Mainsource Financial (MSFG) 10-Q 2013 Q1 Quarterly report

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2013

COMMISSION FILE NUMBER 0-12422

MAINSOURCE FINANCIAL GROUP, INC.

(Exact name of registrant as specified in its charter)

INDIANA	35-1562245
(State or other jurisdiction of	(IRS Employer
incorporation or organization)	Identification No.)

2105 NORTH STATE ROAD 3 BYPASS, GREENSBURG,
INDIANA	47240
(Address of principal executive offices)	(Zip Code)

(812) 663-6734

(Registrant’s telephone number, including area code)

N/A

(Former name, former address and former fiscal year, if changed since last report.)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x No o

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 definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o	Accelerated filer x
Non-accelerated filer o	Smaller reporting company o
(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 o No x

As of May 9, 2013 there were outstanding 20,377,209 shares of common stock, without par value, of the registrant.

MAINSOURCE FINANCIAL GROUP, INC.

FORM 10-Q

INDEX

PART I. FINANCIAL INFORMATION
Item 1. Financial Statements	3
Consolidated Balance Sheets	3
Consolidated Statements of Income	4
Consolidated Statements of Comprehensive Income	5
Consolidated Statements of Cash Flows	6
Notes to Consolidated Financial Statements	7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	26
Item 3. Quantitative and Qualitative Disclosures About Market Risk	30
Item 4. Controls and Procedures	30
PART II. OTHER INFORMATION
Item 1A. Risk Factors
Item 6. Exhibits	31
Signatures	32

2

MAINSOURCE FINANCIAL GROUP, INC.

CONSOLIDATED BALANCE SHEETS

(Dollar amounts in thousands except per share data)

Item 1.  Financial Statements

	(Unaudited)
	March 31,			December 31,
	2013			2012
Assets
Cash and due from banks	$	31,385		$	58,100
Money market funds and federal funds sold	4,512			7,550
Cash and cash equivalents	35,897			65,650
Securities available for sale	906,396			902,341
Loans held for sale	5,094			17,025
Loans, net of allowance for loan losses of $31,728 and $32,227	1,521,592			1,521,156
Restricted stock, at cost	15,637			15,639
Premises and equipment, net	55,025			54,101
Goodwill	64,379			63,947
Purchased intangible assets	6,513			6,993
Cash surrender value of life insurance	59,752			59,410
Interest receivable and other assets	62,324			63,026
Total assets	$	2,732,609		$	2,769,288
Liabilities
Deposits
Noninterest bearing	$	418,916		$	405,167
Interest bearing	1,763,781			1,779,887
Total deposits	2,182,697			2,185,054
Other borrowings	39,479			34,519
Federal Home Loan Bank (FHLB) advances	104,404			141,052
Subordinated debentures	50,455			50,418
Other liabilities	32,901			34,494
Total liabilities	2,409,936			2,445,537
Shareholders’ equity
Preferred stock, no par value: Authorized shares - 400,000; Issued shares - 57,000 Outstanding shares — 15,100 Aggregate liquidation preference — $15,100	14,932			14,918
Common stock $.50 stated value: Authorized shares - 100,000,000 Issued shares — 20,866,227 and 20,859,027 Outstanding shares — 20,326,725 and 20,304,525	10,465			10,450
Treasury stock — 539,502 and 554,502 at cost	(8,798		)	(9,043		)
Additional paid-in capital	224,185			224,096
Retained earnings	60,170			57,602
Accumulated other comprehensive income	21,719			25,728
Total shareholders’ equity	322,673			323,751
Total liabilities and shareholders’ equity	$	2,732,609		$	2,769,288

The accompanying notes are an integral part of these consolidated financial statements.

3

MAINSOURCE FINANCIAL GROUP, INC.

CONSOLIDATED STATEMENTS OF INCOME

(Dollar amounts in thousands except per share data)

	(unaudited)
	Three months ended March 31,
	2013			2012
Interest income
Loans, including fees	$	19,487		$	21,420
Securities	5,808			6,454
Other interest income	21			35
Total interest income	25,316			27,909
Interest expense
Deposits	1,358			2,235
Federal Home Loan Bank advances	915			1,401
Subordinated debentures	429			466
Other borrowings	16			29
Total interest expense	2,718			4,131
Net interest income	22,598			23,778
Provision for loan losses	1,734			3,100
Net interest income after provision for loan losses	20,864			20,678
Non-interest income
Mortgage banking	2,029			2,115
Trust and investment product fees	1,035			828
Service charges on deposit accounts	4,486			4,376
Net realized gains on securities (includes $844 accumulated other comprehensive income reclassifications for unrealized net gains on available-for-sale securities in 2013)	844			987
Other-than-temporary loss
Total impairment loss	—			(500		)
Loss recognized in other comprehensive income	—			—
Net impairment loss recognized in earnings	—			(500		)
Increase in cash surrender value of life insurance	342			287
Interchange income	1,611			1,650
Loss on sale and write-down of OREO	(296		)	(252		)
Other income	214			331
Total non-interest income	10,265			9,822
Non-interest expense
Salaries and employee benefits	13,518			12,256
Net occupancy	1,860			1,662
Equipment	2,355			2,084
Intangibles amortization	480			452
Telecommunications	456			405
Stationery printing and supplies	374			317
FDIC assessment	437			908
Marketing	1,045			948
Collection expense	950			1,049
Prepayment penalty on FHLB advance	2,239			—
Consultant expense	375			50
Interchange expense	449			307
Other expenses	2,590			2,843
Total non-interest expense	27,128			23,281
Income before income tax	4,001			7,219
Income tax expense (includes $287 income tax expense from reclassification items in 2013)	10			1,208
Net income	$	3,991		$	6,011
Redemption of preferred stock	—			1,242
Preferred dividends and discount accretion	(202		)	(763		)
Net income available to common shareholders	$	3,789		$	6,490
Cash dividends declared per common share	$	0.06		$	0.01
Net income per common share — basic and diluted	$	0.19		$	0.32

The accompanying notes are an integral part of these consolidated financial statements.

4

MAINSOURCE FINANCIAL GROUP, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Dollar amounts in thousands except per share data)

	(unaudited)
	Three months ended
	March 31,
	2013			2012
Net income	$	3,991		$	6,011
Other comprehensive income:
Unrealized holding gains/(losses) on securities available for sale	(5,324		)	428
Reclassification adjustment for (gains) on securities available for sale included in net income	(844		)	(987		)
Reclassification adjustment for other than temporary impairment on securities available for sale included in net income	—			500
Tax effect	2,159			20
Other comprehensive income/(loss)	(4,009		)	(39		)
Comprehensive income/(loss)	$	(18	)	$	5,972

The accompanying notes are an integral part of these consolidated financial statements.

5

MAINSOURCE FINANCIAL GROUP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollar amounts in thousands)

	(unaudited)
	Three months ended
	March 31, 2013
	2013			2012
Operating Activities
Net income	$	3,991		$	6,011
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses	1,734			3,100
Depreciation expense	1,413			1,332
Securities amortization, net	1,045			1,055
Stock based compensation expense	141			52
Stock portion of director retainer fee expense	97			82
Amortization of purchased intangible assets	480			452
Amortization of mortgage servicing rights	493			501
Earnings on cash surrender value of life insurance policies	(342		)	(287		)
Recovery of valuation allowance on mortgage servicing rights	(250		)	—
Prepayment penalty on FHLB advance	2,239			—
Securities gains, net of impairment	(844		)	(487		)
Loss on sale and write-down of OREO	296			252
Gain on loans sold	(2,069		)	(1,190		)
Loans originated for sale	(98,723		)	(56,687		)
Proceeds from loan sales	112,723			55,304
Change in other assets and liabilities	213			674
Net cash provided by operating activities	22,637			10,164
Investing Activities
Purchases of securities available for sale	(126,915		)	(57,380		)
Proceeds from calls, maturities, and payments on securities available for sale	39,101			27,286
Proceeds from sales of securities available for sale	77,390			19,956
Proceeds from sale of OREO	1,520			6,361
Loan originations and payment, net	(3,137		)	(3,979		)
Purchases of premises and equipment	(2,337		)	(1,385		)
Proceeds from redemption of restricted stock	2			2
Net cash (used) by investing activities	(14,376		)	(9,139		)
Financing Activities
Net change in deposits	(2,789		)	(902		)
Net change in other borrowings	4,960			3,876
Repayment of FHLB advances	(88,887		)	(73		)
Proceeds from FHLB advances	50,000			—
Proceeds from exercise of stock options	111			—
Cash dividends on preferred stock	(189		)	(713		)
Cash dividends on common stock	(1,220		)	(202		)
Net cash provided/(used) by financing activities	(38,014		)	1,986
Net change in cash and cash equivalents	(29,753		)	3,011
Cash and cash equivalents, beginning of year	65,650			109,148
Cash and cash equivalents, end of period	$	35,897		$	112,159
Supplemental non cash disclosure
Loan balances transferred to foreclosed real estate	$	967		$	1,831

The accompanying notes are an integral part of these consolidated financial statements.

6

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollar amounts in thousands except per share data)

NOTE 1 - BASIS OF PRESENTATION

The significant accounting policies followed by MainSource Financial Group, Inc. (“Company”) for interim financial reporting are consistent with the accounting policies followed for annual financial reporting. The consolidated interim financial statements have been prepared according to accounting principles generally accepted in the United States of America and in accordance with the instructions for Form 10-Q. The interim statements do not include all information and footnotes normally included in the annual financial statements. All adjustments which are, in the opinion of management, necessary for a fair presentation of the results for the periods reported have been included in the accompanying unaudited consolidated financial statements and all such adjustments are of a normal recurring nature. Some items in prior period financial statements were reclassified to conform to current presentation. It is suggested that these consolidated financial statements and notes be read in conjunction with the financial statements and notes thereto in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.

Adoption of New Accounting Standards

In February, 2013, the FASB issued Accounting Standards Update 2013-02, “Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income”. This update amended guidance on the reporting of reclassifications out of accumulated other comprehensive income.  The guidance requires an entity to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items of net income if the amount being reclassified is required under U.S. generally accepted accounting principles. For other amounts that are not required under U.S. generally accepted accounting principles, an entity is required to disclose in the notes to the financial statements these amounts. This amended guidance became effective on January 1, 2013 and was applied prospectively.  The effect of adopting this standard did not have a material impact on the Company’s consolidated operating results or financial condition, but the additional disclosures are included on the Consolidated Statements of Income.

