Bank of Kentucky Financial (BKYF) 10-Q 2010 Q2 Quarterly report

U.S. 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 June 30, 2010

¨ 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 incorporation or organization)	(I.R.S. Employer 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.    Yes  x    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).    Yes  ¨    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See 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 filer	x
Non-accelerated filer	¨  (do not check if a smaller reporting company)	Smaller reporting company	¨

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

As of July 19, 2010, 5,666,707 shares of the registrant’s Common Stock, no par value, were issued and outstanding.

TheBank 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	17
Item 3 – Quantitative and Qualitative Disclosures About Market Risk	33
Item 4 – Controls and Procedures	33
PART II                   OTHER INFORMATION
Item 1 – Legal Proceedings	34
Item 1A – Risk Factors	34
Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds	34
Item 3 – Defaults Upon Senior Securities	34
Item 4 – Submission of Matters to a Vote of Security Holders	34
Item 5 – Other Information	35
Item 6 – Exhibits	35

2

THE BANK OF KENTUCKY FINANCIAL CORPORATION

PART I FINANCIAL INFORMATION

Item 1. Financial Statements

THE BANK OF KENTUCKY FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in thousands - unaudited)

	June 30 2010		December  31 2009
Assets
Cash and cash equivalents	$	69,094	$	98,738
Interest bearing deposits with banks		100		100
Available-for-sale securities		204,514		183,845
Held-to-maturity securities		29,203		30,722
Loans held for sale		6,795		6,798
Total loans		1,122,964		1,154,984
Less: Allowances for loan losses		16,531		15,153
Net loans		1,106,433		1,139,831
Premises and equipment, net		23,690		23,588
FHLB stock, at cost		4,959		4,959
Goodwill		21,889		21,889
Acquisition intangibles, net		4,289		5,047
Cash surrender value of life insurance		24,707		24,240
Accrued interest receivable and other assets		23,947		25,241
Total assets	$	1,519,620	$	1,564,998
Liabilities & Shareholders’ Equity
Liabilities
Deposits	$	1,301,179	$	1,343,272
Short-term borrowings		18,097		21,669
Notes payable		44,770		44,781
Accrued interest payable and other liabilities		10,664		14,143
Total liabilities		1,374,710		1,423,865
Shareholders’ Equity
Preferred stock, no par value, $34,000 liquidation value, authorized and issued 34,000 shares		33,400		33,226
Common stock, no par value, 15,000,000 shares authorized, 5,666,707 (2010) and 5,666,707 (2009) shares issued and outstanding		3,098		3,098
Additional paid-in capital		5,579		5,423
Retained earnings		100,292		98,432
Accumulated other comprehensive income		2,541		954
Total shareholders’ equity		144,910		141,133
Total liabilities and shareholders’ equity	$	1,519,620	$	1,564,998

See accompanying notes.

3

THE BANK OF KENTUCKY FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2010 AND 2009

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

	Three Months Ended June 30						Six Months Ended June 30
	2010			2009			2010			2009
INTEREST INCOME
Loans, including related fees	$	15,309		$	14,313		$	30,574		$	28,184
Securities and other		1,504			1,215			3,012			2,457
Total interest income		16,813			15,528			33,586			30,641
INTEREST EXPENSE
Deposits		3,061			4,149			6,606			8,567
Borrowings		298			401			592			860
Total interest expense		3,359			4,550			7,198			9,427
Net interest income		13,454			10,978			26,388			21,214
Provision for loan losses		4,500			2,800			9,000			4,325
Net interest income after provision for loan losses		8,954			8,178			17,388			16,889
NON-INTEREST INCOME
Service charges and fees		2,622			2,289			4,889			4,304
Mortgage banking income		337			478			659			1,004
Net securities gains		—			—			—			263
Trust fee income		602			271			1,152			501
Other		1,379			1,184			2,845			2,252
Total non-interest income		4,940			4,222			9,545			8,324
NON-INTEREST EXPENSE
Salaries and benefits		4,764			4,048			9,329			8,047
Occupancy and equipment		1,187			1,169			2,637			2,406
Data processing		443			385			904			779
Advertising		314			271			562			468
Other		3,608			3,712			7,497			6,733
Total non-interest expense		10,316			9,585			20,929			18,433
INCOME BEFORE INCOME TAXES		3,578			2,815			6,004			6,780
Less: income taxes		968			744			1,534			1,893
NET INCOME	$	2,610		$	2,071		$	4,470		$	4,887
Preferred stock dividend and discount accretion		(514	)		(519	)		(1,024	)		(777	)
Net Income available to common shareholders	$	2,096		$	1,552		$	3,446		$	4,110
Comprehensive Income	$	3,993		$	1,993		$	6,057		$	4,813
Net income per common share:
Earnings per share, basic	$	.37		$	.28		$	.61		$	.73
Earnings per share, diluted	$	.37		$	.27		$	.61		$	.73

See accompanying notes

4

THE BANK OF KENTUCKY FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

FOR THE SIX MONTHS ENDED JUNE 30

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

	2010			2009
Balance January 1	$	141,133		$	101,448
Comprehensive Income:
Net Income		4,470			4,887
Change in net unrealized gain(loss), net of tax		1,587			(74	)
Total Comprehensive Income		6,057			4,813
Cash dividends paid		(1,587	)		(1,572	)
Exercise of stock options (0 and 6,000 shares), including tax benefit		—			115
Stock-based compensation expense		157			282
Preferred stock issued		—			32,931
Common stock warrant issued		—			1,015
Accrued dividends on preferred stock		(850	)		(650	)
Balance June 30	$	144,910		$	138,382
Dividends per share	$	0.28		$	0.28

See accompanying notes

5

THE BANK OF KENTUCKY FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE SIX MONTHS ENDED JUNE 30

(Dollars in thousands - unaudited)

	2010			2009
Cash Flows from Operating Activities
Net income	$	4,470		$	4,887
Adjustments to reconcile net income to net cash
From operating activities		8,170			(3,276	)
Net cash from operating activities		12,640			1,611
Cash flows from Investing Activities
Proceeds from paydowns and maturities of held-to-maturity securities		2,800			1,575
Proceeds from paydowns and maturities of available-for-sale securities		98,559			38,596
Purchases of held-to-maturity securities		(1,286	)		(3,648	)
Purchases of available-for-sale securities		(117,934	)		(94,758	)
Purchases of company owned life insurance		—			(2,000	)
Net change in loans		23,244			(28,916	)
Proceeds from the sale of other real estate		1,693			631
Proceeds from sale of securities		—			13,852
Property and equipment expenditures		(1,017	)		(763	)
Net cash from investing activities		6,059			(75,431	)
Cash Flows from Financing Activities
Net change in deposits		(42,323	)		48,182
Net change in short-term borrowings		(3,572	)		(7,586	)
Proceeds from exercise of stock options		—			115
Cash dividends paid		(2,437	)		(2,006	)
Proceeds from issuance of preferred stock and warrants		—			33,946
Payments on note payable		(11	)		(9	)
Net cash from financing activities		(48,343	)		72,642
Net change in cash and cash equivalents		(29,644	)		(1,178	)
Cash and cash equivalents at beginning of period		98,738			38,656
Cash and cash equivalents at end of period	$	69,094		$	37,478

