Bank of Kentucky Financial (BKYF) 10-Q 2014 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, 2014

¨ 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 May 2, 2014, 7,662,170 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	34
	Item 3 – Quantitative and Qualitative Disclosures About Market Risk	50
	Item 4 – Controls and Procedures	51
Part II	OTHER INFORMATION
	Item 1 – Legal Proceedings	51
	Item 1A – Risk Factors	51
	Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds	51
	Item 3 – Defaults upon Senior Securities	52
	Item 4 – Mine Safety Disclosures	52
	Item 5 – Other Information	52
	Item 6 – Exhibits	52

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, 2014			December 31, 2013
Assets
Cash and cash equivalents	$	89,102		$	78,621
Interest-bearing deposits with banks		252			252
Available-for-sale securities		321,677			341,123
Held-to-maturity securities		74,804			77,010
Loans held for sale		6,248			3,214
Total loans		1,261,863			1,249,645
Less:  Allowance for loan losses		16,349			16,306
Net loans		1,245,514			1,233,339
Premises and equipment, net		22,845			22,444
FHLB stock, at cost		4,850			5,099
Goodwill		22,023			22,023
Acquisition intangibles, net		1,714			1,848
Cash surrender value of life insurance		40,097			39,806
Accrued interest receivable and other assets		30,297			32,713
Total assets	$	1,859,423		$	1,857,492
Liabilities & Shareholders’ Equity
Liabilities
Deposits	$	1,584,076		$	1,587,585
Short-term borrowings		29,220			27,643
Notes payable		45,515			45,577
Accrued interest payable and other liabilities		13,981			15,548
Total liabilities		1,672,792			1,676,353
Shareholders’ Equity
Common stock, no par value, 15,000,000 shares authorized, 7,649,493 (2014) and 7,619,999 (2013) shares issued		3,098			3,098
Additional paid-in capital		38,941			38,100
Retained earnings		144,957			141,718
Accumulated other comprehensive income (loss)		(365	)		(1,777	)
Total shareholders’ equity		186,631			181,139
Total liabilities and shareholders’ equity	$	1,859,423		$	1,857,492

See accompanying notes.

3

THE BANK OF KENTUCKY FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

FOR THE THREE MONTHS ENDED MARCH 31, 2014 AND 2013

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

	2014		2013
INTEREST INCOME
Loans, including related fees	$	12,980	$	13,284
Securities and other		1,949		1,582
Total interest income		14,929		14,866
INTEREST EXPENSE
Deposits		824		1,044
Borrowings		236		239
Total interest expense		1,060		1,283
Net interest income		13,869		13,583
Provision for loan losses		900		2,000
Net interest income after provision for loan losses		12,969		11,583
NON-INTEREST INCOME
Service charges and fees		2,434		2,131
Mortgage banking income		165		539
Net securities gains		-		274
Company owned life insurance earnings		290		269
Bankcard transaction revenue		999		957
Trust fee income		941		852
Other		753		840
Total non-interest income		5,582		5,862
NON-INTEREST EXPENSE
Salaries and benefits		5,873		5,913
Occupancy and equipment		1,435		1,306
Data processing		535		550
Advertising		374		343
Electronic banking processing fees		386		430
Outside service fees		244		266
State bank taxes		642		575
Amortization of intangible assets		133		159
FDIC insurance		554		295
Other		1,942		1,932
Total non-interest expense		12,118		11,769
INCOME BEFORE INCOME TAXES		6,433		5,676
Less:  income taxes		1,815		1,586
NET INCOME	$	4,618	$	4,090
Net income per common share:
Earnings per share, basic	$	0.60	$	0.55
Earnings per share, diluted	$	0.60	$	0.54

See accompanying notes.

4

THE BANK OF KENTUCKY FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

FOR THE THREE MONTHS ENDED MARCH 31, 2014 AND 2013

(Dollars in thousands - unaudited)

	2014			2013
Net income	$	4,618		$	4,090
Other comprehensive income:
Unrealized gains/losses on securities
Unrealized holding gain/ (loss) arising during the period		2,130			(670	)
Reclassification adjustment for losses (gains) included in net income		-			(274	)
Tax effect		(718	)		320
Total other comprehensive income (loss)		1,412			(624	)
Comprehensive income	$	6,030		$	3,466

See accompanying notes.

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)

	2014			2013
Balance as of January 1	$	181,139		$	170,440
Net income		4,618			4,090
Change in net unrealized gain(loss), net of tax		1,412			(624	)
Cash dividends paid on common stock		(1,379	)		(1,272	)
Exercise of stock options (29,494 and 12,540 shares), including tax benefit		735			278
Stock-based compensation expense		106			44
Balance as of March 31	$	186,631		$	172,956
Dividends per share	$	0.18		$	0.17

See accompanying notes.

6

THE BANK OF KENTUCKY FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE THREE MONTHS ENDED MARCH 30, 2014 AND 2013

(Dollars in thousands - unaudited)

	2014			2013
Cash Flows from Operating Activities
Net income	$	4,618		$	4,090
Adjustments to reconcile net income to net cash From operating activities		(618	)		4,819
Net cash from operating activities		4,000			8,909
Cash Flows from Investing Activities
Proceeds from paydowns and maturities of held-to-maturity securities		2,836			1,138
Proceeds from paydowns and maturities of available-for-sale securities		20,991			27,903
Proceeds from retirement of FHLB stock		249			-
Purchases of held-to-maturity securities		(645	)		(11,385	)
Purchases of available-for-sale securities		-			(20,154	)
Purchases of company owned life insurance		-			(5,000	)
Net change in loans		(14,031	)		5,144
Proceeds from the sale of other real estate		567			562
Proceeds from the sale of available-for-sale securities		-			5,230
Property and equipment expenditures		(848	)		(445	)
Net cash from investing activities		9,119			2,993
Cash Flows from Financing Activities
Net change in deposits		(3,509	)		(11,074	)
Net change in short-term borrowings		1,577			(13,099	)
Proceeds from exercise of stock options		735			278
Cash dividends paid		(1,379	)		(1,272	)
Payments on note payable		(62	)		(6	)
Net cash from financing activities		(2,638	)		(25,173	)
Net change in cash and cash equivalents		10,481			(13,271	)
Cash and cash equivalents at beginning of period		78,621			151,832
Cash and cash equivalents at end of period	$	89,102		$	138,561

See accompanying notes.

7

THE BANK OF KENTUCKY FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2014

(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, 2013.

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 months 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, 2014 and 2013, 0 and 51,129 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,
	2014		2013
Weighted average shares outstanding		7,640,872		7,478,901
Dilutive effects of assumed exercises of stock options and warrant		46,234		104,643
Shares used to compute diluted earnings per share		7,687,106		7,583,544

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 $5,000 (net of taxes) in the three months ended March 31, 2014, and $12,000 (net of taxes) in the three months ended March 31, 2013.