In July, 2012 the FASB issued Accounting Standards Update 2012-02, “Goodwill and Other, Testing Indefinite-Lived Assets for Impairment” to respond to feedback received during the outreach period performed before the issuance of Accounting Standards Update 2011-08, “Intangibles – Goodwill and Other, Testing Goodwill for Impairment”.   The amendment permits an assessment of qualitative factors to determine whether the existence of events and circumstances indicates that it is more likely than not that the indefinite-lived intangible asset is impaired. If, after assessing the totality of events and circumstances, it is concluded that it is not more likely than not that the indefinite-lived intangible asset is impaired, then no further action is required. However, after the same assessment, if it is concluded that it is more likely than not that the indefinite-lived intangible asset is impaired, then a quantitative impairment test should be performed whereby the fair value of the indefinite-lived intangible asset is compared to the carrying amount. The amendments in this guidance are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. Early adoption is permitted. The effect of adopting this standard did not have a material effect on the Company’s operating results or financial condition.

NOTE 2 - STOCK PLANS AND STOCK BASED COMPENSATION

From time to time, common stock and options to buy common stock are granted to directors and officers of the Company under the MainSource Financial Group, Inc. 2007 Stock Incentive Plan (the “2007 Stock Incentive Plan”), which was adopted and approved by the Board of Directors of the Company on January 16, 2007. The plan was effective upon the approval of the plan by the Company’s shareholders, which occurred on April 26, 2007 at the Company’s annual meeting of shareholders. The 2007 Stock Incentive Plan provides for the grant of incentive stock options, nonstatutory stock options, stock bonuses and restricted stock awards. Incentive stock options may be granted only to employees. An aggregate of 650,000 shares of common stock are reserved for issuance under the 2007 Stock Incentive Plan. Shares issuable under the 2007 Stock Incentive Plan will be authorized from unissued shares of common stock or treasury shares. The 2007 Stock Incentive Plan is in addition to, and not in replacement of, the MainSource Financial Group, Inc. 2003 Stock Option Plan (“the 2003 Option Plan”), which was approved by the Company’s Board of Directors on January 21, 2003, and was effective upon approval by the Company’s shareholders on April 23, 2003. The 2003 Option Plan provided for the grant of up to 607,754 incentive and nonstatutory stock options. Upon the approval of the 2007 Stock Incentive Plan, no further awards of options may be made under the 2003 Option Plan. Unexercised options which were previously issued under the 2003 Option Plan have not been terminated, but will otherwise continue in accordance with the 2003 Option Plan and the agreements pursuant to which the options were issued. All stock options granted under either the 2003 Option Plan or the 2007 Stock Incentive Plan have an exercise price that is at least equal to the fair market value of the Company’s common stock on the date the options were granted. The maximum option term is ten years, and options vest immediately for the directors’ grant and over four years for the officers’ grant, except as otherwise determined by the Executive Compensation Committee of the Board of Directors.

All share-based payments to employees, including grants of employee stock options, are recognized as compensation expense over the service period (generally the vesting period) in the consolidated financial statements based on their fair values.  For options with graded vesting, the Company values the stock option grants and recognizes compensation expense as if each vesting portion of the award was a single award.

7

The following table summarizes stock option activity:

	Three Months Ended March 31, 2013
	Shares		Weighted Average Exercise Price
Outstanding, beginning of year	433,132		$	13.06
Granted	2,500		14.24
Exercised	(15,000	)	7.40
Forfeited or expired	(1,000	)	11.85
Outstanding, period end	419,632		$	13.27
Options exercisable at period end	329,622		$	13.81
Fully vested and expected to vest	411,602		$	13.30

The following table details stock options outstanding:

	March 31, 2013		December 31, 2012
Stock options vested and currently exercisable:
Number	329,622		344,722
Weighted average exercise price	$	13.81	$	13.53
Aggregate intrinsic value	$	931	$	826
Weighted average remaining life (in years)	3.8		4.1

The intrinsic value for stock options is calculated based on the exercise price of the underlying awards and the market price of our common stock as of the reporting date. The Company recorded $36 in stock compensation expense during the three month ended March 31, 2013 and $17 in stock compensation expense during the three months ended March 31, 2012 to salaries and employee benefits. There were 2,500 options granted in the first quarter of 2013.  In order to calculate the fair value of the options granted in 2013, the following weighted-average assumptions were used as of the grant dates:  risk free interest rate of 1.26%, expected option life 7.0 years, expected price volatility 34.5%, and dividend yield of 1.69%.  The fair value of each stock option granted is estimated on the date of grant using the Black-Scholes based stock option valuation model. This model requires the input of subjective assumptions that will usually have a significant impact on the fair value estimate. Expected volatilities are based on historical volatility of the Company’s stock, and other factors. Expected dividends are based on dividend trends and the market price of the Company’s stock price at grant. The Company uses historical data to estimate option exercises within the valuation model. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant.

Unrecognized stock option compensation expense related to unvested awards for the remainder of 2013 and beyond is estimated as follows:

Year	(in thousands)
April 2013 - December 2013	$	108
2014	120
2015	113
2016	3

During the second quarters of 2011 and 2012, the Compensation Committee of the Board of Directors of the Company granted restricted stock awards in lieu of cash awards to certain executive officers pursuant to the Company’s annual performance-based incentive bonus plan.  Compensation expense is recognized over the vesting period of the awards based on the fair value of the stock at the issue date.  The value of the awards was determined by multiplying the award amount by the closing price of a share of Company common stock on the grant date, April 25, 2012 ($11.85) and April 8, 2011 ($9.68).  The stock awards vest as follows — 80% on the second anniversary of the date of grant and 20% on the third anniversary of the date of grant.  A total of 48,061 shares of common stock of the Company were granted in 2012.  Total compensation expense for the restricted stock grants was $105 and $35 for the first three months of 2013 and 2012 respectively.

A summary of changes in the Company’s nonvested shares for the first quarter of 2013 follows:

8

	Shares	Weighted Average Grant Date Fair Value
Nonvested at January 1, 2013	94,305	10.79
Granted	0	$	0
Vested	0	0
Forfeited	0	0
Nonvested at March 31, 2013	94,305	$	10.79

As of March 31, 2013, there were $640 of total unrecognized compensation costs related to nonvested restricted stock awards granted under the 2007 Plan that will be recognized over the remaining vesting period of approximately 1.5 years.

During the second quarter of 2011, members of the Board of Directors of the Company were given the option of having their retainer paid in cash, Company stock, or a combination of cash and stock.  The retainer is paid quarterly, on May 1, August 1, November 1, and February 1, for all directors serving on the Board on those dates.  Other expense is recognized over the three month period of the awards based on the fair value of the stock at the issue dates.  The value of the quarterly awards paid in stock were determined by multiplying the award amount by the average closing price of a share of Company common stock on the five trading days prior to the issuance of the stock.  The shares issued vest immediately. Shares awarded by quarter were as follows:

Quarter	Year	Shares	Price Per Share
2 Q	2011	6,750	$	9.53
3 Q	2011	7,902	$	8.80
4 Q	2011	9,130	$	9.44
1Q	2012	8,750	$	9.29
2Q	2012	7,200	$	11.83
3Q	2012	7,200	$	11.58
4Q	2012	7,200	$	12.25
1Q	2013	7,200	$	13.38

9

NOTE 3 - SECURITIES

The amortized cost and fair value of securities available for sale and related unrealized gains/losses recognized in accumulated other comprehensive income was as follows:  

			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value
As of March 31, 2013
Available for Sale	$		$		$			$
U. S. government agency	1,360		30		—			1,390
State and municipal	314,292		24,388		(271		)	338,409
Mortgage-backed securities-residential (GSE’s)	211,112		6,221		(173		)	217,160
Collateralized mortgage obligations (GSE’s)	337,729		3,653		(423		)	340,959
Equity securities	4,939		—		—			4,939
Other securities	3,550		—		(11		)	3,539
Total available for sale	$	872,982	$	34,292	$	(878	)	$	906,396
As of December 31, 2012
Available for Sale
U. S. government agency	$	1,600	$	38	$	—		$	1,638
State and municipal	310,552		27,484		(97		)	337,939
Mortgage-backed securities-residential (GSE’s)	219,352		7,711		(8		)	227,055
Collateralized mortgage obligations (GSE’s)	322,758		4,604		(139		)	$	327,223
Equity securities	4,939		—		—			4,939
Other securities	3,558		—		(11		)	3,547
Total available for sale	$	862,759	$	39,837	$	(255	)	$	902,341

The amortized cost and fair value of the investment securities portfolio are shown by expected maturity.  Expected maturities may differ from contractual maturities if borrowers have the right to call or prepay obligations with or without call or prepayment penalties.  Securities not due at a single maturity or with no maturity are shown separately.

	Available for Sale
March 31, 2013	Amortized Cost		Fair Value
Within one year	$	7,262	$	7,414
One through five years	54,150		56,878
Six through ten years	104,927		112,216
After ten years	152,863		166,830
Mortgage-backed securities-residential (Government Sponsored Entity)	211,112		217,160
Collateralized mortgage obligations (Government Sponsored Entity)	337,729		340,959
Equity securities	4,939		4,939
Total available for sale securities	$	872,982	$	906,396

Proceeds from sales of securities available for sale were $77,390 and $19,956 for the three months ended March 31, 2013 and 2012, respectively. Gross gains of $899 and $1,022 and gross losses of $55 and $35 were realized on these sales during 2013 and 2012, respectively.  In addition to the gross gains and losses from sales, there was a $500 impairment loss recognized on one investment during the first quarter of 2012, reducing its cost basis to $250 before and after the charge.  The charge established a new cost basis.  This amount is shown as an impairment loss on the income statement.

Below is a summary of securities with unrealized losses as of March 31, 2013 and December 31, 2012 presented by length of time the securities have been in a continuous unrealized loss position.

	Less than 12 months					12 months or longer				Total
March 31, 2013 Description of securities	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
State and municipal	$	18,870	$	(271	)	$	—	$	—	$	18,870	$	(271	)
Mortgage-backed securities-residential (GSE’s)	16,847		(173		)	—		—		16,847		(173		)
Collateralized mortgage obligations (GSE’s)	108,679		(423		)	—		—		108,679		(423		)
Other securities	990		(11		)	—		—		990		(11		)
Total temporarily impaired	$	145,386	$	(878	)	$	—	$	—	$	145,386	$	(878	)

	Less than 12 months					12 months or longer				Total
December 31, 2012 Description of securities	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
State and municipal	$	6,646	$	(97	)	$	—	$	—	$	6,646	$	(97	)
Mortgage-backed securities-residential (GSE’s)	12,766		(8		)	—		—		12,766		(8		)
Collateralized mortgage obligations (GSE’s)	32,330		(139		)	—		—		32,330		(139		)
Other securities	990		(11		)	—		—		990		(11		)
Total temporarily impaired	$	52,732	$	(255	)	$	—	$	—	$	52,732	$	(255	)

10

Other-Than-Temporary-Impairment

Management evaluates securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. The investment securities portfolio is evaluated for OTTI by segregating the portfolio into two general segments and applying the appropriate OTTI model. Investment securities are generally evaluated for OTTI under ASC 320. However, certain purchased beneficial interests, including non-agency mortgage-backed securities, asset-backed securities, and collateralized debt obligations, that had credit ratings at the time of purchase of below AA are evaluated using the model outlined in ASC 325-10.