See accompanying notes

6

THE BANK OF KENTUCKY FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2010

(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 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, 2009.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States 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 outstanding during the three and six month periods. Diluted earnings per share are computed assuming that average stock options outstanding are exercised and the proceeds, including the relevant tax benefit, are used entirely to reacquire shares at the average price for the period. For the three months ended June 2010 and 2009, 837,204 and 518,629 options were not considered, as they were not dilutive, and for the six months ended June 2010 and 2009, 846,830 and 604,600 options were not considered, as they were not dilutive. For the three months ended June 2010 and 2009, 274,784 and 0 warrants were not considered, as they were not dilutive, and for the six months ended June 2010 and 2009, 274,784 and 0 warrants 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:

	Three Months Ended June 30		Six Months Ended June 30
	2010	2009	2010	2009
Weighted average shares outstanding	5,666,707	5,612,607	5,666,707	5,612,107
Dilutive effects of assumed exercises of stock options and warrants	—	46,211	—	15,958
Shares used to compute diluted
Earnings per share	5,666,707	5,658,818	5,666,707	5,628,065

7

Note 4 – Stock Compensation:

Options to buy stock are granted to directors, officers and employees under the Company’s stock option and incentive plan (the “Plan”) which provides for the issuance of up to 1,200,000 shares. 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 $79,000 ($79,000 net of taxes) and $157,000 ($157,000 net of taxes) in the three and six months ended June 30, 2010, and $139,000 ($129,000 net of taxes) and $282,000 ($260,000 net of taxes) in the three and six months ended June 30, 2009.

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, and interest-bearing balances with banks and short-term borrowings with maturities of 90 days or less.

Note 6 – Reclassification:

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

Note 7 – New Accounting Pronouncements:

In June 2009, the FASB issued Statement of Financial Accounting Standards No. 166, Accounting for Transfers of Financial Assets, an Amendment of FASB Statement No. 140 (ASC 810). The new accounting requirement amends previous guidance relating to the transfers of financial assets and eliminates the concept of a qualifying special purpose entity. This new accounting requirement must be applied as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period and for interim and annual reporting periods thereafter. This Statement must be applied to transfers occurring on or after the effective date. Additionally, on and after the effective date, the concept of a qualifying special-purpose entity is no longer relevant for accounting purposes. Therefore, formerly qualifying special-purpose entities should be evaluated for consolidation by reporting entities on and after the effective date in accordance with the applicable consolidation guidance. Additionally, the disclosure provisions of this Statement were also amended and apply to transfers that occurred both before and after the effective date of this Statement. The effect of adopting this new guidance did not have a material affect on the Company’s results of operations or financial position.

8

Note 8 – Securities:

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

Available-for-Sale	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Gains			Fair Value
June 30, 2010
U.S. Government, federal agencies and Government sponsored enterprises	$	106,215	$	681	$	—		$	106,896
U.S. Government agency mortgage-backed		93,264		3,169		—			96,433
Corporate		1,185		—		—			1,185
	$	200,664	$	3,850	$	—		$	204,514
		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Gains			Fair Value
December 31, 2009
U.S. Government, federal agencies and Government sponsored enterprises	$	99,400	$	239	$	(77	)	$	99,562
U.S. Government mortgage-backed		81,815		1,485		(202	)		83,098
Corporate		1,185		—		—			1,185
	$	182,400	$	1,724	$	(279	)	$	183,845

All mortgage-backed securities are secured by residential properties.

9

Note 8 – Securities (Continued)

The amortized cost, unrecognized gains and losses, and fair value of securities held to maturity were as follows:

Held-to-Maturity	Amortized Cost		Gross Unrecognized Gains		Gross Unrecognized Losses			Fair Value
2010
Municipal and other obligations	$	29,203	$	641	$	(12	)	$	29,832
2009
Municipal and other obligations	$	30,722	$	556	$	(3	)	$	31,275

The amortized cost and fair value of debt securities at June 30, 2010 by contractual maturity were as follows. Securities not due at a single maturity date, primarily mortgage backed securities, are shown separately.

	Available-for-Sale				Held-to-Maturity
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
Due in one year or less	$	854	$	879	$	1,864	$	1,882
Due after one year through five years		105,361		106,017		11,552		11,914
Due after five years through ten years		—		—		9,207		9,456
Due after ten years		1,185		1,185		6,580		6,580
U.S. Government agency mortgage-backed		93,264		96,433		—		—
	$	200,664	$	204,514	$	29,203	$	29,832

At June 30, 2010 and December 31, 2009, securities with a carrying value of $221,733 and $200,882 were pledged to secure public deposits and repurchase agreements.

Securities with unrealized losses at June 30, 2010 and December 31, 2009, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows:

	Less than 12 Months					12 Months or More					Total
Description of Securities	Fair Value		Unrealized Loss			Fair Value		Unrealized Loss			Fair Value		Unrealized Loss
June 30, 2010
U.S. Gov’t, federal agencies and government sponsored enterprises	$	—	$	—		$	—	$	—		$	—	$	—
U.S. Gov’t mortgage-backed		—		—			—		—			—		—
Municipal & other obligations		1,274		(12	)		—		—			1,274		(12	)
Total temporarily impaired	$	1,274	$	(12	)	$	—	$	—		$	1,274	$	(12	)
December 31, 2009
U.S. Gov’t., federal agencies and government sponsored enterprises	$	20,920	$	(77	)	$	—	$	—		$	20,920	$	(77	)
U.S Gov’t. mortgage-backed		52,662		(202	)		—		—			52,662		(202	)
Municipal & other obligations		—		—			852		(3	)		852		(3	)
Total temporarily impaired	$	73,582	$	(279	)	$	852	$	(3	)	$	74,434	$	(282	)

10

There were no sales of available for sale securities in 2010. Gains from sales of securities available for sale were $263,000 for the first six months of 2009, with no losses.

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 under the SFAS No. 115 model, 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 is recognized earnings. The amount of the total OTTI related to other factors shall be recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings shall become the new amortized cost basis of the investment.

As of June 30, 2010, The Bank’s security portfolio consisted of 127 securities, four of which were in an unrealized loss position: this loss position was $12. There was no OTTI of securities at June 30, 2010. 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 the Bank will not be required to sell the securities before their anticipated recovery.

11

Note 9 – Fair Value:

ASC 820-10 establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

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

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

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

The fair values of securities available for sale are determined by 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.

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.

