FIRST MERCHANTS CORP - Quarter Report: 2017 June (Form 10-Q)

FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

___________________

[x] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2017

[ ] 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 0-17071

FIRST MERCHANTS CORPORATION

(Exact name of registrant as specified in its charter)

Indiana 35-1544218

(State or other jurisdiction of (I.R.S. Employer

incorporation or organization) Identification No.)

200 East Jackson Street, Muncie, IN 47305-2814

(Address of principal executive offices) (Zip code)

(Registrant’s telephone number, including area code): (765) 747-1500

Not Applicable

(Former name, former address and former fiscal year,

if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ]

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 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 [ ]

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,” “smaller reporting company,” and "emergining growth company" in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer [X] Accelerated filer [ ] Non-accelerated filer [ ] (Do not check if smaller reporting company) Smaller reporting company [ ] Emerging growth company [ ]

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. [ ]

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

As of July 31, 2017, there were 49,121,249 outstanding common shares of the registrant.

Table of Contents

TABLE OF CONTENTS

FIRST MERCHANTS CORPORATION



		Page No.
Glossary of Defined Terms		3

Part I. Financial Information
Item 1.	Financial Statements:
	Consolidated Condensed Balance Sheets	4
	Consolidated Condensed Statements of Income	5
	Consolidated Condensed Statements of Comprehensive Income	6
	Consolidated Condensed Statement of Stockholders' Equity	7
	Consolidated Condensed Statements of Cash Flows	8
	Notes to Consolidated Condensed Financial Statements	9
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	41
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	54
Item 4.	Controls and Procedures	55

Part II. Other Information
Item 1.	Legal Proceedings	56
Item 1A.	Risk Factors	56
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	56
Item 3.	Defaults Upon Senior Securities	56
Item 4.	Mine Safety Disclosures	56
Item 5.	Other Information	56
Item 6.	Exhibits	57
	Signatures	58
	Index to Exhibits	59

Table of Contents

GLOSSARY OF DEFINED TERMS

FIRST MERCHANTS CORPORATION



Ameriana	Ameriana Bancorp, Inc., which was acquired by the Corporation on December 31, 2015.
Arlington Bank	The Arlington Bank, which was acquired by the Corporation on May 19, 2017.
ASC	Accounting Standards Codification
Bank	First Merchants Bank, a wholly-owned subsidiary of the Corporation
CET1	Common Equity Tier 1
C Financial	C Financial Corporation, which was acquired by the Corporation on April 17, 2015.
CFS	CFS Bancorp, Inc., which was acquired by the Corporation on November 12, 2013.
CMT	Constant Maturity Treasury
Community	Community Bancshares, Inc., which was acquired by the Corporation on November 7, 2014.
Corporation	First Merchants Corporation
ESPP	Employee Stock Purchase Plan
FDIC	Federal Deposit Insurance Corporation
FHLB	Federal Home Loan Bank
FTE	Fully taxable equivalent
GAAP	Generally Accepted Accounting Principles
Indiana DFI	Indiana Department of Financial Institutions
RSA	Restricted Stock Awards
SCB	SCB Bank, of which the Bank assumed substantially all the deposits and certain other liabilities and acquired certain other assets from the FDIC as receiver on February 10, 2012.
TEFRA	Tax Equity and Fiscal Responsibility Act. The TEFRA disallowance reduces the amount of interest expense an entity may deduct for the purpose of carrying tax-free investment securities.

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

CONSOLIDATED CONDENSED BALANCE SHEETS



	June 30, 2017		December 31, 2016
	(Unaudited)
ASSETS
Cash and cash equivalents	$	142,650	$	127,927
Interest-bearing time deposits	48,305		24,459
Investment securities available for sale	742,759		696,862
Investment securities held to maturity (fair value of $609,256 and $611,933)	600,564		607,643
Loans held for sale	4,036		2,929
Loans, net of allowance for loan losses of $70,471 and $66,037	5,542,673		5,073,608
Premises and equipment	92,637		94,432
Federal Home Loan Bank stock	19,015		17,964
Interest receivable	27,597		26,194
Core deposit intangibles	17,498		14,866
Goodwill	292,188		244,000
Cash surrender value of life insurance	200,125		201,671
Other real estate owned	11,893		8,966
Tax asset, deferred and receivable	27,331		39,384
Other assets	35,758		30,706
TOTAL ASSETS	$	7,805,029	$	7,211,611
LIABILITIES
Deposits:
Noninterest-bearing	$	1,398,237	$	1,348,267
Interest-bearing	4,618,867		4,208,231
Total Deposits	6,017,104		5,556,498
Borrowings:
Federal funds purchased	134,608		120,349
Securities sold under repurchase agreements	127,884		146,480
Federal Home Loan Bank advances	312,715		298,923
Subordinated debentures and term loans	128,742		128,445
Total Borrowings	703,949		694,197
Interest payable	3,477		3,110
Other liabilities	45,383		56,149
Total Liabilities	6,769,913		6,309,954
COMMITMENTS AND CONTINGENT LIABILITIES
STOCKHOLDERS' EQUITY
Cumulative Preferred Stock, $1,000 par value, $1,000 liquidation value:
Authorized - 600 shares
Issued and outstanding - 125 shares	125		125
Common Stock, $.125 stated value:
Authorized - 100,000,000 and 50,000,000 shares
Issued and outstanding - 43,153,509 and 40,912,697 shares	5,394		5,114
Additional paid-in capital	593,904		509,018
Retained earnings	434,309		400,981
Accumulated other comprehensive income (loss)	1,384		(13,581		)
Total Stockholders' Equity	1,035,116		901,657
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY	$	7,805,029	$	7,211,611

See NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS.

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

CONSOLIDATED CONDENSED STATEMENTS OF INCOME

(Unaudited)



	Three Months Ended June 30,				Six Months Ended June 30,
	2017		2016		2017		2016
INTEREST INCOME
Loans receivable:
Taxable	$	59,386	$	52,099	$	115,743	$	102,588
Tax exempt	2,492		1,465		4,825		2,780
Investment securities:
Taxable	4,180		4,202		8,488		8,530
Tax exempt	5,091		4,583		10,094		9,092
Deposits with financial institutions	114		122		158		228
Federal Reserve and Federal Home Loan Bank stock	204		233		393		713
Total Interest Income	71,467		62,704		139,701		123,931
INTEREST EXPENSE
Deposits	5,137		4,039		9,261		8,102
Federal funds purchased	103		7		331		35
Securities sold under repurchase agreements	110		92		198		192
Federal Home Loan Bank advances	1,177		818		2,155		1,614
Subordinated debentures and term loans	1,840		1,786		3,657		3,571
Total Interest Expense	8,367		6,742		15,602		13,514
NET INTEREST INCOME	63,100		55,962		124,099		110,417
Provision for loan losses	2,875		790		5,260		1,340
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES	60,225		55,172		118,839		109,077
OTHER INCOME
Service charges on deposit accounts	4,438		4,416		8,612		8,561
Fiduciary activities	2,609		2,376		5,249		4,870
Other customer fees	5,406		4,695		10,269		9,754
Increase in cash surrender value of life insurance	817		873		1,715		1,878
Gains on life insurance benefits	2,154		424		2,154		895
Net gains and fees on sales of loans	1,617		1,717		2,892		3,177
Net realized gains on sales of available for sale securities	567		706		1,165		1,703
Other income	826		1,178		1,224		1,384
Total Other Income	18,434		16,385		33,280		32,222
OTHER EXPENSES
Salaries and employee benefits	27,076		25,570		52,808		52,907
Net occupancy	3,965		4,059		8,181		8,081
Equipment	2,907		3,243		5,714		6,481
Marketing	792		851		1,357		1,588
Outside data processing fees	3,086		2,025		5,702		4,094
Printing and office supplies	275		369		539		733
Core deposit amortization	991		977		1,894		1,955
FDIC assessments	579		1,002		1,149		1,952
Other real estate owned and foreclosure expenses	731		915		1,262		1,666
Professional and other outside services	3,266		1,478		5,000		3,640
Other expenses	3,648		4,346		6,809		8,213
Total Other Expenses	47,316		44,835		90,415		91,310
INCOME BEFORE INCOME TAX	31,343		26,722		61,704		49,989
Income tax expense	7,207		6,716		14,375		12,290
NET INCOME AVAILABLE TO COMMON STOCKHOLDERS	$	24,136	$	20,006	$	47,329	$	37,699
Per Share Data:
Basic Net Income Available to Common Stockholders	$	0.57	$	0.50	$	1.14	$	0.93
Diluted Net Income Available to Common Stockholders	$	0.57	$	0.49	$	1.13	$	0.92
Cash Dividends Paid	$	0.18	$	0.14	$	0.33	$	0.25
Average Diluted Shares Outstanding (in thousands)	42,244		40,969		41,735		40,941

See NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS.

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

CONSOLIDATED CONDENSED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)



	Three Months Ended June 30,						Six Months Ended June 30,
	2017			2016			2017			2016
Net income	$	24,136		$	20,006		$	47,329		$	37,699
Other comprehensive income net of tax:
Unrealized holding gain on securities available for sale arising during the period, net of tax of $3,033, $3,096, $8,476 and $5,861	5,632			5,750			15,741			10,885
Unrealized loss on cash flow hedges arising during the period, net of tax of $142, $284, $131 and $969	(262		)	(529		)	(239		)	(1,798		)
Reclassification adjustment for net gains included in net income, net of tax of $110, $136, $226 and $371	(206		)	(252		)	(420		)	(690		)
Defined benefit pension plan amortization of prior service cost, net of tax of $31 and $63	(58		)				(117		)
	5,106			4,969			14,965			8,397
Comprehensive income	$	29,242		$	24,975		$	62,294		$	46,096

See NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS.

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

CONSOLIDATED CONDENSED STATEMENT OF STOCKHOLDERS’ EQUITY

(Unaudited)



	Preferred			Common Stock					Additional						Accumulated Other
	Shares	Amount		Shares		Amount			Paid in Capital			Retained Earnings			Comprehensive Income (Loss)			Total
Balances, December 31, 2016	125	$	125	40,912,697		$	5,114		$	509,018		$	400,981		$	(13,581	)	$	901,657
Comprehensive income
Net income												47,329						47,329
Other comprehensive income, net of tax															14,965			14,965
Cash dividends on common stock ($.33 per share)												(14,001		)				(14,001		)
Issuance of common stock related to acquisition				2,080,833		260			82,328									82,588
Share-based compensation				81,397		10			1,051									1,061
Stock issued under employee benefit plans				7,288		1			245									246
Stock issued under dividend reinvestment and stock purchase plan				10,681		1			445									446
Stock options exercised				92,054		12			2,070									2,082
Stock redeemed				(31,441	)	(4		)	(1,253		)							(1,257		)
Balances, June 30, 2017	125	$	125	43,153,509		$	5,394		$	593,904		$	434,309		$	1,384		$	1,035,116

See NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS.

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

(Unaudited)



	Six Months Ended
	June 30, 2017			June 30, 2016
Cash Flow From Operating Activities:
Net income	$	47,329		$	37,699
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses	5,260			1,340
Depreciation and amortization	3,669			3,604
Change in deferred taxes	3,697			5,571
Share-based compensation	1,061			1,235
Loans originated for sale	(127,275		)	(199,281		)
Proceeds from sales of loans held for sale	136,014			190,321
Gains on sales of loans held for sale	(2,220		)	(2,658		)
Gains on sales of securities available for sale	(1,165		)	(1,703		)
Increase in cash surrender of life insurance	(1,715		)	(1,878		)
Gains on life insurance benefits	(2,154		)	(895		)
Change in interest receivable	(750		)	1,064
Change in interest payable	123			(41		)
Other adjustments	(4,379		)	(1,704		)
Net cash provided by operating activities	57,495			32,674
Cash Flows from Investing Activities:
Net change in interest-bearing deposits	(23,554		)	(30,218		)
Purchases of:
Securities available for sale	(104,956		)	(96,873		)
Securities held to maturity	(30,220		)	(76,395		)
Proceeds from sales of securities available for sale	41,180			85,081
Proceeds from maturities of:
Securities available for sale	32,838			32,286
Securities held to maturity	36,150			54,810
Change in Federal Reserve and Federal Home Loan Bank stock	40			19,537
Net change in loans	(257,201		)	(102,735		)
Net cash and cash equivalents received in acquisition	48,528
Proceeds from the sale of other real estate owned	4,703			4,633
Proceeds from life insurance benefits	5,415			1,895
Other adjustments	(608		)	(1,671		)
Net cash used in investing activities	(247,685		)	(109,650		)
Cash Flows from Financing Activities:
Net change in :
Demand and savings deposits	127,901			173,705
Certificates of deposit and other time deposits	79,922			(56,969		)
Borrowings	697,727			279,518
Repayment of borrowings	(688,153		)	(290,687		)
Cash dividends on common stock	(14,001		)	(10,264		)
Stock issued under employee benefit plans	246			216
Stock issued under dividend reinvestment and stock purchase plans	446			384
Stock options exercised	2,082			211
Stock redeemed	(1,257		)	(837		)
Net cash provided by financing activities	204,913			95,277
Net Change in Cash and Cash Equivalents	14,723			18,301
Cash and Cash Equivalents, January 1	127,927			102,170
Cash and Cash Equivalents, June 30	$	142,650		$	120,471
Additional cash flow information:
Interest paid	$	15,235		$	13,555
Income tax paid	10,000			3,155
Loans transferred to other real estate owned	7,556			320
Fixed assets transferred to other real estate owned				360
Non-cash investing activities using trade date accounting	7,759			4,414

In conjunction with the acquisition, liabilities were assumed as follows:
Fair value of assets acquired	$	338,725
Cash paid in acquisition	(4		)
Less: Common stock issued	82,588
Liabilities assumed	$	256,133		$	—

See NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS.

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)

NOTE 1

GENERAL

Financial Statement Preparation

The significant accounting policies followed by the Corporation and its wholly owned subsidiaries for interim financial reporting are consistent with the accounting policies followed for annual financial reporting. All adjustments, which are of a normal recurring nature and are in the opinion of management necessary for a fair statement of the results for the periods reported, have been included in the accompanying consolidated condensed financial statements.

The Consolidated Condensed Balance Sheet of the Corporation as of December 31, 2016, has been derived from the audited consolidated balance sheet of the Corporation as of that date. Certain information and note disclosures normally included in the Corporation’s annual financial statements, prepared in accordance with accounting principles generally accepted in the United States of America, have been condensed or omitted. These consolidated condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2016 filed with the Securities and Exchange Commission. The results of operations for the three and six months ended June 30, 2017, are not necessarily indicative of the results to be expected for the year. Reclassifications have been made to prior financial statements to conform to the current financial statement presentation. These reclassifications had no effect on net income.

NOTE 2

ACQUISITIONS

The Arlington Bank

On May 19, 2017, the Corporation acquired 100 percent of Arlington Bank. Arlington Bank, an Ohio savings bank, merged with and into the Bank, with the Bank continuing as the surviving bank. Arlington Bank was headquartered in Columbus, Ohio and had 3 banking centers serving the Columbus, Ohio market. Pursuant to the merger agreement, each Arlington Bank shareholder received 2.7245 shares of the Corporation's common stock for each outstanding share of Arlington Bank common stock held. The Corporation issued approximately 2.1 million shares of common stock, which was valued at approximately $82.6 million. The Corporation engaged in this transaction with the expectation that it would be accretive and expand the existing footprint in Columbus, Ohio. Goodwill resulted from this transaction due to the expected synergies and economies of scale.

Under the acquisition method of accounting, the total purchase price is allocated to net tangible and intangible assets based on their current estimated fair values on the date of the acquisition. Based on preliminary valuations of the fair value of tangible and intangible assets acquired and liabilities assumed, which are based on assumptions that are subject to change, the purchase price for the Arlington Bank acquisition is detailed in the following table. If prior to the end of the one-year measurement period for finalizing the purchase price allocation, information becomes available which would indicate adjustments are required to the purchase price allocation, such adjustments will be included in the purchase price allocation retrospectively.



	Fair Value
Cash and cash equivalents	$	48,532
Interest-bearing time deposits	292
Loans held for sale	7,626
Loans	224,680
Premises and equipment	1,266
Federal Home Loan Bank stock	1,091
Interest receivable	653
Other assets	1,871
Deposits	(252,783		)
Interest payable	(244		)
Other liabilities	(3,106		)
Net tangible assets acquired	29,878
Core deposit intangible	4,526
Goodwill	48,188
Purchase price	$	82,592

Of the total purchase price, $4,526,000 has been allocated to a core deposit intangible that will be amortized over its estimated life of 10 years. The remaining purchase price has been allocated to goodwill, which is not deductible for tax purposes.

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)

Pro Forma Financial Information

The results of operations of Arlington Bank have been included in the Corporation's consolidated financial statements since the acquisition date. The following schedule includes pro forma results for the period ended December 31, 2016, as if the Arlington Bank acquisition occurred as of the beginning of the comparable prior annual reporting period.



	2016
Total revenue (net interest income plus other income)	$	307,246
Net income	$	84,356
Earnings per share:
Basic	$	1.96
Diluted	$	1.95

The pro forma information includes adjustments for interest income on loans, amortization of intangibles arising from the transaction, interest expense on deposits acquired and the related income tax effects. The pro forma information for the year ended December 31, 2016 includes operating results from Arlington Bank as if the acquisition occurred at the beginning of the year. The pro forma information is presented for information purposes only and is not indicative of the results of operations that actually would have been achieved had the acquisition been consummated as of that time, nor is it intended to be a projection of future results.

NOTE 3

INVESTMENT SECURITIES

The amortized cost, gross unrealized gains, gross unrealized losses and approximate market value of the Corporation's investment securities at the dates indicated were:



	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Available for sale at June 30, 2017
U.S. Treasury	$	499					$	499
State and municipal	366,026		$	13,156	$	2,005	377,177
U.S. Government-sponsored mortgage-backed securities	330,413		1,998		2,176		330,235
Corporate obligations	31						31
Equity securities	21,820		12,997				34,817
Total available for sale	718,789		28,151		4,181		742,759
Held to maturity at June 30, 2017
U.S. Government-sponsored agency securities	22,618				382		22,236
State and municipal	242,125		5,991		747		247,369
U.S. Government-sponsored mortgage-backed securities	334,821		4,875		1,045		338,651
Foreign Investments	1,000						1,000
Total held to maturity	600,564		10,866		2,174		609,256
Total Investment Securities	$	1,319,353	$	39,017	$	6,355	$	1,352,015



	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Available for sale at December 31, 2016
U.S. Government-sponsored agency securities	$	100					$	100
State and municipal	360,779		$	8,443	$	5,564	363,658
U.S. Government-sponsored mortgage-backed securities	313,459		1,904		3,071		312,292
Corporate obligations	31						31
Equity securities	21,820				1,039		20,781
Total available for sale	696,189		10,347		9,674		696,862
Held to maturity at December 31, 2016
U.S. Government-sponsored agency securities	22,619				479		22,140
State and municipal	224,811		3,136		1,796		226,151
U.S. Government-sponsored mortgage-backed securities	360,213		4,956		1,527		363,642
Total held to maturity	607,643		8,092		3,802		611,933
Total Investment Securities	$	1,303,832	$	18,439	$	13,476	$	1,308,795

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)

The amortized cost and fair value of available for sale and held to maturity securities at June 30, 2017 and December 31, 2016, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.



	Available for Sale				Held to Maturity
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
Maturity Distribution at June 30, 2017:
Due in one year or less	$	2,287	$	2,288	$	6,111	$	6,201
Due after one through five years	7,944		8,294		70,140		71,314
Due after five through ten years	70,137		73,381		56,851		57,493
Due after ten years	286,188		293,744		132,641		135,597
	$	366,556	$	377,707	$	265,743	$	270,605
U.S. Government-sponsored mortgage-backed securities	330,413		330,235		334,821		338,651
Equity securities	21,820		34,817
Total Investment Securities	$	718,789	$	742,759	$	600,564	$	609,256



	Available for Sale				Held to Maturity
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
Maturity Distribution at December 31, 2016
Due in one year or less	$	2,703	$	2,717	$	2,046	$	2,047
Due after one through five years	16,359		17,068		61,921		63,193
Due after five through ten years	60,614		62,241		61,606		61,145
Due after ten years	281,234		281,763		121,857		121,906
	$	360,910	$	363,789	$	247,430	$	248,291
U.S. Government-sponsored mortgage-backed securities	313,459		312,292		360,213		363,642
Equity securities	21,820		20,781
Total Investment Securities	$	696,189	$	696,862	$	607,643	$	611,933

The carrying value of securities pledged as collateral, to secure borrowings and for other purposes, was $519,265,000 at June 30, 2017, and $572,896,000 at December 31, 2016.

The book value of securities sold under agreements to repurchase amounted to $127,020,000 at June 30, 2017, and $145,936,000 at December 31, 2016.

Gross gains on the sales and redemptions of available for sale securities for the three and six months ended June 30, 2017 and 2016 are shown below.



