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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 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, 2011

Or

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

OF THE SECURITIES EXCHANGE ACT OF 1934


Commission File Number: 0-12507


ARROW FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)


New York


22-2448962

(State or other jurisdiction of


(IRS Employer Identification

incorporation or organization)


Number)


250 GLEN STREET, GLENS FALLS, NEW YORK 12801

(Address of principal executive offices)   (Zip Code)


Registrants telephone number, including area code:   (518) 745-1000


Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for shorter period that the registrant was required to

file such reports), and (2) has been subject to such filing requirements for the past 90 days.

 x   Yes          No

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

 


     Yes          No

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definition of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer     

Accelerated filer   x 

Non-accelerated filer       (Do not check if a smaller reporting company)

Smaller reporting company     

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

     Yes      x   No


Indicate the number of shares outstanding of each of the issuers classes of common stock, as of the latest practicable date.


Class




Outstanding as of July 29, 2011

Common Stock, par value $1.00 per share




11,359,117



ARROW FINANCIAL CORPORATION

FORM 10-Q

June 30, 2011


INDEX



PART I - FINANCIAL INFORMATION

Page

Item 1.

Financial Statements:



Consolidated Balance Sheets

    as of June 30, 2011, December 31, 2010 and June 30, 2010

3


Consolidated Statements of Income

    for the Three and Six Month Periods Ended June 30, 2011 and 2010

4


Consolidated Statements of Changes in Stockholders Equity

    for the Six Month Periods Ended June 30, 2011 and 2010

5


Consolidated Statements of Cash Flows

    for the Six Month Periods Ended June 30, 2011 and 2010

7


Notes to Unaudited Consolidated Interim Financial Statements

8


Independent Auditors Review Report

25

Item 2.

Management's Discussion and Analysis of

   Financial Condition and Results of Operations

26

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

55

Item 4.

Controls and Procedures

56

PART II - OTHER INFORMATION


Item 1.

Legal Proceedings

56

Item 1.A.

Risk Factors

56

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

56

Item 3.

Defaults Upon Senior Securities

57

Item 4.

Removed and Reserved

57

Item 5.

Other Information

57

Item 6.

Exhibits

57

SIGNATURES


57


ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Dollars in Thousands)(Unaudited)





June 30, 

December 31,

      June 30,


2011

2010

2010

ASSETS




Cash and Due from Banks

$    33,202 

$     25,961 

$  33,071 

Interest-Bearing Deposits at Banks

      24,118 

      5,118 

      6,701 





Investment Securities:




Available-for-Sale

511,094 

517,364 

447,867 

Held-to-Maturity (Approximate Fair Value of $143,327 at June 30, 2011, $162,713 at December 31, 2010 and $162,077 at June 30, 2010)

138,334 

159,938 

158,226 

Other Investments

7,019 

8,602 

9,474 

            




Loans

1,120,096 

1,145,508 

1,144,959 

  Allowance for Loan Losses

     (14,820)

     (14,689)

     (14,411)

     Net Loans

1,105,276 

1,130,819 

1,130,548 

Premises and Equipment, Net

 19,490 

 18,836 

 19,252 

Other Real Estate and Repossessed Assets, Net

 31 

 58 

 23 

Goodwill

20,823 

15,783 

15,783 

Other Intangible Assets, Net

4,221 

1,458 

1,423 

Accrued Interest Receivable

6,689 

6,512 

6,464 

Other Assets

       31,477 

       17,887 

       17,287 

      Total Assets

$1,901,774 

$1,908,336 

$1,846,119 





LIABILITIES          




Noninterest-Bearing Deposits

$  219,403 

$  214,393 

$  201,839 

NOW Accounts

545,022 

569,076 

485,837 

Savings Deposits

414,487 

382,130 

366,639 

Time Deposits of $100,000 or More

123,640 

120,330 

134,220 

Other Time Deposits

     239,307 

     248,075 

     250,489 

    Total Deposits

  1,541,859 

  1,534,004 

  1,439,024 





Federal Funds Purchased and Securities Sold Under Agreements to Repurchase

60,361 

51,581 

60,847 

Other Short-Term Borrowings

2,211 

1,633 

1,619 

Federal Home Loan Bank Advances

90,000 

130,000 

150,000 

Junior Subordinated Obligations Issued to Unconsolidated Subsidiary Trusts

20,000 

20,000 

20,000 

Accrued Interest Payable

1,549 

1,957 

2,094 

Other Liabilities

      22,205 

      16,902 

      19,832 

    Total Liabilities

 1,738,185 

 1,756,077 

 1,693,416 













STOCKHOLDERS EQUITY




Preferred Stock, $5 Par Value; 1,000,000 Shares Authorized

--- 

--- 

--- 

Common Stock, $1 Par Value; 20,000,000 Shares Authorized

   (15,625,512 Shares Issued at June 30, 2011 and at December 31, 2010, and 15,170,399 Shares Issued at June 30, 2010)

15,626 

15,626 

15,170 

Additional Paid-in Capital

194,276 

191,068 

179,850 

Retained Earnings

30,039 

24,577 

29,757 

Unallocated ESOP Shares (118,292 Shares at June 30, 2011, 132,296 Shares   at December 31, 2010, and 87,551 Shares at June 30, 2010)

(2,600)

(2,876)

(1,876)

Accumulated Other Comprehensive Loss

 (2,983)

 (6,423)

 (1,682)

Treasury Stock, at Cost (4,152,043 Shares at June 30, 2011, 4,237,435 Shares




  at December 31, 2010, and 4,111,704 Shares at June 30, 2010)

      (70,769)

      (69,713)

      (68,516)

    Total Stockholders Equity

     163,589 

     152,259 

     152,703 

      Total Liabilities and Stockholders Equity

$1,901,774 

$1,908,336 

$1,846,119 









See Notes to Unaudited Consolidated Interim Financial Statements.

ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

 (In Thousands, Except Per Share Amounts) (Unaudited)



Three Months

Six Months


Ended June 30,

Ended June 30,


2011

2010

2011

2010

INTEREST AND DIVIDEND INCOME





Interest and Fees on Loans

$14,714 

$16,293

$29,729 

$32,456

Interest on Deposits at Banks

22 

34

44 

74

Interest and Dividends on Investment Securities:





  Fully Taxable

3,323 

3,890

6,673 

7,861

  Exempt from Federal Taxes

   1,497 

   1,461

   3,001 

   2,938

    Total Interest and Dividend Income

 19,556 

 21,678

 39,447 

 43,329

INTEREST EXPENSE





NOW Accounts

 1,361 

 1,454

 2,692 

2,877

Savings Deposits

503 

570

1,006 

1,110

Time Deposits of $100,000 or More

664 

727

1,331 

1,443

Other Time Deposits

1,292 

1,480

2,644 

2,966

Federal Funds Purchased and

  Securities Sold Under Agreements to Repurchase

23 

32

47 

62

Federal Home Loan Bank Advances

    986 

    1,615

    2,302 

    3,219

Junior Subordinated Obligations Issued to

  Unconsolidated Subsidiary Trusts

      146 

      145

      290 

      286

Total Interest Expense

   4,975 

   6,023

10,312 

 11,963

NET INTEREST INCOME

14,581 

15,655

29,135 

31,366

  Provision for Loan Losses

     170 

       375

       390 

      750

NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES

 14,411 

  15,280

 28,745 

 30,616

NONINTEREST INCOME





Income from Fiduciary Activities

1,526 

1,322 

3,072 

2,728

Fees for Other Services to Customers

2,058 

1,997 

3,973 

3,853

Insurance Commissions

1,815 

728 

3,281 

1,349

Net Gains on Securities Transactions

482 

878 

1,024 

878 

Net Gains on Sale of Loans

167 

34 

218 

55

Other Operating Income

      180 

      69 

      280 

      183

Total Noninterest Income

   6,228 

   5,028 

  11,848 

   9,046

NONINTEREST EXPENSE  





Salaries and Employee Benefits

7,233 

7,053

14,435 

13,655

Occupancy Expense, Net

1,894 

1,772

3,812 

3,549

FDIC Assessments

267 

492

780 

986

Other Operating Expense

   2,777 

   2,685

   5,463 

   5,352

Total Noninterest Expense

 12,171 

 12,002

 24,490 

 23,542

INCOME BEFORE PROVISION FOR INCOME TAXES

8,468 

8,306

16,103 

16,120

Provision for Income Taxes

   2,619 

   2,592

   4,973 

   4,991

NET INCOME

$ 5,849 

$ 5,714

$11,130 

 $11,129

Average Shares Outstanding:





  Basic

11,387 

11,307

11,361 

11,284

  Diluted

11,399 

11,344

11,378 

11,323

Per Common Share:   





  Basic Earnings

$   .51 

$    .51

$   .98 

$   0.99

  Diluted Earnings

    .51 

    .50

    .98 

 0.98



Shares and Per Share Amounts have been restated for the September 2010 3% stock dividend.

See Notes to Unaudited Consolidated Interim Financial Statements.

ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY

 (In Thousands, Except Share and Per Share Amounts) (Unaudited)



Common

Shares

Issued

Common

Stock

Additional Paid-in Capital

Retained

Earnings

Unallo-

cated

ESOP

Shares

Accumulated

Other Com-

prehensive

Income

(Loss)

Treasury

Stock

Total

Balance at December 31, 2010

15,625,512

$15,626 

$191,068 

$24,577 

$(2,876)

$ (6,423)

$(69,713)

$152,259 

Comprehensive Income, Net of Tax:









  Net Income

--- 

--- 

--- 

11,130 

--- 

--- 

--- 

    11,130 

  Net Unrealized Securities Holding

    Gains Arising During the Period,

    Net of Tax (Pre-tax $6,272)

--- 

--- 

--- 

--- 

--- 

3,787 

--- 

     3,787 

  Reclassification Adjustment for Net   Securities Gains Included in Net Income, Net of Tax (Pre-tax $1,024)

--- 

--- 

--- 

--- 

--- 

(618)

--- 

(618)

  Amortization of Net Retirement

    Plan Actuarial Loss (Pre-tax $512)

--- 

--- 

--- 

--- 

--- 

309 

--- 

309 

  Accretion of Net Retirement Plan

    Prior Service Credit (Pre-tax $63)

--- 

--- 

--- 

--- 

--- 

(38)

--- 

      (38)

   Other Comprehensive Income








   3,440

        Comprehensive Income








  14,570










Cash Dividends Paid,

  $.50 per Share

--- 

--- 

--- 

(5,668)

--- 

--- 

--- 

(5,668)

Stock Options Exercised

  (14,717 Shares)

--- 

--- 

183

--- 

--- 

--- 

130 

313 

Shares Issued Under the Directors   Stock Plan (3,634 Shares)

--- 

--- 

55

--- 

--- 

--- 

33 

88 

Shares Issued Under the Employee

  Stock Purchase Plan (10,263

  Shares)

--- 

--- 

154

--- 

--- 

--- 

92 

246 

Tax Benefit for Disposition of Stock Options

--- 

--- 

2

--- 

--- 

--- 

--- 

Shares Issued for Dividend

  Reinvestment Plans (37,689 Shares)

--- 

--- 

541

--- 

--- 

--- 

348 

889 

Stock-Based Compensation

  Expense

--- 

--- 

174

--- 

--- 

--- 

--- 

174 

Purchase of Treasury Stock

  (113,415 Shares)

              --- 

         --- 

           --- 

         --- 

        --- 

        --- 

      (2,759)

     (2,759)

Acquisition of Subsidiary (132,504 Shares)

--- 

--- 

2,034

--- 

--- 

--- 

1,100 

3,134 

Allocation of ESOP Stock

  (14,004 Shares)

       --- 

        --- 

        65

      --- 

     276 

        --- 

         --- 

       341

Balance at June 30, 2011

15,625,512

$15,626

$194,276

$30,039

$(2,600)

$(2,983)

$(70,769)

$163,589












(Continued on Next Page)



















ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY

 (In Thousands, Except Share and Per Share Amounts) (Unaudited)



Common

Shares

Issued

Common

Stock

Additional Paid-in Capital

Retained

Earnings

Unallo-

cated

ESOP

Shares

Accumulated

Other Com-

prehensive

Income

(Loss)

Treasury

Stock

Total

Balance at December 31, 2009

15,170,399

$15,170 

$178,192 

$24,100 

$(2,204)

$ (6,640)

$(67,800)

$140,818 

Comprehensive Income, Net of Tax:









  Net Income

--- 

--- 

--- 

11,129 

--- 

--- 

--- 

    11,129 

  Amortization of Net Retirement

    Plan Actuarial Loss (Pre-tax $505)

--- 

--- 

--- 

--- 

--- 

304 

--- 

304 

  Accretion of Net Retirement Plan

    Prior Service Credit (Pre-tax $86)

--- 

--- 

--- 

--- 

--- 

(53)

--- 

(53)

  Reclassification Adjustment for

    Net Securities Gains Included

    In Net Income, Net of Tax

    (Pre-tax $878)

--- 

--- 

--- 

--- 

--- 

(530)

--- 

(530)

  Net Unrealized Securities Holding

    Gains Arising During the Period,

    Net of Tax (Pre-tax $8,672)

--- 

--- 

--- 

--- 

--- 

5,237 

--- 

     5,237 

        Other Comprehensive Income








     4,958 

Comprehensive Income








   16,087 










Cash Dividends Paid,

  $.49 per Share

--- 

--- 

--- 

(5,472)

--- 

--- 

--- 

(5,472)

Stock Options Exercised

  (26,518 Shares)

--- 

--- 

94 

--- 

--- 

--- 

225 

319 

Shares Issued Under the Directors

  Stock Plan (2,866 Shares)

--- 

--- 

50 

--- 

--- 

--- 

24 

74 

Shares Issued Under the Employee

  Stock Purchase Plan (9,443

  Shares)

--- 

--- 

154 

--- 

--- 

--- 

81 

235 

Stock-Based Compensation

  Expense

--- 

--- 

147 

--- 

--- 

--- 

--- 

147 

Tax Benefit for Disposition of

  Stock Options

--- 

--- 

63 

--- 

--- 

--- 

--- 

63 

Allocation of ESOP Stock

  (17,616 Shares)

--- 

--- 

125 

--- 

328 

--- 

--- 

453 

Shares Issued for Dividend Reinvestment Plans (32,801 Shares)

--- 

--- 

566 

--- 

--- 

--- 

279 

845 

Acquisition of Subsidiary

  (26,240 Shares)

--- 

--- 

459 

--- 

--- 

--- 

223 

682 

Purchase of Treasury Stock

  (61,761 Shares)

              --- 

         --- 

           --- 

         --- 

        --- 

        --- 

    (1,548)

     (1,548)

Balance at June 30, 2010

15,170,399 

$15,170 

$179,850 

$29,757

$(1,876)

$(1,682)

$(68,516)

$152,703





















Cash dividends paid in 2010 have been restated for the September 2010 3% stock dividend.

See Notes to Unaudited Consolidated Interim Financial Statements.

ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in Thousands) (Unaudited)


Six months


Ended June 30,


2011

2010

Cash Flows from Operating Activities:



Net Income

 $11,130 

 $ 11,129 

Adjustments to Reconcile Net Income to Net Cash Provided By Operating Activities:



  Provision for Loan Losses

390 

750 

  Depreciation and Amortization

2,945 

1,700 

  Compensation Expense for Allocated ESOP Shares

65 

125 

  Gains on the Sale of Securities Available-for-Sale

(1,041)

(878)

  Other-Than-Temporary Impairment

17 

--- 

  Loans Originated and Held-for-Sale

(18,066)

(3,540)

  Proceeds from the Sale of Loans Held-for-Sale

28,317 

3,595

  Net Gains on the Sale of Loans

(218)

(55)

  Net Loss (Gain) on the Sale of Premises and Equipment,

     Other Real Estate Owned and Repossessed Assets

2

(2)

  Contributions to Pension Plans

(1,698)

(160)

  Deferred Income Tax Expense (Benefit)

537 

(515)

  Shares Issued Under the Directors Stock Plan

88 

74 

  Stock-Based Compensation Expense

174 

147 

  Net Increase in Other Assets

(2,439)

(1,225)

  Net Increase (Decrease) in Other Liabilities

     4,026 

  (1,714)

Net Cash Provided By Operating Activities

  24,229 

    9,431 

Cash Flows from Investing Activities:



Proceeds from the Sales of Securities Available-for-Sale

16,971 

10,859 

Proceeds from the Maturities and Calls of Securities Available-for-Sale

145,744 

122,722 

Purchases of Securities Available-for-Sale

 (151,655)

 (135,469)

Proceeds from the Maturities and Calls of Securities Held-to-Maturity

24,205

12,163

Purchase of Securities Held-to-Maturity

(2,757)

(1,613)

Net Decrease (Increase) in Loans

14,892 

 (33,486)

Proceeds from the Sales of Premises and Equipment,  Other Real Estate Owned and Repossessed Assets

252 

415 

Purchases of Premises and Equipment

     (1,415)

     (877)

Acquisition of Subsidiary

(3,487)

264

Purchase of Bank-Owned Life Insurance

(12,833)

---

Net Decrease (Increase) in Other Investments

     1,583

  (539)

Net Cash Provided By (Used In) Investing Activities

   31,500

 (25,561)

Cash Flows from Financing Activities:



Net Increase (Decrease) in Deposits

7,855 

(4,542)

Net Increase (Decrease) in Short-Term Borrowings

9,358 

   (11,442)

Federal Home Loan Bank Advances

10,000 

10,000 

Federal Home Loan Bank Repayments

(50,000)

--- 

Purchase of Treasury Stock

(2,759)

(1,548)

Stock Options Exercised

313 

319 

Shares Issued under the Employee Stock Purchase Plan

246 

235 

Tax Benefit from Exercise of Stock Options

63 

Treasury Stock Issued for Dividend Reinvestment Plans

889 

845 

Allocation of Common Stock Purchased by the ESOP

276 

328 

Cash Dividends Paid

   (5,668)

   (5,472)

Net Cash Used In Financing Activities

 (29,488)

 (11,214)

Net Increase (Decrease) in Cash and Cash Equivalents

26,241 

(27,344)

Cash and Cash Equivalents at Beginning of Period

  31,079 

  67,116 

Cash and Cash Equivalents at End of Period

$57,320 

$39,772 

Supplemental Disclosures to Statements of Cash Flow Information:



Interest on Deposits and Borrowings

 $10,706 

 $12,117 

Income Taxes

   4,181 

   9,933 

Non-cash Investing and Financing Activity:



Transfer of Loans to Other Real Estate Owned and Repossessed Assets

     228 

     324 

Net Unrealized Securities Holding Gains Arising During the Period, Net of Tax

3,787 

5,237 

Reclassification Adjustment for Net Securities Gains Included in Net Income, Net of Tax

618 

(530)

Additional Shares Issued for Acquisition of Subsidiary

3,134 

682 

Amortization of Net Retirement Plan Actuarial Loss

309 

304 

Accretion of Net Retirement Plan Prior Service Credit

(38)

(53)

Fair Value of Assets from Acquisition of Subsidiary

7,688 

882 

Fair Value of Liabilities from Acquisition of Subsidiary

1,067 

465 

See Notes to Unaudited Consolidated Interim Financial Statements.

ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED INTERIM FINANCIAL STATEMENTS

FORM 10-Q

June 30, 2011


1.   Accounting Policies


In the opinion of the management of Arrow Financial Corporation (Arrow), the accompanying unaudited consolidated interim financial statements contain all of the adjustments necessary to present fairly the financial position as of June 30, 2011, December 31, 2010 and June 30, 2010; the results of operations for three and six-month periods ended June 30, 2011 and 2010; the changes in stockholders equity for the six-month periods ended June 30, 2011 and June 30, 2010; and the cash flows for the six-month periods ended June 30, 2011 and 2010.  All such adjustments are of a normal recurring nature.  The preparation of financial statements requires the use of management estimates.  The unaudited consolidated interim financial statements should be read in conjunction with the audited annual consolidated financial statements of Arrow for the year ended December 31, 2010, included in Arrows 2010 Form 10-K.


Recent Accounting Pronouncements:


ASU 2011-05, Comprehensive Income (Topic 220) Presentation of Comprehensive Income. ASU 2011-05 eliminates the option of presenting the components of comprehensive income as part of the statement of changes in stockholders equity and provides an entity the option to present the total of comprehensive income, the components of net income and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two but separate consecutive statements.  The update is effective, retrospectively, for interim and annual periods beginning after December 15, 2011.  The changes are limited to matters of presentation and will not have an impact on our financial condition or results of operation.


ASU 2011-04, Fair Value Measurement (Topic 820) - Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. In 2006, the FASB and the International Accounting Standards Board (IASB) published a Memorandum of Understanding, which has served as the foundation of the Boards efforts to create a common set of high quality global accounting standards. Consistent with the Memorandum of Understanding and the Boards commitment to achieving that goal, the amendments in ASU 2011-04 are the result of the work by the FASB and the IASB to develop common requirements for measuring fair value and for disclosing information about fair value measurements in accordance with U.S. generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRSs).The Boards worked together to ensure that fair value has the same meaning in U.S. GAAP and in IFRSs and that their respective fair value measurement and disclosure requirements are the same (except for minor differences in wording and style).  The amendments in ASU 2011-04 explain how to measure fair value. They do not require additional fair value measurements and are not intended to establish valuation standards or affect valuation practices outside of financial reporting. We have determined that this pronouncement will not have a material impact on our financial condition or results of operations.


ASU 2011-03, Transfers and Servicing (Topic 860) - Reconsideration of Effective Control for Repurchase Agreements. The amendments in ASU 2011-03 remove from the assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, and (2) the collateral maintenance implementation guidance related to that criterion. Other criteria applicable to the assessment of effective control are not changed by the amendments in this Update. Those criteria indicate that the transferor is deemed to have maintained effective control over the financial assets transferred (and thus must account for the transaction as a secured borrowing) for agreements that both entitle and obligate the transferor to repurchase or redeem the financial assets before their maturity if all of the following conditions are met: 1. The financial assets to be repurchased or redeemed are the same or substantially the same as those transferred. 2. The agreement is to repurchase or redeem them before maturity, at a fixed or determinable price. 3. The agreement is entered into contemporaneously with, or in contemplation of, the transfer.  The update is effective, retrospectively, for interim and annual periods beginning after December 15, 2011.  Currently, we report all of our repurchase agreements as secured borrowings and accordingly, we have determined that this pronouncement will not have a material impact on our financial condition or results of operations.


ASU 2011-02, Receivables (Topic 310) A Creditors determination of whether a Restructuring Is a Trouble Debt Restructuring. ASU 2011-02 provides additional guidance in evaluating whether a restructuring constitutes a troubled debt restructuring.  Under this guidance, a creditor must separately conclude that both of the following exist: 1. The restructuring constitutes a concession. 2. The debtor is experiencing financial difficulties.  The amendments in this Update are effective for the first interim or annual period beginning on or after June 15, 2011, and should be applied retrospectively to the beginning of the annual period of adoption. We have determined that this pronouncement will not have a material impact on our financial condition or results of operations.