12

Assets and Liabilities Measured on a Recurring Basis

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

			Fair Value Measurements at June 30, 2010 Using:
	Total June  30 2010		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets
Investment securities available-for-sale
U.S. government-sponsored entities and agencies	$	106,896	$	—	$	106,896	$	—
U.S. government agency mortgage backed		96,433		—		96,433		—
Corporate		1,185		—		—		1,185
Derivatives		861		—		861		—
Total	$	205,375	$	—	$	204,190	$	1,185
Liabilities
Derivatives	$	861	$	—	$	861	$	—
Total	$	861	$	—	$	861	$	—
			Fair Value Measurements at December 31, 2009 Using:
	Total December 31 2009		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets
Investment securities available-for-sale
U.S. government-sponsored entities and agencies	$	99,562	$	—	$	99,562	$	—
U.S. government agency mortgage backed		83,098		—		83,098		—
Corporate		1,185		—		—		1,185
Derivatives		675		—		675		—
Total	$	184,520	$	—	$	183,335	$	1,185
Liabilities
Derivatives	$	675	$	—	$	675	$	—
Total	$	675	$	—	$	675	$	—

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 June 30, 2010.

13

There were no changes in unrealized gains and losses recorded in earnings for the quarter ended June 30, 2010 for Level 3 assets and liabilities that are still held at June 30, 2010.

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 June 30, 2010 Using:
	Total June 30 2010	Quoted Prices in Active Markets for Identical Assets (Level 1)	Significant Other Observable Inputs (Level 2)	Significant Unobservable Inputs (Level 3)
Assets
Impaired loans	19,337	—	12,083	7,254
		Fair Value Measurements at December 31, 2009 Using:
	Total December 31 2009	Quoted Prices in Active Markets for Identical Assets (Level 1)	Significant Other Observable Inputs (Level 2)	Significant Unobservable Inputs (Level 3)
Assets
Impaired loans	26,222		11,730	14,496

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount of $23,806, with a valuation allowance of $4,469 resulting in a reduction in provision for loan losses of $1,447 at June 30, 2010 and a carrying amount of $32,142, with a valuation allowance of $5,916, resulting in an additional provision for loan losses of $1,931 at December 31, 2009.

Values for collateral dependent loans 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. Values using the market comparison approach evaluates the sales price of similar properties in the same market area. The income approach considers net operating income generated by the property and an investor’s required return. The final fair value is based on a reconciliation of these three approaches. The loans classified as Level 2 had current appraisals, while loans classified as Level 3 had older appraisal and required the use of other unobservable inputs.

14

The carrying amounts and estimated fair values of financial instruments, at June 30, 2010 and December 31, 2009 are as follows (in thousands):

	June 30, 2010						December 31, 2009
	Carrying Value			Fair Value			Carrying Value			Fair Value
Financial assets
Cash and cash equivalents	$	69,094		$	69,094		$	98,738		$	98,738
Interest-bearing deposits with banks		100			100			100			100
Available-for-sale securities		204,514			204,514			183,845			183,845
Held-to-maturity securities		29,203			29,832			30,722			31,275
Loans held for sale		6,795			6,795			6,798			6,798
Loans (net)		1,106,433			1,086,193			1,139,831			1,132,167
Federal Home Loan Bank stock		4,959			N/A			4,959			N/A
Accrued interest receivable		4,684			4,684			4,504			4,504
Derivative assets		861			861			675			675
Financial liabilities
Deposits	$	(1,301,179	)	$	(1,304,854	)	$	(1,343,272	)	$	(1,344,179	)
Short-term borrowings		(18,097	)		(18,097	)		(21,669	)		(21,669	)
Notes payable		(44,770	)		(39,324	)		(44,781	)		(37,294	)
Accrued interest payable		(3,417	)		(3,417	)		(3,856	)		(3,856	)
Standby letters of credit		(260	)		(260	)		(303	)		(303	)
Derivative liabilities		(861	)		(861	)		(675	)		(675	)

The estimated fair value approximates carrying amount for all items except those described below. Estimated fair value for both securities available for sale and held to maturity is as previously described for securities available for sale. It is not practicable to determine the fair value of Federal Home Loan Bank (“FHLB”) stock due to restrictions placed on its transferability. Estimated fair value of loans held for sale is based on market quotes for similar loans. Estimated fair value for loans is based on the interest rates charged at period-end for new loans with similar maturities, applied until the loan is assumed to reprice or be paid. Estimated fair value for time deposits is based on the interest rates paid at period end, for new deposits, applied until maturity. Estimated fair value of debt is based on current interest rates for similar financing. Estimated fair value of standby letters of credit are based on their related current unearned fee balances. Estimated fair value for commitments to make loans and unused lines of credit are considered nominal. Estimated fair value for derivatives is determined as previously described.

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Note 10 - Preferred Stock:

On February 13, 2009, BKFC entered into an agreement to sell preferred, non-voting shares having a liquidation value of $34 million to the U.S. Treasury Department as part of the Capital Purchase Program (“CPP”) for healthy financial institutions announced in late October 2008. The preferred shares qualify as Tier 1 capital. The preferred shares have a dividend rate of 5% per year for the first five years and 9% per year thereafter. The preferred shares have priority in the payment of dividends over any cash dividends paid to common stockholders. No cash dividends can be paid to common stockholders unless all dividends on the preferred shares have been declared and paid in full (or an amount sufficient for the payment of the dividends on the preferred shares has been set aside for the payment of such dividends). The American Recovery and Reinvestment Act of 2009 (the “ARRA”) permits BKFC to redeem the preferred stock without penalty and without the need to raise new capital, subject to the Treasury’s consultation with BKFC’s regulatory agency.

As part of the agreement described above, BKFC issued a warrant to purchase 274,784 shares of the Company’s common stock at an initial exercise price of $18.56 per share. The warrant provides for the adjustment of the exercise price and number of shares pursuant to customary anti-dilution provisions, such as stock splits.

The net proceeds were allocated between the preferred shares and warrant based on relative fair value. The preferred shares will be accreted to liquidation value over the expected life of the shares, with accretion charged to retained earnings.

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

This Form 10-Q contains forward-looking statements. Statements that are not historical or current facts, including statements about beliefs and expectations, are forward-looking statements. These forward-looking statements cover, among other things, anticipated future revenue and expenses and the future prospects of either The Bank of Kentucky Financial Corporation (“BKFC” or the “Company”) or The Bank of Kentucky, Inc (the “Bank”) or both.

Forward-looking statements involve inherent risks and uncertainties, and important factors could cause actual results to differ materially from those anticipated, including, in addition to those described in Item 1A of BKFC’s annual report on Form 10-K or other BKFC reports on file with the Commission, the following: (i) 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; (ii) changes in the domestic interest rate environment could reduce net interest income and could increase credit losses; (iii) the conditions of the securities markets could change, adversely affecting revenues from capital markets businesses, the value or credit quality of the Company’s assets, or the availability and terms of funding necessary to meet the Company’s liquidity needs; (iv) the impact of recent turmoil in the financial markets and the effectiveness of governmental actions taken in response, such as the U.S. Treasury’s Troubled Asset Relief Program, and the effect of such governmental actions on BKFC, its competitors and counterparties, financial markets generally and availability of credit specifically, including potentially higher Federal Deposit Insurance Corporation (“FDIC”) premiums arising from increased payments from FDIC insurance funds as a result of depository institution failures; (v) changes in the extensive laws, regulations and policies governing financial services companies could alter BKFC’s and the Bank’s business environment or affect operations; (vi) 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; (vii) 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 (viii) acquisitions may not produce revenue enhancements or cost savings at levels or within timeframes originally anticipated, or may result in unforeseen integration difficulties. Forward-looking statements speak only as of the date they are made, and BFKC undertakes no obligation to update them in light of new information or future events.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

BKFC has prepared all of the consolidated financial information in this report in accordance with 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.

