Bank of Marin Bancorp - Quarter Report: 2014 June (Form 10-Q)

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 the quarterly period ended June 30, 2014

o 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 001-33572

Bank of Marin Bancorp

(Exact name of Registrant as specified in its charter)



California		20-8859754
(State or other jurisdiction of incorporation)		(IRS Employer Identification No.)

504 Redwood Blvd., Suite 100, Novato, CA		94947
(Address of principal executive office)		(Zip Code)

Registrant’s telephone number, including area code: (415) 763-4520

Indicate by check mark whether the registrant (1) has filed all reports to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate 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 x No o

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



Large accelerated filer o	Accelerated filer x	Non-accelerated filer o	Smaller reporting company o

Indicate by check mark if the registrant is a shell company, as defined in Rule 12b-2 of the Exchange Act.

Yes o No x

As of July 31, 2014, there were 5,925,980 shares of common stock outstanding.

TABLE OF CONTENTS




PART I	FINANCIAL INFORMATION	Page-3

ITEM 1.	Financial Statements	Page-3

	Consolidated Statements of Condition	Page-3
	Consolidated Statements of Comprehensive Income	Page-4
	Consolidated Statements of Changes in Stockholders' Equity	Page-5
	Consolidated Statements of Cash Flows	Page-6
	Notes to Consolidated Financial Statements	Page-7

ITEM 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	Page-36

ITEM 3.	Quantitative and Qualitative Disclosure about Market Risk	Page-55

ITEM 4.	Controls and Procedures	Page-55

PART II	OTHER INFORMATION	Page-56

ITEM 1.	Legal Proceedings	Page-56

ITEM 1A.	Risk Factors	Page-56

ITEM 2.	Unregistered Sales of Equity Securities and Use of Proceeds	Page-56

ITEM 3.	Defaults Upon Senior Securities	Page-56

ITEM 4.	Mine Safety Disclosures	Page-56

ITEM 5.	Other Information	Page-56

ITEM 6.	Exhibits	Page-57

SIGNATURES		Page-58

Page-2

PART I FINANCIAL INFORMATION

ITEM 1. Financial Statements

BANK OF MARIN BANCORP

CONSOLIDATED STATEMENTS OF CONDITION

at June 30, 2014 and December 31, 2013



(dollars in thousands, except share data; 2014 unaudited)	June 30, 2014		December 31, 2013
Assets
Cash and due from banks	$	81,380	$	103,773
Investment securities
Held-to-maturity, at amortized cost	123,085		122,495
Available-for-sale, at fair value (amortized cost $214,627 and $245,158 at June 30, 2014 and December 31, 2013, respectively)	215,873		243,998
Total investment securities	338,958		366,493
Loans, net of allowance for loan losses of $14,900 and $14,224 at June 30, 2014 and December 31, 2013, respectively	1,323,611		1,255,098
Bank premises and equipment, net	9,296		9,110
Goodwill	6,436		6,436
Core deposit intangible	4,117		4,503
Interest receivable and other assets	60,103		59,781
Total assets	$	1,823,901	$	1,805,194

Liabilities and Stockholders' Equity
Liabilities
Deposits
Non-interest-bearing	$	724,975	$	648,191
Interest-bearing
Transaction accounts	95,052		137,748
Savings accounts	121,890		118,770
Money market accounts	500,720		520,525
CDARS® time accounts	—		400
Other time accounts	156,186		161,468
Total deposits	1,598,823		1,587,102
Federal Home Loan Bank borrowings	15,000		15,000
Subordinated debentures	5,077		4,969
Interest payable and other liabilities	14,095		17,236
Total liabilities	1,632,995		1,624,307

Stockholders' Equity
Preferred stock, no par value Authorized - 5,000,000 shares, none issued	—		—
Common stock, no par value Authorized - 15,000,000 shares; Issued and outstanding - 5,912,774 and 5,877,524 at June 30, 2014 and December 31, 2013, respectively	81,219		80,095
Retained earnings	108,922		101,464
Accumulated other comprehensive income (loss), net	765		(672		)
Total stockholders' equity	190,906		180,887
Total liabilities and stockholders' equity	$	1,823,901	$	1,805,194

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

Page-3

BANK OF MARIN BANCORP

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME



	Three months ended					Six months ended
(dollars in thousands, except per share amounts; unaudited)	June 30, 2014		June 30, 2013			June 30, 2014		June 30, 2013
Interest income
Interest and fees on loans	$	16,363	$	13,366		$	32,682	$	27,001
Interest on investment securities
Securities of U.S. government agencies	1,193		585			2,425		1,210
Obligations of state and political subdivisions	607		437			1,241		1,075
Corporate debt securities and other	256		339			524		663
Interest due from banks and other	37		3			88		11
Total interest income	18,456		14,730			36,960		29,960
Interest expense
Interest on interest-bearing transaction accounts	26		12			49		23
Interest on savings accounts	11		8			22		16
Interest on money market accounts	131		95			289		194
Interest on CDARS® time accounts	—		2			—		7
Interest on other time accounts	231		224			466		456
Interest on FHLB and overnight borrowings	78		84			156		163
Interest on subordinated debentures	105		—			210		—
Total interest expense	582		425			1,192		859
Net interest income	17,874		14,305			35,768		29,101
Provision for loan losses	600		1,100			750		870
Net interest income after provision for loan losses	17,274		13,205			35,018		28,231
Non-interest income
Service charges on deposit accounts	528		515			1,084		1,036
Wealth Management and Trust Services	613		539			1,177		1,086
Debit card interchange fees	360		280			660		532
Merchant interchange fees	207		222			405		427
Earnings on Bank-owned life insurance	211		186			424		587
Gain on sale of securities	97		—			89		—
Other income	352		202			745		382
Total non-interest income	2,368		1,944			4,584		4,050
Non-interest expense
Salaries and related benefits	6,232		5,430			13,162		10,728
Occupancy and equipment	1,329		1,052			2,663		2,125
Depreciation and amortization	403		353			819		689
Federal Deposit Insurance Corporation insurance	269		223			519		437
Data processing	748		696			2,108		1,245
Professional services	412		814			1,040		1,341
Other expense	2,064		1,851			3,989		3,549
Total non-interest expense	11,457		10,419			24,300		20,114
Income before provision for income taxes	8,185		4,730			15,302		12,167
Provision for income taxes	3,017		1,675			5,601		4,246
Net income	$	5,168	$	3,055		$	9,701	$	7,921
Net income per common share:
Basic	$	0.88	$	0.56		$	1.65	$	1.47
Diluted	$	0.86	$	0.55		$	1.62	$	1.44
Weighted average shares used to compute net income per common share:
Basic	5,888		5,419			5,879		5,404
Diluted	5,993		5,509			5,987		5,498
Dividends declared per common share	$	0.19	$	0.18		$	0.38	$	0.36
Comprehensive income:
Net income	$	5,168	$	3,055		$	9,701	$	7,921
Other comprehensive income (loss)
Change in net unrealized gain (loss) on available-for-sale securities	976		(1,666		)	2,391		(1,969		)
Reclassification adjustment for loss on sale of available-for-sale securities included in net income	—		—			15		—
Net change in unrealized gain (loss) on available-for-sale securities, before tax	976		(1,666		)	2,406		(1,969		)
Deferred tax expense (benefit)	450		(700		)	969		(826		)
Other comprehensive income (loss), net of tax	526		(966		)	1,437		(1,143		)
Comprehensive income	$	5,694	$	2,089		$	11,138	$	6,778

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

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BANK OF MARIN BANCORP

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY

for the year ended December 31, 2013 and the six months ended June 30, 2014



(dollars in thousands; 2014 unaudited )	Common Stock				Retained Earnings			Accumulated Other Comprehensive Income, Net of Taxes			Total
(dollars in thousands; 2014 unaudited )	Shares		Amount		Retained Earnings			Accumulated Other Comprehensive Income, Net of Taxes			Total
Balance at December 31, 2012	5,389,210		$	58,573	$	91,164		$	2,055		$	151,792
Net income	—		—		14,270			—			14,270
Other comprehensive loss	—		—		—			(2,727		)	(2,727		)
Stock options exercised	71,237		2,218		—			—			2,218
Excess tax benefit - stock-based compensation	—		125		—			—			125
Stock issued under employee stock purchase plan	870		34		—			—			34
Restricted stock granted	11,850		—		—			—			—
Restricted stock forfeited / cancelled	(3,998	)	—		—			—			—
Stock-based compensation - stock options	—		175		—			—			175
Stock-based compensation - restricted stock	—		228		—			—			228
Cash dividends paid on common stock	—		—		(3,970		)	—			(3,970		)
Stock purchased by directors under director stock plan	160		6								6
Stock issued in payment of director fees	5,619		222		—			—			222
Stock issued to NorCal Community Bancorp shareholders	402,576		18,514		—			—			18,514
Balance at December 31, 2013	5,877,524		$	80,095	$	101,464		$	(672	)	$	180,887
Net income	—		—		9,701			—			9,701
Other comprehensive income	—		—		—			1,437			1,437
Stock options exercised	25,206		672		—			—			672
Excess tax benefit - stock-based compensation	—		106		—			—			106
Stock issued under employee stock purchase plan	329		14		—			—			14
Restricted stock granted	8,523		—		—			—			—
Restricted stock forfeited / cancelled	(1,191	)	—		—			—			—
Stock-based compensation - stock options	—		108		—			—			108
Stock-based compensation - restricted stock	—		121		—			—			121
Cash dividends paid on common stock	—		—		(2,243		)	—			(2,243		)
Stock issued in payment of director fees	2,383		103		—			—			103
Balance at June 30, 2014	5,912,774		$	81,219	$	108,922		$	765		$	190,906

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

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BANK OF MARIN BANCORP

CONSOLIDATED STATEMENTS OF CASH FLOWS

for the six months ended June 30, 2014 and 2013



(dollars in thousands, unaudited)	June 30, 2014			June 30, 2013
Cash Flows from Operating Activities:
Net income	$	9,701		$	7,921
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses	750			870
Compensation expense--common stock for director fees	133			110
Stock-based compensation expense	229			211
Excess tax benefits from exercised stock options	(67		)	(66		)
Amortization of core deposit intangible	386			—
Amortization of investment security premiums, net of accretion of discounts	1,300			1,676
Accretion of discount on acquired loans	(2,410		)	(789		)
Accretion of discount on subordinated debentures	108			—
Net amortization of deferred loan origination costs/fees	(265		)	(674		)
(Gain) on sale of investment securities	(89		)	—
Depreciation and amortization	819			689
Gain on sale of repossessed assets	—			(5		)
Earnings on bank owned life insurance policies	(424		)	(587		)
Net change in operating assets and liabilities:
Interest receivable	139			86
Interest payable	(35		)	(20		)
Deferred rent and other rent-related expenses	69			44
Other assets	(670		)	(2,804		)
Other liabilities	(3,191		)	705
Total adjustments	(3,218		)	(554		)
Net cash provided by operating activities	6,483			7,367
Cash Flows from Investing Activities:
Purchase of available-for-sale securities	(9,872		)	—
Proceeds from sale of available-for-sale securities	2,023			1,082
Proceeds from sale of held-to-maturity securities	2,146			—
Proceeds from paydowns/maturity of held-to-maturity securities	10,891			6,550
Proceeds from paydowns/maturity of available-for-sale securities	23,584			20,736
Loans originated and principal collected, net	(66,666		)	(19,220		)
Purchase of premises and equipment	(1,005		)	(523		)
Proceeds from sale of repossessed assets	—			40
Cash paid for low income housing tax credit investment	(208		)	—
Net cash (used in) provided by investing activities	(39,107		)	8,665
Cash Flows from Financing Activities:
Net increase (decrease) in deposits	11,721			(28,852		)
Proceeds from stock options exercised	672			1,304
Proceeds from stock issued - employee and director stock purchase	14			26
Advance on Federal Home Loan Bank borrowings	—			17,200
Cash dividends paid on common stock	(2,243		)	(1,950		)
Excess tax benefits from exercised stock options	67			66
Net cash provided by (used in) financing activities	10,231			(12,206		)
Net (decrease) increase in cash and cash equivalents	(22,393		)	3,826
Cash and cash equivalents at beginning of period	103,773			28,349
Cash and cash equivalents at end of period	$	81,380		$	32,175
Supplemental disclosure of cash flow information:
Cash paid for interest	$	1,126		$	879
Cash paid for income taxes	$	4,680		$	7,889
Supplemental disclosure of non-cash investing and financing activities:
Change in unrealized gain on available-for-sale securities	$	2,406		$	(1,969	)
Loans transferred to repossessed assets	$	—		$	192
Securities transferred from available-for-sale to held-to-maturity	$	14,297		$	—
Subscription in low income housing tax credit investment	$	1,000		$	1,000
Stock issued in payment of director fees	$	103		$	110

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

Page-6

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Introductory Explanation

References in this report to “Bancorp” mean the Bank of Marin Bancorp as the parent holding company for Bank of Marin, the wholly-owned subsidiary (the “Bank”). References to “we,” “our,” “us” mean Bancorp and the Bank that are consolidated for financial reporting purposes.

Note 1: Basis of Presentation

The consolidated financial statements include the accounts of Bancorp and its only wholly-owned bank subsidiary, the Bank. All material intercompany transactions have been eliminated. In the opinion of Management, the unaudited interim consolidated financial statements contain all adjustments necessary to present fairly our financial position, results of operations, changes in stockholders' equity and cash flows. All adjustments are of a normal, recurring nature. Management has evaluated subsequent events through the date of filing, and has determined that there are no subsequent events that require recognition or disclosure.

On November 29, 2013, we completed the merger of NorCal Community Bancorp ("NorCal"), parent company of Bank of Alameda, to enhance our market presence (the “Acquisition”). On the date of acquisition, Bancorp assumed ownership of NorCal Community Bancorp Trusts I and II, respectively (the "Trusts"), which were formed for the sole purpose of issuing trust preferred securities. Bancorp is not considered the primary beneficiary of the Trusts (variable interest entities), therefore the Trusts are not consolidated in our consolidated financial statements, but rather the subordinated debentures are shown as a liability on our consolidated statements of condition. Bancorp's investment in the common stock of the Trusts is accounted for under the equity method and is included in interest receivable and other assets on the consolidated statements of condition.

Certain information and footnote disclosures presented in the annual consolidated financial statements are not included in the interim consolidated financial statements. Accordingly, the accompanying unaudited interim consolidated financial statements should be read in conjunction with our 2013 Annual Report on Form 10-K. The results of operations for the three months and six months ended June 30, 2014 are not necessarily indicative of the operating results for the full year.

The following table shows: 1) weighted average basic shares, 2) potentially diluted common shares related to stock options, unvested restricted stock and stock warrant, and 3) weighted average diluted shares. Basic earnings per share (“EPS”) are calculated by dividing net income by the weighted average number of common shares outstanding during each period, excluding unvested restricted stock. Diluted EPS are calculated using the weighted average diluted shares. The number of potentially diluted common shares included in quarterly diluted EPS is computed using the average market prices during the three months included in the reporting period under the treasury stock method. The number of potentially diluted common shares included in year-to-date diluted EPS is a year-to-date weighted average of potentially diluted common shares included in each quarterly diluted EPS computation. We have two forms of outstanding common stock: common stock and unvested restricted stock awards. Holders of restricted stock awards receive non-forfeitable dividends at the same rate as common shareholders and they both share equally in undistributed earnings.

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	Three months ended				Six months ended
(shares and dollars in thousands; except per share data; unaudited)	June 30, 2014		June 30, 2013		June 30, 2014		June 30, 2013
Weighted average basic shares outstanding	5,888		5,419		5,879		5,404
Add: Potentially diluted common shares related to stock options	40		39		42		41
Potentially diluted common shares related to unvested restricted stock	2		2		4		4
Potentially diluted common shares related to the warrant	63		49		62		49
Weighted average diluted shares outstanding	5,993		5,509		5,987		5,498

Net income	$	5,168	$	3,055	$	9,701	$	7,921
Basic EPS	$	0.88	$	0.56	$	1.65	$	1.47
Diluted EPS	$	0.86	$	0.55	$	1.62	$	1.44

Weighted average anti-dilutive shares not included in the calculation of diluted EPS	54		60		44		54

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Note 2: Recently Issued Accounting Standards

In February 2013, the FASB issued ASU No. 2013-04, Liabilities (Topic 405) Obligations Resulting from Joint and Several Liability Arrangements for Which the Total Amount of the Obligation is Fixed at the Reporting Date. The ASU requires an entity to measure obligations resulting from joint and several liability arrangements for which the total amount of the obligation is fixed at the reporting date. Entities are required to record the amount the entity agreed to pay on the basis of its arrangement among its co-obligors and any additional amount the reporting entity expects to pay on behalf of its co-obligors at the reporting date. Examples of obligations within the scope of this guidance include debt arrangements, other contractual obligations, settled litigation and judicial rulings. ASU 2013-04 is effective retrospectively to all periods presented for fiscal years and interim periods beginning after December 15, 2013 for public entities. We adopted this ASU in 2014 and the adoption did not have an impact on our financial condition or results of operations.

In July 2013, the FASB issued ASU No. 2013-10, Derivatives and Hedging (Topic 815) Inclusion of the Fed Funds Effective Swap Rate (or Overnight Index Swap Rate) as a Benchmark Interest Rate for Hedging Accounting Purposes. The ASU provides for the inclusion of the Fed Funds Effective Swap Rate or also referred to as the Overnight Index Swap Rate ("OIS") as a U.S. benchmark interest rate for hedge accounting purposes, in addition to direct Treasury obligations of the U.S. government ("UST") and London Interbank Offered Rate ("LIBOR"). The ASU is a result of the financial crisis in 2008, as the exposure to and the demand for hedging the Fed Funds rate have increased significantly. ASU 2013-10 is effective prospectively for qualifying new or re-designated hedging relationships entered into on or after July 17, 2013. We do not expect this ASU to have a significant impact on our financial condition or results of operations.

In July 2013, the FASB issued ASU No. 2013-11, Income Taxes (Topic 740) Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. The ASU requires an entity to present an unrecognized tax benefit as a reduction of a deferred tax asset for a net operating loss ("NOL") carryforward, or similar tax loss or tax credit carryforward, rather than as a liability, when (1) the uncertain tax position would reduce the NOL or other carryforward under the tax law of the applicable jurisdiction and (2) the entity intends to and is able to use the deferred tax asset for that purpose. Otherwise, the unrecognized tax benefit should be presented as a liability and should not be combined with deferred tax assets. ASU 2013-11 is effective prospectively for fiscal years, and interim periods beginning after December 15, 2013 for public entities. We adopted this ASU in the first quarter of 2014 and the adoption did not have an impact on our financial condition or results of operations.

In January 2014, the FASB issued ASU No. 2014-01, Investments - Equity Method and Joint Ventures (Topic 323) Accounting for Investments in Qualified Affordable Housing Projects. This ASU permits entities to make an accounting policy election to account for their investments in qualified affordable housing projects using the proportional amortization method if certain conditions are met. Under the proportional amortization method, the initial cost of the investment is amortized in proportion to the tax credits and other tax benefits received and the net investment performance is recognized in the income statement as part of income tax expense (benefit). We adopted this ASU in the first quarter of 2014 and elected to account for all low income housing investments using the proportional amortization method instead of cost method. The change in accounting policy did not have a significant impact on our financial condition or results of operations.

