UNITED STATES SECURITIES AND EXCHANGE COMMISSION

~~SECURITIES~~WASHINGTON, ~~AND~~D.C. ~~EXCHANGE COMMISSION~~20549

~~Washington,~~FORM ~~D.C. 20549~~10-K

Form 10-K

(Mark One)

[X] Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934



[X]	Annual report pursuant to Section 13 or l5(d) of the Securities Exchange Act of 1934
	For the fiscal year ended December 31, 2013

[ ]	Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
	For the transition period from ________ to ________

For the fiscal year ended December 31, 2012

[ ] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from ________ to ________

Commission File Number 000-24503

~~Washington~~WASHINGTON ~~Banking~~BANKING ~~Company~~COMPANY

(Exact name of registrant as specified in its charter)



	Washington	91-1725825
	(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification Number)

450 SW Bayshore Drive

Oak Harbor, Washington 98277

(Address of principal executive offices) (Zip Code)

~~Registrant’s Telephone Number, Including Area Code:~~ (360) 679-3121

(Registrant’s telephone number, including area code)

Securities Registered Pursuant to Section 12(b) of the Act: None

Securities Registered Pursuant to Section 12(g) of the the Act: Common Stock, No Par Value

Common Stock, No Par Value

(Title of Class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

~~oYes x~~Yes [ ] No [X]

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

~~Indicate~~Yes by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities and Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. xYes o [ ] No [X]

Indicate by check mark whether the registrant: (1) has ~~submitted~~filed ~~electronically~~all ~~and~~reports ~~posted on its corporate Web site, if any, every Interactive Data File~~ required to be ~~submitted~~filed ~~and~~by ~~posted~~Section ~~pursuant~~13 toor ~~Rule~~15(d) ~~405~~ of ~~Regulation~~the ~~S-T~~Securities ~~(§232.405~~Exchange Act of ~~this~~1934 ~~chapter)~~ during the preceding 12 months (or for such shorter period that the registrant was required to ~~submit~~file such reports), and ~~post~~(2) has been subject to such ~~files)~~filing requirements for the past 90 days. ~~xYes o~~ Yes [X] No [ ]

Indicate by check mark ifwhether ~~disclosure~~the ofregistrant ~~delinquent~~has ~~filers~~submitted ~~pursuant~~electronically toand ~~Item~~posted ~~405~~on ofits ~~Regulation~~corporate ~~S-K~~web ~~(17~~site, ~~C.F.R.~~if ~~229.405)~~any, isevery ~~not~~Interactive ~~contained~~Data ~~herein,~~File ~~and~~required ~~will~~to ~~not~~ be ~~contained,~~submitted and posted pursuant to ~~the~~Rule ~~best~~405 of ~~registrant’s~~Regulation ~~knowledge,~~S-T in(§ ~~definitive~~229.405 ~~proxy~~ of ~~information~~this ~~statements~~chapter) ~~incorporated~~during bythe ~~reference~~preceding in12 ~~Part~~months ~~III~~(or offor ~~this~~such ~~Form~~shorter ~~10-K~~period orthat ~~any~~the ~~amendments~~registrant was required to ~~this~~submit ~~Form~~and ~~10-K.~~post xsuch files).

~~Indicate~~Yes by[X] No ~~check mark if the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.~~[ ~~See the definitions of “large accelerated filer,” “acclerated filer,” “non-accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.~~]

~~Large~~Indicate ~~accelerated~~by ~~filer~~check omark ~~Accelerated~~if ~~filer~~disclosure xof ~~Non~~delinquent filers pursuant to Item 405 of Regulation S-~~Accelerated~~K ~~filer~~(17 oC.F.R. ~~Smaller~~229.405) ~~Reporting~~is ~~Company~~not ocontained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy of information statements incorporated by reference in Part III of this Form 10-K or any amendments to this Form 10-K. [ ]

Indicate by check mark if the registrant is a ~~shell~~large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See ~~(as~~the ~~defined~~definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act). ~~oYes x No~~

~~The~~Large ~~aggregate,~~accelerated ~~market~~filer ~~value~~[ of] ~~Common~~Accelerated ~~Stock~~filer ~~held~~[X] ~~by non~~Non-~~affiliates~~Accelerated offiler ~~registrant~~[ at] ~~June~~Smaller ~~30,~~reporting ~~2012~~company ~~was~~[ ~~approximately $208,633,000 based upon the closing price of the registrant’s common stock as quoted on NASDAQ on June 29, 2012 of $13.90.~~]

~~The~~Indicate ~~number~~by ofcheck ~~shares~~mark ofif the registrant’s ~~Common~~is ~~Stock~~a ~~outstanding~~shell atcompany ~~March~~as 7,defined ~~2013~~in ~~was~~Rule 1512b-2 under the Securities Exchange Act of 1934,~~503,694~~ as amended. Yes [ ] No [ X ]

~~Documents~~The ~~incorporated~~aggregate, market value of Common Stock held by ~~reference~~non-affiliates ~~and~~of ~~parts~~registrant at June 30, 2013 was approximately $216,517,000 based upon the closing price of ~~Form~~the ~~10-K~~registrant’s ~~into~~common ~~which~~stock ~~incorporated:~~as quoted on NASDAQ on June 28, 2013 of $14.20.

~~Registrant’s~~The ~~definitive~~number ~~Proxy Statement for the 2013 Annual Meeting~~ of ~~Shareholders~~shares ~~to be filed within 120 days~~ of ~~our~~the ~~2012~~issuer’s ~~fiscal~~Common ~~year~~Stock ~~end~~outstanding ~~Part~~at ~~III~~March 7, ~~except~~2014 ~~the~~was ~~reports~~15,587,041 ~~of the audit and compensation committees are “furnished” not filed and deemed to be incorporated by reference~~

TABLE OF CONTENTS



PART I
		Page
Item 1.	Business	1
Item 1A.	Risk Factors	9
Item 1B.	Unresolved Staff Comments	14
Item 2.	Properties	15
Item 3.	Legal Proceedings	15
Item 4.	Mine Safety Disclosures	15

PART II

Item 5.	Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	16
Item 6.	Selected Financial Data	18
Item 7.	Management's Discussion and Analysis of Financial Condition and Results of Operations	20
Item 7A.	Quantitative and Qualitative Disclosures about Market Risk	44
Item 8.	Financial Statements and Supplementary Data	47
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	101
Item 9A.	Controls and Procedures	101
Item 9B.	Other Information	102

PART III

Item 10.	Directors, Executive Officers and Corporate Governance	102
Item 11.	Executive Compensation	107
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	121
Item 13.	Certain Relationships and Related Transactions and Director Independence	122
Item 14.	Principal Accounting Fees and Services	123

PART IV

Item 15.	Exhibits, Financial Statement Schedules	124

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PART I
		Page
Item 1.	Business		1
Item 1A.	Risk Factors		14
Item 1B.	Unresolved Staff Comments		20
Item 2.	Properties		20
Item 3.	Legal Proceedings		20
Item 4.	Mine Safety Disclosures		20
PART II
Item 5.	Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities		21
Item 6.	Selected Financial Data		24
Item 7.	Management's Discussion and Analysis of Financial Condition and Results of Operations		26
Item 7A.	Quantitative and Qualitative Disclosures about Market Risk		52
Item 8.	Financial Statements and Supplementary Data		54
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure		120
Item 9A.	Controls and Procedures		120
Item 9B.	Other Information		120
PART III
Item 10.	Directors, Executive Officers and Corporate Governance		121
Item 11.	Executive Compensation		121
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters		121
Item 13.	Certain Relationships and Related Transactions and Director Independence		121
Item 14.	Principal Accounting Fees and Services		121
PART IV
Item 15.	Exhibits and Financial Statement Schedules		121

