1,400	$	115
CRE - owner-occupied		2,266		3,590		24		2,337		2,675		-
CRE - investor income producing		3,850		8,919		202		4,243		4,424		-
AC&D		2,275		9,775		-		4,855		9,306		-
Other commercial		153		196		-		168		172		-
Total commercial loans		8,870		24,715		242		12,210		17,977		115
Consumer:
Residential mortgage		4,951		5,782		182		3,463		3,613		249
Home equity lines of credit		3,287		5,790		509		1,925		3,146		351
Residential construction		79		1,522		13		71		551		-
Other loans to individuals		62		108		-		73		75		-
Total consumer loans		8,379		13,202		704		5,532		7,385		600

Total impaired loans	$	17,249	$	37,917	$	946	$	17,742	$	25,362	$	715

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

The average recorded investment and interest income recognized on impaired loans, by class, for the three and nine months ended September 30, 2013 and September 30, 2012 are shown in the table below.

	Three Months Ended September 30,								Nine Months Ended September 30,
	2013				2012				2013				2012
	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
	(dollars in thousands)
Impaired Loans with No Related Allowance Recorded:
Commercial:
Commercial and industrial	$	219	$	4	$	708	$	-	$	345	$	4	$	772	$	-
CRE - owner-occupied		2,033		93		366		5		1,903		93		368		17
CRE - investor income producing		180		-		2,851		-		1,816		-		2,536		-
AC&D		2,300		58		6,775		14		3,982		181		8,884		44
Other commercial		154		-		160		-		160		-		102		-
Total commercial loans		4,886		155		10,860		19		8,206		278		12,662		61
Consumer:
Residential mortgage		2,876		14		621		-		2,207		46		715		-
Home equity lines of credit		1,139		16		770		-		1,183		16		928		-
Residential construction		-		-		76		-		24		-		128		-
Other loans to individuals		62		1		6		1		68		3		7		3
Total consumer loans		4,077		31		1,473		1		3,482		65		1,778		3
Total impaired loans with no related allowance recorded	$	8,963	$	186	$	12,333	$	20	$	11,688	$	343	$	14,440	$	64

Impaired Loans with an Allowance Recorded:
Commercial:
Commercial and industrial	$	437	$	-	$	230	$	-	$	516	$	1	$	88	$	-
CRE - owner-occupied		74		-		-		-		30		-		-		-
CRE - investor income producing		3,675		37		-		-		2,192		112		-		-
AC&D		125		-		-		-		50		-		-		-
Other commercial		-		-		-		-		-		-		-		-
Total commercial loans		4,311		37		230		-		2,788		113		88		-
Consumer:
Residential mortgage		1,283		10		424		7		1,241		26		221		22
Home equity lines of credit		1,431		1		315		-		876		2		317		-
Residential construction		40		1		-		-		16		1		-		-
Other loans to individuals		3		-		-		-		1		-		-		-
Total consumer loans		2,757		12		739		7		2,134		29		538		22
Total impaired loans with an allowance recorded	$	7,068	$	49	$	969	$	7	$	4,922	$	142	$	626	$	22

Total Impaired Loans:
Commercial:
Commercial and industrial	$	656	$	4	$	938	$	-	$	861	$	5	$	860	$	-
CRE - owner-occupied		2,107		93		366		5		1,933		93		368		17
CRE - investor income producing		3,855		37		2,851		-		4,008		112		2,536		-
AC&D		2,425		58		6,775		14		4,032		181		8,884		44
Other commercial		154		-		160		-		160		-		102		-
Total commercial loans		9,197		192		11,090		19		10,994		391		12,750		61
Consumer:
Residential mortgage		4,159		24		1,045		7		3,448		72		936		22
Home equity lines of credit		2,570		17		1,085		-		2,059		18		1,245		-
Residential construction		40		1		76		-		40		1		128		-
Other loans to individuals		65		1		6		1		69		3		7		3
Total consumer loans		6,834		43		2,212		8		5,616		94		2,316		25

Total impaired loans	$	16,031	$	235	$	13,302	$	27	$	16,610	$	485	$	15,066	$	86

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

During the three and nine months ended September 30, 2013, the Company recognized $235 thousand and $485 thousand, respectively, in interest income with respect to impaired loans, primarily accruing TDRs, within the period the loans were impaired. During the three and nine months ended September 30, 2012, the Company recognized $27 thousand and $86 thousand, respectively, with respect to impaired loans.

Nonaccrual and Past Due Loans -It is the general policy of the Company to place a loan on nonaccrual status when there is probable loss or when there is reasonable doubt that all principal will be collected, or when it is over 90 days past due. At September 30, 2013, there was $357 thousand in loans past due 90 days or more and accruing interest. These loans are being evaluated for collectability at September 30, 2013. At December 31, 2012, there was a $77 thousand loan past due 90 days or more and accruing interest. The recorded investment in nonaccrual loans at September 30, 2013 and December 31, 2012 follows:

	September 30, 2013		December 31, 2012
	(dollars in thousands)
Commercial:
Commercial and industrial	$	256	$	607
CRE - owner-occupied		539		1,996
CRE - investor income producing		213		633
AC&D		542		3,872
Other commercial		153		168
Total commercial loans		1,703		7,276
Consumer:
Residential mortgage		2,456		1,096
Home equity lines of credit		2,576		1,925
Residential construction		40		71
Other loans to individuals		3		6
Total consumer loans		5,075		3,098
Total nonaccrual loans	$	6,778	$	10,374

PCI Loans–PCI loans had an unpaid principal balance of $220.7 million and $278.2 million and a carrying value of $184.8 million and $234.3 million at September 30, 2013 and December 31, 2012, respectively. PCI loans represented 9.5% and 11.5% of total assets at September 30, 2013 and December 31, 2012, respectively. Determining the fair value of the PCI loans at acquisition required the Company to estimate cash flows expected to result from those loans and to discount those cash flows at appropriate rates of interest. For such loans, the excess of cash flows expected to be collected at acquisition over the estimated fair value is recognized as interest income over the remaining lives of the loans and is called the accretable yield. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition reflects the impact of estimated credit losses and is called the nonaccretable difference. In accordance with GAAP, there was no carry-over of previously established allowance for loan losses from acquired companies.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

In conjunction with the Citizens South acquisition, the PCI loan portfolio was accounted for at fair value as follows (dollars in thousands):

	October 1, 2012

Contractual principal and interest at acquisition	$	294,283
Nonaccretable difference		(47,941	)
Expected cash flows at acquisition		246,342
Accretable yield		(37,724	)

Basis in PCI loans at acquisition - estimated fair value	$	208,618

In conjunction with the acquisition of Community Capital Corporation (“Community Capital”) in 2011, the PCI loan portfolio was accounted for at fair value as follows (dollars in thousands):

	November 1, 2011

Contractual principal and interest at acquisition	$	146,843
Nonaccretable difference		(61,145	)
Expected cash flows at acquisition		85,698
Accretable yield		(14,424	)

Basis in PCI loans at acquisition - estimated fair value	$	71,274

A summary of changes in the accretable yield for PCI loans for the nine months ended September 30, 2013 and 2012 follows:

	Nine Months Ended September 30,
	2013			2012
	(dollars in thousands)

Accretable yield, beginning of period	$	42,734		$	14,264
Addition from the Community Capital acquisition		-			218
Interest income		(11,201	)		(3,540	)
Reclassification of nonaccretable difference due toimprovement in expected cash flows		7,445			9,374
Other changes, net		725			(1,893	)
Accretable yield, end of period	$	39,703		$	18,423

Troubled Debt Restructuring -In situations where, for economic or legal reasons related to a borrower's financial difficulties, management may grant a concession for other than an insignificant period of time to the borrower that would not otherwise be considered, the related loan is classified as a TDR. Management strives to identify borrowers in financial difficulty early and work with them to modify to more affordable terms. These modified terms may include rate reductions, principal forgiveness, payment forbearance and other actions intended to minimize the economic loss and to avoid foreclosure or repossession of the collateral. All loan modifications are made on a case-by-case basis.

The Company had allocated $248 thousand and $54 thousand, respectively, of specific reserves to customers whose loan terms have been modified in a TDR as of September 30, 2013 and December 31, 2012. As of September 30, 2013, the Company had 13 TDR loans totaling $7.6 million, of which $70 thousand are nonaccrual loans. As of December 31, 2012, the Company had 18 TDR loans totaling $10.2 million, of which $2.8 million were nonaccrual loans.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

The following tables represent a breakdown of the types of concessions made by loan class for the three- and nine-month periods ended September 30, 2013 and 2012.

	Three months ended September 30, 2013						Nine months ended September 30, 2013
(dollars in thousands)	Number of loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Number of loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Below market interest rate
Residential mortgage		-	$	-	$	-		1	$	43	$	43
Total		-		-		-		1		43		43

Extended payment terms
AC&D		-		-		-		1		962		962
Total		-		-		-		1		962		962

Total		-	$	-	$	-		2	$	1,005	$	1,005

	Three months ended September 30, 2012						Nine months ended September 30, 2012
(dollars in thousands)	Number of loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Number of loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Below market interest rate
CRE - investor income producing		1	$	3,610	$	3,610		1	$	3,610	$	3,610
Total		1	$	3,610	$	3,610		1	$	3,610	$	3,610

There were no loans that were modified as TDRs within the 12 months ended September 30, 2013 and for which there was a payment default during the three months or nine months ended June 30, 2013. The following table presents loans that were modified as TDRs within the 12 months ended September 30, 2012 and for which there was a payment default during the three or nine months ended September 30, 2012 (dollars in thousands):

	Three months ended September 30, 2012				Nine months ended September 30, 2012
	Number of loans		Recorded Investment		Number of loans		Recorded Investment
Below market interest rate
Residential mortgage		-	$	-		1	$	323
Total		-	$	-		1	$	323

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

The Company does not deem a TDR to be successful until it has been re-established as an accruing loan. The following table presents the successes and failures of the types of modifications indicated within the 12 months ended September 30, 2013 and 2012 (dollars in thousands):

Twelve Months Ended September 30, 2013
	Paid in full				Paying as restructured				Nonaccrual				Foreclosure/Default
	Number of loans		Recorded Investment		Number of loans		Recorded Investment		Number of loans		Recorded Investment		Number of loans		Recorded Investment

Below market interest rate		2	$	164		1	$	42		-	$	-		-	$	-
Extended payment terms		1		329		1		109		-		-		-		-
Total		3	$	493		2	$	151		-	$	-		-	$	-

Twelve Months Ended September 30, 2012
	Paid in full				Paying as restructured				Nonaccrual				Foreclosure/Default
	Number of loans		Recorded Investment		Number of loans		Recorded Investment		Number of loans		Recorded Investment		Number of loans		Recorded Investment

Below market interest rate		-	$	-		1	$	3,592		1	$	322		-	$	-
Extended payment terms		-		-		2		415		2		426		-		-
Total		-	$	-		3	$	4,007		3	$	748		-	$	-

Related Party Loans–From time to time, the Company engages in loan transactions with its directors, executive officers and their related interests (collectively referred to as “related parties”). Such loans are made in the ordinary course of business and on substantially the same terms and collateral as those for comparable transactions prevailing at the time and do not involve more than the normal risk of collectability or present other unfavorable features. A summary of activity in loans to related parties is as follows:

Loans to Directors, Executive Officers and Their Related Interests

	Nine Months Ended September 30,
	2013			2012
	(dollars in thousands)

Beginning balance	$	4,184		$	3,998
Disbursements		12,830			710
Repayments		(1,928	)		(429	)
Ending balance	$	15,086		$	4,279

At September 30, 2013 and December 31, 2012, the Company had pre-approved but unused lines of credit totaling $2.8 million and $1.8 million, respectively, to related parties.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

Note 6 – FDIC Loss Share Agreements

In connection with the Citizens South acquisition, the Bank assumed two purchase and assumption agreements with the FDIC that cover approximately $76.0 million of loans (the “covered loans”) and $6.2 million of OREO (the “covered OREO”) at September 30, 2013. Citizens South acquired these assets in prior transactions with the FDIC.

Within the first purchase and assumption agreement are two loss share agreements, which originated in April 2011, related to Citizens South’s acquisition of New Horizons Bank, a Georgia state-chartered bank headquartered in East Ellijay, Georgia. The first loss share agreement covers certain residential loans and OREO for a period of ten years. The other loss-share agreement covers all remaining covered assets for a period of five years. Pursuant to the terms of these loss-share agreements, the FDIC is obligated to reimburse the Bank for 80% of all eligible losses, which begins with the first dollar of loss incurred, and certain collection and disposition expenses with respect to covered assets. The Bank has a corresponding obligation to reimburse the FDIC for 80% of eligible recoveries with respect to covered assets for a period of ten years for residential properties and eight years for all other covered assets. At September 30, 2013, the Bank recorded an estimated receivable from the FDIC for $5.9 million, which represents the discounted value of the FDIC’s estimated portion of the expected future loan losses.

Within the second purchase and assumption agreement are two loss share agreements, which originated in March 2010, related to Citizen South’s acquisition of Bank of Hiawassee, a Georgia state-chartered bank headquartered in Hiawassee, Georgia. Under these loss-share agreements, the FDIC will cover 80% of net loan losses up to $102 million and 95% of net loan losses that exceed $102 million. The term of the loss-share agreements is ten years for losses and recoveries on residential real estate loans, five years for losses on all other loans and eight years for recoveries on all other loans. At September 30, 2013, the Bank recorded an estimated receivable from the FDIC for $8.1 million, which represents the discounted value of the FDIC’s estimated portion of the expected future loan losses.

The following table provides changes in the receivable from the FDIC for the nine months ended September 30, 2013:

FDIC Loss Share Receivable

(dollars in thousands)

Balance, beginning of period	$	18,697
Increase in expected losses on loans		297
Additional losses to OREO		438
Reimbursable expenses (income)		321
Amortization discounts and premiums, net		(209	)
Reimbursements from the FDIC		(6,104	)
Other changes, net		519
Balance, end of period	$	13,959

The FDIC receivable for loss share agreements is measured separately from the related covered assets and is recorded at carrying value. At September 30, 2013, the projected cash flows related to the FDIC receivable for losses on covered loans and assets were approximately $12.7 million. At December 31, 2012, the projected cash flows related to the FDIC receivable for a loss on covered loans and assets was approximately $19.6 million.

In relation to the FDIC indemnification asset is an expected "true-up" with the FDIC related to the loss share agreements described above. The loss share agreements between the Bank and the FDIC with respect to New Horizons Bank and Bank of Hiawassee each contain a provision that obligates us to make a "true-up" payment to the FDIC if the realized losses of each of these acquired banks are less than expected. This amount is determined each reporting period. At both September30, 2013 and December 31, 2012, the “true-up” amount was estimated to be approximately $4.9 million at the end of the loss share agreements. These amounts are recorded in other liabilities on the balance sheet. The actual payment will be determined at the end of the term of the loss sharing agreements and is based on the negative bid, expected losses, intrinsic loss estimate, and assets covered under the loss share agreements.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

Note 7 – Other Real Estate Owned

The Company owned $14.9 million and $25.1 million in OREO at September30, 2013 and December 31, 2012, respectively. In 2012, the Company acquired $16.1 million in OREO through the merger with Citizens South. Approximately $6.2 million of this OREO is covered under the loss share agreements with the FDIC. Transactions in OREO for the three and nine months ended September30, 2013 and 2012 are summarized below:

	Three months ended						Nine months ended
Non-covered OREO	September 30, 2013			September 30, 2012			September 30, 2013			September 30, 2012
	(dollars in thousands)
Beginning balance	$	9,741		$	14,744		$	18,427		$	14,403
Additions		772			1,286			1,735			7,464
Sales		(1,667	)		(2,247	)		(11,009	)		(7,043	)
Writedowns		(138	)		(755	)		(445	)		(1,796	)
Ending balance	$	8,708		$	13,028		$	8,708		$	13,028

	Three months ended					Nine months ended
Covered OREO	September 30, 2013			September 30, 2012		September 30, 2013			September 30, 2012
	(dollars in thousands)
Beginning balance	$	6,542		$	-	$	6,646		$	-
Additions		1,887			-		5,203			-
Sales		(2,255	)		-		(4,969	)		-
Writedowns		(1	)		-		(707	)		-
Ending balance	$	6,173		$	-	$	6,173		$	-

Note 8 – Income Taxes

Income taxes are provided based on the asset-liability method of accounting, which includes the recognition of deferred tax assets (“DTAs”) and liabilities for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. In general, the Company records a DTA when the event giving rise to the tax benefit has been recognized in the consolidated financial statements.

