Bank of Kentucky Financial (BKYF) 10-Q 2013 Q1 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For quarterly period ended March 31, 2013

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

For the transition period from______________to___________________

Commission File Number:001-34214

THE BANK OF KENTUCKY FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

Kentucky	61-1256535
(State or other jurisdiction of	(I.R.S. Employer
incorporation or organization)	Identification Number)

111 Lookout Farm Drive, Crestview Hills, Kentucky 41017  

(Address of principal executive offices) (Zip Code)

Registrant’s telephone number:(859) 371-2340

Indicate by checkmark whether the registrant (1) 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. Yesx   No¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yesx 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 definition of “accelerated filer,” “large accelerated filer,” and “smaller reporting company,” in Rule 12b-2 of the Exchange Act (Check one):

Large accelerated filer¨	Accelerated filerx
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¨   Nox

As of April 29, 2013, 7,489,014 shares of the registrant's Common Stock, no par value, were issued and outstanding.

The Bank of Kentucky Financial Corporation

INDEX

			PAGE
Part I		FINANCIAL INFORMATION
		Item 1 – Financial Statements	3
		Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations	30
		Item 3 – Quantitative and Qualitative Disclosures About Market Risk	47
		Item 4 – Controls and Procedures	47
Part II		OTHER INFORMATION
		Item 1 – Legal Proceedings	48
		Item 1A – Risk Factors	48
		Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds	48
		Item 3 – Defaults upon Senior Securities	48
		Item 4 – Mine Safety Disclosures	48
	��	Item 5 – Other Information	48
		Item 6 – Exhibits	48

2

PART I FINANCIAL INFORMATION

Item 1. Financial Statements

THE BANK OF KENTUCKY FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in thousands, except per share data - unaudited)

	March 31,		December 31,
	2013		2012
Assets
Cash and cash equivalents	$	138,561	$	151,832
Interest-bearing deposits with banks		250		250
Available-for-sale securities		299,380		314,444
Held-to-maturity securities		77,074		66,843
Loans held for sale		14,038		16,324
Total loans		1,187,742		1,195,409
Less:  Allowance for loan losses		16,641		16,568
Net loans		1,171,101		1,178,841
Premises and equipment, net		22,559		22,494
FHLB stock, at cost		5,099		5,099
Goodwill		22,023		22,023
Acquisition intangibles, net		2,065		2,462
Cash surrender value of life insurance		38,903		33,808
Accrued interest receivable and other assets		29,458		29,684
Total assets	$	1,820,511	$	1,844,104
Liabilities & Shareholders’ Equity
Liabilities
Deposits	$	1,558,933	$	1,570,007
Short-term borrowings		28,309		41,408
Notes payable		48,709		48,715
Accrued interest payable and other liabilities		11,604		13,534
Total liabilities		1,647,555		1,673,664
Shareholders’ Equity
Common stock, no par value, 15,000,000 shares authorized, 7,482,776 (2013) and 7,470,236 (2012) shares issued		3,098		3,098
Additional paid-in capital		35,449		35,126
Retained earnings		131,106		128,289
Accumulated other comprehensive income		3,303		3,927
Total shareholders’ equity		172,956		170,440
Total liabilities and shareholders’ equity	$	1,820,511	$	1,844,104

See accompanying notes.

3

THE BANK OF KENTUCKY FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

FOR THE THREE MONTHS ENDED MARCH 31, 2013 AND 2012

(Dollars in thousands, except per share data - unaudited)

	2013		2012
INTEREST INCOME
Loans, including related fees	$	13,284	$	13,801
Securities and other		1,582		1,887
Total interest income		14,866		15,688
INTEREST EXPENSE
Deposits		1,044		1,566
Borrowings		239		278
Total interest expense		1,283		1,844
Net interest income		13,583		13,844
Provision for loan losses		2,000		1,800
Net interest income after provision for loan losses		11,583		12,044
NON-INTEREST INCOME
Service charges and fees		2,131		2,201
Mortgage banking income		539		586
Company owned life insurance earnings		269		320
Bankcard transaction revenue		957		902
Net securities gains		274		207
Trust fee income		852		689
Other		840		701
Total non-interest income		5,862		5,606
NON-INTEREST EXPENSE
Salaries and benefits		5,913		5,451
Occupancy and equipment		1,306		1,277
Data processing		550		535
Advertising		343		382
Electronic banking processing fees		430		359
Outside service fees		266		302
State bank taxes		575		559
Amortization of intangible assets		159		200
FDIC insurance		295		305
Other		1,932		1,972
Total non-interest expense		11,769		11,342
INCOME BEFORE INCOME TAXES		5,676		6,308
Less:  income taxes		1,586		1,793
NET INCOME	$	4,090	$	4,515
Net income per common share:
Earnings per share, basic	$	0.55	$	0.61
Earnings per share, diluted	$	0.54	$	0.60

See accompanying notes.

4

THE BANK OF KENTUCKY FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

FOR THE THREE MONTHS ENDED MARCH 31, 2013 AND 2012

(Dollars in thousands, except per share data - unaudited)

	2013			2012
Net income	$	4,090		$	4,515
Other comprehensive income:
Unrealized gains/losses on securities
Unrealized holding gain/ (loss) arising during the period		(670	)		77
Reclassification adjustment for losses (gains)		(274	)		(206	)
included in net income
Tax effect		(320	)		(44	)
Net of tax		(624	)		(85	)
Total other comprehensive income (loss)		(624	)		(85	)
Comprehensive income	$	3,466		$	4,430

5

THE BANK OF KENTUCKY FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

FOR THE THREE MONTHS ENDED MARCH 31

(Dollars in thousands, except per share data -unaudited)

	2013			2012
Balance as of January 1	$	170,440		$	156,570
Net income		4,090			4,515
Change in net unrealized gain(loss), net of tax		(624	)		(85	)
Cash dividends paid on common stock		(1,272	)		(2,235	)
Exercise of stock options (12,540 and 31,846 shares), including tax  benefit		278			685
Stock-based compensation expense		43			24
Balance as of  March 31	$	172,956		$	159,474
Dividends per share	$	0.17		$	0.30

See accompanying notes.

6

THE BANK OF KENTUCKY FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE THREE MONTHS ENDED MARCH 31

(Dollars in thousands - unaudited)

	2013			2012
Cash Flows from Operating Activities
Net income	$	4,090		$	4,515
Adjustments to reconcile net income to net cash From operating activities		4,819			1,097
Net cash from operating activities		8,909			5,612
Cash Flows from Investing Activities
Proceeds from paydowns and maturities of held-to-maturity securities		1,138			265
Proceeds from paydowns and maturities of available-for-sale securities		27,903			39,119
Purchases of held-to-maturity securities		(11,385	)		(2,396	)
Purchases of available-for-sale securities		(20,154	)		(47,481	)
Purchases of company owned life insurance		(5,000	)		-
Net change in loans		5,144			(3,568	)
Proceeds from the sale of other real estate		562			1,071
Proceeds from the sale of securities		5,230			-
Property and equipment expenditures		(445	)		(799	)
Net cash from investing activities		2,993			(13,789	)
Cash Flows from Financing Activities
Net change in deposits		(11,074	)		6,888
Net change in short-term borrowings		(13,099	)		34
Proceeds from exercise of stock options		278			685
Cash dividends paid		(1,272	)		(2,235	)
Payments on note payable		(6	)		(6	)
Net cash from financing activities		(25,173	)		5,366
Net change in cash and cash equivalents		(13,271	)		(2,811	)
Cash and cash equivalents at beginning of period		151,832			135,964
Cash and cash equivalents at end of period	$	138,561		$	133,153

See accompanying notes.

7

THE BANK OF KENTUCKY FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2013

(unaudited)

Note 1 - Basis of Presentation:

The condensed consolidated financial statements include the accounts of The Bank of Kentucky Financial Corporation (“BKFC” or the “Company”) and its wholly owned subsidiary, The Bank of Kentucky, Inc. (the “Bank”). All significant intercompany accounts and transactions have been eliminated.

Note 2 - General:

These financial statements were prepared in accordance with the instructions for Form 10-Q and Rule 10-01 of Regulation S-X and, therefore, do not include all of the disclosures necessary for a complete presentation of financial position, results of operations and cash flows in conformity with U.S. generally accepted accounting principles. Except for required accounting changes, these financial statements have been prepared on a basis consistent with the annual financial statements and include, in the opinion of management, all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of the results of operations and financial position at the end of and for the periods presented. These financial statements and notes should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto as set forth in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and future results could differ. The allowance for loan losses and the fair values of financial instruments, in particular, are subject to change.

Note 3 - Earnings per Share:

Earnings per share are computed based upon the weighted average number of shares of common stock outstanding during the three month period. Diluted earnings per share show the potential dilutive effect of additional common shares issuable under the Company’s stock compensation plan and warrants. For the three months ended March 31, 2013 and 2012, 51,129 and 284,238 options were not considered, as they were not dilutive. The following table presents the numbers of shares used to compute basic and diluted earnings per share for the indicated periods:

8

	Three Months
	Ended
	March 31
	2013		2012
Weighted average shares outstanding		7,478,901		7,448,604
Dilutive effects of assumed exercises of stock options and warrant		104,643		71,458
Shares used to compute diluted earnings per share		7,583,544		7,520,062

Note 4 – Stock-Based Compensation:

Stock-based compensation in the form of options to buy stock and restricted stock units (“RSUs”) are granted to directors, officers and employees under the Company’s incentive stock plan (the “Plan”), which provides for the issuance of up to 1,000,000 shares.

Stock Options

The specific terms of each option agreement are determined by the Compensation Committee at the date of the grant. For current options outstanding, options granted to directors vest immediately and options granted to employees generally vest evenly over a five-year period.

The Company recorded stock option expense of $12,000 (net of taxes) in the three months ended March 31, 2013, and $24,000 (net of taxes) in the three months ended March 31, 2012.

Restricted Stock Units

The specific terms of each RSU award are determined by the Compensation Committee at the date of the grant. Compensation expense is recognized over the vesting period of the awards based on the fair value of the stock at issue date. The fair value of the stock was determined using the total number of RSUs granted multiplied by the grant date fair market value of a share of company stock. RSU’s fully vest on the first anniversary of the grant date.

