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EX-31.2 - FIRST FINANCIAL SERVICE CORPv216547_ex31x2.htm
EX-99.1 - FIRST FINANCIAL SERVICE CORPv216547_ex99x1.htm
EX-99.2 - FIRST FINANCIAL SERVICE CORPv216547_ex99x2.htm
EX-31.1 - FIRST FINANCIAL SERVICE CORPv216547_ex31x1.htm




Washington, D.C. 20549





For the fiscal year ended December 31, 2010

Commission File Number: 0-18832



(Exact name of registrant as specified in its charter)

Kentucky   61-1168311
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)

2323 Ring Road, Elizabethtown, Kentucky   42701
(Address of principal executive offices)   Zip Code

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 o 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 o 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 o

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 o   Accelerated Filer o   Non-Accelerated Filer x   Smaller Reporting Company o

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 o No o

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. o

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

The aggregate market value of the outstanding voting stock held by non-affiliates of the registrant based on a June 30, 2010 closing price of $7.24 as quoted on the NASDAQ Global Market was $28,167,770. 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, 2011 there were issued and outstanding 4,739,622 shares of the registrant’s common stock.


1. Portions of the Registrant’s Definitive Proxy Statement for the 2011 Annual Meeting of Shareholders to be held May 18, 2011 are incorporated by reference into Part III of this Form 10-K.











Risk Factors



Unresolved Staff Comments






Legal Proceedings



[Removed and Reserved]



Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities



Selected Financial Data



Management’s Discussion and Analysis of Financial Condition and Results of Operations



Quantitative and Qualitative Disclosures about Market Risk



Financial Statements and Supplementary Data



Changes in and Disagreements with Accountants on Accounting and Financial Disclosure



Controls and Procedures



Other Information


ITEM 10.

Directors and Executive Officers of the Registrant


ITEM 11.

Executive Compensation


ITEM 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters


ITEM 13.

Certain Relationships and Related Transactions


ITEM 14.

Principal Accountant Fees and Services


ITEM 15.

Exhibits and Financial Statement Schedules






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 after the date of the statement to reflect the occurrence of unanticipated events.






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. In 2004 we amended our articles of incorporation to change our name from First Federal Financial Corporation of Kentucky to First Financial Service Corporation.

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

a broad array of residential mortgage products, both fixed and adjustable rate;
consumer loans, including home equity lines of credit, auto loans, recreational vehicle, and other secured and unsecured loans;
specialized financing programs to support community development;
mortgages for multi-family real estate;
commercial real estate loans;
commercial loans to businesses, including revolving lines of credit and term loans;
real estate development;
construction lending; and
agricultural lending.

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

multiple checking and NOW accounts for both personal and business accounts;
various savings accounts, including those for minors;
money market accounts;
tax qualified deposit accounts such as Health Savings Accounts and Individual Retirement Accounts; and
a broad array of certificate of deposit products.

We also support our customers by providing services such as:

providing access to merchant bankcard services;
supplying various forms of electronic funds transfer;




providing debit cards and credit cards; and
providing telephone and Internet banking.

Through our personal investment financial counseling services, we offer a wide variety of 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, and collateralized mortgage obligations.

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 and provisions for loan losses.

Recent Developments

In 2009, as part of an informal regulatory agreement with the FDIC, the Bank agreed to maintain a Tier 1 leverage ratio of 8%. At December 31, 2010, we were not in compliance the Tier 1 capital requirement. On January 27, 2011, the Bank entered into a Consent Order, a formal agreement with the FDIC and KDFI. A copy of the Consent Order is set forth as Exhibit 10.1 of the Form 8-K filed with the SEC on January 27, 2011. Under the terms of the Consent Order, the Bank cannot declare dividends without the prior written approval of the FDIC and KDFI. Other material provisions of the Consent Order require the Bank to:

obtain an independent assessment of executive management and senior commercial lending staff;
increase the Bank’s capital ratios;
develop and implement a plan to reduce the level of non-performing assets;
develop and implement a plan to reduce concentrations of credit in commercial real estate loans;
maintain adequate reserves for loan and lease losses;
implement revised credit risk management practices and credit administration policies and procedures;
implement procedures to ensure compliance with applicable laws, rules, regulations and policy statements;
periodically evaluate the Bank’s strategic plan and budget for fiscal 2011;
develop revisions to the Bank’s funding contingency plan, which identifies available sources of liquidity and plans for dealing with potential adverse economic and market conditions; and
prepare and submit progress reports to the FDIC and KDFI.

The Consent Order requires the Bank to achieve certain minimum capital ratios as set forth below:

  Actual as of
  Ratio Required
by the Order at
  Ratio Required
by the Order at
Total capital to risk-weighted assets     11.49 %      11.50 %      12.00 % 
Tier 1 capital to average total assets     7.26 %      8.50 %      9.00 % 

The Consent Order will remain in effect until modified or terminated by the FDIC and KDFI.




Market Area

We operate 22 full-service banking centers and a commercial private banking center in eight contiguous counties in central Kentucky along the Interstate 65 corridor and within the Louisville metropolitan area, including southern Indiana. 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 to Harrison County, Indiana approximately 60 miles northwest of our headquarters. 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 and in Harrison and Floyd counties in southern Indiana. We control in the aggregate 23% of the deposit market share in our central Kentucky markets outside of Louisville.

In our markets surrounding the Ft. Knox military base, residential activity remains robust as a result of the increase in 3,200 civilian families relocating to Ft. Knox with the Base Realignment and Closure Act. The Army’s Human Resource Command is being relocated to the Ft. Knox military base, resulting in a substantial economic benefit to this area. Fort Knox is located in Hardin County, where we have a 26% market share. Growth in deposits, coupled with positive signs of economic growth in our home markets, which is fueled by the Ft. Knox base realignment, will provide a sound basis for us as the local economy recovers.

The following table shows our market share and rank in terms of deposits as of June 30, 2010, in each Kentucky and Indiana 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.

County   Number of
Share %
Meade     3       55.0       1  
Hardin     5       26.0       1  
Bullitt     3       21.0       3  
Hart     1       17.0       3  
Harrison     3       13.0       4  
Nelson     2       8.0       5  
Floyd     1       2.0       10  
Jefferson     4       1.0       11  

Lending Activities

Commercial Real Estate & Construction Lending.  The largest portion of our lending activity is the origination of commercial loans that are primarily secured by real estate, including construction loans. We generate loans 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. At December 31, 2010, we had $557.8 million outstanding in commercial real estate loans. 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 $32.1 million of the loan portfolio at December 31, 2010. These loans are included in the $557.8 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.




Construction loans involve additional risks because loan funds are advanced upon the security of the project under construction, which is of uncertain value before the completion of construction. The uncertainties inherent in estimating construction costs, delays arising from labor problems, material shortages, and other unpredictable contingencies make it relatively difficult to evaluate accurately the total loan funds required to complete a project and related loan-to-value ratios. The analysis of prospective construction loan projects requires significantly different expertise from that required for permanent residential mortgage lending. At December 31, 2010, we had $11.0 million outstanding in construction loans.

Our underwriting criteria are designed to evaluate and minimize the risks of each construction loan. Among other things, we consider evidence of the availability of permanent financing or a takeout commitment to the borrower; the reputation of the borrower and his or her financial condition; the amount of the borrower’s equity in the project; independent appraisals and cost estimates; pre-construction sale and leasing information; and cash flow projections of the borrower.

Commercial Business Lending.  The commercial business loan portfolio has grown in recent years as a result of our focus on small 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, 2010, totaled $42.3 million.

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, 2010, we had $164.0 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, 2010, approximately 44.3% 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. The origination of 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%.

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, 2010, consumer loans outstanding were $107.4 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, 2010, totaled $58.5 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 Loan 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, 2010, total loans under the indirect consumer loan program totaled $29.6 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 $95,000 for the year ended December 31, 2010.

First Federal Office Park, LLC, holds commercial lots adjacent to our home office on Ring Road in Elizabethtown, that are available for sale. Currently, one of the original nine lots held for sale remains unsold.