1.    Accounting Policies, continued


ASU 2010-20, Receivables (Topic 310) - Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses & ASU 2011-01, Receivables (Topic 310) Deferral of the Effective Date of Disclosures about Trouble Debt Restructurings in Update No. 2010-20: The main objective of this guidance is to provide financial statement users with greater transparency about an entitys allowance for credit losses and the credit quality of its financing receivables. This pronouncement requires additional disclosures to assist financial statement users in assessing an entitys credit risk exposures and evaluating the adequacy of its allowance for credit losses.  These new disclosures are required for interim and annual reporting periods ending on or after December 15, 2010, except for disclosures relating to loan modifications, which were subsequently extended to interim and annual filings after June 15, 2011.  We have determined that this pronouncement will not have a material impact on our financial condition or results of operations.



2.   Comprehensive Income (In Thousands)


The following table presents the components, net of tax, of accumulated other comprehensive loss as of June 30, 2011, December 31, 2010, and June 30, 2010:


June 30,

December 31,

June 30,


2011

2010

2010

Retirement Plan Net Loss

$(10,648)

$(10,610)

$(9,881)

Retirement Plan Prior Service Cost

741 

432 

342 

Net Unrealized Securities Holding Gains

    6,924 

    3,755 

   7,857 

  Total Accumulated Other Comprehensive Loss

$ (2,983)

$ (6,423)

$(1,682)


3.   Earnings Per Share (In Thousands, Except Per Share Amounts)


The following table presents a reconciliation of the numerator and denominator used in the calculation of basic and diluted earnings per common share (EPS) for the six-month periods ended June 30, 2011 and 2010, as restated for the September 2010 3% stock dividend:



Income

Shares

Per Share


(Numerator)

(Denominator)

Amount

For the Three Months Ended June 30, 2011:




Basic EPS

$5,849 

 11,387 

$.51 

Dilutive Effect of Stock Options

       --- 

      12 


Diluted EPS

$5,849 

11,399 

$.51 

For the Three Months Ended June 30, 2010:




Basic EPS

$5,714

 11,307

$.51

Dilutive Effect of Stock Options

      ---

       37


Diluted EPS

$5,714

11,344

$.50





For the Six Months Ended June 30, 2011:




Basic EPS

$11,130 

 11,361 

$.98 

Dilutive Effect of Stock Options

         --- 

      17 


Diluted EPS

$11,130 

11,378 

$.98 

For the Six Months Ended June 30, 2010:




Basic EPS

$11,129

 11,284

$.99

Dilutive Effect of Stock Options

        ---

       39


Diluted EPS

$11,129

11,323

$.98



4.   Investments, Debt and Equity Securities (In Thousands)


A summary of the amortized costs and the approximate fair values of securities at June 30, 2011, December 31, 2010, and June 30, 2010 are presented below.  Amortized cost is reported net of other-than-temporary impairment charges.


Securities Available-for-Sale:



Amortized

Cost


Fair

Value

Gross Unrealized Gains

Gross Unrealized Losses

June 30, 2011:

U.S. Agency Securities

$ 49,312

$ 49,551

$   239

$   ---

State and Municipal Obligations

90,451

90,700

251

2

Collateralized Mortgage Obligations

152,751

159,985

7,311

77

Mortgage-Backed Securities Residential

204,443

208,044

3,815

214

Corporate and Other Debt Securities

1,357

1,345

---

 12

Mutual Funds and Equity Securities

      1,314

      1,469

      165

     10

  Total Securities Available-for-Sale

$499,628

$511,094

$11,781

$ 315


December 31, 2010:

U.S. Agency Securities

$  97,943

$  98,173

$   326

$      96

State and Municipal Obligations

89,471

89,528

72

15

Collateralized Mortgage Obligations

161,247

166,964

6,692

975

Mortgage-Backed Securities Residential

159,636

159,926

2,532

2,242

Corporate and Other Debt Securities

1,516

1,417

---

99

Mutual Funds and Equity Securities

      1,333

      1,356

       70

       47

  Total Securities Available-for-Sale

$511,146

$517,364

$9,692

$3,474






June 30, 2010:





U.S. Agency Securities

$162,937

$163,858

$     921

$    --

State and Municipal Obligations

18,876

18,953

84

7

Collateralized Mortgage Obligations

169,355

177,863

8,547

39

Mortgage-Backed Securities Residential

80,824

84,552

3,728

---

Corporate and Other Debt Securities

1,552

1,433

---

119

Mutual Funds and Equity Securities

      1,311

      1,208

         51

  154

  Total Securities Available-for-Sale

$434,855

$447,867

$13,331

$319


Securities Held-to-Maturity:




Amortized

Cost


Fair

Value

Gross

Unrealized

Gains

Gross

Unrealized

Losses

June 30, 2011:






State and Municipal Obligations

$137,334

$142,327

$5,008

$15

Corporate and Other Debt Securities

     1,000

     1,000

       ---

  ---

  Total Securities Held-to-Maturity

$138,334

$143,327

$5,008

$15

 

December 31, 2010:






State and Municipal Obligations

$158,938

$161,713

$2,911

$136

Corporate and Other Debt Securities

      1,000

      1,000

       ---

    ---

  Total Securities Held-to-Maturity

$159,938

$162,713

$2,911

$136






June 30, 2010:





State and Municipal Obligations

$157,226

$161,077

$3,970

$119

Corporate and Other Debt Securities

     1,000

     1,000

       ---

    ---

  Total Securities Held-to-Maturity

$158,226

$162,077

$3,970

$119



4.     Investments, Debt and Equity Securities, continued


As reported in the Consolidated Balance Sheets, Other Investments include Federal Home Loan Bank of New York (FHLBNY) and Federal Reserve Bank (FRB) stock, which are reported at cost.  FHLBNY and FRB stock are restricted investment securities and amounted to $6,060 and $959 at June 30, 2011, respectively, $7,743 and $859 at December 31, 2010, respectively, and $8,642 and $832 at June 30, 2010, respectively.  The required level of FHLBNY stock is based on the amount of FHLBNY borrowings and is pledged to secure those borrowings.   While some Federal Home Loan Banks have stopped paying dividends and repurchasing stock upon reductions in debt levels, the FHLBNY continues to pay dividends and repurchase its stock.  Accordingly, we have not recognized any impairment on our holdings of FHLBNY common stock.  However, the FHLBNY has reported impairment issues among its holdings of mortgage-backed securities.


A summary of the maturities of securities as of June 30, 2011 is presented below.  Mutual funds and equity securities, which have no stated maturity, are not included in the table below.  Collateralized mortgage obligations and other mortgage-backed-securities are included in the schedule based on their expected average lives.  Actual maturities will differ from the table below because issuers may have the right to call or prepay obligations with or without prepayment penalties.


Maturities of Debt Securities:


  Available-for-Sale

  Held-to-Maturity



Amortized

Cost

Fair

Value

Amortized

Cost

Fair

Value

Within One Year:






  U.S. Agency Securities


$ 15,754

$  15,824

$         ---

$          ---

  State and Municipal Obligations


66,530

66,580

16,057

16,234

  Collateralized Mortgage Obligations


19,685

19,897

---

---

  Mortgage-Backed Securities Residential


     2,238

    2,309

           ---

           ---

    Total


  104,207

  104,610

    16,057

    16,234


From 1 - 5 Years:

  U.S. Agency Securities


33,558

33,727

   ---

   ---

  State and Municipal Obligations


20,180

20,355

51,686

52,778

  Collateralized Mortgage Obligations


96,013

101,434

---

---

  Mortgage-Backed Securities Residential


159,910

162,114

   ---

   ---

  Corporate and Other Debt Securities


       28

         28

           ---

           ---

    Total


 309,689

  317,658

    51,686

    52,778


From 5 - 10 Years:






  State and Municipal Obligations


1,098

1,122

59,191

62,535

  Collateralized Mortgage Obligations


37,053

38,653

    ---

    ---

  Mortgage-Backed Securities Residential


   24,137

   24,965

          ---

          ---

    Total


   62,288

   64,740

   59,191

   62,535







Over 10 Years:






  State and Municipal Obligations


2,643

2,643

 10,400

10,780

  Mortgage-Backed Securities Residential


18,158

18,657

--- 

--- 

  Corporate and Other Debt Securities


      1,329

      1,317

      1,000

      1,000

    Total


    22,130

    22,617

    11,400

    11,780

      Total Debt Securities


$498,314

$509,625

$138,334

$143,327



The fair value of securities pledged to secure repurchase agreements amounted to $60,361, $51,581 and $60,847 at June 30, 2011, December 31, 2010 and June 30, 2010, respectively.  The fair value of securities pledged to secure public and trust deposits and for other purposes totaled $371,408, $382,142 and $327,439 at June 30, 2011, December 31, 2010, and June 30, 2010, respectively.  Other mortgage-backed securities at June 30, 2011, December 31, 2010 and June 30, 2010 included $1,325, $1,598 and $1,865, respectively, of loans previously securitized by Arrow, which it continues to service.


4.     Investments, Debt and Equity Securities, continued


Temporarily Impaired Securities




June 30, 2011

Less than 12 Months

12 Months or Longer

Total

Available-for-Sale Portfolio:

Fair

Value

Unrealized

Losses

Fair

Value

Unrealized

Losses

Fair

Value

Unrealized

Losses

U.S. Agency Securities

$        ---

$   ---

$   ---

$     ---

$       ---

$     ---

State & Municipal Obligations

   3,359

  2

 ---

    ---

   3,359

  2

Collateralized Mortgage Obligations

11,804

   77

  146

---

11,950

 77

Mortgage-Backed Securities Residential

53,587

    214

   ---

---

 53,587

  214

Corporate & Other Debt Securities

---

---

317

12

317

 12

Mutual Funds and Equity Securities

          28

      8

    46

       2

        74

      10

  Total Securities Available-for-Sale

$68,778

$301

$509

$     14

$ 69,287

$  315

Held-to-Maturity Portfolio







State & Municipal Obligations

$---

$---

$1,561

$15

$1,561

$15


The table above for June 30, 2011 consists of 33 securities where the current fair value is less than the related amortized cost.  These unrealized losses do not reflect any deterioration of the credit worthiness of the issuing entities.  All of the CMOs are agency backed and are all rated AAA, as are the mortgage-backed securities.  The municipal obligations are general obligations supported by the general taxing authority of the issuer, and in some cases are insured.  Obligations issued by school districts are supported by state aid.  For any non-rated municipal securities, credit analysis shows no widespread deterioration in the credit worthiness of the municipalities.  Corporate and other debt securities consist of one private placement trust preferred, and one trust preferred pool.  The private placement trust preferred is rated AAA by Standard & Poors; the trust preferred pool is rated investment grade, with the privately issued securities securing the note performing.  Subsequent to June 30, 2011, there were no securities downgraded below investment grade.  


The unrealized losses on these temporarily impaired securities are primarily the result of changes in interest rates for fixed rate securities where the interest rate received is less than the current rate available for new offerings of similar securities, changes in market spreads as a result of shifts in supply and demand, and/or changes in the level of prepayments for mortgage related securities.   Because we do not currently intend to sell any of our temporarily impaired securities, and because it is not more likely than not that we would be required to sell the securities prior to recovery, the impairment is considered temporary.



Temporarily Impaired Securities




December 31, 2010

Less than 12 Months

12 Months or Longer

Total

Available-for-Sale Portfolio:

Fair

Value

Unrealized

Losses

Fair

Value

Unrealized

Losses

Fair

Value

Unrealized

Losses

U.S. Agency Securities

$  23,928

  $    72

$  5,976

$  24

$  29,904

$    96

State & Municipal Obligations

11,632

11

2,432

4

14,064

15

Collateralized Mortgage Obligations

32,027

975

    ---

---

32,027

  975

Mortgage-Backed Securities - Residential

69,461

1,957

12,129

285

81,590

2,242

Corporate & Other Debt Securities

283

48

949

51

1,232

99

Mutual Funds and Equity Securities

     1,095

      47

         ---    

    ---  

     1,095

      47

  Total Securities Available-for-Sale

$138,426

$3,110

$21,486

$364

$159,912

$3,474

Held-to-Maturity Portfolio







State & Municipal Obligations

$6,449

$73

$4,552

$63

$11,001

$136


The table above for December 31, 2010 consists of 104 securities where the current fair value is less than the related amortized cost.  These unrealized losses do not reflect any deterioration of the credit worthiness of the issuing entities.  Agency-backed CMOs are all rated AAA, as are the mortgage-backed securities.  The municipal obligations are general obligations supported by the general taxing authority of the issuer, and in some cases are insured.  Obligations issued by school districts are supported by state aid.  For any non-rated municipal securities, third party credit analysis shows no deterioration in the credit worthiness of the municipalities.  Corporate and other debt securities consist of one private placement trust preferred, and one trust preferred pool.  The private placement trust preferred is rated AAA by Standard & Poors; the trust preferred pool is rated investment grade, with the privately issued securities securing the note performing.  Subsequent to December 31, 2010, there were no securities downgraded below investment grade.  


4.     Investments, Debt and Equity Securities, continued


Temporarily Impaired Securities




June 30, 2010

Less than 12 Months

12 Months or Longer

Total

Available-for-Sale Portfolio:

Fair

Value

Unrealized

Losses

Fair

Value

Unrealized

Losses

Fair

Value

Unrealized

Losses

State & Municipal Obligations

  $  1,589

$     7

$     ---

$    --

$  1,589

$    7

Collateralized Mortgage Obligations

9,403

   39

---

---

 9,403

 39

Mortgage-Backed Securities Residential

---

  ---

---

---

--- 

--- 

Corporate & Other Debt Securities

---

---

1,263

120

1,263

 120

Mutual Funds and Equity Securities

       948

   146

      40

     7

      988

  153

  Total Securities Available-for-Sale

$11,940

$  192

$1,303

$127

$13,243

$319

Held-to-Maturity Portfolio







State & Municipal Obligations

$4,381

$35

$3,591

$84

$7,972

$119


The table above for June 30, 2010 consists of 96 securities where the current fair value is less than the related amortized cost.  These unrealized losses do not reflect any deterioration of the credit worthiness of the issuing entities.  Agency-backed CMOs are all rated AAA, as are the mortgage-backed securities.  The municipal obligations are general obligations supported by the general taxing authority of the issuer, and in some cases are insured.  Obligations issued by school districts are supported by state aid.  For any non-rated municipal securities, credit analysis shows no deterioration in the credit worthiness of the municipalities.  Corporate and other debt securities consist of one private placement trust preferred, and one trust preferred pool.  The private placement trust preferred is rated AAA by Standard & Poors; the trust preferred pool is rated investment grade, with the privately issued securities securing the note performing.  Subsequent to June 30, 2010, there were no securities downgraded below investment grade.  


Other-Than-Temporary Impairment


On a quarterly basis, Arrow performs an assessment to determine whether there have been any events or economic circumstances indicating that a security with an unrealized loss has suffered other-than-temporary impairment. A debt security is considered impaired if the fair value is less than its amortized cost basis at the reporting date. If impaired, Arrow then assesses whether the unrealized loss is other-than-temporary. An unrealized loss on a debt security is generally deemed to be other-than-temporary and a credit loss is deemed to exist if the present value of the expected future cash flows is less than the amortized cost basis of the debt security. As a result, the credit loss component of an other-than-temporary impairment write-down for debt securities is recorded in earnings while the remaining portion of the impairment loss is recognized, net of tax, in other comprehensive income provided that Arrow does not intend to sell the underlying debt security and it is more-likely-than not that Arrow would not have to sell the debt security prior to recovery.


At June 30, 2011 and December 31, 2010 mutual funds and equity securities included shares of one common stock that had been deemed to be other-than-temporarily impaired.  The common stock had a book value of $1,469 prior to the recognition of $375 in losses charged to earnings for the year ended December 31, 2009.  The approximate fair value for this security was $1,210, 1,050 and $948 at June 30, 2011, December 31, 2010 and June 30, 2010, respectively.  During the second quarter of 2011, we recorded a $17 other-than-temporary impairment on a security in our held-to-maturity portfolio.



5.     Loans


Loan balances outstanding as of June 30, 2011, December 31, 2010 and June 30, 2010 consisted of the following:


Loans

As of June 30, 2011, December 31, 2010 and June 30, 2010






June 30,

December 31,

June 30,


2011

2010

2010

Commercial

$   97,201

$     97,621

$     93,100

Commercial real estate:




      Commercial real estate construction

6,907

7,090

12,961

      Commercial real estate other

228,542

214,291

203,299

Consumer:




      Consumer other

5,981

6,482

6,728

      Consumer automobile

316,692

334,656

331,303

Residential prime

     464,773

     485,368

     497,568

        Total

$1,120,096

$1,145,508

$1,144,959





Supplemental Information:




Loans held for sale at period-end, included in the above balances

$261

$10,294

--- 



Credit Quality Indicators


The following table provides information about loan credit quality at June 30, 2011 and December 31, 2010:


Credit Quality Indicators

As of June 30, 2011


Commercial Credit Exposure

Credit Risk Profile by Creditworthiness Category







Commercial Real

Commercial Real

Indicator

Commercial

Estate - Construction

Estate - Other

Satisfactory

$90,354

$4,967

$206,900

Special Mention

4,222

263

1,048

Substandard

2,625

1,677

20,594

Doubtful

         ---

        ---

            ---

        Total

$97,201

$6,907

$228,542


Consumer Credit Exposure

Credit Risk Profile Based on Payment Activity



Consumer-Other

Consumer-Automobile

Residential-Prime

Performing

$5,981

$316,198

$461,342

Nonperforming

       ---

         494

      3,431

     Total

$5,981

$316,692

$464,773



5.     Loans, continued


Credit Quality Indicators

As of December 31, 2010


Commercial Credit Exposure

Credit Risk Profile by Creditworthiness Category







Commercial Real

Commercial Real

Indicator

Commercial

Estate - Construction

Estate - Other

Satisfactory

$94,290

$5,117

$187,070

Special Mention

160

---

7,318

Substandard

3,171

1,973

19,903

Doubtful

          ---

        ---

            ---

        Total

$97,621

$7,090

$214,291


Consumer Credit Exposure

Credit Risk Profile Based on Payment Activity



Consumer-Other

Consumer-Automobile

Residential-Prime

Performing

$6,477

$333,847

$483,725

Nonperforming

         5

         809

      1,643

     Total

$6,482

$334,656

$485,368


We use an internally developed system of five credit quality indicators to rate the credit worthiness of each commercial loan.  The system has eight levels of credit quality (the first four have been combined in the preceding table), defined as follows: 1) Satisfactory - Satisfactory borrowers have acceptable financial condition with satisfactory record of earnings and sufficient historical and projected cash flow to service the debt.  Borrowers have satisfactory repayment histories and primary and secondary sources of repayment can be clearly identified; 2) Special Mention - Loans in this category have potential weaknesses that deserve managements close attention.  If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the institutions credit position at some future date.  Special mention assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification.  Loans which might be assigned this risk rating include loans to borrowers with deteriorating financial strength and/or earnings record, loans with potential for problems due to weakening economic or market conditions, loans subject to an inadequate loan agreement, loans with insufficient or flawed documentation, loans where the loan officer lacks sufficient expertise to properly control the account, and other deviations from prudent lending practice; 3) Substandard - Loans classified as substandard are inadequately protected by the current sound net worth or paying capacity of the borrower or the collateral pledged, if any.  Loans in this category have well defined weaknesses that jeopardize the repayment.  They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected.  Substandard loans may include loans which are likely to require liquidation of collateral to effect repayment, and other loans where character or ability to repay has become suspect.  Loss potential, while existing in the aggregate amount of substandard assets, does not have to exist in individual assets classified substandard; 4) Doubtful - Loans classified as doubtful have all of the weaknesses inherent in those classified as substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of current existing facts, conditions, and values highly questionable and improbable.  Although possibility of loss is extremely high, classification of these loans as loss has been deferred due to specific pending factors or events which may strengthen the value (i.e. possibility of additional collateral, injection of capital, collateral liquidation, debt restructure, economic recovery, etc).  Loans classified as doubtful need to be placed on non-accrual; and 5) Loss - Loans classified as loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted.  As of the date of the balance sheet, all loans in this category have been charged-off to the allowance for loan losses.  However, this classification does not mean that the asset has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be affected in the future.  Commercial loans are evaluated on an annual basis, unless the credit quality indicator falls to a level of 5 or below, when the loan is evaluated quarterly.  The credit quality indictor is one of the factors used to determine any loss, as further described in this footnote.


Past Due Loans


The following table provides an analysis of the age of the recorded investment in loans that are past due as of June 30, 2011 and December 31, 2010.  Consistent with regulatory instructions, Arrow considers an amortizing loan past due 30 or more days only if the borrower is two or more payments past due.  Matured loans and all other loans are considered past due 30 or more days based on the payment due date.  Nonaccrual loans are included in the first three columns, unless the loan is past due less than 30 days.


5.      Loans, continued


Age Analysis of Past Due Loans

As of June 30, 2011









30-59

60-89

90 Days





Days

Days

or More

Total


Total


Past Due

Past Due

Past Due

Past Due

Current

Loans








Commercial

$  268

$  251

$   250

$  769

$    96,432

$     97,201

Commercial Real Estate:







   Commercial Real Estate construction

---

---

---

---

6,907

6,907

   Commercial Real Estate other

76

1,106

169

1,351

227,191

228,542

Consumer:







   Consumer-other

58

4

---

62

5,919

5,981

   Consumer-automobile

2,853

843

220

3,916

312,776

316,692

Residential-prime

    314

  1,565

  2,269

    4,148

     460,625

     464,773

   Total

$3,569

$3,769

$2,908

$10,246

$1,109,850

$1,120,096









Age Analysis of Past Due Loans

As of December 31, 2010









30-59

60-89

90 Days





Days

Days

or More

Total


Total


Past Due

Past Due

Past Due

Past Due

Current

Loans








Commercial

$  591

$  377

$     79

$  1,047

$    96,572

$     97,619

Commercial Real Estate:







   Commercial Real Estate construction

---

---

---

---

7,090

7,090

   Commercial Real Estate other

483

---

254

737

213,554

214,291

Consumer:







   Consumer-other

5

---

---

5

6,477

6,482

   Consumer-automobile

3,542

1,547

508

5,597

329,061

334,658

Residential-prime

     212

  1,884

  1,145

    3,241

     482,127

     485,368

   Total

$4,833

$3,808

$1,986

$10,627

$1,134,881

$1,145,508









Nonaccrual Loans and Loans Past Due 90 or More Days and Still Accruing Interest


Arrow designates certain loans as nonaccrual and suspends the accrual of interest and the amortization of net deferred fees or costs when payment of interest and/or principal is due and unpaid for a period of nonperformance (generally 90 days for consumer installment loans, 120 days for home equity lines of credit and 150 days for other residential real estate loans) or the likelihood of repayment is uncertain in the opinion of management.  The nonaccrual status for all commercial loans is evaluated on a loan-by-loan basis.  The balance of any accrued interest deemed uncollectible at the date the loan is placed on nonaccrual status is reversed against earnings for interest accrued during the calendar year and against the allowance for loan losses for prior accrued interest.  A loan is returned to accrual status at the later of the date when the past due status of the loan falls below the threshold for nonaccrual status or management deems that it is likely that the borrower will repay all interest and principal.  For payments received while the loan is on nonaccrual status, we may recognize interest income on a cash basis if the repayment of the remaining principal and accrued interest is deemed likely.  We had no material commitments to make additional advances to borrowers with nonperforming loans at June 30, 2011 or 2010.




