Mainsource Financial (MSFG) 10-Q 2014 Q3 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 SEPTEMBER 30, 2014

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 November 7, 2014 there were outstanding 21,687,075 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/(Loss)	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	36
Item 3. Quantitative and Qualitative Disclosures About Market Risk	45
Item 4. Controls and Procedures	45
PART II. OTHER INFORMATION	46
Item 1A. Risk Factors	46
Item 6. Exhibits	46
Signatures	47

2

MAINSOURCE FINANCIAL GROUP, INC.

CONSOLIDATED BALANCE SHEETS

(Dollar amounts in thousands except per share data)

Item 1.  Financial Statements

	(Unaudited)
	September 30,			December 31,
	2014			2013
Assets
Cash and due from banks	$	60,150		$	55,826
Money market funds and federal funds sold	9,764			5,494
Cash and cash equivalents	69,914			61,320
Interest bearing time deposits	1,915			—
Securities available for sale	840,101			891,106
Loans held for sale	4,779			5,999
Loans, net of allowance for loan losses of $24,549 and $27,609	1,728,675			1,644,317
Restricted stock, at cost	15,625			15,629
Premises and equipment, net	55,157			55,957
Goodwill	64,900			64,900
Purchased intangible assets	3,872			5,125
Cash surrender value of life insurance	61,682			61,292
Interest receivable and other assets	53,332			54,219
Total assets	$	2,899,952		$	2,859,864
Liabilities
Deposits
Noninterest bearing	$	464,058		$	436,550
Interest bearing	1,757,641			1,764,078
Total deposits	2,221,699			2,200,628
Other borrowings	34,490			38,594
Federal Home Loan Bank (FHLB) advances	240,343			247,858
Subordinated debentures	41,239			46,394
Other liabilities	29,391			20,864
Total liabilities	2,567,162			2,554,338
Shareholders’ equity
Preferred stock, no par value: Authorized shares - 400,000; Issued shares — 0; Outstanding shares — 0; Aggregate liquidation preference — $0	—			—
Common stock $.50 stated value: Authorized shares - 100,000,000; Issued shares — 20,996,415 and 20,940,298; Outstanding shares — 20,460,763 and 20,417,224	10,537			10,508
Treasury stock — 535,652 and 523,074 at cost	(8,708		)	(8,495		)
Additional paid-in capital	225,539			224,793
Retained earnings	93,682			77,586
Accumulated other comprehensive income	11,740			1,134
Total shareholders’ equity	332,790			305,526
Total liabilities and shareholders’ equity	$	2,899,952		$	2,859,864

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 September 30,						Nine months ended September 30,
	2014			2013			2014			2013
Interest income
Loans, including fees	$	19,133		$	19,185		$	57,384		$	57,800
Securities	5,888			6,182			18,289			17,876
Other interest income	20			10			55			53
Total interest income	25,041			25,377			75,728			75,729
Interest expense
Deposits	844			1,166			2,764			3,799
Federal Home Loan Bank advances	862			819			2,562			2,510
Subordinated debentures	312			421			975			1,284
Other borrowings	21			18			60			50
Total interest expense	2,039			2,424			6,361			7,643
Net interest income	23,002			22,953			69,367			68,086
Provision for loan losses	—			1,000			1,500			3,734
Net interest income after provision for loan losses	23,002			21,953			67,867			64,352
Non-interest income
Mortgage banking	1,677			1,553			4,655			5,496
Trust and investment product fees	1,087			1,238			3,503			3,542
Service charges on deposit accounts	5,429			5,518			15,321			15,128
Net realized gains/(loss) on securities (includes $0 and ($4) accumulated other comprehensive income (AOCI) reclassifications for unrealized losses on available-for-sale securities in 2014 and includes $2 and $835 accumulated other comprehensive income reclassifications for unrealized net gains on available-for-sale securities in 2013)	—			2			(4		)	835
Increase in cash surrender value of life insurance	328			350			978			1,042
Interchange income	1,912			1,804			5,671			5,317
Gain/(loss) on sale and write-down of OREO	(9		)	(38		)	(47		)	(356		)
Other income	721			756			1,546			1,805
Total non-interest income	11,145			11,183			31,623			32,809
Non-interest expense
Salaries and employee benefits	13,000			13,090			40,272			39,407
Net occupancy	1,819			1,737			5,731			5,315
Equipment	2,669			2,583			7,568			7,378
Intangibles amortization	389			455			1,253			1,413
Telecommunications	430			450			1,298			1,356
Stationery printing and supplies	317			281			876			917
FDIC assessment	385			431			1,185			1,335
Marketing	769			647			2,127			2,656
Collection expense	156			625			987			2,434
Prepayment penalty on FHLB advance	—			—			—			2,239
Consultant expense	350			475			1,050			1,225
Interchange expense	605			491			1,666			1,404
Other expenses	2,288			2,224			7,172			7,393
Total non-interest expense	23,177			23,489			71,185			74,472
Income before income tax	10,970			9,647			28,305			22,689
Income tax expense (includes — and ($1) income tax benefit from AOCI reclassification in 2014 and — and $292 income tax expense from AOCI reclassification items in 2013)	2,513			2,015			5,869			3,742
Net income	$	8,457		$	7,632		$	22,436		$	18,947
Preferred dividends and discount accretion	—			(99		)	—			(504		)
Redemption of preferred stock	—			(148		)	—			(148		)
Net income available to common shareholders	$	8,457		$	7,385		$	22,436		$	18,295
Cash dividends declared per common share	$	0.11		$	0.08		$	0.31		$	0.20
Net income per common share — basic	$	0.41		$	0.36		$	1.10		$	0.90
Net income per common share — diluted	$	0.41		$	0.36		$	1.09		$	0.90

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

4

MAINSOURCE FINANCIAL GROUP, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME/(LOSS)

(Dollar amounts in thousands except per share data)

	(unaudited)						(unaudited)
	Three months ended						Nine months ended
	September 30,						September 30,
	2014			2013			2014			2013
Net income	$	8,457		$	7,632		$	22,436		$	18,947
Other comprehensive income/(loss):
Unrealized holding gains/(losses) on securities available for sale	(1,597		)	(1,907		)	16,039			(29,234		)
Reclassification adjustment for (gains)/losses included in net income	—			(2		)	4			(835		)
Tax effect	542			667			(5,437		)	10,524
Other comprehensive income/(loss)	(1,055		)	(1,242		)	10,606			(19,545		)
Comprehensive income/(loss)	$	7,402		$	6,390		$	33,042		$	(598	)

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)
	Nine months ended
	September 30
	2014			2013
Operating Activities
Net income	$	22,436		$	18,947
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses	1,500			3,734
Depreciation expense	4,375			4,309
Securities amortization, net	1,417			2,505
Stock based compensation expense	551			502
Stock portion of director retainer fee expense	270			282
Amortization of purchased intangible assets	1,253			1,413
Amortization of mortgage servicing rights	750			1,232
Earnings on cash surrender value of life insurance policies	(978		)	(1,042		)
(Recovery) of valuation allowance on mortgage servicing rights	(50		)	(650		)
Prepayment penalty on FHLB advance	—			2,239
Securities (gains)/losses, net	4			(835		)
Loss on sale and write-down of OREO	47			356
Gain on loans sold	(2,914		)	(4,716		)
Loans originated for sale	(115,118		)	(185,631		)
Proceeds from loan sales	119,252			201,484
Change in other assets and liabilities	2,192			5,146
Net cash provided by operating activities	34,987			49,275
Investing Activities
Net change in interest bearing time deposits	(1,915		)	—
Purchases of securities available for sale	(35,236		)	(203,148		)
Proceeds from calls, maturities, and payments on securities available for sale	78,891			101,427
Proceeds from sales of securities available for sale	21,972			79,136
Proceeds from sale of OREO	3,002			4,441
Proceeds from life insurance benefit	588			—
Loan originations and payment, net	(87,977		)	(68,623		)
Purchases of premises and equipment	(3,575		)	(6,787		)
Purchase of life insurance policies	—			(504		)
Proceeds from redemption of restricted stock	4			9
Net cash provided/(used) by investing activities	(24,246		)	(94,049		)
Financing Activities
Net change in deposits	21,071			(17,212		)
Net change in other borrowings	(4,104		)	(4,084		)
Repayment of FHLB advances	(722,515		)	(326,000		)
Proceeds from FHLB advances	715,000			430,000
Purchase of treasury shares	(319		)	(204		)
Proceeds from exercise of stock options, including tax benefit	60			383
Repayment of subordinated debentures, net	(5,000		)	—
Repurchase of preferred stock	—			(15,100		)
Cash dividends on preferred stock	—			(470		)
Cash dividends on common stock	(6,340		)	(4,075		)
Net cash (used)/provided by financing activities	(2,147		)	63,238
Net change in cash and cash equivalents	8,594			18,464
Cash and cash equivalents, beginning of year	61,320			65,650
Cash and cash equivalents, end of period	$	69,914		$	84,114
Supplemental cash flow information
Interest paid	$	6,669		$	8,028
Income taxes paid	2,405			1,380
Supplemental non cash disclosure
Loan balances transferred to foreclosed real estate	$	2,119		$	2,904

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, 2013.

