UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-K

 

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

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

For the transition period from                      to                     

FINANCIAL INSTITUTIONS, INC.

(Exact name of registrant as specified in its charter)

NEW YORK		16-0816610
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
220 LIBERTY STREET, WARSAW, NEW YORK		14569
(Address of principal executive offices)		(ZIP Code)

Registrant’s telephone number, including area code: (585) 786-1100

Securities registered under Section 12(b) of the Exchange Act:

Title of each class		Name of exchange on which registered
Common stock, par value $.01 per share		NASDAQ Global Select Market

Securities registered under Section 12(g) of the Exchange Act: NONE

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

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 þ

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 past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of the 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 large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o		Accelerated filer þ		Non-accelerated filer o		Smaller reporting company o

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

The aggregate market value of common stock held by non-affiliates of the registrant, as computed by reference to the June 30, 2008 closing price reported by NASDAQ, was $160,362,000.

As of February 28, 2009, there were issued and outstanding, exclusive of treasury shares, 10,846,519 shares of the registrant’s common stock.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the 2009 Annual Meeting of Shareholders are incorporated by reference in Part III.

 

 

TABLE OF CONTENTS

			PAGE
PART I
Item 1. Business			5
Item 1A. Risk Factors			20
Item 1B. Unresolved Staff Comments			25
Item 2. Properties			26
Item 3. Legal Proceedings			27
Item 4. Submission of Matters to a Vote of Security Holders			27
PART II
Item 5. Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities			28
Item 6. Selected Financial Data			30
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations			33
Item 7A. Quantitative and Qualitative Disclosures About Market Risk			56
Item 8. Financial Statements and Supplementary Data			58
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure			99
Item 9A. Controls and Procedures			99
Item 9B. Other Information			99
PART III
Item 10. Directors, Executive Officers and Corporate Governance			100
Item 11. Executive Compensation			100
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters			100
Item 13. Certain Relationships and Related Transactions, and Director Independence			100
Item 14. Principal Accountant Fees and Services			100
PART IV
Item 15. Exhibits and Financial Statement Schedules			101
Signatures			103
Exhibit 3.1
Exhibit 3.2
Exhibit 3.3
Exhibit 3.4
Exhibit 10.7
Exhibit 12
Exhibit 21
Exhibit 23
Exhibit 31.1
Exhibit 31.2
Exhibit 32

PART I

FORWARD LOOKING INFORMATION

Statements in this Annual Report on Form 10-K that are based on other than historical data are forward-looking within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements provide current expectations or forecasts of future events and include, among others:

•

statements with respect to the beliefs, plans, objectives, goals, guidelines, expectations, anticipations, and future financial condition, results of operations and performance of Financial Institutions, Inc. (“the parent” or “FII”) and its subsidiaries (collectively “the Company,” “we,” “our,” “us”);

•

statements preceded by, followed by or that include the words “may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “intend,” “plan,” “projects,” or similar expressions.

These forward-looking statements are not guarantees of future performance, nor should they be relied upon as representing management’s views as of any subsequent date. Forward-looking statements involve significant risks and uncertainties and actual results may differ materially from those presented, either expressed or implied, in this Annual Report on Form 10-K, including, but not limited to, those presented in the Management’s Discussion and Analysis. Factors that might cause such differences include, but are not limited to:

•

the Company’s ability to successfully execute its business plans, manage its risks, and achieve its objectives;

•

changes in political and economic conditions, including the political and economic effects of the current economic crisis and other major developments, including wars, military actions and terrorist attacks;

•

changes in financial market conditions, either internationally, nationally or locally in areas in which the Company conducts its operations, including without limitation, reduced rates of business formation and growth, commercial and residential real estate development and real estate prices;

•

fluctuations in markets for equity, fixed-income, commercial paper and other securities, including availability, market liquidity levels, and pricing;

•

changes in interest rates, the quality and composition of the loan and securities portfolios, demand for loan products, deposit flows and competition;

•

acquisitions and integration of acquired businesses;

•

increases in the levels of losses, customer bankruptcies, claims and assessments;

•

changes in fiscal, monetary, regulatory, trade and tax policies and laws, including policies of the U.S. Department of Treasury and the Federal Reserve Board (“FRB”);

•

the Company’s participation or lack of participation in governmental programs implemented under the Emergency Economic Stabilization Act (“EESA”) and the American Recovery and Reinvestment Act (“ARRA”), including without limitation the Troubled Asset Relief Program (“TARP”), the Capital Purchase Program (“CPP”), and the Temporary Liquidity Guarantee Program (“TLGP”) and the impact of such programs and related regulations on the Company and on international, national, and local economic and financial markets and conditions;

•

the impact of the EESA and the ARRA and related rules and regulations on the business operations and competitiveness of the Company and other participating American financial institutions, including the impact of the executive compensation limits of these acts, which may impact the ability of the Company and other American financial institutions to retain and recruit executives and other personnel necessary for their businesses and competitiveness;

•

the impact of certain provisions of the EESA and ARRA and related rules and regulations on the attractiveness of governmental programs to mitigate the effects of the current economic crisis, including the risks that certain financial institutions may elect not to participate in such programs, thereby decreasing the effectiveness of such programs;

•

continuing consolidation in the financial services industry;

•

new litigation or changes in existing litigation;

•

success in gaining regulatory approvals, when required;

•

changes in consumer spending and savings habits;

•

increased competitive challenges and expanding product and pricing pressures among financial institutions;

•

demand for financial services in the Company’s market areas;

•

inflation and deflation;

•

technological changes and the Company’s implementation of new technologies;

•

the Company’s ability to develop and maintain secure and reliable information technology systems;

•

legislation or regulatory changes which adversely affect the Company’s operations or business;

•

the Company’s ability to comply with applicable laws and regulations;

•

changes in accounting policies or procedures as may be required by the Financial Accounting Standards Board or regulatory agencies;

•

increased costs of deposit insurance and changes with respect to Federal Deposit Insurance Corporation (“FDIC”) insurance coverage levels; and

•

further declines in the market value of the Company’s publicly traded stock price or declines in the Company’s ability to generate future cash flows may increase the potential that goodwill recorded on the Company’s consolidated statement of financial position be designated as impaired and that the Company may incur a goodwill write-down in the future.

The Company cautions readers not to place undue reliance on any forward-looking statements, which speak only as of the date made, and advises readers that various factors, including those described above, could affect the Company’s financial performance and could cause the Company’s actual results or circumstances for future periods to differ materially from those anticipated or projected. See also Item 1A, Risk Factors, in this Form 10-K.

Except as required by law, the Company does not undertake, and specifically disclaims any obligation to publicly release any revisions to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.

GLOSSARY OF ACRONYMS

ABS		–		Asset-Backed Security
AFS		–		Available-for-Sale
ALCO		–		Asset/Liability Committee
ALM		–		Asset-Liability Management
AML		–		Anti-Money Laundering
ARM		–		Adjustable Rate Mortgage
ARRA		–		American Recovery and Reinvestment Act
ATM		–		Automated Teller Machine
BCBS		–		Basel Committee on Banking Supervision
BSA		–		Bank Secrecy Act
CDO		–		Collateralized Debt Obligation
CMC		–		Capital Management Committee
COSO		–		Committee of Sponsoring Organizations of the Treadway Commission
CPP		–		Capital Purchase Program
CRA		–		Community Reinvestment Act
CRE		–		Commercial Real Estate
EESA		–		Emergency Economic Stabilization Act
EITF		–		Emerging Issues Task Force
FAMC		–		Federal Agricultural Mortgage Corporation
FASB		–		Financial Accounting Standards Board
FDIC		–		Federal Deposit Insurance Corporation
FHLB		–		Federal Home Loan Bank
FHLMC		–		Federal Home Loan Mortgage Corporation
FIN		–		FASB Interpretation
FNMA		–		Federal National Mortgage Association
FRB		–		Federal Reserve Board
FSP		–		FASB Staff Position
FTE		–		Full-Time Equivalent
GNMA		–		Government National Mortgage Association
HTM		–		Held-to-Maturity
MD&A		–		Management’s Discussion and Analysis
OCI		–		Other Comprehensive Income
OREO		–		Other Real Estate Owned
OTC		–		Over-the-Counter
OTTI		–		Other-Than-Temporary-Impairment
PCAOB		–		Public Company Accounting Oversight Board
SBA		–		Small Business Administration
SEC		–		Securities and Exchange Commission
SFAS		–		Statement of Financial Accounting Standards
TARP		–		Troubled Asset Relief Program
TLGP		–		Temporary Liquidity Guarantee Program
VIE		–		Variable Interest Entity

GENERAL

Financial Institutions, Inc. is a financial holding company organized in 1931 under the laws of New York State. Through its subsidiaries, including its wholly-owned, New York State chartered banking subsidiary, Five Star Bank, Financial Institutions, Inc. provides deposit, lending and other financial services to individuals and businesses in Central and Western New York State. All references in this Form 10-K to the parent company are to Financial Institutions, Inc. (“FII”). Unless otherwise indicated or unless the context requires otherwise, all references in this Form 10-K to “the Company” means Financial Institutions, Inc. and its subsidiaries on a consolidated basis. Five Star Bank is referred to as Five Star Bank, “FSB” or “the Bank”. The parent company is a legal entity separate and distinct from its subsidiaries, assisting those subsidiaries by providing financial resources and management. The Company’s executive offices are located at 220 Liberty Street, Warsaw, New York.

We conduct our business primarily through our banking subsidiary, Five Star Bank, which adopted its current name in 2005 when the Company merged three of its bank subsidiaries, Wyoming County Bank, National Bank of Geneva and Bath National Bank into its New York State chartered bank subsidiary, First Tier Bank & Trust, which was then renamed Five Star Bank. In addition, our business operations include a broker-dealer subsidiary, Five Star Investment Services, Inc. (100% owned) (“FSIS”).

In February 2001, the FISI Statutory Trust I (the “Trust”) was formed to facilitate the private placement of $16.2 million in capital securities (“trust preferred securities”). FII capitalized the Trust with a $502 thousand investment in the Trust’s common securities. The Trust is a variable interest entity as defined by Financial Accounting Standards Board (“FASB”) Interpretation No. 46, “Consolidation of Variable Interest Entities,” and, as such, the Trust is accounted for as an unconsolidated subsidiary. Therefore, the Company’s consolidated statements of financial position reflect the $16.7 million in junior subordinated debentures as a liability and the $502 thousand investment in the Trust’s common securities is included in other assets.

During the second quarter of 2008, the Company received Federal Reserve approval for an election to reinstate its status as a financial holding company under the Gramm-Leach-Bliley Act, which permits the Company to engage in business activities that are financial in nature or incidental to financial activity.

OTHER INFORMATION

This annual report, including the exhibits and schedules filed as part of the annual report, may be inspected at the public reference facility maintained by the SEC at its public reference room at 100 F. Street, N.E., Room 1580, Washington, DC 20549 and copies of all or any part thereof may be obtained from that office upon payment of the prescribed fees. You may call the SEC at 1-800-SEC-0330 for further information on the operation of the public reference room and you can request copies of the documents upon payment of a duplicating fee, by writing to the SEC. In addition, the SEC maintains a website that contains reports, proxy and information statements and other information regarding registrants, including us, that file electronically with the SEC which can be accessed at www.sec.gov.

The Company also makes available, free of charge through its website at www.fiiwarsaw.com, all reports filed with the SEC, including our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, as well as any amendments to those reports, as soon as reasonably practicable after those documents are filed with, or furnished to, the SEC. Information available on our website is not a part of, and is not incorporated into, this annual report on Form 10-K.

MARKET AREAS AND COMPETITION

The Company provides a wide range of consumer and commercial banking and financial services to individuals, municipalities and businesses through a network of 52 offices and over 70 ATMs in fourteen contiguous counties of Western and Central New York State: Allegany, Cattaraugus, Cayuga, Chautauqua, Chemung, Erie, Genesee, Livingston, Monroe, Ontario, Seneca, Steuben, Wyoming and Yates Counties.

The Company’s market area is geographically and economically diversified in that it serves both rural markets and the larger more affluent markets of suburban Rochester and suburban Buffalo. Rochester and Buffalo are the two largest cities in New York State outside of New York City, with combined metropolitan area populations of over two million people. The Company anticipates increasing its presence in the markets around these two cities and opened two branches in the Rochester suburbs during 2008.

The Company faces significant competition in both making loans and attracting deposits, as Western and Central New York have a high density of financial institutions. The Company’s competition for loans comes principally from commercial banks, savings banks, savings and loan associations, mortgage banking companies, credit unions, insurance companies and other financial service companies. Its most direct competition for deposits has historically come from commercial banks, savings banks and credit unions. The Company faces additional competition for deposits from non-depository competitors such as the mutual fund industry, securities and brokerage firms and insurance companies.

LENDING ACTIVITIES

General

The Company offers a broad range of loans including commercial and agricultural working capital and revolving lines of credit, commercial and agricultural mortgages, equipment loans, crop and livestock loans, residential mortgage loans and home equity loans and lines of credit, home improvement loans, automobile loans and personal loans. Newly originated and refinanced fixed rate residential mortgage loans are either retained in the Company’s portfolio or sold to the secondary market and servicing rights are retained.

The Company has thoroughly evaluated and updated its lending policy in recent years. The revisions to the loan policy include a renewed focus on lending philosophy and credit objectives.

The key elements of the Company’s lending philosophy include the following:

•

To ensure consistent underwriting, all employees must share a common view of the risks inherent in lending activities as well as the standards to be applied in underwriting and managing credit risk;

•

Pricing of credit products should be risk-based;

•

The loan portfolio must be diversified to limit the potential impact of negative events; and

•

Careful, timely exposure monitoring through dynamic use of our risk rating system is required to provide early warning and assure proactive management of potential problems.

Commercial and Agricultural Lending

The Company originates commercial loans in its primary market areas and underwrites them based on the borrower’s ability to service the loan from operating income. The Company offers a broad range of commercial lending products, including term loans and lines of credit. Short and medium-term commercial loans, primarily collateralized, are made available to businesses for working capital (including inventory and receivables), business expansion (including acquisition of real estate, expansion and improvements) and the purchase of equipment. As a general practice, where possible, a collateral lien is placed on any available real estate, equipment or other assets owned by the borrower and a personal guarantee of the owner is obtained. As of December 31, 2008, $46.6 million, or 29.4%, of the aggregate commercial loan portfolio were at fixed rates, while $111.9 million, or 70.6%, were at variable rates. The Company utilizes government loan guarantee programs where available and appropriate. See “Government Guarantee Programs” below.

Agricultural loans are offered for short-term crop production, farm equipment and livestock financing and agricultural real estate financing, including term loans and lines of credit. Short and medium-term agricultural loans, primarily collateralized, are made available for working capital (crops and livestock), business expansion (including acquisition of real estate, expansion and improvement) and the purchase of equipment. As of December 31, 2008, $12.6 million, or 28.3%, of the agricultural loan portfolio were at fixed rates, while $32.1 million, or 71.7%, were at variable rates. The Company utilizes government loan guarantee programs where available and appropriate. See “Government Guarantee Programs” below.

Commercial Real Estate Lending

In addition to commercial loans secured by real estate, the Company makes commercial real estate loans to finance the purchase of real property, which generally consists of real estate with completed structures. Commercial real estate loans are secured by first liens on the real estate and are typically amortized over a 10 to 20 year period. The underwriting analysis includes credit verification, appraisals and a review of the borrower’s financial condition and repayment capacity. As of December 31, 2008, $58.0 million, or 22.1%, of the aggregate commercial real estate loan portfolio were at fixed rates, while $204.2 million, or 77.9%, were at variable rates.

