GRAND RIVER COMMERCE INC - Annual Report: 2011 (Form 10-K)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

S ANNUAL REPORT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2011

¨ 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 333-147456

Grand River Commerce, Inc.

(Exact name of registrant as specified in its charter)

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes¨ No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes x  No ¨

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 shorter period that the registrant as 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 Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

x Yes ¨ No

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405) of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.

¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.

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

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

The aggregate market value of the registrant’s outstanding common stock held by non-affiliates of the registrant as of June 30, 2011, was approximately $16.2 million, based on the last reported trade as of such date. This price reflects inter-dealer prices without retail mark up, mark down, or commissions, and may not represent actual transactions.

The number of common shares outstanding of each of the issuers classes of common stock, as of the latest practicable date: 1,700,120 shares of the Company’s Common Stock ($0.01 par value per share) were outstanding as of March 26, 2012.

Grand River Commerce, Inc.

table of contents

Documents Incorporated by Reference

Part III. Items 10 through 14 incorporate by reference portions of the Company’s Definitive Proxy Statement for the Company’s Annual Meeting of Shareholders to be held May 24, 2012.

Part I

Forward-Looking Statements

This annual report contains forward-looking statements. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” or “continue” or the negative of these terms or other comparable terminology. These statements are only predictions and involve known and unknown risks, uncertainties and other factors that may cause our or our industry’s actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements.

Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Except as required by applicable laws, including the securities laws of the United States, we do not intend to update any of the forward-looking statements to conform these statements to actual results.

References

As used in this annual report, the terms “we,” “us,” “our,” “GRCI” and “the Company” means Grand River Commerce, Inc. and its wholly-owned subsidiary, Grand River Bank, on a consolidated basis, unless otherwise indicated. As used in this annual report the term “the Bank” means Grand River Bank, a wholly-owned subsidiary of the Company. All dollar amounts in this annual report refer to U.S. dollars unless otherwise indicated.

Overview

General

Grand River Commerce, Inc., the parent company for its wholly-owned subsidiary Grand River Bank, was incorporated in August 2006 for the purpose of operating as a bank holding company. The Company and the Bank were incorporated under the laws of the state of Michigan. The Bank commenced banking operations on April 30, 2009. In January 2012, the Bank established a subsidiary, GRO Properties, LLC, to hold properties acquired by the Bank through foreclosure.

Our offices and the Bank are located at 4471 Wilson Ave SW, Grandville, Michigan. This facility is composed of two suites which total approximately 8,500 square feet and is currently subject to a 36 month lease which expires on December 31, 2013. Our telephone number is (616) 929-1600. Currently the Bank serves its market through a single location.

Grand River Bank is a Michigan state chartered community bank that provides banking services to small- to medium-sized commercial, professional and service companies and consumers, principally in Kent and Ottawa Counties. Our primary market area consists of the Grand Rapids area located in Kent County and the areas adjoining Grandville, some of which are located in Ottawa County. The economic base is growing in diversity and today includes the expanding industries of medical research, health care and alternative energy in addition to the automotive, furniture and related manufacturing industries which have historically been the economic foundation of the region. This growth is the result of private investment in the infrastructure of the local economy and a strong partnership between business and government in the area. In addition, the area is growing as an art and cultural center following the success of recent nationally recognized annual events such as Art Prize and Laughfest.

The Bank is a full-service banking institution that offers a variety of deposit, payment, credit and other financial services to all types of customers. These services include savings, time and demand deposit products as well as electronic banking services that include internet banking and remote deposit services for commercial customers. Loans, both commercial and consumer, are extended primarily on a secured basis to corporations, partnerships and individuals. The principal source of income for the Company and the Bank is interest and fee income earned on loans. Interest and fee income on loans accounted for 92% of income in 2011 and in 2010. The Company and the Bank have no foreign assets or income.

Lending Activities

General. We emphasize a range of lending services, including real estate, commercial, equity-line and consumer loans to individuals, small- to medium-sized businesses, and professional concerns that are located in or conduct a substantial portion of their business in the Bank’s market area. We compete for these loans with competitors who are well established in our service area and have greater resources and lending limits. As a result, in some instances, we may charge lower interest rates or structure more customized loan facilities to attract borrowers.

The national and super-regional banks in our service area will likely make proportionately more loans to medium- to large-sized businesses in comparison to the Bank. Many of the Bank’s commercial loans are made to small- to medium-sized businesses which may be less able to withstand competitive, economic, and financial conditions than larger borrowers.

Loan Approval and Review. Our loan approval policies provide for various levels of officer lending authority. When the amount of aggregate loans to a single borrower exceeds that individual officer’s lending authority, the loan request is considered and approved by an officer with a higher lending limit, the loan committee or the Board of Directors. We do not make loans to any officer or director of the Bank unless the loan is approved by the Board of Directors of the Bank (with the interested director recusing him or herself from the deliberation process and the vote) and is made on terms not more favorable to the person than would be available to a person not affiliated with the Bank as per the requirements of the Board of Governors of the Federal Reserve System Regulation O.

Loan Distribution. The percentage distribution of our loans following our three years of operation is as follows as of December 31:

Our loan distribution will depend on our customers and will likely vary over time. Current market conditions combined with the skills of our lending staff have presented the greatest opportunities for commercial real estate lending. Commercial and industrial loans are generally associated with business growth and expansion which is currently minimized in both the West Michigan marketplace as well as nationally. Additionally, competition for the demand that does exist for commercial and industrial loans is strong due to limitations on many local competitors’ ability to finance loans secured by commercial real estate.

Allowance for Loan Losses. We maintain an allowance for loan losses, which we establish through a provision for loan losses charged against income. We will charge-off loans against this allowance when we believe that the collectability of the principal is unlikely. The allowance is an estimated amount that we believe will be adequate to absorb losses inherent in the loan portfolio based on evaluations of its collectability. Our allowance for loan losses equals 1.13% of the actual outstanding balance of our loans as of December 31, 2011. Over time, we periodically determine the amount of the allowance based on our consideration of several factors, including:

Lending Limits. The Bank’s lending activities are subject to a variety of lending limits imposed by federal law. In general, the Bank is subject to a legal limit on loans to a single borrower equal to 15% of the Bank’s capital and unimpaired surplus. This limit may be increased to 25% of the Bank’s capital and unimpaired surplus with 2/3 of the Board of Directors approving such limit. These limits will increase or decrease as the Bank’s capital increases or decreases. Unless the Bank is able to sell participations in our loans to other financial institutions, the Bank is not able to meet all of the lending needs of loan customers requiring aggregate extensions of credit above these limits.

Credit Risk. The principal credit risk associated with each category of loans is the creditworthiness of the borrower. Borrower creditworthiness is affected by general economic conditions and the strength of the manufacturing, health care and other services, and retail market segments. General economic factors affecting a borrower’s ability to repay include interest, inflation, employment rates, and the strength of local and national economy, as well as other factors affecting a commercial borrower’s customers, suppliers, and employees.

Commercial Loans. We make many types of loans available to business organizations and individuals on primarily a secured basis, including commercial, term, working capital, asset based, SBA loans, commercial real estate, lines of credit, and mortgages. We intend to focus our commercial lending efforts on companies with revenue of less than $20 million. Construction loans are also available for eligible individuals and contractors. The construction lending will be short-term, generally with maturities of less than twelve months, and be set up on a draw basis. Commercial loans primarily have risk that the primary source of repayment, the borrowing business, will be insufficient to service the debt. Often this occurs as the result of changes in local economic conditions or in the industry in which the borrower operates which impact cash flow or collateral value. While our Bank routinely takes real estate as collateral, our credit policy places emphasis on the cash flow characteristics of our borrowers. We expect that our commercial lending will be focused on small- to medium-size businesses located in or serving the primary service area. We consider “small businesses” to include commercial, professional including health care, and retail firms with annual sales of $20 million or less. Commercial lending will include loans to entrepreneurs, professionals and small- to medium-sized firms.

Small business products include:

Within small business lending, we also utilize government enhancements such as the U.S. Small Business Administration (“SBA”) programs. These loans will typically be partially guaranteed by the federal government. Government guarantees of SBA loans will not exceed 75% of the loan value, and will generally be less than 75% of the loan value.

Real Estate Loans. We expect that loans secured by first or second mortgages on real estate will make up a significant portion of the Bank’s loan portfolio. These loans generally fall into one of two categories: commercial real estate loans and construction development loans. These loans include commercial loans where the Bank takes a security interest in real estate out of abundance of caution and not as the principal collateral for the loan, but exclude home equity loans, which are classified as consumer loans. We expect to focus our real estate-related activity in four areas: (1) owner-occupied commercial real estate loans, (2) home equity loans, (3) conforming and non-conforming residential mortgages and (4) commercial investment property loans.

We offer fixed and variable rates on mortgages. These loans are made consistent with the Bank’s appraisal policy and with the ratio of the loan principal to the value of collateral as established by independent appraisal generally not to exceed 80%. We expect these loan to value ratios will be sufficient to compensate for fluctuations in real estate market value. Some loans may be sold in the secondary market in conjunction with performance management or portfolio management goals.

Real estate-related products include:

Real estate loans are subject to the same general risks as other loans. Real estate loans are also sensitive to fluctuations in the value of the real estate securing the loan. On first and second mortgage loans, we do not advance more than regulatory limits. We require a valid mortgage lien on all real property loans along with a title lien policy which insures the validity and priority of the lien. We also require borrowers to obtain hazard insurance policies and flood insurance if applicable. Additionally, certain types of real estate loans have specific risk characteristics that vary according to the collateral type securing the loan and the terms and repayment sources for the loan.

Consumer Loans. We offer consumer loans to customers in our primary service area. Consumer lending products include:

Consumer loans are generally considered to have greater risk than first or second mortgages on residential real estate because the value of the secured property may depreciate rapidly, they are often dependent on the borrower’s employment status as the sole source of repayment, and some of them are unsecured. To mitigate these risks, we analyze selective underwriting criteria for each prospective borrower, which may include the borrower’s employment history, income history, credit bureau reports, or debt to income ratios. If the consumer loan is secured by property, such as an automobile loan, we also attempt to offset the risk of rapid depreciation of the collateral with a shorter loan amortization period. Despite these efforts to mitigate our risks, consumer loans have a higher rate of default than real estate loans. For this reason, we also attempt to reduce our loss exposure to these types of loans by limiting their sizes relative to other types of loans. We have no plans to engage in any sub-prime or speculative lending, including plans to originate loans with relatively high loan-to-value ratios.

Deposit Services

We offer a full range of deposit services that are typically available in most banks and savings and loan associations, including checking accounts, NOW accounts, Health Savings Accounts, commercial accounts, savings accounts, and time deposits accounts. The transaction accounts and time certificates are tailored to our primary service area at competitive rates. In addition, we offer certain retirement account services, including IRAs. We solicit these accounts from individuals, businesses, and other organizations.

Other Banking Services

We offer cashier’s checks, banking by mail, remote deposit capture, online banking, ATM/debit cards and United States Savings Bonds. We are associated with national ATM networks that may be used by the Bank’s customers throughout the country. We believe that by being associated with a shared network of ATMs, we are better able to serve our customers and will be able to attract customers who are accustomed to the convenience of using ATMs. We offer credit card services through a third party. We do not have trust powers and we do not offer non-traditional banking products.

Competition

The banking business is highly competitive. We compete as a financial intermediary with other commercial banks, savings banks, credit unions, finance companies, and money market mutual funds operating in our primary service area. Many of these institutions have substantially greater resources and lending limits than we will have, and many of these competitors offer services, including extensive and established branch networks and trust services that we either do not expect to provide or will not provide in the near term. Our competitors include large national, super regional and regional banks like Bank of America, PNC, Comerica Bank, Chemical Bank, Fifth Third and Huntington Bank, as well as established local community banks such as Macatawa Bank, Mercantile Bank and Founders Bank. Nevertheless, we believe that our management team, our focus on relationship banking, and the economic and demographic dynamics of our service area will allow us to gain a meaningful share of the area’s deposits and lending activities.