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:

	Nine Months Ended September 30, 2014
	Shares		Weighted Average Exercise Price
Outstanding, beginning of year	402,139		$	13.79
Granted	31,327		16.11
Exercised	(6,500	)	9.24
Forfeited or expired	(48,726	)	18.48
Outstanding, period end	378,240		$	13.46
Options exercisable at period end	251,254		$	13.41
Fully vested and expected to vest	369,481		$	13.44

The following table details stock options outstanding:

	September 30, 2014		December 31, 2013
Stock options vested and currently exercisable:
Number	251,254		295,680
Weighted average exercise price	$	13.41	$	14.21
Aggregate intrinsic value	$	1,119	$	1,327
Weighted average remaining life (in years)	3.5		3.9

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 $42 and $124 in stock compensation expense during the three and nine months ended September 30, 2014 and $26 and $98 in stock compensation expense during the three and nine months ended September 30, 2013 to salaries and employee benefits. There were 29,389 options granted in the first quarter of 2014 and 1,938 options granted in the second quarter of 2014.  2,500 and 49,783 options were granted in the first and second quarters of 2013.  There were no options granted in the third quarter of 2014 or 2013.  In order to calculate the fair value of the options granted in 2014, the following weighted-average assumptions were used as of the grant dates:  risk free interest rate of 2.07%, expected option life 7.0 years, expected price volatility 28.1%, and dividend yield of 2.49%.  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 2014 and beyond is estimated as follows:

Year	(in thousands)
October 2014 - December 2014	$	36
2015	170
2016	93
2017	38

During the second quarter of 2013, the Executive 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 long-term incentive plan (the “LTIP”). 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 10, 2013 ($13.67). The restricted 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 10,792 shares of common stock of the Company were granted in 2013.

Also in 2013 and the first,  second, and third quarters of 2014, the Executive Compensation Committee of the Board of Directors of the Company granted restricted stock awards to certain executive officers and other employees pursuant to the Company’s LTIP. 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

8

determined by multiplying the award amount by the closing price of a share of Company common stock on the grant date. The restricted stock awards vest as follows — 100% on the third anniversary of the date of grant. A total of 21,726 shares of common stock were granted in the first quarter of 2014 at a weighted average cost of $16.12 per share; 10,611 shares of common stock were granted in the second quarter of 2014 at a weighted average cost of $16.53 and 2,000 shares of common stock were granted in the third quarter of 2014 at a weighted average cost of $17.32.  A total of 47,971 shares of common stock of the Company were granted in 2013.

A summary of changes in the Company’s non-vested restricted shares for 2014 follows:

	Restricted Shares		Weighted Average Grant Date Fair Value
Non-vested at January 1, 2014	105,283		$	12.85
Granted	34,337		16.30
Vested	(47,697	)	11.43
Forfeited	—		—
Non-vested at September 30, 2014	91,923		$	14.88

As of  September 30, 2014, there was $865 of total unrecognized compensation costs related to non-vested restricted stock awards granted under the 2007 Stock Incentive Plan that will be recognized over the remaining vesting period of approximately 1.4 years. The recognized compensation costs related to the 2007 Stock Incentive Plan were $125 and $427 for the three and nine month periods ending September 30, 2014 and $157 and $403 for the three and nine month periods ending September 30, 2013.

In the first quarter of 2013, members of the Board of Directors received the fourth installment of Company common stock for their annual retainer for the previous Board year that ended on the date of the 2013 annual meeting of shareholders. In the second quarter of 2013, members of the Board of Directors received their entire annual retainer in restricted Company stock for the following Board year ended with the 2014 annual meeting of shareholders. The 2013 award vested quarterly for all directors who remained on the Board of Directors on the vesting date, with 25% of the award vesting on each of May 1, August 1, and November 1, 2013, and February 1, 2014. The value of the 2013 retainer award was determined by multiplying the award amount by the closing price of the stock on the issuance date.

In the second quarter of 2014, members of the Board of Directors received their entire annual retainer in restricted Company stock for the following Board year that ends with the 2015 annual meeting of shareholders. The 2014 award vested quarterly for all directors who remained on the Board of Directors on the vesting date, with 25% of the award vesting on each of May 1, August 1, and November 1, 2014, and February 1, 2015. The value of the 2014 retainer award was determined by multiplying the award amount by the closing price of the stock on the issuance date.

For all awards, other expense is recognized over the three month period of the awards based on the fair value of the stock at the issue dates. Shares awarded by quarter were as follows:

Quarter		Shares	Price per Share
2013	1Q	7,200	$	13.38
	2Q	26,100	$	13.79
2014	2Q	21,780	$	16.53

A total of $90 and $90 was recognized as other expense in the third quarter of 2014 and 2013 respectively for these grants and $270 and $187 was recognized in the first nine months of 2014 and 2013 respectively.

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 September 30, 2014
Available for Sale
U. S. government agency	$	577	$	5	$	—		$	582
State and municipal	304,700		19,304		(306		)	323,698
Mortgage-backed securities-residential (GSE’s)	154,664		3,499		(1,259		)	156,904
Collateralized mortgage obligations (GSE’s)	354,174		2,180		(5,635		)	350,719
Equity securities	4,689		—		—			4,689
Other securities	3,508		1		—			3,509
Total available for sale	$	822,312	$	24,989	$	(7,200	)	$	840,101
As of December 31, 2013
Available for Sale
U. S. government agency	$	793	$	5	$	—		$	798
State and municipal	321,151		12,173		(2,212		)	331,112
Mortgage-backed securities-residential (GSE’s)	186,054		3,175		(3,800		)	185,429
Collateralized mortgage obligations (GSE’s)	372,896		1,642		(9,229		)	$	365,309
Equity securities	4,939		—		—			4,939
Other securities	3,527		—		(8		)	3,519
Total available for sale	$	889,360	$	16,995	$	(15,249	)	$	891,106

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
September 30, 2014	Amortized Cost		Fair Value
Within one year	$	15,516	$	15,707
One through five years	51,381		53,390
Six through ten years	128,201		135,014
After ten years	113,687		123,678
Mortgage-backed securities-residential (Government Sponsored Entity)	154,664		156,904
Collateralized mortgage obligations (Government Sponsored Entity)	354,174		350,719
Equity securities	4,689		4,689
Total available for sale securities	$	822,312	$	840,101

Proceeds from sales of securities available for sale were $21,972 and $79,136 for the nine months ended September 30, 2014 and 2013, respectively. Gross gains of $542 and $912 and gross losses of $546 and $77 were realized on these sales during 2014 and 2013, respectively.

Proceeds from sales of securities available for sale were $0 and $782 for the three months ended September 30, 2014 and 2013, respectively. Gross gains of $0 and $2 and gross losses of $0 and $0 were realized on these sales during 2014 and 2013, respectively.

10

Below is a summary of securities with unrealized losses as of September 30, 2014 and December 31, 2013 presented by length of time the securities have been in a continuous unrealized loss position.

	Less than 12 months					12 months or longer					Total
September 30, 2014 Description of securities	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
State and municipal	$	2,489	$	(11	)	$	15,981	$	(295	)	$	18,470	$	(306	)
Mortgage-backed securities-residential (GSE’s)	10,200		(26		)	49,874		(1,233		)	60,074		(1,259		)
Collateralized mortgage obligations (GSE’s)	75,368		(648		)	150,728		(4,987		)	226,096		(5,635		)
Total temporarily impaired	$	88,057	$	(685	)	$	216,583	$	(6,515	)	304,640		$	(7,200	)

	Less than 12 months					12 months or longer					Total
December 31, 2013 Description of securities	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
State and municipal	$	31,660	$	(1,791	)	$	4,153	$	(421	)	$	35,813	$	(2,212	)
Mortgage-backed securities-residential (GSE’s)	114,036		(3,800		)	—		—			114,036		(3,800		)
Collateralized mortgage obligations (GSE’s)	267,579		(9,040		)	4,100		(189		)	271,679		(9,229		)
Other securities	—		—			993		(8		)	993		(8		)
Total temporarily impaired	$	413,275	$	(14,631	)	$	9,246	$	(618	)	$	422,521	$	(15,249	)

11

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 September 30, 2014, the Company’s securities portfolio consisted of 1,009 securities, 108 of which were in an unrealized loss position.  Unrealized losses on state and municipal securities of $306 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 current rate environment 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 September 30, 2014, 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 $1,259 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 September 30, 2014.

The Company’s collateralized mortgage obligation securities portfolio includes agency collateralized mortgage obligations with a market value of $350,719 which had unrealized losses of approximately $5,635 at September 30, 2014. The Company monitors to insure it has adequate credit support and as of September 30, 2014, 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.