Restricted Stock Units (RSUs)

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 three months ended March 31, 2014 follows:

			Weighted-Average
			Grant-Date
Nonvested Shares	Shares		Fair Value
Non-vested at January 1, 2014		4,494	$	26.25
Granted		8,274		35.16
Vested		-		-
Forfeited		-		-
Non-vested at March 31, 2014		12,768	$	32.02

9

The Company recorded RSU expense of $101,000 for the three months ended March 31, 2014. As of March 31, 2014, there was $224,000 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–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, 2014
U.S. government, federal agencies and government sponsored enterprises	$	110,402	$	137	$	(2,068	)	$	108,471
U.S. government residential mortgage-backed		210,913		2,860		(1,492	)		212,281
Corporate		925		-		-			925
	$	322,240	$	2,997	$	(3,560	)	$	321,677

			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value
December 31, 2013
U.S. Government, federal agencies and Government sponsored enterprises	$	122,905	$	142	$	(2,908	)	$	120,139
U.S. Government mortgage-backed		219,986		2,408		(2,335	)		220,059
Corporate		925		-		-			925
	$	343,816	$	2,550	$	(5,243	)	$	341,123

10

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
March 31, 2014
Municipal and other obligations	$	74,804	$	1,190	$	(1,301	)	$	74,693
December 31, 2013
Municipal and other obligations	$	77,010	$	1,085	$	(1,638	)	$	76,457

The amortized cost and fair value of debt securities at March 31, 2014 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	$	7,219	$	7,251	$	3,816	$	3,846
Due after one year through five years		41,036		40,390		36,370		36,940
Due after five years through ten years		58,274		56,878		29,403		28,692
Due after ten years		4,798		4,877		5,215		5,215
U.S. governmentagency mortgage-backed		210,913		212,281		-		-
	$	322,240	$	321,677	$	74,804	$	74,693

No securities were sold in the first three months of 2014. 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.

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.

11

As of March 31, 2014 and December 31, 2013, the Bank’s security portfolio consisted of 243 securities, 74 of which were in an unrealized loss position of $4,861,000 and 250 securities, 91 of which were in an unrealized loss position; totaling $6,881,000 respectively. There was no OTTI of securities at March 31, 2014 or December 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. At March 31, 2014, 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.

At March 31, 2014 and December 31, 2013, securities with a carrying value of $385,577 and $402,999 were pledged to secure public deposits and repurchase agreements.

Securities with unrealized losses at March 31, 2014 and December 31, 2013, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows (in thousands):

Available for Sale:	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, 2014
U.S. government, federal agencies and government sponsored enterprises	$	80,235	$	(1,725	)	$	6,039	$	(343	)	$	86,274	$	(2,068	)
U.S government residential mortgage-backed		77,521		(1,418	)		6,997		(74	)		84,518		(1,492	)
Total temporarily impaired	$	157,756	$	(3,143	)	$	13,036	$	(417	)	$	170,792	$	(3,560	)

Held to Maturity:	Less than 12 Months					12 Months or More					Total
	Fair		Unrecognized			Fair		Unrecognized			Fair		Unrecognized
Description of Securities	Value		Loss			Value		Loss			Value		Loss
March 31, 2014
Municipal & other obligations	$	15,670	$	(651	)	$	13,738	$	(650	)	$	29,408	$	(1,301	)
Total temporarily impaired	$	15,670	$	(651	)	$	13,738	$	(650	)	$	29,408	$	(1,301	)

12

Available for Sale:	Less than 12 Months					12 Months or More					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
Description of Securities	Value		Loss			Value		Loss			Value		Loss
December 31, 2013
U.S. government, federal agencies and government sponsored enterprises	$	94,641	$	(2,522	)	$	5,996	$	(386	)	$	100,637	$	(2,908	)
U.S Gov’t. mortgage-backed		116,709		(2,241	)		7,530		(94	)		124,239		(2,335	)
Total temporarily impaired	$	211,350	$	(4,763	)	$	13,526	$	(480	)	$	224,876	$	(5,243	)

Held to Maturity:	Less than 12 Months					12 Months or More					Total
	Fair		Unrecognized			Fair		Unrecognized			Fair		Unrecognized
Description of Securities	Value		Loss			Value		Loss			Value		Loss
December 31, 2013
Municipal & other obligations	$	26,936	$	(1,262	)	$	6,570	$	(376	)	$	33,506	$	(1,638	)
Total temporarily impaired	$	26,936	$	(1,262	)	$	6,570	$	(376	)	$	33,506	$	(1,638	)

Note 8 – Loans

Loan balances were as follows (in thousands):	March 31,			December 31,
	2014			2013
Commercial	$	248,108		$	241,794
Residential real estate		282,502			283,356
Nonresidential real estate		578,241			571,221
Construction		103,352			103,019
Consumer		14,986			15,806
Municipal obligations		36,200			36,058
Gross loans		1,263,389			1,251,254
Less:   Deferred loan origination fees and discount		(1,526	)		(1,609	)
Allowance for loan losses		(16,349	)		(16,306	)
Net loans	$	1,245,514		$	1,233,339

13

The following tables present the activity in the allowance for loan losses for the three months ending March 31, 2014 and 2013, 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, 2014 (in thousands):

							Non
				Residential			Residential								Municipal
	Commercial			Real estate			Real estate			Construction		Consumer			Obligations			Total
March 31, 2014
Allowance for loan losses
Beginning balance	$	3,247		$	4,554		$	6,502		$	1,538	$	373		$	92		$	16,306
Provision for loan losses		274			404			170			3		51			(2	)		900
Loans charged off		(44	)		(714	)		(83	)		-		(122	)		-			(963	)
Recoveries		20			11			3			1		71			-			106
Total ending allowance balance	$	3,497		$	4,255		$	6,592		$	1,542	$	373		$	90		$	16,349
Ending allowance balance attributable to loans
Individually evaluated for impairment	$	1,880		$	818		$	809		$	732	$	-		$	-		$	4,239
Collectively evaluated for impairment		1,617			3,437			5,783			810		373			90			12,110
Total ending allowance balance	$	3,497		$	4,255		$	6,592		$	1,542	$	373		$	90		$	16,349
Loans
Loans individually evaluated for impairment	$	8,097		$	7,477		$	14,401		$	2,534	$	-		$	-		$	32,509
Loans collectively evaluated for impairment		240,011			275,025			563,840			100,818		14,986			36,200			1,230,880
Total ending loans balance	$	248,108		$	282,502		$	578,241		$	103,352	$	14,986		$	36,200		$	1,263,389

							Non
				Residential			Residential									Municipal
	Commercial			Real estate			Real estate			Construction			Consumer			Obligations		Total
March 31, 2013
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