Effects of Compliance with Environmental Regulations

The nature of the business of the Bank is such that it may hold title, on a temporary or permanent basis, to parcels of real property. These can include properties owned for branch offices and other business purposes as well as properties taken in or in lieu of foreclosure to satisfy loans in default. Under current state and federal laws, present and past owners of real property may be exposed to liability for the cost of cleanup of environmental contamination on or originating from those properties, even if they are wholly innocent of the actions that caused the contamination. These liabilities can be material and can exceed the value of the contaminated property. Management is not presently aware of any instances where compliance with these provisions will have a material effect on the capital expenditures, earnings or competitive position of the Company or the Bank, or where compliance with these provisions will adversely affect a borrower's ability to comply with the terms of loan contracts. The Company does not currently own any real property.

Employees

As of December 2011, the Bank had approximately 19 full-time employees and 1 part-time employee. The Company believes that its relations with its employees are good.

Supervision and Regulation

Banking is a complex, highly regulated industry. Consequently, the growth and earnings performance of Grand River Commerce, Inc. and Grand River Bank can be affected, not only by management decisions in general and local economic conditions, but also by the statutes administered by, and the regulations and policies of, various governmental regulatory authorities. These authorities include, but are not limited to the Securities and Exchange Commission (SEC), the Board of Governors of the Federal Reserve System (Federal Reserve), the FDIC (Federal Deposit Insurance Corporation), OFIR (Michigan Office of Financial and Insurance Regulation), the IRS (Internal Revenue Service) and state taxing authorities. The effect of these statutes, regulations and policies and any changes to any of them can be significant and cannot be predicted.

The primary goals of the bank regulatory scheme are to maintain a safe and sound banking system and to facilitate the conduct of sound monetary policy. In furtherance of these goals, Congress has created several largely autonomous regulatory agencies and enacted numerous laws that govern banks, bank holding companies and the banking industry. The system of supervision and regulation applicable to Grand River Commerce, Inc. and Grand River Bank establishes a comprehensive framework for their respective operations and is intended primarily for the protection of the FDIC’s deposit insurance funds, the Bank’s depositors and the public, rather than the shareholders and creditors. The following is an attempt to summarize some of the relevant laws, rules and regulations governing banks and bank holding companies, but does not purport to be a complete summary of all applicable laws, rules and regulations governing banks and bank holding companies. The descriptions are qualified in their entirety by reference to the specific statutes and regulations discussed.

Grand River Commerce, Inc.

General. The Company, as the sole shareholder of the Bank, is a bank holding company. As a bank holding company, the Company is required to register with, and is subject to regulation by, the Federal Reserve under the Bank Holding Company Act, as amended (the “BHCA”). Under the BHCA, the Company is subject to periodic examination by the Federal Reserve and is required to file periodic reports of its operations and such additional information as the Federal Reserve may require.

The BHCA and other federal laws subject bank holding companies to particular restrictions on the types of activities in which they may engage, and to a range of supervisory requirements and activities, including regulatory enforcement actions for violations of laws and regulations.

Source of Strength. Under the Federal Reserve’s “source of strength” doctrine, a bank holding company is required to act as a source of financial and managerial strength to any subsidiary bank. The holding company is expected to commit resources to support a subsidiary bank, including at times when the holding company may not be in a financial position to provide such support. A bank holding company’s failure to meet its source-of-strength obligations may constitute an unsafe and unsound practice or a violation of the Federal Reserve’s regulations, or both. The source-of-strength doctrine most directly affects bank holding companies in situations where the bank holding company’s subsidiary bank fails to maintain adequate capital levels. This doctrine was codified by the Dodd-Frank Act, but the Federal Reserve has not yet adopted regulations to implement this requirement. As discussed below, we could be required to guarantee the capital plan of the Bank if it becomes undercapitalized for purposes of banking regulations.

Certain acquisitions. The BHCA requires every bank holding company to obtain the prior approval of the Federal Reserve before (i) acquiring more than five percent of the voting stock of any bank or other bank holding company, (ii) acquiring all or substantially all of the assets of any bank or bank holding company, or (iii) merging or consolidating with any other bank holding company.

Additionally, the BHCA provides that the Federal Reserve may not approve any of these transactions if it would result in or tend to create a monopoly or substantially lessen competition or otherwise function as a restraint of trade, unless the anti-competitive effects of the proposed transaction are clearly outweighed by the public interest in meeting the convenience and needs of the community to be served. The Federal Reserve is also required to consider the financial and managerial resources and future prospects of the bank holding companies and banks involved and the convenience and needs of the community to be served. The Federal Reserve’s consideration of financial resources generally focuses on capital adequacy, which is discussed below. As a result of the Patriot Act, which is discussed below, the Federal Reserve is also required to consider the record of a bank holding company and its subsidiary bank(s) in combating money laundering activities in its evaluation of bank holding company merger or acquisition transactions.

Under the BHCA, if adequately capitalized and adequately managed, any bank holding company located in Michigan may purchase a bank located outside of Michigan. Conversely, an adequately capitalized and adequately managed bank holding company located outside of Michigan may purchase a bank located inside Michigan. In each case, however, restrictions currently exist on the acquisition of a bank that has only been in existence for a limited amount of time or will result in specified concentrations of deposits.

Change in bank control. Subject to various exceptions, the BHCA and the Change in Bank Control Act of 1978, together with related regulations, require Federal Reserve approval prior to any person or company acquiring “control” of a bank holding company. Control is conclusively presumed to exist if an individual or company acquires 25% or more of any class of voting securities of the bank holding company. With respect to Grand River Commerce, control is rebuttably presumed to exist if a person or company acquires 10% or more, but less than 25%, of any class of voting securities.

Permitted activities. Generally, bank holding companies are prohibited under the BHCA, from engaging in or acquiring direct or indirect control of more than 5% of the voting shares of any company engaged in any activity other than (i) banking or managing or controlling banks or (ii) an activity that the Federal Reserve determines to be so closely related to banking as to be a proper incident to the business of banking.

Activities that the Federal Reserve has found to be so closely related to banking as to be a proper incident to the business of banking include:

Despite prior approval, the Federal Reserve has the authority to require a bank holding company to terminate an activity or terminate control of or liquidate or divest certain subsidiaries or affiliates when the Federal Reserve believes the activity or the control of the subsidiary or affiliate constitutes a significant risk to the financial safety, soundness or stability of any of its banking subsidiaries. A bank holding company that qualifies and elects to become a financial holding company is permitted to engage in additional activities that are financial in nature or incidental or complementary to financial activity. The BHCA expressly lists the following activities as financial in nature:

To qualify to become a financial holding company, Grand River Bank and any other depository institution subsidiary that we may own at the time must be well capitalized and well managed and must have a Community Reinvestment Act rating of at least satisfactory. Additionally, the Company is required to file an election with the Federal Reserve to become a financial holding company and to provide the Federal Reserve with 30 days’ written notice prior to engaging in a permitted financial activity. A bank holding company that falls out of compliance with these requirements may be required to cease engaging in some of its activities. The Federal Reserve serves as the primary “umbrella” regulator of financial holding companies, with supervisory authority over each parent company and limited authority over its subsidiaries. Expanded financial activities of financial holding companies generally will be regulated according to the type of such financial activity: banking activities by banking regulators, securities activities by securities regulators and insurance activities by insurance regulators. We remain a bank holding company but may at some time in the future elect to become a financial holding company.

Sound banking practice. Bank holding companies are not permitted to engage in unsound banking practices. For example, the Federal Reserve’s Regulation Y requires a holding company to give the Federal Reserve prior notice of any redemption or repurchase of its own equity securities, if the consideration to be paid, together with the consideration paid for any repurchases in the preceding year, is equal to 10% or more of the company’s consolidated net worth. The Federal Reserve may oppose the transaction if it believes that the transaction would constitute an unsafe or unsound practice or would violate any law or regulation. As another example, a holding company could not impair its subsidiary bank’s soundness by causing it to make funds available to non-banking subsidiaries or their customers if the Federal Reserve believed it not prudent to do so.

The Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”) expanded the Federal Reserve’s authority to prohibit activities of bank holding companies and their non-banking subsidiaries which represent unsafe and unsound banking practices or which constitute violations of laws or regulations. FIRREA increased the amount of civil money penalties which the Federal Reserve can assess for activities conducted on a knowing and reckless basis, if those activities caused a substantial loss to a depository institution. The penalties can be as high as $1,000,000 for each day the activity continues. FIRREA also expanded the scope of individuals and entities against which such penalties may be assessed.

Anti-tying restrictions. Bank holding companies and affiliates are prohibited from tying the provision of services, such as extensions of credit, to other services offered by a holding company or its affiliates.

Dividends. Consistent with its policy that bank holding companies should serve as a source of financial strength for their subsidiary banks, the Federal Reserve has stated that, as a matter of prudence, Grand River Commerce, Inc. as a bank holding company, generally should not maintain a rate of distributions to shareholders unless its available net income has been sufficient to fully fund the distributions, and the prospective rate of earnings retention appears consistent with the bank holding company’s capital needs, asset quality and overall financial condition. In addition, we are subject to certain restrictions on the making of distributions as a result of the requirement that the Bank maintain an adequate level of capital as described below. As a Michigan corporation, we are restricted under the Michigan Business Corporation Act from paying dividends if we are unable to meet our current obligations or in doing so the total assets of the company plus the amount of the dividend become less than the liabilities rendering the company insolvent.

Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 was enacted in response to public concerns regarding corporate accountability in connection with certain accounting scandals. The stated goals of the Sarbanes-Oxley Act are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies, and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws.

The Sarbanes-Oxley Act includes specific additional disclosure requirements, requires the Securities and Exchange Commission and national securities exchanges to adopt extensive additional disclosure, corporate governance and other related rules, and mandates further studies of certain issues by the Securities and Exchange Commission. The Sarbanes-Oxley Act represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a Board of Directors and management and between a Board of Directors and its committees.

Grand River Bank

General. The Bank is a Michigan state-chartered bank, the deposit accounts of which are insured by the FDIC. As a state-chartered non-member bank, the Bank is subject to the examination, supervision, reporting and enforcement requirements of the OFIR, as the chartering authority for state banks, and the FDIC, as administrator of the deposit insurance fund, and to the statutes and regulations administered by the OFIR and the FDIC governing such matters as capital standards, mergers, establishment of branch offices, subsidiary investments and activities and general investment authority. The Bank is required to file reports with the OFIR and the FDIC concerning its activities and financial condition and is required to obtain regulatory approvals prior to entering into certain transactions, including mergers with, or acquisitions of, other financial institutions.

Business Activities. The Bank’s activities are governed primarily by Michigan’s Banking Code of 1999 (the “Banking Code”) and the Federal Deposit Insurance Act, as amended (“FDIA”). The Gramm-Leach-Bliley Financial Services Modernization Act of 1999, expands the types of activities in which a holding company or national bank may engage. Subject to various limitations, the act generally permits holding companies to elect to become financial holding companies and, along with national banks, conduct certain expanded financial activities related to insurance and securities, including securities underwriting, dealing and market making; sponsoring mutual funds and investment companies; insurance underwriting and agency activities; merchant banking activities; and activities that the Federal Reserve has determined to be closely related to banking. The Gramm-Leach-Bliley Act also provides that state chartered banks meeting the above requirements may own or invest in “financial subsidiaries” to conduct activities that are financial in nature, with the exception of insurance underwriting and merchant banking, although five years after enactment, regulators will be permitted to consider allowing financial subsidiaries to engage in merchant banking. Banks with financial subsidiaries must establish certain firewalls and safety and soundness controls, and must deduct their equity investment in such subsidiaries from their equity capital calculations. Expanded financial activities of financial holding companies and banks will generally be regulated according to the type of such financial activity: banking activities by banking regulators, securities activities by securities regulators, and insurance activities by insurance regulators. Under Section 487.14101 of the Michigan Banking Code, a Michigan state chartered bank, upon satisfying certain conditions, may generally engage in any activity in which a national bank can engage. Accordingly, a Michigan state chartered bank generally may engage in certain expanded financial activities as described above. The Bank currently has no plans to conduct any activities through financial subsidiaries.