12

NOTE 4 - LOANS AND ALLOWANCE

Loans were as follows:

	September 30,2014			December 31, 2013
Commercial
Commercial and industrial	$	229,669		$	180,378
Agricultural	48,314			30,323
Commercial Real Estate
Farm	73,253			76,082
Hotel	80,588			108,226
Construction and development	47,427			35,731
Other	564,703			546,970
Residential
1-4 family	406,562			403,733
Home equity	258,017			244,277
Consumer
Direct	43,987			45,129
Indirect	704			1,077
Total loans	1,753,224			1,671,926
Allowance for loan losses	(24,549		)	(27,609		)
Net loans	$	1,728,675		$	1,644,317

Activity in the allowance for loan losses for the nine months ended September 30, 2014 and 2013 and the recorded investment of loans and allowances by portfolio segment and impairment method as of September 30, 2014 and December 31, 2013 were as follows:

	Commercial			Commercial Real Estate			Residential			Consumer			Total
Allowance for loan loss
Balance, January 1, 2014	$	3,291		$	20,210		$	3,409		$	699		$	27,609
Provision charged to expense	(699		)	(548		)	1,427			1,320			1,500
Losses charged off	(166		)	(4,786		)	(1,925		)	(2,166		)	(9,043		)
Recoveries	1,048			2,112			298			1,025			4,483
Balance, September 30, 2014	$	3,474		$	16,988		$	3,209		$	878		$	24,549

	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	366			506			1,659			1,203			3,734
Losses charged off	(1,058		)	(5,270		)	(1,767		)	(2,364		)	(10,459		)
Recoveries	262			564			375			1,146			2,347
Balance, September 30, 2013	$	3,464		$	19,957		$	3,447		$	981		$	27,849
As of September 30, 2014
Ending Balance individually evaluated for impairment	$	12		$	1,676		$	95		$	—		$	1,783
Ending Balance collectively evaluated for impairment	3,462			15,312			3,114			878			22,766
Total ending allowance balance	$	3,474		$	16,988		$	3,209		$	878		$	24,549
Loans
Ending Balance individually evaluated for impairment	$	537		$	24,232		$	10,167		$	118		$	35,054
Ending Balance collectively evaluated for impairment	277,446			741,739			654,412			44,573			1,718,170
Total ending loan balance excludes $5,108 of accrued interest	$	277,983		$	765,971		$	664,579		$	44,691		$	1,753,224

13

As of December 31, 2013	Commercial		Commercial Real Estate		Residential		Consumer		Total
Ending Balance individually evaluated for impairment	$	13	$	1,167	$	105	$	2	$	1,287
Ending Balance collectively evaluated for impairment	3,278		19,043		3,304		697		26,322
Total ending allowance balance	$	3,291	$	20,210	$	3,409	$	699	$	27,609
Loans
Ending Balance individually evaluated for impairment	$	300	$	21,240	$	10,797	$	785	$	33,122
Ending Balance collectively evaluated for impairment	210,401		745,769		637,213		45,421		1,638,804
Total ending loan balance excludes $5,043 of accrued interest	$	210,701	$	767,009	$	648,010	$	46,206	$	1,671,926

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

The allowance for loans collectively evaluated for impairment consists of reserves on groups of similar loans based on historical loss experience adjusted for other factors, as well as reserves on certain loans that are classified but determined not to be impaired based on an analysis which incorporates probability of default with a loss given default scenario. The reserves on these loans totaled $2,856 at September 30, 2014 and $5,783 at December 31, 2013.

Activity in the allowance for loan losses for the three months ended September 30, 2014 and 2013 was as follows:

	Commercial			Commercial Real Estate			Residential			Consumer			Total
Allowance for loan loss
Balance, July 1, 2014	$	3,201		$	16,994		$	3,110		$	562		$	23,867
Provision charged to expense	(685		)	(548		)	464			769			—
Losses charged off	(17		)	(131		)	(548		)	(795		)	(1,491		)
Recoveries	975			673			183			342			2,173
Balance, September 30, 2014	$	3,474		$	16,988		$	3,209		$	878		$	24,549

	Commercial			Commercial Real Estate			Residential			Consumer			Total
Allowance for loan loss
Balance, July 1, 2013	$	3,635		$	20,108		$	3,459		$	800		$	28,002
Provision charged to expense	(121		)	175			288			658			1,000
Losses charged off	(91		)	(584		)	(448		)	(864		)	(1,987		)
Recoveries	41			258			148			387			834
Balance, September 30, 2013	$	3,464		$	19,957		$	3,447		$	981		$	27,849

The following table presents loans individually evaluated for impairment by class of loans as of September 30, 2014.  Performing troubled debt restructurings totaling $2,706 were excluded as allowed by ASC 310-40.

14

September 30, 2014	Unpaid Principal Balance		Recorded Investment		Allowance for Loan Losses Allocated
With an allowance recorded
Commercial
Commercial and industrial	$	88	$	71	$	12
Commercial Real Estate
Farm	76		76		21
Hotel	1,912		1,909		617
Construction and development	—		—		—
Other	3,084		2,633		1,038
Residential
1-4 Family	831		788		90
Home Equity	169		169		5
Consumer
Direct	—		—		—
Subtotal — impaired with allowance recorded	6,160		5,646		1,783
With no related allowance recorded
Commercial
Commercial & industrial	128		55
Agricultural	413		411
Commercial Real Estate
Farm	1,010		772
Hotel	11,487		11,441
Construction and development	84		78
Other	6,732		4,617
Residential
1-4 Family	7,816		6,869
Home Equity	2,548		2,341
Consumer
Direct	141		115
Indirect	3		3
Subtotal — impaired with no allowance recorded	30,362		26,702		—
Total impaired loans	$	36,522	$	32,348	$	1,783

15

The following table presents loans individually evaluated for impairment by class of loans as of December 31, 2013.  Performing troubled debt restructurings totaling $6,593 were excluded as allowed by ASC 310-40.

December 31, 2013	Unpaid Principal Balance		Recorded Investment		Allowance for Loan Losses Allocated
With an allowance recorded
Commercial
Commercial and industrial	$	194	$	177	$	13
Agricultural`	—		—		—
Commercial Real Estate
Farm	625		436		61
Hotel	—		—		—
Construction and development	—		—		—
Other	7,309		6,382		1,106
Residential
1-4 Family	1,089		981		102
Home Equity	50		50		3
Consumer
Direct	126		126		2
Indirect	—		—		—
Subtotal — impaired with allowance recorded	9,393		8,152		1,287
With no related allowance recorded
Commercial
Commercial & industrial	204		123
Agricultural	—		—
Commercial Real Estate
Farm	767		657
Hotel	—		—
Construction and development	942		795
Other	8,651		6,377
Residential
1-4 Family	8,931		8,007
Home Equity	1,860		1,759
Consumer
Direct	675		649
Indirect	11		10
Subtotal — impaired with no allowance recorded	22,041		18,377		—
Total impaired loans	$	31,434	$	26,529	$	1,287

The following tables present the average balance of impaired loans and interest income and cash basis interest recognized for the nine month periods ending September 30, 2014 and September 30, 2013, excluding performing troubled debt restructurings as allowed by ASC 310-40.

Nine months ended September 30, 2014	Average Balance Impaired Loans		Interest Income Recognized		Cash Basis Income Recognized
Commercial
Commercial & Industrial	$	247	$	9	$	9
Agricultural	206		—		—
Commercial Real Estate
Farm	921		—		—
Hotel	6,225		—		—
Construction and development	318		—		—
Other	10,305		75		75
Residential
1-4 Family	8,108		16		16
Home Equity	2,472		11		11
Consumer
Direct	276		7		7
Indirect	6		6		6
	$	29,084	$	124	$	124

16

Nine months ended September 30, 2013	Average Balance Impaired Loans		Interest Income Recognized		Cash Basis Income Recognized
Commercial
Commercial & Industrial	$	1,171	$	4	$	4
Agricultural	—		—		—
Commercial Real Estate
Farm	1,426		11		11
Hotel	1,492		1		1
Construction and development	1,694		45		45
Other	19,501		55		55
Residential
1-4 Family	10,716		3		3
Home Equity	2,572		4		4
Consumer
Direct	922		16		16
Indirect	15		—		—
	$	39,509	$	139	$	139

The following tables present the average balance of impaired loans and interest income and cash basis interest recognized for the three month periods ending September 30, 2014 and September 30, 2013, excluding performing troubled debt restructurings as allowed by ASC 310-40.

Three months ended September 30, 2014	Average Balance Impaired Loans		Interest Income Recognized		Cash Basis Income Recognized
Commercial
Commercial & Industrial	$	211	$	1	$	1
Agricultural	412		—		—
Commercial Real Estate
Farm	852		—		—
Hotel	12,450		—		—
Construction and development	78		—		—
Other	8,656		4		4
Residential
1-4 Family	7,449		11		11
Home Equity	2,629		4		4
Consumer
Direct	104		2		2
Indirect	2		5		5
	$	32,843	$	27	$	27

Three months ended September 30, 2013	Average Balance Impaired Loans		Interest Income Recognized		Cash Basis Income Recognized
Commercial
Commercial & Industrial	$	751	$	2	$	2
Agricultural	—		—		—
Commercial Real Estate
Farm	1,255		3		3
Hotel	—		1		1
Construction and development	1,302		44		44
Other	16,472		23		23
Residential
1-4 Family	10,421		—		—
Home Equity	2,500		1		1
Consumer
Direct	858		5		5
Indirect	12		—		—
	$	33,571	$	79	$	79

17

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 September 30, 2014 and December 31, 2013:

	Non-accrual				Past due over 90 days and still accruing
	September 30, 2014		December 31, 2013		September 30, 2014		December 31, 2013
Commercial
Commercial and industrial	$	38	$	159			$	14
Agricultural	410		—
Commercial Real Estate
Farm	848		1,093
Hotel	1,912		—
Construction and development	78		329
Other	4,832		11,489
Residential
1-4 Family	6,363		7,635		59
Home Equity	1,552		1,452
Consumer
Direct	77		174
Indirect	3		10
Total	$	16,113	$	22,341	$	59	$	14

The following table presents the aging of the recorded investment in past due loans as of September 30, 2014 by class of loans:

September 30, 2014	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	$	229,669	$	210	$	54	$	39	$	303	$	229,366
Agricultural	48,314		—		—		—		—		48,314
Commercial Real Estate
Farm	73,253		—		—		332		332		72,921
Hotel	80,588		1,912		—		—		1,912		78,676
Construction and development	47,427		—		—		—		—		47,427
Other	564,703		137		206		2,262		2,605		562,098
Residential
1-4 Family	406,562		1,587		1,660		3,387		6,634		399,928
Home Equity	258,017		876		482		967		2,325		255,692
Consumer
Direct	43,987		42		3		58		103		43,884
Indirect	704		—		—		3		3		701
Total — excludes $5,108 of accrued interest	$	1,753,224	$	4,764	$	2,405	$	7,048	$	14,217	$	1,739,007