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 $171,000 in income for the year ended December 31, 2010, of which our portion was $82,000.

Heritage Properties, LLC, holds real estate acquired through foreclosure which is available for sale. Currently, fifty-two properties valued at $26.6 million are held for sale.


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 southern Indiana, 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. Retail establishments effectively compete for loans by offering credit cards and retail installment contracts for the purchase of goods, merchandise and services (for example, Home Depot, Lowe’s, etc.). We believe that we have been able to compete effectively in our primary market area.

We have offices in nine cities in six central Kentucky counties and offices in four cities in two southern Indiana 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.


As of December 31, 2010, we employed 335 employees, of which 315 were full-time and 20 part-time. None of our employees are subject to a collective bargaining agreement, and we believe that we enjoy good relations with our personnel.


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 a well-rated Kentucky bank 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 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 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. As part of an informal regulatory agreement with the FDIC, the Bank was required to maintain a Tier 1 leverage ratio of 8%. At December 31, 2010, we were not in compliance with the Tier 1 capital requirement. On January 27, 2011, the Bank entered into a Consent Order, a formal agreement with the FDIC and KDFI, under which, among other things, the Bank has agreed to achieve and maintain a Tier 1 leverage ratio of at least 8.5% by March 31, 2011 and 9.0% by June 30, 2011. The Consent Order supersedes the prior informal regulatory agreement.

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 Executive Director 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 Executive Director 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. Although the Corporation and the Bank remain above the regulatory capital levels for “well-capitalized” standards, because of the losses we have incurred in recent quarters, our elevated levels of non-performing loans and other real estate, and the ongoing economic stress in Jefferson and Oldham Counties, Kentucky, the FDIC, KDFI and the Bank entered into the Consent Order referred to above under the section “Recent 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” despite its current capital levels. 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.

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. According to the terms of the Consent Order referred to above under the section “Recent Developments,” the Bank cannot 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 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”).  The 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. The 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 the HMDA.

Equal Credit Opportunity Act (“ECOA”).  The ECOA 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”).  The 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 the 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 the 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, the 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 the TILA.

Real Estate Settlement Procedures Act (“RESPA”).  The RESPA requires lenders to provide borrowers with disclosures regarding the nature and cost of real estate settlements. The RESPA also prohibits certain abusive practices, such as kickbacks, and places limitations on the amount of escrow accounts. Violations of the 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 (“FACT”).  The 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. The FCRA gives consumers the ability to challenge banks with respect to credit reporting information provided by the bank. The 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”) 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.  The Bank Secrecy Act of 1970 (“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 USA PATRIOT Act of 2001 (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. The 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 our bank subsidiary are insured up to applicable limits by the Deposit Insurance Fund, or the DIF, of the FDIC and are subject to deposit insurance assessments to maintain the DIF. The FDIC utilizes a risk-based assessment system that imposes insurance premiums based upon a risk matrix that takes into account a bank’s capital level and supervisory rating.

Effective January 1, 2007, the FDIC imposed deposit assessment rates based on the risk category of the bank subsidiary. 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, or the BIF, 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 the Company’s 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 (FICO), 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 $2.7 million was reflected in our 2010 income statement.

On February 7, 2011, the FDIC Board of Directors adopted a final rule (with changes to go into effect beginning with the second quarter 2011), which redefines the deposit insurance assessment base as required by the Dodd-Frank Act; makes changes to assessment rates; implements Dodd-Frank’s DIF dividend provisions; and revises the risk-based assessment system for all large insured depository institutions (“IDIs”), 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 will pay smaller assessments as a result of this final rule. The final rule:

Redefines the deposit insurance assessment base as average consolidated total assets minus average tangible equity (defined as Tier I Capital);
Makes generally conforming changes to the unsecured debt and brokered deposit adjustments to assessment rates;
Creates a depository institution debt adjustment;
Eliminates the secured liability adjustment; and
Adopts a new assessment rate schedule effective April 1, 2011, and, in lieu of dividends, other rate schedules when the reserve ratio reaches certain levels.

The FDIC is authorized to set the reserve ratio for the DIF 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 DIF 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.  In October 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”) was enacted. The EESA authorizes 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 has allocated $250 billion towards the




TARP Capital Purchase Program (“CPP”). Under the CPP, Treasury has 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 “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operation — Capital and Note 13 of the Notes to Consolidated Financial Statements.”

EESA also increased FDIC deposit insurance on most accounts from $100,000 to $250,000. This increase is in place until December 31, 2013 and is not covered by deposit insurance premiums paid by the banking industry.

Temporary Liquidity Guarantee Program.  The FDIC established a Temporary Liquidity Guarantee Program (“TLGP”) on October 14, 2008. The TLGP includes the Transaction Account Guarantee Program (“TAGP”), which provides unlimited deposit insurance coverage through December 31, 2012 for noninterest-bearing transaction accounts (typically business checking accounts) and certain funds swept into noninterest-bearing savings accounts. Institutions participating in the TAGP pay a 10 basis points fee (annualized) on the balance of each covered account in excess of $250,000, while the extra deposit insurance is in place. The TLGP also includes the Debt Guarantee Program (“DGP”), under which the FDIC guarantees certain senior unsecured debt of FDIC-insured institutions and their holding companies. The unsecured debt must be issued on or after October 14, 2008 and not later than October 31, 2009, and the guarantee is effective through the earlier of the maturity date or June 30, 2012. The DGP coverage limit is generally 125% of the eligible entity’s eligible debt outstanding on September 30, 2008 and scheduled to mature on or before June 30, 2009 or, for certain insured institutions, 2% of their liabilities as of September 30, 2008. Depending on the term of the debt maturity, the nonrefundable DGP fee ranges from 50 to 100 basis points (annualized) for covered debt outstanding until the earlier of maturity or June 30, 2012. The TAGP and DGP are in effect for all eligible entities, unless the entity opted out on or before December 5, 2008. First Financial Service Corporation’s bank subsidiary elected to participate in the TAGP and both the bank subsidiary and the holding company are eligible to participate in DGP.

Certificate of Deposit Account Registry Service.  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”). 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.  On February 17, 2009, the American Recovery and Reinvestment Act of 2009 (“ARRA”) was signed into law by President Obama. 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 First Financial Service 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.

Dodd-Frank Act.  The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”) was signed into law on July 21, 2010. The Dodd-Frank Act is intended to effect 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 are likely to affect the Corporation are the following:

Corporate Governance.  The Dodd-Frank Act will require 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 will apply 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 will be eliminated. The Dodd-Frank Act will additionally prohibit 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 will have 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 will have authority to prevent unfair, deceptive or abusive 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 extends 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. 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 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.





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, future results of operations, and future cash flows.

If we continue to incur significant losses, it may be difficult to continue in operation without additional capital.

We recorded a net loss to common shareholders of $9.3 million in 2010 and $7.7 million in 2009, for a two year total of $17.0 million. The net loss for 2010 was due in part to a $4.4 million deferred tax valuation allowance. The net loss for 2009 was due in part to an $11.9 million non-cash pre-tax goodwill impairment charge.

Provisions for loan losses and investment impairments also contributed to our losses. During 2010 and 2009, we recorded total provisions for loan losses of $26.4 million and other than temporary losses on investments of $1.9 million. While our losses also included a charge off of goodwill of $11.9 million, and a charge to establish an allowance against the realization of our deferred tax asset of $4.4 million, these latter charges were largely influenced by the losses on loans and investments.

We could be required to make additional provisions for loan losses and impairments to investments 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 without capital levels decreasing below the minimum levels set forth in the Consent Order. See Part I, Item 1 — Business — 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 the KDFI and a memorandum of understanding 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 the continuation of our businesses. In January 2011, the Bank agreed to a Consent Order by the FDIC and KDFI by which the Bank agreed to develop and implement actions to reduce the amount of classified assets and improve earnings. Compliance with the Consent Order will increase our operating expense, which could adversely affect our financial performance. Any material failures to comply with the consent order would likely result in more stringent enforcement actions by the FDIC and KDFI, which could damage the reputation of the Bank and have a material adverse effect on our business. The provisions of the Consent Order are outlined above in the “Recent Developments” section.