As of September 30, 2013 and December 31, 2012, the Company had a net DTA in the amount of approximately $38.5 million and $41.0 million, respectively. The decrease is a function of earnings through September 30, 2013. The Company evaluates the carrying amount of its DTA on a quarterly basis in accordance with the guidance provided in FASB ASC Topic 740 (“ASC 740”), in particular, applying the criteria set forth therein to determine whether it is more likely than not (i.e., a likelihood of more than 50%) that some portion, or all, of the DTA will not be realized within its life cycle, based on the weight of available evidence. In most cases, the realization of the DTA is dependent upon the Company generating a sufficient level of taxable income in future periods, which can be difficult to predict. If the Company’s forecast of taxable income within the carry forward periods available under applicable law is not sufficient to cover the amount of net deferred assets, such assets may be impaired. Based on the weight of available evidence, the Company has determined, as of September 30, 2013 and December 31, 2012, that it is more likely than not that it will be able to fully realize the existing DTA and therefore considers it appropriate not to establish a DTA valuation allowance at either September 30, 2013 or December 31, 2012.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

The Company considers all available evidence, positive and negative, to determine whether a DTA valuation allowance is appropriate. In conducting the DTA analysis, the Company currently believes it is essential to differentiate between the unique characteristics of each industry or business. In particular, characteristics such as business model, level of capital and reserves held by financial institutions and their ability to absorb potential losses are important distinctions to be considered for bank holding companies, such as the Company.

Negative Evidence. The Company considered the following five areas of potential negative evidence identified in ASC 740 as part of its DTA analysis:

Rolling twelve-quarter cumulative loss.

The Bank commenced operations in late 2006, attained profitability in the third quarter of 2008 and remained profitable through the second quarter of 2010 before its business was materially impacted by the recent economic downturn. As a result, the Bank moved into a rolling twelve-quarter cumulative pre-tax loss position during the third quarter of 2010. A cumulative loss in recent years is a significant piece of negative evidence that is difficult to overcome. However, the Company evaluates the circumstances behind those losses and considers them in the context of the current economic environment and the significant changes it has made to address the circumstances underlying the losses.

As of September 30, 2013, the Company is no longer in a rolling three-year cumulative pre-tax loss position, as earnings have continued to improve. However, the Company is in a rolling three-year cumulative after-tax loss position of $2.0 million as of September 30, 2013. The Company’s three-year cumulative pre-tax loss position was $19.6 million and $25.4 million at December 31, 2012 and 2011, respectively. The September 30, 2013 after-tax and December 31, 2012 and December 31, 2011 pre-tax loss positions were driven, in large part, by rolling twelve-quarter cumulative provision expenses of $20.0 million. This high level of provision expense reflects the negative impact on the Company’s loan portfolio from the effects of the extended economic downturn. The risk of loan loss is inherent to the banking industry. The Company considered the special circumstances of the economic environment of the last few years, which led to these high historical provision levels and currently believes they are unlikely to be repeated going forward, given changes in the Company’s lending practices, business strategy, risk tolerance, capital levels and operating practices.

Based on current internal loss data analysis, approximately 75% of rolling twelve-quarter cumulative net charge-offs are associated with construction & development (“C&D”, which includes both commercial AC&D and residential construction) lending (which was impacted the most by the economic downturn). Prior to the Bank’s public offering in August 2010, the Bank had allowed an excessive concentration to build in C&D exposures, which peaked at $159 million, or 43% of total loans, in the fourth quarter of 2008. In the second quarter of 2010, C&D exposures were $124 million, or 31% of total loans. Following the public offering, the Company reconstituted its executive management team with significant new hires, immediately curtailed originating new residential C&D exposures and significantly tightened standards for all other types of C&D lending. These changes reflect both the Company’s new business strategies and risk tolerance, which include building a more diversified loan portfolio both by geography and product type. As of September 30, 2013, C&D exposures were 14% of total loans, or $189.3 million.

The Company has also significantly strengthened its lending practices including the additions of a new chief risk officer, chief credit officer, head of special assets, manager of credit underwriting and additional credit underwriters. The Company currently believes it has remediated many of the circumstances that led to the rolling twelve-quarter cumulative pre-tax loss position and currently does not expect these losses to continue in the future.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

History of operating loss or tax credit carry forwards expiring unused.

The Company has no history of operating loss or tax carry forwards expiring unused.

Losses expected in early future years (by a presently profitable entity).

Management currently expects to be profitable in early future years.

Unsettled circumstances that, if unfavorably unresolved, would adversely affect future operations and profit levels on a continuing basis in future years.

The Company is not currently aware of any unsettled circumstances that, if unfavorably resolved, would adversely affect future operations and profit levels on a continuing basis in future years.

Carryback or carry forward period that is so brief it would limit realization of tax benefits if a significant deductible temporary difference is expected to reverse in a single year or the entity operates in a traditionally cyclical business.

Approximately $13.7 million, or 35.6%, of the DTA existing atSeptember30, 2013 related to net operating loss carry forwards that do not expire until December 31, 2032, leaving over eighteen years for utilization. Approximately $14.4 million, or 34%, of the DTA existing at December 31, 2012 related to net operating loss carry forwards with availability for application out as far as 20 years.

Positive Evidence. The Company considered the following sources of future taxable income identified in ASC 740 as positive evidence to weigh against the negative evidence described above:

Future reversals of existing taxable temporary differences and carry forwards.

The Company’s largest future reversals relate to its PCI loans and allowance for loan losses, which represented $32.0 million and $2.9 million, respectively, of the DTA at September 30, 2013. Current tax, accounting and regulatory treatment of the allowance generally results in substantial taxable temporary differences for financial institutions engaged in lending activities. The following is a brief description of the Company’s current expectations regarding recognition or reversal of the major components of the allowance:

●

Specific reserves, which totaled $946 thousand at September 30, 2013, relate to identified impairments and are based on individual loan-collectability analyses. The Company currently estimates that specific reserves will generally reverse within two quarters of establishment, and currently believes these reserves are very unlikely to remain unaddressed after four quarters of establishment. To be conservative, specific reserves are currently assumed to reverse within one year.

●

Quantitative and qualitative reserves on the non-acquired portfolio, which totaled $7.3 million at September 30, 2013, are based on model-driven estimates of inherent loss content in the performing loan portfolio based on historical loss rates by loan product type. The Company currently estimates that these reserves will generally reverse within six to eight quarters of establishment. However, the Company currently estimates that the average life of the underlying loan pool is approximately three years; therefore, all quantitative reserves are currently assumed to reverse within approximately three years.

●

Qualitative reserves on purchased performing loans, which totaled $380 thousand at September 30, 2013, are based on the Company’s judgment around the timing difference expected to occur between accretion of the fair market value credit adjustment and realization of actual loans losses. The Company currently estimates that the average life of the underlying loan pool is approximately three years and these reserves are currently assumed to reverse within that time.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

●

Quantitative reserves on PCI loans, which totaled $6 thousand at September 30, 2013, are determined in connection with the quarterly cash flows analyses for this portion of the acquired loan book. The Company compares the initial expected cash flows to the new remaining expected cash flows. Increases in cash flows over those expected at the acquisition date are recognized as interest income prospectively. Decreases in expected cash flows after the acquisition date are recognized by recording an allowance for loan losses. The Company currently estimates that the average life of the underlying loan pool is approximately three years and these reserves are currently assumed to reverse within that time.

Given these assumptions, the Company currently expects the full allowance-driven component of its DTA to reverse within approximately three years, meaning either (i) the Company will generate sufficient taxable income to fully utilize these reversals through reduced tax payments or (ii) these reversals will shift to net operating loss carry forwards with an expected 20-year life, which would be utilized as the Company generates sufficient taxable income over that period.

Taxable income in carryback year(s).

Approximately $14.4 million, or 40%, of the estimated DTA at December 31, 2012 related to net operating loss carry forwards with expected expiration dates out over 18 years. Approximately $13.7 million, or 35.6%, of the estimated DTA at September 30, 2013 related to net operating loss carryforwards with expected expiration dates out as long as 20 years. Management currently believes that the Company will generate sufficient taxable income to fully utilize these net operating losses before expiration.

Future taxable income, exclusive of reversing temporary differences and carry forwards.

Projecting future taxable income requires estimates and judgments about future events that may be predictable, but that are less certain than past events that can be objectively measured. In projecting future taxable income, the Company considered the significant change in its strategy that occurred in mid-2010, from previously growing organically at a moderate pace to creating a regional community bank through a combination of mergers and acquisitions and accelerated organic growth. This transition was facilitated by the completion of the public offering in August 2010 and the addition of new executive management and additional independent board members. The Company is focused on long-term results and has taken actions to achieve this objective, including:

●

Addressing legacy problem assets, particularly C&D-related exposures, to move more rapidly through the cycle;

●

Consummating the merger with Community Capital;

●

Consummating the merger with Citizens South and expanding its market into Georgia;

●

Hiring experienced bankers and openingde novo offices in three new markets (Charleston, South Carolina, the Upstate and Midlands areas of South Carolina and the Research Triangle region of North Carolina);

●

Hiring bankers to begin a new asset-based lending line of business;

●

Significantly strengthening the leadership team with the addition of a new chief credit officer, head of special assets, head of managerial reporting, chief accounting officer and other positions; and

●

Maintaining significant excess capital to support both the above-mentioned organic and acquisition-related growth initiatives.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

The progress already made indicates that the change in business plan is well on track to achieve its intended objectives. Management presents, generally on a monthly basis, a financial forecast to the board of directors that incorporates current assumptions and timelines regarding the Company’s baseline activities, including assumptions regarding loan and deposit growth. These assumptions and timelines are periodically evaluated both in terms of their historical trends and absolute levels. Under each scenario, the Company currently expects its pre-tax profitability to build to levels sufficient to fully absorb the existing DTA.

Tax-planning strategies that could, if necessary, be implemented.

As provided by ASC 740, the Company considers certain prudent and feasible tax-planning strategies that, if implemented, could prevent an operating loss or tax credit carry forward from expiring unused and could result in realization of the existing DTA. The Company currently expects that these tax-planning strategies could generate pre-tax profitability at levels sufficient to fully absorb the existing DTA. The Company has no present intention to implement such strategies.

The Company has determined that it is more likely than not that it will be able to fully realize the existing DTA. Additionally, the Company has considered the fact that as of September 30, 2013, it is no longer in a three-year cumulative pre-tax loss position, thereby eliminating that area of negative evidence. Management will continue to evaluate the carrying value of the Company’s DTA on a quarterly basis, in accordance with ASC 740, and will determine any need for a valuation allowance based upon circumstances and expectations then in existence.

Note 9 - Per Share Results

Basic earnings per share represent income available to common shareholders divided by the weighted-average number of shares outstanding during the year. Diluted earnings per share reflect additional shares that would have been outstanding if dilutive potential shares had been issued. Potential shares that may be issued by the Company relate solely to outstanding stock options and restricted shares (non-vested shares), and are determined using the treasury stock method. Under the treasury stock method, the number of incremental shares is determined by assuming the issuance of stock for the outstanding stock options reduced by the number of shares assumed to be repurchased from the issuance proceeds, using the average market price for the year of the Company's stock. Weighted-average shares for the basic and diluted EPS calculations have been reduced by the average number of unvested restricted shares.

Weighted-Average Shares for Earnings Per Share Calculation

	Three Months Ended September 30				Nine Months Ended September 30
	2013		2012		2013		2012

Weighted-average number of commonshares outstanding		44,170,964		32,138,367		44,098,417		32,111,466

Effect of dilutive stock options and restricted shares		102,857		187		74,052		61

Weighted-average number of commonshares and dilutive potential common shares outstanding		44,273,821		32,138,554		44,172,469		32,111,527

There were 2,664,625 outstanding stock options that were anti-dilutive for the three-month period ended September 30, 2013 and 2,678,958 for the nine-month period ended September 30, 2013. There were 2,155,189 and 2,156,689 outstanding stock options that were antidilutive for each of the three- and nine-month periods ended September 30, 2012. In all periods, the anti-dilution was due to the exercise prices exceeding the market price for the period.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

There were 554,400 outstanding restricted shares that were anti-dilutive for the three- and nine-month periods ended September 30, 2013, due to the vesting price exceeding the average market price for the periods, which were omitted from the calculation. At September 30, 2013, these restricted shares had performance conditions, which will vest one-third each when the Company’s share price achieves, for 30 consecutive trading days, $8.125, $9.10 and $10.40, respectively. For the three- and nine-month periods ended September 30, 2012, 631,260 and 568,260 outstanding restricted shares, respectively, were anti-dilutive.

Note 10 – Preferred Stock

In connection with the Citizens South acquisition, the Company issued 20,500 shares of its Senior Non-Cumulative Perpetual Preferred Stock, Series C (the “Series C Preferred Stock”) upon conversion of Citizens South’s preferred stock that previously was issued to the Treasury pursuant to a Securities Purchase Agreement between Citizens South and the Treasury in connection with Citizens South’s participation in the SBLF program.

On September 30, 2013, the Company fully redeemed the 20,500 shares of the Series C Preferred Stock and exited the SBLF program.

Note 11 - Commitments and Contingencies

In the normal course of business, there are various outstanding commitments and contingent liabilities, such as commitments to extend credit, which are not reflected in the accompanying unaudited condensed consolidated financial statements. At September 30, 2013, we had $264.9 million of pre-approved but unused lines of credit, $3.8 million of standby letters of credit and $4.2 million of commercial letters of credit. At December 31, 2012, we had $251.9 million of pre-approved but unused lines of credit, $3.9 million of standby letters of credit and $5.6 million of commercial letters of credit. In management’s opinion, these commitments represent no more than normal lending risk to us and will be funded from normal sources of liquidity.

Note 12 - Derivative Financial Instruments and Hedging Activities

As of September 30, 2013, the Company maintained two loan swaps accounted for as fair value hedges in accordance with ASC 815. The aggregate original notional amount of these loan swaps was $6.2 million. These derivative instruments are used to protect the Company from interest rate risk caused by changes in the LIBOR curve in relation to certain designated fixed rate loans and are accounted for as fair value hedges. The derivative instruments are used to convert these fixed rate loans to an effective floating rate. If the LIBOR rate is below the stated fixed rate of the loan for a given period, the Company will owe the floating rate payer the notional amount times the difference between LIBOR and the stated fixed rate. If LIBOR is above the stated rate for any given period during the term of the contract, the Company will receive payments based on the notional amount times the difference between LIBOR and the stated fixed rate. These derivative instruments are carried at a fair market value of $(0.3) million and $(0.5) million at September 30, 2013 and December 31, 2012, respectively, and are included in other liabilities. The loans being hedged are also recorded at fair value. These fair value hedges had no indications of ineffectiveness for any of the periods presented. The Company recorded interest expense on these loan swaps of $35 thousand and $0.2 million, respectively, in the three and nine months ended September 30, 2013, and $0.1 million and $0.3 million, respectively, in the three and nine months ended September 30, 2012.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

The following table presents information on the individual loan swaps at September 30, 2013:

Individual Loan Swap Information

(Dollars in thousands)

Original Notional Amount		Current Notional Amount		Termination Date	Fixed Rate			Floating Rate	Floating Rate Payer Spread
$	2,555	$	2,423	10/15/15		5.50	%	USD-LIBOR-BBA		2.88	%
	3,595		3,260	04/27/17		5.25	%	USD-LIBOR-BBA		2.73	%
$	6,150	$	5,683

Note 13 - Fair Value Measurements

The Company is required to disclose the estimated fair value of financial instruments, both assets and liabilities on and off the balance sheet, for which it is practicable to estimate fair value. These fair value estimates are made at each balance sheet date, based on relevant market information and information about the financial instruments. Fair value estimates are intended to represent the price at which an asset could be sold or the price for which a liability could be settled in an orderly transaction between market participants at the measurement date. However, given there is no active market or observable market transactions for many of the Company’s financial instruments, the Company has made estimates of many of these fair values which are subjective in nature, involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimated values. The methodologies used for estimating the fair value of financial assets and financial liabilities are discussed below:

Cash and Cash Equivalents

Cash and cash equivalents, which are comprised of cash and due from banks, interest-bearing balances at banks and Federal funds sold, approximate their fair value.

Investment Securities

Fair value for investment securities is based on the quoted market price if such information is available. If a quoted market price is not available, fair values are based on quoted market prices of comparable instruments.

Nonmarketable Equity Securities

Cost is a reasonable estimate of fair value for nonmarketable equity securities because no quoted market prices are available and the securities are not readily marketable. The carrying amount is adjusted for any permanent declines in value.

Loans, Net of Allowance and Loans Held for Sale

For certain homogenous categories of loans, such as residential mortgages, fair value is estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. The fair value of other types of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Further adjustments are made to reflect current market conditions. There is no discount for liquidity included in the expected cash flow assumptions.

FDIC Indemnification Asset

The fair value of the FDIC indemnification asset is estimated based on discounted future cash flows using current discount rates.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

Accrued Interest Receivable

The carrying amount is a reasonable estimate of fair value.

Deposits

The fair value of deposits that have no stated maturities, including demand deposits, savings, money market and NOW accounts, is the amount payable on demand at the reporting date. The fair value of deposits that have stated maturity dates, primarily time deposits, is estimated by discounting expected cash flows using the rates currently offered for instruments of similar remaining maturities.

Borrowings

The fair values of short-term and long-term borrowings are based on discounting expected cash flows at the interest rate for debt with the same or similar remaining maturities and collateral requirements.

Subordinated Debentures

The fair value of fixed rate subordinated debentures is estimated using a discounted cash flow calculation that applies the Company’s current borrowing rate. The carrying amounts of variable rate borrowings are reasonable estimates of fair value because they can reprice frequently.