18

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

December 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	$	180,378	$	64	$	24	$	72	$	160	$	180,218
Agricultural	30,323		—		—		—		—		30,323
Commercial Real Estate
Farm	76,082		—		—		697		697		75,385
Hotel	108,226		—		—		—		—		108,226
Construction and development	35,731		466		—		329		795		34,936
Other	546,970		984		187		5,944		7,115		539,855
Residential
1-4 Family	403,733		7,381		1,969		4,936		14,286		389,447
Home Equity	244,277		646		313		1,025		1,984		242,293
Consumer
Direct	45,129		192		32		126		350		44,779
Indirect	1,077		2		4		—		6		1,071
Total — excludes $5,043 of accrued interest	$	1,671,926	$	9,735	$	2,529	$	13,129	$	25,393	$	1,646,533

19

Troubled Debt Restructurings

During the periods ending September 30, 2014 and 2013, 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 total of troubled debt restructurings at September 30, 2014 and December 31, 2013 was $20,554 and $14,347 respectively.  The large increase in the TDR balance is the result of one credit relationship which was structured into an A/B note in the second quarter of 2014 with the B note being written off.  Included in the TDR totals are non-accrual loans of $1,569 and $3,566 at September 30, 2014 and December 31, 2013.  The Company has allocated $697 of specific reserves to customers whose loan terms have been modified in troubled debt restructurings as of September 30, 2014. 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, 2013, the comparable numbers were $534 of specific reserves and $0 of commitments.

The troubled debt restructurings resulted in no change to the allowance for loan losses for the three month periods ending September 30, 2014 and 2013 and decreased the allowance for loan losses by $20 and increased the allowance for loan losses by $30 for the nine month periods ending September 30, 2014 and 2013.  These troubled debt restructurings resulted in charge offs of $0 and $22 during the three month periods ending September 30, 2014 and 2013 and $3,848 and $442 during the nine month periods ending September 30, 2014 and 2013.

The following table presents loans by class modified as troubled debt restructurings that occurred during the nine month period ending September 30, 2014:

		Pre-Modification		Post-Modification
		Outstanding Recorded		Outstanding Recorded
For the nine month period ending September 30, 2014	Number of Loans	Investment		Investment
Commercial real estate
Hotel	2	$	15,362	$	11,550
Other	2	1,015		1,015
Residential
1-4 Family	1	140		140
Home Equity	1	34		34
Consumer
Direct	1	26		26
Total	7	$	16,577	$	12,765

The following table presents loans by class modified as troubled debt restructurings that occurred during the nine month period ending September 30, 2013:

		Pre-Modification		Post-Modification
		Outstanding Recorded		Outstanding Recorded
For the nine month period ending September 30, 2013	Number of Loans	Investment		Investment
Commercial real estate
Other	1	$	28	$	28
Commercial real estate
Other	3	344		344
Residential
1-4 Family	5	261		261
Home equity	1	20		20
Consumer
Direct	1	30		30
Total	11	$	683	$	683

20

The following table presents loans by class modified as troubled debt restructurings that occurred during the three month periods ending September 30, 2014 and 2013:

		Pre-Modification		Post-Modification
		Outstanding Recorded		Outstanding Recorded
For the three month period ending September 30, 2014	Number of Loans	Investment		Investment
Residential
Home Equity	1	$	34	$	34
Consumer
Direct	1	26		26
Total	2	$	60	$	60

		Pre-Modification		Post-Modification
		Outstanding Recorded		Outstanding Recorded
For the three month period ending September 30, 2013	Number of Loans	Investment		Investment
Residential
1-4 Family	—	$	—	$	—
Total	—	$	—	$	—

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 nine month period ending September 30, 2014:

For the nine month period ending September 30, 2014	Number of Loans	Recorded Investment
Commercial real estate:
Other	1	$	1,431
Residential
1-4 Family	1	53
Home Equity	1	14
Total	3	$	1,498

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 nine month period ending September 30, 2013:

For the nine month period ending September 30, 2013	Number of Loans	Recorded Investment
Residential:
1-4 Family	2	$	89
Home Equity	1	15
Consumer
Direct	1	4
Total	4	$	108

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 September 30, 2014:

For the three month period ending September 30, 2014	Number of Loans	Recorded Investment
Residential:
Home Equity	1	$	14
Total	1	$	14

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 September 30, 2013:

For the three month period ending September 30, 2013	Number of Loans	Recorded Investment
Residential:
1-4 Family	1	$	52
Home Equity	1	15
Consumer
Direct	1	4
Total	3	$	71

21

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 resulted in no change in the allowance for loan losses and no  charge offs during the three month periods ending September 30, 2014 and 2013, respectively.  For the nine month periods ending September 30, 2014 and 2013, the troubled debt restructurings that subsequently defaulted increased the allowance for loan losses by $0 and $0 and resulted in charge offs of $36 and $0.

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 terms of certain other loans were modified during the three month period ending September 30, 2014 that did not meet the definition of a troubled debt restructuring. These loans have a total recorded investment as of September 30, 2014 of $162. 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.

22

As of September 30, 2014, and based on the most recent analysis performed, the risk category of loans by class of loans is as follows:

September 30, 2014	Pass		Special Mention		Substandard		Non-accrual
Commercial
Commercial and industrial	$	189,192	$	5,537	$	1,867	$	38
Agricultural	47,494		—		410		410
Commercial Real Estate
Farm	71,357		976		72		848
Hotel	64,614		2,575		11,487		1,912
Construction and development	47,147		—		—		78
Other	427,484		16,231		8,811		4,832
Total	$	847,288	$	25,319	$	22,647	$	8,118

At December 31, 2013, the risk category of loans by class of loans was as follows:

December 31, 2013	Pass		Special Mention		Substandard		Non-accrual
Commercial
Commercial and industrial	$	144,744	$	4,538	$	1,250	$	159
Agricultural	30,206		—		—		—
Commercial Real Estate
Farm	73,006		105		—		1,093
Hotel	61,195		31,401		15,630		—
Construction and development	34,672		—		466		329
Other	388,719		20,893		9,931		11,489
Total	$	732,542	$	56,937	$	27,277	$	13,070

Loans not analyzed individually as part of the above described process are classified by delinquency. These loans are primarily smaller (<$250) commercial, smaller commercial real estate (<$250), residential mortgage and consumer loans. All commercial, commercial real estate, consumer loans fully or partially secured by 1-4 family residential real estate that are 60-89 days past due will be classified as Watch. If loans are greater than 90 days past due, they will be classified as Substandard. Smaller commercial and commercial real estate loans on non-accrual are included in the non-accrual tables above. 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 September 30, 2014 and December 31, 2013, the grading of loans by category of loans is as follows:

September 30, 2014	Performing		Watch		Substandard
Commercial
Commercial and industrial	$	33,035	$	—	$	—
Commercial Real Estate
Construction and development	202		—		—
Other	107,336		9		—
Total	$	140,573	$	9	$	—

December 31, 2013	Performing		Watch		Substandard
Commercial
Commercial and industrial	$	29,664	$	23	$	—
Agricultural	117		—		—
Commercial Real Estate
Farm	1,878		—		—
Construction and development	264		—		—
Other	115,938		—		—
Total	$	147,861	$	23	$	—

23

September 30, 2014	Performing		Watch		Substandard
Residential
1-4 Family	$	401,515	$	1,660	$	3,387
Home Equity	257,002		48		967
Total	$	658,517	$	1,708	$	4,354

December 31, 2013	Performing		Watch		Substandard
Residential
1-4 Family	$	396,098	2,703		4,932
Home Equity	242,825		424		1,028
Total	$	638,923	$	3,127	$	5,960

September 30, 2014	Performing		Substandard		Loss
Consumer
Direct	$	43,923	$	15	$	49
Indirect	704		—		—
Total	$	44,627	$	15	$	49

December 31, 2013	Performing		Substandard		Loss
Consumer
Direct	$	44,955	$	47	$	127
Indirect	1,067		10		—
Total	$	46,022	$	57	$	127

24

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:

	Three months ended September 30						Nine months ended September 30
	2014			2013			2014			2013
Beginning Balance	$	3,723		$	5,183		$	4,120		$	6,677
Transfer to other real estate owned	220			816			2,119			2,904
Sales — out of other real estate owned	(753		)	(1,120		)	(2,929		)	(4,155		)
Write-down	—			(95		)	(120		)	(642		)
Ending Balance — September 30	$	3,190		$	4,784		$	3,190		$	4,784

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:

	Three months ended September 30						Nine months ended September 30
	2014			2013			2014			2013
Beginning Balance	$	(391	)	$	(1,353	)	$	(1,328	)	$	(1,672	)
Impairments during year	—			(95		)	(120		)	(642		)
Recovery on impairments	—			—			—			—
Reductions	33			74			1,090			940
Ending Balance — September 30	$	(358	)	$	(1,374	)	$	(358	)	$	(1,374	)

Expenses related to foreclosed assets for the period ending September 30 include:

	Three months ended September 30					Nine months ended September 30
	2014		2013			2014			2013
Write downs	$	—	$	95		$	120		$	642
Losses / (gains) on sales	9		(57		)	(73		)	(286		)
Net loss / (gain)	$	9	$	38		$	47		$	356
Operating expenses	$	28	$	79		$	120		$	290

NOTE 6 — DEPOSITS

	September 30, 2014		December 31, 2013
Noninterest-bearing demand	$	464,058	$	436,550
Interest-bearing demand	917,369		884,128
Savings	527,829		501,494
Certificates of deposit of $100 or more	100,874		129,132
Other certificates and time deposits	211,569		249,324
Total deposits	$	2,221,699	$	2,200,628

25

NOTE 7 - EARNINGS PER SHARE

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

	September 30, 2014					September 30, 2013
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	$	8,457	20,459,709			$	7,632		20,400,808
Redemption of preferred shares	—					(148		)
Preferred dividends and accretion	—					(99		)
Net income available to common shareholders	$	8,457	20,459,709	$	0.41	$	7,385		20,400,808	$	0.36
Effect of dilutive warrants			72,978						—
Effect of dilutive stock options			68,757						51,013
Net income available to common shareholders and assumed conversions	$	8,457	20,601,444	$	0.41	$	7,385		20,451,821	$	0.36

Stock options for 123,964 common shares in 2014 and stock options for 290,146 common shares and stock warrants for 571,906 common shares in 2013 were not considered in computing diluted earnings per share because they were antidilutive.

