MERCANTILE BANK CORP - Quarter Report: 2014 June (Form 10-Q)

mbwm20140630_10q.htm Table Of Contents

U.S. SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

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

SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2014

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

SECURITIES EXCHANGE ACT OF 1934

For the transition period from to .

Commission File No. 000-26719

MERCANTILE BANK CORPORATION

(Exact name of registrant as specified in its charter)

Michigan				38-3360865
(State or other jurisdiction of				(IRS Employer Identification No.)
incorporation or organization)

310 Leonard Street, NW, Grand Rapids, MI 49504

(Address of principal executive offices) (Zip Code)

(616) 406-3000

(Registrant’s telephone number, including area code)

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

Yes X No ___

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes X No ___

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

Large accelerated filer ___				Accelerated filer X
Non-accelerated filer				Smaller reporting company __

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

Yes No X

At August 8, 2014, there were 16,851,320 shares of common stock outstanding.

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MERCANTILE BANK CORPORATION

INDEX

PART I.	Financial Information	Page No.

	Item 1. Financial Statements

	Condensed Consolidated Balance Sheets - June 30, 2014 (Unaudited) and December 31, 2013	1

	Condensed Consolidated Statements of Income - Three and Six Months Ended June 30, 2014 (Unaudited) and June 30, 2013 (Unaudited)	2

	Condensed Consolidated Statements of Comprehensive Income - Three and Six Months Ended June 30, 2014 (Unaudited) and June 30, 2013 (Unaudited)	3

	Condensed Consolidated Statements of Changes in Shareholders’ Equity - Six Months Ended June 30, 2014 (Unaudited) and June 30, 2013 (Unaudited)	4

	Condensed Consolidated Statements of Cash Flows - Six Months Ended June 30, 2014 (Unaudited) and June 30, 2013 (Unaudited)	6

	Notes to Condensed Consolidated Financial Statements (Unaudited)	8

	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	65

	Item 3. Quantitative and Qualitative Disclosures About Market Risk	83

	Item 4. Controls and Procedures	86

PART II.	Other Information

	Item 1. Legal Proceedings	87

	Item 1A. Risk Factors	87

	Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	87

	Item 3. Defaults Upon Senior Securities	87

	Item 4. Mine Safety Disclosures	87

	Item 5. Other Information	87

	Item 6. Exhibits	88

	Signatures	89

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MERCANTILE BANK CORPORATION

PART I --- FINANCIAL INFORMATION

Item 1. Financial Statements

CONDENSED CONSOLIDATED BALANCE SHEETS

	June 30,			December 31,
	2014			2013
	(Unaudited)			(Audited)
ASSETS
Cash and due from banks	$	58,730,000		$	17,149,000
Interest-bearing deposits		48,150,000			6,389,000
Federal funds sold		11,973,000			123,427,000
Total cash and cash equivalents		118,853,000			146,965,000

Securities available for sale		475,275,000			131,178,000
Federal Home Loan Bank stock		19,226,000			11,961,000

Loans		2,073,482,000			1,053,243,000
Allowance for loan losses		(20,856,000	)		(22,821,000	)
Loans, net		2,052,626,000			1,030,422,000

Premises and equipment, net		49,003,000			24,898,000
Bank owned life insurance		55,693,000			51,377,000
Goodwill		50,870,000			0
Core deposit intangible		17,213,000			0
Net deferred tax asset		9,238,000			17,754,000
Accrued interest receivable		7,711,000			3,649,000
Other real estate owned and repossessed assets		2,878,000			2,851,000
Other assets		20,696,000			5,911,000

Total assets	$	2,879,282,000		$	1,426,966,000

LIABILITIES AND SHAREHOLDERS' EQUITY
Deposits
Noninterest-bearing	$	515,646,000		$	224,580,000
Interest-bearing		1,787,615,000			894,331,000
Total deposits		2,303,261,000			1,118,911,000

Securities sold under agreements to repurchase		124,108,000			69,305,000
Federal Home Loan Bank advances		57,044,000			45,000,000
Subordinated debentures		54,131,000			32,990,000
Other borrowed money		14,348,000			1,620,000
Accrued interest and other liabilities		10,252,000			5,815,000
Total liabilities		2,563,144,000			1,273,641,000

Shareholders' equity
Preferred stock, no par value; 1,000,000 shares authorized; none issued		0			0
Common stock, no par value; 40,000,000 shares authorized; 16,839,175 shares outstanding at June 30, 2014 and 8,739,108 shares outstanding at December 31, 2013		318,452,000			162,999,000
Retained earnings (deficit)		673,000			(4,101,000	)
Accumulated other comprehensive income (loss)		(2,987,000	)		(5,573,000	)
Total shareholders’ equity		316,138,000			153,325,000

Total liabilities and shareholders’ equity	$	2,879,282,000		$	1,426,966,000

See accompanying notes to condensed consolidated financial statements.

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MERCANTILE BANK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

	Three Months			Three Months			Six Months			Six Months
	Ended			Ended			Ended			Ended
	June 30, 2014			June 30, 2013			June 30, 2014			June 30, 2013
	(Unaudited)			(Unaudited)			(Unaudited)			(Unaudited)
Interest income
Loans, including fees	$	16,657,000		$	12,687,000		$	28,756,000		$	25,533,000
Securities, taxable		1,393,000			1,007,000			2,627,000			2,014,000
Securities, tax-exempt		374,000			257,000			557,000			552,000
Federal funds sold		41,000			35,000			109,000			89,000
Interest-bearing deposits		17,000			6,000			21,000			13,000
Total interest income		18,482,000			13,992,000			32,070,000			28,201,000

Interest expense
Deposits		2,272,000			2,223,000			4,307,000			4,543,000
Short-term borrowings		27,000			19,000			49,000			39,000
Federal Home Loan Bank advances		156,000			119,000			306,000			238,000
Other borrowings		474,000			319,000			791,000			615,000
Total interest expense		2,929,000			2,680,000			5,453,000			5,435,000

Net interest income		15,553,000			11,312,000			26,617,000			22,766,000

Provision for loan losses		(700,000	)		(1,500,000	)		(2,600,000	)		(3,000,000	)

Net interest income after provision for loan losses		16,253,000			12,812,000			29,217,000			25,766,000

Noninterest income
Services charges on accounts		522,000			384,000			887,000			758,000
Earnings on bank owned life insurance		282,000			350,000			581,000			688,000
Mortgage banking activities		349,000			225,000			412,000			477,000
Rental income from other real estate owned		43,000			156,000			99,000			355,000
Other income		1,092,000			657,000			1,815,000			1,321,000
Total noninterest income		2,288,000			1,772,000			3,794,000			3,599,000

Noninterest expense
Salaries and benefits		7,037,000			4,981,000			12,267,000			9,838,000
Occupancy		914,000			624,000			1,626,000			1,282,000
Furniture and equipment		368,000			256,000			615,000			512,000
FDIC insurance costs		224,000			175,000			401,000			420,000
Problem asset costs		(36,000	)		279,000			(56,000	)		410,000
Merger-related costs		3,453,000			46,000			3,830,000			60,000
Other expense		4,106,000			2,452,000			6,590,000			4,875,000
Total noninterest expenses		16,066,000			8,813,000			25,273,000			17,397,000

Income before federal income tax expense		2,475,000			5,771,000			7,738,000			11,968,000

Federal income tax expense		966,000			1,755,000			2,649,000			3,552,000

Net income	$	1,509,000		$	4,016,000		$	5,089,000		$	8,416,000

Basic earnings per share	$	0.13		$	0.46		$	0.50		$	0.97
Diluted earnings per share	$	0.13		$	0.46		$	0.50		$	0.97
Cash dividends per share	$	2.12		$	0.11		$	2.24		$	0.21

Average basic shares outstanding	$	11,406,908		$	8,705,667		$	10,080,242		$	8,705,673
Average diluted shares outstanding	$	11,435,867		$	8,718,649		$	10,094,725		$	8,718,627

See accompanying notes to condensed consolidated financial statements.

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MERCANTILE BANK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

	Three Months			Three Months			Six Months			Six Months
	Ended			Ended			Ended			Ended
	June 30, 2014			June 30, 2013			June 30, 2014			June 30, 2013
	(Unaudited)			(Unaudited)			(Unaudited)			(Unaudited)

Net income	$	1,509,000		$	4,016,000		$	5,089,000		$	8,416,000

Other comprehensive income (loss):
Unrealized holding gains (losses) on securities available for sale		1,537,000			(3,787,000	)		4,148,000			(4,789,000	)
Fair value of interest rate swap		(140,000	)		763,000			(126,000	)		797,000
		1,397,000			(3,024,000	)		4,022,000			(3,992,000	)

Tax effect of unrealized holding gains (losses) on securities available for sale		(568,000	)		1,325,000			(1,481,000	)		1,676,000
Tax effect of fair value of interest rate swap		49,000			(266,000	)		45,000			(226,000	)
		(519,000	)		1,059,000			(1,436,000	)		1,450,000

Other comprehensive income (loss), net of tax		878,000			(1,965,000	)		2,586,000			(2,542,000	)

Comprehensive income	$	2,387,000		$	2,051,000		$	7,675,000		$	5,874,000

See accompanying notes to condensed consolidated financial statements.

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MERCANTILE BANK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF

CHANGES IN SHAREHOLDERS’ EQUITY

(Unaudited)

									Accumulated
						Retained			Other			Total
($ in thousands)	Preferred		Common			Earnings			Comprehensive			Shareholders’
	Stock		Stock			(Deficit)			Income (Loss)			Equity

Balances, January 1, 2014	$	0	$	162,999		$	(4,101	)	$	(5,573	)	$	153,325

Stock option exercises (5,920 shares)				75									75

Stock grants to directors for retainer fees (7,375 shares)				155									155

Stock-based compensation expense				351									351

Cash dividends ($2.24 per common share)				(20,102	)		(315	)					(20,417	)

Common stock issued in connection with Firstbank merger (8,087,272 shares)				173,310									173,310

Stock options issued to replace existing Firstbank options at merger date				1,664									1,664

Net income for the six months ended June 30, 2014							5,089						5,089

Change in net unrealized holding gain on securities available for sale, net of tax effect										2,667			2,667

Change in fair value of interest rate swap, net of tax effect										(81	)		(81	)

Balances, June 30, 2014	$	0	$	318,452		$	673		$	(2,987	)	$	316,138

See accompanying notes to condensed consolidated financial statements.

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MERCANTILE BANK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF

CHANGES IN SHAREHOLDERS’ EQUITY (Continued)

(Unaudited)

									Accumulated
						Retained			Other			Total
($ in thousands)	Preferred		Common			Earnings			Comprehensive			Shareholders’
	Stock		Stock			(Deficit)			Income (Loss)			Equity

Balances, January 1, 2013	$	0	$	166,074		$	(21,134	)	$	1,650		$	146,590

Employee stock purchase plan (1,098 shares)				19									19

Dividend reinvestment plan (1,954 shares)				33									33

Stock-based compensation expense				236									236

Cash dividends ($0.21 per common share)				(1,814	)								(1,814	)

Net income for the six months ended June 30, 2013							8,416						8,416

Change in net unrealized holding gain on securities available for sale, net of tax effect										(3,113	)		(3,113	)

Change in fair value of interest rate swap, net of tax effect										571			571

Balances, June 30, 2013	$	0	$	164,548		$	(12,718	)	$	(892	)	$	150,938

See accompanying notes to condensed consolidated financial statements.

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MERCANTILE BANK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

	Six Months			Six Months
	Ended			Ended
	June 30, 2014			June 30, 2013
Cash flows from operating activities
Net income	$	5,089,000		$	8,416,000
Adjustments to reconcile net income to net cash from operating activities
Depreciation and amortization		1,967,000			1,086,000
Accretion of acquired loans		(512,000	)		0
Provision for loan losses		(2,600,000	)		(3,000,000	)
Stock-based compensation expense		351,000			236,000
Proceeds from sales of mortgage loans held for sale		16,958,000			29,298,000
Origination of mortgage loans held for sale		(16,525,000	)		(28,383,000	)
Net gain from sales of mortgage loans held for sale		(383,000	)		(395,000	)
Net gain from sale and valuation write-down of foreclosed assets		(605,000	)		(895,000	)
Earnings on bank owned life insurance		(581,000	)		(688,000	)
Net change in:
Accrued interest receivable		312,000			214,000
Other assets		(1,678,000	)		11,930,000
Accrued interest and other liabilities		(5,844,000	)		(1,368,000	)
Net cash from (for) operating activities		(4,051,000	)		16,451,000

Cash flows from investing activities
Cash received in merger		91,806,000			0
Loan originations and payments, net		(75,655,000	)		(20,433,000	)
Purchases of securities available for sale		(11,679,000	)		(28,973,000	)
Proceeds from maturities, calls and repayments of securities available for sale		22,800,000			28,538,000
Proceeds from sales of securities available for sale		0			3,905,000
Proceeds from sales of foreclosed assets		1,940,000			5,659,000
Purchases of premises and equipment		(874,000	)		(134,000	)
Net cash from (for) investing activities		28,338,000			(11,438,000	)

Cash flows from financing activities
Net decrease in time deposits		(15,516,000	)		(51,608,000	)
Net decrease in all other deposits		(29,743,000	)		(22,281,000	)
Net increase (decrease) in securities sold under agreements to repurchase		319,000			(7,437,000	)
Net increase in other borrowed money		12,728,000			49,000
Proceeds from stock option exercises		75,000			0
Employee stock purchase plan		0			19,000
Dividend reinvestment plan		0			33,000
Stock grants to directors for retainer fee		155,000			0
Payment of cash dividends to common shareholders		(20,417,000	)		(1,814,000	)
Net cash for financing activities		(52,399,000	)		(83,039,000	)

Net change in cash and cash equivalents		(28,112,000	)		(78,026,000	)
Cash and cash equivalents at beginning of period		146,965,000			136,003,000
Cash and cash equivalents at end of period	$	118,853,000		$	57,977,000

See accompanying notes to condensed consolidated financial statements.

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MERCANTILE BANK CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

(Unaudited)

Supplemental disclosures of cash flows information
Cash paid during the period for:
Interest	$	5,336,000	$	6,068,000
Federal income tax		1,400,000		0
Noncash financing and investing activities:
Transfers from loans to foreclosed assets		175,000		1,710,000

See accompanying notes to condensed consolidated financial statements.

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MERCANTILE BANK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation: The unaudited financial statements for the six months ended June 30, 2014 include the consolidated results of operations of Mercantile Bank Corporation and its consolidated subsidiaries. These subsidiaries include Mercantile Bank of Michigan (“our bank”) and our bank’s two subsidiaries, Mercantile Bank Real Estate Co., LLC (“our real estate company”) and Mercantile Insurance Center, Inc. (“our insurance center”). These consolidated financial statements have been prepared in accordance with the instructions for Form 10-Q and Item 303(b) of Regulation S-K and do not include all disclosures required by accounting principles generally accepted in the United States of America for a complete presentation of our financial condition and results of operations. In the opinion of management, the information reflects all adjustments (consisting only of normal recurring adjustments) which are necessary in order to make the financial statements not misleading and for a fair presentation of the results of operations for such periods. The results for the period ended June 30, 2014 should not be considered as indicative of results for a full year. For further information, refer to the consolidated financial statements and footnotes included in our annual report on Form 10-K for the year ended December 31, 2013.

We have five separate business trusts that were formed to issue trust preferred securities. Subordinated debentures were issued to the trusts in return for the proceeds raised from the issuance of the trust preferred securities. The trusts are not consolidated, but instead we report the subordinated debentures issued to the trusts as a liability.

Earnings Per Share: Basic earnings per share is based on the weighted average number of common shares and participating securities outstanding during the period. Diluted earnings per share include the dilutive effect of additional potential common shares issuable under our stock-based compensation plans and are determined using the treasury stock method. Our unvested restricted shares, which contain non-forfeitable rights to dividends whether paid or accrued (i.e., participating securities), are included in the number of shares outstanding for both basic and diluted earnings per share calculations. In the event of a net loss, our unvested restricted shares are excluded from the calculation of both basic and diluted earnings per share.

Stock options for approximately 159,000 shares of common stock were included in determining diluted earnings per share for the three and six months ended June 30, 2014. Stock options for approximately 177,000 shares of common stock were antidilutive and not included in determining diluted earnings per share for the three and six months ended June 30, 2014.

Approximately 64,000 unvested restricted shares were included in determining both basic and diluted earnings per share for the three and six months ended June 30, 2013. In addition, stock options for approximately 21,000 shares of common stock were included in determining diluted earnings per share for the three and six months ended June 30, 2013. Stock options for approximately 132,000 shares of common stock were antidilutive and not included in determining diluted earnings per share for the three and six months ended June 30, 2013.

(Continued)

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MERCANTILE BANK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. SIGNIFICANT ACCOUNTING POLICIES (Continued)

Loans: Loans that we have the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of deferred loan fees and costs and an allowance for loan losses. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized in interest income using the level-yield method without anticipating prepayments.

Interest income on commercial loans and mortgage loans is discontinued at the time the loan is 90 days delinquent unless the loan is well-secured and in process of collection. Consumer and credit card loans are typically charged-off no later than when they are 120 days past due. Past due status is based on the contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal and interest is considered doubtful.

All interest accrued but not received for loans placed on nonaccrual is reversed against interest income. Interest received on such loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

Allowance for Loan Losses: The allowance for loan losses (“allowance”) is a valuation allowance for probable incurred credit losses. Loan losses are charged against the allowance when we believe the uncollectability of a loan is confirmed. Subsequent recoveries, if any, are credited to the allowance. We estimate the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in our judgment, should be charged-off.

A loan is considered to be impaired when, based on current information and events, it is probable we will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Factors considered 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. We determine 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 delay, the reasons for 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 construction 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 or the fair value of collateral if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment.

(Continued)

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MERCANTILE BANK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. SIGNIFICANT ACCOUNTING POLICIES (Continued)

Troubled Debt Restructurings: A loan is accounted for as a troubled debt restructuring if we, for economic or legal reasons, grant a concession to a borrower considered to be experiencing financial difficulties that we would not otherwise consider. A troubled debt restructuring may involve the receipt of assets from the debtor in partial or full satisfaction of the loan, or a modification of terms such as a reduction of the stated interest rate or balance of the loan, a reduction of accrued interest, an extension of the maturity date or renewal of the loan at a stated interest rate lower than the current market rate for a new loan with similar risk, or some combination of these concessions. Troubled debt restructurings can be in either accrual or nonaccrual status. Nonaccrual troubled debt restructurings are included in nonperforming loans. Accruing troubled debt restructurings are generally excluded from nonperforming loans as it is considered probable that all contractual principal and interest due under the restructured terms will be collected.

In accordance with current accounting guidance, loans modified as troubled debt restructurings are, by definition, considered to be impaired loans. Impairment for these loans is measured on a loan-by-loan basis similar to other impaired loans as described above under “Allowance for Loan Losses.” Certain loans modified as troubled debt restructurings may have been previously measured for impairment under a general allowance methodology (i.e., pooling), thus at the time the loan is modified as a troubled debt restructuring the allowance will be impacted by the difference between the results of these two measurement methodologies. Loans modified as troubled debt restructurings that subsequently default are factored into the determination of the allowance in the same manner as other defaulted loans.

Investments: Investments are presented at fair value as required by accounting principles. Our investment portfolio is classified as available for sale, as such: adjustments to the fair value are reported as a change in equity. If a security is deemed to be other than temporarily impaired, the adjustment to fair value is recorded through the income statement.

Securities available for sale consist of bonds and notes which might be sold prior to maturity due to changes in interest rates, prepayment risks, yield and availability of alternative investments, liquidity needs or other factors. Securities classified as available for sale are reported at their fair value and the related unrealized holding gain or loss (the difference between the fair value and amortized cost of the securities so classified) is reported in other comprehensive income. Other securities such as Federal Home Loan Bank stock are carried at cost. Interest income includes amortization of purchase premium or accretion of purchase discount. Premiums and discounts on securities are amortized or accreted on the level-yield method. Gains and losses on sales are recorded on the trade date and are determined using the specific identification method.

Declines in the fair value of securities below their cost that are other than temporary are reflected as realized losses. In estimating other-than-temporary losses, management considers: (1) the length of time and extent that fair value has been less than carrying value; (2) the financial condition and near-term prospects of the issuer; and (3) the Company’s ability and intent to hold the security for a period of time sufficient to allow for any anticipated recovery in fair value.

(Continued)

10.

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MERCANTILE BANK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. SIGNIFICANT ACCOUNTING POLICIES (Continued)

Loans Held for Sale: Mortgage loans originated and intended for sale in the secondary market are carried at the lower of aggregate cost or market, as determined by outstanding commitments from investors. Net unrealized losses, if any, are recorded as a valuation allowance and charged to earnings. As of June 30, 2014 and December 31, 2013, we determined that the fair value of our mortgage loans held for sale approximated the recorded cost of $1.9 million and $1.1 million, respectively.

Mortgage loans held for sale are generally sold with servicing rights retained. Gains and losses on sales of mortgage loans are based on the difference between the selling price and the carrying value of the related loan sold, which is reduced by the cost allocated to the servicing right. We generally lock in the sale price to the purchaser of the loan at the same time we make a rate commitment to the borrower. These mortgage banking activities are not designated as hedges and are carried at fair value. The net gain or loss on mortgage banking derivatives is included in the gain on sale of loans. Mortgage loans serviced for others totaled $593.0 million as of June 30, 2014.

Mortgage Banking Activities: Servicing rights are recognized as assets based on the allocated fair value of retained servicing rights on loans sold. Servicing rights are carried at the lower of amortized cost or fair value and are expensed in proportion to, and over the period of, estimated net servicing income. Impairment is evaluated quarterly based on the fair value of the servicing rights, using groupings of the underlying loans as to interest rates, types of loans, loan size, term and other factors. Any temporary impairment of a grouping is reported as a valuation allowance which is recovered when impairment no longer exists. Other-than-temporary impairments are recorded as a direct write-down to the carrying value of the servicing assets.

