UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

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

For the fiscal year ended December 31, 2012

Commission File Number: 0-18832

FIRST FINANCIAL SERVICE CORPORATION

(Exact name of registrant as specified in its charter)

Registrant's telephone number, including area code: (270) 765-2131

Securities registered pursuant to Section 12(b) of the Act:

Common Stock, par value $1.00 per share

(Title of Class)

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

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

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

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

Large Accelerated Filer ¨ Accelerated Filer ¨ Non-Accelerated Filer ¨ Smaller Reporting Company x

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨

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

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

The aggregate market value of the outstanding voting stock held by non-affiliates of the registrant based on a June 29, 2012 closing price of $2.25 as quoted on the NASDAQ Global Market was $8,830,859. Solely for purposes of this calculation, the shares held by directors and executive officers of the registrant and by any stockholder beneficially owning more than 5% of the registrant's outstanding common stock are deemed to be shares held by affiliates.

As of March 15, 2013 there were issued and outstanding 4,789,962 shares of the registrant's common stock.

DOCUMENTS INCORPORATED BY REFERENCE

FIRST FINANCIAL SERVICE CORPORATION

2012 ANNUAL REPORT AND FORM 10-K

TABLE OF CONTENTS 

PRELIMINARY NOTE REGARDING

FORWARD-LOOKING STATEMENTS

Statements in this report that are not statements of historical fact are forward-looking statements. First Financial Service Corporation (the “Corporation”) may make forward-looking statements in future filings with the Securities and Exchange Commission (“SEC”), in press releases, and in oral and written statements made by or with the approval of the Corporation. Forward-looking statements include, but are not limited to: (1) projections of revenues, income or loss, earnings or loss per share, capital structure and other financial items; (2) plans and objectives of the Corporation or its management or Board of Directors; (3) statements regarding future events, actions or economic performance; and (4) statements of assumptions underlying such statements. Words such as “estimate,” “strategy,” “believes,” “anticipates,” “expects,” “intends,” “plans,” “targeted,” and similar expressions are intended to identify forward-looking statements, but are not the exclusive means of identifying such statements.

Various risks and uncertainties may cause actual results to differ materially from those indicated by our forward-looking statements. In addition to those risks described under “Item 1A Risk Factors,” of this report and our Annual Report on Form 10-K, the following factors could cause such differences: changes in general economic conditions and economic conditions in Kentucky and the markets we serve, any of which may affect, among other things, our level of non-performing assets, charge-offs, and provision for loan loss expense; changes in interest rates that may reduce interest margins and impact funding sources; changes in market rates and prices which may adversely impact the value of financial products including securities, loans and deposits; changes in tax laws, rules and regulations; various monetary and fiscal policies and regulations, including those determined by the Federal Reserve Board, the Federal Deposit Insurance Corporation (“FDIC”) and the Kentucky Department of Financial Institutions (“KDFI”); competition with other local and regional commercial banks, savings banks, credit unions and other non-bank financial institutions; our ability to grow core businesses; our ability to develop and introduce new banking-related products, services and enhancements and gain market acceptance of such products; and management’s ability to manage these and other risks.

Our forward-looking statements speak only as of the date on which they are made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances occurring after the date of any such statement.

PART I

ITEM 1. BUSINESS

General Business Overview

First Financial Service Corporation was incorporated in August 1989 under Kentucky law and became the holding company for First Federal Savings Bank of Elizabethtown (the “Bank”), effective on June 1, 1990. Since that date, we have engaged in no significant activity other than holding the stock of the Bank and directing, planning and coordinating its business activities. Unless the text clearly suggests otherwise, references to "us," "we," or "our" include First Financial Service Corporation and its wholly owned subsidiary, the Bank. Accordingly, the information set forth in this report, including financial statements and related data, relates primarily to the Bank and its subsidiaries.

We are headquartered in Elizabethtown, Kentucky. The Bank was originally founded in 1923 as a state-chartered institution and became federally chartered in 1940. In 1987, the Bank became a federally chartered savings bank and converted from mutual to stock form. The Bank is a member of the Federal Home Loan Bank (“FHLB”) of Cincinnati and, since converting to a state charter in 2003, has been subject to regulation, examination and supervision by the FDIC and the KDFI. Our deposits are insured by the Deposit Insurance Fund administered by the FDIC.

We serve the needs and cater to the economic strengths of the local communities in which we operate, and we strive to provide a high level of personal and professional customer service. We offer a variety of financial services to our retail and commercial banking customers. These services include personal and corporate banking services and personal investment financial counseling services.

Our full complement of lending services includes:

We also provide a broad selection of deposit instruments. These include:

We also support our customers by providing services such as:

Through our personal investment financial counseling services, we offer a wide variety of non - insured investments including mutual funds, equity investments, and fixed and variable annuities. We invest in the wholesale capital markets to manage a portfolio of securities and use various forms of wholesale funding. The security portfolio contains a variety of instruments, including callable debentures, taxable and non-taxable debentures, fixed and adjustable rate mortgage backed securities, collateralized mortgage obligations and corporate securities.

Our results of operations depend primarily on net interest income, which is the difference between interest income from interest-earning assets and interest expense on interest-bearing liabilities. Our operations are also affected by non-interest income, such as service charges, loan fees, gains and losses from the sale of mortgage loans and revenue earned from bank owned life insurance. Our principal operating expenses, aside from interest expense, consist of compensation and employee benefits, occupancy costs, data processing expense, FDIC insurance premiums, costs associated with other real estate and provisions for loan losses.

Regulatory Developments

On January 27, 2011, the Bank entered into a Consent Order with the FDIC and KDFI. The 2011 Consent Order required the Bank to achieve a total capital to risk-weighted assets ratio of 12% and a Tier 1 capital to average total assets ratio of 9% by June 30, 2011. The 2011 Consent Order also forbade the Bank from declaring dividends without the prior written approval of the FDIC and KDFI and required the Bank to develop and implement plans to reduce its level of non-performing assets and concentrations of credit in commercial real estate loans, maintain adequate reserves for loan and lease losses, implement procedures to ensure compliance with applicable laws, and take certain other actions. A copy of the Consent Order is an exhibit to our Form 8-K filed on January 27, 2011.

On March 9, 2012, the Bank entered into a new Consent Order with the FDIC and KDFI. The 2012 Consent Order requires the Bank to achieve the minimum capital ratios in the 2011 Consent Order by June 30, 2012. The Bank also agreed that if it should be unable to reach the required capital levels by that date, and if directed in writing by the FDIC, then the Bank would within 30 days develop, adopt and implement a written plan to sell or merge itself into another federally insured financial institution. To date, the Bank has not received such a written direction. The 2012 Consent Order includes the substantive provisions of the 2011 Consent Order and requires the Bank to continue to adhere to the plans implemented in response to the 2011 Consent Order. A copy of the March 9, 2012 Consent Order is included as Exhibit 10.8 to our 2011 Annual Report on Form 10-K filed March 30, 2012.

The Consent Orders also resulted in the Bank being designated as a "troubled institution," which status prohibits the Bank from accepting, renewing or rolling over brokered deposits, restricts the amount of interest the Bank may pay on deposits, and increases its deposit insurance assessment.

At December 31, 2012, the Bank’s Tier 1 capital ratio was 6.53% and the total risk-based capital ratio was 12.21%. We notified the bank regulatory agencies that one of the two capital ratios would not be achieved and are continuing our efforts to meet and maintain the required regulatory capital levels and all of the other consent order issues for the Bank.

The following table shows the ratios of Tier 1 capital, total capital to risk-adjusted assets and the leverage ratios for the Corporation and the Bank as of December 31, 2012.

Bank regulatory agencies can exercise discretion when an institution does not meet the terms of a regulatory order. The agencies may initiate changes in management, issue mandatory directives, impose monetary penalties or refrain from formal sanctions, depending on individual circumstances. Any material failures to comply with our regulatory orders would likely result in more stringent enforcement actions by the bank regulatory agencies, which could damage our reputation and have a material adverse effect on our business.

In April 2011, the Corporation entered into a formal agreement with the Federal Reserve Bank of St. Louis, which requires the Corporation to obtain regulatory approval before declaring any dividends and to take steps to ensure the Bank complies with the Consent Order. We also may not redeem shares or obtain additional borrowings without prior approval.

The 2012 Consent Order and the formal agreement will remain in effect until modified or terminated by the FDIC, KDFI and Federal Reserve Bank of St. Louis.

Market Area

We operate 17 full-service banking centers in six contiguous counties in central Kentucky along the Interstate 65 corridor and within the Louisville metropolitan area. Our markets range from Louisville in Jefferson County, Kentucky approximately 40 miles north of our headquarters in Elizabethtown, Kentucky to Hart County, Kentucky, approximately 30 miles south of Elizabethtown. Our markets are supported by a diversified industry base and have a regional population of over 1 million. We operate in Hardin, Nelson, Hart, Bullitt, Meade and Jefferson counties in Kentucky. We control in the aggregate 22% of the deposit market share in our central Kentucky markets outside of Louisville.

The following table shows our market share and rank in terms of deposits as of June 30, 2012, in each Kentucky county where we have offices. We have four offices in Jefferson County, which is Louisville, Kentucky. The Louisville metropolitan area has a population of more than one million.

Lending Activities

Commercial Real Estate Lending. At December 31, 2012, we had $317.7 million outstanding in commercial real estate loans. We originate commercial loans that are primarily secured by real estate and primarily in our market area. In recent years, we have put greater emphasis on originating loans for small and medium-sized businesses from our various locations. We make commercial loans to a variety of industries. Substantially all of the commercial real estate loans we originate have adjustable interest rates with maturities of 25 years or less or are loans with fixed interest rates and maturities of five years or less. The security for commercial real estate loans includes retail businesses, warehouses, churches, apartment buildings and motels. In addition, the payment experience of loans secured by income producing properties typically depends on the success of the related real estate project and thus may be more vulnerable to adverse conditions in the real estate market or in the economy generally.

Loans secured by multi-family residential property, consisting of properties with more than four separate dwelling units, amounted to $24.6 million of the loan portfolio at December 31, 2012. These loans are included in the $317.7 million outstanding in commercial real estate loans discussed above. We generally do not lend above 75% of the appraised values of multi-family residences on first mortgage loans. The mortgage loans we currently offer on multi-family dwellings are generally one or five year ARMs with maturities of 25 years or less.

Residential Real Estate. Residential mortgage loans are secured primarily by single-family homes. The majority of our mortgage loan portfolio is secured by real estate in our markets outside of Louisville and our residential mortgage loans do not have sub-prime characteristics. Fixed rate residential real estate loans we originate have terms ranging from ten to thirty years. Interest rates are competitively priced within the primary geographic lending market and vary according to the term for which they are fixed. At December 31, 2012, we had $110.0 million in residential mortgage loans outstanding.

We generally emphasize the origination of adjustable-rate mortgage loans ("ARMs") when possible. We offer seven ARM products with an annual adjustment, which is tied to a national index with a maximum adjustment of 2% annually, and a lifetime maximum adjustment cap of 6%. As of December 31, 2012, approximately 58% of our residential real estate loans were adjustable rate loans with adjustment periods ranging from one to seven years and balloon loans of seven years or less. Originating these ARMs can be more difficult in a low interest rate environment where there is a significant demand for fixed rate mortgages. We limit the maximum loan-to-value ratio on one-to-four-family residential first mortgages to 90% of the appraised value and generally limit the loan-to-value ratio on second mortgages on one-to-four-family dwellings to 90%.

Commercial Business Lending. We make secured and unsecured loans for commercial, corporate, business, and agricultural purposes, including issuing letters of credit and engaging in inventory financing and commercial leasing activities. Commercial loans generally are made to small-to-medium size businesses located within our defined market area. Commercial loans generally carry a higher yield and are made for a shorter term than real estate loans. Commercial loans, however, involve a higher degree of risk than residential real estate loans due to potentially greater volatility in the value of the assigned collateral, the need for more technical analysis of the borrower’s financial position, the potentially greater impact that changing economic conditions may have on the borrower’s ability to retire debt, and the additional expertise required for commercial lending personnel. Commercial business loans outstanding at December 31, 2012, totaled $19.9 million.