5.      Loans, continued


The following table presents information concerning loans on nonaccrual status and loans past due 90 or more days and still accruing interest at June 30, 2011 and December 31, 2010:


Loans on Nonaccrual Status and Past Due 90 or More Days and Still Accruing Interest

As of June 30, 2011 and December 31, 2010







June 30, 2011

December 31, 2010



90 Days


90 Days



or More


or More


Nonaccrual

Past Due

Nonaccrual

Past Due

Commercial

$   319

$  ---

$     94

$  ---

Commercial real estate:





  Commercial real estate - construction

---

---

---

---

  Commercial real estate - other

1,173

110

2,237

83

Consumer:





  Consumer other

---

---

5

---

  Consumer automobile

489

23

809

---

Residential prime

  3,009

  422

     916

  727

    Total nonaccrual loans and loans past due

       90 or more days and still accruing interest

 $4,990

$555

 $4,061

$810










Impaired Loans


We evaluate restructured loans and all commercial and real estate nonaccrual loans over $250 thousand individually for impairment.  We determine impairment primarily by evaluating the fair value of all collateral and secondarily by analysis of all other cash-flows available to the borrower to satisfy all contractual loan payments.   For return to accrual status and for payments received after the loan has been designated as impaired, we use the same analysis as applied to nonaccrual loans, as described above.


Impaired Loans

As of June 30, 2011 and December 31, 2010









Unpaid


Average

Interest


Recorded

Principal

Related

Recorded

Income


Investment

Balance

Allowance

Investment

Recognized

June 30, 2011






With no related allowance recorded:






Commercial real estate

$   994

$   994

$---

$   996

$---

Residential real estate

  1,812

  1,812

  ---

  1,793

  23

  Total Impaired Loans

$2,806

$2,806

$---

$2,789

$23







December 31, 2010






With no related allowance recorded:






  Commercial real estate

$1,986

$1,986

$---

$1,937

$116

  Residential Real Estate   

     252

     252

  ---

     254

      9

    Total Impaired Loans

$2,238

$2,238

$---

$2,191

$125


5.      Loans, continued


Allowance for Loan Losses


Through the provision for loan losses, an allowance is maintained that reflects our best estimate of probable incurred loan losses related to specifically identified loans and losses for categories of loans in the remaining portfolio.  Actual loan losses are charged against this allowance when loans are deemed uncollectible.


We use a two-step process to determine the provision for loans losses and the amount of the allowance for loan losses.  We evaluate impaired commercial and real estate loans over $250 thousand individually, as described above, while we evaluate the remainder of the portfolio on a pooled basis as described below.


Homogenous Loan Pools:  Under our pooled analysis, we group homogeneous loans as follows, each with its own estimated loss-rate:

i)

Secured and unsecured commercial loans,

ii)

Secured construction and development loans,

iii)

Secured commercial loans non-owner occupied,

iv)

Secured commercial loans owner occupied,

v)

One to four family residential real estate loans,

vi)

Home equity loans,

vii)

Indirect loans low risk tiers (based on credit scores),

viii)

Indirect loans high risk tiers, and

ix)

Other consumer loans.


Within the group of other commercial and commercial real estate loans, we sub-group loans based on our internal system of risk-rating, which is applied to all commercial and commercial real estate loans.  We establish loss rates for each of these pools.  


Estimated losses reflect consideration of all significant factors that affect the collectability of the portfolio as of June 30, 2011.  In our evaluation, we do both a quantitative and qualitative analysis of the homogeneous pools.


Quantitative Analysis:  Quantitatively, we determine the historical loss rate for each homogeneous loan pool.  During the past five years we have had little charge-off activity on loans secured by residential real estate.  Indirect consumer lending (principally automobile loans) represents a significant component of our total loan portfolio and is the only category of loans that has a history of losses that lends itself to a trend analysis.  We have had one small loss on commercial real estate loans in the past five years.  Losses on commercial loans (other than those secured by real estate) are also historically low, but can vary widely from year-to-year; this is the most complex category of loans in our loss analysis.  


Our net charge-offs for the past five years have been at or near historical lows for our Company.  Annualized net charge-offs have ranged from .04% to .09% of average loans during this period.   


Qualitative Analysis:  While historical loss experience provides a reasonable starting point for our analysis, historical losses, or even recent trends in losses, do not by themselves form a sufficient basis to determine the appropriate level for the allowance.  Therefore, we have also considered and adjusted historical loss factors for qualitative and environmental factors that are likely to cause credit losses associated with our existing portfolio.  These included:

Changes in the volume and severity of past due, nonaccrual and adversely classified loans

Changes in the nature and volume of the portfolio and in the terms of loans

Changes in the value of the underlying collateral for collateral dependent loans

Changes in lending policies and procedures, including changes in underwriting standards and collection, charge-off, and recovery practices not considered elsewhere in estimating credit losses

Changes in the quality of the loan review system

Changes in the experience, ability, and depth of lending management and other relevant staff

Changes in international, national, regional, and local economic and business conditions and developments that affect the collectability of the portfolio

The existence and effect of any concentrations of credit, and changes in the level of such concentrations

The effect of other external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in the existing portfolio or pool


For each homogeneous loan pool, we estimate a loss factor expressed in basis points for each of the qualitative factors above, and for historical credit losses.  We update and change, if necessary, the loss-rates assigned to various pools based on the analysis of loss trends and the change in qualitative and environmental factors.  

5.      Loans, continued


From June 2004 to June 2006, the Federal Reserve Bank increased prevailing short-term rates in an effort to slow down national economic growth and check potential increases in the inflation rate.  However, from August 2007 through December 2008, the Federal Reserve Bank began to cut rates in response to the growing financial crisis in credit markets and evidence of a significant economic recession.  In our market area there was little impact from these developments in credit markets and the national economy on unemployment rates, job growth and business failures until the last quarter of 2008; overall, our market area has not experienced in the past six quarters the degree of negative impact on lending, credit and property values that the U.S. as a whole has experienced, although this may change in upcoming periods.


Due to the imprecise nature of the loan loss estimation process and ever changing economic conditions, the risk attributes of our portfolio may not be adequately captured in data related to the formula-based loan loss components used to determine allocations in our analysis of the adequacy of the allowance for loan losses. Management, therefore, has established and held an unallocated portion within the allowance for loan losses reflecting the uncertainty of future economic conditions within our market area.  This unallocated portion of the allowance was $1.5 million, or 10.4% of the total allowance for loan losses, at June 30, 2011.


The following summarizes the changes in the allowance for credit losses by portfolio segment for the six-month period ended June 30, 2011:

Allowance for Credit Losses

As of June 30, 2011



Commercial

Commercial

Other



Unallo-



Commercial

Construction

Real Estate

Consumer

Automobile

Residential

cated

Total

Beginning  balance

$2,037 

$135 

$2,993 

$328 

$4,760 

$3,163 

$1,273

$14,689

        Charge-offs

(50)

--- 

--- 

(49)

(288)

(1)

--- 

(388)

        Recoveries

--- 

--- 

22 

104 

--- 

--- 

129

        Provision

   (914)

  508 

    621 

     3 

       20 

   (118)

    270

       390

Ending balance

$1.076 

$643 

$3.614 

$304

$4.596 

$3.044 

$1,543

$14,820

Ending balance:  

  Individually evaluated

   for impairment

$      ---

$  --- 

$      --- 

$  --- 

$     --- 

$      --- 



Ending balance:  

  Collectively evaluated

  for impairment

$1,076 

$643 

$3,614 

$304

$4,596 

$3,044 



Loans:









Ending balance

$97,201

$6,907 

$227,548 

$5,981

$316,692 

$462,961 


$1,117,290

Ending balance:  

  Individually evaluated

   for impairment

$        --

$      ---

$       994 

$    --- 

$          --- 

$    1,812 


$      2,806

Ending balance:  

  Collectively evaluated

  for impairment

$97,201

$6,907

$228,542 

$5,981

$316,692 

$464,773 


$1,120,096


Loan Modifications


In general, loans requiring modification are restructured to accommodate the projected cash-flows of the borrower.  No loans modified during the preceding twelve months subsequently defaulted as of June 30, 2011.  The following table presents information on loans that were modified during 2011:


Loans Modified During 2011




Number of

Loans

Pre-Modification

Outstanding

Recorded

Investment

Post-Modification

Outstanding

Recorded

Investment

Commercial Other

1

$  62

$  62

Automobile

  9

    88

    88

    Total

10

$150

$150


Off-Balance Sheet Credit Exposures


Currently, our off-balance sheet credit exposures are limited to commitments to make future loans and for outstanding letters of credit.  We follow the same procedures for evaluating the loss on these financial obligations as for our loans with outstanding balances.  Any loss is charged to other operating expenses.


6.   Retirement Plans (In Thousands)


The following table provides the components of net periodic benefit costs for the three months ended June 30:



Pension

Benefits

Postretirement

Benefits


2011

2010

2011

2010

Service Cost

$395 

$282 

$  40 

$ 36 

Interest Cost

431 

438 

67 

105 

Expected Return on Plan Assets

(746)

(468)

--- 

--- 

Accretion of Prior Service Credit

(3)

(19)

(28)

(24)

Amortization of Net Loss

  233 

  235 

    23 

   17 

  Net Periodic Benefit Cost

$310 

$468 

$102 

$134 







The following table provides the components of net periodic benefit costs for the six months ended June 30:



Pension

Benefits

Postretirement

Benefits


2011

2010

2011

2010

Service Cost

$  715 

$  565 

$ 80 

$ 73 

Interest Cost

910 

875 

182 

223 

Expected Return on Plan Assets

(1,390)

(1,055)

--- 

--- 

Accretion of Prior Service Credit

(6)

(38)

(57)

(48)

Amortization of Net Loss

    465 

    471 

   47 

   34 

  Net Periodic Benefit Cost

$  694 

$  818 

$252 

$282 



We contributed $1.5 million to our qualified pension plan in both 2011 and 2010, although we were not required to make any contribution in either year.  The expected 2011 contribution for the nonqualified plan is $396.  Arrow makes contributions for its postretirement benefits in an amount equal to actual expenses for the year.  The expected contribution is estimated to be $344 for 2011.



7.   Stock-Based Compensation Plans (Dollars In Thousands)


Under our 2008 Long-Term Incentive Plan, we granted options in both the first quarters of 2011 and 2010 to purchase shares of our common stock.  The fair values of the options were estimated on the date of grant using the Black-Scholes option-pricing model.  The fair value of our grants is expensed over the four year vesting period.  The expense for the second quarter of 2011 and 2010 was $92 and $78, respectively.  The expense for the first six months of 2011 and 2010 was $174 and $147, respectively.  Other information on the options is presented in the following table:


Grants Issued During the First Quarter:

2011

2010

Shares Granted

74,648

73,336

Fair Value of Options Granted

$6.43

$6.43




Assumptions:



  Dividend Yield

4.00%

3.80%

  Expected Volatility

36.5%

35.4%

  Risk Free Interest Rate

2.54%

3.14%

  Expected Lives (in years)

6.40   

7.79   




7.   Stock-Based Compensation Plans (Continued)


The following table presents the activity in Arrows compensatory stock options for the first six months of 2011 and 2010:



2011

2010




Options:




Shares

Weighted-

Average

Exercise

Price




Shares

Weighted-

Average

Exercise

Price

  Outstanding at January 1

466,944 

$22.75 

452,502 

$21.70 

  Granted

74,648 

25.47 

73,336 

23.86 

  Exercised

(14,717)

21.30 

(27,315)

11.69 

  Forfeited

 (10,071)

26.84 

         --- 

---  

  Outstanding at June 30

516,804 

23.11 

498,523 

22.56 

  Exercisable at June 30

339,475 

22.74 

334,343 

22.61 


Arrow also sponsors an Employee Stock Purchase Plan under which employees purchase Arrows common stock at a 5% discount below market price.  Under current accounting guidance, a stock purchase plan with a discount of 5% or less is not considered a compensatory plan.   



8.   Guarantees


Arrow does not issue any guarantees that would require liability-recognition or disclosure, other than its standby letters of credit.  Standby and other letters of credit are conditional commitments issued by Arrow to guarantee the performance of a customer to a third party.  Those guarantees are primarily issued to support public and private borrowing arrangements, including bond financing and similar transactions.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.  Typically, these instruments have terms of twelve months or less.  Some expire unused, and therefore, the total amounts do not necessarily represent future cash requirements.  Some have automatic renewal provisions.


For letters of credit, the amount of the collateral obtained, if any, is based on managements credit evaluation of the counter-party.   Arrow had approximately $8.3 million of standby letters of credit on June 30, 2011, most of which will expire within one year and some of which were not collateralized.  At that date, all standby letters of credit were for private borrowing arrangements.  The fair value of Arrows standby letters of credit at June 30, 2011 was insignificant.



9.  Fair Value Measurements and Disclosures (In Thousands)


FASB ASC Subtopic 820-10 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP) and requires certain disclosures about fair value measurements.  We do not have any nonfinancial assets or liabilities measured at fair value. The only assets or liabilities that Arrow measured at fair value on a recurring basis at June 30, 2011, December 31, 2010 and June 30, 2010 were securities available-for-sale.  Arrow held no securities or liabilities for trading on such date.  


We determine the fair value of financial instruments under the following hierarchy:

"

Level 1 Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;

"

Level 2 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 inputs that are observable, either directly or indirectly, for substantially the full term of the asset or liability;

Level 3 Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market activity).  


A financial instruments level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.  



9.  Fair Value Measurements and Disclosures, continued


The fair value measurement of securities available-for-sale on such date was as follows:




Fair Value Measurements at Reporting Date Using:

Description

Total

Quoted Prices

In Active Markets for Identical Assets

(Level 1)

Significant Other

Observable Inputs

(Level 2)

Significant Unobservable Inputs

(Level 3)

June 30, 2011:





Securities Available-for Sale:





U.S. Agency Securities

$  49,551

$---

$  49,551

$    ---

State and Municipal Obligations

90,700

---

90,700

---

Collateralized Mortgage Obligations

159,985

---

159,985

---

Mortgage-Backed Securities - Residential

208,044

---

208,044

---

Corporate and Other Debt Securities

1,345

---

1,028

317

Mutual Funds and Equity Securities

     1,469

  215

     1,254

    ---

  Total Securities Available-for-Sale

$511,094

$215

$510,562

$317






December 31, 2010:





Securities Available-for Sale:





U.S. Agency Securities

$  98,173

$  ---

$  98,173

$    ---

State and Municipal Obligations

89,528

---

89,528

---

Collateralized Mortgage Obligations

166,964

---

166,964

---

Mortgage-Backed Securities - Residential

159,926

---

159,926

---

Corporate and Other Debt Securities

1,417

             ---

             1,134

283

Mutual Funds and Equity Securities

     1,356

  421

        935

    ---

  Total Securities Available-for-Sale

$517,364

$421

$516,660

$283






June 30, 2010:





Securities Available-for Sale:





U.S. Agency Securities

$163,858

$---

$163,858

$    ---

State and Municipal Obligations

18,953

---

18,953

---

Collateralized Mortgage Obligations

177,863

---

177,863

---

Mortgage-Backed Securities - Residential

84,552

---

84,552

---

Corporate and Other Debt Securities

1,433

---

1,119

314

Mutual Funds and Equity Securities

     1,208

  ---

     1,208

     ---

  Total Securities Available-for-Sale

$447,867

$---

$447,553

$314


Fair value for securities available-for-sale was determined utilizing an independent bond pricing service for identical assets or significantly similar securities.  The pricing service uses a variety of techniques to arrive at fair value including market maker bids, quotes and pricing models.  Inputs to the pricing models include recent trades, benchmark interest rates, spreads and actual and projected cash flows.  There were no assets or liabilities measured at fair value on a nonrecurring basis at June 30, 2011.  


Level 3 securities available-for-sale at June 30, 2011, December 31, 2010 and June 30, 2010, in the table above, included one trust preferred pooled security.   In our analysis of fair value, we determined that the market for this security was inactive.  We reviewed the collateral within the pool and performed a discounted cash flow analysis using additional value estimates from unobservable inputs including expected cash flows after estimated deferrals and defaults.  The discount rate used was based on a market based rate of return including an assumed risk premium for securities with similar credit characteristics plus a market price adjustment for the small size and lack of an established market for this type of security.



9.  Fair Value Measurements and Disclosures, continued


The following table is a reconciliation of the beginning and ending balances for June 30, 2011 and 2010 of the Level 3 assets of Arrow, i.e., as to which fair value is measured using significant unobservable inputs, all of which are securities available-for-sale:



2011

2010

Beginning Balance, January 1

$283 

$305 

Transfers In

--- 

--- 

Principal payment received

(2)

(3)

Purchases, issuances and settlements

--- 

--- 

Total net losses (realized/unrealized):



Included in earnings    

--- 

--- 

Included in earnings, as a result of other-than-temporary impairment

--- 

--- 

Included in other comprehensive income

    36 

   12 

Ending Balance, June 30

$317 

$314 

The amount of total losses for the year included in earnings attributable to the change in unrealized gains or losses relating to assets still held at period-end, as a result of other-than-temporary impairment

$--- 

$--- 


Other impaired assets which might have been included in this table include other real estate owned, mortgage servicing rights, goodwill and other intangible assets.  Arrow evaluates each of these assets for impairment on a quarterly basis, with no impairment recognized for these assets at June 30, 2011, December 31, 2010 or June 30, 2011.  


The following table presents a summary at June 30, 2011, December 31, 2010, and June 30, 2010 of the carrying amount and fair value of Arrows financial instruments:



June 30, 2011

December 31, 2010

June 30, 2010


Carrying

Amount

Fair

Value

Carrying

Amount

Fair

Value

Carrying

Amount

Fair

Value

Cash and Due from Banks

$    33,202

$    33,202

$    25,961

$   25,961

$    33,071

$   33,071

Interest-Bearing Deposits at Banks

24,118

24,118

5,118

5,118

 6,701

 6,701

Securities Available-for-Sale

511,094

511,094

517,364

517,364

447,867

447,867

Securities Held-to-Maturity

138,334

143,327

159,938

162,713

  158,226

  162,077

Other Investments

7,019

7,019

8,602

8,602

9,474

9,474

Net Loans

1,105,276

1,132,069

1,130,819

1,158,129

1,130,548

1,154,469

Non-Maturity Deposits

1,178,912

1,178,912

1,165,599

1,165,599

1,054,314

1,054,314

Time Deposits

362,947

371,578

368,405

377,224

384,709

395,146

Federal Funds Purchased and Securities

  Sold Under Agreements to Repurchase

60,361

60,361

51,581

51,581

60,847

60,847

Other Short-Term Borrowings

2,211

2,211

1,633

1,633

1,619

1,619

FHLBNY Advances

90,000

93,236

130,000

134,676

150,000

156,776

Junior Subordinated Obligations Issued to

   Unconsolidated Subsidiary Trusts

20,000

20,000

20,000

20,000

20,000

20,000

Accrued Interest Receivable

6,689

6,689

6,512

6,512

6,464

6,464

Accrued Interest Payable

1,549

1,549

1,957

1,957

2,094

2,094


Fair value for securities held-to-maturity was determined utilizing an independent bond pricing service for identical assets or significantly similar securities.  The pricing service uses a variety of techniques to arrive at fair value including market maker bids, quotes and pricing models.  Inputs to the pricing models include recent trades, benchmark interest rates, spreads and actual and projected cash flows.


Fair values for loans are estimated for portfolios of loans with similar financial characteristics.  Loans are segregated by type such as commercial, commercial real estate, residential mortgage, indirect and other consumer loans.  Each loan category is further segmented into fixed and adjustable interest rate terms and by performing and nonperforming categories.  The fair value of performing loans is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan.  The estimate of maturity is based on historical experience with repayments for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions.   Fair value for nonperforming loans is generally based on recent external appraisals.  If appraisals are not available, estimated cash flows are discounted using a rate commensurate with the risk associated with the estimated cash flows.  Assumptions regarding credit risk, cash flows and discount rates are judgmentally determined using available market information and specific borrower information.


9.  Fair Value Measurements and Disclosures, continued


The fair value of time deposits is based on the discounted value of contractual cash flows, except that the fair value is limited to the extent that the customer could redeem the certificate after imposition of a premature withdrawal penalty.  The discount rates are estimated using the FHLBNY yield curve, which is considered representative of Arrows time deposit rates.


The fair value of FHLBNY advances is estimated based on the discounted value of contractual cash flows.  The discount rate is estimated using current rates on FHLBNY advances with similar maturities and call features.


Based on Arrows capital adequacy, the book value of the outstanding trust preferred securities (Junior Subordinated Obligations Issued to Unconsolidated Subsidiary Trusts) are considered to approximate fair value since the interest rates are variable (indexed to LIBOR) and Arrow is well-capitalized.


Report of Independent Registered Public Accounting Firm


The Board of Directors and Stockholders

Arrow Financial Corporation:


We have reviewed the consolidated balance sheets of Arrow Financial Corporation and subsidiaries (the Company) as of June 30, 2011 and 2010, the related consolidated statements of income for the three-month and six-month periods ended June 30, 2011 and 2010 and the related consolidated statements of changes in stockholders equity and cash flows for the six-month periods ended June 30, 2011 and 2010.  These consolidated financial statements are the responsibility of the Companys management.


We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.


Based on our reviews, we are not aware of any material modifications that should be made to the consolidated financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.


We have previously audited, in accordance with standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Arrow Financial Corporation and subsidiaries as of December 31, 2010, and the related consolidated statements of income, changes in stockholders equity, and cash flows for the year then ended (not presented herein); and in our report dated March 8, 2011, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2010, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.



/s/ KPMG LLP



Albany, New York

August 8, 2011

Item 2.

ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

June 30, 2011


Note on Terminology - In this Quarterly Report on Form 10-Q, the terms Arrow, the registrant, the company, we, us, and our generally refer to Arrow Financial Corporation and its subsidiaries as a group, except where the context indicates otherwise.  Arrow is a two-bank holding company headquartered in Glens Falls, New York.  Our banking subsidiaries are Glens Falls National Bank and Trust Company (Glens Falls National) whose main office is located in Glens Falls, New York, and Saratoga National Bank and Trust Company (Saratoga National) whose main office is located in Saratoga Springs, New York.  Our non-bank subsidiaries include Capital Financial Group, Inc. (an insurance agency specializing in selling and servicing group health care policies), Loomis & LaPann, Inc. (a property and casualty insurance agency), Upstate Agency, LLC (also a property and casualty insurance agency), North Country Investment Advisers, Inc. (a registered investment adviser that provides investment advice to our proprietary mutual funds), Glens Falls National Community Development Corporation, and Arrow Properties, Inc. (a real estate investment trust, or REIT).  All of these are wholly owned or majority owned subsidiaries of Glens Falls National.


At certain points in this Report, our performance is compared with that of our peer group of financial institutions.  Unless otherwise specifically stated, this peer group is comprised of the group of 299 domestic bank holding companies with $1 to $3 billion in total consolidated assets as identified in the Federal Reserve Boards Bank Holding Company Performance Report for March 31, 2011 (the most recent such Report currently available), and peer group data has been derived from such Report.  


Forward Looking Statements - The information contained in this Quarterly Report on Form 10-Q contains statements that are not historical in nature but rather are based on our beliefs, assumptions, expectations, estimates and projections about the future.  These statements are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and involve a degree of uncertainty and attendant risk.  Words such as expects, believes, anticipates, estimates and variations of such words and similar expressions are intended to identify such forward-looking statements.  Some of these statements, such as those included in the interest rate sensitivity analysis in Item 3, entitled Quantitative and Qualitative Disclosures About Market Risk, are merely presentations of what future performance or changes in future performance would look like based on hypothetical assumptions and on simulation models.  Other forward-looking statements are based on our general perceptions of market conditions and trends in business activity, both our own and in the banking industry generally, as well as current management strategies for future operations and development.