Note Regarding Forward-Looking Statements: This Annual Report on Form 10-K includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements describe Washington Banking Company’s (the “Company”) management’s expectations regarding future events and developments such as the proposed strategic merger with Heritage, future operating results, growth in loans and deposits, the FDIC indemnification asset and covered loans, credit quality and adequacy of the allowance for loan losses, and continued success of the Company’s business plan. Readers should not place undue reliance on forward-looking statements, which reflect management’s views only as of the date hereof. The words “will,” “believe,” “expect,” “should,” “anticipate” and words of similar meaning are intended in part to help identify forward-looking statements. Future events are difficult to predict, and the expectations described below are necessarily subject to risk and uncertainty that may cause actual results to differ materially. In addition to discussions about risks and uncertainties set forth from time to time in the Company’s filings with the Securities and Exchange Commission (the “SEC”), factors that may cause actual results to differ materially from those contemplated in such forward-looking statements include, among others: (1) local and national economic conditions; (2) changes in interest rates and their impact on net interest margin; (3) competition among financial institutions; (4) legislation or regulatory requirements; (5) the ability to realize efficiencies expected from investment in personnel and infrastructure; (6) the possibility that the proposed merger with Heritage does not close when expected or at all because required regulatory, shareholder or other approvals and other conditions to closing are not received or satisfied; (7) the effect on the trading price of our stock if the proposed merger with Heritage is not completed; (8) benefits from the proposed merger with Heritage may not be fully realized or may take longer to realize than expected; (9) the integration of the Company’s and Heritage’s business may take longer to accomplish than expected; (10) the anticipated growth opportunities and cost savings from the proposed merger with Heritage may not be fully realized by the combined company or may take longer to realize than expected; (11) operating costs, customer and employee losses and business disruption related to the proposed merger may be greater than expected; and (12) management time and effort will be diverted to completion of the proposed merger and merger-related matters. However, the reader should be aware that these factors are not an exhaustive list, and it should not be assumed that these are the only factors that may cause actual results to differ from expectations. In addition, the reader should note that the Company does not intend to update any of the forward-looking statements or the uncertainties that may adversely impact those statements.

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Note Regarding Forward-Looking Statements: This Annual Report on Form 10-K includes forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) that are subject to risks and uncertainties. These forward-looking statements describe management's expectations regarding future events and developments such as future operating results, growth in loans and deposits, credit quality and loan losses, adequacy of the allowance for loan losses and continued success of the Company’s business plan. Readers should not place undue reliance on forward-looking statements, which reflect management’s views only as of the date hereof. The words “anticipate,” “expect,” “will,” “believe,” and words of similar meaning are intended, in part, to help identify forward-looking statements. Future events are difficult to predict, and the expectations described above are subject to risk and uncertainty that may cause actual results to differ materially. In addition to risks and uncertainties set forth from time to time in the Company’s filings with the Securities and Exchange Commission including Item 1a of this Annual Report, the following factors may cause actual results to differ materially from those contemplated in these forward-looking statements: (1) local and national general and economic condition; (2) changes in interest rates and their impact on net interest margin; (3) competition among financial institutions; (4) legislation or regulatory requirements; (5) the ability to realize the efficiencies expected from investment in personnel and infrastructure and (6) the integration of acquisitions. For a more detailed discussion of some of the risk factors, see the section entitled “Risk Factors” below. Washington Banking Company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements were made. Any such statements are made in reliance on the safe harbor protections provided under the Securities Exchange Act of 1934, as amended.

PART I

Item 1. Business

General

Washington Banking Company (the “Company”) was formed on April 30, 1996 and is a registered bank holding company whose primary business is conducted by its wholly-owned subsidiary, Whidbey Island Bank (the “Bank”). The business of the Bank, which is focused in the northern area of Western Washington, consists primarily of attracting deposits from the general public and originating loans.

Whidbey Island Bank is a Washington state-chartered bank that conducts a full-service, community, commercial banking business. The Bank also offers nondeposit managed investment products and services, which are not Federal Deposit Insurance Corporation (“FDIC”) insured. These programs are provided through unrelated investment advisory company, Elliott Cove Capital Management LLC.

Washington Banking Master Trust (the “Master Trust”) is a wholly-owned subsidiary of the Company. The Master Trust was formed in April 2007 for the exclusive purpose of issuing trust preferred securities to acquire junior subordinated debentures issued by the Company. Those debentures are the sole assets of the Master Trust and payments on the debentures are the sole revenues of the Master Trust. See Note (13) Trust Preferred Securities and Junior Subordinated Debentures to the consolidated financial statements for further details.

Rural One, LLC (“Rural One”) is a majority-owned ~~subsidary~~subsidiary of the Bank and is certified as a Community Development Entity by the Community Development Financial Institutions Fund of the United Stated Department of Treasury. Rural One was formed in September 2006, for the exclusive purpose of an investment in federal tax credits related to the New Markets Tax Credit program.

At December 31, ~~2012~~2013, the Company had total assets of $1.7 billion, total deposits of $1.5 billion and shareholders’ equity of $~~182~~179.6 9 million. A more thorough discussion of the Company’s financial performance appears in Item 7- Management’s Discussion and Analysis of Financial Condition and Results of Operations.

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The Company’s website address is www.wibank.com. Reports filed by the Company under the Securities Exchange Act of the 1934 (the “Exchange Act”) are available free of charge from the Company’s website. The reports can also be obtained through the Securities and Exchange Commission’s (the “SEC”) EDGAR database at http://www.sec.gov. The contents of the Company’s Internet website are not incorporated into this report or into any other communication delivered to security holders or furnished to the SEC.

Proposed Merger

On October 23, 2013, the Company and Heritage Financial Corporation jointly announced the signing of a definitive agreement under which the Company and Heritage will enter into a strategic merger to create one of the premier community banking franchises in Western Washington and the Pacific Northwest. Under the merger agreement, Washington Banking will merge with and into Heritage, with Heritage as the surviving corporation.

Growth Strategy

The Company’s strategy is one of value-added growth. Management believes that qualitative and sustainable growth of the Company, coupled with maintaining profitability, iswill ~~currently~~provide ~~the most appropriate path to providing~~ good value ~~for~~to ~~its~~ shareholders. Prior to 2010, the Company’s growth had been primarily achieved organically. The Company attributes its reputation for focusing on customer service and satisfaction as one of the cornerstones to the Company’s success. The Company’s primary objectives are to improve profitability and operating efficiencies, increase market penetration in areas currently served and to continue an expansion strategy in appropriate market areas.

The Company’s geographical expansion to date has primarily been concentrated along the I-5 corridor from Snohomish to Whatcom Counties; however, additional areas will be considered if they meet the Company’s criteria. Acquisition of banks or branches may also be used as a means of expansion if appropriate opportunities are presented. The primary factors considered in determining the areas of geographic expansion are the availability of knowledgeable personnel, such as managers and lending officers with experience in their fields of expertise, longstanding community presence and extensive banking relationships, customer demand and perceived market potential. On April 16, 2010 and September 24, 2010, the Bank acquired certain assets and assumed certain liabilities of City Bank and North County Bank, respectively, from the Federal Deposit Insurance Corporation (“FDIC”) in FDIC-assisted transactions. The acquisition of City Bank resulted in expansion into King County. In December 2012, the Bank opened its 31^st branch in Woodinville, located in the northeast quadrant of King County.

Management believes that adding customers to current branches and expanding into appropriate market places while managing up-front costs is an excellent way to build franchise value and increase business. The Company’s strategy is to support its employees in providing a high level of personal service to its customers while expanding the loan, deposit and investment products and other services that the Company offers. Maintenance of asset quality will be emphasized by controlling nonperforming assets and adhering to prudent underwriting standards. In addition, management will maintain its focus on improving operating efficiencies and internal operating systems to further manage noninterest expense.

Growth requires expenditures of substantial sums to purchase or lease real property and equipment and to hire experienced personnel. New branch offices are often not profitable for a period of time after opening and management expects that earnings may be negatively affected in the short term.