In January 2014, the FASB issued ASU No. 2014-04, Receivables - Troubled Debt Restructurings by Creditors (Subtopic 310-40) Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure. Current accounting literature on troubled debt restructurings include guidance on when a creditor obtains one or more collateral assets in satisfaction of all or part of the receivable. The accounting literature indicates that a creditor should reclassify a collateralized mortgage loan such that the loan should be de-recognized and the collateral asset recognized when it is determined that there has been in substance a repossession or foreclosure by the creditor. However, in substance repossession or foreclosure and physical possession are not currently defined and there is diversity about when a creditor should de-recognize the loan receivable and recognize the real estate property. This ASU clarifies when an in substance repossession or foreclosure occurs. ASU 2014-04 is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2014 for public entities. We do not expect this ASU to have a significant impact on our financial condition or results of operations.

In June 2014, the FASB issued ASU No. 2014-12, Compensation - Stock Compensation (Topic 718) Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period. This ASU provides guidance for entities that grant their employees share-based payment

Page-9

awards where a performance target that affects vesting could be achieved after the requisite service period. That is the case when an employee is eligible to retire or otherwise terminate employment before the end of the period in which a performance target could be achieved and still be eligible to vest in the award if and when the performance target is achieved. This ASU stipulates that compensation expense should be recognized in the period where the performance target becomes probable of being achieved as opposed to the date that the award was granted. ASU 2014-12 is effective for annual periods and interim periods within those annual periods beginning after December 15, 2015. We do not expect this ASU to have a significant impact on our financial condition or results of operations, as we currently do not grant share-based payment awards where a performance target that affects vesting could be achieved after the requisite service period.

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Note 3: Acquisition

On November 29, 2013, we completed the merger of NorCal, parent company of Bank of Alameda, to enhance our market presence. The merger added $173.8 million in loans, $241.0 million in deposits and $53.7 million in investment securities to Bank of Marin as well as four branch offices serving Alameda, Emeryville, and Oakland. The assets acquired and liabilities assumed, both tangible and intangible, were recorded at their fair values as of the acquisition date in accordance with ASC 805, Business Combinations. We have up to a year from the acquisition date to obtain additional information that existed at the acquisition date and affected the identification and measurement of assets acquired and liabilities assumed. There have been no additional information nor significant changes in the acquisition-date fair value of assets acquired or liabilities assumed as of June 30, 2014. The acquisition was treated as a "reorganization" within the definition of section 368(a) of the Internal Revenue Code and is generally considered tax-free for U.S. federal income tax purposes.

As a result of the Acquisition, we recorded $6.4 million in goodwill, which represents the excess of the total purchase price paid over the fair value of the assets acquired, net of the fair values of liabilities assumed. Goodwill mainly reflects expected value created through the combined operations of Bank of Alameda and Bank of Marin and our expanded footprint in the East Bay. It is evaluated for impairment annually. We determined that the fair value of our traditional community banking activities (provided through our branch network) exceeded its carrying amount and no impairment on goodwill has been recorded. The goodwill is not expected to be deductible for tax purposes. The following is a description of the methods used to determine the fair values of significant assets and liabilities at acquisition date presented above.

The core deposit intangible represents estimated future benefits of acquired deposits and is booked separately from the related deposits in other assets. We recorded a core deposit intangible asset of $4.6 million on November 29, 2013, of which $69 thousand was amortized in 2013 and $386 thousand was amortized in the first six months of 2014. It is amortized on an accelerated basis over an estimated ten-year life. The core deposit intangible asset is evaluated periodically for impairment, and no impairment loss was recognized as of June 30, 2014.

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Note 4: Fair Value of Assets and Liabilities

Fair Value Hierarchy and Fair Value Measurement

We group our assets and liabilities that are measured at fair value in three levels within the fair value hierarchy, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

Level 1: Valuations are based on quoted prices in active markets for identical assets or liabilities. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these products does not involve a significant degree of judgment.

Level 2: Valuations are based on quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active and model-based valuations for which all significant assumptions are observable or can be corroborated by observable market data.

Level 3: Valuations are based on unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Values are determined using pricing models and discounted cash flow models and include management judgment and estimation which may be significant.

Transfers between levels of the fair value hierarchy are recognized on the actual date of the event or circumstances that caused the transfer, which generally coincides with our monthly and/or quarterly valuation process.

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The following table summarizes our assets and liabilities that were required to be recorded at fair value on a recurring basis.



(dollars in thousands) Description of Financial Instruments	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
At June 30, 2014 (unaudited):
Securities available-for-sale:
Mortgage-backed securities and collateralized mortgage obligations issued by U.S. government-sponsored agencies	$	173,936	$	—	$	171,149	$	2,787
Debentures of government-sponsored agencies	$	14,581	$	—	$	14,581	$	—
Privately-issued collateralized mortgage obligations	$	8,255	$	—	$	8,255	$	—
Obligations of state and political subdivisions	$	14,104	$	—	$	14,104	$	—
Corporate bonds	$	4,997	$	—	4,997		$	—
Derivative financial assets (interest rate contracts)	$	400	$	—	$	400	$	—
Derivative financial liabilities (interest rate contracts)	$	1,645	$	—	$	1,645	$	—
At December 31, 2013:
Securities available-for-sale:
Mortgage-backed securities and collateralized mortgage obligations issued by U.S. government-sponsored agencies	$	190,604	$	—	$	190,604	$	—
Debentures of government-sponsored agencies	$	21,312	$	—	$	21,312	$	—
Privately-issued collateralized mortgage obligations	$	10,874	$	—	$	10,874	$	—
Obligations of state and political subdivisions	$	15,771	$	—	$	15,771	$	—
Corporate bonds	$	5,437	$	—	$	5,437	$	—
Derivative financial assets (interest rate contracts)	$	961	$	—	$	961	$	—
Derivative financial liabilities (interest rate contracts)	$	2,519	$	—	$	2,519	$	—

Securities available-for-sale are recorded at fair value on a recurring basis. When available, quoted market prices (Level 1) are used to determine the fair value of securities available-for-sale. If quoted market prices are not available, we obtain pricing information from a reputable third-party service provider, who may utilize valuation techniques that use current market-based or independently sourced parameters, such as bid/ask prices, dealer-quoted prices, interest rates, benchmark yield curves, prepayment speeds, probability of default, loss severity and credit spreads (Level 2). Level 2 securities include U.S. agencies or government sponsored agencies' debt securities, mortgage-backed securities, government agency-issued and privately-issued collateralized mortgage obligations. As of June 30, 2014 and December 31, 2013, there are no securities that are considered Level 1 securities. As of June 30, 2014, we have one available-for-sale security that is considered Level 3 security. The security is a U.S. government agency obligation collateralized by a small pool of business equipment loans guaranteed by the Small Business Administration program. This security is not actively traded and is owned by a few investors. The significant unobservable data that is reflected in the fair value measurement include dealer quotes, projected prepayment speeds/average life and credit information, among other things. It was transferred to Level 3 security during the second quarter of 2014 and the increase in unrealized gain during the second quarter is $18 thousand.

On a recurring basis, derivative financial instruments are recorded at fair value, which is based on the income approach using observable Level 2 market inputs, reflecting market expectations of future interest rates as of the measurement date. Standard valuation techniques are used to calculate the present value of the future expected cash flows assuming an orderly transaction. Valuation adjustments may be made to reflect both our own credit risk and the counterparties’

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credit quality in determining the fair value of the derivatives. Level 2 inputs for the valuations are limited to observable market prices for LIBOR cash rates (for the very short term), quoted prices for LIBOR futures contracts, observable market prices for LIBOR swap rates, and one-month and three-month LIBOR basis spreads at commonly quoted intervals. Mid-market pricing of the inputs is used as a practical expedient in the fair value measurements. Key inputs for interest rate valuations are used to project spot rates at resets specified by each swap, as well as to discount those future cash flows to present value at the measurement date. When the value of any collateral placed with counterparties is less than the interest rate derivative liability, the interest rate liability position is further discounted to reflect our potential credit risk to counterparties. We have used the spread between the Standard & Poor's BBB rated U.S. Bank Composite rate and LIBOR with the maturity term corresponding to the duration of the swaps to calculate this credit-risk-related discount of future cash flows.

The following table presents the carrying value of financial instruments that were measured at fair value on a nonrecurring basis and that were still held in the statements of condition at each respective period end, by level within the fair value hierarchy as of June 30, 2014 and December 31, 2013.



(dollars in thousands) Description of Financial Instruments	Carrying Value¹		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3) ¹
At June 30, 2014 (unaudited):
Impaired loans carried at fair value:
Construction	2,654		—		—		2,654
Installment and other consumer	32		—		—		32
Total	$	2,686	$	—	$	—	$	2,686

At December 31, 2013:
Impaired loans carried at fair value:
Construction	3,037		—		—		3,037
Installment and other consumer	35		—		—		35
Total	$	3,072	$	—	$	—	$	3,072

¹ Represents collateral-dependent loan principal balances that had been generally written down to the values of the underlying collateral, net of specific valuation allowances of $250 thousand and $363 thousand at June 30, 2014 and December 31, 2013, respectively. The carrying value of loans fully charged-off, which includes unsecured lines of credit, overdrafts and all other loans, is zero.

Certain financial assets may be measured at fair value on a non-recurring basis. These assets are subject to fair value adjustments that result from the application of the lower of cost or fair value accounting or write-downs of individual assets, such as impaired loans and other real estate owned ("OREO").

When a loan is identified as impaired, it is reported at the lower of cost or fair value, measured based on the loan's observable market price (Level 1) or the current net realizable value of the underlying collateral securing the loan, if the loan is collateral dependent (Level 3). Net realizable value of the underlying collateral is the fair value of the collateral less estimated selling costs and any prior liens. Appraisals, recent comparable sales, offers and listing prices are factored in when valuing the collateral. We review and verify the qualifications and licenses of the certified general appraisers used for appraising commercial properties or certified residential appraisers for residential properties. Real estate appraisals may utilize a combination of approaches including replacement cost, sales comparison and the income approach. Comparable sales and income data are analyzed by the appraisers and adjusted to reflect differences between them and the subject property such as type, leasing status and physical condition. When the appraisals are received, Management reviews the assumptions and methodology utilized in the appraisal, as well as the overall resulting value in conjunction with independent data sources such as recent market data and industry-wide statistics. We generally use a 6% discount for selling costs which is applied to all properties, regardless of size. Appraised values may be adjusted to reflect changes in market conditions that have occurred subsequent to the appraisal date, or for revised estimates regarding the timing or cost of the property sale. These adjustments are based on qualitative judgments made by management on a case-by-case basis. There have been no significant changes in the valuation techniques during the quarter and six-month period ended June 30, 2014.

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OREO represents collateral acquired through foreclosure and is initially recorded at fair value as established by a current appraisal, adjusted for disposition costs. Subsequently, OREO is measured at lower of cost or fair value. OREO values are reviewed on an ongoing basis and any subsequent decline in fair value is recorded as a foreclosed asset expense in the current period. The value of OREO is determined based on independent appraisals, similar to the process used for impaired loans, discussed above, and is generally classified as Level 3. At June 30, 2014 and December 31, 2013, we had $461 thousand of OREO acquired from Bank of Alameda as part of the Acquisition. There was no change in the estimated fair value of the OREO from the date of the Acquisition through June 30, 2014.

Securities held-to-maturity may be written down to fair value (determined using the same techniques discussed above for securities available-for-sale) as a result of an other-than-temporary impairment, if any.

Disclosures about Fair Value of Financial Instruments

The table below is a summary of fair value estimates for financial instruments as of June 30, 2014 and December 31, 2013, excluding financial instruments recorded at fair value on a recurring basis (summarized in the first table in this note). The carrying amounts in the following table are recorded in the consolidated statements of condition under the indicated captions. We have excluded non-financial assets and non-financial liabilities defined by the Codification (ASC 820-10-15-1A), such as Bank premises and equipment, deferred taxes and other liabilities. In addition, we have not disclosed the fair value of financial instruments specifically excluded from disclosure requirements of the Financial Instruments Topic of the Codification (ASC 825-10-50-8), such as Bank-owned life insurance policies.



	June 30, 2014					December 31, 2013
(dollars in thousands; 2013 unaudited)	Carrying Amounts		Fair Value		Fair Value Hierarchy	Carrying Amounts		Fair Value		Fair Value Hierarchy
Financial assets
Cash and cash equivalents	$	81,380	$	81,380	Level 1	$	103,773	$	103,773	Level 1
Investment securities held-to-maturity	123,085		125,298		Level 2	122,495		123,858		Level 2
Loans, net	1,323,611		1,326,184		Level 3	1,255,098		1,245,475		Level 3
Interest receivable	5,628		5,628		Level 2	5,767		5,767		Level 2
Financial liabilities
Deposits	1,598,823		1,599,827		Level 2	1,587,102		1,588,278		Level 2
Federal Home Loan Bank borrowings	15,000		15,566		Level 2	15,000		15,665		Level 2
Subordinated debentures	5,077		5,250		Level 3	4,969		4,950		Level 3
Interest payable	218		218		Level 2	253		253		Level 2

Following is a description of methods and assumptions used to estimate the fair value of each class of financial instrument not recorded at fair value but required for disclosure purposes:

Cash and Cash Equivalents - The carrying amounts of cash and cash equivalents approximate their fair value because of the short-term nature of these instruments.

Held-to-maturity Securities - Held-to-maturity securities, which generally consist of mortgage-backed securities, obligations of state and political subdivisions and corporate bonds, are recorded at their amortized cost. Their fair value for disclosure purposes is determined using methodologies similar to those described above for available-for-sale securities using Level 2 inputs. If Level 2 inputs are not available, we may utilize pricing models that incorporate unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities (Level 3). As of June 30, 2014 and December 31, 2013, we did not hold any held-to-maturity securities whose fair value was measured using significant unobservable inputs.

Loans - The fair value of loans with variable interest rates approximates current carrying value, because loan rates are regularly adjusted to current market rates. The fair value of fixed rate loans or variable loans at negotiated interest rate floors or ceilings with remaining maturities in excess of one year is estimated by discounting the future cash flows using current market rates at which similar loans would be made to borrowers with similar credit worthiness and similar remaining maturities. The allowance for loan losses (“ALLL”) is considered to be a reasonable estimate of the portion of loan discount attributable to credit risks.

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Interest Receivable and Payable - The interest receivable and payable balances approximate their fair value due to the short-term nature of their settlement dates.

Deposits - The fair value of non-interest-bearing deposits, interest-bearing transaction accounts, savings accounts and money market accounts is the amount payable on demand at the reporting date. The fair value of time deposits is estimated by discounting the future cash flows using current rates offered for deposits of similar remaining maturities.

Federal Home Loan Bank Borrowing - The fair value is estimated by discounting the future cash flows using current rates offered by the Federal Home Loan Bank of San Francisco ("FHLB") for similar credit advances corresponding to the remaining duration of our fixed-rate credit advances.

Subordinated Debentures - As part of the Acquisition, we assumed two tranches of subordinated debentures from NorCal. See Note 7 for further information. The fair values of the subordinated debentures were estimated by discounting the future cash flows (interest payment at a rate of three-month LIBOR plus 3.05% and 1.40%, respectively) to their present values using current market rates at which similar bonds would be issued with similar credit ratings as ours and similar remaining maturities. Each future quarterly interest payment was discounted at the spot rate for the corresponding term based on comparable trust preferred securities, plus an illiquidity premium of 3.00%. In July 2010, the Dodd-Frank Act was signed into law and limits the ability of certain bank holding companies to treat trust preferred security debt issuances as Tier 1 capital. This law effectively closed the trust-preferred securities markets for new issuance and led to the absence of observable or comparable transactions in the market place. Due to the use of unobservable inputs in the valuation of trust preferred securities, we consider the fair value to be a Level 3 measurement.

Commitments - Loan commitments and standby letters of credit generate ongoing fees, which are recognized over the term of the commitment period. Given the uncertainty in the likelihood and timing of a commitment being drawn upon, the carrying value of the related unamortized commitment fees and the reserve for these off-balance sheet commitments are determined to approximate fair value, which is not material.

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Note 5: Investment Securities

Our investment securities portfolio consists of obligations of state and political subdivisions, corporate bonds, U.S. government agency securities, including mortgage-backed securities (“MBS”) and collateralized mortgage obligations (“CMOs”) issued or guaranteed by Federal National Mortgage Association ("FNMA"), Federal Home Loan Mortgage Corporation ("FHLMC"), or Government National Mortgage Association ("GNMA"), debentures issued by government-sponsored agencies such as FNMA and FHLMC, as well as privately issued CMOs, as reflected in the table below:



	June 30, 2014									December 31, 2013
	Amortized		Fair		Gross Unrealized					Amortized		Fair		Gross Unrealized
(dollars in thousands; 2014 unaudited)	Cost		Value		Gains		(Losses)			Cost		Value		Gains		(Losses)
Held-to-maturity
Obligations of state and political subdivisions	$	69,136	$	70,799	$	1,848	$	(185	)	$	80,381	$	81,429	$	1,764	$	(716	)
Corporate bonds	40,469		40,872		412		(9		)	42,114		42,429		375		(60		)
MBS pass-through securities issued by FHLMC and FNMA	13,480		13,627		427		(280		)	—		—		—		—
Total held-to-maturity	123,085		125,298		2,687		(474		)	122,495		123,858		2,139		(776		)

Available-for-sale
Securities of U.S. government agencies:
MBS pass-through securities issued by FHLMC and FNMA	104,272		104,981		775		(66		)	124,063		123,033		616		(1,646		)
CMOs issued by FNMA	16,887		16,872		85		(100		)	18,573		18,438		60		(195		)
CMOs issued by FHLMC	30,372		30,344		111		(139		)	23,710		23,679		144		(175		)
CMOs issued by GNMA	21,329		21,739		437		(27		)	24,944		25,454		609		(99		)
Debentures of government- sponsored agencies	14,760		14,581		133		(312		)	21,845		21,312		108		(641		)
Privately issued CMOs	8,045		8,255		228		(18		)	10,649		10,874		257		(32		)
Obligations of state and political subdivisions	14,032		14,104		101		(29		)	15,948		15,771		14		(191		)
Corporate bonds	4,930		4,997		71		(4		)	5,426		5,437		25		(14		)
Total available-for-sale	214,627		215,873		1,941		(695		)	245,158		243,998		1,833		(2,993		)

Total investment securities	$	337,712	$	341,171	$	4,628	$	(1,169	)	$	367,653	$	367,856	$	3,972	$	(3,769	)

As part of our ongoing review of our investment securities portfolio, we reassessed the classification of certain MBS pass-through securities issued by FHLMC and FNMA that are qualified for Community Reinvestment Act ("CRA") credit. Effective January 31, 2014, we transferred $14.2 million of these CRA qualified MBS, which we intend and have the ability to hold to maturity, from available-for-sale securities to held-to-maturity at fair value. The unrealized pre-tax holding gain of $84 thousand at the date of transfer remained in accumulated other comprehensive income and is amortized over the remaining lives of the securities as an adjustment to yield.