Financial Reform - The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was signed into law on July 21, 2010 as a response to the recent recession, is the most sweeping change to financial regulation in the United States since the Great Depression and represents a significant change in the American financial regulatory environment affecting all Federal financial regulatory agencies and affecting almost every aspect of the nation's financial services industry. The Dodd-Frank Act implements far-reaching changes across the financial regulatory landscape, including provisions that, among other things, will:

Many aspects of the Dodd-Frank Act are subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on the Company, its customers or the financial industry more generally. Provisions in the legislation that affect the payment of interest on demand deposits and interchange fees are likely to increase the costs associated with deposits as well as place limitations on certain revenues those deposits may generate. Some of the rules that have been proposed and, in some cases, adopted to comply with the Dodd-Frank Act’s mandates are discussed further under “Regulatory Capital Requirements”.

Deposit Insurance. Substantially all of the deposits of Grand River Bank are insured up to applicable limits by the Deposit Insurance Fund (“DIF”) of the FDIC and are subject to deposit insurance assessments to maintain the DIF. The FDIC utilizes a risk-based assessment system that imposes insurance premiums based upon a risk matrix that takes into account a bank’s capital level and supervisory rating (“CAMELS rating”). The risk matrix utilizes four risk categories which are distinguished by capital levels and supervisory ratings.

In February 2009, the FDIC issued final rules to amend the DIF restoration plan, change the risk-based assessment system and set assessment rates for Risk Category 1 institutions beginning in the second quarter of 2009. For Risk Category 1 institutions that have long-term debt issuer ratings, the FDIC determines the initial base assessment rate using a combination of weighted-average CAMELS component ratings, long-term debt issuer ratings (converted to numbers and averaged) and the financial ratios method assessment rate (as defined), each equally weighted. The initial base assessment rates for Risk Category 1 institutions range from 12 to 16 basis points, on an annualized basis. After the effect of potential base-rate adjustments, total base assessment rates range from 7 to 24 basis points. The potential adjustments to a Risk Category 1 institution’s initial base assessment rate include (i) a potential decrease of up to 5 basis points for long-term unsecured debt, including senior and subordinated debt and (ii) a potential increase of up to 8 basis points for secured liabilities in excess of 25% of domestic deposits.

Newly insured institutions are defined as any bank or thrift that has not been chartered for at least five years. Effective January 1, 2010, any new institution in Risk Category I, regardless of whether it has CAMELS component ratings or not, is assessed at the maximum initial base assessment rate applicable to Risk Category I institutions. Beginning with the June 2010 invoice, the maximum initial base assessment rate for a Risk Category I newly insured institution continues until the institution has become an established federal depository institution.

In November 2009, the FDIC issued a rule that required all insured depository institutions, with limited exceptions, to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. The FDIC also adopted a uniform three-basis point increase in assessment rates effective on January 1, 2011. In December 2009, the Bank paid approximately $40,000 in prepaid risk-based assessments which was based on the Bank’s level of deposits in 2009, the year the bank commenced operations. Since the Bank’s deposits grew at a faster pace than the prepayment calculation accounted for, the majority of the prepayment was utilized in 2010. The balance remaining and included in accrued interest receivable and other assets was $0 as of December 31, 2011 and $2,000 as of December 31, 2010 on the accompanying consolidated balance sheets.

In October 2010, the FDIC adopted a new DIF restoration plan to ensure that the fund reserve ratio reaches 1.35% by September 30, 2020, as required by the Dodd-Frank Act. Under the new restoration plan, the FDIC agreed to forego the uniform three-basis point increase in initial assessment rates that were scheduled to take place on January 1, 2011 and maintain the current schedule of assessment rates for all depository institutions. At least semi-annually, the FDIC will update its loss and income projections for the fund and, if needed, will increase or decrease assessment rates, following notice-and-comment rulemaking if required.

In November 2010, the FDIC issued a notice of proposed rulemaking to change the deposit insurance assessment base from total domestic deposits to average total assets minus average tangible equity, as required by the Dodd-Frank Act, effective April 1, 2011. The FDIC also issued a notice of proposed rulemaking to revise the deposit insurance assessment system for large institutions.

In February 2011, the Board of Directors of the Federal Deposit Insurance Corporation (FDIC) approved a final rule on Assessments, Dividends, Assessment Base and Large Bank Pricing. The final rule encompasses the November 2010 change to the assessment base and the October 2010 DIF restoration plan. The rule revises the assessment system applicable to large banks to eliminate reliance on debt issuer ratings and make it more forward looking. Dodd-Frank required that the base on which deposit insurance assessments are charged be revised from one based on domestic deposits to one based on assets.

The new large bank pricing system will result in higher assessment rates for banks with high-risk asset concentrations, less stable balance sheet liquidity, or potentially higher loss severity in the event of failure. Over the long term, large institutions that pose higher risk will pay higher assessments when they assume these risks rather than when conditions deteriorate.

The final rule also revised the assessment rate schedule effective April 1, 2011, and adopts additional rate schedules that will go into effect when the Deposit Insurance Fund (DIF) reserve ratio reaches various milestones. These future rate schedules should accomplish the goals of maintaining a positive fund balance, even during periods of large fund losses, and maintaining steady, predictable assessment rates throughout economic and credit cycles. The changes went into effect beginning with the second quarter of 2011 and were payable at the end of September 2011.

Our FDIC insurance expense totaled $61,000 in 2011 and $50,000 in 2010. FDIC insurance expense includes deposit insurance assessments and Financing Corporation (“FICO”) assessments related to outstanding FICO bonds. The FICO is a mixed-ownership government corporation established by the Competitive Equality Banking Act of 1987 whose sole purpose was to function as a financing vehicle for the now defunct Federal Savings & Loan Insurance Corporation.

Under the FDIA, the FDIC may terminate deposit insurance upon a finding that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC.

De Novo Bank Supervision. In August 2009, the FDIC published guidance that extended supervisory procedures for de novo banks from three years to seven years. Under this guidance, the Bank will be subject to the de novo supervisory procedures until April 2016. The effect of the extension is to lengthen the period of time that the Bank will be subject to increased capital requirements, which require the Bank to maintain a leverage ratio of at least 8.0%; to require prior regulatory approval of any material deviation from the Bank’s business plan until April 2016; and to subject the Bank to more frequent regulatory examinations. In August 2009, when the FDIC published the extended supervisory period for de novo banks, the Bank was operating under a three year business plan approved by the FDIC. The Bank is required to submit a new business plan to cover the period from April 30, 2012, to April, 30, 2016, the end of the Bank’s de novo supervisory period. See “Prompt Corrective Regulatory Action” below for more information.

Temporary Liquidity Guarantee Program. On November 21, 2008, the FDIC adopted final regulations implementing the Temporary Liquidity Guarantee Program (“TLGP”) pursuant to which depository institutions could elect to participate. Coverage under the TLGP was available to any eligible institution that did not elect to opt out of the TLGP on or before December 5, 2008. The Bank was not in existence at this time. However, the Bank did make application to participate in the Transaction Account Guarantee portion of the TLGP. Participating institutions were assessed a 10 basis point surcharge on the portion of eligible accounts that exceeds the general limit on deposit insurance coverage. Pursuant to the TLGP, the FDIC will (i) guarantee, through the earlier of maturity or June 30, 2012, certain newly issued senior unsecured debt issued by participating institutions on or after October 14, 2008 and before June 30, 2009 (the “Debt Guarantee”), and (ii) provide full FDIC deposit insurance coverage for noninterest bearing deposit transaction accounts regardless of dollar amount for an additional fee assessment by the FDIC (the “Transaction Account Guarantee”).

On November 15, 2010, the FDIC published a final rule to provide temporary separate insurance coverage for noninterest-bearing transaction accounts. The November final rule defined noninterest-bearing transaction account as “a deposit or account maintained at an insured depository institution with respect to which interest is neither accrued nor paid. In the November final rule, the FDIC noted that, unlike the definition of noninterest bearing transaction account in the FDIC’s Transaction Account Guarantee Program (“TAGP”), the definition did not include NOW accounts (regardless of the interest rate paid on the account) or IOLTAs (“Interest on Lawyers Trust Account”).

On December 29, 2010, President Obama signed legislation passed by Congress to amend the Federal Deposit Insurance Act. This amendment will provide IOLTAs with the same temporary, unlimited insurance coverage afforded to noninterest-bearing transaction accounts under the Dodd-Frank Act. These amendments take effect December 31, 2010, and require the FDIC to “fully insure the net amount that any depositor at an insured depository institution maintains in a noninterest-bearing transaction account.” This unlimited insurance coverage will be in effect only through December 31, 2012.

Branching. Michigan chartered banks, such as the Bank, have the authority under Michigan law to establish branches throughout Michigan and in any state, the District of Columbia, any U.S. territory or protectorate, and foreign countries, subject to the receipt of all required regulatory approvals.

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 allows the FDIC and other federal bank regulators to approve applications for mergers of banks across state lines without regard to whether such activity is contrary to state law. Previously, each state could determine if it will permit out of state banks to acquire only branches of a bank in that state or to establish de novo branches. However, under the Dodd-Frank Act branching requirements have been relaxed and national and state banks will be able to establish branches in any state if that state would permit the establishment of the branch by a state bank charted in that state.

Loans to One Borrower. Under Michigan law, a bank’s total loans and extensions of credit and leases to one person is limited to 15% of the bank’s capital and surplus, subject to several exceptions. This limit may be increased to 25% of the bank’s capital and surplus upon approval by a 2/3 vote of its Board of Directors. Certain loans, including loans secured by bonds or other instruments of the United States and fully guaranteed by the United States as to principal and interest, are not subject to the limit just referenced. In addition, certain loans, including loans arising from the discount of nonnegotiable consumer paper which carries a full recourse endorsement or unconditional guaranty of the person transferring the paper, are subject to a higher limit of 30% of capital and surplus.

Enforcement. The OFIR and FDIC each have enforcement authority with respect to the Bank. The Commissioner of the OFIR has the authority to issue cease and desist orders to address unsafe and unsound practices and actual or imminent violations of law and to remove from office bank directors and officers who engage in unsafe and unsound banking practices and who violate applicable laws, orders, or rules. The Commissioner of the OFIR also has authority in certain cases to take steps for the appointment of a receiver or conservator of a bank.

The FDIC has similar broad authority, including authority to bring enforcement actions against all “institution-affiliated parties” (including shareholders, directors, officers, employees, attorneys, consultants, appraisers and accountants) who knowingly or recklessly participate in any violation of law or regulation or any breach of fiduciary duty, or other unsafe or unsound practice likely to cause financial loss to, or otherwise have an adverse effect on, an insured institution. Civil penalties under federal law cover a wide range of violations and actions. Criminal penalties for most financial institution crimes include monetary fines and imprisonment. In addition, the FDIC has substantial discretion to impose enforcement action on banks that fail to comply with its regulatory requirements, particularly with respect to capital levels. Possible enforcement actions range from requiring the preparation of a capital plan or imposition of a capital directive, to receivership, conservatorship, or the termination of deposit insurance.

Assessments and Fees. The Bank pays a supervisory fee to the OFIR of not less than $4,000 and not more than 25 cents for each $1,000 of total assets. This fee is invoiced prior to July 1 each year and is due no later than August 15. The OFIR imposes additional fees, in addition to those charged for normal supervision, for applications, special evaluations and analyses, and examinations. The Bank paid a supervisory fee of $11,000 in 2011 and a $7,000 fee for 2010.

Regulatory Capital Requirements. The Bank is required to comply with capital adequacy standards set by the FDIC. The FDIC may establish higher minimum requirements if, for example, a bank has previously received special attention or has a high susceptibility to interest rate risk. Banks with capital ratios below the required minimum are subject to certain administrative actions. More than one capital adequacy standard applies, and all applicable standards must be satisfied for an institution to be considered to be in compliance. There are three basic measures of capital adequacy: a total risk-based capital ratio, a Tier 1 risk-based capital ratio; and a leverage ratio.