In December 2009, we entered into a memorandum of understanding with the Federal Reserve Bank of St. Louis. Pursuant to the memorandum, we made informal commitments including, among other things, to use our financial and management resources to assist the Bank in addressing weaknesses identified by the FDIC and KDFI. Following our agreement to the Consent Order with the FDIC and KDFI, we were notified that the Federal Reserve Bank of St. Louis expects to enter into a similar formal agreement with the Corporation. Any material failures to comply with the agreement would likely result in more stringent enforcement actions by the Federal Reserve which could damage our reputation and have a material adverse effect on our business.

Our ability to pay cash dividends on our common and preferred stock and pay interest on the junior subordinated debentures that relate to our trust preferred securities is currently restricted. Our inability to resume paying 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 third quarter of 2010, we also suspended cash dividends on the Treasury Preferred Stock and have begun deferring interest payments on the junior subordinated notes relating to our trust preferred securities. Deferring interest payments on the junior subordinated notes will result in a deferral of distributions on our trust preferred securities. Future payment of cash dividends on our common stock and future payment on treasury preferred stock will be subject to the prior payment of 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. 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. If we become subject to any liquidation, dissolution or winding up of affairs, holders of the trust preferred securities and then holders of the preferred stock will be entitled to receive the liquidation amounts to which they are entitled including the amount of any accrued and unpaid distributions and dividends, before any distribution to the holders of common stock.

We need to raise additional capital in the future, but that capital may not be available when needed or at all.

The Bank has agreed with the FDIC and the KDFI to develop a plan to increase its tier one leverage ratio to 8.50% and its total capital as a percentage of risk weighted assets to 11.50% by March 31, 2011. The Bank also agreed to develop a plan to increase its tier one leverage ratio to 9.00% and its total capital as a percentage of risk weighted assets to 12.00% by June 30, 2011. We are evaluating various specific initiatives to increase our regulatory capital and to reduce our total assets. Strategic alternatives include divesting of branch offices, selling loans, raising capital by selling stock, and seeking a business combination transaction.

Our ability to raise additional capital 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. Our inability to raise additional capital on acceptable terms when needed could have a material adverse effect on our businesses, 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. These strategies may result in 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.

We cannot guarantee whether such financing will be available to us on acceptable terms or at all. If we are unable to obtain future financing, we may not have the capital and financial resources needed to operate our business or to meet regulatory requirements.

Ongoing market developments may continue to adversely affect our industry, businesses and results of operations.

Since mid-2007, the financial services industry as a whole has been materially and adversely affected by very significant declines in the values of nearly all asset classes and by a very serious lack of liquidity. Financial institutions in particular have been subject to increased volatility and an overall loss in investor confidence. Concerns about the stability of the financial markets generally and the strength of counterparties have caused many lenders and institutional investors to reduce, and in some cases, cease to provide funding to borrowers including financial institutions.




The lack of available credit, loss of confidence in the financial sector, increased volatility in the financial markets and reduced business activity have materially and adversely affected our business, financial condition and results of operations. Further negative market developments may affect consumer confidence levels and may cause adverse changes in payment patterns, causing increases in delinquencies and default rates, which may impact our charge-offs and provisions for credit losses. A worsening of these conditions would likely exacerbate the adverse effects that these difficult market conditions have had on us and others in the financial services industry.

Sustained weakness or weakening in business and economic conditions generally or specifically in our markets has had and could continue to have the following adverse effects on our business:

A decrease in the demand for loans and other products and services that we offer;
A decrease in the value of our loans held for sale or other assets secured by consumer or commercial real estate;
An impairment of certain intangible assets;
An increase in the number of clients who become delinquent, file for protection under bankruptcy laws or default on their loans or other obligations to us.

Higher numbers of delinquencies, bankruptcies or defaults have resulted in a higher level of nonperforming assets, net charge-offs, and provision for loan losses.

Overall, the general business environment has had an adverse effect on our business in recent years, and there can be no assurance that the environment will improve in the near term. Until conditions improve, we expect our businesses, financial condition and results of operations will continue to be adversely affected.

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, or meet the operating cash needs of the Corporation.

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 does not have any additional borrowing capacity under its FHLB line of credit.

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. Regulations limit the amount of dividends that the Bank may pay to us. Recent losses have had the consequence of not allowing the Bank to pay any dividends to the Corporation without prior regulatory approval. The Corporation has no other sources of revenue. At December 31, 2010 the Corporation had liquidity in the form of cash of $240,000.

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 non-core brokered deposits, 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.

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. Bank regulatory agencies, as an integral part of their supervisory functions, periodically review the adequacy of our allowance for loan losses. Regulatory agencies have 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 loan portfolio possesses increased risk due to our relatively high concentration of loans collateralized by real estate.

Approximately 89.0%of our loan portfolio as of December 31, 2010 was comprised of loans collateralized by real estate. An adverse change in the economy that depresses values of real estate generally or in our primary markets such as we have recently experienced 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 2010 and 2009. If during a period of reduced 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.

Declines in asset values may result in impairment charges and adversely affect the value of our investments, financial performance and capital.

Under U.S. generally accepted accounting principles, we are required to review our investment portfolio periodically for the presence of other-than-temporary impairment of our securities, taking into consideration current market conditions, the extent and nature of change in fair value, issuer rating changes and trends, volatility of earnings, current analysts’ evaluations, our ability and intent to hold investments until a recovery of fair value, as well as other factors. Adverse developments with respect to one or more of the foregoing factors may require us to deem particular securities to be other-than-temporarily impaired, with the reduction in the value recognized as a charge to earnings. Recent market volatility has made it extremely difficult to value certain securities. Subsequent valuations, in light of factors prevailing at that time, may result in significant changes in the values of these securities in future periods. Any of these factors could require us to recognize further impairments in the value of our securities portfolio, which may have an adverse effect on our results of operations in future periods.

Our profitability depends significantly on local economic conditions.

Because most of our business activities are conducted in central Kentucky and adjacent counties of Indiana, 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 further declines, the rates of delinquencies, foreclosures, bankruptcies and losses in our loan portfolio would likely increase. Moreover, the value of real estate or other collateral that secures our loans could be adversely affected by economic downturn or a localized natural disaster. An economic downturn or other events that




affect our markets could, therefore, result in losses that may materially and adversely affect our business, financial condition, results of operations and future prospects.

Our small to medium-sized business target market may have fewer resources to weather the 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 or two persons or a small group of persons, and the death, disability or resignation of one or more of these persons could have a material adverse impact on the business and its ability to repay our loan. Economic downturns and other events 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 our interest-earning assets mature or reprice more quickly than our interest-bearing liabilities in a given period, as a result of decreasing interest rates, our net interest income may decrease. Likewise, our net interest income may decrease if interest-bearing liabilities mature or reprice 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 repricing before assets become subject to repricing. 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. In the current low interest rate environment, there may be an increase in prepayments on loans as the borrowers refinance their loans at lower interest rates, which could reduce net interest income and harm our results of operations.

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. Competition in making loans in the Louisville metropolitan area has increased in recent years after changes in banking law allowed several banks to enter the market by establishing new branches. Likewise, competition is increasing in our other 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 clients. 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:

offer higher interest rates on deposits and lower interest rates on loans than we can;
offer a broader range of services than we do;
maintain numerous branch locations; and
mount extensive promotional and advertising campaigns.




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 clients 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 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 financial reform legislation could have a material effect on our future operations.

The recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act institutes a wide range of reforms that will have an impact on all financial institutions. The Dodd-Frank Act changes the deposit insurance and financial regulatory systems, enhances bank capital requirements and requires new regulations to protect consumers in financial transactions, among other things. Many of these provisions require rule-making and studies that will be conducted in the future. For these reasons, we cannot assess the impact the Dodd-Frank Act may have on us at the present time.