14

					Non
			Residential		Residential						Municipal
	Commercial		Real estate		Real estate		Construction		Consumer		Obligations		Total
December 31, 2013
Ending allowance balance attributable to loans
Individually evaluated for impairment	$	709	$	1,085	$	951	$	674	$	-	$	-	$	3,419
Collectively evaluated for impairment		2,538		3,469		5,551		864		373		92		12,887
	$	3,247	$	4,554	$	6,502	$	1,538	$	373	$	92	$	16,306
Loans
Loans individually evaluated for impairment	$	4,116	$	8,179	$	14,220	$	2,549	$	-	$	-	$	29,064
Loans collectively evaluated for impairment		237,678		275,177		557,001		100,470		15,806		36,058		1,222,190
Total ending loans balance	$	241,794	$	283,356	$	571,221	$	103,019	$	15,806	$	36,058	$	1,251,254

15

The following table presents individually impaired loans by class of loans as of and for the three months ended March 31, 2014 (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	$	1,102	$	1,102	$	-	$	1,103	$	-	$	-
Residential real estate
Home equity lines of credit		-		-		-		-		-		-
Multifamily properties		1,293		943		-		951		-		-
Other		1,975		1,848		-		1,771		-		-
Nonresidential real estate
Owner occupied properties		1,541		1,541		-		1,287		-		-
Non owner occupied properties		3,659		3,609		-		3,716		-		-
Construction		-		-		-		-		-		-
Consumer		-		-		-		-		-		-
With an allowance recorded
Commercial		6,995		6,995		1,880		5,004		79		78
Residential real estate
Home equity lines of credit		339		339		186		356		3		3
Multifamily properties		1,485		1,485		238		1,485		20		20
Other		3,145		2,862		394		3,266		10		10
Nonresidential real estate
Owner occupied properties		9,051		7,295		692		6,914		2		2
Non owner occupied properties		2,582		1,956		117		2,395		34		30
Construction		2,815		2,534		732		2,542		25		22
Consumer		-		-		-		-		-		-
Total	$	35,982	$	32,509	$	4,239	$	30,790	$	173	$	165

16

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		-		-
Total	$	37,789	$	33,935	$	3,937	$	33,897	$	117	$	110

17

The following table presents loans individually evaluated for impairment by class of loans as of December 31, 2013 (in thousands):

	Unpaid				Allowance for
	Principal		Recorded		Loan Losses
	Balance		Investment		Allocated
With no related allowance recorded
Commercial	$	1,104	$	1,104	$	-
Residential real estate
Home equity lines of credit		-		-		-
Multifamily properties		1,308		958		-
Other		1,949		1,694		-
Nonresidential real estate
Owner occupied properties		1,032		1,032		-
Non owner occupied properties		3,873		3,823		-
Construction		-		-		-
Consumer		-		-		-
With an allowance recorded
Commercial		3,012		3,012		709
Residential real estate
Home equity lines of credit		388		373		155
Multifamily properties		1,484		1,484		239
Other		3,776		3,670		691
Nonresidential real estate
Owner occupied properties		8,288		6,532		685
Non owner occupied properties		3,439		2,833		266
Construction		2,830		2,549		674
Consumer		-		-		-
Total	$	32,483	$	29,064	$	3,419

18

The following table presents the aging of the recorded investment in past due loans by class of loans as of March 31, 2014 and December 31, 2013 (in thousands):

	Loans		Loans over
	30-90 days		90 days				Loans not
	past due		past due		Nonaccrual		past due		Total
March 31, 2014
Commercial	$	12	$	-	$	327	$	247,769	$	248,108
Residential real estate
Home equity lines of credit		352		-		386		97,709		98,447
Multifamily properties		224		-		-		70,790		71,014
Other residential real estate		2,572		-		5,030		105,439		113,041
Nonresidential real estate
Owner occupied properties		1,370		-		6,977		289,529		297,876
Non owner occupied properties		48		-		2,298		278,019		280,365
Construction		-		-		509		102,843		103,352
Consumer
Credit card balances		44		11		-		6,800		6,855
Other consumer		10		1		4		8,116		8,131
Municipal obligations		-		-		-		36,200		36,200
Total	$	4,632	$	12	$	15,531	$	1,243,214	$	1,263,389

	Loans		Loans over
	30-90 days		90 days				Loans not
	past due		past due		Nonaccrual		past due		Total
December 31, 2013
Commercial	$	100	$	-	$	385	$	241,309	$	241,794
Residential real estate
Home equity lines of credit		550		-		622		97,786		98,958
Multifamily properties		-		-		-		67,964		67,964
Other residential real estate		3,693		-		4,738		108,003		116,434
Nonresidential real estate
Owner occupied properties		838		-		6,583		294,389		301,810
Non owner occupied properties		608		-		2,573		266,230		269,411
Construction		-		-		510		102,509		103,019
Consumer
Credit card balances		16		20		-		7,103		7,139
Other consumer		9		1		6		8,651		8,667
Municipal obligations		-		-		-		36,058		36,058
Total	$	5,814	$	21	$	15,417	$	1,230,002	$	1,251,254

19

Troubled Debt Restructurings (dollars in thousands):

The Company allocated $1,661 and $879 of specific reserves to customers whose loan terms had been modified in troubled debt restructurings as of March 31, 2014 and March 31, 2013, respectively. Troubled debt restructurings totaled $20,529 and $17,765 as of March 31, 2014 and March 31, 2013, respectively. The Company had not committed to lend additional amounts as of March 31, 2014 and March 31, 2013 to customers with outstanding loans that were 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 to twelve months.

The following table presents loans by class modified as troubled debt restructurings that occurred during the three months ended March 31, 2014 and 2013 (dollars in thousands):

	2014						2013
		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		7	$	3,500	$	3,500		2	$	148	$	148
Residential real estate
Home equity lines of credit		-		-		-		-		-		-
Multifamily properties		-		-		-		1		970		970
Other residential real estate		-		-		-		-		-		-
Nonresidential real estate						-
Owner occupied properties		3		433		433		-		-		-
Non owner occupied properties		1		137		137		2		1,201		1,193
Construction		-		-		-		-		-		-
Consumer
Credit card balances		-		-		-		-		-		-
Other consumer		-		-		-		-		-		-
Municipal obligations		-		-		-		-		-		-
Total		11	$	4,070	$	4,070		5	$	2,319	$	2,311

The eleven restructured notes added during the first quarter of 2014 for $4,070 were added as performing troubled debt restructured loans. The five restructured note added in the first quarter 2013 for a total of $2,319 were added as performing troubled debt restructured loans.

The troubled debt restructurings described above increased the allowance for loan losses by $756 and $29, which resulted in charge-offs of $0 and $730 during the first quarter ending March 31, 2014 and 2013 respectively.

20

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 first quarter ending March 31, 2014.

(dollars in thousands)

Troubled Debt Restructurings
That Subsequently Defaulted:	Number of Loans	Recorded Investment
Commercial	2	$	163
Residential real estate
Home equity lines of credit	-		-
Multifamily properties	-		-
Other residential real estate	1		491
Nonresidential real estate
Owner occupied properties	-		-
Non owner occupied properties	-		-
Construction	3		584
Consumer
Credit card balances	-		-
Other consumer	-		-
Municipal obligations	-		-
Total	6	$	1,238

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 first quarter ending March 31, 2013.