Servicing fee income is recorded for fees earned for servicing loans. The fees are based on a contractual percentage of the outstanding principal or a fixed amount per loan and are recorded as income when earned. Amortization of mortgage servicing rights is netted against loan servicing income in the income statement.

Derivatives: Derivative financial instruments are recognized as assets or liabilities at fair value. The accounting for changes in the fair value of derivatives depends on the use of the derivatives and whether the derivatives qualify for hedge accounting. Used as part of our asset and liability management to help manage interest rate risk, our derivatives have generally consisted of interest rate swap agreements that qualified for hedge accounting. In February 2012, we entered into an interest rate swap agreement that qualifies for hedge accounting. The current outstanding interest rate swap is discussed in more detail in Note 11. We do not use derivatives for trading purposes.

Changes in the fair value of derivatives that are designated, for accounting purposes, as a hedge of the variability of cash flows to be received on various loans and are effective are reported in other comprehensive income. They are later reclassified into earnings in the same periods during which the hedged transaction affects earnings and are included in the line item in which the hedged cash flows are recorded. If hedge accounting does not apply, changes in the fair value of derivatives are recognized immediately in current earnings as interest income or expense.

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. SIGNIFICANT ACCOUNTING POLICIES (Continued)

If designated as a hedge, we formally document the relationship between derivatives as hedged items, as well as the risk-management objective and the strategy for undertaking hedge transactions. This documentation includes linking cash flow hedges to specific assets and liabilities on the balance sheet. If designated as a hedge, we also formally assess, both at the hedge’s inception and on an ongoing basis, whether the derivative instruments that are used are highly effective in offsetting changes in cash flows of the hedged items. Ineffective hedge gains and losses are recognized immediately in current earnings as noninterest income or expense. We discontinue hedge accounting when we determine the derivative is no longer effective in offsetting changes in the cash flows of the hedged item, the derivative is settled or terminates, or treatment of the derivative as a hedge is no longer appropriate or intended.

Goodwill and Core Deposit Intangible: Goodwill results from business acquisitions and represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets. Goodwill is assessed at least annually for impairment and any such impairment is recognized in the period identified. A more frequent assessment is performed if conditions in the market place or changes in the company’s organizational structure occur. We use a discounted income approach and a market valuation model, which compares the inherent value of our company to valuations of recent transactions in the market place to determine if our goodwill has been impaired.

The core deposit intangible that arose from the Firstbank Corporation acquisition was initially measured at fair value and is being amortized into noninterest expense over a ten-year period using the sum-of-the-years-digits methodology.

Adoption of New Accounting Standards: In January of 2014, the FASB issued ASU 2014-04, Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure. This ASU clarifies that an in substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either (1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or (2) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. The ASU also requires additional related interim and annual disclosures. The guidance in this ASU is effective for annual and interim periods beginning after December 15, 2014. The adoption of this ASU is not expected to have a material effect on our financial position or results of operations.

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. SIGNIFICANT ACCOUNTING POLICIES (Continued)

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers. This ASU establishes a comprehensive revenue recognition standard for virtually all industries under U.S. GAAP, including those that previously followed industry-specific guidance such as the real estate, construction and software industries. The revenue standard’s core principle is built on the contract between a vendor and a customer for the provision of goods and services. It attempts to depict the exchange of rights and obligations between the parties in the pattern of revenue recognition based on the consideration to which the vendor is entitled. To accomplish this objective, the standard requires five basic steps: i) identify the contract with the customer, (ii) identify the performance obligations in the contract, (iii) determine the transaction price, (iv) allocate the transaction price to the performance obligations in the contract, and (v) recognize revenue when (or as) the entity satisfies a performance obligation. This ASU is effective for annual and interim periods beginning after December 15, 2016 with three transition methods available – full retrospective, retrospective and cumulative effect approach. Adoption of this ASU is not expected to have a material effect on our financial position or results of operations.

In June 2014, the FASB issued ASU 2014-11, Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures. This ASU requires two accounting changes. First, repurchase-to-maturity transactions will be accounted for as secured borrowing transactions on the balance sheet, rather than sales. Second, for repurchase financing arrangements, the ASU requires separate accounting for a transfer of a financial asset executed contemporaneously with (or in contemplation of) a repurchase agreement with the same counterparty, which also will generally result in secured borrowing accounting for the repurchase agreement. The ASU also introduces new disclosures to increase transparency about the types of collateral pledged for repurchase agreements, securities lending transactions, and repurchase-to-maturity transactions that are accounted for as secured borrowings. The ASU also requires a transferor to disclose information about transactions accounted for as a sale in which the transferor retains substantially all of the exposure to the economic return on the transferred financial assets through an agreement with the transferee. The accounting changes and disclosure for certain transactions accounted for as a sale are effective for the first interim or annual period beginning after December 15, 2014. The disclosure for transactions accounted for as secured borrowings is required for annual periods beginning after December 15, 2014, and for interim periods beginning after March 15, 2015. Adoption of this ASU is not expected to have a material effect on our financial position or results of operations.

2. BUSINESS COMBINATION

We completed the merger of Firstbank Corporation (“Firstbank”), a Michigan corporation with approximately $1.5 billion in total assets and 46 branch locations, into Mercantile Bank Corporation as of June 1, 2014 (“Merger Date”). The results of operations due to the Firstbank transaction have been included in Mercantile’s financial results since the Merger Date. All of Firstbank’s common stock was converted into the right to receive one share of Mercantile common stock for each share of Firstbank common stock. The conversion of Firstbank’s common stock into Mercantile’s common stock resulted in Mercantile issuing 8,087,272 shares of its common stock. The merger provided an expanded geographic footprint for the Company and increased the size of the balance sheet wherein the combined companies can realize economies of scale and other operating efficiencies. In conjunction with the completion of the merger, Mercantile assumed the obligations of Firstbank Capital Trust I, Firstbank Capital Trust II, Firstbank Capital Trust III and Firstbank Capital Trust IV.

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

2. BUSINESS COMBINATION (Continued)

The Firstbank transaction was accounted for using the acquisition method of accounting and accordingly, assets acquired, liabilities assumed and consideration exchanged were recorded at estimated fair value on the Merger Date. Preliminary goodwill of $50.9 million was calculated as the purchase premium after adjusting for the fair value of net assets acquired and represents the value expected from the synergies created from combining the two banking organizations as well as the economies of scale expected from combining the operations of the two companies. None of the goodwill is deductible for income tax purposes as the merger is accounted for as a tax-free exchange.

The following table provides the purchase price calculation as of the Merger Date and the identifiable assets purchased and the liabilities assumed at their estimated fair values. These fair value measurements are provisional based on third-party valuations that are currently under review and are subject to refinement for up to one year after the Merger Date based on additional information that may be obtained by us that existed as of the Merger Date.

Purchase Price:

Mercantile common shares issued for Firstbank common shares		8,087,272
Price per share, based on Mercantile closing price on May 30, 2014	$	21.43
Value of common stock issued		173,310,000
Replacement stock options		1,664,000
Total purchase price	$	174,974,000

Preliminary Statement of Net Assets Acquired at Fair Value:

Assets
Cash and cash equivalents	$	91,806,000
Securities		358,599,000
Total loans		943,662,000
Premises and equipment		24,049,000
Core deposit intangible		17,478,000
Mortgage servicing rights		7,389,000
Other assets		8,500,000
Total Assets	$	1,451,483,000
Liabilities
Deposits	$	1,229,609,000
Borrowings		87,615,000
Other liabilities		10,155,000
Total Liabilities	$	1,327,379,000
Net Identifiable Assets Acquired			$	124,104,000
Goodwill			$	50,870,000

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

2. BUSINESS COMBINATION (Continued)

The fair value of mortgage servicing rights was $7.4 million at the Acquisition Date. During the month of June 2014, new servicing rights amounting to less than $0.1 million and amortization expense of $0.1 million were recorded.

Firstbank’s results of operations prior to the Merger Date are not included in our consolidated statements of income or consolidated statements of comprehensive income. The operations of the former Firstbank organization provided approximately $4.5 million in net interest income for the period from the Merger Date to June 30, 2014.

We recorded merger-related expenses of $3.5 million and $3.8 million during the three month and six month periods ended June 30, 2014, respectively. Such expenses were generally for professional services, costs related to termination of existing contractual arrangements for various services, retention and severance compensation costs, marketing and promotional expenses, travel costs, and printing and supplies costs. Virtually all of Mercantile and Firstbank’s operating systems are now integrated.

The following table provides the unaudited pro forma information for the results of operations for the three and six month periods ended June 30, 2014 and 2013, as if the acquisition had occurred on January 1 of each year. These adjustments reflect the impact of certain purchase accounting fair value measurements, primarily comprised of Firstbank’s loan and deposit portfolios. In addition, the $3.8 million in merger-related expenses noted earlier are included in each period presented. We expect to achieve further operating cost savings and other business synergies as a result of the merger which are not reflected in the pro forma amounts. These unaudited pro forma results are presented for illustrative purposes only and are not intended to represent or be indicative of the actual results of operations of the combined banking organization that would have been achieved had the merger occurred at the beginning of each period presented, nor are they intended to represent or be indicative of future results of operations.

	Three months ended June 30,				Six months ended June 30,
	2014		2013		2014		2013

Net interest income	$	15,453,000	$	11,212,000	$	26,417,000	$	22,566,000
Noninterest expense		17,160,000		13,407,000		26,862,000		22,786,000
Net income		863,000		900,000		4,186,000		5,043,000
Net income per diluted share		0.05		0.05		0.25		0.30

In most instances, determining the fair value of the acquired assets and assumed liabilities required us to estimate cash flows expected to result from those assets and liabilities and to discount those cash flows at appropriate rates of interest. The most significant of those determinations relates to the valuation of acquired loans. For such loans, the excess of cash flows expected at acquisition over the estimated fair value is recognized as interest income over the remaining lives of the loans. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition reflects the impact of estimated credit losses and other factors, such as prepayments. In accordance with the applicable accounting guidance for business combinations, there was no carry-over of Firstbank’s previously established allowance for loan losses.

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

2. BUSINESS COMBINATION (Continued)

The acquired loans were divided into loans with evidence of credit quality deterioration, which are accounted for under ASC 310-30 (“acquired impaired”), and loans that do not meet this criteria, which are accounted for under ASC 310-20 (“acquired non-impaired”). In addition, the loans are further categorized into different loan pools based primarily on the type and purpose of the loan.

The provisional fair value of loans at the Acquisition Date is presented in the following table:

	Acquired		Acquired		Acquired
	Impaired		Non-Impaired		Total Loans
Commercial Loans:
Commercial & industrial	$	878,000	$	163,316,000	$	164,194,000
Commercial real estate		12,973,000		378,016,000		390,989,000
Construction & development		1,289,000		33,726,000		35,015,000
Total Commercial Loans	$	15,140,000	$	575,058,000	$	590,198,000

Consumer Loans:
Residential mortgages	$	9,694,000	$	216,653,000	$	226,347,000
Instalment		167,000		61,657,000		61,824,000
Home equity lines		288,000		52,054,000		52,342,000
Construction		76,000		12,875,000		12,951,000
Total Consumer Loans	$	10,225,000	$	343,239,000	$	353,464,000
Total Loans	$	25,365,000	$	918,297,000	$	943,662,000

The following table presents data on acquired impaired loans at the Acquisition Date:

	Acquired
	Impaired

Contractual required payments	$	44,936,000
Nonaccretable difference		17,057,000
Expected cash flows		27,879,000
Accretable yield		2,514,000
Carrying balance	$	25,365,000

The nonaccretable difference includes $10.4 million in principal cash flows not expected to be collected, $2.8 million of pre-acquisition charge-offs and $3.9 million of future interest not expected to be collected. The unpaid principal balance of acquired performing loans was $926.4 million at the Acquisition Date, and the unaccreted discount on such loans was $8.1 million.

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

2. BUSINESS COMBINATION (Continued)

We also assumed obligations under junior subordinated debentures with an aggregate balance of $36.1 million and an aggregate fair value of $21.1 million as of the Acquisition Date, payable to four unconsolidated trusts (Firstbank Capital Trust I, Firstbank Capital Trust II, Firstbank Capital Trust III, and Firstbank Capital Trust IV) that have issued trust preferred securities. The junior subordinated debentures are the sole assets of each trust. Interest rates on all trust preferred securities issued by the trusts are tied to the 90 Day Libor rate with spreads ranging from 135 basis points to 199 basis points, and reset quarterly. The trust preferred securities have maturity dates ranging from October, 2034 to July, 2037, and are callable by us in whole or in part quarterly. The junior subordinated debentures are unsecured obligations of Mercantile, who has guaranteed that interest payments on the junior subordinated debentures made to the trust will be distributed by the trust to the holders of the trust preferred securities. The trust preferred securities currently fully qualify as Tier 1 Capital, and under current risk-based capital guidelines, will remain fully qualified as Tier 1 Capital until maturity unless called by us at an earlier date.

3. SECURITIES

The amortized cost and fair value of available for sale securities and the related pre-tax gross unrealized gains and losses recognized in accumulated other comprehensive income (loss) are as follows:

			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value
June 30, 2014
U.S. Government agency debt obligations	$	219,141,000	$	731,000	$	(6,166,000	)	$	213,706,000
Mortgage-backed securities		107,145,000		1,249,000		(222,000	)		108,172,000
Municipal general obligation bonds		139,996,000		894,000		(721,000	)		140,169,000
Municipal revenue bonds		11,244,000		115,000		(35,000	)		11,324,000
Other Investments		1,909,000		0		(5,000	)		1,904,000

	$	479,435,000	$	2,989,000	$	(7,149,000	)	$	475,275,000

December 31, 2013
U.S. Government agency debt obligations	$	108,279,000	$	263,000	$	(10,065,000	)	$	98,477,000
Mortgage-backed securities		12,456,000		1,102,000		0			13,558,000
Municipal general obligation bonds		16,488,000		388,000		(4,000	)		16,872,000
Municipal revenue bonds		878,000		38,000		0			916,000
Mutual funds		1,386,000		0		(31,000	)		1,355,000

	$	139,487,000	$	1,791,000	$	(10,100,000	)	$	131,178,000

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

3. SECURITIES (Continued)

Securities with unrealized losses at June 30, 2014 and December 31, 2013, aggregated by investment category and length of time that individual securities have been in a continuous loss position, are as follows:

	Less than 12 Months					12 Months or More					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
	Value		Loss			Value		Loss			Value		Loss

June 30, 2014
U.S. Government agency debt obligations	$	90,627,000	$	(373,000	)	$	69,159,000	$	(5,793,000	)	$	159,786,000	$	(6,166,000	)
Mortgage-backed securities		64,108,000		(222,000	)		0		0			64,108,000		(222,000	)
Municipal general obligation bonds		92,461,000		(721,000	)		0		0			92,461,000		(721,000	)
Municipal revenue bonds		7,775,000		(35,000	)		0		0			7,775,000		(35,000	)
Other Investments		0		0			1,395,000		(5,000	)		1,395,000		(5,000	)

	$	254,971,000	$	(1,351,000	)	$	70,554,000	$	(5,798,000	)	$	325,525,000	$	(7,149,000	)


December 31, 2013
U.S. Government agency debt obligations	$	57,117,000	$	(5,798,000	)	$	29,679,000	$	(4,267,000	)	$	86,796,000	$	(10,065,000	)
Mortgage-backed securities		0		0			0		0			0		0
Municipal general obligation bonds		295,000		(4,000	)		0		0			295,000		(4,000	)
Municipal revenue bonds		0		0			0		0			0		0
Mutual funds		1,355,000		(31,000	)		0		0			1,355,000		(31,000	)

	$	58,767,000	$	(5,833,000	)	$	29,679,000	$	(4,267,000	)	$	88,446,000	$	(10,100,000	)

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

3. SECURITIES (Continued)

We evaluate securities for other-than-temporary impairment at least on a quarterly basis. Consideration is given to the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability we have to retain our investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. For those debt securities whose fair value is less than their amortized cost basis, we also consider our intent to sell the security, whether it is more likely than not that we will be required to sell the security before recovery and if we do not expect to recover the entire amortized cost basis of the security. In analyzing an issuer’s financial condition, we may consider whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred and the results of reviews of the issuer’s financial condition.

At June 30, 2014, 452 debt securities and one mutual fund with fair values totaling $325.5 million have unrealized losses aggregating $7.1 million. After we considered whether the securities were issued by the federal government or its agencies and whether downgrades by bond rating agencies had occurred, we determined that unrealized losses were due to changing interest rate environments. As we do not intend to sell our debt securities before recovery of their cost basis and we believe it is more likely than not that we will not be required to sell our debt securities before recovery of the cost basis, no unrealized losses are deemed to be other-than-temporary.

The amortized cost and fair value of debt securities at June 30, 2014, by maturity, are shown in the following table. The contractual maturity is utilized for U.S. Government agency debt obligations and municipal bonds. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Securities not due at a single maturity date, primarily mortgage-backed securities, are shown separately. Weighted average yields are also reflected, with yields for municipal securities shown at their tax equivalent yield.

	Weighted
	Average		Amortized		Fair
	Yield		Cost		Value

Due in 2014		0.86%	$	20,435,000	$	20,538,000
Due in 2015 through 2019		1.25		178,246,000		182,962,000
Due in 2020 through 2024		2.95		78,336,000		88,647,000
Due in 2025 and beyond		3.63		89,198,000		73,052,000
Mortgage-backed securities		1.73		103,209,000		108,172,000
Other Investments		1.55		1,909,000		1,904,000

		2.07%	$	471,333,000	$	475,275,000

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

3. SECURITIES (Continued)

Securities issued by the State of Michigan and all its political subdivisions had a combined amortized cost of $114.8 million and $17.4 million at June 30, 2014 and December 31, 2013, respectively, with estimated market values of $115.2 million and $17.8 million, respectively. Securities issued by all other states and their political subdivisions had a combined amortized cost of $36.4 million and estimated market value of $36.3 million at June 30, 2014. Total securities of any other specific issuer, other than the U.S. Government and its agencies and the State of Michigan and all its political subdivisions, did not exceed 10% of shareholders’ equity.

The carrying value of U.S. Government agency debt obligations and mortgage-backed securities that are pledged to secure repurchase agreements was $272.6 million and $94.4 million at June 30, 2014 and December 31, 2013, respectively. Investments in Federal Home Loan Bank stock are restricted and may only be resold or redeemed by the issuer.

4. LOANS AND ALLOWANCE FOR LOAN LOSSES

Loans originated for investment are stated at their principal amount outstanding adjusted for partial charge-offs, the allowance, and net deferred loan fees and costs. Interest income on loans is accrued over the term of the loans primarily using the simple interest method based on the principal balance outstanding. Interest is not accrued on loans where collectability is uncertain. Accrued interest is presented separately in the consolidated balance sheet. Loan origination fees and certain direct costs incurred to extend credit are deferred and amortized over the term of the loan or loan commitment period as an adjustment to the related loan yield.

Acquired loans are those purchased in the Firstbank merger (See Note 2 – Business Combination for further information). These loans were recorded at estimated fair value at the Acquisition Date with no carryover of the related allowance. The acquired loans were segregated between those considered to be performing (“acquired non-impaired loans”) and those with evidence of credit deterioration (“acquired impaired loans”). Acquired loans are considered impaired if there is evidence of credit deterioration and if it is probable, at acquisition, all contractually required payments will not be collected. Acquired loans restructured after acquisition are not considered or reported as troubled debt restructurings if the loans evidenced credit deterioration as of the Acquisition Date and are accounted for in pools. No acquired loans were modified as troubled debt restructurings after the Acquisition Date.

The fair value estimates for acquired loans are based on expected prepayments and the amount and timing of discounted expected principal, interest and other cash flows. Credit discounts representing the principal losses expected over the life of the loan are also a component of the initial fair value. In determining the Acquisition Date fair value of acquired impaired loans, and in subsequent accounting, we have generally aggregated acquired commercial and consumer loans into pools of loans with common risk characteristics.

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

The difference between the fair value of an acquired non-impaired loan and contractual amounts due at the Acquisition Date is accreted into income over the estimated life of the loan. Contractually required payments represent the total undiscounted amount of all uncollected principal and interest payments. Acquired non-impaired loans are placed on nonaccrual status and reported as nonperforming or past due using the same criteria applied to the originated loan portfolio.

The excess of an acquired impaired loan’s contractually required payments over the amount of its undiscounted cash flows expected to be collected is referred to as the non-accretable difference. The non-accretable difference, which is neither accreted into income nor recorded on the consolidated balance sheet, reflects estimated future credit losses and uncollectible contractual interest expected to be incurred over the life of the acquired impaired loan. The excess cash flows expected to be collected over the carrying amount of the acquired loan is referred to as the accretable yield. This amount is accreted into interest income over the remaining life of the acquired loans or pools using the level yield method. The accretable yield is affected by changes in interest rate indices for variable rate loans, changes in prepayment speed assumptions and changes in expected principal and interest payments over the estimated lives of the acquired impaired loans.

We evaluate quarterly the remaining contractual required payments receivable and estimate cash flows expected to be collected over the life of the impaired loans. Contractually required payments receivable may increase or decrease for a variety of reasons, for example, when the contractual terms of the loan agreement are modified, when interest rates on variable rate loans change, or when principal and/or interest payments are received. Cash flows expected to be collected on acquired impaired loans are estimated by incorporating several key assumptions similar to the initial estimate of fair value. These key assumptions include probability of default, loss given default, and the amount of actual prepayments after the Acquisition Date. Prepayments affect the estimated lives of loans and could change the amount of interest income, and possibly principal, expected to be collected. In re-forecasting future estimated cash flows, credit loss expectations are adjusted as necessary. The adjustments are based, in part, on actual loss severities recognized for each loan type, as well as changes in the probability of default. For periods in which estimated cash flows are not re-forecasted, the prior reporting period’s estimated cash flows are adjusted to reflect the actual cash received and credit events that transpired during the current reporting period.