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The amortized cost and fair value of investment debt securities by contractual maturity at June 30, 2014 are shown below. Expected maturities will differ from contractual maturities because the issuers of the securities may have the right to call or prepay obligations with or without call or prepayment penalties.



	June 30, 2014								December 31, 2013
	Held-to-Maturity				Available-for-Sale				Held-to-Maturity				Available-for-Sale
(dollars in thousands; 2014 unaudited)	Amortized Cost		Fair Value		Amortized Cost		Fair Value		Amortized Cost		Fair Value		Amortized Cost		Fair Value
Within one year	$	21,157	$	21,366	$	2,459	$	2,467	$	8,731	$	8,784	$	5,522	$	5,521
After one year but within five years	67,640		68,736		41,026		41,356		88,255		89,095		42,229		42,338
After five years through ten years	19,554		20,351		19,701		19,476		24,244		24,786		26,232		25,478
After ten years	14,734		14,845		151,441		152,574		1,265		1,193		171,175		170,661
Total	$	123,085	$	125,298	$	214,627	$	215,873	$	122,495	$	123,858	$	245,158	$	243,998

We sold one available-for-sale and six held-to-maturity securities in the first six months of 2014 with total proceeds of $2.0 million and $2.1 million, respectively, and incurred a loss of $15 thousand and net gain of $104 thousand, respectively. The sales of the held-to-maturity securities were due to evidence of significant deterioration of creditworthiness of the issuers since purchase. Two available-for-sale securities were sold in January 2013 with proceeds of $1.1 million and a small net gain of $339.

Investment securities carried at $70.1 million and $61.8 million at June 30, 2014 and December 31, 2013, respectively, were pledged with the State of California: $69.4 million and $61.1 million to secure public deposits in compliance with the Local Agency Security Program at June 30, 2014 and December 31, 2013, respectively, and $739 thousand and $732 thousand to provide collateral for trust deposits at June 30, 2014 and December 31, 2013, respectively. In addition, investment securities carried at $1.1 million were pledged to collateralize an internal Wealth Management and Trust Services (“WMTS”) checking account at both June 30, 2014 and December 31, 2013.

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Other-Than-Temporarily Impaired Debt Securities

We have evaluated the credit ratings of our investment securities and their issuer and/or insurers. Based on our evaluation, Management has determined that no investment security in our investment portfolio is other-than-temporarily impaired. We do not have the intent, and it is more likely than not that we will not have to sell the remaining securities temporarily impaired at June 30, 2014 before recovery of the cost basis.

Forty-one and ninety-five investment securities were in unrealized loss positions at June 30, 2014 and December 31, 2013, respectively. The table below shows investment securities that were in unrealized loss positions at June 30, 2014 and December 31, 2013, respectively. They are summarized and classified according to the duration of the loss period as follows:



June 30, 2014	< 12 continuous months					> 12 continuous months					Total securities in a loss position
(dollars in thousands; unaudited)	Fair value		Unrealized loss			Fair value		Unrealized loss			Fair value		Unrealized loss
Held-to-maturity
Obligations of state & political subdivisions	$	5,687	$	(22	)	7,509		(163		)	$	13,196	$	(185	)
Corporate bonds	—		—			3,558		(9		)	3,558		(9		)
MBS pass-through securities issued by FNMA and FHLMC	—		—			6,917		(280		)	6,917		(280		)
Total held-to-maturity	5,687		(22		)	17,984		(452		)	23,671		(474		)
Available-for-sale
MBS pass-through securities issued by FNMA and FHLMC	16,747		(66		)	—		—			16,747		(66		)
CMOs issued by FNMA	7,904		(100		)	—		—			7,904		(100		)
CMOs issued by FHLMC	25,620		(139		)	—		—			25,620		(139		)
CMOs issued by GNMA	—		—			3,689		(27		)	3,689		(27		)
Debentures of government- sponsored agencies	492		(3		)	9,691		(309		)	10,183		(312		)
Privately issued CMOs	327		(5		)	2,295		(13		)	2,622		(18		)
Obligations of state & political subdivisions	4,634		(29		)	—		—			4,634		(29		)
Corporate bonds	988		(4		)	—		—			988		(4		)
Total available-for-sale	56,712		(346		)	15,675		(349		)	72,387		(695		)
Total temporarily impaired securities	$	62,399	$	(368	)	$	33,659	$	(801	)	$	96,058	$	(1,169	)

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December 31, 2013	< 12 continuous months					> 12 continuous months					Total securities in a loss position
(dollars in thousands)	Fair value		Unrealized loss			Fair value		Unrealized loss			Fair value		Unrealized loss
Held-to-maturity
Obligations of state & political subdivisions	$	13,933	$	(419	)	$	9,033	$	(297	)	$	22,966	$	(716	)
Corporate bonds	3,017		(11		)	4,963		(49		)	7,980		(60		)
Total held-to-maturity	16,950		(430		)	13,996		(346		)	30,946		(776		)
Available-for-sale
MBS pass-through securities issued by FHLMC and FNMA	90,914		(1,297		)	3,172		(349		)	94,086		(1,646		)
CMOs issued by FNMA	17,535		(195		)	—		—			17,535		(195		)
CMOs issued by FHLMC	17,899		(175		)	—		—			17,899		(175		)
CMOs issued by GNMA	3,966		(99		)	—		—			3,966		(99		)
Debentures of government- sponsored agencies	16,872		(641		)	—		—			16,872		(641		)
Privately issued CMOs	4,634		(31		)	159		(1		)	4,793		(32		)
Obligations of state & political subdivisions	11,516		(191		)	—		—			11,516		(191		)
Corporate bonds	1,479		(14		)	—		—			1,479		(14		)
Total available-for-sale	164,815		(2,643		)	3,331		(350		)	168,146		(2,993		)
Total temporarily impaired securities	$	181,765	$	(3,073	)	$	17,327	$	(696	)	$	199,092	$	(3,769	)

As of June 30, 2014, there were thirteen investment positions that had been in a continuous loss position for more than 12 months. These securities consisted of debentures of government-sponsored agencies, obligations of U.S. state and political subdivisions, MBS, privately issued CMOs, CMOs issued by GNMA and a corporate bond. We have evaluated each of the bonds and believe that the decline in fair value is primarily driven by factors other than credit. It is probable that we will be able to collect all amounts due according to the contractual terms and no other-than-temporary impairment exists. MBS are supported by the U.S. Federal government to protect us from credit losses. Additionally, the obligations of state and political subdivisions and corporate bonds were deemed creditworthy based on our review of the issuers' recent financial information and their insurers, if any. The principal of the CMO issued by GNMA is fully guaranteed by the U.S. government. The private-labeled CMOs are collateralized by residential mortgages with low loan-to-value ratios and high credit support percentages and are rated AA+ by Standard & Poor's. Based upon our assessment of expected credit losses given the performance of the underlying collateral and the credit enhancements, we concluded that the security was not other-than-temporarily impaired at June 30, 2014.

Twenty-eight investment securities in our portfolio were in a temporary loss position for less than twelve months as of June 30, 2014. They consisted of obligations of U.S. state and political subdivisions, a corporate bond, MBS, CMOs, debentures issued by government agencies and privately issued CMOs. We determine that the strengths of GNMA and FNMA through guarantee or support from the U.S. Federal Government are sufficient to protect us from credit losses. The other temporarily impaired securities are deemed creditworthy after our internal analysis. Additionally, all are rated as investment grade by at least one major rating agency. As a result of this impairment analysis, we concluded that these securities were not other-than-temporarily impaired at June 30, 2014.

Securities Carried at Cost

As a member of the FHLB, we are required to maintain a minimum investment in the FHLB capital stock determined by the Board of Directors of the FHLB. The minimum investment requirements can also increase in the event we need to increase our borrowings with the FHLB. Shares cannot be purchased or sold except between the FHLB and its members at its $100 per share par value. We held $8.2 million and $7.8 million of FHLB stock recorded at cost in other assets on the consolidated statements of condition at June 30, 2014 and December 31, 2013, respectively. On July 29, 2014, the FHLB announced a cash dividend for the second quarter of 2014 at an annualized dividend rate of

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7.4% to be distributed in mid-August. Management does not believe that the FHLB stock is other-than-temporarily-impaired, as we expect to be able to redeem this stock at cost.

As a member bank of Visa U.S.A., we hold 16,939 shares of Visa Inc. Class B common stock with a carrying value of zero, which is equal to our cost basis. These shares are restricted from resale until their conversion into Class A (voting) shares upon the termination of Visa Inc.'s covered litigation escrow account. As a result of the restriction, these shares are not considered available-for-sale and are not carried at fair value. Converting this Class B common stock to Class A common stock at a conversion rate of 0.4206, the value would be $1.5 million and $1.6 million at June 30, 2014 and December 31, 2013, respectively. The conversion rate is subject to further reduction upon the final settlement of the covered litigation against Visa Inc. and its member banks. See Note 9 herein.

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Note 6: Loans and Allowance for Loan Losses

Credit Quality of Loans

Outstanding loans by class and payment aging as of June 30, 2014 and December 31, 2013 are as follows:



Loan Aging Analysis by Class as of June 30, 2014 and December 31, 2013
(dollars in thousands; 2014 unaudited)	Commercial and industrial			Commercial real estate, owner-occupied			Commercial real estate, investor			Construction			Home equity			Other residential ¹			Installment and other consumer			Total
June 30, 2014
30-59 days past due	$	634		$	—		$	—		$	—		$	253		$	—		$	109		$	996
60-89 days past due	475			—			—			—			—			—			—			475
Greater than 90 days past due (non-accrual) ²	335			1,403			2,618			5,197			444			—			152			10,149
Total past due	1,444			1,403			2,618			5,197			697			—			261			11,620
Current	192,958			231,864			666,607			35,000			105,504			80,399			14,559			1,326,891
Total loans ³	$	194,402		$	233,267		$	669,225		$	40,197		$	106,201		$	80,399		$	14,820		$	1,338,511
Non-accrual loans to total loans	0.2		%	0.6		%	0.4		%	12.9		%	0.4		%	—		%	1.0		%	0.8		%
December 31, 2013
30-59 days past due	$	18		$	—		$	—		$	—		$	240		$	717		$	17		$	992
60-89 days past due	—			—			—			—			—			—			3			3
Greater than 90 days past due (non-accrual) ²	1,187			1,403			2,807			5,218			234			660			169			11,678
Total past due	1,205			1,403			2,807			5,218			474			1,377			189			12,673
Current	182,086			239,710			622,212			26,359			97,995			71,257			17,030			1,256,649
Total loans ³	$	183,291		$	241,113		$	625,019		$	31,577		$	98,469		$	72,634		$	17,219		$	1,269,322
Non-accrual loans to total loans	0.6		%	0.6		%	0.4		%	16.5		%	0.2		%	0.9		%	1.0		%	0.9		%

¹ Our residential loan portfolio includes no sub-prime loans, nor is it our normal practice to underwrite loans commonly referred to as "Alt-A mortgages", the characteristics of which are loans lacking full documentation, borrowers having low FICO scores or higher loan-to-value ratios.

² Amounts include $1.4 million of Purchased Credit Impaired ("PCI") loans that had stopped accreting interest at both June 30, 2014 and December 31, 2013, and exclude accreting PCI loans of $3.8 million and $5.7 million at June 30, 2014 and December 31, 2013, respectively, as their accretable yield interest recognition is independent from the underlying contractual loan delinquency status. There were no accruing loans past due more than ninety days at June 30, 2014 or December 31, 2013.

³ Amounts include net deferred loan costs of $288 thousand and $24 thousand at June 30, 2014 and December 31, 2013, respectively. Amounts are also net of unaccreted purchase discounts on non-PCI loans of $5.6 million and $7.6 million at June 30, 2014 and December 31, 2013, respectively.

Our commercial loans are generally made to established small and mid-sized businesses to provide financing for their working capital needs, equipment purchases, acquisitions, or refinancings. Management examines historical, current, and projected cash flows to determine the ability of the borrower to repay obligations as agreed. Commercial loans are primarily made based on the identified cash flows of the borrower and secondarily on the underlying collateral. The cash flows of borrowers, however, may not occur as expected, and the collateral securing these loans may fluctuate in value. Most commercial and industrial loans are secured by the assets being financed, such as accounts receivable or inventory, and include a personal guarantee. Some short-term loans may be made on an unsecured basis. We target stable local businesses with guarantors that have proven to be more resilient in periods of economic stress. Typically, the guarantors provide an additional source of repayment for most of our credit extensions.

Commercial real estate loans are subject to underwriting standards and processes similar to commercial loans discussed above. We underwrite these loans to be repaid from cash flow and to be supported by real property collateral. Repayment of commercial real estate loans is largely dependent on the successful operation of the property securing the loan, or of the business conducted on the property securing the loan. Underwriting standards for commercial real estate loans include, but are not limited to, conservative debt coverage and loan-to-value ratios. Furthermore, substantially all of our loans are guaranteed by the owners of the properties. Commercial real estate loans may be adversely affected by conditions in the real estate markets or in the general economy. When a vacancy has occurred, strong guarantors have historically carried the loans until a replacement tenant could be found. The owner's substantial equity investment provides a strong economic incentive to continue to support the commercial real estate projects. As a result, we have generally experienced a relatively low level of loss and delinquencies in this portfolio.

Construction loans are generally made to developers and builders to finance land acquisition as well as the subsequent construction. These loans are underwritten after evaluation of the borrower's financial strength, reputation, prior track

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record, and after obtaining independent appraisals. The construction industry can be impacted by significant events, including: the inherent volatility of real estate markets and vulnerability to delays due to weather, change orders, ability to obtain construction permits, labor or material shortages, and price hikes. Estimates of construction costs and value associated with the completed project may be inaccurate. Repayment of construction loans is largely dependent on the ultimate success of the project.

Consumer loans primarily consist of home equity lines of credit, other residential (tenants-in-common) loans, and other personal loans. We originate consumer loans utilizing credit score information, debt-to-income ratio and loan-to-value ratio analysis. Diversification, relatively small loan amounts that are spread across many individual borrowers, also mitigates risk. Additionally, trend reports are reviewed by Management on a regular basis. Underwriting standards for home equity lines of credit include, but are not limited to, a conservative loan-to-value ratio, the number of such loans a borrower can have at one time, and documentation requirements. Personal loans are nearly evenly split between mobile home loans and floating home loans along with a small number of installment loans.

We use a risk rating system to evaluate asset quality, and to identify and monitor credit risk in individual loans, and ultimately in the portfolio. Definitions of loans that are risk graded “Special Mention” or worse are consistent with those used by the Federal Deposit Insurance Corporation ("FDIC"). Our internally assigned grades are as follows:

Pass – Loans to borrowers of acceptable or better credit quality. Borrowers in this category demonstrate fundamentally sound financial condition, repayment capacity, credit history and management expertise. Loans in this category must have an identifiable and stable source of repayment and meet the Bank’s policy regarding debt service coverage ratios. These borrowers are capable of sustaining normal economic, market or operational setbacks without significant financial impacts. Negative external industry factors are generally not present. The loan may be secured, unsecured or supported by non-real estate collateral for which the value is more difficult to determine and/or marketability is more uncertain. This category also includes “Watch” loans, where the primary source of repayment has been delayed. “Watch” is intended to be a transitional grade, with either an upgrade or downgrade within a reasonable period.

Special Mention - Potential weaknesses that deserve close attention. If left uncorrected, those potential weaknesses may result in deterioration of the payment prospects for the asset. Special Mention assets do not present sufficient risk to warrant adverse classification.

Substandard - Inadequately protected by either the current sound worth and paying capacity of the obligor or the collateral pledged, if any. A Substandard asset has a well-defined weakness or weaknesses that jeopardize(s) the liquidation of the debt. Substandard assets are characterized by the distinct possibility that we will sustain some loss if such weaknesses or deficiencies are not corrected. Well-defined weaknesses include adverse trends or developments of the borrower’s financial condition, managerial weaknesses and/or significant collateral deficiencies.

Doubtful - Critical weaknesses that make collection or liquidation in full improbable. There may be specific pending events that work to strengthen the asset; however, the amount or timing of the loss may not be determinable. Pending events generally occur within one year of the asset being classified as Doubtful. Examples include: merger, acquisition, or liquidation; capital injection; guarantee; perfecting liens on additional collateral; and refinancing. Such loans are placed on non-accrual status and usually are collateral-dependent.

We regularly review our credits for accuracy of risk grades whenever new information is received. Borrowers are required to submit financial information at regular intervals:


•	Generally, commercial borrowers with lines of credit are required to submit financial information with reporting intervals ranging from monthly to annually depending on credit size, risk and complexity.


•	Investor commercial real estate borrowers with loans greater than $500 thousand are required to submit rent rolls or property income statements at least annually.


•	Construction loans are monitored monthly, and assessed on an ongoing basis.


•	Home equity and other consumer loans are assessed based on delinquency.


•	Loans graded “Watch” or more severe, regardless of loan type, are assessed no less than quarterly.

The following table represents our analysis of loans by internally assigned grades, including the PCI loans, at June 30, 2014 and December 31, 2013:

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(dollars in thousands; 2014 unaudited)	Commercial and industrial		Commercial real estate, owner-occupied		Commercial real estate, investor		Construction		Home equity		Other residential		Installment and other consumer		Purchased credit-impaired		Total
Credit Risk Profile by Internally Assigned Grade:
June 30, 2014
Pass	$	173,707	$	209,958	$	650,071	$	33,591	$	100,788	$	76,494	$	13,874	$	2,191	$	1,260,674
Special Mention	16,365		11,242		8,822		848		2,298		3,336		417		1,152		44,480
Substandard	3,997		9,484		8,137		5,747		3,048		569		529		1,846		33,357
Total loans	$	194,069	$	230,684	$	667,030	$	40,186	$	106,134	$	80,399	$	14,820	$	5,189	$	1,338,511

December 31, 2013
Pass	$	162,625	$	216,537	$	609,157	$	25,069	$	93,792	$	69,176	$	16,336	$	1,340	$	1,194,032
Special Mention	13,990		16,533		8,570		725		2,164		1,047		227		894		44,150
Substandard	6,343		3,224		5,413		5,768		2,444		2,411		656		4,881		31,140
Total loans	$	182,958	$	236,294	$	623,140	$	31,562	$	98,400	$	72,634	$	17,219	$	7,115	$	1,269,322

Troubled Debt Restructuring

Our loan portfolio includes certain loans that have been modified in a Troubled Debt Restructuring (“TDR”), where economic concessions have been granted to borrowers experiencing financial difficulties. These concessions typically result from our loss mitigation activities and could include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance or other actions. TDRs on nonaccrual status at the time of restructure may be returned to accruing status after considering the borrower’s sustained repayment performance for a reasonable period, generally six months, and there is reasonable assurance of repayment and performance.