Consumer Lending. Consumer loans include loans on automobiles, boats, recreational vehicles and other consumer goods, as well as loans secured by savings accounts, home improvement loans, and unsecured lines of credit. As of December 31, 2012, consumer loans outstanding were $74.1 million. These loans involve a higher risk of default than loans secured by one-to-four-family residential loans. We believe, however, that the shorter term and the normally higher interest rates available on various types of consumer loans help maintain a profitable spread between the average loan yield and cost of funds. Home equity lines of credit as of December 31, 2012, totaled $44.7 million.

Our underwriting standards reflect the greater risk in consumer lending than in residential real estate lending. Among other things, the capacity of individual borrowers to repay can change rapidly, particularly during an economic downturn, collection costs can be relatively higher for smaller loans, and the value of collateral may be more likely to depreciate. Our Consumer Lending Policy establishes the appropriate consumer lending authority for all loan officers based on experience, training, and past performance for approving high quality loans. Loans beyond the authority of individual officers must be approved by additional officers, the Executive Loan Committee or the Board of Directors, based on the size of the loan. We require detailed financial information and credit bureau reports for each consumer loan applicant to establish the applicant’s credit history, the adequacy of income for debt retirement, and job stability based on the applicant’s employment records. Co-signers are required for applicants who are determined marginal or who fail to qualify individually under these standards. Adequate collateral is required on the majority of consumer loans. The Executive Credit Committee monitors and evaluates unsecured lending activity by each loan officer.

The indirect consumer loan portfolio is comprised of new and used automobile, motorcycle and all terrain vehicle loans originated on our behalf by a select group of auto dealers within the service area. Indirect consumer loans are considered to have greater risk of loan losses than direct consumer loans due to, among other things: borrowers may have no existing relationship with us; borrowers may not be residents of the lending area; less detailed financial statement information may be collected at application; collateral values can be more difficult to determine; and the condition of vehicles securing the loan can deteriorate rapidly. To address the additional risks associated with indirect consumer lending, the Executive Loan Committee continually evaluates data regarding the dealers enrolled in the program, including monitoring turn down and delinquency rates. All applications are approved by specific lending officers, selected based on experience in this field, who obtain credit bureau reports on each application to assist in the decision. Aggressive collection procedures encourage more timely recovery of late payments. At December 31, 2012, total loans under the indirect consumer loan program totaled $16.2 million.

Subsidiary Activities

First Service Corporation of Elizabethtown (“First Service”), our licensed brokerage affiliate, provides investment services to our customers and offers tax-deferred annuities, government securities, mutual funds, and stocks and bonds. First Service employs four full-time employees. The net income of First Service was $56,000 for the year ended December 31, 2012.

First Federal Office Park, LLC, held commercial lots adjacent to our home office on Ring Road in Elizabethtown that were available for sale. During the second quarter of 2012 we recorded $175,000 in gains from the sale of the last of nine lots we held for sale.

We provide title insurance coverage for mortgage borrowers through two subsidiaries: First Heartland Title, LLC, and First Federal Title Services, LLC. First Heartland Title is a joint venture with a title insurance company in Hardin County and First Federal Title Services is a joint venture with a title insurance company in Louisville. We hold a 48% interest in First Heartland Title and a 49% interest in First Federal Title Services. The subsidiaries generated $165,000 in income for the year ended December 31, 2012, of which our portion was $79,000.

Heritage Properties, LLC, holds real estate acquired through foreclosure that is available for sale. Currently, forty-seven properties valued at $22.3 million are held for sale.

Competition

The banking business is highly competitive. We face substantial competition both in attracting and retaining deposits and in lending. Direct competition for deposits comes from commercial banks, savings institutions, and credit unions located in north-central Kentucky, and less directly from money market mutual funds and from sellers of corporate and government debt securities.

The primary competitive factors in lending are interest rates, loan origination fees and the range of services offered by the various financial institutions. Competition for origination of real estate loans normally comes from commercial banks, savings institutions, mortgage bankers, mortgage brokers, and insurance companies. Many of these competitors have substantially greater resources and lending limits than the Bank currently has.

We have offices in nine cities in six central Kentucky counties. In addition to the financial institutions with offices in these counties, we compete with several commercial banks and savings institutions in surrounding counties, many of which have assets substantially greater than we have. These competitors attempt to gain market share through their financial product mix, pricing strategies, internet banking and banking center locations. In addition, Kentucky's interstate banking statute, which permits banks in all states to enter the Kentucky market if they have reciprocal interstate banking statutes, has further increased competition for us. We believe that competition from both bank and non-bank entities will continue to remain strong in the near future.

Employees

As of December 31, 2012, we employed 281 employees, of which 266 were full-time and 15 part-time. None of our employees are subject to a collective bargaining agreement.

Regulation

General Regulatory Matters. The Bank is a Kentucky chartered commercial bank and is subject to supervision and regulation, which involves regular bank examinations, by both the FDIC and the KDFI. Our deposits are insured by the FDIC. Kentucky’s banking statutes contain a “super-parity” provision that permits certain well-rated Kentucky banks to engage in any banking activity in which a national bank operating in any state, a state bank, thrift or savings bank operating in any other state, or a federally chartered thrift or federal savings association meeting the qualified thrift lender test and operating in any state could engage, provided the Kentucky bank first obtains a legal opinion specifying the statutory or regulatory provisions that permit the activity.

In connection with our conversion, we registered to become a bank holding company under the Bank Holding Company Act of 1956, and are subject to supervision and regulation by the Federal Reserve Board. As a bank holding company, we are required to file with the Federal Reserve Board annual and quarterly reports and other information regarding our business operations and the business operations of our subsidiaries. We are also subject to examination by the Federal Reserve Board and to its operational guidelines. We are subject to the Bank Holding Company Act and other federal laws and regulations regarding the types of activities in which we may engage, and to other supervisory requirements, including regulatory enforcement actions for violations of laws and regulations.

Regulators have broad enforcement powers over bank holding companies and banks, including, but not limited to, the power to mandate or restrict particular actions, activities, or divestitures, impose monetary fines and other penalties for violations of laws and regulations, issue consent, cease and desist or removal orders, seek injunctions, publicly disclose such actions and prohibit unsafe or unsound practices. This authority includes both informal actions and formal actions to effect corrective actions or sanctions.

Certain regulatory requirements applicable to the Corporation and the Bank are referred to below or elsewhere in this filing. The description of statutory provisions and regulations applicable to banks and their holding companies set forth in this filing does not purport to be a complete description of such statutes and regulations and their effect on the Corporation or the Bank and is qualified in its entirety by reference to the actual laws and regulations.

We are required by regulation to maintain adequate levels of capital to support our operations. In its 2012 Consent Order, the Bank agreed to achieve and maintain a Tier 1 capital ratio of 9.0% and a total risk-based capital ratio of 12.0% by June 30, 2012. At December 31, 2012, our Tier 1 capital ratio was 6.53% and our total risk-based capital ratio was 12.21%. We notified the bank regulatory agencies that one of the two capital ratios would not be achieved and that we are continuing our efforts to meet and maintain the required regulatory capital levels and all of the other consent order requirements applicable to the Bank.

On April 20, 2011 the Corporation entered into a formal agreement with the Federal Reserve Bank of St. Louis which requires the Corporation to obtain regulatory approval before declaring any dividends. We also may not redeem shares or obtain additional borrowings without prior approval.

Acquisitions, Change in Control and Branching. As a bank holding company, we must obtain Federal Reserve Board approval before acquiring, directly or indirectly, ownership or control of more than 5% of the voting stock of a bank, and before engaging in, or acquiring a company that is not a bank but is engaged in certain non-banking activities. In approving these acquisitions, the Federal Reserve Board considers a number of factors, and weighs the expected benefits to the public such as greater convenience, increased competition and gains in efficiency, against the risks of possible adverse effects such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. The Federal Reserve Board also considers the financial and managerial resources of the bank holding company, its subsidiaries and any company to be acquired, and the effect of the proposed transaction on these resources. It also evaluates compliance by the holding company's financial institution subsidiaries and the target institution with the Community Reinvestment Act. The Community Reinvestment Act generally requires each financial institution to take affirmative steps to ascertain and meet the credit needs of its entire community, including low and moderate income neighborhoods.

Federal law also prohibits a person or group of persons from acquiring “control” of a bank holding company without notifying the Federal Reserve Board in advance and then only if the Federal Reserve Board does not object to the proposed transaction. The Federal Reserve Board has established a rebuttable presumptive standard that the acquisition of 10% or more of the voting stock of a bank holding company, in the absence of a larger shareholder, would constitute an acquisition of control of the bank holding company. In addition, any company is required to obtain the approval of the Federal Reserve Board before acquiring 25% (5% in the case of an acquirer that is a bank holding company) or more of any class of a bank holding company’s voting securities, or otherwise obtaining control or a “controlling influence” over a bank holding company.

Kentucky law generally permits a Kentucky chartered bank to establish a branch office in any county in Kentucky. A Kentucky bank may also, subject to regulatory approval and certain restrictions, establish a branch office outside of Kentucky. Well-capitalized Kentucky banks that have been in operation at least three years and that satisfy certain criteria relating to, among other things, their composite and management ratings, may establish a branch in Kentucky without the approval of the Commissioner of the KDFI, upon notice to the KDFI and any other state bank with its main office located in the county where the new branch will be located. Branching by all other banks requires the approval of the Commissioner of the KDFI, who must ascertain and determine that the public convenience and advantage will be served and promoted and that there is a reasonable probability of the successful operation of the branch. In any case, the transaction must also be approved by the FDIC, which considers a number of factors, including financial history, capital adequacy, earnings prospects, character of management, needs of the community and consistency with corporate powers.

Section 613 of the Dodd-Frank Act effectively eliminated the interstate branching restrictions set forth in the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994. Banks located in any state may now de novo branch in any other state, including Kentucky. Such unlimited branching power will likely increase competition within the markets in which the Corporation and the Bank operate.

Other Financial Activities. The Gramm-Leach-Bliley Act of 1999 permits a bank holding company to elect to become a financial holding company, which permits the holding company to conduct activities that are “financial in nature.” To become and maintain its status as a financial holding company, the bank holding company and all of its affiliated depository institutions must be well-capitalized, well managed, and have at least a satisfactory Community Reinvestment Act rating. We have not filed an election to become a financial holding company and are ineligible to do so due to the Bank’s “troubled institution” designation and entering into the Consent Order.

Subject to certain exceptions, insured state banks are permitted to control or hold an interest in a financial subsidiary that engages in a broader range of activities than are permissible for national banks to engage in directly, subject to any restrictions imposed on a bank under the laws of the state under which it is organized. Conducting financial activities through a bank subsidiary can impact capital adequacy and regulatory restrictions may apply to affiliate transactions between the bank and its financial subsidiaries.

Other Holding Company Regulations. Federal law substantially restricts transactions between financial institutions and their affiliates. As a result, a bank is limited in extending credit to its holding company (or any non-bank subsidiary), in investing in the stock or other securities of the bank holding company or its non-bank subsidiaries, and/or in taking such stock or securities as collateral for loans to any borrower. Moreover, transactions between a bank and a bank holding company (or any non-bank subsidiary) for loans to any borrower must generally be on terms and under circumstances at least as favorable to the bank as those prevailing in comparable transactions with independent third parties or, in the absence of comparable transactions, on terms and under circumstances that in good faith would be available to nonaffiliated companies.

Under Federal Reserve Board policy, a bank holding company is expected to act as a source of financial strength to each of its banking subsidiaries and to commit resources for their support. Such support may restrict the Corporation’s ability to pay dividends, and may be required at times when, absent this Federal Reserve Board policy, a holding company may not be inclined to provide it. A bank holding company may also be required to guarantee the capital restoration plan of an undercapitalized banking subsidiary. In addition, any capital loans by the Corporation to the Bank are subordinate in right of payment to deposits and to certain other indebtedness of the Bank. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of subsidiary banks will be assumed by the bankruptcy trustee and entitled to a priority of payment. The Dodd-Frank Act codifies the Federal Reserve Board’s existing “source of strength” policy that holding companies act as a source of strength to their insured institution subsidiaries by providing capital, liquidity and other support in times of distress.