Increases in expected cash flows of acquired impaired loans subsequent to the Acquisition Date are recognized prospectively through adjustments of the yield on the loans or pools over their remaining lives, while decreases in expected cash flows are recognized as impairment through a provision for loan losses and an increase in the allowance.

Our total loans at June 30, 2014 were $2.07 billion compared to $1.05 billion at December 31, 2013, an increase of $1.02 billion, or 96.9%. The components of our loan portfolio disaggregated by class of loan within the loan portfolio segments at June 30, 2014 and December 31, 2013, and the percentage change in loans from the end of 2013 to the end of the second quarter of 2014, are as follows:

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

									Percent
	June 30, 2014				December 31, 2013				Increase
	Balance		%		Balance		%		(Decrease)
Originated loans
Commercial:
Commercial and industrial	$	342,375,000	29.9	%	$	286,373,000	27.2	%		19.6	%
Vacant land, land development, and residential construction		32,214,000	2.8			36,741,000	3.5			(12.3	)
Real estate – owner occupied		264,596,000	23.1			261,877,000	24.9			1.0
Real estate – non-owner occupied		399,855,000	34.9			364,066,000	34.6			9.8
Real estate – multi-family and residential rental		37,569,000	3.3			37,639,000	3.5			(0.2	)
Total commercial		1,076,609,000	94.0			986,696,000	93.7			9.1

Retail:
Home equity and other		35,151,000	3.1			35,080,000	3.3			0.2
1-4 family mortgages		33,337,000	2.9			31,467,000	3.0			5.9
Total retail		68,488,000	6.0			66,547,000	6.3			2.9

Total originated loans	$	1,145,097,000	100.0	%	$	1,053,243,000	100.0	%		8.7	%

								Percent
	June 30, 2014				December 31, 2013			Increase
	Balance		%		Balance		%	(Decrease)
Acquired loans
Commercial:
Commercial and industrial	$	273,684,000	29.5	%	$	0	NA	NM
Vacant land, land development, and residential construction		21,091,000	2.3			0	NA	NM
Real estate – owner occupied		119,818,000	12.9			0	NA	NM
Real estate – non-owner occupied		149,434,000	16.1			0	NA	NM
Real estate – multi-family and residential rental		47,099,000	5.1			0	NA	NM
Total commercial		611,126,000	65.8			0	NA	NM

Retail:
Home equity and other		134,557,000	14.5			0	NA	NM
1-4 family mortgages		182,702,000	19.7			0	NA	NM
Total retail		317,259,000	34.2			0	NA	NM

Total acquired loans	$	928,385,000	100.0	%	$	0	NA	NM

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

											Percent
	June 30, 2014					December 31, 2013					Increase
	Balance		%			Balance		%			(Decrease)
Total loans
Commercial:
Commercial and industrial	$	616,059,000		29.7	%	$	286,373,000		27.2	%		115.1	%
Vacant land, land development, and residential construction		53,305,000		2.6			36,741,000		3.5			45.1
Real estate – owner occupied		384,414,000		18.5			261,877,000		24.9			46.8
Real estate – non-owner occupied		549,289,000		26.5			364,066,000		34.6			50.9
Real estate – multi-family and residential rental		84,668,000		4.1			37,639,000		3.5			124.9
Total commercial		1,687,735,000		81.4			986,696,000		93.7			71.0

Retail:
Home equity and other		169,708,000		8.2			35,080,000		3.3			383.8
1-4 family mortgages		216,039,000		10.4			31,467,000		3.0			586.6
Total retail		385,747,000		18.6			66,547,000		6.3			479.7

Total loans	$	2,073,482,000		100.0	%	$	1,053,243,000		100.0	%		96.9	%

The total outstanding balance and carrying value of acquired impaired loans was $42.6 million and $26.1 million, respectively, as of June 30, 2014. Changes in the accretable yield for acquired impaired loans for the three and six months ended June 30, 2014 were as follows:

Balance at January 1, 2014	$	0
Additions		2,514,000
Accretion		(103,000	)
Net reclassification from nonaccretable to accretable		0
Disposals		0

Ending balance	$	2,411,000

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Nonperforming originated loans as of June 30, 2014 and December 31, 2013 were as follows:

	June 30,		December 31,
	2014		2013

Loans past due 90 days or more still accruing interest	$	0	$	0
Nonaccrual loans		5,741,000		6,718,000

Total nonperforming originated loans	$	5,741,000	$	6,718,000

The recorded principal balance of nonaccrual loans was as follows:

	June 30,		December 31,
	2014		2013
Commercial:
Commercial and industrial	$	824,000	$	1,501,000
Vacant land, land development, and residential construction		235,000		785,000
Real estate – owner occupied		640,000		389,000
Real estate – non-owner occupied		129,000		168,000
Real estate – multi-family and residential rental		470,000		208,000
Total commercial		2,298,000		3,051,000

Retail:
Home equity and other		772,000		788,000
1-4 family mortgages		2,671,000		2,879,000
Total retail		3,443,000		3,667,000

Total nonaccrual loans	$	5,741,000	$	6,718,000

Acquired impaired loans are not subject to individual evaluation for impairment and are not reported as nonperforming loans based on acquired impaired loan accounting. Acquired non-impaired loans are placed on nonaccrual status and reported as nonperforming or past due using the same criteria applied to the originated loan portfolio.

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

An age analysis of past due loans is as follows as of June 30, 2014:

					Greater								Recorded
	30 – 59		60 – 89		Than 89								Balance > 89
	Days		Days		Days		Total				Total		Days and
	Past Due		Past Due		Past Due		Past Due		Current		Loans		Accruing
Originated loans
Commercial:
Commercial and industrial	$	0	$	0	$	121,000	$	121,000	$	342,254,000	$	342,375,000	$	0
Vacant land, land development, and residential construction		0		0		0		0		32,214,000		32,214,000		0
Real estate – owner occupied		35,000		0		90,000		125,000		264,471,000		264,596,000		0
Real estate – non-owner occupied		0		0		0		0		399,855,000		399,855,000		0
Real estate – multi-family and residential rental		0		0		0		0		37,569,000		37,569,000		0
Total commercial		35,000		0		211,000		246,000		1,076,363,000		1,076,609,000		0

Retail:
Home equity and other		2,000		0		0		2,000		35,149,000		35,151,000		0
1-4 family mortgages		0		0		347,000		347,000		32,990,000		33,337,000		0
Total retail		2,000		0		347,000		349,000		68,139,000		68,488,000		0

Total past due loans	$	37,000	$	0	$	558,000	$	595,000	$	1,144,502,000	$	1,145,097,000	$	0

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

					Greater								Recorded
	30 – 59		60 – 89		Than 89								Balance > 89
	Days		Days		Days		Total				Total		Days and
	Past Due		Past Due		Past Due		Past Due		Current		Loans		Accruing
Acquired loans
Commercial:
Commercial and industrial	$	587,000	$	19,000	$	1,202,000	$	1,808,000	$	271,876,000	$	273,684,000	$	0
Vacant land, land development, and residential construction		0		0		748,000		748,000		20,343,000		21,091,000		0
Real estate – owner occupied		363,000		0		949,000		1,312,000		118,506,000		119,818,000		0
Real estate – non-owner occupied		65,000		1,347,000		1,436,000		2,848,000		146,586,000		149,434,000		0
Real estate – multi-family and residential rental		0		0		0		0		47,099,000		47,099,000		0
Total commercial		1,015,000		1,366,000		4,335,000		6,716,000		604,410,000		611,126,000		0

Retail:
Home equity and other		681,000		142,000		12,000		835,000		133,722,000		134,557,000		0
1-4 family mortgages		1,796,000		115,000		860,000		2,771,000		179,931,000		182,702,000		0
Total retail		2,477,000		257,000		872,000		3,606,000		313,653,000		317,259,000		0

Total past due loans	$	3,492,000	$	1,623,000	$	5,207,000	$	10,322,000	$	918,063,000	$	928,385,000	$	0

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

An age analysis of past due loans is as follows as of December 31, 2013:

					Greater								Recorded
	30 – 59		60 – 89		Than 89								Balance > 89
	Days		Days		Days		Total				Total		Days and
	Past Due		Past Due		Past Due		Past Due		Current		Loans		Accruing
Originated loans
Commercial:
Commercial and industrial	$	0	$	0	$	309,000	$	309,000	$	286,064,000	$	286,373,000	$	0
Vacant land, land development, and residential construction		0		0		0		0		36,741,000		36,741,000		0
Real estate – owner occupied		65,000		0		50,000		115,000		261,762,000		261,877,000		0
Real estate – non-owner occupied		0		0		0		0		364,066,000		364,066,000		0
Real estate – multi-family and residential rental		0		0		64,000		64,000		37,575,000		37,639,000		0
Total commercial		65,000		0		423,000		488,000		986,208,000		986,696,000		0

Retail:
Home equity and other		14,000		0		0		14,000		35,066,000		35,080,000		0
1-4 family mortgages		21,000		44,000		375,000		440,000		31,027,000		31,467,000		0
Total retail		35,000		44,000		375,000		454,000		66,093,000		66,547,000		0

Total past due loans	$	100,000	$	44,000	$	798,000	$	942,000	$	1,052,301,000	$	1,053,243,000	$	0

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Impaired loans as of June 30, 2014, and average impaired loans for the three and six months ended June 30, 2014, were as follows:

						Second Quarter		Year-To-Date
	Unpaid					Average		Average
	Contractual		Recorded			Recorded		Recorded
	Principal		Principal		Related	Principal		Principal
	Balance		Balance		Allowance	Balance		Balance

With no related allowance recorded
Commercial:
Commercial and industrial	$	1,620,000	$	132,000		$	169,000	$	283,000
Vacant land, land development and residential construction		0		0			171,000		235,000
Real estate – owner occupied		1,171,000		640,000			662,000		703,000
Real estate – non-owner occupied		578,000		577,000			1,169,000		1,024,000
Real estate – multi-family and residential rental		41,000		0			1,000		1,000
Total commercial		3,410,000		1,349,000			2,172,000		2,246,000
Retail:
Home equity and other		707,000		644,000			647,000		585,000
1-4 family mortgages		1,107,000		559,000			585,000		606,000
Total retail		1,814,000		1,203,000			1,232,000		1,191,000

Total with no related allowance recorded	$	5,224,000	$	2,552,000		$	3,404,000	$	3,437,000

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

							Second Quarter		Year-To-Date
	Unpaid						Average		Average
	Contractual		Recorded				Recorded		Recorded
	Principal		Principal		Related		Principal		Principal
	Balance		Balance		Allowance		Balance		Balance
With an allowance recorded
Commercial:
Commercial and industrial	$	939,000	$	810,000	$	322,000	$	882,000	$	1,068,000
Vacant land, land development and residential construction		3,614,000		3,300,000		351,000		3,604,000		3,782,000
Real estate – owner occupied		2,460,000		2,460,000		679,000		1,974,000		1,820,000
Real estate – non-owner occupied		17,753,000		17,731,000		7,414,000		18,591,000		19,418,000
Real estate – multi-family and residential rental		1,677,000		1,549,000		674,000		1,319,000		1,774,000
Total commercial		26,443,000		25,850,000		9,440,000		26,370,000		27,862,000
Retail:
Home equity and other		118,000		90,000		90,000		91,000		157,000
1-4 family mortgages		2,220,000		2,112,000		832,000		2,136,000		2,168,000
Total retail		2,338,000		2,202,000		922,000		2,227,000		2,325,000

Total with an allowance recorded	$	28,781,000	$	28,052,000	$	10,362,000	$	28,597,000	$	30,187,000

Total impaired loans:
Commercial	$	29,853,000	$	27,199,000	$	9,440,000	$	28,542,000	$	30,108,000
Retail		4,152,000		3,405,000		922,000		3,459,000		3,516,000
Total impaired loans	$	34,005,000	$	30,604,000	$	10,362,000	$	32,001,000	$	33,624,000

Acquired impaired loans are not subject to individual evaluation for impairment and are not reported as impaired loans based on acquired impaired loan accounting. Acquired non-impaired loans are placed on nonaccrual status and reported as impaired using the same criteria applied to the originated loan portfolio. In accordance with purchase accounting rules, acquired loans were recorded at fair value at the Acquisition Date and the prior allowance was eliminated. No allowance has been established on these acquired loans through June 30, 2014. Interest income of $0.4 million and $0.8 million was recognized on impaired loans during the second quarter and first six months of 2014, respectively.

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Impaired loans as of June 30, 2013, and average impaired loans for the three and six months ended June 30, 2013, were as follows:

						Second Quarter		Year-To-Date
	Unpaid					Average		Average
	Contractual		Recorded			Recorded		Recorded
	Principal		Principal		Related	Principal		Principal
	Balance		Balance		Allowance	Balance		Balance
With no related allowance recorded
Commercial:
Commercial and industrial	$	2,793,000	$	1,277,000		$	1,416,000	$	1,483,000
Vacant land, land development and residential construction		1,543,000		1,010,000			1,194,000		1,263,000
Real estate – owner occupied		2,020,000		1,383,000			1,366,000		1,430,000
Real estate – non-owner occupied		8,067,000		5,194,000			4,956,000		5,134,000
Real estate – multi-family and residential rental		1,468,000		514,000			599,000		537,000
Total commercial		15,891,000		9,378,000			9,531,000		9,847,000
Retail:
Home equity and other		508,000		468,000			474,000		477,000
1-4 family mortgages		1,235,000		676,000			721,000		744,000
Total retail		1,743,000		1,144,000			1,195,000		1,221,000

Total with no related allowance recorded	$	17,634,000	$	10,522,000		$	10,726,000	$	11,068,000

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

							Second Quarter		Year-To-Date
	Unpaid						Average		Average
	Contractual		Recorded				Recorded		Recorded
	Principal		Principal		Related		Principal		Principal
	Balance		Balance		Allowance		Balance		Balance
With an allowance recorded
Commercial:
Commercial and industrial	$	1,708,000	$	1,587,000	$	1,154,000	$	2,046,000	$	2,006,000
Vacant land, land development and residential construction		5,058,000		4,515,000		1,223,000		2,998,000		2,738,000
Real estate – owner occupied		2,402,000		2,350,000		922,000		2,652,000		2,976,000
Real estate – non-owner occupied		29,249,000		29,233,000		9,672,000		29,778,000		30,840,000
Real estate – multi-family and residential rental		2,589,000		2,527,000		835,000		2,609,000		3,047,000
Total commercial		41,006,000		40,212,000		13,806,000		40,083,000		41,607,000
Retail:
Home equity and other		350,000		324,000		134,000		335,000		355,000
1-4 family mortgages		2,644,000		2,619,000		896,000		1,545,000		1,189,000
Total retail		2,994,000		2,943,000		1,030,000		1,880,000		1,544,000

Total with an allowance recorded	$	44,000,000	$	43,155,000	$	14,836,000	$	41,963,000	$	43,151,000

Total impaired loans:
Commercial	$	56,897,000	$	49,590,000	$	13,806,000	$	49,614,000	$	51,454,000
Retail		4,737,000		4,087,000		1,030,000		3,075,000		2,765,000
Total impaired loans	$	61,634,000	$	53,677,000	$	14,836,000	$	52,689,000	$	54,219,000

Interest income of $0.7 million and $1.3 million was recognized on impaired loans during the second quarter and first six months of 2013, respectively.

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Credit Quality Indicators. We utilize a comprehensive grading system for our commercial loans. All commercial loans are graded on a ten grade rating system. The rating system utilizes standardized grade paradigms that analyze several critical factors such as cash flow, operating performance, financial condition, collateral, industry condition and management. All commercial loans are graded at inception and reviewed and, if appropriate, re-graded at various intervals thereafter. The risk assessment for retail loans is primarily based on the type of collateral and payment activity.

Credit quality indicators were as follows as of June 30, 2014:

Originated Loans

Commercial credit exposure – credit risk profiled by internal credit risk grades:

			Commercial						Commerical
			Vacant Land,		Commerical		Commercial		Real Estate -
	Commerical		Land Development,		Real Estate -		Real Estate -		Multi-Family
	and		and Residential		Owner		Non-Owner		and Residential
	Industrial		Construction		Occupied		Occupied		Rental

Internal credit risk grade groupings:
Grades 1 – 4	$	220,771,000	$	7,310,000	$	163,184,000	$	253,470,000	$	17,258,000
Grades 5 – 7		120,587,000		21,604,000		97,802,000		132,604,000		18,745,000
Grades 8 – 9		1,017,000		3,300,000		3,610,000		13,781,000		1,566,000
Total commercial	$	342,375,000	$	32,214,000	$	264,596,000	$	399,855,000	$	37,569,000

Retail credit exposure – credit risk profiled by collateral type:

Retail

Home Equity

1-4 Family

and Other

Mortgages

Total retail

35,151,000

33,337,000

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Acquired loans

Commercial credit exposure – credit risk profiled by internal credit risk grades:

			Commercial						Commerical
			Vacant Land,		Commerical		Commerical		Real Estate -
	Commercial		Land Development,		Real Estate -		Real Estate -		Multi-Family
	and		and Residential		Owner		Non-Owner		and Residential
	Industrial		Construction		Occupied		Occupied		Rental

Internal credit risk grade groupings:
Grades 1 – 4	$	111,223,000	$	4,240,000	$	28,670,000	$	44,344,000	$	19,438,000
Grades 5 – 7		154,550,000		15,552,000		83,142,000		100,032,000		27,051,000
Grades 8 – 9		7,911,000		1,299,000		8,006,000		5,058,000		610,000
Total commercial	$	273,684,000	$	21,091,000	$	119,818,000	$	149,434,000	$	47,099,000

Retail credit exposure – credit risk profiled by collateral type:

Retail

Home Equity

1-4 Family

and Other

Mortgages

Total retail

134,557,000

182,702,000

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Credit quality indicators were as follows as of December 31, 2013:

Originated loans

Commercial credit exposure – credit risk profiled by internal credit risk grades:

			Commerical						Commercial
			Vacant Land,		Commerical		Commercial		Real Estate -
	Commerical		Land Development,		Real Estate -		Real Estate		Multi-Family
	and		and Residential		Owner		Non-Owner		and Residential
	Industrial		Construction		Occupied		Occupied		Rental

Internal credit risk grade groupings:
Grades 1 – 4	$	208,151,000	$	6,973,000	$	156,230,000	$	219,325,000	$	15,465,000
Grades 5 – 7		76,237,000		25,535,000		103,066,000		122,717,000		19,469,000
Grades 8 – 9		1,985,000		4,233,000		2,581,000		22,024,000		2,705,000
Total commercial	$	286,373,000	$	36,741,000	$	261,877,000	$	364,066,000	$	37,639,000

Retail credit exposure – credit risk profiled by collateral type:

Retail

Home Equity

1-4 Family

and Other

Mortgages

Total retail

35,080,000

31,467,000

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

All commercial loans are graded using the following criteria:

Grade 1. Excellent credit rating that contain very little, if any, risk of loss.

Grade 2. Strong sources of repayment and have low repayment risk.

Grade 3. Good sources of repayment and have limited repayment risk.

Grade 4. Adequate sources of repayment and acceptable repayment risk; however, characteristics are present that render the credit more vulnerable to a negative event.

Grade 5. Marginally acceptable sources of repayment and exhibit defined weaknesses and negative characteristics.

Grade 6. Well defined weaknesses which may include negative current cash flow, high leverage, or operating losses. Generally, if the credit does not stabilize or if further deterioration is observed in the near term, the loan will likely be downgraded and placed on the Watch List (i.e., list of lending relationships that receive increased scrutiny and review by the Board of Directors and senior management).

Grade 7. Defined weaknesses or negative trends that merit close monitoring through Watch List status.

Grade 8. Inadequately protected by current sound net worth, paying capacity of the obligor, or pledged collateral, resulting in a distinct possibility of loss requiring close monitoring through Watch List status.

Grade 9. Vital weaknesses exist where collection of principal is highly questionable.

Grade 10. Considered uncollectable and of such little value that continuance as an asset is not warranted.

The primary risk elements with respect to commercial loans are the financial condition of the borrower, the sufficiency of collateral, and timeliness of scheduled payments. We have a policy of requesting and reviewing periodic financial statements from commercial loan customers and employ a disciplined and formalized review of the existence of collateral and its value. The primary risk element with respect to each residential real estate loan and consumer loan is the timeliness of scheduled payments. We have a reporting system that monitors past due loans and have adopted policies to pursue creditor’s rights in order to preserve our collateral position.