Contingent Payable

The carrying amount is a reasonable estimate of fair value.

Accrued Interest Payable

The carrying amount is a reasonable estimate of fair value.

Derivative Instruments

Derivative instruments, including interest rate swaps and swap fair value hedges, are recorded at fair value on a recurring basis. Fair value measurement is based on discounted cash flow models. All future floating cash flows are projected and both floating and fixed cash flows are discounted to the valuation date.

Financial Instruments with Off-Balance Sheet Risk

With regard to financial instruments with off-balance sheet risk, it is not practicable to estimate the fair value of future financing commitments.

The Company utilizes fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. Securities available-for-sale and derivative instruments are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record other assets at fair value on a nonrecurring basis. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

The Company groups assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.

Level 1

Valuation is based upon quoted prices for identical instruments traded in active markets.

Level 2

Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active and model-based valuation techniques for which all significant assumptions are observable in the market.

Level 3

Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques may include the use of option pricing models, discounted cash flow models and similar techniques.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

The carrying amounts and estimated fair values of the Company’s financial instruments, none of which are held for trading purposes, at September 30, 2013 and December 31, 2012 are as follows:

Financial Instruments Carrying Amounts and Estimated Fair Values

					Fair Value Measurements
(Dollars in thousands)	Carrying Amount		Estimated Fair Value		Quoted Prices in Active Markets for Identical Assets or Liabilities (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
September 30, 2013:
Financial assets:
Cash and cash equivalents	$	52,697	$	52,697	$	52,697	$	-	$	-
Investment securities		355,032		355,076		1,839		352,827		410
Nonmarketable equity securities		6,805		6,805		-		6,805		-
Loans held for sale		3,070		3,070		-		3,070		-
Loans, net of allowance		1,307,690		1,280,248		-		5,973		1,274,275
FDIC indemnification asset		13,959		12,674		-		-		12,674
Accrued interest receivable		4,006		4,006		-		-		4,006

Financial liabilities:
Deposits with no stated maturity		991,322		991,322		-		991,322		-
Deposits with stated maturities		564,641		565,085		-		565,085		-
Swap fair value hedge		290		290		-		290		-
Borrowings		99,634		99,453		-		99,453		-
Contingent payable		3,003		3,003		-		3,003		-
Accrued interest payable		425		425		-		425		-

December 31, 2012:
Financial assets:
Cash and cash equivalents	$	184,142	$	184,142	$	184,142	$	-	$	-
Investment securities		245,571		245,571		-		245,156		415
Nonmarketable equity securities		7,422		7,422		-		7,422		-
Loans held for sale		14,147		14,147		-		14,147		-
Loans, net of allowance		1,346,116		1,332,683		-		11,390		1,321,293
FDIC indemnification asset		18,697		18,697		-		-		18,697
Accrued interest receivable		3,821		3,821				-		3,821

Financial liabilities:
Deposits with no stated maturity		1,002,258		1,002,258		-		1,002,258		-
Deposits with stated maturities		629,746		631,289		-		631,289		-
Swap fair value hedge		453		453		-		453		-
Borrowings		101,716		101,307		-		101,307		-
Contingent payable		3,003		3,003		-		3,003		-
Accrued interest payable		516		516		-		516		-

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

The following is a description of valuation methodologies used for assets and liabilities recorded at fair value:

Investment Securities

Investment securities available-for-sale are recorded at fair value on a recurring basis. Investment securities held-to-maturity are valued at quoted market prices or dealer quotes similar to securities available for sale. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include MBS issued by government-sponsored entities or private label entities, municipal bonds and corporate debt securities that are valued using quoted prices for similar instruments in active markets. Securities classified as Level 3 include a corporate debt security in a less liquid market whose value is determined by reference to the going rate of a similar debt security if it were to enter the market at period end. The derived market value requires significant management judgment and is further substantiated by discounted cash flow methodologies.

Derivative Instruments

Derivative instruments held or issued by the Company for risk management purposes are traded in over-the-counter markets where quoted market prices are not readily available. For those derivatives, the Company uses a third party to measure the fair value on a recurring basis. The Company classifies derivative instruments held or issued for risk management purposes as Level 2. As of September 30, 2013 and December 31, 2012, the Company’s derivative instruments consist of swap fair value hedges.

Loans

Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures it for the estimated impairment. The fair value of impaired loans is estimated using one of several methods, including collateral value, discounted cash flows or a pooled probability of default and loss given default calculation. Those impaired loans not requiring a specific allowance represent loans for which the fair value exceeds the recorded investments in such loans. Impaired loans where a specific allowance is established based on the fair value of collateral require classification in the fair value hierarchy. The Company records such impaired loans as nonrecurring Level 3.

The Company recorded the two loans involved in fair value hedges at fair market value on a recurring basis. The Company does not record other loans at fair value on a recurring basis.

Loans held for sale

Loans held for sale are adjusted to lower of cost or market upon transfer from the loan portfolio to loans held for sale. Subsequently, loans held for sale are carried at the lower of carrying value or fair value. Fair value is based upon independent market prices, appraised values of the collateral, management’s estimation of the value of the collateral or commitments on hand from investors within the secondary market for loans with similar characteristics. The fair value adjustments for loans held for sale are recorded as nonrecurring Level 2.

Other real estate owned

OREO is adjusted to fair value upon transfer of the loans to OREO. Subsequently, OREO is carried at the lower of carrying value or fair value less costs to sell. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is measured due to further deterioration in the value of the OREO since initial recognition, the Company records the foreclosed asset as nonrecurring Level 3.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

The table below presents, by level, the recorded amount of assets and liabilities at September 30, 2013 and December 31, 2012 measured at fair value on a recurring basis:

Fair Value on a Recurring Basis

Description	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)		Assets/Liabilities at Fair Value
	(Dollars in thousands)
September 30, 2013
U.S. Government agencies	$	-	$	563		$	-	$	563
Municipal securities		-		16,614			-		16,614
Residential agency mortgage-backed securities		-		94,660			-		94,660
Commercial mortgage-backed securities		-		62,061			-		62,061
All other debt securities		-		152,249			410		152,659
All other equity securities		1,839		-			-		1,839
Fair value loans		-		5,973			-		5,973
Swap fair value hedge		-		(290	)		-		(290	)

December 31, 2012
U.S. Government agencies	$	-	$	583		$	-	$	583
Municipal securities		-		17,986			-		17,986
Residential agency mortgage-backed securities		-		159,113			-		159,113
All other debt securities		-		67,474			415		67,889
Fair value loans		-		11,390			-		11,390
Swap fair value hedge		-		(453	)		-		(453	)

There were no transfers between valuation levels for any accounts. If different valuation techniques are deemed necessary, the Company would consider those transfers to occur at the end of the period that the accounts are valued.

The Company classifies its corporate debt security as a Level 3 asset. A valuation of the corporate debt security is performed using a discounted cash flow method at a rate of 10.25%. Valuation techniques are consistent with techniques used in prior periods. The following are reconciliations of the beginning and ending balances for assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the three and nine months ended September 30, 2013 and 2012. The ending balances for Level 3 assets at September 30, 2013 remained unchanged from December 31, 2012 at $0.4 million.

Level 3 Assets Reconciliation

	Three Months Ended September 30,				Nine Months Ended September 30,
	2013		2012		2013			2012
	(dollars in thousands)
Corporate debt security:
Balance, beginning of period	$	409	$	408	$	415		$	405
(Increase) decrease in unrealized loss		1		4		(5	)		7
				-					-
Balance, end of period	$	410	$	412	$	410		$	412

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

Assets Recorded at Fair Value on a Nonrecurring Basis

The Company may be required, from time to time, to measure certain other financial assets at fair value on a nonrecurring basis in accordance with GAAP. These adjustments to fair value usually result from application of lower of cost or market accounting or impairment charges of individual assets. Processes are in place for overseeing the valuation procedures for Level 3 measurements of OREO and impaired loans. The assets are reviewed on a quarterly basis to determine the accuracy of the observable inputs, generally third party appraisals, auction values, values derived from trade publications and data submitted by the borrower, and the appropriateness of the unobservable inputs, generally discounts due to current market conditions and collection issues. Discounts are based on asset type and valuation source; deviations from the standard are documented. The discounts are periodically reviewed to determine whether they remain appropriate. Consideration is given to current trends in market values for the asset categories and gain and losses on sales of similar assets.

Discounts range from 0% to 100% depending on the nature of the assets and source of value. Real estate is valued based on appraisals or evaluations, discounted by 8% at a minimum with higher discounts for property in poor condition or property with characteristics that may make it more difficult to market. Commercial loans secured by receivables or non-real estate collateral are generally valued using the discounted cash flow method. Inputs are determined on a borrower-by-borrower basis.

Impaired loans and related write-downs are based on the fair value of the underlying collateral if repayment is expected solely from the collateral or using a pooled probability of default and loss given default calculation. Collateral values are reviewed quarterly and estimated using customized discounting criteria and appraisals.

Other real estate owned is based on the lower of the cost or fair value of the underlying collateral less expected selling costs. Collateral values are estimated primarily using appraisals and reflect a market value approach. Fair values are reviewed quarterly and new appraisals are generally obtained annually.

The table below presents the carrying value of assets at September 30, 2013 and December 31, 2012 measured at fair value on a nonrecurring basis:

Fair Value on a Nonrecurring Basis

Description	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Assets/ (Liabilities) at Fair Value
	(Dollars in thousands)
September 30, 2013
OREO	$	-	$	-	$	6,026	$	6,026
Impaired loans:
Commercial and industrial		-		-		83		83
CRE - owner-occupied		-		-		124		124
CRE - investor income producing		-		-		3,469		3,469
Residential mortgage		-		-		1,154		1,154
Home equity lines of credit		-		-		1,591		1,591
Residential construction		-		-		65		65
Other loans to individuals		-		-		2		2

December 31, 2012
OREO	$	-	$	-	$	25,073	$	25,073
Impaired loans:
Commercial and industrial		-		-		115		115
Residential mortgage		-		-		962		962
Home equity lines of credit		-		-		155		155

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

The table below presents the valuation methodology and unobservable inputs for Level 3 assets and liabilities measured at fair value on a nonrecurring basis at September 30, 2013.

(dollars in thousands)	Fair Value		Valuation Methodology	Unobservable Inputs	Range of Inputs			Weighted Average Discount

OREO	$	6,026	Appraisals	Discount to reflect currentmarket conditions	0%	-	55%		17.50%

Impaired loans		5,257	Discounted cash flows	Percent of total contractual cash flows not expectedto be collected	0%	-	50%		12.71%

		1,038	Probability of defaultmodel	Discount to reflect probabilityand loss given default	0%	-	100%		19.19%

		193	Collateral basedmeasurements	Discount to reflect currentmarket conditions andultimate collectability	0%	-	60%		37.73%

	$	12,514

In accordance with accounting for foreclosed property, the carrying value of OREO is periodically reviewed and written down to fair value and any loss is included in earnings. During the three months ended September 30, 2013, OREO with a carrying value of $0.7 million was written down by $0.1 million to $0.6 million. During the nine months ended September 30, 2013, OREO with a carrying value of $7.3 million was written down by $1.2 million to $6.1 million. During the three months ended September 30, 2012, OREO with a carrying value of $2.5 million was written down by $0.8 million to $1.7 million. During the nine months ended September 30, 2012, OREO with a carrying value of $8.6 million was written down by $1.8 million to $6.8 million.

There were no transfers between valuation levels for any accounts for the three and nine months ended September 30, 2013 and 2012. If different valuation techniques are deemed necessary, we would consider those transfers to occur at the end of the period that the accounts are valued.

Note 14 – Shareholders’ Equity

Share-Based Plans

Pursuant to the Park Sterling Corporation 2010 Long-Term Incentive Plan (the “LTIP”), the Company may grant share-based compensation to employees and non-employee directors in the form of stock options, restricted stock or other stock-based awards. Share-based compensation expense is measured based on the fair value of the award at the date of grant and is charged to earnings on a straight-line basis over the requisite service period, which is currently up to seven years. The fair value of stock options is estimated at the date of grant using a Black-Scholes option-pricing model and related assumptions and expensed over each option’s vesting period. The amortization of share-based compensation reflects estimated forfeitures, adjusted for actual forfeiture experience. The fair value of restricted stock awards subject to share price performance vesting requirements is estimated using a Monte Carlo simulation and related estimated assumptions for volatility and a risk free interest rate. The fair value of restricted stock awards, not subject to share price performance, is estimated at the date of the grant based on the grant date closing stock price. As of September 30, 2013, there were 106,493 shares available for future grant under the LTIP.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

As a result of the Citizens South merger, the Company assumed the Citizens South Bank 1999 Stock Option Plan (the “1999 Citizens South Plan”), the Citizens South Banking Corporation 2003 Stock Option Plan (the “2003 Citizens South Plan”) and the Citizens South Banking Corporation 2008 Equity Incentive Plan ( the “2008 Citizens South Plan”), each of which has been renamed as a Park Sterling Corporation plan, and the obligations of awards outstanding under the plans at the effective date of the merger.

Under the 2008 Citizens South Plan, the Company may grant future non-qualified stock options and stock appreciation rights (“SARs”) to eligible employees and directors of, or service providers to, the Company or the Bank who were not employees or directors of or service providers to the Company or the Bank at the effective time of the merger. At September 30, 2013, there were options to purchase 261,833 shares of Common Stock outstanding and 96,125 shares remaining available for future grants under the 2008 Citizens South Plan.

The 1999 Citizens South Plan and the 2003 Citizens South Plan are no longer active plans and no future awards can be granted thereunder. As of September 30, 2013, there were options to purchase 2,190 shares of Common Stock outstanding under the 1999 Citizens South Plan and options to purchase 752,671 shares of Common Stock outstanding under the 2003 Citizens South Plan.

The exercise price of each option under these plans is not less than the market price of the Company’s Common Stock on the date of the grant. The exercise price of all options outstanding at September 30, 2013 under these plans ranges from $3.04 to $15.45 and the average exercise price was $7.88. The Company funds the option shares from authorized but unissued shares. The Company does not typically purchase shares to fulfill the obligations of the stock benefit plans. Options granted become exercisable in accordance with the plans’ vesting schedules that are generally three years. In connection with the retirement of certain directors following the Bank’s public offering, vesting of their director options previously awarded in December 2007 was accelerated from December 2010 to August 2010 at their original exercise price of $13.23 per share. All unexercised options expire ten years after the date of the grant.

Additional information regarding the Company’s share-based plans is presented in Note 19 – Employee and Director Benefit Plans to the 2012 Audited Financial Statements.

Activity in the Company’s share-based plans is summarized in the following table:

	Outstanding Options									Nonvested Restricted Shares
	Number Outstanding			Weighted Average Exercise Price		Weighted Average Contractual Term (Years)		Intrinsic Value		Number Outstanding			Weighted Average Grant Date Fair Value		Aggregate Intrinsic Value

At December 31, 2012		3,119,692		$	7.84		5.27	$	-		646,260		$	4.01	$	3,379,940
Restricted Shares Granted		-			-		-		-		151,500			5.61		971,115
Restricted Shares Vested		-			-		-		-		(21,000	)		4.68		134,613
Exercised		(55,391	)		5.10		-		-		-			-		-
Expired and forfeited		(116,264	)		8.24		-		-		(22,860	)		4.55		146,533

At September 30, 2013		2,948,037		$	7.88		4.53	$	337,538		753,900		$	4.30	$	4,832,496

Exercisable at September 30, 2013		2,816,698		$	7.97		4.39

At September 30, 2013, unrecognized compensation cost related to nonvested stock options of $0.1 million is expected to be recognized over a weighted-average period of 0.36 years. Total compensation expense for stock options was $157 thousand and $323 thousand for the three months ended September 30, 2013 and 2012, respectively, and $801 thousand and $970 thousand for the nine months ended September 30, 2013 and 2012, respectively.

PARK STERLING CORPORATION

Notes to Condensed Consolidated Financial Statements (Unaudited)

At September 30, 2013, unrecognized compensation cost related to nonvested restricted shares of $1.1 million is expected to be recognized over a weighted-average period of 1.09 years. Total compensation expense for restricted shares was $249 thousand and $185 thousand for the three months ended September 30, 2013 and 2012, respectively, and $667 thousand and $529 thousand for the nine months ended September 30, 2013 and 2012, respectively.

Note 15 – Subsequent Event

Dividend Declaration

On October 25, 2013, the Company announced that its Board of Directors has declared a quarterly dividend of $0.02 per common share, payable on November 20, 2013 to all common shareholders of record as of the close of business on November 6, 2013.

Cash Flow Hedge

On October 21, 2013, the Company entered into a three-year forward starting interest rate swap agreement with a notional amount of $20.0 million. The derivative instrument will be used to protect certain designated variable rate FHLB borrowings from the effects of their repricing in the event of an increasing rate environment for a period of five years commencing three years from now. This swap agreement will be accounted for as a cash flow hedge. Until the three-year forward start date, changes in fair value of the swap will be recorded in other comprehensive income net of tax. After that date, changes in fair value of the swap that are deemed effective will be recorded in other comprehensive income net of tax and changes in fair value for the ineffective portion of the swap will be recorded in interestexpense.