	Three Months Ended June 30,				Six Months Ended June 30,
	2017		2016		2017		2016
Sales and Redemptions of Available for Sale Securities:
Gross gains	$	567	$	706	$	1,165	$	1,703
Gross losses

The following tables show the Corporation’s gross unrealized losses and fair value, aggregated by investment category and length of time the individual securities have been in a continuous unrealized loss position at June 30, 2017, and December 31, 2016:



	Less than 12 Months				12 Months or Longer				Total
	Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses
Temporarily Impaired Available for Sale Securities at June 30, 2017
State and municipal	$	56,404	$	1,887	$	2,547	$	118	$	58,951	$	2,005
U.S. Government-sponsored mortgage-backed securities	130,867		2,143		1,443		33		132,310		2,176
Total Temporarily Impaired Available for Sale Securities	187,271		4,030		3,990		151		191,261		4,181
Temporarily Impaired Held to Maturity Securities at June 30, 2017
U.S. Government-sponsored agency securities	17,225		293		4,910		89		22,135		382
State and municipal	25,198		747						25,198		747
U.S. Government-sponsored mortgage-backed securities	79,596		1,045						79,596		1,045
Total Temporarily Impaired Held to Maturity Securities	122,019		2,085		4,910		89		126,929		2,174
Total Temporarily Impaired Investment Securities	$	309,290	$	6,115	$	8,900	$	240	$	318,190	$	6,355

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)



	Less than 12 Months				12 Months or Longer		Total
	Fair Value		Gross Unrealized Losses		Fair Value	Gross Unrealized Losses	Fair Value		Gross Unrealized Losses
Temporarily Impaired Available for Sale Securities at December 31, 2016
State and municipal	$	126,593	$	5,564			$	126,593	$	5,564
U.S. Government-sponsored mortgage-backed securities	185,544		3,071				185,544		3,071
Equity Securities	18,765		1,039				18,765		1,039
Total Temporarily Impaired Available for Sale Securities	330,902		9,674				330,902		9,674
Temporarily Impaired Held to Maturity Securities at December 31, 2016
U.S. Government-sponsored agency securities	19,121		479				19,121		479
State and municipal	50,897		1,796				50,897		1,796
U.S. Government-sponsored mortgage-backed securities	109,377		1,527				109,377		1,527
Total Temporarily Impaired Held to Maturity Securities	179,395		3,802				179,395		3,802
Total Temporarily Impaired Investment Securities	$	510,297	$	13,476			$	510,297	$	13,476

Certain investments in debt and equity securities are reported in the financial statements at an amount less than their historical cost as indicated in the table below.



	June 30, 2017			December 31, 2016
Investments reported at less than historical cost:
Historical cost	$	326,043		$	523,773
Fair value	$	318,190		$	510,297
Percent of the Corporation's investment portfolio	23.7		%	39.1		%

Except as discussed below, management believes the decline in fair value for these securities was temporary. Should the impairment of any of these securities become other-than-temporary, the cost basis of the investment will be reduced and the resulting loss recognized in net income during the period the OTTI is identified.

The Corporation’s management has evaluated all securities with unrealized losses for other-than temporary impairment as of June 30, 2017. The evaluations are based on the nature of the securities, the extent and duration of the loss and the intent and ability of the Corporation to hold these securities either to maturity or through the expected recovery period.

In determining the fair value of the investment securities portfolio, the Corporation utilizes a third party for portfolio accounting services, including market value input, for those securities classified as Level 1 and Level 2 in the fair value hierarchy. The Corporation has obtained an understanding of what inputs are being used by the vendor in pricing the portfolio and how the vendor was classifying these securities based upon these inputs. From these discussions, the Corporation’s management is comfortable that the classifications are proper. The Corporation has gained trust in the data for two reasons: (a) independent spot testing of the data is conducted by the Corporation through obtaining market quotes from various brokers on a periodic basis and (b) actual gains or losses resulting from the sale of certain securities has proven the data to be accurate over time. The fair value of securities classified as Level 3 in the valuation hierarchy was determined using a discounted cash flow model that incorporated market estimates of interest rates and volatility in markets that have not been active.

State and Municipal and U.S. Government-Sponsored Agency Securities

The unrealized losses on the Corporation's investments in state and municipal securities and U.S. Government-Sponsored Agency securities were caused by interest rate increases. The contractual terms of those investments do not permit the issuer to settle the securities at a price less than the amortized cost basis of the investments. Because the Corporation does not intend to sell the investments and it is not more likely than not that the Corporation will be required to sell the investments before recovery of their amortized cost basis, which may be maturity, the Corporation does not consider those investments to be other-than-temporarily impaired at June 30, 2017. The state and municipal securities portfolio contains unrealized losses of $2,005,000 on fifty-six securities and $747,000 on thirty-three securities in the available for sale and held to maturity portfolios, respectively. The U.S. Government-Sponsored Agency securities portfolio contains no unrealized losses in the available for sale portfolio, and $382,000 on four securities in the held to maturity portfolio.

U.S. Government-Sponsored Mortgage-Backed Securities

The unrealized losses on the Corporation's investment in mortgage-backed securities were a result of interest rate changes. The Corporation expects to recover the amortized cost basis over the term of the securities. Because the decline in market value is attributable to changes in interest rates and not credit quality, and because the Corporation does not intend to sell the investments and it is not more likely than not that the Corporation will be required to sell the investments before recovery of their amortized cost basis, which may be maturity, the Corporation does not consider those investments to be other-than-temporarily impaired at June 30, 2017. The mortgage-backed securities portfolio contains unrealized losses of $2,176,000 on thirty-seven securities and $1,045,000 on twenty-three securities in the available for sale and held to maturity portfolios, respectively. All these securities are issued by a U.S. government-sponsored entity.

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)

NOTE 4

LOANS AND ALLOWANCE

The Corporation’s primary lending focus is small business and middle market commercial, commercial real estate and residential real estate. The following tables show the composition of the loan portfolio, the allowance for loan losses and certain credit quality aspects, all excluding loans held for sale. Loans held for sale as of June 30, 2017, and December 31, 2016, were $4,036,000 and $2,929,000, respectively.

The following table shows the composition of the Corporation’s loan portfolio by loan class for the periods indicated:



	June 30, 2017			December 31, 2016
Commercial and industrial loans	$	1,289,884		$	1,194,646
Agricultural production financing and other loans to farmers	75,746			79,689
Real estate loans:
Construction	442,389			418,703
Commercial and farmland	2,167,729			1,953,062
Residential	847,580			739,169
Home equity	436,038			418,525
Individuals' loans for household and other personal expenditures	79,887			77,479
Lease financing receivables, net of unearned income	232			311
Other commercial loans	273,659			258,061
Loans	$	5,613,144		$	5,139,645
Allowance for loan losses	(70,471		)	(66,037		)
Net Loans	$	5,542,673		$	5,073,608

Allowance, Credit Quality and Loan Portfolio

The Corporation maintains an allowance for loan losses to cover probable credit losses identified during its loan review process. Management believes the allowance for loan losses is adequate to cover probable losses inherent in the loan portfolio at June 30, 2017. The process for determining the adequacy of the allowance for loan losses is critical to the Corporation’s financial results. It requires management to make difficult, subjective and complex judgments, to estimate the effect of uncertain matters. The allowance for loan losses considers current factors, including economic conditions and ongoing internal and external examinations, and will increase or decrease as deemed necessary to ensure it remains adequate. In addition, the allowance as a percentage of charge-offs and nonperforming loans will change at different points in time based on credit performance, portfolio mix and collateral values.

The allowance for loan losses is maintained through the provision for loan losses, which is a charge against earnings. The allowance is increased by provision expense and decreased by charge-offs less recoveries. All charge-offs are approved by the Bank's senior credit officers and in accordance with established policies. The Bank charges off a loan when a determination is made that all or a portion of the loan is uncollectible. The amount provided for loan losses in a given period may be greater than or less than net loan losses experienced during the period, and is based on management’s judgment as to the appropriate level of the allowance for loan losses. The determination of the provision amount is based on management’s ongoing review and evaluation of the loan portfolio, including an internally administered loan "watch" list and independent loan reviews. The evaluation takes into consideration identified credit problems, the possibility of losses inherent in the loan portfolio that are not specifically identified and management’s judgment as to the impact of the current environment and economic conditions on the portfolio.

The allowance consists of specific impairment reserves as required by ASC 310-10-35, a component for historical losses in accordance with ASC 450 and the consideration of current environmental factors in accordance with ASC 450. A loan is deemed impaired when, based on current information or events, it is probable that all amounts due of principal and interest according to the contractual terms of the loan agreement will not be collected.

The historical loss allocation for loans not deemed impaired according to ASC 450 is the product of the volume of loans within the non-impaired criticized and non-criticized risk grade classifications, each segmented by call code, and the historical loss factor for each respective classification and call code segment. The historical loss factors are based upon actual loss experience within each risk and call code classification. The historical look back period for non-criticized loans looks to the most recent rolling-four-quarter average and aligns with the look back period for non-impaired criticized loans. Each of the rolling four quarter periods used to obtain the average, include all charge-offs for the previous twelve-month period, therefore the historical look back period includes seven quarters. The resulting allocation is reflective of current conditions. Criticized loans are grouped based on the risk grade assigned to the loan. Loans with a special mention grade are assigned a loss factor, and loans with a classified grade but not impaired are assigned a separate loss factor. The loss factor computation for this allocation includes a segmented historical loss migration analysis of risk grades to charge-off.

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)

In addition to the specific reserves and historical loss components of the allowance, consideration is given to asset quality metrics and various environmental factors to ensure that losses inherent in the portfolio are reflected in the allowance for loan losses. The environmental component adjusts the historical loss allocations for non-impaired loans to reflect relevant current conditions that, in management's opinion, have an impact on loss recognition. Environmental factors that management reviews in the analysis include: national and local economic trends and conditions; trends in growth in the loan portfolio and growth in higher risk areas; levels of, and trends in, delinquencies and non-accruals; experience and depth of lending management and staff; adequacy of, and adherence to, lending policies and procedures including those for underwriting; industry concentrations of credit; and adequacy of risk identification systems and controls through the internal loan review and internal audit processes.

In conformance with ASC 805 and ASC 820, loans purchased after December 31, 2008 are recorded at the acquisition date fair value. Such loans are included in the allowance to the extent a specific impairment is identified that exceeds the fair value adjustment on an impaired loan or the historical loss and environmental factor analysis indicates losses inherent in a purchased portfolio exceeds the fair value adjustment on the portion of the purchased portfolio not deemed impaired.

The following tables summarize changes in the allowance for loan losses by loan segment for the three and six months ended June 30, 2017, and June 30, 2016:



	Three Months Ended June 30, 2017
	Commercial			Commercial Real Estate			Consumer			Residential			Finance Leases		Total
Allowance for loan losses:
Balances, March 31, 2017	$	28,524		$	24,320		$	3,120		$	12,259		$	2	$	68,225
Provision for losses	161			1,402			286			1,026					2,875
Recoveries on loans	297			175			101			153					726
Loans charged-off	(76		)	(661		)	(135		)	(483		)			(1,355		)
Balances, June 30, 2017	$	28,906		$	25,236		$	3,372		$	12,955		$	2	$	70,471



	Six Months Ended June 30, 2017
	Commercial			Commercial Real Estate			Consumer			Residential			Finance Leases		Total
Allowance for loan losses:
Balances, December 31, 2016	$	27,696		$	23,661		$	2,923		$	11,755		$	2	$	66,037
Provision for losses	1,358			1,649			535			1,718					5,260
Recoveries on loans	663			739			202			390					1,994
Loans charged-off	(811		)	(813		)	(288		)	(908		)			(2,820		)
Balances, June 30, 2017	$	28,906		$	25,236		$	3,372		$	12,955		$	2	$	70,471



	Three Months Ended June 30, 2016
	Commercial			Commercial Real Estate			Consumer			Residential			Finance Leases		Total
Allowance for loan losses:
Balances, March 31, 2016	$	26,264		$	22,317		$	2,647		$	10,856		$	2	$	62,086
Provision for losses	400			200			44			146					790
Recoveries on loans	683			276			107			273					1,339
Loans charged-off	(1,026		)	(513		)	(114		)	(376		)			(2,029		)
Balances, June 30, 2016	$	26,321		$	22,280		$	2,684		$	10,899		$	2	$	62,186



	Six Months Ended June 30, 2016
	Commercial			Commercial Real Estate			Consumer			Residential			Finance Leases		Total
Allowance for loan losses:
Balances, December 31, 2015	$	26,478		$	22,145		$	2,689		$	11,139		$	2	$	62,453
Provision for losses	539			414			77			310					1,340
Recoveries on loans	975			1,228			185			585					2,973
Loans charged-off	(1,671		)	(1,507		)	(267		)	(1,135		)			(4,580		)
Balances, June 30, 2016	$	26,321		$	22,280		$	2,684		$	10,899		$	2	$	62,186

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)

The following tables show the Corporation’s allowance for loan losses and loan portfolio by segment as of the periods indicated:



	June 30, 2017
	Commercial		Commercial Real Estate		Consumer		Residential		Finance Leases		Total
Allowance Balances:
Individually evaluated for impairment			$	766			$	465			$	1,231
Collectively evaluated for impairment	$	28,906	24,470		$	3,372	12,490		$	2	69,240
Loans Acquired with Deteriorated Credit Quality
Total Allowance for Loan Losses	$	28,906	$	25,236	$	3,372	$	12,955	$	2	$	70,471
Loan Balances:
Individually evaluated for impairment	$	3,346	$	20,744	$	7	$	4,396			$	28,493
Collectively evaluated for impairment	1,635,295		2,564,375		79,880		1,277,645		$	232	5,557,427
Loans Acquired with Deteriorated Credit Quality	648		24,999				1,577				27,224
Loans	$	1,639,289	$	2,610,118	$	79,887	$	1,283,618	$	232	$	5,613,144



	December 31, 2016
	Commercial		Commercial Real Estate		Consumer		Residential		Finance Leases		Total
Allowance Balances:
Individually evaluated for impairment	$	37	$	553			$	298			$	888
Collectively evaluated for impairment	27,659		23,108		$	2,923	11,457		$	2	65,149
Loans Acquired with Deteriorated Credit Quality
Total Allowance for Loan Losses	$	27,696	$	23,661	$	2,923	$	11,755	$	2	$	66,037
Loan Balances:
Individually evaluated for impairment	$	4,762	$	21,358	$	9	$	4,450			$	30,579
Collectively evaluated for impairment	1,520,981		2,315,686		77,470		1,151,396		$	311	5,065,844
Loans Acquired with Deteriorated Credit Quality	6,653		34,721				1,848				43,222
Loans	$	1,532,396	$	2,371,765	$	77,479	$	1,157,694	$	311	$	5,139,645

The risk characteristics of the Corporation’s material portfolio segments are as follows:

Commercial

Commercial lending is primarily based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. Most commercial loans are secured by the tangible assets being financed such as equipment or real estate or other business assets such as accounts receivable or inventory and may incorporate a personal guarantee. Other loans may be unsecured, secured but under-collateralized or otherwise made on the basis of the enterprise value of an organization. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.

Commercial real estate

These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves higher loan principal amounts and the repayment of these loans is generally dependent on the successful operation of the property securing the loan or the business conducted on the property securing the loan. Commercial real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. Management monitors and evaluates commercial real estate loans based on collateral and risk grade criteria. In addition, management tracks the level of owner-occupied commercial real estate loans versus non-owner occupied loans.

Consumer and Residential

With respect to residential loans that are secured by 1-4 family residences and are typically owner occupied, the Corporation generally establishes a maximum loan-to-value ratio and requires private mortgage insurance if that ratio is exceeded. Home equity loans are secured by a subordinate interest in 1-4 family residences, and consumer loans are secured by consumer assets such as automobiles or recreational vehicles. Some consumer loans are unsecured such as small installment loans and certain lines of credit. Repayment of these loans is primarily dependent on the personal income and credit rating of the borrowers, which can be impacted by economic conditions in their market areas such as unemployment levels. Repayment on loans secured by 1-4 family residences can be impacted by changes in property values. Risk is mitigated by the fact that the loans are of smaller individual amounts and spread over a large number of borrowers.

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)

Loans are reclassified to a non-accruing status when, in management’s judgment, the collateral value and financial condition of the borrower do not justify accruing interest. When the interest accrual is discontinued, all unpaid accrued interest is reversed against earnings when considered uncollectable. Payments subsequently received on non-accrual loans are applied to principal. A loan is returned to accrual status when principal and interest are no longer past due and collectability is probable, typically after a minimum of six consecutive months of performance. Payments received on impaired accruing or delinquent loans are applied to interest income as accrued.

The following table summarizes the Corporation’s non-accrual loans by loan class as of the periods indicated:



	June 30, 2017		December 31, 2016
Commercial and industrial loans	$	1,786	$	1,839
Agriculture production financing and other loans to farmers	662		1,329
Real estate loans:
Construction	69		73
Commercial and farmland	14,110		15,754
Residential	9,633		9,523
Home equity	1,029		1,457
Individuals' loans for household and other personal expenditures	58		23
Total	$	27,347	$	29,998

Commercial impaired loans include non-accrual loans, loans accounted for under ASC 310-30, and loans risk graded as substandard, doubtful and loss that were still accruing but deemed impaired according to the guidance set forth in ASC 310. Also included in impaired loans are accruing loans that are contractually past due 90 days or more and troubled debt loan restructures.

Allowable methods for determining the amount of impairment include estimating fair value using the fair value of the collateral for collateral dependent loans. If the impaired loan is identified as collateral dependent, then the fair value method for measuring the amount of impairment is utilized. This method requires obtaining a current independent appraisal of the collateral and applying a discount factor, which includes selling costs if applicalble, to the value. The fair value of real estate is generally based on appraisals by qualified licensed appraisers. The appraisers typically determine the value of the real estate by utilizing an income or market valuation approach. If an appraisal is not available, the fair value may be determined by using a cash flow analysis. Fair value on other collateral such as business assets is typically ascertained by assessing, either singularly or some combination of, asset appraisals, accounts receivable aging reports, inventory listings and or customer financial statements. Both appraised values and values based on borrower’s financial information are discounted as considered appropriate based on age and quality of the information and current market conditions.

The following tables show the composition of the Corporation’s commercial impaired loans, related allowance and interest income recognized while impaired by loan class as of the periods indicated:



	June 30, 2017
	Unpaid Principal Balance		Recorded Investment		Related Allowance
Impaired loans with no related allowance:
Commercial and industrial loans	$	6,635	$	3,332
Agriculture production financing and other loans to farmers	672		662
Real estate Loans:
Construction	1,238		557
Commercial and farmland	58,749		41,750
Residential	5,575		3,473
Home equity	13		9
Total	$	72,882	$	49,783
Impaired loans with related allowance:
Real estate Loans:
Commercial and farmland	$	3,988	$	3,276	$	766
Residential	765		567		104
Home equity	40		18		11
Total	$	4,793	$	3,861	$	881
Total Impaired Loans	$	77,675	$	53,644	$	881

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)



	December 31, 2016
	Unpaid Principal Balance		Recorded Investment		Related Allowance
Impaired loans with no related allowance:
Commercial and industrial loans	$	17,645	$	10,074
Agriculture production financing and other loans to farmers	757		680
Real estate Loans:
Construction	5,946		3,178
Commercial and farmland	67,936		49,731
Residential	8,039		4,664
Home equity	82		44
Other commercial loans	11
Total	$	100,416	$	68,371
Impaired loans with related allowance:
Agriculture production financing and other loans to farmers	$	660	$	660	$	36
Real estate Loans:
Commercial and farmland	4,238		2,985		553
Residential	65		34		23
Total	$	4,963	$	3,679	$	612
Total Impaired Loans	$	105,379	$	72,050	$	612



	Three Months Ended June 30, 2017				Six Months Ended June 30, 2017
	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
Impaired loans with no related allowance:
Commercial and industrial loans	$	3,398	$	23	$	3,629	$	45
Agriculture production financing and other loans to farmers	663				664
Real estate Loans:
Construction	555		5		556		5
Commercial and farmland	46,343		427		47,875		903
Residential	3,534		34		3,632		67
Home equity	9				9
Total	$	54,502	$	489	$	56,365	$	1,020
Impaired loans with related allowance:
Real estate Loans:
Commercial and farmland	$	3,282			$	3,289	$	2
Residential	570				574
Home equity	18				18
Total	$	3,870			$	3,881	$	2
Total Impaired Loans	$	58,372	$	489	$	60,246	$	1,022



	Three Months Ended June 30, 2016				Six Months Ended June 30, 2016
	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
Impaired loans with no related allowance:
Commercial and industrial loans	$	10,372	$	128	$	10,307	$	231
Agriculture production financing and other loans to farmers	834		2		882		2
Real estate Loans:
Construction	4,085		74		4,074		147
Commercial and farmland	62,173		861		63,136		1,706
Residential	5,069		54		5,390		107
Home equity	138				139
Total	$	82,671	$	1,119	$	83,928	$	2,193
Impaired loans with related allowance:
Commercial and industrial loans	$	2,120	$	9	$	2,129	$	19
Agriculture production financing and other loans to farmers	1,321				1,405
Real estate Loans:
Commercial and farmland	1,986				2,008
Residential	840				860
Total	$	6,267	$	9	$	6,402	$	19
Total Impaired Loans	$	88,938	$	1,128	$	90,330	$	2,212

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)

As part of the ongoing monitoring of the credit quality of the Corporation's loan portfolio, management tracks certain credit quality indicators including trends related to: (i) the level of criticized commercial loans, (ii) net charge-offs, (iii) non-performing loans, (iv) covenant failures and (v) the general national and local economic conditions.

The Corporation utilizes a risk grading of pass, special mention, substandard, doubtful and loss to assess the overall credit quality of large commercial loans. All large commercial credit grades are reviewed at a minimum of once a year for pass grade loans. Loans with grades below pass are reviewed more frequently depending on the grade. A description of the general characteristics of these grades is as follows:


•	Pass - Loans that are considered to be of acceptable credit quality.

•

Special Mention - Loans which possess some credit deficiency or potential weakness, which deserves close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the Corporation's credit position at some future date. Special mention assets are not adversely classified and do not expose the Corporation to sufficient risk to warrant adverse classification. The key distinctions of this category's classification are that it is indicative of an unwarranted level of risk; and weaknesses are considered “potential”, not “defined”, impairments to the primary source of repayment. Examples include businesses that may be suffering from inadequate management, loss of key personnel or significant customer or litigation.