(dollars in thousands)

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 $0, which resulted in charge-offs of $0 and $553 during the first quarter ending March 31, 2014 and 2013 respectively.

21

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.

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, 2014
Commercial	$	224,972	$	13,059	$	10,077	$	-	$	-	$	248,108
Residential real estate
Home equity lines of credit		12,453		888		2,050		-		83,056		98,447
Multifamily properties		69,529		-		1,485		-		-		71,014
Other residential real estate		24,510		3,688		7,983		-		76,860		113,041
Nonresidential real estate
Owner occupied properties		266,707		8,904		22,265		-		-		297,876
Non owner occupied properties		267,771		4,564		8,030		-		-		280,365
Construction		98,102		2,264		2,986		-		-		103,352
Consumer
Credit card balances		-		-		-		-		6,855		6,855
Other consumer		-		-		3		-		8,128		8,131
Municipal obligations		36,200		-		-		-		-		36,200
Total	$	1,000,244	$	33,367	$	54,879	$	-	$	174,899	$	1,263,389

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

22

			Special
	Pass		Mention		Substandard		Doubtful		Not Rated(1)		Total
December 31, 2013
Commercial	$	226,021	$	4,736	$	11,037	$	-	$	-	$	241,794
Residential real estate
Home equity lines of credit		11,775		1,721		1,582		-		83,880		98,958
Multifamily properties		65,521		-		2,443		-		-		67,964
Other residential real estate		24,697		4,594		8,606		-		78,537		116,434
Nonresidential real estate
Owner occupied properties		271,281		9,058		21,471		-		-		301,810
Non owner occupied properties		256,328		5,216		7,867		-		-		269,411
Construction		97,738		2,264		3,017		-		-		103,019
Consumer
Credit card balances		-		-		-		-		7,139		7,139
Other consumer		-		-		4		-		8,663		8,667
Municipal obligations		36,058		-		-		-		-		36,058
Total	$	989,419	$	27,589	$	56,027	$	-	$	178,219	$	1,251,254

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

Note 9 –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.

23

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).

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, 2014 Using:
					Significant
			Quoted Prices in		Other		Significant
	Total		Active Markets for		Observable		Unobservable
	March 31,		Identical Assets		Inputs		Inputs
	2014		(Level 1)		(Level 2)		(Level 3)
Assets
Investment securities available-for-sale
U.S. government sponsored entities and agencies	$	108,471	$	-	$	108,471	$	-
U.S. government agency mortgage backed		212,281		-		212,281		-
Corporate		925		-		-		925
Derivatives		1,940		-		1,940		-
Total	$	323,617	$	-	$	322,692	$	925
Liabilities
Derivatives	$	1,940	$	-	$	1,940	$	-
Total	$	1,940	$	-	$	1,940	$	-

24

			Fair Value Measurements at
			December 31, 2013 Using:
					Significant
			Quoted Prices in		Other		Significant
	Total		Active Markets for		Observable		Unobservable
	December 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	$	120,139	$	-	$	120,139	$	-
U.S. government agency mortgage backed		220,059		-		220,059		-
Corporate		925		-		-		925
Derivatives		1,915		-		1,915		-
Total	$	343,038	$		$	342,113	$	925
Liabilities
Derivatives	$	1,915	$	-	$	1,915	$	-
Total	$	1,915	$	-	$	1,915	$	-

There were no transfers between Level 1 and Level 2 during 2014 or 2013.

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, 2014.

There were no changes in unrealized gains and losses recorded in earnings for the quarter ended March 31, 2014 for Level 3 assets and liabilities that are still held at March 31, 2014.

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 three months ended March 31 (in thousands):

Corporate Securities
	Three months ended Three months ended
	March 31, 2014		March 31, 2013
Balance of recurring Level 3 assets at January 1	$	925	$	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	$	925	$	995

25

The following table presents quantitative information about recurring Level 3 fair value measurements at March 31, 2014 (in thousands):

			Valuation
	Fair value		Technique(s)	Unobservable Input(s)		Value
Corporate	$	925	Discounted cash flow	Probability of default	��		0	%

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

			Valuation
	Fair value		Technique(s)	Unobservable Input(s)	Value
Corporate	$	925	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.

26

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, 2014 Using:
					Significant
			Quoted Prices in		Other		Significant
	Total		Active Markets for		Observable		Unobservable
	March 31,		Identical Assets		Inputs		Inputs
	2014		(Level 1)		(Level 2)		(Level 3)
Assets
Impaired loans
Commercial	$	4,972	$	-	$	-	$	4,972
Nonresidential real estate
Owner occupied properties		6,437		-		-		6,437
Non owner occupied properties		221		-		-		221
Residential real estate
Home equity lines of credit		153		-		-		153
Multifamily properties		1,247		-		-		1,247
Other		1,541		-		-		1,541
Construction		1,802		-		-		1,802
Other real estate owned
Residential		-		-		-		-
Non-Residential		2,565		-		-		2,565
Total	$	18,938	$	-	$	-	$	18,938

			Fair Value Measurements at
			December 31, 2013 Using:
					Significant
			Quoted Prices in		Other		Significant
	Total		Active Markets for		Observable		Unobservable
	December 31,		Identical Assets		Inputs		Inputs
	2013		(Level 1)		(Level 2)		(Level 3)
Assets
Impaired loans
Commercial	$	2,215	$	-	$	-	$	2,215
Nonresidential real estate
Owner occupied properties		5,673		-		-		5,673
Non owner occupied properties		942		-		-		942
Residential real estate
Home equity lines of credit		218		-		-		218
Multifamily properties		1,245		-		-		1,245
Other		2,013		-		-		2,013
Construction		1,875		-		-		1,875
Other real estate owned
Residential		-		-		-		-
Non-Residential		2,772		-		-		2,772
Total	$	16,953	$	-	$	-	$	16,953

27

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a gross carrying amount of $20,612 with a valuation allowance of $4,239, resulting in an increase in provision for loan losses of $762 in the first quarter ending March 31, 2014. As of December 31, 2013, impaired loans had a gross carrying amount of $17,600, with a valuation allowance of $3,419, resulting in a decrease in provision for loan losses of $2,846.

Other real estate owned, measured at fair value less costs to sell, had a net carrying amount of $2,565, which is made up of the outstanding balance of $3,119, net of a valuation allowance of $554 at March 31, 2014, resulting in a write-down of $86, for the quarter ended March 31, 2014. At December 31, 2013, other real estate owned measured at fair value less costs to sell, had a net carrying amount of $2,772, which is made up of the outstanding balance of $3,287, net of a valuation allowance of $515, resulting in a write-down of $263 for the year ended December 31, 2013.

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.