In determining OTTI under ASC 320, management considers many factors, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the entity has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether an other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.

When OTTI occurs under either model, the amount of the OTTI recognized in earnings depends on whether an entity intends to sell the security or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss. If an entity intends to sell or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss, the OTTI shall be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. If an entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis less any current-period loss, the OTTI shall be separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings. The amount of the total OTTI related to other factors is recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings becomes the new amortized cost basis of the investment.

As of March 31, 2013, the Company’s securities portfolio consisted of 1,007 securities, 80 of which were in an unrealized loss position.  Unrealized losses on state and municipal securities of $271 have not been recognized into income because management has the ability to hold for a period of time sufficient to allow for any anticipated recovery in fair value and it is unlikely that management will be required to sell the securities before their anticipated recovery. The decline in value is primarily attributable to temporary illiquidity and the financial crisis affecting these markets and not necessarily the expected cash flows of the individual securities. The Company monitors the financial condition of these issuers. The fair value of these debt securities is expected to recover as the securities approach their maturity date.

At March 31, 2013, almost all of the mortgage-backed securities held by the Company were issued by U.S. government-sponsored entities and agencies, primarily Fannie Mae and Freddie Mac, institutions which the government has affirmed its commitment to support. Because the decline in fair value of approximately $173 is attributable to changes in interest rates and illiquidity, and not credit quality, and because the Company does not have the intent to sell these mortgage-backed securities and it is likely that it will not be required to sell the securities before their anticipated recovery, the Company does not consider these securities to be other-than-temporarily impaired at March 31, 2013.

The Company’s collateralized mortgage obligation securities portfolio includes agency collateralized mortgage obligations with a market value of $340,959 which had unrealized losses of approximately $423 at March 31, 2013. The Company monitors to insure it has adequate credit support and as of March 31, 2013, the Company believes there is no OTTI and does not have the intent to sell these securities and it is likely that it will not be required to sell the securities before their anticipated recovery. All securities are investment grade.

The unrealized losses on other securities are related to one single issue trust preferred security and have not been recognized into income because management has the ability to hold for a period of time sufficient to allow for any anticipated recovery in fair value and it is unlikely that management will be required to sell the security before its anticipated recovery. The Company performs a quarterly review of this security and based on this review, no evidence of adverse changes in expected cash flows is anticipated. The decline in value is primarily attributable to temporary illiquidity and the financial crisis affecting these markets and not the expected cash flows of the individual security. Currently, the issuer has made all contractual payments and given no indication that it will not be able to make them into the future. The fair value of this debt security is expected to recover as the security approaches its maturity date. As of March 31, 2013, the fair value of the security was $990 with an unrealized loss of $11.

During the first quarter of 2012, the Company determined that one of its equity holdings was other than temporarily impaired and wrote down the security by $500 to its fair value of $250. This amount is shown as an impairment loss on the income statement.

11

NOTE 4 - LOANS AND ALLOWANCE

Loans were as follows:

	March 31,2013			December 31, 2012
Commercial
Commercial and industrial	$	136,895		$	134,156
Agricultural	18,091			22,355
Commercial Real Estate
Farm	63,971			66,119
Hotel	127,027			131,495
Construction and development	27,994			25,208
Other	509,373			507,231
Residential
1-4 family	403,083			394,195
Home equity	222,915			224,329
Consumer
Direct	42,032			45,844
Indirect	1,939			2,451
Total loans	1,553,320			1,553,383
Allowance for loan losses	(31,728		)	(32,227		)
Net loans	$	1,521,592		$	1,521,156

Activity in the allowance for loan losses for the three months ended March 31, 2013 and 2012 and the recorded investment of loans and allowances by portfolio segment and impairment method as of March 31, 2013 and December 31, 2012 were as follows:

	Commercial			Commercial Real Estate			Residential			Consumer			Total
Allowance for loan loss
Balance, January 1, 2013	$	3,894		$	24,157		$	3,180		$	996		$	32,227
Provision charged to expense	525			238			631			340			1,734
Losses charged off	(271		)	(1,208		)	(698		)	(819		)	(2,996		)
Recoveries	131			51			150			431			763
Balance, March 31, 2013	$	4,279		$	23,238		$	3,263		$	948		$	31,728

	Commercial			Commercial Real Estate			Residential			Consumer			Total
Allowance for loan loss
Balance, January 1, 2012	$	5,562		$	30,476		$	2,972		$	879		$	39,889
Provision charged to expense	(218		)	2,893			182			243			3,100
Losses charged off	(180		)	(3,908		)	(1,214		)	(619		)	(5,921		)
Recoveries	167			779			72			455			1,473
Balance, March 31, 2012	$	5,331		$	30,240		$	2,012		$	958		$	38,541
As of March 31, 2013
Ending Balance individually evaluated for impairment	$	355		$	3,143		$	121		$	2		$	3,621
Ending Balance collectively evaluated for impairment	3,924			20,095			3,142			946			28,107
Total ending allowance balance	$	4,279		$	23,238		$	3,263		$	948		$	31,728
Loans
Ending Balance individually evaluated for impairment	$	1,384		$	34,518		$	13,137		$	927		$	49,966
Ending Balance collectively evaluated for impairment	153,602			693,847			612,861			43,044			1,503,354
Total ending loan balance excludes $5,230 of accrued interest	$	154,986		$	728,365		$	625,998		$	43,971		$	1,553,320

12

As of December 31, 2012	Commercial		Commercial Real Estate		Residential		Consumer		Total
Ending Balance individually evaluated for impairment	$	150	$	3,067	$	—	$	—	$	3,217
Ending Balance collectively evaluated for impairment	3,744		21,090		3,180		996		29,010
Total ending allowance balance	$	3,894	$	24,157	$	3,180	$	996	$	32,227
Loans
Ending Balance individually evaluated for impairment	$	1,797	$	33,499	$	14,175	$	1,083	$	50,554
Ending Balance collectively evaluated for impairment	154,714		696,554		604,349		47,212		1,502,829
Total ending loan balance excludes $5,206 of accrued interest	$	156,511	$	730,053	$	618,524	$	48,295	$	1,553,383

The recorded investment in loans excludes accrued interest receivable due to immateriality.

The following table presents loans individually evaluated for impairment by class of loans as of March 31, 2013.  Performing troubled debt restructurings totaling $9,619 were excluded as allowed by ASC 310-40.

March 31, 2013	Unpaid Principal Balance		Recorded Investment		Allowance for Loan Losses Allocated		Interest Income Recognized		Cash BasisInterest Recognized
With an allowance recorded
Commercial
Commercial and industrial	$	509	$	496	$	355	$		$
Commercial Real Estate
Farm	625		625		204
Hotel
Construction and development	641		543		252
Other	11,951		11,276		2,687
Residential
1-4 Family	1,239		1,137		118
Home Equity	52		51		3
Consumer
Direct	130		130		2
Subtotal — impaired with allowance recorded	15,147		14,258		3,621
With no related allowance recorded
Commercial
Commercial & industrial	1,475		888
Agricultural	—		—
Commercial Real Estate
Farm	1,093		986
Hotel	—		—
Construction and development	2,539		1,487
Other	12,606		9,982				6		6
Residential
1-4 Family	10,787		9,339				2		2
Home Equity	2,804		2,610				2		2
Consumer
Direct	785		776				4		4
Indirect	23		21
Subtotal — impaired with allowance recorded	32,112		26,089				14		14
Total impaired loans	$	47,259	$	40,347	$	3,621	$	14	$	14

The following table presents the average balance of impaired loans for the quarters ending March 31, 2013 and March 31, 2012, excluding performing troubled debt restructurings as allowed by ASC 310-40.

	Average Balance
	March 31 2013		March 31 2012
Commercial
Commercial & industrial	$	1,590	$	4,871
Agricultural	—		46
Commercial Real Estate
Farm	1,598		1,010
Hotel	2,984		2,986
Construction and development	2,086		6,099
Other	22,530		26,426
Residential
1-4 Family	11,012		11,979
Home Equity	2,645		2,639
Consumer
Direct	986		1,063
Indirect	19		51
Total	$	45,450	$	57,170

The following table presents loans individually evaluated for impairment by class of loans as of December 31, 2012:

December 31, 2012	Unpaid Principal Balance		Recorded Investment		Allowance for Loan Losses Allocated		Interest Income Recognized		Cash Basis Interest Recognized
With an allowance recorded
Commercial
Commercial and industrial	$	305	$	305	$	150
Commercial Real Estate
Farm	922		922		442
Construction and development	742		644		240
Other	9,727		9,419		2,385
Subtotal — impaired with allowance recorded	11,696		11,290		3,217
With no related allowance recorded
Commercial
Commercial & industrial	2,115		1,492				$	76	$	76
Agricultural	1		—
Commercial Real Estate
Farm	741		663				9		9
Hotel	6,257		5,968
Construction and development	2,685		1,499				108		108
Other	20,047		14,384				129		129
Residential
1-4 Family	13,110		11,548				3		3
Home Equity	2,801		2,627				17		17
Consumer
Direct	1,083		1,066				9		9
Indirect	19		17				7		7
Subtotal — impaired with allowance recorded	48,859		39,264				358		358
Total impaired loans	$	60,555	$	50,554	$	3,217	$	358	$	358

13

The following table presents the recorded investment in nonaccrual and loans past due over 90 days still on accrual by class of loans as of March 31, 2013 and December 31, 2012

	Non-accrual				Past due over 90 days and still accruing
	March 31, 2013		December 31, 2012		March 31, 2013		December 31, 2012
Commercial
Commercial and industrial	$	1,365	$	1,777
Agricultural			—
Commercial Real Estate
Farm	1,611		1,584
Hotel			—
Construction and development	1,548		1,657				$	565
Other	19,939		17,442		$	100
Residential
1-4 Family	9,142		10,392
Home Equity	2,256		2,216
Consumer
Direct	196		366
Indirect	21		17
Total	$	36,078	$	35,451	$	100	$	565

The following table presents the aging of the recorded investment in past due loans as of March 31, 2013 by class of loans:

March 31, 2013	Total Loans		30-59 Days Past Due		60-89 Days Past Due		Greater than 90 Days Past Due		Total Past Due		Loans Not Past Due
Commercial
Commercial and industrial	$	136,895	$	693	$	136	$	742	$	1,571	$	135,324
Agricultural	18,091		—		—		—		—		18,091
Commercial Real Estate
Farm	63,971		—		—		1,278		1,278		62,693
Hotel	127,027		—		—		—		—		127,027
Construction and development	27,994		—		—		1,448		1,448		26,546
Other	509,373		703		2,806		10,955		14,464		494,909
Residential
1-4 Family	403,083		5,779		1,269		4,082		11,130		391,953
Home Equity	222,915		703		370		1,475		2,548		220,367
Consumer
Direct	42,032		129		17		125		271		41,761
Indirect	1,939		3		1		4		8		1,931
Total — excludes $5,230 of accrued interest	$	1,553,320	$	8,010	$	4,599	$	20,109	$	32,718	$	1,520,602

The following table presents the aging of the recorded investment in past due loans as of December 31, 2012 by class of loans:

December 31, 2012	Total Loans		30-59 Days Past Due		60-89 Days Past Due		Greater than 90 Days Past Due		Total Past Due		Loans Not Past Due
Commercial
Commercial and industrial	$	134,156	$	1,421	$	311	$	1,094	$	2,826	$	131,330
Agricultural	22,355		—		—		—		—		22,355
Commercial Real Estate
Farm	66,119		158		—		1,417		1,575		64,544
Hotel	131,495		—		—		—		—		131,495
Construction and development	25,208		—		—		2,121		2,121		23,087
Other	507,231		2,516		1,208		10,607		14,331		492,900
Residential
1-4 Family	394,195		7,788		2,605		5,492		15,885		378,310
Home Equity	224,329		1,170		357		1,428		2,955		221,374
Consumer
Direct	45,844		182		49		242		473		45,371
Indirect	2,451		33		12		5		50		2,401
Total — excludes $5,206 of accrued interest	$	1,553,383	$	13,268	$	4,542	$	22,406	$	40,216	$	1,513,167

14

Troubled Debt Restructurings

During the periods ending March 31, 2013 and 2012, the terms of certain loans were modified as troubled debt restructurings. The modification of the terms of such loans included one or a combination of the following: a reduction of the stated interest rate of the loan or an extension of the maturity date at a stated rate of interest lower than the current market rate for new debt with similar risk.