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

			Weighted-Average
			Grant-Date
Nonvested Shares	Shares		Fair Value
Non-vested at January 1, 2013		4,185	$	25.80
Granted		9,982		26.43
Vested		0		-
Forfeited		0		-
Non-vested at March 31, 2013		14,167	$	26.24

9

The Company recorded RSU expense of $31,000 for the three months ended March 31, 2013. As of March 31, 2013, there was $274,000 of total unrecognized compensation cost related to non-vested shares granted under the Plan. The cost is expected to be recognized over a period of nine months.

Note 5 – Cash and Cash Equivalents:

Cash and cash equivalents include cash on hand, amounts due from banks, federal funds sold and investments in money market mutual funds. The Company reports net cash flows for customer loan and deposit transactions, interest-bearing balances with banks and short-term borrowings with maturities of 90 days or less.

Note 6 – Reclassification:

Certain prior period amounts have been reclassified to conform to the current period presentation.Such reclassifications have no effect on previously reported net income or shareholders’ equity.

Note 7 – New Accounting Pronouncements:

In February 2013, the FASB issued ASU 2013-02 with the primary objective of improving the reporting of reclassifications out of accumulated other comprehensive income (AOCI).   For significant reclassifications that are required to be presented in their entirety in net income in the same reporting period by U.S. Generally Accepted Accounting Principles (U.S. GAAP), the ASU requires an entity to report the effect of these reclassifications out of AOCI on the respective line items of net income either on the face of the statement that reports net income or in the financial statement notes.  For AOCI items that that are not reclassified to net income in their entirety, presentation in the financial statement notes is required. This ASU is effective for public companies for fiscal years and interim periods within those years beginning after December 15, 2012, or the first quarter of 2013 for calendar year-end companies.  Adopting this standard did not have a material effect on the Company’s operating results or financial condition.

10

Note 8–Securities:

The fair value of available-for-sale securities and the related gains and losses recognized in accumulated other comprehensive income (loss) was as follows (in thousands):

			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
Available-for-Sale	Cost		Gains		Losses			Value
March 31, 2013
U.S. government, federal agencies and government sponsored enterprises	$	124,725	$	643	$	(113	)	$	125,255
U.S. government residential mortgage-backed		168,655		4,574		(99	)		173,130
Corporate		995		-		-			995
	$	294,375	$	5,217	$	(212	)	$	299,380

			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value
December 31, 2012
U.S. government, federal agencies and government sponsored enterprises	$	127,416	$	1,130	$	(69	)	$	128,477
U.S. government residential mortgage-backed		180,019		4,972		(84	)		184,907
Corporate		1,060		-		-			1,060
	$	308,495	$	6,102	$	(153	)	$	314,444

The carrying amount, unrecognized gains and losses, and fair value of securities held-to-maturity were as follows (in thousands):

			Gross		Gross
	Amortized		Unrecognized		Unrecognized			Fair
Held-to-Maturity	Cost		Gains		Losses			Value
2013
Municipal and other obligations	$	77,074	$	1,849	$	(464	)	$	78,459
2012
Municipal and other obligations	$	66,843	$	1,900	$	(239	)	$	68,504

The amortized cost and fair value of debt securities and carrying amount, if different, at March 31, 2013 by contractual maturity were as follows (in thousands), with securities not due at a single maturity date, primarily mortgage-backed securities, shown separately.

	Available-for-Sale				Held-to-Maturity
	Amortized		Fair		Amortized		Fair
	Cost		Value		Cost		Value
Due in one year or less	$	1,345	$	1,384	$	3,504	$	3,524
Due after one year through five years		44,079		44,257		30,915		31,932
Due after five years through ten years		79,301		79,614		37,075		37,423
Due after ten years		995		995		5,580		5,580
U.S. Government agency mortgage-backed		168,655		173,130		-		-
	$	294,375	$	299,380	$	77,074	$	78,459

11

Proceeds on the sale of $5,230,000 of available-for-sale securities resulted in gains of $274,000 for the first three months of 2013. No securities were sold with losses in the first three months of 2013. $7,176,000 of available-for-sale securities were sold resulting in gains of $207,000 for the first three months of 2012, with no losses. These sales settled and proceeds were received in April 2012.

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. Investment securities classified as available-for-sale or held-to-maturity are evaluated for OTTI under ASC 320,Accounting for Certain Investments in Debt and Equity Securities.

In determining OTTI, 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, the amount of the OTTI recognized in earnings depends on whether an entity intends to sell the security or more likely than not 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 more likely than not 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. Otherwise, the OTTI shall be separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings. The amount of the total OTTI related to other factors shall be recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings shall become the new amortized cost basis of the investment.

As of March 31, 2013, the Bank’s security portfolio consisted of 240 securities, 38 of which were in an unrealized loss position of $676,000. There was no OTTI of securities at March 31, 2013. Unrealized losses have not been recognized into income because the issuers’ bonds are of high credit quality (U.S. government agencies and government sponsored enterprises and “A” rated or better Kentucky municipalities), management 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.

Mortgage-backed Securities

At March 31, 2013, 100% of the mortgage-backed securities held by the Bank 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 a decline in market value would be attributable to changes in interest rates and illiquidity, and not credit quality, and because the Bank 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 Bank does not consider these securities to be other than temporarily impaired at March, 2013.

12

At March 31, 2013 and December 31, 2012, securities with a carrying value of $356,534 and $368,504 were pledged to secure public deposits and repurchase agreements.

Securities with unrealized losses at March 31, 2013 and December 31, 2012, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows (in thousands):

	Less than 12 Months					12 Months or More				Total
	Fair		Unrealized			Fair		Unrealized		Fair		Unrealized
Description of Securities	Value		Loss			Value		Loss		Value		Loss
March 31, 2013
U.S.government, federal agencies andgovernmentsponsored enterprises	$	27,822	$	(113	)	$	-	$	-	$	27,822	$	(113	)
U.S government residential mortgage-backed		32,293		(99	)		-		-		32,293		(99	)
Municipal & other obligations		27,072		(464	)		-		-		27,072		(464	)
Total temporarily impaired	$	87,187	$	(676	)	$	-	$	-	$	87,187	$	(676	)
December 31, 2012
U.S.government, federal agencies andgovernmentsponsored enterprises	$	11,877	$	(69	)	$	-	$	-	$	11,877	$	(69	)
U.S government residential mortgage-backed		18,142		(84	)		-		-		18,142		(84	)
Municipal & other obligations		15,056		(239	)		-		-		15,056		(239	)
Total temporarily impaired	$	45,075	$	(392	)	$	-	$	-	$	45,075	$	(392	)

Note 9 - Loans

Loan balances were as follows (in thousands):

	3/31/2013			12/31/2012
Commercial	$	208,392		$	201,384
Residential real estate		277,226			278,286
Nonresidential real estate		556,879			573,101
Construction		107,287			104,498
Consumer		15,609			16,447
Municipal obligations		23,814			23,128
Gross loans		1,189,207			1,196,844
Less:   Deferred loan origination fees and discount		(1,465	)		(1,435	)
Allowance for loan losses		(16,641	)		(16,568	)
Net loans	$	1,171,101		$	1,178,841

13

The following tables present the activity in the allowance for loan losses for the three months ending March 31, 2013 and 2012, and the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method as of March 31, 2013 and December 31, 2012 (in thousands):

							Non
				Residential			Residential									Municipal
March 31, 2013	Commercial			Real estate			Real estate			Construction			Consumer			Obligations		Total
Allowance for loan losses
Beginning balance	$	2,716		$	4,272		$	6,991		$	1,964		$	584		$	41	$	16,568
Provision for loan losses		433			222			(42	)		1,382			(4	)		9		2,000
Loans charged off		(228	)		(420	)		(1,012	)		(209	)		(255	)		-		(2,124	)
Recoveries		16			24			60			4			93			-		197
Total ending allowance balance	$	2,937		$	4,098		$	5,997		$	3.141		$	418		$	50	$	16,641
Ending allowance balance attributable to loans
Individually evaluated for impairment	$	1,126		$	1,171		$	507		$	1,133		$	-		$	-	$	3,937
Collectively evaluated for impairment		1,811			2,927			5,490			2,008			418			50		12,704
Total ending allowance balance	$	2,937		$	4,098		$	5,997		$	3,141		$	418		$	50	$	16,641
Loans
Loans individually evaluated for impairment	$	2,089		$	9,713		$	17,263		$	4,870		$	-		$	-	$	33,935
Loans collectively evaluated for impairment		206,303			267,513			539,616			102,417			15,609			23,814		1,155,272
Total ending loans balance	$	208,392		$	277,226		$	556,879		$	107,287		$	15,609		$	23,814	$	1,189,207

							Non
				Residential			Residential									Municipal
March 31, 2012	Commercial			Real estate			Real estate			Construction			Consumer			Obligations		Total
Allowance for loan losses
Beginning balance	$	3,207		$	2,591		$	7,614		$	4,701		$	162		$	13	$	18,288
Provision for loan losses		(271	)		692			57			1,018			80			224		1,800
Loans charged off		(356	)		(374	)		(904	)		(27	)		(169	)		-		(1,830	)
Recoveries		1			7			1			2			93			-		104
Total ending allowance balance	$	2,581		$	2,916		$	6,768		$	5,694		$	166		$	237	$	18,362

14

					Non
			Residential		Residential						Municipal
December 31, 2012	Commercial		Real estate		Real estate		Construction		Consumer		Obligations		Total
Ending allowance balance attributable to loans
Individually evaluated for impairment	$	1,266	$	970	$	2,540	$	1,369	$	120	$	-	$	6,265
Collectively evaluated for impairment		1,450		3,302		4,451		595		464		41		10,303
	$	2,716	$	4,272	$	6,991	$	1,964	$	584	$	41	$	16,568
Loans
Loans individually evaluated for impairment	$	1,840	$	8,666	$	18,076	$	5,154	$	120	$	-	$	33,856
Loans collectively evaluated for impairment		199,544		269,620		555,025		99,344		16,327		23,128		1,162,988
Total ending loans balance	$	201,384	$	278,286	$	573,101	$	104,498	$	16,447	$	23,128	$	1,196,844

15

The following table presents individually impaired loans by class of loans as of and for the three months ended March 31, 2013 (in thousands):