Market Areas

The Company’s principal subsidiary, Whidbey Island Bank, provides services through 31 bank branches in 6 counties located in northwestern Washington. The Company’s primary market area currently consists of Island, King, San Juan, Skagit, Snohomish and Whatcom counties. Although the Pacific Northwest is typically associated with industries such as computer technology, aerospace and coffee, the Company’s market encompasses distinct economies that are somewhat removed from the Seattle metropolitan region.

Island County’s largest population center, Oak Harbor, is dominated by a large military presence with naval operations at NAS Whidbey Island. The jobs generated by NAS Whidbey contribute significantly to the county’s economy. Other primary industries providing employment for county residents are: education; health and social services; retail trade; and, manufacturing. Due to its natural beauty, the county attracts tourism and has a number of retirement communities.

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King County is the most populous county in Washington and is the largest business center in both the state of Washington and Pacific Northwest. The county is home to some of the world’s most successful businesses including Amazon, Boeing, Costco, Microsoft and Starbucks. King County is a leading global center for several emerging industries, including aerospace, biotechnology, clean technology, information technology and international trade and logistics.

The economy of San Juan County is predominantly comprised of retail trade, tourism, finance and insurance and real estate services. The county is known for its beautiful locale, which attracts many visitors, and serves as a second home to an affluent sector of the population.

The economy of Skagit County is primarily comprised of agriculture, fishing, wood products, tourism, international trade and specialized manufacturing. With its accessible ports and refineries, Skagit County is the center of the state’s petroleum industry.

Snohomish County industrial sectors include aerospace, biotechnology, and electronics, as well as a military naval base and large retail influences.

Whatcom County, which borders Canada, has an economy with a prominent manufacturing base, as well as a significant academic-research and vocational-technical base, as it is the home of Western Washington University, one of Washington’s largest four-year academic centers. The United States Customs and Border Patrol and municipal, county and state governments give Whatcom County an additional employment base.

The Company operates in a highly competitive banking environment, competing for deposits, loans and other financial services with a number of larger and well-established commercial banks, savings banks, savings and loan associations, credit unions and other institutions, including nonbanking financial services companies.

Some of the Bank’s competitors are not subject to the same regulations as the Bank and may have lower operating costs. Larger institutions have substantially higher lending limits, and may offer certain services that the Bank does not provide. Federal law allows mergers or other combinations, relocations of a bank’s main office and branching across state lines. Recent amendments to the federal banking laws to eliminate certain barriers between banking and commercial firms are expected to result in even greater competition in the future. Although the Company has been able to compete effectively in its market areas to date, there can be no assurance that the Company's competitive efforts will continue to be successful.

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Executive Officers of the Company

The following table sets forth certain information about the executive officers of the Company:

Name	Age		Position	Has served as an executive officer of the Company or Bank since
John L. Wagner		69	President and Chief Executive Officer/Washington Banking Company		2004
Bryan McDonald		41	President and Chief Executive Officer/Whidbey Island Bank		2010
Richard A. Shields		53	Executive Vice President and Chief Financial Officer		2004
George W. Bowen		64	Executive Vice President and Chief Banking Officer		2012
Edward Eng		50	Executive Vice President and Chief Administrative Officer		2012
Daniel E. Kuenzi		48	Executive Vice President and Chief Credit Officer		2012

John L. Wagner. Mr. Wagner has been the President and Chief Executive Officer of WBCO since October 2008 and was the President and Chief Executive Officer of the Bank from April 2007 through December 2011. He joined the Bank in 1999 as Senior Vice President and Regional Manager in Whatcom County. In 2002, Mr. Wagner was selected to oversee branch administration and was promoted to COO in 2004. Mr. Wagner has an extensive background in banking and international finance as well as comprehensive administrative experience as former President of Bank of Washington in Bellingham, Washington.

Bryan McDonald. Mr. McDonald was promoted to President and Chief Executive Officer of the Bank as of January 1, 2012. Mr. McDonald joined the Bank in 2006 as Commercial Banking Manager and he served as Senior Vice President and Chief Operating Officer of the Bank from April 1, 2010 until his promotion to Executive Vice President on August 26, 2010. Mr. McDonald has been serving in the banking industry since 1994, including in regional commercial lending management roles since 1996 for Washington Mutual and Peoples Bank.

Richard A. Shields. Mr. Shields is the Executive Vice President and Chief Financial Officer of the Company and the Bank. Mr. Shields joined the Bank in 2004 and has over 20 years of experience in various accounting-related positions with Pacific Northwest-based banks. From November 1998 until October 2004, he was the Vice President and Controller at a bank in the Pacific Northwest that grew substantially both organically and through multiple acquisitions.

George W. Bowen. Mr. Bowen was promoted to Executive Vice President and Chief Banking Officer effective January 1, 2012. Mr. Bowen’s responsibilities include overseeing retail, mortgage and commercial customer-related business lines. He has over 40 years experience in commercial lending, retail banking, and various management positions. Mr. Bowen has an MBA from Western Washington University. Prior to joining Whidbey Island Bank in 2010, Mr. Bowen was Senior Executive Vice President and Chief Lending Officer at Peoples Bank, a position he had held since 1996.

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Edward Eng. Mr. Eng was promoted to Executive Vice President and Chief Administrative Officer effective January 1, 2012 and has responsibility over the Bank’s backroom support functions and project management. Mr. Eng is a CPA with an MBA from the University of Washington. In addition to experience in public accounting, he has 22 years of banking experience covering accounting, finance, technology, M&A, loan operations and compliance. Mr. Eng was the Division Finance Officer within the commercial banking group of Washington Mutual from 2005 to 2009. He worked as an independent consultant during 2009 and 2010. The Bank engaged him for consulting services in 2010 prior to Mr. Eng accepting the FDIC Loss Share Reporting and Accounting Manager position with the Bank in December 2010.

Daniel E. Kuenzi. Mr. Kuenzi took over as Executive Vice President and Chief Credit Officer on January 1, 2012. Mr. Kuenzi started with Whidbey Island Bank in 2007 as a Commercial Banking Team Leader, then a Region Manager, and transitioned into the role of Senior Credit Administrator in 2010. Mr. Kuenzi has accumulated more than 20 years of commercial credit, lending, and management experience through his positions at Wells Fargo Bank, Washington Mutual, US Bank and Whidbey Island Bank.

Employees

The Company had ~~467~~464 full time equivalent employees at December 31, ~~2012~~2013. None of the Company’s employees are covered by a collective bargaining agreement or represented by a collective bargaining group. Management considers its relations with employees to be good.

Supervision and Regulation

The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956 (“BHC Act”) registered with and subject to examination by the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of San Francisco (“FRB”). The Bank is a Washington state-chartered commercial bank and is subject to examination, supervision and regulation by the Washington State Department of Financial Institutions–Division of Banks (“Division”). The FDIC insures the Bank’s deposits and in that capacity also regulates the Bank.

The following discussion provides an overview of the extensive regulatory framework applicable to the Company and the Bank. Laws and regulations governing the Company and the Bank are primarily designed to protect depositors, consumers, the Deposit Insurance Fund and the banking system, rather than shareholders. To the extent that this section describes statutory and regulatory provisions, it is qualified by reference to those provisions.

The Company’s earnings and activities are affected by legislation, by actions of the FRB, the Division, the FDIC and other regulators, by local legislative and administrative bodies, and by decisions of federal and Washington State courts. These include limitations on the ability of the Bank to pay dividends to the Company, and numerous federal and state consumer protection laws imposing requirements on the making, enforcement, and collection of consumer loans, and restrictions by regulators on the sale of mutual funds and other uninsured investment products to customers. Additional legislation may be enacted or regulations imposed to further regulate banking and financial services or to limit finance charges or other fees or charges earned in such activities. We anticipate significant additional regulation and increased compliance costs in the current environment.