•

Substandard - A substandard loan is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified have a well-defined weakness that jeopardizes the liquidation of the debt. They are characterized by the distinct possibility that the Corporation will sustain some loss if the deficiencies are not corrected. Other characteristics may include:



	o	the likelihood that a loan will be paid from the primary source of repayment is uncertain or financial deterioration is underway and very close attention is warranted to ensure that the loan is collected without loss,



	o	the primary source of repayment is gone, and the Corporation is forced to rely on a secondary source of repayment, such as collateral liquidation or guarantees,



	o	loans have a distinct possibility that the Corporation will sustain some loss if deficiencies are not corrected,



	o	unusual courses of action are needed to maintain a high probability of repayment,



	o	the borrower is not generating enough cash flow to repay loan principal; however, it continues to make interest payments,



	o	the Corporation is forced into a subordinated or unsecured position due to flaws in documentation,



	o	loans have been restructured so that payment schedules, terms and collateral represent concessions to the borrower when compared to the normal loan terms,



	o	the Corporation is seriously contemplating foreclosure or legal action due to the apparent deterioration of the loan, and



	o	there is significant deterioration in market conditions to which the borrower is highly vulnerable.

•

Doubtful - Loans that have all of the weaknesses of those classified as Substandard. However, based on currently existing facts, conditions and values, these weaknesses make full collection of principal highly questionable and improbable. Other credit characteristics may include the primary source of repayment is gone or there is considerable doubt as to the quality of the secondary sources of repayment. The possibility of loss is high, but because of certain important pending factors that may strengthen the loan, loss classification is deferred until the exact status of repayment is known.


•	Loss – Loans that are considered uncollectible and of such little value that continuing to carry them as an asset is not warranted. Loans will be classified as Loss when it is neither practical not desirable to defer writing off or reserving all or a portion of a basically worthless asset, even though partial recovery may be possible at some time in the future.

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)

The following tables summarize the credit quality of the Corporation’s loan portfolio, by loan class for the periods indicated. Consumer non-performing loans include accruing consumer loans 90 plus days delinquent and consumer non-accrual loans. The entire balance of a loan is considered delinquent if the minimum payment contractually required to be made is not received by the specified date. Loans that evidenced deterioration of credit quality since origination and it was probable, at acquisition, that all contractually required payments would not be collected are included in the applicable categories below.



	June 30, 2017
	Commercial Pass		Commercial Special Mention		Commercial Substandard		Commercial Doubtful		Commercial Loss		Consumer Performing		Consumer Non-Performing		Total
Commercial and industrial loans	$	1,235,039	$	19,811	$	35,034									$	1,289,884
Agriculture production financing and other loans to farmers	33,917		25,818		16,011										75,746
Real estate Loans:
Construction	414,112		5,471		1,059						$	21,678	$	69	442,389
Commercial and farmland	2,050,396		47,526		67,681		$	1,687	$	91	343		5		2,167,729
Residential	175,169		3,298		4,069						656,576		8,468		847,580
Home equity	11,847		30		94						422,979		1,088		436,038
Individuals' loans for household and other personal expenditures											79,829		58		79,887
Lease financing receivables, net of unearned income	232														232
Other commercial loans	273,165				494										273,659
Loans	$	4,193,877	$	101,954	$	124,442	$	1,687	$	91	$	1,181,405	$	9,688	$	5,613,144



	December 31, 2016
	Commercial Pass		Commercial Special Mention		Commercial Substandard		Commercial Doubtful	Commercial Loss	Consumer Performing		Consumer Non-Performing		Total
Commercial and industrial loans	$	1,117,545	$	30,919	$	46,182							$	1,194,646
Agriculture production financing and other loans to farmers	30,712		25,273		23,704								79,689
Real estate Loans:
Construction	398,646		3,490		1,858				$	14,636	$	73	418,703
Commercial and farmland	1,811,367		60,028		80,626				1,034		7		1,953,062
Residential	146,251		5,106		6,046				574,054		7,712		739,169
Home equity	7,310		47		516				409,237		1,415		418,525
Individuals' loans for household and other personal expenditures									77,456		23		77,479
Lease financing receivables, net of unearned income	228				83								311
Other commercial loans	257,861				200								258,061
Loans	$	3,769,920	$	124,863	$	159,215			$	1,076,417	$	9,230	$	5,139,645

The tables below show a past due aging of the Corporation’s loan portfolio, by loan class, as of June 30, 2017, and December 31, 2016.



	June 30, 2017
	Current		30-59 Days Past Due		60-89 Days Past Due		Loans > 90 Days And Accruing		Non-Accrual		Total Past Due & Non-Accrual		Total
Commercial and industrial loans	$	1,286,444	$	1,351	$	203	$	100	$	1,786	$	3,440	$	1,289,884
Agriculture production financing and other loans to farmers	74,447		637						662		1,299		75,746
Real estate loans:
Construction	442,320								69		69		442,389
Commercial and farmland	2,151,621		1,007		991				14,110		16,108		2,167,729
Residential	834,286		2,672		541		448		9,633		13,294		847,580
Home equity	433,223		1,140		560		86		1,029		2,815		436,038
Individuals' loans for household and other personal expenditures	79,448		301		80				58		439		79,887
Lease financing receivables, net of unearned income	232												232
Other commercial loans	273,659												273,659
Loans	$	5,575,680	$	7,108	$	2,375	$	634	$	27,347	$	37,464	$	5,613,144

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)



	December 31, 2016
	Current		30-59 Days Past Due		60-89 Days Past Due		Loans > 90 Days And Accruing		Non-Accrual		Total Past Due & Non-Accrual		Total
Commercial and industrial loans	$	1,192,079	$	466	$	162	$	100	$	1,839	$	2,567	$	1,194,646
Agriculture production financing and other loans to farmers	78,360								1,329		1,329		79,689
Real estate loans:
Construction	415,975		2,655						73		2,728		418,703
Commercial and farmland	1,932,896		1,385		3,027				15,754		20,166		1,953,062
Residential	725,338		3,664		635		9		9,523		13,831		739,169
Home equity	415,969		850		246		3		1,457		2,556		418,525
Individuals' loans for household and other personal expenditures	76,929		470		57				23		550		77,479
Lease financing receivables, net of unearned income	311												311
Other commercial loans	258,061												258,061
Loans	$	5,095,918	$	9,490	$	4,127	$	112	$	29,998	$	43,727	$	5,139,645

See the information regarding the analysis of loan loss experience in the "LOAN QUALITY/PROVISION FOR LOAN LOSSES" section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included as ITEM 2 of this Quarterly Report on Form 10-Q.

On occasion, borrowers experience declines in income and cash flow. As a result, these borrowers seek to reduce contractual cash outlays including debt payments. Concurrently, in an effort to preserve and protect its earning assets, specifically troubled loans, the Corporation works to maintain its relationship with certain customers who are experiencing financial difficulty by contractually modifying the borrower's debt agreement with the Corporation. In certain loan restructuring situations, the Corporation may grant a concession to a debtor experiencing financial difficulty, resulting in a trouble debt restructuring. A concession is deemed to be granted when, as a result of the restructuring, the Corporation does not expect to collect all original amounts due, including interest accrued at the original contract rate. If the payment of principal at original maturity is primarily dependent on the value of collateral, the current value of the collateral is considered in determining whether the principal will be paid.

The following tables summarize troubled debt restructurings in the Corporation's loan portfolio that occurred during the periods indicated:



	Three Months Ended June 30, 2017					Six Months Ended June 30, 2017
	Pre-Modification Recorded Balance		Post-Modification Recorded Balance		Number of Loans	Pre-Modification Recorded Balance		Post-Modification Recorded Balance		Number of Loans
Commercial and industrial loans	$	394	$	170	1	$	394	$	170	1
Real estate loans:
Commercial and farmland	250		250		3	357		491		6
Residential	329		276		5	450		398		7
Home equity						122
Total	$	973	$	696	9	$	1,323	$	1,059	14



	Three Months Ended June 30, 2016					Six Months Ended June 30, 2016
	Pre-Modification Recorded Balance		Post-Modification Recorded Balance		Number of Loans	Pre-Modification Recorded Balance		Post-Modification Recorded Balance		Number of Loans
Commercial and industrial loans						$	260	$	260	3
Agriculture production financing and other loans to farmers	$	1,141	$	1,141	3	1,606		1,472		5
Real estate loans:
Commercial and farmland	3,539		3,508		5	3,891		3,860		6
Residential						113		133		3
Home equity	174		146		1	174		146		1
Total	$	4,854	$	4,795	9	$	6,044	$	5,871	18

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)

The following tables summarize the recorded investment of troubled debt restructurings as of June 30, 2017 and 2016, by modification type, that occurred during the periods indicated:



	Three Months Ended June 30, 2017
	Term Modification		Rate Modification		Combination		Total Modification
Commercial and industrial loans					$	169	$	169
Real estate loans:
Commercial and farmland	$	41	$	154			195
Residential			231		43		274
Total	$	41	$	385	$	212	$	638



	Six Months Ended June 30, 2017
	Term Modification		Rate Modification		Combination		Total Modification
Commercial and industrial loans					$	169	$	169
Real estate loans:
Commercial and farmland	$	41	$	154	235		430
Residential			351		43		394
Total	$	41	$	505	$	447	$	993



	Three Months Ended June 30, 2016
	Term Modification		Rate Modification		Combination		Total Modification
Agriculture production financing and other loans to farmers	$	1,141					$	1,141
Real estate loans:
Commercial and farmland	418				$	3,086	3,504
Home equity			$	143			143
Total	$	1,559	$	143	$	3,086	$	4,788



	Six Months Ended June 30, 2016
	Term Modification		Rate Modification		Combination		Total Modification
Commercial and industrial loans					$	198	$	198
Agriculture production financing and other loans to farmers	$	1,141	$	49			1,190
Real estate loans:
Commercial and farmland	418				3,433		3,851
Residential			112				112
Home equity			143				143
Total	$	1,559	$	304	$	3,631	$	5,494

Loans secured by residential and commercial and farmland real estate made up 40 percent and 36 percent, respectively, of the post-modification balance of troubled debt restructured loans made in the three months ended June 30, 2017. The same loan classifications made up 36 percent and 46 percent, respectively, of the post-modification balance of troubled debt restructured loans made in the six months ended June 30. 2017.

There were no troubled debt restructures that occurred during the twelve months ended June 30, 2017, that subsequently defaulted during the three and six month periods ended June 30, 2017 and remained in default at period end. The following tables summarize troubled debt restructures that occurred during the twelve months ended June 30, 2016, that subsequently defaulted during the period indicated and remained in default at period end. For purposes of this discussion, a loan is considered in default if it is 30 or more days past due.



	Three Months Ended June 30, 2016			Six Months Ended June 30, 2016
	Number of Loans	Recorded Balance		Number of Loans	Recorded Balance
Commercial and industrial loans	1	$	72	4	$	269
Real estate loans:
Residential	1	$	55	1	$	55
Total	2	$	127	5	$	324

For potential consumer loan restructures, impairment evaluation occurs prior to modification. Any subsequent impairment is typically addressed through the charge-off process, or may be addressed through a specific reserve. Consumer troubled debt loan restructures are generally included in the general historical allowance for loan loss at the post modification balance. Consumer non-accrual and delinquent troubled debt loan restructures are also considered in the calculation of the non-accrual and delinquency trend environmental allowance allocation. Consumer mortgage loans secured by residential real estate properties for which formal foreclosure proceedings are in process totaled $2,211,000 and $1,530,000 at June 30, 2017 and December 31, 2016, respectively.

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)

Commercial troubled debt restructured loans risk graded special mention, substandard, doubtful and loss are individually evaluated for impairment under ASC 310. Any resulting specific reserves are included in the allowance for loan losses. Commercial 30 - 89 day delinquent troubled debt loan restructures are included in the calculation of the delinquency trend environmental allowance allocation. All commercial non-impaired loans, including non-accrual and 90+ day delinquents, are included in the ASC 450 loss migration analysis.

NOTE 5

ACCOUNTING FOR CERTAIN LOANS ACQUIRED IN A PURCHASE

The acquired loans detailed in the tables below are included in NOTE 4. LOANS AND ALLOWANCE, in the Notes to Consolidated Condensed Financial Statements of this Quarterly Report on Form 10-Q. As described in NOTE 4, loans purchased after December 31, 2008 are recorded at the acquisition date fair value, which could result in a fair value discount or premium. Purchased loans with evidence of credit deterioration since origination and for which it is probable at the date of acquisition that the acquirer will not collect all contractually required principal and interest payments are accounted for under ASC 310-30, Loans Acquired with Deteriorated Credit Quality. The difference between contractually required payments and the cash flows expected to be collected at acquisition is referred to as the nonaccretable difference. The accretable portion of the fair value discount or premium is the difference between the expected cash flows and the net present value of expected cash flows, with such difference accreted into earnings over the term of the loans. All other loans not accounted for under ASC 310-30 are accounted for under ASC 310-20, which allows the fair value adjustment to be accreted into income over the remaining life of the loans.

The Corporation's most recent acquisition, Arlington Bank, is detailed in NOTE 2, ACQUISITIONS, in the Notes to Consolidated Condensed Financial Statements of this Quarterly Report on Form 10-Q. All of the Corporation's acquisitions since December 31, 2008 are as indicated below. The following tables include the outstanding balance and carrying amount of all acquired loans which were included in the Corporation's balance sheet at June 30, 2017, and December 31, 2016.



	June 30, 2017
	Arlington Bank		Ameriana		C Financial		Community		CFS		SCB		Total
Outstanding Balance:
Commercial and industrial loans	$	2,853	$	6,424	$	75	$	459	$	10,595	$	2,191	$	22,597
Agricultural production financing and other loans to farmers							98		50		1,114		1,262
Real estate loans:
Construction	21,990		13,817		1,448		1,770		120				39,145
Commercial and farmland	87,050		92,872		19,034		31,091		91,676		7,837		329,560
Residential	94,047		94,257		38,575		7,664		86,632		3,182		324,357
Home equity	13,542		10,042		6,956		4,951		22,929		11,198		69,618
Individuals' loans for household and other personal expenditures	1,055		545				103		163		25		1,891
Other commercial loans			1,808						62				1,870
Total	$	220,537	$	219,765	$	66,088	$	46,136	$	212,227	$	25,547	$	790,300

Carrying Amount	$	213,976	$	212,297	$	64,449	$	43,514	$	205,695	$	22,962	$	762,893
Allowance			412				53		39				504
Carrying Amount Net of Allowance	$	213,976	$	211,885	$	64,449	$	43,461	$	205,656	$	22,962	$	762,389



	December 31, 2016
	Ameriana		C Financial		Community		CFS		SCB		Total
Outstanding Balance:
Commercial and industrial loans	$	8,003	$	85	$	2,269	$	23,327	$	3,552	$	37,236
Agricultural production financing and other loans to farmers					1,030		50		1,630		2,710
Real estate loans:
Construction	22,017		2,835		4,026		420				29,298
Commercial and farmland	103,075		22,130		36,947		131,895		9,315		303,362
Residential	103,414		44,101		9,363		96,627		4,135		257,640
Home equity	11,728		7,947		6,326		26,894		11,924		64,819
Individuals' loans for household and other personal expenditures	762		2		147		201		30		1,142
Other commercial loans	1,825						65				1,890
Total	$	250,824	$	77,100	$	60,108	$	279,479	$	30,586	$	698,097

Carrying Amount	$	240,053	$	75,194	$	56,007	$	266,845	$	27,318	$	665,417
Allowance	265				23		92				380
Carrying Amount Net of Allowance	$	239,788	$	75,194	$	55,984	$	266,753	$	27,318	$	665,037

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)

The outstanding balance and related carrying amount of loans acquired and accounted for under ASC 310-30 as of June 30, 2017 were $36.7 million and $27.2 million, respectively; with no required allowance for loan losses. The outstanding balance and related carrying amount of those loans as of December 31, 2016 were $60.5 million and $43.2 million, respectively; with no required allowance for loan losses. During the three months ended June 30, 2017, one loan, with a December 31, 2016 outstanding balance of $12.1 million and a carrying amount of $7.6 million, was transferred to Other Real Estate Owned.

As customer cash flow expectations improve, nonaccretable yield can be reclassified to accretable yield. The accretable yield, or income expected to be collected, and reclassifications from nonaccretable yield, are identified in the tables below. The tables reflect only purchased loans accounted for under ASC 310-30 and not the entire portfolio of purchased loans.



	Three Months Ended June 30, 2017
	Arlington Bank		Ameriana			C Financial			Community			CFS			SCB			Total
Beginning balance			$	824		$	68		$	1,202		$	732		$	257		$	3,083
Additions	$	667																667
Accretion			(156		)	(48		)	(371		)	(417		)	(166		)	(1,158		)
Reclassification from nonaccretable			3			43			181			311			144			682
Disposals									(122		)	(545		)				(667		)
Ending balance	$	667	$	671		$	63		$	890		$	81		$	235		$	2,607



			Six Months Ended June 30, 2017
	Arlington Bank		Ameriana			C Financial			Community			CFS			SCB			Total
Beginning balance			$	1,630		$	73		$	1,233		$	736		$	279		$	3,951
Additions	$	667																667
Accretion			(2,658		)	(88		)	(433		)	(887		)	(330		)	(4,396		)
Reclassification from nonaccretable			1,699			78			212			777			286			3,052
Disposals									(122		)	(545		)				(667		)
Ending balance	$	667	$	671		$	63		$	890		$	81		$	235		$	2,607



	Three Months Ended June 30, 2016
	Ameriana			C Financial			Community			CFS			SCB			Total
Beginning balance	$	2,120		$	100		$	1,456		$	1,033		$	590		$	5,299
Additions
Accretion	(47		)	(71		)	(849		)	(855		)	(293		)	(2,115		)
Reclassification from nonaccretable	5			52			738			737			154			1,686
Disposals	(232		)							(11		)				(243		)
Ending balance	$	1,846		$	81		$	1,345		$	904		$	451		$	4,627



	Six Months Ended June 30, 2016
	Ameriana			C Financial			Community			CFS			SCB			Total
Beginning balance	$	2,160		$	114		$	1,508		$	1,188		$	642		$	5,612
Additions
Accretion	(87		)	(86		)	(912		)	(2,145		)	(381		)	(3,611		)
Reclassification from nonaccretable	5			53			749			1,872			190			2,869
Disposals	(232		)							(11		)				(243		)
Ending balance	$	1,846		$	81		$	1,345		$	904		$	451		$	4,627

The following table presents loans acquired, as of the respective acquisition date, during the period ended June 30, 2017, for which it was probable that all contractually required payments would not be collected:



	Arlington Bank
Contractually required payments receivable at acquisition date	$	6,183
Nonaccretable difference	2,891
Expected cash flows at acquisition date	3,292
Accretable difference	667
Basis in loans at acquisition date	$	2,625

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)

NOTE 6

GOODWILL

Goodwill is recorded on the acquisition date of an entity. During the measurement period, the Corporation may record subsequent adjustments to goodwill for provisional amounts recorded at the acquisition date. The Arlington Bank acquisition on May 19, 2017 resulted in $48,188,000 of goodwill. The Ameriana acquisition on December 31, 2015 resulted in $38,624,000 of goodwill, of which, $871,000 was recorded during the first quarter of 2016 as a measurement period adjustment. Details regarding the Arlington Bank acquisition are discussed in NOTE 2. ACQUISITIONS, in the Notes to Consolidated Financial Statements of this Quarterly Report on Form 10-Q.



	2017
Balance, January 1	$	244,000
Goodwill acquired	48,188
Balance, June 30	$	292,188



	2016
Balance, January 1	$	243,129
Measurement period adjustment	871
Balance, December 31	$	244,000

NOTE 7

CORE DEPOSIT INTANGIBLES

A core deposit intangible is recorded on the acquisition date of an entity. During the measurement period, the Corporation may record subsequent adjustments to the core deposit intangible for provisional amounts recorded at the acquisition date. The Arlington Bank acquisition on May 19, 2017 resulted in a core deposit intangible of $4,526,000. The Ameriana acquisition on December 31, 2015 resulted in a core deposit intangible of $5,342,000, of which, $2,142,000 was recorded as a measurement period adjustment in the first quarter of 2016. Details regarding the Arlington Bank acquisition are discussed in NOTE 2. ACQUISITIONS, in the Notes to Consolidated Financial Statements of this Quarterly Report on Form 10-Q.

The carrying basis and accumulated amortization of recognized core deposit intangibles are noted below.



	June 30, 2017			December 31, 2016
Gross carrying amount	$	63,940		$	61,798
Core deposit intangibles acquired	4,526
Measurement period adjustment				2,142
Accumulated amortization	(50,968		)	(49,074		)
Core deposit intangibles	$	17,498		$	14,866

Estimated future amortization expense is summarized as follows:



	Amortization Expense
2017	$	2,329
2018	3,202
2019	2,609
2020	2,268
2021	2,022
After 2021	5,068
	$	17,498

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)

NOTE 8

DERIVATIVE FINANCIAL INSTRUMENTS

Risk Management Objective of Using Derivatives

The Corporation is exposed to certain risks arising from both its business operations and economic conditions. The Corporation principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Corporation manages economic risks, including interest rate, liquidity, and credit risk, primarily by managing the amount, sources, and duration of its assets and liabilities and through the use of derivative financial instruments. Specifically, the Corporation enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. The Corporation’s derivative financial instruments are used to manage differences in the amount, timing, and duration of the Corporation’s known or expected cash payments principally related to certain variable-rate liabilities. The Corporation also has derivatives that are a result of a service the Corporation provides to certain qualifying customers, and, therefore, are not used to manage interest rate risk in the Corporation’s assets or liabilities. The Corporation manages a matched book with respect to its derivative instruments offered as a part of this service to its customers in order to minimize its net risk exposure resulting from such transactions.

