Mainsource Financial (MSFG) 10-Q 2016 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, 2016

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 ☒ No ☐

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 ☒ No ☐

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

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

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

As of November 8, 2016 there were outstanding 24,033,881 shares of common stock, without par value, of the registrant.

MAINSOURCE FINANCIAL GROUP, INC.

FORM 10-Q

INDEX

PART I. FINANCIAL INFORMATION
Item 1. Financial Statements	3
Consolidated Balance Sheets	3
Consolidated Statements of Income	4
Consolidated Statements of Comprehensive Income	5
Consolidated Statements of Cash Flows	6
Notes to Consolidated Financial Statements	7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	39
Item 3. Quantitative and Qualitative Disclosures About Market Risk	49
Item 4. Controls and Procedures	49
PART II. OTHER INFORMATION
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	50
Item 6. Exhibits	50
Signatures	51

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MAINSOURCE FINANCIAL GROUP, INC.

CONSOLIDATED BALANCE SHEETS

(Dollar amounts in thousands except share and per share data)

Item 1. Financial Statements

		(Unaudited)
	September 30,		December 31,
	2016		2015
Assets
Cash and due from banks	$	62,809	$	56,104
Money market funds and federal funds sold		17,520		11,474
Cash and cash equivalents		80,329		67,578
Interest bearing time deposits		1,960		1,960
Securities available for sale		1,025,048		925,279
Loans held for sale		6,977		7,533
Loans, net of allowance for loan losses of $21,828 and $22,020		2,563,079		2,133,372
FHLB and other stock, at cost		21,537		11,300
Premises and equipment, net		76,436		62,973
Goodwill		100,889		75,953
Purchased intangible assets		7,762		4,662
Cash surrender value of life insurance		80,083		62,451
Interest receivable and other assets		49,843		32,347
Total assets	$	4,013,943	$	3,385,408
Liabilities
Deposits
Noninterest bearing	$	705,428	$	641,439
Interest bearing		2,418,600		2,009,336
Total deposits		3,124,028		2,650,775
Other borrowings		108,076		28,363
Federal Home Loan Bank (FHLB) advances		259,638		269,488
Subordinated debentures		41,239		41,239
Other liabilities		21,354		14,183
Total liabilities		3,554,335		3,004,048
Commitments and contingent liabilities
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 — 24,676,409 and 22,266,107
Outstanding shares — 24,033,381 and 21,579,575		12,430		11,201
Treasury stock — 643,028 and 686,532 shares, at cost		(11,105)		(11,812)
Additional paid-in capital		298,649		247,629
Retained earnings		137,852		121,718
Accumulated other comprehensive income		21,782		12,624
Total shareholders’ equity		459,608		381,360
Total liabilities and shareholders’ equity	$	4,013,943	$	3,385,408

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

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MAINSOURCE FINANCIAL GROUP, INC.

CONSOLIDATED STATEMENTS OF INCOME

(Dollar amounts in thousands except per share data)

	(Unaudited)				(Unaudited)
	Three months ended				Nine months ended
	September 30,				September 30,
	2016		2015		2016		2015
Interest income
Loans, including fees	$	26,782	$	22,040	$	73,810	$	64,858
Securities
Taxable		4,009		3,010		10,488		8,780
Tax exempt		3,023		3,035		9,009		8,939
Other interest income		43		28		166		96
Total interest income		33,857		28,113		93,473		82,673
Interest expense
Deposits		1,066		915		3,094		2,708
Federal Home Loan Bank advances		1,093		773		3,282		2,501
Subordinated debentures		355		318		1,051		942
Other borrowings		353		19		486		36
Total interest expense		2,867		2,025		7,913		6,187
Net interest income		30,990		26,088		85,560		76,486
Provision for loan losses		150		800		855		800
Net interest income after provision for loan losses		30,840		25,288		84,705		75,686
Non-interest income
Service charges on deposit accounts		5,696		6,102		15,597		16,221
Interchange income		2,877		2,256		8,317		6,445
Mortgage banking		2,602		2,270		7,135		6,734
Trust and investment product fees		1,163		1,204		3,626		3,664
Increase in cash surrender value of life insurance		410		310		1,056		931
Net realized gains on securities (includes $23 and $144 accumulated other comprehensive income (AOCI) reclassifications for realized net gains on available for sale securities in 2016 and $45 and $360 in 2015)		23		45		144		360
Gain/(Loss) on sale and write-down of OREO		67		(19)		253		(63)
Other income		1,076		1,176		3,113		3,312
Total non-interest income		13,914		13,344		39,241		37,604
Non-interest expense
Salaries and employee benefits		16,686		14,674		47,430		43,185
Net occupancy		2,412		2,064		6,877		6,276
Equipment		3,315		2,823		9,493		8,381
Intangibles amortization		302		431		999		1,270
Telecommunications		459		410		1,256		1,290
Stationery printing and supplies		263		302		809		894
FDIC assessment		395		435		1,250		1,245
Marketing		780		948		2,523		2,413
Collection expense		174		263		596		769
Prepayment penalty on FHLB advance		—		—		—		2,364
Acquisition related expenses		601		617		6,964		617
Consultant expense		156		250		428		750
Interchange expense		830		696		2,558		1,986
Other expenses		2,568		2,722		8,012		7,942
Total non-interest expense		28,941		26,635		89,195		79,382
Income before income tax		15,813		11,997		34,751		33,908
Income tax expense (includes $8 and $50 income tax expense from AOCI reclassification items in  2016 and $16 and $126 in 2015)		4,117		2,886		8,172		7,474
Net income attributable to common shareholders	$	11,696	$	9,111	$	26,579	$	26,434
Net income per common share:
Basic	$	0.49	$	0.42	$	1.17	$	1.22
Diluted	$	0.48	$	0.42	$	1.15	$	1.21
Dividend per share	$	0.15	$	0.14	$	0.45	$	0.40

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

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MAINSOURCE FINANCIAL GROUP, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Dollar amounts in thousands)

	(Unaudited)				(Unaudited)
	Three months ended				Nine months ended
	September 30,				September 30,
	2016		2015		2016		2015
Net income	$	11,696	$	9,111	$	26,579	$	26,434
Other comprehensive income:
Unrealized holding gains/(losses) on securities available for sale		(4,616)		6,723		14,232		3,044
Reclassification adjustment for (gains) included in net income		(23)		(45)		(144)		(360)
Tax effect		1,624		(2,271)		(4,930)		(912)
Other comprehensive income		(3,015)		4,407		9,158		1,772
Comprehensive income	$	8,681	$	13,518	$	35,737	$	28,206

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,
	2016		2015
Operating Activities
Net income	$	26,579	$	26,434
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		855		800
Depreciation expense		5,390		4,733
Amortization of mortgage servicing rights		1,068		1,034
(Recovery)/additional impairment of valuation allowance on mortgage servicing rights		175		(175)
Securities amortization, net		3,792		2,332
Amortization of purchased intangible assets		999		1,270
Earnings on cash surrender value of life insurance policies		(1,056)		(931)
Gain on life insurance benefit		—		(307)
Securities gains, net		(144)		(360)
Gain on loans sold		(4,512)		(4,381)
Loans originated for sale		(185,098)		(183,802)
Proceeds from loan sales		190,166		191,644
Stock based compensation expense		713		633
Stock portion of director retainer fee expense		282		230
(Gain)/Loss on sale and write-down of OREO		(253)		63
Prepayment penalty on FHLB advance		—		2,364
Change in other assets and liabilities		(7,520)		2,072
Net cash provided by operating activities		31,436		43,653
Investing Activities
Net change in short term investments		—		(45)
Purchases of securities available for sale		(186,209)		(284,755)
Proceeds from calls, maturities, and payments on securities available for sale		100,835		104,182
Proceeds from sales of securities available for sale		85,738		139,547
Loan originations and payments, net		(73,574)		(101,145)
Purchases of premises and equipment		(12,179)		(5,543)
Proceeds from sale of OREO		3,185		1,352
Proceeds from redemption of restricted stock		3,090		2,784
Purchase of restricted stock		(4,676)		—
Proceeds from sale of portfolio loans		—		11,356
Proceeds from life insurance benefit		—		1,094
Cash received/(paid) from bank/branch acquisitions, net		(11,289)		57,083
Net cash used by investing activities		(95,079)		(74,090)
Financing Activities
Net change in deposits		28,558		40,251
Net change in other borrowings		59,713		13,090
Proceeds from FHLB advances		420,000		585,000
Repayment of FHLB advances		(442,006)		(546,361)
Proceeds from line of credit		30,000		—
Cash dividends on common stock		(10,445)		(8,659)
Purchase of treasury shares		(333)		(3,280)
Repayment on line of credit		(10,000)		—
Proceeds from exercise of stock options, including tax benefit		907		264
Net cash provided by financing activities		76,394		80,305
Net change in cash and cash equivalents		12,751		49,868
Cash and cash equivalents, beginning of period		67,578		62,485
Cash and cash equivalents, end of period	$	80,329	$	112,353
Supplemental cash flow information
Interest paid	$	8,330	$	6,233
Income taxes paid		3,005		3,285
Supplemental non cash disclosure
Loan balances transferred to foreclosed real estate		1,547		1,164
Loan balances transferred to loans held for sale		—		11,356
Due to broker for securities purchases		—		86,395
Due from broker for securities sales		—		44,202

See NOTE 12 regarding non-cash transactions included in acquisitions.

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

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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(Dollar amounts in thousands except share and 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, 2015.

Adoption of New Accounting Standards and Newly-Issued, Not Yet Effective Accounting Standards

In August 2016, the FASB issued ASU No. 2016-15, “Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments.” ASU 2016-15 adds or clarifies guidance on the presentation and classification of eight specific types of cash receipts and cash payments in the statement of cash flows, with the intent of reducing diversity in practice. This ASU 2016-15 is effective for fiscal years, including interim periods within those fiscal years, beginning after December 15, 2017, with early adoption permitted. Entities must apply the guidance retrospectively to all periods presented; however, entities may apply prospectively if retrospective application is impracticable. The Company is currently assessing the impact that the adoption of ASU 2016-15 will have on its consolidated financial statements.

In June 2016, the FASB issued ASU 2016-13 “Financial Instruments (Topic 326) Measurement of Credit Losses on Financial Instrument”  ( “CECL”).  ASU 2016-13 requires an allowance for expected credit losses on financial assets be recognized as early as day one of the instrument.  This ASU departs from the incurred loss model which means the probability threshold is removed.  It considers more forward-looking information and requires the entity to estimate its credit losses over the life of the asset.  This ASU is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years.  Early adoption is permitted.  The Company will be evaluating the impact of this ASU over the next several years.