Regulatory Capital Requirements. The Federal Reserve Board and the FDIC have substantially similar risk-based and leverage capital guidelines applicable to the banking organizations they supervise. Under the risk-based capital requirements, we are generally required to maintain a minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) of 8%. At least half of the total capital (4%) must be composed of common equity, retained earnings and qualifying perpetual preferred stock and certain hybrid capital instruments, less certain intangibles (“Tier 1 capital”). The remainder may consist of certain subordinated debt, certain hybrid capital instruments, qualifying preferred stock and a limited amount of the loan loss allowance (“Tier 2 capital” which, together with Tier 1 capital, composes “total capital”). To be considered well-capitalized under the risk-based capital guidelines, an institution must maintain a total risk-weighted capital ratio of at least 10% and a Tier 1 risk-weighted ratio of 6% or greater.

The Federal Deposit Insurance Corporation Act of 1991 (“FDICIA”), among other things, identifies five capital categories for insured depository institutions: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. Due to the losses we have incurred in recent quarters and our elevated levels of non-performing loans and other real estate, the FDIC, KDFI and the Bank entered into the Consent Order described above under “Regulatory Developments.” The Consent Order resulted in the Bank being categorized as a "troubled institution" by bank regulators, which by definition does not permit the Bank to be considered "well-capitalized". The "troubled institution" designation also prohibits the Bank from accepting, renewing or rolling over brokered deposits and restricts the amount of interest the Bank may pay on deposits. Unless the Bank is granted a waiver because it resides in a market that the FDIC determines is a high rate market, the Bank is limited to paying deposit interest rates within .75% of the average rates computed by the FDIC. The Bank must apply annually to be granted this waiver, which it has done and was granted for 2012. However, the Bank recently elected to adhere to average rates computed by the FDIC plus the .75% rate cap.

FDICIA also requires the bank regulatory agencies to implement systems for “prompt corrective action” for institutions that fail to meet minimum capital requirements within these five categories, with progressively more severe restrictions on operations, management and capital distributions according to the category in which an institution is placed. Failure to meet capital requirements can also cause an institution to be directed to raise additional capital. FDICIA also mandates that the agencies adopt safety and soundness standards relating generally to operations and management, asset quality and executive compensation, and authorizes administrative action against an institution that fails to meet such standards.

In addition, the Federal Reserve Board and the FDIC have each adopted risk-based capital standards that explicitly identify concentrations of credit risk and the risk arising from non-traditional activities, as well as an institution’s ability to manage these risks, as important factors to be taken into account by each agency in assessing an institution’s overall capital adequacy. The capital guidelines also provide that an institution’s exposure to a decline in the economic value of its capital due to changes in interest rates be considered by the agency as a factor in evaluating a banking organization’s capital adequacy. In addition to the “prompt corrective action” directives, failure to meet capital guidelines can subject a banking organization to a variety of other enforcement remedies, including additional substantial restrictions on its operations and activities, termination of deposit insurance by the FDIC, and under some conditions the appointment of a conservator or receiver.

Dividends. The Corporation is a legal entity separate and distinct from the Bank. The majority of our revenue is from dividends we receive from the Bank. The Bank is subject to laws and regulations that limit the amount of dividends it can pay. If, in the opinion of a federal regulatory agency, an institution under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice, the agency may require, after notice and a hearing, that the institution cease and desist from such practice. The federal banking agencies have indicated that paying dividends that deplete an institution's capital base to an inadequate level would be an unsafe and unsound banking practice. Under FDICIA, an insured institution may not pay a dividend if payment would cause it to become undercapitalized or if it already is undercapitalized. Moreover, the Federal Reserve Board and the FDIC have issued policy statements providing that bank holding companies and banks should generally pay dividends only out of current operating earnings.

Under Kentucky law, dividends by Kentucky banks may be paid only from current or retained net profits. Before any dividend may be declared for any period (other than with respect to preferred stock), a bank must increase its capital surplus by at least 10% of the net profits of the bank for the period until the bank's capital surplus equals the amount of its stated capital attributable to its common stock. Moreover, the KDFI Commissioner must approve the declaration of dividends if the total dividends to be declared by a bank for any calendar year would exceed the bank's total net profits for such year combined with its retained net profits for the preceding two years, less any required transfers to surplus or a fund for the retirement of preferred stock or debt. We are also subject to the Kentucky Business Corporation Act, which generally prohibits dividends to the extent they result in the insolvency of the corporation from a balance sheet perspective or if becoming unable to pay debts as they come due. Under the terms of the Consent Order described under “Regulatory Developments” above, the Bank cannot pay any dividends or distributions without prior regulatory approval. The Corporation has also agreed with the Federal Reserve Bank of St. Louis to not pay any dividends or distributions without prior regulatory approval.

Consumer Protection Laws. We are subject to a number of federal and state laws designed to protect borrowers and promote lending to various sectors of the economy and population. These laws include, among others, the Equal Credit Opportunity Act, the Fair Credit Reporting Act, the Truth in Lending Act, the Home Mortgage Disclosure Act, and the Real Estate Settlement Procedures Act, and state law counterparts.

Home Mortgage Disclosure Act (“HMDA”). HMDA has grown out of public concern over credit shortages in certain urban neighborhoods. One purpose of HMDA is to provide public information that will help show whether financial institutions are serving the housing credit needs of the neighborhoods and communities in which they are located. HMDA also includes a “fair lending” aspect that requires the collection and disclosure of data about applicant and borrower characteristics, as a way of identifying possible discriminatory lending patterns and enforcing anti-discrimination statutes. HMDA requires institutions to report data regarding applications for loans for the purchase or improvement of single family and multi-family dwellings, as well as information concerning originations and purchases of such loans. Federal bank regulators rely, in part, upon data provided under HMDA to determine whether depository institutions engage in discriminatory lending practices. The appropriate federal banking agency, or in some cases the Department of Housing and Urban Development, enforces compliance with HMDA and implements its regulations. Administrative sanctions, including civil money penalties, may be imposed by supervisory agencies for violations of HMDA.

Equal Credit Opportunity Act. This statute prohibits discrimination against an applicant in any credit transaction, whether for consumer or business purposes, on the basis of race, color, religion, national origin, sex, marital status, age (except in limited circumstances), receipt of income from public assistance programs or good faith exercise of any rights under the Consumer Credit Protection Act. Under the Fair Housing Act, it is unlawful for any lender to discriminate in its housing-related lending activities against any person because of race, color, religion, national origin, sex, handicap or familial status. Among other things, these laws prohibit a lender from denying or discouraging credit on a discriminatory basis, making excessively low appraisals of property based on racial considerations, or charging excessive rates or imposing more stringent loan terms or conditions on a discriminatory basis. In addition to private actions by aggrieved borrowers or applicants for actual and punitive damages, the U.S. Department of Justice and other regulatory agencies can take enforcement action seeking injunctive and other equitable relief or sanctions for alleged violations.

Truth in Lending Act (“TILA”). TILA is designed to ensure that credit terms are disclosed in a meaningful way so that consumers may compare credit terms more readily and knowledgeably. As result of TILA, all creditors must use the same credit terminology and expressions of rates, and disclose the annual percentage rate, the finance charge, the amount financed, the total of payments and the payment schedule for each proposed loan. Violations of TILA may result in regulatory sanctions and in the imposition of both civil and, in the case of willful violations, criminal penalties. Under certain circumstances, TILA also provides a consumer with a right of rescission, which if exercised within three business days would require the creditor to reimburse any amount paid by the consumer to the creditor or to a third party in connection with the loan, including finance charges, application fees, commitment fees, title search fees and appraisal fees. Consumers may also seek actual and punitive damages for violations of TILA.

Real Estate Settlement Procedures Act (“RESPA”). RESPA requires lenders to provide borrowers with disclosures regarding the nature and cost of real estate settlements. RESPA also prohibits certain abusive practices, such as kickbacks, and places limitations on the amount of escrow accounts. Violations of RESPA may result in imposition of penalties, including: (1) civil liability equal to three times the amount of any charge paid for the settlement services or civil liability of up to $1,000 per claimant, depending on the violation; (2) awards of court costs and attorneys’ fees; and (3) fines of not more than $10,000 or imprisonment for not more than one year, or both.

Fair Credit Reporting Act (“FCRA”). FCRA requires the Bank to adopt and implement a written identity theft prevention program, paying particular attention to several identified “red flag” events. The program must assess the validity of address change requests for card issuers and for users of consumer reports to verify the subject of a consumer report in the event of notice of an address discrepancy. FCRA gives consumers the ability to challenge banks with respect to credit reporting information provided by the bank. FCRA also prohibits banks from using certain information it may acquire from an affiliate to solicit the consumer for marketing purposes unless the consumer has been given notice and an opportunity to opt out of such solicitation for a period of five years.

Loans to One Borrower. Under current limits, loans and extensions of credit outstanding at one time to a single borrower and not fully secured generally may not exceed 15% of an institution’s unimpaired capital and unimpaired surplus. Loans and extensions of credit fully secured by certain readily marketable collateral may represent an additional 10% of unimpaired capital and unimpaired surplus.

Federal law currently contains extensive customer privacy protection provisions. Under these provisions, a financial institution must provide to its customers, at the inception of the customer relationship and annually thereafter, the institution’s policies and procedures regarding the handling of customers’ nonpublic personal financial information. These provisions also provide that, except for certain limited exceptions, an institution may not provide such personal information to unaffiliated third parties unless the institution discloses to the customer that such information may be so provided and the customer is given the opportunity to opt out of such disclosure. Federal law makes it a criminal offense, except in limited circumstances, to obtain or attempt to obtain customer information of a financial nature by fraudulent or deceptive means.

The Community Reinvestment Act (“CRA”). This statute requires the FDIC to assess our record in meeting the credit needs of the communities we serve, including low- and moderate-income neighborhoods and persons. The FDIC's assessment of our record is made available to the public. The assessment also is part of the Federal Reserve Board's consideration of applications to acquire, merge or consolidate with another banking institution or its holding company, to establish a new branch office or to relocate an office. The Federal Reserve Board will also assess the CRA record of the subsidiary banks of a bank holding company in its consideration of any application to acquire a bank or other bank holding company, which may be the basis for denying the application.

Bank Secrecy Act (“BSA”). BSA was enacted to deter money laundering, establish regulatory reporting standards for currency transactions and improve detection and investigation of criminal, tax and other regulatory violations. BSA and subsequent laws and regulations require us to take steps to prevent the use of the Bank in the flow of illegal or illicit money, including, without limitation, ensuring effective management oversight, establishing sound policies and procedures, developing effective monitoring and reporting capabilities, ensuring adequate training and establishing a comprehensive internal audit of BSA compliance activities.

In recent years, federal regulators have increased the attention paid to compliance with the provisions of BSA and related laws, with particular attention paid to “Know Your Customer” practices. Banks have been encouraged by regulators to enhance their identification procedures prior to accepting new customers in order to deter criminal elements from using the banking system to move and hide illegal and illicit activities.

USA Patriot Act. The Patriot Act contains anti-money laundering measures affecting insured depository institutions, broker-dealers and certain other financial institutions. The Patriot Act requires financial institutions to implement policies and procedures to combat money laundering and the financing of terrorism, including standards for verifying customer identification at account opening, and rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering. The Patriot Act also grants the Secretary of the Treasury broad authority to establish regulations and to impose requirements and restrictions on financial institutions’ operations. In addition, the Patriot Act requires the federal bank regulatory agencies to consider the effectiveness of a financial institution’s anti-money laundering activities when reviewing bank mergers and bank holding company acquisitions.

The Corporation and the Bank, like all U.S. companies and individuals, are prohibited from transacting business with certain individuals and entities named on the Office of Foreign Asset Control's ("OFAC") list of Specially Designated Nationals and Blocked Persons. Failure to comply may result in fines and other penalties. OFAC issued guidance for financial institutions in which it asserted that it may, in its discretion, examine institutions determined to be high risk or to be lacking in their efforts to comply with these prohibitions.

Federal Deposit Insurance Assessments. The deposits of the Bank are insured up to applicable limits by the Deposit Insurance Fund of the FDIC and are subject to deposit insurance assessments to maintain that Fund. The FDIC utilizes a risk-based assessment system that imposes insurance premiums based upon a risk matrix that takes into account a bank's capital level and supervisory rating.

In 2007, the FDIC imposed deposit assessment rates based on the risk category of insured banks.  Risk Category I is the lowest risk category while Risk Category IV is the highest risk category.  Because of favorable loss experience and a healthy reserve ratio in the Bank Insurance Fund of the FDIC at that time, well-capitalized and well-managed banks, have in recent years paid minimal premiums for FDIC insurance.