28

The following table presents quantitative information about recurring Level 3 fair value measurements at March 31, 2014 (in thousands):

	Fair Value		Valuation Technique(s)	Unobservable Input(s)	Discount Range (Avg discount)
Assets
Impaired Loans:
Commercial	$	4,972	Cost, sales, income approach	Adjustment for comparable properties or equipment, market conditions	15-100% (56%)
Nonresidential real estate
Owner occupied properties		6,437	Cost, sales, income approach	Adjustment for comparable properties, market conditions	6-80% (17%)
Non owner occupied properties		221	Cost, sales, income approach	Adjustment for comparable properties, market conditions	3-36% (11%)
Residential real estate
Home equity lines of credit		153	Cost, sales, income approach	Adjustment for comparable properties, market conditions	21% (21%)
Multifamily properties		1,247	Cost, sales, income approach	Adjustment for comparable properties, market conditions	6% (6%)
Other		1,541	Cost, sales, income approach	Adjustment for comparable properties, market conditions	0-100% (17%)
Construction		1,802	Cost, sales, income approach	Adjustment for comparable properties, market conditions	11-100% (22%)
Other real estate owned
Non-residential		2,565	Cost, sales, income approach	Adjustment for comparable properties, market conditions	0-0% (0%)
Total	$	18,938

29

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

	Fair Value		Valuation Technique(s)	Unobservable Input(s)	Discount Range (Avg discount)
Assets
Impaired Loans:					%
Commercial		2,215	Cost, sales, income approach	Adjustment for comparable properties, market conditions	6-25% (11%)
Nonresidential real estate
Owner occupied properties		5,673	Cost, sales, income approach	Adjustment for comparable properties, market conditions	6-76% (17%)
Non owner occupied properties		942	Cost, sales, income approach	Adjustment for comparable properties, market conditions	3-66% (15%)
Residential real estate
Home equity lines of credit		218	Cost, sales, income approach	Adjustment for comparable properties, market conditions	6-26% (8%)
Multifamily properties		1,245	Cost, sales, income approach	Adjustment for comparable properties, market conditions	6% (6%)
Other		2,013	Cost, sales, income approach	Adjustment for comparable properties, market conditions	0-100% (36%)
Construction		1,875	Cost, sales, income approach	Adjustment for comparable properties, market conditions	6-16% (14%)
Other real estate owned
Residential		-	Cost, sales, income approach	Adjustment for comparable properties, market conditions	0-0% (0%)
Non-residential		2,772	Cost, sales, income approach	Adjustment for comparable properties, market conditions	0-0% (0%)
Total	$	16,953

30

The carrying amounts and estimated fair values of financial instruments at March 31, 2014 and December 31, 2013 are as follows (in thousands):

				Fair Value Measurements at
				March 31, 2014 Using:
	Carrying Value			Level 1			Level 2			Level 3			Total
(Dollars in thousands)
Financial assets
Cash and cash equivalents	$	89,102		$	89,102		$	-		$	-		$	89,102
Interest-bearing deposits with banks		252			252			-			-			252
Securities available-for-sale		321,677			-			320,752			925			321,677
Securities held-to-maturity		74,804			-			74,693			-			74,693
Federal Home Loan Bank stock		4,850			N/A			N/A			N/A			N/A
Loans held for sale		6,248			-			6,248			-			6,248
Loans, net		1,245,514			-			-			1,251,027			1,251,027
Accrued interest receivable		4,195			-			1,438			2,757			4,195
Derivative assets		1,940			-			1,940			-			1,940
Financial liabilities
Deposits	$	(1,584,076	)	$	(1,284,043	)	$	(301,001	)	$	-		$	(1,585,044	)
Short-term borrowings		(29,220	)		-			(29,220	)		-			(29,220	)
Notes payable		(45,515	)		-			(20,003	)		(17,653	)		(37,656	)
Accrued interest payable		(615	)		-			(603	)		(12	)		(615	)
Standby letters of credit		(308	)		-			-			(308	)		(308	)
Derivative liabilities		(1,940	)		-			(1,940	)		-			(1,940	)

				Fair Value Measurements at
				December 31, 2013 Using:
	Carrying Value			Level 1			Level 2			Level 3			Total
(Dollars in thousands)
Financial assets
Cash and cash equivalents	$	78,621		$	78,621		$	-		$	-		$	78,621
Interest-bearing deposits with banks		252			252			-			-			252
Securities available-for-sale		341,123			-			340,198			925			341,123
Securities held-to-maturity		77,010			-			76,457			-			76,457
Federal Home Loan Bank stock		5,099			N/A			N/A			N/A			N/A
Loans held for sale		3,214			-			3,214			-			3,214
Loans, net		1,233,339			-			-			1,236,112			1,236,112
Accrued interest receivable		4,123			-			1,420			2,703			4,123
Derivative assets		1,915			-			1,915			-			1,915
Financial liabilities
Deposits	$	(1,587,585	)	$	(1,286,733	)	$	(302,701	)	$	-		$	(1,589,434	)
Short-term borrowings		(27,643	)		-			(27,643	)		-			(27,643	)
Notes payable		(45,577	)		-			(20,083	)		(17,414	)		(37,497	)
Accrued interest payable		(693	)		-			(680	)		(13	)		(693	)
Standby letters of credit		(415	)		-			-			(415	)		(415	)
Derivative liabilities		(1,915	)		-			(1,915	)		-			(1,915	)

31

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 interest-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 1, 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 a Level 1 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 a Level 2 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 2 classification.

32

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.

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, which results in a level 3 classification. 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.

Note 10- Accumulated Other Comprehensive Income

The following table summarizes the changes within each classification of accumulated other comprehensive income for the three months ended March 31, 2014:

Reclassifications Out Of Accumulated Other Comprehensive Income

Details about Accumulated other Comprehensive Income Components	Amount Reclassified From Accumulated Other Comprehensive Income		Affected Line Item In the Statement Where Net Income is Presented
	(in thousands)
Unrealized gains and losses on available-for-sale securities	$	-	Net securities gains
		-	Income tax expense
	$	-	Net of tax

There were no reclassifications out of accumulated other comprehensive income for the three months ended March 31, 2014

33

The following table summarizes the changes within each classification of accumulated other comprehensive income for the three months ended March 31, 2013:

Details about Accumulated other Comprehensive Income Components	Amount Reclassified From Accumulated Other Comprehensive Income			Affected Line Item In the Statement Where Net Income is Presented
	(in thousands)
Unrealized gains and losses on available-for-sale securities	$	274		Net securities gains
		(96	)	Income tax expense
	$	178		Net of tax

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 the “Company,” “BKFC,” “we,” “us,” and “our” in this section refer to the Bank of Kentucky Financial Corporation 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;

34

· 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; and

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

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 the Securities and Exchange Commission (“SEC”),including those described in Item 1A of our Annual Report on Form 10-K, for the year ended December 31, 2013.

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.

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.

35

The Bank maintains an allowance to absorb probable, incurred loan losses inherent in the loan portfolio. The Bank’s policy is to maintain an allowance for loan losses at an adequate level 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 loans which meet certain criteria that are considered impaired. An insignificant delay or insignificant shortfall in amount of payments is not considered an impairment. In addition, a loan is not impaired during a period of delay in payment if the creditor expects to collect all amounts due including interest accrued at the contractual interest rate for the period of delay. Thus, a demand loan or loan that has been extended beyond its original maturity date is not impaired if the creditor expects to collect all amounts due including interest accrued at the contractual interest rate during the period the loan is outstanding.