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Bank Holding Company Regulation. As a bank holding company, the Company is subject to regulation, supervision and examination by the FRB. In general, the BHC Act limits the business of bank holding companies to owning or controlling banks and engaging in other activities closely related to banking. The Company must file reports with and provide the Federal Reserve such additional information as it may require.

Congress enacted major federal financial institution reform legislation in 1999, allowing bank holding companies to elect to become financial holding companies. In addition to activities previously permitted bank holding companies, financial holding companies may engage in nonbanking activities that are financial in nature, such as securities, insurance and merchant banking activities, subject to certain limitations.

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The activities of bank holding companies, such as the Company, that are not financial holding companies, are generally limited to managing or controlling banks. A bank holding company is required to obtain the prior approval of the FRB for the acquisition of more than 5% of the outstanding shares of any class of voting securities or substantially all of the assets of any bank or bank holding company. Nonbank acquisitions by bank holding companies such as the Company are generally limited to 5% of voting shares of a company and activities previously determined by the FRB by regulation or order to be so closely related to banking as to be a proper incident to banking or managing or controlling banks.

Transactions with Affiliates. There are various legal restrictions on transactions between the Company and any nonbank subsidiaries, and between the Company and the Bank. With certain exceptions, federal law also imposes limitations on, and requires collateral for, extensions of credit by insured depository institutions, such as the Bank, to their nonbank affiliates, such as the Company. These regulations limit the Company’s ability to obtain funds from the Bank for its liquidity needs.

Tying Arrangements. The Company is prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, sale or lease of property or furnishing of services. For example, with certain exceptions, neither the Company nor its subsidiaries may condition an extension of credit to a customer on either (i) a requirement that the customer obtain additional services provided by us; or (ii) an agreement by the customer to refrain from obtaining other services from a competitor.

Support of the Bank. Under Federal Reserve policy, the Company is expected to act as a source of financial and managerial strength to the Bank. The Company is required to commit, as necessary, resources to support the operations of the Bank. Any loans a bank holding company makes to its subsidiary banks are subordinate to deposits and other indebtedness of those subsidiary banks.

State Law Restrictions. As a Washington corporation, the Company is subject to certain limitations and restrictions under Washington corporate law, including those related to indemnification of directors, distributions to shareholders, transactions involving directors, officers or interested shareholders, maintenance of books, records, and minutes, and observance of corporate formalities.

Consumer Privacy. The Gramm-Leach-Bliley Act (“GLB Act”) included the most extensive consumer privacy provisions ever enacted by Congress. These provisions, among other things, require full disclosure of the Company’s privacy policy to consumers and mandate offering the consumer the ability to “opt out” of having non-public personal information disclosed to third parties. Pursuant to these provisions, the federal banking regulators have adopted privacy regulations. In addition, the states are permitted to adopt more extensive privacy protections through legislation or regulation.

Interstate Banking and Branching. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (“Interstate Act”) permits nationwide interstate banking and branching under certain circumstances. Subject to certain limitations and restrictions, a bank holding company, with prior approval of the FRB, may acquire an out-of-state bank. Banks in states that do not prohibit out-of-state mergers may merge with the approval of the appropriate federal banking agency. The Dodd-Frank Act removed Interstate Act restrictions on de novo branching across state lines and banks can now open a new branch or purchase a branch in another state to the same extent that a bank chartered in such state may do.

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Federal and State Bank Regulation. Among other things, applicable federal and state statutes and regulations which govern a bank’s activities relate to minimum capital requirements, required reserves against deposits, investments, loans, legal lending limits, mergers and consolidations, borrowings, issuance of securities, payment of dividends, establishment of branches and other aspects of its operations. The Division and the FDIC also have authority to prohibit banks under their supervision from engaging in what they consider to be unsafe and unsound practices.

The Bank is required to file periodic reports with the FDIC and the Division and is subject to periodic examinations and evaluations by those regulatory authorities. The FDIC and the Division may each accept the results of an examination by the other in lieu of conducting an independent examination.

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In the liquidation or other resolution of a failed insured depository institution, deposits in offices and certain claims for administrative expenses and employee compensation are afforded a priority over other general unsecured claims, including nondeposit claims, and claims of a parent company such as the Company. Such priority creditors would include the FDIC, which succeeds to the position of insured depositors.

Insider Credit Transactions. Banks are subject to restrictions on extensions of credit to executive officers, directors, principal shareholders or any related interests of such persons. “Insider” transactions must be made on substantially the same terms, including interest rates and collateral, and follow credit underwriting procedures that are at least as stringent as those prevailing at the time for comparable transactions with persons not covered above and who are not employees. In addition, such transactions must not involve more than the normal risk of repayment or present other unfavorable features. Banks are also subject to certain lending limits and restrictions on overdrafts to insiders. A violation of these restrictions may result in the assessment of substantial civil monetary penalties, the imposition of a cease and desist order, and other regulatory sanctions.

Management. Federal law sets forth circumstances under which officers or directors of a bank may be removed by the institution’s federal supervisory agency and prohibits management personnel of a bank from serving as a director or in other management positions of another financial institution whose assets exceed a specified amount or which has an office within a specified geographic area.

Additional Safety and Soundness Standards. Federal law imposes certain non-capital safety and soundness standards upon banks. These standards cover internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, fees and benefits, such other operational and managerial standards as the agency determines to be appropriate, and standards for asset quality, earnings and stock valuation. An institution that fails to meet these standards must develop a plan acceptable to its regulators, specifying the steps that the institution will take to meet the standards. Failure to submit or implement such a plan may subject the institution to regulatory sanctions.

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Federal Deposit Insurance. Substantially all deposits with the Bank are insured up to applicable limits by the Deposit Insurance Fund (“DIF”) of the FDIC and are subject to deposit insurance assessments to maintain the DIF. The FDIC uses a risk-based assessment system that imposes insurance premiums based upon a bank’s capital level and supervisory ratings. The base assessment rates under the Federal Deposit Insurance Reform Act of 2005 (“Reform Act”), enacted in February 2006, ranged from $0.02 to $0.40 per $100 of deposits annually.

In ~~December~~October ~~2008~~2010, the FDIC adopted a ~~rule~~new ~~that~~DIF ~~amended~~restoration ~~the~~plan ~~system~~to ~~for~~ensure ~~risk-based~~that ~~assessments~~the ~~and~~fund ~~changed assessment rates in attempt to restore targeted~~ reserve ~~ratios~~ratio inreaches ~~the DIF~~1.35% ~~Effective~~by ~~January~~September 130, ~~2009~~2020, ~~the~~as ~~risk-based~~required ~~assessment~~by ~~rates~~the ~~were~~Dodd-Frank ~~uniformly~~Act. ~~raised~~Under bythe ~~seven~~new ~~basis~~restoration ~~points (annualized). On February 27~~plan, ~~2009,~~ the FDIC ~~adopted~~will maintain ~~further modified~~ the ~~risk-based~~current ~~assessment~~schedule ~~system, effective April 1, 2009, to effectively require larger risk institutions to pay a larger share~~ of ~~the~~ assessment. ~~The final assessment~~ rates ~~ranged from $0~~.07 toAt ~~$0.775~~least ~~per $100 of deposits~~ semi-annually., ~~Initial~~the ~~base~~FDIC ~~assessment~~will ~~rates~~update ~~for~~its ~~well~~loss ~~managed,~~and ~~well~~income ~~capitalized~~projections ~~institutions~~for ~~ranged~~the ~~from~~DIF ~~$0.12~~and, toif ~~$0.16~~needed, ~~per~~increase ~~$100~~or ofdecrease ~~deposits annually. The Bank’s~~ assessment ~~rate for 2012 fell within this range~~rates.

In October 2010, the FDIC adopted a new DIF restoration plan to ensure that the fund reserve ratio reaches 1.35% by September 30, 2020, as required by the Dodd-Frank Act. Under the new restoration plan, the FDIC will forego the uniform three basis point increase in initial assessment rates schedules for January 1, 2011, and maintain the current schedule of assessment rates. At least semi-annually, the FDIC will update its loss and income projections for the DIF and, if needed, increase or decrease assessment rates. The FDIC has proposed additional rules to change the deposit insurance assessment system.