On October 16, 2008, the FDIC published a restoration plan designed to replenish the Deposit Insurance Fund over a period of five years and to increase the deposit insurance reserve ratio, which decreased to 1.01% of insured deposits on June 30, 2008, to the statutory minimum of 1.15% of insured deposits by December 31, 2013.  In order to implement the restoration plan, the FDIC proposed to change both its risk-based assessment system and its base assessment rates.  For the first quarter of 2009 only, the FDIC increased all FDIC deposit assessment rates by 7 basis points. These new rates range from 12 to 14 basis points for Risk Category I institutions to 50 basis points for Risk Category IV institutions.

Under the FDIC's restoration plan, the FDIC proposed to establish new initial base assessment rates that will be subject to adjustment as described below.  Beginning April 1, 2009, the base assessment rates would range from 12 to 16 basis points for Risk Category I institutions to 45 basis points for Risk Category IV institutions.

Changes to the risk-based assessment system include increasing premiums for institutions that rely on excessive amounts of brokered deposits, increasing premiums for excessive use of secured liabilities (including Federal Home Loan Bank advances), lowering premiums for smaller institutions with very high capital levels, and adding financial ratios and debt issuer ratings to the premium calculations for banks with over $10 billion in assets, while providing a reduction for their unsecured debt.

Either an increase in the Risk Category of our bank subsidiary or adjustments to the base assessment rates could result in a material increase in our expense for federal deposit insurance. Because the Bank entered into the Consent Order and is designated a “troubled institution” it is in a higher risk category and now pays one of the highest deposit assessment rates.

In addition, all institutions with deposits insured by the FDIC are required to pay assessments to fund interest payments on bonds issued by the Financing Corporation, a mixed-ownership government corporation established to recapitalize a predecessor to the Deposit Insurance Fund. The current annualized assessment rate is 1.14 basis points, or approximately .285 basis points per quarter. These assessments will continue until the Financing Corporation bonds mature in 2019.

The FDIC implemented a five basis point emergency special assessment on insured depository institutions as of June 30, 2009.  The special assessment was paid on September 30, 2009.  This assessment resulted in a cost of $477,000 and is reflected in our income statement for 2009. The interim rule also authorizes the FDIC to impose an additional emergency assessment of up to 10 basis points in respect to deposits for quarters ended after June 30, 2009 if necessary to maintain public confidence in federal deposit insurance. In addition, during the fourth quarter of 2009, the FDIC approved that all banks prepay three and a quarter years worth of FDIC assessments on December 31, 2009.  The prepayment is based on average third quarter deposits.  The prepaid amount will be amortized over the prepayment period.  Our prepayment was $7.5 million of which $1.3 million was reflected in our 2012 income statement and has now been fully amortized.  

On February 7, 2011, the FDIC Board of Directors adopted a final rule (with changes that went into effect beginning with the second quarter 2011), which redefined the deposit insurance assessment base as required by the Dodd-Frank Act; made changes to assessment rates; implemented Dodd-Frank’s Deposit Insurance Fund dividend provisions; and revised the risk-based assessment system for all large insured depository institutions, which are generally those institutions with at least $10 billion in total assets. Nearly all of the 7,600-plus institutions with assets less than $10 billion paid smaller assessments as a result of this final rule. The final rule:

The FDIC is authorized to set the reserve ratio for the Deposit Insurance Fund annually at between 1.15% and 1.50% of estimated insured deposits. The Dodd-Frank Act mandates that the statutory minimum reserve ratio of the Deposit Insurance Fund increase from 1.15% to 1.35% of insured deposits by September 30, 2020. Banks with assets of less than $10 billion are exempt from any additional assessments necessary to increase the reserve fund above 1.15%.

The FDIC may terminate the deposit insurance of any insured depository institution, including the Bank, if it determines after a hearing that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed by an agreement with the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital. If insurance of accounts is terminated, the accounts at the institution at the time of the termination, less subsequent withdrawals, shall continue to be insured for a period of six months to two years, as determined by the FDIC. Management is aware of no existing circumstances which would result in termination of the Bank's deposit insurance.

Emergency Economic Stabilization Act (“EESA”). Enacted in October 2008, EESA authorized the Treasury Department to purchase from financial institutions and their holding companies up to $700 billion in mortgage loans, mortgage-related securities and certain other financial instruments, including debt and equity securities issued by financial institutions and their holding companies in a troubled asset relief program (“TARP”). The purpose of TARP is to restore confidence and stability to the U.S. banking system and to encourage financial institutions to increase their lending to customers and to each other. The Treasury Department allocated $250 billion towards the TARP Capital Purchase Program (“CPP”). Under the CPP, Treasury purchased debt or equity securities from participating institutions, including us.

The TARP also includes direct purchases or guarantees of troubled assets of financial institutions. Participants in the CPP are subject to executive compensation limits and are encouraged to expand their lending and mortgage loan modifications. For details regarding our sale of $20 million of preferred stock to the Treasury Department through the CPP, see “Item7 – Management’s Discussion and Analysis of Financial Condition and Results of Operation – Capital and Note 12 of the Notes to Consolidated Financial Statements.” In recent months, the Treasury has been holding auctions to sell securities issued in the TARP program. The Corporation has been notified of Treasury’s intent to sell at auction the Corporation’s preferred securities, but a date for such action has not been set at this time.

EESA also increased FDIC deposit insurance on most accounts from $100,000 to $250,000. This increase was in place until December 31, 2013, and has since been made permanent by the Dodd-Frank Act.

Certificate of Deposit Account Registry Service (“CDARS”). To mitigate the risks associated with carrying balances in excess of federally insured limits, we are participating in the Certificate of Deposit Account Registry Service. CDARS is a system that allows certificates of deposit that would be in excess of FDIC coverage in a single financial institution to be redistributed to other financial institutions within the CDARS network in increments under the current FDIC coverage limit. Consequently, the full amount of the certificates of deposit becomes eligible for FDIC protection. Even though we have deposits that will remain in the CDARS network, those deposits are considered brokered deposits and the Bank’s “troubled institution” designation prevents us from accepting, renewing or rolling over brokered deposits. Therefore, as long as the Consent Order remains in effect, we will be able to retain only our deposits within the CDARS network that do not come up for renewal or roll over.

American Recovery and Reinvestment Act (“ARRA”). Enacted in February 2009, ARRA includes a wide variety of programs intended to stimulate the economy and provide for extensive infrastructure, energy, health, and education needs. In addition, ARRA imposes certain new executive compensation and corporate expenditure limits on all current and future CPP recipients, including the Corporation, until the institution has repaid the Treasury. ARRA also permits CPP participants to redeem the preferred shares held by the Treasury Department without penalty and without the need to raise new capital, subject to the Treasury’s consultation with the recipient’s appropriate regulatory agency. We have not redeemed any of the preferred shares we issued to the Treasury.

Dodd–Frank Act. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 is intended to affect a fundamental restructuring of federal banking regulation. Among other things, the Dodd-Frank Act creates a new Financial Stability Oversight Council to identify systemic risks in the financial system and gives federal regulators new authority to take control of and liquidate financial firms. The Dodd-Frank Act additionally creates a new independent federal regulator to administer federal consumer protection laws.

It is difficult to predict at this time what impact the new legislation and implementing regulations will have on community banks like the Bank, including the lending and credit practices of such banks. Moreover, many of the provisions of the Dodd-Frank Act will not take effect for several months, and the legislation requires various federal agencies to promulgate numerous and extensive implementing regulations over the next several years. Although the substance and scope of these regulations cannot be determined at this time, it is expected that the legislation and implementing regulations, particularly those provisions relating to the new Consumer Financial Protection Bureau will increase our operating and compliance costs and restrict our ability to pay dividends.

The Dodd-Frank Act is expected to have a significant impact on the Corporation's business operations as its provisions take effect. Among the provisions that affect the Corporation are the following:

Corporate Governance. The Dodd-Frank Act requires publicly traded companies to give stockholders a non-binding vote on executive compensation at their first annual meeting taking place six months after the date of enactment and at least every three years thereafter and on so-called “golden parachute” payments in connection with approvals of mergers and acquisitions. The new legislation also authorizes the SEC to promulgate rules that would allow stockholders to nominate their own candidates using a company’s proxy materials. Additionally, the Dodd-Frank Act directs the federal banking regulators to promulgate rules prohibiting excessive compensation paid to executives of depository institutions and their holding companies with assets in excess of $1 billion, regardless of whether the company is publicly traded or not. The Dodd-Frank Act gives the SEC authority to prohibit broker discretionary voting on elections of directors and executive compensation matters.

Transactions with Affiliates and Insiders. The Dodd-Frank Act applies Section 23A and Section 22(h) of the Federal Reserve Act (governing transactions with insiders) to derivative transactions, repurchase agreements and securities lending and borrowing transactions that create credit exposure to an affiliate or an insider. Any such transactions with affiliates must be fully secured. The current exemption from Section 23A for transactions with financial subsidiaries is eliminated. The Dodd-Frank Act additionally prohibits an insured depository institution from purchasing an asset from or selling an asset to an insider unless the transaction is on market terms and, if representing more than 10% of capital, is approved in advance by the disinterested directors.

Consumer Financial Protection Bureau. The Dodd-Frank Act creates a new, independent federal agency called the Consumer Financial Protection Bureau (“CFPB”), which is granted broad rulemaking, supervisory and enforcement powers under various federal consumer financial protection laws, including the ECOA, TILA, RESPA, FCRA, Fair Debt Collection Act, the Consumer Financial Privacy provisions of the Gramm-Leach Bliley Act ("GLBA") and certain other statutes. The CFPB has examination and primary enforcement authority with respect to depository institutions with $10 billion or more in assets. Smaller institutions will be subject to rules promulgated by the CFPB, but will continue to be examined and supervised by federal banking regulators for consumer compliance purposes. The CFPB has authority to prevent unfair, deceptive or abusive acts or practices in connection with the offering of consumer financial products. The

Dodd-Frank Act authorizes the CFPB to establish certain minimum standards for the origination of residential mortgages including a determination of the borrower’s ability to repay. In addition, the Dodd-Frank Act will allow borrowers to raise certain defenses to foreclosure if they receive any loan other than a “qualified mortgage” as defined by the CFPB. The Dodd-Frank Act permits states to adopt consumer protection laws and standards that are more stringent than those adopted at the federal level and, in certain circumstances, permits state attorneys general to enforce compliance with both the state and federal laws and regulations. Federal preemption of state consumer protection law requirements, traditionally an attribute of the federal savings association charter, has also been modified by the Dodd-Frank Act and now requires a case-by-case determination of preemption by the Office of the Comptroller of the Currency (“OCC”) and eliminates preemption for subsidiaries of a bank. Depending on the implementation of this revised federal preemption standard, the operations of the Bank could become subject to additional compliance burdens in the states in which it operates.

Deposit Insurance. The Dodd-Frank Act permanently increases the maximum deposit insurance amount for banks, savings institutions and credit unions to $250,000 per depositor, retroactive to January 1, 2009, and extended unlimited deposit insurance to non interest-bearing transaction accounts through December 1, 2012. The Dodd-Frank Act also broadens the base for FDIC insurance assessments. Assessments will now be based on the average consolidated total assets less tangible equity capital of a financial institution. As described above, the Dodd-Frank Act requires the FDIC to increase the reserve ratio of the Deposit Insurance Fund from 1.15% to 1.35% of insured deposits by 2020 and eliminates the requirement that the FDIC pay dividends to insured depository institutions when the reserve ratio exceeds certain thresholds. The Dodd-Frank Act also eliminates the federal statutory prohibition against the payment of interest on business checking accounts.

Capital. Under the Dodd-Frank Act, the proceeds of trust preferred securities are excluded from Tier 1 capital unless such securities were issued prior to May 19, 2010 by bank or savings and loan holding companies with less than $15 billion of assets. The legislation also establishes a floor for capital of insured depository institutions that cannot be lower than the standards in effect today, and directs the federal banking regulators to implement new leverage and capital requirements within 18 months that take into account off-balance sheet activities and other risks, including risks relating to securitized products and derivatives.