Cash Flow Hedges of Interest Rate Risk

The Corporation’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish these objectives, the Corporation primarily uses interest rate swaps and interest rate caps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the payment of fixed amounts to a counterparty in exchange for the Corporation receiving variable payments over the life of the agreements without exchange of the underlying notional amount. Interest rate caps designated as cash flow hedges involve the receipt of variable amounts from a counterparty if interest rates rise above the strike rate on the contract in exchange for an up-front premium. As of June 30, 2017 and December 31, 2016, the Corporation had five interest rate swaps with a notional amount of $56.0 million and one interest rate cap with a notional amount of $13.0 million that were designated as cash flow hedges.

The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in accumulated other comprehensive income and is subsequently reclassified into interest expense as interest payments are made on the Corporation’s variable-rate liabilities. During the next twelve months, the Corporation expects to reclassify $864,000 from accumulated other comprehensive income to interest expense.

During 2017, $26.0 million of the interest rate swaps and the $13.0 million interest rate cap were used to hedge the variable cash outflows (LIBOR-based) associated with existing trust preferred securities when the outflows converted from a fixed rate to variable rate in September of 2012. In addition, the remaining $30.0 million of interest rate swaps were used to hedge the variable cash outflows (LIBOR-based) associated with three Federal Home Loan Bank advances. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. During the six months ended June 30, 2017, and 2016, the Corporation did not recognize any ineffectiveness.

Non-designated Hedges

The Corporation does not use derivatives for trading or speculative purposes. Derivatives not designated as hedges are not speculative and result from a service the Corporation provides to certain customers. The Corporation executes interest rate swaps with commercial banking customers to facilitate their respective risk management strategies. Those interest rate swaps are simultaneously hedged by offsetting interest rate swaps that the Corporation executes with a third party, such that the Corporation minimizes its net risk exposure resulting from such transactions. As the interest rate swaps associated with this program do not meet the strict hedge accounting requirements, changes in the fair value of both the customer swaps and the offsetting swaps are recognized directly in earnings. As of June 30, 2017, the notional amount of customer-facing swaps was approximately $318,652,000. This amount is offset with third party counterparties, as described above.

Fair Values of Derivative Instruments on the Balance Sheet

The table below presents the fair value of the Corporation’s derivative financial instruments, as well as their classification on the Balance Sheet, as of June 30, 2017, and December 31, 2016.

Asset Derivatives

Liability Derivatives

June 30, 2017

December 31, 2016

June 30, 2017

December 31, 2016

Balance
Sheet
Location

Fair
Value

Balance
Sheet
Location

Fair
Value

Balance
Sheet
Location

Fair
Value

Balance
Sheet
Location

Fair
Value

Derivatives designated as hedging instruments:

Interest rate contracts

Other Assets

Other Liabilities

2,114

Other Liabilities

2,182

Derivatives not designated as hedging instruments:

Interest rate contracts

Other Assets

6,120

Other Assets

6,295

Other Liabilities

6,120

Other Liabilities

6,295

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)

The amount of gain (loss) recognized in other comprehensive income is included in the table below for the periods indicated.



Derivatives in Cash Flow Hedging Relationships	Amount of Gain (Loss) Recognized in Other Comprehensive Income on Derivative (Effective Portion)
	Three Months Ended						Six Months Ended
	June 30, 2017			June 30, 2016			June 30, 2017			June 30, 2016
Interest Rate Products	$	(404	)	$	(813	)	$	(370	)	$	(2,767	)

Effect of Derivative Instruments on the Income Statement

The tables below present the effect of the Corporation’s derivative financial instruments on the Income Statement for the three and six months ended June 30, 2017 and 2016.



Derivatives Not Designated as Hedging Instruments under FASB ASC 815-10	Location of Gain (Loss) Recognized Income on Derivative	Amount of Gain (Loss) Recognized in Income on Derivative
	Location of Gain (Loss) Recognized Income on Derivative	Three Months Ended June 30, 2017	Three Months Ended June , 2016
Interest rate contracts	Other income		$	(242	)



Derivatives Not Designated as Hedging Instruments under FASB ASC 815-10	Location of Gain (Loss) Recognized Income on Derivative	Amount of Gain (Loss) Recognized in Income on Derivative
	Location of Gain (Loss) Recognized Income on Derivative	Six Months Ended June 30, 2017	Six Months Ended June 30, 2016
Interest rate contracts	Other income		$	(488	)

The amount of gain (loss) reclassified from other comprehensive income into income is included in the table below for the periods indicated.



Derivatives Designated as Hedging Instruments under FASB ASC 815-10	Location of Gain (Loss) Recognized Income on Derivative	Amount of Gain (Loss) Reclassed from Other Comprehensive Income into Income (Effective Portion)
	Location of Gain (Loss) Recognized Income on Derivative	Three Months Ended June 30, 2017			Three Months Ended June , 2016
Interest rate contracts	Interest Expense	$	(251	)	$	(318	)



Derivatives Designated as Hedging Instruments under FASB ASC 815-10	Location of Gain (Loss) Recognized Income on Derivative	Amount of Gain (Loss) Reclassed from Other Comprehensive Income into Income (Effective Portion)
	Location of Gain (Loss) Recognized Income on Derivative	Six Months Ended June 30, 2017			Six Months Ended June 30, 2016
Interest rate contracts	Interest Expense	$	(519	)	$	(642	)

The Corporation’s exposure to credit risk occurs because of nonperformance by its counterparties. The counterparties approved by the Corporation are usually financial institutions, which are well capitalized and have credit ratings through Moody’s and/or Standard & Poor’s at or above investment grade. The level of risk is monitored by performing quarterly financial reviews, comparing mark-to-mark values with policy limitations, monitoring credit ratings and pledging of collateral.

Credit-risk-related Contingent Features

The Corporation has agreements with certain of its derivative counterparties that contain a provision where if the Corporation fails to maintain its status as a well or adequately capitalized institution, then the Corporation could be required to terminate or fully collateralize all outstanding derivative contracts.

The Corporation also has agreements with certain of its derivative counterparties that contain a provision where if the Corporation defaults on any of its indebtedness, including default where repayment of the indebtedness has not been accelerated by the lender, the Corporation could also be declared in default on its derivative obligations. As of June 30, 2017, the termination value of derivatives in a net liability position related to these agreements was $3,936,000. As of June 30, 2017, the Corporation had minimum collateral posting thresholds with certain of its derivative counterparties and had posted collateral of $9,266,000. If the Corporation had breached any of these provisions at June 30, 2017, it could have been required to settle its obligations under the agreements at their termination value.

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)

NOTE 9

DISCLOSURES ABOUT FAIR VALUE OF ASSETS AND LIABILITIES

The Corporation used fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. The accounting guidance defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. ASC 820 applies only when other guidance requires or permits assets or liabilities to be measured at fair value; it does not expand the use of fair value in any new circumstances.

As defined in ASC 820, fair value is the price to sell an asset or transfer a liability in an orderly transaction between market participants. It represents an exit price at the measurement date. Market participants are buyers and sellers, who are independent, knowledgeable, and willing and able to transact in the principal (or most advantageous) market for the asset or liability being measured. Current market conditions, including imbalances between supply and demand, are considered in determining fair value. The Corporation values its assets and liabilities in the principal market where it sells the particular asset or transfers the liability with the greatest volume and level of activity. In the absence of a principal market, the valuation is based on the most advantageous market for the asset or liability (i.e., the market where the asset could be sold or the liability transferred at a price that maximizes the amount to be received for the asset or minimizes the amount to be paid to transfer the liability).

Valuation inputs refer to the assumptions market participants would use in pricing a given asset or liability. Inputs can be observable or unobservable. Observable inputs are those assumptions which market participants would use in pricing the particular asset or liability. These inputs are based on market data and are obtained from a source independent of the Corporation. Unobservable inputs are assumptions based on the Corporation’s own information or estimate of assumptions used by market participants in pricing the asset or liability. Unobservable inputs are based on the best and most current information available on the measurement date. All inputs, whether observable or unobservable, are ranked in accordance with a prescribed fair value hierarchy which gives the highest ranking to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1) and the lowest ranking to unobservable inputs for which there is little or no market activity (Level 3). Fair values for assets or liabilities classified as Level 2 are based on one or a combination of the following factors: (i) quoted prices for similar assets; (ii) observable inputs for the asset or liability, such as interest rates or yield curves; or (iii) inputs derived principally from or corroborated by observable market data. The level in the fair value hierarchy within which the fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement in its entirety. The Corporation considers an input to be significant if it drives 10 percent or more of the total fair value of a particular asset or liability.

RECURRING MEASUREMENTS

Assets and liabilities are considered to be measured at fair value on a recurring basis if fair value is measured regularly (i.e., daily, weekly,

monthly or quarterly). Recurring valuation occurs at a minimum on the measurement date. Assets and liabilities are considered to be measured

at fair value on a nonrecurring basis if the fair value measurement of the instrument does not necessarily result in a change in the amount

recorded on the balance sheet. Generally, nonrecurring valuation is the result of the application of other accounting pronouncements which

require assets or liabilities to be assessed for impairment or recorded at the lower of cost or fair value. The fair value of assets or liabilities

transferred in or out of Level 3 is measured on the transfer date, with any additional changes in fair value subsequent to the transfer considered

to be realized or unrealized gains or losses.

Following is a description of the valuation methodologies used for instruments measured at fair value on a recurring basis and recognized in the

accompanying balance sheets, as well as the general classification of such instruments pursuant to the valuation hierarchy.

Investment Securities

Where quoted, market prices are available in an active market and securities are classified within Level 1 of the valuation hierarchy. Level 1

securities include U.S. Treasury and equity securities. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics or discounted cash flows. Level 2 securities include agencies, government-sponsored mortgage backs, state and municipal and equity securities. In certain cases where Level 1 or Level 2 inputs are not available, securities are classified within Level 3 of the hierarchy and include state and municipal, corporate obligations and equity securities. Level 3 fair value for state and municipal, corporate obligations and equity securities was determined using a discounted cash flow model that incorporated market estimates of interest rates and volatility in markets that have not been active.

Third party vendors compile prices from various sources and may apply such techniques as matrix pricing to determine the value of identical or

similar investment securities (Level 2). Matrix pricing is a mathematical technique widely used in the banking industry to value investment

securities without relying exclusively on quoted prices for specific investment securities but rather relying on the investment securities’

relationship to other benchmark quoted investment securities. Any investment security not valued based upon the methods above are

considered Level 3.

Interest Rate Derivative Agreements

See information regarding the Corporation's interest rate derivative products in NOTE 8. DERIVATIVE FINANCIAL INSTRUMENTS, in the Notes to Consolidated Condensed Financial Statements of this Quarterly Report on Form 10-Q.

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)

The following tables present the fair value measurements of assets and liabilities recognized in the Consolidated Condensed Balance Sheets measured at fair value on a recurring basis and the level within the fair value hierarchy in which the fair value measurements fall at June 30, 2017, and December 31, 2016.



			Fair Value Measurements Using:
June 30, 2017	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Available for sale securities:
U.S. Treasury	$	499	$	499
State and municipal	377,177				$	373,882	$	3,295
U.S. Government-sponsored mortgage-backed securities	330,235				330,235
Corporate obligations	31						31
Equity securities	34,817		32,801		2,012		4
Interest rate swap asset	6,120				6,120
Interest rate cap	3				3
Interest rate swap liability	8,234				8,234



			Fair Value Measurements Using:
December 31, 2016	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Available for sale securities:
U.S. Government-sponsored agency securities	$	100			$	100
State and municipal	363,658				358,524		$	5,134
U.S. Government-sponsored mortgage-backed securities	312,292				312,292
Corporate obligations	31						31
Equity securities	20,781		$	18,765	2,012		4
Interest rate swap asset	6,295				6,295
Interest rate cap	15				15
Interest rate swap liability	8,477				8,477

Level 3 Reconciliation

The following is a reconciliation of the beginning and ending balances of recurring fair value measurements recognized in the Consolidated Condensed Balance Sheets using significant unobservable (Level 3) inputs for the three and six months ended June 30, 2017 and 2016.



	Available for Sale Securities
	Three Months Ended				Six Months ended
	June 30, 2017		June 30, 2016		June 30, 2017			June 30, 2016
Balance at beginning of the period	$	3,279	$	5,504	$	5,169		$	5,932
Included in other comprehensive income	48		59		59			96
Principal payments	3		1		(1,898		)	(464		)
Ending balance	$	3,330	$	5,564	$	3,330		$	5,564

There were no gains or losses for the period included in earnings that were attributable to the changes in unrealized gains or losses related to assets or liabilities held at June 30, 2017 or December 31, 2016.

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)

Transfers Between Levels

There were no transfers in or out of Level 3 for the three and six months ended June 30, 2017 and 2016.

Nonrecurring Measurements

Following is a description of valuation methodologies used for instruments measured at fair value on a non-recurring basis and recognized in the

accompanying balance sheets, as well as the general classification of such instruments pursuant to the valuation hierarchy for

June 30, 2017, and December 31, 2016.



			Fair Value Measurements Using
June 30, 2017	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)	Significant Other Observable Inputs (Level 2)	Significant Unobservable Inputs (Level 3)
Impaired loans (collateral dependent)	$	7,460			$	7,460
Other real estate owned	416				416



			Fair Value Measurements Using
December 31, 2016	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)	Significant Other Observable Inputs (Level 2)	Significant Unobservable Inputs (Level 3)
Impaired loans (collateral dependent)	$	15,318			$	15,318
Other real estate owned	1,612				1,612

Impaired Loans (collateral dependent)

Loans for which it is probable that the Corporation will not collect all principal and interest due according to contractual terms are measured for impairment. Allowable methods for determining the amount of impairment include estimating fair value of the collateral for collateral dependent loans. If the impaired loan is identified as collateral dependent, then the fair value method of measuring the amount of impairment is utilized. This method requires obtaining a current independent appraisal of the collateral and applying a discount factor to the value. A portion of the allowance for loan losses is allocated to impaired loans if the value of such loans is deemed to be less than the unpaid balance. If these allocations cause the allowance for loan losses to increase, such increase is reported as a component of the provision for loan losses. Loan losses are charged against the allowance when management believes the uncollectability of the loan is confirmed. During 2017, certain impaired loans were partially charged off or re-evaluated. Impaired loans that are collateral dependent are classified within Level 3 of the fair value hierarchy when impairment is determined using the fair value method.

Other Real Estate Owned

The fair value for impaired loans and other real estate owned is measured based on the value of the collateral securing those loans or real

estate and is determined using several methods. The fair value of real estate is generally determined based on appraisals by qualified licensed

appraisers. The appraisers typically determine the value of the real estate by utilizing an income or market valuation approach. If an appraisal is

not available, the fair value may be determined by using a discounted cash flow analysis. Fair value on other collateral such as business assets

is typically ascertained by assessing, either singularly or some combination of, asset appraisals, accounts receivable aging reports, inventory

listings and or customer financial statements. Both appraised values and values based on borrower’s financial information are discounted as

considered appropriate based on age and quality of the information and current market conditions.

Unobservable (Level 3) Inputs

The following table presents quantitative information about unobservable inputs used in recurring and nonrecurring Level 3 fair value measurements, other than goodwill, at June 30, 2017 and December 31, 2016.



June 30, 2017	Fair Value		Valuation Technique	Unobservable Inputs	Range (Weighted-Average)
State and municipal securities	$	3,295	Discounted cash flow	Maturity/Call date	1 month to 20 yrs
				US Muni BQ curve	A- to BBB-
				Discount rate	.69% - 5%

Corporate obligations and Equity securities	$	35	Discounted cash flow	Risk free rate	3 month LIBOR
				plus premium for illiquidity	plus 200bps

Impaired loans (collateral dependent)	$	7,460	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability	0% - 10% (1%)

Other real estate owned	$	416	Appraisals	Discount to reflect current market conditions	0% - 15% (5%)

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)



December 31, 2016	Fair Value		Valuation Technique	Unobservable Inputs	Range (Weighted-Average)
State and municipal securities	$	5,134	Discounted cash flow	Maturity/Call date	1 month to 20 yrs
				US Muni BQ curve	A- to BBB-
				Discount rate	.69% - 5%

Corporate obligations and Equity securities	$	35	Discounted cash flow	Risk free rate	3 month LIBOR
				plus premium for illiquidity	plus 200bps

Impaired loans (collateral dependent)	$	15,318	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability	0% - 10% (1%)

Other real estate owned	$	1,612	Appraisals	Discount to reflect current market conditions	0% - 10% (9%)

Sensitivity of Significant Unobservable Inputs

The following is a discussion of the sensitivity of significant unobservable inputs, the interrelationships between those inputs and other unobservable inputs used in recurring fair value measurement and how those inputs might magnify or mitigate the effect of changes in the unobservable inputs on the fair value measurement.

State and Municipal Securities, Corporate Obligations and Equity Securities

The significant unobservable inputs used in the fair value measurement of the Corporation's state and municipal securities, corporate obligations

and equity securities are premiums for unrated securities and marketability discounts. Significant increases or decreases in either of those

inputs in isolation would result in a significantly lower or higher fair value measurement. Generally, changes in either of those inputs will not

affect the other input.

Fair Value of Financial Instruments

The following table presents estimated fair values of the Corporation’s financial instruments and the level within the fair value hierarchy in which the fair value measurements fall at June 30, 2017, and December 31, 2016.



			June 30, 2017
			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
	Carrying Amount		(Level 1)		(Level 2)		(Level 3)
Assets:
Cash and cash equivalents	$	142,650	$	142,650
Interest-bearing time deposits	48,305		48,305
Investment securities available for sale	742,759		33,300		$	706,129	$	3,330
Investment securities held to maturity	600,564				596,015		13,241
Loans held for sale	4,036				4,036
Loans	5,542,673						5,435,004
Federal Home Loan Bank stock	19,015				19,015
Interest rate swap and cap asset	6,123				6,123
Interest receivable	27,597				27,597
Liabilities:
Deposits	$	6,017,104	$	4,724,324	$	1,275,619
Borrowings:
Federal funds purchased	134,608				134,608
Securities sold under repurchase agreements	127,884				127,839
Federal Home Loan Bank advances	312,715				316,819
Subordinated debentures and term loans	128,742				106,962
Interest rate swap liability	8,234				8,234
Interest payable	3,477				3,477

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)



			December 31, 2016
			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
	Carrying Amount		(Level 1)		(Level 2)		(Level 3)
Assets:
Cash and cash equivalents	$	127,927	$	127,927
Interest-bearing time deposits	24,459		24,459
Investment securities available for sale	696,862		18,765		$	672,928	$	5,169
Investment securities held to maturity	607,643				597,246		14,687
Loans held for sale	2,929				2,929
Loans	5,073,608						4,933,552
Federal Home Loan Bank stock	17,964				17,964
Interest rate swap and cap asset	6,310				6,310
Interest receivable	26,194				26,194
Liabilities:
Deposits	$	5,556,498	$	4,427,605	$	1,111,491
Borrowings:
Federal funds purchased	120,349				120,349
Securities sold under repurchase agreements	146,480				146,449
Federal Home Loan Bank advances	298,923				297,465
Subordinated debentures and term loans	128,445				105,930
Interest rate swap liability	8,477				8,477
Interest payable	3,110				3,110

The following methods were used to estimate the fair value of all other financial instruments recognized in the Consolidated Condensed Balance

Sheets at amounts other than fair value.

Cash and cash equivalents: The fair value of cash and cash equivalents approximates carrying value.

Interest-bearing time deposits: The fair value of interest-bearing time deposits approximates carrying value.

Investment securities: Fair value is based on quoted market prices, if available. If a quoted market price is not available, fair value is estimated

using quoted market prices for similar securities. The fair value of certain Level 3 securities is estimated using a discounted cash flow model that incorporated market estimates of interest rates and volatility in markets that have not been active.

Loans held for sale: The carrying amount approximates fair value due to the short duration between origination and date of sale.

Loans: The fair value for loans is estimated using discounted cash flow analysis, using interest rates currently being offered for loans with similar

terms to borrowers of similar credit quality. See Impaired Loans above.

Federal Home Loan Bank stock: The fair value of Federal Home Loan Bank stock is based on the price which it may be resold to the Federal Home Loan Bank.

Derivative instruments: The fair value of interest rate swaps reflects the estimated amounts that would have been received to terminate these

contracts at the reporting date based upon pricing or valuation models applied to current market information. Interest rate caps are valued using

the market standard methodology of discounting the future expected cash receipts that would occur if variable interest rates rose above the

strike rate of the caps. The projected cash receipts on the caps are based on an expectation of future interest rates derived from observed

market interest rate curves and volatilities.

Interest receivable and Interest payable: The fair value of interest receivable and payable approximates carrying value.

Deposits: The fair values of noninterest-bearing and interest-bearing demand accounts and savings deposits are equal to the amount payable

on demand at the balance sheet date. The carrying amounts for variable rate, fixed-term certificates of deposit approximate their fair values at

the balance sheet date. Fair values for fixed-rate certificates of deposit and other time deposits are estimated using a discounted cash flow

calculation that applies interest rates currently being offered to a schedule of aggregated expected monthly maturities on such time deposits.

Borrowings: The fair value of federal funds purchased approximates the carrying amount. The fair value of all other borrowings is estimated

using a discounted cash flow calculation, based on current rates for similar debt.