Government Guarantee Programs

The Company participates in government loan guarantee programs offered by the SBA, United States Department of Agriculture, Rural Economic and Community Development and Farm Service Agency, among others. As of December 31, 2008, the Company had loans with an aggregate principal balance of $37.6 million that were covered by guarantees under these programs. The guarantees only cover a certain percentage of these loans. By participating in these programs, the Company is able to broaden its base of borrowers while minimizing credit risk.

Consumer Lending

The Company offers a variety of loan products to its consumer customers located in Western and Central New York, including home equity loans and lines of credit, automobile loans, secured installment loans and various other types of secured and unsecured personal loans. At December 31, 2008, outstanding consumer loan balances were concentrated in indirect automobile loans and home equity products.

The Company indirectly originates, through dealers, consumer indirect automobile loans. The consumer indirect loan portfolio is primarily comprised of new and used automobile loans with terms that typically range from 36 to 72 months. The Company has expanded its relationships with franchised new car dealers in our general market area and has selectively originated a mix of new and used automobile loans from those dealers. As of December 31, 2008, the consumer indirect portfolio totaled $255.1 million, nearly all of which were fixed rate automobile loans.

The Company also originates, independently of the indirect loans described above, consumer automobile loans, recreational vehicle loans, boat loans, home improvement loans, closed-end home equity loans, home equity lines of credit, personal loans (collateralized and uncollateralized) and deposit account collateralized loans. The terms of these loans typically range from 12 to 180 months and vary based upon the nature of the collateral and the size of loan. The majority of the consumer lending program is underwritten on a secured basis using the customer’s home or the financed automobile, mobile home, boat or recreational vehicle as collateral. As of December 31, 2008, $134.0 million, or 60.1%, of consumer and home equity loans were at fixed rates, while $88.9 million, or 39.9%, were at variable rates.

Residential Mortgage Lending

The Company originates fixed and variable rate one-to-four family residential mortgages collateralized by owner-occupied properties located in its market areas. The Company offers a variety of real estate loan products, which are generally amortized for periods up to 30 years. Loans collateralized by one-to-four family residential real estate generally have been originated in amounts of no more than 80% of appraised value or have mortgage insurance. Mortgage title insurance and hazard insurance are normally required. The Company sells certain one-to-four family residential mortgages to the secondary mortgage market and typically retains the right to service the mortgages. To assure maximum salability of the residential loan products for possible resale, the Company has formally adopted the underwriting, appraisal, and servicing guidelines of the FHLMC as part of its standard loan policy. As of December 31, 2008, the residential mortgage servicing portfolio totaled $315.7 million, the majority of which have been sold to FHLMC. As of December 31, 2008, $138.8 million, or 78.1%, of residential real estate loans retained in portfolio were at fixed rates, while $38.9 million, or 21.9%, were at variable rates. The Company does not engage in sub-prime or other high-risk residential mortgage lending as a line-of-business.

Credit Administration

The Company’s loan policy establishes standardized underwriting guidelines, as well as the loan approval process and the committee structures necessary to facilitate and insure the highest possible loan quality decision-making in a timely and businesslike manner. The policy establishes requirements for extending credit based on the size, risk rating and type of credit involved. The policy also sets limits on individual loan officer lending authority and various forms of joint lending authority, while designating which loans are required to be approved at the committee level.

The Company’s credit objectives are as follows:

•

Compete effectively and service the legitimate credit needs of our target market;

•

Enhance our reputation for superior quality and timely delivery of products and services;

•

Provide pricing that reflects the entire relationship and is commensurate with the risk profiles of our borrowers;

•

Retain, develop and acquire profitable, multi-product, value added relationships with high quality borrowers;

•

Focus on government guaranteed lending and establish a specialization in this area to meet the needs of the small businesses in our communities; and

•

Comply with the relevant laws and regulations.

The Company’s policy includes loan reviews, under the supervision of the Audit Committee of the Board of Directors and directed by the Chief Risk Officer, in order to render an independent and objective evaluation of the Company’s asset quality and credit administration process.

Risk ratings are assigned to loans in the commercial, commercial real estate and agricultural portfolios. The risk ratings are specifically used as follows:

•

Profile the risk and exposure in the loan portfolio and identify developing trends and relative levels of risk;

•

Identify deteriorating credits; and

•

Reflect the probability that a given customer may default on its obligations.

Through the loan approval process, loan administration and loan review program, management seeks to continuously monitor the credit risk profile of the Company and assesses the overall quality of the loan portfolio and adequacy of the allowance for loan losses.

The Company has several procedures in place to assist in maintaining the overall quality of its loan portfolio. Delinquent loan reports are monitored by credit administration to identify adverse levels and trends. Loans are generally placed on nonaccruing status and cease accruing interest when the payment of principal or interest is delinquent for 90 days, or earlier in some cases, unless the loan is in the process of collection and the underlying collateral further supports the carrying value of the loan.

Allowance for Loan Losses

The allowance for loan losses is established through charges or credits to earnings in the form of a provision (credit) for loan losses. The allowance reflects management’s estimate of the amount of probable loan losses in the portfolio, based on factors such as:

•

Specific allocations for individually analyzed credits;

•

Risk assessment process;

•

Historical net charge-off experience;

•

Evaluation of the loan portfolio with loan reviews;

•

Levels and trends in delinquent and nonaccruing loans;

•

Trends in volume and terms;

•

Collateral values;

•

Effects of changes in lending policy;

•

Experience, ability and depth of management;

•

National and local economic trends and conditions; and

•

Concentrations of credit.

The Company’s methodology in the estimation of the allowance for loan losses includes the following broad areas:

1.

Impaired commercial, commercial real estate and agricultural loans, in excess of $50 thousand are reviewed individually and assigned a specific loss allowance, if considered necessary, in accordance with SFAS No. 114, “Accounting by Creditors for Impairment of a Loan — an amendment of FASB Statements No. 5 and 15.”

2.

The remaining portfolios of commercial, commercial real estate and agricultural loans are segmented by risk rating into the following loan classification categories: uncriticized or pass, special mention and substandard. Uncriticized loans, special mention loans and all substandard loans not assigned a specific loss allowance are assigned allowance allocations based on historical net loan charge-off experience for each of the respective loan categories, supplemented with additional reserve amounts, if considered necessary, based upon qualitative factors. These qualitative factors include the levels and trends in delinquencies, nonaccruing loans, and risk ratings; trends in volume and terms of loans; effects of changes in lending policy; experience, ability, and depth of management; national and local economic conditions; and concentrations of credit, among others.

3.

The consumer loan portfolio is segmented into six types of loans: residential real estate, home equity loans, home equity lines of credit, consumer direct, consumer indirect, and overdrafts. Each of those categories is subdivided into categories based on delinquency status, either 90 days and over past due or under 90 days. Allowance allocations on these types of loans are based on the average loss experience over the last three years for each subdivision of delinquency status supplemented with qualitative factors containing the same elements as described above.

Management presents a quarterly review of the adequacy of the allowance for loan losses to the Company’s Board of Directors based on the methodology described above. See also the sections titled “Analysis of Allowance for Loan Losses” and “Allocation of Allowance for Loan Losses” in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

INVESTMENT ACTIVITIES

The Company’s investment policy is contained within its overall Asset-Liability Management and Investment Policy. This policy dictates that investment decisions will be made based on the safety of the investment, liquidity requirements, potential returns, cash flow targets, need for collateral and desired risk parameters. In pursuing these objectives, the Company considers the ability of an investment to provide earnings consistent with factors of quality, maturity, marketability and risk diversification. The Company’s Treasurer, guided by the ALCO Committee, is responsible for investment portfolio decisions within the established policies.

The Company’s investment securities strategy centers on providing liquidity to meet loan demand and redeeming liabilities, meeting pledging requirements, managing overall interest rate and credit risks and maximizing portfolio yield. The Company’s policy generally limits security purchases to the following:

•

U.S. treasury securities;

•

U.S. government agency securities, which are securities issued by official Federal government bodies (e.g. the Government National Mortgage Association (“GNMA”)) and U.S. government-sponsored enterprise (“GSE”) securities, which are securities issued by independent organizations that are in part sponsored by the federal government (e.g. the Federal Home Loan Bank (“FHLB”) system, the Federal National Mortgage Association (“FNMA”), the Federal Home Loan Mortgage Corporation (“FHLMC”) and the Small Business Administration (“SBA”));

•

Mortgage-backed securities (“MBS”) include mortgage-backed pass-through securities (“pass-throughs”) and collateralized mortgage obligations (“CMO”) issued by GNMA, FNMA and FHLMC and privately issued whole loan CMOs that contain some exposure to sub-prime loans. See also the section titled “Investing Activities” in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations;”

•

Other asset-backed securities (“ABS”) and other privately issued investment grade quality securities;

•

Investment grade municipal securities, including tax, revenue and bond anticipation notes and general obligation bonds;

•

Certain creditworthy un-rated securities issued by municipalities;

•

Investment grade corporate debt, certificates of deposit and qualified preferred equity securities issued by U.S. government-sponsored enterprises (such as FNMA or FHLMC) rated A+ or better;

•

Equity securities at the holding company level; and

•

Limited partnership investments in Small Business Investment Companies (“SBIC”).

SOURCES OF FUNDS

The Company’s primary sources of funds are deposits, borrowed funds and repurchase agreements, scheduled amortization and prepayments of principal from loans and mortgage-backed securities, maturities and calls of investment securities and funds provided by operations.

The Company offers a variety of deposit account products with a range of interest rates and terms. The deposit accounts consist of noninterest-bearing demand, interest-bearing demand, savings, money market, club accounts and certificates of deposit. The Company also offers certificates of deposit with balances in excess of $100,000 to local municipalities, businesses, and individuals as well as Individual Retirement Accounts and other qualified plan accounts. The flow of deposits is influenced significantly by general economic conditions, changes in money market rates, prevailing interest rates and competition. The Company’s deposits are obtained predominantly from the areas in which its branch offices are located. The Company relies primarily on competitive pricing of its deposit products, customer service and long-standing relationships with customers to attract and retain these deposits. In the past, the Company has also utilized certificate of deposit sales in the national brokered market (“brokered deposits”) as a wholesale funding source. The Company had no brokered deposits at December 31, 2008. The Company’s borrowings consist mainly of advances entered into with the FHLB, federal funds purchased and securities sold under repurchase agreements.

OPERATING SEGMENTS

The Company’s primary operating segment is its subsidiary bank, FSB. The Company’s brokerage subsidiary, FSIS, is also deemed an operating segment; however it does not meet the thresholds included in SFAS No. 131 for separation.

SUPERVISION AND REGULATION

General

FII and FSB are subject to extensive federal and state laws and regulations that impose restrictions on, and provide for regulatory oversight of, FII’s and FSB’s operations. These laws and regulations are generally intended to protect depositors and not shareholders. Any change in any applicable statute or regulation could have a material effect on FII’s and FSB’s business.

The supervision and regulation of financial and bank holding companies and their subsidiaries is intended primarily for the protection of depositors, the deposit insurance funds regulated by the FDIC and the banking system as a whole, and not for the protection of shareholders or creditors of bank holding companies. The various bank regulatory agencies have broad enforcement power over bank holding companies and banks, including the power to impose substantial fines, operational restrictions and other penalties for violations of laws and regulations.

The Company is also affected by various governmental requirements and regulations, general economic conditions, and the fiscal and monetary policies of the federal government and the FRB. The monetary policies of the FRB influence to a significant extent the overall growth of loans, investments, deposits, interest rates charged on loans, and interest rates paid on deposits. The nature and impact of future changes in monetary policies are often not predictable.

The following description summarizes some of the laws to which the Company is subject. References to applicable statutes and regulations are brief summaries and do not claim to be complete. They are qualified in their entirety by reference to such statutes and regulations. Management believes the Company is in compliance in all material respects with these laws and regulations. Changes in the laws, regulations or policies that impact the Company cannot necessarily be predicted, but they may have a material effect on the Company’s consolidated financial position, consolidated results of operations, or liquidity.

Regulation of FII

FII is a financial holding company registered under the Bank Holding Company Act of 1956, as amended, and is subject to supervision, regulation and examination by the FRB. The Bank Holding Company Act and other federal laws subject bank holding companies to particular restrictions on the types of activities in which they may engage, and to a range of supervisory requirements and activities, including regulatory enforcement actions for violations of laws and regulations.

Regulatory Restrictions on Dividends; Source of Strength. It is the policy of the FRB that bank holding companies should pay cash dividends on common stock only out of income available over the past year, and only if prospective earnings retention is consistent with the holding company’s expected future needs and financial condition. The policy provides that bank holding companies should not maintain a level of cash dividends that undermines the bank holding company’s ability to serve as a source of strength to its subsidiaries.

Under FRB policy, a bank holding company is expected to act as a source of financial strength to each of its subsidiaries and commit resources to their support. Such support may be required at times when, absent this FRB policy, a holding company may not be inclined to provide it. As discussed below, a bank holding company in certain circumstances could be required to guarantee the capital plan of an undercapitalized banking subsidiary.

Safe and Sound Banking Practices. Bank holding companies are not permitted to engage in unsafe and unsound banking practices. The FRB’s Regulation Y, for example, generally requires a holding company to give the FRB prior notice of any redemption or repurchase of its own equity securities, if the consideration to be paid, together with the consideration paid for any repurchases or redemptions in the preceding year, is equal to 10% or more of the company’s consolidated net worth. The FRB may oppose the transaction if it believes that the transaction would constitute an unsafe or unsound practice or would violate any law or regulation. Depending upon the circumstances, the FRB could take the position that paying a dividend would constitute an unsafe or unsound banking practice.

The FRB has broad authority to prohibit activities of bank holding companies and their non-banking subsidiaries which represent unsafe and unsound banking practices or which constitute violations of laws or regulations, and can assess civil money penalties for certain activities conducted on a knowing and reckless basis, if those activities caused a substantial loss to a depository institution. The penalties can be as high as $1,000,000 for each day the activity continues.

Anti-Tying Restrictions. Bank holding companies and their affiliates are prohibited from tying the provision of certain services, such as extensions of credit, to other services offered by a holding company or its affiliates. In 2002, the FRB adopted Regulation W, a comprehensive synthesis of prior opinions and interpretations under Sections 23A and 23B of the Federal Reserve Act. Regulation W contains an extensive discussion of tying arrangements, which could impact the way banks and bank holding companies transact business with affiliates.

Capital Adequacy Requirements. The FRB has adopted a system using risk-based capital guidelines to evaluate the capital adequacy of bank holding companies. Under the guidelines, specific categories of assets are assigned different risk weights, based generally on the perceived credit risk of the asset. These risk weights are multiplied by corresponding asset balances to determine a “risk-weighted” asset base. The guidelines require a minimum total risk-based capital ratio of 8.0% (of which at least 4.0% is required to consist of Tier 1 capital elements). Total capital is the sum of Tier 1 and Tier 2 capital. As of December 31, 2008, the Company’s ratio of Tier 1 capital to total risk-weighted assets was 11.83% and the ratio of total capital to total risk-weighted assets was 13.08%. See also the section titled “Capital Resources” in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 10, Regulatory Matters, of the notes to consolidated financial statements.