Our issuance of securities to the US Department of the Treasury may limit our ability to return capital to our shareholders and is dilutive to our common shares. In addition, the dividend rate increases substantially after five years if we cannot redeem the shares by that time.

On January 9, 2009, as part of the Capital Purchase Program established by the U.S. Department of the Treasury under the Emergency Economic Stabilization Act of 2008 (“EESA”), we sold $20 million of senior preferred stock to the Department of the Treasury. We also issued to the Department of the Treasury a warrant to purchase approximately 216,000 shares of our common stock at $13.89 per share. The terms of the transaction with the Department of the Treasury limit our ability to pay dividends and repurchase our shares. For three years after issuance or until the Department of the Treasury no longer holds any preferred shares, we will not be able to increase our dividends above the most recent level before October 14, 2008 ($.19 per common share on a quarterly basis) nor repurchase any of our shares without the Department of the Treasury’s approval with limited exceptions, most significantly purchases in connection with benefit plans.




Also, we will not be able to pay any dividends at all unless we are current on our dividend payments on the preferred shares. These restrictions, as well as the dilutive impact of the warrant, may have an adverse effect on the market price of our common stock.

Unless we are able to redeem the preferred stock during the first five years, the dividends on this capital will increase substantially at that point, 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 and liquidity.

The US Department of the 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 US Department of the Treasury under which it purchased our securities imposes restrictions on our conduct of our business, including restrictions related to our payment of dividends and repurchase of our stock and related to our executive compensation and governance. The US Department of the 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 of EESA relating to compensation and governance as they affect companies that have sold securities to the US Department of the Treasury. In some cases, these amendments require action by the US Department of the Treasury to implement them. 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.

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.

ITEM 1B. Unresolved Staff Comments

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 and Southern Indiana. The location of our 22 full-service banking centers, an operations building and a commercial private banking center, whether owned or leased, and their respective approximate square footage is described in the following table.

2323 Ring Road     Owned       57,295  
325 West Dixie Avenue     Owned       5,880  
2101 North Dixie Avenue     Owned       3,150  
101 Financial Place     Owned       20,619  
475 West Lincoln Trail     Owned       2,728  
1671 North Wilson Road     Owned       3,479  
401 East John Rowan Blvd.     Owned       4,500  
315 North Third Street     Owned       1,271  
925 Main Street     Owned       2,928  
395 N. Buckman Street     Owned       7,600  
1707 Cedar Grove Road, Suite 1     Leased       3,425  
279 Bardstown Road     Owned       6,310  
416 East Broadway     Leased       4,395  
50 Old Mill Road     Leased       575  
4055 Flaherty Road     Leased       1,216  
11810 Interchange Drive     Owned       4,675  
3650 South Hurstbourne Parkway     Owned       4,428  
12629 Taylorsville Road     Owned       3,479  
4965 U.S. Highway 42, Suite 2100     Leased       2,035  
301 Blakenbaker Parkway     Owned       3,479  
2030 Hwy 337 NW     Leased       2,000  
8160 Beech Street NE     Owned       2,442  
6500 State Road 64     Owned       3,536  
7340 Main Street     Owned       4,230  





Although, from time to time, we are involved in various legal proceedings in the normal course of business, we believe that after consultation with legal counsel that at December 31, 2010 there were no material pending legal proceedings to which we are a party, or to which any of our property is subject.







(a)  Market Information

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.

  Quarter Ended
2010:   3/31   6/30   9/30   12/31
High   $ 9.79     $ 8.81     $ 7.13     $ 5.14  
Low     8.03       7.24       4.76       3.75  
Cash dividends                        

2009:   3/31   6/30   9/30   12/31
High   $ 13.71     $ 19.99     $ 17.77     $ 13.06  
Low     10.00       11.37       13.47       8.24  
Cash dividends     0.19       0.19       0.05        

(b)  Holders

At December 31, 2010, the number of shareholders was approximately 1,308.

(c)  Dividends

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.”

(d)  Securities Authorized for Issuance Under Equity Compensation Plans

The following table summarizes the securities authorized for issuance under our equity compensation plans as of December 31, 2010. We have no equity compensation plans that have not been approved by our shareholders.

Plan category   Number of
securities to be
issued upon
exercise of
options, warrants and rights
  Weighted-average exercise price of
options, warrants
and rights
  Number of
securities to be
issued upon
vesting of
restricted shares
  Number of
for future issuance
under equity
compensation plans
Equity compensation plans approved by security holders     296,521     $ 13.70       36,855       430,559  

See Note 17 of the Notes to Consolidated Financial Statements for additional information required by this item.

(e)  Issuer Purchases of Equity Securities

We did not repurchase any shares of our common stock during the quarter ended December 31, 2010.




(f)  Performance Graph

The graph below compares the cumulative total return on the common stock of the Corporation between December 31, 2005 through December 31, 2010 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, 2005 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.

First Financial Service Corporation


  Period Ending
Index   12/31/05   12/31/06   12/31/07   12/31/08   12/31/09   12/31/10
First Financial Service Corporation     100.00       119.82       105.59       54.06       42.70       19.18  
NASDAQ Composite     100.00       110.39       122.15       73.32       106.57       125.91  
Peer Group 2010*     100.00       115.19       82.53       49.40       44.12       56.92  

* Peer Group 2010 consists of BB&T Corp. (BBT), Fifth Third Bancorp (FITB), First Horizon National Corp. (FHN), Huntington Bancshares Inc. (HBAN), KeyCorp (KEY), M&T Bank Corp. (MTB), Marshall & Ilsley Corp. (MI), PNC Financial Services Group (PNC), Regions Financial Corp (RF), SunTrust Banks Inc. (STI), Synovus Financial Corp. (SNV), Zions Bancorp. (ZION).





(Dollars in thousands,
except per share data)
  At December 31,
  2010   2009   2008   2007   2006
Financial Condition Data:
Total assets   $ 1,320,495     $ 1,209,504     $ 1,017,047     $ 872,691     $ 822,826  
Net loans outstanding(1)     865,657       985,390       899,436       760,114       698,026  
Investments     196,153       46,931       22,797       39,685       52,447  
Deposits     1,173,908       1,049,815       775,399       689,243       641,037  
Borrowings     70,532       72,245       165,816       105,883       106,724  
Stockholders’ equity     72,438       85,132       72,952       73,460       72,098  
Number of:
Offices     22       22       20       15       14  
Full time equivalent employees     325       324       316       284       270  

  Year Ended December 31,
     2010   2009   2008   2007   2006
Operations Data:
Interest income   $    59,565     $    58,856     $    57,564     $  60,545     $  53,832  
Interest expense     23,485       21,792       24,799       29,751       24,108  
Net interest income     36,080       37,064       32,765       30,794       29,724  
Provision for loan losses     16,881       9,524       5,947       1,209       540  
Non-interest income     8,101       8,519       8,449       8,203       7,739  
Non-interest expense     33,730       43,917       28,286       23,790       21,952  
Income tax expense/(benefit)     1,845       (1,149 )      2,184       4,646       4,634  
Net income/(loss) attributable to common shareholders     (9,329 )      (7,741 )      4,797       9,352       10,337  
Earnings/(loss) per common share:(2)
Basic     (1.97 )      (1.65 )    $ 1.03     $ 1.98     $ 2.14  
Diluted     (1.97 )      (1.65 )      1.02       1.96       2.12  
Book value per common share(2)     11.13       13.87       15.63       15.76       14.95  
Dividends paid per common share(2)           0.43       0.76       0.73       0.66  
Return on average assets     (.66 )%      (.61 )%      0.51 %      1.10 %      1.31 % 
Average equity to average assets     6.77 %      8.56 %      8.02 %      8.54 %      8.71 % 
Return on average equity     (9.67 )%      (7.18 )%      6.37 %      12.88 %      15.03 % 
Efficiency ratio(3)     76 %      70 %      69 %      61 %      59 % 

(1) Includes loans held for sale.
(2) Amounts adjusted to reflect 10% stock dividends declared August 16, 2007.
(3) Excludes goodwill impairment





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.