In 2006, the Reform Act increased the deposit insurance limit for certain retirement plan deposit accounts from $100,000 to $250,000. The basic insurance limit for other deposits, including individuals, joint account holders, businesses, government entities, and trusts, remained at $100,000. The Reform Act also provided for the merger of the two deposit insurance funds administered by the FDIC, the Bank Insurance Fund (“BIF”) and the Savings Association Insurance Fund (“SAIF”), into the DIF. On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”) temporarily raised the basic limit on federal deposit insurance coverage from $100,000 to $250,000 per depositor. The basic deposit insurance limit would have returned to $100,000 after December 31, 2009. On May 20, 2009, the Helping Families Save Their Homes Act extended the temporary increase in the standard maximum deposit insurance amount to $250,000 per depositor through December 31, 2013. The standard maximum deposit insurance amount would return to $100,000 on January 1, 2014. The Dodd-Frank Act permanently raises the current standard maximum federal deposit insurance amount from $100,000 to $250,000 per qualified account.

In November 2008, the FDIC approved the final rule establishing the Transaction Account Guarantee Program (“TAGP”) as part of the Temporary Liquidity Guarantee Program (“TLGP”)~~. Under this program~~, ~~effective~~which ~~immediately~~included ~~and~~provisions ~~through~~that ~~December 31, 2009,~~ all noninterest bearing transaction accounts became fully guaranteed by the FDIC for the entire amount in the account. This unlimited coverage also extended to NOW accounts (interest bearing deposit accounts) earning an interest rate no greater than 0.50% ~~and all IOLTAs~~ (~~lawyers’~~subsequently trust accounts). Coverage under the TAGP, funded through insurance premiums paid by participating financial institutions, was in addition to and separate from the additional coverage announced under EESA. In August 2009, the FDIC extended the TAGP portion of the TLGP through June 30, 2010. In June 2010, the FDIC extended the TAGP portion of the TLGP for an additional six months, from July 1, 2010 to December 31, 2010. The rule required that interest rates on qualifying NOW accounts offered by banks participating in the program be reduced to 0.25%) ~~from~~and ~~0.50%.~~all ~~The~~IOLTAs rule provided for an additional extension of the program, without further rulemaking, for a period of time not to exceed December 31, 2011. The Bank elected to participate in the TAGP program through the extended period. The Dodd-Frank Act provided for unlimited deposit insurance for noninterest bearing transactions accounts (~~excluding~~lawyers’ ~~NOW,~~trust ~~but including IOLTAs~~accounts) ~~beginning December 31, 2010 for a period of two years~~. The TAGP expired as of December 31, 2012 and the FDIC no longer provides separate, unlimited deposit insurance under that program.

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~~Capital Adequacy.~~ The ~~Company~~FDIC ~~and~~may terminate the ~~Bank~~deposit ~~are~~insurance ~~subject~~of toany ~~risk-based~~insured ~~capital~~depository ~~and~~institution ~~leverage~~if ~~guidelines~~it ~~issued~~determines bythat ~~federal~~the ~~banking~~institution ~~agencies~~has ~~for~~engaged ~~banks~~in ~~and~~or ~~bank~~is ~~holding~~engaging ~~companies. These~~in ~~agencies~~unsafe ~~are~~and ~~required~~unsound bybanking ~~law~~practices, tois ~~take~~in ~~specific~~an ~~prompt~~unsafe ~~corrective~~or ~~actions~~unsound ~~with~~condition ~~respect~~or tohas ~~institutions~~violated ~~that~~any doapplicable ~~not meet minimum capital standards. As of December 31~~law, ~~2012,~~regulation ~~the~~or ~~Company~~order ~~and~~or ~~the~~any ~~Bank~~condition ~~exceeded~~imposed ~~the~~in ~~minimum~~writing ~~capital~~by, ~~standards.~~or ~~Broad~~pursuant ~~regulatory authority is given~~ to ~~the FDIC if capital levels drop below minimum standards including restrictions on growth~~, ~~acquisition,~~any ~~branching~~written ~~and~~agreement ~~new~~with ~~lines~~the ~~of business as well as interest rate restrictions on deposit gathering activities~~FDIC.

~~Dividends. The~~Community ~~Bank~~Reinvestment ~~is subject to restrictions on the payment of cash dividends to the Company~~Act. The ~~principal~~Community ~~source~~Reinvestment ofAct ~~the~~(CRA) ~~Company’s~~requires ~~cash flow is dividends received from the Bank~~that, ~~the~~in ~~issuance~~connection ofwith ~~junior~~examinations ~~subordinated debentures, and cash received from the exercise~~ of ~~stock~~financial ~~options. Regulatory~~institutions ~~authorities~~within ~~may~~their ~~prohibit banks and bank holding companies from paying dividends which would constitute an unsafe or unsound banking practice. In addition~~jurisdiction, aregulators ~~bank~~must ~~may~~evaluate ~~not pay cash dividends if that payment could reduce~~ the ~~amount~~records of ~~its~~financial ~~capital~~institutions ~~below~~in ~~that~~meeting ~~necessary to meet~~ the ~~“adequately~~credit ~~capitalized”~~needs ~~level~~of intheir ~~accordance~~local ~~with regulatory capital requirements. Also~~communities, ~~the~~including ~~payment~~low ~~of cash dividends by the Bank must satisfy a net profits test~~ and anmoderate ~~undivided~~income ~~profits~~neighborhoods, ~~test~~consistent orwith the ~~Bank~~safe ~~must~~and ~~obtain~~sound ~~prior~~operation ~~approval~~ of ~~its~~those ~~regulators before such dividend is paid~~banks. ~~The~~These ~~net~~factors ~~profits~~are ~~test~~also ~~limits~~considered ~~the dividend declared~~ in ~~any~~evaluating ~~calendar~~mergers, ~~year~~acquisitions to the net profits of the current year plus retained net income of the preceding two years. The undivided profits test limits the dividends declared to the undivided profits on hand after deducting bad debts in excess of the allowance for loan and ~~lease~~applications ~~losses. Washington law also provides that no cash dividend may be paid if, after giving effect~~ to ~~the~~open ~~dividend, (1)~~ a ~~corporation~~branch ~~would not be able to pay its debts as they become due in the usual course of business,~~ or ~~(2) a corporation’s total assets would be less than the sum of its total liabilities~~facility.

Capital Adequacy. The Company and the Bank are subject to risk-based capital and leverage guidelines issued by federal banking agencies for banks and bank holding companies. These agencies are required by law to take specific prompt corrective actions with respect to institutions that do not meet minimum capital standards. As of December 31, 2013, the Company and the Bank exceeded the minimum capital standards. Broad regulatory authority is given to the FDIC if capital levels drop below minimum standards including restrictions on growth, acquisition, branching and new lines of business as well as interest rate restrictions on deposit gathering activities.

Dividends. The Bank is subject to restrictions on the payment of cash dividends to the Company. The principal source of the Company’s cash flow is dividends received from the Bank. Regulatory authorities may prohibit banks and bank holding companies from paying dividends which would constitute an unsafe or unsound banking practice. In addition, a bank may not pay cash dividends if that payment could reduce the amount of its capital below that necessary to meet the “adequately capitalized” level in accordance with regulatory capital requirements. Also, the payment of cash dividends by the Bank must satisfy a net profits test and an undivided profits test or the Bank must obtain prior approval of its regulators before such dividend is paid. The net profits test limits the dividend declared in any calendar year to the net profits of the current year plus retained net income of the preceding two years. The undivided profits test limits the dividends declared to the undivided profits on hand after deducting bad debts in excess of the allowance for loan and lease losses. Washington law also provides that no cash dividend may be paid if, after giving effect to the dividend, (1) a corporation would not be able to pay its debts as they become due in the usual course of business, or (2) a corporation’s total assets would be less than the sum of its total liabilities.