Modifications involving a reduction of the stated interest rate of the loan were for periods ranging from 60 months to 30 years. Modifications involving an extension of the maturity date were for periods ranging from 6 months to 14 months.

The troubled debt restructurings increased the allowance for loan losses by $30 and $0 for the three month periods ending March 31, 2013 and 2012 and resulted in charge offs of $0 and $0 during the three month periods ending March 31, 2013 and 2012.  Reserves of $0 in 2013 and $0 in 2012 were provided for these loans in prior quarters.

The following table presents loans by class modified as troubled debt restructurings that occurred during the three month period ending March 31, 2013:

		Pre-Modification		Post-Modification
		Outstanding Recorded		Outstanding Recorded
March 31, 2013	Number of Loans	Investment		Investment
Commercial real estate
Other	2	$	249	$	249
Residential
1-4 Family	3	186		186
Consumer
Direct	1	30		30
Total	6	$	465	$	465

The following table presents loans by class modified as troubled debt restructurings that occurred during the three month period ending March 31, 2012:

		Pre-Modification		Post-Modification
		Outstanding Recorded		Outstanding Recorded
March 31, 2012	Number of Loans	Investment		Investment
Consumer
Direct	1	$	4	$	4
Total	1	$	4	$	4

The following table presents loans by class modified as troubled debt restructurings for which there was a payment default within twelve months following the modification during the three month period ending March 31, 2013:

March 31, 2013	Number of Loans	Recorded Investment
Residential:
1-4 Family	1	$	37
Total	1	$	37

The following table presents loans by class modified as troubled debt restructurings for which there was a payment default within twelve months following the modification during the three month period ending March 31, 2012:

March 31, 2012	Number of Loans	Recorded Investment
Commercial real estate:
Other	6	$	942
Total	6	$	942

A loan is considered to be in payment default once it is 90 days contractually past due under the modified terms.  The troubled debt restructurings that subsequently defaulted described above increased the allowance for loan losses by $0 and $146 and resulted in charge offs of $0 and $0 during the three month period ending March 31, 2013 and 2012 respectively.

In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the probability that the borrower will be in payment default on any of its debt in the foreseeable future without the modification. This evaluation is performed under the company’s internal underwriting policy.

The Company has allocated $411 of specific reserves to customers whose loan terms have been modified in troubled debt restructurings as of March 31, 2013. The Company has committed to lend additional amounts totaling $0 to customers with outstanding loans that are classified as troubled debt restructurings.  At December 31, 2012, the comparable numbers were $567 of specific reserves and $0 of commitments.  The total of troubled debt restructurings at March 31, 2013 and December 31, 2012 was $18,820 and $18,932 respectively.  Included in the TDR totals are non-accrual loans of $4,919 and $3,829 at March 31, 2013 and December 31, 2012 respectively.

The terms of certain other loans were modified during the three month period ending March 31, 2013 that did not meet the definition of a troubled debt restructuring. These loans have a total recorded investment as of March 31, 2013 of $0. The modification of these loans involved either a modification of the terms of a loan to borrowers who were not experiencing financial difficulties or a delay in a payment that was considered to be insignificant

Credit Quality Indicators:

The Company categorizes loans into risk categories based on relevant information about the ability of the borrower to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company analyzes commercial and commercial real estate loans individually by classifying the loans as to credit risk. This analysis includes credit relationships with an outstanding balance greater than $1 million on an annual basis. The Company uses the following definitions for risk ratings:

Special Mention — Loans classified as special mention have above average risk that requires management’s ongoing attention. The borrower may have demonstrated the inability to generate profits or to maintain net worth, chronic delinquency and/or a demonstrated lack of willingness or capacity to meet obligations.

Substandard — Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are classified by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

Non-accrual — Loans classified as non-accrual are loans where the further accrual of interest is stopped because payment in full of principal and interest is not expected. In most cases, the principal and interest has been in default for a period of 90 days or more.

15

As of March 31, 2013, and based on the most recent analysis performed, the risk category of loans by class of loans is as follows:

March 31, 2013	Pass		Special Mention		Substandard		Non-accrual
Commercial
Commercial and industrial	$	129,488	$	4,134	$	1,908	$	1,365
Agricultural	18,087		—		4		—
Commercial Real Estate
Farm	61,940		420		—		1,611
Hotel	77,272		49,755		—		—
Construction and development	22,484		1,395		2,567		1,548
Other	441,754		29,833		17,847		19,939
Total	$	751,025	$	85,537	$	22,326	$	24,463

At December 31, 2012, the risk category of loans by class of loans was as follows:

December 31, 2012	Pass		Special Mention		Substandard		Non-accrual
Commercial
Commercial and industrial	$	119,755	$	9,824	$	2,800	$	1,777
Agricultural	22,350		—		5		—
Commercial Real Estate
Farm	63,294		1,094		147		1,584
Hotel	83,522		47,973		—		—
Construction and development	18,719		1,465		3,367		1,657
Other	439,702		27,621		22,466		17,442
Total	$	747,342	$	87,977	$	28,785	$	22,460

Loans not analyzed individually as part of the above described process are classified by delinquency. These loans are primarily residential mortgage and consumer loans. All consumer loans fully or partially secured by 1-4  family residential real estate that are 60-89 days will be classified as Watch. If loans are greater than 90 days past due, they will be classified as Substandard. Consumer loans not secured by 1-4 family residential real estate that are 60-119 days past due will be classified Substandard while loans greater than 119 days will be classified as Loss. As of March 31, 2013 and December 31, 2012, the grading of loans by category of loans is as follows:

March 31, 2013	Performing		Watch		Substandard
Residential
1-4 Family	$	397,732	$	1,269	$	4,082
Home Equity	221,069		371		1,475
Total	$	618,801	$	1,640	$	5,557

December 31, 2012	Performing		Watch		Substandard
Residential
1-4 Family	$	386,098	2,605		5,492
Home Equity	222,544		357		1,428
Total	$	608,642	$	2,962	$	6,920

March 31, 2013	Performing		Substandard		Loss
Consumer
Direct	$	41,890	$	86	$	56
Indirect	1,933		1		5
Total	$	43,823	$	87	$	61

December 31, 2012	Performing		Substandard		Loss
Consumer
Direct	$	45,553	$	195	$	96
Indirect	2,434		12		5
Total	$	47,987	$	207	$	101

16

NOTE 5 — OTHER REAL ESTATE OWNED

Other real estate owned is recorded in other assets on the balance sheet.  Activity in other real estate owned was as follows:

	2013			2012
Beginning Balance — January 1	$	6,677		$	15,456
Transfer to other real estate owned	967			1,831
Sales — out of other real estate owned	(1,370		)	(6,051		)
Write-down	(446		)	(562		)
Ending Balance — March 31	$	5,828		$	10,674

The value of the sale amount above is the carrying value of the property when it was sold.

Activity in the valuation account for other real estate was as follows:

	2013			2012
Beginning Balance — January 1	$	(1,672	)	$	(2,279	)
Impairments during year	(446		)	(562		)
Recovery on impairments	—			—
Reductions	405			756
Ending Balance — March 31	$	(1,713	)	$	(2,085	)

Expenses related to foreclosed assets for the period ending March 31 include:

	2013			2012
Write downs	$	446		$	562
Losses / (gains) on sales	(150		)	(310		)
Net loss / (gain)	$	296		$	252
Operating expenses	92			198

NOTE 6 — DEPOSITS

	March 31, 2013		December 31, 2012
Noninterest-bearing demand	$	418,916	$	405,167
Interest-bearing demand	829,538		855,049
Savings	498,288		470,265
Certificates of deposit of $100 or more	144,604		149,806
Other certificates and time deposits	291,351		304,767
Total deposits	$	2,182,697	$	2,185,054

NOTE 7 - EARNINGS PER SHARE

Earnings per common share (EPS) were computed as follows:

	March 31, 2013						March 31, 2012
For the three months ended:	Net Income			Weighted Average Shares	Per Share Amount		Net Income			Weighted Average Shares	Per Share Amount
Basic earnings per common share:
Net income	$	3,991		20,316,189			$	6,011		20,211,983
Redemption of preferred shares	—						1,242		(1)
Preferred dividends and accretion	(202		)				(763		)
Net income available to common shareholders	$	3,789		20,316,189	$	0.19	$	6,490		20,211,983	$	0.32
Effect of Dilutive stock options				62,465						53,588
Net income available to common shareholders and assumed conversions	$	3,789		20,378,654	$	0.19	$	6,490		20,265,571	$	0.32

(1) See Note 10 for additional information on this amount.

17

Stock options for 257,516 common shares and stock warrants for 571,906 common shares in 2013 and stock options for 251,655 common shares and stock warrants for 571,906 common shares in 2012 were not considered in computing diluted earnings per share because they were antidilutive.

NOTE 8 — FAIR VALUE

ASC 820 establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The fair values of securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs) or using market data utilizing pricing models, primarily Interactive Data Corporation (IDC), that vary based upon asset class and include available trade, bid, and other market information. Matrix pricing is used for most municipals, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities. The grouping of securities is done according to insurer, credit support, state of issuance, and rating to incorporate additional spreads and municipal curves. For the general market municipals, the Thomson Municipal Market Data curve is used to determine the initial curve for determining the price, movement, and yield relationships with the municipal market (Level 2 inputs). Level 3 securities are largely comprised of small, local municipality issuances.  Fair values are derived through consideration of funding type, maturity and other features of the issuance, and include reviewing financial statements, earnings forecasts, industry trends and the valuation of comparative issuers.  In most cases, the book value of the security is used as the fair value as meaningful pricing data is not readily available.  The fair values are determined a third party and reviewed by the Company’s investment advisor who reports to the Company’s Asset/Liability and Investments Manager who reports to the Company’s Chief Financial Officer.  Twice a year, a sample of prices supplied by the pricing agent is validated by comparison to prices obtained from other third party sources.