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This report contains, and Park Sterling Corporation (the “Company”) and its management may make, certain statements that constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These statements can be identified by the fact that they do not relate strictly to historical or current facts and often use words such as “may,” “plan,” “contemplate,” “anticipate,” “believe,” “intend,” “continue,” “expect,” “project,” “predict,” “estimate,” “could,” “should,” “would,” “will,” “goal,” “target” and similar expressions. These forward-looking statements express management’s current expectations or forecasts of future events, results and conditions, including financial and other estimates and expectations regarding the merger with Citizens South Banking Corporation (“Citizens South”); the general business strategy of engaging in bank mergers, organic growth, branch openings and closings, expansion or addition of product capabilities, expected footprint of the banking franchise and anticipated asset size; anticipated loan growth; changes in loan mix and deposit mix; capital and liquidity levels; net interest income; provision expense, noninterest income and noninterest expenses; credit trends and conditions, including loan losses, allowance for loan loss, charge-offs, delinquency trends and nonperforming asset levels; net interest margin trends and the impact of the acquired portfolio fair value mark; the amount, timing and prices of share repurchases; the initiation of payment of common stock dividends; and other similar matters. These forward-looking statements are not guarantees of future results or performance and by their nature involve certain risks and uncertainties that are based on management’s beliefs and assumptions and on the information available to management at the time that these disclosures were prepared. Actual outcomes and results may differ materially from those expressed in, or implied by, any of these forward-looking statements.

You should not place undue reliance on any forward-looking statement and should consider all of the following uncertainties and risks, as well as those more fully discussed in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012 filed with the Securities and Exchange Commission (“SEC”) on March 15, 2013 (the “2012 Form 10-K”) and in any of the Company’s subsequent filings with the SEC: failure to realize synergies and other financial benefits from the Citizens South merger within the expected time frames; increases in expected costs or decreases in expected savings or difficulties related to integration of the merger; inability to identify and successfully negotiate and complete additional combinations with potential merger partners or to successfully integrate such businesses into the Company, including the Company’s ability to adequately estimate or to realize the benefits and cost savings from and limit any unexpected liabilities acquired as a result of any such business combination; failure to effectively redeploy resources from custody business to the core asset management business; the effects of negative or soft economic conditions or a “double-dip” recession, including stress in the commercial real estate markets or delay or failure of recovery in the residential real estate markets; the impact of deterioration of the United States credit standing; changes in consumer and investor confidence and the related impact on financial markets and institutions; changes in interest rates; failure of assumptions underlying the establishment of allowances for loan losses; deterioration in the credit quality of the loan portfolio or in the value of the collateral securing those loans; deterioration in the value of securities held in the investment securities portfolio; the impacts on the Company of a potential increasing rate environment; the potential impacts of any additional government shutdown and further debt ceiling impasse, including the risk of a U.S. credit rating downgrade or default which could cause disruptions in the financial markets, impact interest rates, and cause other potential unforeseen consequences; fluctuations in the market price of the common stock, regulatory, legal and contractual requirements, other uses of capital, the Company’s financial performance, market conditions generally or future actions by the board of directors, in each case impacting repurchases of common stock or declaration of dividends; legal and regulatory developments including changes in the federal risk-based capital rules; increased competition from both banks and nonbanks; changes in accounting standards, rules and interpretations, inaccurate estimates or assumptions in accounting, including acquisition accounting fair market value assumptions and accounting for purchased credit-impaired loans, and the impact on the Company’s financial statements; and management’s ability to effectively manage credit risk, market risk, operational risk, legal risk, and regulatory and compliance risk.

Forward-looking statements speak only as of the date they are made, and the Company undertakes no obligation to update any forward-looking statement to reflect the impact of circumstances or events that arise after the date the forward-looking statement was made.

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

The purpose of this discussion and analysis is to focus on significant changes in our financial condition as of and results of operations during the three- and nine-month periods ended September 30, 2013. This discussion and analysis highlights and supplements information contained elsewhere in this Quarterly Report on Form 10-Q, particularly the preceding unaudited condensed consolidated financial statements and accompanying notes (the “Unaudited Financial Statements”).

Executive Overview

Park Sterling Corporation (the “Company”) reported net income available to common shareholders of $10.9 million, or $0.25 per share, for the nine months ended September 30, 2013 compared to $3.0 million, or $0.09 per share, for the nine months ended September 30, 2012. The increase resulted, in part, from sound expense controls, continued improvements in asset quality and continued organic growth coupled with the higher net interest income associated with the merger with Citizens South, which was completed on October 1, 2012.

Asset quality continued to improve in the third quarter and remains a point of strength for the Company. Nonperforming loans decreased $3.2 million, or 17.7%, to $14.7 million at September 30, 2013, or 1.11% of total loans, compared to $17.8 million at December 31, 2012, or 1.31% of total loans. Nonperforming assets decreased $13.3 million, or 31.1%, to $29.5 million at September 30, 2013, or 1.52% of total assets, compared to $42.9 million at December 31, 2012, or 2.11% of total assets. Nonperforming assets at September 30, 2013 include $6.2 million of covered other real estate owned (“OREO”) for which the Company expects 80% of losses and associated expenses to be reimbursed under the FDIC loss share agreements.

Total assets decreased $92.9 million, or 5%, at September 30, 2013 to $1.94 billion compared to total assets at December 31, 2012 of $2.03 billion. Cash and equivalents decreased $131.4 million, or 71%, to $52.7 million. The majority of the proceeds were redeployed into securities, which increased $108.8 million to $361.8 million from $253.0 million at December 31, 2012. In addition, an additional $20.5 million was used to fully redeem the Company’s Senior Non-Cumulative Perpetual Preferred Stock, Series C (“Series C Preferred Stock”). The Series C Preferred Stock was issued to the U.S. Department of the Treasury (“Treasury”) in October 2012 in connection with the acquisition of Citizens South and resulted from conversion of the Citizens South preferred stock previously issued to the Treasury in connection with Citizens South’s participation in the Small Business Lending Fund (“SBLF”) program.

Total deposits decreased $76.0 million, or 5%, to $1.56 billion at September 30, 2013 compared to $1.63 billion at December 31, 2012 due in part to management’s election not to renew certain maturing brokered certificates. Total shareholders’ equity decreased $15.9 million, or 6%, to $259.8 million at September 30, 2013 compared to $275.7 million at December 31, 2012, driven by the redemption of the Company’s $20.5 million of Series C Preferred Stock. The Company's ratio of equity to assets was 13.39% at September 30, 2013 compared to 13.56% at December 31, 2012. The Company’s ratio of tangible common equity to tangible assets increased to 11.78% at September 30, 2013 from 10.97% at December 31, 2012. The Company’s Tier 1 leverage ratio decreased to 11.11% at September 30, 2013 from 11.15% at December 31, 2012. All ratios include a $1.6 million increase in goodwill, related to the Citizens South merger, to adjust for a decrease in the estimated fair market value of deferred tax assets determined in connection with the preparation and filing of the final Citizen’s South tax returns. Tangible common equity and tangible assets, and related ratios, are non-GAAP financial measures. For reconciliations to the most comparable GAAP measure, see “Non-GAAP Financial Measures” below.

Business Overview

The Company, a North Carolina corporation, was formed in October 2010 to serve as the holding company for Park Sterling Bank (the “Bank”) and is a bank holding company registered with the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). The Bank was incorporated in September 2006 as a North Carolina-chartered commercial nonmember bank. On January 1, 2011, the Company acquired all of the outstanding common stock of the Bank in exchange for shares of the Company’s Common Stock, on a one-for-one basis, in a statutory share exchange transaction effected under North Carolina law pursuant to which the Company became the bank holding company for the Bank. Prior to January 1, 2011, the Company conducted no operations other than obtaining regulatory approval for the holding company reorganization.

Consistent with our growth strategy, during 2011 the Bank opened a full-service branch in Charleston, South Carolina and loan production offices in Raleigh, North Carolina and Greenville, South Carolina, and subsequently opened full-service branches in Greenville and Raleigh in the first quarter of 2012. The Bank currently anticipates that it will open additional branch offices and/or loan production offices in its target markets in the future.

As part of our growth strategy, the Company acquired Community Capital Corporation (“Community Capital”) in November 2011. The aggregate merger consideration consisted of 4,024,269 shares of Common Stock and approximately $13.3 million in cash. The final transaction value was approximately $28.8 million based on the $3.85 per share closing price of the Common Stock on October 31, 2011.

In addition, in October 2012, the Company acquired Citizens South, the parent company of Citizens South Bank. As a result of the merger of Citizens South into the Company, Citizens South Bank, which operated 20 branches in North Carolina, South Carolina and Georgia, became a wholly-owned subsidiary of the Company and thereafter was merged into the Bank. The aggregate merger consideration consisted of 11,857,226 shares of Common Stock and $24.3 million in cash. The final transaction value was approximately $82.9 million based on the $4.94 per share closing price of the Common Stock on September 28, 2012. In addition, in connection with the merger, the preferred stock previously issued by Citizens South to the Treasury in connection with Citizens South’s participation in the SBLF program was converted into 20,500 shares of a substantially identical newly created series of our preferred stock, the Series C Preferred Stock. On September 30, 2013, the Company redeemed all 20,500 shares of the Series C Preferred Stock, which resulted in the Company’s exit from the SBLF program. Citizens South contributed approximately $929.5 million in total assets, $683.4 million in total loans (including loans held for sale), $30.3 million in goodwill and intangibles, and $828.3 million in total deposits to the Company, after acquisition accounting fair market value adjustments.

The Company provides a full array of retail and commercial banking services, including wealth management, through its offices located in North Carolina, South Carolina, and Georgia. Our objective since inception has been to provide the strength and product diversity of a larger bank and the service and relationship attention that characterizes a community bank.

Non-GAAP Financial Measures

In addition to traditional measures, management uses tangible assets, tangible common equity, adjusted allowance for loan losses to loans, adjusted net charge-offs, adjusted non interest expenses and adjusted net interest margin, and related ratios and per-share measures, each of which is a non-GAAP financial measure. Management uses (i) tangible assets and tangible common equity (which exclude goodwill and other intangibles from equity and assets) and related ratios to evaluate the adequacy of shareholders' equity and to facilitate comparisons with peers; (ii) adjusted allowance for loan losses (which includes acquisition accounting fair market value adjustments related to acquired loans) and adjusted net charge-offs/recoveries (which exclude the impact of acquisition accounting related to PCI loans),and related ratios to evaluate both its asset quality and asset quality trends, and to facilitate comparisons with peers; and (iii) adjusted noninterest expense (which excludes merger-related expenses and gain on sale of securities, as applicable) and adjusted net interest margin (which excludes accelerated net acquisition accounting fair market value adjustments) to evaluate its core earnings and to facilitate comparisons with peers.

The following table presents these non-GAAP financial measures and provides a reconciliation of these non-GAAP measures to the most directly comparable GAAP measure reported in the unaudited condensed consolidated financial statements:

Reconciliation of Non-GAAP Financial Measures

	September 30,			December 31,
	2013			2012
	(Unaudited)			(Unaudited)
	(dollars in thousands)
Tangible common equity to tangible assets
Total assets (as reported)	$	1,940,060		$	2,033,062
Less: intangible assets		(35,475	)		(36,247	)
Tangible assets	$	1,904,585		$	1,996,815

Total equity (as reported)	$	259,753		$	275,702
Less: preferred stock		-			(20,500	)
intangible assets		(35,475	)		(36,247	)
Tangible common equity	$	224,278		$	218,955

Tangible common equity		224,278			218,955
Divided by: tangible assets		1,904,585			1,996,815
Tangible common equity to tangible assets		11.78	%		10.97	%
Total equity to total assets		13.39	%		13.56	%

Adjusted allowance for loan losses
Allowance for loan losses (as reported)	$	8,652		$	10,591
Plus: acquisition accounting FMV adjustments to acquired loans		41,389			53,719
Adjusted allowance for loan losses	$	50,041		$	64,310
Divided by: total loans (excluding LHFS)		1,316,342			1,356,707
Adjusted allowance for loan losses to total loans		3.80	%		4.74	%
Allowance for loan losses to total loans		0.66	%		0.78	%

	Three months ended						Nine months ended
	September 30,			September 30,			September 30,			September 30,
	2013			2012			2013			2012
	(Unaudited)			(Unaudited)			(Unaudited)			(Unaudited)
	(dollars in thousands)
Adjusted net interest margin
Net interest income (as reported)	$	18,314		$	9,971		$	54,721		$	31,792
Less: accelerated mark accretion		(529	)		17			(1,089	)		(1,729	)
Adjusted net interest income		17,785			9,988			53,632			30,063
Divided by: average earning assets		1,747,886			998,669			1,740,912			1,008,300
Multiplied by: annualization factor		3.97			3.98			1.34			1.34
Adjusted net interest margin		4.04	%		3.98	%		4.12	%		3.98	%
Net interest margin		4.16	%		3.97	%		4.20	%		4.21	%

Adjusted net charge-offs (recoveries) (annualized)
Net charge-offs (recoveries) (as reported)	$	1,776		$	231		$	2,201		$	1,976
Less: net charge-offs (recoveries) of PCI loans (ASC 310-30)		(959	)		-			(1,350	)		-
Adjusted net charge-offs (recoveries)		817			231			851			1,976
Divided by: average loans		1,319,026			719,397			1,334,216			731,617
Multiplied by: annualization factor		3.97			3.98			1.34			1.34
Adjusted net charge-offs (recoveries) (annualized)		0.25	%		0.13	%		0.09	%		0.36	%
Net charge-offs (recoveries) (annualized)		0.53	%		0.13	%		0.22	%		0.36	%

Adjusted noninterest expense
Noninterest expense (as reported)	$	15,670		$	12,203		$	48,375		$	33,910
Less: merger-related expenses		(167	)		(1,364	)		(1,825	)		(2,728	)
Adjusted noninterest expense	$	15,503		$	10,839		$	46,550		$	31,182

Recent Accounting Pronouncements

See Note 2 to the Unaudited Financial Statements for a description of recent accounting pronouncements including the respective expected dates of adoption and effects on results of operations and financial condition.

Critical Accounting Policies and Estimates

In the preparation of our financial statements, we have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States (“GAAP”) and in accordance with general practices within the banking industry. Our significant accounting policies are described in Note 2 – Summary of Significant Accounting Policies to the Company’s audited consolidated financial statements and accompanying notes (the “2012 Audited Financial Statements”) included in the 2012 Form 10-K. While all of these policies are important to understanding our financial statements, certain accounting policies described below involve significant judgment and assumptions by management that have a material impact on the carrying value of certain assets and liabilities. We consider these accounting policies to be critical accounting policies. The judgment and assumptions we use are based on historical experience and other factors, which we believe to be reasonable under the circumstances. Because of the nature of the judgment and assumptions we make, actual results could differ from these judgments and assumptions that could have a material impact on the carrying values of our assets and liabilities and our results of operations.

Purchased Credit-Impaired Loans.Loans purchased with evidence of credit deterioration since origination and for which it is probable that all contractually required payments will not be collected are considered credit impaired. Evidence of credit quality deterioration as of the purchase date may include statistics such as internal risk grade, past due and nonaccrual status, recent borrower credit scores and recent loan-to-value (“LTV”) percentages. PCI loans are initially measured at fair value, which includes estimated future credit losses expected to be incurred over the life of the loan. Accordingly, the associated allowance for credit losses related to these loans is not carried over at the acquisition date. We estimated the cash flows expected to be collected at acquisition using specific credit review of certain loans, quantitative credit risk, interest rate risk and prepayment risk models, and qualitative economic and environmental assessments, each of which incorporated our best estimate of current key relevant factors, such as property values, default rates, loss severity and prepayment speeds.

Under the accounting guidance for PCI loans, the excess of cash flows expected to be collected over the estimated fair value is referred to as the accretable yield and is recognized in interest income over the remaining life of the loan, or pool of loans, in situations where there is a reasonable expectation about the timing and amount of cash flows to be collected. The difference between the contractually required payments and the cash flows expected to be collected at acquisition, considering the impact of prepayments, is referred to as the nonaccretable difference and is available to absorb future charge-offs.

In addition, subsequent to acquisition, we periodically evaluate our estimate of cash flows expected to be collected. These evaluations, performed quarterly, require the continued usage of key assumptions and estimates, similar to the initial estimate of fair value. In the current economic environment, estimates of cash flows for PCI loans require significant judgment given the impact of home price and property value changes, changing loss severities, prepayment speeds and other relevant factors. Decreases in the expected cash flows will generally result in a charge to the provision for credit losses resulting in an increase in the allowance for loan losses. Significant increases in the expected cash flows will generally result in an increase in interest income over the remaining life of the loan, or pool of loans. In pools where impairment has already been recognized, an increase in cash flows will result in a reversal of prior impairment.Disposals of loans, which may include sales of loans to third parties, receipt of payments in full or part from the borrower or foreclosure of the collateral, result in removal of the loan from the PCI loan portfolio at its carrying amount.