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 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.

36

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 an update has been received by the Bank. 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 one to four 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 cannot 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.

The general component of the allowance covers non-impaired loans and is based on historical loss experience adjusted for current factors. For loans that are risk rated, the historical loss experience is determined based on the actual loss history experienced by the Company over the most recent four years. These loss ratios are calculated from a migration analysis of the charge offs over this period, but excludes the ratios from the most recent twelve months period as they are not appropriately seasoned. The loss ratios for loans designated as belonging to homogeneous pools, including smaller balance consumer loans, are calculated for a five year period and a one year period, with the higher of the two loss ratio’s currently used in the allowance calculation. These actual loss experiences are supplemented with other economic factors based on the risks present for each portfolio segment. These economic factors include consideration of the following: levels of and trends in delinquencies and impaired loans; trends in volume and terms of loans; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations. These factors are consistent within each of the portfolio segments, which have been identified as: commercial, residential real estate, nonresidential real estate, construction, consumer and municipal obligations.

37

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.

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.

OVERVIEW

Economic Overview

The first quarter ended March 31, 2014 saw the pace of growth slow both nationally and in the geographic markets where we operate, as adverse winter weather conditions impacted economic output.  The United States’ gross domestic product (GDP) was impacted by weakness in the housing market and a drop in consumer spending. 

Overall economic growth continued to expand as the labor market improved, represented by the 533,000 non-farm jobs produced in the first quarter.   The decline in the unemployment rate stabilized during the quarter.  However, the percent of eligible workforce employed remains well below historical averages. 

2014 First Quarter Performance Overview

The Company completed the first quarter of 2014 with an 11% increase in diluted earnings per share. The results reflect overall improving credit metrics, net interest income growth and contained non-interest expense, which was partially offset by lower non-interest income. The 11% increase in diluted earnings per share for the first quarter of 2014 compared with the same period in 2013 was the result of a $1,100,000 (55%) reduction in the provision for loan losses, and $286,000 (2%) growth in net interest income, which were partially offset by a $349,000 (3%) increase in non-interest expense and a $280,000 (5%) decrease in non-interest income compared with the same period in 2013. The reduction in the provision for loan losses was accompanied by lower levels of charge-offs and lower levels of adversely classified loans from the previous year. The growth in net interest income is a result of loan growth, which has increased $74,121,000 or 6% from March 31, 2013. The decrease in non-interest income was the result of a $274,000 decrease in gains on the sale of securities and $374,000 decrease in gains on the sale of real estate loans. The decrease in gains on the sale of real estate was the result of lower refinancing volume due to slightly higher long term rates compared to 2013.

38

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

FINANCIAL CONDITION

Total assets at March 31, 2014 were $1,859,423,000compared with $1,857,492,000 at December 31, 2013, an increase of $1,931,000. Loans outstanding increased $12,218,000 from $1,249,645,000 at December 31, 2013 to $1,261,863,000 at March 31, 2014. Available-for-sale securities decreased $19,446,000 (6%) from $341,123,000 at December 31, 2013 to $321,677,000 at March 31, 2014.

As Table 1 illustrates, the increase in the loan portfolio in 2014 was the result of an increases in commercial real estate loans of $7,020,000 (1%) and commercial loans of $6,314,000 (3%). Management expects a steady, although slow, increase in loan demand in 2014, mirroring the current economic conditions as discussed above. The Bank intends to continue to make loans that meet its longstanding prudent lending standards.

Deposits decreased $3,509,000 to $1,584,076,000 at March 31, 2014, compared to $1,587,585,000 at December 31, 2013. The largest decrease in deposits came from money market deposits which decreased $8,560,000 (4%), which was partially offset with a $8,039,000 (5%) increase in savings deposits.

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

	March 31,2014					December 31, 2013
	Amount		%			Amount		%
	(Dollars in thousands)
Type of Loan:
Commercial real estate loans	$	578,241		45.8	%	$	571,221		45.7	%
One- to four-family residential real estate loans		282,502		22.4			283,356		22.6
Commercial loans		248,108		19.6			241,794		19.3
Consumer loans		14,986		1.1			15,806		1.3
Construction and land development loans		103,352		8.2			103,019		8.2
Municipal obligations		36,200		2.9			36,058		2.9
Total loans	$	1,263,389		100.0	%	$	1,251,254		100.0	%
Less:
Deferred loan fees		1,526					1,609
Allowance for loan losses		16,349					16,306
Net loans	$	1,245,514				$	1,233,339
Type of Deposit:
Non-interest bearing deposits		352,003		22.2	%		359,201		22.6	%
Interest bearing transaction deposits		565,394		35.7			560,365		35.3
Money market deposits		206,685		13.0			215,245		13.6
Savings deposits		159,959		10.1			151,920		9.6
Certificates of deposits		246,258		15.5			245,350		15.5
Individual retirement accounts		53,777		3.4			55,504		3.4
Total deposits	$	1,584,076		100.0	%	$	1,587,585		100.0	%

39

RESULTS OF OPERATIONS

GENERAL

Net income for the quarter ended March 31, 2014 was $4,618,000 ($.60 diluted earnings per share) as compared to $4,090,000 ($.54 diluted earnings per share) during the same period of 2013, an increase of $528,000 (13%). The primary reason for the increase in net income from the first quarter of 2013 compared with the first quarter of 2014 was a $1,100,000 (55%) decrease in the provision for loan losses, which was reflective of lower charge-offs and lower levels of non-performing loans compared with the first quarter of 2013. Also, contributing to the increase in net income from the first quarter of 2013 to the first quarter of 2014 was a $286,000 (2%) increase in net interest income, which was offset by a $280,000 decrease in non-interest income and an $349,000 increase in non-interest expense. The decrease in non-interest income included a decrease in net securities gains of $274,000 and a decrease in mortgage banking income of $374,000 (69%), which were partially offset by increases in trust fee income of $89,000 (10%) and service charges on deposits of $303,000 (14%). The increase in non-interest expense included a $259,000 (88%) increase in FDIC insurance expense.

NET INTEREST INCOME

Net interest income increased $286,000 in the first quarter of 2014 as compared to the same period in 2013. As illustrated in Table 2 below, the net interest margin of 3.39% for the first quarter of 2014 was one basis point less than the 3.40% net interest margin for the first quarter of 2013. The cost of interest-bearing liabilities decreased six basis points from .39% for the first quarter of 2013 to .33% in the first quarter of 2014, while the yield on earning assets decreased six basis points from 3.71% for the first quarter of 2013 to 3.65% for the first quarter of 2014.