The risk-based framework was adopted to assist in the assessment of capital adequacy of financial institutions by, (i) making regulatory capital requirements more sensitive to differences in risk profiles among organizations; (ii) introducing off-balance-sheet items into the assessment of capital adequacy; (iii) reducing the disincentive to holding liquid, low-risk assets; and (iv) achieving greater consistency in evaluation of capital adequacy of major banking organizations throughout the world. The risk-based guidelines include both a definition of capital and a framework for calculating risk-weighted assets by assigning assets and off-balance sheet items to different risk categories. An institution’s risk-based capital ratios are calculated by dividing its qualifying capital by its risk-weighted assets.

Qualifying capital consists of two types of capital components: “core capital elements” (or Tier 1 capital) and “supplementary capital elements” (or Tier 2 capital). Tier 1 capital is generally defined as the sum of core capital elements less goodwill and certain other intangible assets. Core capital elements consist of (i) common shareholders’ equity, (ii) noncumulative perpetual preferred stock (subject to certain limitations), and (iii) minority interests in the equity capital accounts of consolidated subsidiaries. Tier 2 capital consists of (i) allowance for loan and lease losses (subject to certain limitations); (ii) perpetual preferred stock which does not qualify as Tier 1 capital (subject to certain conditions); (iii) hybrid capital instruments and mandatory convertible debt securities; (iv) term subordinated debt and intermediate term preferred stock (subject to limitations); and (v) net unrealized holding gains on equity securities.

The Bank must also meet a leverage capital requirement. In general, the minimum leverage capital requirement is not less than 4% of Tier 1 capital to total assets if a bank has the highest regulatory rating and is not anticipating or experiencing any significant growth. However, as a condition of the Bank’s charter it must maintain a minimum Tier 1 capital to total assets of 8% during its initial three years of operation, which period was subsequently extended to seven years of operation.

The Dodd-Frank Act requires the Federal Reserve, the OCC and the FDIC to adopt regulations imposing a continuing “floor” of the Basel I-based capital requirements in cases where the Basel II-based capital requirements and any changes in capital regulations resulting from Basel III (see below) otherwise would permit lower requirements. In December 2010, the Federal Reserve, the OCC and the FDIC issued a joint notice of proposed rulemaking that would implement this requirement.

In December 2010, the Basel Committee released its final framework for strengthening international capital and liquidity regulation, now officially identified by the Basel Committee as “Basel III”. Basel III, when implemented by the U.S. banking agencies and fully phased-in, will require bank holding companies and their bank subsidiaries to maintain substantially more capital, with a greater emphasis on common equity.

The Basel III final capital framework, among other things, (i) introduces as a new capital measure “Common Equity Tier 1” (“CET1”), (ii) specifies that Tier 1 capital consists of CET1 and “Additional Tier 1 capital” instruments meeting specified requirements, (iii) defines CET1 narrowly by requiring that most adjustments to regulatory capital measures be made to CET1 and not to the other components of capital, and (iv) expands the scope of the adjustments as compared to existing regulations.

When fully phased in on January 1, 2019, Basel III will require banks to maintain (i) as a newly adopted international standard, a minimum ratio of CET1 to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (which is added to the 4.5% CET1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of CET1 to risk-weighted assets of at least 7%), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation), (iii) a minimum ratio of Total (that is, Tier 1 plus Tier 2) capital to risk-weighted assets of at least 8.0%, plus the capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation), and (iv) as a newly adopted international standard, a minimum leverage ratio of 3%, calculated as the ratio of Tier 1 capital to balance sheet exposures plus certain off-balance sheet exposures (computed as the average for each quarter of the month-end ratios for the quarter).

Basel III also provides for a “countercyclical capital buffer,” generally to be imposed when national regulators determine that excess aggregate credit growth becomes associated with a buildup of systemic risk, that would be a CET1 add-on to the capital conservation buffer in the range of 0% to 2.5% when fully implemented (potentially resulting in total buffers of between 2.5% and 5%).

The aforementioned capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of CET1 to risk-weighted assets above the minimum but below the conservation buffer (or below the combined capital conservation buffer and countercyclical capital buffer, when the latter is applied) will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall.

The implementation of the Basel III final framework will commence January 1, 2013. On that date, banking institutions will be required to meet the following minimum capital ratios:  

The Basel III final framework provides for a number of new deductions from and adjustments to CET1. These include, for example, the requirement that mortgage servicing rights, deferred tax assets dependent upon future taxable income and significant investments in non-consolidated financial entities be deducted from CET1 to the extent that any one such category exceeds 10% of CET1 or all such categories in the aggregate exceed 15% of CET1.

Implementation of the deductions and other adjustments to CET1 will begin on January 1, 2014 and will be phased-in over a five-year period (20% per year). The implementation of the capital conservation buffer will begin on January 1, 2016 at 0.625% and be phased in over a four-year period (increasing by that amount on each subsequent January 1, until it reaches 2.5% on January 1, 2019).

Notwithstanding its release of the Basel III framework as a final framework, the Basel Committee is considering further amendments to Basel III, including the imposition of additional capital surcharges on globally systemically important financial institutions. In addition to Basel III, the Dodd-Frank Act requires or permits the Federal banking agencies to adopt regulations affecting banking institutions’ capital requirements in a number of respects, including potentially more stringent capital requirements for systemically important financial institutions. Accordingly, the regulations ultimately applicable to the Company may be substantially different from the Basel III final framework as published in December 2010. Requirements to maintain higher levels of capital or to maintain higher levels of liquid assets could adversely impact the Company’s net income and return on equity.

Prompt Corrective Regulatory Action. The FDIC is required to take certain supervisory actions against undercapitalized institutions, the severity of which depends upon the institution’s degree of undercapitalization. Generally, a bank is considered “well capitalized” if its risk-based capital ratio is at least 10%, its Tier 1 risk-based capital ratio is at least 6%, its leverage ratio is at least 5%, and the bank is not subject to any written agreement, order, or directive by the FDIC.

A bank generally is considered “adequately capitalized” if it does not meet each of the standards for well-capitalized institutions, and its risk-based capital ratio is at least 8%, its Tier 1 risk-based capital ratio is at least 4%, and its leverage ratio is at least 4% (or 3% if the institution receives the highest rating under the Uniform Financial Institution Rating System). A bank that has a risk-based capital ratio less than 8%, or a Tier 1 risk-based capital ratio less than 4%, or a leverage ratio less than 4% (3% or less for institutions with the highest rating under the Uniform Financial Institution Rating System) is considered to be “undercapitalized.” A bank that has a risk-based capital ratio less than 6%, or a Tier 1 capital ratio less than 3%, or a leverage ratio less than 3% is considered to be “significantly undercapitalized,” and a bank is considered “critically undercapitalized” if its ratio of tangible equity to total assets is equal to or less than 2%.

The FDIC generally prohibits a depository institution from making any capital distribution (including payment of a dividend) or paying any management fee to its holding company if the depository institution would thereafter be “undercapitalized.” An “undercapitalized” institution must develop a capital restoration plan and its parent holding company must guarantee that institution’s compliance with such plan. The liability of the parent holding company under any such guarantee is limited to the lesser of five percent of the institution’s assets at the time it became “undercapitalized” or the amount needed to bring the institution into compliance with all capital standards. Furthermore, in the event of the bankruptcy of the parent holding company, such guarantee would take priority over the parent’s general unsecured creditors. If a depository institution fails to submit an acceptable capital restoration plan, it shall be treated as if it is “significantly undercapitalized.” “Significantly undercapitalized” depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become “adequately capitalized,” requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. “Critically undercapitalized” institutions are subject to the appointment of a receiver or conservator. Finally, the FDIC requires the various regulatory agencies to set forth certain standards that do not relate to capital. Such standards relate to the safety and soundness of operations and management and to asset quality and executive compensation, and permit regulatory action against a financial institution that does not meet such standards.

If an insured bank fails to meet its capital guidelines, it may be subject to a variety of other enforcement remedies, including a prohibition on the taking of brokered deposits and the termination of deposit insurance by the FDIC. Bank regulators continue to indicate their desire to raise capital requirements beyond their current levels.

Subject to a narrow exception, the FDIC is required to appoint a receiver or conservator for a bank that is “critically undercapitalized.” In addition, a capital restoration plan must be filed with the FDIC within 45 days of the date a bank receives notice that it is “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized.” Compliance with the plan must be guaranteed by each company that controls a bank that submits such a plan, up to an amount equal to 5% of the bank’s assets at the time it was notified regarding its deficient capital status. In addition, numerous mandatory supervisory actions become immediately applicable to an undercapitalized institution, including, but not limited to, increased monitoring by regulators and restrictions on growth, capital distributions, and expansion. The FDIC could also take any one of a number of discretionary supervisory actions, including the issuance of a capital directive and the replacement of senior executive officers and directors.

Payment of Dividends by the Bank. There are state and federal requirements limiting the amount of dividends which the Bank may pay. Generally, a bank’s payment of cash dividends must be consistent with its capital needs, asset quality, and overall financial condition. Due to FDIC requirements, it is expected that the Bank will not be permitted to make dividend payments to the Company during the first three (3) years of the Bank’s operations. Additionally, OFIR and the FDIC have the authority to prohibit the Bank from engaging in any business practice (including the payment of dividends) which they consider to be unsafe or unsound.

Under Michigan law, the payment of dividends is subject to several additional restrictions. The Bank cannot declare or pay a cash dividend or dividend in kind unless the Bank will have a surplus amounting to not less than 20% of its capital after payment of the dividend. The Bank will be required to transfer 10% of net income to surplus until its surplus is equal to its capital before the declaration of any cash dividend or dividend in kind. In addition, the Bank may pay dividends only out of net income then on hand, after deducting its losses and bad debts. These limitations can affect the Bank’s ability to pay dividends.

Loans to Directors, Executive Officers, and Principal Shareholders. Under FDIC regulations, the Bank’s authority to extend credit to executive officers, directors, and principal shareholders is subject to substantially the same restrictions set forth in Federal Reserve Regulation O. Among other things, Regulation O (i) requires that any such loans be made on terms substantially similar to those offered to nonaffiliated individuals, (ii) places limits on the amount of loans the Bank may make to such persons based, in part, on the Bank’s capital position, and (iii) requires that certain approval procedures be followed in connection with such loans.

Certain Transactions with Related Parties. Under Michigan law, the Bank may purchase securities or other property from a director, or from an entity of which the director is an officer, manager, director, owner, employee, or agent, only if such purchase (i) is made in the ordinary course of business, (ii) is on terms not less favorable to the Bank than terms offered by others, and (iii) the purchase is authorized by a majority of the Board of Directors not interested in the sale. The Bank may also sell securities or other property to its directors, subject to the same restrictions (except in the case of a sale by the Bank, the terms may not be more favorable to the director than those offered to others).

In addition, the Bank is subject to certain restrictions imposed by federal law on extensions of credit to the Company, on investments in the stock or other securities of the Company, and on the acceptance of stock or other securities of the Company as collateral for loans. Various transactions, including contracts, between the Bank and the Company must be on substantially the same terms as would be available to unrelated parties.

Standards for Safety and Soundness. The FDIC has established safety and soundness standards applicable to the Bank regarding such matters as internal controls, loan documentation, credit underwriting, interest-rate risk exposure, asset growth, compensation and other benefits, and asset quality and earnings. If the Bank were to fail to meet these standards, the FDIC could require it to submit a written compliance plan describing the steps the Bank will take to correct the situation and the time within which such steps will be taken. The FDIC has authority to issue orders to secure adherence to the safety and soundness standards.

Reserve Requirement. Under a regulation promulgated by the Federal Reserve, depository institutions, including the Bank, are required to maintain cash reserves against a stated percentage of their transaction accounts. Effective October 9, 2008, Federal Reserve Banks are now authorized to pay interest on such reserves. The current reserve requirements are as follows:

The dollar amounts and percentages reported here are all subject to adjustment by the Federal Reserve. As of December 31, 2011, the Bank had no reserve requirement.