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)

NOTE 10

TRANSFERS ACCOUNTED FOR AS SECURED BORROWINGS

The collateral pledged for all repurchase agreements that are accounted for as secured borrowings as of June 30, 2017 and December 31, 2016 were:



	June 30, 2017
	Remaining Contractual Maturity of the Agreements
	Overnight and Continuous		Up to 30 Days		30-90 Days	Greater Than 90 Days		Total
U.S. Government-sponsored mortgage-backed securities	$	116,406	$	1,338		$	10,140	$	127,884



	December 31, 2016
	Remaining Contractual Maturity of the Agreements
	Overnight and Continuous		Up to 30 Days		30-90 Days		Greater Than 90 Days		Total
U.S. Government-sponsored mortgage-backed securities	$	129,617	$	1,337	$	10,253	$	5,273	$	146,480

NOTE 11

ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

The following table summarizes the changes in the balances of each component of accumulated other comprehensive income (loss), net of tax, as of June 30, 2017 and 2016:



	Accumulated Other Comprehensive Income (Loss)
	Unrealized Gains (Losses) on Securities Available for Sale			Unrealized Gains (Losses) on Cash Flow Hedges			Unrealized Gains (Losses) on Defined Benefit Plans			Total
Balance at December 31, 2016	$	1,035		$	(1,774	)	$	(12,842	)	$	(13,581	)
Other comprehensive income before reclassifications	15,741			(239		)				15,502
Amounts reclassified from accumulated other comprehensive income	(757		)	337			(117		)	(537		)
Period change	14,984			98			(117		)	14,965
Balance at June 30, 2017	$	16,019		$	(1,676	)	$	(12,959	)	$	1,384


Balance at December 31, 2015	$	12,325		$	(2,347	)	$	(11,340	)	$	(1,362	)
Other comprehensive income before reclassifications	10,885			(1,798		)				9,087
Amounts reclassified from accumulated other comprehensive income	(1,107		)	417						(690		)
Period change	9,778			(1,381		)	—			8,397
Balance at June 30, 2016	$	22,103		$	(3,728	)	$	(11,340	)	$	7,035

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)

The following tables present the reclassification adjustments out of accumulated other comprehensive income (loss) that were included in net income in the Consolidated Condensed Statements of Income for the three and six months ended June 30, 2017 and 2016.



	Amount Reclassified from Accumulated Other Comprehensive Income (Loss) For the Three Months Ended June 30,
Details about Accumulated Other Comprehensive Income (Loss)Components	2017			2016			Affected Line Item in the Statements of Income
Unrealized gains (losses) on available for sale securities ⁽¹⁾
Realized securities gains reclassified into income	$	567		$	706		Other income - net realized gains on sales of available for sale securities
Related income tax expense	(198		)	(247		)	Income tax expense
	$	369		$	459

Unrealized gains (losses) on cash flow hedges ⁽²⁾
Interest rate contracts	$	(251	)	$	(318	)	Interest expense - subordinated debentures and term loans
Related income tax benefit	88			111			Income tax expense
	$	(163	)	$	(207	)

Unrealized gains (losses) on defined benefit plans
Amortization of prior service costs	$	89					Other expenses - salaries and employee benefits
Related income tax expense	(31		)				Income tax expense
	$	58		$	—

Total reclassifications for the period, net of tax	$	264		$	252




	Amount Reclassified from Accumulated Other Comprehensive Income (Loss) For the Six Months Ended June 30,
Details about Accumulated Other Comprehensive Income (Loss)Components	2017			2016			Affected Line Item in the Statements of Income
Unrealized gains (losses) on available for sale securities ⁽¹⁾
Realized securities gains reclassified into income	$	1,165		$	1,703		Other income - net realized gains on sales of available for sale securities
Related income tax expense	(408		)	(596		)	Income tax expense
	$	757		$	1,107

Unrealized gains (losses) on cash flow hedges ⁽²⁾
Interest rate contracts	$	(519	)	$	(642	)	Interest expense - subordinated debentures and term loans
Related income tax benefit	182			225			Income tax expense
	$	(337	)	$	(417	)

Unrealized gains (losses) on defined benefit plans
Amortization of net loss and prior service costs	$	180					Other expenses - salaries and employee benefits
Related income tax expense	(63		)				Income tax expense
	$	117		$	—

Total reclassifications for the period, net of tax	$	537		$	690

⁽¹⁾For additional detail related to unrealized gains (losses) on available for sale securities and related amounts reclassified from accumulated other comprehensive income see NOTE 3. INVESTMENT SECURITIES, in the Notes to Consolidated Condensed Financial Statements of this Quarterly Report on Form 10-Q.

⁽²⁾ For additional detail related to unrealized gains (losses) on cash flow hedges and related amounts reclassified from accumulated other comprehensive income see NOTE 8. DERIVATIVE FINANCIAL INSTRUMENTS, in the Notes to Consolidated Condensed Financial Statements of this Quarterly Report on Form 10-Q.

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)

NOTE 12

SHARE-BASED COMPENSATION

Stock options and RSAs have been issued to directors, officers and other management employees under the Corporation's 1999 Long-term Equity Incentive Plan and the 2009 Long-term Equity Incentive Plan. The stock options, which have a ten year life, become 100 percent vested ranging from six months to two years and are fully exercisable when vested. Option exercise prices equal the Corporation's common stock closing price on NASDAQ on the date of grant. RSAs issued to employees and non-employee directors provide for the issuance of shares of the Corporation's common stock at no cost to the holder and generally vest after three years. The RSAs vest only if the employee is actively employed by the Corporation on the vesting date and, therefore, any unvested shares are forfeited. For non-employee directors, the RSAs vest only if the non-employee director remains as an active board member on the vesting date and, therefore, any unvested shares are forfeited. RSAs for employees and non-employee directors retired from the Corporation are either immediately vested at retirement or continue to vest after retirement, depending on the plan under which the shares were granted. Deferred Stock Units ("DSU") can be credited to non-employee directors who have elected to defer payment of compensation under the Corporation's 2008 Equity Compensation Plan for Non-employee Directors. DSUs credited are equal to the restricted shares that the non-employee director would have received under the plan. As of June 30, 2017, there were no outstanding DSUs.

The Corporation’s 2009 ESPP provides eligible employees of the Corporation and its subsidiaries an opportunity to purchase shares of common stock of the Corporation through quarterly offerings financed by payroll deductions. The price of the stock to be paid by the employees shall be equal to 85 percent of the average of the closing price of the Corporation’s common stock on each trading day during the offering period. However, in no event shall such purchase price be less than the lesser of an amount equal to 85 percent of the market price of the Corporation’s stock on the offering date or an amount equal to 85 percent of the market value on the date of purchase. Common stock purchases are made quarterly and are paid through advance payroll deductions up to a calendar year maximum of $25,000.

Compensation expense related to unvested share-based awards is recorded by recognizing the unamortized grant date fair value of these awards over the remaining service periods of those awards, with no change in historical reported fair values and earnings. Awards are valued at fair value in accordance with provisions of share-based compensation guidance and are recognized on a straight-line basis over the service periods of each award. To complete the exercise of vested stock options, RSA’s and ESPP options, the Corporation generally issues new shares from its authorized but unissued share pool. Share-based compensation for the three and six months ended June 30, 2017 was $488,000 and $1,061,000, respectively, compared to $641,000 and $1,235,000, respectively, for the three and six months ended June 30, 2016. Share-based compensation has been recognized as a component of salaries and benefits expense in the accompanying Consolidated Condensed Statements of Income.

The estimated fair value of the stock options granted during 2014 and in prior years was calculated using a Black Scholes option pricing model. There have been no stock options granted since 2014.

The Black Scholes model incorporates assumptions to value share-based awards. The risk-free rate of interest, for periods equal to the expected life of the option, is based on a U.S. government instrument over a similar contractual term of the equity instrument. Expected price volatility is based on historical volatility of the Corporation’s common stock. In addition, the Corporation generally uses historical information to determine the dividend yield and weighted-average expected life of the options until exercise. Separate groups of employees that have similar historical exercise behavior with regard to option exercise timing and forfeiture rates are considered separately for valuation and attribution purposes.

Share-based compensation expense recognized in the Consolidated Condensed Statements of Income is based on awards ultimately expected to vest and is reduced for estimated forfeitures. Share-based compensation guidance requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods, if actual forfeitures differ from those estimates. Pre-vesting forfeitures were estimated to be approximately 2.8 percent for the six months ended June 30, 2017, based on historical experience.

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)

The following table summarizes the components of the Corporation's share-based compensation awards recorded as expense and the income tax benefit of such awards. The income tax benefit increase in the three and six months ended June 30, 2017 is due to the implementation of ASU 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. This ASU requires all income tax effects of awards to be recognized as income tax expense or benefit in the income statement when the awards vest or are settled. Implementation of the ASU was effective January 1, 2017 and resulted in approximately $66,000 and $837,000 of income tax benefit in the three and six months ended June 30, 2017, respectively.



	Three Months Ended June 30,						Six Months Ended June 30,
	2017			2016			2017			2016
Stock and ESPP Options
Pre-tax compensation expense	$	22		$	21		$	70		$	36
Income tax expense (benefit)	(59		)	10			(305		)	10
Stock and ESPP option expense, net of income taxes	$	(37	)	$	31		$	(235	)	$	46
Restricted Stock Awards
Pre-tax compensation expense	$	466		$	620		$	991		$	1,199
Income tax benefit	(170		)	(217		)	(880		)	(420		)
Restricted stock awards expense, net of income taxes	$	296		$	403		$	111		$	779
Total Share-Based Compensation
Pre-tax compensation expense	$	488		$	641		$	1,061		$	1,235
Income tax benefit	(229		)	(207		)	(1,184		)	(410		)
Total share-based compensation expense, net of income taxes	$	259		$	434		$	(123	)	$	825

As of June 30, 2017, unrecognized compensation expense related to RSAs was $2,748,000 and is expected to be recognized over a weighted-average period of 1.35 years. The Corporation did not have any unrecognized compensation expense related to stock options as of June 30, 2017.

Stock option activity under the Corporation's stock option plans as of June 30, 2017 and changes during the six months ended June 30, 2017, were as follows:



	Number of Shares		Weighted-Average Exercise Price		Weighted Average Remaining Contractual Term (in Years)	Aggregate Intrinsic Value
Outstanding at January 1, 2017	260,211		$	19.26
Granted
Exercised	(92,054	)	$	22.61
Canceled
Outstanding June 30, 2017	168,157		$	17.42	2.71	$	3,820,566
Vested and Expected to Vest at June 30, 2017	168,157		$	17.42	2.71	$	3,820,566
Exercisable at June 30, 2017	168,157		$	17.42	2.71	$	3,820,566

The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the Corporation's closing stock price on the last trading day of the first six months of 2017 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their stock options on June 30, 2017. The amount of aggregate intrinsic value will change based on the fair market value of the Corporation's common stock. The aggregate intrinsic value of stock options exercised during the six months ended June 30, 2017 and 2016 was $1,514,000 and $116,000, respectively. Cash receipts of stock options exercised during this same period were $2,082,000 and $211,000, respectively.

The following table summarizes information on unvested RSAs outstanding as of June 30, 2017:



	Number of Shares		Weighted-Average Grant Date Fair Value
Unvested RSAs at January 1, 2017	328,347		$	22.87
Granted	7,445		$	39.77
Vested	(81,397	)	$	20.46
Forfeited	(4,020	)	$	23.09
Unvested RSAs at June 30, 2017	250,375		$	24.15

The grant date fair value of ESPP options was estimated at the beginning of the April 1, 2017 quarterly offering period of approximately $22,000. The ESPP options vested during the three months ending June 30, 2017, leaving no unrecognized compensation expense related to unvested ESPP options at June 30, 2017.

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)

NOTE 13

INCOME TAX

The following table summarizes the major components creating differences between income taxes at the federal statutory and the effective tax rate recorded in the consolidated statements of income for the three and six months ended June 30, 2017 and 2016:



	Three Months Ended June 30,						Six Months Ended June 30,
	2017			2016			2017			2016
Reconciliation of Federal Statutory to Actual Tax Expense:
Federal statutory income tax at 35%	$	10,970		$	9,353		$	21,596		$	17,496
Tax-exempt interest income	(2,632		)	(2,104		)	(5,181		)	(4,130		)
Share-based compensation	(29		)	17			(784		)	19
Tax-exempt earnings and gains on life insurance	(1,040		)	(453		)	(1,354		)	(970		)
Tax credits	(132		)	(129		)	(264		)	(258		)
Other	70			32			362			133
Actual Tax Expense	$	7,207		$	6,716		$	14,375		$	12,290

Effective Tax Rate	23.0		%	25.1		%	23.3		%	24.6		%

NOTE 14

NET INCOME PER SHARE

Basic net income per share is computed by dividing net income by the weighted-average shares outstanding during the reporting period. Diluted net income per share is computed by dividing net income by the combination of the weighted-average shares outstanding during the reporting period and all potentially dilutive common shares. Potentially dilutive common shares include stock options and RSAs issued under the Corporation's share-based compensation plans. Potentially dilutive common shares are excluded from the computation of diluted earnings per share in the periods where the effect would be antidilutive.

The following table reconciles basic and diluted net income per share for the three and six months ended June 30, 2017 and 2016.



	Three Months Ended June 30,
	2017					2016
	Net Income		Weighted-Average Shares	Per Share Amount		Net Income		Weighted-Average Shares	Per Share Amount
Net income available to common stockholders	$	24,136	42,038,824	$	0.57	$	20,006	40,751,720	$	0.50
Effect of potentially dilutive stock options and restricted stock awards			204,715					217,391
Diluted net income per share	$	24,136	42,243,539	$	0.57	$	20,006	40,969,111	$	0.49



	Six Months Ended June 30,
	2017					2016
	Net Income		Weighted-Average Shares	Per Share Amount		Net Income		Weighted-Average Shares	Per Share Amount
Net income available to common stockholders	$	47,329	41,514,565	$	1.14	$	37,699	40,721,147	$	0.93
Effect of potentially dilutive stock options and restricted stock awards			220,456					220,338
Diluted net income per share	$	47,329	41,735,021	$	1.13	$	37,699	40,941,485	$	0.92

For the three months ended June 30, 2017, there were no stock options with an option price greater than the average market price of the common stock. Stock options to purchase 111,750 shares for the three months ended June 30, 2016 were excluded from the computation of diluted net income per share because the options exercise price was greater than the average market price of the common stock.

For the six months ended June 30, 2017, there were no stock options with an option price greater than the average market price of the common stock. Stock options to purchase 142,259 shares for the six months ended June 30, 2016 were excluded from the computation of diluted net income per share because the options exercise price was greater than the average market price of the common stock.

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)

NOTE 15

IMPACT OF ACCOUNTING CHANGES

The Corporation continually monitors potential accounting changes and pronouncements. The following pronouncements have been deemed to have the most applicability to the Corporation's financial statements:

FASB Accounting Standards Update No. 2017-08 - Receivables - Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities

Summary - The FASB has issued Accounting Standards Update (ASU) 2017-08, Receivables-Nonrefundable Fees and Other Costs (Subtopic 310-20), Premium Amortization on Purchased Callable Debt Securities. The ASU shortens the amortization period for certain callable debt securities held at a premium to the earliest call date.

Under current GAAP, entities normally amortize the premium as an adjustment of yield over the contractual life of the instrument. Stakeholders have expressed concerns with the current approach on the basis that current GAAP excludes certain callable debt securities from consideration of early repayment of principal even if the holder is certain that the call will be exercised. As a result, upon the exercise of a call on a callable debt security held at a premium, the unamortized premium is recorded as a loss in earnings. Further, there is diversity in practice (1) in the amortization period for premiums of callable debt securities, and (2) in how the potential for exercise of a call is factored into current impairment assessments.

Another issue is that the practice in the United States is to quote, price, and trade callable debt securities assuming a model that incorporates consideration of calls (also referred to as “yield-to-worst” pricing).

The ASU shortens the amortization period for certain callable debt securities held at a premium and requires the premium to be amortized to the earliest call date. However, the amendments do not require an accounting change for securities held at a discount; the discount continues to be amortized to maturity.

The amendments are effective for public business entities for annual periods beginning after December 15, 2018, including interim periods within those annual periods. For other entities, the amendments are effective for annual periods beginning after December 15, 2019, and interim periods within annual periods beginning after December 15, 2020. Early adoption is permitted.

Entities are required to apply the amendments on a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. The entity is required to provide disclosures about a change in accounting principle in the period of adoption. Adoption of this ASU is not expected to have a significant effect on the Corporation’s consolidated financial statements.

FASB Accounting Standards Update No. 2017-07 - Compensation - Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost

Summary - The FASB has issued Accounting Standards Update (ASU) No. 2017-07, Compensation - Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost. The amendments apply to all employers, including not-for-profit entities, that offer to their employees defined benefit pension plans, other postretirement benefit plans, or other types of benefits accounted for under Topic 715, Compensation - Retirement Benefits.

The amendments require that an employer report the service cost component in the same line item or items as other compensation costs arising from services rendered by the pertinent employees during the period. The other components of net benefit cost are required to be presented in the income statement separately from the service cost component and outside a subtotal of income from operations, if one is presented. If a separate line item or items are used to present the other components of net benefit cost, that line item or items must be appropriately described. If a separate line item or items are not used, the line item or items used in the income statement to present the other components of net benefit cost must be disclosed.

The amendments also allow only the service cost component to be eligible for capitalization when applicable (e.g., as a cost of internally manufactured inventory or a self-constructed asset).

The amendments are effective for public business entities for annual periods beginning after December 15, 2017, including interim periods within those annual periods. For other entities, the amendments are effective for annual periods beginning after December 15, 2018, and interim periods within annual periods beginning after December 15, 2019. Early adoption is permitted as of the beginning of an annual period for which financial statements (interim or annual) have not been issued or made available for issuance. Adoption of this ASU is not expected to have a significant effect on the Corporation’s consolidated financial statements.

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)

FASB Accounting Standards Update No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments

Summary - The FASB has issued Accounting Standards Update (ASU) No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. This new guidance was issued to address concerns that current generally accepted accounting principles (GAAP) restricts the ability to record credit losses that are expected, but do not yet meet the “probable” threshold by replacing the current “incurred loss” model for recognizing credit losses with an “expected life of loan loss” model referred to as the Current Expected Credit Loss (CECL) model.

Under the CECL model, certain financial assets carried at amortized cost, such as loans held for investment and held-to-maturity debt securities, are required to be presented at the net amount expected to be collected. The measurement of expected credit losses is to be based on information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. This measurement will take place at the time the financial asset is first added to the balance sheet and periodically thereafter. This differs significantly from the “incurred loss” model required under current GAAP, which delays recognition until it is probable a loss has been incurred. The change could materially affect how the allowance for loan losses is determined and cause a charge to earnings through the provision for loan losses. Such would adversely affect the financial condition of the Corporation.

The ASU is effective for SEC filers for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019 (i.e., January 1, 2020, for calendar year entities). Early application will be permitted for all organizations for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018.

The impact of CECL model implementation is being evaluated, but it’s expected a one-time cumulative-effect adjustment to the allowance for loan losses will be recognized in retained earnings on the consolidated balance sheet as of the beginning of the first reporting period in which the new standard is effective, as is consistent with regulatory expectations set forth in interagency guidance issued at the end of 2016. The magnitude of any such adjustment or the overall impact of the new standard on financial condition or results of operations cannot yet be determined.

FASB Accounting Standards Update No. 2016-02 - Leases (Topic 842)

Summary - The FASB has issued its new lease accounting guidance in Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842).

Under the new guidance, lessees will be required to recognize the following for all leases (with the exception of short-term leases) at the commencement date:


•	A lease liability, which is a lessee‘s obligation to make lease payments arising from a lease, measured on a discounted basis; and


•	A right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term.

Under the new guidance, lessor accounting is largely unchanged. Certain targeted improvements were made to align, where necessary, lessor accounting with the lessee accounting model and Topic 606, Revenue from Contracts with Customers. The new lease guidance simplified the accounting for sale and leaseback transactions primarily because lessees must recognize lease assets and lease liabilities. Lessees will no longer be provided with a source of off-balance sheet financing.

Public business entities should apply the amendments in ASU 2016-02 for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years (i.e., January 1, 2019, for a calendar year entity). Nonpublic business entities should apply the amendments for fiscal years beginning after December 15, 2019 (i.e., January 1, 2020, for a calendar year entity), and interim periods within fiscal years beginning after December 15, 2020. Early application is permitted for all public business entities and all nonpublic business entities upon issuance.

Lessees (for capital and operating leases) and lessors (for sales-type, direct financing, and operating leases) must apply a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The modified retrospective approach would not require any transition accounting for leases that expired before the earliest comparative period presented. Lessees and lessors may not apply a full retrospective transition approach. The impact of this ASU is being evaluated, but it’s expected a one-time adjustment to the Corporation’s other assets and other liabilities on the consolidated balance sheet will occur as of the beginning of the first reporting period in which the new standard is effective. The magnitude of any such adjustment or the overall impact of the new standard on financial condition, results of operations and regulatory capital cannot yet be determined.

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)

FASB Accounting Standards Updates No. 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities

Summary - The FASB has issued Accounting Standards Update (ASU) No. 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. The new guidance is intended to improve the recognition and measurement of financial instruments. The ASU affects public and private companies, not-for-profit organizations, and employee benefit plans that hold financial assets or owe financial liabilities.

The new guidance makes targeted improvements to existing U.S. GAAP by:


•	Requiring equity investments (except those accounted for under the equity method of accounting, or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income;


•	Requiring public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes;


•	Requiring separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (i.e., securities or loans and receivables) on the balance sheet or the accompanying notes to the financial statements;


•	Eliminating the requirement to disclose the fair value of financial instruments measured at amortized cost for organizations that are not public business entities;


•	Eliminating the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet; and


•	Requiring a reporting organization to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk (also referred to as “own credit”) when the organization has elected to measure the liability at fair value in accordance with the fair value option for financial instruments.