The increase in net interest income was the result of higher levels of earning assets and a higher yielding mix of earning assets in the first quarter of 2014 as compared to the first quarter of 2013. As illustrated in Table 2, average interest earning assets increased $40,316,000 or 2% from the first quarter of 2013 to the first quarter of 2014. The mix of earning assets also improved as average loan balances increased $60,895,000 or 5% which had a yield of 4.24%, while other interest-earning assets with a yield of .91% decreased $56,256,000 or 7% from the first quarter of 2013. 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 $826,000, which was offset with a negative rate variance of $510,000. As further illustrated in Table 3, the favorable volume variance was driven by the increase in interest income attributable to loans of $672,000. As the negative rate variance in the first quarter of 2014 shows, if rates were to continue to fall in 2014, the effect on the Company is expected to be negative, as shown and explained below.

40

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, 2014 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		(.28	)%
Increase 100 bp		(.29	)
Decrease 100 bp		(3.70	)

Tables 2 set 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 daily 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.

41

Table 2- Average Balance Sheet Rates for Three Months Ended March 31, 2014 and 2013 (presented on a tax equivalent basis in thousands)

	Three Months ended March 31, 2014								Three Months ended March 31, 2013
	Average outstanding balance			Interest earned/ paid		Yield/ rate			Average outstanding balance			Interest earned/ paid		Yield/ rate
Interest-earning assets:
Loans receivable (1)(2)	$	1,255,552		$	13,123		4.24	%	$	1,194,657		$	13,396		4.55	%
Securities (2)		412,047			2,074		2.04			376,370			1,679		1.81
Other interest-earning assets		29,854			67		0.91			86,110			96		0.45
Total interest-earning assets		1,697,453			15,264		3.65			1,657,137			15,171		3.71
Non-interest-earning assets		158,850								154,538
Total assets	$	1,856,303							$	1,811,675
Interest-bearing liabilities:
Transaction accounts		947,221			386		0.17			892,609			399		0.18
Time deposits		298,020			438		0.60			351,751			645		0.74
Borrowings		73,529			236		1.30			75,375			239		1.29
Total interest-bearing liabilities		1,318,770			1,060		0.33			1,319,735			1,283		0.39
Non-interest-bearing liabilities		353,648								320,242
Total liabilities		1,672,418								1,639,977
Shareholders’ equity		183,885								171,698
Total liabilities and shareholders’ equity	$	1,856,303							$	1,811,675
Net interest income				$	14,204							$	13,888
Interest rate spread							3.32	%							3.32	%
Net interest margin (net interest income as a percent of average interest-earning assets)							3.39	%							3.40	%
Effect of net free funds (earning assets funded by non-interest bearing liabilities)							0.07	%							0.08	%
Average interest-earning assets to interest-bearing liabilities		128.71	%							125.57	%

(1) Includes non-accrual loans.

(2) Income presented on a tax equivalent basis using a 35.00% tax rate in 2014 and 2013, respectively. The tax equivalent adjustment was $335,000 and $305,000 in 2014 and 2013, respectively

42

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.

Table 3-Volume/Rate Analysis (in thousands)

	Three months ended March 31, 2014 Compared to Three months ended March 31, 2013
	Increase (Decrease) Due to
	Volume			Rate			Total
Interest income attributable to:
Loans receivable	$	672		$	(945	)	$	(273	)
Securities		170			225			395
Other interest-earning assets(1)		(89	)		60			(29	)
Total interest-earning assets		753			(660	)		93
Interest expense attributable to:
Transactions accounts		24			(37	)		(13	)
Time deposits		(91	)		(116	)		(207	)
Borrowings		(6	)		3			(3	)
Total interest-bearing liabilities		(73	)		(150	)		(223	)
Increase (decrease) in net interest income	$	826		$	(510	)	$	316

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

43

PROVISION FOR LOAN LOSSES

Like many other financial institutions, the Bank has been significantly affected by the most recent national economic recession and the continued challenging economic environment. While the Bank experienced an increase in defaults and foreclosures since the recession began, the levels of such activity has 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 years preceding this recession, as other markets had.

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 the economic conditions continue to be challenging, the provision for loan losses reflected the improving economy. While still above historical levels, the credit metrics showed significant improvement in 2014 compared with 2013. Management believes that loan growth experienced in 2014 is consistent with the slowly improving economic conditions, and management anticipates growing demand for loans in the coming quarters.

Provision for loan losses decreased $1,100,000 in the first quarter of 2014 as compared to the same period in 2013. The decrease in the provision for loan losses in the first quarter of 2014 reflected significantly lower levels of charged-off loans in the first quarter of 2014 versus the first quarter of 2013. For the first quarter of 2014, net charge-offs were $857,000 or .27% of average loan balances compared to 2013 figures of $1,927,000 or .66% of average loan balances. The first quarter of 2014 saw stable levels of non-performing loans compared with December 31, 2013. As illustrated in Table 5 below, total non-accrual loans plus loans past due 90 days or more were $15,543,000 (1.23% of loans outstanding) at March 31, 2014, compared to $15,438,000 (1.24% of loans outstanding) at December 31, 2013. 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 quarterly basis, the provision for loan losses of $900,000 in the first quarter of 2014 was $400,000 higher than the provision in the fourth quarter of 2013. Net charge-offs on a sequential basis increased slightly from $826,000 (.27% of loans) in the fourth quarter of 2013 to $857,000 (.27% of loans) in the first quarter of 2014. The fourth quarter provision was lower as a result of release of certain specific reserves on impaired loans during the quarter.

The provision for loan losses by portfolio segment for the first quarter of 2014, included in Note 9 of the financial statements, included the effects of added specific reserves in the commercial portfolio, compared with the fourth quarter of 2013 which were partially offset by the effects of lower levels of specific reserves in the commercial compared to the same period.

44

The aggregate amounts of the Bank’s classified assets at March 31, 2014 and December 31, 2013 were as follows:

	March 31, 2014		December 31, 2013
	(Dollars in thousands)
Special mention (risk rating 6)	$	33,367	$	27,589
Substandard (risk rating 7 & 8)		54,879		56,027
Doubtful (risk rating 9)		0		0
Total classified assets	$	88,246	$	83,616

Non-performing assets, which include non-performing loans, other real estate owned (“OREO”) and repossessed assets, totaled $21,100,000 at March 31, 2014 versus $20,743,000 at December 31, 2013. This represents 1.14% of total assets at March 31, 2014 compared to 1.12% at December 31, 2013. Both non-performing loans, as discussed above, and OREO balances increased slightly from December 31, 2013 to the first quarter of 2014. OREO balances increased $252,000 (5%) from $5,305,000 at December 31, 2013 to $5,557,000 at March 31, 2014. 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.

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 $11,825,000 at March 31, 2014 as compared to $8,816,000 at December 31, 2013. Total nonperforming TDRs were $8,704,000 at March 31, 2014 as compared to $8,246,000 at December 31, 2013. 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.