When a loan is modified, Management evaluates any possible impairment based on the present value of expected future cash flows, discounted at the contractual interest rate of the original loan agreement, except when the sole (remaining) source of repayment for the loan is the operation or liquidation of the collateral. In these cases Management uses the current fair value of the collateral, less selling costs, instead of discounted cash flows. If Management determines that the value of the modified loan is less than the recorded investment in the loan (net of previous charge-offs and unamortized premium or discount), impairment is recognized through a specific allowance or a charge-off of the loan.

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The table below summarizes outstanding TDR loans by loan class as of June 30, 2014 and December 31, 2013. The summary includes those TDRs that are on non-accrual status and those that continue to accrue interest.



(dollars in thousands; 2014 unaudited)	As of
Recorded investment in Troubled Debt Restructurings ¹	June 30, 2014		December 31, 2013

Commercial and industrial	$	6,247	$	5,117
Commercial real estate, owner-occupied	4,292		4,333
Commercial real estate, investor	529		534
Construction	6,678		6,335
Home equity	638		506
Other residential	1,327		2,063
Installment and other consumer	1,864		1,693
Total	$	21,575	$	20,581

¹Includes $14.3 million and $12.9 million of TDR loans that were accruing interest as of June 30, 2014 and December 31, 2013, respectively.

Includes $1.8 million of acquired loans at both June 30, 2014 and December 31, 2013, respectively.

The tables below present the following information for TDRs modified during the periods presented: number of contracts modified, the recorded investment in the loans prior to modification, and the recorded investment in the loans after the loans were restructured. The tables below exclude fully paid-off or fully charged-off TDR loans.



(dollars in thousands; unaudited)	Number of Contracts Modified	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment at period end
Troubled Debt Restructurings during the three months ended June 30, 2014:
Commercial and industrial	3	$	308	$	354	$	354
Installment and other consumer	3	111		110		109
Total	6	$	419	$	464	$	463

Troubled Debt Restructurings during the three months ended June 30, 2013:
Construction	1	$	4,745	$	4,766	$	4,806



Troubled Debt Restructurings during the six months ended June 30, 2014:
Commercial and industrial	6	$	1,728	$	1,759	$	1,471
Home equity	1	150		150		149
Installment and other consumer	6	281		278		276
Total	13	$	2,159	$	2,187	$	1,896

Troubled Debt Restructurings during the six months ended June 30, 2013:
Commercial and Industrial ¹	2	$	499	$	497	$	464
Construction	1	$	4,745	$	4,766	$	4,806
Total	3	$	5,244	$	5,263	$	5,270

¹Excludes two contracts modified and subsequently paid off during the six months ended June 30, 2013. The pre-modification and post-modification outstanding recorded investment balances were both $218 thousand.

Modifications during the six months ended June 30, 2014 primarily involved maturity extensions, while modifications during the six months ended June 30, 2013 primarily involved renewals and maturity extensions. During the first six months of both 2014 and 2013, there were no loans modified as troubled debt restructuring that subsequently defaulted, where the default occurred within the first twelve months after modification into a TDR. We are reporting these defaulted TDRs based on a payment default definition of more than ninety days past due.

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Impaired Loan Balances and Their Related Allowance by Major Classes of Loans

The tables below summarize information on impaired loans and their related allowance. Total impaired loans include non-accrual loans, accruing TDR loans and accreting PCI loans that have experienced post-acquisition declines in cash flows expected to be collected.



(dollars in thousands; unaudited)	Commercial and industrial		Commercial real estate, owner-occupied		Commercial real estate, investor		Construction		Home equity		Other residential		Installment and other consumer		Total
June 30, 2014
Recorded investment in impaired loans:
With no specific allowance recorded	$	897	$	1,403	$	3,147	$	2,314	$	558	$	528	$	292	$	9,139
With a specific allowance recorded	5,350		4,069		—		4,376		304		799		1,599		16,497
Total recorded investment in impaired loans	$	6,247	$	5,472	$	3,147	$	6,690	$	862	$	1,327	$	1,891	$	25,636
Unpaid principal balance of impaired loans:
With no specific allowance recorded	$	897	$	2,897	$	5,139	$	5,088	$	1,044	$	528	$	334	$	15,927
With a specific allowance recorded	5,506		5,025		—		4,569		304		799		1,599		17,802
Total unpaid principal balance of impaired loans	$	6,403	$	7,922	$	5,139	$	9,657	$	1,348	$	1,327	$	1,933	$	33,729
Specific allowance	$	1,111	$	61	$	—	$	232	$	29	$	16	$	312	$	1,761

Average recorded investment in impaired loans during the quarter ended June 30, 2014	$	6,217	$	5,476	$	3,186	$	6,503	$	755	$	1,686	$	1,898	$	25,721
Interest income recognized on impaired loans during the quarter ended June 30, 2014	$	103	$	83	$	7	$	23	$	5	$	19	$	19	$	259
Average recorded investment in impaired loans during the six months ended June 30, 2014	$	6,081	$	5,480	$	3,235	$	6,513	$	666	$	1,870	$	1,891	$	25,736
Interest income recognized on impaired loans during the six months ended June 30, 2014	$	221	$	166	$	14	$	44	$	9	$	42	$	37	$	533
Average recorded investment in impaired loans during the quarter ended June 30, 2013	$	7,327	$	2,534	$	6,041	$	8,820	$	1,158	$	2,590	$	1,879	$	30,349
Interest income recognized on impaired loans during the quarter ended June 30, 2013	$	107	$	53	$	—	$	185	$	12	$	22	$	18	$	397
Average recorded investment in impaired loans during the six months ended June 30, 2013	8,409		2,528		6,073		6,468		1,145		2,828		1,900		29,351
Interest income recognized on impaired loans during the six months ended June 30, 2013	241		107		—		212		20		45		34		659



(dollars in thousands)	Commercial and industrial		Commercial real estate, owner-occupied		Commercial real estate, investor		Construction		Home equity		Other residential		Installment and other consumer		Total

December 31, 2013
Recorded investment in impaired loans:
With no specific allowance recorded	$	977	$	1,403	$	3,341	$	2,806	$	349	$	1,254	$	112	$	10,242
With a specific allowance recorded	4,725		4,085		—		3,927		157		809		1,750		$	15,453
Total recorded investment in impaired loans	$	5,702	$	5,488	$	3,341	$	6,733	$	506	$	2,063	$	1,862	$	25,695
Unpaid principal balance of impaired loans:
With no specific allowance recorded	$	977	$	3,060	$	5,333	$	5,547	$	835	$	1,254	$	154	$	17,160
With a specific allowance recorded	4,930		5,088		—		4,114		157		809		1,750		16,848
Total recorded investment in impaired loans	$	5,907	$	8,148	$	5,333	$	9,661	$	992	$	2,063	$	1,904	$	34,008
Specific allowance	$	1,170	$	90	$	—	$	341	$	1	$	23	$	364	$	1,989

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The gross interest income that would have been recorded, had non-accrual loans been current, totaled $180 thousand and $272 thousand in the quarters ended June 30, 2014, and June 30, 2013, respectively, and totaled $385 thousand and $536 thousand for the six months ended June 30, 2014 and June 30, 2013, respectively. PCI loans are excluded from the foregone interest data above as their accretable yield interest recognition is independent from the underlying contractual loan delinquency status. See “Purchased Credit-Impaired Loans” below for further discussion.

Management monitors delinquent loans continuously and identifies problem loans, generally loans graded substandard or worse, to be evaluated individually for impairment testing. Generally, we charge off our estimated losses related to specifically-identified impaired loans when it is deemed uncollectible. The charged-off portion of impaired loans outstanding at June 30, 2014 totaled approximately $5.7 million. At June 30, 2014, there were $252 thousand outstanding commitments to extend credit on impaired loans, including loans to borrowers whose terms have been modified in troubled debt restructurings.

The following table discloses loans by major portfolio category and activity in the ALLL, as well as the related ALLL disaggregated by impairment evaluation method:



Allowance for Loan Losses and Recorded Investment in Loans
(dollars in thousands; unaudited)	Commercial and industrial			Commercial real estate, owner-occupied			Commercial real estate, investor		Construction			Home equity		Other residential		Installment and other consumer			Unallocated		Total

For the three months ended June 30, 2014
Allowance for loan losses:
Beginning balance	$	2,772		$	1,985		$	6,469	$	536		$	887	$	409	$	565		$	609	$	14,232
Provision (reversal)	310			(6		)	213		42			56		45		(84		)	24		600
Charge-offs	(5		)	—			—		(7		)	—		—		(1		)	—		(13		)
Recoveries	48			—			31		—			1		—		1			—		81
Ending balance	$	3,125		$	1,979		$	6,713	$	571		$	944	$	454	$	481		$	633	$	14,900

For the six months ended June 30, 2014
Allowance for loan losses:
Beginning balance	$	3,056		$	2,012		$	6,196	$	633		$	875	$	317	$	629		$	506	$	14,224
Provision (reversal)	55			(33		)	481		142			67		137		(226		)	127		750
Charge-offs	(66		)	—			—		(204		)	—		—		(4		)	—		(274		)
Recoveries	80			—			36		—			2		—		82			—		200
Ending balance	$	3,125		$	1,979		$	6,713	$	571		$	944	$	454	$	481		$	633	$	14,900

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Allowance for Loan Losses and Recorded Investment in Loans
(dollars in thousands; unaudited)	Commercial and industrial			Commercial real estate, owner-occupied			Commercial real estate, investor			Construction			Home equity			Other residential			Installment and other consumer			Unallocated		Total

As of June 30, 2014:
Ending ALLL related to loans collectively evaluated for impairment	$	2,014		$	1,918		$	6,713		$	339		$	915		$	438		$	169		$	633	$	13,139
Ending ALLL related to loans individually evaluated for impairment	$	928		$	3		$	—		$	229		$	29		$	16		$	312		$	—	$	1,517
Ending ALLL related to purchased credit-impaired loans	$	183		$	58		$	—		$	3		$	—		$	—		$	—		$	—	$	244

Loans outstanding:
Collectively evaluated for impairment	$	188,118		$	227,795		$	663,883		$	33,508		$	105,272		$	79,072		$	12,929		$	—	$	1,310,577
Individually evaluated for impairment¹	5,951			2,889			3,147			6,678			862			1,327			1,891			—		22,745
Purchased credit-impaired	333			2,583			2,195			11			67			—			—			—		5,189
Total	$	194,402		$	233,267		$	669,225		$	40,197		$	106,201		$	80,399		$	14,820		$	—	$	1,338,511
Ratio of allowance for loan losses to total loans	1.61		%	0.85		%	1.00		%	1.42		%	0.89		%	0.56		%	3.25		%	NM		1.11		%
Allowance for loan losses to non-accrual loans	933		%	141		%	256		%	11		%	213		%	NM			316		%	NM		147		%

¹ Total excludes $2.9 million of PCI loans that have experienced post-acquisition declines in cash flows expected to be collected.These loans are included in the "purchased credit-impaired" amount in the next line below.

NM - Not Meaningful



Allowance for Loan Losses and Recorded Investment in Loans
(dollars in thousands)	Commercial and industrial			Commercial real estate, owner-occupied			Commercial real estate, investor			Construction			Home equity			Other residential			Installment and other consumer			Unallocated		Total

As of December 31, 2013:
Ending ALLL related to loans collectively evaluated for impairment	$	1,886		$	1,922		$	6,196		$	292		$	874		$	294		$	265		$	506	$	12,235
Ending ALLL related to loans individually evaluated for impairment	$	987		$	31		$	—		$	341		$	1		$	23		$	364		$	—	$	1,747
Ending ALLL related to purchased credit-impaired loans	$	183		$	59		$	—		$	—		$	—		$	—		$	—		$	—	$	242

Loans outstanding:
Collectively evaluated for impairment	$	177,550		$	233,330		$	619,833		$	24,829		$	97,894		$	70,571		$	15,357		$	—	$	1,239,364
Individually evaluated for impairment¹	5,408			2,930			3,341			6,733			506			2,063			1,862			—		22,843
Purchased credit-impaired	333			4,853			1,845			15			69			—			—			—		7,115
Total	$	183,291		$	241,113		$	625,019		$	31,577		$	98,469		$	72,634		$	17,219		$	—	$	1,269,322
Ratio of allowance for loan losses to total loans	1.67		%	0.83		%	0.99		%	2.00		%	0.89		%	0.44		%	3.65		%	NM		1.12		%
Allowance for loan losses to non-accrual loans	257		%	143		%	221		%	12		%	374		%	48		%	372		%	NM		122		%

¹ Total excludes $2.9 million PCI loans that have experienced credit deterioration post-acquisition, which are included in the "purchased credit-impaired" amount in the next line below.

NM - Not Meaningful

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Allowance for Loan Losses and Recorded Investment in Loans
(dollars in thousands; unaudited)	Commercial and industrial			Commercial real estate, owner-occupied			Commercial real estate, investor			Construction			Home equity			Other residential			Installment and other consumer			Unallocated			Total

For the three months ended June 30, 2013
Allowance for loan losses:
Beginning balance	$	4,032		$	1,348		$	4,020		$	650		$	1,216		$	431		$	1,366		$	371		$	13,434
Provision (reversal)	(189		)	(26		)	345			1,084			63			(30		)	28			(175		)	1,100
Charge-offs	(386		)	—			—			(13		)	(126		)	—			(85		)	—			(610		)
Recoveries	342			84			3			—			—			—			4			—			433
Ending balance	$	3,799		$	1,406		$	4,368		$	1,721		$	1,153		$	401		$	1,313		$	196		$	14,357

For the six months ended June 30, 2013
Allowance for loan losses:
Beginning balance	$	4,100		$	1,313		$	4,372		$	611		$	1,264		$	551		$	1,231		$	219		$	13,661
Provision (reversal)	(239		)	9			(30		)	1,126			14			(150		)	163			(23		)	870
Charge-offs	(457		)	—			—			(17		)	(133		)	—			(86		)	—			(693		)
Recoveries	395			84			26			1			8			—			5			—			519
Ending balance	$	3,799		$	1,406		$	4,368		$	1,721		$	1,153		$	401		$	1,313		$	196		$	14,357

Purchased Credit-Impaired Loans

We evaluated loans purchased in acquisitions in accordance with accounting guidance in ASC 310-30 related to loans acquired with deteriorated credit quality. Acquired loans are considered credit-impaired if there is evidence of deterioration of credit quality since origination and it is probable, at the acquisition date, that we will be unable to collect all contractually required payments receivable. Management has determined certain loans purchased in the acquisitions to be PCI loans based on credit indicators such as nonaccrual status, past due status, loan risk grade, loan-to-value ratio, etc. Revolving credit agreements (e.g., home equity lines of credit and revolving commercial loans) are not considered PCI loans as cash flows cannot be reasonably estimated.

The following table reflects the outstanding balance and related carrying value of PCI loans as of June 30, 2014 and December 31, 2013:



	June 30, 2014				December 31, 2013
PCI Loans (dollars in thousands; 2014 unaudited)	Unpaid principal balance		Carrying value		Unpaid principal balance		Carrying value
Commercial and industrial	$	522	$	333	$	1,094	$	333
Commercial real estate	6,871		4,778		9,152		6,698
Construction	141		11		149		15
Home equity	235		67		239		69
Total purchased credit-impaired loans	$	7,769	$	5,189	$	10,634	$	7,115

The activities in the accretable yield, or income expected to be earned, for PCI loans were as follows:



Accretable Yield	Three months ended						Six months ended
(dollars in thousands, unaudited)	June 30, 2014			June 30, 2013			June 30, 2014			June 30, 2013
Balance at beginning of period	$	5,301		$	3,583		$	3,649		$	3,960
Removals ¹	(273		)	(195		)	(273		)	(791		)
Accretion	(187		)	(156		)	(367		)	(392		)
Reclassifications (to) from nonaccretable difference ²	(327		)	45			1,505			500
Balance at end of period	$	4,514		$	3,277		$	4,514		$	3,277

¹ Represents the accretable difference that is relieved when a loan exits the PCI population due to payoff, full charge-off, or transfer to repossessed assets, etc.

²Primarily relates to changes in expected credit performance and changes in expected amounts and/or timing of cash flows.

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Pledged Loans

Our FHLB line of credit is secured under terms of a blanket collateral agreement by a pledge of certain qualifying loans with an unpaid principal balance of $835.4 million and $716.2 million at June 30, 2014 and December 31, 2013, respectively. Our FHLB line of credit totaled $491.7 million and $416.3 million at June 30, 2014 and December 31, 2013, respectively. In addition, we pledge a certain residential loan portfolio, which totaled $27.0 million and $24.4 million at June 30, 2014 and December 31, 2013, respectively, to secure our borrowing capacity with the Federal Reserve Bank (“FRB”). Also see Note 7 below.

Note 7: Borrowings

Federal Funds Purchased – We had unsecured lines of credit totaling $87.0 million with correspondent banks for overnight borrowings at both June 30, 2014 and December 31, 2013. In general, interest rates on these lines approximate the Federal funds target rate. At June 30, 2014 and December 31, 2013, we had no overnight borrowings outstanding under these credit facilities.

Federal Home Loan Bank Borrowings – As of June 30, 2014 and December 31, 2013, we had lines of credit with the FHLB totaling $491.7 million and $416.3 million, respectively, based on eligible collateral of certain loans. At June 30, 2014 and December 31, 2013, we had no FHLB overnight borrowings.

On February 5, 2008, we entered into a ten-year borrowing agreement under the same FHLB line of credit for $15.0 million at a fixed rate of 2.07%, which remained outstanding at June 30, 2014. Interest-only payments are required every three months until the entire principal is due on February 5, 2018. The FHLB has the unconditional right to accelerate the due date on August 5, 2014 and every three months thereafter (the “put dates”). If the FHLB exercises its right to accelerate the due date, the FHLB will offer replacement funding at the current market rate, subject to certain conditions. We must comply with the put date, but are not required to accept replacement funding.

At June 30, 2014, $476.5 million was remaining as available for borrowing from the FHLB, net of the term borrowing and letters of credit acquired from NorCal totaling $241 thousand.

Federal Reserve Line of Credit – We have a line of credit with the FRB secured by a certain residential loan portfolio. At June 30, 2014 and December 31, 2013, we had borrowing capacity under this line totaling $27.0 million and $24.4 million, respectively, and had no outstanding borrowings with the FRB.

As part of the Acquisition, we assumed two tranches of subordinated debentures due to the NorCal Community Bancorp grantor trusts at fair values totaling $4.95 million at acquisition date and contractual values totaling $8.2 million. The difference between the contractual balance and the fair value at acquisition date is accreted into interest expense over the lives of the debentures. Accretion on the subordinated debentures totaled $108 thousand in the first six months of 2014. The Trusts have the option to defer payment of the distributions for a period of up to five years, as long as there is no default on the subordinated debentures. In the event of interest deferral, dividends to common stockholders are prohibited. The trust preferred securities were sold and issued in private transactions pursuant to an exemption from registration under the Securities Act of 1933, as amended. Bancorp has guaranteed, on a subordinated basis, distributions and other payments due on trust preferred securities totaling $8.0 million issued by the grantor trusts which have identical maturity, repricing and payment terms as the subordinated debentures.