	Unpaid				Allowance for		Average		Interest
	Principal		Recorded		Loan Losses		Recorded		Income		Interest
	Balance		Investment		Allocated		Investment		Recognized		Received
With no related allowance recorded Commercial	$	175	$	175	$	-	$	102	$	-	$	-
Residential real estate
Home equity lines of credit		-		-		-		25		-		-
Multifamily properties		1,320		970		-		485		-		-
Other		2,386		2,108		-		1,894		-		-
Nonresidential real estate
Owner occupied properties		7,341		6,390		-		3,195		-		-
Non owner occupied properties		4,144		4,094		-		4,323		-		-
Construction		2,750		1,542		-		771		-		-
Consumer		-		-		-		-		-		-
With an allowance recorded Commercial		1,964		1,914		1,126		1,863		12		8
Residential real estate
Home equity lines of credit		816		616		172		591		3		3
Multifamily properties		-		-		-		660		0		0
Other		6,129		6,019		999		5,535		23		23
Nonresidential real estate
Owner occupied properties		2,195		2,194		58		5,192		2		2
Non owner occupied properties		5,126		4,585		449		4,960		41		38
Construction		3,443		3,328		1,133		4,241		36		36
Consumer		-		-		-		60		0		0
Total	$	37,789	$	33,935	$	3,937	$	33,897	$	117	$	110

16

The following table presents individually impaired loans by class of loans as of, and for the three months ended March 31, 2012 (in thousands):

	Unpaid				Allowance for		Average		Interest
	Principal		Recorded		Loan Losses		Recorded		Income		Interest
	Balance		Investment		Allocated		Investment		Recognized		Received
With no related allowance recorded Commercial	$	349	$	309	$	-	$	310	$	-	$	-
Residential real estate
Home equity lines of credit		50		50		-		50		-		-
Multifamily properties		858		527		-		533		-		-
Other		2,072		2,072		-		1,888		-		-
Nonresidential real estate
Owner occupied properties		960		960		-		1,031		-		-
Non owner occupied properties		2,994		2,742		-		2,429		-		-
Construction		-		-		-		160		-		-
With an allowance recorded
Commercial		1,669		1,444		177		1,026		1		-
Residential real estate
Home equity lines of credit		137		137		137		69		-		-
Multifamily properties		-		-		-		-		-		-
Other		3,630		3,630		451		3,720		24		23
Nonresidential real estate
Owner occupied properties		9,167		9,067		917		9,432		80		79
Non owner occupied properties		8,540		7,669		1,232		7,522		62		50
Construction		11,683		9,928		4,699		8,732		72		69
Total	$	42,109	$	38,535	$	7,613	$	36,902	$	239	$	221

17

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

	Unpaid				Allowance for
	Principal		Recorded		Loan Losses
	Balance		Investment		Allocated
With no related allowance recorded Commercial	$	28	$	28	$	-
Residential real estate
Home equity lines of credit		50		50		-
Multifamily properties		-		-		-
Other		1,922		1,679		-
Nonresidential real estate
Owner occupied properties		-		-		-
Non owner occupied properties		5,056		4,551		-
Construction		-		-		-
Consumer		-		-		-
With an allowance recorded Commercial		1,812		1,812		1,266
Residential real estate
Home equity lines of credit		766		566		212
Multifamily properties		1,320		1,320		248
Other		5,196		5,051		510
Nonresidential real estate
Owner occupied properties		9,142		8,190		1,644
Non owner occupied properties		5,876		5,335		896
Construction		6,274		5,154		1,369
Consumer		120		120		120
Total	$	37,562	$	33,856	$	6,265

18

The following table presents the aging of the recorded investment in past due loans by class of loans as of March 31, 2013 and December 31, 2012 (in thousands):

	Loans		Loans over
	30-90 days		90 days				Loans not
	past due		past due		Nonaccrual		past due		Total
March 31, 2013
Commercial	$	1,158	$	-	$	680	$	206,554	$	208,392
Residential real estate
Home equity lines of credit		350		-		779		98,375		99,504
Multifamily properties		970		-		-		50,224		51,194
Other residential real estate		3,471		-		6,205		116,852		126,528
Nonresidential real estate
Owner occupied properties		2,739		-		8,382		268,104		279,225
Non owner occupied properties		369		-		4,019		273,266		277,654
Construction		700		-		1,658		104,929		107,287
Consumer
Credit card balances		100		26		-		6,533		6,659
Other consumer		47		10		48		8,845		8,950
Municipal obligations		-		-		-		23,814		23,814
Total	$	9,904	$	36	$	21,771	$	1,157,496	$	1,189,207

	Loans		Loans over
	30-90 days		90 days				Loans not
	past due		past due		Nonaccrual		past due		Total
December 31, 2012
Commercial	$	1,668	$	-	$	740	$	198,976	$	201,384
Residential real estate
Home equity lines of credit		476		-		775		98,806		100,057
Multifamily properties		-		-		-		48,558		48,558
Other residential real estate		6,615		17		4,468		118,571		129,671
Nonresidential real estate
Owner occupied properties		2,809		-		7,000		278,362		288,171
Non owner occupied properties		2,788		-		5,138		277,004		284,930
Construction		738		-		1,075		102,685		104,498
Consumer
Credit card balances		32		22		-		6,905		6,959
Other consumer		5		-		48		9,435		9,488
Municipal obligations		-		-		-		23,128		23,128
Total	$	15,131	$	39	$	19,244	$	1,162,430	$	1,196,844

19

Troubled Debt Restructurings (dollars in thousands):

The Company has allocated $879 and $2,391 of specific reserves to customers whose loan terms have been modified in troubled debt restructurings as of March 31, 2013 and March 31, 2012, respectively. Troubled debt restructurings totaled $18,812 and $17,765 as of March 31, 2013 and March 31, 2012, respectively. The Company has not committed to lend additional amounts as of March 31, 2013 and March 31, 2012 to customers with outstanding loans that are classified as troubled debt restructurings.

Modifications involving a reduction of the stated interest rate of the loan were for periods up to three years. Modifications involving an extension of the maturity date were for periods ranging from eight months to twelve months.

The following table presents loans by class modified as troubled debt restructurings that occurred during three months ended March 31, 2013 and 2012 (dollars in thousands):

	2013						2012
	Number Of Loans		Pre- Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Number Of Loans		Pre- Modification Outstanding Recorded Investment		Post- Modification Outstanding Recorded Investment
Troubled Debt Restructurings:
Commercial		2	$	148	$	148		-	$	-	$	-
Residential real estate
Home equity lines of credit		-		-		-		-		-		-
Multifamily properties		1		970		970		2		538		528
Other residential real estate		-		-		-		-		-		-
Nonresidential real estate
Owner occupied properties		-		-		-		1		2,259		2,259
Non owner occupied properties		2		1,201		1,193		-		-		-
Construction		-		-		-		1		154		154
Consumer
Credit card balances		-		-		-		-		-		-
Other consumer		-		-		-		-		-		-
Municipal obligations		-		-		-		-		-		-
Total		5	$	2,319	$	2,311		4	$	2,951	$	2,941

20

NOTE 3 - LOANS (Continued)

The five restructured notes added during first quarter of 2013 for $2,319 were added as performing troubled debt restructured loans. The four restructured notes added in first quarter 2012 for a total of $2,941 were added as performing troubled debt restructured loans.

The troubled debt restructurings described above increased the allowance for loan losses by $29 and resulted in charge-offs of $730 during the first quarter ending March 31, 2013

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 period ending March 31, 2013:

Troubled Debt Restructurings
That Subsequently Defaulted:	Number of Loans		Recorded Investment
Commercial		2	$	164
Residential real estate
Home equity lines of credit
Multifamily properties		1		970
Other residential real estate		1		462
Nonresidential real estate
Owner occupied properties		2		6,541
Non owner occupied properties		3		3,137
Construction		4		1,542
Consumer
Credit card balances
Other consumer
Municipal obligations		-		-
Total		13	$	12,816

A loan is considered to be in payment default once it is 30 days contractually past due under the modified terms.

The troubled debt restructurings that subsequently defaulted described above increased the allowance for loan losses by $0 and resulted in charge-offs of$553 during the first quarter ending March 31, 2013

Credit Quality Indicators:

The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt, including: current financial information, historical payment experience, credit documentation, public information and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis includes loans with an outstanding balance greater than $100,000 and non-homogeneous loans, such as commercial and commercial real estate loans. This analysis is performed on a quarterly basis. Loans with balances below $100,000 and homogenous loans, such as residential real estate and consumer loans, are analyzed for credit quality based on aging status, which was previously presented. The Company uses the following definitions for risk ratings:

Special Mention. Loans classified as special mention have a potential weakness that deserves management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution's credit position at some future date.

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 characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

21

Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable.

Based on the most recent analysis performed, the risk category of loans by class of loans is as follows (in thousands):

			Special
	Pass		Mention		Substandard		Doubtful		Not Rated(1)		Total
March 31, 2013
Commercial	$	197,209	$	3,297	$	7,886	$	-	$	-	$	208,392
Residential real estate
Home equity lines of credit		11,741		892		1,362		-		85,509		99,504
Multifamily properties		48,297		226		2,671		-		-		51,194
Other residential real estate		37,419		621		11,132		-		77,356		126,528
Nonresidential real estate
Owner occupied properties		245,599		7,181		22,508		-		-		275,288
Non owner occupied properties		262,672		5,969		12,950		-		-		281,591
Construction		91,302		2,264		13,721		-		-		107,287
Consumer
Credit card balances		-		-		-		-		6,659		6,659
Other consumer		-		-		20		-		8,930		8,950
Municipal obligations		23,814		-		-		-		-		23,814
Total	$	918,053	$	20,450	$	72,250	$	0	$	178,454	$	1,189,207

(1) Not rated loans represent the homogenous pools risk category.

			Special
	Pass		Mention		Substandard		Doubtful		Not Rated(1)		Total
December 31, 2012
Commercial	$	188,686	$	8,469	$	4,229	$	-	$	-	$	201,384
Residential real estate
Home equity lines of credit		10,840		999		1,388		-		86,830		100,057
Multifamily properties		45,329		99		3,130		-		-		48,558
Other residential real estate		35,922		1,146		10,477		-		82,126		129,671
Nonresidential real estate
Owner occupied properties		258,816		13,648		15,707		-		-		288,171
Non owner occupied properties		264,442		8,098		12,390		-		-		284,930
Construction		96,154		2,264		6,080		-		-		104,498
Consumer
Credit card balances		-		-		-		-		6,959		6,959
Other consumer		-		-		141		-		9,347		9,488
Municipal obligations		23,128		-		-		-		-		23,128
Total	$	923,317	$	34,723	$	53,542	$	-	$	185,262	$	1,196,844

(1) Not rated loans represent the homogenous pools risk category.

22

Note 10 –Fair Value:

Accounting guidance 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.