The unfavorable economic conditions that have persisted since 2007 continued to significantly impact the banking industry and our performance during 2010. During 2010 we continued to experience an increase in our non-performing assets and loan loss provisions. Our decline in credit quality impacted our operations during 2010 in the areas of net interest income, provision for loans losses, non-interest income, non-interest expense, and reversals of tax benefits.

Our net loss attributable to common shareholders for 2010 was $9.3 million, or $1.97 per diluted common share compared to a net loss attributable to common shareholders of $7.7 million or $1.65 per diluted common share in 2009. The 2010 results include provision for loans losses of $16.9 million, other than temporary securities impairment of $1.0 million, write downs on other real estate owned of $1.5 million, an increase in FDIC insurance expense of $813,000, and a charge to establish an allowance against the realization of our deferred tax asset of $4.4 million.

The increase in provision for loan losses was primarily attributable to residential housing development loans in Jefferson and Oldham Counties. Five individual loan relationships totaling $34.7 million make up 48% of our non-performing assets. Four of these relationships totaling $21.9 million represent 47% of our non-performing loans. These high-end subdivisions, while showing initial progress, have stalled due to the recession. At December 31, 2010, substantially all of the residential housing development loan portfolio concentration in these counties has been classified as impaired. The provision for loan loss expense exceeded net charge-offs by $4.9 million.

The allowance to total loans was 2.57% at December 31, 2010 while net charge-offs totaled 125 basis points for 2010, compared to 55 basis points in 2009. Non-performing loans were $46.1 million, or 5.22% of total loans at December 31, 2010 compared to $38.0 million, or 3.82% of total loans for December 31, 2009. The allowance for loan losses to non-performing loans was 49% at December 31, 2010 compared to 47% at December 31, 2009. Non-performing assets increased to $72.7 million or 5.51% of total assets compared to $46.5 million or 3.85% of total assets at December 31, 2009.

Net interest income was $36.1 million for 2010 compared to $37.1 million for 2009, while the net interest margin was 3.05% for 2010 compared to 3.66% in 2009. The net interest margin was negatively impacted by a higher level of non-accrual loans and due to our efforts to increase liquidity by placing assets into lower yielding investments other than loans. Non-interest income decreased $418,000 primarily driven by an increase of $958,000 in the loss on sale and write downs on real estate acquired through foreclosure for 2010. Offsetting this increase was an increase in the gain on the sale mortgage loans of $566,000. Non-interest expense decreased $10.3 million primarily due to the goodwill impairment charge of $11.9 million taken in 2009. The 2010 expenses include increases in FDIC insurance premiums of $813,000 and other real estate owned costs of $1.0 million.

Despite our recent losses, we remained well capitalized at December 31, 2010 under regulatory capital guidelines. Although, subsequent to December 31, 2010, we were classified as a troubled institution and cannot be considered well capitalized under that designation. In 2009, as part of an informal regulatory agreement with the FDIC, the Bank agreed to maintain a Tier 1 leverage ratio of 8%. At December 31, 2010, we were not in compliance with the Tier 1 capital requirement. On January 27, 2011, the Bank entered into a Consent Order, a formal agreement with the FDIC and KDFI, under which, among other things, the Bank has agreed to achieve and maintain a Tier 1 leverage ratio of at least 8.5% by March 31, 2011 and 9.0% by June 30, 2011. A copy of the Consent Order is set forth as Exhibit 10.1 of the Form 8-K filed with the SEC on January 27, 2011. The Consent Order supersedes the prior informal regulatory agreement.




In order to meet these capital requirements, the Board of Directors and management are continuing to evaluate strategies including the following:

Raising capital by selling capital stock through a public offering or private placement.
Continuing to operate the Company and the Bank in a safe and sound manner. Until we can complete a capital raise, this will most likely require us to reduce lending concentrations, potentially sell loans, and take significant operating expense reductions and other cost cutting measures aimed at lowering expenses. Additionally, we would adjust the mix of our assets to reduce the total risk weight of our assets, reduce total assets over time and potentially sell branches, deposits and loans.
Evaluating other strategic alternatives, such as a sale of assets, one or more branches, or the institution.

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.

Over the past several years we have focused on enhancing and expanding our retail and commercial banking network in our core central Kentucky markets as well as establishing our presence in the metropolitan Louisville market. Our core markets, where we have a combined 23% market share, have become increasingly competitive as several new banks have entered those markets during the past few years. In order to protect and grow our market share, we have replaced existing branches with newer, enhanced facilities. While the market is very competitive, we believe this creates an opportunity for smaller community banks with more power to make decisions locally. We believe our investment in these initiatives along with our continued commitment to a high level of customer service will enhance our market share in our core markets and our development in the Louisville market.

Although we had a disappointing year in our loan portfolio, we believe that the strength of our retail franchise will enhance our ability to persevere through this economic recovery. This is evidenced by our total deposits increasing $124.1 million, or 11.8% for 2010, continuing the momentum from 2009 where we achieved a record growth year in the amount of $274.4 million, or a 35.4% increase in total deposits over 2008. Growth in deposits, coupled with positive signs of economic growth in our home markets, which is fueled by the Ft. Knox base realignment, will provide a sound basis for us as the local economy recovers. While our concerns about economic conditions in our market continue, opportunities for deposit growth helps us progress towards our long-range financial objectives, including building additional core customer relationships, maintaining sufficient liquidity and capital levels, improving shareholder value and remediating our problem assets.


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 reflect different estimates, assumptions, and judgments. Certain policies inherently have a greater reliance 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 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, evaluates the allowance for loan losses on a monthly basis. We estimate 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 or loans otherwise classified as substandard or doubtful. The general component covers non-classified loans and is based on historical loss experience 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 $22.7 million or 2.57% of total loans was our estimate of probable incurred losses within the loan portfolio as of December 31, 2010. This estimate required a provision for loan losses on the income statement of$16.9 million for the 2010 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 the lower of cost or the 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.

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. Valuation allowances are 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 tax provision in the period for which the credits may be utilized. During 2010, we determined that it was more likely than not that we would not realize our deferred tax asset and recorded a $4.4 million valuation allowance.


Net loss attributable to common shareholders for the period ended December 31, 2010 was $9.3 million or $1.97 per diluted common share compared to net loss attributable to common shareholders of $7.7 million or $1.65 per diluted common share for the same period in 2009. Contributing to the net loss for 2010 was a decrease in our net interest margin, an increase of $7.4 million in provision for loan losses, a valuation allowance against deferred tax assets of $4.4 million write downs taken on investment securities that were




other-than-temporarily impaired, write downs taken on real estate acquired through foreclosure, and higher FDIC insurance premiums. Net loss attributable to common shareholders was also impacted by dividends paid on preferred shares. Our book value per common share decreased from $13.87 at December 31, 2009 to $11.13 at December 31, 2010.

Net loss attributable to common shareholders for the period ended December 31, 2009 was $7.7 million or $1.65 per diluted common share compared to net income attributable to common shareholders of $4.8 million or $1.02 per diluted common share for the same period in 2008. Earnings decreased for 2009 compared to 2008 due to a decrease in our net interest margin, an increase in provision for loan loss expense, write downs taken on investment securities that were other-than-temporarily impaired, write downs taken on real estate acquired through foreclosure, higher FDIC insurance premiums, a goodwill impairment charge and higher operating expenses. Net income attributable to common shareholders was also impacted by dividends paid on preferred shares. Our book value per common share decreased from $15.63 at December 31, 2008 to $13.87 at December 31, 2009.

Net Interest Income — The principal source of our revenue is net interest income. Net interest income is the difference between interest income on interest-earning assets, such as loans and securities and the interest expense on liabilities used to fund those assets, such as interest-bearing deposits and borrowings. Net interest income is affected by both changes in the amount and composition of interest-earning assets and interest-bearing liabilities as well as changes in market interest rates.