Examples of Forward-Looking Statements

Topic

Page

Location

Estimation of potential losses related to Visa obligation

34

3rd paragraph

Impact of market rate structure on net interest margin,  loan yields and deposit rates

35

3rd paragraph


37

Last paragraph


38

3rd paragraph


41

Last 3 paragraphs


42

1st paragraph

Provision for loan losses

44

1st paragraph

Future level of residential real estate loans

40

1st paragraph


39

4th paragraph


44

4th & 8th paragraph

Future level of indirect consumer loans

40

6th paragraph

Future level of commercial loans

41

1st paragraph

Impact of changing capital standards and legislative developments

33

2nd paragraph


45

4th paragraph

Liquidity

47

Next to last paragraph

Fees for other services to customers

50

Last paragraph

Interchange fees

50

Next to last paragraph

Insurance commissions

51

1st paragraph


53

Last paragraph

Impact of change in FDIC premium calculation, under Dodd-Frank

34

1st paragraph

Impact of Heath Care Reform

33

1st paragraph


These statements are not guarantees of future performance and involve certain risks and uncertainties that are difficult to quantify or, in some cases, to identify.  In the case of all forward-looking statements, actual outcomes and results may differ materially from what the statements predict or forecast.  Factors that could cause or contribute to such differences include, but are not limited to, rapid and dramatic changes in economic and market conditions, such as the fluctuations that the U.S. economy has recently experienced and continues to experience; sharp changes in interest rates and/or consumer spending patterns; sudden changes in the market for products we provide, such as real estate loans; significant new banking laws and regulations, as are presently anticipated or occurring; enhanced competition from unforeseen sources; and similar uncertainties inherent in banking operations or business generally.  


In the current environment of continuing economic turmoil affecting all sectors of business in the U.S., including the financial sector, all forward-looking statements should be understood as embracing a degree of uncertainty far exceeding that accompanying such statements under normal economic conditions.


Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof.  We undertake no obligation to revise or update these forward-looking statements to reflect the occurrence of unanticipated events.  This Quarterly Report should be read in conjunction with our Annual Report on Form 10-K for December 31, 2010.

USE OF NON-GAAP FINANCIAL MEASURES


The Securities and Exchange Commission (SEC) has adopted Regulation G, which applies to all public disclosures, including earnings releases, made by registered companies that contain non-GAAP financial measures.  GAAP is generally accepted accounting principles in the United States of America.  Under Regulation G, companies making public disclosures containing non-GAAP financial measures must also disclose, along with each non-GAAP financial measure, certain additional information, including a reconciliation of the non-GAAP financial measure to the closest comparable GAAP financial measure and a statement of the Companys reasons for utilizing the non-GAAP financial measure as part of its financial disclosures.  As a parallel measure with Regulation G, the SEC stipulated in Item 10 of its Regulation S-K that public companies must make the same types of supplemental disclosures whenever they include non-GAAP financial measures in their filings with the SEC.  The SEC has exempted from the definition of non-GAAP financial measures certain commonly used financial measures that are not based on GAAP.  When these exempted measures are included in public disclosures or SEC filings, supplemental information is not required.  The following measures used in this Report, which although commonly utilized by financial institutions have not been specifically exempted by the SEC, may constitute "non-GAAP financial measures" within the meaning of the SEC's new rules, although we are unable to state with certainty that the SEC would so regard them.


Tax-Equivalent Net Interest Income and Net Interest Margin: Net interest income, as a component of the tabular presentation by financial institutions of Selected Financial Information regarding their recently completed operations, is commonly presented on a tax-equivalent basis.  That is, to the extent that some component of the institution's net interest income, which is presented on a before-tax basis, is exempt from taxation (e.g., is received by the institution as a result of its holdings of state or municipal obligations), an amount equal to the tax benefit derived from that component is added back to the net interest income total.  This adjustment is considered helpful in comparing one financial institution's net interest income to that of another institution or to better analyze any institutions net interest income trend line over time, to correct any distortion that might otherwise arise from the fact that any two institutions typically will have different proportions of tax-exempt items in their portfolios, and that even a single institution may significantly alter the proportion of its own interest income derived from tax-exempt obligations from period to period.  Moreover, net interest income is itself a component of a second financial measure commonly used by financial institutions, net interest margin, which is the ratio of net interest income to average earning assets.  For purposes of this measure as well, tax-equivalent net interest income is generally used by financial institutions, again to provide a better basis of comparison from institution to institution and to better demonstrate a single institutions performance over time.  We follow these practices.


The Efficiency Ratio: Financial institutions often use an "efficiency ratio" as a measure of expense control.  The efficiency ratio typically is defined as the ratio of noninterest expense to net interest income and noninterest income.  Net interest income as utilized in calculating the efficiency ratio is typically expressed on a tax-equivalent basis.  Moreover, most financial institutions, in calculating the efficiency ratio, also adjust both noninterest expense and noninterest income to exclude from these items (as calculated under GAAP) certain recurring component elements of income and expense, such as intangible asset amortization (deducted from noninterest expense) and securities gains or losses (excluded from noninterest income), as well as certain nonrecurring components, such as gain or loss from sale of business lines.  We follow these practices.


Tangible Equity and Tangible Book Value per Share:  Tangible equity is total stockholders equity less intangible assets.  Tangible book value per share is tangible equity divided by total shares issued and outstanding.  Tangible book value per share is often regarded as a more meaningful comparative ratio than book value per share as calculated under GAAP, that is, total stockholders equity including intangible assets divided by total shares issued and outstanding.  Intangible assets, as a category of assets, includes many items, but is essentially represented by goodwill for Arrow. We regard tangible equity and tangible book value per share as meaningful and useful financial measures.


Adjustments for One-Time Items of Income or Expense:  In addition to disclosures of net income, earnings per share, return on average assets, return on average equity and other financial measures in accordance with GAAP, we may also provide comparative disclosures on a period-to-period basis that adjust one or more of these GAAP financial measures for one or more of the comparative periods, typically by removing therefrom material one-time items of income or expense.  We believe that the resultant non-GAAP financial measures may be helpful in understanding the results of operations separate and apart from such items which, if included, may or could have a disproportional positive or negative impact on the results for a particular period. Additionally, we believe that the adjustment for one-time items allows a better comparison from period to period in our results of operations with respect to our fundamental lines of business including the commercial banking business.


We believe that these non-GAAP financial measures are useful in evaluating our performance and that this information should be considered as supplemental in nature and not as a substitute for or superior to the related financial information prepared in accordance with GAAP.  These non-GAAP financial measures may differ from similar measures presented by other companies.

Selected Quarterly Information - Unaudited

(Dollars in Thousands)



Jun 2011

Mar 2011

Dec 2010

Sep 2010

Jun 2010

Net Income

$5,849

$5,281

$5,188

$5,575

$5,714







Transactions Recorded in Net Income (Net of Tax):






Net Gain on Securities Transactions

291 

327 

7

373

530

Net Gain on Sales of Loans

101 

31 

299

285

21







Share and Per Share Data:1






Period End Shares Outstanding

11,355

11,402

11,256

11,234

11,300

Basic Average Shares Outstanding

11,387

11,334

11,239

11,257

11,307

Diluted Average Shares Outstanding

11,399

11,347

11,292

11,260

11,344

Basic Earnings Per Share

$.51

$.47

$.46

$.50

$.51

Diluted Earnings Per Share

.51

.47

.46

.50

.50

Cash Dividend Per Share

.25

.25

.25

.24

.24







Selected Quarterly Average Balances:






Interest-Bearing Deposits at Banks

$31,937

$35,772

$76,263

$49,487

$51,457

Investment Securities

697,796

683,839

672,071

594,738

608,477

Loans

1,128,006

1,130,539

1,147,889

1,148,196

1,130,638

Deposits

1,596,876

1,564,677

1,568,466

1,466,541

1,476,912

Other Borrowed Funds

179,989

193,960

223,425

236,115

225,687

Shareholders Equity

161,680

155,588

154,677

153,653

149,026

Total Assets

1,961,908

1,935,409

1,970,085

1,880,099

1,873,690







Return on Average Assets

1.20%

1.11%

1.04%

1.18%

1.22%

Return on Average Equity

14.51

13.77

     13.31

14.39

15.38

Return on Tangible Equity2

17.61

16.07

14.97

16.21  

17.39  







Average Earning Assets

$1,857,739

$1,850,150

$1,884,402

$1,792,421

$1,790,572

Average Paying Liabilities

1,559,014

1,546,849

1,579,765

1,485,639

1,502,052

Interest Income, Tax-Equivalent

20,500

20,821

21,554

21,829

22,530

Interest Expense

4,975

5,336

5,903

5,829

6,023

Net Interest Income, Tax-Equivalent

15,525

15,485

15,651

16,000

16,507

Tax-Equivalent Adjustment

944

931

908

832

852

Net Interest Margin 3 , 4

3.35%

3.39%

3.30%

3.54%

3.70%

Efficiency Ratio Calculation:






Noninterest Expense

$12,171 

$12,319 

$11,770 

$12,106 

$12,002 

Less: Intangible Asset Amortization

      (134)

     (100)

       (66)

       (67)

       (65)

   Net Noninterest Expense

$12,037 

$12,219 

$11,704 

$12,039 

$11,937 

Net Interest Income, Tax-Equivalent

$15,525 

$15,485 

$15,651 

$16,000 

$16,507 

Noninterest Income

6,228 

5,620 

4,738 

5,305 

5,028 

Less: Net Securities Gains

     (482)

     (542)

       (11)

     (618)

     (878)

   Net Gross Income

$21,271 

$20,563 

$20,378 

$20,687 

$20,657 

Efficiency Ratio 4

56.59%

59.42%

57.43%

58.20%

57.79%

Period-End Capital Information:






Total Stockholders Equity (i.e. Book Value)

$163,589

$159,188

$152,259

$153,457

$152,703

Book Value per Share

14.41

13.96

13.53

13.66

13.51

Intangible Assets

25,044

24,900

17,241

17,209

17,206

Tangible Book Value per Share

12.20

11.78

12.00

12.13

11.99

Capital Ratios:






Tier 1 Leverage Ratio

8.67%

8.66%

8.53%

8.79%

8.71%

Tier 1 Risk-Based Capital Ratio

14.76   

14.37   

14.50   

14.16   

14.25   

Total Risk-Based Capital Ratio

16.02   

15.63   

15.75   

15.41   

15.50   







Assets Under Trust Administration

  and Investment Management

$1,017,091

$1,011,618

$984,394 

$925,940 

$854,831 







1Share and Per Share Data have been restated for the September 29, 2010 3% stock dividend.

2Tangible Book Value and Tangible Equity exclude intangible assets from total equity.  These are non-GAAP financial measures which we believe provide investors with information that is useful in understanding our financial performance.

3Net Interest Margin is the ratio of our annualized tax-equivalent net interest income to average earning assets.  This is also a non-GAAP financial measure which we believe provides investors with information that is useful in understanding our financial performance.

4 See Use of Non-GAAP Financial Measures on page 27.


Selected Six-Month Period Information:

(Dollars In Thousands, Except Per Share Amounts)






Jun 2011

Jun 2010

Net Income




$11,130

$11,129







Transactions Recorded in Net Income (Net of Tax):






Net Securities Gains



 618 

 530 

Net Gain on Sales of Loans



132

33







Period-End Shares Outstanding




11,355

11,300

Basic Average Shares Outstanding




11,361

11,284

Diluted Average Shares Outstanding




11,378

11,323

Basic Earnings Per Share




$0.98  

$0.99  

Diluted Earnings Per Share




0.98  

0.98  

Cash Dividends Per Share




.50  

.49  







Average Assets




$1,948,732

$1,859,013

Average Equity




158,651

146,528

Return on Average Assets




1.15%

1.21%

Return on Average Equity




14.15   

15.32   







Average Earning Assets




$1,853,966

$1,776,607

Average Interest-Bearing Liabilities




1,552,965

1,492,842

Interest Income, Tax-equivalent 1




41,322

45,042

Interest Expense




10,312

11,963

Net Interest Income, Tax-equivalent 1




31,010

33,079

Tax-equivalent Adjustment




1,875

1,713

Net Interest Margin 1




3.37%

3.75%


Efficiency Ratio Calculation 1






Noninterest Expense




$24,490

$23,542

Less: Intangible Asset Amortization




     (235)

     (138)

   Net Noninterest Expense




 24,255

 23,404

Net Interest Income, Tax-equivalent 1




31,010

33,079

Noninterest Income




11,848

9,046

Less: Net Securities Gains




   (1,024)

     (878)

   Net Gross Income, Adjusted




  41,834

  41,247

Efficiency Ratio 1




57.98%

56.74%

Period-End Capital Information:






Tier 1 Leverage Ratio




8.67%

8.71%

Total Stockholders Equity (i.e. Book Value)




$163,589

$152,703

Book Value per Share




14.41

13.51

Intangible Assets




25,044

17,206

Tangible Book Value per Share  1




12.20

11.99

Asset Quality Information:






Net Loans Charged-off as a

  Percentage of Average Loans, Annualized




.05%

.06%

Provision for Loan Losses as a

  Percentage of Average Loans, Annualized




 .07

 .13

Allowance for Loan Losses as a

  Percentage of Period-end Loans




1.32

1.26

Allowance for Loan Losses as a

  Percentage of Nonperforming Loans




253.30

324.13

Nonperforming Loans as a

  Percentage  of Period-end Loans




 .52

 .39

Nonperforming Assets as a

  Percentage of Period-end Total Assets




 .31

 .24


1 See Use of Non-GAAP Financial Measures on page 27.


Average Consolidated Balance Sheets and Net Interest Income Analysis

(see Use of Non-GAAP Financial Measures on page 27)

(Fully Taxable Basis using a marginal tax rate of 35%)

(Dollars In Thousands)


Quarter Ended June 30,

2011

2010



Interest

Rate


Interest

Rate


Average

Income/

Earned/

Average

Income/

Earned/


Balance

Expense

Paid

Balance

Expense

Paid

Interest-Bearing Deposits at Banks

$     31,937 

 $       21 

0.26%

$     51,457 

$        34 

0.27%

Investment Securities:







  Fully Taxable

451,463 

 3,323 

2.95   

423,698

 3,896

3.69  

  Exempt from Federal Taxes

246,333 

   2,370 

3.86   

184,779

 2,245

4.87  

Loans

  1,128,006 

 14,786 

5.26   

 1,130,638

 16,355

5.80  

  Total Earning Assets

1,857,739 

 20,500 

4.43   

1,790,572

 22,530

5.05  








Allowance For Loan Losses

(14,774)



(14,268)



Cash and Due From Banks

27,789 



27,637



Other Assets

       91,154 



       69,749



  Total Assets

$1,961,908 



$1,873,690










Deposits:







 NOW Accounts

$   605,664 

1,361 

0.90   

$  534,157

1,454

1.09  

 Savings Deposits

409,179 

  503 

0.49   

359,094

  570

0.64  

 Time Deposits of  $100,000 or More

123,179 

664 

2.16   

133,737

  727

2.18  

 Other Time Deposits

     241,003 

   1,292 

2.15   

  249,377

  1,480

2.38  

   Total Interest-Bearing Deposits

1,379,025 

 3,820 

1.11   

1,276,365

 4,231

1.33  

 







Short-Term Borrowings

 59,150 

  23 

0.16   

 63,889

  32

0.20  

FHLBNY Advances and Long-Term Debt

     120,839 

   1,132 

3.76   

   161,798

  1,760

4.36  

  Total Interest-Bearing Funds

1,559,014 

   4,975 

1.28   

1,502,052

  6,023

1.61  








Demand Deposits

217,851 



200,547



Other Liabilities

       23,363 



      22,065



  Total Liabilities

1,800,228 



1,724,664



Stockholders Equity

     161,680 



    149,026



  Total Liabilities and Stockholders Equity

$1,961,908 



$1,873,690










Net Interest Income (Tax-equivalent Basis)


15,525 



16,507


Reversal of Tax-Equivalent Adjustment


     (944)

(.20)  


     (852)

(.19)

Net Interest Income


$14,581 



$15,655


Net Interest Spread (Tax-equivalent Basis)



3.15   



3.44

Net Interest Margin (Tax-equivalent Basis)



3.35   



3.70

















Average Consolidated Balance Sheets and Net Interest Income Analysis

(see Use of Non-GAAP Financial Measures on page 27)

(Fully Taxable Basis using a marginal tax rate of 35%)

(Dollars In Thousands)


Six Months Ended June 30,

2011

2010



Interest

Rate


Interest

Rate


Average

Income/

Earned/

Average

Income/

Earned/


Balance

Expense

Paid

Balance

Expense

Paid

Interest-Bearing Deposits at Banks

$     33,844 

 $       44 

0.26%

$    56,615

$       74

0.26%

Investment Securities:







  Fully Taxable

445,067 

 6,682 

3.03   

413,090

 7,875

3.84  

  Exempt from Federal Taxes

245,790 

   4,732 

3.88   

185,729

   4,513

4.90  

Loans

  1,129,265 

 29,864 

5.33   

 1,121,173

 32,580

5.86  

  Total Earning Assets

1,853,966 

 41,322 

4.49   

1,776,607

 45,042

5.11  








Allowance For Loan Losses

(14,735)



(14,180)



Cash and Due From Banks

26,646 



28,105



Other Assets

       82,855 



       68,481



  Total Assets

$1,948,732 



$1,859,013










Deposits:







 NOW Accounts

$   600,013 

2,692 

0.90   

$   530,170

2,877

1.09  

 Savings Deposits

401,569 

 1,006 

0.51   

351,130

1,110

0.64  

 Time Deposits of  $100,000 or More

120,894 

1,331 

2.22   

140,269

1,443

2.07  

 Other Time Deposits

     243,553 

   2,644 

2.19   

   247,365

   2,966

2.42  

   Total Interest-Bearing Deposits

1,366,029 

 7,673 

1.13   

1,268,934

8,396

1.33  

 







Short-Term Borrowings

 56,003 

  47 

0.17   

 63,005

  62

0.20  

FHLBNY Advances and Long-Term Debt

     130,933 

   2,592 

3.99   

   160,903

   3,505

4.39  

  Total Interest-Bearing Funds

1,552,965 

  10,312 

1.34   

1,492,842

 11,963

1.62  








Demand Deposits

214,836 



196,272



Other Liabilities

       22,280 



      23,371



  Total Liabilities

1,790,081 



1,712,485



Stockholders Equity

     158,651 



    146,528



  Total Liabilities and Stockholders Equity

$1,948,732 



$1,859,013










Net Interest Income (Tax-equivalent Basis)


31,010 



33,079


Reversal of Tax-Equivalent Adjustment


   (1,875)

(.20)  


   (1,713)

(.19)

Net Interest Income


$29,135 



$31,366


Net Interest Spread (Tax-equivalent Basis)



3.15   



3.49

Net Interest Margin (Tax-equivalent Basis)



3.37   



3.75















OVERVIEW


We reported net income for the second quarter of 2011 of $5.8 million, representing diluted earnings per share (EPS) of $.51, as compared to net income of $5.7 million and $.50 of diluted EPS for the second quarter of 2010, an increase in diluted EPS of $.01 per share or 2.0%. Return on average equity (ROE) for the 2011 quarter continued to be very strong at 14.51%, although down from the ROE of 15.38% for the quarter ended June 30, 2010. Return on average assets (ROA) for the 2011 quarter continued to be strong at 1.20%, although down slightly from ROA of 1.22% for the quarter ended June 30, 2010.


Total assets were $1.902 billion at June 30, 2011, which represented an increase of $55.7 million, or 3.0%, above the level at June 30, 2010, but a decrease of $6.6 million, or 0.3%, from the December 31, 2010 level.  


Stockholders equity was $163.6 million at June 30, 2011, an increase of $10.9 million, or 7.1%, from the year earlier level.  Stockholders' equity was also up $11.3 million, or 7.4%, from the December 31, 2010 level of $152.3 million.  The components of the change in stockholders equity since year-end 2010 are presented in the Consolidated Statement of Changes in Stockholders Equity on page 5, and are discussed in more detail in the last section of this Overview on page 34 entitled, Increase in Stockholder Equity.  Our risk-based capital ratios and Tier 1 leverage ratios at the holding company and bank levels continued to significantly exceed regulatory minimum requirements at period-end.  At June 30, 2011 both of our banks, as well as our holding company, qualified as "well-capitalized" under federal bank regulatory guidelines.  


Economic recession and loan quality:  As the economic recession occurred in late 2008 and early 2009, our market area of northeastern New York was relatively sheltered from falling real estate values and increasing unemployment, partially due to the fact that our market area had been less affected by the preceding real estate bubble than other areas of the U.S.  As the recession became stronger and deeper through the end of the recession in late 2009, even northeastern New York began to feel the impact of the worsening national economy reflected in a slow-down in real estate sales and increasing unemployment rates.   By year-end 2009, we had experienced a very modest decline in the credit quality of our loan portfolio, although by standard measures our portfolio continued to be significantly stronger than the average for our peer group of U.S. bank holding companies with $1 billion to $3 billion in total assets (see page 26 for peer group information).  In 2010, our loan quality continued to decline modestly, but by year-end appeared to be stabilizing, a trend that continued in the first six months of 2011.  During this period, although nonperforming loans increased slightly, charge-offs decreased.  Nonperforming loans were $5.9 million at June 30, 2011, an increase of $964 thousand from year-end 2010.  The ratio of nonperforming loans to period-end loans at June 30, 2011 was .52%, an increase from .43% at December 31, 2010.  This ratio was .39% at June 30, 2010.  By way of comparison, this ratio for our peer group was 3.43% at March 31, 2011, with only a small improvement from year-end 2010.  Our loans charged-off (net of recoveries) against our allowance for loan losses were a very low $95 thousand for the second quarter of 2011, as compared to $164 thousand for the preceding quarter ended March 31, 2011 and $147 thousand for the second quarter of 2010.  Total net charge-offs for the six-month period ended June 30, 2011 were $259 thousand as compared to $353 thousand for the first six months of 2010.  At June 30, 2011, the allowance for loan losses was $14.8 million, representing 1.32% of total loans, an increase of 4 basis points from the prior year-end and 6 basis points from June 30, 2010. Since the onset of the financial crisis in 2008, we have not experienced significant deterioration in any of our three major loan portfolio segments:


o

Commercial Loans:  We lend to small and medium size businesses, which typically do not encounter liquidity problems, since we often also provide support for their supplementary liquidity needs.  However, current unemployment rates in our region are higher than in the past few years and the total number of jobs has decreased, although these trends are largely attributable to a scaling back of local operations on the part of a few large corporations having operations in our service area.  Commercial property values have not shown significant deterioration and we update the appraisals on our nonperforming and watched commercial properties as deemed necessary, usually when the loan is downgraded or when we perceive significant market deterioration since our last appraisal.

o

Residential Real Estate Loans:  We have not experienced a notable increase in our foreclosure rates, primarily due to the fact that we never have originated or participated in underwriting subprime or other high-risk mortgage loans, such as so called Alt A, negative amortization, option ARMs or negative equity loans.  We originate all of the residential real estate loans held in our portfolio and apply conservative underwriting standards to all of our originations.  

o

Indirect Consumer Lending (Primarily Automobile Loans):  These loans comprise approximately 30% of our loan portfolio.  During the first six months of 2011 and during 2010, we did not experience any significant change in our delinquency rate or level of charge-offs on these loans, although both delinquencies and charge-offs did increase modestly during 2009.