Uncertainty remains as to ultimate impact of the Dodd-Frank Act, but the Board and management anticipates that the provisions summarized above, as well as others set forth in the Dodd-Frank Act, could have an adverse impact on the financial services industry as a whole and our business, results of operations and financial condition.

Available Information

Our internet website address is http://www.ffsbky.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act are available or may be accessed free of charge through the Investor Relations section of our internet website as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission, or SEC.

ITEM 1A. RISK FACTORS

The risks identified below, as well as in the other cautionary statements made throughout this report, identify factors that could materially and adversely affect our business, financial condition, and/or operating results.

If we continue to incur significant losses, it may be difficult to continue to operate.

We recorded a net loss to common shareholders of $9.4 million in 2012, a net loss to common shareholders of $24.2 million in 2011 and a net loss to common shareholders of $10.5 million in 2010, for a three year total of $44.1 million. The net loss for 2012 was due in part to provision for loan losses of $6.8 million and write downs and losses on the sale of other real estate owned properties of $6.1 million. The net loss for 2011 was due in part to provision for loan losses of $21.2 million and write downs on other real estate owned properties of $9.3 million and the net loss for 2010 was due in part to a $4.8 million deferred tax valuation allowance.

During 2012, 2011 and 2010, we recorded total provisions for loan losses of $44.9 million and total write downs on other real estate owned of $16.7 million. While our losses also included a charge to establish an allowance against the realization of our deferred tax asset of $4.8 million, these latter charges were largely influenced by the losses on loans and other real estate owned.

We could be required to make additional provisions for loan losses and write downs on other real estate owned if asset values continue to decline in the current economic climate. This in turn may require the Corporation to raise additional capital to fund the Bank's operations so that the Bank can sustain such losses and attain compliance with the minimum capital levels set forth in the Consent Order. See Part I, Item 1 – Business – Regulatory Matters & Recent Developments, for a description of the Bank's capital requirements set forth in the Consent Order.

We are subject to a consent order with the FDIC and KDFI and a formal agreement with the Federal Reserve that restrict the conduct of our operations and may have a material adverse effect on our business. 

Our good standing with bank regulatory agencies is of fundamental importance to our business. The Bank has operated under the terms of a consent order imposed by the FDIC and KDFI since January 2011, which required the Bank to achieve a total capital to risk-weighted assets ratio of 12.00% and a Tier 1 capital to average total assets ratio of 9.00% initially by June 30, 2011, and to develop and implement actions to reduce the amount of classified assets and improve earnings.   The Bank’s total capital to risk-weighted assets ratio exceeded 12.00% at December 31, 2012, and its Tier 1 capital to average total assets ratio at that date was 6.53%.

In April 2011, the Corporation entered into a formal agreement with the Federal Reserve Bank of St. Louis, which requires the Corporation to obtain regulatory approval before declaring any dividends and to take steps to ensure the Bank complies with the Consent Order. We also may not redeem shares or obtain additional borrowings without prior approval of the Federal Reserve Bank.

Bank regulatory agencies can exercise discretion when an institution does not meet the terms of a regulatory order. The agencies may initiate changes in management, issue mandatory directives, impose monetary penalties or refrain from formal sanctions, depending on individual circumstances. Any material failures to comply with our regulatory orders would likely result in more stringent enforcement actions by the bank regulatory agencies, which could damage our reputation and have a material adverse effect on our business. Compliance with these bank regulatory orders will also increase our operating expense, which could adversely affect our financial performance.

Regulatory and contractual restrictions currently prevent us from paying cash dividends on our common and preferred stock and pay interest on the junior subordinated debentures that relate to our trust preferred securities. Our inability to pay dividends and distributions on these securities may adversely affect our common shareholders.

We historically paid quarterly cash dividends on our common stock until we suspended dividend payments in December 2009. During the fourth quarter of 2010, we suspended cash dividends on the preferred stock held by the U.S. Treasury and began deferring interest payments on the junior subordinated debentures relating to our trust preferred securities. Deferring these interest payments resulted in the deferral of distributions on our trust preferred securities. Dividends on the Treasury preferred stock and deferred distributions on our trust preferred securities are cumulative, and therefore unpaid dividends and distributions will accrue and compound on each subsequent payment date. We will not be able to pay cash dividends on our common stock in the future until we first pay all unpaid dividends on the Treasury preferred stock and all deferred distributions on our trust preferred securities.

If we miss six quarterly dividend payments on the Treasury preferred stock, whether or not consecutive, the Treasury Department will have the right to appoint two directors to our board of directors until all accrued but unpaid dividends have been paid. During 2012, a representative from the U.S. Treasury attended Board meetings. If we become subject to any liquidation, dissolution or winding up, holders of the trust preferred securities and holders of the preferred stock will be entitled to receive the liquidation amounts to which they are entitled, plus all accrued and unpaid distributions and dividends, before any distribution can be made to the holders of common stock.

We may not be able to sell stock to raise additional capital to meet the requirements of our consent order.

The Bank has agreed with the FDIC and the KDFI to develop a plan to increase its Tier 1 capital to average total assets to 9.00% and its total capital to risk-weighted asset ratio to 12.00%. We continue to evaluate several specific initiatives to increase our regulatory capital and to reduce our total assets, such as divesting of branch offices, selling loans and raising capital by selling stock.

Our ability to raise additional capital by selling stock will depend on, among other things, conditions in the capital markets at that time, which are outside of our control, and our financial performance. We may not have access to capital on acceptable terms or at all. If we are unable to raise capital through the sale of stock, we may not have the capital and financial resources needed to operate our business or to meet regulatory requirements, which could have a material adverse effect on our business, financial condition and results of operations.

Future sales of our common stock or other securities will dilute the ownership interests of our existing shareholders and could depress the market price of our common stock.

We are currently evaluating strategies to meet our capital needs and regulatory requirements including the issuance of additional common shares. We can issue common shares without shareholder approval, up to the number of authorized shares set forth in our articles of incorporation. Our Board of Directors may determine to seek additional capital through the issuance and sale of common shares, preferred shares or other securities convertible into or exercisable for our common shares, subject to limitations imposed by the NASDAQ Stock Market and the Federal Reserve. We may not be able to issue common shares at prices or on terms better than or equal to the prices and terms on which our current shareholders acquired their shares. Our future issuance of any additional common shares or other securities may have the effect of reducing the book value or market price of then-outstanding common shares. Our issuance of additional common or securities convertible into or exercisable for common shares will reduce the proportionate ownership and voting power of our existing shareholders.

In addition, if our shareholders sell a substantial number of our common shares or securities convertible into or exercisable for our common shares in the public market, or if there is a perception that such sales are likely to occur, it could cause the market price of our common shares to continue declining. We cannot predict the effect, if any, that either future sales of a substantial volume of our common shares in the market, or the potential for large volumes of sales in the market, would have on the market price of our common shares. However, if the market price of our common shares declines, it could impair our ability to raise capital through sales of stock.

Our business has been and may continue to be adversely affected by current conditions in the financial markets and by economic conditions generally.

Although the economic slowdown that the United States has experienced since 2008 has begun to reverse and the markets have generally improved, businesses across a wide range of industries continue to face serious difficulties due to the lack of consumer spending and the lack of liquidity in the global credit markets. Ongoing weakness in business and economic conditions generally or specifically in our markets has had, and could continue to have one or more of the following adverse effects on our business:

The general business environment has had an adverse effect on our business during the past four years. Although the general business environment has shown some improvement, there can be no assurance that such improvement can be sustained. In addition, the improvement of certain economic indicators, such as real estate asset values and rents and unemployment, may vary between geographic markets and may continue to lag behind improvement in the overall economy. These economic indicators typically affect the real estate and financial services industries, in which we have a significant number of customers, more significantly than other economic sectors. Furthermore, we have a substantial lending business that depends upon the ability of borrowers to make debt service payments on loans. Should unemployment or real estate asset values fail to recover for an extended period of time, or if economic conditions worsen or remain volatile, our business, financial condition or results of operations could be adversely affected.

Our designation as a “troubled institution” limits our sources of funding. If we cannot borrow funds through access to the capital markets, we may not be able to meet the cash flow requirements of our depositors and borrowers.

Liquidity is the ability to meet cash flow needs on a timely basis at a reasonable cost. If our liquidity policies and strategies don’t work as well as intended, then we may be unable to make loans and to repay deposit liabilities as they become due or are demanded by customers. Our Asset Liability Committee follows established board-approved policies and monitors guidelines to diversify our wholesale funding sources to avoid concentrations in any one-market source. Wholesale funding sources include Federal funds purchased, securities sold under repurchase agreements, non-core brokered deposits, and medium and long-term debt, which includes Federal Home Loan Bank advances that are collateralized with mortgage-related assets.

As long as the Consent Order remains in effect, the Bank will not be able to rely on brokered deposits (including deposits through the CDARs program) for its liquidity needs. The designation of the Bank as a "troubled institution" in connection with the issuance of the Consent Order prohibits the Bank from accepting new brokered deposits or renewing or rolling over any existing brokered deposits at the Bank. The Bank is also restricted in the amount of interest it may pay on core deposits. See Part I, Item I –Business – Regulation – Regulatory Capital Requirements for a description of the Bank's interest rate restrictions. The Bank's designation as a "troubled institution" may also limit the amount of additional advances available from the FHLB. The Bank currently has sufficient collateral to borrow, approximately, an additional $6.7 million in advances from the FHLB.

We maintain a portfolio of securities that can be used as a secondary source of liquidity. There are other available sources of liquidity, including the sale or securitization of loans, the ability to acquire additional collateralized borrowings such as FHLB advances, the issuance of debt securities, and the issuance of preferred or common securities in public or private transactions. If we were unable to access any of these funding sources when needed, we might not be able to meet the needs of our customers, which could adversely impact our financial condition, our results of operations, cash flows, and our level of regulatory-qualifying capital. For further discussion, see the “Liquidity” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations.

We may not be able to meet the cash flow requirements and operating cash needs of the Corporation due to restrictions on the Bank’s ability to pay dividends.

The Corporation is a separate and distinct legal entity from the Bank. Historically, the Corporation has received substantially all of its revenue in the form of dividends from the Bank. Due to the losses we have incurred in recent years, the Bank is not allowed to pay any dividends to the Corporation without prior regulatory approval. At December 31, 2012 the Corporation’s liquid assets consisted of $333,000 in cash. With no sources of revenue other than dividends paid by the Bank, the Corporation will be constrained to meet to meet its cash flow requirements and operating cash needs.

Our decisions regarding credit risk may not be accurate, and our allowance for loan losses may not be sufficient to cover actual losses, which could adversely affect our business, financial condition and results of operations.

We maintain an allowance for loan losses at a level we believe is adequate to absorb any probable incurred losses in our loan portfolio based on historical loan loss experience, specific problem loans, value of underlying collateral and other relevant factors. If our assessment of these factors is ultimately inaccurate, the allowance may not be sufficient to cover actual loan losses, which would require us to increase our provision for loan losses and adversely affect our operating results. Our estimates are subjective and their accuracy depends on the outcome of future events. Changes in economic, operating and other conditions that are generally beyond our control could cause the financial condition of our borrowers to deteriorate and our actual loan losses to increase significantly. In addition, bank regulatory agencies, as an integral part of their supervisory functions, periodically review the adequacy of our allowance for loan losses. Regulatory agencies have from time to time required us to increase our provision for loan losses or to recognize further loan charge-offs when their judgment has differed from ours, and they may do so in the future, which could have a material negative impact on our operating results.

Our relatively high concentration of loans collateralized by real estate increases our risk if real estate values decline.

Approximately 91% of our loan portfolio as of December 31, 2012 was comprised of loans collateralized by real estate. An adverse change in the economy such as we have recently experienced which depresses values of real estate in our primary markets could significantly impair the value of our collateral and our ability to sell the collateral upon foreclosure. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. When real estate values decline, it becomes more likely that we would be required to increase our allowance for loan losses as we did in 2011 and 2010. If during a period of depressed real estate values we are required to liquidate the collateral securing a loan to satisfy the debt or to increase our allowance for loan losses, it could materially reduce our profitability and adversely affect our financial condition.

Our profitability depends significantly on local economic conditions.