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

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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. Impaired loans are those that management has determined are probable that the customer will be unable to comply with the contractual terms of the loan. The specific reserve component is an estimate of loss based upon an impairment review of larger loans that are considered impaired. The general reserve includes an estimate of commercial and consumer loans with similar characteristics. Depending on the set of facts with respect to a particular loan, the Bank utilizes one of the following methods for determining the proper impairment of a loan:

• The present value of expected future cash flows of a loan;

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

• Fair value of collateral.

The allowance established for impaired loans is generally based, for all collateral-dependent loans, on the fair market value of the collateral, less 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 included in the ASC 310 component carry no specific reserve allocation. These loans were reviewed for impairment and considered adequately collateralized with respect to their respective outstanding principal loan balance. The majority of these loans are loans which have had their respective impairment (or 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.

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 typical, but in those cases when an adjustment is necessary it is documented with supporting information and is typically an adjustment to decrease the property’s value because of additional information obtained concerning the property after the appraisal or update has been received by the Bank. The Bank’s practice is to obtain new or updated appraisals on the loans subject to impairment review. 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. Loans secured by a 1 to 4 family residential property with small to moderate value, are generally valued utilizing a broker’s opinion of value (“BPO”). 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.

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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 troubled debt restructured (“TDR”) loan. However, if the above conditions can not be reasonably met, the loan remains on non-accrual status.

In addition, the Bank evaluates the collectability of both principal and interest when assessing the need for loans being 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 (120 days past due for consumer loans); or (ii) for which payment in full of both principal and interest can not be reasonably expected.

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

A high and low range of reserve percentages is calculated to recognize the imprecision in estimating and measuring loss when evaluating reserves for pools of loans. The position of the allowance for loan losses within the computed range may be adjusted for significant factors that, in management’s judgment, reflect the impact of any current conditions of credit quality. Factors that management considers in this analysis include the effects of the local economy, trends in the nature and volume of loans (delinquencies, charge-offs and nonaccrual loans), changes in mix of loans, asset quality trends, risk management and loan administration, changes in the internal lending policies and credit standards, and examination results from bank regulatory agencies and internal review by the credit department.

Reserves on individual loans and historical loss rates are reviewed quarterly and adjusted as necessary based on changing borrower and/or collateral conditions and 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

The results of the second quarter and first six months of 2010 reflect strong revenue growth, which offset the continuing effects of the deep economic downturn that the country and region has experienced for over the last two and a half years. The 37% increase in diluted earnings per share for the second quarter of 2010 as compared to the same period in 2009 was the result of a 21% growth in revenue, which more than offset the continued high level of provisioning for loan losses driven by these economic conditions. For the first six months of 2010, diluted earnings per share decreased 16%, with a 22% increase in revenue partially offsetting the increase in the provision for loan losses. The second quarter of 2010 saw a significant increases in net interest income (23%) and non-interest income (17%) as compared to the second quarter of 2009. The increase in net interest income was the result of both the growth in earning assets and a stronger net interest margin. The increase in non-interest income was aided by strong growth in service charges on deposits, trust fee income and bankcard transaction revenue. The second quarter of 2010 saw a significant increase in charge-offs and non-performing loans as compared to the second quarter of 2009, which contributed to the $1,700,000, or 61%, increase in the provision for loan losses expense from the second quarter of 2009 to the second quarter of 2010. Although there were significant decreases in the credit quality metrics from the second quarter of 2009, on a sequential basis some of the credit metrics showed improvement. On a sequential basis, the provision for loan losses of $4,500,000 in the second quarter of 2010 equaled the provision in the first quarter of 2010, and the net charge-offs on a sequential basis decreased, while the levels of non-performing loans increased slightly from the first quarter of 2010 levels.

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Also, the comparison of the earnings from the second quarter of 2009 to the second quarter of 2010 was impacted by the FDIC special assessment charged in the second quarter of 2009. As a result of this FDIC insurance expense decreased $440,000, or 43%, in the second quarter of 2010 as compared to the second quarter of 2009.

Two acquisitions that were completed in the fourth quarter of 2009 had a significant impact on the Company’s balance sheet and income statement as compared to the second quarter of 2009. In the fourth quarter of 2009, the Bank completed the purchase of three banking offices of Integra Bank Corporation’s wholly-owned bank subsidiary, Integra Bank N.A., located in Crittenden, Dry Ridge and Warsaw, Kentucky and a portfolio of selected commercial loans originated by Integra Bank’s Covington, Kentucky loan production office. This transaction added $76 million in deposits and $107 million in loans. The Bank also announced in the fourth quarter that investment professionals from Tapke Asset Management, LLC (“TAM”) joined the Bank.

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

FINANCIAL CONDITION

Total assets at June 30, 2010 were $1,519,620,000 as compared to $1,564,998,000 at December 31, 2009, a decrease of $45,378,000 (3%). Loans outstanding decreased $32,020,000 (3%) from $1,154,984,000 at December 31, 2009 to $1,122,964,000 at June 30, 2010. The decrease in cash and cash equivalents of $29,644,000 (30%) was partially offset with in increase in available-for-sale securities of $20,669,000 (11%).

As Table 1 illustrates, contributing to the decrease in the loan portfolio in the second quarter of 2010 was the decrease in construction and land development loans of $43,471,000 (29%) and was partially offset with an increase in commercial real estate loans of $11,501,000 (2%). The decrease in the construction and land development loans and the corresponding increase in commercial real estate loans was the result of a number of loans completing the construction phase of their project, and were moved into permanent financing. Contributing to the overall decrease in loans was the fact that the Bank continues to experience decreased levels of new and renewed residential real estate, commercial and consumer loans originated as a result of the current economic conditions. While management expects continued decreases in new and renewed loan origination, the Bank intends to continue to work to make loans that meet its longstanding prudent lending standards.

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Deposits decreased $42,093,000 (3%) to $1,301,179,000 at June 30, 2010, compared to $1,343,272,000 at December 31, 2009. The largest decrease in deposits came from interest bearing transaction accounts which decreased $46,316,000, or 13%, from December 31, 2009 and was partially offset with a increase in saving deposits, which increased $15,129,000, or 25%, from December 31, 2009. The decrease in interest bearing transaction accounts was the result of the seasonal decrease in public fund deposits, which decreased approximately $57,000,000, or 19%, from the end of 2009. Public funds are deposits of local municipalities, schools and other public entities, and tend to be cyclical in nature with higher balances in the fourth quarter of the year as a result of property tax receipts. These public fund balances are collateralized with BKFC’s security portfolio and letter of credit guarantees from the FHLB.

Other changes in the balance sheet included a $3,249,000 (23%) decrease in other liabilities, which included an approximately $3,400,000 final escrow payment on the Integra acquisition.