The increase in the volume of interest earning assets was off-set by the change in the mix of interest earning assets, causing a negative impact on net interest income, which decreased $984,000 for 2010 compared to a year ago. Average interest earning assets increased $179.0 million for 2010 compared to 2009. The increase was primarily attributed to our efforts to increase liquidity which resulted in an increase of lower yielding investments, interest bearing deposits and cash. The result was a shift in the mix of assets with the addition of lower yielding assets lowering our net interest margin. Net interest margin was also negatively impacted by the increase in the amount of non-accrual loans. The yield on earning assets averaged 5.00% for 2010 compared to an average yield on earning assets of 5.79% for 2009. This decrease was offset somewhat by a decrease in our cost of funds. Net interest margin as a percent of average earning assets decreased 61 basis points to 3.05% for 2010 compared to 3.66% for the 2009 period.

Our cost of funds averaged 2.13% for the 2010 period compared to an average cost of funds of 2.33% for the same period in 2009. Competition for deposits combined with continued re-pricing of variable rate loans and our efforts to increase liquidity by placing assets into lower yielding investments other than loans is likely to compress our net interest margin in future quarters.

Comparative information regarding net interest income follows:

(Dollars in thousands)   2010   2009   2008   2010/2009
Net interest income, tax equivalent basis   $ 36,536     $ 37,326     $ 32,970       -2.1 %      13.2 % 
Net interest spread     2.87 %      3.46 %      3.53 %      (59) bp       (7) bp  
Net interest margin     3.05 %      3.66 %      3.78 %      (61) bp       (12) bp  
Average earnings assets   $ 1,199,777     $ 1,020,803     $ 871,940       17.5 %      17.1 % 

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





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.

  Year Ended December 31,
     2010   2009   2008
(Dollars in thousands)   Average
  Interest   Average
  Interest   Average
  Interest   Average
Interest earning assets:
U.S. Treasury and agencies   $ 64,354     $ 1,600       2.49 %    $ 9,603     $ 251       2.61 %    $ 6,469     $ 257       3.97 % 
Mortgage-backed securities     36,203       1,403       3.88 %      6,963       290       4.16 %      9,006       390       4.33 % 
Equity securities     502       57       11.35 %      959       106       11.05 %      1,543       67       4.34 % 
State and political subdivision securities(1)     20,633       1,342       6.50 %      11,848       771       6.51 %      9,426       600       6.37 % 
Corporate bonds     1,770       101       5.71 %      2,121       117       5.52 %      2,533       159       6.28 % 
Loans(2)(3)(4)     954,354       54,977       5.76 %      971,750       57,113       5.88 %      830,748       55,739       6.71 % 
FHLB stock     7,140       338       4.73 %      8,515       383       4.50 %      8,116       423       5.21 % 
Interest bearing deposits     114,821       203       0.18 %      9,044       87       0.96 %      4,099       134       3.27 % 
Total interest earning assets     1,199,777       60,021       5.00 %      1,020,803       59,118       5.79 %      871,940       57,769       6.63 % 
Less: Allowance for loan losses     (19,223 )                        (14,972 )                        (9,114 )                   
Non-interest earning assets     82,625                         86,398                         76,343                    
Total assets   $ 1,263,179                       $ 1,092,229                       $ 939,169                    
Interest bearing liabilities:
Savings accounts   $ 113,438     $ 883       0.78 %    $ 119,745     $ 905       0.76 %    $ 106,901     $ 1,666       1.56 % 
NOW and money market accounts     267,144       3,022       1.13 %      179,917       1,402       0.78 %      136,796       1,307       0.96 % 
Certificates of deposit and other time deposits     653,293       15,824       2.42 %      515,764       15,610       3.03 %      444,718       17,539       3.94 % 
Short-term borrowings     523       38       7.27 %      50,602       152       0.30 %      44,454       896       2.02 % 
FHLB advances     52,603       2,388       4.54 %      52,742       2,405       4.56 %      53,009       2,413       4.55 % 
Subordinated debentures     18,000       1,330       7.39 %      18,000       1,318       7.32 %      14,667       978       6.67 % 
Total interest bearing liabilities     1,105,001       23,485       2.13 %      936,770       21,792       2.33 %      800,545       24,799       3.10 % 
Non-interest bearing liabilities:
Non-interest bearing deposits     69,434                         58,945                         57,962                    
Other liabilities     3,194                         3,073                         5,349                    
Total liabilities     1,177,629                         998,788                         863,856                    
Stockholders’ equity     85,550                         93,441                         75,313                    
Total liabilities and stockholders’ equity   $ 1,263,179                       $ 1,092,229                       $ 939,169                    
Net interest income            $ 36,536                       $ 37,326                       $ 32,970           
Net interest spread                       2.87 %                        3.46 %                        3.53 % 
Net interest margin                       3.05 %                        3.66 %                        3.78 % 
Ratio of average interest earning assets to average interest bearing liabilities                       108.58 %                        108.97 %                        108.92 % 

(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.





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.

  Year Ended December 31,
2010 vs. 2009
Increase (decrease)
Due to change in
  Year Ended December 31,
2009 vs. 2008
Increase (decrease)
Due to change in
(Dollars in thousands)   Rate   Volume   Net
  Rate   Volume   Net
Interest income:
U.S. Treasury and agencies   $ (13 )    $ 1,362     $ 1,349     $ (106 )    $ 100     $ (6 ) 
Mortgage-backed securities     (22 )      1,135       1,113       (14 )      (86 )      (100 ) 
Equity securities     3       (52 )      (49 )      72       (33 )      39  
State and political subdivision securities           571       571       14       157       171  
Corporate bonds     4       (20 )      (16 )      (18 )      (24 )      (42 ) 
Loans     (1,123 )      (1,013 )      (2,136 )      (7,409 )      8,783       1,374  
FHLB stock     19       (64 )      (45 )      (60 )      20       (40 ) 
Interest bearing deposits     (125 )      241       116       (137 )      90       (47 ) 
Total interest earning assets     (1,257 )      2,160       903       (7,658 )      9,007       1,349  
Interest expense:
Savings accounts     27       (49 )      (22 )      (942 )      181       (761 ) 
NOW and money market accounts     781       839       1,620       (269 )      364       95  
Certificates of deposit and other time deposits     (3,473 )      3,687       214       (4,466 )      2,537       (1,929 ) 
Short-term borrowings     179       (293 )      (114 )      (853 )      109       (744 ) 
FHLB advances     (11 )      (6 )      (17 )      4       (12 )      (8 ) 
Subordinated debentures     12             12       103       237       340  
Total interest bearing liabilities     (2,485 )      4,178       1,693       (6,423 )      3,416       (3,007 ) 
Net change in net interest income   $ 1,228     $ (2,018 )    $ (790 )    $ (1,235 )    $ 5,591     $ 4,356  

Non-Interest Income and Non-Interest Expense

The following tables compare the components of non-interest income and expenses for the years ended December 31, 2010, 2009 and 2008. The tables show the dollar and percentage change from 2009 to 2010 and from 2008 to 2009. Below each table is a discussion of significant changes and trends.

        2010/2009   2009/2008
(Dollars in thousands)   2010   2009   2008   Change   %   Change   %
Non-interest income
Customer sevice fees on deposit accounts   $ 6,479     $ 6,677     $ 6,601     $ (198 )      -3.0 %    $ 76       1.2 % 
Gain on sale of mortgage loans     1,760       1,194       697       566       47.4 %      497       71.3 % 
Gain on sale of investments     37             55       37       100.0 %      (55 )      -100.0 % 
Net impairment losses recognized in earnings     (1,048 )      (862 )      (516 )      (186 )      21.6 %      (346 )      67.1 % 
Loss on sale and write downs of real estate acquired through foreclosure     (1,536 )      (578 )      (162 )      (958 )      165.7 %      (416 )      256.8 % 
Brokerage commissions     413       373       469       40       10.7 %      (96 )      -20.5 % 
Other income     1,996       1,715       1,305       281       16.4 %      410       31.4 % 
     $ 8,101     $ 8,519     $ 8,449     $ (418 )      -4.9 %    $ 70       0.8 % 




We originate qualified VA, KHC, RHC and conventional secondary market loans and sell them into the secondary market with servicing rights released. Prevailing mortgage interest rates remained at attractive levels during the period helping to contribute to the increase in the volume of loans closed for 2010.