NOTE 2 - STOCK PLANS AND STOCK BASED COMPENSATION

On January 19, 2015, the Board of Directors adopted and approved the MainSource Financial Group, Inc. 2015 Stock Incentive Plan (the “2015 Plan”) which was effective following the approval of the 2015 Plan by the Company’s shareholders at the 2015 Annual Meeting of Shareholders held on April 29, 2015.  The 2015 Plan provides for the grant of incentive stock options, non-qualified stock options, stock appreciation rights, share awards of restricted stock, performance share units and other equity based awards.  Incentive stock options may be granted only to employees.  An aggregate of 1,000,000 shares of common stock are reserved for issuance under the 2015 Plan.  Shares issuable under the 2015 Plan may be authorized and unissued shares of common stock or treasury shares.  The 2015 Plan was a replacement of a similar plan adopted in 2007.  The 2007 Stock Incentive Plan (the “2007 Plan”) provided for the grant of incentive stock options, nonstatutory stock options, stock bonuses and restricted stock awards. An aggregate of 650,000 shares of common stock were reserved for issuance under the 2007 Stock Incentive Plan.  The 2007 Plan was in replacement of a similar plan adopted in 2003, the 2003 Stock Option Plan (the “2003 Plan”).  Any stock or option awards that were previously issued under the 2007 Plan or 2003 Plan have not been terminated as a result of the adoption of the 2015 Plan, but will continue in accordance with the applicable plan terms and the agreements pursuant to which such stock or option awards were issued.

The fair value of each option award is estimated on the date of grant using a closed form option valuation (Black-Scholes) model. Expected volatilities are based on historical volatilities of the Company’s common stock. The Company uses historical data to estimate option exercise and post-vesting termination behavior. Employee and director options are tracked

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separately. The expected term of options granted is based on historical data and represents the period of time that options granted are expected to be outstanding, which takes into account that the options are not transferable. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of the grant.

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.

The following table summarizes stock option activity:

	Nine Months Ended
	September 30, 2016
		Weighted
		Average
		Exercise
Options	Shares	Price
Outstanding, beginning of year	310,665	$	12.83
Granted	—		—
Exercised	(59,625)		14.20
Forfeited or expired	(12,125)		12.16
Outstanding at end of period	238,915	$	12.52
Exercisable at end of period	198,065	$	11.99
Fully vested and expected to vest	237,727	$	12.50

The following table details stock options outstanding:

	September 30,		December 31,
	2016		2015
Stock options vested and currently exercisable:
Number		198,065		269,415
Weighted average exercise price	$	11.99	$	12.48
Aggregate intrinsic value	$	2,567	$	2,801
Weighted average remaining life (in years)		3.3		3.6

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 $21 and $64 in stock compensation expense during the three and nine months ended September 30, 2016 and $48 and $133 in stock compensation expense during the three and nine months ended September 30 2015 to salaries and employee benefits. There were no options granted in the first nine months of 2016 or 2015. 

Unrecognized stock option compensation expense related to unvested awards for the remainder of 2016 and beyond is estimated as follows:

Year	(in thousands)
October 2016 - December 2016	$	22
2017		35

During 2015 and the first and second quarters of 2016, 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 Long Term Incentive Plan (“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. The restricted stock awards for employees vest as follows — 100% on the third anniversary of the date of grant. A total of 24,152 and 16,000 shares of common stock were granted in the first and second quarters of 2016 at a weighted average cost of $21.47 and $22.57 

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per share, respectively.  A total of 28,955 shares of common stock were granted in the first quarter of 2015 at a weighted average cost of $19.57 per share.

A summary of changes in the Company’s nonvested restricted shares for 2016 follows:

		Weighted Average
	Restricted	Grant Date
	Shares	Fair Value
Nonvested at January 1, 2016	101,631	$	16.57
Granted	40,152		21.91
Vested	(30,048)		13.75
Forfeited	(500)		16.55
Nonvested at September 30, 2016	111,235	$	19.26

As of September 30, 2016, there was $1,089 of total unrecognized compensation costs related to nonvested restricted stock awards granted under the 2015 Plan that will be recognized over the remaining vesting period of approximately 2.1 years. The recognized compensation costs related to the plans were $160 and $512 for the three month and nine periods ending September 30, 2016 and $143 and $447 for the three and nine months periods ending September 30, 2015.

Additionally, in the first quarter of 2016 and the second quarter of 2015, the Committee voted to grant performance share units to certain executive officers pursuant to the Company’s LTIP.  The Committee established performance measures, goals and payout calibration for the Performance Share Units. At the end of each three-year performance period, the Committee will certify the results of the performance measures and goals and will pay the earned awards out in cash or shares of Company common stock. Dividends earned during each three-year performance period will be accrued and paid at the end of the performance period, based upon the final number of shares earned. The performance measures and goals are based on financial and shareholder measures, and are evaluated relative to internal goals and the performance of the Company’s peers. Once the performance measures and goals were established, the Committee established threshold, target and superior levels of performance. The LTIP payout of shares will begin once the Company achieves the pre-established threshold (thus, no payout will occur if the performance is equal to or below the threshold). Each executive’s target payout is achieved once the performance equals the target level, and the maximum payout is achieved once the performance equals the superior level (with interpolation between discrete points).

Performance	Payout
Threshold	0	%
Target	100	%
Superior	150	%

The grant of Performance Share Units by the Committee is evidenced by an award agreement between the executive and the Company which provides that each executive will receive shares of Company stock when the Company’s actual performance as compared to its peers and long-term goals exceeds certain thresholds, determined as of December 31, 2017 or 2018, provided the executive remains employed by the Company on such date. The executive’s eligibility for the payout of shares is determined based on the following measures:

			Evaluated
Performance Measure	Weight		vs.
Return on Assets	50	%	Peer
Total Shareholder Return	25	%	Peer
Earnings Per Share	25	%	Goal

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. The performance share units are earned over the three year period of the award. A total of 16,152 performance share units were granted in the first quarter of 2016 at a weighted average cost of $21.41 per share.  A total of 16,205 performance share units were granted in the second quarter of 2015 at a weighted average cost of $19.57 per share.  Compensation expense is recognized over the three year performance period of the awards based on the fair value of the stock at the issue date and the anticipated achievement level of the target performance.  Quarterly, the

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performance measures will be reevaluated and adjustments made to the expense recorded in the financial statements, if needed, to reflect the new revised achievement levels.  $55 and $137 of expense was recognized on these awards for the three and nine month periods ending September 30, 2016 and $27 and $53 of expense was recognized in the three and nine months periods ending September 30, 2015.  A total of $447 will be expensed in future periods if the Target level is achieved.

In the second quarter of 2016, members of the Board of Directors received their entire annual retainer in restricted Company stock for the following Board year ended with the 2017 annual meeting of shareholders. The 2016 award vests quarterly for all directors who remain on the Board of Directors on the vesting dates, with 25% of the award vesting on each of May 1, August 1, and November 1, 2016, and February 1, 2017. The value of the 2016 retainer award was determined by multiplying the award amount by the closing price of the stock on the date of the 2016 annual meeting of shareholders.  Additional shares were granted in June 2016 to a new director who joined the Board following the Company’s acquisition of Cheviot Financial Corp.  The shares granted were pro-rated based on the new director’s time on the Board.

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
2016	1Q	358		19.89
2016	2Q	17,976		21.89

A total of $103 and $70 was recognized as other expense in the third quarter of 2016 and 2015 respectively for these grants and $282 and $230 was recognized in the first nine months of 2016 and 2015 respectively.

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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
	Cost		Gains		Losses		Fair Value
As of September 30, 2016
Available for Sale								��
U. S. government agency	$	426	$	10	$	—	$	436
State and municipal		339,261		20,529		(93)		359,697
Mortgage-backed securities-residential (Government Sponsored Entity)		446,989		9,478		(3)		456,464
Collateralized mortgage obligations (Government Sponsored Entity)		192,100		3,664		(145)		195,619
Equity securities		6,233		—		—		6,233
Other securities		6,529		70		—		6,599
Total available for sale	$	991,538	$	33,751	$	(241)	$	1,025,048
			Gross		Gross
	Amortized		Unrealized		Unrealized
	Cost		Gains		Losses		Fair Value
As of December 31, 2015
Available for Sale
U. S. government agency	$	499	$	5	$	—	$	504
State and municipal		332,999		17,802		(68)		350,733
Mortgage-backed securities-residential (Government Sponsored Entity)		332,525		2,199		(644)		334,080
Collateralized mortgage obligations (Government Sponsored Entity)		228,621		1,966		(1,838)		228,749
Equity securities		4,689		—		—		4,689
Other securities		6,524		—		—		6,524
Total available for sale	$	905,857	$	21,972	$	(2,550)	$	925,279

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
	Amortized Cost		Fair Value
Within one year	$	11,347	$	11,456
One through five years		70,884		74,840
Six through ten years		112,190		119,436
After ten years		151,795		161,000
Mortgage-backed securities-residential (Government Sponsored Entity)		446,989		456,464
Collateralized mortgage obligations (Government Sponsored Entity)		192,100		195,619
Equity securities		6,233		6,233
Total available for sale securities	$	991,538	$	1,025,048

Proceeds from sales of securities available for sale were $85,738 and $139,547 for the nine months ended September 30, 2016 and 2015, respectively. Gross gains of $144 and $1,515 and gross losses of $0 and $1,155 were realized on these sales during 2016 and 2015, respectively.  Income taxes on these net gains were $50 and $126 in 2016 and 2015.

11

Proceeds from sales of securities available for sale were $7,615 and $57,208 for the three months ended September 30, 2016 and 2015, respectively. Gross gains of $23 and $203 and gross losses of $0 and $158 were realized on these sales during 2016 and 2015, respectively.  Income taxes on these net gains were $8 and $16 in 2016 and 2015.

Below is a summary of securities with unrealized losses as of September 30, 2016 and December 31, 2015 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, 2016			Unrealized				Unrealized				Unrealized
Description of securities	Fair Value		Losses		Fair Value		Losses		Fair Value		Losses
U. S. government agency	$	—	$	—	$	—	$	—	$	—	$	—
State and municipal		10,825		(93)		—		—		10,825		(93)
Mortgage-backed securities-residential (Government Sponsored Entity)		10,175		(3)		—		—		10,175		(3)
Collateralized mortgage obligations (Government Sponsored Entity)		17,568		(77)		9,068		(68)		26,636		(145)
Other securities		—		—		—		—		—		—
Total temporarily impaired	$	38,568	$	(173)	$	9,068	$	(68)	$	47,636	$	(241)

	Less than 12 months				12 months or longer				Total
December 31, 2015			Unrealized				Unrealized				Unrealized
Description of securities	Fair Value		Losses		Fair Value		Losses		Fair Value		Losses
U. S. government agency	$	—	$	—	$	—	$	—	$	—	$	—
State and municipal		4,802		(33)		1,367		(35)		6,169		(68)
Mortgage-backed securities-residential (Government Sponsored Entity)		168,950		(644)		—		—		168,950		(644)
Collateralized mortgage obligations (Government Sponsored Entity)		53,324		(591)		52,061		(1,247)		105,385		(1,838)
Other securities		—		—		—		—		—		—
Total temporarily impaired	$	227,076	$	(1,268)	$	53,428	$	(1,282)	$	280,504	$	(2,550)

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

12

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, 2016, the Company’s securities portfolio consisted of 938 securities, 28 of which were in an unrealized loss position.  Unrealized losses on state and municipal securities of $93 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 changes in interest rates. 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, 2016, 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 $3 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, 2016.

The Company’s collateralized mortgage obligation securities portfolio includes agency collateralized mortgage obligations with a market value of $26,636which had unrealized losses of approximately $145at September 30, 2016. As noted above, the decline in fair value is attributable to changes in interest rates and illiquidity and not credit quality. The Company monitors to insure it has adequate credit support and as of September 30, 2016, 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. 