Privacy. Financial institutions are required to disclose their policies for collecting and protecting confidential information. Customers generally may prevent financial institutions from sharing personal financial information with nonaffiliated third parties except for third parties that market the institutions’ own products and services. Additionally, financial institutions generally may not disclose consumer account numbers to any nonaffiliated third party for use in telemarketing, direct mail marketing or other marketing through electronic mail to consumers.

Anti-terrorism Legislation. In the wake of the tragic events of September 11, 2001, President Bush signed into law on October 26, 2001, the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001. Also known as the “Patriot Act,” the law enhances the powers of the federal government and law enforcement organizations to combat terrorism, organized crime and money laundering. The Patriot Act significantly amends and expands the application of the Bank Secrecy Act, including enhanced measures regarding customer identity, new suspicious activity reporting rules and enhanced anti-money laundering programs.

Under the Patriot Act, financial institutions are subject to prohibitions against specified financial transactions and account relationships as well as enhanced due diligence and “know your customer” standards in their dealings with foreign financial institutions and foreign customers. For example, the enhanced due diligence policies, procedures and controls generally require financial institutions to take reasonable steps:

Under the Patriot Act, financial institutions must also establish anti-money laundering programs. The Patriot Act sets forth minimum standards for these programs, including: (i) the development of internal policies, procedures and controls; (ii) the designation of a compliance officer; (iii) an ongoing employee training program; and (iv) an independent audit function to test the programs.

In addition, the Patriot Act requires the bank regulatory agencies to consider the record of a bank in combating money laundering activities in their evaluation of bank merger or acquisition transactions. Regulations proposed by the U.S. Department of the Treasury to effectuate certain provisions of the Patriot Act provide that all transaction or other correspondent accounts held by a U.S. financial institution on behalf of any foreign bank must be closed within 90 days after the final regulations are issued, unless the foreign bank has provided the U.S. financial institution with a means of verification that the institution is not a “shell bank.” Proposed regulations interpreting other provisions of the Patriot Act are continuing to be issued.

Under the authority of the Patriot Act, the Secretary of the Treasury adopted rules on September 26, 2002 increasing the cooperation and information sharing among financial institutions, regulators and law enforcement authorities regarding individuals, entities and organizations engaged in, or reasonably suspected based on credible evidence of engaging in, terrorist acts or money laundering activities. Under these rules, a financial institution is required to:

Under the new rules, a financial institution may also share information regarding individuals, entities, organizations and countries for purposes of identifying and, where appropriate, reporting activities that it suspects may involve possible terrorist activity or money laundering. Such information-sharing is protected under a safe harbor if the financial institution: (i) notifies FinCEN of its intention to share information, even when sharing with an affiliated financial institution; (ii) takes reasonable steps to verify that, prior to sharing, the financial institution or association of financial institutions with which it intends to share information has submitted a notice to FinCEN; (iii) limits the use of shared information to identifying and reporting on money laundering or terrorist activities, determining whether to establish or maintain an account or engage in a transaction, or assisting it in complying with the Security Act; and (iv) maintains adequate procedures to protect the security and confidentiality of the information. Any financial institution complying with these rules will not be deemed to have violated the privacy requirements discussed above.

The Secretary of the Treasury also adopted a rule on September 26, 2002 intended to prevent money laundering and terrorist financing through correspondent accounts maintained by U.S. financial institutions on behalf of foreign banks. Under the rule, financial institutions: (i) are prohibited from providing correspondent accounts to foreign shell banks; (ii) are required to obtain a certification from foreign banks for which they maintain a correspondent account stating the foreign bank is not a shell bank and that it will not permit a foreign shell bank to have access to the U.S. account; (iii) must maintain records identifying the owner of the foreign bank for which they may maintain a correspondent account and its agent in the United States designated to accept services of legal process; (iv) must terminate correspondent accounts of foreign banks that fail to comply with or fail to contest a lawful request of the Secretary of the Treasury or the Attorney General of the United States, after being notified by the Secretary or Attorney General.

Proposed Legislation and Regulatory Action. New regulations and statutes are regularly proposed that contain wide-ranging proposals for altering the structures, regulations and competitive relationships of financial institutions operating in the United States. We cannot predict whether or in what form any proposed regulation or statute will be adopted or the extent to which our business may be affected by any new regulation or statute.

Concentrated Commercial Real Estate Lending Regulations. The Federal Reserve, the FDIC and the OCC promulgated guidance governing financial institutions with concentrations in commercial real estate lending. The guidance provides that a bank has a concentration in commercial real estate lending if (i) total reported loans for construction, land development, and other land represent 100% or more of total capital or (ii) total reported loans secured by multifamily and non-farm residential properties and loans for construction, land development, and other land represent 300% or more of total capital and the Bank’s commercial real estate loan portfolio has increased 50% or more during the prior 36 months. If a concentration is present, management must employ heightened risk management practices including board and management oversight and strategic planning, development of underwriting standards, risk assessment and monitoring through market analysis and stress testing, and increasing capital requirements. We cannot guarantee that any risk management practices we implement will be effective to prevent losses relating to our commercial real estate portfolio. Management will continue to undertake controls to monitor the Bank’s commercial real estate lending, but we cannot predict the extent to which this guidance will continue to impact our operations or capital requirements.

Regulation Z. On April 5, 2011, the Federal Reserve’s Final Rule on Loan Originator Compensation and Steering (Regulation Z) became final. Regulation Z is more commonly known as regulation that implements the Truth in Lending Act. Regulation Z address two components of mortgage lending, i.e., loans secured by a dwelling, and implements restrictions and guidelines for: (a) prohibited payments to loan originators and (b) prohibitions on steering. Under Regulation Z, a creditor is prohibited from paying, directly or indirectly, compensation to a mortgage broker or any other loan originator that is based on a mortgage transaction's terms or conditions, except the amount of credit extended, which is deemed not to be a transaction term or condition. In addition, Regulation Z prohibits a loan originator from “steering” a consumer to a lender or a loan that offers less favorable terms in order to increase the loan originator’s compensation, unless the loan is in the consumer's interest. Regulation Z also contains a record-retention provision requiring that, for each transaction subject to Regulation Z, the financial institution must maintain records of the compensation it provided to the loan originator for that transaction as well as the compensation agreement in effect on the date the interest rate was set for the transaction. These records must be maintained for two years.

UDAP and UDAAP. Recently, banking regulatory agencies have increasingly used a general consumer protection statute to address “unethical” or otherwise “bad” business practices that may not necessarily fall directly under the purview of a specific banking or consumer finance law. The law of choice for enforcement against such business practices has been Section 5 of the Federal Trade Commission Act—the primary federal law that prohibits unfair or deceptive acts or practices and unfair methods of competition in or affecting commerce (“UDAP” or “FTC Act”). “Unjustified consumer injury” is the principal focus of the FTC Act. Prior to the Dodd-Frank Act, there was little formal guidance to provide insight to the parameters for compliance with the UDAP law. However, the UDAP provisions have been expanded under the Dodd-Frank Act to apply to “unfair, deceptive or abusive acts or practices” (“UDAAP”), which has been delegated to the CFPB for supervision. The CFPB has published its first Supervision and Examination Manual that addresses compliance with and the examination of UDAAP.

Effect of Governmental Monetary Policies. The commercial banking business is affected not only by general economic conditions but also by the fiscal and monetary policies of the Federal Reserve. Some of the instruments of fiscal and monetary policy available to the Federal Reserve include changes in the discount rate on member bank borrowings, the fluctuating availability of borrowings at the “discount window,” open market operations, the imposition of and changes in reserve requirements against banks’ deposits and assets of foreign branches, the imposition of and changes in reserve requirements against certain borrowings by banks and their affiliates, and the placing of limits on interest rates that banks may pay on time and savings deposits. Such policies influence to a significant extent the overall growth of bank loans, investments, and deposits and the interest rates charged on loans or paid on time and savings deposits. We cannot predict the nature of future fiscal and monetary policies and the effect of such policies on the future business and our earnings.

All of the above laws and regulations add significantly to the cost of operating Grand River Commerce, Inc. and Grand River Bank and thus have a negative impact on our profitability. We would also note that there has been a tremendous expansion experienced in recent years by certain financial service providers that are not subject to the same rules and regulations as Grand River Commerce and Grand River Bank. These institutions, because they are not so highly regulated, have a competitive advantage over us and may continue to draw large amounts of funds away from traditional banking institutions, with a continuing adverse effect on the banking industry in general.

Available Information

We file annual, quarterly and currents reports and other information with the Securities and Exchange Commission. You may read and copy any document we file at the Securities and Exchange Commission’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. Please call the Securities and Exchange Commission at 1-800-SEC-0330 for further information on the public reference room. Our SEC filings are also available to the public at the Securities and Exchange Commission’s web site at http://www.sec.gov. Our web site is http://www.grandriverbank.com. Except as explicitly provided, information on any web site is not incorporated into this Form 10-K or our other securities filings and is not a part of them.

Not applicable.

None.

The Bank opened for business on April 30, 2009 with one location at 4471 Wilson Avenue, Grandville, Michigan, which is located approximately five miles southwest of the Grand Rapids city limit and eight miles from downtown Grand Rapids, Michigan. On December 10, 2010, we renewed our three year lease agreement, commencing on January 1, 2011, with three options to renew for three years each. On October 24, 2011, we entered into an agreement to lease additional space in the same building commencing on November 1, 2011 to run concurrent with the existing lease agreement. The rent under the terms of the lease is $6,100 per month, subject to a 2% cumulative upward adjustment in each subsequent year. At this time, the Bank does not intend to own any of the properties from which it will conduct banking operations. The Bank does not own or operate any ATM machines.

In the ordinary course of operations, we may be a party to various legal proceedings from time to time. We do not believe that there is any pending or threatened proceeding against us, which, if determined adversely, would have a material effect on our business, results of operations, or financial condition.

Not applicable.

Part II

Market Information

We are currently quoted on the OTC Bulletin Board under the symbol “GNRV” and have a sponsoring broker-dealer to match buy and sell orders for our common stock. Although we are quoted on the OTC Bulletin Board, the trading market of our common stock on the OTC Bulletin Board is limited and lacks the depth, liquidity, and orderliness necessary to maintain a liquid market. There is currently no established public trading market in our common stock. Because there has not been an established market for our common stock, we may not be aware of all prices at which our common stock has been traded. Based on information available to us from a limited number of sellers and purchasers of our common stock who have engaged in privately negotiated transactions of which we are aware, there were a limited number of stock trades in 2011 that ranged from $8.00 to $9.50 per share. We have no current plans to seek listing on any stock exchange, and we do not expect to qualify for listing on NASDAQ or any other exchange in the near future.

The following table sets forth the high and low bid prices as quoted on the OTC Bulletin Board during the periods indicated. The quotations reflect inter-dealer prices, without retail mark-up, mark-down, or commissions, and may not represent actual transactions.

Common Stock

As of December 31, 2011, and 2010, 1,700,120 shares of common stock of the Company were issued and outstanding, and there were approximately 786 shareholders of record. All of our outstanding common stock was issued in connection with our initial public offering, which was completed on April 30, 2009. The price per share in our initial public offering was $10.00.

Dividends

We have not declared or paid any cash dividends on our common stock since our inception. For the foreseeable future we do not intend to declare cash dividends. We intend to retain earnings to grow our business and strengthen our capital base. Our ability to pay dividends depends on the ability of our subsidiary, the Bank, to pay dividends to us. Initially, the Company expects that the Bank will retain all of its earnings to support its operations and to expand its business. Additionally, the Company and the Bank are subject to significant regulatory restrictions on the payment of cash dividends. In light of these restrictions and the need to retain and build capital, neither the Company nor the Bank plans to pay dividends until the Bank becomes profitable and recovers any losses incurred during its initial operations. The payment of future dividends and the dividend policies of the Company and the Bank will depend on the earnings, capital requirements and financial condition of the Company and the Bank, as well as other factors that its respective Boards of Directors consider relevant. For additional discussion of legal and regulatory restrictions on the payment of dividends, see “Part I – Item 1. Business – Supervision and Regulation.”