We invest in various types of liquid assets, including United States Treasury obligations, securities of various federal agencies, obligations of states and political subdivisions, corporate bonds, mutual funds, stocks and others. During 2010 we recorded a gain on the sale of equity investment securities of $37,000. Gains on investment securities are infrequent and are not a consistent recurring core source of income.

We recognized other-than-temporary impairment charges of $1.0 million for the expected credit loss during the 2010 period on all five of our trust preferred securities compared to $862,000 of impairment charges for 2009. Management believes this impairment was primarily attributable to the current economic environment which caused the financial conditions of some of the issuers to deteriorate. During 2008, we recognized other-than-temporary impairment charges of $516,000 on certain equity securities with a cost basis of $840,000. Our remaining exposure related to these equity securities is $291,000.

Further reducing non-interest income for 2010 was an increase of $958,000 in losses on the sale and write down of real estate owned properties.

The increase in other income is primarily the result of gains recorded on the sale of real estate owned properties.

        2010/2009   2009/2008
(Dollars in thousands)   2010   2009   2008   Change   %   Change   %
Non-interest expenses
Employee compensation and benefits   $ 15,662     $ 15,834     $ 14,600     $ (172 )      -1.1 %    $ 1,234       8.5 % 
Office occupancy expense and equipment     3,174       3,271       2,865       (97 )      -3.0 %      406       14.2 % 
Marketing and advertising     715       844       782       (129 )      -15.3 %      62       7.9 % 
Outside services and data processing     2,637       3,194       3,324       (557 )      -17.4 %      (130 )      -3.9 % 
Bank franchise tax     1,810       960       1,010       850       88.5 %      (50 )      -5.0 % 
FDIC insurance premiums     2,713       1,900       716       813       42.8 %      1,184       165.4 % 
Goodwill impairment           11,931             (11,931 )      -100.0 %      11,931       100.0 % 
Amortization of intangible assets     396       510       284       (114 )      -22.4 %      226       79.6 % 
Real estate acquired through foreclosure expense     1,678       668       472       1,010       151.2 %      196       41.5 % 
Other expense     4,945       4,805       4,233       140       2.9 %      572       13.5 % 
     $ 33,730     $ 43,917     $ 28,286     $ (10,187 )      -23.2 %    $ 15,631       55.3 % 

Employee compensation and benefits, office occupancy expense and equipment and marketing and advertising expense decreased in 2010 compared to 2009. These expenses were higher in 2009 due to additional operating expenses related to the opening of two new banking centers. We opened a full-service banking center at Fort Knox and another in the Middletown area of Jefferson County in 2009.

Outside services and data processing decreased due the renewal of our data processing contracts at a lower monthly cost.

During the fourth quarter of 2009, the FDIC adopted a requirement 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 $2.7 million was reflected in our 2010 income statement. 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.

The second largest expense incurred in 2009 was a goodwill impairment charge of $11.9 million. Annual analysis of goodwill indicated an impairment charge was necessary due to continued market deterioration. While this charge flows through our income statement, it is a non-cash item that does not impact our liquidity or adversely affect regulatory or tangible capital ratios.




The increase in real estate acquired through foreclosure expense for 2010 and 2009 was primarily due to increase in expense relating to repair, maintenance and taxes due to increases in real estate we acquired through foreclosure and due to $375,000 in back taxes being paid on a commercial real estate property that was taken into other real estate owned for 2010.

Our efficiency ratio was 76% for 2010 compared to 70% for the 2009 period. The 2009 ratio excludes goodwill impairment.

Income Taxes

We recognized income tax expense of $1.8 million in 2010, as compared to income tax benefit of $1.1 million in 2009, and expense of $2.2 million in 2008. The recognition of income tax expense in 2010 resulted mainly from a non-cash charge of approximately $4.4 million to establish a valuation allowance for our deferred tax asset. The effective tax rate for the year ended December 31, 2009 was 15% compared to 31% for the year ended December 31, 2008. The decrease in the tax rate is related primarily to the loss generated from the goodwill impairment as a portion of this goodwill arose from a taxable business combination. The effective tax rate for the year ended December 31, 2010 is not meaningful due to the size of our operating loss relative to income tax expense recorded resulting from a charge to establish a valuation allowance.

A valuation allowance related to deferred tax assets is required when it is considered more likely than not that all or part of the benefit related to such assets will not be realized. In assessing the need for a valuation allowance, we considered various factors including our three year cumulative loss position and the fact that we did not meet our forecast levels in 2010 that we set in the fourth quarter of 2009 due to higher levels of provision for loan loss expense.

Recording a valuation allowance does not have any impact on our liquidity, nor does it preclude us from using the tax losses, tax credits or other timing differences in the future. To the extent that we generate taxable income in a given quarter, the valuation allowance may be reduced to fully or partially offset the corresponding income tax expense. Any remaining deferred tax asset valuation allowance may be reversed through income tax expense once we can demonstrate a sustainable return to profitability and conclude that it is more likely than not the deferred tax asset will be utilized prior to expiration.

See Note 14 of the Notes to Consolidated Financial Statements for additional discussion of our income taxes.


Total assets at December 31, 2010 increased to $1.3 billion compared to $1.2 billion at December 31, 2009. The increase was due to an increase in cash and cash equivalents and building our investment portfolio to $196.2 million, an increase of $149.2 million since December 31, 2009. This increase was mainly off-set by a decline in gross loans, excluding loans held for sale, of $113.0 million. This shift in the balance sheet reflects a conscious effort by management to add on-balance sheet liquidity to protect us against any adverse changes to our current wholesale funding position.


Net loans decreased $119.7 million to $865.7 million at December 31, 2010 compared to $985.4 million at December 31, 2009. Our commercial real estate and commercial portfolios decreased $90.7 million to $600.0 million at December 31, 2010. Our residential mortgage loan, real estate construction and indirect consumer portfolios all decreased for the 2010 period while our consumer and home equity loan portfolio increased $2.9 million. The decline in our commercial real estate and commercial loan portfolios is a result of pay-offs and charge-offs on several large commercial relationships. The loan portfolio also declined due to our aggressive efforts to resolve problem loans. During 2010, we took deeds in lieu of foreclosure on several large commercial real estate properties, moving them to our other real estate owned portfolio. Although there remains a high demand for loans from quality borrowers, we have elected to shift our focus to preserve capital. We believe, however, we will still be well positioned to benefit from growth in our local markets as the economy rebounds.




Loan Portfolio Composition.  The following table presents a summary of the loan portfolio, net of deferred loan fees, by type. There are no foreign loans in our portfolio and other than the categories noted; there is no concentration of loans in any industry exceeding 10% of total loans.

  December 31,
(Dollars in thousands)   2010   2009   2008   2007   2006
     Amount   %   Amount   %   Amount   %   Amount   %   Amount   %
Type of Loan:
Real Estate:
Residential   $ 164,090       18.47 %    $ 179,130       17.86 %    $ 165,318       18.11 %    $ 132,209       17.21 %    $ 137,155       19.44 % 
Construction     11,034       1.24       14,567       1.45       17,387       1.90       21,383       2.78       23,953       3.39  
Commercial     557,764       62.79       627,788       62.58       563,314       61.70       470,929       61.32       410,146       58.12  
Consumer and home equity     77,781       8.76       74,844       7.46       69,649       7.63       63,090       8.21       62,805       8.90  
Indirect consumer     29,588       3.33       36,628       3.65       31,754       3.48       27,721       3.61       30,857       4.37  
Commercial, other     41,677       4.69       61,969       6.18       56,012       6.13       51,924       6.76       40,121       5.68  
Loans held for sale     6,388       0.72       8,183       0.82       9,567       1.05       780       0.10       673       0.10  
Total loans   $ 888,322       100.00 %    $ 1,003,109       100.00 %    $ 913,001       100.00 %    $ 768,036       100.00 %    $ 705,710       100.00 % 


Loan Maturity Schedule.  The following table shows at December 31, 2010, the dollar amount of loans, net of deferred loan fees, maturing in the loan portfolio based on their contractual terms to maturity.