PCI loans currently represent loans acquired from Community Capital and Citizens South that were deemed credit impaired. PCI loans that were classified as nonperforming loans by Community Capital or Citizens South are no longer classified as nonperforming so long as, at acquisition and quarterly re-estimation periods, we believe we will fully collect the new carrying value of these loans. It is important to note that judgment regarding the timing and amount of cash flows to be collected is required to classify PCI loans as performing, even if the loan is contractually past due.

Allowance for Loan Losses.The allowance for loan losses is based upon management's ongoing evaluation of the loan portfolio and reflects an amount considered by management to be its best estimate of known and inherent losses in the portfolio as of the balance sheet date. The determination of the allowance for loan losses involves a high degree of judgment and complexity. In making the evaluation of the adequacy of the allowance for loan losses, management considers current economic and market conditions, independent loan reviews performed periodically by third parties, portfolio trends and concentrations, delinquency information, management's internal review of the loan portfolio, internal historical loss rates and other relevant factors. While management uses the best information available to make evaluations, future adjustments to the allowance may be necessary if conditions differ substantially from the assumptions used in making the evaluations. In addition, regulatory examiners may require us to recognize changes to the allowance for loan losses based on their judgments about information available to them at the time of their examination. Although provisions have been established by loan segments based upon management's assessment of their differing inherent loss characteristics, the entire allowance for losses on loans, other than the portions related to PCI loans and specific reserves on impaired loans, is available to absorb further loan losses in any segment. Additional information regarding our policies and methodology used to estimate the allowance for possible loan losses is presented in Note 5 – Loans and Allowance for Loan Losses to the 2012 Audited Financial Statements, and Note 5 – Loans and Allowance for Loan Losses to the Unaudited Financial Statements included in this Form 10-Q.

Income Taxes.Income taxes are provided based on the asset-liability method of accounting, which includes the recognition of deferred tax assets (“DTAs”) and liabilities for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. In general, we record a DTA when the event giving rise to the tax benefit has been recognized in the consolidated financial statements.

As of September 30, 2013 and December 31, 2012, we had a net DTA in the amount of approximately $38.5 million and $41.0 million, respectively. We evaluate the carrying amount of our DTA quarterly in accordance with the guidance provided in the Financial Accounting Standards Board (“FASB”) ASC Topic 740 (“ASC 740”), in particular, applying the criteria set forth therein to determine whether it is more likely than not (i.e., a likelihood of more than 50%) that some portion, or all, of the DTA will not be realized within its life cycle, based on the weight of available evidence. In most cases, the realization of the DTA is dependent upon the Company generating a sufficient level of taxable income in future periods, which can be difficult to predict. If our forecast of taxable income within the carry forward periods available under applicable law is not sufficient to cover the amount of net deferred tax assets, such assets may be impaired. Based on the weight of available evidence, including the continued improvement in earnings, we have determined that it is more likely than not that we will be able to fully realize the existing DTA. Accordingly, we consider it appropriate not to establish a DTA valuation allowance at either September 30, 2013 or December 31, 2012.

Additional information regarding our income taxes, including the methodology used to determine the need for a valuation allowance for the existing DTA, if any, is presented in Note 8 —Income Taxes to the Unaudited Financial Statements.

Financial Condition at September30, 2013 and December 31, 2012

Total assets decreased $93.0 million, or 4.6% to $1.94 billion at September 30, 2013 from total assets of $2.03 billion at December 31, 2012. During the nine months ended September 30, 2013, cash, interest-earning balances and Federal funds sold decreased $131.4 million, or 71.4%. Loans, excluding loans held for sale, decreased $38.4 million, or 2.85%, and non-marketable equity securities decreased $0.6 million, or 8.3%. Contraction in mortgage banking activities resulted in a decrease in loans held for sale of $11.1 million, or 78.3% to $3.1 million at September 30, 2013, from $14.2 million at December 31, 2012. These decreases resulted in the redeployment of funds into the securities portfolio and to reduce higher-priced deposits. Investment securities available-for-sale increased $82.8 million, or 33.7%, and the Company also invested in securities held-to-maturity during the third quarter, for a total balance of $26.6 million at September 30, 2013. Additionally, the Company utilized $20.5 million in available funds to fully redeem the Series C Preferred Stock.

Total liabilities decreased $77 million to $1.7 billion at September 30, 2013 compared to $1.8 billion at December 31, 2012. Total deposits decreased $76.1 million, or 4.7%, and total borrowings decreased $2.1 million, or 2.0%, during the first nine months of 2013. Total borrowings included $6.9 million in Tier 2-eligible subordinated debt at September 30, 2013 and December 31, 2012, and $15.0 million and $14.7 million of Tier 1-eligible subordinated debt (after acquisition accounting fair market value adjustments) at September 30, 2013 and December 31, 2012, respectively.

Total shareholders’ equity decreased $15.9 million, or 5.8%, to $259.8 million at September 30, 2013 from December 31, 2012. This decrease was primarily the result of the redemption of the $20.5 million of Series C Preferred Stock, in addition to a $7.2 million decrease in accumulated other comprehensive income from unrealized securities losses and $353 thousand of preferred stock dividends. The Company also initiated a quarterly cash dividend during the third quarter, resulting in $0.9 million in common dividends being paid during the quarter. These decreases were offset by net income before preferred dividends for the nine months ended September 30, 2013 of $11.3 million, $1.5 million of net share-based compensation expense, and $0.3 million in proceeds from the exercise of stock options.

The following table presents selected ratios for the Company for the nine months ended September 30, 2013 and 2012 and for the year ended December 31, 2012:

Selected Ratios

	Nine months ended		Twelve months
	September 30,		ended
	(annualized)		December 31,
	2013	2012	2012
Return on Average Assets	0.74%	0.36%	0.32%

Return on Average Equity	5.21%	2.08%	1.99%

Period End Equity to Total Assets	13.39%	17.64%	13.56%

Tangible Common Equity to Tangible Assets*	11.78%	17.31%	11.99%

* Non-GAAP financial measure. See "Reconciliation of Non-GAAP Financial Measures"

Investments and Other Interest-earning Assets

Investment securities increased $109.5 million, or 34.2%, to $355.0 million at September 30, 2013, from $245.6 million at December 31, 2012. Included in investment securities totals at September 30, 2013 is $328.4 million in investment securities available-for-sale and $26.6 million in investment securities held-to-maturity. Purchases of investment securities available-for-sale were $154.5 million for the nine months ended September 30, 2013. Proceeds from the sales, calls, and maturities of investment securities available-for-sale totaled $60.8 million for the nine months ended September 30, 2013. Purchases of investment securities held-to-maturity were $27.3 million for the nine months ended September 30, 2013, and proceeds from maturities of investment securities held-to-maturity were $0.2 million. Our investment portfolio consists of U.S. government agency securities, small business administration pools, residential agency and commercial mortgage-backed securities, collateralized agency mortgage-backed securities, municipal securities and other debt instruments. At September 30, 2013, our investment portfolio had a net unrealized loss of $6.4 million compared to a $5.1 million net unrealized gain at December 31, 2012 due to movements in market rates. There were no securities with an unrealized loss deemed to be other than temporary at September 30, 2013 or December 31, 2012. Nonmarketable equity securities totaled $6.8 million at September 30, 2013 compared to $7.4 million at December 31, 2012.

At September 30, 2013, we had $0.7 million in federal funds sold, $40.2 million in deposits with the Federal Reserve Bank and $0.05 million in interest-bearing deposits with other FDIC-insured financial institutions. This compares with $46.0 in federal funds sold, $89.7 million in deposits with the Federal Reserve Bank and $11.7 million in interest-bearing deposits at other FDIC-insured financial institutions at December 31, 2012.

Loans

We consider asset quality to be of primary importance, and employ seasoned credit professionals and documented processes to ensure effective oversight of credit approvals and asset quality monitoring. Our internal loan policy is reviewed by our board of directors’ Loan and Risk Committee on an annual basis and our underwriting guidelines are reviewed and updated on a periodic basis. A formal loan review process is maintained both to ensure adherence to lending policies and to ensure accurate loan grading and is reviewed by our board of directors at least annually. Since inception, we have promoted the separation of loan underwriting from the loan production staff through our credit department. Currently, credit administration analysts are responsible for underwriting and assigning proper risk grades for all loans with an individual, or relationship, exposure in excess of $500 thousand. Underwriting is completed on standardized forms including a loan approval form and separate credit memorandum. The credit memorandum includes a summary of the loan's structure and a detailed analysis of loan purpose, borrower strength (including individual and global cash flow worksheets), repayment sources and, when applicable, collateral positions and guarantor strength. The credit memorandum further identifies exceptions to policy and/or regulatory limits, total exposure, internal risk grades and other relevant credit information. Loans are approved or denied by varying levels of signature authority based on total customer relationship exposure, with a minimum requirement, generally, of at least two authorized signatures. A management-level loan committee is responsible for approving all credits in excess of the chief credit officer’s lending authority, which was increased in March 2013 from $1 million to $3 million.

Our loan underwriting policy contains LTV limits that are at or below levels required under regulatory guidance, when such guidance is available, including limitations for non-real estate collateral, such as accounts receivable, inventory and marketable securities. When applicable, we compare LTV with loan-to-cost guidelines and based on loan type and other factors, may limit loan amounts to the lower of the two ratios. We also consider FICO scores and strive to uphold a high standard when extending loans to individuals. LTV limits have been selectively reduced in response to the recent economic cycle. In particular, loans collateralized with 1-4 family properties have seen a reduction in their maximum LTV. We have not underwritten any subprime, hybrid, no-documentation or low-documentation products.

All residential acquisition, construction and development (“AC&D”) loans, whether related to commercial or consumer borrowers, are subject to policies, guidelines and procedures specifically designed to properly identify, monitor and mitigate the risk associated with these loans. Loan officers receive and review a cost budget from the borrower at the time an AC&D loan is originated. Loan draws are monitored against the budgeted line items during the development period in order to identify potential cost overruns. Individual draw requests are verified through review of supporting invoices as well as site inspections performed by an external inspector. Additional periodic site inspections are performed by loan officers at times that do not coincide with draw requests in order to keep abreast of ongoing project conditions. Our exposure to AC&D loans has declined significantly since inception of the Bank and current loan origination is focused on 1 – 4 family residential construction for retail customers, 1 – 4 family residential home construction to selected well-qualified builders as well as owner-occupied commercial build-to-suit properties. Concentrations as a percent of capital are reported to the board of directors on a quarterly basis. Market conditions for AC&D loans continued to improve due to increasing new home sales in our primary markets. As ofSeptember30, 2013, approximately 5% of our AC&D loan portfolio, commercial and consumer, falls under the watch list.

Our second mortgage exposure is primarily attributable to our home equity lines of credit portfolio, which totaled approximately $146 million as ofSeptember30, 2013, of which approximately 65% is secured by second mortgages and approximately 35% is secured by first mortgages.

All loans are assigned an internal risk grade and are reviewed continuously for payment performance and updated through annual portfolio reviews. Loans on the Bank’s watch list are monitored through quarterly watch meetings and monthly impairment meetings. Classified loans are generally managed by a dedicated special asset team who is experienced in various loan rehabilitation and work out practices. Special asset loans are generally managed with a least-loss strategy.

At September 30, 2013, total loans, net of deferred fees and costs, decreased $40.4 million compared to December 31, 2012. This decline was driven by a $49.5 million decline in acquired PCI loans partially offset by a $9.5 million increase in the non-acquired loan portfolio. The composition of the portfolio remained unchanged from December 31, 2012 with commercial loans representing 70% of the total loan portfolio and consumer loans representing 30% of the total loan portfolio at September 30, 2013.

Asset Quality and Allowance for Loan Losses

Our Allowance for Loan Losses Committee (the “Allowance Committee”) is responsible for overseeing our allowance and works with our chief executive officer, senior financial officers, senior risk management officers and the Audit Committee of the board of directors in developing and achieving our allowance methodology and practices. The Company’s allowance for loan loss methodology includes four components – specific reserves, quantitative reserves, qualitative reserves and qualitative reserves on PCI loans.

Since the fourth quarter of 2011, we have introduced certain enhancements to our allowance methodology that, in management’s opinion, provide a better estimate and an allowance for loan losses which better reflects the inherent loss within each loan product. Quantitatively, since the fourth quarter of 2011, we have shifted from historical loss experience of peers to our own actual loss experience and have segregated our loans by product. In the third quarter of 2013, we further segregated the AC&D portfolio by collateral type. These enhancements strengthen the granularity of the allowance methodology and better align with our present origination activities, which are focused on construction rather than development activities. Additionally, we regularly review the look back periods being used for each of our loan products to continue to present an estimated risk and loss consistent with expectations.

Qualitatively, during the second quarter of 2012, we eliminated the use of traditional risk grade factors as a single forward-looking qualitative indicator and instead focus directly on five specific environmental factors. These five factors include portfolio trends, portfolio concentrations, economic and market conditions, changes in lending practices and other factors. During the third quarter of 2013, we applied the qualitative other factors against CRE-investor income producing loans and residential mortgage loans to adjust for inherent risks that, in our judgment, are not adequately reflected in historical loss rates.

The changes and refinements discussed above, in aggregate, did not have a material impact on the estimated allowance at September 30. 2013. The further segregation of the AC&D portfolio, as noted above, resulted in a decrease of approximately $1.2 million from June 30, 2013 and $1.8 million from December 31, 2012. Offsetting this decrease were quantitative increases in the other loan portfolios as a result of extending look back periods which are now contain sufficient build up in loss history. These increases were approximately $800 thousand from June 30, 2013 and $1.6 million from December 31, 2012. The growth in the loan portfolio coupled with the other qualitative factors referenced above resulted in an increase in the qualitative factor of $530 thousand from June 30, 2013 and $313 thousand from December 31, 2012. These changes, in our judgment, produce a non-PCI allowance for loan losses that best reflects the estimate of inherent losses in the loan portfolio at September 30, 2013. Additional information about the four components and our policies and methodology used to estimate the allowance for loan losses are presented in Note 5 – Loans and Allowance for Loan Losses to the Unaudited Financial Statements.

The following table provides a breakdown of the components of our allowance for loan losses by loan segment and their contribution to the allowance at September 30, 2013:

	Specific Reserve					Quantitative Reserve					Qualitative Reserve					PCI Reserve
		$	% of Total Allowance				$	% of Total Allowance				$	% of Total Allowance				$	% of Total Allowance
	(dollars in thousands)
Commercial:
Commercial and industrial	$	16		0.18	%	$	1,343		15.52	%	$	183		2.12	%	$	-		0.00	%
CRE - owner-occupied		24		0.28	%		301		3.48	%		64		0.74	%		-		0.00	%
CRE - investor income producing		202		2.33	%		898		10.38	%		362		4.18	%		-		0.00	%
AC&D		-		0.00	%		2,264		26.17	%		338		3.91	%		-		0.00	%
Other commercial		-		0.00	%		5		0.06	%		1		0.01	%		-		0.00	%
Consumer:									0.00	%
Residential mortgage		182		2.10	%		80		0.92	%		196		2.27	%		6		0.07	%
Home equity lines of credit		509		5.88	%		851		9.84	%		256		2.96	%		-		0.00	%
Residential construction		13		0.15	%		404		4.67	%		59		0.68	%		-		0.00	%
Other loans to individuals		-		0.00	%		84		0.97	%		11		0.13	%		-		0.00	%
	$	946		10.93	%	$	6,230		72.01	%	$	1,470		16.99	%	$	6		0.07	%

The allowance for loan losses is increased by provisions charged to operations and reduced by loans charged off, net of recoveries. The ratio of the allowance for loan losses to total loans was 0.65% and 0.78% at September 30, 2013 and December 31, 2012, respectively. The decrease from December is the result of the reversal of PCI impairment for the nine months ended September 30, 2013 and a reduction in the quantitative and qualitative components of the allowance based on management’s assessment of the inherent loss in the portfolio. The ratio of the adjusted allowance for loan losses to total loans, which includes the remaining acquisition accounting fair market value adjustments for acquired loans, was 3.80% at September 30, 2013 and 4.74% at December 31, 2012. In accordance with GAAP, loans acquired from both Community Capital and Citizens South were adjusted to reflect estimated fair market value at consummation and the associated allowance for loan losses was eliminated. Adjusted allowance for loan losses to loans is a non-GAAP financial measure. For a reconciliation to the most comparable GAAP measure, see “Non-GAAP Financial Measures” above.

While management believes that it uses the best information available to determine the allowance for loan losses, and that its allowance for loan losses is maintained at a level appropriate in light of the risk inherent in our loan portfolio based on an assessment of various factors affecting the loan portfolio, unforeseen market conditions could result in adjustments to the allowance for loan losses, and net income could be significantly affected, if circumstances differ substantially from the assumptions used in making the final determination. The allowance for loan losses to total loans may increase if our loan portfolio deteriorates due to economic conditions or other factors.

We evaluate and estimate off-balance sheet credit exposure at the same time we estimate credit losses for loans by a similar process, including an estimate of commitment usage levels. These estimated credit losses are not recorded as part of the allowance for loan losses, but are recorded to a separate liability account by a charge to income, if material. Loan commitments, unused lines of credit and standby letters of credit make up the off-balance sheet items reviewed for potential credit losses. At both September 30, 2013 and December 31, 2012, $125 thousand was recorded as an other liability for off-balance sheet credit exposure.