The following is a summary of the contractual terms of the subordinated debentures due to NorCal Community Bancorp grantor trusts as of June 30, 2014:



(dollars in thousands)
Subordinated debentures due to NorCal Community Bancorp Trust I on October 7, 2033 with interest payable quarterly, based on 3-month LIBOR plus 3.05%, repricing quarterly (3.28% as of June 30, 2014), redeemable, in whole or in part, on any interest payment date.	$	4,124
Subordinated debentures due to NorCal Community Bancorp Trust II on March 15, 2036 with interest payable quarterly, based on 3-month LIBOR plus 1.40%, repricing quarterly (1.63% as of June 30, 2014), redeemable, in whole or in part, on any interest payment date.	4,124
Total	$	8,248

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Note 8: Stockholders' Equity

Preferred Stock

Under the United States Department of the Treasury Capital Purchase Program (the “TCPP”), which was intended to stabilize and inject liquidity into the financial industry, on December 5, 2008, Bancorp issued to the U.S. Treasury 28,000 shares of senior preferred stock with a zero par value and a $1,000 per share liquidation preference, along with a warrant to purchase 154,242 shares of common stock at a per share exercise price of $27.23, in exchange for aggregate consideration of $28.0 million. The proceeds of $28.0 million were allocated between the preferred stock and the warrant with $27.0 million allocated to preferred stock and $961 thousand allocated to the warrant, based on their relative fair value at the time of issuance. The warrant was immediately exercisable and expires 10 years after the issuance date.

Under the American Recovery and Reinvestment Act of 2009, which allowed participants in the TCPP to withdraw from the program, we repurchased all 28,000 shares of outstanding preferred stock from the U.S. Treasury at $28 million plus accrued but unpaid dividends of $179 thousand on March 31, 2009. At the time of repurchase, we also accelerated the remaining accretion of the preferred stock totaling $945 thousand through retained earnings, reducing our net income available to common stockholders. The warrant was subsequently auctioned to two institutional investors in November 2011 and remains outstanding. It is adjusted for cash dividend increases to represent a right to purchase 156,483 shares of common stock at $26.84 per share as of June 30, 2014 in accordance with Section 13(c) of the Form of Warrant to Purchase Common Stock.

Dividends

Presented below is a summary of cash dividends paid to common shareholders, recorded as a reduction of retained earnings.



	Three months ended				Six months ended
(dollars in thousands except per share data, unaudited)	June 30, 2014		June 30, 2013		June 30, 2014		June 30, 2013
Cash dividends to common stockholders	$	1,123	$	979	$	2,243	$	1,950
Cash dividends per common share	$	0.19	$	0.18	$	0.38	$	0.36

Share-Based Payments

The fair value of stock options on the grant date is recorded as a stock-based compensation expense in the consolidated statements of comprehensive income over the requisite service period with a corresponding increase in common stock. Stock-based compensation also includes compensation expense related to the issuance of unvested restricted common shares pursuant to the 2007 Equity Plan. The grant-date fair value of the restricted common shares, which is equal to its intrinsic value on that date, is being recorded as compensation expense over the requisite service period with a corresponding increase in common stock as the shares vest. In addition, we record excess tax benefits on the exercise

of non-qualified stock options, the disqualifying disposition of incentive stock options and vesting of in-the-money restricted stock as an addition to common stock with a corresponding decrease in current taxes payable.

The holders of the unvested restricted common shares are entitled to dividends on the same per-share ratio as the holders of common stock. Dividends paid on the portion of share-based awards not expected to vest are also included in stock-based compensation expense. Tax benefits on dividends paid on the portion of share-based awards expected to vest are recorded as an increase to common stock with a corresponding decrease in current taxes payable.

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Note 9: Commitments and Contingencies

Financial Instruments with Off-Balance Sheet Risk

We make commitments to extend credit in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit in the form of loans or through standby letters of credit. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being fully drawn upon, the total commitment amount does not necessarily represent future cash requirements.

We are exposed to credit loss equal to the contract amount of the commitment in the event of nonperformance by the borrower. We use the same credit policies in making commitments as we do for on-balance-sheet instruments and we evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by us, is based on Management's credit evaluation of the borrower. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, and real property.

The contractual amount of loan commitments and standby letters of credit not reflected on the consolidated statements of condition was $331.9 million at June 30, 2014. This amount included $173.8 million under commercial lines of credit (these commitments are contingent upon customers maintaining specific credit standards), $106.8 million under revolving home equity lines, $25.7 million under undisbursed construction loans, $13.8 million under standby letters of credit, and a remaining $11.8 million under personal and other lines of credit. We have set aside an allowance for losses in the amount of $664 thousand for these commitments as of June 30, 2014, which is recorded in interest payable and other liabilities on the consolidated statements of condition.

Operating Leases

We rent certain premises and equipment under long-term, non-cancelable operating leases expiring at various dates through the year 2028. Most of the leases contain certain renewal options and escalation clauses. At June 30, 2014, the approximate minimum future commitments payable under non-cancelable contracts for leased premises are as follows:



(dollars in thousands; unaudited)	2014		2015		2016		2017		2018		Thereafter		Total
Operating leases	$	1,789	$	3,648	$	3,691	$	3,681	$	3,708	$	10,078	$	26,595

Litigation Matters

We may be party to legal actions which arise from time to time as part of the normal course of our business. We believe, after consultation with legal counsel, that we have meritorious defenses in these actions, and that litigation contingency liabilities, if any, will not have a material adverse effect on our financial position, results of operations, or cash flows.

We are responsible for our proportionate share of certain litigation indemnifications provided to Visa U.S.A. ("Visa") by its member banks in connection with lawsuits related to anti-trust charges and interchange fees ("Covered Litigation"). On December 13, 2013, the district court issued a memorandum and order approving Visa's definitive class settlement agreement in the interchange multidistrict litigation ("Settlement Agreement") with the class plaintiffs. On January 14, 2014, the court entered the final judgment order approving the settlement. A number of objectors to the settlement have appealed that order. Until the appeals are finally adjudicated, no assurance can be provided that Visa will be able to resolve the class plaintiffs' claims as contemplated by the Settlement Agreement. On January 27, 2014, Visa's portion of the takedown payments related to the opt-out merchants, which was calculated to be approximately $1.1 billion, was deposited into the litigation escrow account. The conversion rate of Visa Class B common stock held by us to Class A common stock (as discussed in Note 5) may reduce if Visa makes more Covered Litigation settlement payments in the future and the full impact to member banks is still uncertain. However, we are not aware of significant future cash settlement payments required by us on the Covered Litigation.

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Note 10: Derivative Financial Instruments and Hedging Activities

We have entered into interest rate swap agreements, primarily as an asset/liability management strategy, in order to mitigate the changes in the fair value of specified long-term fixed-rate loans (or firm commitments to enter into long-term fixed-rate loans) caused by changes in interest rates. These hedges allow us to offer long-term fixed rate loans to customers without assuming the interest rate risk of a long-term asset. Converting our fixed-rate interest payments to floating-rate interest payments, generally benchmarked to the one-month U.S. dollar LIBOR index, protects us against changes in the fair value of our loans associated with fluctuating interest rates.

The fixed-rate payment features of the interest rate swap agreements are generally structured at inception to mirror substantially all of the provisions of the hedged loan agreements. These interest rate swaps, designated and qualified as fair value hedges, are carried on the consolidated statements of condition at their fair value in other assets (when the fair value is positive) or in other liabilities (when the fair value is negative). One of our interest rate swap agreements qualifies for shortcut hedge accounting treatment. The change in fair value of the swap using the shortcut accounting treatment is recorded in other non-interest income, while the change in fair value of swaps using non-shortcut accounting is recorded in interest income. The unrealized gain or loss in fair value of the hedged fixed-rate loan due to LIBOR interest rate movements is recorded as an adjustment to the hedged loan and offset in other non-interest income (for shortcut accounting treatment) or interest income (for non-shortcut accounting treatment).

From time to time, we make firm commitments to enter into long-term fixed-rate loans with borrowers backed by yield maintenance agreements and simultaneously enter into forward interest rate swap agreements with correspondent banks to mitigate the change in fair value of the yield maintenance agreement. Prior to loan funding, yield maintenance agreements with net settlement features that meet the definition of a derivative are considered as non-designated hedges and are carried on the consolidated statements of condition at their fair value in other assets (when the fair value is positive) or in other liabilities (when the fair value is negative). The offsetting changes in the fair value of the forward swap and the yield maintenance agreement are recorded in interest income. In August 2010 and June 2011, two previously undesignated forward swaps were designated to offset the change in fair value of a fixed-rate loan originated in each of those periods. Subsequent to the point of the swap designations, the related yield maintenance agreements are no longer considered derivatives. Their fair value at the designation date was recorded in other assets and is amortized using the effective yield method over the life of the respective designated loans.

The net effect of the change in fair value of interest rate swaps, the amortization of the yield maintenance agreement and the change in the fair value of the hedged loans result in an insignificant amount of hedge ineffectiveness recognized in interest income.

Our credit exposure, if any, on interest rate swaps is limited to the favorable value (net of any collateral pledged to us) and interest payments of all swaps by each counterparty. Conversely, when an interest rate swap is in a liability position exceeding a certain threshold, we may be required to post collateral to the counterparty in an amount determined by the agreements (generally when our derivative liability position is greater than $100 thousand or $1.3 million, depending upon the counterparty). Collateral levels are monitored and adjusted on a regular basis for changes in interest rate swap values.

Page-33

As of June 30, 2014, we have eight interest rate swap agreements, which are scheduled to mature in September 2018, June 2020, August 2020, June 2031, October 2031, July 2032, August 2037 and October 2037. All of our derivatives are accounted for as fair value hedges. Our interest rate swaps are settled monthly with counterparties. Accrued interest on the swaps totaled $40 thousand and $70 thousand as of June 30, 2014 and December 31, 2013, respectively. Information on our derivatives follows:



	Asset derivatives				Liability derivatives
(dollars in thousands; 2014 unaudited)	June 30, 2014		December 31, 2013		June 30, 2014		December 31, 2013
Fair value hedges:
Interest rate contracts notional amount	$	10,430	$	17,956	$	22,019	$	21,577
Interest rate contracts fair value¹	$	400	$	961	$	1,645	$	2,519



	Three months ended
(dollars in thousands; unaudited)	June 30, 2014			June 30, 2013
(Increase) Decrease in value of designated interest rate swaps recognized in interest income	$	(423	)	$	1,956
Payment on interest rate swaps recorded in interest income	(252		)	(359		)
Increase (Decrease) in value of hedged loans recognized in interest income	453			(2,095		)
Decrease in value of yield maintenance agreement recognized against interest income	(15		)	(18		)
Net loss on derivatives recognized against interest income ²	$	(237	)	$	(516	)




	Six months ended
(dollars in thousands; unaudited)	June 30, 2014			June 30, 2013
Increase in value of designated interest rate swaps recognized in interest income	$	313		$	2,603
Payment on interest rate swaps recorded in interest income	(505		)	(717		)
Decrease in value of hedged loans recognized in interest income	(78		)	(2,787		)
Decrease in value of yield maintenance agreement recognized against interest income	(62		)	(36		)
Net loss on derivatives recognized against interest income ²	$	(332	)	$	(937	)

¹See Note 4 for valuation methodology.

²Includes hedge ineffectiveness of $15 thousand and $(157) thousand for the quarters ended June 30, 2014 and June 30, 2013, respectively. Ineffectiveness of $173 thousand and $(220) thousand was recorded in interest income during the six months ended June 30, 2014 and June 30, 2013, respectively. Changes in value of swaps were included in the assessment of hedge effectiveness.

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Our derivative transactions with counterparties are under International Swaps and Derivative Association (“ISDA”) master agreements that include “right of set-off” provisions. “Right of set-off” provisions are legally enforceable rights to offset recognized amounts and there may be an intention to settle such amounts on a net basis. We do not offset such financial instruments for financial reporting purposes.

Information on financial instruments that are eligible for offset in the consolidated statements of condition follows:



Offsetting of Financial Assets and Derivative Assets

(dollars in thousands; 2014 unaudited)							Gross Amounts Not Offset in the Statements of Condition
			Gross Amounts		Net Amounts
	Gross Amounts		Offset in the		of Assets Presented
	of Recognized		Statements of		in the Statements		Financial			Cash Collateral
	Assets¹		Condition		of Condition¹		Instruments			Received		Net Amount
As of June 30, 2014
Derivatives by Counterparty
Counterparty A	$	400	$	—	$	400	$	(400	)	$	—	$	—
Counterparty B	—		—		—		—			—		—
Total	$	400	$	—	$	400	$	(400	)	$	—	$	—

As of December 31, 2013
Derivatives by Counterparty
Counterparty A	$	961	$	—	$	961	$	(825	)	$	—	$	136
Counterparty B	—		—		—		—			—		—
Total	$	961	$	—	$	961	$	(825	)	$	—	$	136

¹Amounts exclude accrued interest totaling $7 thousand and $10 thousand at June 30, 2014 and December 31, 2013, respectively.



Offsetting of Financial Liabilities and Derivative Liabilities

(dollars in thousands; 2014 unaudited)							Gross Amounts Not Offset in the Statements of Condition
			Gross Amounts		Net Amounts of
	Gross Amounts		Offset in the		Liabilities Presented
	of Recognized		Statements of		in the Statements of		Financial			Cash Collateral
	Liabilities²		Condition		Condition²		Instruments			Pledged			Net Amount
As of June 30, 2014
Derivatives by Counterparty
Counterparty A	$	1,192	$	—	$	1,192	$	(400	)	$	—		$	792
Counterparty B	453		—		453		—			(453		)	—
Total	$	1,645	$	—	$	1,645	$	(400	)	$	(453	)	$	792

As of December 31, 2013
Derivatives by Counterparty
Counterparty A	$	825	$	—	$	825	$	(825	)	$	—		$	—
Counterparty B	1,694		—		1,694		—			(1,694		)	—
Total	$	2,519	$	—	$	2,519	$	(825	)	$	(1,694	)	$	—

²Amounts exclude accrued interest totaling $33 thousand and $60 thousand at June 30, 2014 and December 31, 2013, respectively.

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

Management's discussion of the financial condition and results of operations should be read in conjunction with the related consolidated financial statements in this Form 10-Q and with the audited consolidated financial statements and accompanying notes included in our 2013 Annual Report on Form 10-K. Average balances, including balances used in calculating certain financial ratios, are generally comprised of average daily balances.

Forward-Looking Statements

This discussion of financial results includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, (the "1933 Act") and Section 21E of the Securities Exchange Act of 1934, as amended, (the "1934 Act"). Those sections of the 1933 Act and 1934 Act provide a "safe harbor" for forward-looking statements to encourage companies to provide prospective information about their financial performance so long as they provide meaningful, cautionary statements identifying important factors that could cause actual results to differ significantly from projected results.

Our forward-looking statements include descriptions of plans or objectives of Management for future operations, products or services, and forecasts of revenues, earnings or other measures of economic performance. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include the words "believe," "expect," "intend," "estimate" or words of similar meaning, or future or conditional verbs such as "will," "would," "should," "could" or "may."

Forward-looking statements are based on Management's current expectations regarding economic, legislative, and regulatory issues that may impact our earnings in future periods. A number of factors—many of which are beyond Management’s control—could cause future results to vary materially from current Management expectations. Such factors include, but are not limited to our ability to integrate the business from Bank of Alameda, general economic conditions, the economic uncertainty in the United States and abroad, changes in interest rates, deposit flows, real estate values, expected future cash flows on acquired loans and securities, competition; changes in accounting principles, policies or guidelines; changes in legislation or regulation; adverse weather conditions, including the drought in California; and other economic, competitive, governmental, regulatory and technological factors affecting our operations, pricing, products and services.

The events or factors that could cause results or performance to materially differ from those expressed in our prior forward-looking statements concerning the Acquisition include:


•	lower than expected consolidated revenues;


•	losses of deposit and loan customers resulting from the acquisition;


•	greater than expected loan losses;


•	significant increases in competition;


•	the inability to achieve expected cost savings from the acquisition, or the inability to achieve those savings as soon as expected; and


•	unexpected costs, including litigation risk not discovered during the due diligence period.

These and other important factors are detailed in the Risk Factors section of our 2013 Form 10-K as filed with the SEC, copies of which are available from us at no charge. Forward-looking statements apply only as of the date they are made. We do not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events.

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RESULTS OF OPERATIONS

Highlights of the financial results are presented in the following table:



	For the three months ended						For the six months ended
(dollars in thousands, except per share data; unaudited)	June 30, 2014			June 30, 2013			June 30, 2014			June 30, 2013
For the period:
Net income	$	5,168		$	3,055		$	9,701		$	7,921
Net income per share
Basic	$	0.88		$	0.56		$	1.65		$	1.47
Diluted	$	0.86		$	0.55		$	1.62		$	1.44
Return on average equity	10.96		%	7.72		%	10.47		%	10.19		%
Return on average assets	1.14		%	0.86		%	1.08		%	$	1.12	%
Common stock dividend payout ratio	21.74		%	32.06		%	23.11		%	24.63		%
Average shareholders’ equity to average total assets	10.41		%	11.20		%	10.26		%	11.02		%
Efficiency ratio	56.60		%	64.12		%	60.22		%	60.67		%
Tax equivalent net interest margin	4.23		%	4.30		%	4.24		%	4.39		%

(dollars in thousands, except per share data; 2014 unaudited)	June 30, 2014			December 31, 2013
At period end:
Book value per common share	$	32.29		$	30.78
Total assets	$	1,823,901		$	1,805,194
Total loans	$	1,338,511		$	1,269,322
Total deposits	$	1,598,823		$	1,587,102
Loan-to-deposit ratio	83.7		%	80.0		%
Total risk-based capital ratio - Bancorp	13.5		%	13.2		%
Tier 1 leverage ratio (to average assets) - Bancorp	10.2		%	10.8		%

Page-37

Executive Summary

Earnings in the second quarter of 2014 totaled $5.2 million, compared to $4.5 million the first quarter of 2014 and $3.1 million in the second quarter of 2013. Diluted earnings per share totaled $0.86 in the second quarter of 2014, compared to $0.76 in the prior quarter and $0.55 in the same quarter last year. For the six-month period ended June 30, 2014, earnings totaled $9.7 million compared to $7.9 million for the same period a year ago. Diluted earnings per share for the six-month period ended June 30, 2014 totaled $1.62 compared to $1.44 in the same period a year ago.

Gross loans grew to $1.3 billion, an increase of $66.7 million, or 5.2% from December 31, 2013, which was driven by new volume in commercial real estate and commercial and industrial loans. Credit quality improved with non-accrual loans representing 0.76% of total loans at June 30, 2014, down from 0.92% at December 31, 2013. Non-accrual loans decreased from $11.7 million at year-end to $10.1 million at June 30, 2014. Accruing loans past due 30 to 89 days totaled $1.5 million at June 30, 2014, compared to $995 thousand at December 31, 2013.

The provision for loan losses of $600 thousand in the second quarter of 2014 was primarily driven by loan growth, compared to $150 thousand in the prior quarter and $1.1 million in the same quarter a year ago. The ratio of allowance for loan losses ("ALLL") to total loans decreased minimally from 1.12% at December 31, 2013 to 1.11% at June 30, 2014.