The new guidance is effective for public companies for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. For private companies, not-for-profit organizations, and employee benefit plans, the new guidance becomes effective for fiscal years beginning after December 15, 2018, and for interim periods within fiscal years beginning after December 15, 2019. The new guidance permits early adoption of the own credit provision. In addition, the new guidance permits early adoption of the provision that exempts private companies and not-for-profit organizations from having to disclose fair value information about financial instruments measured at amortized cost. Adoption of this ASU is not expected to have a significant effect on the Corporation’s consolidated financial statements.

FASB Accounting Standards Updates No. 2014-09, Revenue from Contracts with Customers (Topic 606):

Summary - The FASB has issued Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606). The amendments in this update supersede virtually all existing GAAP revenue recognition guidance, including most industry-specific revenue recognition guidance. ASU 2014-09 creates a single, principle-based revenue recognition framework and will require entities to apply significantly more judgment and expanded disclosures surrounding revenue recognition. The core principle requires and entity to recognize revenue in a manner that depicts the transfer of goods or services to customers at an amount that reflects the consideration to which the entity expects to be entitled in exchange for those good or services. ASU 2014-09 applies to contracts with customers to provide goods and services, with certain exclusion such as lease contracts, financing arrangements and financial instruments. The amendments in ASU 2014-09 are effective for annual reporting periods beginning after December 15, 2017. Early adoption is permitted for annual reporting periods beginning after December 15, 2016.

The Corporation’s revenue is comprised of net interest income on financial assets and financial liabilities, which is explicitly excluded from the scope of ASU 2014-09, and non-interest income. ASU 2014-09 could require the Corporation to change how certain recurring revenue streams are recognized; however, these changes are not expected to have a significant impact on the Corporation’s financial statements. The impact of ASU 2014-09 on components of non-interest income is still being evaluated. Adoption of the standard is required in the first quarter of 2018 with a cumulative effect adjustment to opening retained earnings if such adjustment is deemed to be significant.

NOTE 16

GENERAL LITIGATION AND REGULATORY EXAMINATIONS

The Corporation is subject to claims and lawsuits that arise primarily in the ordinary course of business. Additionally, the Corporation is subject to periodic examinations by various regulatory agencies. It is the opinion of management that the disposition or ultimate resolution of such claims, lawsuits, and examinations will not have a material adverse effect on the consolidated financial position, results of operations and cash flow of the Corporation.

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(table dollar amounts in thousands, except share data)

(Unaudited)

NOTE 17

SUBSEQUENT EVENTS

On July 14, 2017, Independent Alliance Banks, Inc., an Indiana corporation ("IALB"), merged with and into the Corporation, whereupon the separate corporate existence of IALB ceased and the Corporation survived. Immediately following the merger, IALB's wholly-owned subsidiary, iAB Financial Bank, merged with and into the Bank, with the Bank continuing as the surviving bank. Shareholders of IALB received 1.653 shares of the Corporation's common stock for each share of IALB common stock held, resulting in the issuance of approximately 6.0 million shares of the Corporation's common stock.

On November 21, 2016, the Corporation purchased 495,112 shares, or 12.1 percent of IALB's outstanding common stock, for $19.8 million. The Corporation utilized a market value approach to value the 12.1 percent equity interest, which included an analysis of current trading values and historical acquisition multiples of comparable entities. A minority discount was applied to the valuation due to the purchase being a non-controlling equity interest instead of a whole bank acquisition.

ASC 805-10 - Business Combinations, requires the Corporation to remeasure the 12.1 percent equity interest in IALB’s common stock and recognize any resulting gain or loss in earnings. In the third quarter of 2017, the Corporation remeasured the 12.1 percent equity interest based upon the closing price of IALB’s common stock immediately prior to the acquisition announcement, and prior to the Corporation obtaining control of IALB. The trading price of IALB’s common stock subsequent to the acquisition announcement includes a control or acquisition premium and is not indicative of the fair value of the Corporation’s pre-existing equity interest immediately prior to the acquisition announcement. As a result of the remeasurement, the Corporation will recognize a loss of $50,000 in the third quarter of 2017.

Based on the closing price of the Corporation's common stock on July 14, 2017 of $40.05 per share, the transaction value for the remaining shares of common stock, not owned by the Corporation, was approximately $238.9 million. The combined Corporation has 122 banking centers in Indiana, Illinois and Ohio and expands the Corporation's Indiana footprint into the Ft. Wayne market. Full integration of IALB under the First Merchants brand is expected to be completed during the fourth quarter of 2017.

As of June 30, 2017, IALB had total assets of $1.1 billion, total loans of $754.2 million and deposits of $863.5 million. Certain fair value measurements and the purchase price allocation have not been completed due to the timing of the acquisition and the number of assets acquired and liabilities assumed. Review of the estimated fair values of loans, property and equipment, intangible assets, other assets, deposits and other liabilities, and the evaluation of the assumed tax positions will occur during the measurement period.

Table of Contents

PART I: FINANCIAL INFORMATION

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS

From time to time, we include forward-looking statements in our oral and written communication. We may include forward-looking statements in filings with the Securities and Exchange Commission, such as this Quarterly Report on Form 10-Q, in other written materials and in oral statements made by senior management to analysts, investors, representatives of the media and others. We intend these forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, and we are including this statement for purposes of these safe harbor provisions. Forward-looking statements can often be identified by the use of words like “believe”, “continue”, “pattern”, “estimate”, “project”, “intend”, “anticipate”, “expect” and similar expressions or future or conditional verbs such as “will”, “would”, “should”, “could”, “might”, “can”, “may”, or similar expressions. These forward-looking statements include:


•	statements of our goals, intentions and expectations;


•	statements regarding our business plan and growth strategies;


•	statements regarding the asset quality of our loan and investment portfolios; and


•	estimates of our risks and future costs and benefits.

These forward-looking statements are subject to significant risks, assumptions and uncertainties, including, among other things, the following important factors which could affect the actual outcome of future events:


•	fluctuations in market rates of interest and loan and deposit pricing, which could negatively affect our net interest margin, asset valuations and expense expectations;


•	adverse changes in the economy, which might affect our business prospects and could cause credit-related losses and expenses;


•	adverse developments in our loan and investment portfolios;


•	competitive factors in the banking industry, such as the trend towards consolidation in our market;


•	changes in the banking legislation or the regulatory requirements of federal and state agencies applicable to bank holding companies and banks like our affiliate bank;


•	acquisitions of other businesses by us and integration of such acquired businesses;


•	changes in market, economic, operational, liquidity, credit and interest rate risks associated with our business; and


•	the continued availability of earnings and excess capital sufficient for the lawful and prudent declaration and payment of cash dividends.

Because of these and other uncertainties, our actual future results may be materially different from the results indicated by these forward-looking statements. In addition, our past results of operations do not necessarily indicate our anticipated future results.

CRITICAL ACCOUNTING POLICIES

Generally accepted accounting principles are complex and require us to apply significant judgments to various accounting, reporting and disclosure matters. We must use assumptions and estimates to apply those principles where actual measurement is not possible or practical. For a complete discussion of our significant accounting policies, see “Notes to the Consolidated Financial Statements” in our Annual Report on Form 10-K for the year ended December 31, 2016. Certain policies are considered critical because they are highly dependent upon subjective or complex judgments, assumptions and estimates. Changes in such estimates may have a significant impact on the financial statements. We have reviewed the application of these policies with the Audit Committee of our Board of Directors.

We believe there have been no significant changes during the six months ended June 30, 2017, to the items that we disclosed as our critical accounting policies and estimates in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2016.

BUSINESS SUMMARY

First Merchants Corporation (the “Corporation”) is a financial holding company headquartered in Muncie, Indiana and was organized in September 1982. The Corporation’s Common Stock is traded on NASDAQ’s Global Select Market System under the symbol FRME. The Corporation has one full-service bank charter, First Merchants Bank (the “Bank”), which opened for business in Muncie, Indiana, in March 1893. The Bank also operates Lafayette Bank and Trust, Arlington Bank and First Merchants Private Wealth Advisors as divisions of First Merchants Bank. The Bank includes 106 banking locations in twenty-seven Indiana, two Illinois and two Ohio counties. In addition to its branch network, the Corporation’s delivery channels include ATMs, check cards, remote deposit capture, interactive voice response systems and internet technology. The Corporation’s business activities are currently limited to one significant business segment, which is community banking.

Through the Bank, the Corporation offers a broad range of financial services, including accepting time deposits, savings and demand deposits; making consumer, commercial, agri-business and real estate mortgage loans; renting safe deposit facilities; providing personal and corporate trust services; providing full-service brokerage and private wealth management; and providing letters of credit, repurchase agreements and other corporate services.

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PART I: FINANCIAL INFORMATION

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

RESULTS OF OPERATIONS

Executive Summary

First Merchants Corporation reported second quarter 2017 net income of $24.1 million, compared to $20.0 million during the second quarter of 2016. Diluted earnings per share for the period totaled $.57 per share, an increase of $.08 per share, or 16.3 percent, over the same period in 2016. Year-to-date net income totaled $47.3 million, compared to $37.7 million during the same period in 2016. Diluted earnings per share for the six months ended June 30, 2017 totaled $1.13 per share, an increase of $0.21 per share, or 22.8 percent, over the same period in 2016.

As of June 30, 2017, total assets equaled $7.8 billion, an increase of $593.4 million, or 8.2 percent, from December 31, 2016. On May 19, 2017, the Corporation acquired Arlington Bank, which resulted in $338.7 million of additional assets. Additional details of the acquisition are discussed within NOTE 2. ACQUISITIONS, in the Notes to Consolidated Condensed Financial Statements of this Quarterly Report on Form 10-Q.

The Corporation's total loan portfolio increased $474.6 million, with Arlington Bank contributing $232.3 million in total loans. The largest loan segments that experienced increases were commercial and farmland, residential and commercial and industrial. Additional details of the changes in the Corporation's loans and other earning assets are discussed within NOTE 4. LOANS AND ALLOWANCE, in the Notes to Consolidated Condensed Financial Statements, and the "EARNING ASSETS" section of Management's Discussion and Analysis of Financial Condition and Results of Operations of this Quarterly Report on Form 10-Q.

The Corporation’s allowance for loan losses totaled $70.5 million as of June 30, 2017. The allowance provided 257.7 percent coverage of all non-accrual loans and 1.25 percent of total loans. The Corporation's provision expense and net charge-offs totaled $2.9 million and $629,000, respectively, during the three months ended June 30, 2017, compared to provision expense and net charge-offs of $790,000 and $690,000, respectively, during the same period in 2016. For the six months ended June 30, 2017, the Corporation recorded $5.3 million of provision expense and net charge-offs of $826,000, compared to provision expense of $1.3 million and net charge-offs of $1.6 million during the same period of 2016. The increase in provision expense for the three and six months ended June 30, 2017, compared to the same periods in 2016, was primarily due to organic loan growth in 2017. Additional details are discussed within the “LOAN QUALITY/PROVISION FOR LOAN LOSSES” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Quarterly Report on Form 10-Q.

As of June 30, 2017, total deposits equaled $6.0 billion, an increase of $460.6 million from December 31, 2016. The Arlington Bank acquisition resulted in $252.8 million of additional deposits. The largest increases from December 31, 2016 were in demand and savings deposits.

Total borrowings increased $9.8 million as of June 30, 2017 compared to December 31, 2016 as federal funds purchased and Federal Home Loan Bank advances increased $14.3 million and $13.8 million, respectively, which was partially offset by a decrease in securities sold under repurchase agreements of $18.6 million.

The Corporation was able to maintain all regulatory capital ratios in excess of the regulatory definition of “well-capitalized” as discussed in the “CAPITAL” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Quarterly Report on Form 10-Q.

NET INTEREST INCOME

Net interest income is the most significant component of our earnings, comprising 79 percent of revenues for the six months ended June 30, 2017. Net interest income and margin are influenced by many factors, primarily the volume and mix of earnings assets, funding sources, and interest rate fluctuations. Other factors include the level of accretion income on purchased loans, prepayment risk on mortgage and investment-related assets, and the composition and maturity of earning assets and interest-bearing liabilities. Loans typically generate more interest income than investment securities with similar maturities. Funding from client deposits generally costs less than wholesale funding sources. Factors such as general economic activity, Federal Reserve Board monetary policy, and price volatility of competing alternative investments, can also exert significant influence on our ability to optimize the mix of assets and funding and the net interest income and margin.

Net interest income is the excess of interest received from earning assets over interest paid on interest-bearing liabilities. For analytical purposes, net interest income is also presented on an FTE basis in the table that follows to reflect what our tax-exempt assets would need to yield in order to achieve the same after-tax yield as a taxable asset. The federal statutory rate in effect of 35 percent was used for all periods, adjusted for the TEFRA interest disallowance applicable to certain tax-exempt obligations. This analysis portrays the income tax benefits associated in tax-exempt assets and helps to facilitate a comparison between taxable and tax-exempt assets. Management believes that it is a standard practice in the banking industry to present net interest margin and net interest income on a fully taxable equivalent basis. Therefore, management believes these measures provide useful information for both management and investors by allowing them to make peer comparisons.

For the periods presented, the increases in net interest income were primarily driven by the increase in earning assets attributable to the May 2017 Arlington Bank acquisition and core organic loan growth. Additionally, the recent increases in the federal funds rate have contributed positively to net interest income and net interest margin. Details regarding the Arlington Bank acquisition are discussed in NOTE 2. ACQUISITIONS, in the Notes to Consolidated Financial Statements of this Quarterly Report on Form 10-Q.

Net interest margin for the second quarter of 2017 increased to 3.95 percent compared to the second quarter of 2016 at 3.86 percent. Asset yields increased 14 basis points FTE and interest costs increased 5 basis points, resulting in a 9 basis point FTE increase in net interest income as compared to the same period in 2016.

Table of Contents

PART I: FINANCIAL INFORMATION

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Average earning assets increased $681,013,000 in the second quarter of 2017 compared to the second quarter of 2016. The increase in earning assets attributable to the Arlington Bank acquisition totaled $233,689,000. The Corporation recognized fair value accretion income on purchased loans, which is included in interest income, of $2,279,000 and $3,192,000, respectively, for the three months ended June 30, 2017 and 2016.

Net interest margin for the six months ended June 30, 2017 increased to 3.96 percent compared to the six months ended June 30, 2016 at 3.85 percent, as earning assets increased by $594,480,000. Asset yields increased 14 basis points FTE and interest costs increased 3 basis points, resulting in a 11 basis point FTE increase in net interest income as compared to the same period in 2016. As a result of the Corporation's acquisitions, fair value accretion income was recognized on purchased loans, which is included in interest income, of $6,572,000 and $5,702,000, respectively, for the six months ended June 30, 2017 and 2016.

Additional details of the Corporation's remaining loan fair value discount, accretable and nonaccretable yield can be found in NOTE 5. ACCOUNTING FOR CERTAIN LOANS ACQUIRED IN A PURCHASE, in the Notes to Consolidated Condensed Financial Statements of this Quarterly Report on Form 10-Q.

The following table presents the Corporation’s average balance sheet, interest income/interest expense, and the average rate as a percent of average earning assets/liabilities for the three months ended June 30, 2017, and 2016.



(Dollars in Thousands)	Three Months Ended
	June 30, 2017							June 30, 2016
	Average Balance			Interest Income / Expense		Average Rate		Average Balance			Interest Income / Expense		Average Rate
Assets:
Interest-bearing time deposits	$	42,794		$	114	1.07	%	$	99,734		$	122	0.49	%
Federal Reserve and Federal Home Loan Bank stock	18,655			204		4.37		23,442			233		3.98
Investment Securities: ⁽¹⁾
Taxable	717,818			4,180		2.33		730,179			4,202		2.30
Tax-Exempt ⁽²⁾	596,223			7,832		5.25		539,004			7,050		5.23
Total Investment Securities	1,314,041			12,012		3.66		1,269,183			11,252		3.55
Loans held for sale	3,791			65		6.86		3,664			96		10.48
Loans: ⁽³⁾
Commercial	3,911,477			45,400		4.64		3,501,919			40,501		4.63
Real Estate Mortgage	647,032			7,229		4.47		568,746			6,116		4.30
Installment	546,339			6,692		4.90		470,254			5,386		4.58
Tax-Exempt ⁽²⁾	328,322			3,834		4.67		194,496			2,254		4.64
Total Loans	5,436,961			63,220		4.65		4,739,079			54,353		4.59
Total Earning Assets	6,812,451			75,550		4.44		6,131,438			65,960		4.30
Net unrealized gain on securities available for sale	4,908							10,924
Allowance for loan losses	(69,068		)					(62,235		)
Cash and cash equivalents	153,247							104,372
Premises and equipment	92,026							96,620
Other assets	578,225							576,720
Total Assets	$	7,571,789						$	6,857,839
Liabilities:
Interest-bearing deposits:
Interest-bearing NOW deposits	$	1,596,182		$	1,089	0.27	%	$	1,429,191		$	637	0.18	%
Money market deposits	901,077			600		0.27		849,270			502		0.24
Savings deposits	791,464			161		0.08		717,044			149		0.08
Certificates and other time deposits	1,281,132			3,287		1.03		1,159,247			2,751		0.95
Total Interest-bearing Deposits	4,569,855			5,137		0.45		4,154,752			4,039		0.39
Borrowings	618,335			3,230		2.09		476,852			2,703		2.27
Total Interest-bearing Liabilities	5,188,190			8,367		0.65		4,631,604			6,742		0.58
Noninterest-bearing deposits	1,360,677							1,285,396
Other liabilities	39,826							64,723
Total Liabilities	6,588,693							5,981,723
Stockholders' Equity	983,096							876,116
Total Liabilities and Stockholders' Equity	$	7,571,789		8,367		0.49		$	6,857,839		6,742		0.44
Net Interest Income				$	67,183						$	59,218
Net Interest Margin						3.95	%						3.86	%


⁽¹⁾Average balance of securities is computed based on the average of the historical amortized cost balances without the effects of the fair value adjustments. Annualized amounts are computed utilizing a 30/360 day basis.
⁽²⁾ Tax-exempt securities and loans are presented on a fully taxable equivalent basis, using a marginal tax rate of 35 percent for 2017 and 2016. These totals equal $4,083 and $3,256 for the three months ended June 30, 2017 and 2016, respectively.
⁽³⁾Non-accruing loans have been included in the average balances.

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PART I: FINANCIAL INFORMATION

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS



(Dollars in Thousands)	Six Months Ended
	June 30, 2017							June 30, 2016
	Average Balance			Interest Income / Expense		Average Rate		Average Balance			Interest Income / Expense		Average Rate
Assets:
Interest-bearing time deposits	$	36,662		$	158	0.86	%	$	87,722		$	228	0.52	%
Federal Reserve and Federal Home Loan Bank stock	18,312			393		4.29		30,537			713		4.67
Investment Securities: ⁽¹⁾
Taxable	714,672			8,488		2.38		723,333			8,530		2.36
Tax-Exempt ⁽²⁾	591,401			15,529		5.25		529,963			13,987		5.28
Total Investment Securities	1,306,073			24,017		3.68		1,253,296			22,517		3.59
Loans held for sale	3,197			109		6.82		4,956			218		8.80
Loans: ⁽³⁾
Commercial	3,846,622			89,494		4.65		3,475,684			79,365		4.57
Real Estate Mortgage	596,990			13,350		4.47		572,006			12,510		4.37
Installment	539,272			12,790		4.74		463,454			10,495		4.53
Tax-Exempt ⁽²⁾	323,230			7,423		4.59		188,223			4,277		4.54
Total Loans	5,309,311			123,166		4.64		4,704,323			106,865		4.54
Total Earning Assets	6,670,358			147,734		4.43	%	6,075,878			130,323		4.29	%
Net unrealized gain on securities available for sale	2,762							10,464
Allowance for loan losses	(68,007		)					(62,724		)
Cash and cash equivalents	128,768							103,143
Premises and equipment	92,519							96,659
Other assets	569,050							577,157
Total Assets	$	7,395,450						$	6,800,577
Liabilities:
Interest-bearing deposits:
Interest-bearing NOW deposits	$	1,554,740		$	1,926	0.25	%	$	1,364,729		$	1,181	0.17	%
Money market deposits	845,536			941		0.22		857,601			993		0.23
Savings deposits	784,033			317		0.08		703,174			284		0.08
Certificates and other time deposits	1,223,426			6,077		0.99		1,172,852			5,644		0.96
Total Interest-bearing Deposits	4,407,735			9,261		0.42		4,098,356			8,102		0.40
Borrowings	641,499			6,341		1.98		498,470			5,412		2.17
Total Interest-bearing Liabilities	5,049,234			15,602		0.62		4,596,826			13,514		0.59
Noninterest-bearing deposits	1,353,649							1,270,363
Other liabilities	43,798							64,504
Total Liabilities	6,446,681							5,931,693
Stockholders' Equity	948,769							868,884
Total Liabilities and Stockholders' Equity	$	7,395,450		15,602		0.47		$	6,800,577		13,514		0.44
Net Interest Income				$	132,132						$	116,809
Net Interest Margin						3.96	%						3.85	%


⁽¹⁾ Average balance of securities is computed based on the average of the historical amortized cost balances without the effects of the fair value adjustments. Annualized amounts are computed utilizing a 30/360 day basis.
⁽²⁾ Tax-exempt securities and loans are presented on a fully taxable equivalent basis, using a marginal tax rate of 35 percent for 2017 and 2016. These totals equal $8,033 and $6,392 for the six months ended June 30, 2017 and 2016, respectively.
⁽³⁾ Non-accruing loans have been included in the average balances.