  Due during
the year ended
December 31,
  Due after
1 through
5 years after
December 31,
  Due after
5 years after
December 31,
     (Dollars in thousands)
Residential mortgage   $ 7,184     $ 36,703     $ 120,203     $ 164,090  
Real estate construction     8,928       2,106             11,034  
Real estate commercial     141,885       386,604       29,275       557,764  
Consumer & home equity     14,954       23,117       39,710       77,781  
Indirect consumer     623       26,224       2,741       29,588  
Commercial, other     14,895       25,175       1,607       41,677  
Loans held for sale     6,388                   6,388  
Total   $ 194,857     $ 499,929     $ 193,536     $ 888,322  

The following table breaks down loans maturing after one year, by fixed and adjustable rates.

  Fixed Rates   Floating or
Adjustable Rates
     (Dollars in thousands)
Residential mortgage   $ 87,358     $ 69,548     $ 156,906  
Real estate construction     2,106             2,106  
Real estate commercial     285,625       130,254       415,879  
Consumer & home equity     15,474       47,353       62,827  
Indirect consumer     28,965             28,965  
Commercial, other     19,049       7,733       26,782  
Total   $ 438,577     $ 254,888     $ 693,465  

Allowance and Provision for Loan Losses

Our financial performance depends on the quality of the loans we originate and management’s ability to assess the degree of risk in existing loans when it determines the allowance for loan losses. An increase in loan charge-offs or non-performing loans or an inadequate allowance for loan losses could reduce net interest income, net income and capital and limit the range of products and services we can offer.




The Allowance for Loan Loss Review Committee evaluates the allowance for loan losses monthly to maintain a level sufficient to absorb probable incurred credit losses existing in the loan portfolio. Periodic provisions to the allowance are made as needed. The Committee determines the allowance by applying loss estimates to graded loans by categories, as described below. In addition, the Committee analyzes such factors as changes in lending policies and procedures; underwriting standards; collection; charge-off and recovery history; changes in national and local economic business conditions and developments; changes in the characteristics of the portfolio; ability and depth of lending management and staff; changes in the trend of the volume and severity of past due, non-accrual and classified loans; troubled debt restructuring and other loan modifications; and results of regulatory examinations.

Further declines in collateral values, including commercial real estate, may impact our ability to collect on certain loans when borrowers are dependent on the values of the real estate as a source of cash flow. During the second half of 2008, 2009 and continuing throughout 2010, we substantially increased our provision for loan losses for our general and specific reserves as we identified adverse conditions. The foreseeable future will continue to be a challenging time for our financial institution as we manage the overall level of our credit quality. It is likely that provision for loan losses will remain elevated in the near term.

As discussed in Note 2 to the consolidated financial statements, we entered into a Consent Order with bank regulatory agencies. In addition to increasing capital ratios, we agreed to maintain adequate reserves for loan losses, develop and implement a plan to reduce the level of non-performing assets through collection, disposition, charge-off or improvement in the credit quality of the loans, develop and implement a plan to reduce concentrations of credit in commercial real estate loans, implement revised credit risk management practices and credit administration policies and procedures and to report our progress to the regulators.

The following table analyzes loan loss experience for the periods indicated.

  Year Ended December 31,
(Dollars in thousands)   2010   2009   2008   2007   2006
Balance at beginning of period   $ 17,719     $ 13,565     $ 7,922     $ 7,684     $ 7,377  
Allowance related to acquisition                 327              
Loans charged-off:
Residential mortgage     222       127       15       18       3  
Consumer & home equity     535       778       515       385       446  
Commercial & commercial real estate     11,438       4,721       364       807       165  
Total charge-offs     12,195       5,626       894       1,210       614  
Residential mortgage           2       4       10       7  
Consumer & home equity     188       205       239       222       287  
Commercial & commercial real estate     72       49       20       7       87  
Total recoveries     260       256       263       239       381  
Net loans charged-off     11,935       5,370       631       971       233  
Provision for loan losses     16,881       9,524       5,947       1,209       540  
Balance at end of period   $ 22,665     $ 17,719     $ 13,565     $ 7,922     $ 7,684  
Allowance for loan losses to total loans (excluding loans held for sale)     2.57 %      1.78 %      1.50 %      1.03 %      1.09 % 
Net charge-offs to average loans outstanding     1.25 %      0.55 %      0.08 %      0.13 %      0.03 % 
Allowance for loan losses to total non-performing loans     49 %      47 %      81 %      89 %      159 % 




The provision for loan losses increased $7.4 million to $16.9 million in 2010 compared to 2009. The increase in provision for loan losses was primarily attributable to residential housing development loans in Jefferson and Oldham Counties. During 2010, we continued our efforts to ensure the adequacy of the allowance by adding specific reserves to several large commercial real estate relationships based on updated appraisals of the underlying collateral. We require appraisals on real estate at the time of initial application and subsequently assess the transaction and market conditions to determine if updated appraisals are periodically needed. Additionally, we evaluate the collateral condition and value upon classification as an impaired loan and upon foreclosure. The higher provision was also due to our increasing the general reserve provisioning levels for commercial real estate loans due to the increase in classified loans for the 2010 period. The allowance for loan losses increased $4.9 million to $22.7 million from December 31, 2009 to December 31, 2010. The increase was due to specific reserves placed on loans due to updated appraisal information obtained as part of our on-going monitoring of the loan portfolio, as well as the provision recorded to reflect an increase in classified loans for the 2010 period. Specific reserves as allocated to substandard loans made up 56% of the total allowance for loan loss at December 31, 2010. The increase in charge-offs for 2010 was primarily attributed to charging down previously recorded specific reserves on non-performing loans whose condition worsened during 2010.

The provision for loan losses increased by $3.6 million to $9.5 million in 2009 compared to 2008. The increase was partially related to growth in the loan portfolio, but primarily from the specific reserves set aside for loans classified during 2009 and increases in general reserve provisioning levels. During the fourth quarter of 2009, we added specific reserves to several large commercial real estate relationships based on updated appraisals of the underlying collateral. The higher provision was also due to our increasing the general reserve factors for commercial real estate loans during the period as the level of classified loans has increased sharply since 2008. The allowance for loan losses increased $4.1 million to $17.7 million from December 31, 2008 to December 31, 2009. The increase was due to an increase in net loans for 2009, as well as the provision recorded to reflect a $24.9 million increase in classified loans for the 2009 period. The increase in charge-offs for the 2009 period was primarily attributed to a charge-down of $2.0 million on one large commercial real estate relationship that we foreclosed on during the second quarter of 2009. $1.7 million of the $2.0 million charge-down was previously reserved during the prior year. Also, during the fourth quarter of 2009, we took a write-down of $500,000 on a commercial real estate relationship that was classified and recorded a charge-off of $822,000 on another commercial real estate relationship. Additionally, charge-offs were generally higher in all areas of the loan portfolio for 2009.

The following table depicts management’s allocation of the allowance for loan losses by loan type. Allowance and allocation is based on management’s current evaluation of risk in each category, economic conditions, past loss experience, loan volume, past due history and other factors. Since these factors and management’s assumptions are subject to change, the allocation is not a prediction of future portfolio performance.

  December 31,
     2010   2009   2008   2007   2006
(Dollars in thousands)   Amount of
  Percent of
Total loans
  Amount of
  Percent of
Total loans
  Amount of
  Percent of
Total loans
  Amount of
  Percent of
Total loans
  Amount of