In addition to the risk-based capital guidelines, the FRB uses a leverage ratio as an additional tool to evaluate the capital adequacy of bank holding companies. The leverage ratio is a company’s Tier 1 capital divided by quarterly average consolidated assets. Certain highly rated bank holding companies may maintain a minimum leverage ratio of 3.0%, but other bank holding companies may be required to maintain a leverage ratio of up to 200 basis points above the regulatory minimum. As of December 31, 2008, the Company’s leverage ratio was 8.05%.

The federal banking agencies’ risk-based and leverage ratios are minimum supervisory ratios generally applicable to banking organizations that meet certain specified criteria, assuming that they have the highest regulatory rating. Banking organizations not meeting these criteria are expected to operate with capital positions well above the minimum ratios. The federal bank regulatory agencies may set capital requirements for a particular banking organization that are higher than the minimum ratios when circumstances warrant. FRB guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets.

Imposition of Liability for Undercapitalized Subsidiaries. Bank regulators are required to take “prompt corrective action” to resolve problems associated with insured depository institutions whose capital declines below certain levels. In the event an institution becomes “undercapitalized,” it must submit a capital restoration plan. The capital restoration plan will not be accepted by the regulators unless each company having control of the undercapitalized institution guarantees the subsidiary’s compliance with the capital restoration plan up to a certain specified amount. Any such guarantee from a depository institution holding company is entitled to a priority of payment in bankruptcy.

The aggregate liability of the holding company of an undercapitalized bank is limited to the lesser of 5% of the institution’s assets at the time it became undercapitalized or the amount necessary to cause the institution to be “adequately capitalized.” The bank regulators have greater power in situations where an institution becomes “significantly” or “critically” undercapitalized or fails to submit a capital restoration plan. For example, a bank holding company controlling such an institution can be required to obtain prior FRB approval of proposed dividends, or might be required to consent to a consolidation or to divest the troubled institution or other affiliates.

Acquisitions by Bank Holding Companies. The Bank Holding Company Act requires every bank holding company to obtain the prior approval of the FRB before it may acquire all or substantially all of the assets of any bank, or ownership or control of any voting shares of any bank, if after such acquisition it would own or control, directly or indirectly, more than 5% of the voting shares of such bank. In approving bank acquisitions by bank holding companies, the FRB is required to consider the financial and managerial resources and future prospects of the bank holding company and the banks involved, the convenience and needs of the communities to be served, and various competitive factors.

Control Acquisitions. The Change in Bank Control Act prohibits a person or group of persons from acquiring “control” of a bank holding company unless the FRB has been notified and has not objected to the transaction. Under a rebuttable presumption established by the FRB, the acquisition of 10% or more of a class of voting stock of a bank holding company with a class of securities registered under Section 12 of the Exchange Act, would, under the circumstances set forth in the presumption, constitute acquisition of control of the Company.

In addition, any entity is required to obtain the approval of the FRB under the Bank Holding Company Act before acquiring 25% (5% in the case of an acquirer that is a bank holding company) or more of the Company’s outstanding common stock, or otherwise obtaining control or a “controlling influence” over the Company.

Regulation of FSB

Five Star Bank (“FSB“or the “Bank”) is a New York State-chartered bank and a member of the Federal Reserve System. The FDIC, through the Bank Insurance Fund, insures deposits of the Bank. The supervision and regulation of FSB subjects the Bank to special restrictions, requirements, potential enforcement actions and periodic examination by the FDIC, the FRB and the New York State Banking Department. Because the FRB regulates the holding company parent, the FRB also has supervisory authority that directly affects FSB.

Restrictions on Transactions with Affiliates and Insiders. Transactions between the holding company and its subsidiaries, including the Bank, are subject to Section 23A of the Federal Reserve Act, and to the requirements of Regulation W. In general, Section 23A imposes limits on the amount of such transactions, and also requires certain levels of collateral for loans to affiliated parties. It also limits the amount of advances to third parties, which are collateralized by the securities, or obligations of FII or its subsidiaries.

Affiliate transactions are also subject to Section 23B of the Federal Reserve Act, and to the requirements of Regulation W which generally requires that certain transactions between the holding company and its affiliates be on terms substantially the same, or at least as favorable to the Bank, as those prevailing at the time for comparable transactions with or involving other nonaffiliated persons.

The restrictions on loans to directors, executive officers, principal shareholders and their related interests (collectively referred to herein as “insiders”) contained in the Federal Reserve Act and Regulation O apply to all insured institutions and their subsidiaries and holding companies. These restrictions include limits on loans to one borrower and conditions that must be met before such a loan can be made. There is also an aggregate limitation on all loans to insiders and their related interests. These loans cannot exceed the institution’s total unimpaired capital and surplus, and the FDIC may determine that a lesser amount is appropriate. Insiders are subject to enforcement actions for knowingly accepting loans in violation of applicable restrictions.

Restrictions on Distribution of Subsidiary Bank Dividends and Assets. Dividends paid by the Bank provide a substantial part of FII’s operating funds and, for the foreseeable future, it is anticipated that dividends paid by the Bank will continue to be its principal source of operating funds. Capital adequacy requirements serve to limit the amount of dividends that may be paid by the subsidiaries. Under federal law, the subsidiaries cannot pay a dividend if, after paying the dividend, a particular subsidiary will be “undercapitalized.” The FDIC may declare a dividend payment to be unsafe and unsound even though the bank would continue to meet its capital requirements after the dividend.

Because FII is a legal entity separate and distinct from its subsidiaries, FII’s right to participate in the distribution of assets of any subsidiary upon the subsidiary’s liquidation or reorganization will be subject to the prior claims of the subsidiary’s creditors. In the event of a liquidation or other resolution of an insured depository institution, the claims of depositors and other general or subordinated creditors are entitled to a priority of payment over the claims of holders of any obligation of the institution to its shareholders, including any depository bank holding company (such as FII) or any shareholder or creditor thereof.

Examinations. The New York State Banking Department, the FRB and the FDIC periodically examine and evaluate the Bank. Based upon such examinations, the appropriate regulator may revalue the assets of the institution and require that it establish specific reserves to compensate for the difference between what the regulator determines the value to be and the book value of such assets.

Audit Reports. Insured institutions with total assets of $500 million or more at the beginning of a fiscal year must submit annual audit reports prepared by independent auditors to federal and state regulators. In some instances, the audit report of the institution’s holding company can be used to satisfy this requirement. Auditors must receive examination reports, supervisory agreements and reports of enforcement actions. In addition, financial statements prepared in accordance with U.S. generally accepted accounting principles, management’s certifications concerning responsibility for the financial statements, internal controls and compliance with legal requirements designated by the FDIC, and if total assets exceed $1.0 billion, an attestation by the auditor regarding the statements of management relating to the internal controls must be submitted. The FDIC Improvement Act of 1991 requires that independent audit committees be formed, consisting of outside directors only. The committees of institutions with assets of more than $3.0 billion must include members with experience in banking or financial management must have access to outside counsel and must not include representatives of large customers.

Capital Adequacy Requirements. The FDIC has adopted regulations establishing minimum requirements for the capital adequacy of insured institutions. The FDIC may establish higher minimum requirements if, for example, a bank has previously received special attention or has a high susceptibility to interest rate risk. The most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action.

The FDIC’s risk-based capital guidelines generally require banks to have a minimum ratio of Tier 1 capital to total risk-weighted assets of 4.0% and a ratio of total capital to total risk-weighted assets of 8.0%. The capital categories have the same definitions for the Company. As of December 31, 2008, the ratio of Tier 1 capital to total risk-weighted assets for the Bank was 9.52% and the ratio of total capital to total risk-weighted assets was 10.77%. The FDIC’s leverage guidelines require banks to maintain Tier 1 capital of no less than 4.0% of average total assets, except in the case of certain highly rated banks for which the requirement is 3.0% of average total assets. As of December 31, 2008, the ratio of Tier 1 capital to quarterly average total assets (leverage ratio) was 6.46% for FSB. See the section captioned “Liquidity and Capital Resources” included in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 10, Regulatory Matters, of the notes to consolidated financial statements.

Corrective Measures for Capital Deficiencies. The federal banking regulators are required to take “prompt corrective action” with respect to capital-deficient institutions. Agency regulations define, for each capital category, the levels at which institutions are “well-capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” A “well-capitalized” bank has a total risk-based capital ratio of 10.0% or higher; a Tier 1 risk-based capital ratio of 6.0% or higher; a leverage ratio of 5.0% or higher; and is not subject to any written agreement, order or directive requiring it to maintain a specific capital level for any capital measure. An “adequately capitalized” bank has a total risk-based capital ratio of 8.0% or higher; a Tier 1 risk-based capital ratio of 4.0% or higher; a leverage ratio of 4.0% or higher (3.0% or higher if the bank was rated a composite 1 in its most recent examination report and is not experiencing significant growth); and does not meet the criteria for a well-capitalized bank. A bank is “undercapitalized” if it fails to meet any one of the “adequately capitalized” ratios.

In addition to requiring undercapitalized institutions to submit a capital restoration plan, agency regulations contain broad restrictions on certain activities of undercapitalized institutions including asset growth, acquisitions, branch establishment and expansion into new lines of business. With certain exceptions, an insured depository institution is prohibited from making capital distributions, including dividends, and is prohibited from paying management fees to control persons if the institution would be undercapitalized after any such distribution or payment.

As an institution’s capital decreases, the FDIC’s enforcement powers become more severe. A significantly undercapitalized institution is subject to mandated capital raising activities, restrictions on interest rates paid and transactions with affiliates, removal of management and other restrictions. The FDIC has only very limited discretion in dealing with a critically undercapitalized institution and is virtually required to appoint a receiver or conservator.

Banks with risk-based capital and leverage ratios below the required minimums may also be subject to certain administrative actions, including the termination of deposit insurance upon notice and hearing, or a temporary suspension of insurance without a hearing in the event the institution has no tangible capital.

Deposit Insurance Assessments. The Bank must pay assessments to the FDIC for federal deposit insurance protection that was impacted by legislation enacted during 2006. The Federal Deposit Insurance Reform Act of 2005 and the Federal Deposit Insurance Reform Conforming Amendment Act of 2005 were signed into law in 2006 (collectively the “Reform Act”) providing the following changes:

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Merged the Bank Insurance Fund (“BIF”) and the Savings Association Insurance Fund (“SAIF”) into a new fund, the Deposit Insurance Fund (“DIF”).

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Increased the coverage limit for retirement accounts to $250,000.

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Indexed the coverage limit for deposit insurance for inflation.

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Establishing a range of 1.15 percent to 1.50 percent within which the FDIC may set the Designated Reserve Ratio (“DRR”).

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Eliminating the restrictions on premium rates based on the DRR and granting the FDIC the discretion to price deposit insurance according to risk for all insured institutions regardless of the level of the reserve ratio.

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Granting a one-time initial assessment credit to recognize institutions’ past contributions to the fund.

The Deposit Insurance Fund Act of 1996 contained a comprehensive approach to recapitalizing the Savings Association Insurance Fund and to assuring the payment of the Financing Corporation’s (“FICO”) bond obligations. Under this law, banks insured under the Bank Insurance Fund are required to pay a portion of the interest due on bonds that were issued by FICO in 1987 to help shore up the ailing Federal Savings and Loan Insurance Corporation. The FDIC bills and collects this assessment on behalf of FICO.

As a result of the Reform Act previously described, effective for the FDIC billing period that commenced January 1, 2007, the Company had a $1.3 million assessment credit available to offset future FDIC premium assessments, but not the FICO assessment. The $442 thousand in assessment credits that remained as of December 31, 2007 were fully utilized in 2008, contributing to a $385 increase in the FDIC expense over 2007.

The Reform Act also requires that the FDIC Board of Directors adopt a restoration plan when the DIF reserve ratio falls or is expected to fall below certain minimum levels. The bank failures that occurred in 2008 adversely impacted the deposit insurance fund’s loss provisions, resulting in a decline in the reserve ratio. As part of the restoration plan, the FDIC has increased the insurance assessment rates by seven basis points uniformly for the quarter beginning January 1, 2009. In addition, on February 27, 2009 the FDIC Board adopted an interim rule imposing a 20 basis point emergency special assessment on the industry on June 30, 2009. The assessment is to be collected on September 30, 2009. The interim rule would also permit the Board to impose an emergency special assessment after June 30, 2009, of up to 10 basis points if necessary to maintain public confidence in federal deposit insurance. The Company estimates the combined impact of the seven basis point increase and 20 basis point emergency special assessment to be an approximate increase of $4.6 million in its FDIC deposit insurance assessments for 2009. Subsequently, on March 5, 2009 the Chairman of the FDIC announced that it may cut the 20 basis point emergency special assessment to 10 basis points if legislation passes to expand the FDIC’s existing line of credit with the U.S. Treasury Department.

Enforcement Powers. The FDIC, the New York State Banking Department and the FRB have broad enforcement powers, including the power to terminate deposit insurance, impose substantial fines and other civil and criminal penalties and appoint a conservator or receiver. Failure to comply with applicable laws, regulations and supervisory agreements could subject the Company or the Bank, as well as the officers, directors and other institution-affiliated parties of these organizations, to administrative sanctions and potentially substantial civil money penalties.

Federal Home Loan Bank System. FSB is a member of the FHLB System, which consists of 12 regional Federal Home Loan Banks. The FHLB System provides a central credit facility primarily for member institutions. As members of the FHLB of New York, the Bank is required to acquire and hold shares of capital stock in the FHLB. The minimum investment requirement is determined by a “membership” investment component and an “activity-based” investment component. Under the “membership” component, a certain minimum investment in capital stock is required to be maintained as long as the institution remains a member of the FHLB. Under the “activity-based” component, members are required to purchase capital stock in proportion to the volume of certain transactions with the FLHB. As of December 31, 2008, FSB complied with these requirements.

Brokered Deposit Restrictions. Adequately capitalized institutions cannot accept, renew or roll over brokered deposits except with a waiver from the FDIC, and are subject to restrictions on the interest rates that can be paid on such deposits. Undercapitalized institutions may not accept, renew or roll over brokered deposits. As of December 31, 2008, FSB was considered well-capitalized and subject to the brokered deposit restrictions.

Cross-Guarantee Provisions. The Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”) contains a “cross-guarantee” provision which generally makes commonly controlled insured depository institutions liable to the FDIC for any losses incurred in connection with the failure of a commonly controlled depository institution.

Community Reinvestment Act. The Community Reinvestment Act of 1977 (“CRA”) and the regulations issued hereunder are intended to encourage banks to help meet the credit needs of their service area, including low and moderate income neighborhoods, consistent with the safe and sound operations of the banks. These regulations also provide for regulatory assessment of a bank’s record in meeting the needs of its service area when considering applications regarding establishing branches, mergers or other bank or branch acquisitions. FIRREA requires federal banking agencies to make public a rating of a bank’s performance under the CRA. In the case of a bank holding company, the CRA performance record of the banks involved in the transaction are reviewed in connection with the filing of an application to acquire ownership or control of shares or assets of a bank or to merge with any other bank holding company. An unsatisfactory record can substantially delay or block the transaction. Five Star Bank received a rating of “outstanding” as of its most recent CRA performance evaluation.