NON-INTEREST INCOME

Non-interest income increased $2.0 million, or 12.5 percent, in the second quarter of 2017, compared to the second quarter of 2016. The Corporation's organic growth contributed to increases in other customer fees and fiduciary income of $711,000 and $233,000, respectively, in the second quarter of 2017 when compared to the same period in 2016. Additionally, in the second quarter of 2017, gains on life insurance benefits increased $1.7 million when compared to the second quarter of 2016. The Corporation acquired Arlington Bank in May 2017 which increased the customer base in the second quarter of 2017 compared to the same period of 2016. Details of the acquisition can be found in NOTE 2. ACQUISITIONS, in the Notes to Consolidated Condensed Financial Statements of this Quarterly Report on Form 10-Q.

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PART I: FINANCIAL INFORMATION

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

These increases were offset by decreases in other income, net realized gains on sales of available for sale securities and net gains and fees on sales of loans of $352,000, $139,000 and $100,000, respectively.

During the first six months of 2017, non-interest income increased $1.1 million, or 3.3 percent, over the same period in 2016. The Corporation's organic growth contributed to increases in other customer fees and fiduciary income of $515,000 and $379,000, respectively, in the first six months of 2017 when compared to the same period in 2016. Additionally, in the first six months of 2017, gains on life insurance benefits were $2.2 million compared to $895,000 in the same period of 2016, resulting in an increase of $1.3 million.

These increases were offset by decreases in net realized gains on investment securities, net gains and fees on sales of loans and other income of $538,000, $285,000 and $160,000, respectively, in the first six months of 2017 when compared to the same period of 2016.

NON-INTEREST EXPENSE

Non-interest expense increased $2.5 million, or 5.5 percent, in the second quarter of 2017, compared to the second quarter of 2016. The most significant factor contributing to the increase was the acquisition of Arlington Bank in May 2017. The Corporation recorded $2.5 million of one-time expenses that were primarily merger, integration and system conversion related. The one-time expenses consisted of $649,000 of severance and employee retention expenses, $1.5 million of contract termination and core system conversion expenses and $200,000 of legal and investment banker expenses. Coupled with the acquisition related one-time expenses, the addition of Arlington employees since acquisition contributed $316,000 more in salaries and employee benefits in the second quarter of 2017, compared to the same period in 2016.

During the first six months of 2017, non-interest expense decreased $895,000, or 1.0 percent, when compared to the first six months of 2016.

The Corporation's continued focus on organizational efficiency has resulted in declines in most categories of non-interest expense. Of note, in 2016, the Bank converted its banking charter from a national association, regulated by the Office of the Comptroller of the Currency, to an Indiana state-chartered bank, regulated by the Indiana DFI, resulting in a $529,000 reduction in examination fees compared to the same period in 2016.

Additionally, FDIC expense for the six months ended June 30, 2017 decreased $803,000 from the same period in 2016 as a result of the third quarter 2016 FDIC assessment change for banks under $10 billion in total assets.

Partially offsetting the decreases, were increases in outside data processing fees and professional and other outside services. As a result of a larger franchise and growth in our customer base, the Corporation recognized an increase in on-line banking and ATM/Debit card processing expenses of $937,000 and $405,000, respectively. In the first six months of 2017, professional and other outside services increased $1.4 million, primarily due to $1.5 million of Arlington contract termination and core system conversion expenses recognized in 2017, as compared to 2016.

INCOME TAXES

Income tax expense for the second quarter of 2017 was $7,207,000 on pre-tax net income of $31,343,000. For the same period in 2016, income tax expense was $6,716,000 on pre-tax net income of $26,722,000. The effective income tax rates for the second quarter of 2017 and 2016 were 23.0 percent and 25.1 percent, respectively.

Income tax expense for the six months ended June 30, 2017 was $14,375,000 on pre-tax net income of $61,704,000. For the same period in 2016, income tax expense was $12,290,000 on pre-tax net income of $49,989,000. The effective income tax rates for the six months ended June 30, 2017 and 2016 were 23.3 percent and 24.6 percent, respectively.

The lower effective income tax rate during the three months ended June 30, 2017 when compared to the same period in 2016 was primarily a result of increases in tax-exempt interest income and tax-exempt earnings and gains on life insurance. The lower effective income tax rate during the six months ended June 30, 2017 when compared to the same period in 2016 was primarily due to increases in tax-exempt interest income and tax-exempt earnings and gains on life insurance coupled with the tax benefit from share-based compensation upon adoption of ASU 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. This ASU requires all income tax effects of awards to be recognized as income tax expense or benefit in the income statement when the awards vest or are settled. Implementation of the ASU was effective January 1, 2017 and resulted in approximately $837,000 of income tax benefit in the first six months of 2017.

The detailed reconciliation of federal statutory to actual tax expense is shown in NOTE 13. INCOME TAX, in the Notes to Consolidated Condensed Financial Statements of this Quarterly Report on Form 10-Q.

CAPITAL

Stockholders' Equity

On May 1, 2017, the shareholders of the Corporation approved amendments to the Corporation's Articles of Incorporation to (i) increase the number of shares of common stock which it is authorized to issue from 50,000,000 to 100,000,000 shares; and (ii) eliminate the designations for the Fixed Rate Cumulative Perpetual Preferred Stock, Series A, and the Senior Non-Cumulative Perpetual Preferred Stock, Series B, neither of which Series had any outstanding shares.

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PART I: FINANCIAL INFORMATION

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

On May 19, 2017, the Corporation acquired 100 percent of Arlington Bank. Pursuant to the merger agreement, each Arlington Bank shareholder received 2.7245 shares of the Corporation's common stock for each outstanding share of Arlington Bank common stock held. The Corporation issued approximately 2.1 million shares of common stock, which was valued at approximately $82.6 million. Details regarding the Arlington Bank acquisition are discussed in NOTE 2. ACQUISITIONS, in the Notes to Consolidated Financial Statements of this Quarterly Report on Form 10-Q.

Regulatory Capital

Capital adequacy is an important indicator of financial stability and performance. The Corporation and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies and are assigned to a capital category. The assigned capital category is largely determined by four ratios that are calculated according to the regulations: total risk-based capital, tier 1 risk-based capital, CET1, and tier 1 leverage ratios. The ratios are intended to measure capital relative to assets and credit risk associated with those assets and off-balance sheet exposures of the entity. The capital category assigned to an entity can also be affected by qualitative judgments made by regulatory agencies about the risk inherent in the entity's activities that are not part of the calculated ratios.

There are five capital categories defined in the regulations, ranging from well capitalized to critically undercapitalized. Classification of a bank in any of the undercapitalized categories can result in actions by regulators that could have a material effect on a bank's operations. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios of total and tier 1 capital to risk-weighted assets, and of tier 1 capital to average assets, or leverage ratio, all of which are calculated as defined in the regulations. Banks with lower capital levels are deemed to be undercapitalized, significantly undercapitalized or critically undercapitalized, depending on their actual levels. The appropriate federal regulatory agency may also downgrade a bank to the next lower capital category upon a determination that the bank is in an unsafe or unsound practice. Banks are required to monitor closely their capital levels and to notify their appropriate regulatory agency of any basis for a change in capital category.

Basel III was effective for the Corporation on January 1, 2015. Basel III requires the Corporation and the Bank to maintain minimum amounts and ratio of CET1 capital to risk weighted assets, as defined in the regulation. Under the new Basel III rules, in order to avoid limitations on capital distributions, including dividends, the Corporation must hold a capital conservation buffer above the adequately capitalized CET1 to risk-weighted assets ratio. The capital conservation buffer is being phased in from zero percent to 2.50 percent by 2019. As of January 1, 2017, the Corporation is required to hold a capital conservation buffer of 1.25 percent, increasing by 0.625 percent each successive year until 2019. Under Basel III, the Corporation and Bank elected to opt-out of including accumulated other comprehensive income in regulatory capital.

As of June 30, 2017, the Bank met all capital adequacy requirements to be considered well capitalized. There is no threshold for well capitalized status for bank holding companies. The Corporation's and Bank's actual and required capital ratios as of June 30, 2017 and December 31, 2016 were as follows:



					Prompt Corrective Action Thresholds
	Actual				Adequately Capitalized				Well Capitalized
June 30, 2017	Amount		Ratio		Amount		Ratio		Amount		Ratio
Total risk-based capital to risk-weighted assets
First Merchants Corporation	$	923,474	14.01	%	$	527,417	8.00	%	N/A		N/A
First Merchants Bank	847,079		13.19		530,034		8.00		$	662,543	10.00	%
Tier 1 capital to risk-weighted assets
First Merchants Corporation	$	788,003	11.95	%	$	395,563	6.00	%	N/A		N/A
First Merchants Bank	803,608		12.13		397,526		6.00		$	503,034	8.00	%
CET1 capital to risk-weighted assets
First Merchants Corporation	$	732,635	11.11	%	$	296,672	4.50	%	N/A		N/A
First Merchants Bank	803,608		12.13		298,144		4.50		$	430,653	6.50	%
Tier 1 capital to average assets
First Merchants Corporation	$	788,003	10.84	%	$	290,826	4.00	%	N/A		N/A
First Merchants Bank	803,608		11.05		290,877		4.00		$	363,597	5.00	%



					Prompt Corrective Action Thresholds
	Actual				Adequately Capitalized				Well Capitalized
December 31, 2016	Amount		Ratio		Amount		Ratio		Amount		Ratio
Total risk-based capital to risk-weighted assets
First Merchants Corporation	$	851,521	14.21	%	$	479,470	8.00	%	N/A		N/A
First Merchants Bank	800,598		13.30		481,490		8.00		$	601,862	10.00	%
Tier 1 capital to risk weighted assets
First Merchants Corporation	$	720,484	12.02	%	$	359,603	6.00	%	N/A		N/A
First Merchants Bank	734,561		12.20		361,117		6.00		$	481,490	8.00	%
CET1 capital to risk-weighted assets
First Merchants Corporation	$	665,445	11.10	%	$	269,702	4.50	%	N/A		N/A
First Merchants Bank	734,561		12.20		270,838		4.50		$	391,210	6.50	%
Tier 1 capital to average assets
First Merchants Corporation	$	720,484	10.54	%	$	273,456	4.00	%	N/A		N/A
First Merchants Bank	734,561		10.78		272,461		4.00		$	340,576	5.00	%

Table of Contents

PART I: FINANCIAL INFORMATION

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Management believes that all of the above capital ratios are meaningful measurements for evaluating the safety and soundness of the Corporation. Traditionally, the banking regulators have assessed bank and bank holding company capital adequacy based on both the amount and the composition of capital, the calculation of which is prescribed in federal banking regulations. The Federal Reserve focuses its assessment of capital adequacy on a component of Tier 1 capital known as CET1. Because the Federal Reserve has long indicated that voting common shareholders' equity (essentially Tier 1 risk-based capital less preferred stock and non-controlling interest in subsidiaries) generally should be the dominant element in Tier 1 risk-based capital, this focus on CET1 is consistent with existing capital adequacy categories. Tier I regulatory capital consists primarily of total stockholders’ equity and subordinated debentures issued to business trusts categorized as qualifying borrowings, less non-qualifying intangible assets and unrealized net securities gains or losses.

Additionally, management believes the following tables are also meaningful when considering performance measures of the Corporation. Non-GAAP financial measures such as tangible book value per common share, tangible common equity to tangible assets, return on average tangible capital and return on average tangible assets are important measures of the strength of the Corporation's capital and ability to generate earnings on tangible common equity invested by our shareholders. These non-GAAP measures provide useful supplemental information and may assist investors in analyzing the Corporation’s financial position without regard to the effects of intangible assets and preferred stock. Disclosure of these measures also allows analysts and banking regulators to assess our capital adequacy on these same bases.

Because these measures are not defined in GAAP or federal banking regulations, they are considered non-GAAP financial measures. Non-GAAP financial measures have inherent limitations, are not required to be uniformly applied, and are not audited. Although these non-GAAP financial measures are frequently used by investors to evaluate a company, they have limitations as analytical tools, and should not be considered in isolation, or as a substitute for analyses of results as reported under GAAP.



	June 30, 2017						December 31, 2016
	First Merchants Corporation			First Merchants Bank			First Merchants Corporation			First Merchants Bank
Total Risk-Based Capital
Total Stockholders' Equity (GAAP)	$	1,035,116		$	1,099,762		$	901,657		$	973,641
Adjust for Accumulated Other Comprehensive (Income) Loss ⁽¹⁾	(1,384		)	3,830			13,581			9,701
Less: Preferred Stock	(125		)	(125		)	(125		)	(125		)
Add: Qualifying Capital Securities	55,534						55,415
Less: Tier 1 Capital Deductions	(166		)				(376		)
Less: Disallowed Goodwill and Intangible Assets	(300,307		)	(299,859		)	(249,104		)	(248,656		)
Less: Disallowed Deferred Tax Assets	(665		)				(564		)
Total Tier 1 Capital (Regulatory)	788,003			803,608			720,484			734,561
Qualifying Subordinated Debentures	65,000						65,000
Allowance for Loan Losses Includible in Tier 2 Capital	70,471			70,471			66,037			66,037
Total Risk-Based Capital (Regulatory)	$	923,474		$	874,079		$	851,521		$	800,598

Net Risk-Weighted Assets (Regulatory)	$	6,592,710		$	6,625,427		$	5,993,381		$	6,018,623
Average Assets	$	7,270,651		$	7,271,930		$	6,836,412		$	6,811,519

Total Risk-Based Capital Ratio (Regulatory)	14.01		%	13.19		%	14.21		%	13.30		%
Tier 1 Capital to Risk-Weighted Assets	11.95		%	12.13		%	12.02		%	12.20		%
Tier 1 Capital to Average Assets	10.84		%	11.05		%	10.54		%	10.78		%

CET1 Capital Ratio
Total Tier 1 Capital (Regulatory)	$	788,003		$	803,608		$	720,484		$	734,561
Less: Qualified Capital Securities	(55,534		)				(55,415		)
Add: Additional Tier 1 Capital Deductions	166						376
CET1 Capital (Regulatory)	$	732,635		$	803,608		$	665,445		$	734,561

Net Risk-Weighted Assets (Regulatory)	$	6,592,710		$	6,625,427		$	5,993,381		$	6,018,623
CET1 Capital Ratio (Regulatory)	11.11		%	12.13		%	11.10		%	12.20		%

⁽¹⁾ Includes net unrealized gains or losses on available for sale securities, net gains or losses on cash flow hedges, and amounts resulting from the application of the applicable accounting guidance for defined benefit and other postretirement plans.

Table of Contents

PART I: FINANCIAL INFORMATION

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The Corporation had a strong capital position as evidenced by the tangible common equity to tangible assets ratio of 9.68 percent at June 30, 2017, and 9.24 percent at December 31, 2016.



	Tangible Common Equity to Tangible Assets (non-GAAP)
(Dollars in Thousands, Except Per Share Amounts)	June 30, 2017			December 31, 2016
Total Stockholders' Equity (GAAP)	$	1,035,116		$	901,657
Less: Cumulative preferred stock (GAAP)	(125		)	(125		)
Less: Intangible assets (GAAP)	(309,686		)	(258,866		)
Tangible common equity (non-GAAP)	$	725,305		$	642,666
Total assets (GAAP)	$	7,805,029		$	7,211,611
Less: Intangible assets (GAAP)	(309,686		)	(258,866		)
Tangible assets (non-GAAP)	$	7,495,343		$	6,952,745
Tangible common equity to tangible assets (non-GAAP)	9.68		%	9.24		%

The following table details and reconciles tangible earnings per share, return on tangible capital and tangible assets to traditional GAAP measures for the three and six months ended June 30, 2017 and 2016.



	Three Months Ended June 30,						Six Months Ended June 30,
(Dollars in Thousands, Except Per Share Amounts)	2017			2016			2017			2016
Average goodwill (GAAP)	$	266,942		$	244,000		$	255,534		$	244,000
Average core deposit intangible (GAAP)	15,483			17,273			14,935			17,816
Average deferred tax on CDI (GAAP)	(6,217		)	(6,606		)	(6,002		)	(6,751		)
Intangible adjustment (non-GAAP)	$	276,208		$	254,667		$	264,467		$	255,065
Average stockholders' equity (GAAP)	$	983,096		$	876,116		$	948,769		$	868,884
Average cumulative preferred stock (GAAP)	(125		)	(125		)	(125		)	(125		)
Intangible adjustment (non-GAAP)	(276,208		)	(254,666		)	(264,467		)	(255,065		)
Average tangible capital (non-GAAP)	$	706,763		$	621,325		$	684,177		$	613,694
Average assets (GAAP)	$	7,571,789		$	6,857,839		$	7,395,450		$	6,800,577
Intangible adjustment (non-GAAP)	(276,208		)	(254,666		)	(264,467		)	(255,065		)
Average tangible assets (non-GAAP)	$	7,295,581		$	6,603,173		$	7,130,983		$	6,545,512
Net income available to common stockholders (GAAP)	$	24,136		$	20,006		$	47,329		$	37,699
CDI amortization, net of tax (GAAP)	644			635			1,231			1,271
Tangible net income available to common stockholders (non-GAAP)	$	24,780		$	20,641		$	48,560		$	38,970
Per Share Data:
Diluted net income available to common stockholders (GAAP)	$	0.57		$	0.49		$	1.13		$	0.92
Diluted tangible net income available to common stockholders (non-GAAP)	$	0.59		$	0.50		$	1.16		$	0.95
Ratios:
Return on average GAAP capital (ROE)	9.82		%	9.13		%	9.98		%	8.68		%
Return on average tangible capital	14.02		%	13.29		%	14.20		%	12.70		%
Return on average assets (ROA)	1.28		%	1.17		%	1.28		%	1.11		%
Return on average tangible assets	1.36		%	1.25		%	1.36		%	1.19		%

Return on average tangible capital is tangible net income available to common stockholders (annualized) expressed as a percentage of average tangible capital. Return on average tangible assets is tangible net income available to common stockholders (annualized) expressed as a percentage of average tangible assets.

LOAN QUALITY/PROVISION FOR LOAN LOSSES

The Corporation’s primary lending focus is small business and middle market commercial, commercial real estate and residential real estate, which results in portfolio diversification. Commercial loans are individually underwritten and judgmentally risk rated. They are periodically monitored and prompt corrective actions are taken on deteriorating loans. Retail loans are typically underwritten with statistical decision-making tools and are managed throughout their life cycle on a portfolio basis.

Loan Quality

The quality of the loan portfolio and the amount of non-performing loans may increase or decrease as a result of acquisitions, organic portfolio growth, problem loan recognition and resolution through collections, sales or charge-offs. The performance of any loan can be affected by external factors such as economic conditions, or internal factors specific to a particular borrower, such as the actions of a customer's internal management.

Table of Contents

PART I: FINANCIAL INFORMATION

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

At June 30, 2017, non-performing loans totaled $27,731,000, a decrease of $7,014,000 from December 31, 2016 and $1,065,000 from March 31, 2017. Troubled debt restructured loans of $384,000 decreased $4,363,000 from December 31, 2016. Loans not accruing interest income totaled $27,347,000 at June 30, 2017, a $2,651,000 decrease from December 31, 2016. The Corporation’s coverage ratio of allowance for loan losses to non-accrual loans increased from 220.1 percent at December 31, 2016 to 257.7 percent at June 30, 2017. This non-accrual coverage ratio at March 31, 2017 was 244.4 percent. See additional information regarding the allowance for loan losses in the “Provision for Loan Losses” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included as ITEM 2 of this Quarterly Report on Form 10-Q.

Other real estate owned, totaling $11,893,000 at June 30, 2017, increased $3,600,000 from March 31, 2017 and $2,927,000 from December 31, 2016. For other real estate owned, current appraisals are obtained to determine fair value as management continues to aggressively market these real estate assets.

Commercial impaired loans include non-accrual loans, loans accounted for under ASC 310-30, as well as substandard, doubtful, and loss grade loans that were still accruing but deemed impaired according to guidance set forth in ASC 310. Also included in impaired loans are accruing loans contractually past due 90 days or more and troubled debt restructure loans.

A loan is deemed impaired when, based on current information or events, it is probable that all amounts due of principal and interest according to the contractual terms of the loan agreement will not be collected substantially within the contractual terms of the note. At June 30, 2017, commercial impaired loans totaled $53,644,000 a decrease of $18,406,000 from the December 31, 2016 balance of $72,050,000. At June 30, 2017, a specific allowance for losses was not deemed necessary for commercial impaired loans totaling $49,783,000 as there were no identified losses on these credits. An allowance of $881,000 was recorded for the remaining balance of these commercial impaired loans totaling $3,861,000 and was included in the Corporation’s allowance for loan losses. Also included in the allowance for loan losses were specific reserves for consumer troubled debt restructure loans totaling $350,000.

At June 30, 2017, non-performing assets, which includes non-accrual loans, renegotiated loans, and other real estate owned; plus loans 90-days delinquent, totaled $40,258,000; a decrease of $3,565,000 from December 31, 2016 as displayed in the table below.



(Dollars in Thousands)	June 30, 2017		December 31, 2016
Non-Performing Assets plus loans 90+ Days Delinquent:
Non-accrual loans	$	27,347	$	29,998
Renegotiated loans	384		4,747
Non-performing loans (NPL)	27,731		34,745
Other real estate owned	11,893		8,966
Non-performing assets (NPA)	39,624		43,711
90+ days delinquent	634		112
Non-performing assets plus 90+ days delinquent	$	40,258	$	43,823
Impaired Loans	$	53,644	$	72,050

The non-accrual balances in the table above include troubled debt loan restructures totaling $4,238,000 and $4,478,000 as of June 30, 2017 and December 31, 2016, respectively.

The composition of non-performing assets and 90-day delinquent loans is reflected in the following table.