(Continued)

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MERCANTILE BANK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Activity in the allowance for loan losses and the recorded investments in originated loans as of and during the three and six months ended June 30, 2014 are as follows:

	Commercial			Retail
	Loans			Loans			Unallocated			Total

Allowance for loan losses:
Balance at March 31, 2014	$	19,001,000		$	1,957,000		$	(4,000	)	$	20,954,000
Provision for loan losses		(334,000	)		(345,000	)		(21,000	)		(700,000	)
Charge-offs		(98,000	)		(5,000	)		0			(103,000	)
Recoveries		538,000			167,000			0			705,000
Ending balance	$	19,107,000		$	1,774,000		$	(25,000	)	$	20,856,000


Allowance for loan losses:
Balance at December 31, 2013	$	20,455,000		$	2,358,000		$	8,000		$	22,821,000
Provision for loan losses		(1,788,000	)		(779,000	)		(33,000	)		(2,600,000	)
Charge-offs		(684,000	)		(7,000	)		0			(691,000	)
Recoveries		1,124,000			202,000			0			1,326,000
Ending balance	$	19,107,000		$	1,774,000		$	(25,000	)	$	20,856,000

Ending balance: individually evaluated for impairment	$	9,440,000		$	922,000		$	0		$	10,362,000

Ending balance: collectively evaluated for impairment	$	9,667,000		$	852,000		$	(25,000	)	$	10,494,000


Total loans:
Ending balance	$	1,076,609,000		$	68,488,000					$	1,145,097,000

Ending balance: individually evaluated for impairment	$	27,199,000		$	3,405,000					$	30,604,000

Ending balance: collectively evaluated for impairment	$	1,049,410,000		$	65,083,000					$	1,114,493,000

In accordance with purchase accounting rules, acquired loans were recorded at fair value at the Acquisition Date and the prior allowance was eliminated. No allowance has been established on these acquired loans through June 30, 2014.

(Continued)

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MERCANTILE BANK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Activity in the allowance for loan losses and the recorded investments in originated loans as of and during the three and six months ended June 30, 2013 are as follows:

	Commercial			Retail
	Loans			Loans			Unallocated			Total

Allowance for loan losses:
Balance at March 31, 2013	$	23,717,000		$	2,302,000		$	16,000		$	26,035,000
Provision for loan losses		(1,480,000	)		(10,000	)		(10,000	)		(1,500,000	)
Charge-offs		(363,000	)		(19,000	)		0			(382,000	)
Recoveries		508,000			286,000			0			794,000
Ending balance	$	22,382,000		$	2,559,000		$	6,000		$	24,947,000


Allowance for loan losses:
Balance at December 31, 2012	$	26,043,000		$	2,645,000		$	(11,000	)	$	28,677,000
Provision for loan losses		(2,644,000	)		(373,000	)		17,000			(3,000,000	)
Charge-offs		(2,775,000	)		(22,000	)		0			(2,797,000	)
Recoveries		1,758,000			309,000			0			2,067,000
Ending balance	$	22,382,000		$	2,559,000		$	6,000		$	24,947,000

Ending balance: individually evaluated for impairment	$	13,806,000		$	1,030,000		$	0		$	14,836,000

Ending balance: collectively evaluated for impairment	$	8,576,000		$	1,529,000		$	6,000		$	10,111,000


Total loans:
Ending balance	$	985,616,000		$	73,046,000					$	1,058,662,000

Ending balance: individually evaluated for impairment	$	49,590,000		$	4,087,000					$	53,677,000

Ending balance: collectively ealuated for impairment	$	936,026,000		$	68,959,000					$	1,004,985,000

(Continued)

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MERCANTILE BANK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Loans modified as troubled debt restructurings during the three months ended June 30, 2014 were as follows:

			Pre-		Post-
			Modification		Modification
			Recorded		Recorded
	Number of		Principal		Principal
	Contracts		Balance		Balance
Originated loans
Commercial:
Commercial and industrial		0	$	0	$	0
Vacant land, land development and residential construction		0		0		0
Real estate – owner occupied		1		996,000		996,000
Real estate – non-owner occupied		0		0		0
Real estate – multi-family and residential rental		0		0		0
Total originated commercial		1		996,000		996,000

Retail:
Home equity and other		0		0		0
1-4 family mortgages		0		0		0
Total originated retail		0		0		0

Total originated loans		1	$	996,000	$	996,000

Acquired loans
Commercial:
Commercial and industrial		0	$	0	$	0
Vacant land, land development and residential construction		0		0		0
Real estate – owner occupied		0		0		0
Real estate – non-owner occupied		0		0		0
Real estate – multi-family and residential rental		0		0		0
Total acquired commercial		0		0		0

Retail:
Home equity and other		0		0		0
1-4 family mortgages		0		0		0
Total acquired retail		0		0		0

Total acquired loans		0	$	0	$	0

(Continued)

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MERCANTILE BANK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

			Pre-		Post-
			Modification		Modification
			Recorded		Recorded
	Number of		Principal		Principal
	Contracts		Balance		Balance
Total loans
Commercial:
Commercial and industrial		0	$	0	$	0
Vacant land, land development and residential construction		0		0		0
Real estate – owner occupied		1		996,000		996,000
Real estate – non-owner occupied		0		0		0
Real estate – multi-family and residential rental		0		0		0
Total commercial		1		996,000		996,000

Retail:
Home equity and other		0		0		0
1-4 family mortgages		0		0		0
Total retail		0		0		0

Total loans		1	$	996,000	$	996,000

Loans modified as troubled debt restructurings during the six months ended June 30, 2014 were as follows:

			Pre-		Post-
			Modification		Modification
			Recorded		Recorded
	Number of		Principal		Principal
	Contracts		Balance		Balance
Originated loans
Commercial:
Commercial and industrial		1	$	14,000	$	14,000
Vacant land, land development and residential construction		0		0		0
Real estate – owner occupied		1		996,000		996,000
Real estate – non-owner occupied		1		146,000		146,000
Real estate – multi-family and residential rental		0		0		0
Total originated commercial		3		1,156,000		1,156,000

Retail:
Home equity and other		0		0		0
1-4 family mortgages		0		0		0
Total originated retail		0		0		0

Total originated loans		3	$	1,156,000	$	1,156,000

(Continued)

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MERCANTILE BANK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

			Pre-		Post-
			Modification		Modification
			Recorded		Recorded
	Number of		Principal		Principal
	Contracts		Balance		Balance
Acquired loans
Commercial:
Commercial and industrial		0	$	0	$	0
Vacant land, land development and residential construction		0		0		0
Real estate – owner occupied		0		0		0
Real estate – non-owner occupied		0		0		0
Real estate – multi-family and residential rental		0		0		0
Total acquired commercial		0		0		0

Retail:
Home equity and other		0		0		0
1-4 family mortgages		0		0		0
Total acquired		0		0		0

Total acquired loans		0	$	0	$	0

Total loans
Commercial:
Commercial and industrial		1	$	14,000	$	14,000
Vacant land, land development and residential construction		0		0		0
Real estate – owner occupied		1		996,000		996,000
Real estate – non-owner occupied		1		146,000		146,000
Real estate – multi-family and residential rental		0		0		0
Total commercial		3		1,156,000		1,156,000

Retail:
Home equity and other		0		0		0
1-4 family mortgages		0		0		0
Total retail		0		0		0

Total loans		3	$	1,156,000	$	1,156,000

(Continued)

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MERCANTILE BANK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Loans modified as troubled debt restructurings during the three months ended June 30, 2013 were as follows:

			Pre-		Post-
			Modification		Modification
			Recorded		Recorded
	Number of		Principal		Principal
	Contracts		Balance		Balance
Originated loans
Commercial:
Commercial and industrial		1	$	60,000	$	60,000
Vacant land, land development and residential construction		2		3,247,000		3,247,000
Real estate – owner occupied		2		680,000		680,000
Real estate – non-owner occupied		0		0		0
Real estate – multi-family and residential rental		0		0		0
Total originated commercial		5		3,987,000		3,987,000

Retail:
Home equity and other		0		0		0
1-4 family mortgages		1		1,879,000		1,879,000
Total originated retail		1		1,879,000		1,879,000

Total originated loans		6	$	5,866,000	$	5,866,000

(Continued)

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MERCANTILE BANK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Loans modified as troubled debt restructurings during the six months ended June 30, 2013 were as follows:

			Pre-		Post-
			Modification		Modification
			Recorded		Recorded
	Number of		Principal		Principal
	Contracts		Balance		Balance
Originated loans
Commercial:
Commercial and industrial		1	$	60,000	$	60,000
Vacant land, land development and residential construction		2		3,247,000		3,247,000
Real estate – owner occupied		3		904,000		904,000
Real estate – non-owner occupied		2		2,068,000		2,068,000
Real estate – multi-family and residential rental		0		0		0
Total originated commercial		8		6,279,000		6,279,000

Retail:
Home equity and other		0		0		0
1-4 family mortgages		1		1,879,000		1,879,000
Total originated retail		1		1,879,000		1,879,000

Total originated loans		9	$	8,158,000	$	8,158,000

(Continued)

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MERCANTILE BANK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

The following originated loans, modified as troubled debt restructurings within the previous twelve months, became over 30 days past due within the three months ended June 30, 2014 (amounts as of period end):

			Recprded
	Number of		Principal
	Contracts		Balance
Commercial:
Commercial and industrial		0	$	0
Vacant land, land development and residential construction		0		0
Real estate – owner occupied		0		0
Real estate – non-owner occupied		0		0
Real estate – multi-family and residential rental		0		0
Total commercial		0		0

Retail:
Home equity and other		0		0
1-4 family mortgages		0		0
Total retail		0		0

Total		0	$	0

The following originated loans, modified as troubled debt restructurings within the previous twelve months, became over 30 days past due within the six months ended June 30, 2014 (amounts as of period end):

			Recorded
	Number of		Principal
	Contracts		Balance
Commercial:
Commercial and industrial		0	$	0
Vacant land, land development and residential construction		0		0
Real estate – owner occupied		0		0
Real estate – non-owner occupied		0		0
Real estate – multi-family and residential rental		0		0
Total commercial		0		0

Retail:
Home equity and other		0		0
1-4 family mortgages		0		0
Total retail		0		0

Total		0	$	0

(Continued)

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MERCANTILE BANK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

			Recorded
	Number of		Principal
	Contracts		Balance
Commercial:
Commercial and industrial		0	$	0
Vacant land, land development and residential construction		0		0
Real estate – owner occupied		0		0
Real estate – non-owner occupied		0		0
Real estate – multi-family and residential rental		0		0
Total commercial		0		0

Retail:
Home equity and other		0		0
1-4 family mortgages		0		0
Total retail		0		0

Total		0	$	0

			Recorded
	Number of		Principal
	Contracts		Balance
Commercial:
Commercial and industrial		0	$	0
Vacant land, land development and residential construction		0		0
Real estate – owner occupied		0		0
Real estate – non-owner occupied		0		0
Real estate – multi-family and residential rental		0		0
Total commercial		0		0

Retail:
Home equity and other		0		0
1-4 family mortgages		0		0
Total retail		0		0

Total		0	$	0

(Continued)

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MERCANTILE BANK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Activity for originated loans categorized as troubled debt restructurings during the three months ended June 30, 2014 is as follows:

				Commercial									Commercial
				Vacant Land,			Commercial			Commercial			Real Estate -
	Commercial			Land Development,			Real Estate -			Real Estate -			Multi-Family
	and			and Residential			Owner			Non-Owner			and Residential
	Industrial			Construction			Occupied			Occupied			Rental

Commercial Loan Portfolio:
Beginning Balance	$	1,404,000		$	4,250,000		$	1,756,000		$	21,629,000		$	732,000
Charge-Offs		(67,000	)		0			0			0			0
Payments		(161,000	)		(464,000	)		(42,000	)		(2,965,000	)		(13,000	)
Transfers to ORE		0			0			0			0			0
Net Additions/Deletions		0			0			997,000			0			0
Ending Balance	$	1,176,000		$	3,786,000		$	2,711,000		$	18,664,000		$	719,000

	Retail		Retail
	Home Equity		1-4 Family
	and Other		Mortgages
Retail Loan Portfolio:
Beginning Balance	$	0	$	2,122,000
Charge-Offs		0		0
Payments		0		(45,000	)
Transfers to ORE		0		0
Net Additions/Deletions		0		0
Ending Balance	$	0	$	2,077,000

(Continued)

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MERCANTILE BANK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Activity for originated loans categorized as troubled debt restructurings during the six months ended June 30, 2014 is as follows:

				Commercial									Commercial
				Vacant Land,			Commerical			Commercial			Real Estate -
	Commercial			Land Development,			Real Estate -			Real Estate -			Multi-Family
	and			and Residential			Owner			Non-Owner			and Residential
	Industrial			Construction			Occupied			Occupied			Rental

Commercial Loan Portfolio:
Beginning Balance	$	1,656,000		$	4,501,000		$	1,816,000		$	22,311,000		$	2,620,000
Charge-Offs		(67,000	)		0			(11,000	)		0			(420,000	)
Payments		(427,000	)		(3,613,000	)		(90,000	)		(3,966,000	)		(1,481,000	)
Transfers to ORE		0			0			0			0			0
Net Additions/Deletions		14,000			2,898,000			996,000			319,000			0
Ending Balance	$	1,176,000		$	3,786,000		$	2,711,000		$	18,664,000		$	719,000

	Retail		Retail
	Home Equity		1-4 Family
	and Other		Mortgages
Retail Loan Portfolio:
Beginning Balance	$	0	$	2,191,000
Charge-Offs		0		0
Payments		0		(114,000	)
Transfers to ORE		0		0
Net Additions/Deletions		0		0
Ending Balance	$	0	$	2,077,000

(Continued)

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MERCANTILE BANK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Activity for originated loans categorized as troubled debt restructurings during the three months ended June 30, 2013 is as follows:

				Commercial									Commercial
				Vacant Land,			Commercial			Commercial			Real Estate -
	Commercial			Land Development,			Real Estate -			Real Estate -			Multi-Family
	and			and Residential			Owner			Non-Owner			and Residential
	Industrial			Construction			Occupied			Occupied			Rental

Commercial Loan Portfolio:
Beginning Balance	$	3,269,000		$	2,327,000		$	3,879,000		$	35,003,000		$	2,958,000
Charge-Offs		0			(30,000	)		(70,000	)		(5,000	)		0
Payments		(1,063,000	)		(104,000	)		(979,000	)		(574,000	)		(183,000	)
Transfers to ORE		0			0			0			0			0
Net Additions/Deletions		60,000			3,247,000			749,000			0			0
Ending Balance	$	2,266,000		$	5,440,000		$	3,579,000		$	34,424,000		$	2,775,000

	Retail		Retail
	Home Equity		1-4 Family
	and Other		Mortgages
Retail Loan Portfolio:
Beginning Balance	$	0	$	152,000
Charge-Offs		0		0
Payments		0		(2,000	)
Transfers to ORE		0		0
Net Additions/Deletions		0		1,879,000
Ending Balance	$	0	$	2,029,000

(Continued)

47.

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MERCANTILE BANK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

Activity for originated loans categorized as troubled debt restructurings during the six months ended June 30, 2013 is as follows:

				Commercial									Commercial
				Vacant Land,			Commercial			Commercial			Real Estate -
	Commercial			Land Development,			Real Estate -			Real Estate -			Multi-Family
	and			and Residential			Owner			Non-Owner			and Residential
	Industrial			Construction			Occupied			Occupied			Rental

Commercial Loan Portfolio:
Beginning Balance	$	2,721,000		$	3,071,000		$	4,115,000		$	37,672,000		$	3,025,000
Charge-Offs		(34,000	)		(725,000	)		(70,000	)		(716,000	)		(15,000	)
Payments		(1,578,000	)		(153,000	)		(1,039,000	)		(3,786,000	)		(235,000	)
Transfers to ORE		(74,000	)		0			(363,000	)		(802,000	)		0
Net Additions/Deletions		1,231,000			3,247,000			936,000			2,056,000			0
Ending Balance	$	2,266,000		$	5,440,000		$	3,579,000		$	34,424,000		$	2,775,000

	Retail		Retail
	Home Equity		1-4 Family
	and Other		Mortgages
Retail Loan Portfolio:
Beginning Balance	$	0	$	155,000
Charge-Offs		0		0
Payments		0		(5,000	)
Transfers to ORE		0		0
Net Additions/Deletions		0		1,879,000
Ending Balance	$	0	$	2,029,000

(Continued)

48.

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MERCANTILE BANK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. LOANS AND ALLOWANCE FOR LOAN LOSSES (Continued)

The allowance related to originated loans categorized as troubled debt restructurings was as follows:

	June 30,		December 31,
	2014		2013

Commercial:
Commercial and industrial	$	60,000	$	187,000
Vacant land, land development, and residential construction		341,000		798,000
Real estate – owner occupied		679,000		528,000
Real estate – non-owner occupied		7,285,000		7,828,000
Real estate – multi-family and residential rental		499,000		1,010,000
Total commercial		8,864,000		10,351,000

Retail:
Home equity and other		0		0
1-4 family mortgages		0		0
Total retail		0		0

Total related allowance	$	8,864,000	$	10,351,000

In general, our policy dictates that a renewal or modification of an 8- or 9-rated commercial loan meets the criteria of a troubled debt restructuring, although we review and consider all renewed and modified loans as part of our troubled debt restructuring assessment procedures. Loan relationships rated 8 contain significant financial weaknesses, resulting in a distinct possibility of loss, while relationships rated 9 reflect vital financial weaknesses, resulting in a highly questionable ability on our part to collect principal; we believe borrowers warranting such ratings would have difficulty obtaining financing from other market participants. Thus, due to the lack of comparable market rates for loans with similar risk characteristics, we believe 8- or 9-rated loans renewed or modified were done so at below market rates. Loans that are identified as troubled debt restructurings are considered impaired and are individually evaluated for impairment when assessing these credits in our allowance for loan losses calculation.

(Continued)

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MERCANTILE BANK CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

5. PREMISES AND EQUIPMENT, NET

Premises and equipment are comprised of the following:

	June 30,		December 31,
	2014		2013

Land, buildings and improvements	$	55,352,000	$	33,289,000
Furniture and equipment		15,518,000		12,718,000
		70,870,000		46,007,000
Less: accumulated depreciation		21,867,000		21,109,000

Premises and equipment, net	$	49,003,000	$	24,898,000

Depreciation expense totaled $0.5 million during the second quarter of 2014, compared to $0.3 million during the second quarter of 2013. Depreciation expense totaled $0.8 million during the first six months of 2014, compared to $0.7 million during the first six months of 2013.

6. DEPOSITS

Our total deposits at June 30, 2014 totaled $2.30 billion compared to $1.12 billion at December 31, 2013, an increase of $1.18 billion, or 105.8%. A vast majority of the increase reflects the consummation of the merger with Firstbank effective June 1, 2014. The components of our outstanding balances at June 30, 2014 and December 31, 2013, and percentage change in deposits from the end of 2013 to the end of the second quarter of 2014, are as follows:

											Percent
	June 30, 2014					December 31, 2013					Increase
	Balance		%			Balance		%			(Decrease)

Noninterest-bearing checking	$	515,646,000		22.4	%	$	224,580,000		20.1	%		129.6	%
Interest-bearing checking		424,362,000		18.4			197,388,000		17.6			115.0
Money market		237,798,000		10.3			133,369,000		11.9			78.3
Savings		341,924,000		14.8			52,606,000		4.7			550.0
Time, under $100,000		208,417,000		9.1			43,251,000		3.9			381.9
Time, $100,000 and over		387,305,000		16.8			254,600,000		22.8			52.1
		2,115,452,000		91.8			905,794,000		81.0			133.5

Out-of-area time, under $100,000		3,150,000		0.2			4,078,000		0.4			(22.8	)

Out-of-area time, $100,000 and over		184,659,000		8.0			209,039,000		18.6			(11.7	)
		187,809,000		8.2			213,117,000		19.0			(11.9	)

Total deposits	$	2,303,261,000		100.0	%	$	1,118,911,000		100.0	%		105.8	%

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

7. SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE

Securities sold under agreements to repurchase (“repurchase agreements”) are offered principally to certain large deposit customers. Information relating to our repurchase agreements follows:

	Six Months Ended			Twelve Months Ended
	June 30, 2014			December 31, 2013

Outstanding balance at end of period	$	124,108,000		$	69,305,000
Average interest rate at end of period		0.10	%		0.12	%

Average daily balance during the period	$	79,003,000		$	65,939,000
Average interest rate during the period		0.12	%		0.12	%

Maximum daily balance during the period	$	126,621,000		$	78,960,000

Repurchase agreements generally have original maturities of less than one year. Repurchase agreements are treated as financings and the obligations to repurchase securities sold are reflected as liabilities. Securities involved with the agreements are recorded as assets of our bank and are held in safekeeping by a correspondent bank. Repurchase agreements are secured by securities with an aggregate market value equal to the aggregate outstanding balance.

8. FEDERAL HOME LOAN BANK ADVANCES

Federal Home Loan Bank advances totaled $57.0 million at June 30, 2014, and mature at varying dates from October 2014 through September, 2017, with fixed rates of interest from 0.41% to 1.51% and averaging 1.21%. Federal Home Loan Bank advances totaled $45.0 million at December 31, 2013, maturing at varying dates from March 2017 through September 2017, with fixed rates of interest from 1.22% to 1.51% and averaging 1.34%. The $12.0 million increase during the first six months of 2014 reflects the consummation of the merger with Firstbank effective June 1, 2014.

Each advance is payable at its maturity date and is subject to a prepayment fee if paid prior to the maturity date. The advances are collateralized by residential mortgage loans, first mortgage liens on multi-family residential property loans, first mortgage liens on commercial real estate property loans, and substantially all other assets of our bank, under a blanket lien arrangement. Our borrowing line of credit as of June 30, 2014 totaled about $570 million, with availability based on collateral approximating $509 million.

Maturities of currently outstanding FHLB advances are as follows:

2014	$	3,000,000
2015		6,000,000
2016		3,044,000
2017		45,000,000
2018		0

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

9. STOCK-BASED COMPENSATION

Stock-based compensation plans are used to provide directors and employees with an increased incentive to contribute to our long-term performance and growth, to align the interests of directors and employees with the interests of our shareholders through the opportunity for increased stock ownership and to attract and retain directors and employees. From 2000 through 2005, stock option grants were provided to directors and certain employees through several stock option plans, including the 2000 Employee Stock Option Plan, 2004 Employee Stock Option Plan and Independent Director Stock Option Plan. During 2006, 2007 and 2008, stock option and restricted stock grants were provided to certain employees through the Stock Incentive Plan of 2006. No stock option or restricted stock grants were made during 2009, 2010 or 2011. During 2012, restricted stock grants were provided to directors and certain employees through the Stock Incentive Plan of 2006. No stock option or restricted stock grants were made during 2013 or during the first six months of 2014 due to the pending merger with Firstbank.