NOTE 4 - LOANS AND ALLOWANCE

Loans were as follows:

	September 30,		December 31,
	2016		2015
Commercial
Commercial and industrial	$	422,614	$	380,960
Agricultural		67,745		64,704
Commercial Real Estate
Farm		109,507		97,916
Hotel		90,929		72,193
Construction and development		87,722		77,394
Other		837,838		678,381
Residential
1-4 family		621,259		438,808
Home equity		286,266		288,265
Consumer
Direct		60,675		56,312
Indirect		352		459
Total loans		2,584,907		2,155,392
Allowance for loan losses		(21,828)		(22,020)
Net loans	$	2,563,079	$	2,133,372

13

The Company purchased some financing receivables in the last several years.  The investment by portfolio class at September 30, 2016 is as follows.  These loans are included in the above table and all other tables below at the recorded investment amount.

	September 30,		December 31,
	2016		2015
Commercial and industrial	$	16,337	$	9,406
Agricultural		1,025		—
Construction and development		14,136		3,666
Farm real estate		221		—
Hotel		1,615		—
Other real estate		175,387		81,831
1-4 family		216,057		46,967
Home equity		14,959		19,076
Direct		2,858		2,818
	$	442,595	$	163,764

The remaining discount on the above loans was $7,308 and $2,198 at September 30, 2016 and December 31, 2015 respectively.

Activity in the allowance for loan losses for the three months ended September 30, 2016 and 2015 was as follows:

			Commercial
2016	Commercial		Real Estate		Residential		Consumer		Total
Allowance for loan losses
Balance, July 1	$	6,940	$	8,780	$	4,677	$	1,071	$	21,468
Provision charged to expense		1,525		(1,225)		(257)		107		150
Losses charged off		(23)		(33)		(122)		(1,031)		(1,209)
Recoveries		148		398		106		767		1,419
Balance, September 30	$	8,590	$	7,920	$	4,404	$	914	$	21,828

			Commercial
2015	Commercial		Real Estate		Residential		Consumer		Total
Allowance for loan losses
Balance, July 1	$	5,394	$	12,689	$	3,264	$	1,126	$	22,473
Provision charged to expense		1,331		(1,349)		154		664		800
Losses charged off		(773)		(101)		(401)		(1,076)		(2,351)
Recoveries		246		307		71		477		1,101
Balance, September 30	$	6,198	$	11,546	$	3,088	$	1,191	$	22,023

Activity in the allowance for loan losses for the nine months ended September 30, 2016 and 2015 was as follows:

			Commercial
2016	Commercial		Real Estate		Residential		Consumer		Total
Allowance for loan losses
Balance, January 1	$	6,511	$	10,702	$	3,859	$	948	$	22,020
Provision charged to expense		2,352		(3,314)		1,214		603		855
Losses charged off		(650)		(614)		(967)		(2,748)		(4,979)
Recoveries		377		1,146		298		2,111		3,932
Balance, September 30	$	8,590	$	7,920	$	4,404	$	914	$	21,828

14

			Commercial
2015	Commercial		Real Estate		Residential		Consumer		Total
Allowance for loan losses
Balance, January 1	$	2,977	$	15,605	$	3,501	$	1,167	$	23,250
Provision charged to expense		3,822		(5,298)		927		1,349		800
Losses charged off		(900)		(538)		(1,606)		(2,576)		(5,620)
Recoveries		299		1,777		266		1,251		3,593
Balance, September 30	$	6,198	$	11,546	$	3,088	$	1,191	$	22,023

The following table presents the balance in the allowance for loan losses and the recorded investment by portfolio segment and based on impairment method at September 30, 2016 and December 31, 2015.

			Commercial
September 30, 2016	Commercial		Real Estate		Residential		Consumer		Total
Allowance for loan losses
Ending Balance individually evaluated for impairment	$	454	$	650	$	148	$	—	$	1,252
Ending Balance collectively evaluated for impairment		8,136		7,270		4,256		914		20,576
Total ending allowance balance	$	8,590	$	7,920	$	4,404	$	914	$	21,828
Loans
Ending Balance individually evaluated for impairment	$	2,329	$	7,870	$	10,092	$	121	$	20,412
Ending Balance collectively evaluated for impairment		488,030		1,118,126		897,433		60,906		2,564,495
Total ending loan balance excludes $6,911 of accrued interest	$	490,359	$	1,125,996	$	907,525	$	61,027	$	2,584,907

			Commercial
December 31, 2015	Commercial		Real Estate		Residential		Consumer		Total
Allowance for loan losses
Ending Balance individually evaluated for impairment	$	92	$	1,166	$	171	$	—	$	1,429
Ending Balance collectively evaluated for impairment		6,419		9,536		3,688		948		20,591
Total ending allowance balance	$	6,511	$	10,702	$	3,859	$	948	$	22,020
Loans
Ending Balance individually evaluated for impairment	$	812	$	8,909	$	9,155	$	113	$	18,989
Ending Balance collectively evaluated for impairment		444,852		916,975		717,918		56,658		2,136,403
Total ending loan balance excludes $5,878 of accrued interest	$	445,664	$	925,884	$	727,073	$	56,771	$	2,155,392

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 $2,410 at September 30, 2016 and $1,583 at December 31, 2015.

In connection with the acquisition of Cheviot Financial Corp. (see Note 12), the Company acquired $16,175 of purchased credit impaired loans with $4,615 of non accretable yield and no accretable yield.  The Company provided no allowance for loan losses on these loans at September 30, 2016.

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

15

The following tables present loans individually evaluated for impairment by class of loans as of September 30, 2016 and December 31, 2015.  Performing troubled debt restructurings totaling $1,954 and $2,760 were excluded as allowed by ASC 310-40.

					Allowance
	Unpaid				for Loan
	Principal		Recorded		Losses
September 30, 2016	Balance		Investment		Allocated
With an allowance recorded
Commercial
Commercial and industrial	$	371	$	344	$	85
Agricultural		1,450		1,450		369
Commercial Real Estate
Farm		1,106		1,105		282
Hotel		—		—		—
Construction and development		—		—		—
Other		1,788		1,682		368
Residential
1-4 Family		1,100		1,059		147
Home Equity		107		107		1
Consumer
Direct		—		—		—
Indirect		—		—		—
Subtotal — impaired with allowance recorded		5,922		5,747		1,252
With no related allowance recorded
Commercial
Commercial and industrial	$	1,078	$	352	$	—
Agricultural		183		183		—
Commercial Real Estate
Farm		501		246		—
Hotel		64		64		—
Construction and development		158		84		—
Other		3,872		2,736		—
Residential
1-4 Family		8,984		7,040		—
Home Equity		2,127		1,886		—
Consumer
Direct		127		120		—
Indirect		—		—		—
Subtotal — impaired with no allowance recorded		17,094		12,711		—
Total impaired loans	$	23,016	$	18,458	$	1,252

16

					Allowance
	Unpaid				for Loan
	Principal		Recorded		Losses
December 31, 2015	Balance		Investment		Allocated
With an allowance recorded
Commercial
Commercial and industrial	$	150	$	150	$	92
Agricultural		—		—		—
Commercial Real Estate
Farm		—		—		—
Hotel		—		—		—
Construction and development		—		—		—
Other		2,480		2,363		1,166
Residential
1-4 Family		1,357		1,309		167
Home Equity		159		159		4
Consumer
Direct		—		—		—
Indirect		—		—		—
Subtotal — impaired with allowance recorded		4,146		3,981		1,429
With no related allowance recorded
Commercial
Commercial and industrial	$	676	$	655	$	—
Agricultural		7		7		—
Commercial Real Estate
Farm		496		309		—
Hotel		—		—		—
Construction and development		189		186		—
Other		4,429		3,291		—
Residential
1-4 Family		6,718		5,391		—
Home Equity		2,589		2,296		—
Consumer
Direct		126		113		—
Indirect		—		—		—
Subtotal — impaired with no allowance recorded		15,230		12,248		—
Total impaired loans	$	19,376	$	16,229	$	1,429

The following tables present the average balance of impaired loans and interest income and cash basis interest recognized for the nine months ending September 30, 2016 and September 30, 2015, excluding performing troubled debt restructurings as allowed by ASC 310-40.

17

	Average		Interest		Cash Basis
	Balance		Income		Income
Nine months ended September 30, 2016	Impaired Loans		Recognized		Recognized
Commercial
Commercial and industrial	$	753	$	43	$	43
Agricultural		824		—		—
Commercial Real Estate
Farm		830		—		—
Hotel		16		—		—
Construction and development		155		—		—
Other		4,898		152		152
Residential
1-4 family		7,433		44		44
Home equity		2,270		20		20
Consumer
Direct		121		9		9
Indirect		—		1		1
Total loans	$	17,300	$	269	$	269

	Average		Interest		Cash Basis
	Balance		Income		Income
Nine months ended September 30, 2015	Impaired Loans		Recognized		Recognized
Commercial
Commercial and industrial	$	1,256	$	12	$	12
Agricultural		38		—		—
Commercial Real Estate
Farm		424		4		4
Hotel		3,563		—		—
Construction and development		20		47		47
Other		5,753		141		141
Residential
1-4 family		7,527		43		43
Home equity		2,221		10		10
Consumer
Direct		134		14		14
Indirect		2		5		5
Total loans	$	20,938	$	276	$	276

18

The following tables present the average balance of impaired loans and interest income and cash basis interest recognized for the three months ending September 30, 2016 and September 30, 2015, excluding performing troubled debt restructurings as allowed by ASC 310-40.

	Average		Interest		Cash Basis
	Balance		Income		Income
Three months ended  September 30, 2016	Impaired Loans		Recognized		Recognized
Commercial
Commercial and industrial	$	725	$	12	$	12
Agricultural		1,640		—		—
Commercial Real Estate
Farm		1,357		—		—
Hotel		32		—		—
Construction and development		124		—		—
Other		4,791		35		35
Residential
1-4 family		8,299		17		17
Home equity		2,083		4		4
Consumer
Direct		126		3		3
Indirect		—		—		—
Total loans	$	19,177	$	71	$	71

	Average		Interest		Cash Basis
	Balance		Income		Income
Three months ended  September 30, 2015	Impaired Loans		Recognized		Recognized
Commercial
Commercial and industrial	$	1,677	$	6	$	6
Agricultural		—		—		—
Commercial Real Estate
Farm		405		—		—
Hotel		—		—		—
Construction and development		—		—		—
Other		6,298		86		86
Residential
1-4 family		7,343		8		8
Home equity		2,707		2		2
Consumer
Direct		162		4		4
Indirect		—		1		1
Total loans	$	18,592	$	107	$	107

19

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, 2016 and December 31, 2015:

					Past due over
					90 days and
	Non-accrual				still accruing
	September 30, 2016		December 31, 2015		September 30, 2016		December 31, 2015
Commercial
Commercial and industrial	$	569	$	654	$	—	$	—
Agricultural		1,548		7		—		—
Commercial Real Estate
Farm		1,352		308		—		—
Hotel		63		—		—		—
Construction and development		44		144		—		—
Other		3,219		4,791		—		—
Residential
1-4 Family		6,810		5,211		—		—
Home Equity		1,242		1,639		—		—
Consumer
Direct		97		89		—		—
Indirect		—		—		—		—
Total	$	14,944	$	12,843	$	—	$	—

Included in the above non-accrual loans at September 30, 2016 are $3,544 of loans from the Cheviot acquisition.