Securities Authorized For Issuance Under Equity Compensation Plans

The Company has adopted a stock incentive plan which provides for the issuance of options to purchase shares of our common stock to officers and directors, the details of which are outlined in Note 8 and Note 9 of the Consolidated Financial Statements. Approval of this plan was granted at the Company’s 2010 Annual Meeting of Shareholders.

The following table identifies our equity compensation plans as of December 31, 2011.

Recent Sales of Unregistered Securities.

None.

Not applicable.

The purpose of the following discussion is to address information relating to the financial condition and results of operations of the Company that may not be readily apparent from the consolidated financial statements and accompanying notes included in this Report. This discussion should be read in conjunction with the information provided in the Company’s consolidated financial statements and the notes thereto.

Introduction

The following discussion describes our results of operations for 2011 and also analyzes our financial condition as of December 31, 2011. Like most community banks, we derive most of our income from interest we receive on our loans and investments. Our primary source of funds for making these loans and investments is our deposits, on which the majority of we pay interest. Consequently, one of the key measures of our success is our amount of net interest income, or the difference between the income on our interest-earning assets, such as loans and investments, and the expense on our interest-bearing liabilities, such as deposits. Another key measure is the spread between the yield we earn on these interest-earning assets and the rate we pay on our interest-bearing liabilities.

We have included a number of tables to assist in our description of these measures. For example, the “Average Balances” table shows the average balance in 2011 of each category of our assets and liabilities, as well as the yield we earned or the rate we paid with respect to each category. A review of this table shows that our loans typically provide higher interest yields than do other types of interest earning assets, which is why we intend to channel a substantial percentage of our earning assets into our loan portfolio. We also track the sensitivity of our various categories of assets and liabilities to changes in interest rates, and we have included an “Interest Sensitivity Analysis Table” to help explain this. Finally, we have included a number of tables that provide detail about our investment securities, our loans and our deposits.

Naturally, there are risks inherent in all loans, so we maintain an allowance for loan losses to absorb probable losses on existing loans that may become uncollectible. We establish and maintain this allowance by charging a provision for loan losses against our operating earnings. In the “Provision and Allowance for Loan Losses” section, we have included a detailed discussion of this process.

In addition to earning interest on our loans and investments, we earn income through fees and other expenses we charge to our customers. We describe the various components of this noninterest income, as well as our noninterest expenses, in the “Noninterest Income” and “Noninterest Expense” sections.

Basis of Presentation

The following discussion should be read in conjunction with our consolidated financial statements and the related notes and the other information included elsewhere in this report. The financial information provided below has been rounded in order to simplify its presentation. However, the ratios and percentages provided below are calculated using the detailed financial information contained in the consolidated financial statements and the related notes included elsewhere in this report.

General

Grand River Commerce, Inc. is a bank holding company headquartered in Grandville, Michigan. Our bank subsidiary, Grand River Bank, opened for business on April 30, 2009. In addition, the Bank formed in January 2012 a wholly owned subsidiary, GRO Properties, LLC to hold properties acquired by the Bank through foreclosure. The principal business activity of the Bank is to provide commercial banking services in Kent and Ottawa Counties, Michigan and our surrounding market areas. Our deposits are insured by the FDIC.

Until the Bank opened, our principal activities related to the organization of the Company and the Bank, the conducting of our initial public offering, the pursuit of approvals from the Michigan Office of the Financial and Insurance Regulation (“OFIR”) for our application to charter the Bank, the pursuit of approvals from the FDIC for our application for insurance of the deposits of the Bank, and the pursuit of approvals from the Federal Reserve to become a bank holding company. The organizational costs incurred during the period from our inception on August 15, 2006 through April 30, 2009, related primarily to consulting fees paid to proposed management, occupancy and interest expenses which totaled $1.8 million. We completed the initial public offering of our common stock on April 30, 2009 in which we sold a total of 1,700,120 shares of common stock at $10.00 per share. Offering costs of $1.6 million, which consisted primarily of legal, marketing and consulting fees, were netted against proceeds. We capitalized the Bank with $12,690,000 of the proceeds from the initial stock offering.

Subsequent Events

Effective February 1, 2012, Patrick K. Gill became the new President and Chief Executive Officer of the Bank, following David Blossey’s departure. Mr. Gill, age 60, has over 30 years of experience in the banking industry. He previously served as the President and Chief Executive Officer of OAK Financial and its subsidiary, Byron Bank, until it was acquired by Chemical Bank in 2010. Before joining OAK Financial, Mr. Gill was President and Chief Executive Officer of Pavilion Bancorp, Inc. and its subsidiary, the Bank of Lenawee (now First Federal Bank of the Midwest), headquartered in Adrian, Michigan. Mr. Gill also served as Chairman of the Bank of Washtenaw, an Ann Arbor, Michigan-based de novo formed by Pavilion.

Mr. Gill’s employment agreement with the Bank is for a thirty-six (36) month term. During this term, Mr. Gill is entitled to an initial base salary of $200,000 per year. Mr. Gill is also entitled to participate in a management bonus program (currently there are none), our benefits programs, and receive certain other perquisites and reimbursements. In addition, Mr. Gill was awarded options to purchase 25,000 shares of the Company’s common stock at a price of $10.00 per share.

Summary of Significant Accounting Policies

Our consolidated financial statements are prepared based on the application of certain accounting policies. Certain of these policies require numerous estimates and strategic or economic assumptions, which are subject to valuation, may prove inaccurate and may significantly affect our reported results and financial position for the period or in future periods. The use of estimates, assumptions, and judgments are necessary when financial assets and liabilities are required to be recorded at, or adjusted to reflect, fair value. Assets carried at fair value inherently result in more financial statement volatility. Fair values and information used to record valuation adjustments for certain assets and liabilities are based on either quoted market prices or are provided by other independent third-party sources, when available. When such information is not available, management estimates valuation adjustments. Changes in underlying factors, assumptions, or estimates in any of these areas could have a material impact on our future financial condition and results of operations.

Following is a summary of the significant accounting policies of material estimates of the Company and the Bank.

Allowance for Loan Losses. Currently, the Bank is required by its banking charter to maintain an allowance for loan losses at least equal to 1.00% of the outstanding loan balance. The allowance for loan losses is established to provide for inherent losses which are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectability of the loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in addition to the minimum amount required under regulatory guidelines, the nature and volume of the loan portfolio and the historical losses of peer group institutions, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reason for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and industrial and commercial real estate loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price if obtainable, or the fair value of the collateral if the loan is collateral dependent.

Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment disclosures.

At December 31, 2011, the Company considers the allowance for loan losses of $769,000 or 1.13% of the outstanding loan balance, to be adequate to cover potential losses inherent in the loan portfolio. Our evaluation considers such factors as changes in the composition and volume of the loan portfolio, the impact of changing economic conditions on the credit worthiness of our borrowers, changing collateral values and the overall quality of the loan portfolio.

Income Taxes. We use assumptions and estimates in determining income taxes payable or refundable for the current year, deferred income tax liabilities and assets for events recognized differently in its consolidated financial statements and income tax returns, and income tax expense. Determining these amounts requires analysis of certain transactions and interpretation of tax laws and regulations. Management exercises judgment in evaluating the amount and timing of recognition of resulting tax liabilities and assets. These judgments and estimates are re-evaluated on a continual basis as regulatory and business factors change. A valuation allowance for deferred tax assets is required when it is more likely than not that some portion or all of the deferred tax asset will not be realized. In assessing the realization of the deferred tax assets, management considers the scheduled reversals of deferred tax liabilities, projected future income (in the near-term based on current projections), and tax planning strategies.

The tax returns submitted by us or the income tax reported on the consolidated financial statements may be adjusted by either adverse rulings by the United States Tax Court, changes in the tax code, or assessments made by the Internal Revenue Service. We are subject to potential adverse adjustments, including, but not limited to, an increase in the statutory federal or state income tax rates, the permanent non-deductibility of amounts currently considered deductible either now or in future periods, and the dependency on the generation of future taxable income in order to ultimately realize deferred income tax assets. The Company recognizes interest and/or penalties related to income tax matters in income tax expense. The Company did not have any amounts accrued for interest or penalties at either December 31, 2011 or December 31, 2010.

Share-Based Compensation. The Company recognizes the cost of employee services received in exchange for awards of equity instruments based on the grant-date fair value of those awards. The Company estimates the per share fair value of option grants on the date of grant using the Black-Scholes option pricing model using assumptions for the expected dividend yield, expected stock price volatility, risk-free interest rate and expected option term. These assumptions are subjective in nature, involve uncertainties and, therefore, cannot be determined with precision. The Black-Scholes option pricing model also contains certain inherent limitations when applied to options that are not traded on public markets. The per share fair value of options is highly sensitive to changes in assumptions. In general, the per share fair value of options will move in the same direction as changes in the expected stock price volatility, risk-free interest rate and expected option term, and in the opposite direction as changes in the expected dividend yield. For example, the per share fair value of options will generally increase as expected stock price volatility increases, risk-free interest rate increases, expected option term increases and expected dividend yield decreases. The use of different assumptions or different option pricing models could result in materially different per share fair values of options.

Financial Condition at December 31, 2011

Total Assets

At December 31, 2011, we had total assets of $79.6 million, an increase of $27.8 million, or 54% from $51.8 million at December 31, 2010. The increase is due primarily to a $24.4 million increase in loans, net of allowance for loan losses, since December 31, 2010. Other increases in assets include cash and equivalents of $2.4 million and securities available-for-sale of $870,000 from December 31, 2010. Total assets as of December 31, 2011, consisted of cash and deposits due from banks of $6.1 million, federal funds sold of $841,000, securities available-for-sale of $4.7 million, premises and equipment of $241,000, net loans of $67.4 million, restricted stock of $81,000 and accrued interest receivable and other assets of $286,000. Assets were funded primarily through deposits of $69.0 million, and shareholders’ equity of $10.4 million. Asset growth is expected to continue as the Bank continues to deploy its capital into interest earning assets. However, the rate of growth will decrease as the base level of assets increases.

Loans

Net loans were $67.4 million at December 31, 2011 compared to $43.0 million as of December 31, 2010, excluding loans held for sale. Since loans typically provide higher interest yields than other types of interest-earning assets, a large percentage of our earning assets are invested in our loan portfolio. Average loans outstanding for the year ended December 31, 2011 were $52.6 million compared to $28.6 million for the year ended December 31, 2010. Before the allowance for loan losses and unearned fees, gross loans excluding mortgage loans held for sale outstanding at December 31, 2011, were $68.2 million, representing 86% of our total assets.

At December 31, 2011, our loan portfolio consisted of $3.4 million of construction and land development loans, $55.9 million in commercial real estate loans, $6.1 million in commercial and industrial loans, and $2.8 million in mortgage and consumer loans compared to December 31, 2010, when our loan portfolio consisted of $6.0 million of construction and land development loans, $31.9 million in commercial real estate loans, $4.7 million in commercial and industrial loans, and $854,000 in mortgage and consumer loans. The volume of construction loans will fluctuate as loans complete the construction phase and move into permanent financing. Management expects loans to continue to grow as capital is deployed and excess cash is invested in higher yielding assets per the business plan.

As of December 31, 2011, the Company has unfunded loan commitments totaling approximately $12.4 million compared to $8.6 million as of December 31, 2010. The increase is due to overall growth in loan activity. While the Company has no guarantee these commitments will actually be funded, management has no reason to believe a significant portion of these commitments will not become assets of the Company.

The allowance for loan losses was $769,000 and $458,000 as of December 31, 2011 and 2010, respectively. As of December 31, 2011 the Company had $690,000 in nonaccrual loans representing one loan relationship. As of December 31, 2010, the Company had no nonaccrual or non-performing loans or loans considered to be impaired. The allowance for loan losses as a percent of total loans was approximately 1.13% at December 31, 2011. The allowance for loan losses as a percent of total loans was approximately 1.05% at December 31, 2010.

Future increases in the allowance for loan losses may be necessary based on the growth of the loan portfolio, the change in composition of the loan portfolio, possible future increases in non-performing loans and charge-offs, and the impact of the deterioration of the real estate and economic environments in our lending area. Although the Company uses the best information available, the level of allowance for loan losses remains an estimate that is subject to significant judgment and short-term change.