Deposits totaled $1.6 billion at both June 30, 2014 and December 31, 2013. Non-interest bearing deposits totaled 45.3% of total deposits at June 30, 2014, compared to 40.8% at December 31, 2013. The increase in non-interest bearing deposits reflects organic growth as well as the conversion of certain interest bearing accounts acquired from Bank of Alameda to non-interest bearing accounts in March 2014.

The total risk-based capital ratio for Bancorp was 13.5% at June 30, 2014, up from 13.2% at December 31, 2013. The total tier 1 leverage ratio for Bancorp was 10.2% at June 30, 2014, compared to 10.8% at December 31, 2013. The regulatory capital ratios continue to be well above current regulatory requirements for a well-capitalized institution, as well as new capital requirements effective January 1, 2015 (Basel Committee on Bank Supervision guidelines for determining regulatory capital).

Net interest income totaled $17.9 million in both the second quarter of 2014 and the prior quarter, compared to $14.3 million in the same quarter a year ago. The increase from the same quarter a year ago relates to higher balances on loans and investment securities, as well as accretion and gains on pay-offs of acquired loans. The tax-equivalent net interest margin was 4.23%, 4.25% and 4.30% for these respective periods. The decrease in net interest margin in the second quarter of 2014 compared to the same quarter a year ago relates to the impact of the low interest rate environment on our loan portfolio and higher cash balances as a percentage of interest-earning assets, partially offset by the accretion and gains on pay-offs of acquired loans.

Non-interest income in the second quarter of 2014 totaled $2.4 million, compared to $2.2 million in the prior quarter and $1.9 million in the same quarter a year ago. The increase from the same quarter a year ago primarily relates to gains on the sale of investment securities, higher dividend income from the Federal Home Loan Bank of San Francisco and higher debit card interchange fees.

Non-interest expense totaled $11.5 million in the second quarter of 2014, compared to $12.8 million in the prior quarter and $10.4 million in the same quarter a year ago. Non-interest expense in the second quarter of 2014 decreased $1.4 million, or 10.8%, compared to the prior quarter, primarily related to the absence of Acquisition-related expenses and professional service cost savings in the second quarter. The second quarter of 2014 reflects normalization of non-interest expense with significant declines in salaries and related benefits, data processing costs and professional services as the one-time expenses of the Acquisition were fully absorbed in the fourth quarter of 2013 and the first quarter of 2014. The increase in non-interest expense from the same quarter a year ago reflects the higher cost base associated with a larger-sized bank, expansion into the East Bay, and increased lending staff in the North Bay.

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Critical Accounting Policies

Critical accounting policies are those that are both most important to the portrayal of our financial condition and results of operations and require Management's most difficult, subjective, or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.

Management has determined the following five accounting policies to be critical: Allowance for Loan Losses, Acquired Loans, Other-than-temporary Impairment of Investment Securities, Accounting for Income Taxes, and Fair Value Measurements.

Allowance for Loan Losses

Allowance for Loan Losses is based upon estimates of loan losses and is maintained at a level considered adequate to provide for probable losses inherent in the loan portfolio. The allowance is increased by provisions for loan losses charged against earnings and reduced by charge-offs, net of recoveries.

In periodic evaluations of the adequacy of the allowance balance, Management considers current economic conditions, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, the estimated value of any underlying collateral, our past loan loss experience and other factors. The ALLL is based on estimates, and ultimate losses may vary from current estimates. Our Asset/Liability Management Committee (“ALCO”) reviews the adequacy of the ALLL at least quarterly. The allowance is adjusted based on that review if, in the judgment of the ALCO and Management, changes are warranted.

The overall allowance consists of 1) specific allowances for individually identified impaired loans ("ASC 310-10") and 2) general allowances for pools of loans ("ASC 450-20"), which incorporate changing qualitative and environmental factors (e.g., portfolio growth and trends, credit concentrations, economic and regulatory factors, etc.).

The first component, specific allowances, results from the analysis of identified problem credits and the evaluation of sources of repayment including collateral, as applicable. Through Management's ongoing loan grading and credit monitoring process, individual loans are identified that have conditions indicating the borrower may be unable to pay all amounts due in accordance with the contractual terms. These loans are evaluated for impairment individually by Management. Management considers an originated loan to be impaired when it is probable we will be unable to collect all amounts due according to the contractual terms of the loan agreement. For allowances established on acquired loans, refer to Acquired Loans discussed below. When the fair value of the impaired loan is less than the recorded investment in the loan, the difference is recorded as impairment through the establishment of a specific allowance. For loans determined to be impaired, the extent of the impairment is measured based on the present value of expected future cash flows discounted at the loan's effective interest rate at origination (for originated loans), based on the loan's observable market price, or based on the fair value of the collateral if the loan is collateral dependent or if foreclosure is imminent. Generally with problem credits that are collateral dependent, we obtain appraisals of the collateral at least annually. We may obtain appraisals more frequently if we believe the collateral value is subject to market volatility, if a specific event has occurred to the collateral, or if we believe foreclosure is imminent.

The second component is an estimate of the probable inherent losses in each loan pool with similar characteristics. This analysis encompasses the entire loan portfolio and excludes acquired loans where the discount has not been fully accreted. For allowance established on acquired loans, see below under Acquired Loans. Under our allowance model, loans are evaluated on a pool basis by loan segment which is further delineated by Federal regulatory reporting codes ("call codes"). Each segment is assigned an expected loss factor which is primarily based on a twelve quarter look-back at our historical losses for that particular segment, as well as a number of other factors.

The model determines loan loss reserves based on objective and subjective factors. Objective factors include a rolling historical loss rate using the twelve quarter look-back, changes in the volume and nature of the loan portfolio, changes in credit quality metrics (past due loans, non-accrual loans, net charge-offs), and the existence of credit concentrations. Subjective factors include changes in the overall economic environment, legal and regulatory conditions, lending management and other relevant staff, uncertainties related to acquisitions, as well as the quality of our loan review process. The total amount allocated is determined by applying loss multipliers to outstanding loans by call code.

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Acquired Loans

From time to time, we acquire loans through business acquisitions. Acquired loans are recorded at their estimated fair values at acquisition date in accordance with ASC 805 Business Combinations, factoring in credit losses expected to be incurred over the life of the loan. Accordingly, an allowance for loan losses is not carried over or recorded for acquired loans as of the acquisition date.

The process of estimating fair values of the acquired loans, including the estimate of losses that are expected to be incurred over the estimated remaining lives of the loans at acquisition date and the ongoing updates to Management's expectation of future cash flows, requires significant subjective judgments and assumptions, particularly considering the economic environment. The economic environment and the lack of market liquidity and transparency are factors that have influenced, and may continue to affect, these assumptions and estimates.

We estimated the fair value of acquired loans at the acquisition date based on a discounted cash flow methodology that considered factors including the type of loan and related collateral, risk classification, fixed or variable interest rate, term of loan, whether or not the loan was amortizing, and current discount rates. Loans, except for purchased credit impaired ("PCI") loans, were grouped together according to similar characteristics and were treated in the aggregate when applying various valuation techniques. Expected cash flows incorporates our best estimate of current key assumptions, such as property values, default rates, loss severity and prepayment speeds. Discount rates were based on market rates for new originations of comparable loans, where available, and included adjustments for liquidity factors.

To the extent comparable market rates are not readily available, a discount rate was derived based on the assumptions of market participants' cost of funds, servicing costs and return requirements for comparable risk assets. In either case, the discount rate does not include a factor for credit losses, as that has been considered in estimating the cash flows. The initial estimate of cash flows to be collected was derived from assumptions such as default rates, loss severities and prepayment speeds.

For acquired loans not considered credit impaired ("non-PCI") loans, we recognize the entire fair value discount accretion to interest income, based on the acquired loan's contractual cash flows using an effective interest rate method for term loans, and on a straight line basis for revolving lines, as the timing and amount of cash flows under revolving lines are not predictable. The level of accretion on non-PCI loans varies from period to period due to maturities and early pay-offs of these loans during the reporting periods. Subsequent to acquisition, if the probable and estimable losses for non-PCI loans exceed the amount of the remaining unaccreted discount, the excess is established as an allowance for loan losses.

We acquired some loans from business combinations with evidence of credit quality deterioration subsequent to their origination and for which it was probable, at acquisition, that we would be unable to collect all contractually required payments (PCI loans). These loans are evaluated on an individual basis. Management has applied significant subjective judgment in determining which loans are PCI loans. Evidence of credit quality deterioration as of the purchase date may include data such as past due and nonaccrual status, risk grades and charge-off history. Revolving credit agreements (e.g., home equity lines of credit and revolving commercial loans) where the borrower had revolving rights at acquisition date are not considered PCI loans because the timing and amount of cash flows cannot be reasonably estimated.

According to the accounting guidance for PCI loans, the difference between the contractually required payments and the cash flows expected to be collected at acquisition, considering the impact of prepayments, is referred to as the nonaccretable difference and is not recorded. Furthermore, the difference between the expected cash flows and the fair value at acquisition date ("accretable difference") is accreted into interest income at a level yield of return over the remaining term of the loan, provided that the timing and amount of future cash flows is reasonably estimable.

All PCI loans that were classified as non-accrual loans prior to the acquisition were no longer classified as non-accrual if we believed that we would fully collect the new carrying value of these loans at acquisition. When there is doubt as to the timing and amount of future cash flows to be collected, PCI loans are classified as non-accrual loans. It is important to note that judgment is required to classify PCI loans as accruing or non-accrual, and is dependent on having a reasonable expectation about the timing and amount of cash flows expected to be collected.

If we have probable decreases in cash flows expected to be collected on PCI loans, specific allowances are established for these PCI loans that have experienced credit deterioration subsequent to acquisitions. The amount of cash flows

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expected to be collected and, accordingly, the adequacy of the allowance for loan losses are particularly sensitive to changes in loan credit quality. If we have probable and significant increases in cash flows expected to be collected on PCI loans, we first reverse any previously established specific allowance for loan loss and then increase interest income as a prospective yield adjustment over the remaining life of the loans. The impact of changes in variable interest rates is recognized prospectively as adjustments to interest income.

The estimate of cash flows expected to be collected is updated each quarter and requires the continued usage of key assumptions and estimates similar to the initial estimate of fair value. Given the current economic environment, we apply judgment to develop our estimate of cash flows for PCI loans given the impact of collateral value changes, loan workout plans, changing probability of default, loss severities and prepayments. Therefore, accretion on PCI loans fluctuates based on changes in cash flows expected to be collected.

For purposes of accounting for the PCI loans from past business combinations, we elected not to apply the pooling method but to account for these loans individually. Disposals of loans, which may include sales of loans to third parties, receipt of payments in full by the borrower, or foreclosure of the collateral, result in removal of the loan from the PCI loan portfolio at its carrying amount. If a PCI loan pays-off earlier than expected, a gain is recorded as interest income when the pay-off amount exceeds the recorded investment.

For further information regarding our acquired loans, see Note 6 to our Consolidated Financial Statements in this Form 10-Q.

Other-than-temporary Impairment of Investment Securities

At each financial statement date, we assess whether declines in the fair value of held-to-maturity and available-for-sale securities below their costs are deemed to be other-than-temporary. We consider, among other things, (i) the length of time and the extent to which the fair value has been less than cost, (ii) the financial condition and near-term prospects of the issuer, and (iii) our intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in fair value. Evidence evaluated includes, but is not limited to, the remaining payment terms of the instrument and economic factors that are relevant to the collectability of the instrument, such as: current prepayment speeds, the current financial condition of the issuer(s), industry analyst reports, credit ratings, credit default rates, interest rate trends, the quality of any credit enhancement and the value of any underlying collateral.

For each security in an unrealized loss position, we assess whether we intend to sell the security or if it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis less any current-period credit losses. If we intend to sell the security or it is more likely than not we will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date is recognized against earnings.

For impaired securities that are not intended for sale and will not be required to be sold prior to recovery of our amortized cost basis, we determine if the impairment has a credit loss component. For both held-to-maturity and available-for-sale securities, if the amount of cash flows expected to be collected are less than those at the last reporting date, an other-than-temporary impairment shall be considered to have occurred and the credit loss component is recognized in earnings as the present value of the change in expected future cash flows. In determining the present value of the expected cash flows, we discount the expected cash flows at the effective interest rate implicit in the security at the date of purchase. The remaining difference between the fair value and the amortized basis is deemed to be due to factors that are not credit related and is recognized in other comprehensive income, net of applicable taxes.

For held-to-maturity securities, if there is no credit loss, no impairment is recognized. The other-than-temporary impairment recognized in other comprehensive income for credit impaired debt securities classified as held-to-maturity is accreted from other comprehensive income to the amortized cost of the debt security over the remaining life of the debt security in a prospective manner on the basis of the amount and timing of future estimated cash flows.

Accounting for Income Taxes

Income taxes reported in the consolidated financial statements are computed based on an asset and liability approach. We recognize the amount of taxes payable or refundable for the current year and we recognize deferred tax assets and liabilities related to expected future tax consequences. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial statements and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. We record net deferred tax

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assets to the extent it is more likely than not that they will be realized. In evaluating our ability to recover the deferred tax assets, Management considers all available positive and negative evidence, including scheduled reversals of deferred tax liabilities, projected future taxable income, tax planning strategies and recent financial operations. In projecting future taxable income, Management develops assumptions including the amount of future state and federal pretax operating income, the reversal of temporary differences, and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future taxable income and are consistent with the plans and estimates being used to manage the underlying business. Bancorp files consolidated federal and combined state income tax returns.

We recognize the financial statement effect of a tax position when it is more likely than not, based on the technical merits and all available evidence, that the position will be sustained upon examination, including the resolution through protests, appeals or litigation processes. For tax positions that meet the more-likely-than-not threshold, we measure and record the largest amount of tax benefit that is greater than fifty percent likely of being realized upon ultimate settlement with the taxing authority. The remainder of the benefits associated with tax positions taken is recognized as a liability for unrecognized tax benefits, along with any related interest and penalties. Interest and penalties related to unrecognized tax benefits are recorded in tax expense.

In deciding whether or not our tax positions taken meet the more-likely-than-not recognition threshold, we must make judgments and interpretations about the application of inherently complex state and federal tax laws. To the extent tax authorities disagree with tax positions taken by us, our effective tax rates could be materially affected in the period of settlement with the taxing authorities. Revision of our estimate of accrued income taxes also may result from our own income tax planning, which may impact effective tax rates and results of operations for any given quarter.

Fair Value Measurements

We use fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. We base our fair values on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Securities available-for-sale and derivatives are recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record certain assets at fair value on a non-recurring basis, such as purchased loans recorded at acquisition date, certain impaired loans held for investment, other real estate owned and securities held-to-maturity that are other-than-temporarily impaired. These non-recurring fair value adjustments typically involve write-downs of individual assets due to application of lower-of-cost or market accounting.

When we develop our fair value measurement process, we maximize the use of observable inputs. Whenever there is no readily available market data, we use our best estimate and assumptions in determining fair value, but these estimates involve inherent uncertainties and the application of Management's judgment. As a result, if other assumptions had been used, our recorded earnings or disclosures could have been materially different from those reflected in these financial statements. For detailed information on our use of fair value measurements and our related valuation methodologies, see Note 4 to the Consolidated Financial Statements in this Form 10-Q.

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Net Interest Income

Net interest income is the difference between the interest earned on loans, investments and other interest-earning assets and the interest expense incurred on deposits and other interest-bearing liabilities. Net interest income is impacted by changes in general market interest rates and by changes in the amounts and composition of interest-earning assets and interest-bearing liabilities. Interest rate changes can create fluctuations in the net interest margin due to an imbalance in the timing of repricing or maturity of assets or liabilities. We manage interest rate risk exposure with the goal of minimizing the impact of interest rate volatility on net interest margin.

Net interest margin is expressed as net interest income divided by average interest-earning assets. Net interest rate spread is the difference between the average rate earned on total interest-earning assets and the average rate incurred on total interest-bearing liabilities. Both of these measures are reported on a taxable-equivalent basis. Net interest margin is the higher of the two because it reflects interest income earned on assets funded with non-interest-bearing sources of funds, which include demand deposits and stockholders’ equity.

The following table, Average Statements of Condition and Analysis of Net Interest Income, compares interest income and average interest-earning assets with interest expense and average interest-bearing liabilities for the periods presented. The table also indicates net interest income, net interest margin and net interest rate spread for each period presented.



	Average Statements of Condition and Analysis of Net Interest Income

		Three months ended						Three months ended
		June 30, 2014						June 30, 2013
				Interest						Interest
		Average		Income/		Yield/		Average		Income/		Yield/
(dollars in thousands; unaudited)		Balance		Expense		Rate		Balance		Expense		Rate
Assets
	Interest-bearing due from banks ¹	$	54,313	$	37	0.27	%	$	4,485	$	3	0.26	%
	Investment securities ^{2, 3}	350,938		2,208		2.52	%	266,774		1,452		2.18	%
	Loans ^{1, 3, 4}	1,303,363		16,597		5.04	%	1,070,333		13,537		5.00	%
	Total interest-earning assets ¹	1,708,614		18,842		4.36	%	1,341,592		14,992		4.42	%
	Cash and non-interest-bearing due from banks	41,739						27,331
	Bank premises and equipment, net	9,228						9,313
	Interest receivable and other assets, net	56,954						38,981
Total assets		$	1,816,535					$	1,417,217
Liabilities and Stockholders' Equity
	Interest-bearing transaction accounts	$	94,358	$	26	0.11	%	$	83,285	$	12	0.06	%
	Savings accounts	120,071		11		0.04	%	95,083		8		0.03	%
	Money market accounts	504,597		131		0.10	%	410,823		95		0.09	%
	CDARS® time accounts	—		—		—	%	5,194		2		0.15	%
	Other time accounts	157,239		231		0.59	%	136,759		224		0.66	%
	FHLB fixed-rate advances	15,000		78		2.07	%	27,785		84		1.20	%
	Subordinated debenture ¹	5,043		105		8.24	%	—		—		—	%
	Total interest-bearing liabilities	896,308		582		0.26	%	758,929		425		0.22	%
	Demand accounts	716,774						486,410
	Interest payable and other liabilities	14,281						13,092
	Stockholders' equity	189,172						158,786
Total liabilities & stockholders' equity		$	1,816,535					$	1,417,217
Tax-equivalent net interest income/margin ¹				$	18,260	4.23	%			$	14,567	4.30	%
Reported net interest income/margin ¹				$	17,874	4.14	%			$	14,305	4.21	%
Tax-equivalent net interest rate spread						4.10	%					4.20	%

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		Six months ended						Six months ended
		June 30, 2014						June 30, 2013
				Interest						Interest
		Average		Income/		Yield/		Average		Income/		Yield/
(dollars in thousands; unaudited)		Balance		Expense		Rate		Balance		Expense		Rate
Assets
	Interest-bearing due from banks ¹	$	69,945	$	88	0.25	%	$	5,094	$	11	0.43	%
	Investment securities ^{2, 3}	356,336		4,501		2.53	%	275,553		3,236		2.35	%
	Loans ^{1, 3, 4}	1,286,197		33,117		5.12	%	1,066,665		27,346		5.10	%
	Total interest-earning assets ¹	1,712,478		37,706		4.38	%	1,347,312		30,593		4.52	%
	Cash and non-interest-bearing due from banks	41,766						27,788
	Bank premises and equipment, net	9,158						9,369
	Interest receivable and other assets, net	56,395						38,440
Total assets		$	1,819,797					$	1,422,909
Liabilities and Stockholders' Equity
	Interest-bearing transaction accounts	$	110,637	$	49	0.09	%	$	106,205	$	23	0.04	%
	Savings accounts	120,671		22		0.04	%	95,818		16		0.03	%
	Money market accounts	511,743		289		0.11	%	421,430		194		0.09	%
	CDARS® time accounts	—		—		—	%	9,009		7		0.16	%
	Other time accounts	159,080		466		0.59	%	138,496		456		0.66	%
	FHLB fixed-rate advances	15,000		156		2.07	%	23,175		163		1.40	%
	Subordinated debenture ¹	5,015		210		8.48	%	—		—		—	%
	Total interest-bearing liabilities	922,146		1,192		0.26	%	794,133		859		0.22	%
	Demand accounts	695,848						458,030
	Interest payable and other liabilities	15,010						13,987
	Stockholders' equity	186,793						156,759
Total liabilities & stockholders' equity		$	1,819,797					$	1,422,909
Tax-equivalent net interest income/margin ¹				$	36,514	4.24	%			$	29,734	4.39	%
Reported net interest income/margin ¹				$	35,768	4.15	%			$	29,101	4.30	%
Tax-equivalent net interest rate spread						4.12	%					4.30	%

¹ Interest income/expense is divided by actual number of days in the period times 360 days to correspond to stated interest rate terms, where applicable.
² Yields on available-for-sale securities are calculated based on amortized cost balances rather than fair value, as changes in fair value are reflected as a component of stockholders' equity. Investment security interest is earned on 30/360 day basis monthly.
³ Yields and interest income on tax-exempt securities and loans are presented on a taxable-equivalent basis using the Federal statutory rate of 35 percent.
⁴ Average balances on loans outstanding include non-performing loans. The amortized portion of net loan origination fees is included in interest income on loans, representing an adjustment to the yield.