	September 30, 2014					September 30, 2013
For the nine 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	$	22,436	20,448,054			$	18,947		20,363,514
Redemption of preferred shares						(148		)
Preferred dividends and accretion	—					(504		)
Net income available to common shareholders	$	22,436	20,448,054	$	1.10	$	18,295		20,363,514	$	0.90
Effect of dilutive warrants			67,184						—
Effect of dilutive stock options			66,102						56,681
Net income available to common shareholders and assumed conversions	$	22,436	20,581,340	$	1.09	$	18,295		20,420,195	$	0.90

Stock options for 176,211 common shares in 2014 and stock options for 284,407 common shares and stock warrants for 571,906 common shares in 2013 were not considered in computing diluted earnings per share because they were antidilutive.

26

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. 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.

The fair value of mortgage banking derivatives are based on derivative valuation models using market data inputs as of the valuation date (Level 2). The mortgage banking derivative is classified as Interest receivable and other assets on the balance sheet.

27

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 September 30, 2014 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	$	582			$	582
States and municipals	323,698				310,841		12,857
Mortgage-backed securities — residential —Government Sponsored Entity	156,904				156,904
Collateralized mortgage obligations — Government Sponsored Entity	350,719				350,719
Equity securities	4,689		4,689
Other securities	3,509				1,002		2,507
Total investment securities available-for-sale	$	840,101	$	4,689	$	820,048	$	15,364
Mortgage banking derivative	$	750			$	750

			Fair Value Measurements at December 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	$	798			$	798
States and municipals	331,112				316,692		14,420
Mortgage-backed securities — residential —Government Sponsored Entity	185,429				185,429
Collateralized mortgage obligations — Government Sponsored Entity	365,309				365,309
Equity securities	4,939		4,689		250
Other securities	3,519				993		2,526
Total investment securities available-for-sale	$	891,106	$	4,689	$	869,221	$	17,196
Mortgage banking derivative	$	525			$	525

There were no transfers between Level 1 and Level 2 during the third quarter of 2014 or 2013 or the first nine months of 2014 or 2013.

28

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 and nine month periods ended September 30, 2014 and 2013:

Three months ended September 30:

States and municipal	2014			2013
Beginning balance, July 1	$	13,083		$	14,688
Total gains or losses (realized / unrealized)
Included in other comprehensive income	(8		)	(12		)
Settlements	(218		)	(206		)
Ending balance, September 30	$	12,857		$	14,470

Equity securities	2014		2013
Beginning balance, July 1	$	—	$	250
Total gains or losses (realized / unrealized)
Settlements	—		—
Ending balance, September 30	$	—	$	250

Other securities	2014			2013
Beginning balance, July 1	$	2,511		$	2,542
Total gains or losses (realized / unrealized)
Included in other comprehensive income	(4		)	(8		)
Ending balance, September 30	$	2,507		$	2,534

Nine months ended September 30:

States and municipal	2014			2013
Beginning balance, January 1	$	14,420		$	15,470
Total gains or losses (realized / unrealized)
Included in other comprehensive income	15			(84		)
Settlements	(1,578		)	(916		)
Ending balance, September 30	$	12,857		$	14,470

Equity securities	2014			2013
Beginning balance, January 1	$	250		$	250
Total gains or losses (realized / unrealized)
Settlements	(250		)	—
Ending balance, September 30	$	—		$	250

Other securities	2014			2013
Beginning balance, January 1	$	2,526		$	2,557
Total gains or losses (realized / unrealized)
Included in other comprehensive income	(19		)	(23		)
Ending balance, September 30	$	2,507		$	2,534

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.

29

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 September 30, 2014 Using
	September 30, 2014		Quoted Prices in Active Markets for Identical Assets (Level 1)	Significant Other Observable Inputs (Level 2)	Significant Unobservable Inputs (Level 3)
Assets:
Impaired loans
Farm real estate	$	55			$	55
Hotel	1,292				1,292
Other commercial real estate	1,313				1,313
Total impaired loans	$	2,660			$	2,660
Impaired servicing rights	$	1,459			$	1,459
Other real estate owned
Other commercial real estate	$	198			$	198
1-4 family	28				28
Total other real estate owned	$	226			$	226

			Fair Value Measurements at December 31, 2013 Using
	December 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	$	76			$	76
Farm estate	375				375
Construction and development	226				226
Other commercial real estate	5,112				5,112
Total impaired loans	$	5,789			$	5,789
Impaired servicing rights	$	1,794			$	1,794
Other real estate owned
Construction and development	$	522			$	522
Home equity	67				67
Other commercial real estate	425				425
Total other real estate owned	$	1,014			$	1,014

30

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 $4,232, with a valuation allowance of $1,572 at September 30, 2014. The Company recorded a charge of $1,061 to provision expense associated with these loans for the three months ended September 30, 2014 and a charge of $941 provision expense associated with these loans for the nine month period ended September 30, 2014.  The Company recorded a charge of $526 of provision expense associated with these loans for the three month period ended September 30, 2013 and $842 of provision expense associated with these loans for the nine month period ended September 30, 2013.   At December 31, 2013, impaired loans had a gross carrying amount of $6,879 with a valuation allowance of $1,090. A breakdown of these loans by portfolio class at September 30, 2014 is as follows:

	Gross Balance		Valuation Allowance		Net
Farm real estate	$	76	$	21	$	55
Hotel	1,909		617		1,292
Other commercial real estate	2,247		934		1,313
Ending Balance	$	4,232	$	1,572	$	2,660

Impaired tranches of servicing rights were carried at a fair value of $1,459, which is made up of the gross outstanding balance of $1,784, net of a valuation allowance of $325.  A recovery of $50 was included in the both the third quarter and the nine month period ending September 30, 2014.  A recovery of $225 was included in the third quarter 2013 earnings and a recovery of $650 was included in the nine month period ending September 30, 2013.  At December 31, 2013, impaired servicing rights were carried at a fair value of $1,794 which was made up of the gross outstanding balance of $2,169, net of a valuation allowance of $375.

Other real estate owned 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 September 30, 2014, other real estate owned was carried at a fair value of $226, which is made up of the gross outstanding balance of $256, net of a valuation allowance of $30. During the third quarter of 2014, these properties were written down by $0.  For the first nine months of 2014, these properties were written down by $30.  During the third quarter of 2013, these properties were written down by $95. For the first nine months of 2013, these properties were written down by $193.  At December 31, 2013, other real estate was carried at a fair value of $1,014, which is made up of the gross outstanding balance of $1,362, net of a valuation allowance of $348. A breakdown of these properties by portfolio class at September 30, 2014 is as follows:

	Gross Balance		Valuation Allowance		Net
Other commercial real estate	$	219	$	21	$	198
1-4 family	37		9		28
Ending Balance	$	256	$	30	$	226

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 September 30, 2014 and December 31, 2013. 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.