Recent legislative developments:


Health care reform:  In March 2010,  comprehensive healthcare reform legislation was passed under the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act of 2010 (collectively, the "Act").  Included among the major provisions of the Act, is a change in tax treatment of the federal drug subsidy paid with respect to eligible retirees.  The Act contains provisions that may impact the Company's accounting for some of its benefit plans in future periods.   However, we do not currently expect that impact to be material.  The exact extent of the Act's impact, if any, cannot be determined until final regulations are promulgated and additional interpretations of the Act become available.  The Company will continue to monitor the effect of the Act.


Dodd-Frank Act:  As a result of the recent financial crisis that significantly damaged the economy and the financial sector of the United States, the U.S. Congress passed and the President signed the Dodd-Frank Act on July 21, 2010.  While many of the Acts provisions will not have any direct impact on Arrow, some of the sections will have a significant impact.  These include the establishment of a new regulatory body known as the Bureau of Consumer Financial Protection, which will operate as an independent entity within the Federal Reserve System and is authorized to issue rules for consumer protection, some of which likely will significantly restrain banks profitability, including our banks.  Dodd-Frank also directs the federal banking authorities to issue new capital requirements for banks and holding companies which must be at least as strict as the existing capital requirements and may be much more onerous.  See the discussion under Important New Capital and Liquidity Standards on page 48 of this Report.  Dodd-Frank also provided that any new issuances of trust preferred securities (TRUPs) by bank holding companies under $15 billion in assets will no longer be able to qualify as Tier 1 capital, although previously issued and outstanding TRUPs of small-to-medium-sized bank holding companies, including the $20 million of our TRUPs that are currently outstanding, will continue to qualify as Tier 1 capital until maturity or redemption.


Many of the provisions of Dodd-Frank are still to be enacted by the various agencies and will have phase-in periods once finalized.  The following are some of the Dodd-Frank legal changes that are likely to have a material impact, positive or negative, as the case may be, on us and our customers:


1.

FDIC deposit insurance now provides unlimited coverage for noninterest-bearing accounts.

2.

The FDIC insurance assessment on banks is now asset-based, not deposit-based, which actually reduced insurance cost for most smaller institutions, like Arrow.  (Under the new method, our premiums were reduced from the first quarter level (the last quarter under the deposit-based method) of over $500 thousand of FDIC and FICO assessments, to less than $300 thousand of expense for the second quarter, a decline exceeding 40%.)

3.

Expansion of consumer protection regulations likely will add to our regulatory compliance expense and reduce our income.

4.

Limitation on debit card interchange fees, which technically applies only to the very large banks will also most likely have a negative impact on the fee income of smaller banks, under $10 billion in assets, like ours due to competitive pressures.


Rules still in the formulation process include those related to short-term borrowing disclosures, retention of a portion of loans initiated and sold and executive compensation.  Several of these issues are highly controversial, and the implementing regulations to be forthcoming will be the focus of much discussion and concern.


Liquidity and access to credit markets:  We did not experience any liquidity issues during 2010 and have not in 2011 through the date of this Report.  The terms of our lines of credit with our correspondent banks, the FHLBNY and the Federal Reserve Bank, have not changed, except for some increases in the maximum borrowing capacity (see our general liquidity discussion on page 47).  In general, we rely on asset-based liquidity (i.e., funds in overnight investments and cash flow from maturing investments and loans) with liability-based liquidity as a secondary source (overnight lending arrangements with our correspondent banks, FHLBNY overnight and term advances and the Federal Reserve Bank discount window, as our main sources).  During the recent financial crisis, many financial institutions, small and large, relied extensively on the Feds discount window to support their liquidity positions, but we did not.  In a few well-publicized instances at the height of the crisis, liquidity was such a problem for particular institutions that they experienced a run on deposits, even though there was no reasonable expectation that depositors would lose any of their insured deposits.  We maintain, and periodically test, a contingent liquidity plan whose purpose is to ensure that we can generate an adequate amount of available funds to meet a wide variety of potential liquidity crises, including a severe crisis.     


FDIC Special Assessment & Prepayment in 2009:  The FDIC announced during the second quarter of 2009 that they would levy a special assessment on all FDIC insured financial institutions to rebuild the FDICs insurance fund which was substantially depleted by bank failures during the crisis.  For most insured banks (including ours), the special assessment was set as a designated percentage (0.05%) of the institutions adjusted assets (total assets less Tier 1 capital), as opposed to a percentage of covered deposits which is how the FDIC has historically set regular assessments.  Institutions were instructed to estimate and accrue the special assessment expense in the second quarter of 2009.  We determined that our expense was $787 thousand, which we accrued on June 30, 2009.  During the third quarter of 2009 the FDIC announced that it would not impose any additional special assessments in the remainder of 2009, but would generate additional cash for the insurance fund by requiring insured institutions to prepay in the fourth quarter of 2009 their projected regular assessments for the fourth quarter of 2009 and all of 2010, 2011 and 2012.  Our prepayment amount was $6.8 million, which is being amortized, as required by bank regulatory guidance, into expense during the relevant periods to which such assessment relates.  As a result of Dodd-Frank, beginning with the second quarter of 2011, the calculation of regular FDIC insurance premiums for insured institutions has changed so as to be based on adjusted assets (as defined) rather than deposits, which will have the effect of imposing FDIC insurance fees not only on deposits but on other sources of funding as well, including repurchase agreements.  Because our banks like most small banks have a much higher ratio of deposits to assets than the large banks maintain, we expect that beginning in the second quarter of 2011 our FDIC premiums may actually decrease considerably, perhaps by 40% or more, after effectiveness of the asset-based assessment.  The FDIC will calculate the first asset-based assessment, for the second quarter of 2011, during the third quarter of 2011, based on June 30, 2011 reported assets.


VISA Transactions in 2008 to 2011:  On March 28, 2008, VISA Inc. distributed to its member banks, including Glens Falls National, by way of a mandatory redemption of 38.7% of the Visa Class B shares held by the member banks, some of the proceeds realized by Visa from the initial public offering and sale of its Class A shares just then completed.  With another portion of the IPO proceeds, Visa established a $3 billion escrow fund to cover certain, but not all, of its continuing litigation liabilities under various antitrust claims, which its member banks would otherwise be required to bear.  Accordingly, during the first quarter of 2008, we recorded the following transactions:

 A pre-tax gain of $749 thousand from the mandatory redemption by Visa from us of 38.7% of our Class B Visa Inc. shares, reflected as an increase in noninterest income, and

 A reversal of $306 thousand of the $600 thousand accrual previously recorded by us at December 31, 2007, representing our then estimated proportional share of Visa litigation costs, which reversal was reflected as a reduction in 2008 other operating expense.


In October 2008, Visa announced that it had settled a lawsuit with Discover Financial Services, which was part of the covered litigation for which the Visa member banks remained contingently liable and for which Visa had established its escrow fund. Since that time, Visa has deposited the following additional amounts into the escrow fund for covered litigation: $1.1 billion in December 2008, $700 million in July 2009, $500 million in May 2010, $800 million in October 2010 and $400 million in March 2011.  These developments reduced our proportionate exposure for covered litigation but also reduced the ultimate value of our remaining Class B Visa shares, as Visas settlement of covered litigation claims directly reduces the value of member banks Class B stock.  However, we had not previously recognized any dollar value for our remaining Class B shares in accordance with SEC guidance; thus we did not recognize any income or expense in any of the periods presented as a result of Visas periodic deposits of additional amounts into the escrow fund or settlements of covered litigation with amounts drawn out of the fund. The estimation of our proportionate share of any potential losses on Visas part, not covered by the escrow fund, related to the remaining covered litigation is extremely difficult and involves a high degree of uncertainty. Management has determined that the remaining $294 thousand liability included in Other Liabilities on our June 30, 2011 consolidated balance sheet represents the fair value of our proportionate share of the remaining covered Visa litigation obligations at that date, but this value is subject to change depending upon future developments in the covered litigation.


Increase in Stockholders Equity:  At June 30, 2011, our tangible book value per share (calculated based on stockholders equity reduced by intangible assets including goodwill and other intangible assets) amounted to $12.21, an increase of $0.22, or 1.8%, from June 30, 2010.  Our total stockholders equity at June 30, 2011 increased 7.1% over the year-earlier level, and our total stockholders equity per share increased by 6.6% over the year earlier level.  As of June 30, 2011, total stockholders equity had increased by $11.3 million, or 7.4%, from the year-end 2010 total.  This increase principally reflected the following factors: i) $11.1 million net income for the period; ii) an $3.2 million net unrealized gain in securities available-for-sale, net of tax, and iii) issuance of $3.1 million of common stock in connection with our acquisition of a target company (an insurance agency); offset in part by iv) cash dividends of $5.7 million; and (v) repurchases of our own common stock of $2.7 million.  As of June 30, 2011, our closing stock price was $24.47, resulting in a trading multiple of 2.00 to our tangible book value.  From a regulatory capital standpoint, the Company and each of its subsidiary banks also continued to remain classified as well-capitalized at quarter end.  The Board of Directors declared and the Company paid a quarterly cash dividend of $.25 per share for the second quarter of 2011.


CHANGE IN FINANCIAL CONDITION


Summary of Selected Consolidated Balance Sheet Data

(Dollars in Thousands)


At Period-End

$ Change

$ Change

% Change

% Change


Jun 2011

Dec 2010

Jun 2010

From Dec

From Jun

From Dec

From Jun

 Interest-Bearing Bank Balances

$24,118 

$ 5,118 

$ 6,701 

$19,000 

$  17,417 

371.2%

259.9%

Securities Available-for-Sale

 511,094 

 517,364 

 447,867 

  (6,270)

 63,227 

(1.2)

 14.1

Securities Held-to-Maturity

138,334 

159,938 

158,226 

(21,604)

(19,892)

(13.5)

(12.6)

Loans (1)

 1,120,096 

 1,145,508 

 1,144,959 

(25,412)

(24,863)

   ( 2.2)

(2.2)

Allowance for Loan Losses

14,820 

14,689 

14,411 

     131

 409 

  0.9

2.8

Earning Assets (1)

1,800,661 

1,836,530 

1,767,227 

    (35,869)

33,434 

(2.0)

1.9

Total Assets

1,901,774 

1,908,336 

1,846,119 

(6,562)

 55,655 

(0.3)

3.0









Demand Deposits

$   219,403 

$   214,393 

$   201,839 

$  5,010 

$  17,564 

2.3

8.7

NOW Accounts

 545,022 

 569,076 

 485,837 

(24,054)

59,185 

  (4.2)

12.2

Savings Deposits

 414,487 

 382,130 

 366,639 

32,357 

47,848 

8.5

13.1

Time Deposits of $100,000 or More

123,640 

120,330 

134,220 

3,310 

(10,580)

2.8

( 7.9)

Other Time Deposits

    239,307 

    248,075 

    250,489 

 (8,768)

  (11,182)

(3.5)

(4.5)

Total Deposits

$1,541,859 

$1,534,004 

$1,439,024 

$ 7,855 

$102,835 

0.5

7.1

Federal Funds Purchased and

  Securities Sold Under

  Agreements to Repurchase

$  60,361 

$  51,581 

$  60,847 

$  8,780

$  (486)

  17.0

(0.8)

FHLB Advances

 90,000 

130,000 

150,000 

(40,000)

 (60,000)

(30.8)

(40.0)

Stockholders' Equity

163,589 

152,259 

152,703 

11,330

10,886 

7.4

7.1


(1) Includes Nonaccrual Loans


Municipal Deposits:  Fluctuations in balances of our NOW accounts and time deposits of $100,000 or more are largely the result of municipal deposit seasonality factors.  In recent years, municipal deposits on average have represented from 22% to nearly 29% of our total deposits.  Municipal deposits typically are invested in NOW accounts and time deposits of short duration.  Many of our municipal deposit relationships are subject to annual renewal, by formal or informal agreement.  


In general, there is a seasonal pattern to municipal deposits starting with a low point during July and August.  Account balances tend to increase throughout the fall and into the winter months from tax deposits and receive an additional boost at the end of March from the electronic deposit of state aid to school districts.  In addition to these seasonal fluctuations within accounts, the overall level of municipal deposit balances fluctuates from year-to-year as some municipalities move their accounts in and out of our banks due to competitive factors.  Often, the balances of municipal deposits at the end of a quarter are not representative of the average balances for that quarter.

 

The recent and continuing financial crisis has had a significant negative impact on municipal tax revenues, and consequently on municipal budgets.  To date, this has not resulted in a sustained decrease in municipal deposit levels at our banks, adjusted for seasonal fluctuations, or an elevation in the average rates we pay on such deposits, but we may experience either or both of these adverse developments in the future.


Changes in Sources of Funds:  Our increase in total deposits from December 31, 2010 to June 30, 2011 was $7.9 million, or 0.5%, in spite of the fact that June 30 is the low point in our seasonal pattern of municipal deposits.  From December 31, 2010 to June 30, 2011, we experienced an increase in internally generated non-municipal deposit balances of $19.8 million, or 1.7%, with increases occurring for non-municipal deposits across nearly all of our major deposit products.  Over the same period, our municipal deposits decreased by $11.9 million.  At June 30, 2011 securities sold under agreements to repurchase were $8.8 million above year-end balances.  We replaced only $10 million of $50 million in FHLB advances maturing during the first six months of 2011.


Changes in Earning Assets:  Our loan portfolio decreased by $25.4 million, or 2.2%, from December 31, 2010 to June 30, 2011.  We experienced the following trends in our three largest segments:

1.

Commercial and commercial real estate loans period-end balances for this segment were up over 4% from first-year-end 2010 balances, reflecting moderate demand for commercial lending.

2.

Residential real estate loans these loans decreased by $20.6 million or 4.2% from December 31, 2010 to June 30, 2011, as we sold most of our originations during the period plus over $10 million of loans that were held-for-sale at December 31, 2010.

3.

Automobile Loans The balance of these loans decreased by $18.0 million, of 5.4% over the first six months of 2011, as originations were more than offset by prepayments and normal amortization.


Most of our in-coming cash flows for the first six months of 2011 came from maturing investments and the excess of maturing loans over our loan originations.  During that six-month period, we purchased $151.7 million of securities available-for-sale to replace most of the maturing securities in that portfolio.  Much of the remaining cash flows were used to settle the net $40 million of maturing Federal Home Loan Bank advances.  


Generally, we pursued a strategy in 2010 and 2011 of increasing our holding of liquid assets, with a view to redeploying these funds into longer term earning assets when prevailing interest rates begin to rise, whenever that may be.


Deposit Trends


The following two tables provide information on trends in the balance and mix of our deposit portfolio by presenting, for each of the last five quarters, the quarterly average balances by deposit type and the percentage of total deposits represented by each deposit type.


Quarterly Average Deposit Balances

(Dollars in Thousands)



Quarter Ended



Jun 2011

Mar 2011

Dec 2010

Sep 2010

Jun 2010

Demand Deposits


$   217,851

$   211,788

$   212,126

$   217,017

$   200,547

NOW Accounts


605,664

594,299

605,968

497,981

534,157

Savings Deposits


409,179

393,874

376,618

368,565

359,094

Time Deposits of $100,000 or More


123,179

118,583

124,284

130,471

133,737

Other Time Deposits


     241,003

     246,133

     249,470

     252,507

     249,377

  Total Deposits


$1,596,876

$1,564,677

$1,568,466

$1,466,541

$1,476,912


Percentage of Total Quarterly Average Deposits



Quarter Ended



Jun 2011

Mar 2011

Dec 2010

Sep 2010

Jun 2010

Demand Deposits


13.7%

13.5%

13.5%

14.8%

13.5%

NOW Accounts


37.9   

38.0   

38.7

34.0   

36.2   

Savings Deposits


25.6   

25.2   

24.0

25.1   

24.3   

Time Deposits of $100,000 or More


7.7   

7.6   

7.9

8.9   

9.1   

Other Time Deposits


  15.1   

  15.7   

  15.9

  17.2   

  16.9   

  Total Deposits


100.0%

100.0%

100.0%

100.0%

100.0%


For a variety of reasons, including the seasonality of municipal deposits, we typically experience little net growth or a small contraction in average deposit balances in the second quarter of the year (when municipal deposits normally drop off), modest growth in the first and third quarters, and significant growth in the fourth quarter (when municipal deposits usually increase substantially).  Municipal deposit balances followed their usual pattern of decreasing during the second quarter of 2011, but average balances for the second quarter grew due to the addition of new municipal relationships and the significant increases in non-municipal deposit accounts cited earlier.  During the fourth quarter of 2010, the average deposit balances also increased due to the addition of a few new large municipal account relationships.

  

Quarterly Cost of Deposits



Quarter Ended



Jun 2011

Mar 2011

Dec 2010

Sep 2010

Jun 2010

Demand Deposits


---%

---%

---%

---%

---%

NOW Accounts


0.90

0.91

0.97

0.97

1.09

Savings Deposits


0.49

0.52

0.53

0.56

0.64

Time Deposits of $100,000 or More


2.16

2.28

2.31

2.24

2.18

Other Time Deposits


2.15

2.23

2.31

2.33

2.38

  Total Deposits


0.96

1.00

1.05

1.07

1.15


Average rates paid by us on deposits decreased steadily over the previous five quarters for all deposit categories, except for time deposits of $100,000 or more, which experienced a modest increase followed by a modest decrease in rates.   


Impact of Interest Rate Changes


Our profitability is affected by the prevailing interest rate environment, both short-term rates and long-term rates, the changes in those rates, and by the relationship between short- and long-term rates (i.e., the yield curve).


Changes in Interest Rates.  From mid-2006 to fall 2007, in response to surging prices for certain assets (specifically, residential and commercial real estate, the price of which were being driving upward fast by cheap and readily-available credit), the Fed continued to increase and then maintained at elevated levels short-term interest rates, with an ultimate federal funds target rate of 5.25%.  In September 2007, however, in response to a sudden weakening in the economy and a loss of liquidity in the short-term credit market, precipitated in large part by the collapse in the housing market and resulting problems in subprime residential real estate lending, the Fed began lowering the federal funds target rate, rapidly and by significant amounts.  


By the December 2007 meeting of the Board of Governors, the fed funds rate had decreased 100 basis points, to 4.25%, and in early 2008, the Fed, in response to continuing liquidity concerns in the credit markets, further lowered the targeted federal funds rate by an additional 125 basis points, to 3.00%.  In the ensuing year, the Fed in a series of additional rate reductions lowered the target rate to the maximum extent possible; by January 2009, the fed funds target rate was at an unprecedented low of 0% to .25%, where it has remained to the present.  


We saw an immediate impact in the reduced cost of our deposits when rates began to fall at year-end 2007, and our deposit costs continued falling in 2008 and 2009 and to a much lesser extent throughout 2010.  Yields on our earning assets have also fallen since 2008, but at a different pace than our cost of funds.  Initially, the drop in our asset yields was not as significant as the decline in our deposit rates, but in recent periods (throughout 2009 and 2010) the decline in yields on our earning assets has exceeded the decline in cost of our deposits.  As a result of these trends, our net interest margins generally increased in late 2007 and early 2008, positively impacting our net interest income, but since 2008 we, like almost all banks, have experienced fairly steady contraction in our net interest margin.


Changes in the Yield Curve.  An additional important development with regard to the effect of rate changes on our profitability in the mid-2005 to mid-2007 period was the flattening of the yield curve, especially during 2006 and the first half of 2007.  After the Fed began increasing short-term interest rates in June 2004, the yield curve did not maintain its traditional upward slope (i.e., lower rates for shorter-duration debt; higher rates for longer-term debt) but flattened; that is, as short-term rates increased, longer-term rates stayed unchanged or even decreased.  Therefore, the traditional spread between short-term rates and long-term rates (the upward yield curve) essentially disappeared, i.e., the curve flattened.  In late 2006 and in early 2007, the yield curve actually inverted, with short-term rates exceeding long-term rates.  We, like many banks, typically fund longer-duration assets with shorter-maturity liabilities, and the flattening of the yield curve directly diminishes the benefit of this strategy.  The flattening of the yield curve was the most significant factor in the decrease in our net interest margin during the 2005-2007 period and consequent downward pressure on our net interest income.    


At the end of the second quarter of 2007, however, the yield on longer-term securities began to increase compared to short-term investments, and the yield curve began to resume its more traditional upward sloping shape.  The increase in rate spread between short- and long-term maturities was further enhanced when long-term rates initially held steady after the Fed began lowering short-term rates in September 2007 in response to the economic downturn.  Ultimately, as the crisis deepened, long-term rates also began to decrease, while short-term rates continued to decrease, roughly in parity with each other, to the historically low levels that both short- and long-term rates presently occupy, levels that the Federal Reserve explicitly seeks to perpetuate at least in the near future, through the various means at its disposal.  The upward-sloping yield curve may continue, and continue to be steep, for some time, which should be of benefit to banks and financial institution generally.  On the other hand, all lending institutions, even those like us who have avoided subprime lending problems and continue to maintain high credit quality, have experienced some pressure on credit quality in recent periods, and this may continue if the national or regional economies continue to be weak.  Any credit or asset quality erosion will reduce or possibly outweigh the benefit we may experience from the return of a more positively-sloped yield curve and a highly favorable interest rate environment generally.  Thus, no assurances can be given on future improvements in our net interest income or net income generally, particularly as residential mortgage related borrowings have diminished across the economy and the redeployment of funds from maturing loans and assets into similarly high yielding asset categories has become progressively more difficult.


Effect of Rate Changes on Our Margin.  In September 2007, as noted above, the Fed began lowering short-term interest rates in response to the worsening economy.  From the third quarter of 2007 through mid-2008 our margin steadily improved as the rates we paid on our interest-bearing liabilities began to reprice downward more rapidly than the yields on our earning assets.  This initially had a significant positive impact on our net interest income, but that trend eventually reversed itself.  From mid-2008 into 2009, our net interest margin held steady at around 3.90%, but the margin began to narrow in the last three quarters of 2009 and all four quarters of 2010 as the downward repricing of paying liabilities began to slow while interest earning assets continued to reprice downward at a steady rate.  During the past four quarters, our net interest margin has ranged from 3.54% to 3.30%.  However, even if new assets do not continue to price downward, our average yield on assets may continue to decline in future periods as our older, higher-priced assets continue to mature and pay off.  

Thus, our margins may continue to be under pressure and we may experience slow compression in upcoming periods.  That is, our average yield on assets may decline in upcoming periods at a slightly higher rate than our average cost of deposits.  In this light, no assurances can be given that our net interest income will continue to grow, even if asset growth continues, and earnings may be negatively impacted in future periods.  