Investment Securities: The fair values of securities available-for-sale are determined by matrix pricing, 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 (Level 2 inputs). One corporate security is valued using Level 3 inputs as there is no readily observable market activity. Management determines the value of this security based on expected cash flows, the credit quality of the security and current market interest rates.

Derivatives: The Bank’s derivative instruments consist of over-the-counter interest-rate swaps that trade in liquid markets. The fair value of the derivative instruments is primarily measured by obtaining pricing from broker-dealers recognized to be market participants. The pricing is derived from market observable inputs that can generally be verified and do not typically involve significant judgment by the Bank. This valuation method is classified as Level 2 in the fair value hierarchy.

Impaired Loans: At the time a loan is considered impaired, it is recorded at the lower of cost or fair value. Impaired loans carried at fair value generally receive specific allocations of the allowance for loan losses. For collateral dependent loans, fair value is commonly based on recent real estate appraisals. 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 independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation and management’s expertise and knowledge of the client and client’s business, resulting in a Level 3 fair value classification. Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted accordingly.

Other Real Estate Owned: Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at the lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals. 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 independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

Loans Held For Sale: Loans held for sale are carried at the lower of cost or fair value, which is evaluated on a pool-level basis. The fair value of loans held for sale is determined using quoted prices for similar assets, adjusted for specific attributes of that loan or other observable market data, such as outstanding commitments from third party investors (Level 2).

23

Assets and Liabilities Measured on a Recurring Basis

Assets and liabilities measured at fair value on a recurring basis are summarized below (in thousands):

			Fair Value Measurements at
			March 31, 2013 Using:
					Significant
			Quoted Prices in		Other		Significant
	Total		Active Markets for		Observable		Unobservable
	March 31,		Identical Assets		Inputs		Inputs
	2013		(Level 1)		(Level 2)		(Level 3)
Assets
Investment securities available-for-sale
U.S. government sponsored entities and agencies	$	125,255	$	-	$	125,255	$	-
U.S. government agency mortgage backed		173,130		-		173,130		-
Corporate		995		-		-		995
Derivatives		1,838		-		1,838		-
Total	$	301,218	$	-	$	300,223	$	995
Liabilities
Derivatives	$	1,838	$	-	$	1,838	$	-
Total	$	1,838	$	-	$	1,838	$	-

			Fair Value Measurements at
			December 31, 2012 Using:
					Significant
			Quoted Prices in		Other		Significant
	Total		Active Markets for		Observable		Unobservable
	December 31,		Identical Assets		Inputs		Inputs
	2012		(Level 1)		(Level 2)		(Level 3)
Assets
Investment securities available-for-sale
U.S. government sponsored entities and agencies	$	128,477		-		128,477		-
U.S. government agency mortgage backed		184,907		-		184,907		-
Corporate		1,060		-		-		1,060
Derivatives		1,926		-		1,926		-
Total	$	316,370		-		315,310		1,060
Liabilities
Derivatives	$	1,926		-		1,926		-
Total	$	1,926		-		1,926		-

There were no transfers between Level 1 and Level 2 during 2013 or 2012.

There were no gains or losses for assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the quarter ended March 31, 2013.

There were no changes in unrealized gains and losses recorded in earnings for the quarter ended March 31, 2013 for Level 3 assets and liabilities that are still held at March 31, 2013.

24

The table below presents a reconciliation of all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the period ended March 31 (in thousands):

	Corporate Securities
	3/31/13		3/31/12
Balance of recurring Level 3 assets at January 1	$	1,060	$	1,060
Total gains or losses for the period:
Included in earnings
Included in other comprehensive income
Purchases		-		-
Sales		-		-
Issuances		-		-
Settlements		65		-
Transfers into Level 3		-		-
Transfers out of Level 3		-		-
Balance of recurring Level 3 assets at March 31	$	995	$	1,060

The following table presents quantitative information about recurring Level 3 fair value measurements at March 31, 2013(in thousands):

			Valuation
	Fair value		Technique(s)	Unobservable Input(s)	Value
Corporate security	$	995	Discounted cash flow	Probability of default		0	%

The interest rate on this security is based on interest rates paid for securities with similar credit characteristics, but the probability of default is determined through a credit quality review rather than formal ratings or other observable inputs. The interest rate adjusts to reflect current market conditions of highly rated investments, if probability of default changed significantly, the interest rate would adjust accordingly and the fair value would be updated. Management reviews this interest rate and the security’s credit quality quarterly and a market value adjustment is made if necessary pursuant to this review.

25

Assets and Liabilities Measured on a Non-Recurring Basis

(Dollars in thousands)

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

			Fair Value Measurements at
			March 31, 2013 Using:
					Significant
			Quoted Prices in		Other		Significant
	Total		Active Markets for		Observable		Unobservable
	March 31		Identical Assets		Inputs		Inputs
	2013		(Level 1)		(Level 2)		(Level 3)
Assets
Impaired loans
Commercial	$	653	$	-	$	-	$	653
Nonresidential real estate				-
Owner occupied properties		1,950		-		-		1,950
Non owner occupied properties		1,684		-		-		1,684
Residential real estate
Home equity lines of credit		444		-		-		444
Multifamily properties		-		-		-		-
Other		5,020		-		-		5,020
Construction		1,116		-		-		1,116
Other real estate owned				-		-
Residential		396						396
Non-Residential		2,936		-		-		2,936
Total	$	14,199	$	-	$	-	$	14,199

			Fair Value Measurements at
			December 31, 2012 Using:
					Significant
			Quoted Prices in		Other		Significant
	Total		Active Markets for		Observable		Unobservable
	December 31		Identical Assets		Inputs		Inputs
	2012		(Level 1)		(Level 2)		(Level 3)
Assets
Impaired loans
Commercial	$	546	$	-	$	-	$	383
Nonresidential real estate		-
Owner occupied properties		6,346		-		-		8,320
Non owner occupied properties		2,788		-		-		5,483
Residential real estate
Home equity lines of credit		354		-		-		354
Multifamily properties		1,072		-		-		1,072
Other		4,541		-		-		4,541
Construction		2,657		-		-		2,657
Other real estate owned
Residential		396		-		-		396
Non-Residential		2,683		-		-		2,683
Total	$	21,383	$	-	$	-	$	21,383

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a gross carrying amount of $14,804 with a valuation allowance of $3,937, resulting in a decrease in provision for loan losses of $2,328 for the first quarter of 2013. As of December 31, 2012, impaired loans had a gross carrying amount of $24,560, with a valuation allowance of $6,265, resulting in a decrease in provision for loan losses of $1,178.

26

Other real estate owned, measured at fair value less costs to sell, had a net carrying amount of $3,332, which is made up of the outstanding balance of $4,060, net of a valuation allowance of $728 at March 31, 2013, resulting in a write-down of $253, for the quarter ended March 31, 2013. At December 31, 2012, other real estate owned had a net carrying amount of $3,079, made up of the outstanding balance of $3,728, net of a valuation allowance of $649, resulting in a write-down of $369 for the year ended December 31, 2012.

Values for collateral dependent loans and other real estate owned are generally based on appraisals obtained from licensed real estate appraisers and in certain circumstances consideration of offers obtained to purchase properties prior to foreclosure or other factors management deems relevant to arrive at a representative fair value.  Appraisals for commercial real estate generally use three methods to derive value: cost, sales or market comparison and income approach.  The cost method bases value on the cost to replace the current property.  The market comparison approach evaluates the sales price of similar properties in the same market area.  The income approach considers net operating income generated by the property and an investor’s required return.  The final fair value is based on a reconciliation of these three approaches.

The following table presents quantitative information about recurring Level 3 fair value measurements at March 31, 2013 (in thousands):

		Fair Value	Valuation Technique(s)	Unobservable Input(s)	Discount Range
					(Avg discount)
Assets
Impaired Loans:
				Adjustment for comparable	0-100%
				properties or equipment,	(50)%
Commercial	$	653	Cost, sales, income approach	market conditions
Nonresidential real estate
				Adjustment for comparable	0-100%
Owner occupied properties		1,950	Cost, sales, income approach	properties, market conditions	(5)%
				Adjustment for comparable	0-100%
Non owner occupied properties		1,684	Cost, sales, income approach	properties, market conditions	(4)%
Residential real estate
				Adjustment for comparable	0-100%
Home equity lines of credit		444	Cost, sales, income approach	properties, market conditions	(8)%
				Adjustment for comparable	0-100%
Other		5,020	Cost, sales, income approach	properties, market conditions	(11)%
				Adjustment for comparable	0-100%
Construction		1,116	Cost, sales, income approach	properties, market conditions	(13)%
Other real estate owned
				Adjustment for comparable	0-0%
Owner occupied properties		396	Cost, sales, income approach	properties, market conditions	(0)%
Non owner occupied properties		2,936		Adjustment for comparable	0-0%
			Cost, sales, income approach	properties, market conditions	(0)%
Total	$	14,199

27

The carrying amounts and estimated fair values of financial instruments at March 31, 2013 and December 31, 2012 are as follows (in thousands):

Fair Value Measurements at
				March 31, 2013 Using:
	Carrying Value			Level 1			Level 2			Level 3			Total
(Dollars in thousands)
Financial assets
Cash and cash equivalents	$	138,561		$	138,561		$	-		$	-		$	138,561
Interest-bearing deposits with  Banks		250			-			250			-			250
Securities available-for-sale		299,380			-			298,385			995			299,380
Securities held-to-maturity		77,074			-			78,459			-			78,459
Federal Home Loan Bank stock		5,099			N/A			N/A			N/A			N/A
Loans held for sale		14,038			-			14,038			-			14,038
Loans, net		1,171,101			-			-			1,181,064			1,181,064
Accrued interest receivable		4,534			-			4,534			-			4,534
Derivative assets		1,838			-			1,838			-			1,838
Financial liabilities
Deposits	$	(1,558,933	)	$	(1,214,179	)	$	(346,855	)	$	-		$	(1,561,034	)
Short-term borrowings		(28,309	)		-			(28,309	)		-			(28,309	)
Notes payable		(48,709	)		-			(23,677	)		(17,518	)		(41,195	)
Accrued interest payable		(922	)		-			(922	)		-			(922	)
Standby letters of credit		(222	)		-			-			(222	)		(222	)
Derivative liabilities		(1,838	)		-			(1,838	)		-			(1,838	)

				Fair Value Measurements at
				December 31, 2012 Using:
	Carrying Value			Level 1			Level 2			Level 3			Total
(Dollars in thousands)
Financial assets
Cash and cash equivalents	$	151,832		$	151,832		$	-		$	-		$	151,832
Interest-bearing deposits with  banks		250			250			-			-			250
Securities available-for-sale		314,444			-			313,384			1,060			314,444
Securities held-to-maturity		66,843			-			68,504			-			68,504
Federal Home Loan Bank stock		5,099			N/A			N/A			N/A			N/A
Loans held for sale		16,324			-			16,324			-			16,324
Loans, net		1,178,841			-			-			1,182,273			1,182,273
Accrued interest receivable		4,259			-			1,447			2,812			4,259
Derivative assets		1,926						1,926			-			1,926
Financial liabilities
Deposits	$	(1,570,007	)	$	(1,210,925	)	$	(360,671	)	$	-		$	(1,571,596	)
Short-term borrowings		(41,408	)		-			(41,408	)		-			(41,408	)
Notes payable		(48,721	)		-			(22,392	)		(17,192	)		(39,584	)
Accrued interest payable		(1,031	)		-			(1,018	)		(13	)		(1,031	)
Standby letters of credit		(271	)		-			-			(271	)		(271	)
Derivative liabilities		(1,926	)		-			(1,926	)		-			(1,926	)

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The estimated fair value approximates carrying amounts for all items except those described below. Estimated fair value for both securities available-for-sale and held-to-maturity is as previously described for securities available-for-sale.