The fair value of impaired loans with specific allocations of the allowance for loan losses is generally based on recent real estate appraisals or industry accepted valuation methods. In a limited number of situations, the Company’s appraisal department is determining the value of appraisal.  These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the loan officers to adjust for differences between the comparable sales and income data available as well as costs to sell. Such adjustments are typically significant and result in a Level 3 classification of the inputs for determining fair value.  These adjustments typically range from 0%-50%.  Impaired loans are evaluated quarterly for additional impairment and take into account changing market conditions, specific information in the market the property is located, and the overall economic climate as well as overall changes in the credit.  The Company’s Appraisal Manager has the overall responsibility for all appraisals.  The Company’s loan officer responsible for the loan, the special assets officer, as well as the senior officers of the Company review the adjustments made to the appraisal for market and disposal costs on the loan.

The fair value of servicing rights is based on a valuation model from a third party that calculates the present value of estimated net servicing income.  The valuation model incorporates assumptions that market participants would use in estimating future net servicing income.  The Company is able to compare the valuation model inputs and results to widely available published industry data for reasonableness (Level 2 inputs).

The fair value of other real estate owned is measured based on the value of the collateral securing those assets and is determined using several methods. The fair value of real estate is generally determined based on appraisals by qualified licensed appraisers (third party). The appraisers typically determine the value of the real estate by utilizing an income or market valuation approach. If an appraisal is not available, the fair value may be determined by using a cash flow analysis.  Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by certified general appraisers whose qualifications and licenses have been reviewed and verified by the Company.  Once received, a member of the Appraisal Department reviews the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value in comparison with independent data sources such as recent market data or industry-wide statistics.  Fair values are reviewed on at least an annual basis.  The Company normally applies an internal discount to the value of appraisals used in the fair value evaluation of OREO.  The deductions take into account changing business factors and market conditions as well as disposal costs.  These deductions range from 0% to 50%.  As noted in the impaired loans discussion above, the Company’s Appraisal Manager has the overall responsibility for all appraisals.  The Appraisal Manager reports to the Vice President of Credit Administration who reports to the Chief Credit Officer of the Company.

18

Assets and Liabilities Measured on a Recurring Basis

Assets and liabilities measured at fair value under ASC 820 on a recurring basis, including financial assets and liabilities for which the Company has elected the fair value option, are summarized below:

			Fair Value Measurements at March 31, 2013 Using:
					Significant
			Quoted Prices in		Other		Significant
			Active Markets for		Observable		Unobservable
	Carrying		Identical Assets		Inputs		Inputs
(Dollars in thousands)	Value		(Level 1)		(Level 2)		(Level 3)
Financial Assets
Investment securities available-for sale
U. S. government agency	$	1,390			$	1,390
States and municipals	338,409				323,417		14,992
Mortgage-backed securities — residential —Government Sponsored Entity	217,160				217,160
Collateralized mortgage obligations — Government Sponsored Entity	340,959				340,959
Equity securities	4,939		4,689				250
Other securities	3,539				990		2,549
Total investment securities available-for-sale	$	906,396	$	4,689	$	883,916	$	17,791
Mortgage banking derivative	$	1,375			$	1,375

			Fair Value Measurements at December 31, 2012 Using:
					Significant
			Quoted Prices in		Other		Significant
			Active Markets for		Observable		Unobservable
	Carrying		Identical Assets		Inputs		Inputs
(Dollars in thousands)	Value		(Level 1)		(Level 2)		(Level 3)
Financial Assets
Investment securities available-for sale
U. S. government agency	$	1,638			$	1,638
States and municipals	337,939				322,469		15,470
Mortgage-backed securities — residential —Government Sponsored Entity	227,055				227,055
Collateralized mortgage obligations — Government Sponsored Entity	327,223				327,223
Equity securities	4,939		4,689				250
Other securities	3,547				990		2,557
Total investment securities available-for-sale	$	902,341	$	4,689	$	879,375	$	18,277
Mortgage banking derivative	$	2,200			$	2,200

There were no transfers between Level 1 and Level 2 during the first quarter of 2013 or 2012.

19

The table below presents a reconciliation and income statement classification of gains and losses for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three month periods ended March 31, 2013 and 2012:

Three months ended March 31:

States and municipal	2013			2012
Beginning balance, January 1	$	15,470		$	23,556
Total gains or losses (realized / unrealized)
Included in other comprehensive income	(11		)	(8		)
Sales	—			(6,907		)
Settlements	(467		)	(374		)
Ending balance, March 31	$	14,992		$	16,267

Equity securities	2012		2011
Beginning balance, January 1	$	250	$	750
Total gains or losses (realized / unrealized)
Included in earnings
Other than temporary impairment	—		(500		)
Ending balance, March 31	$	250	$	250

Other securities	2012			2011
Beginning balance, January 1	$	2,557		$	2,587
Total gains or losses (realized / unrealized)
Included in other comprehensive income	(8		)	(8		)
Ending balance, March 31	$	2,549		$	2,579

The Company’s state and municipal security valuations were supported by analysis prepared by an independent third party.  Fair values are derived through consideration of funding type, maturity and other features of the issuance, and include reviewing financial statements, earnings forecasts, industry trends and the valuation of comparative issuers.  In most cases, the book value of the security is used as the fair value as meaningful pricing data is not readily available.

The Company’s equity security valuation was supported by an analysis prepared by the Company’s Investments Manager. Fair value is derived through consideration of funding type, maturity and other features of the issuance, and include reviewing financial statements, earnings forecasts, industry trends and the valuation of comparative issuers.  In this case, the book value of the security is used as the fair value as meaningful pricing data is not readily available.

The Company’s other security valuation was supported by analysis prepared by an independent third party.  Fair values are derived through consideration of funding type, maturity and other features of the issuance, and include reviewing financial statements, earnings forecasts, industry trends and the valuation of comparative issuers.  In most cases, the book value of the security is used as the fair value as meaningful pricing data is not readily available.

20

Assets and Liabilities Measured on a Non-Recurring Basis

Assets and liabilities measured at fair value on a non-recurring basis are summarized below:

			Fair Value Measurements at March 31, 2013 Using
	March 31, 2013		Quoted Prices in Active Markets for Identical Assets (Level 1)	Significant Other Observable Inputs (Level 2)	Significant Unobservable Inputs (Level 3)
Assets:
Impaired loans
Commercial and industrial	$	140			$	140
Farm	421				421
Construction and development	291				291
Other	8,119				8,119
1-4 Family	233				233
Total impaired loans	$	9,204			$	9,204
Impaired servicing rights	$	2,763			$	2,763
Other real estate owned/assets held for sale
Construction and development	$	1,095			$	1,095
Other	348				348
1-4 family	140				140
Total other real estate owned/assets held for sale	$	1,583			$	1,583

			Fair Value Measurements at December 31, 2012 Using
	December 31, 2012		Quoted Prices in Active Markets for Identical Assets (Level 1)	Significant Other Observable Inputs (Level 2)	Significant Unobservable Inputs (Level 3)
Assets:
Impaired loans
Commercial and industrial	$	155			$	155
Farm	480				480
Construction and development	404				404
Other	4,936				4,936
Total impaired loans	$	5,975			$	5,975
Impaired servicing rights	$	2,942			$	2,942
Other real estate owned/assets held for sale
Construction and development	$	1,764			$	1,764
Other	803				803
1-4 family	95				95
Total other real estate owned/assets held for sale	$	2,662			$	2,662

21

The following represent impairment charges recognized during the period:

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a gross carrying amount of $12,598, with a valuation allowance of $3,394 at March 31, 2013. The Company recorded a charge of $1,328 to provision expense associated with these loans for the three months ended March 31, 2013. The Company recorded a credit of $17 of provision expense associated with these loans for the three month period ended March 31, 2012. At December 31, 2012, impaired loans had a gross carrying amount of $9,151 with a valuation allowance of $3,176. A breakdown of these loans by portfolio class at March 31, 2013 is as follows:

	Gross Balance		Valuation Allowance		Net
Commercial and industrial	$	496	$	356	$	140
Farm	625		204		421
Construction and development	543		252		291
Other commercial real estate	10,690		2,571		8,119
1-4 Family	244		11		233
Ending Balance	$	12,598	$	3,394	$	9,204

Impaired tranches of servicing rights were carried at a fair value of $2,763, which is made up of the gross outstanding balance of $3,638, net of a valuation allowance of $875. A recovery of $250 was included in 2013 earnings. No charges were included in the first quarter of 2012 earnings.  At December 31, 2012, impaired servicing rights were carried at a fair value of $2,942, resulting in a valuation allowance of $1,125. The gross outstanding balance was $4,067, net of a valuation allowance of $1,125.

Other real estate owned/assets held for sale is evaluated at the time a property is acquired through foreclosure or shortly thereafter. Fair value is based on appraisals by qualified licensed appraisers. At March 31, 2013, other real estate owned was carried at a fair value of $1,583, which is made up of the gross outstanding balance of $2,317, net of a valuation allowance of $734. During the first quarter of 2013, these properties were written down by $134. At December 31, 2012, other real estate/assets held for sale was carried at a fair value of $2,662, which is made up of the gross outstanding balance of $4,334, net of a valuation allowance of $1,672. During the first quarter of 2012, these properties were written down by $669. A breakdown of these properties by portfolio class at March 31, 2013 is as follows:

	Gross Balance		Valuation Allowance		Net
Construction and development	$	1,621	$	526	$	1,095
Other commercial real estate	483		135		348
1-4 Family	213		73		140
Ending Balance	$	2,317	$	734	$	1,583

The following table presents quantitative information about level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at March 31, 2013 and December 31, 2012. Impaired commercial, commercial real estate loans, and other real estate owned that are deemed collateral dependent are valued based on the fair value of the underlying collateral. These estimates are based on the most recently available appraisals with certain adjustments made based on the type of property, age of appraisal, current status of the property and other related factors to estimate the current value of the collateral.