Nonperforming Assets

Nonperforming assets, which consist of nonaccrual loans, accruing TDRs, accruing loans for which payments are 90 days or more past due, nonaccrual loans held for sale and OREO, totaled $29.5 million at September 30, 2013 compared to $42.9 million at December 31, 2012. OREO, in particular, declined $10.2 million as a result of successful dispositions. Nonperforming loans, which consist of nonaccrual loans, accruing TDRs and accruing loans for which payments are 90 days or more past due, decreased $3.2 million, or 18%, to $14.7 million, or 1.11% of total loans and OREO at September 30, 2013, compared to $17.8 million, or 1.31% of total loans and OREO at December 31, 2012.

It is our general policy to place a loan on nonaccrual status when it is over 90 days past due and there is reasonable doubt that all principal and interest will be collected. Nonaccrual loans decreased $3.6 million, or 35%, in the first nine months of 2013 from $10.4 million at December 31, 2012. Nonaccrual TDRs are included in the nonaccrual loan amounts noted. At September 30, 2013, nonaccrual TDR loans were $71 thousand and had no recorded allowance. At December 31, 2012, nonaccrual TDR loans were $2.8 million and had no recorded allowance. Accruing TDRs totaled $7.5 million and $7.4 million at September 30, 2013 and December 31, 2012, respectively.

We grade loans with an internal risk grade scale of 10 through 90, with grades 10 through 50 representing “pass” loans, grade 60 representing “special mention” and grades 70 and higher representing “classified” credit grades, respectively. Loans are reviewed on a regular basis internally, and at least annually by an external loan review group, to ensure loans are graded appropriately. Credits are reviewed for past due trends, declining cash flows, significant decline in collateral value, weakened guarantor financial strength, management concerns, market conditions and other factors that could jeopardize the repayment performance of the loan. Documentation deficiencies including collateral perfection and outdated or inadequate financial information are also considered in grading loans.

All loans graded 60 or worse are included on our list of “watch loans,” which represent potential problem loans, and are updated and reported to both management and the Loan and Risk Committee of the board of directors quarterly. Additionally, the watch list committee may review other loans with more favorable ratings if there are concerns that the loan may become a problem. Impairment analyses are performed on all loans graded “substandard” (risk grade of 70 or worse) and generally greater than $150 thousand as well as selected other loans as deemed appropriate. At September 30, 2013, we maintained watch loans totaling $33.3 million compared to $44.4 million at December 31, 2012. Approximately $9.3 million and $9.0 million of the watch loans at September 30, 2013 and December 31, 2012, respectively, were acquired loans. The future level of watch loans cannot be predicted, but rather will be determined by several factors, including overall economic conditions in the markets served.

At September 30, 2013, OREO totaled $14.9 million, all of which is recorded at values based on our most recent appraisals. Included in that total is $6.2 million of OREO covered under FDIC loss share agreements assumed by the Bank in connection with the Citizens South merger. At December 31, 2012, OREO totaled $25.1 million, all of which is recorded at values based on our most recent appraisals. Included in that total is $6.6 million of OREO covered under the FDIC loss share agreements.

Deposits and Other Borrowings

We offer a broad range of deposit instruments, including personal and business checking accounts, individual retirement accounts, business and personal money market accounts and certificates of deposit at competitive interest rates. Deposit account terms vary according to the minimum balance required, the time periods the funds must remain on deposit and the interest rate, among other factors. We regularly evaluate the internal cost of funds, survey rates offered by competing institutions, review cash flow requirements for lending and liquidity and execute rate changes when deemed appropriate.

Total deposits at September 30, 2013 were $1.56 billion, representing a decrease of $76.0 million, or 4.7%, from December 31, 2012. Noninterest bearing demand deposits increased $18.6 million, or 7.6%, and represented 17% of total deposits at September 30, 2013. Money market, NOW and savings deposits decreased $28.9 million, or 3.8%, primarily as a result of a decrease in rates paid to depositors during the first nine months of 2013. Non-brokered time deposits decreased $50.6 million, or 9.8%. Finally, brokered deposits decreased $14.5 million, or 13.0%, due to management’s decision to keep rates unchanged, and as management elected not to renew certain maturing certificates.

The following is a summary of deposits at September 30, 2013 and December 31, 2012:

	September 30,		December 31,
	2013		2012
	(dollars in thousands)
Noninterest bearing demand deposits	$	262,114	$	243,495
Interest-bearing demand deposits		294,180		323,037
Money market deposits		385,898		388,809
Savings		49,130		46,917
Brokered deposits		96,585		111,049
Time deposits		468,056		518,697
Total deposits	$	1,555,963	$	1,632,004

Total borrowings decreased $2.1 million, or 2.0%, to $99.6 million at September 30, 2013 compared to $101.7 million at December 31, 2012. Total borrowings at December 31, 2012 included $15.0 million of short-term FHLB advances used for year-end liquidity needs. These borrowings were repaid in January 2013. Borrowings at September 30, 2013 include $15.0 million (after acquisition accounting fair market value adjustments) of Tier 1-eligible subordinated debt and $6.9 million of Tier 2-eligible subordinated debt.

Results of Operations

The following table summarizes components of net income and the changes in those components for the three and nine months ended September 30, 2013 and 2012:

Condensed Consolidated Statements of Income

	Three Months Ended September 30,											Nine Months Ended September 30,
	2013			2012		Change						2013			2012		Change
	(Unaudited)						$		%			(Unaudited)						$		%
	(Dollars in thousands)											(Dollars in thousands)
Gross interest income	$	19,736		$	11,431	$	8,305			72.7	%	$	59,203		$	36,471	$	22,732			62.3	%
Gross interest expense		1,422			1,460		(38	)		-2.6	%		4,482			4,679		(197	)		-4.2	%
Net interest income		18,314			9,971		8,343			83.7	%		54,721			31,792		22,929			72.1	%

Provision for loan losses		(419	)		7		(426	)		-6085.7	%		(35	)		1,029		(1,064	)		-103.4	%

Noninterest income		3,257			3,318		(61	)		-1.8	%		10,683			7,703		2,980			38.7	%
Noninterest expense		15,670			12,203		3,467			28.4	%		48,375			33,910		14,465			42.7	%
Net income before taxes		6,320			1,079		5,241			485.7	%		17,064			4,556		12,508			274.5	%

Income tax expense		2,106			459		1,647			358.8	%		5,798			1,535		4,263			277.7	%

Net income		4,214			620		3,594			579.7	%		11,266			3,021		8,245			272.9	%

Preferred dividends		-			-		-			100.0	%		353			-		353			100.0	%

Net income to common shareholders	$	4,214		$	620	$	3,594			579.7	%	$	10,913		$	3,021	$	7,892			261.2	%

Net Income to common shareholders.Net income to common shareholders for the three months ended September 30, 2013 was $4.2 million compared to $0.6 million for the same period in 2012. Net income available to common shareholders for the nine months ended September 30, 2013, was $10.9 million compared to $3.0 million for the same period in 2012. The increases in net income in both the three and nine month periods were the result of increased earning assets associated with the merger with Citizens South, combined with continued organic growth, accelerated accretion of income associated with the acquired loan portfolio and reduced provision expenses.

Annualized return on average assets improved during the nine-month period ended September 30, 2013 to 0.74% from 0.36% for the same period in 2012. Annualized return on average equity also improved from 2.08% for the nine-month period ended September 30, 2012, to 5.21% for the same period in 2013.

Net Interest Income.Our largest source of earnings is net interest income, which is the difference between interest income on interest-earning assets and interest paid on deposits and other interest-bearing liabilities. The primary factors that affect net interest income are changes in volume and yields of earning assets and interest-bearing liabilities, which are affected, in part, by management's responses to changes in interest rates through asset/liability management. Net interest income increased to $18.3 million for the three-month period ended September 30, 2013 from $10.0 million for the same period in 2012. During the nine-month period ended September 30, 2013, net interest income was $54.7 million as compared to $31.8 million in 2012, an increase of $22.9 million, or 72.1%. These increases are driven by the merger with Citizens South on October 1, 2012.

Net interest income for the three-month and nine-month periods ended September 30, 2013 also includes $0.5 million and $1.1 million, respectively, of accelerated accretion from credit and interest rate marks associated with acquisition accounting adjustments for purchased performing loans, as accounted for under the contractual cash flow method of accounting. The three-month and nine-month periods ended September 30, 2012 include $0.3 million and $1.7 million, respectively, of accelerated accretion. This accelerated accretion, which was not anticipated at the time of the acquisition, resulted from a combination of (i) borrowers repaying loans faster than required by their contractual terms; and (ii) customer driven restructuring related to loan rates and/or terms which effectively result in a new loan under the contractual cash flow method of accounting. In both instances, the remaining acquisition accounting fair value marks associated with the loan are fully accreted into interest income.

Our net interest margin increased to 4.16% in the three-month period ended September 30, 2013, from 3.97% in the corresponding period in 2012. The increase in net interest margin reflects the inclusion of the Citizens South loan portfolio, increased accelerated accretion from credit and interest rate marks associated with acquisition accounting adjustments and reduced funding costs due, primarily, to lower pricing on interest bearing deposits. Our net interest margin decreased 4.20% in the nine-month period ended September 30, 2013 from 4.21% in the corresponding period in 2012. This decrease in net interest margin reflects the decreased accelerated accretion from credit and interest rate marks associated with acquisition accounting adjustments.

Our adjusted net interest margin, which excludes the accelerated accretion discussed above, for the three-month periods ended September 30, 2013 and 2012 was 4.04% and 3.98%, respectively. For the nine-month periods ended September 30, 2013 and 2012, our adjusted net interest margin was 4.12% and 3.98%, respectively. Adjusted net interest margin is a non-GAAP financial measure. For a reconciliation to the most comparable GAAP measure, see “Non-GAAP Financial Measures” above.

Total average interest-earning assets increased by $749.2 million, or 75%, to $1.7 billion for the three months ended September 30, 2013 from $1.0 billion for the same period in the previous year. Total average interest-earning assets increased by $732.6 million, or 73%, to $1.7 billion for the nine months ended September 30, 2013 from $1.0 billion for the same period in the previous year. This increase was driven primarily by the addition of Citizens South assets following the merger on October 1, 2012.

Average balances of total interest-bearing liabilities increased in the three-month period ended September 30, 2013, with average total interest-bearing deposit balances increasing by $664.7 million, or 90%, to $1.4 billion from $738.2 million for the same period in 2012. Average brokered deposits for the three months ended

September 30, 2013 decreased by $38.9 million from the corresponding period in 2012. Average interest-bearing liabilities increased $657.8 million, or 87%, in the first nine months of 2013 from $758.6 million for the same period in 2012 to $1.4 billion. Average brokered deposits for the nine months ended September 30, 2013 decreased by $40.7 million from the corresponding period in 2012. The increases in interest-bearing deposits are a result of the acquisition of Citizens South; the decreases in brokered deposits is a function of management electing not to renew maturing certificates in an effort to reduce reliance on brokered deposits.

The following tables summarize net interest income and average yields and rates paid for the periods indicated:

Average Balance Sheets and Net Interest Analysis

	For the Three Months Ended September 30,
	2013								2012
	Average			Income/		Yield/			Average			Income/		Yield/
	Balance			Expense		Rate			Balance			Expense		Rate
	(dollars in thousands)
Assets
Interest-earning assets:
Loans, including fees (1)(2)	$	1,319,026		$	17,970		5.41	%	$	719,397		$	10,346		5.72	%
Federal funds sold		532			-		0.00	%		26,374			16		0.24	%
Taxable investment securities		327,224			1,494		1.83	%		202,152			826		1.63	%
Tax-exempt investment securities		16,592			187		4.51	%		17,774			187		4.21	%
Nonmarketable equity securities		5,918			37		2.48	%		5,025			22		1.74	%
Interest on deposits at banks		78,594			48		0.24	%		27,947			34		0.48	%

Total interest-earning assets		1,747,886			19,736		4.48	%		998,669			11,431		4.55	%

Allowance for loan losses		(10,295	)							(9,586	)
Cash and due from banks		12,730								17,902
Premises and equipment		56,842								24,986
Other assets		160,741								80,951

Total assets	$	1,967,904							$	1,112,922

Liabilities and shareholders' equity
Interest-bearing liabilities:
Interest-bearing demand	$	287,096		$	59		0.08	%	$	83,813		$	61		0.29	%
Savings and money market		463,309			340		0.29	%		249,760			278		0.44	%
Time deposits - core		477,004			253		0.21	%		199,843			301		0.60	%
Time deposits - brokered		97,086			202		0.83	%		135,950			331		0.97	%
Total interest-bearing deposits		1,324,495			854		0.26	%		669,366			971		0.58	%
Federal Home Loan Bank advances		55,217			137		0.98	%		55,000			149		1.08	%
Other borrowings		23,257			431		7.35	%		13,883			340		9.74	%
Total borrowed funds		78,474			568		2.87	%		68,883			489		2.82	%

Total interest-bearing liabilities		1,402,969			1,422		0.40	%		738,249			1,460		0.79	%

Net interest rate spread					18,314		4.08	%					9,971		3.77	%

Noninterest-bearing demand deposits		261,494								165,050
Other liabilities		24,304								13,610
Shareholders' equity		279,137								196,013

Total liabilities and shareholders' equity	$	1,967,904							$	1,112,922

Net interest margin							4.16	%							3.97	%

(1) Average loan balances include nonaccrual loans.

(2) Interest income and yields include accretion from acquisition accounting adjustments associated with acquired loans.

Average Balance Sheets and Net Interest Analysis

	For the Nine Months Ended September 30,
	2013								2012
	Average			Income/		Yield/			Average			Income/		Yield/
	Balance			Expense		Rate			Balance			Expense		Rate
	(dollars in thousands)
Assets
Interest-earning assets:
Loans, including fees (1)(2)	$	1,334,216		$	54,916		5.50	%	$	731,617		$	32,873		6.00	%
Federal funds sold		19,481			24		0.16	%		21,992			38		0.23	%
Taxable investment securities		285,933			3,429		1.60	%		207,305			2,814		1.81	%
Tax-exempt investment securities		17,353			571		4.39	%		17,764			559		4.20	%
Nonmarketable equity securities		6,154			109		2.37	%		6,733			114		2.26	%
Other interest-earning assets		77,775			154		0.26	%		22,889			73		0.43	%

Total interest-earning assets		1,740,912			59,203		4.55	%		1,008,300			36,471		4.83	%

Allowance for loan losses		(11,244	)							(9,518	)
Cash and due from banks		18,990								16,349
Premises and equipment		57,172								24,656
Other assets		165,363								83,820

Total assets	$	1,971,193							$	1,123,607

Liabilities and shareholders' equity
Interest-bearing liabilities:
Interest-bearing demand	$	292,261		$	212		0.10	%	$	82,108		$	195		0.32	%
Savings and money market		448,237			974		0.29	%		245,633			804		0.44	%
Time deposits - core		492,423			880		0.24	%		217,660			1,133		0.70	%
Time deposits - brokered		102,325			710		0.93	%		142,990			1,040		0.97	%
Total interest-bearing deposits		1,335,246			2,776		0.28	%		688,391			3,172		0.62	%
Federal Home Loan Bank advances		55,128			411		1.00	%		56,095			457		1.09	%
Other borrowings		26,045			1,295		6.65	%		14,143			1,050		9.92	%
Total borrowed funds		81,173			1,706		2.81	%		70,238			1,507		2.87	%

Total interest-bearing liabilities		1,416,419			4,482		0.42	%		758,629			4,679		0.82	%

Net interest rate spread					54,721		4.12	%					31,792		4.01	%

Noninterest-bearing demand deposits		252,793								156,889
Other liabilities		22,019								13,830
Shareholders' equity		279,962								194,259

Total liabilities and shareholders' equity	$	1,971,193							$	1,123,607

Net interest margin							4.20	%							4.21	%

Provision for Loan Losses. Our provision for loan losses decreased $426 thousand, to ($419) thousand during the three months ended September 30, 2013, from $7 thousand during the corresponding period in 2012. For the nine months ended September 30, 2013, our provision decreased $1.1million to ($35) thousand from $1.0 million during the corresponding period in 2012. The decrease in provision, in the three and nine month periods, is a result of both a reduction in outstanding loans and improvement in the quality of our loans and in the nine month period, a $297 thousand benefit attributable to FDIC loss share agreements assumed from Citizens South caused by an increase in expected loss in those acquired loans. Generally, these additional losses are reflected as a provision for loan losses, and offset with an increase in the FDIC indemnification asset for those acquired loans covered by FDIC loss share agreements.

Included in the provision for loan losses for the three months ended September 30, 2013 was net impairment reversal of $0.4 million and for the nine months ended September 30, 2013 included net impairment charges of $0.4 million, associated with PCI loan pools. For the three and nine months ended September 30, 2012, a net impairment charge of $0.2 million was recognized.