Because most of our business activities are conducted in central Kentucky, and most of our credit exposure is in that region, we are at risk from adverse economic or business developments affecting this area, including declining regional and local business activity, a downturn in real estate values and agricultural activities and natural disasters. To the extent the central Kentucky economy remains weak, the rates of delinquencies, foreclosures, bankruptcies and losses in our loan portfolio will likely increase. Moreover, the value of real estate or other collateral that secures our loans could be adversely affected by the economic downturn or a localized natural disaster. The economic downturn has had a negative impact on our financial results and may continue to have a negative impact on our business, financial condition, results of operations and future prospects.

Our target market is small to medium-sized businesses, who may have fewer resources to weather a downturn in the economy.

Our strategy includes lending to small and medium-sized businesses and other commercial enterprises. Small and medium-sized businesses frequently have smaller market shares than their competitors, may be more vulnerable to economic downturns, often need substantial additional capital to expand or compete and may experience substantial variations in operating results, any of which may impair a borrower’s ability to repay a loan. In addition, the success of a small and medium-sized business often depends on the management talents and efforts of one person or a small group, and the death, disability or resignation of one or more key individuals could have a material adverse impact on the business and its ability to repay our loan. A continued economic downturn could have a more pronounced negative impact on our target market, which could cause us to incur substantial credit losses that could materially harm our operating results.

Our profitability is vulnerable to fluctuations in interest rates.

Changes in interest rates could harm our financial condition or results of operations. Our results of operations depend substantially on net interest income, the difference between interest earned on interest-earning assets (such as investments and loans) and interest paid on interest-bearing liabilities (such as deposits and borrowings). Interest rates are highly sensitive to many factors, including governmental monetary policies and domestic and international economic and political conditions. Factors beyond our control, such as inflation, recession, unemployment, and money supply may also affect interest rates. If as a result of decreasing interest rates, our interest-earning assets mature or re-price more quickly than our interest-bearing liabilities in a given period, then our net interest income may decrease. Likewise, our net interest income may decrease if interest-bearing liabilities mature or re-price more quickly than interest-earning assets in a given period as a result of increasing interest rates.

Fixed-rate loans increase our exposure to interest rate risk in a rising rate environment because interest-bearing liabilities would be subject to re-pricing before assets become subject to re-pricing. Adjustable-rate loans decrease the risk associated with changes in interest rates but involve other risks, such as the inability of borrowers to make higher payments in an increasing interest rate environment. At the same time, for secured loans, the marketability of the underlying collateral may be adversely affected by higher interest rates.

The economic downturn that began in 2008 triggered a series of cuts in interest rates. Since fiscal 2010, the Federal Open Market Committee has kept the target federal funds rate between 0% and 0.25%. The current low interest rate environment has compressed our net interest spread and reduced our spread-based revenues. In addition, there may be an increase in prepayments on loans, particularly if the borrowers refinance their adjustable-rate loans to lower fixed rate loans, which could reduce net interest income and adversely affect our financial results.

We face strong competition from other financial institutions and financial service companies, which could adversely affect our results of operations and financial condition.

We compete with other financial institutions in attracting deposits and making loans. Our competition in attracting deposits comes principally from commercial banks, credit unions, savings and loan associations, securities brokerage firms, insurance companies, money market funds and other mutual funds. Our competition in making loans comes principally from other commercial banks, credit unions, mortgage banking firms and consumer finance companies. Competition is increasing in our markets, which may adversely affect our ability to maintain our market share.

Competition in the banking industry may also limit our ability to attract and retain banking customers. We maintain smaller staffs of associates and have fewer financial and other resources than larger institutions with which we compete. Financial institutions that have far greater resources and greater efficiencies than we do may have several marketplace advantages resulting from their ability to:

In addition, banks and other financial institutions with larger capitalization and other financial intermediaries may not be subject to the same regulatory restrictions as we are and may have larger lending limits than we do. Some of our current commercial banking customers may seek alternative banking sources as they develop needs for credit facilities larger than we can accommodate. If we are unable to attract and retain customers, we may not be able to maintain growth and our results of operations and financial condition may otherwise be negatively impacted.

We operate in a highly regulated environment and, as a result, are subject to extensive regulation and supervision that could adversely affect our financial performance and our ability to implement our growth and operating strategies.

We are subject to examination, supervision and comprehensive regulation by federal and state regulatory agencies, which is described under “Item 1 Business – Regulation.” Regulatory oversight of banks is primarily intended to protect depositors, the federal deposit insurance funds, and the banking system as a whole, not our shareholders. Compliance with these regulations is costly and may make it more difficult to operate profitably. Federal and state banking laws and regulations govern numerous matters including the payment of dividends, the acquisition of other banks and the establishment of new banking offices. We must also meet specific regulatory capital requirements. Our failure to comply with these laws, regulations and policies or to maintain our capital requirements affects our ability to pay dividends on common stock, our ability to grow through the development of new offices and our ability to make acquisitions. We currently may not pay a dividend from the Bank to the Corporation without the prior written consent of our primary banking regulators, which limits our ability to pay dividends on our common stock. These limitations may also prevent us from successfully implementing our growth and operating strategies.

In addition, the laws and regulations applicable to banks could change at any time, which could significantly impact our business and profitability. For example, new legislation or regulation could limit the manner in which we may conduct our business, including our ability to attract deposits and make loans. Events that may not have a direct impact on us, such as the bankruptcy or insolvency of a prominent U.S. corporation, can cause legislators and banking regulators and other agencies such as the Financial Accounting Standards Board, the SEC, the Public Company Accounting Oversight Board, the Consumer Financial Protection Bureau and various taxing authorities to respond by adopting and or proposing substantive revisions to laws, regulations, rules, standards, policies, and interpretations. The nature, extent, and timing of the adoption of significant new laws and regulations, or changes in or repeal of existing laws and regulations may have a material impact on our business and results of operations. Changes in regulation may cause us to devote substantial additional financial resources and management time to compliance, which may negatively affect our operating results.

Recent legislation regarding the financial services industry may increase our cost of regulatory compliance and have a significant adverse effect on our operations.

The Dodd-Frank Act will implement significant changes to the U.S. financial system, including among other things:

Many provisions in the Dodd-Frank Act remain subject to regulatory rule-making and implementation, the effects of which are not yet known. As a result, it is difficult to gauge the ultimate impact of certain provisions of the Dodd-Frank Act because the implementation of many concepts is left to regulatory agencies. For example, the CFPB is given the power to adopt new regulations to protect consumers and is given control over existing consumer protection regulations adopted by federal banking regulators.

The provisions of the Dodd-Frank Act and any rules adopted to implement those provisions as well as any additional legislative or regulatory changes may impact the profitability of our business activities and costs of operations, require that we change certain of our business practices, materially affect our business model or affect retention of key personnel, require us to raise additional regulatory capital, including additional Tier 1 capital, and could expose us to additional costs (including increased compliance costs). These and other changes may also require us to invest significant management attention and resources to make any necessary changes and may adversely affect our ability to conduct our business as previously conducted or our results of operations or financial condition.

If we cannot redeem the preferred stock we sold to the U.S. Treasury by January 9, 2014, the dividends accruing on those shares will increase significantly.

On January 9, 2009, we sold to the U.S. Treasury $20 million of senior preferred stock and issued a warrant to purchase approximately 216,000 shares of our common stock at $13.89 per share. Unless we redeem the preferred stock by January 9, 2014, the dividends accruing on the senior preferred stock will increase substantially on that date from 5% (approximately $1 million annually) to 9% (approximately $1.8 million annually). Depending on market conditions and our financial performance at the time, this increase in dividends could significantly impact our capital, liquidity and earnings available to common shareholders.

The terms of the senior preferred stock purchased by the U.S. Treasury also limit our ability to pay dividends and repurchase our shares. Most significantly, we will not be able to pay dividends on our common stock until such time as we can pay all accrued and unpaid dividends on the senior preferred stock, which payments we have deferred since the fourth quarter of 2010. These restrictions may have an adverse effect on the market price of our common stock and our ability to raise capital through the sale of capital stock in the future.

The U.S. Treasury has the unilateral ability to change some of the restrictions imposed on us by virtue of our sale of securities to it.

Our agreement with the U.S. Treasury under which it purchased our senior preferred stock imposes restrictions on our conduct of our business, including restrictions related to our payment of dividends, repurchases of our stock and our executive compensation and corporate governance. The U.S. Treasury has the right under this agreement to unilaterally amend it to the extent required to comply with any future changes in federal statutes. The American Recovery and Reinvestment Act of 2009 amended provisions relating to executive compensation and corporate governance as they affect companies that have sold senior preferred stock to the U.S. Treasury. These amendments could have an adverse impact on the conduct of our business, as could additional amendments in the future that impose further requirements or amend existing requirements.

Our information systems may experience an interruption or security breach.

Failure in or breach of our operational or security systems or infrastructure, or those of our third party vendors and other service providers, including as a result of cyber attacks, could disrupt our businesses, result in the disclosure or misuse of confidential or proprietary information, damage our reputation, increase our costs and cause losses. As a large financial institution, we depend on our ability to process, record and monitor a large number of customer transactions on a continuous basis. As customer, public and regulatory expectations regarding operational and information security have increased, our operational systems and infrastructure must continue to be safeguarded and monitored for potential failures, disruptions and breakdowns. Our business, financial, accounting, data processing systems or other operating systems and facilities may stop operating properly or become disabled or damaged as a result of a number of factors including events that are wholly or partially beyond our control. For example, there could be sudden increases in customer transaction volume; electrical or telecommunications outages; natural disasters such as earthquakes, tornadoes, and hurricanes; disease pandemics; events arising from local or larger scale political or social matters, including terrorist acts; and, as described below, cyber attacks. Although we have business continuity plans and other safeguards in place, our business operations may be adversely affected by significant and widespread disruption to our physical infrastructure or operating systems that support our businesses and customers.

Information security risks for financial institutions have generally increased in recent years in part because of the proliferation of new technologies, the use of the Internet and telecommunications technologies to conduct financial transactions, and the increased sophistication and activities of organized crime, hackers, terrorists, activists, and other external parties. As noted above, our operations rely on the secure processing, transmission and storage of confidential information in our computer systems and networks. In addition, to access our products and services, our customers may use personal smart phones, tablet PC’s, and other mobile devices that are beyond our control systems. Although we believe we have robust information security procedures and controls, our technologies, systems, networks, and our customers’ devices may become the target of cyber attacks or information security breaches that could result in the unauthorized release, gathering, monitoring, misuse, loss or destruction of our customers’ confidential, proprietary and other information or that of our customers, or otherwise disrupt the business operations of ourselves, our customers or other third parties.

Third parties with which we do business or that facilitate our business activities, could also be sources of operational and information security risk to us, including from breakdowns or failures of their own systems or capacity constraints. Although to date we have not experienced any material losses relating to cyber attacks or other information security breaches, there can be no assurance that we will not suffer such losses in the future. Our risk and exposure to these matters remains heightened because of, among other things, the evolving nature of these threats and the prevalence of Internet and mobile banking. As cyber threats continue to evolve, we may be required to expend significant additional resources to continue to modify or enhance our protective measures or to investigate and remediate any information security vulnerabilities. Disruptions or failures in the physical infrastructure or operating systems that support our businesses and customers, or cyber attacks or security breaches of the networks, systems or devices that our customers use to access our products and services could result in customer attrition, regulatory fines, penalties or intervention, reputational damage, reimbursement or other compensation costs, and/or additional compliance costs, any of which could materially adversely affect our business, results of operations or financial condition.

We have had difficulty maintaining effective internal controls over loan review.

As of December 31, 2011, management determined that our controls regarding the review of our loan portfolio and evaluation of the allowance for loan losses were not operating effectively. Specifically, procedures for the review over internal evaluations for impaired loans, mathematical accuracy of impaired loan calculations, and present value cash flow analysis performed on troubled debt restructuring calculations were found to not be operating appropriately. To remediate this material weakness, management enhanced its loan review procedures during the first quarter of 2012 to include an independent review performed and documented by the Chief Credit Officer on all internal evaluations and an independent review performed and documented by the finance department to validate the accuracy of the calculation on all impaired loans and all present value cash flow calculations performed on loans classified as troubled debt restructurings. Although the Company has determined as of December 31, 2012 that this weakness has been remediated, it is possible that we could have additional internal control weakness in this area in future periods.

While management continually monitors and improves our system of internal controls, data processing systems, and corporate wide processes and procedures, there can be no assurance that we will not suffer losses from operational risk in the future.