22

March 31, 2013	Fair Value (in thousands)		Valuation Technique(s)	Unobservable Input(s)	Range
Impaired Loans:
Commercial & industrial	$	140	Liquidation value of inventory	Management adjustment	15% 15% Avg
Farm real estate	421		Sales comparison approach	Adjustment for differences between comparable sales	40% 40% Avg
Construction and development	291		Sales comparison approach	Adjustment for differences between comparable sales	10%-35% 33% Avg
Other	8,352		Sales comparison approach	Adjustment for differences between comparable sales, type of property, current status of property	0%-65% 26% Avg
	$	9,204
Other real estate owned:
Construction and development	$	1,095	Sales comparison approach	Adjustment for differences between comparable sales.	10%-49% 18% Avg
Other and 1-4 family	488		Sales comparison approach	Adjustment for differences between comparable sales.	10%-65% 29% Avg
	$	1,583
Mortgage servicing rights	$	2,763	Cash flow analysis	Discount rate	10%
December 31, 2012	Fair Value (in thousands)		Valuation Technique(s)	Unobservable Input(s)	Range
Impaired Loans:
Commercial & industrial	$	155	Liquidation value of inventory	Management adjustment	15% 15% Avg
Farm real estate	480		Sales comparison approach	Adjustment for differences between comparable sales	35-40% 37% Avg
Construction and development	404		Sales comparison approach	Adjustment for differences between comparable sales	10%-50% 41% Avg
Other	4,936		Sales comparison approach	Adjustment for differences between comparable sales, type of property, current status of property	0%-60% 32% Avg
	$	5,975
Other real estate owned:
Construction and development	$	1,764	Sales comparison approach	Adjustment for differences between comparable sales.	10%-26% 15% Avg
Other and 1-4 family	898		Sales comparison approach	Adjustment for differences between comparable sales.	2%-35% 17% Avg
	$	2,662
Mortgage servicing rights	$	2,942	Cash flow analysis	Discount rate	10%

23

The carrying amounts and estimated fair values of financial instruments, not previously presented, is as follows:

March 31, 1013	Carrying Amount			Level 1		Level 2		Level 3	Total
Financial assets:
Cash and cash equivalents	$	35,897		31,385		4,512			35,897
Loans including loans held for sale, net	1,549,210					5,094		1,538,992	1,544,086
Restricted stock	15,637								N/A
Interest receivable	9,620					4,390		5,230	9,620
Financial liabilities
Deposits	(2,182,697		)	(418,916	)	(1,765,306	)		(2,184,222	)
Other borrowings	(39,479		)			(39,479	)		(39,479	)
FHLB advances	(104,404		)			(112,380	)		(112,380	)
Interest payable	(954		)			(954	)		(954	)
Subordinated debentures	(50,455		)			(31,786	)		(31,786	)

December 31,2012	Carrying Amount			Level 1			Level 2			Level 3	Total
Financial assets:
Cash and cash equivalents	$	65,650		$	58,100		$	7,550			$	65,650
Loans including loans held for sale, net	1,564,433						17,025			1,538,489	1,555,514
Restricted stock	15,639										N/A
Interest receivable	9,827						4,621			5,206	9,827
Financial liabilities
Deposits	(2,185,054		)	(405,167		)	(1,780,511		)		(2,185,678		)
Other borrowings	(34,519		)				(34,519		)		(34,519		)
FHLB advances	(141,052		)				(152,018		)		(152,018		)
Interest payable	(1,195		)				(1,195		)		(1,195		)
Subordinated debentures	(50,418		)				(31,763		)		(31,763		)

The difference between the loan balance included above and the amounts shown in Note 4 are the impaired loans discussed above.

The methods and assumptions, not previously presented, used to estimate fair values are described as follows:

(a) Cash and Cash Equivalents

The carrying amounts of cash and short-term instruments approximate fair values and are classified as either Level 1 or Level 2. Noninterest bearing deposits are Level 1 whereas interest bearing due from bank accounts and fed funds sold are Level 2.

(b) Restricted Stock

It is not practical to determine the fair value of FHLB stock due to restrictions placed on its transferability.

(c) Loans, Net

Fair values of loans are estimated as follows: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification. Loans held for sale is estimated based upon binding contracts and quotes from third party investors resulting in a Level 2 classification.  Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

(d) Deposits

The fair values disclosed for non-interest bearing deposits are, by definition, equal to the amount payable on demand at the reporting date resulting in a Level 1 classification. The carrying amounts of variable rate interest bearing deposits approximate their fair values at the reporting date resulting in either a Level 1 classification.  Fair values for fixed rate interest bearing deposits are estimated using a discounted cash flows calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.

(e) Securities Sold Under Agreements to Repurchase

The carrying amounts of borrowings under repurchase agreements approximate their fair values resulting in a Level 2 classification.

(f) Other Borrowings

The fair values of the Company’s FHLB advances are estimated using discounted cash flow analyses based on the current borrowing rates resulting in a Level 2 classification.

The fair values of the Company’s subordinated debentures are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 2 classification.

The fair values of the Company’s Other borrowings are estimated using discounted cash flow analyses based on the current borrowing rates resulting in a Level 2 classification.

(g) Accrued Interest Receivable/Payable

The carrying amounts of accrued interest approximate fair value resulting in a Level 2 or Level 3 classification based on the level of the asset or liability with which the accrual is associated.

NOTE 9 — REGULATORY CAPITAL

Banks and bank holding companies are subject to various regulatory capital requirements administered by the federal banking agencies and are assigned to a capital category. The assigned capital category is largely determined by three ratios that are calculated according to the regulations. The ratios are intended to measure capital relative to assets and credit risk associated with those assets and off-balance sheet exposures. The capital category assigned to an entity can also be affected by qualitative judgments made by regulatory agencies about the risk inherent in the entity’s activities that are not part of the calculated ratios.

24

Actual and required capital amounts and ratios are presented below:

					Required for
	Actual				Adequate Capital				To Be Well Capitalized
March 31, 2013	Amount		Ratio		Amount		Ratio		Amount	Ratio
MainSource Financial Group
Total capital (to risk-weighted assets)	$	299,513	18.1	%	$	132,669	8.0	%	N/A	N/A
Tier 1 capital (to risk-weighted assets)	278,833		16.8		66,334		4.0		N/A	N/A
Tier 1 capital (to average assets)	278,833		10.4		106,953		4.0		N/A	N/A
MainSource Bank
Total capital (to risk-weighted assets)	278,743		17.0	%	131,469		8.0	%	164,336	10.0	%
Tier 1 capital (to risk-weighted assets)	258,063		15.7		65,734		4.0		98,602	6.0
Tier 1 capital (to average assets)	258,063		9.7		106,153		4.0		132,691	5.0

					Required for				To Comply with
	Actual				Adequate Capital				Regulatory Agreement
December 31, 2012	Amount		Ratio		Amount		Ratio		Amount	Ratio
MainSource Financial Group
Total capital (to risk-weighted assets)	$	296,714	17.8	%	$	133,549	8.0	%	N/A	N/A
Tier 1 capital (to risk-weighted assets)	275,707		16.5		66,774		4.0		N/A	N/A
Tier 1 capital (to average assets)	275,707		10.4		106,077		4.0		N/A	N/A
MainSource Bank
Total capital (to risk-weighted assets)	283,303		17.2	%	132,052		8.0	%	165,065	10.0	%
Tier 1 capital (to risk-weighted assets)	262,527		15.9		66,026		4.0		99,039	6.0
Tier 1 capital (to average assets)	262,527		9.9		106,077		4.0		132,596	5.0

Management believes as of March 31, 2013, the Company and the Bank met all capital adequacy requirements to which they are subject to be considered well-capitalized. The holding company is a source of additional financial strength to the Bank with its $14,000 in cash and its ability to downstream additional capital to the Bank.

NOTE 10 — PREFERRED STOCK AND STOCK REPURCHASE

On January 16, 2009, the Company entered into an agreement with the United States Department of Treasury (the “Treasury Department”) as part of the Treasury Department’s Capital Purchase Program. Under this agreement, the Company issued to the Treasury Department 57,000 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A (“preferred stock”), having a liquidation amount per share of $1,000, for a total price of $57 million and a warrant to purchase up to 571,906 shares (“warrant shares”) of the Company’s common stock, at an initial per share exercise price of $14.95, for an aggregate purchase price of $8,550.

The preferred stock pays cumulative dividends at a rate of 5% per year for the first five years and 9% per year thereafter. Dividends are payable quarterly in arrears on February 15, May 15, August 15 and November 15 of each year. The Company may, at its option and at any time, redeem the preferred stock for the liquidation amount of $1,000 per share, plus any accrued and unpaid dividends. While the preferred stock is outstanding, the Company may only pay dividends on common stock if all accrued and unpaid dividends for the preferred stock have been paid.

On March 28, 2012, the U.S. Department of the Treasury priced its secondary public offering of 57,000 shares of the Company’s Preferred Stock. The Company successfully bid for the purchase of 21,030 shares of the Preferred Stock for a total purchase price of $19,581, plus accrued and unpaid dividends on the Preferred Stock from and including February 15, 2012 to the settlement date, April 3, 2012. The book value of the preferred stock retired was $20,823. As a result of its successful bid in the offering, the Company retired 21,030 shares of its original sale of 57,000 shares of Preferred Stock on March 29, 2012. The difference between the book value and the bid price of $1,242 was credited to retained earnings.  This $1,242 was not included in the earnings per share calculation in the first quarter of 2012 reporting, but was included in the remaining quarters of 2012 in the total year calculation.  It is included in the first quarter 2013 calculations shown in Note 7.

NOTE 11 — INCOME TAXES

In accordance with ASC 740-270-50-1, Accounting for Interim Reporting, the provision for income taxes was recorded at March 31, 2013 and 2012 based on the current estimate of the effective annual rate.  The effective tax rate for the first quarter of 2013 was 0.2% versus 16.7% for the same period 2012.  The decrease was due to the decrease in pre-tax income in the first quarter of 2013 offset by the same amount of tax exempt interest income and tax credits that were taken in the first quarter of 2012.  Also, there were some expenses in the first quarter 2012 that were non-deductible for tax purposes.

NOTE 12 — ACQUISITIONS

In December, 2012, the Company completed its purchase of a branch in Shelbyville, Kentucky. As of the date of acquisition, the Company acquired $27,000 in loans and $37,000 in deposits. Goodwill of $1,000 and a core deposit intangible of $200 were also recorded in 2012. The Company completed its purchase accounting on this acquisition in the first quarter of 2013 and recorded an additional $432 of goodwill with the offset to time deposits.  The time deposit amount is being amortized over 4 years.

NOTE 13 — BRANCH CLOSURES

In January 2013, the Board of Directors approved the closure of eight branch offices in the following locations effective in the second quarter of 2013: Redkey, Fortville, Cambridge City, Fountain City, Trafalgar, East Enterprise, and Covington, Indiana and Troy, Ohio.  The Company currently operates three offices in Troy, Ohio, but intends to consolidate those offices into two locations.  In total, the eight branches being closed represent approximately $85,000 in deposits.  Included in the first quarter of 2013 operating results are $150 of severance costs, $550 of impairment costs for the affected properties, and $50 of other costs related to the closing of the branches.

25

MAINSOURCE FINANCIAL GROUP, INC.