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

Cash and cash equivalents: The carrying amounts of cash and cash equivalents approximate fair values and are classified as Level 1.

Interest-bearing deposits with banks: The carrying amount of interet-bearing deposits equivalents approximate fair value and are classified a Level 1.

Federal Home Loan Bank stock: It is not practicable to determine the fair value of Federal Home Loan Bank stock due to restrictions placed on its transferability.

Loans held for sale: The fair value of loans held for sale is estimated based upon binding contracts and quotes from third party investors resulting in a Level 2 classification.

Loans, net: 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. 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.

Accrued interest receivable/payable: The carrying amounts of accrued interest approximate fair value resulting in a Level 2 or Level 3 classification consistent with the classification of the asset/liability with which they are associated.

Deposits: The fair values disclosed for demand deposits (e.g., interest and non-interest checking, passbook savings and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amount) resulting in either a Level 1 or Level 2 classification. The carrying amounts of variable rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date resulting in either a Level 2 or Level 3 classification. Fair values for fixed rate certificates of deposit 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 3 classification.

Short-term borrowings: The carrying amounts of short-term borrowings, generally maturing within ninety days, approximate their fair values resulting in a Level 2 classification.

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Notes payable: The carrying amounts of borrowings under repurchase agreements approximate their fair values resulting in a Level 2 classification. The fair values of the Company’s long-term borrowings 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 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 3 classification.

Standby letters of credit and off-balance sheet instruments: Fair values for off-balance sheet, credit-related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. The fair value of commitments is not material. Estimated fair value of standby letters of credit are based on their current unearned fee balance. Estimated fair value for commitments to make loans and unused lines of credit are considered nominal.

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

The objective of this section is to help shareholders and potential investors understand our views on our results of operations and financial condition. You should read this discussion in conjunction with the consolidated financial statements and notes to the consolidated financial statements that appear elsewhere in this quarterly report on form 10-Q (this “Quarterly Report”). References to “we,” “us,” and “our” in this section refer to the Bank of Kentucky Financial Corporation (“BKFC”) and its subsidiaries, including The Bank of Kentucky, Inc. (“the Bank”), unless otherwise specified or unless the context otherwise requires.

FORWARD-LOOKING STATEMENTS

Certain statements contained in this quarterly report which are not statements of historical fact constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Examples of forward-looking statements include, but are not limited to, projections of revenues, income or loss, earnings or loss per share, the payment or non-payment of dividends, capital structure and other financial items; statements of plans and objectives of us or our management or Board of Directors; and statements of future economic performance and statements of assumptions underlying such statements. Words such as “believes,” “anticipates,” “intends” and other similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements.

Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those in such statements. Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to, the following:

· indications of an improving economy may prove to be premature;

· general economic or industry conditions could be less favorable than expected, resulting in a deterioration in credit quality, a change in the allowance for credit losses, or a reduced demand for credit or fee-based products and services;

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· changes or volatility in interest rates may adversely impact the value of securities, loans, deposits and other financial instruments and the interest rate sensitivity of our balance sheet as well as our liquidity;

· our ability to determine accurate values of certain assets and liabilities;

· the impact of turmoil in the financial markets and the effectiveness of governmental actions taken in response, and the effect of such governmental actions on us, our competitors and counterparties, financial markets generally and availability of credit specifically;

· changes in the extensive laws, regulations and policies governing financial services companies, including the Dodd-Frank Act and any regulations promulgated thereunder;

· the potential need to adapt to industry changes in information technology systems, on which the Bank is highly dependent, could present operational issues or require significant capital spending;

· competitive pressures could intensify and affect the Bank’s profitability, including as a result of continued industry consolidation, the increased availability of financial services from non-banks, technological developments or bank regulatory reform;

· acquisitions may not produce revenue enhancements or cost savings at levels or within timeframes originally anticipated, or may result in unforeseen integration difficulties; and

· other risks and uncertainties summarized above under “Item 1A., Risk Factors,” in this Annual Report.

Any forward-looking statements made by us or on our behalf speak only as of the date they are made, and we do not undertake any obligation to update any forward-looking statement to reflect the impact of subsequent events or circumstances. Before making an investment decision, you should carefully consider all risks and uncertainties disclosed in our other public documents on file with theSecurities and Exchange Commission (“SEC”),including those described in Item 1A of our Annual Report on Form 10-K, for the year ended December 31, 2012.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

BKFC has prepared all of the consolidated financial information in this quarterly report in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”). In preparing the consolidated financial statements in accordance with GAAP, BKFC makes estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurances that actual results will not differ from those estimates.

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We have identified the accounting policy related to the allowance for loan losses as critical to the understanding of BKFC’s results of operations, since the application of this policy requires significant management assumptions and estimates that could result in reporting materially different amounts if conditions or underlying circumstances were to change.

The Bank maintains an allowance to absorb probable, incurred loan losses inherent in the loan portfolio. The allowance for loan losses is maintained at a level the Bank considers to be adequate and is based upon ongoing quarterly assessments and evaluations of the collectability and historical loss experience of loans. Loan losses are charged and recoveries are credited to the allowance for loan losses. Provisions for loan losses are based on the Bank’s review of its historical loan loss experience and such factors that, in management’s judgment, deserve consideration under existing economic conditions in estimating probable loan losses. The Bank’s strategy for credit risk management includes a combination of well-defined credit policies, uniform underwriting criteria, and ongoing risk monitoring and review processes for all commercial and consumer credit exposures. The credit risk management strategy also includes assessments of compliance with commercial and consumer policies, risk ratings and other important credit information. The strategy also emphasizes regular credit examinations and management reviews of loans exhibiting deterioration in credit quality. The Bank strives to identify potential problem loans early and promptly undertake the appropriate actions necessary to mitigate or eliminate the increasing risk identified in these loans.

The allowance for loan losses consists of two components, the specific reserve, pursuant to ASC 310,Accounting by Creditors for Impairment of a Loan, and the general reserve, pursuant to ASC 450-10,Accounting for Contingencies. A loan is considered impaired when, based upon current information and events, it is probable that the bank will be unable to collect all amounts due according to the contractual terms of the loan. The specific reserve component is an estimate of loss based upon an impairment review of larger loans that are considered impaired. The general reserve includes an estimate of commercial and consumer loans with similar characteristics. Depending on the set of facts with respect to a particular loan, the Bank utilizes one of the following methods for determining the proper impairment of a loan:

· the present value of expected future cash flows of a loan;

· the market price of the loan based upon readily available information for that type of loan; and

· the fair value of collateral.

The allowance established for impaired loans is generally based, for all collateral-dependent loans, on the fair market value of the collateral, less the estimated cost to liquidate. For non-collateral dependent loans (such as accruing troubled debt restructurings), the allowance is based on the present value of expected future cash flows discounted by the loan’s effective interest rate. A small portion of the Bank’s loans which are impaired under the ASC 310 process carry no specific reserve allocation. These loans were reviewed for impairment and are considered adequately collateralized with respect to their respective outstanding principal loan balances. The majority of these loans are loans which have had their respective impairment (or specific reserve) amounts charged off, or are loans related to other impaired loans which continue to have a specific reserve allocation. It is the Bank’s practice to maintain these impaired loans, as analyzed and provided for in the ASC 310 component of the allowance for loan losses, to avoid double counting of any estimated losses that may have been included in the ASC 450-10 component of the allowance for loan losses.

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Generally, the Bank orders a new or updated appraisal on real estate properties which are subject to an impairment review. Upon completion of the impairment review, loan reserves are increased as warranted. Charge-offs, if necessary, are generally recognized in a period after the reserves were established. Adjustments to new or updated appraisal values are not typically done, but in those cases when an adjustment is necessary, it is documented with supporting information and typically results in an adjustment to decrease the property’s value because of additional information obtained concerning the property after the appraisal or update has been received by the Bank. The Bank’s practice is to obtain new or updated appraisals or evaluation on the loans subject to impairment. If a new or updated appraisal is not available at the time of a loan’s impairment review, the Bank typically applies a discount to the value of an old appraisal to reflect the property’s current estimated value if there is believed to be deterioration in either (i) the physical or economic aspects of the subject property or (ii) any market conditions. Updated valuations on 1 to 4 family residential properties with small to moderate values are generally accomplished by obtaining an evaluation or appraisal. Generally, an “as is” value is utilized in most of the Bank’s real estate based impairment analyses. However, under certain limited circumstances, an “as stabilized” valuation may be utilized, provided that the “as stabilized” value is tied to a well-justified action plan to bring the real estate project to a stabilized occupancy under a reasonable period of time.

If a partially charged-off loan has been restructured in a manner that is reasonably assured of repayment and performance according to prudently modified terms, and has sustained historical payment performance for a reasonable period of time prior to and/or after the restructuring, it may be returned to accrual status and is classified as a TDR loan. However, if the above conditions can not be reasonably met, the loan remains on non-accrual status.

In addition, the Bank evaluates the collectability of both principal and interest when assessing the need for loans to be placed on non-accrual status. Non-accrual status denotes loans in which, in the opinion of management, the collection of additional interest is unlikely. A loan is generally placed on non-accrual status if: (i) it becomes 90 days or more past due or (ii) for which payment in full of both principal and interest cannot be reasonably expected.