Management maintains internal operational controls and we have invested in technology to help us process large volumes of transactions. However, there can be no assurance that we will be able to continue processing at the same or higher levels of transactions. If our systems of internal controls should fail to work as expected, if our systems were to be used in an unauthorized manner, or if employees were to subvert the system of internal controls, significant losses could occur.

We process large volumes of transactions on a daily basis and are exposed to numerous types of operation risk, which could cause us to incur substantial losses. Operational risk resulting from inadequate or failed internal processes, people, and systems includes the risk of fraud by employees or persons outside of our company, the execution of unauthorized transactions by employees, errors relating to transaction processing and systems, and breaches of the internal control system and compliance requirements. This risk of loss also includes potential legal actions that could arise as a result of the operational deficiency or as a result of noncompliance with applicable regulatory standards.

We establish and maintain systems of internal operational controls that provide management with timely and accurate information about our level of operational risk. While not foolproof, these systems have been designed to manage operational risk at appropriate, cost effective levels. We have also established procedures that are designed to ensure that policies relating to conduct, ethics, and business practices are followed. Nevertheless, we experience loss from operational risk from time to time, including the effects of operational errors, and these losses may be substantial.

We have no unresolved SEC staff comments.

Our executive offices and principal support are located at 2323 Ring Road in Elizabethtown, Kentucky. Our operational functions are located at 2323 Ring Road and 101 Financial Place in Elizabethtown, Kentucky. All of our banking centers are located in Kentucky. The location of our 17 full-service banking centers and an operations building, whether owned or leased, and their respective approximate square footage are described in the following table.

On June 21, 2012, a lawsuit was filed against the Bank in Jefferson County, Kentucky circuit court. River Glen KHLB, LLC and Keith T. Eberenz vs. First Federal Savings Bank of Elizabethtown, Civil Action No. 12CI03473. The plaintiffs allege fraud, negligent misrepresentation, failure to fund various loans, breach of fiduciary duty and breach of the duty of good faith and fair dealing. Plaintiffs seek compensatory and punitive damages, pre-judgment interest, costs including reasonable attorneys’ fees, and equitable relief.  The Bank filed its answer on June 29, 2012 denying the allegations and seeking judgment for the balances due on promissory notes, enforcement of a guaranty contract and an assignment of rents, foreclosure, and the appointment of a receiver. On July 16, 2012, the court appointed an independent manager to preserve and manage the property, collect rents, pay operating expenses, property taxes, insurance premiums and utilities, and pay the monthly loan payment into an escrow fund. Discovery in this matter is ongoing. We intend to vigorously defend the allegations against the Bank and pursue its claims. Management continues to closely monitor this case, but is unable to estimate, at this time, the possible loss or range of possible loss, if any, that may result from this lawsuit.

On February 11, 2013, seven plaintiffs filed a lawsuit in federal district court in Louisville, Kentucky against the Bank and two co-defendants. William P. Miller, et al. v. First Federal Savings Bank of Elizabethtown, Inc., et. al., No. 3:13-cv-206 M (W.D. Ky.). Plaintiffs allege they invested in two companies organized by one of the co-defendants, which companies purchased commercial property in Addison, Illinois. Plaintiffs also guaranteed loans made by the Bank to the two companies in the principal amount of $3,125,622.74. Plaintiffs allege that the Bank and the co-defendants engaged in a pattern of fraudulent acts, including violations of federal mail fraud, wire fraud, financial institution fraud and conspiracy statutes, which induced plaintiffs to enter into the guaranty agreement with the Bank. Plaintiffs also allege intentional misrepresentation, negligence, and civil conspiracy against all of the co-defendants. Plaintiffs seek compensatory and punitive damages, as well as treble damages under federal racketeering statutes and court costs and legal fees. The Bank has filed its answer in this matter. In addition, two days after plaintiffs filed their complaint, the Bank filed a foreclosure action in Illinois state court related to the commercial property underlying the Kentucky proceedings. First Federal Savings Bank v. Addent, LLC, et. al., No. 2013-CH-000570 (Illinois Circuit Court, DuPage County). We intend to vigorously defend the allegations against the Bank and pursue the foreclosure action on the underlying property.

Not applicable.

PART II

Our common stock is traded on the Nasdaq Global Market (“NASDAQ”) under the symbol “FFKY”. The following table shows the high and low closing prices of our Common Stock and the dividends paid.

At December 31, 2012, the number of shareholders was approximately 1,419.

Historically, the Corporation has depended upon dividends it received from the Bank to pay cash dividends to its shareholders. Currently, the Bank cannot pay such dividends without prior approval of the FDIC and KDFI. For additional discussion regarding dividends, see Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity.”

The following table summarizes the securities authorized for issuance under our equity compensation plans as of December 31, 2012. We have no equity compensation plans that have not been approved by our shareholders.

See Note 16 of the Notes to Consolidated Financial Statements for additional information required by this item.

We did not repurchase any shares of our common stock during the quarter ended December 31, 2012.

The graph below compares the cumulative total return on the common stock of the Corporation between December 31, 2007 through December 31, 2012 with the cumulative total return of the NASDAQ Composite Index and a peer group index over the same period. Dividend reinvestment has been assumed. The graph was prepared assuming that $100 was invested on December 31, 2007 in the common stock of the Corporation and in the indexes. The stock price performance shown on the graph below is not necessarily indicative of future stock performance.

*FFKY Peer Group index consists of BB&T Corp. (BBT), Fifth Third Bancorp (FITB), First Horizon National Corp. (FHN), Huntington BancsharesInc. (HBAN), KeyCorp (KEY), M&T Bank Corp. (MTB), PNC Financial Services Group (PNC), RegionsFinancial Corp. (RF), SunTrust Banks Inc. (STI), Synovus Financial Corp. (SNV), Zions Bancorp.  (ZION)

ITEM 6.    SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA

ITEM  7.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Management’s Discussion and Analysis of Financial Condition and Results of Operations analyzes the major elements of our balance sheets and statements of operations. This section should be read in conjunction with our Consolidated Financial Statements and accompanying Notes and other detailed information.

OVERVIEW

From 2008 to 2011, economic conditions deteriorated in the markets we serve, which has had a significant adverse impact on our business. As a result, our earnings declined due to higher levels of non-performing assets and loan losses, impairment charges on goodwill and real estate we acquired through foreclosure, and a charge to establish a valuation allowance against our deferred tax asset. As economic conditions improved and collateral values stabilized in 2012, our provision for loan losses for the year was much lower than in 2011. However, the effects of the economic downturn continue to impact us due to elevated non-performing assets and reduced net interest income in a continuing low interest rate environment. Low interest rates, coupled with a competitive lending environment, have proven challenging to our efforts to return to profitability. We expect that these challenges will continue until interest rates rise.

Net loss attributable to common shareholders for the period ended December 31, 2012 was $9.4 million or $1.98 per diluted common share compared to net loss attributable to common shareholders of $24.2 million or $5.11 per diluted common share for the same period in 2011. Factors contributing to the net loss for 2012 included the following:

While still elevated, our level of non-performing assets is now the lowest it has been since the second quarter of 2010. Compared to December 31, 2011, we saw a decline in non-performing loans of 46%, a decline in non-performing assets of 36% and a decline in classified and criticized assets of 33%. Compared to September 30, 2012, we saw a decline in non-performing loans of 32%, a decline in non-performing assets of 28% and a decline in classified and criticized assets of 17%. We sold fifty-two OREO properties totaling $16.0 million during the 2012 period. The net proceeds received from the sale of several of these properties exceeded the carrying value on our books, indicating they were appropriately valued.

Our non-performing assets are largely comprised of residential housing development assets, building lots, an office building and strip centers, most of which are located in Jefferson and Oldham Counties. Non-performing assets were $43.8 million or 4.35% of total assets at December 31, 2012 compared to $68.9 million or 5.61% of total assets at December 31, 2011. The decrease in non-performing assets is mainly attributable to a $10.0 million decrease in non-accrual loans, an $8.3 million decrease in restructured non-accruing mortgage, commercial and commercial real estate loans, and a $6.8 million decrease in real estate acquired through foreclosure.

We believe that our level of real estate acquired through foreclosure has stabilized. We anticipate it will decrease over the next several quarters as we continue to sell these properties, while inflow has slowed down substantially compared to 2010 and 2011. During 2011, we had substantially all of our non-performing assets appraised or reappraised, including our high end residential development loans and related OREO, and recorded substantial valuation adjustments and charge offs based on those appraisals. The lower values on the appraisals and reviews of properties appraised within 2012 resulted in $5.1 million in write downs on OREO, including the $1.2 million bulk sale adjustment discussed below, compared to $9.3 million in total write downs recorded during 2011. We believe that we have written down OREO values to levels that will facilitate their liquidation, as indicated by recent sales. We also believe we have appropriately addressed and risk-weighted real estate loans in our portfolio.

We have entered into a bulk sale contract to sell fourteen OREO properties with a carrying value of $12.0 million scheduled to close during the second quarter of 2013.  The net proceeds after sales expenses will be $10.8 million, resulting in a $1.2 million charge against these properties of which $1.1 million was recorded in the quarter ended June 30, 2012.  We incurred higher than usual commission and closing costs due to the size of the transaction.  If sold on a property-by-property basis, it is unlikely that we would have accepted a discount this large. However, the proposed bulk sale presented an opportunity to reduce our OREO balance by 53% from $22.3 million recorded as of December 31, 2012. As with all sales contracts, completing the sale is subject to both parties meeting all of the contractual terms and conditions, and if closing conditions are not satisfied, the proposed sale could be terminated.

The allowance for loan losses to total loans was 3.29% at December 31, 2012 while net charge-offs totaled 1.06% of average loans for 2012 compared to 3.25% for 2011. We attribute the decrease in net charge-offs for 2012 to our aggressive approach of charging off loans to their liquidation value in 2011 and the relative stabilization of collateral values in 2012 compared to 2011. Non-performing loans were $21.5 million or 4.09% of total loans at December 31, 2012 compared to $39.8 million, or 5.39% of total loans for December 31, 2011. The allowance for loan losses to non-performing loans was 80% at December 31, 2012 compared to 44% at December 31, 2011. The increase in the coverage ratio for 2012 was due to a decrease in non-accrual loans and restructured loans on non-accrual for the period.

Net interest income was $26.4 million for the 2012 period compared to $32.8 million for the 2011 period, while the net interest margin was 2.55% for 2012 compared to 2.85% in 2011. The net interest margin continues to be compressed due to the level of non-performing assets, a decline in average loan balances outstanding and assets being placed into lower yielding investments other than loans. We anticipate modest improvement to the net interest margin over the next several quarters, as we focus on restructuring the balance sheet to decrease our cost of funds and improve interest income. However, liquidity may be impacted by the acceleration of loan repayments. To be more proactive, we have hired an investment manager to assist us in our efforts to restructure the balance sheet.

Non-interest income increased $10.5 million for 2012, primarily driven by net gains on the sale of investments, a gain on the sale of our four Indiana branches, a decline in write-downs on OREO properties and an increase in gains on the sale of OREO properties. Non-interest expense increased $698,000 for 2012 compared to 2011. The increase in real estate acquired through foreclosure expense was primarily due to a $1.5 million fee paid to terminate a property investment and management agreement on a residential development held in OREO. We also prepaid two convertible fixed rate advances during the third quarter of 2012 to decrease our cost of funds and improve net interest income, which required payment of $1.5 million in penalties to the FHLB. The increase in other expense for the 2012 period also relates to increases in legal and consulting fees arising from the branch sale completed during the third quarter of 2012. FDIC insurance premiums decreased $991,000 mainly due to the change in the FDIC’s assessment base and rate structure that went into effect during the second quarter of 2011.

In its 2012 Consent Order, the Bank agreed to achieve and maintain a Tier 1 capital ratio of 9.0% and a total risk-based capital ratio of 12.0% by June 30, 2012. The Bank also agreed that if it should be unable to reach the required capital levels by that date, and if directed in writing by the FDIC, then the Bank would within 30 days develop, adopt and implement a written plan to sell or merge itself into another federally insured financial institution. To date the Bank has not received such a written direction. The 2012 Consent Order includes the substantive provisions of the 2011 Consent Order and requires the Bank to continue to adhere to the plans implemented in response to the 2011 Consent Order. A copy of the March 9, 2012 Consent Order is included as Exhibit 10.8 to our 2011 Annual Report on Form 10-K filed March 30, 2012.