Consumer Laws and Regulations. In addition to the laws and regulations discussed herein, the Bank is also subject to certain consumer laws and regulations that are designed to protect consumers in transactions with banks. While the list set forth herein is not exhaustive, these laws and regulations include, among others, the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, the Fair Housing Act, the Home Mortgage Disclosure Act and the Real Estate Settlement Procedures Act. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must deal with customers when taking deposits or making loans to such customers. The Bank must comply with the applicable provisions of these consumer protection laws and regulations as part of their ongoing customer relations. The Check Clearing for the 21st Century Act (“Check 21 Act” or “the Act”), which became effective on October 28, 2004, creates a new negotiable instrument, called a “substitute check”, which banks are required to accept as the legal equivalent of a paper check if it meets the requirements of the Act. The Act is designed to facilitate check truncation, to foster innovation in the check payment system, and to improve the payment system by shortening processing times and reducing the volume of paper checks.

Gramm-Leach-Bliley Act

The Gramm-Leach-Bliley Act (“Gramm-Leach”) was signed into law on November 12, 1999. Gramm-Leach permits, subject to certain conditions, combinations among banks, securities firms and insurance companies. Under Gramm-Leach, bank holding companies are permitted to offer their customers virtually any type of financial service including banking, securities underwriting, insurance (both underwriting and agency), and merchant banking. In order to engage in these additional financial activities, a bank holding company must qualify and register with the Board of Governors of the Federal Reserve System as a “financial holding company” by demonstrating that each of its subsidiaries is “well capitalized,” “well managed,” and has at least a “satisfactory” rating under the CRA. During the second quarter of 2008, FII received FRB approval for an election to re-instate its status as a financial holding company, which the Company terminated during 2003. The change in status did not affect the activities being conducted by the Company or its subsidiaries. Gramm-Leach establishes that the federal banking agencies will regulate the banking activities of financial holding companies and banks’ financial subsidiaries, the SEC will regulate their securities activities and state insurance regulators will regulate their insurance activities. Gramm-Leach also provides new protections against the transfer and use by financial institutions of consumers’ nonpublic, personal information.

The major provisions of Gramm-Leach include:

Financial Holding Companies and Financial Activities. Title I establishes a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms, and other financial service providers by revising and expanding the Bank Holding Company Act framework to permit a holding company system to engage in a full range of financial activities through qualification as a new entity known as a financial holding company. A bank holding company that qualifies as a financial holding company can expand into a wide variety of services that are financial in nature, if its subsidiary depository institutions are “well-managed”, “well-capitalized” and have received at least a “satisfactory” rating on their last CRA examination. Services that have been deemed to be financial in nature include securities underwriting, dealing and market making, sponsoring mutual funds and investment companies, insurance underwriting and agency activities and merchant banking.

Securities Activities. Title II narrows the exemptions from the securities laws previously enjoyed by banks, requires the FRB and the SEC to work together to draft rules governing certain securities activities of banks and creates a new, voluntary investment bank holding company.

Insurance Activities. Title III restates the proposition that the states are the functional regulators for all insurance activities, including the insurance activities of federally chartered banks, and bars the states from prohibiting insurance activities by depository institutions. The law encourages the states to develop uniform or reciprocal rules for the licensing of insurance agents.

Privacy. Under Title V, federal banking regulators were required to adopt rules that have limited the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third parties. These limitations require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to a nonaffiliated third party. Federal banking regulators issued final rules on May 10, 2000 to implement the privacy provisions of Title V. Under the rules, financial institutions must provide:

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Initial notices to customers about their privacy policies, describing the conditions under which they may disclose nonpublic personal information to nonaffiliated third parties and affiliates;

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Annual notices of their privacy policies to current customers; and

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A reasonable method for customers to “opt out” of disclosures to nonaffiliated third parties.

The Bank is in full compliance with the rules.

Safeguarding Confidential Customer Information. Under Title V, federal banking regulators are required to adopt rules requiring financial institutions to implement a program to protect confidential customer information. In January 2000, the federal banking agencies adopted guidelines requiring financial institutions to establish an information security program to:

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Identify and assess the risks that may threaten customer information;

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Develop a written plan containing policies and procedures to manage and control these risks;

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Implement and test the plan; and

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Adjust the plan on a continuing basis to account for changes in technology, the sensitivity of customer information and internal or external threats to information security.

The Bank approved security programs appropriate to its size and complexity and the nature and scope of its operations prior to the effective date of the regulatory guidelines. The implementation of the programs is an ongoing process.

Community Reinvestment Act Sunshine Requirements. In February 2001, the federal banking agencies adopted final regulations implementing Section 711 of Title VII, the CRA Sunshine Requirements. The regulations require nongovernmental entities or persons and insured depository institutions and affiliates that are parties to written agreements made in connection with the fulfillment of the institution’s CRA obligations to make available to the public and the federal banking agencies a copy of each agreement. The regulations impose annual reporting requirements concerning the disbursement, receipt and use of funds or other resources under these agreements. The effective date of the regulations was April 1, 2001. Neither FII nor the Bank is a party to any agreement that would be the subject of reporting pursuant to the CRA Sunshine Requirements.

USA Patriot Act

As part of the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (“USA Patriot Act”), signed into law on October 26, 2001, Congress adopted the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001 (“AML”). AML authorizes the Secretary of the Treasury, in consultation with the heads of other government agencies, to adopt special measures applicable to banks, bank holding companies or other financial institutions. During 2002, the Department of Treasury issued a number of regulations relating to enhanced recordkeeping and reporting requirements for certain financial transactions that are of primary money laundering concern, due diligence requirements concerning the beneficial ownership of certain types of accounts, and restrictions or prohibitions on certain types of accounts with foreign financial institutions. Covered financial institutions also are barred from dealing with foreign “shell” banks. In addition, AML expands the circumstances under which funds in a bank account may be forfeited and requires covered financial institutions to respond under certain circumstances to requests for information from federal banking agencies within 120 hours.

Regulations were also adopted during 2002 to implement minimum standards to verify customer identity, to encourage cooperation among financial institutions, federal banking agencies, and law enforcement authorities regarding possible money laundering or terrorist activities, to prohibit the anonymous use of “concentration accounts,” and to require all covered financial institutions to have in place a Bank Secrecy Act compliance program. AML also amends the Bank Holding Company Act and the Bank Merger Act to require the federal banking agencies to consider the effectiveness of a financial institution’s anti-money laundering activities when reviewing an application under these acts.

The Bank has in place a Bank Secrecy Act compliance program, and it engages in very few transactions of any kind with foreign financial institutions or foreign persons.

Sarbanes-Oxley Act

On July 30, 2002, the President signed into law the Sarbanes-Oxley Act of 2002 (the “Act”) implementing legislative reforms intended to address corporate and accounting fraud. In addition to the establishment of a new accounting oversight board that enforces auditing, quality control and independence standards and is funded by fees from all publicly traded companies, the law restricts accounting firms from providing both auditing and consulting services to the same client. To ensure auditor independence, any non-audit services being provided to an audit client requires pre-approval by the issuer’s audit committee members. In addition, the audit partners must be rotated. The Act requires chief executive officers and chief financial officers, or their equivalent, to certify to the accuracy of periodic reports filed with the SEC, subject to civil and criminal penalties if they knowingly or willfully violate this certification requirement. In addition, under the Act, legal counsel is required to report evidence of a material violation of the securities laws or a breach of fiduciary duty by a company to its chief executive officer or its chief legal officer, and, if such officer does not appropriately respond, to report such evidence to the audit committee or other similar committee of the board of directors or the board itself.

Longer prison terms and increased penalties are also applied to corporate executives who violate federal securities laws, the period during which certain types of suits can be brought against a company or its officers has been extended, and bonuses issued to top executives prior to restatement of a company’s financial statements are subject to disgorgement if such restatement was due to corporate misconduct. Executives are also prohibited from insider trading during retirement plan “blackout” periods, and loans to company executives are restricted. The Act accelerates the time frame for disclosures by public companies, as they must immediately disclose any material changes in their financial condition or operations. Directors and executive officers must also provide information for most changes in ownership in a company’s securities within two business days of the change.

The Act also prohibits any officer or director of a company or any other person acting under their direction from taking any action to fraudulently influence, coerce, manipulate or mislead any independent public or certified accountant engaged in the audit of the company’s financial statements for the purpose of rendering the financial statement’s materially misleading. The Act also requires the SEC to prescribe rules requiring inclusion of an internal control report and assessment by management in the annual report to stockholders. In addition, the Act requires that each financial report required to be prepared in accordance with (or reconciled to) accounting principles generally accepted in the United States of America and filed with the SEC reflect all material correcting adjustments that are identified by a “registered public accounting firm” in accordance with accounting principles generally accepted in the United States of America and the rules and regulations of the SEC.

As directed by Section 302(a) of the Act, the Company’s chief executive officer and chief financial officer are each required to certify that the Company’s quarterly and annual reports do not contain any untrue statement of a material fact. The Act imposes several requirements, including having these officers certify that: they are responsible for establishing, maintaining and regularly evaluating the effectiveness of the Company’s internal controls; they have made certain disclosures to the Company’s auditors and the Audit Committee of the Board of Directors about the Company’s internal controls; and they have included information in the Company’s quarterly and annual reports about their evaluation and whether there have been significant changes in the Company’s internal controls or in other factors that could significantly affect internal controls during the last quarter.

Fair Credit Reporting Act and Fair and Accurate Transactions Act

In 1970, the U. S. Congress enacted the Fair Credit Reporting Act (the “FCRA”) in order to ensure the confidentiality, accuracy, relevancy and proper utilization of consumer credit report information. Under the framework of the FCRA, the United States has developed a highly advanced and efficient credit reporting system. The information contained in that broad system is used by financial institutions, retailers and other creditors of every size in making a wide variety of decisions regarding financial transactions. Employers and law enforcement agencies have also made wide use of the information collected and maintained in databases made possible by the FCRA. The FCRA affirmatively preempts state law in a number of areas, including the ability of entities affiliated by common ownership to share and exchange information freely, the requirements on credit bureaus to reinvestigate the contents of reports in response to consumer complaints, among others. By its terms, the preemption provisions of the FCRA were to terminate as of December 31, 2003. With the enactment of the Fair and Accurate Transactions Act (the “FACT Act”) in late 2003, the preemption provisions of FCRA were extended, although the FACT Act imposes additional requirements on entities that gather and share consumer credit information. The FACT Act required the FRB and the Federal Trade Commission (“FTC”) to issue final regulations within nine months of the effective date of the Act. A series of regulations and announcements have been promulgated, including a joint FTC/FRB announcement of effective dates for FCRA amendments, the FTC’s “Free Credit Report” rule, revisions to the FTC’s FACT Act Rules, the FTC’s final rules on identity theft and proof of identity, the FTC’s final regulation on consumer information and records disposal, the FTC’s final summaries and the final rule on prescreen notices.

Emergency Economic Stabilization Act of 2008

On October 3, 2008, EESA was signed into law as part of a broad initiative to stabilize U.S. financial markets and provide liquidity. EESA enables the federal government, under terms and conditions to be developed by the Secretary of the Treasury, to insure troubled assets, including mortgage-backed securities, and collect premiums from participating financial institutions. EESA includes, among other provisions: (a) the $700 billion TARP, under which the Secretary of the Treasury is authorized to purchase, insure, hold, and sell a wide variety of financial instruments, particularly those that are based on or related to residential or commercial mortgages originated or issued on or before March 14, 2008; and (b) an increase in the amount of deposit insurance provided by the FDIC.

Troubled Assets Relief Program

Under the TARP, the Department of Treasury authorized a voluntary capital purchase program (CPP) to purchase up to $250 billion of senior preferred shares of qualifying financial institutions that elected to participate by November 14, 2008. Participating companies must adopt certain standards for executive compensation, including (a) prohibiting “golden parachute” payments as defined in EESA to senior Executive Officers; (b) requiring recovery of any compensation paid to senior Executive Officers based on criteria that is later proven to be materially inaccurate; and (c) prohibiting incentive compensation that encourages unnecessary and excessive risks that threaten the value of the financial institution. The terms of the CPP also limit certain uses of capital by the issuer, including repurchases of company stock, and increases in dividends.

Federal Deposit Insurance Corporation Insurance Limit Increases

EESA temporarily raised the limit on federal deposit insurance coverage from $100,000 to $250,000 per depositor. Separate from EESA, in October 2008, the FDIC also announced the TLGP. Under one component of this program, the FDIC temporarily provides unlimited coverage for noninterest bearing transaction deposit accounts through December 31, 2009. The limits are scheduled to return to $100,000 on January 1, 2010.

Change in Tax Treatment of Fannie Mae and Freddie Mac Preferred Stock

Section 301 of the EESA changes the tax treatment of gains or losses from the sale or exchange of FNMA or FHLMC preferred stock by an “applicable financial institution,” such as FSB, by stating that a gain or loss on Fannie Mae or Freddie Mac preferred stock shall be treated as ordinary gain or loss instead of capital gain or loss, as was previously the case. This change, which was enacted in the 2008 fourth quarter, provides tax relief to banking organizations that have suffered losses on certain direct and indirect investments in Fannie Mae and Freddie Mac preferred stock. As a result, the Company was able to recognize the tax effects of the other-than-temporary-impairment (“OTTI”) charge on its investment in auction rate preferred equity securities, which are collateralized by FNMA and FHLMC preferred stock, as an ordinary loss in the consolidated financial statements for the year ended December 31, 2008.

Financial Stability Plan

On February 10, 2009, the Financial Stability Plan was announced by the U.S. Treasury Department. The Financial Stability Plan is a comprehensive set of measures intended to shore up the financial system. The core elements of the plan include making bank capital injections, creating a public-private investment fund to buy troubled assets, establishing guidelines for loan modification programs and expanding the Federal Reserve lending program. The U.S. Treasury Department has indicated more details regarding the Financial Stability Plan are to be announced on a newly created government website, www.FinancialStability.gov, in the next several weeks.

American Recovery and Reinvestment Act of 2009

On February 17, 2009, the ARRA was enacted. ARRA is intended to provide a stimulus to the U.S. economy in the wake of the economic downturn brought about by the subprime mortgage crisis and the resulting credit crunch. The bill includes federal tax cuts, expansion of unemployment benefits and other social welfare provisions, and domestic spending in education, healthcare, and infrastructure. The new law also includes numerous non-economic recovery related items, including a limitation on executive compensation in federally-aided banks.

Under ARRA, an institution will be subject to the following restrictions and standards throughout the period in which any obligation arising from financial assistance provided under TARP remains outstanding:

	•		Limits on compensation incentives for risk-taking by senior executive officers.
	•		Requirement of recovery of any compensation paid based on inaccurate financial information.
	•		Prohibition on “Golden Parachute Payments”.
	•		Prohibition on compensation plans that would encourage manipulation of reported earnings to enhance the compensation of employees.
	•		Publicly registered TARP recipients must establish a board compensation committee comprised entirely of independent directors, for the purpose of reviewing employee compensation plans.
	•		Prohibition on bonus, retention award, or incentive compensation, except for payments of long term restricted stock.
	•		Limitation on luxury expenditures.
	•		TARP recipients are required to permit a separate non-binding shareholder vote to approve the compensation of executives, as disclosed pursuant to the SEC’s compensation disclosure rules.
	•		The chief executive officer and chief financial officer of each TARP recipient will be required to provide a written certification of compliance with these standards to the SEC.

Notwithstanding the foregoing, the ARRA provides that the Secretary of the Treasury shall permit a TARP recipient, subject to consultation with the recipient’s appropriate Federal banking agency, to repay such assistance without regard to whether the recipient has replaced such funds from any other source or to any waiting period. ARRA further provides that when the recipient repays such assistance, the Secretary of the Treasury shall liquidate the warrants associated with the assistance at the current market price. While Treasury has not yet issued implementing regulations, it appears that ARRA will permit the Company, if it so elects and following consultation with the FRB, to redeem the Series A Preferred Stock at any time without restriction.