Under our 2000 Employee Stock Option Plan and 2004 Employee Stock Option Plan, stock options granted to employees were granted at the market price on the date of grant, generally fully vested after one year and expired ten years from the date of grant. Stock options granted to non-executive officers during 2005 vested about three weeks after being granted. Under our Independent Director Stock Option Plan, stock options granted to non-employee directors are at 125% of the market price on the date of grant, fully vested after five years and expire ten years from the date of grant.

The Stock Incentive Plan of 2006 replaced all of our outstanding stock option plans for stock options not previously granted. Under the Stock Incentive Plan of 2006, incentive awards may include, but are not limited to, stock options, restricted stock, stock appreciation rights and stock awards. Incentive awards that are stock options or stock appreciation rights are granted with an exercise price not less than the closing price of our common stock on the date of grant, or for stock options granted in 2006 or 2007, the day before the date of grant, if the closing price was higher on the day before the date of grant. Price, vesting and expiration date parameters are determined by Mercantile’s Compensation Committee on a grant-by-grant basis. Generally, the stock options granted to employees during 2006, 2007 and 2008 fully vested after two years and expire after seven years. The restricted stock awards granted to certain employees during 2006, 2007 and 2008 fully vested after four years, while the restricted stock awards granted to directors and certain employees during 2012 fully vest after two years. No payments were required from employees for the restricted stock awards. At year-end 2013, there were approximately 384,000 shares authorized for future incentive awards.

In conjunction with the Firstbank merger, all of our outstanding restricted stock awards, which were schedule to cliff vest in full in November, 2014, became fully vested as of June 1, 2014, resulting in the recognition of compensation expense of $0.2 million in the second quarter of 2014 to reflect the accelerated vesting of the restricted stock awards. As of June 30, 2014, there was no unrecognized compensation cost related to unvested stock option grants under our various stock-based compensation plans, and no unrecognized compensation cost related to unvested restricted stock awards under our Stock Incentive Plan of 2006.

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(Unaudited)

9. STOCK-BASED COMPENSATION (Continued)

Also in conjunction with the Firstbank merger, we assumed, and issued Mercantile stock options in replacement of, all outstanding stock option grants that had been issued to Firstbank employees under the Firstbank Corporation Stock Option and Restricted Stock Plan of 1997 and the Firstbank Corporation 2006 Stock Compensation Plan. In general, stock option grants for 50 shares or less fully vested after one year from date of grant, while stock option grants for more than 50 shares vested over a five-year period at 20% of the grant per annum starting one year from the date of grant. The stock option grants expire ten years from the date of grant. There were approximately 282,200 Mercantile stock options issued as a result of the merger, with about 258,400 of the stock option grants fully vested and exercisable, on the Merger Date. The remaining 23,800 stock options vest over the next six to 18 months. Unrecognized compensation cost related to the unvested stock options was less than $100,000 as of June 30, 2014, which is expected to be fully recognized by November, 2015.

A summary of restricted stock activity from grants issued under the Mercantile plans during the first six months of 2014 and the 2013 and 2012 calendar years is as follows:

	2014					2013					2012
				Weighted					Weighted					Weighted
				Average					Average					Average
	Shares			Fair Value		Shares			Fair Value		Shares			Fair Value
Nonvested at beginning of year		63,800		$	14.30		66,100		$	14.30		38,650		$	6.20
Granted		0		NA			0		NA			66,100			14.30
Vested		(63,300	)		14.30		0		NA			(38,266	)		6.20
Forfeited		(500	)		14.30		(2,300	)		14.30		(384	)		6.20
Nonvested at end of period		0		$	NA		63,800		$	14.30		66,100		$	14.30

A summary of stock option activity from grants issued under the various Mercantile plans during the first six months of 2014 and the 2013 and 2012 calendar years is as follows:

	2014					2013					2012
				Weighted					Weighted					Weighted
				Average					Average					Average
				Exercise					Exercise					Exercise
	Shares			Price		Shares			Price		Shares			Price
Outstanding at beginning of year		60,876		$	33.11		152,896		$	26.15		214,903		$	22.40
Granted		0		NA			0		NA			0		NA
Exercised		(2,845	)		17.74		(51,055	)		13.72		(50,930	)		10.83
Forfeited or expired		(1,141	)		37.55		(40,965	)		31.30		(11,077	)		23.77
Outstanding at end of period		56,890		$	33.79		60,876		$	33.11		152,896		$	26.15

Options exercisable at period-end		56,890		$	33.79		60,876		$	33.11		152,896		$	26.15

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

9. STOCK-BASED COMPENSATION (Continued)

The fair value of each stock option award is estimated on the date of grant using a closed option valuation (Black-Scholes) model that uses the assumptions noted in the table below. Expected volatilities are based on historical volatilities on our common stock. Historical data is used to estimate stock option expense and post-vesting termination behavior. The expected term of stock options granted is based on historical data and represents the period of time that stock options granted are expected to be outstanding, which takes into account that the stock options are not transferable. The risk-free interest rate for the expected term of the stock option is based on the U.S. Treasury yield curve in effect at the time of the stock option grant. Except for the stock options awarded in connection with the merger, no stock option grants were made during 2012 or 2013 or during the first six months of 2014.

Options issued under the various Mercantile plans outstanding at June 30, 2014 were as follows:

					Outstanding					Exercisable
							Weighted Average	Weighted				Weighted
Range of							Remaining	Average				Average
Exercise							Contractual	Exercise				Exercise
Prices					Number		Life (years)	Price		Number		Price

	$6.21	-	$	8.00		2,700	1.4	$	6.21		2,700	$	6.21
	$32.01	-	$	36.00		51,300	0.9		34.87		51,300		34.87
	$40.01	-	$	44.00		2,890	0.3		40.28		2,890		40.28

	Outstanding at end of period					56,890	0.9	$	33.79		56,890	$	33.79

Information related to options issued under the various Mercantile plans outstanding at June 30, 2014 and year-end 2013 and 2012 is as follows:

	2014		2013		2012

Minimum exercise price	$	6.21	$	6.21	$	6.21
Maximum exercise price		40.28		40.28		40.28
Average remaining option term (years)		0.9		1.4		1.9

Information related to stock option grants and exercises issued under the various Mercantile plans during the first six months of 2014 and the 2013 and 2012 calendar years is as follows:

	2014		2013		2012

Aggregate intrinsic value of stock options exercised	$	11,000	$	408,000	$	307,000
Cash received from stock option exercises		50,000		289,000		227,000
Tax benefit realized from stock option exercises		0		0		0
Weighted average per share fair value of stock options granted	NA		NA		NA

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(Unaudited)

9. STOCK-BASED COMPENSATION (Continued)

The aggregate intrinsic value of all stock options issued under the various Mercantile plans outstanding and exercisable at June 30, 2014 was less than $0.1 million. Shares issued as a result of the exercise of stock option grants have been authorized and previously unissued shares.

A summary of stock option activity from grants issued under the various former Firstbank plans that became part of Mercantile’s plans upon consummation of the merger during the month of June, 2014, is as follows:

				Weighted
				Average
				Exercise
	Shares			Price
Outstanding at beginning of year		0		$	NA
Granted		0			NA
Assumed as part of merger		282,178			15.48
Exercised		(3,075	)		7.80
Forfeited or expired		0		NA
Outstanding at end of period		279,103		$	15.57

Options exercisable at period-end		255,373		$	16.44

Options issued under the various Firstbank plans outstanding at June 30, 2014 were as follows:

					Outstanding					Exercisable
							Weighted Average	Weighted				Weighted
Range of							Remaining	Average				Average
Exercise							Contractual	Exercise				Exercise
Prices					Number		Life (years)	Price		Number		Price

	$4.00	-	$	8.00		78,855	5.4	$	6.54		62,215	$	6.90
	$8.01	-	$	12.00		31,830	5.4		8.60		24,740		8.60
	$12.01	-	$	16.00		46,000	3.4		16.00		46,000		16.00
	$20.01	-	$	24.00		85,962	1.9		22.43		85,962		22.43
	$24.01	-	$	28.00		36,456	0.4		24.46		36,456		24.46

Outstanding at end of period						279,103	3.3	$	15.57		255,373	$	16.44

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

9. STOCK-BASED COMPENSATION (Continued)

Information related to options issued under the various Firstbank plans outstanding at June 30, 2014 is as follows:

Minimum exercise price	$	7.80
Maximum exercise price		24.46
Average remaining option term (in years)	3.3

Information related to stock option grants and exercises issued under the various Firstbank plans during the month of June, 2014, is as follows:

Aggregate intrinsic value of stock options exercised	$	40,000
Cash received from stock option exercises		24,000
Tax benefit realized from stock option exercises		0
Weighted average per share fair value of stock options granted	NA

The aggregate intrinsic value of all stock options issued under the various Firstbank plans outstanding and exercisable at June 30, 2014 was $2.1 million.

On June 26, 2014, we granted a total of 7,375 shares of common stock to our Corporate, Bank and Regional Advisory Boards of Directors for retainer payments for the period of July 1, 2014 through December 31, 2014. The associated $155,000 cost will be expensed on a straightline basis over the last six months of 2014.

10. COMMITMENTS AND OFF-BALANCE SHEET RISK

Our bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Loan commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Standby letters of credit are conditional commitments issued by our bank to guarantee the performance of a customer to a third party. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.

These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized, if any, in the balance sheet. Our bank’s maximum exposure to loan loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. Our bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. Collateral, such as accounts receivable, securities, inventory, and property and equipment, is generally obtained based on our credit assessment of the borrower. If required, estimated loss exposure resulting from these instruments is expensed and is generally recorded as a liability. There was no reserve or liability balance for these instruments as of June 30, 2014 and December 31, 2013.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

10. COMMITMENTS AND OFF-BALANCE SHEET RISK (Continued)

A summary of the contractual amounts of our financial instruments with off-balance sheet risk at June 30, 2014 and December 31, 2013 follows:

	June 30,		December 31,
	2014		2013

Commercial unused lines of credit	$	339,146,000	$	257,937,000
Unused lines of credit secured by 1 – 4 family residential properties		60,439,000		23,429,000
Credit card unused lines of credit		9,180,000		9,013,000
Other consumer unused lines of credit		9,302,000		5,695,000
Commitments to make loans		177,363,000		58,799,000
Standby letters of credit		37,598,000		19,670,000
	$	633,028,000	$	374,543,000

Certain of our commercial loan customers have entered into interest rate swap agreements directly with our correspondent banks. To assist our commercial loan customers in these transactions, and to encourage our correspondent banks to enter into the interest rate swap transactions with minimal credit underwriting analyses on their part, we have entered into risk participation agreements with the correspondent banks whereby we agree to make payments to the correspondent banks owed by our commercial loan customers under the interest rate swap agreement in the event that our commercial loan customers do not make the payments. We are not a party to the interest rate swap agreements under these arrangements. As of June 30, 2014, the total notional amount of the underlying interest rate swap agreements was $17.6 million, with a net fair value from our commercial loan customers’ perspective of negative $2.6 million. These risk participation agreements are considered financial guarantees in accordance with applicable accounting guidance and are therefore recorded as liabilities at fair value, generally equal to the fees collected at the time of their execution. These liabilities are accreted into income during the term of the interest rate swap agreements, generally ranging from four to fifteen years.

11. HEDGING ACTIVITIES

Our interest rate risk policy includes guidelines for measuring and monitoring interest rate risk. Within these guidelines, parameters have been established for maximum fluctuations in net interest income. Possible fluctuations are measured and monitored using net interest income simulation. Our policy provides for the use of certain derivative instruments and hedging activities to aid in managing interest rate risk to within the policy parameters. To help mitigate the negative impact to our net interest income in an increasing interest rate environment resulting from our cost of funds likely increasing at a higher rate than the yield on our assets, we may periodically enter into derivative financial instruments.

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(Unaudited)

11. HEDGING ACTIVITIES (Continued)

In February 2012, we entered into an interest rate swap agreement with a correspondent bank to hedge the floating rate on our subordinated debentures, which became effective in January 2013 and matures in January 2018. Our $32.0 million of subordinated debentures have a rate equal to the 90-Day Libor Rate plus a fixed spread of 218 basis points, and are subject to repricing quarterly. The interest rate swap agreement provides for us to pay our correspondent bank a fixed rate, while our correspondent bank will pay us the 90-Day Libor Rate on a $32.0 million notional amount. The quarterly re-set dates for the floating rate on the interest rate swap agreement are the same as the re-set dates for the floating rate on the subordinated debentures. The interest rate swap agreement does qualify for hedge accounting; therefore, monthly fluctuations in the present value of the interest rate swap agreement, net of tax effect, are recorded to other comprehensive income. As of June 30, 2014 and December 31, 2013, the present value of the interest rate swap agreement was recorded as a liability in the amount of $0.4 million and $0.3 million, respectively.

12. FAIR VALUES OF FINANCIAL INSTRUMENTS

The carrying amounts, estimated fair values and level within the fair value hierarchy of financial instruments were as follows as of June 30, 2014 and December 31, 2013 (dollars in thousands):

	Level in		June 30, 2014				December 31, 2013
	Fair Value		Carrying		Fair		Carrying		Fair
	Hierarchy		Values		Values		Values		Values

Financial assets:
Cash	Level 1		$	14,040	$	14,040	$	1,464	$	1,464
Cash equivalents	Level 2			104,813		104,813		145,501		145,501
Securities available for sale		(1)		475,275		475,275		131,178		131,178
FHLB stock		(2)		19,226		19,226		11,961		11,961
Loans, net	Level 3			2,052,626		2,049,625		1,030,422		1,027,300
Bank owned life insurance	Level 2			55,693		55,693		51,377		51,377
Accrued interest receivable	Level 2			7,711		7,711		3,649		3,649

Financial liabilities:
Deposits	Level 2			2,303,261		2,305,253		1,118,911		1,120,576
Repurchase agreements	Level 2			124,108		124,108		69,305		69,305
FHLB advances	Level 2			57,044		57,235		45,000		45,139
Subordinated debentures	Level 2			54,131		54,087		32,990		32,974
Accrued interest payable	Level 2			2,159		2,159		2,041		2,041
Interest rate swap		(1)		390		390		264		264

(1) See Note 13 for a description of the fair value hierarchy as well as a disclosure of levels for classes of financial assets and liabilities.

(2) It is not practical to determine the fair value of FHLB stock due to transferability restrictions.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

12. FAIR VALUES OF FINANCIAL INSTRUMENTS (Continued)

Carrying amount is the estimated fair value for cash and cash equivalents, accrued interest receivable and payable, bank owned life insurance, noninterest checking deposits, securities sold under agreements to repurchase, and variable rate loans and deposits that reprice frequently and fully. Security fair values are based on market prices or dealer quotes, and if no such information is available, on the rate and term of the security and information about the issuer. For fixed rate loans and deposits and for variable rate loans and deposits with infrequent repricing or repricing limits, fair value is based on discounted cash flows using current market rates applied to the estimated life and credit risk. Fair value of subordinated debentures and Federal Home Loan Bank advances is based on current rates for similar financing. Fair value of the interest rate swap is determined primarily utilizing market-consensus forecasted yield curves. Fair value of off-balance sheet items is estimated to be nominal.

13. FAIR VALUES

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability, or in the absence of a principal market, the most advantageous market for the asset or liability. The price of the principal (or most advantageous) market used to measure the fair value of the asset or liability is not adjusted for transaction costs. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets and liabilities; it is not a forced transaction. Market participants are buyers and sellers in the principal market that are (i) independent, (ii) knowledgeable, (iii) able to transact and (iv) willing to transact.

We are required to use valuation techniques that are consistent with the market approach, the income approach and/or the cost approach. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets and liabilities. The income approach uses valuation techniques to convert future amounts, such as cash flows or earnings, to a single present amount on a discounted basis. The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (replacement cost). Valuation techniques should be consistently applied. Inputs to valuation techniques refer to the assumptions that market participants would use in pricing the asset or liability. Inputs may be observable, meaning those that reflect the assumptions market participants would use in pricing the asset or liability based on market data obtained from independent sources, or unobservable, meaning those that reflect our own assumptions about the assumptions market participants would use in pricing the asset or liability based on the best information available in the circumstances. In that regard, we utilize a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:

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

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(Unaudited)

13. FAIR VALUES (Continued)

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

Level 3: Significant unobservable inputs that reflect our own conclusions about the assumptions that market participants would use in pricing an asset or liability.

The following is a description of our valuation methodologies used to measure and disclose the fair values of our financial assets and liabilities that are recorded at fair value on a recurring or nonrecurring basis:

Securities available for sale. Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based on quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models. Level 2 securities include U.S. Government agency bonds, mortgage-backed securities issued or guaranteed by U.S. Government agencies, municipal general obligation and revenue bonds and mutual funds. Level 3 securities include bonds issued by certain relatively small municipalities located within our markets that have very limited marketability due to their size and lack of ratings from a recognized rating service. We carry these bonds at historical cost, which we believe approximates fair value, unless our periodic financial analysis or other information becomes known which necessitates a valuation allowance. There was no such valuation allowance as of June 30, 2014 or December 31, 2013. We have no Level 1 securities available for sale.

Derivatives. The interest rate swap is measured at fair value on a recurring basis. We measure fair value utilizing models that use primarily market observable inputs, such as forecasted yield curves, and accordingly, the interest rate swap agreement is classified as Level 2.

Mortgage loans held for sale. Mortgage loans held for sale are carried at the lower of aggregate cost or fair value and are measured on a nonrecurring basis. Fair value is based on independent quoted market prices, where applicable, or the prices for other mortgage whole loans with similar characteristics. As of June 30, 2014 and December 31, 2013, we determined that the fair value of our mortgage loans held for sale approximated the recorded cost of $1.9 million and $1.1 million, respectively.

Loans. We do not record loans at fair value on a recurring basis. However, from time to time, we record nonrecurring fair value adjustments to collateral dependent loans to reflect partial write-downs or specific reserves that are based on the observable market price or current estimated value of the collateral. These loans are reported in the nonrecurring table below at initial recognition of impairment and on an ongoing basis until recovery or charge-off.

Foreclosed Assets. At time of foreclosure or repossession, foreclosed and repossessed assets are adjusted to fair value less costs to sell upon transfer of the loans to foreclosed and repossessed assets, establishing a new cost basis. We subsequently adjust estimated fair value of foreclosed assets on a nonrecurring basis to reflect write-downs based on revised fair value estimates.

(Continued)

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(Unaudited)

13. FAIR VALUES (Continued)

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The balances of assets and liabilities measured at fair value on a recurring basis as of June 30, 2014 are as follows:

				Quoted
				Prices in
				Active		Significant
				Markets for		Other			Significant
				Identical		Observable			Unobservable
				Assets		Inputs			Inputs
		Total		(Level 1)		(Level 2)			(Level 3)
Available for sale securities
U.S. Government agency debt obligations	$	213,706,000		$	0	$	213,706,000		$	0
Mortgage-backed securities		108,172,000			0		108,172,000			0
Municipal general obligation bonds		140,169,000			0		128,791,000			11,378,000
Municipal revenue bonds		11,324,000			0		11,324,000			0
Other investments		1,904,000			0		1,904,000			0
Interest rate swap		(390,000	)		0		(390,000	)		0
Total	$	474,885,000		$	0	$	463,507,000		$	11,378,000

There were no transfers in or out of Level 1, Level 2 or Level 3 during the first six months of 2014.

The balances of assets and liabilities measured at fair value on a recurring basis as of December 31, 2013 are as follows:

				Quoted
				Prices in
				Active		Significant
				Markets for		Other			Significant
				Identical		Observable			Unobservable
				Assets		Inputs			Inputs
	Total			(Level 1)		(Level 2)			(Level 3)
Available for sale securities
U.S. Government agency debt obligations	$	98,477,000		$	0	$	98,477,000		$	0
Mortgage-backed securities		13,558,000			0		13,558,000			0
Municipal general obligation bonds		16,872,000			0		16,872,000			0
Municipal revenue bonds		916,000			0		916,000			0
Other investments		1,355,000			0		1,355,000			0
Interest rate swap		(264,000	)		0		(264,000	)		0
Total	$	130,914,000		$	0	$	130,914,000		$	0

There were no transfers in or out of Level 1, Level 2 or Level 3 during 2013.

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

13. FAIR VALUES (Continued)

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

The balances of assets and liabilities measured at fair value on a nonrecurring basis as of June 30, 2014 are as follows:

			Quoted
			Prices in
			Active		Significant
			Markets for		Other		Significant
			Identical		Observable		Unobservable
			Assets		Inputs		Inputs
	Total		(Level 1)		(Level 2)		(Level 3)

Impaired loans (1)	$	18,899,000	$	0	$	0	$	18,899,000
Foreclosed assets (1)		2,878,000		0		0		2,878,000
Total	$	21,777,000	$	0	$	0	$	21,777,000

The balances of assets and liabilities measured at fair value on a nonrecurring basis as of December 31, 2013 are as follows:

			Quoted
			Prices in
			Active		Significant
			Markets for		Other		Significant
			Identical		Observable		Unobservable
			Assets		Inputs		Inputs
	Total		(Level 1)		(Level 2)		(Level 3)

Impaired loans (1)	$	23,405,000	$	0	$	0	$	23,405,000
Foreclosed assets (1)		2,851,000		0		0		2,851,000
Total	$	26,256,000	$	0	$	0	$	26,256,000

(1) Represents carrying value and related write-downs for which adjustments are based on the estimated value of the property or other assets.