The principal component of our loan portfolio is loans secured by real estate mortgages. Most of our real estate loans are secured by commercial property. We originate traditional long term residential mortgages, traditional second mortgage residential real estate loans and home equity lines of credit as well. We obtain a security interest in real estate whenever possible, in addition to any other available collateral. This collateral is taken to increase the likelihood of the ultimate repayment of the loan.

The following table summarizes the composition of the outstanding balances of our loan portfolio, as of December 31 (Dollars in thousands):

The majority of the Bank’s loan portfolio is comprised of commercial real estate and commercial and industrial loans. Commercial real estate loans represented 86.7% and 84.4% of total loans at December 31, 2011 and 2010, respectively while commercial and industrial loans represent 9.0% and 10.9% of total loans at December 31, 2011 and 2010, respectively.

As of December 31, 2011 and 2010, loans secured by real estate constituted 91% and 89%, respectively, of the total loan portfolio. While this exceeds the 10% threshold for determining a concentration of credit risk within an industry, we do not consider this to be a concentration with adverse risk characteristics given the diversity of borrowers within the real estate portfolio and other sources of repayment. An industry for this purpose is defined as a group of counterparties that are engaged in similar activities and have similar economic characteristics that would cause their ability to meet contractual obligations to be similarly affected by changes in economic or other conditions. The loan portfolio does not include concentrations of credit risk in loan products that permit the deferral of principal payments or payments that are smaller than normal interest accruals (negative amortization); loans with high loan-to-value ratios; and loans, such as option adjustable-rate mortgages, that may expose the borrower to future increases in repayments that are in excess of increases that would result solely from increases in market interest rates.

During 2011, the balance of loans in the construction and land development and commercial real estate categories has decreased somewhat due to decreased activity. The Bank limits construction loans for non-owner occupied real estate and loans of a speculative nature in its loan policy as these types of loans are considered higher risk.

Under guidance by the federal banking regulators, banks which have concentrations in construction, land development or commercial real estate loans (other than loans for majority owner occupied properties) would be expected to maintain higher levels of risk management and, potentially, higher levels of capital. The banking regulators have established guidance limits of 100% and 300% of total risk-weighted capital for construction and land development, and non-owner occupied commercial real estate loans, respectively. It is possible that we may be required to maintain higher levels of capital than we would otherwise be expected to maintain as a result of our levels of construction, development and commercial real estate loans, which may require us to obtain additional capital. These ratios as of December 31, 2011 were 32% for construction and land development loans and 377% for non-owner occupied commercial real estate loans.

The Company monitors the level of construction and land development, and non-owner occupied commercial real estate loans in relation to its total risk-weighted capital on at least a quarterly basis and has implemented enhanced monitoring and due diligence as required by the regulatory guidance. This monitoring and reporting includes detailed analysis of commercial real estate market trends, stress testing the commercial real estate portfolio and establishment of a contingency plan to reduce concentrations if conditions should deteriorate. Due to the time at which the Bank opened, management believes the risks normally associated with this type of lending have been reduced due to real estate values being at historic lows combined with conservative underwriting standards. At present, our loan policy has a maximum limit for loans secured by construction and land development loans of 100% of total risk-weighted capital and for loans secured by non-owner occupied commercial real estate of 500% of total risk-weighted capital.

See Note 3 to the 2011 consolidated financial statements (the "consolidated financial statements") for additional disclosures related to loan approval and underwriting standards.

Loan Origination/Risk Management. The Bank has certain lending policies and procedures in place that are designed to maximize loan income within an acceptable level of risk. Management reviews and approves these policies and procedures on a regular basis. A reporting system supplements the review process by providing management with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies and non-performing and potential problem loans. Diversification in the loan portfolio is a means of managing risk associated with fluctuations in economic conditions. See the accompanying notes to consolidated financial statements included elsewhere in this report for further details of the Bank’s policies and procedures related to loan origination and risk management.

Commercial Real Estate Loans. Commercial real estate loans totaled $59.1 million at December 31, 2011, increasing $22.4 million, or 60.1%, compared to $36.7 million at December 31, 2010. The majority of this portfolio consists of commercial real estate mortgages, which includes both permanent and intermediate term loans. The Bank’s primary focus for the commercial real estate portfolio has been growth in loans secured by both owner and nonowner occupied properties. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Consequently, these loans must undergo the analysis and underwriting process of a commercial and industrial loan, as well as that of a real estate loan.

The Company has a concentration of loans secured by commercial real estate. The following tables summarize the Company’s commercial real estate loan portfolio, as segregated by the type of property securing the credit. Property type concentrations are stated as a percentage of year-end total commercial real estate loans as of December 31, 2011 and 2010:  

Commercial and Industrial Loans. Commercial and industrial loans increased $1.4 million, or 30.4%, from $4.7 million at December 31, 2010 to $6.2 million at December 31, 2011. The Company’s commercial and industrial loans are a diverse group of loans to small and medium-sized businesses. The purpose of these loans varies from supporting seasonal working capital needs to term financing of equipment. The majority of these loans are secured by the assets being financed with collateral margins that are consistent with the Company’s loan policy guidelines.

Maturities and Sensitivity of Loans to Changes in Interest Rates

The information in the following table is based on the contractual maturities of individual loans, including loans which may be subject to renewal at their contractual maturity. Renewal of such loans is subject to review and credit approval, as well as modification of terms upon maturity. Actual repayments of loans may differ from the maturities reflected below because borrowers have the right to prepay obligations with or without prepayment penalties.

The following table summarizes the loan maturity distribution by type and related interest rate characteristics at December 31, 2011 (dollars in thousands):

Loans maturing- after one year with: 

Provision and Allowance for Loan Losses

We have established an allowance for loan losses through a provision for loan losses charged to expense in our 2011 and 2010 consolidated statements of operations. The allowance for loan losses was $769,000 and $458,000 as of December 31, 2011 and 2010, respectively. The increase is due primarily to growth in the loan portfolio as the allowance for loan losses is based on outstanding loans. The allowance for loan losses represents an amount which we believe will be adequate to absorb probable losses on existing loans that may become uncollectable. Our judgment as to the adequacy of the allowance for loan losses is based on a number of assumptions regarding the current portfolio and economic conditions, which we believe to be reasonable, but which may or may not prove to be accurate. Over time, we will periodically determine the amount of the allowance based on our consideration of several factors, including an ongoing review of the quality, mix and size of our overall loan portfolio, our historical loan loss experience, evaluation of economic conditions and other qualitative factors, specific problem loans and commitments that may affect the borrower’s ability to pay. Periodically, we will adjust the amount of the allowance based on changing circumstances. We will charge recognized losses to the allowance and add subsequent recoveries back to the allowance for loan losses. Charge-offs of loans in future periods may exceed the allowance for loan losses as estimated at any point in time and provisions for loan losses may not be significant to a particular reporting period.

Management maintains the allowance at a level at which it believes adequately provides for losses inherent in the loan portfolio. Management focuses on early identification of problem credits through ongoing reviews by management and the independent loan review function. In order to better identify the risk in total commercial loans, management has created separate loan categories for various classifications of commercial real estate loans and commercial and industrial loans to more closely monitor factors that could affect these portfolios including economic factors, competition and the regulatory environment. Based on the current state of the economy and a recent review of the loan portfolio, management believes that the allowance for loan losses as of December 31, 2011 is adequate. As charge-offs, changes in the level of nonperforming loans, and changes within the composition of the loan portfolio occur, the provision and allowance for loan losses will be reviewed by the Bank's management and adjusted as necessary.

Nonperforming Assets

The Bank has not charged off any loans since commencing operations. There were $690,000 in nonaccrual or nonperforming loans at December 31, 2011, resulting from one loan relationship, and no accruing loans which were contractually past due 90 days or more as to principal or interest payments. Generally, a loan will be placed on nonaccrual status when it becomes 90 days past due as to principal or interest, or when management believes, after considering economic and business conditions and collection efforts, that the borrower’s financial condition is such that collection of the loan is doubtful. Payments on loans classified as nonaccrual are applied first to principal until such time as all principal is satisfied. A payment of interest on a loan that is classified as nonaccrual will be recognized as income when received. There were no nonperforming assets at December 31, 2010.

Subsequent to December 31, 2011, the Bank commenced foreclosure proceedings against the borrower of the $690,000 nonaccrual loans.

Investments

At December 31, 2011, the $4.7 million in our investment securities portfolio represented approximately 6.0% of our total assets. We held U.S. Government agency securities, mortgage-backed securities, and restricted equity securities. We have invested in agency bonds for purposes of liquidity management and to take advantage of somewhat higher yields.

The restricted equity securities are comprised of stock in the Federal Home Loan Bank of Indianapolis. As a condition of its membership in the Federal Home Loan Bank of Indianapolis, the Bank is required to hold stock equivalent to a percentage of its assets plus a percentage of outstanding advances.

Contractual maturities and yields on our investment securities available-for-sale are shown in the following table at fair value. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.

The following table sets forth our interest rate sensitivity at December 31, 2011 (dollars in thousands):

The following table sets forth our interest rate sensitivity at December 31, 2010 (dollars in thousands):

The following table sets forth our interest rate sensitivity at December 31, 2009 (dollars in thousands):

Other investments consisted of Federal Home Loan Bank stock with a cost of $80,500 and $33,400 at December 31, 2011 and 2010, respectively.

The amortized costs and the fair value of our investments are shown in the following table (dollars in thousands):

Cash and Cash Equivalents

Cash and cash equivalents increased to $6.9 million at December 31, 2011, from $4.4 million at December 31, 2010. The increase in cash and cash equivalents is a result of overall planned growth in deposits which have yet been deployed into loans.

Premises and Equipment

During 2011, the Company incurred capitalized expenditures of approximately $132,000 compared to approximately $11,000 in 2010. The Company’s 2011 capital expenditures consisted primarily of leasehold improvements and purchases of furniture and equipment related to the additional leased space and equipment utilized in the ordinary course of our banking business. The Company has no significant commitments for capital expenditures at December 31, 2011.

Deposits and Other Interest-Bearing Liabilities

The principal sources of funds for the Company are core deposits (demand deposits, interest-bearing transaction accounts, money market accounts, savings deposits and certificates of deposit) from the Company's market area. Core deposits, which exclude time deposits of $100,000 or more, provide a relatively stable funding source for our loan portfolio and other earning assets. The Company's deposit base includes transaction accounts, time and savings accounts and other accounts that customers use for cash management purposes and which provide the Company with a source of fee income and cross-marketing opportunities as well as a lower-cost source of funds.

The table shows the balance outstanding and the average rates paid on deposits held by us as of the following:

Our core deposits were 81.7%, 80.9% and 79.6% of total deposits at December 31, 2011, 2010, and 2009 respectively. The increase is due to planned growth in deposits overall and reductions in the level of time deposits as a percentage of total deposits.

Approximately 42.3% and 54.5% of the Company's deposits at December 31, 2011 and 2010, respectively, are made up of time deposits, which are generally the most expensive form of deposit because of their fixed rate and term. Time deposits in denominations of $100,000 or more can be more volatile and more expensive than time deposits of less than $100,000. However, because the Bank focuses on relationship banking, and most of these deposits are obtained from the local community, historical experience has been that large time deposits have not been more volatile or significantly more volatile or expensive than smaller denomination certificates. In the fourth quarter of 2011, management approved to expand the Company's funding sources and added $3.0 million of brokered deposits, which were still outstanding as of December 31, 2011. These funds were obtained at interest rates lower than local market interest rates. However, the amount of brokered deposits the Bank is allowed to utilize is limited per the Bank’s business plan. While sometimes requiring higher interest rates, brokered deposits carry lower acquisition costs (marketing, overhead costs) and can be obtained when required at the maturity dates desired. All of the brokered deposits are fully insured by the FDIC. This insurance and the capital position of the Company reduce the likelihood of large deposit withdrawals for reasons other than interest rate competition. Our loan-to-deposit ratio was 98.8% at December 31, 2011 compared to 107% at December 31, 2010.