Table 1 - Composition of the Bank’s Loans and Deposits at the Dates Indicated

	June 30, 2010				December 31, 2009
	Amount		%		Amount		%
	(Dollars in thousands)
Type of Loan:
Nonresidential real estate loans	$	487,590	43.4	%	$	476,089	41.2	%
Residential real estate loans		260,854	23.2			267,857	23.2
Commercial loans		234,729	20.9			223,404	19.3
Consumer loans		16,797	1.5			20,750	1.8
Construction and land development loans		104,817	9.3			148,288	12.8
Municipal obligations		19,615	1.7			20,232	1.7
Total loans	$	1,124,402	100.0	%	$	1,156,620	100.0	%
Less:
Deferred loan fees		1,438				1,636
Allowance for loan losses		16,531				15,153
Net loans	$	1,106,433			$	1,139,831
Type of Deposit:
Non interest bearing deposits		203,385	15.6	%	$	200,069	14.9	%
Interest bearing transaction deposits		320,988	24.8			367,304	27.3
Money market deposits		252,937	19.4			259,653	19.3
Savings deposits		76,189	5.8			61,060	4.6
Certificates of deposits		379,641	29.2			389,438	29.0
Individual Retirement accounts		68,039	5.2			65,748	4.9
Total Deposits	$	1,301,179	100.0	%	$	1,343,272	100.0	%

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RESULTS OF OPERATIONS

GENERAL

Net income available to common stockholders for the six months ended June 30, 2010 decreased from $4,110,000 ($.73 diluted earnings per share) in 2009 to $3,446,000 ($.61 diluted earnings per share) in 2010, a decrease of $664,000 (16%). Net income available to common shareholders for the quarter ended June 30, 2010 was $2,096,000 ($.37 diluted earnings per share) as compared to $1,552,000 ($.27 diluted earnings per share) during the same period of 2009, an increase of $544,000 (35%). The main reason for the increase in net income from the second quarter of 2009 to 2010 was a $3,194,000 (21%) increase in total revenue, which more than offset the $1,700,000 (61%) increase in the provision for loan losses and the $731,000 (8%) increase in noninterest expense. The increase in revenue included a $2,476,000 (23%) increase in net interest income and $718,000 (17%) increase in non-interest income. Contributing to the increase in noninterest expense was the full quarter effect of both the Integra branch acquisition and the TAM acquisition, which was partially offset by the $440,000 (43%) decrease in FDIC insurance expense. Contributing to the increase in the provision for loan losses was higher levels of net charge-offs and non-performing loans in the second quarter of 2010 versus the same period in 2009 and management’s continuing concerns over the stressed economic conditions.

NET INTEREST INCOME

Net interest income increased $2,476,000 (23%) in the second quarter of 2010 as compared to the same period in 2009, while the year to date total increased $5,174,000 (24%) from $21,214,000 in 2009 to $26,388,000 in 2010. As illustrated in Table 4, both the volume and rate variances had a positive impact on net interest income in the second quarter of 2010 as compared with the second quarter of 2009, with the majority of the growth in net interest income the result of growth in the balance sheet. Table 4 shows the net interest income on a fully tax equivalent basis was positively impacted by the volume additions to the balance sheet by $1,353,000 and by a positive rate variance by $1,125,000. Contributing to the favorable volume variance was the Integra acquisition that added approximately $107,000,000 in loans and $76,000,000 in deposits. As illustrated in Table 2, average earning assets increased $196,958,000 or 16% from the second quarter of 2009 to the second quarter of 2010, while average interest bearing liabilities only increased $178,040,000 or 17% in the same period. As further illustrated in Table 4, the favorable rate variance was driven by the decrease in interest expense attributable to rate of $1,666,000 which was offset by a $541,000 decrease in interest income as a result of rate. Driving the decrease in interest expense were time deposits, which contributed $1,122,000 or 67% of the decrease in interest expense as a result of rate. While BKFC benefited from falling rates in the second quarter of 2010 as compared to the same period in 2009, if rates continue to fall in 2010 the effect on BKFC will be negative, as shown and explained below.

As illustrated in Table 2, the net interest margin of 3.81% for the second quarter of 2010 was 20 basis points greater than the 3.61% net interest margin for the second quarter of 2009. The cost of interest bearing liabilities decreased 65 basis points from 1.76% for the second quarter of 2009 to 1.11% in the second quarter of 2010, while the yield on earning assets only decreased 33 basis points from 5.07% for the second quarter of 2009 to 4.74% in the second quarter of 2010. Table 3 shows that the net interest margin of 3.75% for the first six months of 2010 was 15 basis points higher than the first six months of 2009. On a linked quarter basis, the net interest margin increased 12 basis points from the 3.69% net interest margin in the first quarter of 2010. The increase in the net interest margin from the first quarter of 2010 was also the result of the cost of interest bearing liabilities decreasing faster than the yield on earning assets was decreasing.

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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 June 30, 2010 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	(2.92	)%
Increase 100 bp	(1.33	)
Decrease 100 bp	(3.57	)

Tables 2 and 3 set forth certain information relating to the Bank’s average balance sheet information and reflect the average yield on interest-earning assets, on a tax equivalent basis, and the average cost of interest-bearing liabilities for the periods indicated. Such yields and costs are derived by dividing income or expense by the average monthly balance of interest-earning assets or interest-bearing liabilities, respectively, for the periods presented. Average balances are daily averages for the Bank and include nonaccruing loans in the loan portfolio, net of the allowance for loan losses.

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Table 2 - Average Balance Sheet Rates for Three Months Ended June 30, 2010 and 2009 (presented on a tax equivalent basis in thousands)

	Three Months ended June 30, 2010							Three Months ended June 30, 2009
	Average outstanding balance			Interest earned/ paid		Yield/ rate		Average outstanding balance			Interest earned/ paid		Yield/ rate
Interest-earning assets:
Loans receivable (1)(2)	$	1,139,730		$	15,426	5.43	%	$	1,050,749		$	14,395	5.49	%
Securities (2)		243,572			1,536	2.53			159,767			1,305	3.28
Other interest-earning assets		60,416			97	0.64			36,244			72	.80
Total interest-earning assets		1,443,718			17,059	4.74			1,246,760			15,772	5.07
Non-interest-earning assets		124,119							97,340
Total assets	$	1,567,837						$	1,344,100
Interest-bearing liabilities:
Transaction accounts		695,866			646	0.37			556,248			902	0.65
Time deposits		450,254			2,415	2.15			410,782			3,247	3.17
Borrowings		66,333			298	1.80			67,383			401	2.39
Total interest-bearing liabilities		1,212,453			3,359	1.11			1,034,413			4,550	1.76
Non-interest-bearing liabilities		212,297							172,137
Total liabilities		1,424,750							1,206,550
Shareholders’ equity		143,087							137,550
Total liabilities and shareholders’ equity	$	1,567,837						$	1,344,100
Net interest income				$	13,700						$	11,222
Interest rate spread						3.63	%						3.31	%
Net interest margin (net interest income as a percent of average interest-earning assets)						3.81	%						3.61	%
Effect of net free funds (earning assets funded by non interest bearing liabilities)						0.18	%						0.30	%
Average interest-earning assets to interest-bearing liabilities		119.07	%						120.53	%

(1) Includes non-accrual loans.