The Company is limited in its ability to pay dividends to its shareholders. FRB policy states 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 organization'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 banking subsidiaries. Various federal and state statutory provisions also limit the amount of dividends that subsidiary banks can pay to their holding companies without regulatory approval. Additionally, depending upon the circumstances, the FDIC or the Division could take the position that paying a dividend would constitute an unsafe or unsound banking practice.

Federal Securities Laws; Sarbanes-9Oxley Act of 2002; and NASDAQ Listing Standards. The Company is also subject to the periodic reporting, information disclosure, proxy solicitation, insider trading restrictions and other requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as well as provisions of the Sarbanes-Oxley Act of 2002.

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Federal Securities Laws; Sarbanes-Oxley Act of 2002; and NASDAQ Listing Standards: The Company is also subject to the periodic reporting, information disclosure, proxy solicitation, insider trading restrictions and other requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as well as provisions of the Sarbanes-Oxley Act of 2002.

The Sarbanes-Oxley Act represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and regulation of the relationship between a Board of Directors and management and between a Board of Directors and its committees.

Key components of the Sarbanes-Oxley Act ~~are follows~~include:

·• A prohibition on personal loans by the Company to its directors and executive officers except loans made by the Bank in accordance with federal banking regulations;

·• Independence requirements for Board audit committee members and the Company’s auditors;

·• Certification of Exchange Act reports by the chief executive officer, chief financial officer and principal accounting officer;

·• Disclosure of off-balance sheet transactions;

·• Expedited reporting of stock transactions by insiders; and,

·• Increased criminal penalties for violations of securities laws.

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The Sarbanes-Oxley Act also requires:

·• Management to establish, maintain and evaluate disclosure controls and procedures;

·• Management to report on its annual assessment of the effectiveness of internal controls over financial reporting; and,

·• The Company’s external auditor to attest to the effectiveness of internal controls over financial reporting.

The SEC has adopted regulations to implement various provisions of the Sarbanes-Oxley Act, including disclosures in periodic filings pursuant to the Exchange Act. Also, in response to the Sarbanes-Oxley Act, NASDAQ adopted new corporate governance standards for listed companies. The Company must comply with NASDAQ listing standards, which primarily relate to corporate governance matters, to remain a listed company.

USA Patriot Act of 2001. Under the USA Patriot Act of 2001 (“Patriot Act”), adopted by the U.S. Congress on October 26, 2001 to combat terrorism, FDIC-insured banks and commercial banks are required to increase their due diligence efforts for correspondent accounts and private banking customers. The Patriot Act requires the Bank to engage in additional record keeping or reporting, requiring identification of owners of accounts, or of the customers of foreign banks with accounts, and restricting or prohibiting certain correspondent accounts.

Emergency Economic Stabilization Act of 2008 (EESA). EESA granted broad powers to the U.S. Department of the Treasury, the FDIC and the Federal Reserve to stabilize the financial markets under the following programs:

• the Troubled Asset Relief Program, including the Capital Purchase Program, allocated $250 billion to Treasury to purchase troubled assets and make investments in senior preferred shares and warrants to purchase common stock from approved financial institutions;

• the Temporary Liquidity Guaranty Program authorized the FDIC to insure newly issued senior unsecured debt and insure the total balance in noninterest bearing transactional deposit accounts of those institutions who elect to participate; and

• the Commercial Paper and Money Market Investor Funding Facilities authorized the Federal Reserve Bank of New York to purchase rated commercial paper from U.S. companies and to purchase money market instruments from U.S. money market mutual funds.

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Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). As a result of the recent financial crises, on July 21, 2010, the Dodd-Frank Act was signed into law. The Dodd-Frank Act has had and is expected to continue to have a broad impact on the financial services industry, including significant regulatory and compliance changes and changes to corporate governance matters affecting public companies. Many of the requirements called for in the Dodd-Frank Act will be implemented over time and most will be subject to implementing regulations over the course of several years.

Among other things, the Dodd-Frank Act:

·• centralizes responsibility for consumer financial protection by creating the Consumer Financial Protection Bureau, a new agency responsible for implementing, examining and enforcing compliance with federal consumer financial laws;

·• applies the same leverage and risk-based capital requirements that apply to insured depository institutions to bank holding companies;

·• excludes the proceeds of trust preferred securities from Tier 1 capital except for trust preferred securities issued before May 19, 2010 by bank holding companies, like the Company, with less than $15 billion in assets at December 31, 2009;

·• changes the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital;

·• requires the SEC to complete studies and develop rules or approve stock exchange rules regarding various investor protection issues, including shareholder access to the proxy process, and various matters pertaining to executive compensation and compensation committee oversight;

·• makes permanent the $250,000 limit for federal deposit insurance and provided unlimited federal deposit insurance until December 31, 2012, for noninterest bearing transaction accounts;

·• removes prior restrictions on interstate de novo branching;

·• repeals the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts;

·• gives the FDIC authority to unwind large failing financial firms;

·• extended the FDIC’s Transaction Account Guarantee (TAG) program to December 31, 2012;

·• authorizes banks to pay interest on business checking accounts, which is likely to significantly increase our interest expense;

·• adopts various mortgage lending and predatory lending provisions;

·• requires federal regulators jointly to prescribe regulations mandating that financial institutions with more than $1 billion in assets to disclose to their regulators their incentive compensation plans to permit the regulators to determine whether the plans provide executive officers, employees, directors or principal shareholders with excessive compensation, fees or benefits; or could lead to material financial loss to the institution; and

·• imposes a number of requirements related to executive compensation that apply to all public companies, such as prohibition of broker discretionary voting in connection with a shareholder vote on executive compensation; mandatory shareholder “say on pay” (every one to three years) and “say on golden parachutes”; and clawback of incentive compensation from current or former executive officers following any accounting restatement.

The Company anticipates that the Dodd-Frank Act, directly and indirectly, will impact the business of the Company and the Bank and increase compliance costs.

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~~The~~New ~~proposed~~Capital ~~rules~~Rules. In ~~include~~connection ~~new~~with ~~minimum~~the ~~risk-based~~enactment ~~capital~~of ~~and~~the ~~leverage~~Dodd-Frank ~~ratios~~Act, ~~which~~in ~~would~~June be2012, ~~phased~~the inFederal ~~during~~Reserve, ~~2013~~FDIC and ~~2014,~~the ~~and~~Office ~~would~~of ~~refine~~ the ~~definitions~~Comptroller of ~~what~~the ~~constitutes~~Currency ~~“capital”~~approved ~~for~~proposed ~~purposes~~rules ofthat ~~calculating~~would ~~those~~substantially ~~ratios.~~amend ~~The~~the ~~proposed~~regulatory ~~new~~risk-based ~~minimum~~ capital ~~level~~rules ~~requirements~~ applicable to the Company and the Bank ~~under the proposals would be: (i) a new common equity Tier 1 capital ratio of 4~~.~~5%;~~ On ~~(ii)~~July a2, ~~Tier~~2013, 1federal ~~capital~~banking ~~ratio~~regulators ofapproved 6%final ~~(increased~~rules ~~from~~that ~~4%);~~revise ~~(iii)~~the aregulatory ~~total~~ capital ~~ratio of 8% (unchanged from current~~ rules); ~~and~~to ~~(iv)~~incorporate acertain ~~Tier~~revisions 1by ~~leverage ratio of 4%. The proposed rules would also establish a “capital conservation buffer” of 2.5% above each of~~ the ~~new~~Basel ~~regulatory~~Committee ~~minimum~~on ~~capital~~Banking ~~ratios,~~Supervision ~~which~~to ~~would result in~~ the ~~following~~Basel ~~minimum ratios: (i) a common equity Tier 1~~ capital ~~ratio~~framework ~~of 7.0%,~~ (~~ii)~~"Basel ~~a Tier 1 capital ratio of 8.5% and (iii~~III") ~~a total capital ratio of 10~~.~~5%.~~ The new capital conservation buffer requirement would be phased in beginning in January 2016 at 0.625% of risk-weighted assets and would increase each year until fully implemented in January 2019. An institution would be subject to limitations on paying dividends, engaging in share repurchases and paying discretionary bonuses if its capital level falls below the buffer amount. These limitations would establish a maximum percentage of eligible retained income that could be utilized for such actions.