Potential InflationEffect on Interest Rates and Margins.  Currently, there is considerable discussion, and some disagreement, about the possible or even likely emergence of meaningful inflation across some or all asset classes in the U.S. and world economies. To the extent that such inflation may threaten, or in fact already be occurring, it is widely perceived as attributable in large part to the persistent efforts of the Federal Reserve over recent periods to increase the money supply significantly, both by setting and maintaining the fed funds rate at historically low levels (with consequent downward pressurization of all rates), and by purchasing massive amounts of debt securities through the Federal Reserve Bank (i.e., quantitative easing), which is intended to have the identical effect of lowering and reinforcing already low interest rates and thereby expanding the supply of credit.  The Fed, however, recently discontinued its quantitative easing program, as of June 30, 2011, with apparently no immediate plans to resume such, and the underlying rate of inflation in the U.S., exclusive of the historically volatile categories of fuel and food purchases, has remained quite low.  Nevertheless, many analysts believe that emergent inflation or the threat thereof ultimately will result at some future date in an increase in prevailing rates, driven by the financial markets or perhaps engineered by the Fed itself, either because returns on credit must remain competitive with other asset returns in order to attract sufficient private capital to lending institutions, or because the Fed eventually may be forced out of political considerations to increase rates and thereby curtail the possibility of runaway inflation.


At least for the present, management does not anticipate near-term substantial increases in prevailing rates.  If modest rate increases should occur, there is some expectation that the impact on our margins, as well as on our net interest income and earnings, may be somewhat negative in the short run and reversing in the long run.  Given the extraordinary forces currently in play in the financial markets, however, any speculation on the likely impact of inflation on prevailing interest rates, short- or long-term, or on the interest margins or the net interest income of banks such as ours, or speculation on the depth or sustainability of inflationary pressures themselves, must be regarded as highly subjective and no undue reliance should be placed thereon.  A discussion of the models we use in projecting the impact on net interest income resulting from possible changes in interest rates vis-à-vis the repricing patterns of our earning assets and interest-bearing liabilities is included later in this Report.


Non-Deposit Sources of Funds


We have borrowed funds from the Federal Home Loan Bank ("FHLB") under a variety of programs, including fixed and variable rate short-term borrowings and borrowings in the form of "structured advances."  These structured advances have original maturities of 3 to 10 years and are callable by the FHLB at certain dates.  If the advances are called, we may elect to receive replacement advances from the FHLB at the then prevailing FHLB rates of interest.


The $20 million of Junior Subordinated Obligations Issued to Unconsolidated Subsidiary Trusts (trust preferred securities or TRUPs) on our consolidated balance sheet as of June 30, 2011 currently qualify as Tier 1 regulatory capital under regulatory capital adequacy guidelines, as discussed under Capital Resources beginning on page 45 of this Report.  These trust preferred securities are subject to early redemption by us if the proceeds cease to qualify as Tier 1 capital of Arrow for any reason, or if certain other unanticipated but negative events should occur, such as any adverse change in tax laws that denies the Company the ability to deduct interest paid on these obligations for federal income tax purposes.


Loan Trends


The following two tables present, for each of the last five quarters, the quarterly average balances by loan type and the percentage of total loans represented by each loan type.


Quarterly Average Loan Balances

(Dollars in Thousands)



Quarter Ended



Jun 2011

Mar 2011

Dec 2010

Sep 2010

Jun 2010

Commercial and Commercial Real Estate


$  334,517

$  322,711

$   311,855

$   308,445

$   307,853

Residential Real Estate


345,783

351,759

368,802

375,262

371,482

Home Equity


 77,647

 75,682

 75,263

 73,285

 70,926

Indirect Consumer Loans


334,518

343,329

353,758

351,294

338,950

Other Consumer Loans (1)


       35,541

       37,058

       38,211

       39,910

       41,427

 Total Loans


$1,128,006

$1,130,539

$1,147,889

$1,148,196

$1,130,638


Percentage of Total Quarterly Average Loans



Quarter Ended



Jun 2011

Mar 2011

Dec 2010

Sep 2010

Jun 2010

Commercial and Commercial Real Estate


29.7%

28.5%

27.2%

26.8%

27.2%

Residential Real Estate


30.6   

31.1   

32.1

32.7   

32.9   

Home Equity


6.9   

6.7   

6.6

6.4   

6.3   

Indirect Consumer Loans


29.6   

30.4   

30.8

30.6   

30.0   

Other Consumer Loans (1)


    3.2   

    3.3   

    3.3

    3.5   

    3.6   

 Total Loans


100.0%

100.0%

100.0%

100.0%

100.0%


(1) The category Other Consumer Loans, in the tables above, includes home improvement loans secured by mortgages, which are otherwise reported with residential real estate loans in tables of period-end balances.


Maintenance of High Quality in the Loan Portfolio:  In the second half of 2008 and throughout most of 2009, the U.S. experienced significant disruption and volatility in its financial and capital markets.  A major cause of the disruption was a significant decline in residential real estate values across much of the U.S., which in turn triggered widespread defaults on subprime mortgage loans and steep devaluations of portfolios containing these loans and securities collateralized by them.  In mid-2009, as real estate values continued to fall in most areas of the U.S., problems spread from subprime loans to better quality mortgage portfolios, and in some cases prime mortgage loans, as well as home equity and credit card loans.  In addition, in mid- to late-2009, commercial real estate values also began to decline and commercial real estate mortgage portfolios began to experience the same problems that previously beset residential mortgage portfolios.  In 2010, the decline in residential and commercial property values was eased in many markets, at least temporarily, due in part to federal tax incentive programs which encouraged home purchases.  However, in late 2010 and the first half of 2011 the general decline in residential property values resumed in many markets (the so-called double dip), which continues to the present.  The continuing damage to asset portfolios remains a serious concern, which has been offset somewhat, particularly for larger diversified financial organizations, by a continuing general rise in the equity markets following the sharp rebound in late 2009 and early 2010.  Nevertheless, many lending institutions large and small have suffered sizable charge-offs and losses in their loan portfolios since 2008 as a result of their origination of or investment in residential and commercial real estate loans, and for these institutions losses may be expected to continue for at least the next few years.


For a variety of reasons, we have largely been spared the negative impact on asset quality that many banks have suffered.  Through June 2011, we have not experienced a significant deterioration in our loan or investment portfolios, except for one impaired security discussed in our December 31, 2010 Form 10-K.  We have never engaged in subprime mortgage lending as a business line and we do not extend or purchase any so-called Alt-A, negative amortization, option ARM, or negative equity mortgage loans.  On occasion we have made loans to borrowers having a FICO score of 660 or below or have had extensions of credit outstanding to borrowers who have developed credit problems after origination resulting in deterioration of their FICO scores.  


We also on occasion have extended community development loans to borrowers whose creditworthiness is below our normal standards as part of the community support program we have developed in fulfillment of our statutorily-mandated duty to support low- and moderate-income borrowers within our service area.  However, we are a prime lender and apply prime lending standards and this, together with the fact that the service area in which we make most of our loans has not experienced as severe a decline in property values or economic conditions generally as other parts of the U.S., are the principal reasons that we have not to date experienced significant deterioration in our loan portfolio, including the real estate categories of our loan portfolio.  


If, however, the current weaknesses in the U.S. economy persist or worsen, our region will continue to be negatively impacted, and despite our conservative underwriting standards we may experience elevated charge-offs, higher provisions to our loan loss reserve, and increasing expense related to asset maintenance and supervision.


Residential Real Estate Loans: In recent years, residential real estate and home equity loans have represented the largest single segment of our loan portfolio, eclipsing both indirect loans and our commercial and commercial real estate loans.  In 2010, our gross originations for residential real estate loans exceeded $94 million, as compared to $91.9 million in 2009.  In the first half of 2011, we originated $32.8 million of residential mortgage loans.  During the last quarter of 2008 and the first two quarters of 2009, as prevailing mortgage rates began to decline, we sold most of our mortgage originations in the secondary market.  During the second half of 2009 and the first two quarters of 2010, for a variety of reasons, we once again began to retain most of the newly originated residential real estate loans in our loan portfolio, selling only a relatively small portion of the originations to Freddie Mac (with further offsets as a result of normal principal amortization and prepayments on pre-existing loans).  


After April 2010, rates on conventional real estate mortgages began to fall once again, even as demand for such mortgages (other than refinancings) remained relatively weak.  The national average for 30-year conventional (fixed rate) mortgage loans for April 2010 was 5.21%, reaching a low point with an average of 4.24% for October 2010.   In response, we determined to sell most of our originations to Freddie Mac, amounting to $27.2 million for the last half of 2010 and $28.1 million for the first six months of 2011.  If the current low-rate environment for newly originated residential real estate loans persists, we may continue to sell a higher portion of our loan originations and, as a result, may even experience a decrease in our outstanding balances in this segment of our portfolio.  Moreover, if our local economy or real estate market suffers further major downturns, the demand for residential real estate loans in our service area may decrease, which also may negatively impact our real estate portfolio and our financial performance.


Indirect Consumer Loans (primarily automobile loans):  At June 30, 2011, indirect consumer loans (primarily automobile loans originated through dealerships located primarily in the eastern region of upstate New York) represented the second largest category of loans in our portfolio and a significant component of our business.  In the early post-2000 years, indirect loans were the largest segment of our loan portfolio.  For much of this period, these loans also were the fastest growing segment of our loan portfolio, both in terms of absolute dollar amount and as a percentage of the overall portfolio.


However, in the last quarter of 2007 and the first two quarters of 2008, we encountered enhanced rate competition on auto loans from other lenders, principally, the finance affiliates of the auto manufacturers who increased their offerings of heavily subsidized, low- or zero-rate loans.  This increasingly competitive environment, combined with softening demand for vehicles, especially for SUVs and light trucks, had a tempering effect on our indirect originations, and we actually experienced decreases in these balances in the first two quarters of 2008.  During the last two quarters of 2008, our share of the local indirect auto loan market increased somewhat as many of the major lenders in the indirect market, including the auto companies financing affiliates, pulled back on their bargain rate lending programs.  Our portfolio at December 31, 2008 exceeded the balance at December 31, 2007 by $19.5 million, or 5.7%.  However, in 2009, despite the fact that automobile sales nationwide rose modestly (adjusting for the mid-year spike in sales under the federally subsidized cash for clunkers program), our outstanding balances of indirect loans steadily declined from month-to-month.  Our ending balance at December 31, 2009 was $28.1 million, or 7.8%, below the 2008 year-end balance.  Originations of indirect loans for 2009 were approximately $127.8 million, a decrease of $50.0 million, or 36.7%, from 2008.


In the second quarter of 2010, we introduced more competitive financing rates and as a result experienced some growth in our indirect loan balances in both the second and third quarters of 2010, before declining again in the fourth quarter of 2010.  Overall, our originations for 2010 were approximately $176.7 million. These indirect loan originations represented an increase of $48.9 million, or 38.3%, over the originations for 2009.  During 2010, the borrowers on the newly originated indirect loans had an average credit score at origination of over 757.  Our experienced lending staff not only utilizes software tools but also reviews and evaluates each loan individually. We believe our disciplined approach to evaluating risk has contributed to maintaining our strong loan quality in this portfolio.  


For the first six months of 2011, our originations of indirect loans were $63.9 million, a decrease of $30.3 million, or 32.2%, from the total for the first six months of 2010.  Prepayments and normal amortization during the quarter exceeded our originations, and as a consequence the outstanding balance of our automobile loan portfolio decreased by $18.0 million, or 5.4%, during the first six months of 2011.


In the first six months of 2011, net charge-offs for our automobile loans were less than our net-charge offs for the 2010 period.  However, if weakness in auto demand persists, our portfolio is likely to experience limited, if any, overall growth, either in real terms or as a percentage of the total portfolio, regardless of whether the auto company affiliates are offering highly-subsidized loans.  Continuing weak demand for vehicle loans could negatively impact our financial performance.


Commercial, Commercial Real Estate and Construction and Land Development Loans:  In recent years, we have experienced moderate and occasionally strong demand for commercial and commercial real estate loans.  These loan balances have generally increased, both in dollar amount and as a percentage of the overall loan portfolio.  However, in response to the 2008-2009 crisis, demand began to ease and our outstanding balances at the end of 2009 were essentially unchanged from year-end 2008.  During 2010, commercial loan demand began to revive in our market area and our balances increased by $28.9 million, or nearly 10.0%.  In the first six months of 2011 our balances grew at a similar pace, increasing by $13.6 million, or at an annualized rate of 8.6%.


Substantially all commercial and commercial real estate loans in our portfolio are extended to businesses or borrowers located in our regional market.  Many of the loans in the commercial portfolio have variable rates tied to prime, FHLBNY rates or U.S. Treasury indices.  We have not experienced any significant weakening in the quality of our commercial loan portfolio in recent years, despite the financial crisis, although in the 2008-2009 period, on a national scale the commercial real estate market suffered a major downturn from which it has not fully recovered.


It is entirely possible that we may yet experience a reduction in the demand for such loans and/or a weakening in the quality of our commercial and commercial real estate loan portfolio in upcoming periods.  Generally, however, the corporate sector, in both our area and the nation at large, appears to be in good financial condition at present, except for the most highly leveraged enterprises, to whom we normally do not extend credit of any sort.


Our greatest risk in our loan portfolio at present is not credit risk but interest rate risk, as rate compression steadily erodes our ability to maintain healthy margins.


The following table indicates the annualized tax-equivalent yield of each loan category for the past five quarters.


Quarterly Taxable Equivalent Yield on Loans



Quarter Ended



Jun 2011

Mar 2011

Dec 2010

Sep 2010

Jun 2010

Commercial and Commercial Real Estate


5.58%

5.74%

5.81%

5.92%

6.23%

Residential Real Estate


5.44   

5.61   

5.55

5.59   

5.69   

Home Equity


2.96   

3.00   

3.04

2.96   

3.04   

Indirect Consumer Loans


5.10   

5.25   

5.41

5.64   

5.94   

Other Consumer Loans


6.91   

6.97   

7.06

7.17   

7.16   

 Total Loans


5.26   

5.41   

5.46

5.58   

5.80   


In summary, average rates across our portfolio have steadily declined over the last 5 quarters, in direct response to the Feds maintaining historically low interest rates in its attempt to revive the economy, coupled with a general moderation of loan demand on the part of highly-leveraged consumers.  


In the second quarter of 2011 the average yield on our loan portfolio declined by 15 basis points from the first quarter of 2011, from 5.41% to 5.26%.  The decrease was exacerbated by extremely competitive pressures on rates for new commercial and commercial real estate loans as well as automobile loans and the decreasing rate environment generally.  The yields on new 30 year fixed-rate residential real estate loans (the choice of most of our mortgage customers) remained very low during the quarter, so we continued to sell most of those originations to the secondary market, specifically, to Freddie Mac.  The decrease in average yield on our loan portfolio of 15 basis points was 11 basis points greater than the 4 basis point decline in our average cost of deposits during the latest quarter compared to the prior quarter, resulting in a shrinkage of our net interest margin.  We expect that average loan yields will continue to decline at a somewhat faster rate than our average cost of deposits, although further declines in yields for newly originated loans will likely be very modest.


In general, the yield (tax-equivalent interest income divided by average loans) on our loan portfolio and other earning assets has been impacted by changes in prevailing interest rates, as previously discussed in this Report beginning on page 36 under the heading "Impact of Interest Rate Changes."  We expect that such will continue to be the case; that is, that loan yields will continue to rise and fall with changes in prevailing market rates, although the timing and degree of responsiveness will be influenced by a variety of other factors, including the extent of federal government and Federal Reserve participation in the home mortgage market, the makeup of our loan portfolio, the shape of the yield curve, consumer expectations and preferences, and the rate at which the portfolio expands.   Additionally, there is a significant amount of cash flow from normal amortization and prepayments in all loan categories, and this cash flow reprices at current rates as new loans are generated at the current yields.  


As noted in the earlier discussion, during the 2007-2008 period of decreasing rates, we experienced a time lag between the impact of the change on our deposit portfolio (which was felt relatively quickly) and the impact of the change on our loan portfolio (which occurred more slowly).  This (downward) repricing time lag had a positive impact on net interest margins during the beginning of the period but a negative impact on the margin at the end of the period.  Historically, the converse effect has also generally been experienced by us in periods of upward repricing; that is, during a period of rising rates, we also tend to experience a time lag, between the upward repricing of deposits (which rise more quickly) and the upward repricing of assets (which occurs later in the period).  This generally has a negative impact on our margins and income in the short term and a positive effect later on, when deposit rates stabilize but loan rates keep rising.  In the present volatile financial markets, management expects, but is far from certain, that such a repricing time lag would likely accompany a general increase in rates, but the extent or very existence of such a time lag, or even the occurrence of comparable upward adjustments in both yields on assets and the cost of funds, may be in some doubt, given the existence of unusual and unpredictable variables in the markets, including the nature and degree of the Feds intervention in rate markets and the GSEs participation in the residential mortgage markets.  


Any of these factors could impact the traditional repricing time lag between deposits and assets or on the comparability of overall upward movement in rates as between deposits and assets.


Investment Portfolio Trends


The following table presents the changes in the period-end balances for the securities available-for-sale and the securities held-to-maturity investment portfolios from December 31, 2010 to June 30, 2011 (in thousands):



Fair Value at Period-End

Net Unrealized Gain (Loss)


Jun 2011

Dec 2010

Change

Jun 2011

Dec 2010

Change

Securities Available-for-Sale:







U.S. Agency Securities

$ 49,551

$  98,173

$(48,622)

$     239 

$    230 

$        9 

State and Municipal Obligations

90,700

89,528

1,172 

249 

57 

192 

Collateralized Mortgage Obligations

159,985

166,964

(6,979)

7,233 

5,717 

1,516 

Mortgage-Backed Securities-Residential

208,044

159,926

 48,118 

3,602 

290 

3,312 

Corporate and Other Debt Securities

1,345

1,417

  (72)

(12)

(99)

87 

Mutual Funds and Equity Securities

     1,469

      1,356

      113 

      155 

       23 

        132 

  Total

$511,094

$517,364

$ (6,270)

$11,466

$6,218 

$5,248 








Securities Held-to-Maturity:







State and Municipal Obligations

$142,327

$161,713

$(19,386)

$3,993

$1,775 

$2,218 

Corporate and Other Debt Securities

      1,000

      1,000

            --- 

       ---

       --- 

        --- 

  Total

$143,327

$162,713

$(19,386)

$3,993

$1,775 

$2,218 


Other-Than-Temporary Impairment


Each quarter we evaluate all investment securities with a fair value less than amortized cost, both in the available-for-sale portfolio and the held-to-maturity portfolio, to determine if there exists other-than-temporary impairment as defined under generally accepted accounting principles.  During the last quarter of 2009, we recognized a $375 thousand impairment charge on one equity security which we continue to hold in our available-for-sale portfolio.  In the second quarter of 2011 we recognized an impairment charge of $17 thousand, on one security in our held-to-maturity portfolio.  As of both period-ends presented in the above table, all listed mortgage-backed securities and collateralized mortgage obligations (CMOs) are guaranteed by agency and government sponsored enterprises (GSE).  Pass-through securities provide to the investor monthly portions of principal and/or interest pursuant to the contractual obligations of the underlying mortgages.  In the case of most CMOs, the principal and interest payments on the pooled mortgages are separated into two or more components (tranches), where each tranche has a separate estimated life, risk profile and yield.  Our practice has been to purchase MBSs and CMOs that are guaranteed by GSEs or other federal agencies and, in the case of CMOs, those tranches with shorter maturities and no more than moderate risk.  Included in corporate and other debt securities are corporate bonds and trust preferred securities which were highly rated at the time of purchase.  The category of mutual funds and equity securities includes the other-than-temporarily impaired security held in the available-for-sale portfolio discussed above.



Investment Sales, Purchases and Maturities: Available-for-Sale Portfolio

(In Thousands)


Three Months Ended

Six Months Ended


Jun 2011

Jun 2010

Jun 2011

Jun 2010

Sales





Collateralized Mortgage Obligations

$ 5,780

$  9,839

$15,734

$  9,839

Mortgage-Backed Securities-Residential

---

   ---

---

   ---

Mutual Funds and Equity Securities

    ---

         104

    ---

        142

Other

    206

   ---

    213

     ---

   Total Sales

5,986

9,943

15,947

9,981

Net Gains on Securities Transactions

    482

      878

   1,024

      878

Proceeds on the Sales of Securities

$6,468

$10,821

$16,971

$10,859




Three Months Ended

Six Months Ended


Jun 2011

Jun 2010

Jun 2011

Jun 2010

Purchases





U.S. Agency Securities

$15,059

$79,991

$  54,055

$129,176

State and Municipal Obligations

4,659

5,333

14,354

6,059

Collateralized Mortgage Obligations

20,412

---

20,412

---

Mortgage-Backed Securities-Residential

26,154

      ---

62,797

        ---

Other

        16

      134

         37

        234

  Total Purchases

$66,300

$85,458

$151,655

$135,469






Maturities & Calls

$97,054

$59,120

$145,727

$122,722


Asset Quality


The following table presents information related to our allowance and provision for loan losses for the past five quarters.  


Summary of the Allowance and Provision for Loan Losses

(Dollars in Thousands, Loans Stated Net of Unearned Income)


Jun 2011

Mar 2011

Dec 2010

Sep 2010

Jun 2010

Loan Balances:






Period-End Loans

$1,120,096 

$1,135,743 

$1,145,508 

$1,154,676 

$1,144,959 

Average Loans, Year-to-Date

1,129,265 

1,130,539 

1,134,718 

1,130,280 

1,121,173 

Average Loans, Quarter-to-Date

1,128,006 

1,130,539 

1,147,889 

1,148,196 

1,130,638 

Period-End Assets

1,901,774 

1,978,404 

1,908,336 

1,960,294 

1,846,119 







Allowance for Loan Losses, Year-to-Date:






Allowance for Loan Losses, Beginning of Period

 $14,689 

 $14,689 

 $14,014 

 $14,014 

 $14,014 

Provision for Loan Losses, YTD

  390 

  220 

1,302 

  1,125 

  750 

Loans Charged-off, YTD

(388)

(238)

(894)

(712)

(495)

Recoveries of Loans Previously Charged-off

       129 

         74 

       267 

       202 

       142 

  Net Charge-offs, YTD

     (259)

     (164)

     (627)

     (510)

     (353)

Allowance for Loan Losses, End of Period

 $14,820 

 $14,745 

 $14,689 

 $14,629 

 $14,411 







Allowance for Loan Losses, Quarter-to-Date:






Allowance for Loan Losses, Beginning of Period

 $14,745 

 $14,689 

 $14,629 

 $14,411 

 $14,183 

Provision for Loan Losses, QTD

  170 

  220 

   177 

  375 

  375 

Loans Charged-off, QTD

(150)

(238)

(182)

(217)

(210)

Recoveries of Loans Previously Charged-off

        55 

         74 

         65 

         60 

          63 

  Net Charge-offs, QTD

      ( 95)

     (164)

     (117)

     (157)

      (147)

Allowance for Loan Losses, End of Period

 $14,820 

 $14,745 

 $14,689 

 $14,629 

 $14,411 







Nonperforming Assets, at Period-End:






Nonaccrual Loans

 $4,990 

 $4,296 

 $4,061 

 $3,713 

 $3,227 

Restructured

306 

362 

16 

--- 

--- 

Loans Past due 90 Days or More

 





 

and Still Accruing Interest

    555 

       93 

    810 

    244 

  1,219 

Total Nonperforming Loans

 5,851 

 4,751 

 4,887 

 3,957 

 4,446 

Repossessed Assets

18 

60 

58 

32 

23 

Other Real Estate Owned

      13 

        --- 

       --- 

       --- 

       --- 

Total Nonperforming Assets

$5,882 

$4,811 

$4,945 

$3,989 

$4,469 







Asset Quality Ratios:






Allowance to Nonperforming Loans

253.30% 

310.36% 

300.57% 

369.69% 

324.13% 

Allowance to Period-End Loans

  1.32    

  1.30    

  1.28    

  1.27    

  1.26    

Provision to Average Loans (Quarter)

 0.06    

 0.08    

 0.06    

 0.13    

 0.13    

Provision to Average Loans (YTD)

 0.07    

 0.08    

 0.11    

 0.13    

 0.13    

Net Charge-offs to Average Loans (Quarter)

    0.03    

    0.06    

    0.04    

    0.05    

    0.05    

Net Charge-offs to Average Loans (YTD)

    0.05    

    0.06    

    0.06    

    0.06    

    0.06    

Nonperforming Loans to Total Loans

0.52    

0.42    

0.43    

0.34    

0.39    

Nonperforming Assets to Total Assets

0.31    

0.24    

0.26    

0.20    

0.24    









Provision for Loan Losses


Through the provision for loan losses, an allowance is maintained that reflects our best estimate of probable incurred loan losses related to specifically identified loans as well as the inherent risk of loss related to the remaining portfolio.  Loan charge-offs are recorded to this allowance when loans are deemed uncollectible, in whole or in part.