Homeowner Affordability and Stability Plan

On February 18, 2009, the Homeowner Affordability and Stability Plan (“HASP”) was announced by the President of the United States. HASP is intended to support a recovery in the housing market and ensure that workers can continue to pay off their mortgages through the following elements:

	•		Provide access to low-cost refinancing for responsible homeowners suffering from falling home prices.
	•		A $75 billion homeowner stability initiative to prevent foreclosure and help responsible families stay in their homes.
	•		Support low mortgage rates by strengthening confidence in Fannie Mae and Freddie Mac.

Impact of Inflation and Changing Prices

The Company’s financial statements included herein have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). GAAP requires the Company to measure financial position and operating results principally using historic dollars. Changes in the relative value of money due to inflation or recession are generally not considered. The primary effect of inflation on the operations of the Company is reflected in increased operating costs. In the Company’s view, changes in interest rates affect the financial condition of a financial institution to a far greater degree than changes in the inflation rate. While interest rates are generally influenced by changes in the inflation rate, they do not necessarily change at the same rate or in the same magnitude. Interest rates are sensitive to many factors that are beyond the control of the Company, including changes in the expected rate of inflation, general and local economic conditions and the monetary and fiscal policies of the United States government, its agencies and various other governmental regulatory authorities.

Regulatory and Economic Policies

The Company’s business and earnings are affected by general and local economic conditions and by the monetary and fiscal policies of the U.S. government, its agencies and various other governmental regulatory authorities. The FRB regulates the supply of money in order to influence general economic conditions. Among the instruments of monetary policy available to the FRB are (i) conducting open market operations in U.S. government obligations, (ii) changing the discount rate on financial institution borrowings, (iii) imposing or changing reserve requirements against financial institution deposits, and (iv) restricting certain borrowings and imposing or changing reserve requirements against certain borrowings by financial institutions and their affiliates. These methods are used in varying degrees and combinations to directly affect the availability of bank loans and deposits, as well as the interest rates charged on loans and paid on deposits. For that reason, the policies of the FRB could have a material effect on the earnings of the Company.

EMPLOYEES

At December 31, 2008, the Company had 532 full-time and 133 part-time employees.

EXECUTIVE OFFICERS OF REGISTRANT

The following table sets forth current information regarding executive officers and other significant employees (ages are as of the 2009 Annual Meeting).

						Starting
Name		Age				In				Positions/Offices
Peter G. Humphrey			54				1977			President and Chief Executive Officer of FII and Five Star Bank.
Ronald A. Miller			60				1996			Executive Vice President, Chief Financial Officer and Corporate Secretary of FII and Five Star Bank.
James T. Rudgers			59				2004			Executive Vice President and Chief of Community Banking Officer of FII and Five Star Bank. Executive Vice President of Retail Banking at Hudson United Bank Corporation from 2002 to 2004.
John J. Witkowski			46				2005			Senior Vice President and Regional President / Retail Banking Executive Officer of Five Star Bank. Senior Vice President and Director of Sales for Business Banking / Client Development Group at Bank of America from 1993 to 2005.
Martin K. Birmingham			42				2005			Senior Vice President and Regional President / Commercial Banking Executive Officer of Five Star Bank. Senior Team Leader and Regional President of the Rochester Market at Bank of America (formally Fleet Boston Financial) from 2000 to 2005.
George D. Hagi			56				2006			Executive Vice President and Chief Risk Officer of FII and Five Star Bank. Senior Vice President and Director of Risk Management at First National Bankshares of Florida and FNB Corp from 1997 to 2005.
Kevin B. Klotzbach			56				2001			Senior Vice President and Treasurer of Five Star Bank.
Bruce H. Nagle			60				2006			Senior Vice President and Director of Human Resources of FII and Five Star Bank. Vice President of Human Resources at University of Pittsburgh Medical Center from 2000 to 2006.
Richard J. Harrison			63				2003			Senior Vice President and Senior Retail Lending Administrator of Five Star Bank. Executive Vice President and Chief Credit Officer at Savings Bank of the Fingerlakes from 2000 to 2003.

ITEM 1A. RISK FACTORS

Making or continuing an investment in securities issued by the Company, including its common stock, involves certain risks that you should carefully consider. The risks and uncertainties described below are not the only risks that may have a material adverse effect on the Company. Additional risks and uncertainties also could adversely affect the Company’s business, financial condition and results of operations. If any of the following risks actually occur, the Company’s business, financial condition or results of operations could be negatively affected, the market price for your securities could decline, and you could lose all or a part of your investment. Further, to the extent that any of the information contained in this Annual Report on Form 10-K constitutes forward-looking statements, the risk factors set forth below also are cautionary statements identifying important factors that could cause the Company’s actual results to differ materially from those expressed in any forward-looking statements made by or on behalf of the Company.

The Company’s business may be adversely impacted by adverse conditions in the financial markets and economic conditions generally.

The capital and credit markets have been experiencing unprecedented levels of volatility and disruption for more than a year. In some cases, the markets have produced downward pressure on stock prices and credit availability for certain issuers without regard to those issuers’ underlying financial strength. As a consequence of the recession that the United States now finds itself in, business activity across a wide range of industries face serious difficulties due to the lack of consumer spending and the extreme lack of liquidity in the global credit markets. Unemployment has also increased significantly.

A sustained weakness or weakening in business and economic conditions generally or specifically in the principal markets in which the Company does business could have one or more of the following material adverse impacts on the Company’s business, financial condition and results of operations:

•

A decrease in the demand for loans and other products and services offered by the Company;

•

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, such as goodwill;

•

An increase in the number of clients and counterparties who become delinquent, file for protection under bankruptcy laws or default on their loans or other obligations to the Company. An increase in the number of delinquencies, bankruptcies or defaults could result in a higher level of non-performing assets, net charge-offs, provision for loan losses, and valuation adjustments on loans held for sale.

Current market developments may adversely impact the Company’s industry and business.

Dramatic declines in the housing market during the prior year, with falling home prices and increasing foreclosures and unemployment, have resulted in, and may continue to result in, significant write-downs of asset values by the Company and other financial institutions, including government-sponsored entities and major commercial and investment banks. These write-downs, initially of mortgage-backed securities but spreading to credit default swaps and other derivative securities, have caused many financial institutions to seek additional capital, to merge with larger and stronger institutions and, in some cases, to fail. Reflecting concern about the stability of the financial markets generally and the strength of counterparties, many lenders and institutional investors have reduced, and in some cases, ceased to provide funding to borrowers including financial institutions.

This market turmoil and tightening of credit have led to an increased level of commercial and consumer delinquencies, lack of consumer confidence, increased market volatility and widespread reduction of business activity generally. The resulting lack of available credit, lack of confidence in the financial sector, increased volatility in the financial markets and reduced business activity could have a material adverse impact on the Company’s business, financial condition or 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 of these difficult market conditions on the financial services industry and could have a material adverse impact on the Company’s business, financial condition or results of operations.

The Company is subject to liquidity risks.

The Company maintains liquidity primarily through customer deposits and other funding sources. If economic influences change so that we do not have access to short-term credit, or our depositors withdraw a substantial amount of their funds for other uses, Five Star Bank might experience liquidity issues. Our efforts to monitor and manage liquidity risk may not be successful or sufficient to deal with dramatic or unanticipated reductions in our liquidity. In such events, our cost of funds may increase, thereby reducing our net interest revenue, or we may need to sell a portion of our investment portfolio, which, depending upon market conditions, could result in our realizing a loss.

The soundness of other financial institutions, including Federal Home Loan Bank, could adversely impact the Company.

The Company’s ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of counterparty relationships. The Company has exposure to many different industries and counterparties, and routinely executes transactions with counterparties in the financial services industry. The most important counterparty for the Company, in terms of liquidity, is the Federal Home Loan Bank of New York (“FHLBNY”). The Company uses FHLBNY as its primary source of long-term wholesale funding. At December 31, 2008, the Company had a total of $30.7 million in borrowed funds with FHLBNY.

There are twelve branches of the Federal Home Loan Bank (“FHLB”), including New York. Several members have warned that they have either breached risk-based capital requirements or that they are close to breaching those requirements. To conserve capital, some FHLB branches are suspending dividends, cutting dividend payments, and not buying back excess FHLB stock that members hold. FHLBNY has stated that they expect to be able to continue to pay dividends, redeem excess capital stock, and provide competitively priced advances in the future. The most severe problems in the FHLB system have been at some of the other FHLB branches. Nonetheless, the twelve FHLB branches are jointly liable for the consolidated obligations of the FHLB system. To the extent that one FHLB branch cannot meet its obligations to pay its share of debt, other FHLB branches may be called upon to make the payment.

As a member of the FHLB System, the Company is required to hold stock in FHLBNY. The carrying value and fair value of the Company’s FHLBNY common stock as of December 31, 2008 was $3.2 million based on its par value. In an extreme situation, it is possible that the capitalization of an FHLB, including FHLBNY, could be substantially diminished or reduced to zero. Consequently, given that there is no market for the Company’s FHLBNY common stock, there is a risk that the investment could be determined to be impaired in the future.

Deterioration in the soundness of FHLBNY or the FHLB System could have a material adverse impact on the Company’s business, financial condition, results of operations or liquidity.

The value of certain securities in the Company’s investment securities portfolio may be negatively affected by disruptions in the market for these securities.

In addition to interest rate risk typically associated with an investment portfolio, the market for certain investment securities held within the Company’s investment portfolio has, over the past year, become much less liquid. This coupled with uncertainly surrounding the credit risk associated with the underlying collateral has caused material discrepancies in valuation estimates obtained from third parties. The Company values some of its investments using internally developed cash flow and valuation models, which include certain subjective estimates which are believed to reflect the estimates a purchaser of such securities would use if such a transaction were to occur. The volatile market may affect the value of these securities, such as through reduced valuations due to the perception of heightened credit and liquidity risks, in addition to interest rate risk typically associated with these securities. There can be no assurance that the declines in market value associated with these disruptions will not result in impairments of these assets, which could have a material adverse impact on the Company’s business, financial condition, results of operations or liquidity.

FDIC insurance premiums may increase materially.

The FDIC insures deposits at FDIC insured financial institutions, including FSB. The FDIC charges the insured financial institutions premiums to maintain the Deposit Insurance Fund at a certain level. Current economic conditions have increased bank failures and expectations for further failures, in which case the FDIC ensures payments of deposits up to insured limits from the Deposit Insurance Fund. In December 2008 and again in February 2009, the FDIC adopted rules that will increase premiums paid by insured institutions and make other changes to the assessment system. Significant increases in deposit insurance premiums could have a material adverse impact on the Company’s business, financial condition, results of operations or liquidity.

There can be no assurance that the EESA and other recently enacted government programs will help stabilize the U.S. financial system.

On October 3, 2008, the EESA was signed into law by the President. The legislation was the result of a proposal by the Secretary of the Treasury on September 20, 2008 in response to the financial crises affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions. The U.S. Treasury and federal banking regulators are implementing a number of programs under this legislation and otherwise to address capital and liquidity issues in the banking system, including the CPP, in which the Company participates. In addition, other regulators have taken steps to attempt to stabilize and add liquidity to the financial markets, such as the FDIC’s TLGP.

On February 10, 2009, the Secretary of the Treasury announced the Financial Stability Plan, which earmarks the second $350 billion originally authorized under the EESA. The Financial Stability Plan is intended to, among other things, make capital available to financial institutions, purchase certain legacy loans and assets from financial institutions, restart securitization markets for loans to consumers and businesses and relieve certain pressures on the housing market, including the reduction of mortgage payments and interest rates.

In addition, the ARRA, which was signed into law on February 17, 2009, includes, among other things, extensive new restrictions on the compensation arrangements of financial institutions participating in TARP.

There can be no assurance, however, as to the actual impact that the EESA, as supplemented by the Financial Stability Plan, the ARRA and other programs will have on the financial markets, including the extreme levels of volatility and limited credit availability currently being experienced. The failure of the EESA, the ARRA, the Financial Stability Plan and other programs to stabilize the financial markets and a continuation or worsening of current financial market conditions could materially and adversely affect the Company’s business, financial condition, results of operations, access to credit or the trading price of the Company’s common stock.

The EESA, ARRA and the Financial Stability Plan are relatively new initiatives and, as such, are subject to change and evolving interpretation. There can be no assurances as to the effects that any further changes will have on the effectiveness of the government’s efforts to stabilize the credit markets and economy or on the Company’s business, financial condition, results of operations or liquidity.

The limitations on incentive compensation contained in the ARRA may adversely affect the Company’s ability to retain its highest performing employees.

The Company received CPP funds and the ARRA contains restrictions on bonus and other incentive compensation payable to the five executives named in the Company’s proxy statement. Depending upon the limitations placed on incentive compensation by the final regulations issued under the ARRA, it is possible that the Company may be unable to create a compensation structure that permits it to retain its highest performing employees. If this were to occur, it could have a material adverse impact on the Company’s business, financial condition, results of operations or liquidity.

Participants in the CPP are subject to certain restrictions on dividends, repurchases of common stock and executive compensation.

The Company is subject to restrictions on dividends, repurchases of common stock, and executive compensation. Compliance with these restrictions and other restrictions may increase the Company’s costs and limit its ability to pursue business opportunities. Additionally, any reduction of, or the elimination of, the Company’s common stock dividend in the future could adversely affect the market price of the Company’s common stock. The current restrictions, as well as any possible future restrictions, associated with participation in the CPP could have a material adverse impact on the Company’s business, financial condition, results of operations.

The Company may need to raise additional capital in the future and such capital may not be available when needed or at all.

The Company may need to raise additional capital in the future to provide sufficient capital resources and liquidity to meet the Company’s commitments and business needs. The Company’s ability to raise additional capital, if needed, will depend on, among other things, conditions in the capital markets at that time, which are outside of the Company’s control, and its financial performance. The ongoing liquidity crisis and the loss of confidence in financial institutions may increase the Company’s cost of funding and limit its access to some of its customary sources of capital.

The Company cannot assure that such capital will be available to it on acceptable terms or at all. Any occurrence that may limit the Company’s access to the capital markets, such as a decline in the confidence of debt purchasers, depositors of Five Star Bank or counterparties participating in the capital markets, or a downgrade of the Company’s debt rating, may adversely affect the Company’s capital costs and ability to raise capital and, in turn, its liquidity. An inability to raise additional capital on acceptable terms when needed could have a material adverse impact on the Company’s business, financial condition, results of operations or liquidity.

FII is a holding company and is dependent on its banking subsidiary for dividends, distributions and other payments.

The parent company, FII, is a legal entity separate and distinct from its banking and other subsidiaries. FII’s principal source of cash flow, including cash flow to pay dividends to its shareholders and principal and interest on its outstanding debt, is dividends from Five Star Bank. There are statutory and regulatory limitations on the payment of dividends by FSB to the parent company, as well as by FII to its shareholders. Regulations of both the Federal Reserve and the State of New York affect the ability of FSB to pay dividends and other distributions, as well as make loans to FII. Given the loss recorded at FSB during the year ended December 31, 2008, under New York State Banking Department rules, FSB does not expect to be able to pay dividends to FII in the near term without first obtaining regulatory approval. If FSB is unable to make dividend payments to FII and sufficient capital is not otherwise available, FII may not be able to make dividend payments to its common shareholders or principal and interest payments on its outstanding debt. See also the section titled “Supervision and Regulation—Restrictions on Distribution of Subsidiary Bank Dividends and Assets” of this Annual Report on Form 10-K.