14. REGULATORY MATTERS

We are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weightings, and other factors, and the regulators can lower classifications in certain cases. Failure to meet various capital requirements can initiate regulatory action that could have a direct material effect on our financial statements.

(Continue)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

14. REGULATORY MATTERS (Continued)

The prompt corrective action regulations provide five classifications, including well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If an institution is not well capitalized, regulatory approval is required to accept brokered deposits. Subject to limited exceptions, no institution may make a capital distribution if, after making the distribution, it would be undercapitalized. If an institution is undercapitalized, it is subject to close monitoring by its principal federal regulator, its asset growth and expansion are restricted, and plans for capital restoration are required. In addition, further specific types of restrictions may be imposed on the institution at the discretion of the federal regulator. At June 30, 2014 and December 31, 2013, our bank was in the well capitalized category under the regulatory framework for prompt corrective action. There are no conditions or events since June 30, 2014 that we believe have changed our bank’s categorization. Our actual capital levels (dollars in thousands) and the minimum levels required to be categorized as adequately and well capitalized were:

											Minimum Required
											to be Well
						Minimum Required					Capitalized Under
						for Capital					Prompt Corrective
	Actual					Adequacy Purposes					Action Regulations
	Amount		Ratio			Amount		Ratio			Amount		Ratio
June 30, 2014
Total capital (to risk weighted assets)
Consolidated	$	323,221		14.0	%	$	184,700		8.0	%	$	NA	NA
Bank		318,888		13.7			185,762		8.0			232,203		10.0	%
Tier 1 capital (to risk weighted assets)
Consolidated		302,365		13.1			92,350		4.0		NA		NA
Bank		298,032		12.8			92,881		4.0			139,322		6.0
Tier 1 capital (to average assets)
Consolidated		302,365		16.7			72,553		4.0		NA		NA
Bank		298,032		16.4			72,810		4.0			91,012		5.0

December 31, 2013
Total capital (to risk weighted assets)
Consolidated	$	193,925		15.9	%	$	97,498		8.0	%	$	NA	NA
Bank		190,493		15.7			97,329		8.0			121,662		10.0	%
Tier 1 capital (to risk weighted assets)
Consolidated		178,598		14.7			48,749		4.0		NA		NA
Bank		175,192		14.4			48,665		4.0			72,997		6.0
Tier 1 capital (to average assets)
Consolidated		178,598		12.5			57,006		4.0			NA	NA
Bank		175,192		12.3			56,860		4.0			71,075		5.0

(Continued)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

14. REGULATORY MATTERS (Continued)

Our consolidated capital levels as of June 30, 2014 and December 31, 2013 include $52.1 million and $32.0 million, respectively, of trust preferred securities subject to certain limitations. Under applicable Federal Reserve guidelines, the trust preferred securities constitute a restricted core capital element. The guidelines provide that the aggregate amount of restricted core elements that may be included in our Tier 1 capital must not exceed 25% of the sum of all core capital elements, including restricted core capital elements, net of goodwill less any associated deferred tax liability. Our ability to include the trust preferred securities in Tier 1 capital in accordance with the guidelines is not affected by the provision of the Dodd-Frank Act generally restricting such treatment, because (i) the trust preferred securities were issued before May 19, 2010, and (ii) our total consolidated assets as of December 31, 2009 were less than $15.0 billion. As of June 30, 2014 and December 31, 2013, all $52.1 million and $32.0 million, respectively, of the trust preferred securities were included in our consolidated Tier 1 capital.

Our and our bank’s ability to pay cash and stock dividends is subject to limitations under various laws and regulations and to prudent and sound banking practices. On January 16, 2014, our Board of Directors declared a cash dividend on our common stock in the amount of $0.12 per share that was paid on March 10, 2014 to shareholders of record as of February 10, 2014. On May 9, 2014, our Board of Directors declared a cash dividend on our common stock in the amount of $0.12 per share that was paid on June 25, 2014 to shareholders of record as of June 13, 2014. On July 17, 2014, our Board of Directors declared a cash dividend on our common stock in the amount of $0.12 per share that will be paid on September 24, 2014 to shareholders of record as of September 12, 2014. In addition, on May 9, 2014, our Board of Directors declared a special cash dividend on our common stock in the amount of $2.00 per share that was paid on May 29, 2014 to shareholders of record as of May 22, 2014. The special cash dividend, in contemplation of the plan of merger with Firstbank, was paid to Mercantile shareholders prior to the effective date of the merger with Firstbank and before the issuance of Mercantile shares in exchange for Firstbank shares.

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

Forward Looking Statements

This report contains forward-looking statements that are based on management’s beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy, and our company. Words such as “anticipates,” “believes,” “estimates,” “expects,” “forecasts,” “intends,” “is likely,” “plans,” “projects,” and variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions (“Future Factors”) that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. We undertake no obligation to update, amend, or clarify forward looking-statements, whether as a result of new information, future events (whether anticipated or unanticipated), or otherwise.

Future Factors include, among others, changes in interest rates and interest rate relationships; demand for products and services; the degree of competition by traditional and non-traditional competitors; changes in banking regulation or actions by bank regulators; changes in tax laws; changes in prices, levies, and assessments; our ability to successfully integrate the operations of Mercantile and Firstbank and their respective subsidiary banks; the ability of the combined company to compete in the highly competitive banking and financial services industry; the impact of technological advances; governmental and regulatory policy changes; the outcomes of contingencies; trends in customer behavior as well as their ability to repay loans; changes in local real estate values; changes in the national and local economies; and risk factors described in our annual report on Form 10-K for the year ended December 31, 2013 or in this report. These are representative of the Future Factors that could cause a difference between an ultimate actual outcome and a forward-looking statement.

Introduction

The following discussion compares the financial condition of Mercantile Bank Corporation and its consolidated subsidiaries, including Mercantile Bank of Michigan (“our bank”) and our bank’s two subsidiaries, Mercantile Bank Real Estate Co., LLC (“our real estate company”) and Mercantile Insurance Center, Inc. (“our insurance company”), at June 30, 2014 and December 31, 2013 and the results of operations for the three months and six months ended June 30, 2014 and June 30, 2013. This discussion should be read in conjunction with the interim consolidated financial statements and footnotes included in this report. Unless the text clearly suggests otherwise, references in this report to “us,” “we,” “our” or “the company” include Mercantile Bank Corporation and its consolidated subsidiaries referred to above.

Critical Accounting Policies

Accounting principles generally accepted in the United States of America are complex and require us to apply significant judgment to various accounting, reporting and disclosure matters. We must use assumptions and estimates to apply these principles where actual measurements are not possible or practical. Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our unaudited financial statements included in this report. For a discussion of our significant accounting policies, see Note 1 of the Notes to our Consolidated Financial Statements included on pages F-48 through F-53 in our Form 10-K for the fiscal year ended December 31, 2013 (Commission file number 000-26719). Our allowance for loan losses policy and accounting for income taxes are highly dependent upon subjective or complex judgments, assumptions and estimates. Changes in such estimates may have a significant impact on the financial statements, and actual results may differ from those estimates. We have reviewed the application of these policies with the Audit Committee of our Board of Directors.

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Allowance for Loan Losses: The allowance for loan losses (“allowance”) is maintained at a level we believe is adequate to absorb probable incurred losses identified and inherent in the loan portfolio. Our evaluation of the adequacy of the allowance is an estimate based on past loan loss experience, the nature and volume of the loan portfolio, information about specific borrower situations and estimated collateral values, guidance from bank regulatory agencies, and assessments of the impact of current and anticipated economic conditions on the loan portfolio. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in our judgment, should be charged-off. Loan losses are charged against the allowance when we believe the uncollectability of a loan is likely. The balance of the allowance represents our best estimate, but significant downturns in circumstances relating to loan quality or economic conditions could result in a requirement for an increased allowance in the future. Likewise, an upturn in loan quality or improved economic conditions may result in a decline in the required allowance in the future. In either instance, unanticipated changes could have a significant impact on the allowance and operating results.

The allowance is increased through a provision charged to operating expense. Uncollectable loans are charged-off through the allowance. Recoveries of loans previously charged-off are added to the allowance. A loan is considered impaired when it is probable that contractual interest and principal payments will not be collected either for the amounts or by the dates as scheduled in the loan agreement. Impairment is evaluated in aggregate for smaller-balance loans of similar nature such as residential mortgage, consumer and credit card loans, and on an individual loan basis for other loans. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. The timing of obtaining outside appraisals varies, generally depending on the nature and complexity of the property being evaluated, general breadth of activity within the marketplace and the age of the most recent appraisal. For collateral dependent impaired loans, in most cases we obtain and use the “as is” value as indicated in the appraisal report, adjusting for any expected selling costs. In certain circumstances, we may internally update outside appraisals based on recent information impacting a particular or similar property, or due to identifiable trends (e.g., recent sales of similar properties) within our markets. The expected future cash flows exclude potential cash flows from certain guarantors. To the extent these guarantors provide repayments, a recovery would be recorded upon receipt. Loans are evaluated for impairment when payments are delayed, typically 30 days or more, or when serious deficiencies are identified within the credit relationship. Our policy for recognizing income on impaired loans is to accrue interest unless a loan is placed on nonaccrual status. We put loans into nonaccrual status when the full collection of principal and interest is not expected.

Income Tax Accounting: Current income tax assets and liabilities are established for the amount of taxes payable or refundable for the current year. In the preparation of income tax returns, tax positions are taken based on interpretation of federal and state income tax laws for which the outcome may be uncertain. We periodically review and evaluate the status of our tax positions and make adjustments as necessary. Deferred income tax assets and liabilities are also established for the future tax consequences of events that have been recognized in our financial statements or tax returns. A deferred income tax asset or liability is recognized for the estimated future tax effects attributable to temporary differences that can be carried forward (used) in future years. The valuation of our net deferred income tax asset is considered critical as it requires us to make estimates based on provisions of the enacted tax laws. The assessment of the realizability of the net deferred income tax asset involves the use of estimates, assumptions, interpretations and judgments concerning accounting pronouncements, federal and state tax codes and the extent of future taxable income. There can be no assurance that future events, such as court decisions, positions of federal and state tax authorities, and the extent of future taxable income will not differ from our current assessment, the impact of which could be significant to the consolidated results of operations and reported earnings.

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Accounting guidance requires that we assess whether a valuation allowance should be established against our deferred tax assets based on the consideration of all available evidence using a “more likely than not” standard. In making such judgments, we consider both positive and negative evidence and analyze changes in near-term market conditions as well as other factors which may impact future operating results. Significant weight is given to evidence that can be objectively verified. During 2011, we returned to pre-tax profitability for four consecutive quarters. Additionally, we experienced lower provision expense, continued declines in nonperforming assets and problem asset administration costs, a higher net interest margin, a further strengthening of our regulatory capital ratios and additional reductions in wholesale funding. This positive evidence allowed us to conclude that, as of December 31, 2011, it was more likely than not that we returned to sustainable profitability in amounts sufficient to allow for realization of our deferred tax assets in future years. Consequently, we reversed the valuation allowance that we had previously determined necessary to carry against our entire net deferred tax asset starting on December 31, 2009.

Securities and Other Financial Instruments: Securities available for sale consist of bonds and notes which might be sold prior to maturity due to changes in interest rate, prepayment risks, yield and availability of alternative investments, liquidity needs or other factors. Securities classified as available for sale are reported at their fair value. Declines in the fair value of securities below their cost that are other than temporary are reflected as realized losses. In estimating other than temporary losses, management considers: (1) the length of time and extent that fair value has been less than carrying value; (2) the financial condition and near term prospects of the issuer; and (3) the Company’s ability and intent to hold the security for a period of time sufficient to allow for any anticipated recovery in fair value. Fair values for securities available for sale are obtained from outside sources and applied to individual securities within the portfolio. The difference between the amortized cost and the current fair value of securities is recorded as a valuation adjustment and reported in other comprehensive income.

Mortgage Servicing Rights: Mortgage servicing rights are recognized as assets based on the allocated fair value of retained servicing rights on loans sold. Servicing rights are carried at the lower of amortized cost or fair value and are expensed in proportion to, and over the period of, estimated net servicing income. We utilize a discounted cash flow model to determine the value of our servicing rights. The valuation model utilizes mortgage prepayment speeds, the remaining life of the mortgage pool, delinquency rates, our cost to service loans, and other factors to determine the cash flow that we will receive from serving each grouping of loans. These cash flows are then discounted based on current interest rate assumptions to arrive at the fair value of the right to service those loans. Impairment is evaluated quarterly based on the fair value of the servicing rights, using groupings of the underlying loans classified by interest rates. Any impairment of a grouping is reported as a valuation allowance.

Goodwill: Generally accepted accounting principles require us to determine the fair value of all of the assets and liabilities of an acquired entity, and record their fair value on the date of acquisition. We employ a variety of means in determination of the fair value, including the use of discounted cash flow analysis, market comparisons, and projected future revenue streams. For certain items that we believe we have the appropriate expertise to determine the fair value, we may choose to use our own calculation of the value. In other cases, where the value is not easily determined, we consult with outside parties to determine the fair value of the asset or liability. Once valuations have been adjusted, the net difference between the price paid for the acquired company and the value of its balance sheet is recorded as goodwill.

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Goodwill results from business acquisitions and represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets. Goodwill is assessed at least annually for impairment and any such impairment is recognized in the period identified. A more frequent assessment is performed if conditions in the market place or changes in the company’s organizational structure occur. We use a discounted income approach and a market valuation model, which compares the inherent value of our company to valuations of recent transactions in the market place to determine if our goodwill has been impaired.

Firstbank Merger

We completed the merger of Firstbank Corporation (“Firstbank”), a Michigan corporation with approximately $1.5 billion in total assets and 46 branch locations, into Mercantile Bank Corporation as of June 1, 2014 (“Merger Date”). The results of operations due to the Firstbank transaction have been included in Mercantile’s financial results since the Merger Date. All of Firstbank’s common stock was converted into the right to receive one share of Mercantile common stock for each share of Firstbank common stock. The conversion of Firstbank’s common stock into Mercantile’s common stock resulted in Mercantile issuing 8,087,272 shares of its common stock. In conjunction with the completion of the merger, Mercantile assumed the obligations of four business trusts that were formed by Firstbank to issue trust preferred securities.

The Firstbank transaction was accounted for using the acquisition method of accounting and accordingly, assets acquired, liabilities assumed and consideration exchanged were recorded at estimated fair value on the Merger Date. In accordance with the applicable accounting guidance for business combinations, these fair values are preliminary and subject to refinement for up to one year after the closing date of the transaction as additional information relative to closing date fair value may become available.

Our operating results for the quarter ended June 30, 2014 include the operating results of the acquired assets and assumed liabilities for the 30 days subsequent to the Merger Date. The operations of the former Firstbank organization provided approximately $4.5 million in net interest income for the period from the Merger Date to June 30, 2014, and are included in our consolidated financial statements for the three and six month periods ending June 30, 2014. Firstbank’s results of operations prior to the Merger Date are not included in our consolidated statements of income or comprehensive income.

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Financial Overview

We reported net income of $1.5 million, or $0.13 per diluted share, for the second quarter of 2014, and net income of $5.1 million, or $0.50 per diluted share, during the first six months of 2014.

Our second quarter and year-to-date earnings results were significantly impacted by the Firstbank merger. In addition to our earnings results reflecting one month of operations as a combined organization, we recorded relatively large merger-related costs during the first six months of 2014, primarily during the second quarter. Merger-related costs totaled $3.5 million during the second quarter and $3.8 million during the first six months of 2014. On an after-tax basis, that equated to $2.4 million, or $0.21 per diluted share, during the second quarter, and $2.7 million, or $0.27 per diluted share, during the first six months of 2014. We expect to record additional merger-related costs during the next several quarters, although we expect future costs to be considerably lower than the amounts expensed during the second quarter.

The quality of our loan portfolio continues to improve, which when combined with recoveries of prior loan charge-offs and the eliminations of and reductions in specific reserves, have produced a positive impact on our allowance calculations and allowed us to make negative provisions in six consecutive quarters and in eight of the last nine quarters. We have recorded a net loan recovery during the past five consecutive quarters and during seven out of the last nine quarters. The improvement in the quality of the loan portfolio and reductions in foreclosed asset balances have also resulted in significantly lower problem asset administration costs. In fact, when gains on the sale of foreclosed assets are netted against problem asset administration costs, we recorded a slightly negative net expense during both the first and second quarters of 2014.

New term loan originations totaled approximately $75 million during the second quarter of 2014 and about $121 million during the first six months of 2014. We have also experienced net increases in commercial lines of credit, in large part reflecting lines that are part of new commercial lending relationships established during recent quarterly periods. Our loan portfolio is well diversified post-merger, with commercial and industrial loans comprising 30% of total loans, commercial real estate non-owner occupied loans equaling 27%, and commercial real estate owner occupied along with residential mortgage and consumer loans both at 19% of total loans. As a percent of total commercial loans, commercial and industrial loans and commercial real estate owner occupied loans equal 59%.

The merger with Firstbank also had a significant positive impact on our funding structure, resulting in a well diversified funding mix. Noninterest-bearing checking accounts comprise 21% of total funds, interest-bearing checking and sweep accounts combine for 22%, savings deposits and money market accounts aggregate to 24% and local time deposits account for 23%. Wholesale funds, comprised of brokered deposits and FHLB advances, represent 10% of total funds.

Financial Condition

Primarily reflecting the merger with Firstbank, our total assets increased $1.45 billion during the first six months of 2014, and totaled $2.88 billion as of June 30, 2014. Total loans increased $1.02 billion and securities available for sale were up $344 million, while cash and cash equivalents decreased $28.1 million. Total deposits increased $1.18 billion and securities sold under agreements to repurchase (“repurchase agreements”) were up $54.8 million during the first six months of 2014.

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Our loan portfolio has historically been primarily comprised of commercial loans, although less so now with the Firstbank merger. Commercial loans increased $701 million during the first six months of 2014, and at June 30, 2014 totaled $1.69 billion, or 81.4% of the loan portfolio. As of December 31, 2013, the commercial loan portfolio comprised 93.7% of total loans. The increase in commercial loans during the first six months of 2014 includes about $121 million in new commercial term loans to existing and new borrowers, with the remainder generally reflecting the Firstbank merger. Commercial and industrial loans were up $330 million, non-owner occupied commercial real estate (“CRE”) loans increased $185 million, owner occupied CRE loans increased $123 million, multi-family and residential rental loans increased $47 million and vacant land, land development and residential construction loans were up $17 million. As a percent of total commercial loans, commercial and industrial loans and commercial real estate owner occupied loans equal 59%.

We significantly enhanced our commercial loan sales efforts over the past couple of years. We are very pleased with the approximately $525 million in new commercial term loan fundings since the beginning of 2012, and our current pipeline reports indicate continued strong commercial loan funding opportunities in future periods. Also, as of June 30, 2014, availability on existing construction and development loans totaled over $51 million, with most of those funds expected to be drawn over the next twelve months. In addition, we have made additional lending commitments totaling about $177 million, a majority of which we expect to be accepted and funded over the next 12 to 18 months. Our commercial lenders also report substantial additional opportunities they are currently discussing with existing and potentially new borrowers.

We continue to experience some commercial loan principal paydowns and payoffs. A majority of these principal paydowns and payoffs received thus far have been welcomed, such as on stressed loan relationships; however, we have also experienced instances where well-performing relationships have been refinanced at other financial institutions and other situations where the borrower has sold the underlying asset, paying off the loan. In many of those cases where the loans were refinanced elsewhere, we believed the terms and conditions of the new lending arrangements were too aggressive, generally reflecting the very competitive banking environment in our markets. We remain committed to prudent underwriting standards that provide for an appropriate yield and risk relationship. In addition, we continue to receive accelerated principal paydowns from certain borrowers who have elevated deposit balances generally resulting from profitable operations and an apparent unwillingness to expand their businesses and/or replace equipment primarily due to economic- and tax-related uncertainties. Usage of existing commercial lines of credit has remained relatively steady.

Reflecting the Firstbank merger, one-to-four family mortgage loans increased $185 million and other consumer loans were up $135 million during the first six months of 2014, and at June 30, 2014, totaled a combined $386 million, or 18.6% of total loans. One-to-four family mortgage loans and other consumer loans equated to 6.3% of total loans as of December 31, 2013.

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The following table summarizes our loan portfolio at June 30, 2014, broken out by loans originated by Mercantile and loans acquired in the Firstbank merger:

	Originated		Acquired		Total
	Loans		Loans		Loans

Commercial:
Commercial & Industrial	$	342,375,000	$	273,684,000	$	616,059,000
Land Development & Construction		32,214,000		21,091,000		53,305,000
Owner Occupied Commercial RE		264,596,000		119,818,000		384,414,000
Non-Owner Occupied Commercial RE		399,855,000		149,434,000		549,289,000
Multi-Family & Residential Rental		37,569,000		47,099,000		84,668,000
Total Commercial		1,076,609,000		611,126,000		1,687,735,000

Retail:
1-4 Family Mortgages		33,337,000		182,702,000		216,039,000
Home Equity & Other Consumer		35,151,000		134,557,000		169,708,000
Total Retail		68,488,000		317,259,000		385,747,000

Total	$	1,145,097,000	$	928,385,000	$	2,073,482,000

Our credit policies establish guidelines to manage credit risk and asset quality. These guidelines include loan review and early identification of problem loans to provide effective loan portfolio administration. The credit policies and procedures are meant to minimize the risk and uncertainties inherent in lending. In following these policies and procedures, we must rely on estimates, appraisals and evaluations of loans and the possibility that changes in these could occur quickly because of changing economic conditions. Identified problem loans, which exhibit characteristics (financial or otherwise) that could cause the loans to become nonperforming or require restructuring in the future, are included on an internal watch list. Senior management and the Board of Directors review this list regularly. Market value estimates of collateral on impaired loans, as well as on foreclosed and repossessed assets, are reviewed periodically; however, we have a process in place to monitor whether value estimates at each quarter-end are reflective of current market conditions. Our credit policies establish criteria for obtaining appraisals and determining internal value estimates. We may also adjust outside and internal valuations based on identifiable trends within our markets, such as recent sales of similar properties or assets, listing prices and offers received. In addition, we may discount certain appraised and internal value estimates to address distressed market conditions.