(2) Income presented on a tax equivalent basis using a 34.23% and 34.70% tax rate in 2010 and 2009, respectively. The tax equivalent adjustment was $246,000 and $244,000 in 2010 and 2009, respectively.

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Table 3 - Average Balance Sheet Rates for Six Months Ended June 30, 2010 and 2009 (presented on a tax equivalent basis in thousands)

	Six Months ended June 30, 2010							Six Months ended June 30, 2009
	Average outstanding balance			Interest earned/ paid		Yield/ rate		Average outstanding balance			Interest earned/ paid		Yield/ rate
Interest-earning assets:
Loans receivable (1)(2)	$	1,146,378		$	30,803	5.42	%	$	1,039,136		$	28,342	5.50	%
Securities (2)		230,001			3,067	2.69			141,546			2,644	3.77
Other interest-earning assets		68,735			206	.60			35,509			140	.80
Total interest-earning assets		1,445,114			34,076	4.76			1,216,191			31,126	5.16
Non-interest-earning assets		124,880							97,036
Total assets	$	1,569,994						$	1,313,227
Interest-bearing liabilities:
Transaction accounts		699,182			1,596	0.46			548,382			1,912	.70
Time deposits		454,405			5,010	2.22			403,560			6,655	3.33
Borrowings		66,736			592	1.79			67,478			860	2.57
Total interest-bearing liabilities		1,220,323			7,198	1.19			1,019,420			9,427	1.86
Non-interest-bearing liabilities		207,529							165,490
Total liabilities		1,427,852							1,184,910
Shareholders’ equity		142,142							128,317
Total liabilities and shareholders’ equity	$	1,569,994						$	1,313,227
Net interest income				$	26,878						$	21,699
Interest rate spread						3.57	%						3.30	%
Net interest margin (net interest income as a percent of average interest-earning assets)						3.75	%						3.60	%
Effect of net free funds (earning assets funded by non interest bearing liabilities)						0.18	%						0.30	%
Average interest-earning assets to interest-bearing liabilities		118.42	%						119.30	%

(1) Includes non-accrual loans.

(2) Income presented on a tax equivalent basis using a 34.23% and 34.70% tax rate in 2010 and 2009, respectively. The tax equivalent adjustment was $490,000 and $485,000 in 2010 and 2009, respectively.

Table 4 below describes the extent to which changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities have affected the Bank’s interest income and expense during the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (change in volume multiplied by prior year rate), (ii) changes in rate (change in rate multiplied by prior year volume), and (iii) total changes in rate and volume. The combined effects of changes in both volume and rate, which cannot be separately identified, have been allocated proportionately to the change due to volume and the change due to rate.

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Table 4 - Volume/Rate Analysis (in thousands)

	Three months ended June 30, 2010 Compared to Three months ended June 30, 2009									Six months ended June 30, 2010 Compared to Six months ended June 30, 2009
	Increase (Decrease) Due to									Increase (Decrease) Due to
	Volume			Rate			Total			Volume			Rate			Total
Interest income attributable to:
Loans receivable	$	1,210		$	(179	)	$	1,031		$	2,910		$	(450	)	$	2,460
Securities		577			(346	)		231			1,339			(916	)		423
Other interest-earning assets(1)		41			(16	)		25			107			(41	)		66
Total interest-earning assets		1,828			(541	)		1,287			4,356			(1,407	)		2,949
Interest expense attributable to:
Transactions accounts		191			(447	)		(256	)		449			(765	)		(316	)
Time deposits		290			(1,122	)		(832	)		768			(2,413	)		(1,645	)
Borrowings		(6	)		(97	)		(103	)		(10	)		(259	)		(269	)
Total interest-bearing liabilities		475			(1,666	)		(1,191	)		1,207			(3,437	)		(2,230	)
Increase (decrease) in net interest income	$	1,353		$	1,125		$	2,478		$	3,149		$	2,030		$	5,179

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

PROVISION FOR LOAN LOSSES

Like many other financial institutions, the Bank has been significantly affected by the national economic recession. While the Bank has experienced an increase in defaults and foreclosures in this economic period, 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 last several years as other markets.

Management believes that with the continuing economic uncertainty, high unemployment rates and depressed real estate values, negative trends in credit metrics and the resulting pressure on earnings will remain above historical levels. This will include continuing higher levels of charge offs in the loan portfolio, and as a result, higher provisions for loan losses and a higher reserve for loan losses on the balance sheet. Higher provisions will lead to lower earnings and slower capital growth. Management also believes that the current economic conditions will lead to lower demand for loans within all loan types, specifically, real estate related requests.

As discussed above and in the management overview, the provision for loan losses reflected the current deep economic downturn facing the country and the region. The provision for loan losses was $4,500,000 for the second quarter of 2010, compared to $2,800,000 for the same period in 2009. The increase of $1,700,000 (61%) reflected an increase in the level of charge-offs and non-performing loans in 2010 and management’s continuing concerns of the effect that the current economic conditions will have on the Bank’s loan customers. For the for the second quarter of 2010, net charge-offs were $3,576,000 or 1.26% of average loan balances compared to 2009 figures of $1,737,000 or .68% of average loan balances. As illustrated in Table 5 below, total non-accrual loans plus loans past due 90 days or more were $22,397,000 (1.99% of loans outstanding) at June 30, 2010, compared to $14,048,000 (1.34% of loans outstanding) at June 30, 2009. Management’s evaluation of the inherent risk in the loan portfolio considers both historic losses and information regarding specific borrowers. Management continues to monitor the non-performing relationships and has established appropriate reserves.

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Although the credit metrics have deteriorated significantly from the second quarter of 2009, on a sequential basis there are some signs of improvement which has allowed provision expense to remain stable. On a sequential basis, the provision for loan losses of $4,500,000 in the second quarter of 2010 equaled the provision in the first quarter of 2010, and net charge-offs percentage decreased from 1.41% in the first quarter of 2010 to 1.26% in the second quarter of 2010, while the percentage of non-performing loans to total loans increased slightly from 1.91% at March 31, 2010 to 1.99% at June 30, 2010. Also classified loans decreased 5% from $141,849,000 on March 31, 2010 to $135,049,000 at June 30, 2010.

The aggregate amounts of the Bank’s classified assets at June 30, 2010 and December 31, 2009 were as follows:

	6/30/10		12/31/09
	(Dollars in thousands)
Special mention	$	32,573	$	52,177
Substandard		102,103		101,582
Doubtful		373		252
Total classified assets	$	135,049	$	154,011

Non-performing assets, which include non-performing loans, other real estate owned and repossessed assets, totaled $23,794,000 at June 30, 2010 versus $15,257,000 at June 30, 2009. This represents 1.57% of total assets at June 30, 2010 compared to 1.15% at June 30, 2009.