Historical loss rates are applied to all other loans not subject to specific reserve allocations. The loss rates applied to loans are derived from analyzing the loss experience sustained on loans according to their internal risk rating. These loss rates may be adjusted to account for environmental factors. The general reserve also includes homogeneous loans, such as consumer installment, residential mortgage and home equity loans that are not individually risk graded. For these loans that are not individually risk graded, the historical loss experience of the portfolio is used to determine the appropriate allowance for the portfolios. Allocations for the allowance are established for each pool of loans based on the expected net charge-offs for one year.

Management utilizes a detailed approach to setting the environmental adjustments to the historical loss. Factors that management considers as part of this approach in setting the environmental adjustments include economic trends, loan policies, lender experience, loan growth, delinquency trend, non-performing asset trends, classified loan trends and credit concentrations.

Reserves on individual loans and historical loss rates are reviewed quarterly and adjusted as necessary based on changing borrower and/or collateral conditions, as well as actual collection and charge-off experience.

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Charge-offs are recognized when it becomes evident that a loan or a portion of a loan is deemed uncollectible regardless of its delinquent status. The Bank generally charges off that portion of a loan that is determined to be unsupported by an obligor’s continued ability to repay the loan from income and/or assets, both pledged and unpledged as collateral.

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OVERVIEW

Economic Overview

Despite mixed economic news in the first quarter of 2013, the overall economic recovery remains muted after a deep recession, highlighted by high unemployment, depressed real estate values and high levels of problem assets in the banking industry. In the first quarter of 2013, it is anticipated that the economy grew at rate 2.1% over the previous quarter, which remains well below the historical normalized 3% growth rate. For the year, the U.S. economy is expected to grow at a rate of 1.90% over 2012’s output, which is slightly higher than the previous estimate of 1.8%. This is a result of better than expected growth in the first quarter. The unemployment rate fell in the first quarter by 0.10% to 7.73% and the economy also produced 504,000 non-farm jobs in the quarter. The Company believes the major risks to the economy for 2013 will be the ongoing financial stress in Europe, the impact of the sequester and payroll tax increase, and the burden on consumers created by higher food and energy costs. Interest rates remain low and show no signs of increasing in the near term, with the Federal Reserve extending its pledge to keep rates at current historic lows as long as necessary.

2013 First Quarter Performance Overview

The results of the first quarter of 2013 reflect the effects of the compression of the net interest margin and somewhat higher levels of credit cost. For the first quarter of 2013 net interest income decreased $261,000 (2%) and the provision for loan losses increased $200,000 (11%). The compression of the net interest margin is the result of the historically low interest rate environment, where the cost of funds are close to a floor and the yield on earning assets still has room to decline. Contributing to the higher provision for loan losses were higher levels of charge-offs in the first quarter of 2013 as compared to 2012. Also in the first quarter of 2013 a $256,000 (5%) increase in non-interest income was offset by a $427,000 (4%) increase in non-interest expense.

The following sections provide more detail on subjects presented in the overview.

FINANCIAL CONDITION

Total assets at March 31, 2013 were $1,820,511,000 as compared to $1,844,104,000 at December 31, 2012, a decrease of $23,593,000 (1%). Cash and cash equivalents decreased $13,271,000 (9%) from $151,832,000 at December 31, 2012 to $138,561,000 at March 31, 2013. Loans outstanding decreased $7,667,000 from $1,195,409,000 at December 31, 2012 to $1,187,742,000 at March 31, 2013.

As Table 1 illustrates, the decrease in the loan portfolio in 2013 was the result of a decrease in commercial real estate loans of $16,222,000 (3%) and was offset with an increase in commercial loans of $7,008,000 (3%). Management expects a steady, although slow, increase in loan demand in 2013, mirroring the current economic conditions as discussed above. The Bank intends to continue to work to make loans that meet its longstanding prudent lending standards.

35

The increase in the cash surrender value of life insurance was primarily the result of the purchase of $5,000,000 in Bank owned life insurance policies. The Bank is the beneficiary of these policies, and the earnings from the increase in the cash surrender value of the policies is used to offset certain personnel benefit cost.

Deposits decreased $11,074,000 to $1,558,933,000 at March 31, 2013, compared to $1,570,007,000 at December 31, 2012. Decreases in non-interest bearing deposits (down $24,183,000 or 7%) and certificates of deposits (CDs) (down $12,855,000 or 4%) were partially offset by increases in money market deposits (up $12,875,000 or 5%) and savings deposits (up $12,255,000 or 10%). Management believes that the decrease in non-interest bearing deposits reflects the transactional nature of these accounts, while the lower level of interest rates offered on CDs has made them less desirable to consumers and these funds have moved to money market or savings deposits.

Table 1 Composition of the Bank’s loans and deposits at the dates indicated:

	March 31, 2013					December 31, 2012
	Amount		%			Amount		%
	(Dollars in thousands)
Type of Loan:
Commercial real estate loans	$	556,879		46.8	%	$	573,101		47.9	%
One- to four-family residential real estate loans		277,226		23.3			278,286		23.3
Commercial loans		208,392		17.5			201,384		16.8
Consumer loans		15,609		1.3			16,447		1.4
Construction and land development loans		107,287		9.1			104,498		8.7
Municipal obligations		23,814		2.0			23,128		1.9
Total loans	$	1,189,207		100.0	%	$	1,196,844		100.0	%
Less:
Deferred loan fees		1,465					1,435
Allowance for loan losses		16,641					16,568
Net loans	$	1,171,101				$	1,178,841
Type of Deposit:
Non-interest bearing deposits		327,733		21.0	%		351,916		22.4	%
Interest bearing transaction deposits		500,792		32.1			498,699		31.8
Money market deposits		250,717		16.1			237,842		15.2
Savings deposits		134,723		8.7			122,468		7.8
Certificates of deposits		285,906		18.3			298,761		19.0
Individual retirement accounts		59,062		3.8			60,321		3.8
Total Deposits	$	1,558,933		100.0	%	$	1,570,007		100.0	%

36

RESULTS OF OPERATIONS

GENERAL

Net income for the quarter ended March 31, 2013 was $4,090,000 ($.54 diluted earnings per share) as compared to $4,515,000 ($.60 diluted earnings per share) during the same period of 2012, a decrease of $425,000 (9%). Contributing to the decrease in net income from the first quarter of 2012 as compared to the first quarter of 2013 was a $261,000 (2%) decrease in net interest income and $200,000 (11%) increase in the provision for loan losses. The decrease in net interest income was the result of compression of the net interest margin that decreased 17 basis points from 3.57% in the first quarter of 2012 to 3.40% in the first quarter of 2013. The increase in the provision for loan losses was reflective of higher levels of charged-off loans that increased $201,000 or 12% from $1,726,000 in the first quarter of 2012 to $1,927,000 in the first quarter of 2013. The first quarter of 2013 also included a $256,000 (5%) increase in non-interest income that was offset with a $427,000 (4%) increase in non-interest expense. Contributing to the increase in non-interest income was a $163,000 (24%) increase in trust fee income, while the increase in non-interest expense included a $462,000 (8%) increase in salaries and benefits expense.

NET INTEREST INCOME

Net interest income decreased $261,000 (2%) in the first quarter of 2013 as compared to the same period in 2012. As illustrated in Table 2 below, the net interest margin of 3.40% for the first quarter of 2013 was 17 basis points lower than the 3.57% net interest margin for the first quarter of 2012. As discussed in the overview section of the report, the decline in the interest margin was the result of the historically low interest rate environment, where the cost of funds are close to a floor and the yield on earning assets still has room to decline. The cost of interest-bearing liabilities decreased 18 basis points from .57% for the first quarter of 2012 to .39% in the first quarter of 2013, while the yield on earning assets decreased 32 basis points from 4.03% for the first quarter of 2012 to 3.71% for the first quarter of 2013.

As illustrated in Table 2, average earning assets increased $61,146,000 or 4% from the first quarter of 2012 to the first quarter of 2013, while average interest bearing liabilities only increased $14,194,000 or 1% in the same period. Table 3 shows that the net interest income on a fully tax equivalent basis was positively impacted by the volume additions to the balance sheet by $851,000, which was offset with a negative rate variance of $1,129,000. As further illustrated in Table 3, the favorable volume variance was driven by the increase in interest income attributable to loans of $734,000. Driving the increase in interest income from loans was a $61,290,000 or 5% increase in the average balance of loans outstanding from the first quarter of 2012 to the first quarter of 2013. As the negative rate variance in the first quarter of 2013 shows, if rates were to continue to fall in 2013, the effect on the Company is expected to be negative, as shown and explained below.

37

The Company uses an earnings simulation model to estimate and evaluate the impact of changing interest rates on earnings. The model projects the effect of instantaneous movements in interest rates of both 100 and 200 basis points. By simulating the effects of movements in interest rates, the model can estimate the Company’s interest rate exposure. The results of the model are used by management to approximate the results of rate changes and do not indicate actual expected results. As shown below, the March 31, 2013 simulation analysis indicates that the Company is in a slightly liability interest rate sensitive position, with the net interest income negatively impacted by rising rates. As a result of the current historically low rate environment, the effects of a 100 basis point decrease in rates would also be negative to the net interest income. This is the result of a significant portion of the interest-bearing liabilities already having a cost below 1.00%.

Net interest income estimates are summarized below.

	Net Interest Income Change
Increase 200 bp		(3.56	)%
Increase 100 bp		(1.62	)
Decrease 100 bp		(7.10	)

Table 2 sets forth certain information relating to the Bank’s average balance sheet information and reflects the average yield on interest-earning assets, on a tax equivalent basis, and the average cost of interest-bearing liabilities for the periods indicated. Such yields and costs are derived by dividing income or expense by the average monthly balance of interest-earning assets or interest-bearing liabilities, respectively, for the periods presented. Average balances are daily averages for the Bank and include non-accruing loans in the loan portfolio, net of the allowance for loan losses.