Second Quarter of 2014 Compared to Second Quarter of 2013

The tax-equivalent net interest margin was 4.23% in the second quarter of 2014, compared to 4.30% in the same quarter a year ago. The decrease of seven basis points was primarily due to the impact of the low interest rate environment on our loan portfolio, higher cash balances as a percentage of interest-earning assets and slightly higher cost of funds principally from the assumptions of the higher costing subordinated debentures from NorCal, partially offset by the accretion and gains on pay-offs of loans from the Acquisition. The net interest spread decreased ten basis points over the same period for the same reasons.

The average yield on interest-earning assets decreased six basis points in the second quarter of 2014 compared to the second quarter of 2013 due to the reasons listed above. The loan portfolio as a percentage of average interest-earning assets was 76.3% and 79.8% for the second quarter of 2014 and the second quarter of 2013, respectively. Total average interest-earning assets increased $367.0 million, or 27.4%, in the second quarter of 2014, compared to the second quarter of 2013, due to both the Acquisition and organic growth.

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Market interest rates are, in part, based on the target Federal Funds interest rate (the interest rate banks charge each other for short-term borrowings) implemented by the Federal Reserve Open Market Committee ("FOMC"). In December of 2008, the target interest rate reached an historic low with a range of 0% to 0.25% where it remained as of June 30, 2014. The accommodative monetary policy measures taken by the FOMC in recent years, including three rounds of quantitative easing, has led to a prolonged low interest rate environment. As a result, we have experienced downward pricing pressure on our interest-earning assets that negatively impacted our net interest margin and yields on our earning assets.

Six Months 2014 Compared to Six Months 2013

The tax-equivalent net interest margin was 4.24% in the first six months of 2014 compared to 4.39% in the same period last year. The decrease of fifteen basis points was primarily due to the impact of the low interest rate environment on our loan portfolio and higher cash balances as a percentage of interest-earning assets, partially offset by the accretion and gains on pay-offs of loans from the Acquisition. The net interest spread decreased eighteen basis points over the same period for the same reasons.

The average yield on interest-earning assets decreased fourteen basis points in the first six months of 2014 compared to the first six months of 2013 due to the reasons listed above. The loan portfolio as a percentage of average interest-earning assets was 75.1% and 79.2% for the six months ended June 30, 2014 and 2013, respectively. Total average interest-earning assets increased $365.2 million, or 27.1%, in the first six months of 2014 compared to the first six months of 2013, due to both the Acquisition and organic growth.

Our net interest margin fluctuations due to acquired loans were as follows:



	Three months ended						Six months ended
	June 30, 2014			June 30, 2013			June 30, 2014			June 30, 2013
(dollars in thousands; unaudited)	Dollar Amount		Basis point impact to net interest margin	Dollar Amount		Basis point impact to net interest margin	Dollar Amount		Basis point impact to net interest margin	Dollar Amount		Basis point impact to net interest margin
Accretion on PCI loans	$	187	4 bps	$	156	5 bps	$	367	4 bps	$	392	6 bps
Accretion on non-PCI loans	$	713	17 bps	$	246	7 bps	$	2,043	24 bps	$	378	6 bps
Gains on pay-offs of PCI loans	$	622	14 bps	$	149	4 bps	$	622	7 bps	$	469	7 bps

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Provision for Loan Losses

Management assesses the adequacy of the allowance for loan losses on a quarterly basis based on several factors including growth of the loan portfolio, analysis of probable losses in the portfolio, recent loss experience and the current economic climate. Actual losses on loans are charged against the allowance, and the allowance is increased by loss recoveries and through the provision for loan losses charged to expense. For further discussion, see the section captioned “Critical Accounting Policies.”

The provision for loan losses totaled $600 thousand in the second quarter of 2014 due to loan growth, compared to $1.1 million in the same quarter a year ago due to a problem land loan. Provision for loan losses totaled $750 thousand for the six months ended June 30, 2014, compared to $870 thousand for the same period a year ago.

The allowance for loan losses decreased to 1.11% of loans at June 30, 2014, from 1.12% at December 31, 2013. Non-accrual loans totaled $10.1 million, or 0.76% of Bancorp's loan portfolio at June 30, 2014, compared to $11.7 million, or 0.92% at December 31, 2013. The decrease in non-accrual loans primarily relates to commercial loans that were resolved in the first quarter of 2014 and one residential loan that became performing in the second quarter of 2014.

Impaired loan balances totaled $25.6 million at June 30, 2014, compared to $25.7 million at December 31, 2013, with specific valuation allowances of $1.8 million and $2.0 million, respectively. Classified loans, which have regulatory risk grades of "substandard" or "doubtful", increased to $33.2 million at June 30, 2014, from $31.1 million at December 31, 2013.

Net recoveries in the second quarter of 2014 totaled $68 thousand, compared to net charge-offs of $177 thousand in the same quarter a year ago. Net charge-offs for the six months ended June 30, 2014 totaled $75 thousand, compared to $174 thousand for the same period a year ago. The percentage of net charge-offs/(recoveries) to average loans was (0.01)% in the second quarter of 2014, compared to 0.02% in the second quarter of 2013 and 0.01% for the six months ended June 30, 2014, compared to 0.02% for the same period a year ago.

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Non-interest Income

The table below details the components of non-interest income.



	Three months ended				Amount			Percent
(dollars in thousands; unaudited)	June 30, 2014		June 30, 2013		Increase (Decrease)			Increase (Decrease)
Service charges on deposit accounts	$	528	$	515	$	13		2.5	%
Wealth Management and Trust Services	613		539		74			13.7	%
Debit card interchange fees	360		280		80			28.6	%
Merchant interchange fees	207		222		(15		)	(6.8	)%
Earnings on Bank-owned life insurance	211		186		25			13.4	%
Gain on sale of securities	97		—		97			NM
Other income	352		202		150			74.3	%
Total non-interest income	$	2,368	$	1,944	$	424		21.8	%

	Six months ended				Amount			Percent
(dollars in thousands; unaudited)	June 30, 2014		June 30, 2013		Increase (Decrease)			Increase (Decrease)
Service charges on deposit accounts	$	1,084	$	1,036	$	48		4.6	%
Wealth Management and Trust Services	1,177		1,086		91			8.4	%
Debit card interchange fees	660		532		128			24.1	%
Merchant interchange fees	405		427		(22		)	(5.2	)%
Earnings on Bank-owned life insurance	424		587		(163		)	(27.8	)%
Gain on sale of securities	89		—		89			NM
Other income	745		382		363			95.0	%
Total non-interest income	$	4,584	$	4,050	$	534		13.2	%

Service charges on deposit accounts and debit card interchange fees increased for both the three months and the six months ended June 30, 2014 when compared to the respective periods a year ago due to increased volume related to the Acquisition.

The increase in Wealth Management and Trust Services ("WMTS") income in both the three-month and six-month periods ended June 30, 2014 compared to the respective periods last year is due to the addition of new assets and market value appreciation of existing assets under management. Assets under management totaled approximately $336.2 million at June 30, 2014 and $298.1 million at June 30, 2013.

Bank-owned life insurance (“BOLI”) income increased in the quarter ended June 30, 2014 when compared to the quarter ended June 30, 2013 due to new policies from the Acquisition and additional policies purchased during the later half of last year. BOLI income decreased in the six-month period ended June 30, 2014 when compared to the six-month period ended June 30, 2013 due to a $223 thousand death benefit realized on the death of an insured employee in the first quarter of 2013, partially offset by earnings from the additional policies.

Other income increased for the three months ended June 30, 2014 when compared to the same quarter a year ago, primarily due to higher dividend income from the FHLB and commission income from mortgage brokerage. After an extensive review, we are discontinuing the small mortgage brokerage acquired from Bank of Alameda effective June 30, 2014 and the financial impact is not expected to be material. Other income for the six months ended June 30, 2014 when compared to the same period a year ago increased due to higher dividend income from FHLB and other one-time income.

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Non-interest Expense

The table below details the components of non-interest expense.



	Three months ended				Amount			Percent
(dollars in thousands; unaudited)	June 30, 2014		June 30, 2013		Increase (Decrease)			Increase (Decrease)
Salaries and related benefits	$	6,232	$	5,430	$	802		14.8	%
Occupancy and equipment	1,329		1,052		277			26.3	%
Depreciation and amortization	403		353		50			14.2	%
Federal Deposit Insurance Corporation	269		223		46			20.6	%
Data processing	748		696		52			7.5	%
Professional services	412		814		(402		)	(49.4	)%
Other non-interest expense
Advertising	87		114		(27		)	(23.7	)%
Other expense	1,977		1,737		240			13.8	%
Total other non-interest expense	2,064		1,851		213			11.5	%
Total non-interest expense	$	11,457	$	10,419	$	1,038		10.0	%

	Six months ended				Amount			Percent
(dollars in thousands; unaudited)	June 30, 2014		June 30, 2013		Increase (Decrease)			Increase (Decrease)
Salaries and related benefits	$	13,162	$	10,728	$	2,434		22.7	%
Occupancy and equipment	2,663		2,125		538			25.3	%
Depreciation and amortization	819		689		130			18.9	%
Federal Deposit Insurance Corporation	519		437		82			18.8	%
Data processing	2,108		1,245		863			69.3	%
Professional services	1,040		1,341		(301		)	(22.4	)%
Other non-interest expense
Advertising	199		232		(33		)	(14.2	)%
Other expense	3,790		3,317		473			14.3	%
Total other non-interest expense	3,989		3,549		440			12.4	%
Total non-interest expense	$	24,300	$	20,114	$	4,186		20.8	%

Salary and benefit expenses increased in the second quarter of 2014 when compared to the same quarter last year mainly due to an increase in staffing level from the Acquisition and the addition of commercial lenders in our Napa and Santa Rosa offices. Salaries and benefits for the six months ended June 30, 2014 when compared to the same period a year ago increased due to the same reasons, as well as expenses for the temporary acquisition integration staff incurred in 2014.

The increase in occupancy and equipment expenses in the three months ended June 30, 2014 compared to the three months ended June 30, 2013, is primarily due to the rent and common area maintenance expenses and other occupancy expenses related to new branches from the Acquisition. Occupancy and equipment expenses for the six months ended June 30, 2014 when compared to the same period a year ago increased for the same reasons.

Effective October 31, 2014, the commercial banking center in Emeryville, California, which was acquired from Bank of Alameda, will be closed. Management determined that our customers and the business community can be easily supported from our Oakland location. The existing Emeryville staff will be reassigned to existing East Bay locations. The financial impact is expected to be minimal.

Page-48

The increase in data processing in the three months ended June 30, 2014 compared to the three months ended June 30, 2013, is primarily due to increased data processing transaction volumes due to the Acquisition, while the increase for the six months ended June 30, 2014 when compared to the six months ended June 30, 2013 reflects one-time expenses of $442 thousand related to the Acquisition and increased transaction volume.

Since the one-time Acquisition-related expenses were fully absorbed in the first quarter of 2014, non-interest expenses for staffing and data processing are expected to stabilize for the remainder of 2014 at a level commensurate with the Bank's recent expansion.

Professional service expenses decreased in the second quarter of 2014 when compared to the same quarter last year mainly due to cost savings on various professional services in 2014 and the absence of legal fees incurred to facilitate the Acquisition in 2013. Professional service expenses for the six months ended June 30, 2014 when compared to the same period a year ago decreased for the same reasons.

FDIC insurance and other expenses include higher ongoing expenses as a result of the Acquisition. In addition, $193 thousand and $386 thousand of amortization of core deposit intangibles from the Acquisition were recorded in other expenses in the second quarter of 2014 and the first half of 2014, respectively, while there were no core deposit intangibles in the respective periods in 2013.

Provision for Income Taxes

The provision for income taxes for the second quarter of 2014 is $3.0 million at an effective tax rate of 36.9%, compared to $1.7 million at an effective tax rate of 35.4% in the same quarter last year. The provision for income taxes for the first half of 2014 is $5.6 million at an effective tax rate of 36.6%, compared to $4.2 million at an effective tax rate of 34.9% for the first half of 2013. The increase in the effective tax rate is primarily due to a higher expected pre-tax income for 2014 compared to 2013, and the expiration of the California Enterprise Zone tax benefits at January 1, 2014. These provisions reflect accruals for taxes at the applicable rates for federal income tax and California franchise tax based upon pre-tax income, and adjusted for the effects of all permanent differences between income for tax and financial reporting purposes (such as earnings on qualified municipal securities, BOLI, certain tax-exempt loans and low income housing tax credits). Therefore, there are fluctuations in the effective rate from period to period based on the relationship of net permanent differences to income before tax.

Bancorp and the Bank have entered into a tax allocation agreement which provides that income taxes shall be allocated between the parties on a separate entity basis. The intent of this agreement is that each member of the consolidated group will incur no greater tax liability than it would have incurred on a stand-alone basis.

We file a consolidated return in the U.S. Federal tax jurisdiction and a combined return in the State of California tax jurisdiction. We are no longer subject to tax examinations by taxing authorities for years beginning before 2011 for U.S. Federal or before 2010 for California. There were no ongoing federal income tax examinations at the issuance of this report.

The State of California is currently examining 2011 and 2012 corporate income tax returns. At the time of issuance of this quarterly report, no adjustments have been proposed by the California Franchise Tax Board in connection with the examination. Although timing of the resolution or closure of the examination is uncertain, we do not anticipate a need to establish a reserve for uncertain tax positions in the next 12 months. At June 30, 2014, neither the Bank nor Bancorp had accruals for interest and penalties related to unrecognized tax benefits.

FINANCIAL CONDITION SUMMARY

During the first six months of 2014, total assets increased $18.7 million to $1.8 billion. The increase in assets primarily reflects loan growth in the first half of 2014, mainly funded by our cash and maturities and pay-downs of investment securities. As a result, our loan-to-asset ratio has increased from 70.3% at December 31, 2013 to 73.4% at June 30, 2014.

Investment Securities

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Investment securities in our portfolio that may be backed by mortgages having sub-prime or Alt-A features (certain privately issued CMOs) represent 1.2% of our total investment portfolio at June 30, 2014, compared to 1.7% at December 31, 2013.

We sold one available-for-sale and six held-to-maturity securities in the first six months of 2014 with total proceeds of $2.0 million and $2.1 million, respectively, and incurred a loss of $15 thousand and a net gain of $104 thousand, respectively. The sales of the held-to-maturity securities were due to evidence of significant deterioration of creditworthiness of the issuers since purchase, such as continuous operating deficits, declines in assessed values and/or adverse demographic trends.

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At June 30, 2014 and December 31, 2013, distribution of our investment in obligations of state and political subdivisions was as follows:



		June 30, 2014							December 31, 2013
						% of state and		¹					% of state and		¹
(dollars in thousands; unaudited)		Amortized Cost		Fair Value		municipal securities			Amortized Cost		Fair Value		municipal securities
Within California:
	General obligation bonds	$	15,887	$	16,064	19.4	%		$	16,682	$	16,720	17.6	%
	Revenue bonds	25,337		25,681		30.4	%		26,804		26,810		27.6	%
	Tax allocation bonds	8,327		8,304		9.7	%		9,114		8,902		9.1	%
Total in California		49,551		50,049		59.5	%		52,600		52,432		54.3	%

Outside California:
	General obligation bonds	22,635		23,913		27.5	%		30,490		31,819		32.1	%
	Revenue bonds	10,982		10,941		13.0	%		13,239		12,949		13.6	%
Total outside California		33,617		34,854		40.5	%		43,729		44,768		45.7	%

Total obligations of state and political subdivisions		$	83,168	$	84,903	100.0	%		$	96,329	$	97,200	100.0	%

¹Based on par values.

The portion of the portfolio outside the state of California is distributed among 16 states. The largest concentrations are in Ohio (5.6%), Wisconsin (3.9%) and Arizona (3.7%). Revenue bonds, both within and outside California, primarily consisted of bonds relating to essential services (such as roads and utilities) and school district bonds.

Investments in states, municipalities and political subdivisions are subject to an initial pre-purchase credit assessment and ongoing monitoring. Key considerations include:


•	The soundness of a municipality’s budgetary position and stability of its tax revenues;


•	Debt profile and level of unfunded liabilities, diversity of revenue sources, taxing authority of the issuer;


•	Local demographics/economics including unemployment data, largest local employers, income indices and home values;


•	For revenue bonds, the source and strength of revenue for municipal authorities including obligor’s financial condition and reserve levels, annual debt service and debt coverage ratio, and credit enhancement (such as insurer’s strength);


•	Credit ratings by major credit rating agencies.