31

September 30, 2014	Fair Value (in thousands)		Valuation Technique(s)	Unobservable Input(s)	Range
Impaired Loans:
Farm real estate	55		Sales comparison approach	Adjustment for differences between comparable sales	40% 40% Avg
Hotel	1,292		Income approach	Adjustment for type of property, current status of property	20% 20% Avg
Other commercial real estate	1,313		Sales comparison approach	Adjustment for differences between comparable sales, type of property, current status of property	0%-50% 43% Avg
	$	2,660
Other real estate owned:
Other commercial real estate	$	198	Sales comparison approach	Adjustment for differences between comparable sales.	10% 10% Avg
1-4 Family	28		Sales comparison approach	Adjustment for differences between comparable sales.	10% 10% Avg
	$	226
Mortgage servicing rights	$	1,459	Cash flow analysis	Discount rate	10%

December 31, 2013	Fair Value (in thousands)		Valuation Technique(s)	Unobservable Input(s)	Range
Impaired Loans:
Commercial & industrial	$	76	Sales comparison approach	Adjustment for differences between comparable sales	0%-10% 10% Avg
Farm real estate	375		Sales comparison approach	Adjustment for differences between comparable sales	40% 40% Avg
Other/ 1-4 Family	5,338		Sales comparison approach	Adjustment for differences between comparable sales, type of property, current status of property	0%-40% 25% Avg
	5,789
Other real estate owned:
Construction and development	$	522	Sales comparison approach	Adjustment for differences between comparable sales.	10% 10%Avg
Other & Home Equity	492		Sales comparison approach	Adjustment for differences between comparable sales.	10%-15% 10%Avg
	1,014
Mortgage servicing rights	1,794		Cash flow analysis	Discount rate	10%

32

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

September 30, 2014	Carrying Amount			Level 1		Level 2		Level 3	Total
Financial assets:
Cash and cash equivalents	$	69,914		60,150		9,764			69,914
Interest bearing time deposits	1,915					1,915			1,915
Loans including loans held for sale, net	1,730,793					4,928		1,732,588	1,737,516
Restricted stock	15,625								N/A
Interest receivable	9,266					4,158		5,108	9,266
Financial liabilities
Deposits	(2,221,699		)	(464,058	)	(1,756,444	)		(2,220,502	)
Other borrowings	(34,490		)			(34,490	)		(34,490	)
FHLB advances	(240,343		)			(244,060	)		(244,060	)
Interest payable	(491		)			(491	)		(491	)
Subordinated debentures	(41,239		)			(20,560	)		(20,560	)

December 31, 2013	Carrying Amount			Level 1			Level 2			Level 3	Total
Financial assets:
Cash and cash equivalents	$	61,320		$	55,826		$	5,494			$	61,320
Loans including loans held for sale, net	1,644,527						6,158			1,657,199	1,663,357
Restricted stock	15,629										N/A
Interest receivable	9,616						4,573			5,043	9,616
Financial liabilities
Deposits	(2,200,628		)	(436,550		)	(1,764,719		)		(2,201,269		)
Other borrowings	(38,594		)				(38,594		)		(38,594		)
FHLB advances	(247,858		)				(252,402		)		(252,402		)
Interest payable	(799		)				(799		)		(799		)
Subordinated debentures	(46,394		)				(23,130		)		(23,130		)

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, short-term instruments, and interest bearing time deposits 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, fed funds sold, and interest bearing time deposits 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.

33

(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 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) 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.

(f) 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.

34

Actual and required capital amounts and ratios are presented below:

					Required for
	Actual				Adequate Capital				To Be Well Capitalized
September 30, 2014	Amount		Ratio		Amount		Ratio		Amount	Ratio
MainSource Financial Group
Total capital (to risk-weighted assets)	$	315,877	16.7	%	$	150,959	8.0	%	N/A	N/A
Tier 1 capital (to risk-weighted assets)	292,278		15.5		75,480		4.0		N/A	N/A
Tier 1 capital (to average assets)	292,278		10.5		111,444		4.0		N/A	N/A
MainSource Bank
Total capital (to risk-weighted assets)	296,075		15.8	%	149,956		8.0	%	187,445	10.0	%
Tier 1 capital (to risk-weighted assets)	272,633		14.5		74,978		4.0		112,467	6.0
Tier 1 capital (to average assets)	272,633		9.9		110,107		4.0		137,634	5.0

					Required for				To Comply with
	Actual				Adequate Capital				Regulatory Agreement
December 31, 2013	Amount		Ratio		Amount		Ratio		Amount	Ratio
MainSource Financial Group
Total capital (to risk-weighted assets)	$	302,181	16.7	%	$	145,150	8.0	%	N/A	N/A
Tier 1 capital (to risk-weighted assets)	279,440		15.4		72,575		4.0		N/A	N/A
Tier 1 capital (to average assets)	279,440		10.1		110,428		4.0		N/A	N/A
MainSource Bank
Total capital (to risk-weighted assets)	283,653		15.7	%	144,147		8.0	%	180,184	10.0	%
Tier 1 capital (to risk-weighted assets)	261,069		14.5		72,074		4.0		108,111	6.0
Tier 1 capital (to average assets)	261,069		9.6		109,090		4.0		136,363	5.0

Management believes as of September 30, 2014, the Company and the Bank met all capital adequacy requirements to which they are subject to be considered well-capitalized. The Company is a source of additional financial strength to the Bank with its $15,500 in cash and its ability to downstream additional capital to the Bank.

NOTE 10 — INCOME TAXES

In accordance with ASC 740-270-50-1, Accounting for Interim Reporting, the provision for income taxes was recorded at September 30, 2014 and 2013 based on the current estimate of the effective annual rate.  The effective tax rate for the third quarter of 2014 was 22.9% versus 20.9% for the same period 2013.  For the first nine months of 2014 and 2013, the effective tax rate was 20.7% and 16.5% respectively.  The increase in the rate in 2014 was due to the increase in pre-tax income in 2014 with tax exempt income remaining constant.  The difference between the Company’s actual rate and the 35% statutory rate is due primarily to the amount of tax exempt interest received and to a smaller extent to tax credits that the Company is able to use.

NOTE 11 — SUBSEQUENT EVENT - ACQUISITION

The Company’s management and board of directors have periodically conducted strategic reviews as part of their ongoing efforts to improve its banking franchise and enhance shareholder value. In connection with these strategic reviews, the Company has considered potential acquisition targets, including banking institutions in Indiana, Ohio and Kentucky. On April 7, 2014, the Company announced that its board of directors had approved and entered into a definitive agreement  to acquire MBT Bancorp (MBT), headquartered in West Harrison, Indiana.  MBT is the holding company for The Merchant’s Bank and Trust Company (Merchants), which operates six branches in Dearborn County, Indiana and certain suburban communities of Cincinnati, Ohio.  The merger agreement provides that shareholders of MBT may elect to receive either 2.055 shares of MainSource common stock or $35.16 in cash for each share of MBT common stock owned, subject to proration provisions specified in the merger agreement that provide for a targeted aggregate split of total consideration of 60% common stock and 40% cash.  The merger was completed on October 17, 2014 and as of that date, Merchants was merged into the Bank.  At the date of the merger, Merchants had approximately $228.1 million in assets, $187.0 million in loans, $183.6 million in deposits, and $25.1 million in equity.  The Company anticipates approximately 1,226,300 shares being issued and $14.0 million cash being paid.  As of the date that the Company’s third quarter 2014 consolidated financial statements are issued, all of the information required to be disclosed by the Accounting Standards Codification No. 805 was not available since, given the short period between the October 17, 2014 acquisition date and the financial statement issuance, the calculation of the fair value of all material MBT Bancorp assets acquired and liabilities assumed had not yet been completed.  The Company anticipates recording all of the activity related to the merger in the fourth quarter of 2014.

35

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 (within the meaning of the Private Securities Litigation Reform Act of 1995) that are based on current expectations that involve a number of risks and uncertainties. These forward-looking statements include, but are not limited to, statements regarding MainSource’s plans, objectives, expectations and intentions and other statements contained in this report that are not historical facts. Other statements identified by words such as “expects,” “anticipates,” “will,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “targets,” “positioned,” “projects,” or words of similar meaning generally are intended to identify forward-looking statements. 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 the Company’s 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, 2013, and in other reports we file from time to time with the Securities and Exchange Commission.

Results of Operations

Net income for the third quarter of 2014 was $8,457 compared to net income of $7,632 for the third quarter of 2013. The increase in net income was primarily attributable to a decrease in loan loss provision expense and a reduction in operating expenses.  During the third quarter of 2014 the Company realized net recoveries in its allowance for loan losses account of $682 which resulted in no loan loss provision for the quarter.  Diluted earnings per common share for the third quarter of 2014 totaled $0.41, an increase from the $0.36 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 10.17% for the third quarter of 2014 while return on average assets was 1.18% for the same period, compared to 9.91% and 1.09% respectively, in the third quarter of 2013.

For the nine months ended September 30, 2014, net income was $22,436 compared to net income of $18,947 for the same period a year ago.  The increase in net income was primarily attributable to a prepayment penalty on a FHLB advance of $2,239 taken in 2013, an increase in net interest income of $1,281, lower provision expense of $2,234 and lower collection costs of $1,447, offset by a decrease in mortgage banking income of $841, lower securities gains of $839, and higher salary and employee benefit expenses of $865.   Diluted earnings per share was $1.09 for the first nine months of 2014 compared to $.90 for the same period in 2013. Return on average shareholders’ equity was 9.33% for the first nine months of 2014 while return on average assets was 1.05% for the same period, compared to 7.97% and 0.91% in the first nine months of 2013.

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. Third quarter net interest income of $23,002 in 2014 was an increase of 0.2% versus the third quarter of 2013.   Average earning assets were $68 million higher in the third quarter of 2014 compared to 2013 with all of the increase attributable to loan growth offset by a smaller decrease in securities.  Also affecting margin was an increase in average demand deposits, NOW accounts, and savings accounts of $145 million and a decrease in higher costing CD’s of $84 million.  Net interest margin, on a fully-taxable equivalent basis, was 3.80% for the third quarter of 2014, an 11 basis point decrease compared to 3.91% for the same period a year ago and a three basis point decrease on a linked quarter basis.

Net interest income was $1,281 higher in the first nine months of 2014 compared to 2013.  Average earnings assets were $103 million higher in the first nine months of 2014 compared to 2013 with all of the increase again attributable to loan growth.  Also affecting margin was an increase in average demand, NOW accounts, and savings accounts of $127 million and a decrease in higher costing CD’s of $82 million offset by an increase in FHLB advances of $53 million.  The majority of the increase in FHLB advances are of a short term nature.  For the first nine months of 2014, the Company’s net interest margin was 3.84% compared to 3.94% for the first nine months of 2013.

The following tables summarize net interest income (on a tax-equivalent basis) for the three and nine month periods ending September 30, 2014 and 2013.