The following tables present the aging of the recorded investment in past due loans as of September 30, 2016 and December 31, 2015 by class of loans:

							Greater than
	Total		30-59 Days		60-89 Days		90 Days		Total		Loans Not
September 30, 2016	Loans		Past Due		Past Due		Past Due		Past Due		Past Due
Commercial
Commercial and industrial	$	422,614	$	172	$	98	$	209	$	479	$	422,135
Agricultural		67,745		17		49		1,548		1,614		66,131
Commercial Real Estate
Farm		109,507		—		316		933		1,249		108,258
Hotel		90,929		—		—		64		64		90,865
Construction and development		87,722		—		23		44		67		87,655
Other		837,838		445		344		1,592		2,381		835,457
Residential
1-4 Family		621,259		1,795		1,766		4,039		7,600		613,659
Home Equity		286,266		586		206		762		1,554		284,712
Consumer
Direct		60,675		42		20		67		129		60,546
Indirect		352		—		—		—		—		352
Total — excludes $6,911 of accrued interest	$	2,584,907	$	3,057	$	2,822	$	9,258	$	15,137	$	2,569,770

20

							Greater than
	Total		30-59 Days		60-89 Days		90 Days		Total		Loans Not
December 31, 2015	Loans		Past Due		Past Due		Past Due		Past Due		Past Due
Commercial
Commercial and industrial	$	380,960	$	93	$	—	$	249	$	342	$	380,618
Agricultural		64,704		20		—		7		27		64,677
Commercial Real Estate
Farm		97,916		—		—		119		119		97,797
Hotel		72,193		—		13		—		13		72,180
Construction and development		77,394		—		67		144		211		77,183
Other		678,381		873		102		2,601		3,576		674,805
Residential
1-4 Family		438,808		3,726		1,904		2,771		8,401		430,407
Home Equity		288,265		410		446		1,133		1,989		286,276
Consumer
Direct		56,312		40		65		68		173		56,139
Indirect		459		2		—		—		2		457
Total — excludes $5,878 of accrued interest	$	2,155,392	$	5,164	$	2,597	$	7,092	$	14,853	$	2,140,539

Troubled Debt Restructurings

From time to time, the terms of certain loans are modified as troubled debt restructurings. The modification of the terms of such loans includes 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.

The total of troubled debt restructurings at September 30, 2016 and December 31, 2015 was $6,669 and $8,389 respectively. The Company has allocated $501 of specific reserves to customers whose loan terms have been modified in troubled debt restructurings as of September 30, 2016. 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, 2015, the comparable numbers were $863 of specific reserves and $0 of commitments.

The following table presents loans by class modified as troubled debt restructurings that occurred during the nine month period ending September 30, 2016:

		Pre-Modification		Post-Modification
		Outstanding Recorded		Outstanding Recorded
For the nine months ended September 30, 2016	Number of Loans	Investment		Investment
Commercial
Agricultural	1	$	89	$	89
Commercial Real Estate
Other	2		298		298
Residential
1-4 Family	1		124		124
Home Equity	4		76		76
Total	8	$	587	$	587

21

The following table presents loans by class modified as troubled debt restructurings that occurred during the nine month period ending September 30, 2015:

		Pre-Modification		Post-Modification
		Outstanding Recorded		Outstanding Recorded
For the nine months ended September 30, 2015	Number of Loans	Investment		Investment
Commercial
Commercial and industrial	3	$	216	$	216
Commercial real estate
Other	8		1,610		1,349
Residential
1-4 Family	3		215		215
Home Equity	2		44		44
Total	16	$	2,085	$	1,824

The following table presents loans by class modified as troubled debt restructurings that occurred during the three month period ending September 30, 2016:

		Pre-Modification		Post-Modification
		Outstanding Recorded		Outstanding Recorded
For the three months ended September 30, 2016	Number of Loans	Investment		Investment
Commercial real estate
Other	2	$	298	$	298
Total	2	$	298	$	298

The following table presents loans by class modified as troubled debt restructurings that occurred during the three month period ending September 30, 2015:

		Pre-Modification		Post-Modification
		Outstanding Recorded		Outstanding Recorded
For the three months ended September 30, 2015	Number of Loans	Investment		Investment
Commercial real estate
Other	1	$	42	$	42
Residential
1-4 Family	3		215		215
Home Equity	1		38		38
Total	5	$	295	$	295

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, 2016:

For the nine months ended September 30, 2016	Number of Loans	Recorded Investment
Commercial real estate
Other	1	$	125
Residential
1-4 Family	2		250
Total	3	$	375

22

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, 2015:

For the nine months ended September 30, 2015	Number of Loans	Recorded Investment
Commercial real estate
Other	3	$	863
Residential
1-4 Family	1		152
Home Equity	1		47
Total	5	$	1,062

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, 2016:

For the three months ended September 30, 2016	Number of Loans	Recorded Investment
Residential
1-4 Family	1	$	104
Total	1	$	104

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, 2015:

For the three months ended September 30, 2015	Number of Loans	Recorded Investment
Commercial real estate:
Other	2	$	835
Residential
1-4 Family	1		152
Home Equity	1		47
Total	4	$	1,034

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 did not increase the allowance for loan losses or result in any charge offs during the three or nine month periods ending September 30, 2016 and 2015, respectively.

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

The terms of certain other loans were modified during the three and nine month periods ending September 30, 2016 and 2015 that did not meet the definition of a troubled debt restructuring. These modified loans had a total recorded investment of $7,895 and $5,511 for the three month period ending September 30, 2016 and 2015 respectively. These modified loans had a total recorded investment of $10,784 and $6,586 for the nine month period ending September 30, 2016 and 2015 respectively.  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 significant.

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. Only credit relationships over $250 are risk graded.  The Company uses the following definitions for risk ratings:

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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.

As of September 30, 2016, and based on the most recent analysis performed, the risk category of loans by class of loans is as follows:

			Special
September 30, 2016	Pass		Mention		Substandard		Non-accrual
Commercial
Commercial and industrial	$	376,585	$	2,526	$	5,845	$	507
Agricultural		55,797		2,461		—		1,450
Commercial Real Estate
Farm		86,685		2,238		696		1,352
Hotel		87,883		—		2,983		—
Construction and development		61,333		3,596		2,344		31
Other		729,149		9,229		7,937		2,417
Total	$	1,397,432	$	20,050	$	19,805	$	5,757

At December 31, 2015, the risk category of loans by class of loans was as follows:

			Special
December 31, 2015	Pass		Mention		Substandard		Non-accrual
Commercial
Commercial and industrial	$	338,436	$	8,324	$	636	$	555
Agricultural		58,253		—		—		—
Commercial Real Estate
Farm		75,924		328		713		308
Hotel		72,193		—		—		—
Construction and development		60,246		—		2,499		113
Other		576,619		10,367		3,309		3,811
Total	$	1,181,671	$	19,019	$	7,157	$	4,787

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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 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 and are subsequently charged off. As of September 30, 2016 and December 31, 2015, the grading of loans by category of loans is as follows:

September 30, 2016	Performing		Watch		Substandard
Commercial
Commercial and industrial	$	37,072	$	17	$	62
Agricultural		7,929		10		98
Commercial Real Estate
Construction and development		20,391		14		13
Farm		18,536		—		—
Hotel		—		—		63
Other		87,844		460		802
Total	$	171,772	$	501	$	1,038

December 31, 2015	Performing		Watch		Substandard
Commercial
Commercial and industrial	$	32,910	$	—	$	99
Agricultural		6,444		—		7
Commercial Real Estate
Construction and development		14,438		67		31
Farm		20,643		—		—
Other		83,193		102		980
Total	$	157,628	$	169	$	1,117

September 30, 2016	Performing		Watch		Substandard
Residential
1-4 family	$	615,454	$	1,766	$	4,039
Home equity		285,298		206		762
Total	$	900,752	$	1,972	$	4,801

September 30, 2016	Performing		Substandard		Loss
Consumer
Direct	$	60,588	$	20	$	67
Indirect		352		—		—
Total	$	60,940	$	20	$	67

December 31, 2015	Performing		Watch		Substandard
Residential
1-4 family	$	434,133	$	1,904	$	2,771
Home equity		286,686		446		1,133
Total	$	720,819	$	2,350	$	3,904

December 31, 2015	Performing		Substandard		Loss
Consumer
Direct	$	56,179	$	101	$	32
Indirect		459		—		—
Total	$	56,638	$	101	$	32

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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,
	2016		2015		2016		2015
Beginning Balance	$	3,180	$	2,065	$	1,959	$	2,688
Transfer to other real estate owned		564		801		1,547		1,164
Sale — Out of other real estate owned		(1,441)		(429)		(2,841)		(1,377)
Acquisition		—		—		1,668		—
Write-down		(61)		—		(91)		(38)
Ending Balance	$	2,242	$	2,437	$	2,242	$	2,437

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,
	2016		2015		2016		2015
Beginning Balance —	$	(234)	$	(323)	$	(217)	$	(448)
Impairments during year		(61)		—		(91)		(38)
Recovery on impairments		5		—		18		—
Reductions		—		37		—		200
Ending Balance — September 30	$	(290)	$	(286)	$	(290)	$	(286)

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

	Three months ended  September 30,				Nine months ended September 30,
	2016		2015		2016		2015
Write-downs	$	61	$	—	$	91	$	38
Losses/(gains)on sales		(128)		19		(344)		25
Net loss/(gain)	$	(67)	$	19	$	(253)	$	63
Operating expenses	$	46	$	30	$	103	$	124

Foreclosed residential real estate properties included in other assets on the Consolidated Balance Sheets totaled $1,669 and $915 at September 30, 2016 and December 31, 2015, respectively. Retail mortgage loans secured by residential real estate properties for which formal foreclosure proceedings are in process according to local requirements totaled $3,161 and $2,407 at September 30, 2016 and December 31, 2015, respectively.

NOTE 6 — DEPOSITS & REPURCHASE AGREEMENTS

	September 30,		December 31,
	2016		2015
Non-interest-bearing demand	$	705,428	$	641,439
Interest-bearing demand		1,132,290		1,084,786
Savings		756,069		599,729
Certificates of deposit of $250 or more		139,006		73,493
Other certificates and time deposits		391,235		251,328
Total deposits	$	3,124,028	$	2,650,775

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The Company has entered into repurchase agreements with some of its customers.  The agreements are one day in length.  At September 30, 2016, these agreements totaled $34,076 and were secured by a pledged amount of $50,844 of mortgage backed securities.  At December 31, 2015, these agreements totaled $28,363 and were secured by a pledged amount of $48,662.  Management monitors the fair value of the securities on a regular basis. If the fair value of the securities declined to an amount approximating these agreements, more securities would be pledged.

NOTE 7 - EARNINGS PER SHARE

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

	2016					2015
	Net		Average	Share		Net		Average	Share
Three Months Ended September 30,	Income		Shares	Amount		Income		Shares	Amount
Basic Earnings Per Common Share
Net income	$	11,696	24,016,237	$	0.49	$	9,111	21,615,263	$	0.42
Effect of dilutive warrants			202,238					171,062
Effect of dilutive stock options			103,137					110,636
Diluted Earnings Per Common Share
Net income attributable to common shareholders and assumed conversions	$	11,696	24,321,612	$	0.48	$	9,111	21,896,961	$	0.42

There were no antidilutive options in the three month periods ending September 30, 2016 or 2015.