FORM 10-Q

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

(Dollar amounts in thousands except per share data)

Overview

MainSource Financial Group, Inc. (“MainSource or Company”) is a financial holding company whose principal activity is the ownership and management of its subsidiary bank, MainSource Bank (“Bank”) headquartered in Greensburg, Indiana.  Through its non-bank affiliates, the Company provides services incidental to the business of banking.  The Bank operates under a state charter and is subject to regulation by its state regulatory agencies and the Federal Deposit Insurance Corporation.

Forward-Looking Statements

Except for historical information contained herein, the discussion in this report includes certain forward-looking statements based upon management expectations. Actual results and experience could differ materially from the anticipated results or other expectations expressed in the Company’s forward-looking statements. The Company disclaims any intent or obligation to update such forward looking statements. Factors which could cause future results to differ from these expectations include the following: general economic conditions; legislative and regulatory initiatives; monetary and fiscal policies of the federal government; deposit flows; the cost of funds; general market rates of interest; interest rates on competing investments; demand for loan products; demand for financial services; changes in accounting policies or guidelines; changes in the quality or composition of the Company’s loan and investment portfolios; the Company’s ability to integrate acquisitions, the impact of our continuing acquisition strategy, and other factors, including the risk factors set forth in Item 1A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2012, and in other reports we file from time to time with the Securities and Exchange Commission. The Company intends the forward looking statements set forth herein to be covered by the safe harbor provisions for forward looking statements contained in the Private Securities Litigation Reform Act of 1995.

Results of Operations

Net income for the first quarter of 2013 was $3,991 compared to net income of $6,011 for the first quarter of 2012. The decrease in net income was primarily attributable to a prepayment penalty on a FHLB advance of $2,239 and an accrual for expenses and asset write-downs related to branch closures of $750.  Diluted earnings per common share for the first quarter of 2013 totaled $0.19, a decrease from the $0.32 reported in the same period a year ago. Key measures of the financial performance of the Company are return on average shareholders’ equity and return on average assets. Return on average shareholders’ equity was 4.99% for the first quarter of 2013 while return on average assets was 0.59% for the same period, compared to 7.09% and 0.88% respectively, in the first quarter of 2012.

Net Interest Income

The volume and yield of earning assets and interest-bearing liabilities influence net interest income. Net interest income reflects the mix of interest-bearing and non-interest-bearing liabilities that fund earning assets, as well as interest spreads between the rates earned on these assets and the rates paid on interest-bearing liabilities. First quarter net interest income of $22,598 in 2013 was a decrease of 5.0% versus the first quarter of 2012. Average earning assets were flat compared to the first quarter of 2012.  Small increases in loan balances of $14 million and securities of $10 million were offset by a reduction in fed funds sold of $22 million. Also affecting margin was an increase in average demand deposits, NOW accounts, and savings accounts of $144 million which offset a decrease in higher costing CD’s of $93 million.  Net interest margin, on a fully-taxable equivalent basis, was 4.00% for the first quarter of 2013, a 17 basis point decrease compared to 4.17% for the same period a year ago and three basis points lower on a linked quarter basis.

Provision for Loan Losses

See “Loans, Credit Risk and the Allowance and Provision for Probable Loan Losses” below.

26

Non-interest Income

First quarter non-interest income for 2013 was $10,265 compared to $9,822 for the first quarter of 2012.  Contributing to the increase of $443 was an increase in trust and investment product fees of $207, service charges (primarily overdraft fees) of $110, and no impairment loss taken on an investment security in 2012.  The acquisition of two brokerage firms in late 2012 was the primary reason for the increase in brokerage fee income.  Continued organic growth in deposit accounts has resulted in higher fee income.  One security was deemed to be impaired in the first quarter of 2012 and was written down $500. Offsetting these increases was a decrease in securities gains of $143 and other income of $117.  The primary cause of the other income decrease was the write-down of the book value of eight branches that the Board of Directors voted to close effective in the second quarter of 2013 versus the six branches that the Board of Directors voted to close in the first quarter of 2012. (See Note 13 in the Notes to the Consolidated Financial Statements.)

Non-interest Expense

The Company’s non-interest expense was $27,128 for the first quarter of 2013, compared to $23,281 for the same period in 2012.  The primary increases were in employee costs of $1,262, equipment costs of $271, consultant expenses of $325, and a prepayment penalty on a FHLB advance of $2,239, offset by reductions in FDIC assessments of $471 and other expenses of $253.  The increase in employee costs and equipment costs is a result of the investment in new branches and markets in the latter half of 2012.  The reduction in FDIC expenses related to an improvement in the Company’s risk ratings used to compute its premium. Other expenses decreased due to the expenses related to the Treasury’s auction of its Series A Preferred Stock in the Company in the first quarter of 2012. The Company’s efficiency ratio was 78.4% for the first quarter of 2013 compared to 65.8% for the same period a year ago.

Income Taxes

The effective tax rate for the first quarter of 2013 was 0.2% versus 16.7% for the same period 2012.  The decrease was due to the decrease in pre-tax income in the first quarter of 2013 offset by the same amount of tax exempt interest income and tax credits that were taken in the first quarter of 2012.  Also, there were some expenses in the first quarter 2012 that were non-deductible for tax purposes.

Financial Condition

Total assets at March 31, 2013 were $2,732,609, a slight decrease from total assets of $2,769,288 as of December 31, 2012.  The largest decrease was in cash and cash equivalents of $29,753.  Average earning assets represented 89.3% of average total assets for the first three months of 2013 and 89.9% for the same period in 2012. Average loans represented 71.7% of average deposits in the first three months of 2013 and 72.5% for the comparable period in 2012.  Average loans as a percent of average assets were 56.7% and 56.5% for the three month periods ended March 31, 2013 and 2012 respectively.

While deposits remained flat at March 31, 2013 compared to December 31, 2012, noninterest bearing deposits and savings deposits increased $42 million and were offset by a reduction of $19 million in higher-priced CD balances.

Shareholders’ equity was $323 million on March 31, 2013 compared to $324 million on December 31, 2012.  Book value (shareholders’ equity) per common share was $15.14 at March 31, 2013 versus $15.21 at year-end 2012. Accumulated other comprehensive income increased book value per share by $1.07 at March 31, 2013 and increased book value per share by $1.27 at December 31, 2012.  Depending on market conditions, the unrealized gain or loss on securities available for sale can cause fluctuations in shareholders’ equity.

Loans, Credit Risk and the Allowance and Provision for Probable Loan Losses

27

Loans remain the Company’s largest concentration of assets and, by their nature, carry a higher degree of risk. The loan underwriting standards observed by the Bank are viewed by management as a means of controlling problem loans and the resulting charge-offs.  The Company believes credit risks may be elevated if undue concentrations of loans in specific industry segments and to out-of-area borrowers are incurred. Accordingly, the Company’s Board of Directors regularly monitors such concentrations to determine compliance with its loan allocation policy. The Company believes it has no undue concentrations of loans.

Management maintains a list of loans warranting either the assignment of a specific reserve amount or other special administrative attention. This watch list, together with a listing of all classified loans, nonaccrual loans and delinquent loans, is reviewed monthly by management and the Board of Directors. Additionally, the Company evaluates its consumer and residential real estate loan pools for probable losses incurred based on historical trends, adjusted by current delinquency and non-performing loan levels.

The Company has both internal and external loan review personnel who annually review approximately 50% of all loans. External loan review personnel examine the top 100 commercial credit relationships. This equates to approximately all relationships above $1,750.

The ability to absorb loan losses promptly when problems are identified is invaluable to a banking organization. Most often, losses incurred as a result of prompt, aggressive collection actions are much lower than losses incurred after prolonged legal proceedings. Accordingly, the Company observes the practice of quickly initiating stringent collection efforts in the early stages of loan delinquency. During the latter part of 2008, the Company established a separate group to address its deteriorating credit quality. This group consists of seven full-time equivalent employees and reports directly to the Chief Credit Officer of the Company.  At the present time, this group is charged with the task of efficiently resolving non-performing credits and disposing of foreclosed properties.

Total loans (excluding loans held for sale) were basically flat from year end 2012.  The Company is experiencing improving overall demand across all segments.  Residential real estate loans continue to represent a significant portion of the total loan portfolio. Such loans represented 25.9% of total loans at March 31, 2013 and 25.4% at December 31, 2012. On March 31, 2013, the Company had $5,094 of residential real estate loans held for sale, which was a decrease from the year-end balance of $17,025. The Company generally retains the servicing rights on mortgages sold.

Loans are placed on “non-accrual” status when, in management’s judgment, the collateral value and/or the borrower’s financial condition does not justify accruing interest. As a general rule, commercial and real estate loans are reclassified to nonaccrual status at or before becoming 90 days past due. Interest previously recorded is reversed and charged against current income. Subsequent interest payments collected on nonaccrual loans are thereafter applied as a reduction of the loan’s principal balance. Non-performing loans were as follows (non-accrual loans + loans past due 90 days and still accruing + troubled debt restructurings):

	March 31, 2013			December 31, 2012			September 30, 2012			June 30, 2012			March 31, 2012
Amount	$	40,454		$	51,118		$	50,698		$	54,944		$	52,677
Percent of loans	2.60		%	3.29		%	3.31		%	3.55		%	3.44		%

The reduction of $11 million from year end was primarily due to the transfer to performing status of five credits totaling $10 million taken in the first three months of 2013.  The five credits taken out of non performing TDR status were loans that were restructured into A/B notes during mid 2012.  The new restructured notes have made timely payments since the restructuring so they were removed from non performing TDR status at March 31, 2013.  Of the $40,454 of non-performing loans at March 31, 2013, $14,258 had a specific reserve allocated of $3,621.

A reconciliation of the non-performing assets for the first quarter of 2013 and 2012 is as follows:

	2013			2012
Beginning Balance - NPA - January 1,	$	57,795		$	80,732
Non-accrual
Add: New non-accruals	7,778			9,764
Less: To accrual/payoff/restructured	(3,951		)	(2,158		)
Less: To OREO	(967		)	(1,831		)
Less: Charge offs	(2,233		)	(4,448		)
Increase/(Decrease): Non-accrual loans	627			1,327
Other Real Estate Owned (OREO)
Add: New OREO properties	967			1,831
Less: OREO sold	(1,370		)	(6,051		)
Less: OREO losses (write-downs)	(446		)	(562		)
Increase/(Decrease): OREO	(849		)	(4,782		)
Increase/(Decrease): Repossessions	14			(79		)
Increase/(Decrease): 90 Days Delinquent	(465		)	(2,998		)
Increase/(Decrease): TDR’s	(10,826		)	(10,849		)
Total NPA change	(11,499		)	(17,381		)
Ending Balance - NPA - March 31	$	46,296		$	63,351

At March 31, 2013, only three of the non-accrual loan balances were greater than $1,000 compared to one loan balance greater than $1,000 at December 31, 2012. These loans are primarily real estate backed loans. The Company is working with these borrowers in an attempt to minimize its losses. In the course of resolving problem loans, the Company may choose to restructure the contractual terms of certain loans. The Company attempts to work out an alternative payment schedule with the borrower in order to avoid foreclosure actions. Any loans that are modified are reviewed by the Company to identify if a troubled debt restructuring has occurred, which is when for economic or legal reasons related to a borrower’s financial difficulties, the Company grants a concession to the borrower that it would not otherwise consider. Terms may be modified to fit the ability of the borrower to repay in line with its current financial status and could include reduction of the stated interest rate, other than normal market rate adjustments, extension of maturity dates, or reduction of principal balance or accrued interest. The decision to restructure a loan, versus aggressively enforcing the collection of the loan, may benefit us by increasing the ultimate probability of collection. The Company reviews each relationship before it grants the concession to insure the creditor can comply with the new terms. To date, most of the concessions have been extensions of maturity dates.