The maturity of our time deposits over $100,000 at December 31, 2011 is set forth in the following table (dollars in thousands):

Capital Resources

The ability of the Company to grow is dependent on the availability of capital with which to meet regulatory capital requirements, discussed below. To the extent the Company is successful it may need to acquire additional capital through the sale of additional common stock, other qualifying equity instruments, subordinated debt or other qualifying capital instruments. Additional capital may not be available to the Company on a timely basis or on attractive terms.

Total shareholders’ equity was $10.4 million at December 31, 2011 compared to $11.0 million at December 31, 2010. Shareholders’ equity is comprised of proceeds from the completion of our initial public offering in 2009, which raised $13.6 million net of offering expenses, reduced by losses consisting of organization and start-up expenses aggregating $3.4 million. Of the proceeds, $12.7 million was used to capitalize the Bank. We retained the remaining offering proceeds at the Company to provide additional capital for investment in the Bank, if needed, or to fund other activities which are considered appropriate investments of capital at some point in the future. Equity was further reduced by the net loss of $765,000 for 2011 and $1.4 million for 2010.

The Federal Reserve and bank regulatory agencies require bank holding companies and depository institutions to maintain regulatory capital requirements at adequate levels based on a percentage of assets and off-balance sheet exposures. Under the Federal Reserve’s guidelines, we believe we are a “small bank holding company,” and thus qualify for an exemption from the consolidated risk-based and leverage capital adequacy guidelines applicable to bank holding companies with assets of $500 million or more. Regardless, we still maintain levels of capital on a consolidated basis that qualify us as “well capitalized” under the Federal Reserve’s capital guidelines.

Nevertheless, the Bank is subject to regulatory capital requirements. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Under the capital adequacy guidelines, the Bank is required to maintain a certain level of Tier 1 and total risk-based capital to risk-weighted assets. At least half of the Bank’s total risk-based capital must be comprised of Tier 1 capital, which consists of common shareholders’ equity, excluding the unrealized gain or loss on securities available-for-sale, minus certain intangible assets. The remainder may consist of Tier 2 capital, which is subordinated debt, other preferred stock and the general reserve for loan losses, subject to certain limitations. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet assets, are multiplied by a risk-weight factor of 0% to 100% based on the risks believed to be inherent in the type of asset. The Bank is also required to maintain capital at a minimum level based on total average assets, which is known as the Tier 1 leverage ratio.

To be considered “adequately capitalized” under the various regulatory capital requirements administered by the federal banking agencies the Bank must maintain a minimum total risk-based capital of 8%, with at least 4% being Tier 1 capital. In addition, the Bank must maintain a minimum Tier 1 leverage ratio of at least 4%. To be considered “well-capitalized,” the Bank must maintain total risk-based capital of at least 10%, Tier 1 capital of at least 6%, and a leverage ratio of at least 5%. For the first seven years of operation, during the Bank’s “de novo” period, the Bank is required to maintain a leverage ratio of at least 8%. The Bank exceeded its minimum regulatory capital ratios as of December 31, 2011, as well as the ratios to be considered “well capitalized.”

The following table sets forth the Bank’s various capital ratios at December 31, 2011.

We believe that our capital is sufficient to fund the activities of the Bank in its initial years of operation.

Return on Equity and Assets

The following table shows the return on average assets (net loss divided by average total assets), return on average equity (net loss divided by average equity), and equity to assets ratio (average equity divided by average total assets) for the year ended December 31, 2011. Since our inception, we have not paid cash dividends.

Effect of Inflation and Changing Prices

The effect of relative purchasing power over time due to inflation has not been taken into account in our consolidated financial statements. Rather, our consolidated financial statements have been prepared on an historical cost basis in accordance with generally accepted accounting principles.

Unlike most industrial companies, our assets and liabilities are primarily monetary in nature. Therefore, the effect of changes in interest rates will have a more significant impact on our performance than will the effect of changing prices and inflation in general. In addition, interest rates may generally increase as the rate of inflation increases, although not necessarily in the same magnitude.

Off-Balance Sheet Risk

Through the operations of our Bank, we have made contractual commitments to extend credit in the ordinary course of our business activities. These commitments are legally binding agreements to lend money to our customers at predetermined interest rates for a specified period of time. At December 31, 2011, we had issued but unused commitments to extend credit of $12.4 million through various types of lending arrangements which represents an increase of $3.8 million over December 31, 2010. The increase is due to planned growth and the timing delay between commitment and funding and, therefore, may fluctuate significantly at any given time.

We evaluate each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by us upon extension of credit, is based on our credit evaluation of the borrower. Collateral varies but may include accounts receivable, inventory, property, plant and equipment, and commercial and residential real estate. We manage the credit risk on these commitments by subjecting them to normal underwriting and risk management processes.

Results of Operations for the Year Ended December 31, 2011

Net Loss

We incurred a net loss of approximately $765,000 in 2011 as compared to a net loss of $1.4 million in 2010. Basic and diluted loss per share was $0.45 for 2011, and $0.80 for 2010. The decrease in our loss for the year ended December 31, 2011 as compared to December 31, 2010 is a result of the growth in net interest income associated with the growth in earning assets over the prior year as the Bank continues to grow according to plan.

Net Interest Income

Net interest income for 2011 was $2.2 million, which represented a $900,000 increase over 2010. Total interest income for the period was $2.9 million and was offset by interest expense of $716,000. The components of interest income were loans, including fees, of $2.7 million, investment income of $108,000 and federal funds sold and interest earned on excess balances of correspondent accounts of $17,000. Interest income was $1.7 million in 2010 which was comprised of $1.6 million in interest and fee income on loans, $89,000 in investment income and $15,000 in federal funds sold and interest earned on excess balances of correspondent accounts. Interest expense for 2011 of $716,000 was comprised primarily of interest paid on deposit accounts. For 2010, interest expense totaled $427,000 which was comprised primarily of interest paid on deposit accounts.

Average Balances, Income and Expenses, and Rates

The following table sets forth certain information related to our average balance sheet and our average yields on assets and average costs of liabilities for 2011, 2010 and 2009. The yields are calculated by dividing income or expense by the average balance of the corresponding asset or liability. Average balances have been derived from the daily balances throughout the period indicated as of December 31, 2011, 2010 and 2009 (dollars in thousands).

⁽¹⁾ There were no loans in nonaccrual status in 2010 or 2009 and one loan relationship in nonaccrual status in 2011.

⁽²⁾ Borrowings represent over night Federal Funds Purchased through a correspondent bank to test the lines in both 2011 and 2010. Borrowings in 2009 represent a line of credit utilized by the Company during its development stage.

⁽³⁾ Loan fees are included in interest income.

⁽⁴⁾ The Company has sustained a taxable loss, so the Company has not been able to realize any tax benefit from tax-exempt securities.

Our net interest spread and net interest margin were 2.91% and 3.32%, respectively, in 2011 compared to 2.44% and 3.10% in 2010. The net interest spread is the difference between the yield we earn on our interest-earning assets and the rate we pay on our interest-bearing liabilities. The net interest margin is calculated as net interest income divided by average earning assets. The largest component of average earning assets during in 2011 and 2010 was loans. The largest component of average earning assets during 2009 was federal funds sold and interest bearing balances due from banks.

The average balance of interest earning assets grew by $25.4 million and the rate earned increased 24 basis points to 4.42% as the Bank continued to grow higher yielding assets. The average balance of loans increased $24.0 million in 2011 when compared to 2010. This increase in volume caused interest income on loans to increase $1.2 million in 2011 compared to 2010. The increase was partially offset by a decrease in the average rate earned on loans resulting from the overall change in size and mix of the portfolio and the continued low interest rate environment. The average balance of total securities grew by $1.2 million and the rate decreased 17 basis points to 2.13% in 2011 compared to the prior year. The average balance increase, coupled with the lower average rate earned on taxable securities, caused interest income from securities to increase approximately $19,000 in 2011 compared to 2010. The average balance and rate of Federal funds sold and interest bearing due from bank accounts remained relatively unchanged in 2011 compared to 2010.

The average balance of interest-bearing deposits increased $22.9 million in 2011 compared to 2010. The effect of this increase, somewhat offset by a 23 basis point decrease in the average rate paid, caused interest expense to be $289,000 higher in 2011 than in the prior year. Interest bearing checking and savings products grew by $16.6 million and time deposits grew by $6.3 million in 2011. The average balance of borrowings increased slightly in 2011 over 2010 but the rate remained relatively unchanged and had no impact on interest expense. Borrowing expense in 2011 and 2010 was the result of the Bank testing borrowing lines of credit, therefore there was no interest expense impact. The overall effect of the changes in interest bearing deposit expense was a decrease of 23 basis points in the rate paid on interest bearing liabilities to 1.51% in 2011. The increase in the volume of interest bearing liabilities was the result of planned growth while the decrease in the rate paid on interest bearing liabilities is the result of continued low interest rates in the market.

Our net interest spread and net interest margin were 2.44% and 3.10%, respectively, in 2010 compared to (0.04)% and 0.98% in 2009. The largest component of average earning assets during 2010 was loans as compared to 2009 when cash and cash equivalents comprised the largest component of average earning assets.

The average balance of interest earning assets grew by $19.6 million and the rate earned increased 259 basis points to 4.18% as the Bank continued to grow higher yielding assets. The average balance of loans increased $24.7 million in 2010 when compared to 2009. This increase in volume caused interest income on loans to increase $1.8 million in 2010 compared to 2009. The increase was partially offset by a decrease in the average rate earned on loans resulting from the overall change in size and mix of the portfolio. The average balance of total securities grew by $2.7 million and the rate increased 126 basis points to 2.30% in 2010 compared to the prior year. The average balance increase, coupled with the higher average rate earned on taxable securities, caused interest income from securities to increase approximately $81,000 in 2010 compared to 2009. The average balance of Federal funds sold and interest bearing due from bank accounts decreased by $7.8 million. This decrease combined with a slight decrease in the rate of interest earned resulted in a decline in interest income of $9,700 in 2010 compared to 2009. This was due to the Bank utilizing these funds to increase the volume of investment securities and loan balances.

The average balance of interest-bearing deposits increased $18.0 million in 2010 compared to 2009. The effect of this increase along with a 20 basis point increase in the average rate paid caused interest expense to be $361,000 higher in 2010 than in the prior year. Interest bearing checking and savings products grew by $4.7 million and time deposits grew by $13.3 million in 2010. The average balance of borrowings decreased $551,000 and the rate declined 200 basis points resulting in a decrease in interest expense on borrowings of $17,000. Borrowing expense in 2009 was related to borrowings for pre-opening and start up activities of the Bank. In 2010, borrowing expense was the result of the Bank testing borrowing lines of credit. The overall effect of the increase in interest bearing deposit expense and the decrease in borrowing expense in 2010 was an increase of 9 basis points in the rate paid on interest bearing liabilities to 1.74%.

Rate/Volume Analysis (dollars in thousands):

Management anticipates that the level of net interest income will continue to grow in 2012 as the Bank continues to expand according to its business plan. Growth in earning assets may prove to be somewhat more difficult in 2012 given the increased ability of competitors in the local market to increase lending activities. If general market interest rates continue to remain at relatively low levels, the impact on the Company’s net interest spread could be negatively affected as new activity, maturities, and payments may have differing impacts on interest-earning assets and interest-bearing liabilities.

Interest Rate Sensitivity

We monitor and manage the pricing and maturity of our assets and liabilities in order to diminish the potential adverse impact that changes in interest rates could have on our net interest income. The principal monitoring technique employed by us is the measurement of our interest sensitivity “gap,” which is the positive or negative dollar difference between assets and liabilities that are subject to interest rate re-pricing within a given period of time. Interest rate sensitivity can be managed by re-pricing assets or liabilities, selling securities available-for-sale, replacing an asset or liability at maturity, or adjusting the interest rate during the life of an asset or liability. Managing the amount of assets and liabilities re-pricing in this same time interval helps to hedge the risk and minimize the impact on net interest income of rising or falling interest rates.

The following table sets forth our interest rate sensitivity at December 31, 2011.

The following table sets forth our interest rate sensitivity at December 31, 2010.