	2016					2015
	Net		Average	Share		Net		Average	Share
Nine Months Ended September 30,	Income		Shares	Amount		Income		Shares	Amount
Basic Earnings Per Common Share
Net income	$	26,579	22,786,961	$	1.17	$	26,434	21,658,088	$	1.22
Effect of dilutive warrants			182,327					152,171
Effect of dilutive stock options			101,777					103,053
Diluted Earnings Per Common Share
Net income attributable to common shareholders and assumed conversions	$	26,579	23,071,065	$	1.15	$	26,434	21,913,312	$	1.21

Stock options for 10,210 common shares in 2015 were not considered in computing diluted earnings per share because they were antidilutive.  There were no  antidilutive options in 2016.

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),

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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.  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 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.  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 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 3 inputs).

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.

The fair value of interest rate swaps are based on valuation models using observable market data as of the measurement date (Level 2).  The fair value of derivatives are classified as Interest receivable and other assets and Other liabilities on the balance sheet.

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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, 2016 Using:
			Quoted Prices in		Significant		Significant
			Active Markets for		Other 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	$	436	$	—	$	436	$	—
States and municipal		359,697		—		349,443		10,254
Mortgage-backed securities — residential — Government Sponsored Entity		456,464		—		456,464		—
Collateralized mortgage obligations — Government Sponsored Entity		195,619		—		195,619		—
Equity securities		6,233		6,233		—		—
Other securities		6,599		—		—		6,599
Total investment securities available-for-sale	$	1,025,048	$	6,233	$	1,001,962	$	16,853
Mortgage banking derivatives	$	1,057		—	$	1,057		—
Interest rate swap asset	$	6,255		—	$	6,255		—
Interest rate swap liability	$	(6,255)		—	$	(6,255)		—

			Fair Value Measurements at December 31, 2015 Using:
			Quoted Prices in		Significant		Significant
			Active Markets for		Other 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	$	504	$	—	$	504	$	—
States and municipal		350,733		—		339,875		10,858
Mortgage-backed securities — residential — Government Sponsored Entity		334,080		—		334,080		—
Collateralized mortgage obligations — Government Sponsored Entity		228,749		—		228,749		—
Equity securities		4,689		4,689		—		—
Other securities		6,524		—		—		6,524
Total investment securities available-for-sale	$	925,279	$	4,689	$	903,208	$	17,382
Mortgage banking derivative	$	700		—	$	700		—
Interest rate swap asset	$	1,508		—	$	1,508		—
Interest rate swap liability	$	(1,508)		—	$	(1,508)		—

There were no transfers between Level 1 and Level 2 during the third quarter of 2016 or 2015.

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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, 2016 and 2015:

Three months ended September 30:

States and municipal	2016		2015
Beginning balance, July 1	$	10,430	$	11,863
Total gains or losses (realized / unrealized)
Included in other comprehensive income		6		(6)
Settlements		(182)		(510)
Ending balance, September 30	$	10,254	$	11,347

Other securities	2016		2015
Beginning balance, July 1	$	6,601	$	2,527
Total gains or losses (realized / unrealized)
Purchases		—		—
Included in other comprehensive income		(2)		(2)
Ending balance, September 30	$	6,599	$	2,525

Nine months ended September 30:

States and municipal	2016		2015
Beginning balance, January 1	$	10,858	$	12,810
Total gains or losses (realized / unrealized)
Included in other comprehensive income		8		(36)
Settlements		(612)		(1,427)
Ending balance, September 30	$	10,254	$	11,347

Other securities	2016		2015
Beginning balance, January 1	$	6,524	$	2,503
Total gains or losses (realized / unrealized)
Purchases				—
Included in other comprehensive income		75		22
Ending balance, September 30	$	6,599	$	2,525

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 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.

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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, 2016 Using:
			Quoted Prices in	Significant	Significant
			Active Markets for	Other Observable	Unobservable
	September 30,		Identical Assets	Inputs	Inputs
	2016		(Level 1)	(Level 2)	(Level 3)
Assets:
Impaired loans
Commercial and industrial	$	259			$	259
Agricultural		1,081				1,081
Farm real estate		823				823
Other real estate		588				588
Total impaired loans	$	2,751			$	2,751
Impaired servicing rights	$	3,161			$	3,161

			Fair Value Measurements at December 31, 2015 Using:
			Quoted Prices in	Significant	Significant
			Active Markets for	Other Observable	Unobservable
	December 31,		Identical Assets	Inputs	Inputs
	2015		(Level 1)	(Level 2)	(Level 3)
Assets:
Impaired loans
Commercial and industrial	$	58			$	58
Other real estate		1,082				1,082
Total impaired loans	$	1,140			$	1,140
Impaired servicing rights	$	531			$	531

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a gross carrying amount of $3,700, with a valuation allowance of $949 at September 30, 2016. The Company recorded a charge of $228 to provision expense associated with these loans for the three months ended September 30, 2016 and a charge of $634 to provision expense with these loans for the nine month period ending September 30, 2016.  The Company recorded a charge of $426 to provision expense associated with these loans for the three months ended September 30, 2015 and a charge of $1,281 provision expense associated with these loans for the nine month period ending September 30, 2015.  At December 31, 2015, impaired loans had a gross carrying amount of $2,393 with a valuation allowance of $1,253. A breakdown of these loans by portfolio class at September 30, 2016 is as follows:

	Gross		Valuation
	Balance		Allowance		Net
Commercial and industrial	$	344	$	85	$	259
Agricultural		1,450		369		1,081
Farm real estate		1,105		282		823
Other real estate		801		213		588
Ending Balance	$	3,700	$	949	$	2,751

Impaired tranches of servicing rights were carried at a fair value of $3,161, which is made up of the gross outstanding balance of $3,536 net of a valuation allowance of $375.  A $125 charge was made to the valuation allowance in the third quarter of 2016 and a charge of $175 was made to the valuation account in the first nine months of 2016.   A $25 credit to earnings was made to the valuation allowance in the third quarter of 2015 and a credit of $175 was made to the valuation allowance in the first nine months of 2015.  At December 31, 2015, impaired servicing rights were carried at a fair value of $531 which was made up of the gross outstanding balance of $731, net of a valuation allowance of $200.

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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, 2016 and December 31, 2015. Impaired commercial loans, 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.  The fair value of the mortgage servicing rights is valued based on present value of future cash flows to be received taking into account the coupon rate on the mortgage as well as estimated prepayment speeds.

	Fair Value		Valuation	Unobservable	Range/
September 30, 2016	(in thousands)		Technique(s)	Input(s)	Average
Impaired Loans:
Commercial and industrial	$	259	Sales comparison approach	Adjustment for differences between comparable sales		15% - 25%
						21% Avg
Agricultural		1,081	Sales comparison approach	Adjustment for differences between comparable sales		10%
						10% Avg
Farm real estate		823	Sales comparison approach	Adjustment for differences between comparable sales		10%
						10% Avg
Other real estate		588	Sales comparison approach	Adjustment for differences between comparable sales, type of property, current status of property		15% - 25%
						20% Avg
	$	2,751
Mortgage servicing rights	$	3,161	Cash flow analysis	Discount rate		10%

	Fair Value		Valuation	Unobservable	Range/
December 31, 2015	(in thousands)		Technique(s)	Input(s)	Average
Impaired Loans:
Farm real estate	$	58	Sales comparison approach	Adjustment for differences between comparable sales		10%
						10%  Avg
Other		1,082	Sales comparison approach	Adjustment for differences between comparable sales, type of property, current status of property		0%  - 20%
	$	1,140				10%  Avg
Mortgage servicing rights	$	531	Cash flow analysis	Discount rate		10%

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

	Carrying
September 30, 2016	Amount		Level 1		Level 2		Level 3		Total
Assets
Cash and cash equivalents	$	80,329	$	62,809	$	17,520	$		$	80,329
Interest bearing time deposits		1,960				1,960				1,960
Loans including loans held for sale, net		2,567,304				7,222		2,638,678		2,645,900
FHLB and other stock		21,537								N/A
Interest receivable		11,995				5,084		6,911		11,995
Liabilities
Deposits		(3,124,028)		(705,428)		(2,418,500)				(3,123,928)
Other borrowings		(108,076)				(118,876)				(118,876)
FHLB advances		(259,638)				(263,694)				(263,694)
Interest payable		(669)				(669)				(669)
Subordinated debentures		(41,239)				(24,212)				(24,212)

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	Carrying
December 31, 2015	Amount		Level 1		Level 2		Level 3		Total
Assets
Cash and cash equivalents	$	67,578	$	56,104	$	11,474	$		$	67,578
Interest bearing time deposits		1,960				1,960				1,960
Loans including loans held for sale, net		2,139,765				7,726		2,187,366		2,195,092
FHLB and other stock		11,300								N/A
Interest receivable		10,779				4,901		5,878		10,779
Liabilities
Deposits		(2,650,775)		(641,439)		(2,007,405)				(2,648,844)
Other borrowings		(28,363)				(28,363)				(28,363)
FHLB advances		(269,488)				(270,977)				(270,977)
Interest payable		(560)				(560)				(560)
Subordinated debentures		(41,239)				(24,212)				(24,212)

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, and fed funds sold are Level 2.

(b) FHLB and other stock

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

(c) Loans, Net

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

(d) Deposits

The fair values disclosed for non-interest bearing deposits are, by definition, equal to the amount payable on demand at the reporting date resulting in a Level 1 classification. The carrying amounts of variable rate interest bearing deposits approximate their fair values at the reporting date resulting in 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.

33

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 four 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.

On July 2, 2013, the Federal Reserve approved a final rule that establishes an integrated regulatory capital framework. The rule implements the Basel III regulatory capital reforms from the Basel Committee on Banking Supervision and certain changes required by the Dodd-Frank Act. In general, under the new rules, minimum requirements have increased for both the quantity and quality of capital held by banking organizations. Consistent with the international Basel framework, the new rules include a new minimum ratio of common equity Tier 1 capital to risk-weighted assets of 4.5% and a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets that applies to all supervised financial institutions. The rule also raises the minimum ratio of Tier 1 capital to risk-weighted assets from 4% to 6% and includes a minimum leverage ratio of 4% for all banking organizations. Additionally, in order to avoid limitations on capital distributions, the Company will be required to maintain a capital conservation buffer above the adequately capitalized regulatory capital ratios. The capital conservation buffer is being phased in from 0.00% in 2015 to 2.50% in 2019. At September 30, 2016, the capital conservation buffer is 0.625%. At September 30, 2016, the capital levels for the Company and its subsidiary bank remained well in excess of the minimum amounts needed for capital adequacy purposes. The new rules also change the methodology for calculating risk-weighted assets to enhance risk sensitivity and became effective on January 1, 2015.