The Company may not pay dividends on its common stock.

Shareholders of the Company’s common stock are only entitled to receive such dividends as the Company’s Board of Directors may declare out of funds legally available for such payments. Although the Company has historically declared cash dividends on its common stock, it is not required to do so and may reduce or eliminate its common stock dividend in the future. This could adversely affect the market price of the Company’s common stock. Also, participation in the CPP limits our ability to increase our dividend or to repurchase our common stock, for so long as any securities issued under such program remain outstanding, as discussed in greater detail below.

If the Company experiences greater credit losses than anticipated, earnings may be adversely impacted.

As a lender, the Company is exposed to the risk that its customers will be unable to repay their loans according to their terms and that any collateral securing the payment of their loans may not be sufficient to assure repayment. Credit losses are inherent in the business of making loans and could have a material adverse impact on the Company’s results of operations.

The Company makes various assumptions and judgments about the collectibility of its loan portfolio, including the creditworthiness of its borrowers and the value of the real estate and other assets serving as collateral, and provides an allowance for estimated loan losses based on a number of factors. The Company believes that the allowance for loan losses is adequate. However, if the Company’s assumptions or judgments are wrong, its allowance for loan losses may not be sufficient to cover its actual credit losses. The Company may have to increase the allowance in the future in response to the request of one of its primary banking regulators, to adjust for changing conditions and assumptions, or as a result of any deterioration in the quality of its loan portfolio. The actual amount of future provisions for credit losses may vary from the amount of past provisions.

Geographic concentration in one market may unfavorably impact the Company’s operations.

Substantially all of the Company’s business and operations are concentrated in the Western and Central New York region. As a result of this geographic concentration, the Company’s results depend largely on economic conditions in these and surrounding areas. Deterioration in economic conditions in this market could:

•

increase loan delinquencies;

•

increase problem assets and foreclosures;

•

increase claims and lawsuits;

•

decrease the demand for our products and services; and

•

decrease the value of collateral for loans, especially real estate, in turn reducing customers’ borrowing power, the value of assets associated with non-performing loans and collateral coverage.

Generally, the Company makes loans to small to mid-sized businesses whose success depends on the regional economy. These businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities. Adverse economic and business conditions in these market areas could reduce the Company’s growth rate, affect our borrowers’ ability to repay their loans and, consequently, adversely affect the Company’s business, financial condition and performance. For example, the Company places substantial reliance on real estate as collateral for its loan portfolio. A sharp downturn in real estate values in our market area could leave many of these loans inadequately collateralized. If the Company is required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, the impact on the Company’s results of operations could be materially adverse. See also the section titled “Market Area and Competition” of this Annual Report on Form 10-K.

The market price of shares of the Company’s common stock may fluctuate.

The market price of the Company’s common stock could be subject to significant fluctuations due to a change in sentiment in the market regarding the Company’s operations or business prospects. Such risks may be affected by:

•

Operating results that vary from the expectations of management, securities analysts and investors;

•

Developments in the Company’s business or in the financial sector generally;

•

Regulatory changes affecting the financial services industry generally or the Company’s business and operations;

•

The operating and securities price performance of companies that investors consider to be comparable to the Company;

•

Announcements of strategic developments, acquisitions and other material events by the Company or its competitors;

•

Changes in the credit, mortgage and real estate markets, including the markets for mortgage-related securities; and

•

Changes in global financial markets and global economies and general market conditions, such as interest or foreign exchange rates, stock, commodity, credit or asset valuations or volatility.

Stock markets in general and the Company’s common stock in particular have, over the past year, and continue to be experiencing significant price and volume volatility. As a result, the market price of the Company’s common stock may continue to be subject to similar market fluctuations that may be unrelated to its operating performance or prospects. Increased volatility could result in a decline in the market price of the Company’s common stock and may make it more difficult for shareholders to liquidate the common stock.

Future issuances of additional securities could result in dilution of your ownership.

The Company may determine from time to time to issue additional securities to raise additional capital, support growth, or to make acquisitions. Further, the Company may issue stock options or other stock grants to retain and motivate its employees. These issuances of the Company’s securities may dilute the ownership interests of existing shareholders.

The Company’s market value could result in an impairment of goodwill.

The Company’s goodwill is evaluated for impairment on an annual basis at September 30, or when triggering events or circumstances indicate impairment may exist. During the fourth quarter of 2008, the Company experienced a decline in its market capitalization, therefore the Company evaluated its goodwill as of December 31, 2008 and concluded that there was no impairment. In the first quarter of 2009, the Company has experienced further declines in its market capitalization as its common stock has been trading at a price significantly below its book value. Significant and sustained declines in the Company’s stock price and market capitalization, significant declines in the Company’s expected future cash flows, significant adverse changes in the business climate or slower growth rates could result in impairment of goodwill. If impairment of goodwill was determined to exist, the Company would be required to write down its goodwill as a charge to earnings, which could have a material adverse impact on the Company’s results of operations or financial condition. For further discussion, see Note 1, Summary of Significant Accounting Policies, and Note 6, Goodwill and Other Intangible Assets, to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.

Changes in interest rates could adversely impact the Company’s results of operations and financial condition.

The banking industry’s earnings depend largely on the relationship between the yield on earning assets, primarily loans and investments, and the cost of funds, primarily deposits and borrowings. This relationship, known as the interest rate spread, is subject to fluctuation and is affected by economic and competitive factors which influence interest rates, the volume and mix of interest-earning assets and interest-bearing liabilities and the level of non-performing assets. Fluctuations in interest rates affect the demand of customers for the Company’s products and services. The Bank is subject to interest rate risk to the degree that interest-bearing liabilities re-price or mature more slowly or more rapidly or on a different basis than interest-earning assets. Significant fluctuations in interest rates could have a material adverse impact on the Company’s business, financial condition, results of operations or liquidity. For additional information regarding interest rate risk, see Part II, Item 7A, “Quantitative and Qualitative Disclosures About Market Risk” of this Annual Report on Form 10-K.

Industry competition may have an adverse impact on the Company’s success.

The Company’s profitability depends on its ability to compete successfully. The Company operates in a highly competitive environment where certain of its competitors are larger and have more resources. In the Company’s market areas, it faces competition from commercial banks, savings and loan associations, credit unions, internet banks, finance companies, insurance companies, brokerage and investment banking firms, and other financial intermediaries that offer similar services. Some of the Company’s non-bank competitors are not subject to the same extensive regulations that govern FII or FSB and may have greater flexibility in competing for business. The Company expects competition to intensify among financial services companies due to the recent consolidation of certain competing financial institutions and the conversion of certain investment banks to bank holding companies. Should competition in the financial services industry intensify, the Company’s ability to market its products and services may be adversely impacted.

The Company’s deferred tax assets may not ultimately be realized or its tax positions may be subject to challenge by the IRS.

The Company’s deferred tax assets may provide significant future tax savings to the Company. The Company’s use of these deferred tax benefits may depend on a number of factors including the ability of the Company to generate significant taxable income; the absence of a future ownership change of the Company that could limit or eliminate the tax benefits; the acceptance by the taxing authorities of the positions taken on the Company’s tax returns as to the amount and timing of its income and expenses; and future changes in laws or regulations relating to tax deductions and net operating losses.

The Company assesses the likelihood that deferred tax assets will be realizable based on future taxable income and, if necessary, establishes a valuation allowance for those deferred tax assets determined to not likely be realizable. Management judgment is required in determining the appropriate recognition of deferred tax assets and liabilities, including projections of future taxable income. There can be no absolute assurance, however, that the net deferred assets will ultimately be realized.

The Company’s information systems may experience an interruption or breach in security.

The Company depends upon data processing, software, communication and information exchange on a variety of computing platforms and networks and over the internet. Despite instituted safeguards, the Company cannot be certain that all of its systems are entirely free from vulnerability to attack or other technological difficulties or failures. The Company relies on the services of a variety of vendors to meet its data processing and communication needs. If information security is breached or other technology difficulties or failures occur, information may be lost or misappropriated, services and operations may be interrupted and the Company could be exposed to claims from customers. Any of these results could have a material adverse impact on the Company’s business, financial condition, results of operations or liquidity.

ITEM 1B. UNRESOLVED STAFF COMMENTS

Not applicable.

The Company believes that its properties have been adequately maintained, are in good operating condition and are suitable for its business as presently conducted. The Company conducts banking operations at the following locations.

Location		Type		Owned or Leased		Lease Expiration
Allegany		Branch		Owned		—
Amherst		Branch		Leased		February 2020
Attica		Branch		Owned		—
Auburn		Branch		Owned		—
Avoca		Branch		Owned		—
Batavia		Branch		Leased		December 2016
Batavia (In-Store)		Branch		Leased		July 2009
Bath		Branch		Owned		—
Bath		Drive-up Branch		Owned		—
Caledonia		Branch		Leased		July 2012
Canandaigua		Branch		Owned		—
Cuba		Branch		Owned		—
Dansville		Branch		Ground Leased		March 2014
Dundee		Branch		Owned		—
East Aurora		Branch		Leased		January 2013
Ellicottville		Branch		Owned		—
Elmira		Branch		Owned		—
Elmira Heights		Branch		Leased		August 2009
Erwin		Branch		Leased		October 2010
Geneseo		Branch		Owned		—
Geneva		Branch		Owned		—
Geneva		Drive-up Branch		Owned		—
Greece		Branch		Leased		June 2023
Geneva (Plaza)		Branch		Ground Leased		January 2016
Hammondsport		Branch		Owned		—
Henrietta		Branch		Leased		June 2023
Honeoye Falls		Branch		Leased		September 2017
Hornell		Branch		Owned		—
Horseheads		Branch		Leased		September 2012
Lakeville		Branch		Owned		—
Lakewood		Branch		Owned		—
Leroy		Branch		Owned		—
Mount Morris		Branch		Owned		—
Naples		Branch		Owned		—
North Chili		Branch		Owned		—
North Java		Branch		Owned		—
North Warsaw		Branch		Owned		—
Olean		Branch		Owned		—
Olean		Drive-up Branch		Owned		—
Orchard Park		Branch		Ground Leased		January 2019
Ovid		Branch		Owned		—
Pavilion		Branch		Owned		—
Penn Yan		Branch		Owned		—
Pittsford		Administrative Offices		Leased		April 2017
Salamanca		Branch		Owned		—
Strykersville		Branch		Owned		—
Victor		Branch		Owned		—
Warsaw (220 Liberty Street)		Headquarters		Owned		—
Warsaw (29 North Main Street)		Administrative Offices		Owned		—
Warsaw (55 North Main Street)		Main Branch		Owned		—
Waterloo		Branch		Owned		—
Wayland		Branch		Owned		—
Williamsville		Branch		Leased		August 2009
Wyoming		Branch		Leased		March 2009
Yorkshire		Branch		Ground Leased		November 2012

ITEM 3. LEGAL PROCEEDINGS

From time to time the Company is a party to or otherwise involved in legal proceedings arising in the normal course of business. Management does not believe that there is any pending or threatened proceeding against the Company, which, if determined adversely, would have a material adverse effect on the Company’s business, results of operations or financial condition.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

Not applicable.

PART II

ITEM 5.	MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

The Company’s common stock is traded on the NASDAQ Global Select Market under the ticker symbol “FISI.” At December 31, 2008, 10,798,019 shares of the Company’s stock were outstanding by approximately 1,100 shareholders of record. During 2008, the high sales price of our common stock was $22.50 and the low sales price was $10.06. The closing price per share of common stock on December 31, 2008, the last trading day of the Company’s fiscal year, was $14.35. The Company declared dividends of $0.54 per common share during the year ended December 31, 2008. See additional information regarding the market price and dividends paid filed herewith in Part II, Item 6, “Selected Financial Data.”

Equity Compensation Plan Information

The following table sets forth, as of December 31, 2008, information about our equity compensation plans that have been approved by our shareholders, including the number of shares of our common stock exercisable under all outstanding options, warrants and rights, the weighted average exercise price of all outstanding options, warrants and rights and the number of shares available for future issuance under our equity compensation plans. We have no equity compensation plans that have not been approved by our shareholders.

Number of securities

Weighted average

remaining for future

Number of securities to

exercise price

issuance under equity

be issued upon exercise

of outstanding

compensation plans

of outstanding options,

options, warrants

(excluding securities

Plan Category

warrants and rights

and rights

reflected in column (a))

Equity compensation plans approved by shareholders

582,885

$

19.14

763,378

Equity compensation plans not approved by shareholders

—

$

—

—

The Company has paid regular quarterly cash dividends on its common stock and its Board of Directors presently intends to continue this practice, subject to the need for those funds for debt service and other purposes. However, the payment of dividends by the Company is subject to continued compliance with minimum regulatory capital requirements and CPP restrictions. See the discussions in the section captioned “Supervision and Regulation” included in Part I, Item 1, “Business”, in the section captioned “Liquidity and Capital Resources” included in Part II, Item 7, in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in Note 10, Regulatory Matters, in the accompanying financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data”, all of which are included elsewhere in this report and incorporated herein by reference thereto.

The table below sets forth the information with respect to purchases made by the Company (as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934), of our common stock during the three months ended December 31, 2008:

										Total number				Approximate
										of shares				dollar value
										purchased as				of shares that
		Total number				Average				part of publicly				may yet be
		of shares				price paid				announced				purchased
Period		purchased				per share				repurchase plans				under the plans
10/01/08 – 10/31/08			8,444			$	14.60				8,444			$	2,661,113
11/01/08 – 11/30/08			—				—				—				2,661,113
12/01/08 – 12/31/08			—				—				—				—	(1)
Total			8,444			$	14.60				8,444			$	—

Stock Performance Graph

The stock performance graph below compares (a) the cumulative total return on the Company’s common stock for the period beginning December 31, 2003 as reported by the NASDAQ Global Market, through December 31, 2008, (b) the cumulative total return on stocks included in the NASDAQ Composite Index over the same period, and (c) the cumulative total return, as compiled by SNL Financial L.C., of Major Exchange (NYSE, AMEX and NASDAQ) Banks with $1 billion to $5 billion in assets over the same period. Cumulative return assumes the reinvestment of dividends. The graph was prepared by SNL Financial, L.C. and is expressed in dollars based on an assumed investment of $100.