The ~~proposed~~new rules ~~also~~include ~~implement~~new ~~other~~minimum ~~revisions~~risk-based capital and leverage ratios, which will be phased in beginning in January 2016, and refine the definitions of what constitutes “capital” for purposes of calculating those ratios. The new minimum capital level requirements applicable to the ~~current~~Company and the Bank under the proposals will be: (i) a new common equity Tier 1 capital ratio of 4.5%; (ii) a Tier 1 capital ratio of 6% (increased from 4%); (iii) a total capital ratio of 8% (unchanged from current rules); and (iv) a Tier 1 leverage ratio of 4%. The new rules will also establish a “capital conservation buffer” of 2.5% above each of the new regulatory minimum capital ratios, ~~such~~which aswill ~~recognition~~result in the following minimum ratios: (i) a common equity Tier 1 capital ratio of ~~all~~7.0%, ~~unrealized~~(ii) ~~gains~~a Tier 1 capital ratio of 8.5% and ~~losses~~(iii) ona ~~available~~total capital ratio of 10.5%. The new capital conservation buffer requirement will be phased in beginning in January 2016 at 0.625% of risk-~~for-sale~~weighted ~~debt~~assets and ~~equity~~will ~~securities~~increase each year until fully implemented in January 2019. An institution will be subject to limitations on paying dividends, engaging in share repurchases and ~~provide~~paying ~~that~~discretionary ~~instruments~~bonuses ~~that~~if its capital level falls below the buffer amount. These limitations will noestablish ~~longer~~a ~~qualify~~maximum aspercentage ~~capital~~of ~~would~~eligible retained income that could be ~~phased~~utilized ~~out~~for ~~over~~such ~~time~~actions.

The new rules also implement other revisions to the current capital rules, such as recognition of all unrealized gains and losses on available-for-sale debt and equity securities, and provide that instruments that will no longer qualify as capital would be phased out over time.

The federal bank regulatory agencies also proposed revisions to the prompt corrective action framework, which is designed to place restrictions on insured depository institutions, including the Bank, if their capital levels begin to show signs of weakness. These revisions would take effect January 1, 2015. Under the prompt corrective action requirements, insured depository institutions would be required to meet the following increased capital level requirements in order to qualify as “well capitalized:” (i) a new common equity Tier 1 risk-based capital ratio of 6.5%; (ii) a Tier 1 risk-based capital ratio of 8% (increased from 6%); (iii) a Total risk-based capital ratio of 10% (unchanged from current rules); and (iv) a Tier 1 leverage ratio of 5% (unchanged from the current rules).

The proposed rules set forth certain changes for the calculation of risk-weighted assets and utilize an increased number of credit risk and other exposure categories and risk weights. In addition, the proposed rules also address: (i) a proposed alternative standard of creditworthiness consistent with Section 939A of the Dodd-Frank Act; (ii) revisions to recognition of credit risk mitigation; (iii) rules for risk weighting of equity exposures and past due loans; and (iv) revised capital treatment for derivatives and repo-style transactions.

In particular, the proposed rules would expand the risk-weighting categories from the current four categories (0%, 20%, 50% and 100%) to a much larger and more risk-sensitive number of categories, generally ranging from 0% for U.S. government and agency securities, to 600% for certain equity exposures. Higher risk weights would apply to a variety of exposure categories.

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American Recovery and Reinvestment Act of 2009. On February 17, 2009, the American Recovery and Reinvestment Act of 2009 (“ARRA”) was signed into law. ARRA is intended to help stimulate the economy through a combination of tax cuts and spending provisions applicable to a broad range of areas with an estimated cost of about $780 billion. ARRA also amended and enhanced executive compensation restrictions of EESA related to TARP Capital Purchase Program participants.

Overdrafts. On November 17, 2009, the Board of Governors of the Federal Reserve System promulgated the Electronic Fund Transfer rule with an effective date of January 19, 2010 and a mandatory compliance date of July 1, 2010. The rule, which applies to all FDIC-regulated institutions, prohibits financial institutions from assessing an overdraft fee for paying automated teller machine (ATM) and one-time point-of-sale debit card transactions, unless the customer affirmatively opts in to the overdraft service for those types of transactions. The opt-in provision establishes requirements for clear disclosure of fees and terms of overdraft services for ATM and one-time debit card transactions. This rule has had an adverse impact on our noninterest income.

Effects of Governmental Monetary Policies

Profitability in banking depends on interest rate differentials. In general, the difference between the interest earned on a bank’s loans, securities and other interest-earning assets and the interest paid on a bank’s deposits and other interest-bearing liabilities is the major source of a bank’s earnings. Thus, the earnings and growth of the Company are affected not only by general economic conditions, but also by the monetary and fiscal policies of the United States and its agencies, particularly the FRB. The FRB implements national monetary policy for such purposes as controlling inflation and stimulating economic activity by its open market operations in United States government securities, control of the discount rate applicable to borrowing from the FRB, and the establishment of reserve requirements against certain deposits. The actions of the FRB in these areas influence the growth of bank loans, investments and deposits, and also affect interest rates charged on loans and paid on deposits. The nature and impact of future changes in monetary policies and their impact on the Company are not predictable.

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Item 1A. Risk Factors

Historical performance may not be indicative of future performance and, as noted elsewhere in this report, the Company has included forward-looking statements about its business, plans and prospects that are subject to change. Forward-looking statements are particularly located in, but not limited to, the sections Item 1- Business and Item 7- Management’s Discussion and Analysis of Financial Condition and Results of Operations. In addition to the other risks or uncertainties contained in this report, the following risks may affect operating results, financial condition and cash flows. If any of these risks occur, either alone or in combination with other factors, the Company’s business, financial condition or operating results could be adversely affected. Moreover, readers should note this is not an exhaustive list; some risks are unknown or not quantifiable, and other risks that are currently perceived as immaterial may ultimately prove more significant than expected. Statements about plans, predictions or expectations should not be construed to be assurances of performance or promises to take a given course of action.

Additional deterioration in the real estate market would lead to additional losses, which could have a material adverse effect on the Company’s business, financial condition and results of operations.

Approximately 8782% of the Company’s non-covered loan portfolio is secured by real estate, the majority of which is commercial real estate. As a result of increased levels of commercial and consumer delinquencies and declining real estate values, the Company has experienced higher levels of net charge-offs and allowances for loan losses. Continued increases in commercial and consumer delinquency levels or continued declines in real estate market values would result in additional net charge-offs and provision for loan losses, which could have a material adverse effect on the Company’s business, financial condition and results of operations and prospects.

Future loan losses may exceed the allowance for loan losses.

The Company has established a reserve for possible losses expected in connection with loans in the credit portfolio. This allowance reflects estimates of the collectability of certain identified loans, as well as an overall risk assessment of total loans outstanding. The determination of the amount of loan loss allowance is subjective; although the method for determining the amount of the allowance uses criteria such as risk ratings and historical loss rates, these factors may not be adequate predictors of future loan performance. Accordingly, the Company cannot offer assurances that these estimates ultimately will prove correct or that the loan loss allowance will be sufficient to protect against losses that ultimately may occur. If the loan loss allowance proves to be inadequate, it may require unexpected charges to income, which would adversely impact results of operations and financial condition. Moreover, bank regulators frequently monitor banks' loan loss allowances, and if regulators were to determine that the allowance was inadequate, they may require the Company to increase the allowance, which also would adversely impact results of operations and financial condition.