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Table 2- Average Balance Sheet Rates for Three Months Ended March 31, 2013 and 2012 (presented on a tax equivalent basis in thousands)

	Three Months ended March 31, 2013								Three Months ended March 31, 2012
	Average outstanding balance			Interest earned/ paid		Yield/ rate			Average outstanding balance			Interest earned/ paid		Yield/ rate
Interest-earning assets:
Loans receivable (1)(2)	$	1,194,657		$	13,396		4.55	%	$	1,133,367		$	13,958		4.95	%
Securities (2)		376,370			1,679		1.81			374,027			1,960		2.11
Other interest-earning assets		86,110			96		0.45			88,597			92		0.42
Total interest-earning assets		1,657,137			15,171		3.71			1,595,991			16,010		4.03
Non-interest-earning assets		154,538								149,178
Total assets	$	1,811,675							$	1,745,169
Interest-bearing liabilities:
Transaction accounts		892,609			399		0.18			821,643			470		0.23
Time deposits		351,751			645		0.74			403,100			1,096		1.09
Borrowings		75,375			239		1.29			80,798			278		1.38
Total interest-bearing liabilities		1,319,735			1,283		0.39			1,305,541			1,844		0.57
Non-interest-bearing liabilities		320,242								281,606
Total liabilities		1,639,977								1,587,147
Shareholders’ equity		171,698								158,022
Total liabilities and shareholders’ equity	$	1,811,675							$	1,745,169
Net interest income				$	13,888							$	14,166
Interest rate spread							3.32	%							3.46	%
Net interest margin (net interest income as a percent of average interest-earning assets)							3.40	%							3.57	%
Effect of net free funds (earning assets funded by non- interest bearing liabilities)							0.08	%							0.11	%
Average interest-earning assets to interest-bearing liabilities		125.57	%							122.25	%

___________________________

(1) Includes non-accrual loans.

(2) Income presented on a tax equivalent basis using a 35.00% tax rate in 2013 and 2012, respectively. The tax equivalent adjustment was $305,000 and $322,000 in 2013 and 2012, respectively

Table 3 below illustrates the extent to which changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities have affected the Bank’s interest income and expense during the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (change in volume multiplied by prior year rate), (ii) changes in rate (change in rate multiplied by prior year volume) and (iii) total changes in rate and volume. The combined effects of changes in both volume and rate, which cannot be separately identified, have been allocated proportionately to the change due to volume and the change due to rate.

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Table 3-Volume/Rate Analysis (in thousands)

	Three months ended March 31, 2013 Compared to Three months ended March 31, 2012
	Increase (Decrease) Due to
	Volume			Rate			Total
Interest income attributable to:
Loans receivable	$	734		$	(1,296	)	$	(562	)
Securities		12			(293	)		(281	)
Other interest-earning assets(1)		(3	)		7			4
Total interest-earning assets		743			(1,582	)		(839	)
Interest expense attributable to:
Transactions accounts		38			(109	)		(71	)
Time deposits		(128	)		(323	)		(451	)
Borrowings		(18	)		(21	)		(39	)
Total interest-bearing liabilities		(108	)		(453	)		(561	)
Increase (decrease) in net interest income	$	851		$	(1,129	)	$	(278	)

______________________________

(1) Includes federal funds sold and interest-bearing deposits in other financial institutions.

PROVISION FOR LOAN LOSSES

Like many other financial institutions, the Bank has been significantly affected by the national economic downturn that began over five years ago. While the Bank has experienced an increase in defaults and foreclosures in this economic period, the levels of such activity have been significantly less than other regions in the country due, in part, to the fact that the Bank’s market in the northern Kentucky and greater Cincinnati area did not experience as dramatic a rise in real estate values over the last several years as other markets.

Although the Bank is seeing the benefit of the current slow economic recovery, management believes that with the continuing economic uncertainty, high unemployment rates and low real estate values, the resulting pressure on earnings will remain above historical levels. While charge-offs have decreased significantly from the peak of the current recession, management believes that the effect of the continuing economic uncertainty will include higher levels of charge-offs than were experienced before the economic recession began in 2008, as a result, higher provisions for loan losses and a higher reserve for loan losses on the balance sheet. Management believes that loan growth experienced since the first quarter of 2012 is consistent with the slowly improving economic conditions, and management anticipates slowly growing demand for loans in the coming quarters.

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As discussed above, the increase in the provision for loan losses in the first quarter of 2013 reflected higher levels of charged-off loans in the first quarter of 2013 versus the first quarter of 2012. The first quarter of 2013 also saw relatively higher levels of non-performing loans as compared to the first quarter of 2012 and on a sequential basis from the fourth quarter of 2012. The provision for loan losses increased $200,000 (11%) from $1,800,000 for the first quarter of 2012 to $2,000,000 in the first quarter of 2013. The Company’s non-performing loans as a percentage of total loans were 1.84% as of March 31, 2013, as compared to 1.54% as of March 31, 2012, while annualized net charge-offs to average loans increased from .62% in the first quarter of 2012 to .66% in the first quarter of 2013. The Company recorded $1,927,000 in net charge-offs in the first quarter of 2013 as compared to $1,726,000 in the first quarter of 2012. The majority of the loans charged off in the first quarter of 2013 were reserved for in prior quarters. As illustrated in Table 5 below, total non-accrual loans plus loans past due 90 days or more were $21,807,000 (1.84% of loans outstanding) at March 31, 2013, compared to $17,459,000 (1.54% of loans outstanding) at March 31, 2012. Contributing to the increase in non-performing loans was one commercial relationship which added approximately $7,000,000 in non-accruing loans in the fourth quarter of 2012. This relationship was reported as an accruing restructured loan in March of 2012. Management’s evaluation of the inherent risk in the loan portfolio considers both historical losses and information regarding specific borrowers. Management continues to monitor the non-performing relationships and has established appropriate reserves.

On a sequential basis, the provision for loan losses of $2,000,000 in the first quarter of 2013 was $700,000 higher than the provision in the fourth quarter of 2012, while non-performing loans increased from $19,283,000 (1.61% of total loans) at December 31, 2012 to $21,807,000 (1.84% of total loans) at March 31, 2013. Net charge-offs on a sequential basis increased from $1,317,000 (.45% of loans) in the fourth quarter of 2012 to $1,927,000 (.66% of loans) in the first quarter of 2013. Net charge-offs in the fourth quarter of 2012 were reduced by a $961,000 recovery on a loan charged-off in the third quarter of 2012.

The aggregate amounts of the Bank’s classified assets at March 31, 2013 and December 31, 2012 were as follows:

	3/31/13		12/31/12
	(Dollars in thousands)
Special mention (risk rating 6)	$	20,450	$	34,722
Substandard (risk rating 7 & 8)		72,250		53,542
Doubtful (risk rating 9)		0		0
Total classified assets	$	92,700	$	88,264

Non-performing assets, which include non-performing loans, other real estate owned (“OREO”) and repossessed assets, totaled $27,261,000 at March 31, 2013 versus $23,787,000 at March 31, 2012. This represents 1.50% of total assets at March 31, 2013 compared to 1.36% at March 31, 2012. While non-performing loans increased, as discussed above, from the first quarter of 2012 to the first quarter of 2013, OREO balances decreased $874,000 (14%) from $6,328,000 at March 31, 2012 to $5,454,000 at March 31, 2013. These properties are initially recorded at their fair value less estimated costs to sell with the difference between this value and the loan balance being recorded as a charge-off. On a sequential quarterly basis OREO balances increased $58,000 or 1% .

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Accruing Troubled Debt Restructurings (TDRs). In certain circumstances, the Bank may modify the terms of a loan to maximize the collection of amounts due. In cases where the borrower is experiencing financial difficulties or is expected to experience difficulties in the near -term, concessionary modification is granted to minimize or eliminate the economic loss and to avoid foreclosure or repossession of the collateral. Modifications may include interest rate reductions, extension of the maturity date or a reduction in the principal balance. Restructured loans accrue interest as long as the borrower complies with the modified terms. Performing TDRs are loans that are paying pursuant to the agreed upon modified terms and are not more than 30 days past due. Non-performing TDRs are the remainder. Total performing TDRs, which are not considered non-performing loans by management, were $7,499,000 at March 31, 2013 as compared to $15,492,000 at March 31, 2012. Total nonperforming TDRs were $11,313,000 at March 31, 2013 as compared to $2,273,000 at March 31, 2012. In order to proactively manage and resolve problem loans, the Bank expects higher than normal levels of TDRs as it continues to work with relationships that show signs of stress. All TDRs are considered impaired loans and any specific reserves related to the TDRs are included in the allowance for loan losses on the balance sheet. Any additional specific reserves related to TDRs added or reduced in a period would be reflected in the provision for loan losses on the income statement for that period. Ordinarily, loans are identified as potential problem loans, through a higher risk weighting, before actually being restructured.

Allowance for Loan Losses (“ALL”). The ALL was relatively stable as the impact of higher levels of adversely classified loans was offset by lower levels of specific loan reserves. Management believes this is directionally consistent in the first quarter of 2013 with the change in the credit metrics and the continued uncertain economic conditions experienced since December 31, 2012. The ALL increased $73,000 from $16,568,000 at December 31, 2012 to $16,641,000 at March 31, 2013. The increase in the ALL coupled with a slight decrease in loans outstanding in the first quarter led to an increase in the allowance for loan losses as a percentage of total loans from 1.39% at December 31, 2012 to 1.40% at March 31, 2013. The amount of the allowance allocated to impaired loans at the end of the first quarter of 2013, was $3,938,000, which was down $2,327,000 from $6,265,000 at December 31, 2012. As discussed above, the majority of the loans charged off in the first quarter of 2013 were reserved for at December 31, 2012. The impairment process is described in the “Critical Accounting Policies and Estimates” section of this Quarterly Report. Management believes the current level of the ALL is sufficient to absorb probable incurred losses in the loan portfolio. Management continues to monitor the loan portfolio closely and believes the provision for loan losses is directionally consistent with the changes in the probable losses inherent in the loan portfolio from the year end of 2012 to the first quarter of 2013. The Bank does not originate or purchase sub-prime loans for its portfolio. Management will continue to monitor and evaluate the effects of the current housing market conditions and any signs of further deterioration in credit quality on the Bank’s loan portfolio. Management believes the current economic strains will continue throughout 2013 and expects continuing higher than normal credit losses and provisioning expense in the foreseeable future.

Monitoring loan quality and maintaining an adequate allowance is an ongoing process overseen by senior management and the loan review function. On at least a quarterly basis, a formal analysis of the adequacy of the ALL is prepared and reviewed by management and the Board of Directors. This analysis serves as a point in time assessment of the level of the ALL and serves as a basis for provisions for loan losses. The loan quality monitoring process includes assigning loan grades and the use of a watch list to identify loans of concern.