Actual and required capital amounts and ratios are presented below:

					Required for				To Be
	Actual				Adequate Capital				Well Capitalized
September 30, 2016	Amount		Ratio		Amount		Ratio		Amount		Ratio
MainSource Financial Group
Total capital (to risk-weighted assets)	$	397,269	14.7	%	$	215,540	8.0	%		N/A	N/A
Tier 1 capital (to risk-weighted assets)		375,441	13.9			161,655	6.0			N/A	N/A
Common equity Tier 1 capital (to risk-weighted assets)		334,567	12.4			121,241	4.5			N/A	N/A
Tier 1 capital (to average assets)		375,441	9.6			155,726	4.0			N/A	N/A
MainSource Bank
Total capital (to risk-weighted assets)	$	403,466	15.0	%	$	215,538	8.0	%	$	269,423	10.0	%
Tier 1 capital (to risk-weighted assets)		381,638	14.2			161,654	6.0			215,538	8.0
Common equity Tier 1 capital (to risk-weighted assets)		381,638	14.2			121,240	4.5			175,125	6.5
Tier 1 capital (to average assets)		381,638	9.8			155,435	4.0			194,294	5.0

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					Required for				To Be
	Actual				Adequate Capital				Well Capitalized
December 31, 2015	Amount		Ratio		Amount		Ratio		Amount		Ratio
MainSource Financial Group
Total capital (to risk-weighted assets)	$	356,210	15.5	%	$	184,170	8.0	%		N/A	N/A
Tier 1 capital (to risk-weighted assets)		334,190	14.5			138,127	6.0			N/A	N/A
Common equity Tier 1 capital (to risk-weighted assets)		293,316	12.7			103,595	4.5			N/A	N/A
Tier 1 capital (to average assets)		334,190	10.2			130,845	4.0			N/A	N/A
MainSource Bank
Total capital (to risk-weighted assets)	$	334,266	14.5	%	$	184,168	8.0	%	$	230,211	10.0	%
Tier 1 capital (to risk-weighted assets)		312,246	13.6			138,126	6.0			184,168	8.0
Common equity Tier 1 capital (to risk-weighted assets)		312,246	13.6			103,595	4.5			149,637	6.5
Tier 1 capital (to average assets)		312,246	9.6			130,555	4.0			163,194	5.0

Management believes as of September 30, 2016, 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 $4,000 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, 2016 and 2015 based on the current estimate of the effective annual rate.  The effective tax rate for the third quarter of 2016 was 26.0% versus 24.1% for the same period 2015.  For the first nine months of 2016 and 2015, the effective tax rate was 23.5% versus 22.0% respectively.  The increase in the third quarter effective tax rate was due to the increase in pre-tax earnings while tax exempt interest remained flat.  The Company’s effective tax rate was lower than its blended statutory rate due to the Company’s investments in tax-exempt securities, tax-exempt loans, company-owned life insurance, and a subsidiary company domiciled in a state with no state or local income tax.

NOTE 11 — DERIVATIVES

The Bank executes interest rate swaps with commercial banking customers to facilitate their risk management strategies. These derivative positions relate to transactions in which the Bank enters into an interest rate swap with a customer while at the same time entering into an offsetting interest rate swap with another financial institution.  The Bank agrees to pay interest to the customer on a notional amount at a variable interest rate and receive interest from the customer on the same notional amount at a fixed interest rate. At the same time, the Bank agrees to pay another financial institution the same fixed interest rate on the same notional amount and receive the same variable interest rate on the same notional amount. The transaction allows the customer to effectively convert a variable rate loan to a fixed rate. Because the terms of the swaps with the customers and the other financial institutions offset each other, with the only difference being counterparty credit risk, changes in the fair value of the underlying derivative contracts are not materially different and do not significantly impact the Bank’s results of operations.  The notional amounts of these interest rate swaps and the offsetting counterparty derivative instruments were $124.1 million at September 30, 2016 and $53.7 million at December 31, 2015.

Credit risk arises from the possible inability of counterparties to meet the terms of their contracts. The Bank’s exposure is limited to the replacement value of the contracts rather than the notional, principal or contract amounts. There are provisions in the agreements with the counterparties that allow for certain unsecured credit exposure up to an agreed threshold. Exposures in excess of the agreed thresholds are collateralized. In addition, the Bank minimizes credit risk through credit approvals, limits, and monitoring procedures.

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The fair value of interest rate swaps are summarized below:

		September 30, 2016			December 31, 2015
	Notional				Notional
	Amount		Fair Value		Amount		Fair Value
Included in Other Assets:
Interest Rate Swaps at Fair Value	$	124,063	$	6,255	$	53,741	$	1,508
Included in Other Liabilities:
Interest Rate Swaps at Fair Value	$	124,063	$	6,255	$	53,741	$	1,508

The effect of derivative instruments on the Consolidated Statement of Income is presented below:

	Three Months Ended
	September 30,
	2016		2015
Interest Rate Swaps - Fee Income
Included in Other Income / (Expense)	$	257	$	399

	Nine Months Ended
	September 30,
	2016		2015
Interest Rate Swaps – Fee Income
Included in Other Income / (Expense)	$	766	$	548

NOTE 12 – ACQUISITION

On May 20, 2016, the Company acquired 100% of the outstanding common shares of Cheviot Financial Corp. (“Cheviot”) and its subsidiary Cheviot Savings Bank in exchange for stock and cash.  Shareholders of Cheviot were entitled to merger consideration in accordance with the terms of the merger agreement.  At the time of the merger, stockholders of Cheviot received either 0.6916 shares of the Company’s common stock or $15.00 in cash for each share of Cheviot common stock owned, subject to proration provisions specified in the Merger Agreement that provide for a targeted aggregate split of total consideration of approximately 50% common stock and approximately 50% cash.  In total, the Company issued 2,351,816 shares of common stock and paid $49.7 million in cash to the former shareholders of Cheviot.

With the acquisition, the Company expanded its presence in the greater Cincinnati area.  The acquisition offers the Company the opportunity to increase profitability by introducing new products and services to the acquired customer base and adding new customers in the expanded region.  Cheviot’s results of operations were included in the Company’s results beginning May 21, 2016.  Acquisition-related costs of $601 and $6,964 were included in the Company’s income statement for the three month and nine month period ended September 30, 2016, respectively.  The fair value of the common shares issued as part of the consideration paid for Cheviot was determined on the basis of the closing price of the Company’s common shares on the acquisition date. 

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Goodwill of $24,936 arising from the acquisition consisted largely of synergies and the cost savings resulting from the combining of the operations of the companies.  Goodwill will not be deductible for income tax purposes.  The following table summarizes the consideration paid for Cheviot and the amounts of the assets acquired and liabilities assumed recognized at the acquisition date:

Consideration
Cash	$	49,715
Equity Instruments		51,387
Fair Value of Total Consideration	$	101,102
Recognized Amounts of Identifiable Assets Acquired and Liabilities Assumed
Cash and cash equivalents	$	38,426
Securities		89,693
Federal Home Loan Bank stock		8,651
Loans		358,535
Premises and equipment		6,674
Core deposit intangibles		4,099
Bank owned life insurance		16,576
Other assets		13,205
Total assets acquired		535,859
Deposits		444,695
Federal Home Loan Bank advances		12,156
Other liabilities		2,842
Total liabilities assumed		459,693
Total identifiable net assets	$	76,166
Goodwill	$	24,936

The Company will be completing its final fair value adjustments in the fourth quarter of 2016.

The fair value of net assets acquired includes fair value adjustments to certain receivables that were not considered impaired as of the acquisition date. The fair value adjustments were determined using discounted contractual cash flows.  However, the Company believes that all contractual cash flows related to these financial instruments will be collected. As such, these receivables were not considered impaired at the acquisition date and were not subject to the guidance relating to purchased credit impaired loans, which have shown evidence of credit deterioration since origination. Receivables acquired that were not subject to these requirements include non-impaired loans and customer receivables with a fair value and gross contractual amounts receivable of $344,639 and $350,869 on the date of acquisition.

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The following table presents pro forma information as if the acquisition had occurred at the beginning of 2015.  The pro forma information includes adjustments for interest income on loans and securities acquired, amortization of intangibles arising from the transaction, depreciation expense on property acquired, interest expense on deposits acquired, and the related income tax effects.  The pro forma financial information is not necessarily indicative of the results of operations that would have occurred had the transaction been effected on the assumed dates.

	3 months		3 months		9 months		9 months
	9/30/2016		9/30/2015		9/30/2016		9/30/2015
Net interest income	$	30,990	$	30,544	$	86,753	$	89,836
Net income		12,156		9,884		32,045		29,193
Basic earnings per share		0.51		0.41		1.34		1.22
Diluted earnings per share		0.50		0.41		1.32		1.20

Acquisition costs of $460 and $4,801, net of taxes, were excluded from the above table in the three month period ending September 30, 2016 and nine month period ending September 30, 2016, respectively.

Two putative class action lawsuits were filed in the Court of Common Pleas, Hamilton, Ohio, Civil Division, challenging the proposed merger and naming as defendants Cheviot, its directors, and MainSource (collectively, the “defendants”). These actions are captioned: (1) Raymond J. Neiheisel v. Cheviot Financial Corp., et al., Case No. A1600359 (filed January 15, 2016); and (2) Stephen Bushansky v. Steven Hausfeld, et al., Case No. A1600936 (filed February 16, 2016) (together, the “Actions”). On February 29, 2016, each plaintiff filed an amended complaint.  On March 24, 2016, the court consolidated the actions under Raymond J. Neiheisel v. Cheviot Financial Corp., et al., Case No. A1600359 (collectively, the “Actions”). The amended consolidated complaint alleges, among other things, that the directors of Cheviot breached their fiduciary duties of due care, independence, good faith and fair dealing to the stockholders of Cheviot, that the consideration to be received by the stockholders is inadequate and undervalues Cheviot, that the Merger Agreement includes improper deal-protection devices that purportedly lock up the Merger and may operate to prevent other bidders from making successful competing offers for Cheviot, that the deal protection devices unreasonably inhibit the ability of the directors of Cheviot to act with respect to investigating and pursuing superior proposals and alternatives and that the Merger Agreement involves conflicts of interest. The complaint further alleges that Cheviot and MainSource aided and abetted the alleged breaches of fiduciary duty by the directors of Cheviot. The amended consolidated complaint also alleges that the registration statement on Form S-4, initially filed with the Securities and Exchange Commission (the “SEC”) on February 11, 2016 in connection with the Merger, provides materially misleading and incomplete information rendering the stockholders of Cheviot unable to make an informed decision with respect to the Merger.

On April 21, 2016, defendants and lead plaintiffs entered into a memorandum of understanding (“MOU”), which provides for the settlement of the Actions. The settlement contemplated by the MOU is subject to confirmatory discovery and customary conditions, including court approval following notice to Cheviot’s stockholders. If the settlement is finally approved by the court, it will resolve and release all claims by stockholders of Cheviot challenging any aspect of the merger, the merger agreement, and any disclosure made in connection therewith.  The terms of the settlement were disclosed to former Cheviot stockholders pursuant to a Notice mailed on September 27, 2016.  The court is scheduled to consider the final settlement at a hearing to be held on December 2, 2016. 

The Company does not anticipate a material financial impact as a result of the Actions, the MOU, or the settlement.  

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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. (the “Company”) is a financial holding company whose principal activity is the ownership and management of its subsidiary bank, MainSource Bank (the “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 The Indiana Department of Financial Institutions 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 the Company’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 our continuing acquisition strategy, and other factors, including the risk factors set forth in Item 1A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2015, and in other reports the Company files from time to time with the Securities and Exchange Commission.