(Dollars in Thousands)	June 30, 2017		December 31, 2016
Non-Performing Assets plus loans 90+ Days Delinquent:
Commercial and industrial loans	$	1,886	$	2,138
Agricultural production financing and other loans to farmers	662		1,341
Real estate loans:
Construction	3,972		5,312
Commercial and farmland	21,639		22,362
Residential	10,920		10,943
Home Equity	1,115		1,688
Individuals' loans for household and other personal expenditures	64		39
Non-performing assets plus 90+ days delinquent	$	40,258	$	43,823

Although the Corporation believes its underwriting and loan review procedures are appropriate for the various kinds of loans it makes, its results of operations and financial condition could be adversely affected in the event the quality of its loan portfolio declines. Deterioration in the economic environment including residential and commercial real estate values may result in increased levels of loan delinquencies and credit losses.

Table of Contents

PART I: FINANCIAL INFORMATION

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Provision and Allowance for Loan Losses

The allowance for loan losses is maintained through the provision for loan losses, which is a charge against earnings. Based on management’s judgment as to the appropriate level of the allowance for loan losses, the amount provided in any period may be greater or less than net loan losses for the same period. The determination of the provision amount and the adequacy of the allowance in any period is based on management’s continuing review and evaluation of the loan portfolio, including an internally administered loan "watch" list and independent loan reviews. The evaluation also takes into consideration identified credit problems, portfolio growth, management's judgment as to the impact of current economic conditions on the portfolio and the possibility of losses inherent in the loan portfolio that are not specifically identified.

In conformance with ASC 805 and ASC 820, loans purchased after December 31, 2008 are recorded at the acquisition date fair value. Such loans are included in the allowance to the extent a specific impairment is identified that exceeds the fair value adjustment on an impaired loan. An allowance may also be necessary if the historical loss and environmental factor analysis indicates losses inherent in a purchased portfolio exceed the fair value adjustment on the portion of the purchased portfolio not deemed impaired.

At June 30, 2017, the allowance for loan losses was $70,471,000, an increase of $4,434,000 from December 31, 2016. As a percent of loans, the allowance was 1.25 percent at June 30, 2017, compared to 1.28 percent at December 31, 2016 and 1.29 percent at June 30, 2016. The provision for loan losses for the three months and six months ended June 30, 2017 was $2,875,000 and $5,260,000, respectively, and was primarily a result of organic loan growth during the periods. Comparatively, the provision for loan losses for the three months and six months ended June 30, 2016 was $790,000 and $1,340,000, respectively. Specific reserves on impaired loans increased $343,000 from $888,000 at December 31, 2016, to $1,231,000 at June 30, 2017.

Net charge-offs for the three months ended June 30, 2017, were $629,000. Comparatively, the same period in 2016 had net charge-offs of $690,000. For the three and six months ended June 30, 2017 and the three months ended June 30, 2016, there were no charge-offs or recoveries over $500,000. For the six months ended June 30, 2016, there were two charge-offs greater than $500,000 totaling $1,707,000 and one recovery totaling $604,000. The distribution of the net charge-offs or recoveries for the three and six months ended June 30, 2017 and 2016 are reflected in the following table:



	Three Months Ended June 30,					Six Months Ended June 30,
(Dollars in Thousands)	2017			2016		2017			2016
Net Charge-Offs (Recoveries):
Commercial and industrial loans	$	(118	)	$	313	$	206		$	644
Agricultural production financing and other loans to farmers	(103		)	30		(58		)	53
Real estate loans:
Construction	(33		)	21		(27		)	18
Commercial and farmland	519			216		101			261
Residential	66			35		94			422
Home equity	264			68		424			128
Individuals' loans for household and other personal expenditures	34			7		86			82
Other commercial loans									(1		)
Total Net Charge-Offs	$	629		$	690	$	826		$	1,607

Management continually evaluates the commercial loan portfolio by including consideration of specific borrower cash flow analysis and estimated collateral values, types and amounts on non-performing loans, past and anticipated loan loss experience, changes in the composition of the loan portfolio, and the current condition and amount of loans outstanding. The determination of the provision for loan losses in any period is based on management’s continuing review and evaluation of the loan portfolio, and its judgment as to the impact of current economic conditions on the portfolio.

LIQUIDITY

Liquidity management is the process by which the Corporation ensures that adequate liquid funds are available for the holding company and its subsidiaries. These funds are necessary in order to meet financial commitments on a timely basis. These commitments include withdrawals by depositors, funding credit obligations to borrowers, paying dividends to stockholders, paying operating expenses, funding capital expenditures, and maintaining deposit reserve requirements. Liquidity is monitored and closely managed by the asset/liability committee.

The Corporation’s liquidity is dependent upon the receipt of dividends from the Bank, which is subject to certain regulatory limitations and access to other funding sources. Liquidity of the Bank is derived primarily from core deposit growth, principal payments received on loans, the sale and maturity of investment securities, net cash provided by operating activities, and access to other funding sources.

The principal source of asset-funded liquidity is investment securities classified as available for sale, the market values of which totaled $742,759,000 at June 30, 2017, an increase of $45,897,000, or 6.59 percent, from December 31, 2016. Securities classified as held to maturity that are maturing within a short period of time can also be a source of liquidity. Securities classified as held to maturity and that are maturing in one year or less totaled $6,111,000 at June 30, 2017. In addition, other types of assets such as cash and interest-bearing deposits with other banks, federal funds sold and loans maturing within one year are sources of liquidity.

Table of Contents

PART I: FINANCIAL INFORMATION

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The most stable source of liability-funded liquidity for both the long-term and short-term is deposit growth and retention in the core deposit base. Federal funds purchased and securities sold under agreements to repurchase are also considered a source of liquidity. In addition, FHLB advances are utilized as funding sources. At June 30, 2017, total borrowings from the FHLB were $312,715,000. The Bank has pledged certain mortgage loans and investments to the FHLB. The total available remaining borrowing capacity from the FHLB at June 30, 2017 was $560,893,000.

In the normal course of business, the Bank is a party to a number of other off-balance sheet activities that contain credit, market and operational risk that are not reflected in whole or in part in our consolidated financial statements. Such activities include traditional off-balance sheet credit-related financial instruments, commitments under operating leases and long-term debt.

The Bank provides customers with off-balance sheet credit support through loan commitments and standby and commercial letters of credit. Summarized credit-related financial instruments at June 30, 2017 are as follows:



(Dollars in Thousands)	June 30, 2017
Amounts of commitments:
Loan commitments to extend credit	$	2,611,288
Standby and commercial letters of credit	42,061
	$	2,653,349

Since many of the commitments are expected to expire unused or be only partially used, the total amount of unused commitments in the preceding table does not necessarily represent future cash requirements.

In addition to owned banking facilities, the Corporation has entered into a number of long-term leasing arrangements to support ongoing activities. The required payments under such commitments and borrowings at June 30, 2017, are as follows:



(Dollars in Thousands)	Remaining 2017		2018		2019		2020		2021		2022		2023 and after		ASC 805 fair value adjustments at acquisition			Total
Operating leases	$	1,882	$	2,468	$	2,094	$	1,861	$	1,478	$	1,415	$	6,890				$	18,088
Federal funds purchased	134,608																	134,608
Securities sold under repurchase agreements	127,884																	127,884
Federal Home Loan Bank advances	115,860		66,717		38,828		11,310		25,000		20,000		35,000					312,715
Subordinated debentures and term loans	1,196												132,012		(4,466		)	128,742
Total	$	381,430	$	69,185	$	40,922	$	13,171	$	26,478	$	21,415	$	173,902	$	(4,466	)	$	722,037

INTEREST SENSITIVITY AND DISCLOSURE ABOUT MARKET RISK

Asset/Liability Management has been an important factor in the Corporation's ability to record consistent earnings growth through periods of interest rate volatility and product deregulation. Management and the Board of Directors monitor the Corporation's liquidity and interest sensitivity positions at regular meetings to review how changes in interest rates may affect earnings. Decisions regarding investment and the pricing of loan and deposit products are made after analysis of reports designed to measure liquidity, rate sensitivity, the Corporation’s exposure to changes in net interest income given various rate scenarios and the economic and competitive environments.

It is the objective of the Corporation to monitor and manage risk exposure to net interest income caused by changes in interest rates. It is the goal of the Corporation’s Asset/Liability function to provide optimum and stable net interest income. To accomplish this, management uses two asset liability tools. GAP/Interest Rate Sensitivity Reports and Net Interest Income Simulation Modeling are constructed, presented and monitored quarterly.

Net interest income simulation modeling, or earnings-at-risk, measures the sensitivity of net interest income to various interest rate movements. The Corporation's asset liability process monitors simulated net interest income under three separate interest rate scenarios; base, rising and falling. Estimated net interest income for each scenario is calculated over a 12-month horizon. The immediate and parallel changes to the base case scenario used in the model are presented below. The interest rate scenarios are used for analytical purposes and do not necessarily represent management's view of future market movements. Rather, these are intended to provide a measure of the degree of volatility interest rate movements may introduce into the earnings of the Corporation.

The base scenario is highly dependent on numerous assumptions embedded in the model, including assumptions related to future interest rates. While the base sensitivity analysis incorporates management's best estimate of interest rate and balance sheet dynamics under various market rate movements, the actual behavior and resulting earnings impact will likely differ from that projected. For certain assets, the base simulation model captures the expected prepayment behavior under changing interest rate environments. Assumptions and methodologies regarding the interest rate or balance behavior of indeterminate maturity products, such as savings, money market, NOW and demand deposits, reflect management's best estimate of expected future behavior.

Table of Contents

PART I: FINANCIAL INFORMATION

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The comparative rising 200 basis points and falling 100 basis points scenarios below, as of June 30, 2017, assume further interest rate changes in addition to the base simulation discussed above. These changes are immediate and parallel changes to the base case scenario. In the current rate environment, many driver rates are at or near historical lows, thus total rate movements (beginning point minus ending point) to each of the various driver rates utilized by management have the following results:



	June 30, 2017
	RISING	FALLING
Driver Rates	(200 Basis Points)	(100 Basis Points)
Prime	200	(100	)
Federal funds	200	(100	)
One-year CMT	200	(100	)
Three-year CMT	200	(100	)
Five-year CMT	200	(100	)
CD's	200	(16	)
FHLB advances	200	(95	)

Results for the base, rising 200 basis points, and falling 100 basis points interest rate scenarios are listed below based upon the Corporation’s rate sensitive assets and liabilities at June 30, 2017. The net interest income shown represents cumulative net interest income over a 12-month time horizon. Balance sheet assumptions used for the base scenario are the same for the rising and falling simulations.



	June 30, 2017
			RISING			FALLING
(Dollars in Thousands)	Base		(200 Basis Points)			(100 Basis Points)
Net interest income	$	244,544	$	264,624		$	216,565
Variance from base			$	20,080		$	(27,979	)
Percent of change from base			8.21		%	(11.44		)%

The comparative rising 200 basis points and falling 100 basis points scenarios below, as of December 31, 2016, assume further interest rate changes in addition to the base simulation discussed above. These changes are immediate and parallel changes to the base case scenario. In addition, total rate movements (beginning point minus ending point) to each of the various driver rates utilized by management in the base simulation are as follows:



	December 31, 2016
	RISING	FALLING
Driver Rates	(200 Basis Points)	(100 Basis Points)
Prime	200	(50	)
Federal funds	200	(50	)
One-year CMT	200	(77	)
Three-year CMT	200	(100	)
Five-year CMT	200	(100	)
CD's	200	(16	)
FHLB advances	200	(92	)

Results for the base, rising 200 basis points, and falling 100 basis points interest rate scenarios are listed below. The net interest income shown represents cumulative net interest income over a 12-month time horizon. Balance sheet assumptions used for the base scenario are the same for the rising and falling simulations.



	December 31, 2016
			RISING			FALLING
(Dollars in Thousands)	Base		(200 Basis Points)			(100 Basis Points)
Net interest income	$	231,074	$	247,920		$	214,302
Variance from base			$	16,846		$	(16,772	)
Percent of change from base			7.29		%	(7.26		)%

EARNING ASSETS

The following table presents the earning asset mix as of June 30, 2017, and December 31, 2016. Earning assets increased by $538,321,000 during the six months ended June 30, 2017. Loans and loans held for sale increased by $474,606,000. The largest loan segments that experienced increases were commercial and farmland, residential and commercial and industrial. A slight decrease was noted in agricultural production financing and other loans to farmers. Of the increase in loans, $232,306,000 was attributable to the Arlington Bank acquisition and approximately $107,735,000 of Arlington Bank's portfolio was in the residential loan segment. Additional details of the changes in the Corporation's loans are discussed within NOTE 4. LOANS AND ALLOWANCE, in the Notes to Consolidated Condensed Financial Statements of this Quarterly Report on Form 10-Q. Additionally, investment securities increased $38,818,000 as a portion of cash acquired in the Arlington Bank acquisition was invested in the bond portfolio.

Table of Contents

PART I: FINANCIAL INFORMATION

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Additional details of the Arlington Bank acquisition can be found in NOTE 2. ACQUISITIONS, included within the Notes to Consolidated Condensed Financial Statements of this Quarterly Report on Form 10-Q.



(Dollars in Thousands)	June 30, 2017		December 31, 2016
Interest-bearing time deposits	$	48,305	$	24,459
Investment securities available for sale	742,759		696,862
Investment securities held to maturity	600,564		607,643
Loans held for sale	4,036		2,929
Loans	5,613,144		5,139,645
Federal Home Loan Bank stock	19,015		17,964
Total	$	7,027,823	$	6,489,502

OTHER

The Securities and Exchange Commission maintains a web site that contains reports, proxy and information statements and other information regarding registrants that file electronically with the Commission, including the Corporation, and that address is (http://www.sec.gov).

Table of Contents

PART I: FINANCIAL INFORMATION

ITEM 3. QUANTITATIVE AND QUALITATIVE

DISCLOSURES ABOUT MARKET RISK

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The information required under this item is included as part of Management’s Discussion and Analysis of Financial Condition and Results of Operations, under the headings “LIQUIDITY” and “INTEREST SENSITIVITY AND DISCLOSURE ABOUT MARKET RISK”.

Table of Contents

PART I: FINANCIAL INFORMATION

ITEM 4. CONTROLS AND PROCEDURES

At the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective. Disclosure controls and procedures are controls and procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934 are recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.

There have been no changes in the Corporation’s internal control over financial reporting identified in connection with the evaluation discussed above that occurred during the Corporation’s last fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Corporation’s internal control over financial reporting.

Table of Contents

PART II: OTHER INFORMATION

ITEM 1., ITEM 1A., ITEM 2., ITEM 3., ITEM 4. AND ITEM 5.

(table dollar amounts in thousands, except share data)

ITEM 1. LEGAL PROCEEDINGS

There are no pending legal proceedings, other than litigation incidental to the ordinary business of the Corporation or its subsidiaries, of a material nature to which the Corporation or its subsidiaries is a party or of which any of their properties are subject. Further, there are no material legal proceedings in which any director, officer, principal shareholder, or affiliate of the Corporation, or any associate of any such director, officer or principal shareholder, is a party, or has a material interest, adverse to the Corporation or any of its subsidiaries.

None of the routine legal proceedings, individually or in the aggregate, in which the Corporation or its affiliates are involved are expected to have a material adverse impact on the financial position or the results of operations of the Corporation.

ITEM 1A. RISK FACTORS

There have been no material changes to the risk factors previously disclosed in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2016,

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

a. None

b. None

c. Issuer Purchases of Equity Securities

The following table presents information relating to our purchases of equity securities during the three months ended June 30, 2017.



Period	Total Number of Shares Purchased	Average Price Paid per Share	Total Number of Shares Purchased as part of Publicly announced Plans or Programs	Maximum Number of Shares that may yet be Purchased Under the Plans or Programs
April, 2017	75	$37.10
May, 2017
June, 2017

The shares were purchased in connection with the exercise of certain outstanding stock options and vesting of restricted stock awards.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4. MINE SAFETY DISCLOSURES

Not Applicable

ITEM 5. OTHER INFORMATION

a. None

b. None

Table of Contents

PART II: OTHER INFORMATION

ITEM 6. EXHIBITS



Exhibit No:	Description of Exhibits:

2.1	Agreement and Plan of Reorganization and Merger among First Merchants Corporation and Independent Alliance Banks, Inc., dated as of February 17, 2017 (Incorporated by reference to registrant's Form 8-K filed on February 17, 2017) (SEC No. 000-17071)
3.1	First Merchants Corporation Articles of Incorporation, as amended (Incorporated by reference to registrant’s Form 8-K filed on May 2, 2017) (SEC No. 000-17071)
3.2	Bylaws of First Merchants Corporation dated August 11, 2016 (Incorporated by reference to registrant’s Form 10-K filed on March 1, 2017) (SEC No. 000-17071)
4.1	First Merchants Corporation Amended and Restated Declaration of Trust of First Merchants Capital Trust II dated as of July 2, 2007 (Incorporated by reference to registrant's Form 8-K filed on July 3, 2007) (SEC No. 000-17071)
4.2	Indenture dated as of July 2, 2007 (Incorporated by reference to registrant's Form 8-K filed on July 3, 2007) (SEC No. 000-17071)
4.3	Guarantee Agreement dated as of July 2, 2007 (Incorporated by reference to registrant's Form 8-K filed on July 3, 2007) (SEC No. 000-17071)
4.4	Form of Capital Securities Certification of First Merchants Capital Trust II (Incorporated by reference to registrant's Form 8-K filed on July 3, 2007) (SEC No. 000-17071)
4.5	First Merchants Corporation Dividend Reinvestment and Stock Purchase Plan (Incorporated by reference to registrant’s Post-Effective Amendment No. 1 to Form S-3 filed on August 21, 2009) (SEC No. 033-45393)
4.6	Upon request, the registrant agrees to furnish supplementally to the Commission a copy of the instruments defining the rights of holders of its (a) 5.00% Fixed-to-Floating Rate Senior Notes due 2028 in the aggregate principal amount of $5 million and (b) 6.75% Fixed-to-Floating Rate Subordinated Notes due 2028 in aggregate principal amount of $65 million.
31.1	Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes - Oxley Act of 2002 (1)
31.2	Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes - Oxley Act of 2002 (1)
32	Certifications Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (1)
101.INS	XBRL Instance Document (2)
101.SCH	XBRL Taxonomy Extension Schema Document (2)
101.CAL	XBRL Taxonomy Extension Calculation Linkbase Document (2)
101.DEF	XBRL Taxonomy Extension Definition Linkbase Document (2)
101.LAB	XBRL Taxonomy Extension Label Linkbase Document (2)
101.PRE	XBRL Taxonomy Extension Presentation Linkebase Document (2)


	(1) Filed herewith.
	(2) Furnished herewith.

Table of Contents

PART II: OTHER INFORMATION

ITEM 6. EXHIBITS

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.



	First Merchants Corporation
	(Registrant)


Date: August 9, 2017	by /s/ Michael C. Rechin
	Michael C. Rechin
	President and Chief Executive Officer
	(Principal Executive Officer)

Date: August 9, 2017	by /s/ Mark K. Hardwick
	Mark K. Hardwick
	Executive Vice President,
	Chief Financial Officer and Chief Operating Officer
	(Principal Financial and Accounting Officer)

Table of Contents

PART II: OTHER INFORMATION

ITEM 6. EXHIBITS

INDEX TO EXHIBITS



Exhibit No:	Description of Exhibits:

2.1	Agreement and Plan of Reorganization and Merger among First Merchants Corporation and Independent Alliance Banks, Inc., dated as of February 17, 2017 (Incorporated by reference to registrant's Form 8-K filed on February 17, 2017) (SEC No. 000-17071)
3.1	First Merchants Corporation Articles of Incorporation, as amended (Incorporated by reference to registrant’s Form 8-K filed on May 2, 2017) (SEC No. 000-17071)
3.2	Bylaws of First Merchants Corporation dated August 11, 2016 (Incorporated by reference to registrant’s Form 10-K filed on March 1, 2017) (SEC No. 000-17071)
4.1	First Merchants Corporation Amended and Restated Declaration of Trust of First Merchants Capital Trust II dated as of July 2, 2007 (Incorporated by reference to registrant's Form 8-K filed on July 3, 2007) (SEC No. 000-17071)
4.2	Indenture dated as of July 2, 2007 (Incorporated by reference to registrant's Form 8-K filed on July 3, 2007) (SEC No. 000-17071)
4.3	Guarantee Agreement dated as of July 2, 2007 (Incorporated by reference to registrant's Form 8-K filed on July 3, 2007) (SEC No. 000-17071)
4.4	Form of Capital Securities Certification of First Merchants Capital Trust II (Incorporated by reference to registrant's Form 8-K filed on July 3, 2007) (SEC No. 000-17071)
4.5	First Merchants Corporation Dividend Reinvestment and Stock Purchase Plan (Incorporated by reference to registrant’s Post-Effective Amendment No. 1 to Form S-3 filed on August 21, 2009) (SEC No. 033-45393)
4.6	Upon request, the registrant agrees to furnish supplementally to the Commission a copy of the instruments defining the rights of holders of its (a) 5.00% Fixed-to-Floating Rate Senior Notes due 2028 in the aggregate principal amount of $5 million and (b) 6.75% Fixed-to-Floating Rate Subordinated Notes due 2028 in aggregate principal amount of $65 million.
31.1	Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes - Oxley Act of 2002 (1)
31.2	Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes - Oxley Act of 2002 (1)
32	Certifications Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (1)
101.INS	XBRL Instance Document (2)
101.SCH	XBRL Taxonomy Extension Schema Document (2)
101.CAL	XBRL Taxonomy Extension Calculation Linkbase Document (2)
101.DEF	XBRL Taxonomy Extension Definition Linkbase Document (2)
101.LAB	XBRL Taxonomy Extension Label Linkbase Document (2)
101.PRE	XBRL Taxonomy Extension Presentation Linkebase Document (2)


	(1) Filed herewith.
	(2) Furnished herewith.