We reported net charge-offs of $1.8 million during the three months ended September 30, 2013 compared to $0.2 million during the corresponding period in 2012. Year to date net charge-offs in 2013 were $2.2 million compared to $1.9 million during the first nine months of 2012. We reported adjusted net charge-offs, which exclude net charge-offs related to PCI loans, of $817 thousand and $851 thousand for the three and nine months ended September 30, 2013, respectively. There were no net charge-offs related to PCI loans for the respective periods in 2012. Adjusted net charge-offs is a non-GAAP financial measure. For a reconciliation to the most comparable GAAP measure, see “Non-GAAP Financial Measures” above.

Noninterest Income. The following table presents components of noninterest income for the three and nine months ended September 30, 2013 and 2012:

Noninterest Income

	Three months ended September 30,										Nine months ended September 30,
	2013		2012		Change						2013		2012		Change
	(Unaudited)					$		%			(Unaudited)					$		%
	(Dollars in thousands)
Service charges on deposit accounts	$	637	$	324	$	313			96.6	%	$	2,016	$	935	$	1,081			115.6	%
Income from fiduciary activities		795		605		190			31.4	%		2,041		1,700		341			20.1	%
Commissions and fees from investment brokerage		115		61		54			88.5	%		308		226		82			36.3	%
Gain on sale of securities available for sale		-		989		(989	)		-100.0	%		104		1,478		(1,374	)		-93.0	%
Bankcard services income		639		174		465			267.2	%		1,818		560		1,258			224.6	%
Mortgage banking income		401		662		(261	)		-39.4	%		2,346		1,663		683			41.1	%
Income from bank-owned life insurance		537		294		243			82.7	%		1,447		813		634			78.0	%
Other noninterest income		133		209		(76	)		-36.4	%		603		328		275			83.8	%
Total noninterest income	$	3,257	$	3,318	$	(61	)		-1.8	%	$	10,683	$	7,703	$	2,980			38.7	%

Noninterest income was flat for the three months ended September 30, 2013 compared to the three months ended September 30, 2012. Gains on sales of securities available-for-sale were $1.0 million during the three months ended September 30, 2012, compared to no gains in the three months ended September 30, 2013. Income on mortgage banking activities decreased $0.3 million, or 39.4% to $0.4 million for the three months ended September 30, 2013, from $0.7 million for the three months ended September 30, 2012. Included in the decrease is a reduction in revenue recognition associated with ASC 815-10-S99-1(formerly Staff Accounting Bulletin 109) of $0.3 million for the three months ended September 30, 2013, which is due to a decrease in the pipeline of mortgage loans. Also during the three months ended September 30, 2013, the results included an increase in service charges on deposit accounts associated with expanded retail and commercial banking activities. Income from fiduciary activities associated with new asset management, investment brokerage and trust services increased $0.2 million, or 31.4%, for the three months ended September 30, 2013 when compared to the comparable period in 2012. In addition, income from bank-owned life insurance increased in both periods primarily as a result of the bank-owned life insurance acquired from Citizens South.

Noninterest income increased $3.0 million to $10.7 million for the nine months ended September 30, 2013 from $7.7 million for the nine months ended September 30, 2012 primarily as a result of the merger with Citizens South in October 2012. Mortgage banking income increased $0.7 million, or 41.1%, for the nine months ended September 30, 2013, when compared to the nine months ended September 30, 2012, and includes a reduction in revenue recognition associated with ASC 815-10-S99-1(formerly Staff Accounting Bulletin 109)of $0.2 million in the nine months ended September 30, 2013, which is a result of the decrease in the pipeline of mortgage loans.

Income from fiduciary activities increased $0.3 million, or 20.1%, for the nine months ended September 30, 2013, when compared to the comparable period in 2012. Following a review of wealth management activities, the Company has determined to exit the custody business. The transition is expected to be completed by mid-2014. Resources currently focused on the custody business are expected to be redirected to the Company's core asset management business. We expect that this decision will have a negative impact on existing income from fiduciary activities of approximately $0.2 million per quarter.

Increases among many of the categories are the same as listed above for the three-month comparison. Gains on sales of securities available-for-sale decreased $1.4 million from $1.5 million for the nine months ended September 30, 2012, to $0.1 million for the nine months ended September 30, 2013.

Noninterest Expense. The level of noninterest expense substantially affects our profitability. Total noninterest expense was $15.7 million for the three months ended September 30, 2013, representing an increase of 28.5% from $12.2 million for the corresponding period in 2012. Total noninterest expense was $48.4 million for the nine months ended September 30, 2013, an increase of 42.7% from $14.5 million for the corresponding period in 2012. The increase in both periods was due primarily to the inclusion of results from the Citizens South merger.

Excluding merger-related expenses of $0.2 million and $1.4 million for the three-month periods ended September 30, 2013 and 2012, respectively, adjusted noninterest expense increased $4.7 million for the three months ended September 30, 2013 compared to the corresponding period in 2012. Excluding merger-related expenses of $1.8 million and $2.7 million for the nine-month periods ended September 30, 2013 and 2012, respectively, adjusted noninterest expense increased $15.4 million for the nine months ended September 30, 2013 compared to the corresponding period in 2012. Adjusted noninterest expense, which excludes merger-related expenses, is a non-GAAP financial measure. For a reconciliation to the most comparable GAAP measure, see “Non-GAAP Financial Measures” above.

The following table presents components of noninterest expense for the three and nine months ended September 30, 2013 and 2012:

Noninterest Expense

	Three months ended September 30,										Nine months ended September 30,
	2013		2012		Change						2013			2012		Change
	(Unaudited)					$		%			(Unaudited)						$		%
	(Dollars in thousands)
Salaries and employee benefits	$	8,606	$	6,314	$	2,292			36.3	%	$	26,185		$	18,303	$	7,882			43.1	%
Occupancy and equipment		1,861		928		933			100.5	%		5,750			2,712		3,038			112.0	%
Advertising and promotion		186		144		42			29.2	%		556			413		143			34.6	%
Legal and professional fees		732		1,181		(449	)		-38.0	%		2,486			2,113		373			17.7	%
Deposit charges and FDIC insurance		372		261		111			42.5	%		1,268			777		491			63.2	%
Data processing and outside service fees		1,268		784		484			61.7	%		4,561			2,772		1,789			64.5	%
Communication fees		432		198		234			118.2	%		1,312			626		686			109.6	%
Core deposit intangible amortization		257		102		155			152.0	%		772			307		465			151.5	%
Net cost (earnings) of operation of other real estate owned		142		964		(822	)		-85.3	%		(323	)		2,295		(2,618	)		-114.1	%
Loan and collection expense		556		434		122			28.1	%		1,560			974		586			60.2	%
Postage and supplies		188		112		76			67.9	%		815			431		384			89.1	%
Other tax expense		128		70		58			82.9	%		431			208		223			107.2	%
Other noninterest expense		942		711		231			32.5	%		3,002			1,979		1,023			51.7	%
Total noninterest expense	$	15,670	$	12,203	$	3,467			28.4	%	$	48,375		$	33,910	$	14,465			42.7	%

As a result of the merger with Citizens South on October 1, 2012, expenses in almost all categories increased for both the three and nine-month periods ended September 30, 2013. The following discussion highlights specific areas but is not intended to represent all variances.

Salaries and employee benefits expenses increased $2.3 million, or 36.3%, to $8.6 million in the three months ended September 30, 2013 compared to $6.3 million in the comparable period of 2012. Salaries and employee benefits expenses increased $7.9 million, or 43.1%, to $26.2 million in the nine months ended September 30, 2013 compared to $18.3 million in the comparable period of 2012. These increases are primarily due to the increase in number of employees resulting from the Citizens South merger.

Occupancy and equipment expenses increased $0.9 million, or 100.5%, to $1.9 million in the third quarter of 2013, compared to $0.9 million in the comparable period of 2012. Occupancy and equipment expenses increased $3.0 million, or 112.0%, to $5.8 million in the first nine months of 2013, compared to $2.7 million in the comparable period of 2012. The increase is primarily due to the acquisition of property in connection with the merger with Citizens South.

Legal and professional fees decreased $0.4 million, or 38%, to $0.7 million in the third quarter of 2013, compared to $1.2 million in the comparable period of 2012. Legal and professional fees increased $0.4 million, or 17.7%, to $2.5 million in the first nine months of 2013, compared to $2.1 million in the comparable period of 2012. Merger-related expenses included in these results for the third quarters of 2013 and 2012 were $0.1 million and $0.9 million, respectively. Merger-related expenses included in the results for the nine months ended September 30, 2013 and 2012 were $0.6 million and $1.4 million, respectively. The decrease is primarily due to fees associated with the mergers with Citizens South and Community Capital related to merger integration as well as core systems integration in 2012.

Net cost of operation of other real estate during the third quarter of 2013 decreased $0.8 million, or 85.3% to $0.1 million, from $0.9 million during the comparable period of 2012. We realized a net gain on operation of other real estate during the nine months ended September 30, 2013 of $0.3 million compared to a net cost of $2.3 million for the comparable period in 2012. We have sold over 219 properties during the first nine months of 2013 at a net gain of approximately $1.7 million compared to 64 properties in the first nine months of 2012 at a net gain of approximately $0.1 million.

Income Taxes. We generate non-taxable income from tax-exempt investment securities and loans as well as bank-owned life insurance. Accordingly, the level of such income in relation to income before taxes affects our effective tax rate. For the three months ended September 30, 2013, we recognized income tax expense of $2.1 million compared to an income tax expense of $0.5 million for the same period in 2012. The effective tax rate for the three months ended September 30, 2013 is 33.40% compared to 42.542% for the same period in 2012. For the nine months ended September 30, 2013, we recognized income tax expense of $5.8 million compared to an income tax expense of $1.5 million for the same period in 2012. The effective tax rate for the nine months ended September 30, 2013 is 34.01% compared to 33.69% for the same period in 2012. The change in the effective tax rate was due to the amount of tax-exempt income and nondeductible merger-related expenses relative to the size of pre-tax income. A tax benefit is recorded if non-taxable income exceeds income before taxes, resulting in a reduction of total income subject to income taxes.

Liquidity and Capital Resources

Liquidity refers to the ability to manage future cash flows to meet the needs of depositors and borrowers and to fund operations. We strive to maintain sufficient liquidity to fund future loan demand and to satisfy fluctuations in deposit levels. This is achieved primarily in the form of available lines of credit from various correspondent banks, the FHLB, the Federal Reserve Discount Window and through our investment portfolio. In addition, we may have short-term investments at our primary correspondent bank in the form of Federal funds sold. Liquidity is governed by an asset/liability policy approved by the board of directors and administered by an internal Asset-Liability Committee (the “ALCO”). The ALCO reports monthly asset/liability-related matters to the Loan and Risk Committee of the board of directors.

Our internal liquidity ratio (total liquid assets, or cash and cash equivalents, divided by deposits and short-term liabilities) at September 30, 2013 was 19.8% compared to 22.0% at December 31, 2012. Both ratios exceeded our minimum internal target of 10%. In addition, at September 30, 2013, we had $243.8 million of credit available from the FHLB, $157.3 million from the Federal Reserve Discount Window, and available lines totaling $70.0 million from correspondent banks.

At September 30, 2013, we had $264.9 million of pre-approved but unused lines of credit, $3.8 million of standby letters of credit and $4.2 million of commercial letters of credit. In management’s opinion, these commitments represent no more than normal lending risk to us and will be funded from normal sources of liquidity.

Our capital position is reflected in our shareholders’ equity, subject to certain adjustments for regulatory purposes. Shareholders’ equity, or capital, is a measure of our net worth, soundness and viability. We continue to remain in a well-capitalized position. Shareholders’ equity on September 30, 2013 was $259.8 million compared to the December 31, 2012 balance of $275.7 million. The $15.9 million decrease was the result of the redemption of $20.5 million of Series C Preferred Stock, in addition to a $7.2 million decrease in accumulated other comprehensive income from unrealized securities losses and $353 thousand of preferred stock dividends. We also initiated a quarterly cash dividend during the third quarter, resulting in $0.9 million in common dividends being paid during the quarter. These decreases were offset by net income before preferred dividends for the nine months ended September 30, 2013 of $11.3 million, $1.5 million of net share-based compensation expense, and $0.3 million in proceeds from the exercise of stock options.

Risk-based capital regulations adopted by the Federal Reserve Board and the FDIC require bank holding companies and banks to achieve and maintain specified ratios of capital to risk-weighted assets. The risk based capital rules are designed to measure “Tier 1” capital (currently consisting generally of common shareholders’ equity, a limited amount of qualifying perpetual preferred stock and trust preferred securities, and minority interests in consolidated subsidiaries, net of goodwill and other intangible assets, deferred tax assets in excess of certain thresholds and certain other items) and total capital (consisting of Tier 1 capital and Tier 2 capital, which generally includes certain preferred stock, mandatorily convertible debt securities and term subordinated debt) in relation to the credit risk of both on- and off-balance sheet items. Under the existing guidelines, one of four risk weights is applied to the different on-balance sheet items. Off-balance sheet items, such as loan commitments, are also subject to risk weighting after conversion to balance sheet equivalent amounts. Under current regulations, all banks must maintain a minimum total capital to total risk weighted assets ratio of 8.00%, at least half of which must be in the form of core, or Tier 1, capital. These guidelines also specify that banks that are experiencing internal growth or making acquisitions will be expected to maintain capital positions substantially above the minimum supervisory levels. At September 30, 2013, the Company and the Bank both satisfied their minimum regulatory capital requirements and each was “well capitalized” within the meaning of Federal regulatory requirements.

Capital Ratios

							Regulatory Minimums
										To Be Well
							For Capital			Capitalized Under
							Adequacy			Prompt Corrective
							Purposes			Actions Provisions
	September 30,			December 31,
	2013			2012			Ratio			Ratio

Park Sterling Corporation
Tier 1 capital	$	211,121		$	219,060
Tier 2 capital		15,546			17,611

Total capital	$	226,667		$	236,671

Risk-weighted assets	$	1,439,574		$	1,451,532

Average assets for Tier 1	$	1,900,990		$	1,947,156

Risk-based capital ratios
Tier 1 capital		14.67	%		15.09	%		4.00	%		6.00	%
Total capital		15.75	%		16.30	%		8.00	%		10.00	%
Tier 1 leverage ratio		11.11	%		11.25	%		4.00	%		5.00	%

Park Sterling Bank
Tier 1 capital	$	185,960		$	193,018
Tier 2 capital		15,546			17,611

Total capital	$	201,506		$	210,629

Risk-weighted assets	$	1,422,597		$	1,446,233

Average assets for Tier 1	$	1,882,928		$	1,913,420

Risk-based capital ratios
Tier 1 capital		13.07	%		13.35	%		4.00	%		6.00	%
Total capital		14.16	%		14.56	%		8.00	%		10.00	%
Tier 1 leverage ratio		9.88	%		10.09	%		4.00	%		5.00	%

In connection with the Bank’s public offering in August 2010, the Bank had committed to its regulators to maintain a Tier 1 leverage ratio, calculated as Tier 1 capital to average assets, of at least 10.00% for three years. This commitment expired on August 18, 2013.

In July 2013, the federal banking regulatory agencies approved final regulatory capital rules applicable to U.S. banking organizations (the “Final Rules”) which will replace the existing general risk-based capital and related rules, broadly revising the basic definitions and elements of regulatory capital and making substantial changes to the credit risk weightings for banking and trading book assets. The new regulatory capital rules establish the benchmark capital rules and capital floors that are generally applicable to U.S. banks under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and make the capital rules consistent with heightened international capital standards known as Basel III. These new capital standards will apply to all banks, regardless of size, and to all bank holding companies with consolidated assets greater than $500 million.

Under the Final Rules, tier 1 capital will consist of two components: common equity tier 1 capital and additional tier 1 capital. Total tier 1 capital, plus tier 2 capital, will constitute total risk-based capital. The required minimum ratios will be (i) common equity tier 1 risk-based capital ratio of 4.5%; (ii) tier 1 risk-based capital ratio of 6%; (iii) total risk-based capital ratio of 8%; and (iv) tier 1 leverage ratio of average consolidated assets of 4%. Advanced approaches banking organizations (those organizations with either total assets of $250 billion or more, or with foreign exposure of $10 billion or more) also will be subject to a supplementary leverage ratio that incorporates a broader set of exposures in the denominator. The Final Rules also incorporate these changes in regulatory capital into the prompt corrective action framework, under which the thresholds for “adequately capitalized” banking organizations will be equal to the new minimum capital requirements. Under this framework, in order to be considered “well capitalized”, insured depository institutions will be required to maintain a tier 1 leverage ratio of 5%, a common equity tier 1 risk-based capital measure of 6.5%, a tier 1 risked-based capital ratio of 8% and a total risk-based capital ratio of 10%.

The Final Rules also provide that all covered banking organizations must maintain a new capital conservation buffer of common equity tier 1 capital in an amount greater than 2.5% of total risk-weighted assets to avoid being subject to limitations on capital distributions and discretionary bonus payments to executive officers. Advanced approaches organizations also will be subject to a countercyclical capital buffer. Failure to satisfy the capital buffer requirements would result in increasingly stringent limitations on various types of capital distributions, including dividends, share buybacks and discretionary payments on tier 1 instruments, and discretionary bonus payments.