Nonperforming assets, comprised of nonaccrual loans and foreclosed properties, totaled $8.6 million (0.3% of total assets) as of June 30, 2014, compared to $9.6 million (0.7% of total assets) as of December 31, 2013. The volume of nonperforming assets has generally been on a declining trend since the peak of $117.6 million on March 31, 2010, and is currently at its lowest level since year-end 2006. Reductions in nonperforming assets during the first six months of 2014 primarily reflect principal payments on nonaccrual loans and sales proceeds on foreclosed properties. Foreclosed properties acquired in the Firstbank merger totaled $1.2 million. Acquired loans are recorded at fair value with no allowance brought forward in accordance with acquisition accounting. Acquired impaired loans are considered performing due to the application of the accretion method under acquisition accounting.

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The following tables provide a breakdown of nonperforming assets by collateral type:

NONPERFORMING LOANS

	6/30/14		3/31/14		12/31/13		9/30/13		6/30/13
Residential Real Estate:
Land Development	$	36,000	$	38,000	$	40,000	$	43,000	$	317,000
Construction		0		0		0		0		0
Owner Occupied / Rental		3,898,000		4,026,000		4,219,000		2,859,000		3,201,000
		3,934,000		4,064,000		4,259,000		2,902,000		3,518,000

Commercial Real Estate:
Land Development		235,000		361,000		389,000		627,000		650,000
Construction		0		0		0		0		0
Owner Occupied		1,176,000		784,000		885,000		718,000		960,000
Non-Owner Occupied		129,000		335,000		169,000		3,251,000		4,642,000
		1,540,000		1,480,000		1,443,000		4,596,000		6,252,000

Non-Real Estate:
Commercial Assets		267,000		798,000		1,016,000		1,111,000		755,000
Consumer Assets		0		0		0		0		1,000
		267,000		798,000		1,016,000		1,111,000		756,000

Total	$	5,741,000	$	6,342,000	$	6,718,000	$	8,609,000	$	10,526,000

OTHER REAL ESTATE OWNED & REPOSSESSED ASSETS

	6/30/14		3/31/14		12/31/13		9/30/13		6/30/13
Residential Real Estate:
Land Development	$	427,000	$	427,000	$	427,000	$	495,000	$	619,000
Construction		22,000		22,000		22,000		89,000		89,000
Owner Occupied / Rental		968,000		186,000		207,000		219,000		315,000
		1,417,000		635,000		656,000		803,000		1,023,000

Commercial Real Estate:
Land Development		92,000		92,000		92,000		6,000		31,000
Construction		0		0		0		0		0
Owner Occupied		300,000		75,000		164,000		501,000		606,000
Non-Owner Occupied		1,069,000		1,548,000		1,939,000		2,239,000		2,256,000
		1,461,000		1,715,000		2,195,000		2,746,000		2,893,000

Non-Real Estate:
Commercial Assets		0		0		0		0		0
Consumer Assets		0		0		0		0		0
		0		0		0		0		0

Total	$	2,878,000	$	2,350,000	$	2,851,000	$	3,549,000	$	3,916,000

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The following tables provide a reconciliation of nonperforming assets:

NONPERFORMING LOANS RECONCILIATION

	2nd Qtr			1st Qtr			4th Qtr			3rd Qtr			2nd Qtr
	2014			2014			2013			2013			2013

Beginning balance	$	6,342,000		$	6,718,000		$	8,609,000		$	10,526,000		$	12,395,000
Additions, net of transfers to ORE		(11,000	)		174,000			1,734,000			502,000			438,000
Principal payments		(523,000	)		(449,000	)		(3,072,000	)		(2,363,000	)		(1,988,000	)
Loan charge-offs		(67,000	)		(101,000	)		(553,000	)		(56,000	)		(319,000	)

Total	$	5,741,000		$	6,342,000		$	6,718,000		$	8,609,000		$	10,526,000

OTHER REAL ESTATE OWNED & REPOSSESSED ASSETS RECONCILIATION

	2nd Qtr			1st Qtr			4th Qtr			3rd Qtr			2nd Qtr
	2014			2014			2013			2013			2013

Beginning balance	$	2,350,000		$	2,851,000		$	3,549,000		$	3,916,000		$	6,505,000
Additions - originated loans		175,000			0			134,000			350,000			57,000
Additions - merger ORE		1,187,000			0			0			0			0
Sale proceeds		(790,000	)		(501,000	)		(797,000	)		(527,000	)		(2,374,000	)
Valuation write-downs		(44,000	)		0			(35,000	)		(190,000	)		(272,000	)

Total	$	2,878,000		$	2,350,000		$	2,851,000		$	3,549,000		$	3,916,000

During the first six months of 2014, loan charge-offs totaled $0.7 million while recoveries of prior period charge-offs aggregated to $1.3 million, resulting in a net recovery $0.6 million. We recorded a net recovery of prior period charge-offs of $1.3 million during all of 2013.

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The following table provides a breakdown of net loan charge-offs (recoveries) by collateral type:

	2nd Qtr			1st Qtr			4th Qtr			3rd Qtr			2nd Qtr
	2014			2014			2013			2013			2013
Residential Real Estate:
Land Development	$	(4,000	)	$	(1,000	)	$	(78,000	)	$	(387,000	)	$	(119,000	)
Construction		0			0			0			0			0
Owner Occupied / Rental		(572,000	)		(139,000	)		(144,000	)		(105,000	)		(301,000	)
		(576,000	)		(140,000	)		(222,000	)		(492,000	)		(420,000	)

Commercial Real Estate:
Land Development		(11,000	)		0			0			0			30,000
Construction		0			0			0			0			0
Owner Occupied		98,000			37,000			47,000			(74,000	)		(6,000	)
Non-Owner Occupied		(70,000	)		336,000			1,206,000			(1,215,000	)		79,000
		17,000			373,000			1,253,000			(1,289,000	)		103,000

Non-Real Estate:
Commercial Assets		(45,000	)		(267,000	)		(1,154,000	)		(172,000	)		(95,000	)
Consumer Assets		2,000			1,000			(4,000	)		5,000			1,000
		(43,000	)		(266,000	)		(1,158,000	)		(167,000	)		(94,000	)

Total	$	(602,000	)	$	(33,000	)	$	(127,000	)	$	(1,948,000	)	$	(411,000	)

In each accounting period, we adjust the allowance to the amount we believe is necessary to maintain the allowance at an adequate level. Through the loan review and credit departments, we establish portions of the allowance based on specifically identifiable problem loans. The evaluation of the allowance is further based on, but not limited to, consideration of the internally prepared Allowance Analysis, loan loss migration analysis, composition of the loan portfolio, third party analysis of the loan administration processes and portfolio, and general economic conditions.

The Allowance Analysis applies reserve allocation factors to non-impaired outstanding loan balances, the result of which is combined with specific reserves to calculate an overall allowance dollar amount. For non-impaired commercial loans, reserve allocation factors are based on the loan ratings as determined by our standardized grade paradigms and by loan purpose. Our commercial loan portfolio is segregated into five classes: 1) commercial and industrial loans; 2) vacant land, land development and residential construction loans; 3) owner occupied real estate loans; 4) non-owner occupied real estate loans; and 5) multi-family and residential rental property loans. The reserve allocation factors are primarily based on the historical trends of net loan charge-offs through a migration analysis whereby net loan losses are tracked via assigned grades over various time periods, with adjustments made for environmental factors reflecting the current status of, or recent changes in, items such as: lending policies and procedures; economic conditions; nature and volume of the loan portfolio; experience, ability and depth of management and lending staff; volume and severity of past due, nonaccrual and adversely classified loans; effectiveness of the loan review program; value of underlying collateral; loan concentrations; and other external factors such as competition and regulatory environment. Adjustments for specific lending relationships, particularly impaired loans, are made on a case-by-case basis. Non-impaired retail loan reserve allocations are determined in a similar fashion as those for non-impaired commercial loans, except that retail loans are segmented by type of credit and not a grading system. We regularly review the Allowance Analysis and make needed adjustments based upon identifiable trends and experience.

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A migration analysis is completed quarterly to assist us in determining appropriate reserve allocation factors for non-impaired commercial loans. Our migration analysis takes into account various time periods, with most weight placed on a twelve-quarter time frame. We believe the twelve-quarter period represents an appropriate range of economic conditions, and that it provides for an appropriate basis in determining reserve allocation factors given current economic conditions and the general consensus of economic conditions in the near future.

Although the migration analysis provides a historical accounting of our net loan losses, it is not able to fully account for environmental factors that will also very likely impact the collectability of our commercial loans as of any quarter-end date. Therefore, we incorporate the environmental factors as adjustments to the historical data. Environmental factors include both internal and external items. We believe the most significant internal environmental factor is our credit culture and the relative aggressiveness in assigning and revising commercial loan risk ratings, with the most significant external environmental factor being the assessment of the current economic environment and the resulting implications on our commercial loan portfolio.

The primary risk elements with respect to commercial loans are the financial condition of the borrower, the sufficiency of collateral, and timeliness of scheduled payments. We have a policy of requesting and reviewing periodic financial statements from commercial loan customers, and we have a disciplined and formalized review of the existence of collateral and its value. The primary risk element with respect to each residential real estate loan and consumer loan is the timeliness of scheduled payments. We have a reporting system that monitors past due loans and have adopted policies to pursue creditor’s rights in order to preserve our collateral position.

The allowance equaled $20.9 million as of June 30, 2014, or 1.8% of total originated loans outstanding, compared to 2.2% as of December 31, 2013. A large portion of the decline in the level of the allowance during the first six months of 2014 reflects elimination and reduction of specific reserves due to successful collection efforts, while the remainder of the decline is primarily associated with commercial loan upgrades and reductions in most reserve allocation factors on non-impaired commercial loans resulting from the impact of lower net loan charge-offs in recent periods on our migration calculations. The allowance equaled 363.3% of nonperforming loans as of June 30, 2014, compared to 339.7% as of December 31, 2013. This particular allowance measurement has increased significantly during the past several years primarily due to total nonperforming loans declining at a faster rate than the balance of the allowance and certain accruing higher-balance commercial loan relationships having been categorized as troubled debt restructurings resulting in higher specific reserve allocations.

As of June 30, 2014, the allowance was comprised of $10.5 million in general reserves relating to non-impaired loans, $1.5 million in specific reserve allocations relating to nonaccrual loans, and $8.9 million in specific reserves on other loans, primarily accruing loans designated as troubled debt restructurings. Troubled debt restructurings totaled $29.1 million at June 30, 2014, consisting of $4.2 million that are on nonaccrual status and $24.9 million that are on accrual status. The latter, while considered and accounted for as impaired loans in accordance with accounting guidelines, is not included in our nonperforming loan totals. Impaired loans with an aggregate carrying value of $2.4 million as of June 30, 2014 had been subject to previous partial charge-offs aggregating $2.4 million. Those partial charge-offs were recorded as follows: $0.1 million during the first six months of 2014, $0.5 million in 2013, $1.1 million in 2012, $0.5 million in 2011 and $0.2 million in 2010. As of June 30, 2014, there were no specific reserves allocated to impaired loans that had been subject to a previous partial charge-off.

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The following table provides a breakdown of our loans categorized as troubled debt restructurings:

	6/30/14		3/31/14		12/31/13		9/30/13		6/30/13

Performing	$	24,901,000	$	27,093,000	$	30,247,000	$	41,707,000	$	42,991,000
Nonperforming		4,232,000		4,800,000		4,645,000		5,782,000		7,523,000

Total	$	29,133,000	$	31,893,000	$	34,892,000	$	47,489,000	$	50,514,000

Although we believe the allowance is adequate to absorb loan losses in our originated loan portfolio as they arise, there can be no assurance that we will not sustain loan losses in any given period that could be substantial in relation to, or greater than, the size of the allowance.

Reflecting the merger with Firstbank, securities increased $344 million during the first six months of 2014, totaling $475 million as of June 30, 2014. Purchases during the first six months of 2014, consisting almost exclusively of U.S. Government agency bonds, totaled $11.7 million. Proceeds from matured and called U.S. Government agency bonds and municipal bonds during the first six months of 2014 totaled $11.0 million and $7.8 million, respectively, with another $3.9 million from principal paydowns on mortgage-backed securities. At June 30, 2014, the portfolio was primarily comprised of U.S. Government agency bonds (45%), municipal bonds (32%) and U.S. Government agency issued or guaranteed mortgage-backed securities (23%). All of our securities are currently designated as available for sale, and are therefore stated at fair value. The fair value of securities designated as available for sale at June 30, 2014 totaled $475 million, including a net unrealized loss of $4.2 million. We maintain the securities portfolio at levels to provide adequate pledging and secondary liquidity for our daily operations. In addition, the securities portfolio serves a primary interest rate risk management function.

FHLB stock totaled $19.2 million as of June 30, 2014, an increase of $7.3 million from the balance at December 31, 2013 resulting from the Firstbank merger. Our investment in FHLB stock is necessary to engage in their advance and other financing programs. We have received regularly quarterly cash dividends, and we expect a cash dividend will continue to be paid in future quarterly periods.

Market values on our U.S. Government agency bonds, mortgage-backed securities issued or guaranteed by U.S. Government agencies and municipal bonds are generally determined on a monthly basis with the assistance of a third party vendor. Evaluated pricing models that vary by type of security and incorporate available market data are utilized. Standard inputs include issuer and type of security, benchmark yields, reported trades, broker/dealer quotes and issuer spreads. We believe our valuation methodology provides for a reasonable estimation of market value, and that it is consistent with the requirements of accounting guidelines.

Federal funds sold, consisting of excess funds sold overnight to a correspondent bank, along with investments in interest-bearing deposits at correspondent and other banks, are used to manage daily liquidity needs and interest rate sensitivity. During the first six months of 2014, the average balance of these funds equaled $93.2 million, or 6.1% of average earning assets. We expect the level of these funds to average approximately 1% to 2% of average earning assets in future quarters.

Net premises and equipment equaled $49.0 million at June 30, 2014, an increase of $24.1 million during the first six months of 2014. The merger with Firstbank accounts for virtually the entire increase.

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Foreclosed and repossessed assets totaled $2.9 million at June 30, 2014, unchanged from the balance at December 31, 2013. Foreclosed property sales totaled $1.3 million during the first six months of 2014, while foreclosed properties from the Firstbank merger totaling $1.2 million were added during the period. While we expect some transfers from loans to foreclosed and repossessed assets in future periods reflecting our collection efforts on impaired lending relationships, we expect that sales activity will limit any increase in, and average balance of, this nonperforming asset category.

Primarily reflecting the merger with Firstbank, total deposits increased $1.18 billion during the first six months of 2014, totaling $2.30 billion at June 30, 2014. Out-of-area deposits decreased $25.3 million during the first six months of 2014, and as a percent of total deposits, equaled 8.2% as of June 30, 2014, compared to 19.0% as of December 31, 2013.

Noninterest-bearing checking accounts increased $291 million during the first six months of 2014. While the growth is primarily due to the Firstbank merger, noninterest-bearing checking accounts also increased due to deposit account openings as part of new commercial lending relationships. Also reflecting the impact of the Firstbank merger, interest-bearing checking accounts increased $227 million, money market deposit accounts grew $104 million, savings deposits increased $289 million and local time deposits grew $298 million during the first six months of 2014.

Repurchase agreements increased $54.8 million during the first six months of 2014, totaling $124 million as of June 30, 2014. The increase is primarily due to the merger with Firstbank. As part of our sweep account program, collected funds from certain business noninterest-bearing checking accounts and savings deposits are invested into over-night interest-bearing repurchase agreements. Such repurchase agreements are not deposit accounts and are not afforded federal deposit insurance.

Reflecting the merger with Firstbank, FHLB advances increased $12.0 million during the first six months of 2014. As of June 30, 2014, FHLB advances totaled $57.0 million. The FHLB advances are collateralized by residential mortgage loans, first mortgage liens on multi-family residential property loans, first mortgage liens on commercial real estate property loans, and substantially all other assets of our bank, under a blanket lien arrangement. Our borrowing line of credit as of June 30, 2014 totaled about $570 million, with availability approximating $509 million.

Liquidity

Liquidity is measured by our ability to raise funds through deposits, borrowed funds, and capital, or cash flow from the repayment of loans and securities. These funds are used to fund loans, meet deposit withdrawals, maintain reserve requirements and operate our company. Liquidity is primarily achieved through local and out-of-area deposits and liquid assets such as securities available for sale, matured and called securities, federal funds sold and interest-bearing balances. Asset and liability management is the process of managing our balance sheet to achieve a mix of earning assets and liabilities that maximizes profitability, while providing adequate liquidity.

To assist in providing needed funds, we have regularly obtained monies from wholesale funding sources. Wholesale funds, primarily comprised of deposits from customers outside of our market areas and advances from the FHLB, totaled $245 million, or 9.9% of combined deposits and borrowed funds, as of June 30, 2014, compared to $258 million, or 20.9% of combined deposits and borrowed funds, as of December 31, 2013.

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As part of our sweep account program, collected funds from certain business noninterest-bearing checking accounts and savings deposits are invested into over-night interest-bearing repurchase agreements. Such repurchase agreements are not deposit accounts and are not afforded federal deposit insurance. Repurchase agreements increased $54.8 million during the first six months of 2014, totaling $124 million as of June 30, 2014. The increase is primarily attributable to the merger with Firstbank. Information regarding our repurchase agreements as of June 30, 2014 and during the first six months of 2014 is as follows:

Outstanding balance at June 30, 2014	$	124,108,000
Weighted average interest rate at June 30, 2014		0.10	%
Maximum daily balance six months ended June 30, 2014	$	126,621,000
Average daily balance for six months ended June 30, 2014	$	79,003,000
Weighted average interest rate for six months ended June 30, 2014		0.12	%

As a member of the FHLB, we have access to the FHLB advance borrowing programs. FHLB advances increased $12.0 million during the first six months of 2014, reflecting the merger with Firstbank. As of June 30, 2014, FHLB advances totaled $57.0 million. Based on available collateral at June 30, 2014, we could borrow an additional $509 million.

We also have the ability to borrow up to $63.0 million on a daily basis through correspondent banks using established unsecured federal funds purchased lines of credit. We did not access these lines of credit during first six months of 2014; in fact, we have not accessed the lines of credit since January of 2010. In contrast, federal funds sold averaged $86.9 million during the first six months of 2014. We have a line of credit through the Discount Window of the Federal Reserve Bank of Chicago. Using certain municipal bonds as collateral, we could have borrowed up to $12.4 million as of June 30, 2014. We did not utilize this line of credit during the first six months of 2014 or at any time during the previous five fiscal years, and do not plan to access this line of credit in future periods.

The following table reflects, as of June 30, 2014, significant fixed and determinable contractual obligations to third parties by payment date, excluding accrued interest:

	One Year		One to		Three to		Over
	or Less		Three Years		Five Years		Five Years		Total

Deposits without a stated maturity	$	1,519,730,000	$	0	$	0	$	0	$	1,519,730,000
Certificates of deposit		382,018,000		287,746,000		113,767,000		0		783,531,000
Short-term borrowings		124,108,000		0		0		0		124,108,000
Federal Home Loan Bank advances		9,000,000		23,044,000		25,000,000		0		57,044,000
Subordinated debentures		0		0		0		54,131,000		54,131,000
Other borrowed money		9,545,000		1,455,000		0		3,348,000		14,348,000
Property leases		301,000		614,000		532,000		195,000		1,642,000

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In addition to normal loan funding and deposit flow, we must maintain liquidity to meet the demands of certain unfunded loan commitments and standby letters of credit. As of June 30, 2014, we had a total of $595 million in unfunded loan commitments and $37.6 million in unfunded standby letters of credit. Of the total unfunded loan commitments, $418 million were commitments available as lines of credit to be drawn at any time as customers’ cash needs vary, and $177 million were for loan commitments generally expected to close and become funded within the next twelve months. We regularly monitor fluctuations in loan balances and commitment levels, and include such data in our overall liquidity management.

We monitor our liquidity position and funding strategies on an ongoing basis, but recognize that unexpected events, changes in economic or market conditions, a reduction in earnings performance, declining capital levels or situations beyond our control could cause liquidity challenges. While we believe it is unlikely that a funding crisis of any significant degree is likely to materialize, we have developed a comprehensive contingency funding plan that provides a framework for meeting liquidity disruptions.

Capital Resources

Shareholders’ equity was $316 million at June 30, 2014, compared to $153 million at December 31, 2013. The $163 million increase during the first six months of 2014 was primarily due to the merger with Firstbank. We issued 8,087,272 shares of common stock, valued at $173 million, in connection with the merger. Net income during the first six months of 2014 totaled $5.1 million. Negatively impacting shareholder’s equity during the first six months of 2014 were cash dividends on common shares totaling $20.4 million. In accordance with the plan of merger with Firstbank, we declared and paid a special $2.00 per share cash dividend to Mercantile shareholders prior to the effective date of the merger and before the issuance of Mercantile shares in exchange for Firstbank shares. In addition, we declared and paid a $0.12 per share cash dividend in both the first and second quarters of 2014.