36

Average Balance Sheet and Net Interest Analysis (Taxable Equivalent Basis)* - three months ended September 30

	2014								2013
	Average Balance			Interest		Average Rate ***			Average Balance			Interest		Average Rate ***
Assets
Short-term investments	$	10,066		$	9	0.35		%	$	8,087		$	5	0.25	%
Federal funds sold and money market accounts	14,234			11		0.31			7,729			5		0.26
Securities
Taxable	531,965			2,964		2.21			576,468			3,112		2.14
Non-taxable*	303,611			4,498		5.88			315,616			4,723		5.94
Total securities	835,576			7,462		3.54			892,084			7,835		3.48
Loans**
Commercial*	1,010,393			11,633		4.57			908,436			11,428		4.99
Residential real estate	408,050			4,333		4.21			411,845			4,542		4.38
Consumer	298,957			3,253		4.32			281,357			3,320		4.68
Total loans	1,717,400			19,219		4.44			1,601,638			19,290		4.78
Total earning assets	2,577,276			26,701		4.11			2,509,538			27,135		4.29
Cash and due from banks	39,539								39,258
Unrealized gains (losses) on securities	18,874								5,936
Allowance for loan losses	(24,248		)						(27,999		)
Premises and equipment, net	54,917								56,611
Intangible assets	68,939								70,156
Accrued interest receivable and other assets	117,668								118,426
Total Assets	$	2,852,965							$	2,771,926
Liabilities
Interest-bearing deposits DDA, savings, and money market accounts	$	1,465,523		$	401	0.11			$	1,360,538		$	350	0.10
Certificates of deposit	318,275			443		0.55			401,994			816		0.81
Total interest-bearing deposits	1,783,798			844		0.19			1,762,532			1,166		0.26
Short-term borrowings	32,728			21		0.25			33,292			18		0.21
Subordinated debentures	40,000			312		3.09			49,000			421		3.41
Notes payable and FHLB borrowings	182,182			862		1.88			182,170			819		1.78
Total interest-bearing liabilities	2,038,708			2,039		0.40			2,026,994			2,424		0.47
Demand deposits	455,767								415,825
Other liabilities	28,516								23,427
Total liabilities	2,522,991								2,466,246
Shareholders’ equity	329,974								305,680
Total liabilities and shareholders’ equity	$	2,852,965							$	2,771,926
Net interest income				$	24,662	$	3.80	****				$	24,711	3.91	****
Conversion of tax exempt income to a fully taxable equivalent basis using a marginal rate of 35%				$	1,660							$	1,758

*	Adjusted to reflect income related to securities and loans exempt from Federal income taxes of 35%
**	Nonaccruing loans have been included in the average balances.
***	Annualized
****	Net interest income divided by total earning assets.

37

Volume/Rate Analysis of Changes in Net Interest Income

(Tax Equivalent Basis)

	3Q 2014 vs 3Q 3013
	Volume			Rate			Total
Interest income
Loans	$	1,344		$	(1,415	)	$	(71	)
Securities	(503		)	130			(373		)
Federal funds sold and money market funds	5			1			6
Short-term investments	1			3			4
Total interest income	847			(1,281		)	(434		)
Interest expense
Interest-bearing DDA, savings, and money market accounts	$	28		$	23		$	51
Certificates of deposit	(149		)	(224		)	(373		)
Borrowings	(2		)	48			46
Subordinated debentures	(73		)	(36		)	(109		)
Total interest expense	(196		)	(189		)	(385		)
Change in net interest income	1,043			(1,092		)	(49		)
Change in tax equivalent adjustment							(98		)
Change in net interest income before tax equivalent adjustment							$	49

Average Balance Sheet and Net Interest Analysis (Taxable Equivalent Basis)* - nine months ended September 30

	2014								2013
	Average Balance			Interest		Average Rate ***			Average Balance			Interest		Average Rate ***
Assets
Short-term investments	$	11,173		$	25	0.30		%	$	14,724		$	29	0.26	%
Federal funds sold and money market accounts	13,210			30		0.30			12,362			23		0.25
Securities
Taxable	559,263			9,377		2.24			568,991			8,741		2.05
Non-taxable*	308,281			13,711		5.95			311,824			14,055		6.03
Total securities	867,544			23,088		3.56			880,815			22,796		3.46
Loans**
Commercial*	997,977			34,692		4.65			894,906			34,510		5.16
Residential real estate	408,086			13,219		4.33			411,971			13,868		4.50
Consumer	294,100			9,737		4.43			273,905			9,732		4.75
Total loans	1,700,163			57,648		4.53			1,580,782			58,110		4.91
Total earning assets	2,592,090			80,791		4.17			2,488,683			80,958		4.35
Cash and due from banks	41,797								41,416
Unrealized gains (losses) on securities	14,706								24,990
Allowance for loan losses	(26,336		)						(30,136		)
Premises and equipment, net	55,146								55,776
Intangible assets	69,356								70,492
Accrued interest receivable and other assets	115,444								120,739
Total Assets	$	2,862,203							$	2,771,960
Liabilities
Interest-bearing deposits DDA, savings, and money market accounts	$	1,448,213		$	1,139	0.11			$	1,360,544		$	1,071	0.11
Certificates of deposit	342,452			1,625		0.63			424,042			2,728		0.86
Total interest-bearing deposits	1,790,665			2,764		0.21			1,784,586			3,799		0.28
Short-term borrowings	32,735			60		0.25			32,637			50		0.20
Subordinated debentures	41,389			975		3.15			49,000			1,284		3.50
Notes payable and FHLB borrowings	200,330			2,562		1.71			147,215			2,510		2.28
Total interest-bearing liabilities	2,065,119			6,361		0.41			2,013,438			7,643		0.51
Demand deposits	449,873								410,999
Other liabilities	25,657								29,576
Total liabilities	2,540,649								2,454,013
Shareholders’ equity	321,554								317,947
Total liabilities and shareholders’ equity	$	2,862,203							$	2,771,960
Net interest income				$	74,430	$	3.84	****				$	73,315	3.94	****
Conversion of tax exempt income to a fully taxable equivalent basis using a marginal rate of 35%				$	5,063							$	5,229

*	Adjusted to reflect income related to securities and loans exempt from Federal income taxes of 35%
**	Nonaccruing loans have been included in the average balances.
***	Annualized
****	Net interest income divided by total earning assets.

38

Volume/Rate Analysis of Changes in Net Interest Income

(Tax Equivalent Basis)

	Nine months 2014 vs Nine months 2013
	Volume			Rate			Total
Interest income
Loans	$	4,221		$	(4,683	)	$	(462	)
Securities	(347		)	639			292
Federal funds sold and money market funds	2			5			7
Short-term investments	(8		)	4			(4		)
Total interest income	3,868			(4,035		)	(167		)
Interest expense
Interest-bearing DDA, savings, and money market accounts	$	69		$	(1	)	$	68
Certificates of deposit	(467		)	(636		)	(1,103		)
Borrowings	664			(602		)	62
Subordinated debentures	(187		)	(122		)	(309		)
Total interest expense	79			(1,361		)	(1,282		)
Change in net interest income	3,789			(2,674		)	1,115
Change in tax equivalent adjustment							(166		)
Change in net interest income before tax equivalent adjustment							$	1,281

Variances not attributed to rate or volume are allocated between rate and volume in proportion to the relationship of the absolute dollar amount of the change in each.

Provision for Loan Losses

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

39

Non-interest Income

Third quarter non-interest income for 2014 was $11,145 compared to $11,183 for the third quarter of 2013.  Contributing to the decrease of $38 was a decrease in trust and investment product fees of $151.  Offsetting this decrease were increases in mortgage banking of $124 and interchange income of $108.  Continued organic growth in deposit accounts has resulted in higher interchange income.

For the nine months ended September 30, 2014, non-interest income was $31,623 compared to $32,809 for the same period a year ago. Contributing to the decrease of $1,186 were decreases in securities gains of $839, mortgage banking of $841, and other income (primarily title company revenue) of $259.  Offsetting these decreases were increases in service charges of $193, interchange income of $354, and smaller losses on OREO properties in 2014 compared to 2013 of $309.

Non-interest Expense

The Company’s non-interest expense was $23,177 for the third quarter of 2014, compared to $23,489 for the same period in 2013.  The primary reasons for the decrease were lower collection expenses of $469 and consultant expenses of $125.  Offsetting these decreases were increases in marketing expenses of $122 and interchange expenses of $114.  Lower collection expenses are due to the continued reduction in problem credits.  The increase in marketing expenses is due to timing of marketing programs between years.    The increase in interchange expenses is directly related to the increase in interchange income.  The Company’s efficiency ratio was 64.7% for the third quarter of 2014 compared to 65.4% for the same period a year ago.

For the nine months ended September 30, 2014, non-interest expense was $71,185 compared to $74,472 for the same period a year ago. Contributing to the decrease of $3,287 was a prepayment penalty on a FHLB advance of $2,239 in 2013, lower collection expenses of $1,447, and lower marketing expenses of $529.  Offsetting these decreases were increases in salary and employee benefits of $865 and net occupancy costs of $416.  The increase in salaries and employee benefits is primarily due to the costs involved in starting the new de novo branch in Louisville, Kentucky.  The increase in occupancy expenses is due primarily to the colder than normal winter months in 2014 which increased snow removal and heating costs.  The Company’s efficiency ratio was 67.1% for the first nine months of 2014 compared to 70.2% for the same period a year ago.