Results of Operations

Net income for the third quarter of 2016 was $11,696 compared to net income of $9,111 for the third quarter of 2015. The increase in net income was primarily attributable to increases in net interest income of $4,902, mortgage banking of $332, and interchange income of $621.  The increase in mortgage banking was the result of the continued low interest rate environment which continued to extend the refinancing activity.  The increase in interchange income is a result of the Company converting its debit cards from Visa to MasterCard which has resulted in a higher interchange rate as well as the higher number of debit cards in use with the acquisition of Cheviot in the second quarter of 2016 and the acquisition of the five Old National Bank branches in the third quarter of 2015. Offsetting these positive items to net income were increases in the loan loss provision of $650,  a decrease in services charges of $406, an increase in salaries and employee benefits of $2,012,  an increase in occupancy expenses of $348, and an increase in equipment expenses of $492. The increases in salaries and benefits, occupancy expenses, and equipment expenses are the result of the aforementioned acquisitions.  The increase in the allowance for loan losses is a result of organic loan growth in the quarter. Diluted earnings per common share for the third quarter of 2016 totaled $0.48, a $0.06 increase from the $0.42 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 10.19% for the third quarter of 2016 while return on average assets was 1.16% for the same period, compared to 9.71% and 1.10% respectively, in the third quarter of 2015.

For the nine months ended September 30, 2016, net income was $26,579  compared to net income of $26,434 for the same period a year ago. The increase in net income was again primarily attributable to the increases in net interest income of $9,074 and interchange income of $1,872 as well as a prepayment penalty on a FHLB advance of $0 compared to $2,364

39

taken in the first quarter of 2015.  These items were offset by increases in salaries and benefits of $4,245, occupancy expenses of $601, equipment expenses of $1,112, expenses related to the acquisition of Cheviot of $6,347, and a reduction in service charges of $624.  Diluted earnings per common share was $1.15 for the first nine months of 2016, a $0.06 decrease from the $1.21 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 8.45% for the first nine months of 2016 while return on average assets was 0.96% for the same period, compared to 9.57% and 1.10% respectively, in the first nine months of 2015.

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 $30,990 in 2016 was an increase of 18.8% versus the third quarter of 2015. Average earning assets were $639 million higher in the third quarter of 2016 compared to 2015 with the majority of the increase attributable to loan growth and securities growth. The growth came from the acquisition of Cheviot in the second quarter of 2016, the acquisition of five Old National branches in the third quarter of 2015 as well as from organic loan growth.  Also affecting margin was an increase in average demand deposits of $109 million.  Net interest margin, on a fully-taxable equivalent basis, was 3.62% for the third quarter of 2016, a ten basis point decrease compared to 3.72% for the same period a year ago and one basis point decrease on a linked quarter basis.

Net interest income was $9,074 higher in the first nine months of 2016 compared to 2015.  Average earning assets were $441 million higher in the first nine months of 2016 compared to 2015 with the majority of the increase again attributable to loan growth and securities growth.  Also affecting margin was an increase in average demand deposits of $103 million.  Net interest margin, on a fully-taxable equivalent basis, was 3.64% for the first nine months of 2016, a twelve basis point decrease compared to 3.76% for the same period a year ago.

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The following tables summarize net interest income (on a tax-equivalent basis) for the three month periods ending September 30, 2016 and 2015.

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

	2016						2015
	Average				Average		Average				Average
	Balance		Interest		Rate***		Balance		Interest		Rate***
Assets
Short‑term investments	$	10,840	$	15	0.55	%	$	19,418	$	10	0.20	%
Federal funds sold and money market accounts		14,770		28	0.75			24,653		18	0.29
Securities
Taxable		686,655		4,009	2.32			560,466		3,010	2.13
Non‑taxable*		335,414		4,638	5.50			329,303		4,588	5.53
Total securities		1,022,069		8,647	3.37			889,769		7,598	3.39
Loans**
Commercial*		1,589,095		17,057	4.27			1,260,161		14,089	4.44
Residential real estate		593,526		6,165	4.13			439,570		4,577	4.13
Consumer		377,619		3,790	3.99			335,169		3,573	4.23
Total loans		2,560,240		27,012	4.20			2,034,900		22,239	4.34
Total earning assets		3,607,919		35,702	3.94			2,968,740		29,865	3.99
Cash and due from banks		57,386						50,188
Unrealized gains (losses) on securities		35,617						18,768
Allowance for loan losses		(21,781)						(22,601)
Premises and equipment, net		76,378						61,480
Intangible assets		107,159						77,556
Accrued interest receivable and other assets		133,814						128,753
Total assets	$	3,996,492					$	3,282,884
Liabilities
Interest‑bearing deposits DDA, savings, and money market accounts	$	1,928,454	$	546	0.11		$	1,674,027	$	483	0.11
Certificates of deposit		469,833		520	0.44			337,868		432	0.51
Total interest‑bearing deposits		2,398,287		1,066	0.18			2,011,895		915	0.18
Short‑term borrowings		138,913		353	1.01			37,335		19	0.20
Subordinated debentures		40,000		355	3.53			40,000		318	3.15
Notes payable and FHLB borrowings		243,828		1,093	1.78			178,389		773	1.72
Total interest‑bearing liabilities		2,821,028		2,867	0.40			2,267,619		2,025	0.35
Demand deposits		696,073						587,527
Other liabilities		22,699						55,437
Total liabilities		3,539,800						2,910,583
Shareholders’ equity		456,692						372,301
Total liabilities and shareholders’ equity	$	3,996,492		2,867	0.32		$	3,282,884		2,025	0.27
Net interest income			$	32,835	3.62****				$	27,840	3.72****
Conversion of tax exempt income to a fully taxable equivalent basis using a marginal rate of 35%			$	1,845					$	1,752

*	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.

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Volume/Rate Analysis of Changes in Net Interest Income

(Tax Equivalent Basis)

	3Q 2016 OVER 3Q 2015
	Volume		Rate		Total
Interest income
Loans	$	5,502	$	(729)	$	4,773
Securities		1,099		(50)		1,049
Federal funds sold and money market funds		(9)		19		10
Short‑term investments		(6)		11		5
Total interest income		6,586		(749)		5,837
Interest expense
Interest‑bearing DDA, savings, and money market accounts	$	71	$	(8)	$	63
Certificates of deposit		150		(62)		88
Borrowings		628		26		654
Subordinated debentures		—		37		37
Total interest expense		849		(7)		842
Change in net interest income		5,737		(742)		4,995
Change in tax equivalent adjustment						93
Change in net interest income before tax equivalent adjustment					$	4,902

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.

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The following tables summarize net interest income (on a tax-equivalent basis) for the nine month periods ending September 30, 2016 and 2015.

	2016						2015
	Average				Average		Average				Average
	Balance		Interest		Rate***		Balance		Interest		Rate***
Assets
Short‑term investments	$	17,824	$	68	0.51	%	$	28,112	$	51	0.24	%
Federal funds sold and money market accounts		20,387		98	0.64			20,883		45	0.29
Securities
Taxable		635,718		10,488	2.20			545,076		8,780	2.15
Non‑taxable*		330,066		13,823	5.59			320,305		13,509	5.64
Total securities		965,784		24,311	3.36			865,381		22,289	3.44
Loans**
Commercial*		1,465,434		47,493	4.33			1,227,272		41,314	4.50
Residential real estate		512,426		15,781	4.11			438,217		13,676	4.17
Consumer		363,160		11,244	4.14			323,863		10,435	4.31
Total loans		2,341,020		74,518	4.25			1,989,352		65,425	4.40
Total earning assets		3,345,015		98,995	3.95			2,903,728		87,810	4.04
Cash and due from banks		54,885						47,821
Unrealized gains (losses) on securities		30,567						22,231
Allowance for loan losses		(21,657)						(23,328)
Premises and equipment, net		71,043						61,011
Intangible assets		91,844						77,923
Accrued interest receivable and other assets		115,122						122,121
Total assets	$	3,686,819					$	3,211,507
Liabilities
Interest‑bearing deposits DDA, savings, and money market accounts	$	1,821,586	$	1,605	0.12		$	1,649,107	$	1,471	0.12
Certificates of deposit		390,048		1,489	0.51			335,993		1,237	0.49
Total interest‑bearing deposits		2,211,634		3,094	0.19			1,985,100		2,708	0.18
Short‑term borrowings		68,360		486	0.95			28,004		36	0.17
Subordinated debentures		40,000		1,051	3.51			40,000		942	3.15
Notes payable and FHLB borrowings		262,753		3,282	1.67			187,240		2,501	1.79
Total interest‑bearing liabilities		2,582,747		7,913	0.41			2,240,344		6,187	0.37
Demand deposits		663,380						560,604
Other liabilities		20,498						41,159
Total liabilities		3,266,625						2,842,107
Shareholders’ equity		420,194						369,400
Total liabilities and shareholders’ equity	$	3,686,819		7,913	0.31		$	3,211,507		6,187	0.28
Net interest income			$	91,082	3.64****				$	81,623	3.76****
Conversion of tax exempt income to a fully taxable equivalent basis using a marginal rate of 35%			$	5,521					$	5,137

*	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.

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	Nine months 2016 OVER Nine months 2015
	Volume		Rate		Total
Interest income
Loans	$	11,312	$	(2,220)	$	9,092
Securities		2,556		(534)		2,022
Federal funds sold and money market funds		(1)		54		53
Short‑term investments		(24)		41		17
Total interest income		13,843		(2,659)		11,184
Interest expense
Interest‑bearing DDA, savings, and money market accounts	$	153	$	(19)	$	134
Certificates of deposit		206		46		252
Borrowings		1,324		(93)		1,231
Subordinated debentures		—		109		109
Total interest expense		1,683		43		1,726
Change in net interest income		12,160		(2,702)		9,458
Change in tax equivalent adjustment						384
Change in net interest income before tax equivalent adjustment					$	9,074

Provision for Loan Losses

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

Non-interest Income

Third quarter non-interest income for 2016 was $13,914 compared to $13,344 for the third quarter of 2015.  Contributing to the increase of $570 was an increase in interchange income of $621 and mortgage banking of $332 offset by a reduction in service charges on deposit accounts of $406.  The Company switched its debit cards from VISA to MasterCard in late 2015 which resulted in a higher interchange rate.  The continued low interest rate environment has kept mortgage rates low.

For the nine months ended September 30, 2016, non-interest income was $39,241 compared to $37,604 for the first nine months of 2015.  Contributing to the increase of $1,637 was an increase in interchange income of $1,872.

Non-interest Expense

The Company’s non-interest expense was $28,941 for the third quarter of 2016, compared to $26,635 for the same period in 2015.  The primary reasons for the increase were increases in salaries and employee benefits of $2,012, net occupancy expenses of $348, and equipment expenses of $492.  The increases  were related to the acquisition of Cheviot in the second quarter of 2016 as well as the acquisition of five Old National Bank branches in the third quarter of 2015.  The Company’s efficiency ratio was 61.9% for the third quarter of 2016 compared to 64.7% for the same period a year ago.