There are six California tax allocation bonds totaling $3.0 million at amortized cost and at fair value for which Moody’s credit ratings diverge from the internal assessment. In June 2012, Moody’s Investor Service downgraded to Ba1 all uninsured California redevelopment agency tax allocation bonds (“RDA”s) that were rated Baa3 or higher. The downgrade to Ba1 was prompted by the increased risk of default resulting from the state's dissolution of all redevelopment agencies. The downgrade was based on the potential risk that new laws governing "successor" agencies (Assembly bills 26 and 1484) might further reduce credit quality, and uncertainty as to whether there was sufficient information available to assess the credit quality of tax allocation bonds. In 2013, certain ratings of RDAs were withdrawn by Moody’s. Internal research shows the dispute between the California State Department of Finance and certain successor agencies regarding funds on hand required for payment of debt service, has been successfully resolved in the successor agencies’ favor by the State Superior Court. In addition, the California State Department of Finance is in the process of approving refinancing requests from the successor agencies. Debt coverage ratios and assessed property value trends indicate that Moody’s rating downgrade/withdrawal is not necessarily reflective of the issuers’ credit profiles. Standard & Poors is still rating these six bonds at A.

Page-51

Loans

We had a strong level of loan originations in the first six months of 2014, reflecting our recent success in sourcing commercial real estate and commercial/industrial loans from new and existing relationships. Loan originations were partially offset by early pay-offs and refinancing activity, in line with current market pressure and strong competition for quality loans, as well as maturities, and our successful resolution of problem loans. Our residential loan portfolio includes no sub-prime loans, nor is it our normal practice to underwrite loans commonly referred to as "Alt-A mortgages," the characteristics of which are loans lacking full documentation, borrowers having low FICO scores or collateral compositions reflecting high loan-to-value ratios. Refer to Note 6 for the composition of our outstanding loans by class.

Liabilities

During the first six months of 2014, total liabilities increased $8.7 million to $1.6 billion primarily due to an increase in deposits as a result of organic growth in the Marin and Sonoma markets. The lower level of money market accounts primarily reflects attrition in certain high-priced deposits from Bank of Alameda after repricing during the system conversion in March 2014. Non-interest-bearing deposits increased $76.8 million while interest-bearing transaction accounts decreased $42.7 million during the first half of 2014. Non-interest bearing deposits totaled $724 million at June 30, 2014, and represented 45.3% of total deposits as of June 30, 2014, up from 40.8% at December 31, 2013.

Capital Adequacy

We are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a material effect on our consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and the Bank’s prompt corrective action classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Prompt corrective action provisions are not directly applicable to bank holding companies such as Bancorp.

Quantitative measures established by regulation to ensure capital adequacy require Bancorp and the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital to risk-weighted assets and of Tier 1 capital to quarterly average assets.

Capital ratios are reviewed by Management on a regular basis to ensure that capital exceeds the prescribed regulatory minimums and is adequate to meet our anticipated future needs. For all periods presented, the Bank’s ratios exceed the regulatory definition of “well capitalized” under the regulatory framework for prompt corrective action and Bancorp’s ratios exceed the required minimum ratios for capital adequacy purposes. We expect the Bank to remain well capitalized under the current requirements for capital adequacy, as well as under the new Basel III rules.

In December 2010, the Basel Committee on Bank Supervision finalized a set of international guidelines for determining regulatory capital known as “Basel III.” These guidelines were developed to address many of the perceived weaknesses in the banking industry that contributed to the past financial crisis, including excessive leverage, inadequate and low quality capital and insufficient liquidity buffers. In July 2013, the Board of Governors of the Federal Reserve, the FDIC and the Office of the Comptroller, finalized a rule to implement Basel III. The rule is subject to a phase in period beginning January 2015, and all changes should be implemented by January 2019. The guidelines, among other things, increase minimum capital requirements of bank holding companies, including increasing the Tier 1 capital to risk-weighted assets ratio to 6%, introducing a new requirement to maintain a minimum ratio of common equity Tier 1 capital to risk-weighted assets of 4.5%, and in 2019, when fully phased in, a capital conservation buffer of an additional 2.5% of risk-weighted assets. In addition, there have been several updates to the way risk-weighted assets are assessed. The three changes that will affect the Bank most significantly are: the movement of past due exposures from 100% to 150% risk weight; the movement of off-balance sheet items with an original maturity of one year or less from 0% to 20% risk weight; and the risk weighting of mortgage-backed securities using the gross-up approach instead of the ratings based approach. As a result of their implementation, we have modeled our ratios under the finalized rules and we do not expect that we will be required to raise additional capital.

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The Bank’s and Bancorp’s capital adequacy ratios as of June 30, 2014 and December 31, 2013 are presented in the following tables. Bancorp's tier one capital includes the subordinated debentures, which are not included at the Bank level. We continue to build capital in 2014 due to the accumulation of net income.



Capital Ratios for Bancorp (dollars in thousands; June 30, 2014 unaudited)	Actual Ratio				Ratio to Capital Adequacy Purposes
As of June 30, 2014	Amount		Ratio		Amount	Ratio
Total Capital (to risk-weighted assets)	$	200,228	13.45	%	≥$119,127	≥ 8.0%
Tier 1 Capital (to risk-weighted assets)	$	184,665	12.40	%	≥$59,564	≥ 4.0%
Tier 1 Capital (to average assets)	$	184,665	10.23	%	≥$72,202	≥ 4.0%

As of December 31, 2013
Total Capital (to risk-weighted assets)	$	190,738	13.21	%	≥$115,524	≥ 8.0%
Tier 1 Capital (to risk-weighted assets)	$	175,835	12.18	%	≥$57,762	≥ 4.0%
Tier 1 Capital (to average assets)	$	175,835	10.78	%	≥$65,222	≥ 4.0%

Capital Ratios for the Bank

(dollars in thousands; June 30, 2014 unaudited)

Actual Ratio

Ratio for Capital Adequacy Purposes

Ratio to be Well Capitalized under Prompt Corrective Action Provisions

As of June 30, 2014

Amount

Ratio

Amount

Ratio

Amount

Ratio

Total Capital (to risk-weighted assets)

193,932

13.03

≥$119,097

≥ 8.0%

≥$148,872

≥ 10.0%

Tier 1 Capital (to risk-weighted assets)

178,369

11.98

≥$59,549

≥ 4.0%

≥$89,323

≥ 6.0%

Tier 1 Capital (to average assets)

178,369

9.88

≥$72,187

≥ 4.0%

≥$90,233

≥ 5.0%

As of December 31, 2013

Total Capital (to risk-weighted assets)

181,911

12.60

≥$115,495

≥ 8.0%

≥$144,368

≥ 10.0%

Tier 1 Capital (to risk-weighted assets)

167,007

11.57

≥$57,747

≥ 4.0%

≥$86,621

≥ 6.0%

Tier 1 Capital (to average assets)

167,007

10.24

≥$65,215

≥ 4.0%

≥$81,519

≥ 5.0%

Liquidity

The goal of liquidity management is to provide adequate funds to meet both loan demand and unexpected deposit withdrawals. We accomplish this goal by maintaining an appropriate level of liquid assets, and formal lines of credit with the FHLB, FRB and correspondent banks that enable us to borrow funds as needed. Our ALCO, which is comprised of certain directors of the Bank, is responsible for establishing and monitoring our liquidity targets and strategies.

Management regularly adjusts our investments in liquid assets based upon our assessment of expected loan demand, expected deposit flows, yields available on interest-earning securities and the objectives of our asset/liability management program. Management monitors the Bank's liquidity and capital markets on a regular basis for signs of stress and has a contingency funding plan should liquidity risk increase above internal limits.

We obtain funds from the repayment and maturity of loans as well as deposit inflows, investment security maturities, sales and pay-downs, Federal Funds purchases, FHLB advances, and other borrowings. Our primary uses of funds are the origination of loans, the purchase of investment securities, withdrawals of deposits, maturities of certificates of deposits, repayment of borrowings, and dividends to common stockholders.

We attract and retain new deposits, which depends upon the variety and effectiveness of our customer account products, service and convenience, and rates paid to customers, as well as our financial strength. Any long-term decline in retail deposit funding would adversely impact our liquidity. We have secured borrowing capacity through the FHLB and FRB that can be drawn upon to ensure diversification of funding sources. Management anticipates our current strong liquidity position and core deposit base will provide adequate liquidity to fund our operations.

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As presented in the accompanying unaudited consolidated statements of cash flows, the sources of liquidity vary between periods. Our cash and cash equivalents at June 30, 2014 totaled $81.4 million, a decrease of $22.4 million from December 31, 2013. The primary uses of funds during the first six months of 2014 were $66.7 million in loan originations (net of principal collections) and $9.9 million in purchases of available-for-sale investment securities. The primary sources of funds included $38.6 million in proceeds from sales, pay-downs and maturities of investment securities, a net increase in deposits of $11.7 million and $6.5 million net cash provided by operating activities.

At June 30, 2014, our cash and cash equivalents and unpledged available-for-sale securities with estimated maturities within one year totaled $85.8 million. The remainder of the unpledged available-for-sale securities portfolio of $211.5 million provides additional liquidity. These liquid assets equaled 16.3% of our assets at June 30, 2014, compared to 18.4% at December 31, 2013.

We anticipate that cash and cash equivalents on hand and other sources of funds will provide adequate liquidity for our operating, investing and financing needs and our regulatory liquidity requirements for the foreseeable future. Management monitors our liquidity position daily, balancing loan fundings/payments with changes in deposit activity and overnight investments. Our emphasis on local deposits combined with our well-capitalized equity position, provides a very stable funding base. In addition to cash and cash equivalents, we have substantial additional borrowing capacity including unsecured lines of credit totaling $87.0 million with correspondent banks. Further, we have pledged a certain residential loan portfolio to secure our borrowing capacity with the FRB, which totaled $27.0 million at June 30, 2014. As of June 30, 2014, there is no debt outstanding to correspondent banks or the FRB. We are also a member of the FHLB and have a line of credit (secured under terms of a blanket collateral agreement by a pledge of essentially all of our unencumbered financial assets) in the amount of $491.7 million, of which $476.5 million was available at June 30, 2014. The interest rates on overnight borrowings with both correspondent banks and the FHLB are determined daily and generally approximate the Federal Funds target rate.

Undisbursed loan commitments, which are not reflected on the consolidated statements of condition, totaled $331.9 million at June 30, 2014. This amount included $173.8 million under commercial lines of credit (these commitments are generally contingent upon customers maintaining specific credit standards), $106.8 million under revolving home equity lines, $25.7 million under undisbursed construction loans, $13.8 million under standby letters of credit, and a remaining $11.8 million under personal and other lines of credit. These commitments, to the extent used, are expected to be funded primarily through the repayment of existing loans, deposit growth and existing balance sheet liquidity. Over the next twelve months $92.1 million of time deposits will mature.

Since Bancorp is a holding company and does not conduct regular banking operations, its primary sources of liquidity are dividends from the Bank. Under the California Financial Code, payment of a dividend from the Bank to Bancorp without advance regulatory approval is restricted to the lesser of the Bank’s retained earnings or the amount of the Bank’s undistributed net profits from the previous three fiscal years. The primary uses of funds for Bancorp are shareholder dividends, interest payments on subordinated debentures and ordinary operating expenses. Bancorp held $5.9 million of cash at June 30, 2014. These funds are deemed sufficient to cover Bancorp's operational needs and cash dividends to shareholders through the end of 2014. Management anticipates that there will be sufficient earnings at the Bank level to provide dividends to Bancorp to meet its funding requirements for the foreseeable future.

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ITEM 3. Quantitative and Qualitative Disclosure about Market Risk

Market risk is defined as the risk of loss arising from an adverse change in the market value of financial instruments caused by fluctuations in market prices or interest rates. Our most significant form of market risk is interest rate risk, which is inherent in our investment, borrowing, lending and deposit gathering activities. Interest rate changes can create fluctuations in the net interest margin due to an imbalance in the timing of repricing or maturity of assets and liabilities. Management, together with ALCO, seeks to minimize the exposure of our earnings, liquidity and capital to changes in interest rates by minimizing the impact of interest rate volatility on our net interest margin.

Sensitivity of net interest income (“NII”), liquidity and capital to interest rate changes results from changes in market prices as well as differences in the maturity or repricing of asset and liability portfolios. To mitigate this risk, the structure of our assets and liabilities is managed with the objective of correlating the movements of interest rates on loans and investments with those of deposits and borrowings. Our policies set limits on the acceptable amount of change to NII, liquidity and capital in changing interest rate environments. We use simulation models to forecast cash flows that produce NII and liquidity.

In addition to our solid core deposit base, we have mitigated earnings sensitivity to a certain extent through the use of interest rate swaps from time to time. We enter into these interest rate swap contracts designated as fair value hedges to mitigate the changes in the fair value of specified long-term fixed-rate loans and firm commitments to enter into long-term fixed-rate loans caused by changes in interest rates. See Note 10 to the Consolidated Financial Statements in this Form 10-Q.

Exposure to interest rate and liquidity risk is reviewed at least quarterly by the ALCO and the Board of Directors. Simulation models are used to measure these risks and to develop ways to improve profitability. A simplified statement of condition is prepared on a quarterly basis as a starting point, using as inputs, actual loans, investments, borrowings and deposits. If potential changes to net equity value, liquidity and net interest income resulting from hypothetical interest changes are not within the limits established by the Board of Directors, Management may adjust the asset and liability mix to bring the risk position within approved limits.

Since 2008, there have been no changes in the Federal funds target rate which has been kept at an historically low level of 0-0.25%. In their policy meeting in June 2014, Federal Reserve officials agreed to end their bond-buying program, also known as quantitative easing which was aimed to hold down long-term interest rates, in October of 2014. The Bank is expected to benefit when market yields in new loans respond to the steepening or upward shifts of the yield curve, although it may be on a lagged basis. The Bank currently has low interest rate risk and is asset sensitive (net interest margin positioned to increase if rates go up).

ITEM 4. Controls and Procedures

We maintain a system of disclosure controls and procedures that is designed to provide reasonable assurance that information required to be disclosed is accumulated and communicated to management in an appropriate manner to allow timely decisions regarding required disclosures. Management, including the Chief Executive Officer and Chief Financial Officer, or persons performing similar functions, has reviewed this system of disclosure controls and procedures and believes that our disclosure controls and procedures (as that term is defined in Rule 13a-15(e) of the Exchange Act) were effective, as of the end of the period covered by this report, in recording, processing, summarizing and reporting information required to be disclosed in reports that we file or submit under the Securities and Exchange Act of 1934, within the time periods specified in the Securities and Exchange Commission’s rules and forms. No material changes were made in our internal controls over financial reporting during the last fiscal quarter.

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PART II OTHER INFORMATION

ITEM 1 Legal Proceedings

We may be party to legal actions which arise from time to time as part of the normal course of our business. We believe, after consultation with legal counsel, that we have meritorious defenses in these actions, and that litigation contingency liability, if any, will not have a material adverse effect on our financial position, results of operations, or cash flows.

We are responsible for our proportionate share of certain litigation indemnifications provided to Visa U.S.A. by its member banks in connection with lawsuits related to anti-trust charges and interchange fees. For further details, see Note 13 to the Consolidated Financial Statements in Item 8 of our 2013 Form 10-K and Note 9 to the Consolidated Financial Statements in this Form 10-Q herein.

ITEM 1A Risk Factors

There have been no material changes from the risk factors previously disclosed in our 2013 Form 10-K. Refer to “Risk Factors” in our 2013 Form 10-K, pages 12 through 20.

ITEM 2 Unregistered Sales of Equity Securities and Use of Proceeds

We did not have any unregistered sales of our equity securities during the three months ended June 30, 2014.

ITEM 3 Defaults Upon Senior Securities

None.

ITEM 4 Mine Safety Disclosures

Not applicable.

ITEM 5 Other Information

None.

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ITEM 6 Exhibits

The following exhibits are filed as part of this report or hereby incorporated by references to filings previously made with the SEC.



		Incorporated by Reference
Exhibit Number	Exhibit Description	Form	File No.	Exhibit	Filing Date	Herewith
2.01	Modified Whole Bank Purchase and Assumption Agreement dated February 18, 2011 among Federal Deposit Insurance Corporation, Receiver of Charter Oak Bank, Napa, California, Federal Deposit Insurance Corporation, and Bank of Marin	8-K	001-33572	99.2	February 28, 2011
2.02	Agreement and Plan of Merger with NorCal Community Bancorp, dated July 1, 2013	8-K	001-33572	2.1	July 5, 2013
3.01	Articles of Incorporation, as amended	10-Q	001-33572	3.01	November 7, 2007
3.02	Bylaws, as amended	10-Q	001-33572	3.02	May 9, 2011
4.01	Rights Agreement dated as of July 2, 2007	8-A12B	001-33572	4.1	July 2, 2007
4.02	Form of Warrant for Purchase of Shares of Common Stock, as amended	POS AM S-3	333-156782	4.4	December 20, 2011
10.01	2007 Employee Stock Purchase Plan	S-8	333-144810	4.1	July 24, 2007
10.02	1989 Stock Option Plan	S-8	333-144807	4.1	July 24, 2007
10.03	1999 Stock Option Plan	S-8	333-144808	4.1	July 24, 2007
10.04	2007 Equity Plan	S-8	333-144809	4.1	July 24, 2007
10.05	2010 Director Stock Plan	S-8	333-167639	4.1	June 21, 2010
10.06	Form of Indemnification Agreement for Directors and Executive Officers dated August 9, 2007	10-Q	001-33572	10.06	November 7, 2007
10.07	Form of Employment Agreement dated January 23, 2009	8-K	001-33572	10.1	January 26, 2009
10.08	2010 Director Stock Plan	S-8	333-167639	4.1	June 21, 2010
10.09	2010 Annual Individual Incentive Compensation Plan	8-K	001-33572	99.1	October 21, 2010
10.10	Salary Continuation Agreement with four executive officers, Russell Colombo, Chief Executive Officer, Kevin Coonan, Chief Credit Officer, and Peter Pelham, Director of Retail Banking, dated January 1, 2011	8-K	001-33572	10.1 10.2 10.3 10.4	January 6, 2011
10.11	2007 Form of Change in Control Agreement	8-K	001-33572	10.1	October 31, 2007
10.12	Information Technology Services Agreement with Fidelity Information Services, LLC, dated July 11, 2012	8-K	001-33572	10.1	July 17, 2012
11.01	Earnings Per Share Computation - included in Note 1 to the Consolidated Financial Statements					Filed
14.01	Code of Ethical Conduct	8-K	001-33572	14.01	January 26, 2008
31.01	Certification of Principal Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002					Filed
31.02	Certification of Principal Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002					Filed
32.01	Certification pursuant to 18 U.S.C. §1350 as adopted pursuant to §906 of the Sarbanes-Oxley Act of 2002					Filed
101.01*	XBRL Interactive Data File					Furnished


*	As provided in Rule 406T of Regulation S-T, this information is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934.

Page-57

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.




			Bank of Marin Bancorp
			(registrant)


	August 8, 2014		/s/ Russell A. Colombo
	Date		Russell A. Colombo
			President &
			Chief Executive Officer
			(Principal Executive Officer)


	August 8, 2014		/s/ Tani Girton
	Date		Tani Girton
			Executive Vice President &
			Chief Financial Officer
			(Principal Financial Officer)


	August 8, 2014		/s/ Cecilia Situ
	Date		Cecilia Situ
			First Vice President &
			Manager of Finance & Treasury
			(Principal Accounting Officer)

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