Income Taxes

The effective tax rate for the third quarter of 2014 was 22.9% versus 20.9% for the same period 2013.  The increase was due to the increase in pre-tax income in the third quarter of 2014.

The effective tax rate for the first nine months of 2014 was 20.7% for 2014 compared to 16.5% for the same period a year ago.  The increase in the effective tax rate was due to the increase in income before taxes while the Company’s tax exempt income and credits remained relatively consistent with prior periods.

Financial Condition

Total assets at September 30, 2014 were $2,899,952, a $40,000 increase from total assets of $2,859,864 as of December 31, 2013.  Average earning assets represented 90.3% of average total assets for the third quarter of 2014 and 90.5% for the same period in 2013. Average loans represented 76.8% of average deposits in the third quarter of 2014 and 73.7% for the comparable period in 2013.  Average loans as a percent of average assets were 60.2% and 57.8% for the three month periods ended September 30, 2014 and 2013 respectively.

Deposits increased $21 million at September 30, 2014 compared to December 31, 2013.   Noninterest bearing and interest bearing deposits and savings deposits increased $87 million and were offset by a reduction of $66 million in higher-priced CD balances.

Shareholders’ equity was $333 million on September 30, 2014 compared to $306 million on December 31, 2013.  Book value (shareholders’ equity) per common share was $16.26 at September 30, 2014 versus $14.96 at year-end 2013. Accumulated other comprehensive income increased book value per share by $0.57 at September 30, 2014 and increased book value per share by $0.06 at December 31, 2013.  Depending on market conditions, the unrealized gain or loss on securities available for sale can cause fluctuations in shareholders’ equity.

40

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

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 75 commercial credit relationships.

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 six 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) increased $81 million from year end 2013 with most categories of loans contributing to the increase.  Residential real estate loans continue to represent a significant portion of the total loan portfolio. Such loans represented 23.2% of total loans at September 30, 2014 and 24.1% at December 31, 2013. On September 30, 2014, the Company had $4,779 of residential real estate loans held for sale, which was a slight decrease from the year-end balance of $5,999. 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):

	September 30, 2014			June 30, 2014			March 31, 2014			December 31, 2013			September 30, 2013
Amount	$	32,446		$	33,232		$	24,112		$	26,543		$	32,134
Percent of loans	1.85		%	1.95		%	1.43		%	1.59		%	2.00		%

The increase in the amount of non-performing loans at June 30, 2014 is the direct result of one large credit that the Company restructured into an A/B note.  The B note was written off ($3.8 million) and the A note ($11.6 million) was classified as a TDR.  The amount charged off on the B note was previously reserved for in the collective reserve pool, as this loan was not previously determined to be impaired until shortly before it was restructured.  Of the $32,446 of non-performing loans at September 30, 2014, $5,658 had a specific reserve allocated of $1,783.

41

A reconciliation of the non-performing assets for the first nine months of 2014 and 2013 is as follows:

	2014			2013
Beginning Balance - NPA - January 1,	$	30,663		$	57,795
Non-accrual
Add: New non-accruals	8,841			13,226
Less: To accrual/payoff/restructured	(8,390		)	(9,689		)
Less: To OREO	(2,119		)	(2,904		)
Less: Charge offs	(4,560		)	(8,112		)
Increase/(Decrease): Non-accrual loans	(6,228		)	(7,479		)
Other Real Estate Owned (OREO)
Add: New OREO properties	2,119			2,904
Less: OREO sold	(2,929		)	(4,155		)
Less: OREO losses (write-downs)	(120		)	(642		)
Increase/(Decrease): OREO	(930		)	(1,893		)
Increase/(Decrease): Repossessions	—			—
Increase/(Decrease): 90 Days Delinquent	45			(565		)
Increase/(Decrease): TDR’s	12,086			(10,940		)
Total NPA change	4,973			(20,877		)
Ending Balance - NPA - September 30,	$	35,636		$	36,918

At September 30, 2014, only one of the non-accrual loan balances was greater than $1,000 compared to two loan balances greater than $1,000 at December 31, 2013. 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 third quarter of 2014.  These loans decreased $36 million from the end of 2013.  The loans upgraded were the result of overall improvement in the underlying fundamentals of the credit.

42

The provision for loan losses was $0 in the third quarter of 2014 compared to $1,000 for the same period in 2013 and $750 for the second quarter of 2014. For the first nine months of 2014 and 2013, the provision for loan loss was $1,500 and $3,734 respectively.  The decrease in provision expense from 2013 was primarily due to the relative stabilization in the amount of non-performing and watch list loans in the aggregate and the net recoveries.  The amount of new non-accrual loans in the third quarter of 2014 was approximately $2,600 higher than the second quarter of 2014 with approximately 75% due to one credit.

Net recoveries were $682 for the third quarter of 2014 compared to charge offs of $1,153 for the same period a year ago and $4,560 for the first nine months of 2014 compared to $8,112 a year ago.   The Company received a large recovery on one loan in the third quarter of 2014 which accounted for the majority of the net recovery for the quarter. Over 80% of the Company’s charge-offs for the first nine months of 2014 was related to one commercial credit from a B note modification mentioned above.

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 September 30, 2014 was considered adequate by management.  The allowance for loan losses was $24,549 as of September 30, 2014 and represented 1.40% of total outstanding loans compared to $27,609 as of December 31, 2013 or 1.65% of total outstanding loans.  The decrease in the percentage was due to the continued improvement in nonperforming assets for the year.

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 September 30, 2014, the Company had $840,101 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 $17,789 was recorded to adjust the AFS portfolio to current market value at September 30, 2014, compared to an unrealized pre-tax gain of $1,746 at December 31, 2013. 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 86.3% and 88.1% of total average earning assets for the nine month periods ending September 30, 2014 and 2013. Total interest-bearing deposits averaged 79.9% and 81.2% of average total deposits for the nine month periods ending September 30, 2014 and 2013, 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 $240,343 outstanding at September 30, 2014. These advances have interest rates ranging from 0.43% to 4.80%.  Approximately $56,000 of these advances are short term advances while the remaining advances were originally long-term advances, $25,000 maturing in 2015, $15,000 maturing in 2016, $20,000 maturing in 2017, and $124,000 maturing in 2018 and beyond.

43

Capital Resources

Total shareholders’ equity was $332,790 at September 30, 2014, which was an increase of $27,264 compared to the $305,526 of shareholders’ equity at December 31, 2013. The increase in shareholders’ equity was primarily attributable to the Company’s net income of $22,436, other comprehensive income of $10,606, and activity in stock option and restricted stock programs of $881, offset by common dividends paid of $6,340 for the first nine months of 2014 and purchase of treasury stock of $319.

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 September 30, 2014, Tier 1 capital to total average assets was 10.5%. Tier 1 capital to risk-adjusted assets was 15.5%. Total capital to risk-adjusted assets was 16.7%. 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.

Beginning January 1, 2015, the Company and Bank will be subject to the new capital regulations of Basel III.  The new regulations establish higher minimum risk-based capital ratio requirements, a new common equity Tier 1 risk-based capital ratio and a new capital conservation buffer.  The new regulations also include revisions to the definition of capital and changes in the risk-weighting on certain assets.  To be considered “well capitalized,” as well as in compliance with the capital conservation buffer, a financial institution must maintain a 7.0%  common equity Tier 1 risk-based capital ratio, an 8.5% Tier 1 risk-based capital ratio and a 10.5% total risk-based capital ratio.  The capital conservation buffer is being phased-in and will be in full effect beginning January 1, 2019.  Under the new regulations, all financial institutions must maintain a Tier 1 leverage ratio of 4% to be considered “adequately capitalized” and 5% to be considered “well-capitalized.”  Management has completed a preliminary analysis of the impact of these new regulations to the capital ratios of both the Company, and the Bank and estimates that the ratios for both the Company and the Bank would exceed the capital ratio requirements to be considered “well-capitalized” and in compliance with the capital conservation buffer under Basel III if they were effective at September 30, 2014

The Company declared and paid common dividends of $0.11 per share in the third quarter of 2014 versus $0.08 per share for the third quarter of 2013.  The Company has increased its common dividend in the last few quarters as it has eliminated its preferred dividend requirement and its earnings have increased.

44

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 86.4% of total earning assets for the nine months ended September 30, 2014 and 82.3% for the same period in 2013.

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 September 30, 2014 from the analysis and disclosures provided in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013.

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 third fiscal quarter of 2014 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

45

PART II. OTHER INFORMATION

Item 1A. Risk Factors.

There have been no material changes to the Company’s risk factors previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013.

Item 6. Exhibits

2.1	Agreement and Plan of Merger, dated April 7, 2014, by and between MainSource Financial Group, Inc. and MBT Bancorp (incorporated by reference to Exhibit 2.1 to the Report on Form 8-K of the registrant filed April 7, 2013 with the Commission (Commission File No. 0-12422)).
3.1	Amended and Restated Articles of Incorporation of MainSource Financial Group, Inc. (incorporated by reference to Exhibit 3.1 to the Report on Form 8-K of the registrant filed December 13, 2013 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)).
10.1	Form of Voting Agreement by and among directors of MBT Bancorp (incorporated by reference to Exhibit 10.1 to the Report on Form 8-K of the registrant filed April 7, 2013 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 September 30, 2014, 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.

46

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.

November 7, 2014

/s/ Archie M. Brown, Jr.

Archie M. Brown, Jr.

President and Chief Executive Officer

November 7, 2014

/s/ James M. Anderson

James M. Anderson

Executive Vice President & Chief Financial Officer

47