		Period Ending
Index		12/31/03				12/31/04				12/31/05				12/31/06				12/31/07				12/31/08
Financial Institutions, Inc.			100.00				84.68				72.97				87.10				68.96				57.35
NASDAQ Composite			100.00				108.59				110.08				120.56				132.39				78.72
SNL Bank $1B-$5B			100.00				123.42				121.31				140.38				102.26				84.81

ITEM 6. SELECTED FINANCIAL DATA

		At or for the year ended December 31,
(Dollars in thousands, except per share data)		2008				2007				2006				2005				2004
Selected financial condition data:
Total assets		$	1,916,919			$	1,857,876			$	1,907,552			$	2,022,392			$	2,156,329
Loans, net			1,102,330				948,652				909,434				972,090				1,213,219
Investment securities			606,038				754,720				775,536				833,448				766,515
Deposits			1,633,263				1,575,971				1,617,695				1,717,261				1,818,949
Borrowings			70,820				68,210				87,199				115,199				132,614
Shareholders’ equity			190,300				195,322				182,388				171,757				184,287
Common shareholders’ equity (1)			137,226				177,741				164,765				154,123				166,565
Tangible common shareholders’ equity (2)			99,577				139,786				126,502				115,440				127,452
Selected operations data:
Interest income		$	98,948			$	105,212			$	103,070			$	103,887			$	106,175
Interest expense			33,617				47,139				43,604				36,395				30,768
Net interest income			65,331				58,073				59,466				67,492				75,407
Provision (credit) for loan losses			6,551				116				(1,842	)			28,532				19,676
Net interest income after provision (credit) for loan losses			58,780				57,957				61,308				38,960				55,731
Noninterest (loss) income (3)			(48,778	)			20,680				21,911				29,384				22,149
Noninterest expense			57,461				57,428				59,612				65,492				61,767
(Loss) income from continuing operations before income taxes			(47,459	)			21,209				23,607				2,852				16,113
Income tax (benefit) expense from continuing operations			(21,301	)			4,800				6,245				(1,766	)			3,170
(Loss) Income from continuing operations			(26,158	)			16,409				17,362				4,618				12,943
Loss on discontinued operations, net of tax			—				—				—				2,452				450
Net (loss) income		$	(26,158	)		$	16,409			$	17,362			$	2,166			$	12,493
Preferred stock dividends and accretion			1,538				1,483				1,486				1,488				1,495
Net (loss) income applicable to common shareholders		$	(27,696	)		$	14,926			$	15,876			$	678			$	10,998
Stock and related per share data:
(Loss) earnings from continuing operations per common share:
Basic		$	(2.56	)		$	1.34			$	1.40			$	0.28			$	1.02
Diluted			(2.56	)			1.33				1.40				0.28				1.02
(Loss) earnings per common share:
Basic			(2.56	)			1.34				1.40				0.06				0.98
Diluted			(2.56	)			1.33				1.40				0.06				0.98
Cash dividends declared on common stock			0.54				0.46				0.34				0.40				0.64
Common book value per share (1)			12.71				16.14				14.53				13.60				14.81
Tangible common book value per share (2)			9.22				12.69				11.15				10.19				11.31
Market price (NASDAQ: FISI):
High			22.50				23.71				25.38				24.93				29.03
Low			10.06				16.18				17.43				15.52				20.52
Close			14.35				17.82				23.05				19.62				23.25

		At or for the year ended December 31,
(Dollars in thousands, except per share data)		2008				2007				2006				2005				2004
Selected financial ratios and other data:
Performance ratios:
Net (loss) income (returns on):
Average assets			-1.37	%			0.86	%			0.90	%			0.10	%			0.57	%
Average equity			-14.30				8.84				9.86				1.22				6.73
Average common equity (1)			-16.84				8.89				10.02				0.43				6.55
Average tangible common equity (2)			-21.87				11.50				13.23				0.56				8.57
Common dividend payout ratio (3)		NA					34.33				24.29				666.67				65.31
Net interest margin (fully tax-equivalent)			3.93				3.53				3.55				3.65				3.90
Efficiency ratio (4)			64.07	%			68.77	%			69.78	%			70.18	%			60.41	%
Capital ratios:
Leverage ratio			8.05	%			9.35	%			8.91	%			7.60	%			7.13	%
Tier 1 risk-based capital			11.83				15.74				15.85				13.75				11.27
Total risk-based capital			13.08				16.99				17.10				15.01				12.54
Equity to assets (5)			9.60				9.73				9.08				8.37				8.48
Common equity to assets (1) (5)			8.63				8.81				8.17				7.54				7.67
Tangible common equity to tangible assets (2) (5)			6.78	%			6.95	%			6.32	%			5.80	%			5.97	%
Asset quality (6):
Non-accruing loans		$	8,189			$	8,075			$	15,837			$	17,761			$	51,946
Other non-performing assets			56				2				3				276				2,018
Allowance for loan losses			18,749				15,521				17,048				20,231				39,186
Net loan charge-offs		$	3,323			$	1,643			$	1,341			$	47,487			$	9,554
Total non-performing loans to total loans			0.73	%			0.84	%			1.71	%			1.82	%			4.31	%
Total non-performing assets to total assets			0.48				0.51				0.89				0.97				2.56
Net charge-offs to average loans			0.32				0.18				0.14				4.27				0.74
Allowance for loan losses to total loans			1.67				1.61				1.84				2.04				3.13
Allowance for loan losses to non-performing loans			229	%			192	%			108	%			112	%			73	%
Other data:
Number of branches			52				50				50				50				50
Full time equivalent employees			600				621				640				700				765

SELECTED QUARTERLY DATA

		2008
		Fourth				Third				Second				First
(Dollars in thousands, except per share data)		Quarter				Quarter				Quarter				Quarter
Interest income		$	24,582			$	24,558			$	24,536			$	25,272
Interest expense			7,269				7,812				8,349				10,187
Net interest income			17,313				16,746				16,187				15,085
Provision for loan losses			2,586				1,891				1,358				716
Net interest income, after provision for loan losses			14,727				14,855				14,829				14,369
Noninterest (loss) income			(25,106	)			(29,348	)			932				4,744
Noninterest expense			15,394				13,409				14,385				14,273
(Loss) income before income taxes			(25,773	)			(27,902	)			1,376				4,840
Income tax (benefit) expense			(22,631	)			524				(255	)			1,061
Net (loss) income		$	(3,142	)		$	(28,426	)		$	1,631			$	3,779
Preferred stock dividends			426				371				370				371
Net (loss) income applicable to common shareholders		$	(3,568	)		$	(28,797	)		$	1,261			$	3,408
(loss) earnings per common share (1):
Basic		$	(0.33	)		$	(2.68	)		$	0.12			$	0.31
Diluted			(0.33	)			(2.68	)			0.12				0.31
Market price (NASDAQ: FISI):
High		$	20.27			$	22.50			$	20.00			$	20.78
Low			10.06				14.82				15.25				15.10
Close			14.35				20.01				16.06				18.95
Dividends declared		$	0.10			$	0.15			$	0.15			$	0.14

		2007
		Fourth				Third				Second				First
(Dollars in thousands, except per share data)		Quarter				Quarter				Quarter				Quarter
Interest income		$	26,397			$	26,553			$	26,458			$	25,806
Interest expense			11,192				11,692				12,406				11,850
Net interest income			15,205				14,861				14,052				13,956
Provision (credit) for loan losses			351				(82	)			(153	)			—
Net interest income, after provision (credit) for loan losses			14,854				14,943				14,205				13,956
Noninterest income			5,002				6,334				4,606				4,738
Noninterest expense			14,543				14,609				14,348				13,928
Income before income taxes			5,313				6,668				4,463				4,766
Income tax expense			1,215				1,414				1,020				1,151
Net income		$	4,098			$	5,254			$	3,443			$	3,615
Preferred stock dividends			370				371				371				371
Net income applicable to common shareholders		$	3,728			$	4,883			$	3,072			$	3,244
Earnings per common share (1):
Basic		$	0.34			$	0.44			$	0.27			$	0.29
Diluted			0.34				0.44				0.27				0.29
Market price (NASDAQ: FISI):
High		$	19.80			$	20.46			$	20.62			$	23.71
Low			16.42				16.18				18.62				19.30
Close			17.82				17.94				20.19				20.07
Dividends declared		$	0.13			$	0.12			$	0.11			$	0.10

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

GENERAL

The principal objective of this discussion is to provide an overview of the financial condition and results of operations of the Company during the year ended December 31, 2008 and the preceding two years. The following analysis of financial condition and results of operations should be read in conjunction with the consolidated financial statements and related notes filed herewith in Part II, Item 8, “Financial Statements and Supplementary Data” and the description of the business filed herewith in Part I, Item 1, “Business.”

Income. The Company’s results of operations are dependent primarily on net interest income, which is the difference between the income earned on loans and securities and the interest paid on deposits and borrowings. Results of operations are also affected by the (credit) provision for loan losses, service charges on deposits, financial services group fees and commissions, mortgage banking revenues, gain or loss on the sale of securities, gain or loss on sale of loans and other miscellaneous income.

Expenses. The Company’s expenses primarily consist of salaries and employee benefits, occupancy and equipment, supplies and postage, amortization of other intangible assets, computer and data processing, professional fees and services, advertising and promotions and other miscellaneous expense and income tax expense (benefit). Results of operations are also significantly affected by general economic and competitive conditions, particularly changes in consumer and business spending, interest rates, government policies and the actions of regulatory authorities.

RECENT MARKET DEVELOPMENTS

The global and U.S. economies are experiencing significantly reduced business activity as a result of, among other factors, disruptions in the financial system during the past year. Dramatic declines in the housing market during the past year, with falling home prices and increasing foreclosures and unemployment, have resulted in significant write-downs of asset values by financial institutions, including government-sponsored entities and major commercial and investment banks. These write-downs, initially of residential-related loans and mortgage-backed securities, but spreading to credit default swaps and other derivative securities, have caused many financial institutions to seek additional capital, to merge with larger and stronger institutions and, in some cases, to fail.

Reflecting concern about the stability of the financial markets generally and the strength of counterparties, many lenders and institutional investors have reduced, and in some cases, ceased to provide funding to borrowers, including other financial institutions. The availability of credit, confidence in the financial sector, and level of volatility in the financial markets have been significantly adversely affected as a result. In recent months, volatility and disruption in the capital and credit markets have reached unprecedented levels. In some cases, the markets have produced downward pressure on stock prices and credit capacity for certain issuers without regard to those issuers’ underlying financial strength.

In response to the financial crises affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions, EESA was signed into law on October 3, 2008. The EESA authorizes the Treasury to, among other things, purchase up to $700 billion of mortgages, mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets. The EESA also provided a temporary increase in deposit insurance coverage from $100,000 to $250,000 per insured account until December 31, 2009.

On October 14, 2008, the Secretary of the Treasury, after consulting with the Federal Reserve and the FDIC, announced that the Treasury will purchase equity stakes in certain banks and thrifts. Under this program, known as the CPP, the Treasury will make $250 billion of capital available to U.S. financial institutions in the form of preferred stock (from the $700 billion authorized by the EESA). In conjunction with the purchase of preferred stock, the Treasury will receive warrants to purchase common stock with an aggregate market price equal to 15% of the preferred investment. Participating financial institutions will be required to adopt the Treasury’s standards for executive compensation and corporate governance for the period during which the Treasury holds equity issued under the CPP.

Also on October 14, 2008, after receiving a recommendation from the boards of the FDIC and the Federal Reserve, and consulting with the President, the Secretary of the Treasury signed the systemic risk exception to the FDIC Act, enabling the FDIC to temporarily provide a 100% guarantee of the senior unsecured debt of all FDIC-insured institutions and their holding companies, as well as deposits in noninterest-bearing transaction deposit accounts under the TLGP through December 31, 2009. All insured depository institutions automatically participated in the TLGP for 30 days following the announcement of the program without charge (subsequently extended to December 5, 2008) and thereafter, unless an institution opted out, at a cost of 75 basis points per annum for senior unsecured debt and 10 basis points per annum for noninterest-bearing transaction deposits.

The Company elected to participate in the CPP, and on December 23, 2008 received $37.5 million in additional capital through the program. In exchange, the Treasury received a like amount of the FII preferred stock that pays an annual dividend of 5% for the first five years, and an annual dividend of 9% in any years thereafter. The Company may redeem the preferred shares issued to Treasury in full during the first three years following issuance only with the proceeds of a qualifying equity offering. Thereafter, the preferred shares may be redeemed in full or in part at any time. The Company also issued a warrant to the Treasury to purchase 378,175 shares of FII common stock, which, upon issuance, would represent approximately 3.4% of our outstanding common shares, based upon current information. The warrant is exercisable at any time during the ten-year period following issuance at an exercise price of $14.88.

Notwithstanding the foregoing, the ARRA, which was signed into law by President Obama on February 17, 2009, provides that the Secretary of the Treasury shall permit a recipient of funds under the TARP, subject to consultation with the recipient’s appropriate Federal banking agency, to repay such assistance without regard to whether the recipient has replaced such funds from any other source or to any waiting period. ARRA further provides that when the recipient repays such assistance, the Secretary of the Treasury shall liquidate the warrants associated with the assistance at the current market price. While Treasury has not yet issued implementing regulations, it appears that ARRA will permit the Company, if it so elects and following consultation with the FRB, to redeem the Series A Preferred Stock at any time without restriction.

The FDIC Act also requires that the FDIC Board of Directors adopt a restoration plan when the Deposit Insurance Fund reserve ratio falls or is expected to fall below certain minimum levels. The bank failures that resulted in 2008 adversely impacted the deposit insurance funds loss provisions, resulting in a decline in the reserve ratio. As part of the restoration plan, the FDIC has increased the insurance assessment rates by seven basis points uniformly for the quarter beginning January 1, 2009. In addition, on February 27, 2009 the FDIC Board adopted an interim rule imposing a 20 basis point emergency special assessment on the industry on June 30, 2009. The assessment is to be collected on September 30, 2009. The interim rule would also permit the Board to impose an emergency special assessment after June 30, 2009, of up to 10 basis points if necessary to maintain public confidence in federal deposit insurance. The Company estimates the combined impact of the seven basis point increase and 20 basis point emergency special assessment to be an approximate increase of $4.6 million in its FDIC deposit insurance assessments for 2009. Subsequently, on March 5, 2009 the Chairman of the FDIC announced that it may cut the 20 basis point emergency special assessment to 10 basis points if legislation passes to expand the FDIC’s existing line of credit with the U.S. Treasury Department.

Additionally, the Company opted to continue to participate in the Transaction Account Guarantee portion of the TLGP following the expiration of the initial opt-out period. Participation includes the full guarantee of noninterest bearing deposit transaction accounts and eligible, low interest-earning demand accounts (interest rate equal to or less than 0.50%) regardless of dollar amount.

It is not clear at this time what impact the EESA, the CPP, the TLGP, or other liquidity and funding initiatives will have on the financial markets and the other difficulties described above, including the high levels of volatility and limited credit availability currently being experienced, or on the U.S. banking and financial industries and the broader U.S. global economies. Further adverse effects could have an adverse effect on our business.

OVERVIEW

For the year ended December 31, 2008, the Company’s net loss totaled $26.2 million (or $2.56 loss per share), which included a pre-tax non-cash charge of $68.2 million for OTTI on certain investment securities. The Company reported net income of $16.4 million ($1.33 per diluted share) and $17.4 million ($1.40 per diluted share) for the years ended December 31, 2007 and 2006, respectively.

Net interest income, the principal source of the Company’s earnings, was $65.3 million in 2008, up from $58.1 million in 2007 and $59.5 million in 2006. Net interest margin improved substantially to 3.93% for the year ended December 31, 2008, compared with 3.53% and 3.55% for the two prior years. The improved net interest margin resulted principally from lower funding costs and the benefits associated with a higher percentage of earning assets being deployed in higher yielding loan assets. Total loans increased $156.9 million, or 16%, to $1.121 billion for the one year period ended December 31, 2008. Indirect auto loans increased $120.1 million or 89%, and commercial-related increased $35.5 million or 8% during that same one year period.

The Company recorded a provision for loan losses of $6.6 million for the year ended December 31, 2008, compared with $116 thousand in 2007. The increase in the provision for loan losses is primarily due to growth in the loan portfolio and the changing mix of the loan portfolio together with higher net charge offs. For the year ended December 31, 2008, net charge-offs were $3.3 million, or 32 basis points of average loans, compared with $1.6 million, or 18 basis points of average loans, for the year ended December 31, 2007. The allowance for loan losses was $18.7 million at December 31, 2008, compared with $15.5 million at December 31, 2007. Non-performing loans were $8.2 million at December 31, 2008, compared with $8.1 million at December 31, 2007. The ratio of allowance for loan losses to non-performing loans improved to 229% at December 31, 2008 versus 192% at December 31, 2007.