Accruing Troubled Debt Restructurings (TDRs). In certain circumstances, the Bank may modify the terms of a loan to maximize the collection of amounts due. In cases where the borrower is experiencing financial difficulties or is expected to experience difficulties in the near-term, concessionary modification is granted to minimize or eliminate the economic loss and to avoid foreclosure or repossession of the collateral. Modifications may include interest rate reductions, extension of the maturity date or a reduction in the principal balance. Restructured loans accrue interest as long as the borrower complies with the revised terms. Total accruing TDRs were $3,441,000 at June 30, 2010 versus $632,000 at June 30, 2009. The Bank expects increases in TDRs as the Bank works with relationships that show signs of stress, in order to proactively manage and resolve problem loans.

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Allowance for Loan Losses (“ALL”). The increase in the ALL was directionally consistent in 2010 with the change in the credit metrics and the current economic conditions since June 30, 2009. The ALL increased 40% from $11,816,000 at June 30, 2009 to $16,531,000 at June 30, 2010, which increased the allowance for loan losses as a percentage of total loans from 1.12% at June 30, 2009, to 1.47% at June 30, 2010. Removing the loans purchased from Integra, the ALL would be 1.62% of loans. The loans from Integra were purchased at a discount of .98%, and current accounting does not allow this discount to be added to the ALL. The amount of the allowance allocated to impaired loans at the end of the second quarter of 2010 was $4,469,000, which was down 11% from the $5,036,000 at June 30, 2009. The impairment process is described in the critical accounting policies section of this report. Contributing to both the increase in charge-offs in 2010 and the increase in the allowance for loan losses was the significant decrease in real estate values experienced in the current economic recession. Management believes the current level of the allowance for loan losses 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 second quarter of 2009 to 2010. The Bank does not originate or purchase sub-prime loans for its portfolio. Management will continue to monitor and evaluate the effects of the slumping housing market conditions and any signs of further deterioration in credit quality on the Bank’s loan portfolio. Management believes these economic strains will continue into 2010 and expects continuing higher than normal credit losses and provisioning expense in the foreseeable future.

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

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

Table 5 - Summary of Loan Loss Experience and Allowance for Loan Loss Analysis (in thousands)

	Three Months ended June 30,						Six Months ended June 30,
	2010			2009			2010			2009
Balance of allowance at beginning of period	$	15,607		$	10,753		$	15,153		$	9,910
Recoveries of loans previously charged off:
Commercial loans		39			20			47			29
Consumer loans		120			72			203			152
Mortgage loans		3			0			4			0
Total recoveries		162			92			254			181
Loans charged off:
Commercial loans		(3,116	)		(1,332	)		(6,116	)		(1,804	)
Consumer loans		(606	)		(312	)		(1,471	)		(560	)
Mortgage loans		(16	)		(185	)		(289	)		(236	)
Total charge-offs		(3,738	)		(1,829	)		(7,876	)		(2,600	)
Net charge-offs		(3,576	)		(1,737	)		(7622	)		(2,419	)
Provision for loan losses		4,500			2,800			9,000			4,325
Balance of allowance at end of period	$	16,531		$	11,816		$	16,531		$	11,816
Net charge-offs to average loans outstanding for period		1.26	%		0.68	%		1.33	%		0.47	%
Allowance at end of period to loans at end of period		1.47	%		1.12	%		1.47	%		1.12	%
Allowance to nonperforming loans at end of period		73.81	%		84.11	%		73.81	%		84.11	%

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Table 6 - Analysis of non-performing loans for the periods indicated (in thousands)

	June 30, 2010			December 31, 2009
Loans accounted for on a non-accrual basis:
Nonresidential real estate	$	9,804		$	8,588
Residential real estate		3,369			5,113
Construction		6,358			7,302
Commercial		2,639			2,712
Consumer and other		14			111
Total		22,184			23,826
Accruing loans which are contractually past due 90 days or more:
Nonresidential real estate	$	192		$	220
Residential real estate		—			758
Construction		—			682
Commercial		—			34
Consumer and other loans		21			42
Total		213			1,736
Total non-performing loans	$	22,397		$	25,562
Non-performing loans as a percentage of total loans		1.99	%		2.21	%
Accruing troubled debt restructured loans	$	3,441		$	3,568
Other real estate owned		1,397			1,381
Loans designated as impaired with allowance allocated		23,806			32,142
Impaired loans with no allowance allocated		6,014			3,922
Allowance allocated to impaired loans at year end		4,469			5,916

NON-INTEREST INCOME

Table 7 - Major Components of Non-Interest Income (in thousands)

	Three Months ended June 30,				Six Months ended June 30,
	2010		2009		2010		2009
Non-interest income:
Service charges and fees	$	2,622	$	2,289	$	4,889	$	4,304
Net securities gains		—		—		—		263
Mortgage banking income		337		478		659		1,004
Trust fee income		602		271		1,152		501
Bankcard transaction revenue		749		551		1,422		1,042
Company owned life insurance earnings		231		228		468		459
Gain/(loss) on other real estate owned		30		39		171		52
Other		369		366		784		699
Total non-interest income	$	4,940	$	4,222	$	9,545	$	8,324

As illustrated in Table 7 above, total non-interest income increased $1,221,000 (15%) for the first six months of 2010 from $8,324,000 at June 30, 2009 to $9,545,000 at June 30, 2010. For the second quarter of 2010 non-interest income increased $718,000 (17%) to $4,940,000 compared to $4,222,000 for the same period in 2009. Increases for the first six months ended June 30, 2010 included service charges and fees (up $585,000 14%), trust fee income (up $651,000 130%) and bankcard transaction revenue (up $380,000 36%) and was offset with lower mortgage banking income (down $345,000, 34%) and net securities gains (down $263,000, 100%). Contributing to the increase in service charges and bankcard transaction revenue was the addition of the Integra branches customer base. The increase in the trust fee income reflects the TAM acquisition. The decrease in mortgage banking income was a result of a lower volume of sold loans in the first six months ended June 30, 2010 as compared to the same period in 2009.

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NON-INTEREST EXPENSE

Table 8 - Major Components of Non-Interest Expense (in thousands)

	Three Months ended June  30,				Six Months ended June  30,
	2010		2009		2010		2009
Non-interest expense:
Salaries and benefits	$	4,764	$	4,048	$	9,329	$	8,047
Occupancy and equipment		1,187		1,169		2,637		2,406
Data processing		443		385		904		779
Advertising		314		271		562		468
Electronic banking		298		262		580		501
Outside servicing fees		456		416		926		753
State bank taxes		507		360		997		720
Other real estate owned and loan collection		257		176		627		357
Amortization of intangible assets		375		283		759		579
FDIC insurance		587		1,027		1,172		1,426
Other		1,128		1,188		2,436		2,397
Total non-interest expense	$	10,316	$	9,585	$	20,929	$	18,433

As illustrated in Table 8 above, non-interest expense increased to $20,929,000 in the first half of 2010 and to $10,316,000 for the second quarter of 2010 from $18,433,000 and $9,585,000 in the same periods of 2009, an increase of $2,496,000 (14%) and $731,000 (8%), respectively. The first six months of 2010 included the effect of both the Integra and TAM acquisitions. The largest increase in non-interest expense was in salaries and benefits expense, which increased $1,282,000 (16%) in the first six months of 2010 compared to the same period in 2009, contributing to this increase was the added staff from both the Integra and TAM acquisitions. The next largest increase in non-interest expense was other real estate owned and loan collection expense, which increased $270,000 (76%) in the first six months of 2010 compared to the same period in 2009, as a result of the higher charge offs and nonperforming assets in the first six months of 2010 as compared to the first six months of 2009. Contributing to the $254,000 (18%) decrease in FDIC insurance was special assessment charged to all FDIC insured institutions in 2009. The FDIC special assessments and higher assessment have been imposed to increase the Deposit Insurance Fund’s reserve ratio, which has been impacted by an increased number of bank failures.