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The following tables set forth an analysis of certain credit risk information for the periods indicated:

Table 4-Summary of Loan Loss Experience and Allowance for Loan Loss Analysis (in thousands)

	Three Months ended March 31,
	2013			2012
Balance of allowance at beginning of period	$	16,568		$	18,288
Recoveries of loans previously charged off:
Commercial loans		91			4
Consumer loans		104			95
Mortgage loans		2			5
Total recoveries		197			104
Loans charged off:
Commercial loans		1,411			1,152
Consumer loans		275			376
Mortgage loans		438			302
Total charge-offs		2,124			1,830
Net charge-offs		(1,927	)		(1,726	)
Provision for loan losses		2,000			1,800
Balance of allowance at end of period	$	16,641		$	18,362
Net charge-offs to average loans outstanding for period		.66	%		.62	%
Allowance at end of period to loans at end of period		1.40	%		1.62	%
Allowance to non-performing loans at end of period		76	%		105	%

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Table 5 - Analysis of non-performing loans for the periods indicated (in thousands)

	March 31, 2013			December31, 2012
Loans accounted for on a non-accrual basis:
Nonresidential real estate	$	12,401		$	12,138
Residential real estate		6,984			5,243
Construction		1,658			1,075
Commercial		680			740
Consumer and other		48			48
Total		21,771			19,244
Accruing loans which are contractually past due 90 days or more:
Nonresidential real estate	$	-		$	-
Residential real estate		-			17
Construction		-			-
Commercial		-			-
Consumer and other loans		36			22
Total		36			39
Total non-performing loans	$	21,807		$	19,283
Non-performing loans as a percentage of total loans		1.84	%		1.61	%
Other real estate owned	$	5,454		$	5,396
Trouble debt restructured (TDR) loans:
Performing troubled debt restructured (TDR) loans	$	7,499		$	6,046
Nonperforming trouble debt restructured (TDR) loans (included in nonaccrual loans)		11,313		$	11,095
Total troubled debt restructured loans	$	18,812		$	17,141

The amount of gross interest income that would have been recorded for nonaccrual loans in the first quarter of 2013 if loans had been current in accordance with their original terms was $201,000 and $169,000 in the first quarter of 2012.

NON-INTEREST INCOME

Table 6-Major components of non-interest income (in thousands)

	Three Months ended March 31,
Non-interest income:	2013			2012
Service charges and fees	$	2,131		$	2,201
Net securities gains		274			207
Mortgage banking income		539			586
Trust fee income		852			689
Bankcard transaction revenue		957			902
Company owned life insurance earnings		269			320
Gain/(loss) on other real estate owned		(4	)		(94	)
Other		844			795
Total non-interest income	$	5,862		$	5,606

44

As illustrated in Table 6, total non-interest income increased $256,000 (5%) for the first three months of 2013, from $5,606,000 at March 31, 2012 to $5,862,000 at March 31, 2013. Contributing to the increase in non-interest income was a $163,000 (24%) increase in trust fee income. Contributing to the increase in trust income was growth in the market value of the trust accounts under management and higher brokerage product sales. Other increases for the three months ended March 31, 2013 included net securities gains (up $67,000 or 32% from March 31, 2011) and lower level of losses on OREO (down $90,000 from March 31, 2012). The Bank also took advantage of the current low interest rate environment to sell approximately $5,230,000 of available-for-sale mortgage backed securities for a $274,000 gain. The Bank’s available-for-sale security portfolio is made up of high quality government sponsored agency bonds which are implicitly guaranteed by the U.S. Treasury and therefore their credit quality was not negatively affected by the current economic recession.

NON-INTEREST EXPENSE

Table 7-Major components of non-interest expense (in thousands)

	Three Months ended March 31,
Non-interest expense:	2013		2012
Salaries and benefits	$	5,913	$	5,451
Occupancy and equipment		1,306		1,277
Data processing		550		535
Advertising		343		382
Electronic banking		430		359
Outside servicing fees		266		302
State bank taxes		575		559
Other real estate owned and loan collection		244		426
Amortization of intangible assets		159		200
FDIC insurance		295		305
Other		1,688		1,546
Total non-interest expense	$	11,769	$	11,342

As illustrated in Table 7 above, non-interest expense increased to $11,769,000 in the first three months of 2013 from $11,342,000 in the same period of 2012, an increase of $427,000 (4%). Contributing to the increase in non-interest expense were salaries and benefits expense (up $462,000 or 8% from March 31, 2012. The increase in salaries and benefits included $109,000 in higher accruals for pension plan expense. Contributing to the higher pension plan expense was a lower discount rate applied to future benefits and higher levels or compensation.

INCOME TAX EXPENSE

During the first quarter of 2013, income tax expense decreased $207,000 (12%) from $1,793,000 in the first quarter of 2012 to $1,586,000 in the same period of 2013 as a result of lower earnings. For the first quarter of 2013, the effective tax rate decreased to 27.94% compared to 28.42% for the same period of 2012.

45

LIQUIDITY AND CAPITAL RESOURCES

The Bank achieves liquidity by maintaining an appropriate balance between its sources and uses of funds to assure that sufficient funds are available to meet loan demands and deposit fluctuations. As indicated on the statement of cash flows, cash and cash equivalents have decreased $13,271,000, from $151,832,000 at December 31, 2012 to $138,561,000 at March 31, 2013.

The Company’s total shareholders’ equity increased $2,516,000 from $170,440,000 at December 31, 2012 to $172,956,000 at March 31, 2013. In the first three months of 2013, the Company paid a cash dividend of $.17 per share totaling $1,272,000 to common shareholders. In September 2012 the Board of Directors voted to change from a semi-annual cash dividend to a quarterly cash dividend, commencing with the fourth quarter of 2012. This resulted in cash dividends declared to decrease from $.30 in the first quarter of 2012 to $.17 in the same period of 2013.

The Company’s liquidity depends primarily on the dividends paid to it as the sole shareholder of the Bank and the Company’s cash on hand. The Company needs liquidity to meet its financial obligations under certain subordinated debentures issued by the Company in connection with the issuance of trust preferred securities issued by the Company’s unconsolidated subsidiary, for the payment of dividends to common shareholders and for general operating expenses. The Board of Governors of the Federal Reserve System and the FDIC have legal requirements, which provide that insured banks and bank holding companies should generally only pay dividends out of current operating earnings. The FDIC prohibits the payment of any dividend by a bank that would constitute an unsafe or unsound practice. Compliance with the minimum capital requirements limits the amounts that the Company and the Bank can pay as dividends. At March 31, 2013, the Bank had capital in excess of the FDIC’s most restrictive minimum capital requirements in an amount over $45,237,000 from which dividends could be paid, subject to the FDIC’s general safety and soundness review and state banking regulations.

For purposes of determining a bank’s deposit insurance assessment, the FDIC has issued regulations that define a "well capitalized" bank as one with a leverage ratio of 5% or more and a total risk-based capital ratio of 10% or more. At March 31, 2013, the Bank's leverage and total risk-based capital ratios were 8.97% and 13.08%, respectively, which exceed the well-capitalized thresholds.

In 2009, the Company filed a universal shelf registration statement on Form S-3 that was declared effective in November 2010. This registration statement permits the Company to engage in offerings of up to $50 million aggregate principal amount of debt securities, common stock, preferred stock, purchase contracts, units, warrants, rights and any combination of the foregoing. The Company utilized the shelf registration to offer common stock in connection with the $28.1 million common stock offering completed in November 2010. As of the date of this quarterly report, $21.9 million of unused capacity remains available for future use. We may in the future utilize the unused portion of our existing shelf registration statement, or any future registration statements that we may file with the SEC, to conduct subsequent registered debt or equity offerings.

46

CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS

There have been no significant changes to the Bank’s contractual obligations or off-balance sheet arrangements since December 31, 2012. For additional information regarding the Bank’s contractual obligations and off-balance sheet arrangements, refer to the Company’s Form 10-K for the year ending December 31, 2012.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

There has been no material change in market risk since December 31, 2012. For information regarding the Company’s market risk, refer to the Company’s Form 10-K for the year ending December 31, 2012. Market risk is discussed further under the heading “Net Interest Income” above.

Item 4. Controls and Procedures.

Disclosure Controls and Procedures

Disclosure controls and procedures are the Company’s controls and other procedures that are designed to ensure that information required to be disclosed by the Company in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be included in the reports filed or submitted under the Exchange Act is accumulated and communicated to Management, including the Company’s Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

Under the supervision, and with the participation of Management, including the Company’s Chief Executive Officer and Chief Financial Officer, the Company has evaluated the effectiveness of the design and operation of the disclosure controls and procedures as of March 31, 2013, and, based upon this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that these controls and procedures were effective to ensure that information requiring disclosure is communicated to Management in a timely manner and reported within the timeframe specified by the SEC’s rules and forms.

Changes in Internal Control over Financial Reporting

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

47

The Bank of Kentucky Financial Corporation

PART II OTHER INFORMATION

Item 1. Legal Proceedings

From time to time, the Company and the Bank are involved in litigation incidental to the conduct of business, but neither the Company nor the Bank is presently involved in any lawsuit or proceeding which, in the opinion of management, is likely to have a material adverse effect on the Company.

Item 1A. Risk Factors

There have been no material changes in the Company’s risk factors from those previously disclosed in the Company’s Form 10-K for the year ended December 31, 2012.

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

Not applicable

Item 3. Defaults Upon Senior Securities

Not applicable

Item 4. Mine Safety Disclosures

Not applicable

Item 5. Other Information

None

Item 6. Exhibits

Exhibit Number	Description
31.1	Rule 13a – 14(a) Certification of Robert W. Zapp
31.2	Rule 13a – 14(a) Certification of Martin J. Gerrety
32.1	Section 1350 Certification of Robert W. Zapp
32.2	Section 1350 Certification of Martin J. Gerrety
101.INS	XBRL Instance Document*
101.SCH	XBRL Taxonomy Extension Schema Document*
101.CAL	XBRL Taxonomy Extension Calculation Linkbase*
101.LAB	XBRL Taxonomy Extension Label Linkbase*
101.PRE	XBRL Taxonomy Extension Presentation Linkbase*
101.DEF	XBRL Taxonomy Extension Definition Linkbase*

*As provided in Rule 406T of Regulation S-T, this interactive data file shall not be deemed “filed” for purposes of Section 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934 or otherwise subject to liability under those sections.

48

SIGNATURES

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

		The Bank of Kentucky Financial Corporation
Date:	May 7, 2013		/s/ Robert W. Zapp
			Robert W. Zapp
			President and Chief Executive Officer
			(principal executive officer)
Date:	May 7, 2013		/s/ Martin J.Gerrety
			Martin J. Gerrety
			Treasurer and Assistant Secretary
			(principal financial officer)