For the year ended December 31, 2008, noninterest income (loss) was $(48.8) million, compared with $20.7 million for the same period in 2007. The loss reflects OTTI charges on investment securities totaling $68.2 million for the year ended December 31, 2008. Exclusive of OTTI charges, noninterest income was $19.4 million for the year, compared with $20.7 million in 2007. Aside from the impact of the OTTI charges in 2007, most of the remaining decrease in noninterest income was due to the receipt of $1.1 million in proceeds from company owned life insurance.

For the year ended December 31, 2008, noninterest expense was $57.5 million compared with $57.4 million for the same period in 2007. Total salaries and benefits cost declined $1.7 million for the year ended December 31, 2008 compared with 2007, and was offset by a $599 thousand increase in occupancy and equipment expense, a $385 thousand increase in FDIC insurance, and a $557 thousand prepayment charge on borrowed funds.

The Company retained its “well-capitalized” equity position with total equity capital of $190.3 million, which includes $37.5 million in preferred equity issued in December 2008 under the U.S. Treasury Department’s CPP. As of December, 31, 2008, the leverage capital ratio was 8.05% and total risk-based capital ratio was 13.08%.

The Company also expanded its branch network in the metro-Rochester area of New York State, adding de novo branches in Henrietta and Greece during the third and fourth quarters of 2008, respectively.

CRITICAL ACCOUNTING ESTIMATES

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States and are consistent with predominant practices in the financial services industry. Application of critical accounting policies, which are those policies that management believes are the most important to the Company’s financial position and results, requires management to make estimates, assumptions, and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes and are based on information available as of the date of the financial statements. Future changes in information may affect these estimates, assumptions and judgments, which, in turn, may affect amounts reported in the financial statements.

The Company has numerous accounting policies, of which the most significant are presented in Note 1, Summary of Significant Accounting Policies, of the notes to consolidated financial statements. These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets, liabilities, revenues and expenses are reported in the consolidated financial statements and how those reported amounts are determined. Based on the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has determined that the accounting policies with respect to the allowance for loan losses, valuation of goodwill and deferred tax assets, the valuation of securities and determination of OTTI, and accounting for defined benefit plans require particularly subjective or complex judgments important to the Company’s financial position and results of operations, and, as such, are considered to be critical accounting policies as discussed below. These estimates and assumptions are based on management’s best estimates and judgment and are evaluated on an ongoing basis using historical experience and other factors, including the current economic environment. The Company adjusts these estimates and assumptions when facts and circumstances dictate. Illiquid credit markets and volatile equity have combined with declines in consumer spending to increase the uncertainty inherent in these estimates and assumptions. As future events cannot be determined with precision, actual results could differ significantly from the Company’s estimates.

Adequacy of the Allowance for Loan Losses

The allowance for loan losses represents management’s estimate of probable credit losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of subjective measurements including management’s assessment of the internal risk classifications of loans, changes in the nature of the loan portfolio, industry concentrations and the impact of current local, regional and national economic factors on the quality of the loan portfolio. Changes in these estimates and assumptions are reasonably possible and may have a material impact on the Company’s consolidated financial statements, results of operations or liquidity.

A commercial-related loan is considered impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts of principal and interest under the original terms of the agreement and all loans restructured in a troubled debt restructuring. Accordingly, the Company evaluates impaired commercial-related loans individually, primarily based on the net realizable value of the collateral, as the majority of the Company’s impaired loans are collateral dependent.

Loans, including impaired loans, are generally classified as nonaccruing if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-collateralized and in the process of collection. Loans that are on a current payment status or past due less than 90 days may also be classified as nonaccruing if repayment in full of principal and/or interest is uncertain.

For additional discussion related to the Company’s accounting policies for the allowance for loan losses, see the sections titled “Analysis of Allowance for Loan Losses” and “Allocation of Allowance for Loan Losses” in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 1, Summary of Significant Accounting Policies, of the notes to consolidated financial statements.

Valuation of Goodwill

Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets” prescribes the accounting for goodwill and intangible assets subsequent to initial recognition. The provisions of SFAS No. 142 discontinue the amortization of goodwill and intangible assets with indefinite lives. Instead, these assets are subject to at least an annual impairment review and more frequently if certain impairment indicators are in evidence. Goodwill impairment testing is performed at the segment (or “reporting unit”) level. Currently, the Company’s goodwill is evaluated at the entity level as there is only one reporting unit. Goodwill is assigned to reporting units at the date it is initially recorded. Once goodwill has been assigned to reporting units, it no longer retains its association with a particular acquisition, and all of the activities within a reporting unit, whether acquired or organically grown, are available to support the value of the goodwill. Changes in the estimates and assumptions are reasonably possible and may have a material impact on the Company’s consolidated financial statements, results of operations or liquidity. For additional discussion related to the Company’s accounting policy for goodwill and other intangible assets, see Note 1, Summary of Significant Accounting Policies, of the notes to consolidated financial statements.

Valuation of Deferred Tax Assets

The determination of deferred tax expense or benefit is based on changes in the carrying amounts of assets and liabilities that generate temporary differences. The carrying value of the Company’s net deferred tax assets assumes that the Company will be able to generate sufficient future taxable income based on estimates and assumptions (after consideration of historical taxable income as well as tax planning strategies). If these estimates and related assumptions change, the Company may be required to record valuation allowances against its deferred tax assets resulting in additional income tax expense in the consolidated statements of operations. Management evaluates its deferred tax assets on a quarterly basis and assesses the need for a valuation allowance, if any. A valuation allowance is established when management believes that it is more likely than not that some portion of its deferred tax assets will not be realized. Changes in valuation allowance from period to period are included in the Company’s tax provision in the period of change. For additional discussion related to the Company’s accounting policy for income taxes see Note 14, Income Taxes, of the notes to consolidated financial statements.

Valuation and Other Than Temporary Impairment of Securities

The Company records all of its securities that are classified as available for sale at fair value. The fair value of equity securities are determined using public quotations, when available. Where quoted market prices are not available, fair values are estimated based on dealer quotes, pricing models, discounted cash flow methodologies, or similar techniques for which the determination of fair value may require significant judgment or estimation. Fair values of public bonds and those private securities that are actively traded in the secondary market have been determined through the use of third-party pricing services using market observable inputs. Private placement securities and other corporate fixed maturities where the Company does not receive a public quotation are valued by discounting the expected cash flows. Market rates used are applicable to the yield, credit quality and average maturity of each security. Private equity securities may also utilize internal valuation methodologies appropriate for the specific asset. Fair values might also be determined using broker quotes or through the use of internal models or analysis.

Securities are evaluated quarterly to determine whether a decline in their fair value is other than temporary. Management utilizes criteria such as, the magnitude and duration of the decline and, when appropriate, consideration of adverse changes in cash flows, in addition to the reasons underlying the decline, including creditworthiness, capital adequacy and near term prospects of issuers, the level of credit subordination, estimated loss severity, prepayments and future delinquencies, to determine whether the loss in value is other than temporary. The term “other than temporary” is not intended to indicate that the decline is permanent, but indicates that the prospect for a near-term recovery of value is not necessarily favorable. Once a decline in fair value is determined to be other than temporary the cost basis of the security is reduced through a charge to earnings.

Defined Benefit Pension Plan

Management is required to make various assumptions in valuing its defined benefit pension plan assets and liabilities. These assumptions include, but are not limited to, the expected long-term rate of return on plan assets, the weighted average discount rate used to value certain liabilities and the rate of compensation increase. The Company uses a third-party specialist to assist in making these estimates and assumptions. Changes in these estimates and assumptions are reasonably possible and may have a material impact on the Company’s consolidated financial statements, results of operations or liquidity.

ANALYSIS OF FINANCIAL CONDITION

Overview

At December 31, 2008, the Company had total assets of $1.917 billion, an increase of 3% from $1.858 billion as of December 31, 2007, primarily a result of growth of its core business of loans and deposits. Loans totaled $1.121 billion as of December 31, 2008, up $156.9 million, or 16%, when compared to $964.2 million as of December 31, 2007. The increase in loans was primarily attributed to the expansion of the indirect lending program and commercial business development efforts. Nonperforming assets totaled $9.3 million as of December 31, 2008, down $246 thousand from a year ago despite the increase the loan portfolio. For the year ended December 31, 2008, net charge-offs were $3.3 million, or 32 basis points of average loans, compared with $1.6 million, or 18 basis points of average loans, for the year ended December 31, 2007. The increase in net charge-offs in 2008 related principally to the commercial mortgage and consumer indirect loan portfolios. Total deposits amounted to $1.633 billion and $1.576 billion as of December 31, 2008 and 2007, respectively. The increase in deposits was due in part to the Company’s successfully expansion of its branch network in the metro-Rochester area, where de novo branches were added in Henrietta and Greece during the third and fourth quarters of 2008, respectively. As of December 31, 2008, total borrowed funds were $70.8 million, comparable to $68.2 million as of December 31, 2007. While the outstanding balance of borrowed funds is up slightly, the average cost of the borrowed funds is down considerably as the Company took advantage of the low interest rate environment and prepaid a portion of its higher cost long term debt in the fourth quarter of 2008. Book value per common share was $12.71 and $16.14 as of December 31, 2008 and 2007, respectively. As of December 31, 2008 the Company’s total shareholders’ equity was $190.3 million compared to $195.3 million a year earlier.

Goodwill

At December 31, 2008, the carrying amount of our goodwill totaled $37.4 million. On September 30, 2008, the Company performed the annual goodwill impairment test and determined the estimated fair value of our reporting unit to be in excess of its carrying amount. Accordingly, as of the Company’s annual impairment test date, there was no indication of goodwill impairment. The Company tests its goodwill for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of our reporting unit below its carrying amount. Accordingly, an evaluation of the goodwill for impairment was performed as of December 31, 2008 due to the market’s continued contraction. The estimated fair value of the Company’s reporting unit was in excess of its carrying amount at December 31, 2008. No assurance can be given that the Company will not record an impairment loss on goodwill in 2009. However, the Company’s tangible capital ratio and Bank’s regulatory capital ratios would not be affected by this potential non-cash expense since goodwill is not included in these calculations.

Subsequent to December 31, 2008, the Company’s stock price significantly declined as was the case for the financial services sector as a whole. The Company considers this to be primarily a financial services industry issue and not related specifically to the Company. If this decline does not reverse by March 31, 2009, there may be a triggering event requiring a goodwill impairment analysis under SFAS No. 142 that may result in an impairment charge.

Investing Activities

The following table summarizes the composition of the available for sale and held to maturity security portfolios (in thousands).

		At December 31,
		2008								2007								2006
		Adjusted
		Amortized				Fair				Amortized				Fair				Amortized				Fair
		Cost				Value				Cost				Value				Cost				Value
Securities available for sale:
U.S. Government agency and government-sponsored enterprise securities		$	67,871			$	68,173			$	158,920			$	158,940			$	235,863			$	231,936
Mortgage-backed securities:			339,574				342,552				297,798				295,872				304,833				296,738
Other asset-backed securities			3,918				3,918				34,115				33,198				7,082				7,077
State and municipal obligations			129,572				131,711				171,294				172,601				198,428				198,310
Equity securities			923				1,152				33,930				34,630				80				1,087
Total available for sale securities			541,858				547,506				696,057				695,241				746,286				735,148
Securities held to maturity:
State and municipal obligations Total held to maturity securities			58,532				59,147				59,479				59,902				40,388				40,421
Total investment securities		$	600,390			$	606,653			$	755,536			$	755,143			$	786,674			$	775,569

The deteriorating credit quality of assets linked to the sub-prime mortgage market has led to a lack of liquidity and downgrades to certain whole-loan mortgage-backed securities, trust preferred and auction rate securities. This, in turn, has contributed to a broad-based liquidity shortfall in the financial system. The subsequent increase in risk aversion has contributed to a decline in credit availability in the financial and capital markets. The U.S. Government has attempted to stabilize the financial and capital markets through an injection of liquidity and capital, but it is unclear if and how long it may take for those efforts to be successful.

For the year ended December 31, 2008, the Company recorded OTTI non-cash charges on certain equity, mortgage-backed and other asset-backed investment securities totaling $68.2 million. There were no such charges in prior years. Further deterioration in credit quality and/or a continuation of the current imbalances in liquidity that exist in the marketplace may adversely effect the fair values of the Company’s investment portfolio and increase the potential that certain unrealized losses may be designated as “other than temporary” in future periods and that the Company may incur additional write-downs in the future that could be material.

U.S. Government Agency and U.S. Government-Sponsored Enterprise (“GSE”) Obligations

The U.S. government agency and GSE obligations portfolio, all of which was classified as available for sale, was comprised of debt obligations issued directly by the U.S. government agencies or GSEs and totaled $68.2 million and $158.9 million as of December 31, 2008 and December 31, 2007, respectively. At December 31, 2008, the portfolio consisted of approximately $20.2 million, or 30%, callable securities. As of December 31, 2008, this category of investment securities also included $7.2 million of structured notes, the majority of which were step-callable debt issues that step-up in rate at specified intervals and are periodically callable by the issuer. As of December 31, 2008, the structured notes had a current average coupon rate of 4.21% that adjust on average to 6.00% within five years. However, under current market conditions these notes are likely to be called at the time of the rate adjustment.

Mortgage-Backed Securities (“MBS”)

The MBS portfolio totaled $342.6 million as of December 31, 2008, which was comprised of $239.5 million of mortgage-backed pass-through securities (“pass-through”) and $103.1 million of collateralized mortgage obligations (“CMO”). As of December 31, 2007, the available for sale MBS portfolio totaled $295.9 million, which consisted of $160.0 million of pass-throughs and $135.9 million of CMOs.

The pass-throughs were predominately issued by FNMA, FHLMC or GNMA. The majority of the pass-through portfolio was in fixed rate securities that were most frequently formed with mortgages having an original balloon payment of five or seven years and 15, 20 and 30 year seasoned mortgages. The remainder of the pass-through portfolio was principally adjustable rate securities indexed to the one-year Treasury bill.

The CMO portfolio consisted of two principal groups, with balances as of December 31, 2008 as follows: (1) $63.6 million of fixed and variable rate CMOs issued by FNMA, FHLMC or GNMA that carried a full guaranty by the issuing agency of both principal and interest, and (2) $39.5 million of privately issued whole loan CMOs.

The following table details, by credit rating, the privately issued whole loan CMOs as of December 31, 2008 (dollars in thousands):

		Moody’s		S&P		Fitch		Fair
Number of Securities		Rating		Rating		Rating		Value
Five (1)		Aaa		AAA		—		$	11,408
Two		Aaa		—		AAA			6,240
Four		—		AAA		AAA			6,261
One		—		—		AAA			5,651
Two (2)		Aa1		AAA		AAA			4,698
One		Baa3		—		AAA			2,467
One		—		BB		AAA			1,518
Total whole loan CMOs with prime and Alt-A collateral (at least 90% prime collateral)									38,243
One (3)		A3		AAA		—			426
One		—		BBB-		AAA			657
One		A3		BB		—			124
Total whole loan CMOs with a high level of sub-prime collateral (more than 35% sub-prime collateral)									1,207
Total privately issued whole loan CMOs								$	39,450