The Final Rules reflect changes from the June 2012 proposals that minimize the impact of the revised capital regulations on community banks. In particular, banking organizations with less than $15 billion in total assets (including the Company and the Bank) will not be subject to the phase-out of non-qualifying tier 1 capital instruments, such as trust preferred securities (“TruPS”), that were issued and outstanding prior to May 19, 2010. In addition, non-advanced approaches banking organizations will have a one-time option to exclude certain components of accumulated other comprehensive income from inclusion in regulatory capital, comparable to treatment under the current capital rules. The Final Rules also retain the existing treatment for residential mortgage exposures in the current risk-based capital rules, rather than adopt the proposed changes that would have required banking organizations to determine the risk weights based on a complex categorization and loan-to-value assessment.

Although the Final Rules alleviate some of the concerns of community banks with the capital standards as originally proposed, the new capital standards will impose significant changes on the definition of capital, including the inability to include instruments such as TruPS in tier 1 capital going forward and new constraints on the inclusion of minority interests, mortgage servicing assets, deferred tax assets and certain investments in the capital of unconsolidated financial institutions. In addition, the Final Rules increase the risk-weights of various assets, including certain high volatility commercial real estate and past due asset exposures.

Non-advanced approaches banking organizations, including the Company and the Bank, must begin compliance with the new minimum capital ratios and the standardized approach for risk-weighted assets as of January 1, 2015, and the revised definitions of regulatory capital and the revised regulatory capital deductions and adjustments will be phased in over time for such organizations beginning as of that date. The capital conservation buffer will be phased in for all banking organizations beginning January 1, 2016.

Management is currently assessing the impact of the Final Rules to its regulatory capital ratios but does not expect these changes to result in a material difference.

Contractual Obligations, Commitments and Off-Balance Sheet Arrangements

In the ordinary course of operations, we enter into certain contractual obligations. Such obligations include the funding of operations through debt issuances as well as leases for premises and equipment.

Information about our off-balance sheet risk exposure is presented in Note 16 of the 2012 Audited Financial Statements. As part of ongoing business, we have not participated in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as special purpose entities (“SPE”s), which generally are established for facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of September 30, 2013, we were not involved in any unconsolidated SPE transactions.

Impact of Inflation and Changing Prices

As a financial institution, we have an asset and liability make-up that is distinctly different from that of an entity with substantial investments in plant and inventory because the major portions of a commercial bank’s assets are monetary in nature. As a result, our performance may be significantly influenced by changes in interest rates. Although the banking industry and we are more affected by changes in interest rates than by inflation in the prices of goods and services, inflation is a factor that may influence interest rates. However, the frequency and magnitude of interest rate fluctuations do not necessarily coincide with changes in the general inflation rate. Inflation does affect operating expenses in that personnel expenses and the cost of supplies and outside services tend to increase more during periods of high inflation.

Interest Rate Sensitivity

The ALCO actively evaluates and manages interest rate risk using a process developed by the Company. The ALCO is also responsible for approving our asset/liability management policies, overseeing the formulation and implementation of strategies to improve balance sheet positioning and earnings, and reviewing our interest rate sensitivity position.

The primary measures that management uses to evaluate short-term interest rate risk include (i) cumulative gap summary, which measures potential changes in cash flows should interest rates rise or fall; (ii) net interest income at risk, which projects the impact of different interest rate scenarios on net interest income over one-year and two-year time horizons; and (iii) economic value of equity at risk, which measures potential long-term risk in the balance sheet by valuing our assets and liabilities at “market” under different interest rate scenarios.

These measures have historically been calculated under a simulation model prepared by an independent correspondent bank assuming incremental 100 basis point shocks (or immediate shifts) in interest rates up to a total increase or decrease of 300 basis points. These simulations estimate the impact that various changes in the overall level of interest rates over a one- and two-year time horizon have on net interest income. The results help us develop strategies for managing exposure to interest rate risk. Like any forecasting technique, interest rate simulation modeling is based on a large number of assumptions. In this case, the assumptions relate primarily to loan and deposit growth, asset and liability prepayments and interest rates. We believe that the assumptions are reasonable, both individually and in the aggregate. Nevertheless, the simulation modeling process produces only a sophisticated estimate, not a precise calculation of exposure. The overall interest rate risk management process is subject to annual review by an outside professional services firm to ascertain its effectiveness as required by Federal regulations.

Our current guidelines for risk management call for preventive measures if a 300 basis point shock, or immediate increase or decrease, would affect net interest income by more than 22.50% over the next twelve months. We currently operate well within these guidelines. As of September 30, 2013, based on the results of this simulation model, which assumed a static environment with no contemplated asset growth or changes in our balance sheet management strategies, we could expect net interest income to decrease by approximately 8.8% over twelve months if short-term interest rates immediately decreased by 300 basis points, which is unlikely based on current rate levels. This decrease results, in part, from our cost of interest-bearing liabilities, which was 0.42% for the nine months ended September 30, 2013, being unable to fully benefit from a 300 basis point decline in rates, while our yield on interest-earning assets, which was 4.55% for the period, could suffer from the full decline. Conversely, if short-term interest rates increased by 300 basis points, net interest income could be expected to decrease by approximately 3.3% over twelve months given that we are currently in a slight liability-sensitive position. As of December 31, 2012, based on the results of this simulation model, which assumed a dynamic environment with contemplated asset growth, we expected net interest income to decrease by approximately 3% over twelve months if short-term interest rates immediately decreased by 300 basis points, which was unlikely based on the rate levels at that time. Conversely, if short term interest rates increased by 300 basis points, net interest income was expected to decrease by approximately 3% over twelve months.

As of September 30, 2013, we maintained two loan swaps accounted for as fair value hedges. The aggregate original notional amount of these swaps was $6.2 million. These derivative instruments are used to protect us from interest rate risk caused by changes in the London InterBank Offered Rate (“LIBOR”) curve in relation to certain designated fixed rate loans. These derivative instruments are carried at a fair market value of $(0.3) million and $(0.5) million at September 30, 2013 and December 31, 2012, respectively. We recorded interest expense on these loan swaps of $35 thousand and $0.2 million, respectively, in the three and nine months ended September 30, 2013, and $0.1 million and $0.3 million, respectively, in the three and nine months ended September 30, 2012.

For fair value hedges, ASC Topic 815 requires that the method selected for assessing hedge effectiveness must be reasonable, be defined at the inception of the hedging relationship and be applied consistently throughout the hedging relationship. The Company uses the dollar-offset method for assessing effectiveness using the cumulative approach. The dollar-offset method compares the fair value of the hedging derivative with the fair value of the hedged exposure. The cumulative approach involves comparing the cumulative changes in the hedging derivative’s fair value to the cumulative changes in the hedged exposure’s fair value. The calculation of dollar offset is the change in clean fair value of hedging derivative, divided by the change in fair value of the hedged exposure attributable to changes in the LIBOR curve. To the extent that the cumulative change in fair value of the hedging derivative offsets from 80% to 125% of the cumulative change in fair value of the hedged exposure, the hedge will be deemed effective. The change in fair value of the hedging derivative and the change in fair value of the hedged exposure are recorded in earnings. Any hedge ineffectiveness is also reflected in current earnings.

Prime rate swaps (pay floating, received fixed) are recorded on the balance sheet in other assets or liabilities at fair market value. Loan swaps (pay fixed, receive floating) are carried at fair market value and are included in loans. Changes in fair value of the hedged loans have been completely offset by the fair value changes in the derivatives, which are in contra asset accounts included in loans.

See Note 17 – Derivative Financial Instruments and Hedging Activities of the 2012 Audited Financial Statements and Note 12 – Derivative Financial Instruments and Hedging Activities of the Unaudited Financial Statements for further discussion on our derivative financial instruments and hedging activities.

Financial institutions are subject to interest rate risk to the degree that their interest-bearing liabilities, primarily deposits, mature or reprice more or less frequently, or on a different basis, than their interest-earning assets, primarily loans and investment securities. The match between the scheduled repricing and maturities of our interest-earning assets and liabilities within defined periods is referred to as “gap” analysis. At September 30, 2013, our cumulative one year gap was $(237.3) million, or –12.2% of total assets, indicating a net liability-sensitive position. Our cumulative one year gap at December 31, 2012 was $(10.0) million, or -0.5% of total assets.

The following table reflects our rate sensitive assets and liabilities by maturity as of September 30, 2013. Variable rate loans are shown in the category of due “within three months” because they reprice with changes in the prime lending rate. Fixed rate loans are presented assuming the entire loan matures on the final due date, although payments are actually made at regular intervals and are not reflected in this schedule.

Interest Rate Gap Sensitivity

	Within Three Months			Three Months to One Year			One Year to Five Years			After Five Years		Total
	(Dollars in thousands)
At September 30, 2013:
Interest-earning assets:
Interest-bearing deposits	$	40,222		$	-		$	-		$	-	$	40,222
Federal funds sold		695			-			-			-		695
Securities		49,884			29,627			109,870			172,456		361,837
Loans and loans held for sale		463,918			209,699			541,866			103,929		1,319,412
Total interest-earning assets		554,719			239,326			651,736			276,385		1,722,166

Interest-bearing liabilities:
Demand deposits		58,836			-			134,482			100,862		294,180
MMDA and savings		435,028			-			-			-		435,028
Time deposits		135,199			325,094			104,348			-		564,641
Short term borrowings		2,702			-			-			-		2,702
Long term borrowings		70,037			-			20,000			6,895		96,932
Total interest-bearing liabilities		701,802			325,094			258,830			107,757		1,393,483

Derivatives		6,150			-			(6,150	)		-		-

Interest sensitivity gap	$	(140,933	)	$	(85,768	)	$	386,756		$	168,628	$	328,683
Cumulative interest sensitivity gap	$	(140,933	)	$	(226,701	)	$	160,055		$	328,683

Percentage of total assets					-11.69	%

At December 31, 2012:
Interest-earning assets:
Interest-bearing deposits	$	101,431		$	-		$	-		$	-	$	101,431
Federal funds sold		45,995			-			-			-		45,995
Securities		19,608			31,765			97,089			104,531		252,993
Loans and loans held for sale		519,789			268,764			492,638			89,663		1,370,854
Total interest-earning assets		686,823			300,529			589,727			194,194		1,771,273

Interest-bearing liabilities:
Demand deposits		53,274			-			121,769			146,842		321,885
MMDA and savings		437,951			-			-			-		437,951
Time deposits		152,722			284,894			190,408			649		628,673
Short term borrowings		10,143			-			-			-		10,143
Long term borrowings		64,678			-			20,000			6,895		91,573
Total interest-bearing liabilities		718,768			284,894			332,177			154,386		1,490,225

Derivatives		10,415			(4,265	)		(6,150	)		-		-

Interest sensitivity gap	$	(21,530	)	$	11,370		$	251,400		$	39,808	$	281,048
Cumulative interest sensitivity gap	$	(21,530	)	$	(10,160	)	$	241,240		$	281,048

Percentage of total assets					-0.50	%

Item 3. Quantitative and Qualitative Disclosures about Market Risk.

See “Interest Rate Sensitivity” in the Management’s Discussion and Analysis of Financial Condition and Results of Operations in Part I, Item 2 for disclosures about market risk.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by this Quarterly Report on Form 10-Q, the management of the Company, under the supervision and with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, carried out an evaluation of the effectiveness of the Company’s disclosure controls and procedures as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended. Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of such date.

Changes in Internal Control Over Financial Reporting

There was no change in the Company’s internal control over financial reporting that occurred during the third fiscal quarter of 2013 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

Part II. OTHER INFORMATION

Item 1. Legal Proceedings

In the ordinary course of business, the Company may be a party to various legal proceedings from time to time. There are no material pending legal proceedings to which the Company is a party or of which any of its property is subject. In addition, the Company is not aware of any threatened litigation, unasserted claims or assessments that could have a material adverse effect on its business, operating results or financial condition.

As previously disclosed, on June 6, 2012, a putative stockholder class action lawsuit was filed against Citizens South, Citizens South's directors and the Company in the Delaware Court of Chancery (the “Court”) in connection with the Citizens South merger agreement: Heath v. Kim S. Price, et al., C.A. No. 7601-VCP (Court of Chancery of the State of Delaware). The lawsuit asserts that the members of the Citizens South board of directors breached their fiduciary duties owed to Citizens South stockholders in connection with the approval of the proposed merger with the Company and that Citizens South and the Company aided and abetted the alleged breaches of fiduciary duty. On August 6, 2012, an amended complaint was filed adding an allegation that the members of the Citizens South board of directors breached their fiduciary duties of disclosure. The Company believes this lawsuit is without merit.

On September 12, 2012, the Company entered into a memorandum of understanding (the “MOU”) with plaintiffs and other named defendants regarding the settlement of the lawsuit. Pursuant to the terms of the MOU, the parties agreed to enter into a Stipulation of Settlement whereby the plaintiffs agreed to the dismissal of the lawsuit with prejudice and to withdraw all motions filed in connection with the lawsuit in exchange for the Company and Citizens South making available additional information to Citizens South's stockholders in the Company's Current Report on Form 8-K filed September 14, 2012. On September 20, 2013, the parties filed the Stipulation of Settlement with the Court. The settlement is conditioned upon, among other things, final certification of the settlement class and final approval of the proposed settlement by the Court. The Court has scheduled a hearing for January 8, 2014 concerning, among other things, whether the settlement should be approved as fair, reasonable, adequate and in the best interests of the settlement class. There can be no assurance that the Court will approve the settlement. If the settlement conditions are not met, the proposed settlement would become void.

Item 1A Risk Factors

There have been no material changes in risk factors previously disclosed in the Company’s 2012 Form 10-K.

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

The following table provides information regarding the Company’s purchases of common stock during the three months endedSeptember 30, 2013:

Period	(a) Total Number of Shares Purchased		(b) Average Price Paid per Share		(c) Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs		(d) Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs

Repurchases from July 1, 2013through July 31, 2013		-	$	-		-		2,197,000

Repurchases from August 1, 2013 through August 31, 2013		-		-		-		2,197,000

Repurchases from September 1, 2013through Septebmer 30, 2013		-		-		-		2,197,000

Total		-	$	-		-		2,197,000

(1)

On November 2, 2012, we announced a program which expires on December 31, 2014 to repurchase up to 2,200,000 of our common shares from time to time, depending on market conditions and other factors.

The Company’s ability to pay dividends is subject to the various regulatory policies and requirements relating to the payment of dividends, including requirements to maintain capital above regulatory minimums.

During the three months endedSeptember 30, 2013,the Company did not have any unregistered sales of equity securities.

Item 3. Defaults Upon Senior Securities

Not applicable.

Item 4. Mine Safety Disclosures

Not applicable.

Item 5. Other Information

Not applicable.

Item 6. Exhibits

The following documents are filed or furnished as exhibits to this report:

Exhibit Number	Description of Exhibits

3.1	Articles of Incorporation of the Company, as amended, incorporated by reference to Exhibit 3.1 of the Company’s Quarterly Report on Form 10-Q (File No. 001-35032) filed November 9, 2012

3.2	Bylaws of the Company, incorporated by reference to Exhibit 3.2 of the Company’s Current Report on Form 8-K (File No. 001-35032) filed January 13, 2011

31.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1	Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2	Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

101	Interactive data files pursuant to Rule 405 of Regulation S-T: (i) Condensed Consolidated Balance Sheets as of September 30, 2013 and December 31, 2012; (ii) Condensed Consolidated Statements of Income for the three and nine months ended September 30, 2013 and 2012; (iii) Condensed Consolidated Statements of Comprehensive Income (Loss) for the three and nine months ended September 30, 2013 and 2012; (iv) Condensed Consolidated Statements of Changes in Shareholders’ Equity for the nine months ended September 30, 2013 and 2012; (v) Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2013 and 2012; and (vi) Notes to Condensed Consolidated Financial Statements*

*The information is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934

SIGNATURES

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


		PARK STERLING CORPORATION

Date: November 8, 2013	By:	/s/ James C. Cherry
		James C. Cherry
		Chief Executive Officer (authorized officer)

Date: November 8, 2013	By:	/s/ David L. Gaines
		David L. Gaines
		Chief Financial Officer

Exhibit Index

Exhibit Number	Description of Exhibits

3.1	Articles of Incorporation of the Company, as amended, incorporated by reference to Exhibit 3.1 of the Company’s Quarterly Report on Form 10-Q (File No. 001-35032) filed November 9, 2012

3.2	Bylaws of the Company, incorporated by reference to Exhibit 3.2 of the Company’s Current Report on Form 8-K (File No. 001-35032) filed January 13, 2011

31.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1	Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2	Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

101	Interactive data files pursuant to Rule 405 of Regulation S-T: (i) Condensed Consolidated Balance Sheets as of September 30, 2013 and December 31, 2012; (ii) Condensed Consolidated Statements of Income for the three and nine months ended September 30, 2013 and 2012; (iii) Condensed Consolidated Statements of Comprehensive Income (Loss) for the three and nine months ended September 30, 2013 and 2012; (iv) Condensed Consolidated Statements of Changes in Shareholders’ Equity for the nine months ended September 30, 2013 and 2012; (v) Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2013 and 2012; and (vi) Notes to Condensed Consolidated Financial Statements*

*The information is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934

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Litigous
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Park Sterling (PSTB) Inactive 10-Q2013 Q3 Quarterly report

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