45

Allowance for Loan Losses (“ALL”). The ALL was relatively stable as the impact of higher levels of specific loan reserves and adversely classified loans was offset by lower historic loss ratios. Management believes this is directionally consistent in the first three months of 2014 with the change in the credit metrics and the continued uncertain economic conditions experienced since December 31, 2013. The ALL increased $43,000 from $16,306,000 at December 31, 2013 to $16,349,000 at March 31, 2014. The increase in the ALL relatively matched the increase in loans outstanding in the first three months of 2014 and as the result the allowance for loan losses as a percentage of total loans remained stable at 1.30% at December 31, 2013 and at March 31, 2014. The amount of the allowance allocated to impaired loans at the end of the first quarter of 2014 was $4,239,000, which was up $820,000 from $3,419,000 at December 31, 2013. 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 2013 to March 31, 2014. 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.

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.

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,
	2014			2013
Balance of allowance at beginning of period	$	16,306		$	16,568
Recoveries of loans previously charged off:
Commercial loans		20			91
Consumer loans		71			104
Mortgage loans		15			2
Total recoveries		106			197
Loans charged off:
Commercial loans		44			1,411
Consumer loans		122			275
Mortgage loans		797			438
Total charge-offs		963			2,124
Net charge-offs		(857	)		(1,927	)
Provision for loan losses		900			2,000
Balance of allowance at end of period	$	16,349		$	16,641
Net charge-offs to average loans outstanding for period
		0.27	%		.66	%
Allowance at end of period to loans at end of period
		1.30	%		1.40	%
Allowance to non-performing loans at end of period
		105	%		76	%

46

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

	March 31, 2014			December 31, 2013
Loans accounted for on a non-accrual basis:
Nonresidential real estate	$	9,275		$	9,156
Residential real estate		5,416			5,360
Construction		509			510
Commercial		327			385
Consumer and other		4			6
Total		15,531			15,417
Accruing loans which are contractually past due 90 days or more:
Nonresidential real estate	$	-		$	-
Residential real estate		-			-
Construction		-			-
Commercial		-			-
Consumer and other loans		12			21
Total		12			21
Total non-performing loans	$	15,543		$	15,438
Non-performing loans as a percentage of total loans		1.23	%		1.24	%
Other real estate owned	$	5,557		$	5,305
Trouble debt restructured (TDR) loans:
Performing troubled debt restructured (TDR) loans	$	11,825		$	8,816
Nonperforming trouble debt restructured (TDR) loans (included in nonaccrual loans)		8,704			8,246
Total troubled debt restructured loans	$	20,529		$	17,062

The amount of gross interest income that would have been recorded for nonaccrual loans in the first quarter of 2014 if loans had been current in accordance with their original terms was $173,000 and $201,000 in the first quarter of 2013.

Loans detailed on the credit quality table and the non-performing loan table are the indicators of potential problem loans and there are no other known problems beyond what is disclosed in these tables.

47

NON-INTEREST INCOME

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

	Three Months ended March 31,
Non-interest income:	2014			2013
Service charges and fees	$	2,434		$	2,131
Net securities gains		-			274
Mortgage banking income		165			539
Trust fee income		941			852
Bankcard transaction revenue		999			957
Company owned life insurance earnings		290			269
Gain/(loss) on other real estate owned		(81	)		(4	)
Other		834			844
Total non-interest income	$	5,582		$	5,862

As illustrated in Table 6, total non-interest income decreased $280,000 (5%) for the first three months of 2014, from $5,862,000 at March 31, 2013 to $5,582,000 at March 31, 2014. Contributing to the decrease in non-interest income was a $374,000 (69%) decrease in mortgage banking income and a $274,000 (100%) decrease in net securities gains, which were partially offset by a $303,000 (14%) increase in service charges and fees. The decrease in mortgage banking income was the result of lower refinancing volume due to slightly higher long term rates compared with 2013. In the first quarter of 2013, the Bank also took advantage of the 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 economic recession.

48

NON-INTEREST EXPENSE

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

	Three Months ended March 31,
Non-interest expense:	2014		2013
Salaries and benefits	$	5,873	$	5,913
Occupancy and equipment		1,435		1,306
Data processing		535		550
Advertising		374		343
Electronic banking		386		430
Outside servicing fees		244		266
State bank taxes		642		575
Other real estate owned and loan collection		342		334
Amortization of intangible assets		133		159
FDIC insurance		554		295
Other		1,600		1,598
Total non-interest expense	$	12,118	$	11,769

As illustrated in Table 7 above, non-interest expense increased to $12,118,000 in the first three months of 2014 from $11,769,000 in the same period of 2013, an increase of $349,000 (3%). The largest increase in non-interest expense was FDIC insurance expense (up $259,000 or 88% from March 31, 2013. The increase in FDIC insurance was the result of an insurance rate increase for the Bank.

INCOME TAX EXPENSE

During the first quarter of 2014, income tax expense increased $229,000 (14%) from $1,586,000 in the first quarter of 2013 to $1,815,000 in the same period of 2014 as a result of higher earnings. For the first quarter of 2014, the effective tax rate increased to 28.21% compared to 27.94% for the same period of 2013.

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 increased $10,481,000, from $78,621,000 at December 31, 2013 to $89,102,000 at March 31, 2014.

49

The Company’s total shareholders’ equity increased $5,492,000 from $181,139,000 at December 31, 2013 to $186,631,000 at March 31, 2014. In the first three months of 2014, the Company paid a cash dividend of $.18 per share totaling $1,379,000 to common shareholders. The change in the shareholders’ equity in 2014 included a $1,412,000 increase in accumulated other comprehensive income, which was the result of the increase in the market value of the available-for-sale securities. The market value of these securities increased as a result of the decrease in long term interest rates since December 31, 2013. The after tax market value of these securities changed from an unrealized loss at December 31, 2013 of $1,777,000 to an unrealized loss of $365,000 at March 31, 2014.

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 other notes payable and 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, 2014, the Bank had capital in excess of the FDIC’s most restrictive minimum capital requirements in an amount over $52,389,000 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, 2014, the Bank's leverage and total risk-based capital ratios were 9.82% and 13.38%, respectively, which exceed the well-capitalized thresholds.

As described in more detail in our Annual Report on Form 10-K for the year ended December 31, 2013, in July 2013, U.S. federal banking authorities approved final capital rules that revise risk-based and leverage capital requirements that will apply to BKFC and the Bank once fully implemented.

Based on our current capital composition and levels, we believe that we would be in compliance with the requirements as set forth in the Final Capital Rules if they were presently in effect.

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, 2013. 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, 2013.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

There has been no material change in market risk since December 31, 2013. For information regarding the Company’s market risk, refer to the Company’s Form 10-K for the year ending December 31, 2013. Market risk is discussed further under the heading “Net Interest Income” above.

50

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, 2014, 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.

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, 2013.

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

Not applicable

51

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

52

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, 2014		/s/ Robert W. Zapp
			Robert W. Zapp
			President and Chief Executive Officer
			(principal executive officer)
Date:	May 7, 2014		/s/ Martin J.Gerrety
			Martin J. Gerrety
			Treasurer and Assistant Secretary
			(principal financial officer)