In the second quarter of 2011, we made a provision for loan losses of $170 thousand following a provision of $220 thousand in the first quarter of 2011.    The second quarter 2011 provision was less than the $375 thousand provision for the second quarter of 2010, as our credit quality over the intervening period remained stable and in some respects improved; in the 2011 second quarter, we experienced a decrease in net charge-offs compared to the second quarter of 2010.  


We consider our accounting policy relating to the allowance for loan losses to be a critical accounting policy, given the uncertainty involved in evaluating the level of the allowance required to cover credit losses inherent in the loan portfolio, and the material effect that such judgments may have on our results of operations.  Our process for determining the provision for loan losses is described in Note 5 beginning on page 14.


Risk Elements


Our nonperforming assets at June 30, 2011 amounted to $5.9 million, an increase of $934 thousand, or 18.9%, from the December 31, 2010 total.  The increase is primarily due to two nonaccrual residential real estate loans on which we do not currently expect to incur any losses.  At June 30, 2011, our ratio of nonperforming assets to total assets was .31%, well below the 3.18% ratio for our peer group at March 31, 2011.


The following table presents the balance of other non-current loans at period-end as to which interest income was being accrued (i.e. loans 30 to 89 days past due, as defined in bank regulatory guidelines).


Loans Past Due 30-89 Days and Accruing Interest




6/30/2011

12/31/2010

6/30/2010

Commercial Loans

$   519

$   968

$   595

Commercial Real Estate Loans

588

400

966

Residential Real Estate Loans

1,998

2,033

1,172

Other Consumer Loans

  3,688

  4,967

  4,848

  Total delinquent loans

$6,793

$8,368

$7,581


At June 30, 2011, delinquent loans totaled $6.8 million, or 0.61% of loans then outstanding, a decrease of $1.6 million, or 18.8%, from the $8.4 million of delinquent loans at December 31, 2010. The year-end 2010 total, in turn, equaled .66% of loans then outstanding, and represented an increase of $787 thousand, or 10.4%, from the June 30, 2010 total of $7.6 million, which represented 0.68% of loans then outstanding.  


The number and dollar amount of our performing loans that demonstrate characteristics of potential weakness from time-to-time (potential problem loans) typically is a very small percentage of our portfolio.  See the table of Credit Quality Indicators in Note 5 to the financial statements.  We consider all commercial and commercial real estate loans classified as substandard to be potential problem loans.  The amount of such loans depends principally on economic conditions in our geographic market area of northeastern New York State.  In general, the economy in this area has been relatively strong in recent years, although we believe that a general weakening of the U.S. economy in upcoming periods would have an adverse effect on the economy in our market area as well.    


As of June 30, 2011, we owned only one real estate property acquired as a result of the foreclosure process. As a result of our conservative underwriting standards, we do not expect to acquire a significant number of other real estate properties in the near term as a result of payment defaults or the foreclosure process, nor do we expect significant losses to be incurred generally from residential real estate borrowers who are experiencing stress due to the current economic environment.


In light of current developments, including signs of strengthening in the U.S. economy generally and in our own market area (albeit not in real estate markets), we do not currently anticipate significant increases in our nonperforming assets, other non-current loans as to which interest income is still being accrued or potential problem loans, but can give no assurances in this regard.


CAPITAL RESOURCES


Stockholders' Equity:  Stockholders' equity increased by $11.3 million or 7.4%, during the first six months of 2011, from $152.3 million to $163.6 million.  Components of the change in stockholders' equity over the six-month period are presented in the Consolidated Statement of Changes in Stockholders' Equity, on page 5 of this Report and discussed in more detail under the heading Increase in Stockholder Equity on page 34.  The second quarter 2011 cash dividend was $.25 per share and at its July 2011 meeting the Board declared another $.25 cash dividend to be paid on September 15, 2011.


Stock Repurchase Program:  At its annual meeting in April 2011, the Board of Directors approved a 12-month stock repurchase program authorizing the repurchase, at the discretion of senior management, of up to $5 million of Arrows common stock over the ensuing one-year period in open market or privately negotiated transactions.  This program replaced a similar $5 million repurchase program approved one year earlier, in April 2010, of which amount approximately $3.1 million was used to make repurchases prior to replacement of the 2010 program with the 2011 program.  See Part II, Item 2 of this Report for further information on stock repurchases and repurchase programs.  Management may affect stock repurchases under the 2011 program from time-to-time in upcoming periods, to the extent that it believes the Companys stock is reasonably priced and such repurchases appear to be an attractive use of available capital and in the best interests of stockholders.


Regulatory Capital:  The following discussion of capital focuses on regulatory capital ratios, as defined and mandated for financial institutions by federal bank regulatory authorities.  Regulatory capital, although a financial measure that is not provided for or governed by GAAP, nevertheless has been exempted by the SEC from the definition of "non-GAAP financial measures" in the SEC's Regulation G governing disclosure by registered companies of non-GAAP financial measures.  Thus, certain information which is generally required to be presented in connection with our disclosure of non-GAAP financial measures need not be provided, and has not been provided, for the regulatory capital measures discussed below.  


New Capital Standards to be Promulgated:  The discussion and disclosure below on regulatory capital is qualified in its entirety by reference to the fact that the Dodd-Frank Act, among other financial reforms, directed the federal bank regulatory authorities to promulgate new capital standards for all financial institutions, including banks like ours.  These standards when adopted by regulators must be at least as strict as the preexisting capital standards for U.S. financial institutions or, if more restrictive, any commonly accepted capital standards then in effect for financial institutions in the advanced economies generally, as defined in Dodd-Frank.  The latter reference is generally understood as embracing the new, enhanced financial institution capital requirements that are currently being drafting and reviewed by the financial regulators for a consortium of the worlds most advanced nations, including the U.S., and are expected to be implemented, in whole or in part, by those nations.  These proposed new capital requirements, commonly known as Basel III, currently await final approval by the advanced nations (the Group of 20), but will be implemented by the participating nations, to the extend implemented, only over a relatively protracted time period.  The Basel III standards, if approved and included in the new U.S. bank capital standards, ultimately may require significantly higher minimum levels of capital for U.S. financial institutions when fully implemented. See the discussion under Important New Capital and Liquidity Standards on page 48 of this Report.


Current Capital Standards:  Our holding company and our subsidiary banks are currently subject to two sets of regulatory capital measures, risk-based capital guidelines and a leverage ratio test.  The risk-based guidelines assign risk weightings to all assets and certain off-balance sheet items of financial institutions, which generally results in a substantial discounting of low-risk or risk-free assets, that is, a significant dollar amount of such assets disappears from the balance sheet.  The guidelines then establish an 8% minimum ratio of qualified total capital to risk-weighted assets.  At least half of total capital must consist of "Tier 1" capital, which comprises common equity and common equity equivalents, retained earnings, a limited amount of permanent preferred stock and (for holding companies) a limited amount of trust preferred securities (see the discussion below on these securities), less intangible assets, net of associated deferred tax liabilities.  Up to half of total capital may consist of so-called "Tier 2" capital, comprising a limited amount of subordinated debt, other preferred stock, certain other instruments and a limited amount of the allowance for loan losses.  


The second regulatory capital measure, the leverage ratio test, establishes minimum limits on the ratio of Tier 1 capital to total tangible assets, without risk weighting (i.e, discounting).  For top-rated companies, the minimum leverage ratio currently is 4%, but lower-rated or rapidly expanding companies may be required by bank regulators to meet substantially higher minimum leverage ratios.  Federal banking law mandates certain actions to be taken by banking regulators for financial institutions that are deemed undercapitalized as measured under regulatory capital guidelines.  The law establishes five levels of capitalization for financial institutions ranging from "well-capitalized (the highest ranking) to "critically undercapitalized" (the lowest ranking).  The Gramm-Leach-Bliley Financial Modernization Act also ties the ability of banking organizations to engage in certain types of non-banking financial activities to such organizations' continuing to qualify as "well-capitalized" under these standards.  


Trust Preferred Securities Under Dodd-Frank:  In each of 2003 and 2004, we issued $10 million of trust preferred securities (TRUPs) in a private placement.  Under the Federal Reserve Boards pre-existing rules on regulatory capital, TRUPs typically would qualify as Tier 1 capital for bank holding companies such as ours but only in amounts up to 25% of Tier 1 capital, net of goodwill less any associated deferred tax liability.  Under the recently enacted Dodd-Frank Act, trust preferred securities generally will no longer qualify as Tier 1 or Tier 2 capital under the bank regulatory capital guidelines; however, TRUPs outstanding at the effective date of the Act may continue to qualify as Tier 1 capital, until the redemption or maturity thereof, if the issuing bank holding company is, like Arrow, a relatively small company, having total assets of less than $15 billion securities on the effective date.  However, trust preferred securities issued in the future even by small bank holding companies will no longer qualify as capital for this treatment.


As of June 30, 2011, the Tier 1 leverage and risk-based capital ratios for our holding company and our subsidiary banks were as follows:  


Summary of Capital Ratios



Tier 1

Total


Tier 1

Risk-Based

Risk-Based


Leverage

Capital

Capital


Ratio

Ratio

Ratio

Arrow Financial Corporation

8.67%   

14.76%     

16.02%     

Glens Falls National Bank & Trust Co.

8.46      

14.83        

16.08        

Saratoga National Bank & Trust Co.

9.20      

14.12        

15.38        


Regulatory Minimum

4.00      

4.00        

8.00        

FDICIA's "Well-Capitalized" Standard

5.00      

6.00        

10.00        


All capital ratios for our holding company and our subsidiary banks at June 30, 2011 were well above minimum capital standards for financial institutions.  Additionally, at such date our holding company and our subsidiary banks qualified as well-capitalized under federal banking law, based on their capital ratios on that date.


Stock Prices and Dividends


Our common stock is traded on NasdaqGS® - AROW.  The high and low stock prices for the past six quarters listed below represent actual sales transactions, as reported by NASDAQ.  On July 27, 2011, our Board of Directors declared the 2011 third quarter cash dividend of $.25 payable on September 15, 2011.




Cash

Dividends

Declared


Market Price



Low

High


2010




First Quarter

$23.04

$26.90

$.243

Second Quarter

22.36

28.49

.243

Third Quarter

21.29

25.32

.243

Fourth Quarter

24.00

28.51

.250





2011




First Quarter

$22.59

$28.09

$.250

Second Quarter

23.03

25.23

.250

Third Quarter (dividend payable September 15, 2011)



.250




Quarter Ended June 30,


2011

2010

Dividends Per Share

$.25   

$.24   

Diluted Earnings Per Share

.51   

.50   

Dividend Payout Ratio

49.02%

48.00%

Total Equity (in thousands)

$163,589   

$152,703   

Shares Issued and Outstanding (in thousands)

11,355   

11,300   

Book Value Per Share

$14.41   

$13.51   

Intangible Assets (in thousands)

$25,044   

$17,206   

Tangible Book Value Per Share

$12.20   

$11.99   


LIQUIDITY


Our liquidity is measured by our ability to raise funds when we need it at a reasonable cost.  We must be capable of meeting expected and unexpected obligations to our customers at any time.  Given the uncertain nature of customer demands as well as for earnings considerations, we must have available reasonably priced sources of funds, on- and off-balance sheet that can be accessed quickly in time of need.


Our primary sources of available liquidity are overnight investments in federal funds sold, interest bearing bank balances at the Federal Reserve Bank, cash deposits at other banks and cash flow from investment securities and loans, both from normal repayment cash-flows and prepayments, as well as the ability to quickly pledge marketable investment securities and loans to standard institutional lenders to obtain funds.  Certain investment securities are selected at purchase as available-for-sale based on their marketability and collateral value, as well as their yield and maturity.  Our securities available-for-sale portfolio was $511.1 million at June 30, 2011, of which $431.8 million was pledged for various purposes.  Due to the volatility in market values, we are not able to assume that large quantities of such securities could be sold at short notice at their carrying value to provide needed liquidity. But, if market conditions are favorable resulting in unrealized gains in the available-for-sale portfolio, we may pursue modest sales of such securities conducted in an orderly fashion, to provide needed liquidity.


In addition to liquidity from short-term investments, investment securities and loans, we have supplemented available liquidity with additional off-balance sheet sources such as federal funds lines of credit and credit lines with the Federal Home Loan Bank of New York (FHLBNY).  We have established federal funds lines of credit with three correspondent banks totaling $30 million, but did not draw on those lines during 2011.  


We participate in the Overnight Advance program with the FHLBNY, which allows for overnight advances up to the limit of pledged collateral, including mortgage-backed securities and loans.  The amount available for overnight advances amounted to $72.5 million at June 30, 2011.   During 2011, we used this facility for a short period.  The average balance of these overnight advances was $3.1 million for the second quarter of 2011.


The balance in other short-term borrowings at June 30, 2011 consisted entirely of treasury, tax and loan balances at the Federal Reserve Bank of New York.


In addition, we have identified brokered certificates of deposit as an appropriate off-balance sheet source of funding accessible in a relatively short time period.  Also, our two bank subsidiaries have each established a borrowing facility with the Federal Reserve Bank of New York, pledging certain consumer loans as collateral for potential discount window advances.  At June 30, 2011, the amount available under this facility was $244.6 million, but there were no advances then outstanding.  We measure and monitor our basic liquidity as a ratio of liquid assets to short-term liabilities, both with and without the availability of borrowing arrangements.  Based on the level of overnight funds investments, available liquidity from our investment securities portfolio, cash flow from our loan portfolio, our stable core deposit base and our significant borrowing capacity, we believe that our liquidity is sufficient to meet any reasonably likely events or occurrences.


During the past several quarters, our liquidity position has been strong, as depositors and investors in the wholesale funding markets have shown no hesitations on placing or maintaining their funds with our banks.  In addition, management has consciously maintained a strong liquidity position by emphasizing its short maturity asset portfolios, including cash due from banks, as opposed to investments in longer-term assets which might generate slightly higher rates but rates that are still historically low for the maturities in question.  The financial markets have been challenging for many financial institutions, and in the view of many, lack of liquidity has been as great a problem as capital shortage.  As a result, liquidity premiums have widened and many banks have experienced certain liquidity constraints, including substantially increased pricing to retain deposit balances.  Because of Arrows favorable credit quality and strong balance sheet, Arrow has not experienced any significant liquidity constraints through June 30, 2011 and the date of this Report.


Important New Capital and Liquidity Standards

 

In December, 2009, the Basel Committee on Banking Supervision (the Basel Committee) released a comprehensive list of proposals for changes to capital and liquidity requirements for banks (commonly referred to as Basel III).  In July 2010, the Basel Committee announced the design for its new capital and liquidity standards.


In September 2010, the oversight body of the Basel Committee announced minimum capital ratios and transition periods providing:  (i) a new Tier 1 common equity standard requiring a minimum ratio of common equity to total risk-weighted assets of 4.5% (to be phased in by January 1, 2015), with common equity defined to include essentially only paid-in common stock amounts and retained earnings; (ii) an increased minimum Tier 1 capital ratio of 6.0%, up from 4.0% (to be phased in by January 1, 2015); (iii) an additional minimum capital buffer of Tier 1 common equity equal to 2.5% of total risk-weighted assets (to be phased in between January 1, 2016 and January 1, 2019; bringing the minimum Tier 1 common equity ratio to 7.0% and the minimum Tier 1 capital ratio to 8.5%), and (iv) a minimum leverage ratio of 3.0% (to be tested starting January 1, 2013).  The proposals also narrow the definition of capital, excluding instruments that no longer qualify as Tier 1 common equity as of January 1, 2013, and phasing out other instruments, including certain TRUPs, over several years. 

 

The liquidity proposals under Basel III include:  (i) a liquidity coverage ratio (to become effective January 1, 2015); and (ii) a net stable funding ratio (to become effective January 1, 2018).  Each of these ratios, if implemented in accordance with the preliminary proposals disseminated by the bank regulatory authorities, may prove extremely challenging to banks generally, although the precise shape of the regulatory liquidity measures remains very uncertain.

 

Many of the details of Basel IIIs new minimum capital ratios will remain uncertain until the Committees proposals are ultimately reviewed and ratified by the Group of 20 finance ministers and the final form of the liquidity measures is even more uncertain and subject to significant change in the rule promulgation process.


The final provisions of Basel III, as thus approved, also must await final implementing regulations by U.S. regulators before they go into effect.  Dodd-Frank directs U.S. regulators to promulgate new capital and liquidity guidelines for banks and implicitly directs that the new guidelines should comply at a minimum with the final Basel III standards.  


Because of the uncertainty surrounding these new capital and liquidity requirements, we are not able to predict at this time the content thereof or the impact that any changes in regulation may have on the Company.




RESULTS OF OPERATIONS:

Three Months Ended June 30, 2011 Compared With

Three Months Ended June 30, 2010


Summary of Earnings Performance

(Dollars in Thousands, Except Per Share Amounts)



Quarter Ended




Jun 2011

Jun 2010

Change

% Change

Net Income

$5,849   

$5,714   

$  135  

  2.4% 

Diluted Earnings Per Share

.51   

$.50   

   0.01  

2.0   

Return on Average Assets

1.20%

1.22%

(0.02) 

(1.6)  

Return on Average Equity

14.51%

15.38%

(0.87) 

(5.7)  







We reported earnings (net income) of $5.8 million for the second quarter of 2011, an increase of $135 million, or 2.4%, from the second quarter of 2010.   Diluted earnings per share were $.51 and $.50 for the respective quarters.  


The following narrative discusses the quarter-to-quarter changes in net interest income, noninterest income, noninterest expense and income taxes.


Net Interest Income

Summary of Net Interest Income

(Taxable Equivalent Basis, Dollars in Thousands)


Quarter Ended




Jun 2011

Jun 2010

Change  

% Change

Interest and Dividend Income

$20,500 

$22,530 

$(2,030)

(9.0)%

Interest Expense

   4,975 

    6,023 

 (1,048)

(17.4)

Net Interest Income

  $15,525 

  $16,507 

$ (  982)

  (5.9)





Tax-Equivalent Adjustment

      $ 944 

       $852 

$92 

10.8





Average Earning Assets (1)

  $1,857,739 

  $1,790,572 

 $  67,167 

    3.8

Average Interest-Bearing Liabilities

   1,559,014 

   1,502,052 

56,962 

   3.8





Yield on Earning Assets (1)

      4.43%

      5.05%

   (0.62)%

    (12.3)

Cost of Interest-Bearing Liabilities

      1.28   

      1.61   

   (0.33)   

    (20.5)

Net Interest Spread

      3.15   

      3.44   

(0.29)   

( 8.4)

Net Interest Margin

      3.35   

      3.70   

     (0.35)   

( 9.5)


(1) Includes Nonaccrual Loans


Our net interest margin (net interest income on a tax-equivalent basis divided by average earning assets, annualized) decreased from 3.70% to 3.35% from the second quarter of 2010 to the second quarter of 2011.  (See the discussion under Use of Non-GAAP Financial Measures, on page 27, regarding our net interest margin and net interest income, which are commonly used non-GAAP financial measures.)  As a result of this margin shrinkage, our net interest income for the just completed quarter, on a taxable equivalent basis, decreased $982 thousand, or 5.9%, from the second quarter of 2010.  In essence, a $67.2 million increase in average earning assets between the quarters was not enough to offset the negative impact of a quarter-to-quarter decrease in the yield on our earning assets (62 basis points), which significantly exceeded the quarter-to-quarter decrease in the cost of our interest-bearing liabilities (33 basis points).  The impact of recent interest rate changes on our net interest margin and net interest income is discussed above in this Report under the sections entitled Deposit Trends, Impact of Interest Rate Changes and Loan Trends.  


The provisions for loan losses were $170 thousand and $375 thousand for the quarters ended June 30, 2011 and 2010, respectively.  The provision for loan losses is discussed above in this Report under the heading "Asset Quality" beginning on page 43.



Noninterest Income


Summary of Noninterest Income

(Dollars in Thousands)


Quarter Ended




Jun 2011

Jun 2010

Change

% Change

Income From Fiduciary Activities

  $1,526 

  $1,322 

$   204 

   15.4%

Fees for Other Services to Customers

   2,058 

   1,997 

61 

    3.1

Insurance Commissions

1,815 

728 

1,087 

149.3

Net Gain on Securities Transactions

482 

  878  

(396)

(45.1)

Net Gain on the Sale of Loans

167 

34 

133 

    391.2

Other Operating Income

    180 

      69 

    111 

     160.9

Total Noninterest Income

$6,228 

$5,028 

$  1,200

23.9


Total noninterest income in the just completed quarter was $6.2 million, an increase of $1.2 million, or 23.9%, from total noninterest income of $5.0 million for the second quarter of 2010.  We experienced increases in all three of the major sources of noninterest income: income from fiduciary activities, fees for other services to customers and insurance commissions.


For the just completed 2011 quarter, income from fiduciary activities increased $204 thousand, or 15.4%, from the comparable 2010 quarter.  The increase reflects a recovery in the dollar amount of assets under administration, which followed a general recovery in the U.S. stock markets and from the addition of new account relationships. At quarter-end 2011, the market value of assets under trust administration and investment management amounted to $1.0 billion, an increase of $162.3 million, or 19.0%, from the June 2010 quarter-end.  A significant portion of our fiduciary fees is indexed to the dollar amount of assets under administration.  Any significant downturn in the U.S. stock markets in future periods would likely have a corresponding negative impact on our income from fiduciary activities.  


Fees for other services to customers (primarily service charges on deposit accounts, revenues related to the sale of mutual funds to our customers by third party providers and servicing income on sold loans) were $2.1 million for 2011, an increase of $61 thousand, or 3.1%, from the 2010 quarter.  The increase between the two periods in fees for other services to customers was attributable to an increase in revenues derived from third-party mutual fund sales and to an increase in income from debit card transactions, which increased from $568 thousand for 2010 to $630 thousand for 2011.  These two increases were offset, in part, by a decrease in fee income from service charges on deposit accounts.