The 2012 Consent Order requires us to obtain the consent of the FDIC and the KDFI in order for the Bank to pay cash dividends to the Corporation. In addition, the “troubled institution” designation resulting from the Consent Order does not allow the Bank to accept, renew or rollover brokered deposits, restricts the amount of interest the Bank may pay on deposits, and increases its deposit insurance assessment.

At December 31, 2012, the Bank’s Tier 1 capital ratio was 6.53% and the total risk-based capital ratio was 12.21%. We notified the bank regulatory agencies that one of the two capital ratios would not be achieved and are continuing our efforts to meet and maintain the required regulatory capital levels and all of the other consent order issues for the Bank.

On April 20, 2011, the Corporation entered into a formal agreement with the Federal Reserve Bank of St. Louis, which requires the Corporation to obtain regulatory approval before declaring any dividends and to take steps to ensure the Bank complies with the Consent Order. We also may not redeem shares or obtain additional borrowings without prior approval.

Bank regulatory agencies can exercise discretion when an institution does not meet the terms of a consent order. The agencies may initiate changes in management, issue mandatory directives, impose monetary penalties or refrain from formal sanctions, depending on individual circumstances. Any action taken by bank regulatory agencies could damage our reputation and have a material adverse effect on our business.

In response to the 2011 Consent Order, we engaged an investment banking firm with expertise in the financial services sector to assist with a review of all of our strategic alternatives as we work to achieve the higher regulatory capital ratios. One of these alternatives was to sell branches located outside of our core market. On July 6, 2012, we sold our four banking centers in Southern Indiana, receiving a 3.65% premium on the $102.3 million of consumer and commercial deposits at closing. The buyer assumed a total of approximately $115.4 million in non-brokered deposits, which included $13.1 million of government, corporate, other financial institution and municipal deposits for which we received no premium or discount. We also sold approximately $30.4 million in performing loans at a discount of 0.80%. Other assets sold included vault cash of $367,000 and fixed assets of $887,000. The consummated transaction resulted in a gain of $3.1 million.

In addition to the sale of our Indiana branches, we also sold commercial real estate loans totaling $10.7 million at par during 2012.

On May 15, 2012, we entered into an agreement to sell our four banking centers in Louisville, Kentucky. The sale was subject to the buyer raising additional capital, regulatory approval and other customary closing conditions. On November 14, 2012, the buyer terminated the agreement due to its inability to raise sufficient capital to obtain governmental approval of the sale.

We continue to reduce non-interest costs where possible to offset the increased credit costs associated with OREO and non-performing loans, while maintaining the resources needed to execute our strategies. We have implemented various cost savings initiatives, including suspending the annual employee stock ownership contribution, freezing most executive management compensation for three years through 2012, freezing most officer compensation for the past year, eliminating cash compensation for the board of directors, reducing marketing and community donation expense, and reducing personnel. Expense reductions totaled $1.1 million for 2011 and $1.3 million for 2012. We are currently evaluating the remaining terms on existing contracts in an effort to identify expenses that can be eliminated in the near future. Our cost savings efforts will remain ongoing.

Our plans for 2013 include the following:

While our concerns about economic conditions in our market continue, we are working towards our long-range financial objectives, including building additional core customer relationships, maintaining sufficient liquidity and capital levels, improving shareholder value, remediating our problem assets and building upon the sustained success of our retail franchise.

CRITICAL ACCOUNTING POLICIES

Our accounting and reporting policies comply with U.S. generally accepted accounting principles and conform to general practices within the banking industry. The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires us to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements. Accordingly, as this information changes, the financial statements could change as our estimates, assumptions, and judgments change. Certain policies inherently rely more heavily on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. We consider our critical accounting policies to include the following:

Allowance for Loan Losses – We maintain an allowance we believe to be sufficient to absorb probable incurred credit losses existing in the loan portfolio. Our Allowance for Loan Loss Review Committee, which is comprised of senior officers and certain accounting associates, evaluates the allowance for loan losses on a monthly basis.  We estimate the amount of the allowance using past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of the underlying collateral, and current economic conditions.  While we estimate the allowance for loan losses based in part on historical losses within each loan category, estimates for losses within the commercial real estate portfolio depend more on credit analysis and recent payment performance. Allocations of the allowance may be made for specific loans or loan categories, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. 

The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired. The general component covers non-impaired loans and is based on historical loss experience for certain categories adjusted for current factors. Allowance estimates are developed with actual loss experience adjusted for current economic conditions. Allowance estimates are considered a prudent measurement of the risk in the loan portfolio and are applied to individual loans based on loan type.

Based on our calculation, an allowance of $17.3 million or 3.29% of total loans was our estimate of probable incurred losses within the loan portfolio as of December 31, 2012.  This estimate required us to record a provision for loan losses on the income statement of $6.8 million for the 2012 period.  If the mix and amount of future charge off percentages differ significantly from those assumptions used by management in making its determination, the allowance for loan losses and provision for loan losses on the income statement could materially increase.

Impairment of Investment Securities – We review all unrealized losses on our investment securities to determine whether the losses are other-than-temporary. We evaluate our investment securities on at least a quarterly basis, and more frequently when economic or market conditions warrant, to determine whether a decline in their value below amortized cost is other-than-temporary. We evaluate a number of factors including, but not limited to: valuation estimates provided by investment brokers; how much fair value has declined below amortized cost; how long the decline in fair value has existed; the financial condition of the issuer; significant rating agency changes on the issuer; and management’s assessment that we do not intend to sell or will not be required to sell the security for a period of time sufficient to allow for any anticipated recovery in fair value.

The term “other-than-temporary” is not intended to indicate that the decline is permanent, but indicates that the possibility for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support a realizable value equal to or greater than the carrying value of the investment. Once a decline in value is determined to be other-than-temporary, the cost basis of the security is written down to fair value and a charge to earnings is recognized for the credit component and the non-credit component is recorded to other comprehensive income.

Real Estate Owned – The estimation of fair value is significant to real estate owned-acquired through foreclosure. These assets are recorded at fair value less estimated selling costs at the date of foreclosure. Fair value is based on the appraised market value of the property based on sales of similar assets when available. The fair value may be subsequently reduced if the estimated fair value declines below the original appraised value. Appraisals are performed at least annually, if not more frequently. Typically, appraised values are discounted for the projected sale below appraised value in addition to the selling cost. With certain appraised values where management believes a solid liquidation value has been established, the appraisal has been discounted only by the selling cost. We have dedicated a team of associates and management to the resolution and work out of OREO due to it having become a larger portion of our assets and a larger area of our risk. Appropriate policies, committees and procedures have been put in place to ensure the proper accounting treatment and risk management of this area.

Income Taxes – The provision for income taxes is based on income/(loss) as reported in the financial statements. Deferred income tax assets and liabilities are computed for differences between the financial statement and tax basis of assets and liabilities that will result in taxable or deductible amounts in the future. The deferred tax assets and liabilities are computed based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. An assessment is made as to whether it is more likely than not that deferred tax assets will be realized. A valuation allowance is established when necessary to reduce deferred tax assets to an amount expected to be realized. Income tax expense is the tax payable or refundable for the period plus or minus the change during the period in deferred tax assets and liabilities. Tax credits are recorded as a reduction to the tax provision in the period for which the credits may be utilized.

In assessing the need for a valuation allowance, we considered various factors including our four year cumulative loss position, the level of our non-performing assets, our inability to meet our forecasted levels in 2012 and 2011 and our non-compliance with the capital requirements of our Consent Order. These factors represent the most significant negative evidence that we considered in concluding that a valuation allowance was necessary at December 31, 2012 and December 31, 2011.

RESULTS OF OPERATIONS

Net loss attributable to common shareholders for the period ended December 31, 2012 was $9.4 million or $1.98 per diluted common share compared to net loss attributable to common shareholders of $24.2 million or $5.11 per diluted common share for the same period in 2011. Factors contributing to the net loss for 2012 included the following:

Net loss attributable to common shareholders was also increased by dividends accrued on preferred shares. Our book value per common share decreased from $7.07 at December 31, 2011 to $5.12 at December 31, 2012.

Net loss attributable to common shareholders for the period ended December 31, 2011 was $24.2 million or $5.11 per diluted common share compared to net loss attributable to common shareholders of $10.5 million or $2.21 per diluted common share for the same period in 2010. Contributing to the increases in the net loss for 2011 was a decrease in our net interest margin, an increase of $4.3 million in provision for loan losses, a valuation allowance against deferred tax assets of $11.4 million, write downs taken on real estate acquired through foreclosure, higher FDIC insurance premiums, and a higher level of other non-interest expense. Net loss attributable to common shareholders was also impacted by dividends accrued on preferred shares. Our book value per common share decreased from $10.89 at December 31, 2010 to $7.07 at December 31, 2011.

Net Interest Income – The largest component of our net income is our net interest income. Net interest income is the difference between interest income, principally from loans and investment securities, and interest expense, principally on customer deposits and borrowings. Changes in net interest income result from changes in volume, net interest spread and net interest margin. Volume refers to the average dollar levels of interest-earning assets and interest-bearing liabilities. Net interest spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities. Net interest margin refers to net interest income divided by average interest-earning assets and is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities.

The majority of our assets are interest-earning and our liabilities are interest-bearing.  Accordingly, changes in interest rates may impact our net interest margin. The Federal Open Markets Committee (“FOMC”) uses the federal funds rate, which is the interest rate used by banks to lend to each other, to influence interest rates and the national economy. Changes in the federal funds rate have a direct correlation to changes in the prime rate, the underlying index for most of the variable-rate loans we issue.  The FOMC has held the target federal funds rate at a range of 0-25 basis points since December 2008.  As we are asset sensitive, continued low rates will negatively impact our earnings and net interest margin.

The large decline in the volume of interest earning assets and the change in the mix of interest earning assets reduced net interest income for 2012 by $6.5 million compared to the prior year. Average interest earning assets decreased $123.5 million for 2012 compared to 2011 driven by a decrease in average loans, partially offset by an increase in average securities. The decrease in average loans was due to loans included in the branch sale during the third quarter, loan principal payments, payoffs, charge-offs and the conversion of nonperforming loans to OREO properties. In addition, due to the higher regulatory capital ratios required by our consent order, we elected not to replace much of this loan run-off in accordance with our efforts to reduce asset size. The average loan yield was 5.42% for 2012 compared to an average loan yield of 5.63% for 2011. We redeployed available liquidity into more liquid but lower yielding investments.

The yield on earning assets averaged 4.01% for 2012 compared to an average yield on earning assets of 4.61% for 2011. This decrease was partially offset by a decrease in our cost of funds, which averaged 1.56% for 2012 compared to an average cost of funds of 1.87% for 2011. Net interest margin as a percent of average earning assets decreased 30 basis points to 2.55% for 2012 compared to 2.85% for 2011.

To decrease our cost of funds and improve net interest income, during the third quarter we prepaid a $10.0 million convertible fixed rate advance having an interest rate of 3.99% and a scheduled maturity date of 2014. In addition, we also prepaid a $5.0 million convertible fixed rate advance having an interest rate of 4.22% and a scheduled date of 2017. We anticipate being able to take advantage of the continued low interest rate environment to reduce our cost of funds, as term deposits re-price at more favorable terms.

Comparative information regarding net interest income follows:

bp = basis point = 1/100th of a percent

AVERAGE BALANCE SHEETS

The following table provides information relating to our average balance sheet and reflects the average yield on assets and average cost of liabilities for the indicated periods. Yields and costs for the periods presented are derived by dividing income or expense by the average balances of assets or liabilities, respectively.

(1) Taxable equivalent yields are calculated assuming a 34% federal income tax rate.

(2) Includes loan fees, immaterial in amount, in both interest income and the calculation of yield on loans.

(3) Calculations include non-accruing loans in the average loan amounts outstanding.

(4) Includes loans held for sale.

RATE/VOLUME ANALYSIS

The table below shows changes in interest income and interest expense for the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (1) changes in rate (changes in rate multiplied by old volume); (2) changes in volume (change in volume multiplied by old rate); and (3) changes in rate-volume (change in rate multiplied by change in volume). Changes in rate-volume are proportionately allocated between rate and volume variance.