The Company continued to see a reduction in its Special Mention and Substandard Loans in the first quarter of 2013.  These loans decreased $9 million from the end of 2012.  The loans upgraded were the result of overall improvement in the underlying fundamentals of the credit.

28

The provision for loan losses was $1,734 in the first quarter of 2012 compared to $3,100 for the same period in 2012 and $2,250 for the fourth quarter of 2012. The decrease in provision expense from 2012 was primarily due to the relative stabilization in the amount of non-performing and watch list loans in the aggregate.  The amount of new non-accrual loans in the first quarter of 2013 was approximately $2 million higher than the fourth quarter of 2012.

Net charge-offs were $2,233 for the first quarter of 2013 compared to $4,448 for the same period a year ago.  One third of the Company’s charge-offs for the first three months of 2013 were related to 5 commercial credits.  These charge-offs were fully reserved for in prior quarters.  All other charge-offs were smaller dollar amounts.

The adequacy of the allowance for loan losses is reviewed at least quarterly. The determination of the provision amount in any period is based upon management’s continuing review and evaluation of loan loss experience, changes in the composition of the loan portfolio, classified loans including non-accrual and impaired loans, current economic conditions, the amount of loans presently outstanding, and the amount and composition of loan growth. The allowance for loan losses as of March 31, 2013 was considered adequate by management.  The allowance for loan losses was $31,728 as of March 31, 2013 and represented 2.04% of total outstanding loans compared to $32,227 as of December 31, 2012 or 2.07% of total outstanding loans.  The slight decrease in the percentage was due to an improvement in nonperforming assets for the quarter.

Investment Securities

Investment securities offer flexibility in the Company’s management of interest rate risk and are an important source of liquidity as a response to changing characteristics of assets and liabilities. The Company’s investment policy prohibits trading activities and does not allow investment in high-risk derivative products, junk bonds or foreign investments.

As of March 31, 2013, the Company had $906,396 of investment securities. All of these securities were classified as “available for sale” (“AFS”) and were carried at fair value with unrealized gains and losses, net of taxes, reported as a separate component of shareholders’ equity. An unrealized pre-tax gain of $33,414 was recorded to adjust the AFS portfolio to current market value at March 31, 2013, compared to an unrealized pre-tax gain of $39,582 at December 31, 2012. Unrealized losses on AFS securities have not been recognized into income because management does not intend to sell and does not expect to be required to sell these securities for the foreseeable future and the decline in fair value is largely due to temporary illiquidity and the financial crisis affecting these markets and not necessarily the expected cash flows of the individual securities. The fair value is expected to recover as the securities approach their maturity dates.  All securities in the Company’s portfolio are performing as expected with no disruption in cash flows and all rated securities are rated investment grade.

Sources of Funds

The Company relies primarily on customer deposits, securities sold under agreements to repurchase and shareholders’ equity to fund earning assets. FHLB advances are also used to provide additional funding.

Deposits generated within local markets provide the major source of funding for earning assets. Average total deposits funded 88.5% and 86.7% of total average earning assets for the three-month periods ending March 31, 2013 and 2012. Total interest-bearing deposits averaged 81.4% and 85.0% of average total deposits for the three-month periods ending March 31, 2013 and 2012, respectively. Management constantly strives to increase the percentage of transaction-related deposits to total deposits due to the positive effect on earnings.

The Company had FHLB advances of $104,404 outstanding at March 31, 2013. These advances have interest rates ranging from 1.04% to 4.76%.  All of the current advances were originally long-term advances with approximately $15,000 maturing in 2013, $15,000 maturing in 2016, and $74,000 maturing in 2017 and beyond.

Capital Resources

Total shareholders’ equity was $322,673 at March 31, 2013, which was a decrease of $1,078 compared to the $323,751 of shareholders’ equity at December 31, 2012. The decrease in shareholders’ equity was primarily attributable to the Company’s other comprehensive loss of $4,009 and preferred and common dividends of $189 and $1,220 respectively, offset by net income of $3,991 for the first three months of 2013.

The Federal Reserve Board and other regulatory agencies have adopted risk-based capital guidelines that assign risk weightings to assets and off-balance sheet items. The Company’s core capital consists of shareholders’ equity, excluding accumulated other comprehensive income/loss, while Tier 1 capital consists of core capital less goodwill and intangibles. Trust preferred securities qualify as Tier 1 capital or core capital with respect to the Company under the risk-based capital guidelines established by the Federal Reserve. Under such guidelines, capital received from the proceeds of the sale of trust preferred securities cannot constitute more than 25% of the total core capital of the Company. Consequently, the amount of trust preferred securities in excess of the 25% limitation constitutes Tier 2 capital of the Company. Total regulatory capital consists of Tier 1, certain debt instruments and a portion of the allowance for loan losses. At March 31, 2013, Tier 1 capital to total average assets was 10.4%. Tier 1 capital to risk-adjusted assets was 16.8%. Total capital to risk-adjusted assets was 18.1%. All three ratios exceed all required ratios established for bank holding companies.  Risk-adjusted capital levels of the Bank exceed regulatory definitions of well-capitalized institutions.

The Company declared and paid common dividends of $0.06 per share in the first quarter of 2013 versus $0.01 per share for the first quarter of 2012.  The Company has increased its common dividend in the last few quarters as it has reduced its preferred dividend requirement and its credit metrics have continued to improve.

29

Liquidity

Liquidity management involves maintaining sufficient cash levels to fund operations and to meet the requirements of borrowers, depositors, and creditors. Higher levels of liquidity bear higher corresponding costs, measured in terms of lower yields on short-term, more liquid earning assets, and higher interest expense involved in extending liability maturities. Liquid assets include cash and cash equivalents, loans and securities maturing within one year, and money market instruments. In addition, the Company holds AFS securities maturing after one year, which can be sold to meet liquidity needs.

Maintaining a relatively stable funding base, which is achieved by diversifying funding sources and extending the contractual maturity of liabilities, supports liquidity and limits reliance on volatile short-term purchased funds. Short-term funding needs arise from declines in deposits or other funding sources, funding of loan commitments and requests for new loans. The Company’s strategy is to fund assets to the maximum extent possible with core deposits that provide a sizable source of relatively stable and low-cost funds. Average core deposits funded approximately 82.5% of total earning assets for the three months ended March 31, 2013 and 80.0% for the same period in 2012.

Management believes the Company has sufficient liquidity to meet all reasonable borrower, depositor, and creditor needs in the present economic environment. In addition, the Bank has access to the Federal Home Loan Bank for borrowing purposes.

Interest Rate Risk

Asset/liability management strategies are developed by the Company to manage market risk. Market risk is the risk of loss in financial instruments including investments, loans, deposits and borrowings arising from adverse changes in prices/rates. Interest rate risk is the Company’s primary market risk exposure, and represents the sensitivity of earnings to changes in market interest rates.

Effective asset/liability management requires the maintenance of a proper ratio between maturing or repriceable interest-earning assets and interest-bearing liabilities. In an effort to estimate the impact of sustained interest rate movements to the Company’s earnings, the Company monitors interest rate risk through computer-assisted simulation modeling of its net interest income. The Company’s simulation modeling monitors the potential impact to net interest income under various interest rate scenarios. The Company’s objective is to actively manage its asset/liability position within a one-year interval and to limit the risk in any of the interest rate scenarios to a reasonable level of tax-equivalent net interest income within that interval.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Market risk of the Company encompasses exposure to both liquidity and interest rate risk and is reviewed monthly by the Asset/Liability Committee and the Board of Directors. There have been no material changes in the quantitative and qualitative disclosures about market risks as of March 31, 2013 from the analysis and disclosures provided in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.

Item 4. Controls and Procedures

As of the end of the quarterly period covered by this report, an evaluation was carried out under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e) under the Securities Exchange Act of 1934 (“Exchange Act”)). Based on their evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures were, to the best of their knowledge, effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms as of such date.

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

30

PART II. OTHER INFORMATION

Item 1A. Risk Factors.

Other than as set forth above, there have been no material changes to the risk factors disclosed in the Corporation’s Form 10-K for the year ended December 31, 2012, as filed with the SEC on March 14, 2013.

Item 6. Exhibits

3.1	Amended and Restated Articles of Incorporation of MainSource Financial Group, Inc. (incorporated by reference to Exhibit 3.1 to the Quarterly Report on Form 10-Q of the registrant filed August 10, 2009 with the Commission (Commission File No. 0-12422)).
3.2	Amended and Restated Bylaws of MainSource Financial Group, Inc. dated July 19, 2010 (incorporated by reference to Exhibit 3.1 to the Report on Form 8-K of the registrant filed July 22, 2010 with the Commission (Commission File No. 0-12422)).
31.1	Certification pursuant to Rule 13a-14(a)/15d-14(a) by Chief Executive Officer
31.2	Certification pursuant to Rule 13a-14(a)/15d-14(a) by Chief Financial Officer

The following exhibits shall not be deemed filed for purposes of Section 18 of the Securities Exchange Act of 1934 and Sections 11 and 12 of the Securities Act of 1933, and are not incorporated by reference into any filing under the Securities Act or the Exchange Act, except to the extent the Company specifically incorporates them by reference.

32.1	Certification pursuant to Section 1350 by Chief Executive Officer
32.2	Certification pursuant to Section 1350 by Chief Financial Officer
101	The following financial statements and notes from the MainSource Financial Group Quarterly Report on Form 10-Q for the quarter ended March 31, 2013, formatted in XBRL pursuant to Rule 405 of Regulation S-T: (i)  Condensed Consolidated Balance Sheets; (ii) Condensed Consolidated Statements of Income; (iii) Condensed Consolidated Statements of Comprehensive Income (iv) Condensed Consolidated Statements of Cash Flows; and (v) the Notes to the condensed consolidated financial statements.

31

MAINSOURCE FINANCIAL GROUP, INC.

FORM 10-Q

SIGNATURES

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

MAINSOURCE FINANCIAL GROUP, INC.

May 9, 2013

/s/ Archie M. Brown, Jr.

Archie M. Brown, Jr.

President and Chief Executive Officer

May 9, 2013

/s/ James M. Anderson

James M. Anderson

Senior Vice President & Chief Financial Officer

32