INCOME TAX EXPENSE

During the first six months of 2010, income tax expense decreased $359,000 (19%) from $1,893,000 in the first six months of 2009 to $1,534,000 in the same period of 2010 as a result of lower earnings. For the second quarter of 2010, income tax expense increased $224,000 (30%) from $744,000 in the second quarter of 2009 to $968,000 in the same period of 2010 as a result of higher earnings. The effective tax rate decreased to 25.55% for the first six months of 2010 compared to 27.92% for the same period in 2009. For the first quarter of 2010 the effective tax rate increased to 27.05% compared to 26.43% for the same period of 2009. Contributing to the changes in the effective tax rates was the percentage of tax free income as compared to taxable income.

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LIQUIDITY AND CAPITAL RESOURCES

The Bank achieves liquidity by maintaining an appropriate balance between its sources and uses of funds to assure that sufficient funds are available to meet loan demands and deposit fluctuations. As indicated on the statement of cash flows, cash and cash equivalents have decreased $29,644,000, from $98,738,000 at December 31, 2009 to $69,094,000 at June 30, 2010.

The Company’s total shareholders’ equity increased $3,777,000 from $141,133,000 at December 31, 2009 to $144,910,000 at June 30, 2010. In the first six months of 2010, the Company paid a cash dividend of $.28 per share totaling $1,587,000 to common shareholders and $850,000 to preferred shareholders.

The Company’s liquidity depends primarily on the dividends paid to it as the sole shareholder of the Bank and the Company’s cash on hand. The Company needs liquidity to meet its financial obligations under certain subordinated debentures issued by the Company in connection with the issuance of trust preferred securities issued by the Company’s unconsolidated subsidiary, for the payment of dividends to preferred and 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 June 30, 2010, the Bank had capital in excess of the FDIC’s most restrictive minimum capital requirements in an amount over $33,923,000 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 June 30, 2010, the Bank’s leverage and total risk-based capital ratios were 8.47% and 12.57% respectively, which exceed the well-capitalized thresholds.

As of January 1, 2009, the Company did not have a repurchase program in place.

On February 13, 2009, the Company entered into a Letter Agreement (the “Purchase Agreement”) with the Treasury Department under the CPP, pursuant to which the Company agreed to issue 34,000 shares of Series A Preferred Stock for a total price of $34 million. The Series A Preferred Stock pays cumulative dividends at a rate of 5% per year for the first five years and thereafter at a rate of 9% per year. Pursuant to the American Recovery and Reinvestment Act of 2009 (the “ARRA”), the Company may redeem the Series A Preferred Stock at any time, subject to the approval of its primary federal regulator. As part of its purchase of the Series A Preferred Stock, the Treasury Department received a Warrant to purchase 274,784 shares of the Company’s common stock at an initial per share exercise price of $18.56. The Warrant provides for the adjustment of the exercise price and the number of shares of common stock issuable upon exercise pursuant to customary anti-dilution provisions, such as upon stock splits or distributions of securities or other assets to holders of the Company’s common stock, and upon certain issuances of the Company’s common stock at or below a specified price relative to the initial exercise price. The Warrant expires ten years from the issuance date. Pursuant to the Purchase Agreement, the Treasury Department has agreed not to exercise voting power with respect to any shares of common stock issued upon exercise of the Warrant. Under the ARRA, the Warrant would be liquidated upon the redemption by the Company of the Series A Preferred Stock.

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Both the Series A Preferred Stock and the Warrant are accounted for as components of Tier 1 capital.

Prior to February 13, 2012, unless the Company has redeemed the Series A Preferred Stock or the Treasury Department has transferred the Series A Preferred Stock to a third party, the consent of the Treasury Department will be required for the Company to (1) declare or pay any dividend or make any distribution on its common stock (other than regular semiannual cash dividends of not more than $0.28 per share of common stock) or (2) redeem, purchase or acquire any shares of its common stock or other equity or capital securities, other than in connection with benefit plans consistent with past practice and certain other circumstances specified in the Purchase Agreement.

CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS

There have been no other significant changes to the Bank’s contractual obligations or off-balance sheet arrangements since December 31, 2009. 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, 2009.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

There has been no material change in market risk since December 31, 2009. For information regarding the Company’s market risk, refer to the Company’s Form 10-K for the year ending December 31, 2009. Market risk is discussed further under the heading “Net Interest Income” above.

Item 4. Controls and Procedures

Disclosure Controls and Procedures

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

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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 June 30, 2010, and, based upon this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that these controls and procedures are 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 affect 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, 2010. In addition to the risk factors in the Company’s Form 10-K for the year ended December 31, 2010, the following supplemental risk factor related to the Dodd-Frank Wall Street Reform and Consumer Protection Act should be considered. The risks and uncertainties described below are not the only ones facing BKFC or the Bank. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair the business operations of BKFC or the Bank.

Compliance with the recently enacted Dodd-Frank Reform Act may adversely impact our earnings.

On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). The Dodd-Frank Act represents a significant overhaul of many aspects of the regulation of the financial-services industry, addressing, among other things, systemic risk, capital adequacy, deposit insurance assessments, consumer financial protection, interchange fees, derivatives, lending limits, and changes among the bank regulatory agencies. Many of these provision are subject to further study, rule making, and to the discretion of regulatory bodies, such as the Financial Stability Oversight Council.

The majority of the provisions in the Dodd-Frank Act are aimed at financial institutions that are significantly larger than the Company or the Bank. Nonetheless, there are provisions with which we will have to comply now that the Dodd-Frank Act is signed into law. As rules and regulations are promulgated by the federal agencies responsible for implementing and enforcing the provisions in the Dodd-Frank Act, we will have to work to apply resources to ensure that we are in compliance with all applicable provisions, which may adversely impact our earnings.

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

Not applicable

Item 3. Defaults Upon Senior Securities

Not applicable

Item 4. Submission of Matters to a Vote of Security Holders

None

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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

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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:	August 6, 2010	/s/ Robert W. Zapp
		Robert W. Zapp
		President and Chief Executive Officer (principal executive officer)
Date:	August 6, 2010	/s/ Martin J. Gerrety
		Martin J. Gerrety
		Treasurer and Assistant Secretary (principal financial officer)

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