For the nine months ended September 30, 2016, non-interest expense was $89,195 compared to $79,382 for the first nine months of 2015.  The primary reasons for the increase of $9,813 were the increases in expenses related to the acquisition of Cheviot of $6,347, increases in salaries and employee benefits of $4,245,  occupancy expenses of $601, and equipment expenses of $1,112. Offsetting these increases was a prepayment penalty on the repayment of a FHLB advance of $2,364 taken in the first quarter of 2015.  The Company’s efficiency ratio was 68.4% for the first nine months of 2016 compared to 66.6% for the same period a year ago.

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Income Taxes

The effective tax rate for the third quarter of 2016 was 26.0% versus 24.1% for the same period  of 2015.  The increase was due to the increase in pre-tax income in the second quarter of 2016 with tax exempt income remaining flat.

The effective tax rate for the first nine months of 2016 was 23.5% versus 22.0% for the same period of 2015.

The Company’s effective tax rate was lower than its blended statutory rate due to the Company’s investments in tax-exempt securities, tax-exempt loans, company-owned life insurance, and a subsidiary company domiciled in a state with no state or local income tax.

Financial Condition

Total assets at September 30, 2016 were $4,013,943, a 18.6% increase from total assets of $3,385,408 as of December 31, 2015.  The large increase was primarily the result of the acquisition of Cheviot in the second quarter of 2016.  Average earning assets represented 90.3% of average total assets for the third quarter of 2016 and 90.4% for the same period in 2015. Average loans represented 83.0%  of average deposits in the third quarter of 2016 and 78.7% for the comparable period in 2015.  Average loans as a percent of average assets were 64.3% and 62.3% for the three month periods ended September 30, 2016 and 2015, respectively.

Deposits increased significantly at September 30, 2016 compared to December 31, 2015.  All categories of deposits increased due to the acquisition of Cheviot. 

Shareholders’ equity was $460 million on September 30, 2016 compared to $381 million on December 31, 2015.  Book value (shareholders’ equity) per common share was $19.12 at September 30, 2016 versus $17.67 at year-end 2015. Accumulated other comprehensive income increased book value per share by $0.91 at September 30, 2016 and increased book value per share by $0.58 at December 31, 2015.  Depending on market conditions, the unrealized gain or loss on securities available for sale can cause fluctuations in shareholders’ equity.

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

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. This equates to approximately all relationships above $3,675.

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.

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Total loans (excluding loans held for sale) increased $429,515 from year end 2015.  $358,535 of the increase came from the Cheviot acquisition.  Residential real estate loans continue to represent a significant portion of the total loan portfolio. Such loans represented 24.0% of total loans at September 30, 2016 and 20.4% at December 31, 2015. On September 30, 2016, the Company had $6,977 of loans held for sale, which was a $556 decrease from the year-end balance of $7,533. 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, 2016			June 30, 2016			March 31, 2016			December 31, 2015			September 30, 2015
Amount	$	18,277		$	19,829		$	14,428		$	16,039		$	16,893
Percent of loans		0.71	%		0.78	%		0.67	%		0.74	%		0.81	%

Of the $18,277 of non-performing loans at September 30, 2016, $5,532 had a specific reserve allocated of $1,252.

A reconciliation of the non-performing assets for the first nine months of 2016 and 2015 is as follows:

	2016		2015
Beginning Balance — NPA — January 1	$	17,998	$	31,527
Non‑accrual
Add: New non‑accruals		8,368		10,472
Add: Acquisition		4,052		—
Less: To accrual/payoff/restructured		(7,725)		(7,369)
Less: To OREO		(1,547)		(1,164)
Less: Net charge offs		(1,047)		(2,027)
Increase/(Decrease): Non‑accrual loans		2,101		(88)
Other Real Estate Owned (OREO)
Add: New OREO properties		1,547		1,164
Add: New OREO from acquisition		1,668		—
Less: OREO sold		(2,841)		(1,377)
Less: OREO losses (write‑downs)		(91)		(38)
Increase/(Decrease): OREO		283		(251)
Increase/(Decrease): Repossessions		—		—
Increase/(Decrease): 90 Days Delinquent		—		75
Increase/(Decrease): TDR’s		137		(11,933)
Total NPA change		2,521		(12,197)
Ending Balance — NPA — September 30,	$	20,519	$	19,330

The large decrease in TDR’s in 2015 is due to the sale of two large loans in 2015.

At September 30, 2016, the Company had two non-accrual loans over $500.  This was the same number at December 31, 2015. These loans are 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

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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 the Company by increasing the ultimate probability of collection. The Company reviews each relationship before it grants the concession to ensure the creditor can comply with the new terms. To date, most of the concessions have been extensions of maturity dates.

The Company saw an  increase in its Special Mention and Substandard Loans in the third quarter of 2016.  These loans increased $13,679 from the end of 2015, with $12,774 of the increase due to the acquisition of Cheviot. 

The provision for loan losses was $150 in the third quarter of 2016 compared to $800 for the same period in 2015 and $205 for the second quarter of 2016. The decrease in provision expense from the second quarter of 2015 was primarily due to the improvement in credit metrics as well a net recovery on charge-offs for the quarter.  For the first nine months of 2016 and 2015, the provision for loan loss was $855 and $800, respectively.  The slight increase in provision expense from 2015 was primarily due to the growth in loan balances.  The amount of new non-accrual loans in the third quarter of 2016 was approximately 16% lower than the second quarter of 2016.

The Company realized net recoveries of $210 for the third quarter of 2016 compared to net charge-offs of $1,250 for the same period a year ago.  The net recovery was due to the recoveries of three large credits that were written off in a prior quarter.  For the first nine months of 2016 and 2015, net charge-offs were $1,047 and $2,027.

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, 2016 was considered adequate by management.  The allowance for loan losses was $21,828 as of September 30, 2016 and represented 0.84% of total outstanding loans compared to $22,020 as of December 31, 2015 or 1.02% of total outstanding loans.  The decrease in the percentage was due primarily to the large increase of loans acquired from the Cheviot acquisition which were recorded at fair value with no associated allowance.

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, 2016, the Company had $1,025,048 of investment securities. All of these securities were classified as “available for sale” (“AFS”) and were carried at fair value with unrealized gains and losses, net of taxes, reported as a separate component of shareholders’ equity. An unrealized pre-tax gain of $33,510 was recorded to adjust the AFS portfolio to current market value at September 30, 2016, compared to an unrealized pre-tax gain of $19,422 at December 31, 2015. 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 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, fed funds sold, and lines of credit 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 85.9% and 87.7% of total average earning assets for the nine month periods ending September 30 2016 and 2015. Total interest-bearing deposits averaged 76.9% and 78.0% of average total deposits for the nine month periods ending

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September 30, 2016 and 2015, 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 long term FHLB advances of $259,638 outstanding at September 30, 2016. These advances have interest rates ranging from 0.97% to 4.07%.  These advances were long term advances with approximately $10,000 maturing in 2016, $20,000 maturing in 2017, $45,000 maturing in 2018, and $185,000 maturing in 2019 and beyond.

The Company has short term FHLB advances of $54,000 outstanding at September 30, 2016 at an interest rate of 0.67%.  These advances have a maturity of six month or less.

The Company has repurchase agreements totally $34,076 at September 30, 2016.  The agreements are one day in length.

The Company also obtained a $30,000 line of credit that was entered in the second quarter of 2016 that has a current balance of $20,000 and an interest rate of 2.75%.

Capital Resources

Total shareholders’ equity was $459,608 at September 30, 2016, which was an increase of $78,248 compared to the $381,360 of shareholders’ equity at December 31, 2015. The increase in shareholders’ equity was primarily attributable to the Company’s acquisition of Cheviot of $51,387 as well as net income of $26,579, activity in stock option and restricted stock programs of $1,902, and other comprehensive income of $9,158, offset by common dividends paid of $10,445 and purchase of stock in connection with stock option exercises and vesting of restricted stock of $333 for the first nine months of 2016.

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. On January 1, 2015 the Federal Reserve established an integrated regulatory framework that required a new ratio of common equity Tier 1 capital to risk-weighted assets as well raising the minimum ratio of Tier 1 capital to risk-weighted assets.  At September 30, 2016, Tier 1 capital to total average assets was 9.6%. Common equity Tier 1 capital to risk-adjusted assets was 12.4%.  Tier 1 capital to risk-adjusted assets was 13.9%. Total capital to risk-adjusted assets was 14.7%. All four ratios exceed all required ratios established for bank holding companies.  Additionally, in order to avoid limitations on capital distributions, the Company will be required to maintain a capital conservation buffer above the adequately capitalized regulatory capital ratios. The capital conservation buffer is being phased in from 0.00% in 2015 to 2.50% in 2019. At September 30, 2016, the capital conservation buffer is 0.625%.  The capital levels for the Company and its subsidiary bank remained well in excess of the minimum amounts needed for capital adequacy purposes.  Risk-adjusted capital levels of the Bank exceed regulatory definitions of well-capitalized institutions.

The Company declared and paid common dividends of $0.15 per share in the third quarter of 2016 versus $0.14 per share for the third quarter of 2015.  The Company has increased its common dividend in the last few quarters as its net income has increased.

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

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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 81.5% of total earning assets for the nine months ended September 30, 2016 and 83.3% for the same period in 2015.

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 quarterly by the Credit and Risk Committee of the Board of Directors. There have been no material changes in the quantitative and qualitative disclosures about market risks as of September 30, 2016 from the analysis and disclosures provided in the Company’s Annual Report on Form 10-K for the year ended December 31, 2015.

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 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 2016 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

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PART II. OTHER INFORMATION

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

(c)Issuer Purchases of Equity Securities

The Company purchased the following equity securities of the Company during the quarter ended September 30, 2016:

				Total Number of Shares	Maximum Number (or
				(or Units) Purchased as	Approximate Dollar Value)
	Total Number			Part of Publicly	of Shares (or Units) That
	of Shares (or		Average Price Paid Per	Announced Plans or	May Yet Be Purchased
Period	Units) Purchased (1)		Share (or Unit)	Programs	Under the Plans or Programs
July 1‑31, 2016	1,200	$	22.96	—	—
August 1‑31, 2016	—		—	—	—
September 1-30, 2016	—		—	—	—
Total:	1,200	$	22.96	—	—

(1) Represents shares withheld, delivered or attested (under the terms of grants under employee stock compensation plans) to offset tax withholding obligations that occur upon vesting and release of restricted shares. The Company's employee stock compensation plans provide that the value of the shares withheld, delivered or attested, shall be determined using the fair market value of the Company's common stock on the date the relevant transaction occurs.

Item 6. Exhibits

3.1	Amended and Restated Articles of Incorporation of MainSource Financial Group, Inc. (incorporated by reference to Exhibit 3.1 to the Report on Form 8K 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)).
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
101	The following financial statements and notes from the MainSource Financial Group Quarterly Report on Form 10-Q for the quarter ended September 30, 2016, formatted in XBRL pursuant to Rule 405 of Regulation S-T: (i) Consolidated Balance Sheets; (ii) Consolidated Statements of Income; (iii) Consolidated Statements of Comprehensive Income (iv) Consolidated Statements of Cash Flows; and (v) the Notes to the consolidated financial statements.

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

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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 8, 2016

/s/ Archie M. Brown, Jr.

Archie M. Brown, Jr.

President and Chief Executive Officer

November 8, 2016

/s/ James M. Anderson

James M. Anderson

Executive Vice President & Chief Financial Officer

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