We and our bank are subject to regulatory capital requirements administered by state and federal banking agencies. Failure to meet the various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements. As of June 30, 2014, our bank’s total risk-based capital ratio was 13.7%, with our bank’s total regulatory capital equaling $319 million, or approximately $87 million in excess of the 10.0% minimum which is among the requirements to be categorized as “well capitalized.” Our and our bank’s capital ratios as of June 30, 2014 and December 31, 2013 are disclosed in Note 14 of the Notes to Condensed Consolidated Financial Statements.

Results of Operations

We recorded net income of $1.5 million for the second quarter of 2014 ($0.13 per basic and diluted share), compared to net income of $4.0 million ($0.46 per basic and diluted share) recorded during the second quarter of 2013. We recorded net income of $5.1 million ($0.50 per basic and diluted share) for the first six months of 2014, compared to net income of $8.4 million ($0.97 per basic and diluted share) recorded during the first six months of 2013. The results for the second quarter and the first six months of 2014 were impacted by the merger with Firstbank, which was consummated on June 1, 2014; operating results for the 2014 periods include one month of operations as a combined organization. After-tax merger-related costs totaled $2.4 million, or $0.21 per diluted share, during the second quarter of 2014 and $2.7 million, or $0.27 per diluted share, during the first six months of 2014; total merger-related expenses were negligible during the respective 2013 periods. We expect to record additional merger-related costs during the next several quarters, although we expect future costs to be considerably lower than the amounts expensed during the second quarter.

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The decline in earnings performance in the second quarter and the first six months of 2014 compared to the respective prior-year periods primarily resulted from increased overhead costs. As noted above, significant merger-related costs were incurred in the 2014 periods, while a nominal level of such costs were recorded during the comparable 2013 periods. In addition, various nonmerger-related costs necessary to operate the combined company contributed to the increase in overhead costs. Higher net interest income, primarily resulting from the increase in average earning assets associated with the completion of the merger, partially mitigated the impact of the higher level of overhead costs on earnings performance.

Interest income during the second quarter of 2014 was $18.5 million, an increase of $4.5 million, or 32.1%, from the $14.0 million earned during the second quarter of 2013. Interest income during the first six months of 2014 was $32.1 million, an increase of $3.9 million, or 13.1%, from the $28.2 million earned during the first six months of 2013. The increase in interest income in the 2014 periods compared to the respective 2013 periods is attributable to an increase in earning assets, which more than offset a declining yield on earning assets. Average earning assets include Firstbank’s assets from the date of acquisition. The decreased yield on earning assets in the second quarter of 2014 was mainly attributable to a lower yield on average securities and a change in earning asset mix, while the decreased yield on earning assets during the first six months of 2014 was mainly due to decreased yields on average securities and average loans.

Interest expense during the second quarter of 2014 was $2.9 million, an increase of $0.2 million, or 9.3%, from the $2.7 million expensed during the second quarter of 2013. Interest expense during the first six months of 2014 was $5.5 million, a slight increase from the $5.4 million expensed during the first six months of 2013. The increase in interest expense in the 2014 periods compared to the respective 2013 periods is attributable to an increase in the volume of average interest-bearing liabilities. Average interest-bearing liabilities include Firstbank’s liabilities from the date of acquisition. The impact of the higher volume of average interest-bearing liabilities on interest expense was substantially offset by a decrease in the weighted average cost of interest-bearing liabilities. Maturing fixed-rate certificates of deposit were renewed at lower rates, replaced by lower-costing funds, or allowed to runoff during 2013 and the first six months of 2014. In addition, the lowering of interest rates on certain non-certificate of deposit accounts in the latter part of the fourth quarter of 2013 and the absorption of Firstbank’s lower-costing interest-bearing liability base positively impacted the cost of funds in the 2014 periods.

Net interest income during the second quarter of 2014 was $15.6 million, an increase of $4.3 million, or 37.5%, from the $11.3 million earned during the second quarter of 2013. Net interest income during the first six months of 2014 was $26.6 million, an increase of $3.8 million, or 16.9%, from the $22.8 million earned during the first six months of 2013. The increase in net interest income in the 2014 periods compared to the respective 2013 periods was due to an increase in earning assets, which more than offset a decline in the net interest margin. The net interest margin during the second quarter of 2014 was 3.62%, compared to 3.66% during the second quarter of 2013. During the first six months of 2014, the net interest margin was 3.53%, compared to 3.67% during the same time period in 2013. The declined net interest margin in the 2014 periods reflects the decreased yield on earning assets, which more than offset the reduction in the cost of funds.

The following table sets forth certain information relating to our consolidated average interest-earning assets and interest-bearing liabilities and reflects the average yield on assets and average cost of liabilities for the second quarter of 2014 and 2013. Such yields and costs are derived by dividing income or expense by the average daily balance of assets or liabilities, respectively, for the period presented. Tax-exempt securities interest income and yield have been computed on a tax equivalent basis using a marginal tax rate of 35%. Securities interest income was increased by $100,000 and $114,000 in the second quarter of 2014 and 2013, respectively, for this adjustment.

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	Quarters ended June 30,
	2 0 1 4								2 0 1 3
		Average				Average			Average					Average
		Balance		Interest		Rate			Balance			Interest		Rate
		(dollars in thousands)
ASSETS
Loans	$	1,377,986		$	16,657		4.85	%	$	1,044,527		$	12,687		4.87	%
Investment securities		267,273			1,867		2.79			145,614			1,378		3.79
Federal funds sold		65,622			41		0.25			55,796			35		0.25
Interest-bearing deposits		24,119			17		0.28			7,724			6		0.29
Total interest - earning assets		1,735,000			18,582		4.30			1,253,661			14,106		4.51

Allowance for loan losses		(21,138	)							(26,100	)
Other assets		168,756								136,809

Total assets	$	1,882,618							$	1,364,370


LIABILITIES AND SHAREHOLDERS’ EQUITY
Interest-bearing deposits	$	1,169,863		$	2,272		0.78	%	$	887,408		$	2,223		1.00	%
Short-term borrowings		81,565			27		0.12			63,526			19		0.12
Federal Home Loan Bank advances		48,971			156		1.26			35,000			119		1.35
Other borrowings		46,410			474		4.04			34,482			319		3.68
Total interest-bearing liabilities		1,346,809			2,929		0.87			1,020,416			2,680		1.05

Noninterest-bearing deposits		318,632								188,352
Other liabilities		11,620								5,124
Shareholders’ equity		205,558								150,478

Total liabilities and shareholders’ equity	$	1,882,619		$					$	1,364,370

Net interest income				$	15,653							$	11,426

Net interest rate spread							3.43	%							3.46	%
Net interest spread on average assets							3.33	%							3.36	%
Net interest margin on earning assets							3.62	%							3.66	%

A negative loan loss provision expense of $0.7 million was recorded during the second quarter of 2014, compared to a negative provision expense of $1.5 million during the second quarter of 2013. A negative loan loss provision expense of $2.6 million was recorded during the first six months of 2014, compared to a negative provision expense of $3.0 million during the first six months of 2013. The negative provision expense reflects recoveries of previously charged-off loans, reversals of specific reserves, a reduced level of loan-rating downgrades, and ongoing loan-rating upgrades as the quality of the loan portfolio continued to improve. Continued progress in the stabilization of economic and real estate market conditions and resulting collateral valuations also positively impacted provision expense.

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Recoveries of previously charged-off loans totaled $0.7 million during the second quarter of 2014, while loan charge-offs not specifically reserved for in prior periods amounted to $0.1 million, resulting in a net positive impact of $0.6 million on provision expense. Recoveries of previously charged-off loans totaled $1.3 million during the first six months of 2014, while loan charge-offs not specifically reserved for in prior periods amounted to $0.2 million, resulting in a net positive impact of $1.1 million on provision expense. Net loan recoveries of $0.6 million were recorded during the second quarter of 2014, compared to net loan recoveries of $0.4 million during the prior-year second quarter. Net loan recoveries of $0.6 million were recorded during the first six months of 2014, compared to net loan charge-offs of $0.7 million during the same time period in 2013. Of the $0.7 million in gross loans charged-off during the first six months of 2014, $0.6 million, or about 80%, represents the elimination of specific reserves that were established through provision expense in earlier periods. Nonperforming loans totaled $5.7 million, or 0.5% of total originated loans, as of June 30, 2014, compared to $10.5 million, or 1.0% of total loans, as of June 30, 2013. The allowance equaled 1.8% of total originated loans as of June 30, 2014, compared to 2.4% of total loans as of June 30, 2013.

Noninterest income during the second quarter of 2014 was $2.3 million, an increase of $0.5 million, or 29.1%, from the $1.8 million earned during the prior-year second quarter. Noninterest income during the first six months of 2014 was $3.8 million, an increase of $0.2 million, or 5.4%, from the $3.6 million earned during the same time period in 2013. The increase in noninterest income in the 2014 periods was mainly due to higher debit and credit card fee income and service charges on deposit accounts. Increased mortgage referral and sale fees also contributed to the higher level of noninterest income during the second quarter of 2014. These categories of noninterest income benefited from the consummation of the merger with Firstbank.

Noninterest expense during the second quarter of 2014 was $16.1 million, an increase of $7.3 million, or 82.3%, from the $8.8 million expensed during the second quarter of 2013. Noninterest expense during the first six months of 2014 was $25.3 million, an increase of $7.9 million, or 45.3%, from the $17.4 million expensed during the same time period in 2013. The increase in noninterest expense in the second quarter of 2014 and the first six months of 2014 primarily resulted from higher merger-related costs and salary and benefit expenses. Merger-related costs totaled $3.5 million and $3.8 million during the second quarter of 2014 and the first six months of 2014, respectively; these costs were nominal during the respective 2013 periods. Salary and benefit expenses totaled $7.0 million during the second quarter of 2014, an increase of $2.0 million, or 41.3%, from the $5.0 million expensed during the prior-year second quarter. Salary and benefit expenses were $12.3 million during the first six months of 2014, an increase of $2.5 million, or 24.7%, from the $9.8 million expensed during the first six months of 2013. The increase in salary and benefit expenses was mainly due to the hiring of additional staff members over the past year and officer merit pay increases, along with the increase in employees associated with the completion of the merger with Firstbank. As of June 30, 2014, full-time equivalent employees numbered 645, up from 239 as of June 30, 2013. Increases in other categories of nonmerger-related costs necessary to operate the combined company also contributed to the higher level of overhead costs.

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During the second quarter of 2014, we recorded income before federal income tax of $2.5 million and a federal income tax expense of $1.0 million. During the second quarter of 2013, we recorded income before federal income tax of $5.8 million and a federal income tax expense of $1.8 million. The decrease in federal income tax expense in the second quarter of 2014 resulted from the lower level of income before federal income tax, which more than offset an increase in our effective tax rate from 30.4% in the second quarter of 2013 to 39.0% in the second quarter of 2014. During the first six months of 2014, we recorded income before federal income tax of $7.7 million and a federal income tax expense of $2.6 million. During the first six months of 2013, we recorded income before federal income tax of $12.0 million and a federal income tax expense of $3.6 million. The decrease in federal income tax expense during the first six months of 2014 resulted from the lower level of income before federal income tax, which more than offset an increase in our effective tax rate from 29.7% in the 2013 period to 34.2% in the 2014 period. The increase in the effective tax rate in the 2014 periods is primarily due to the recording of nondeductible merger-related expenses.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Our primary market risk exposure is interest rate risk and, to a lesser extent, liquidity risk. All of our transactions are denominated in U.S. dollars with no specific foreign exchange exposure. We have only limited agricultural-related loan assets and therefore have no significant exposure to changes in commodity prices. Any impact that changes in foreign exchange rates and commodity prices would have on interest rates is assumed to be insignificant. Interest rate risk is the exposure of our financial condition to adverse movements in interest rates. We derive our income primarily from the excess of interest collected on our interest-earning assets over the interest paid on our interest-bearing liabilities. The rates of interest we earn on our assets and owe on our liabilities generally are established contractually for a period of time. Since market interest rates change over time, we are exposed to lower profitability if we cannot adapt to interest rate changes. Accepting interest rate risk can be an important source of profitability and shareholder value; however, excessive levels of interest rate risk could pose a significant threat to our earnings and capital base. Accordingly, effective risk management that maintains interest rate risk at prudent levels is essential to our safety and soundness.

Evaluating the exposure to changes in interest rates includes assessing both the adequacy of the process used to control interest rate risk and the quantitative level of exposure. Our interest rate risk management process seeks to ensure that appropriate policies, procedures, management information systems and internal control procedures are in place to maintain interest rate risk at prudent levels with consistency and continuity. In evaluating the quantitative level of interest rate risk, we assess the existing and potential future effects of changes in interest rates on our financial condition, including capital adequacy, earnings, liquidity and asset quality.

We use two interest rate risk measurement techniques. The first, which is commonly referred to as GAP analysis, measures the difference between the dollar amounts of interest sensitive assets and liabilities that will be refinanced or repriced during a given time period. A significant repricing gap could result in a negative impact to our net interest margin during periods of changing market interest rates.

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The following table depicts our GAP position as of June 30, 2014:

	Within			Three to			One to			After
	Three			Twelve			Five			Five
	Months			Months			Years			Years			Total
Assets:
Commercial loans (1)	$	281,817,000		$	240,418,000		$	983,392,000		$	157,418,000		$	1,663,045,000
Residential real estate loans		28,126,000			22,729,000			123,824,000			171,764,000			346,443,000
Consumer loans		1,729,000			3,398,000			45,687,000			13,180,000			63,994,000
Securities (2)		30,465,000			31,026,000			159,516,000			273,494,000			494,501,000
Federal funds sold		11,973,000			0			0			0			11,973,000
Interest-bearing deposits		46,903,000			250,000			997,000			0			48,150,000
Allowance for loan losses		0			0			0			0			(20,856,000	)
Other assets		0			0			0			0			272,032,000
Total assets		401,013,000			297,821,000			1,313,416,000			615,856,000		$	2,879,282,000

Liabilities:
Interest-bearing checking		424,362,000			0			0			0			424,362,000
Savings deposits		341,924,000			0			0			0			341,924,000
Money market accounts		237,798,000			0			0			0			237,798,000
Time deposits under $100,000		36,474,000			80,858,000			94,235,000			0			211,567,000
Time deposits $100,000 & over		107,251,000			157,435,000			307,278,000			0			571,964,000
Short-term borrowings		124,108,000			0			0			0			124,108,000
Federal Home Loan Bank advances		0			6,000,000			51,044,000			0			57,044,000
Other borrowed money		66,479,000			545,000			1,455,000			0			68,479,000
Noninterest-bearing checking		0			0			0			0			515,646,000
Other liabilities		0			0			0			0			10,252,000
Total liabilities		1,338,396,000			244,838,000			454,012,000			0			2,563,144,000
Shareholders' equity		0			0			0			0			316,138,000
Total liabilities & shareholders' equity		1,338,396,000			244,838,000			454,012,000			0		$	2,879,282,000

Net asset (liability) GAP	$	(937,383,000	)	$	52,983,000		$	859,404,000		$	615,856,000

Cumulative GAP	$	(937,383,000	)	$	(884,400,000	)	$	(24,996,000	)	$	590,860,000

Percent of cumulative GAP to total assets		(32.6%	)		(30.7%	)		(0.9%	)		20.5	%

(1)	Floating rate loans that are currently at interest rate floors are treated as fixed rate loans and are reflected using maturity date and not repricing frequency.

(2)	Mortgage-backed securities are categorized by average life calculations based upon prepayment trends as of June 30, 2014.

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The second interest rate risk measurement we use is commonly referred to as net interest income simulation analysis. We believe that this methodology provides a more accurate measurement of interest rate risk than the GAP analysis, and therefore, it serves as our primary interest rate risk measurement technique. The simulation model assesses the direction and magnitude of variations in net interest income resulting from potential changes in market interest rates.

Key assumptions in the model include prepayment speeds on various loan and investment assets; cash flows and maturities of interest sensitive assets and liabilities; and changes in market conditions impacting loan and deposit volume and pricing. These assumptions are inherently uncertain, subject to fluctuation and revision in a dynamic environment; therefore, the model cannot precisely estimate net interest income or exactly predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude, and frequency of interest rate changes and changes in market conditions and our strategies, among other factors.

We conducted multiple simulations as of June 30, 2014, in which it was assumed that changes in market interest rates occurred ranging from up 400 basis points to down 400 basis points in equal quarterly instalments over the next twelve months. The following table reflects the suggested impact on net interest income over the next twelve months in comparison to estimated net interest income based on our balance sheet structure, including the balances and interest rates associated with our specific loans, securities, deposits and borrowed funds, as of June 30, 2014. The resulting estimates are well within our policy parameters established to manage and monitor interest rate risk.

	Dollar Change			Percent Change
	In Net			In Net
Interest Rate Scenario	Interest Income			Interest Income

Interest rates down 400 basis points	$	(4,700,000	)		(4.8%)
Interest rates down 300 basis points		(3,100,000	)		(3.2)
Interest rates down 200 basis points		(1,400,000	)		(1.5)
Interest rates down 100 basis points		400,000			0.4
No change in interest rates		3,100,000			3.2
Interest rates up 100 basis points		5,300,000			5.5
Interest rates up 200 basis points		7,500,000			7.8
Interest rates up 300 basis points		9,700,000			10.1
Interest rates up 400 basis points		11,400,000			11.9

The resulting estimates have been significantly impacted by the current interest rate and economic environments, as adjustments have been made to critical model inputs with regards to traditional interest rate relationships. This is especially important as it relates to floating rate commercial loans, which comprise a sizable portion of our balance sheet.

In addition to changes in interest rates, the level of future net interest income is also dependent on a number of other variables, including: the growth, composition and absolute levels of loans, deposits, and other earning assets and interest-bearing liabilities; level of nonperforming assets; economic and competitive conditions; potential changes in lending, investing, and deposit gathering strategies; client preferences; and other factors.

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Item 4. Controls and Procedures

As of June 30, 2014, an evaluation was performed under the supervision of and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on that evaluation, our management, including our Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were effective as of June 30, 2014.

There have been no changes in our internal control over financial reporting during the quarter ended June 30, 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II – OTHER INFORMATION

Item 1. Legal Proceedings.

From time to time, we may be involved in various legal proceedings that are incidental to our business. In our opinion, we are not a party to any current legal proceedings that are material to our financial condition, either individually or in the aggregate.

Item 1A. Risk Factors.

There have been no material changes in our risk factors from those previously disclosed in our annual report on Form 10-K for the year ended December 31, 2013, and incorporated therein by reference.

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

We made no unregistered sale of equity securities, nor did we purchase our equity securities, during the quarter ended June 30, 2014.

Item 3. Defaults Upon Senior Securities.

Not applicable.

Item 4. Mine Safety Disclosures.

Not applicable.

Item 5. Other Information.

Not applicable.

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Item 6. Exhibits

EXHIBIT NO.		EXHIBIT DESCRIPTION

2.1		Agreement and Plan of Merger dated August 14, 2013, incorporated by reference to Exhibit 2.1 to our Current Report on Form 8-K filed August 15, 2013

2.2		First Amendment to Merger Agreement dated February 20, 2014, incorporated by reference to Exhibit 10.1 to our Current Report on Form 8-K filed February 21, 2014

3.1		Our Articles of Incorporation are incorporated by reference to Exhibit 3.1 of our Form 10-Q for the quarter ended June 30, 2009

3.2		Our Amended and Restated Bylaws dated as of January 16, 2003 are incorporated by reference to Exhibit 3.2 of our Registration Statement on Form S-3 (Commission File No. 333-103376) that became effective on February 21, 2003

31		Rule 13a-14(a) Certifications

32.1		Section 1350 Chief Executive Officer Certification

32.2		Section 1350 Chief Financial Officer Certification

101		The following financial information from Mercantile’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2014, formatted in XBRL (eXtensible Business Reporting Language): (i) the Condensed Consolidated Balance Sheets, (ii) the Condensed Consolidated Statements of Income, (iii) the Condensed Consolidated Statements of Comprehensive Income, (iv) the Condensed Consolidated Statements of Changes in Shareholders’ Equity, (v) the Condensed Consolidated Statements of Cash Flows, and (vi) the Notes to Condensed Consolidated Financial Statements

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on August 8, 2014.

	MERCANTILE BANK CORPORATION




	By:	/s/ Michael H. Price
	Michael H. Price
	President and Chief Executive Officer
	(Principal Executive Officer)



	By:	/s/ Charles E. Christmas
	Charles E. Christmas
	Senior Vice President, Chief Financial Officer and Treasurer
	(Principal Financial and Accounting Officer)

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EXHIBIT INDEX

EXHIBIT NO.		EXHIBIT DESCRIPTION

2.1		Agreement and Plan of Merger dated August 14, 2013, incorporated by reference to Exhibit 2.1 to our Current Report on Form 8-K filed August 15, 2013

2.2		First Amendment to Merger Agreement dated February 20, 2014, incorporated by reference to Exhibit 10.1 to our Current Report on Form 8-K filed February 21, 2014

3.1		Our Articles of Incorporation are incorporated by reference to Exhibit 3.1 of our Form 10-Q for the quarter ended June 30, 2009

3.2		Our Amended and Restated Bylaws dated as of January 16, 2003 are incorporated by reference to Exhibit 3.2 of our Registration Statement on Form S-3 (Commission File No. 333-103376) that became effective on February 21, 2003

31		Rule 13a-14(a) Certifications

32.1		Section 1350 Chief Executive Officer Certification

32.2		Section 1350 Chief Financial Officer Certification

101		The following financial information from Mercantile’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2014, formatted in XBRL (eXtensible Business Reporting Language): (i) the Condensed Consolidated Balance Sheets, (ii) the Condensed Consolidated Statements of Income, (iii) the Condensed Consolidated Statements of Comprehensive Income, (iv) the Condensed Consolidated Statements of Changes in Shareholders’ Equity, (v) the Condensed Consolidated Statements of Cash Flows, and (vi) the Notes to Condensed Consolidated Financial Statements