Certain provisions of Dodd-Frank limit the amount of interchange fees that large banks may charge on customers debit card transactions.  Although these provisions do not directly apply to smaller community banks like ours, the law may indirectly restrict the ability of smaller banks to continue to charge their current interchange fees because of their need to compete on price with larger banks, including on interchange fees.  However, we do not believe that the new laws limits on debit transaction interchange fees will have a material adverse impact on our financial condition or results of operations in future periods.  Our two banks, as smaller banks, are technically exempt from the new fee restrictions, but we, like other exempt small banks, are subject to competition on fees from the larger banks. However, our interchange fees are already reasonably competitive with the new limits applicable to larger banks fees and we do think we will be forced to make significant reductions in our fees as a result of competitive pressures.  Moreover, debit card usage by our customers continues to grow.


Another recent change in banking law and regulation that may restrict the ability of banks to generate fee income is the change affecting overdraft practices, including fees.  On November 12, 2009, the Federal Reserve issued amendments to Regulation E implementing certain provisions in the Electronic Fund Transfer Act.  The new rules, which became effective on July 1, 2010, among other things, set limits on the ability of banks to provide deposit customers with overdraft protection on their deposit accounts, and to charge them overdraft fees for covered overdrafts, without the customers consent.  However, unlike many of our competitors, we do not offer so-called privilege, bounce or similar automated overdraft protection programs of the sort that led to substantial increases in overdraft fee income at these banks and provided the impetus for the new regulations.  In this area, too, we do not believe the new legal restrictions will adversely affect our fee income in upcoming periods.  



Insurance commissions became a significant source of noninterest income for us following our 2004 acquisition of an insurance agency, Capital Financial Group, Inc.  Capital Financial specializes in selling and servicing group health care policies as well as life insurance.  During the past two years we have acquired three additional insurance agencies which sell primarily property and casualty insurance to retail customers in our service area.  On April 1, 2010, we acquired Loomis and LaPann, Inc., and on February 1, 2011, we acquired Upstate Agency, Inc., in each case retaining all key insurance agency personnel as well as insurance agency offices.  On August 1, 2011, we completed the acquisition of W. Joseph McPhillips, Inc. and McPhillipsNorthern, Inc., property and casualty insurance agencies operating four offices in the Greater Glens Falls area.  All 20 employees will continue to operate the acquired businesses for us.  Therefore, we expect that noninterest income from insurance commissions will continue to increase in upcoming periods as a result of our expansion of this line of business.


Noninterest Expense


Summary of Noninterest Expense

(Dollars in Thousands)


Quarter Ended




Jun 2011

Jun 2010

Change

% Change

Salaries and Employee Benefits

  $  7,233

  $  7,053 

    $180 

2.6%

Occupancy Expense of Premises, Net

     964

     887 

    77 

 8.7

Furniture and Equipment Expense

     930

     885 

     45 

   5.1

FDIC and FICO Assessments

     267

492 

    (225)

   (45.7)

Amortization

    134

65 

     69 

  106.2

Other Operating Expense

    2,643

    2,620 

    23 

  0.9

Total Noninterest Expense

 $12,171

  $12,002 

 $169 

      1.4





Efficiency Ratio

56.59%

57.79%

(1.20)%

 (2.1)


Noninterest expense for the second quarter of 2011 was $12.2 million, an increase of $169 thousand, or 1.4%, over the expense for the second quarter of 2010.  For the second quarter of 2011, our efficiency ratio was 56.59%.  This ratio, which is a commonly used non-GAAP financial measure in the banking industry, is a comparative measure of a financial institution's operating efficiency.  The efficiency ratio (a ratio where lower is better), as we define it, is the ratio of noninterest expense (excluding intangible asset amortization) to net interest income (on a tax-equivalent basis) plus noninterest income (excluding net securities gains or losses).  See the discussion on page 27 of this Report under the heading Use of Non-GAAP Financial Measures.  The efficiency ratio as defined by the Federal Reserve Board and reported for banks in its "Peer Holding Company Performance Reports" excludes net securities gains or losses from the denominator (as does our calculation), but unlike our ratio does not exclude intangible asset amortization from the numerator, and thus tends to result in higher ratios than our definition.  Our efficiency ratios in recent periods compared favorably to the ratios of our peer group, even as adjusted not to exclude intangible asset amortization.  For the fourth quarter of 2010 (the most recent quarter for which peer group information is available), our peer group ratio was 69.56%, and our ratio was 59.91%.


The financial results of Upstate Agency, the insurance agency we acquired in the first quarter of 2011, are fully reflected in our financial results for this quarter, but not the prior year quarter.  Thus, both the $169 thousand increase in noninterest expenses for the 2011 quarter, as well as the $1.1 million increase in insurance commission income for the quarter, discussed earlier, reflect Upstates expenses and income for the quarter.  The results for the prior year quarter, however, do not reflect any expense or income attributable to Upstate.  All categories of noninterest expense, including amortization, experienced increases from the acquisition of the Upstate Agency (except for FDIC and FICO assessments).


Salaries and employee benefits expense increased by $180 thousand, or 2.6%, from the second quarter of 2010 to the second quarter of 2011.  All full-time equivalent employees of the Upstate Agency continued employment with us after the early 2011 acquisition of Upstate and the related expense is included in the 2011 expense total, but not the 2010 expense total.


Occupancy expense increased from the second quarter of 2010 to the second quarter of 2011.  The increase was primarily attributable to increases in net rental expense, including offices rented by the Upstate Agency.  The increase in furniture and equipment expense was primarily attributable to building and equipment maintenance.


Risk-based FDIC assessments have increased since 2008 in response to the current financial crisis.  In the completed quarter, we continued to pay the lowest possible rate.  Beginning with the second quarter of 2011, the risk-based calculation for the premium converted to the new FDIC method, a method based on adjusted assets rather than deposits.  That resulted in a 45.5% decrease in our FDIC insurance assessment in the 2011 quarter.


Other operating expense remained essentially unchanged from the second quarter of 2010.  This was the result of offsetting increases and decreases among a variety of operating categories.


Income Taxes


Summary of Income Taxes

(Dollars in Thousands)


Quarter Ended




Jun 2011

Jun 2010

Change

% Change

Provision for Income Taxes

  $2,619

  $2,592

    $  27

 1.0 %

Effective Tax Rate

 30.9%

 31.2%

  (0.3)% 

(1.0)


The provisions for federal and state income taxes amounted to $2.6 million for the second quarter of 2011 and 2010.  The effective tax rate was similar for both periods, as well.

 

RESULTS OF OPERATIONS:

Six Months Ended June 30, 2011 Compared With

Six Months Ended June 30, 2010


Summary of Earnings Performance

(Dollars in Thousands, Except Per Share Amounts)



Six Months Ended




Jun 2011

Jun 2010

Change

% Change

Net Income

$11,130   

$11,129   

$    1

  0.0%

Diluted Earnings Per Share

$0.98   

$0.98   

 $    0

  0.0  

Return on Average Assets

1.15%

1.21%

(0.06)%

( 5.0)

Return on Average Equity

14.15%

15.32%

(1.17)%

( 7.6)






1  See Use of Non-GAAP Financial Measures on page 27.






We reported earnings (net income) of $11.1 million for the first six months of 2011, unchanged from the first six months of 2010.   Diluted earnings per share were $0.98 for both the respective periods


The following narrative discusses the six-month to six-month changes in net interest income, noninterest income, noninterest expense and income taxes.


Net Interest Income

Summary of Net Interest Income

(Taxable Equivalent Basis, Dollars in Thousands)


Six Months Ended




Jun 2011

   Jun 2010

Change  

% Change

Interest and Dividend Income

$41,322 

$45,042 

$(3,720)

(8.3)%

Interest Expense

  10,312 

  11,963 

  (1,651)

(13.8)

Net Interest Income

  $31,010 

  $33,079 

$(2,069)

(6.3)





Tax-Equivalent Adjustment

     $1,875 

     $1,713 

$162 

  9.5





Average Earning Assets (1)

  $1,853,966 

  $1,776,607 

 $ 77,359 

    4.4

Average Interest-Bearing Liabilities

   1,552,965 

   1,492,842 

 60,123 

   4.0





Yield on Earning Assets (1)

      4.49%

      5.11%

   (0.62)%

    (12.1)

Cost of Interest-Bearing Liabilities

      1.34   

      1.62   

   (0.28)

    (17.3)

Net Interest Spread

      3.15   

      3.49   

(0.34)

(9.7)

Net Interest Margin

      3.37   

      3.75   

     (0.38)

(10.1)


(1) Includes Nonaccrual Loans


Our net interest margin (net interest income on a tax-equivalent basis divided by average earning assets, annualized) decreased from 3.75% to 3.37% between the first six months of 2010 and the first six months of 2011.  (See the discussion under Use of Non-GAAP Financial Measures, on page 27, regarding our net interest margin and net interest income, which are commonly used non-GAAP financial measures.)  Consistent with this margin decrease, net interest income for the just completed six month period, on a taxable equivalent basis, decreased $2.1 million, or 6.3%, from the first six months of 2010.  


A $77.4 million increase in average earning assets between the periods was not enough to offset the negative impact from the fact that our yield on our earning assets decreased at a faster pace than the costs of our paying liabilities; our yield decrease was 34 basis points greater than the cost of funds decrease.  The impact of recent interest rate changes on our net interest margin and net interest income are discussed above in this Report under the sections entitled Deposit Trends, Impact of Interest Rate Changes and Loan Trends.  


The provisions for loan losses were $390 thousand and $750 thousand for the six-month periods ended June 30, 2011 and 2010, respectively.  The provision for loan losses is discussed above under the heading "Asset Quality" beginning on page 43.


Noninterest Income


Summary of Noninterest Income

(Dollars in Thousands)


Six Months Ended




Jun 2011

Jun 2010

Change

% Change

Income From Fiduciary Activities

  $3,072 

  $2,728 

$     344 

   12.6%

Fees for Other Services to Customers

   3,973 

   3,853 

    120 

       3.1 

Insurance Commissions

3,281 

1,349 

1,932 

143.2

Net Gains on Securities Transactions

     1,024 

     878 

    146 

 16.6

Net Gains on the Sale of Loans

218 

55 

  163 

296.4 

Other Operating Income

     280 

     183 

        97 

     53.0 

  Total Noninterest Income

$11,848

$9,046 

$  2,802 

  31.0 


Total noninterest income in the just completed six-month period was $11.8 million, an increase of $2.8 million, or 31.0%, from total noninterest income of $9.0 million for the first six months of 2010.  The total for both the 2011 and 2010 periods included net gains on securities transactions of $1.0 million and $878 thousand, respectively.


For the just completed 2011 period, income from fiduciary activities increased $344 thousand, or 12.6%, from the comparable 2010 period.  The increase reflected an increase in the dollar amount of assets under administration, largely a result of the general rebound in the U.S. stock markets between the periods. At period-end 2011, the market value of assets under trust administration and investment management amounted to $1.0 billion, an increase of $162.3 million, or 19.0%, from period-end 2010.  A significant portion of our fiduciary fees is indexed to the dollar amount of assets under administration.  Any significant downturn in the U.S. stock markets in future periods would likely have a corresponding negative impact on our income from fiduciary activities.  


Fees for other services to customers (primarily service charges on deposit accounts, revenues related to the sale of mutual funds to our customers by third party providers and servicing income on sold loans) were $4.0 million for the first six months of 2011, an increase of $120 thousand, or 3.1%, from the 2010 first six months total.  The increase between the two periods in fees for other services to customers was attributable to an increase in revenues derived from third-party mutual fund sales and to an increase in income from debit card transactions, which increased from $1.1 million for 2010 to $1.2 million for 2011.  These two increases were offset, in part, by a decrease in fee income from service charges on deposit accounts.  For a discussion on how recent changes in law and regulation may impact our fees for other services in upcoming periods, see the discussion under Three Months Ended June 30, 2011, compared with the Three Months Ended June 30, 2010 Noninterest Income, above, on page 49 of this Report.  


Insurance commissions first became a significant source of noninterest income for us following our 2004 acquisition of an insurance agency, Capital Financial Group, Inc.  Capital Financial specializes in selling and servicing group health care policies as well as life insurance.  During the past two years we have acquired three additional insurance agencies which sell primarily property and casualty insurance to retail customers in our service area.  On April 1, 2010, we acquired Loomis and LaPann, Inc., and on February 1, 2011, we acquired Upstate Agency, Inc., in each case retaining all key insurance agency personnel as well as insurance agency offices.  On August 1, 2011, we completed the acquisition of W. Joseph McPhillips, Inc. and McPhillipsNorthern, Inc., property and casualty insurance agencies operating four offices in the Greater Glens Falls area.  All 20 employees will continue to operate the acquired businesses for us.  Therefore, we expect that noninterest income from insurance commissions will continue to increase in upcoming periods as a result of our expansion of this line of business.



Noninterest Expense


Summary of Noninterest Expense

(Dollars in Thousands)


Six Months Ended




Jun 2011

Jun 2010

Change

% Change

Salaries and Employee Benefits

  $14,435

  $13,655

    $780 

5.7%

Occupancy Expense of Premises, Net

   1,940

   1,765

    175 

  9.9

Furniture and Equipment Expense

   1,872

   1,784

     88 

    4.9

FDIC and FICO Assessments

780

986

(206)

(20.9)

Amortization of Intangible Assets

235

138

  97 

 70.3

Other Operating Expense

    5,228

    5,214

    14 

 0.3

Total Noninterest Expense

$24,490

$23,542

   $ 948 

     4.0





Efficiency Ratio

57.98%

56.74%

1.24%

 2.2


Noninterest expense for the first six months of 2011 was $24.5 million, an increase of $948 thousand, or 4.0%, over the expense for the first six months of 2010.  For the first six months of 2011, our efficiency ratio was 57.98%.  For a discussion of how we calculate the efficiency ratio, versus how the Federal Reserve calculates the efficiency ratio of banks, see the discussion under Three Months Ended June 30, 2011, compared with the Three Months Ended June 30, 2010 Noninterest Expense, above, on page 49 of this Report.  Our efficiency ratio for the 2011 six-month period compared favorably to the first quarter 2011 efficiency ratio of our peer group as reported by the Federal Reserve Peer Holding Company Performance Report.


Salaries and employee benefits expense increased by $780 thousand, or 5.7%, from the first six months of 2010 to the first six months of 2011.  Some of this increase is attributable to the fact that all full-time equivalent employees of the insurance agencies we acquired, Upstate Agency (in February 2011) and Loomis and LaPann (in April 2010), continued employment with us after the acquisitions.


Occupancy expense increased from the first six months of 2010 to the first six months of 2011 by $175 thousand, or 9.9%.  The increase was primarily attributable to decreases in building maintenance and utilities.  The increase in furniture and equipment expense was 4.9% period over period, and was primarily attributable to equipment maintenance expenses.


Risk-based FDIC assessments have increased since 2008 in response to the current financial crisis.  In the completed quarter, we continued to pay the lowest possible rate.  Beginning with the second quarter of 2011, the risk-based calculation for the premium converted to the new FDIC method, a method based on adjusted assets rather than deposits.  That resulted in a 45.5% decrease in our FDIC insurance assessment.


Other operating expense for 2011 was essentially unchanged from the prior year six-month period.


Income Taxes


Summary of Income Taxes

(Dollars in Thousands)


Six Months Ended




Jun 2011

Jun 2010

Change

% Change

Provision for Income Taxes

  $4,973

  $4,991

    $( 18)

(0.4)%

Effective Tax Rate

 30.9%

 31.0%

    (.10)%

 (0.3)


The provisions for federal and state income taxes amounted to $5.0 million for both the first six months of 2011 and 2010.  The effective tax rate was similar for both periods.

Item 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK


In addition to credit risk in our loan portfolio and liquidity risk, discussed earlier, our business activities also generate market risk.  Market risk is the possibility that changes in future market rates (interest rates) or prices (fees for products and services) will make our position less valuable.  The ongoing monitoring and management of market risk, principally interest rate risk, is an important component of our asset/liability management process, which is governed by policies that are reviewed and approved annually by the Board of Directors.  The Board of Directors delegates responsibility for carrying out asset/liability oversight and control to managements Asset/Liability Committee (ALCO).  In this capacity ALCO develops guidelines and strategies impacting our asset/liability profile based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends.  We have not made use of derivatives, such as interest rate swaps, in our risk management process.


Interest rate risk is the most significant market risk affecting us, more important to us, we believe, than credit risk or liquidity risk.  Interest rate risk is the exposure of our net interest income to changes in interest rates. Interest rate risk is directly related to the different maturities and repricing characteristics of interest-bearing assets and liabilities, as well as to the risk of prepayment of loans and early withdrawal of time deposits, and the fact that the speed and magnitude of responses to interest rate changes varies by product.


The ALCO utilizes the results of a detailed and dynamic simulation model to quantify the estimated exposure of net interest income to sustained interest rate changes.  While ALCO routinely monitors simulated net interest income sensitivity over a rolling two-year horizon, it also utilizes additional tools to monitor potential longer-term interest rate risk.


Our current simulation model attempts to capture the impact of changing interest rates on the interest income received and interest expense paid on all interest-sensitive assets and liabilities reflected on our consolidated balance sheet.  This sensitivity analysis is compared to ALCO policy limits which specify a maximum tolerance level for net interest income exposure over a one year horizon, assuming no balance sheet growth and a 200 basis point upward and a 100 basis point downward shift in interest rates, and a repricing of interest-bearing assets and liabilities at their earliest reasonably predictable repricing date.  We normally apply a parallel and pro-rata shift in rates for both assets and liabilities, over a 12 month period.  


We occasionally are forced to make ad hoc adjustments to our model.  At quarter-end 2011, the targeted federal funds rate was a range of 0 to .25%.  This abnormally low short-term rate interferes with our ability to perform our usual decreasing rate simulation for short-term liabilities and assets.  Hence, although we applied our usual 100 basis point downward shift in interest rates for liabilities and assets on the long end of the yield curve, for short-term modeling our rate decreases were limited by an absolute floor of a zero interest rate.  We also assume that hypothetical interest rate shifts, upward or downward, affect assets and liabilities simultaneously, depending upon the contractual maturities of the particular assets and liabilities in question.  In practice, however, as discussed elsewhere in this report, shifts in prevailing interest rates are typically experienced by us more rapidly in our liability portfolios (primarily deposits) than in our asset portfolios, irrespective of differences in contractual maturities (which, however, also tend to favor more rapid liabilities repricing).   


Applying the simulation model analysis as of June 30, 2011, a 200 basis point increase in interest rates demonstrated a .47% increase in net interest income, and a 100 basis point decrease in long-term interest rates, adjusted as described above, demonstrated a .62% decrease in net interest income when compared with our base projection.  These amounts were well within our ALCO policy limits.  The preceding sensitivity analysis does not represent a forecast on our part and should not be relied upon as being indicative of expected operating results.  


The hypothetical estimates underlying the sensitivity analysis are based upon numerous assumptions including: the nature and timing of changes in interest rates including yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment/replacement of asset and liability cash flows, and others.  While assumptions are developed based upon current economic and local market conditions, we cannot make any assurance as to the predictive nature of these assumptions including how customer preferences or competitor influences might change.


Also, as market conditions vary from those assumed in the sensitivity analysis, actual results will differ due to: prepayment/refinancing levels likely deviating from those assumed, the varying impact of interest rate changes on caps or floors on adjustable rate assets, the potential effect of changing debt service levels on customers with adjustable rate loans, depositor early withdrawals and product preference changes, unanticipated shifts in the yield curve and other internal/external variables.  Furthermore, the sensitivity analysis does not reflect actions that ALCO might take in responding to or anticipating changes in interest rates.


Item 4.

CONTROLS AND PROCEDURES


Senior management, including the Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the design and operation of Arrow's disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended) as of June 30, 2011. Based upon that evaluation, senior management, including the Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were effective. Further, there were no changes made in our internal control over financial reporting that occurred during the most recent fiscal quarter that had materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.


PART II - OTHER INFORMATION

Item 1.

Legal Proceedings


We are not the subject of any material pending legal proceedings, other than ordinary routine litigation occurring in the normal course of our business.  On an ongoing basis, we are the subject of or a party to various legal claims against us, by us against other parties, or involving us, which arise in the normal course of our business.  The various pending legal claims against us will not, in the opinion of management based upon consultation with counsel, result in any material liability.


Item 1.A.

Risk Factors


We do not believe that any of the risk factors identified in our Annual Report on Form 10-K for the year ended December 31, 2010, need to be modified in any material respect or withdrawn, or that any additional risk factors need to be presented in this Report.  Please refer to the risk factors listed in Part I, Item 1A. of our Annual Report filed on Form 10-K for December 31, 2010, which still pertain to our business.


Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds


Issuer Purchases of Equity Securities


The following table presents information about purchases by Arrow of its own equity securities (i.e. Arrows common stock) during the three months ended June 30, 2011:


Second Quarter 2011

Calendar Month

(A)

Total Number of

Shares Purchased1

(B)

Average Price

Paid Per Share1

(C)

Total Number of

Shares Purchased as

Part of Publicly

Announced

Plans or Programs2

(D)

Maximum

Approximate Dollar

Value of Shares that

May Yet be

Purchased Under the

Plans or Programs3

April

2,924

$24.55

---

$5,000,000

May

22,175

24.24

20,000

4,514,600

June

  83,825

24.27

62,000

2,993,120

Total

108,924

24.27

82,000



1Share amounts and average prices listed in columns A and B (total number of shares purchased and the average price paid per share) include, in addition to shares repurchased under the Companys publicly announced stock repurchase program, shares purchased in open market transactions under the Arrow Financial Corporation Automatic Dividend Reinvestment Plan (DRIP) by the administrator of the DRIP and shares surrendered (or deemed surrendered) to Arrow by holders of options to acquire Arrow common stock in connection with the exercise of such options.  In the months indicated, the total number of shares purchased listed in column A included the following numbers of shares purchased through such additional methods:  April DRIP market purchases (2,924 shares); May DRIP market purchases (2,175 shares); June DRIP market purchases (21,825 shares).


2Share amounts listed in column C include only those shares repurchased under the Companys publicly-announced stock repurchase program in effect during such period, which during May and June of 2011 was the $5 million stock repurchase program authorized by the Board of Directors in April 2011 (the 2011 Repurchase Program).  Column C amounts do not include shares purchased under the DRIP or upon exercise of outstanding stock options.


3Dollar amount of repurchase authority remaining at each month-end during the quarter as listed in column D represents the amount remaining under the 2011 Repurchase Program, the Companys only publicly-announced stock repurchase program in effect at the end of each such month.  In April 2011, the Board authorized a new $5 million stock repurchase program, replacing the 2010 Repurchase Program.

Item 3.

Defaults Upon Senior Securities - None


Item 4.

Removed and Reserved


Item 5.

Other Information - None


Item 6.

Exhibits


(a) Exhibits:


Exhibit 15

Awareness Letter

Exhibit 31.1

Certification of Chief Executive Officer under SEC Rule 13a-14(a)/15d-14(a)

Exhibit 31.2

Certification of Chief Financial Officer under SEC Rule 13a-14(a)/15d-14(a)

Exhibit 32

Certification of Chief Executive Officer under 18 U.S.C. Section 1350 and

Certification of Chief Financial Officer under 18 U.S.C. Section 1350






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.


ARROW FINANCIAL CORPORATION

Registrant


Date:    August 8, 2011

/s/Thomas L. Hoy


Thomas L. Hoy, Chairman, President and


Chief Executive Officer


Date:    August 8, 2011

/s/Terry R. Goodemote


Terry R. Goodemote, Executive Vice President,


Treasurer and Chief Financial Officer


(Principal Financial Officer and


Principal Accounting Officer)




1