Nonperforming loans take significant time and expense to resolve and adversely affect our results of operations and financial condition.

The Company expects to incur losses related to elevated levels of nonperforming loans. The Company does not record interest income on nonaccrual loans, which adversely affects its income. Loan administration costs increase as the Company attempts to resolve nonperforming loans and as it receives collateral through foreclosures or other proceedings. Increases in levels of ~~nonperfoming~~nonperforming loans may impact the capital levels the FDIC expects the Bank to maintain.

Defaults may negatively impact the Company.

Credit risk arises from the possibility that losses will be sustained if a significant number of borrowers, guarantors and related parties fail to perform in accordance with the terms of their loans. The Company has adopted underwriting and credit monitoring procedures and credit policies, including the establishment and review of the allowance for credit losses, which management believes are appropriate to minimize risk by assessing the likelihood of nonperformance, tracking loan performance and diversifying the credit portfolio. These policies and procedures, however, may not prevent unexpected losses that could materially affect results of operations.

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The Company’s operations are geographically concentrated in Northwest Washington State and therefore are affected by local economic conditions.

Substantially all of the Company’s business is derived from a five-county area in northwest Washington State. Employment opportunities within these communities have traditionally been primarily in the areas of military spending, oil and gas industries, tourism and manufacturing. While the Company’s expansion strategy has been built around these growing and diverse geographic markets, the Company’s business is, and will remain, sensitive to economic factors that relate to these industries and to local and regional business conditions. As a result, local or regional economic downturns, or downturns that disproportionately affect one or more of the key industries in the Company’s markets, may have a more pronounced effect upon the Company’s business than they might on an institution that is more broadly diverse in geographic concentration. The extent of the future impact of these events on economic and business conditions cannot be predicted; however, prolonged or acute fluctuations could have a material and adverse impact upon the Company’s results of operation and financial condition. There has been high unemployment and a decline in housing prices in the communities the Bank serves. If regional economic conditions do not improve, or worsen, the Company expects increased loan delinquencies and defaults, higher level of nonperforming assets and lower demand for its services.

Acquisitions present significant challenges in integration and failure to realize expected cost savings and synergies could have an adverse impact.

The Company may make opportunistic whole or partial acquisitions of other banks, branches, financial institutions, or related businesses from time to time that it expects to further its business strategy. These acquisitions could involve numerous risks, including lower than expected performance or higher than expected costs, difficulties related to integration, diversion of management’s attention from other business activities, changes in relationships with customers, and the potential loss of key employees. Any possible acquisition will be subject to regulatory approval, and there can be no assurance that the Company will be able to obtain such approval. The Company may not be successful in identifying acquisition candidates, integrating acquired institutions, or preventing deposit erosion or loan quality deterioration at acquired institutions. Competition for acquisitions in the Company’s market area is highly competitive, and the Company may not be able to acquire other institutions on attractive terms. There can be no assurance that the Company will be successful in completing or will even pursue future acquisitions, or if such transactions are completed, that it will be successful in integrating acquired businesses into its operations. The Company’s ability to grow may be limited if it chooses not to pursue or is unable to successfully make acquisitions in the future.

A rapid change in interest rates could reduce the Company’s net interest margin, net interest income and fee income.

The Company’s earnings are impacted by changing interest rates. Changes in interest rates affect the demand for new loans, the credit profile of existing loans, the rates received on loans and securities, and rates paid on deposits and borrowings. The relationship between the rates received on loans and securities and the rates paid on deposits and borrowings is known as the net interest spread. Based on the Company’s current volume and mix of interest-bearing liabilities and interest-earning assets, net interest spread could be expected to increase during times when interest rates rise in a parallel shift along the yield curve and, conversely, to decline during times of similar falling interest rates. Exposure to interest rate risk is managed by monitoring the re-pricing frequency of rate-sensitive assets and rate-sensitive liabilities over any given period. Although management believes the current level of interest rate sensitivity is reasonable, significant fluctuations in interest rates could potentially have an adverse affect on the Company’s business, financial condition and results of operations.

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Tightening of credit markets and liquidity needs could result in higher funding costs, adversely affecting net income.

Liquidity measures the ability to meet loan demand and deposit withdrawals and to service liabilities as they come due. Dramatic fluctuations in loan or deposit balances make it challenging to manage liquidity. A sharp reduction in deposits could force the Company to borrow heavily in the wholesale deposit market. In addition, rapid loan growth during periods of low liquidity could induce the Company to purchase federal funds from correspondent banks, borrow at the Federal Home Loan Bank of Seattle or Federal Reserve discount window, raise deposit interest rates or reduce lending activity. Wholesale deposits and federal funds or other sources for borrowings may not be available to us due to regulatory constraints, market upheaval or unfavorable terms.

Internal control systems could fail to detect certain events.

The Company is subject to many operating risks, including but not limited to data processing system failures and errors and customer or employee fraud. If such an event is not prevented or detected by the Company’s internal controls, and it is uninsured or is in excess of applicable insurance limits, it could have a significant adverse impact on the Company’s reputation in the business community and the Company’s business, financial condition, and results of operations.

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The Company’s operations could be interrupted if third party service providers experience difficulty, terminate their services, or fail to comply with banking regulations.

The Company depends, and will continue to depend to a significant extent, on a number of relationships with third-party service providers. Specifically, the Company utilizes software and hardware systems for processing, essential web hosting, debit and credit card processing, merchant processing, Internet banking systems, and other processing services from third-party service providers. These vendors provide services that support our operations, including the storage and processing of sensitive consumer and business customer data, as well as our sales efforts. If these third-party service providers experience difficulties or terminate their services, and the Company is unable to replace them with other qualified service providers, the Company’s operations could be interrupted. If an interruption were to continue for a significant period of time, the Company’s business, financial condition, and results of operations could be materially adversely affected. A cyber security breach of a vendor’s system may result in theft of our data or disruption of business processes. A material breach of customer data security at a service provider’s site may negatively impact our business reputation and cause a loss of customers, result in increased expense to contain the event or require that the Company provide credit monitoring services for affected customers, result in regulatory fines and sanctions and result in litigation. In most cases, the Company will remain primarily liable to its customers for losses arising from a breach of a vendor’s data security system. The Company relies on its outsourced service providers to implement and maintain prudent cyber security controls. The Company has procedures in place to assess a vendor’s cyber security controls prior to establishing a contractual relationship and to periodically review assessments of those control systems.

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The network and computer systems on which the Company depends could fail or experience a security breach.

The Company’s computer systems could be vulnerable to unforeseen problems. Because the Company conducts part of its business over the Internet and outsources several critical functions to third parties, operations depend on the Company’s ability, and to a degree on the ability of third-party service providers, to protect computer systems and network infrastructure against damage from fire, power loss, telecommunications failure, mechanical failure, software errors, operator errors, physical break-ins, or similar catastrophic events. Any damage or failure that causes interruptions in operations could have a material adverse effect on the Company’s business, financial condition, and results of operations. The Company stores and processes sensitive consumer and business customer data as a routine part of its business. A cyber security breach may result in theft of data or disruption of our processing systems. Our inability to use or access information systems at critical points in time could unfavorably impact the timeliness of our operations. A material breach of customer data security may negatively impact our business reputation and cause a loss of customers, result in increased expense to contain the event or require that it provide credit monitoring services for affected customers, result in regulatory fines and sanctions and could result in class action litigation. Cyber security risk management programs are expensive to maintain and will not protect the Company from all risks associated with maintaining the security of customer data and the Company’s proprietary data from external and internal intrusions, disaster recovery and failures in the controls used by our vendors.

In addition, a significant barrier to online financial transactions is the secure transmission of confidential information over public networks. The Company’s Internet banking system relies on encryption and authentication technology to provide the security and authentication necessary to effect secure transmission of confidential information. Advances in computer capabilities, new discoveries in the field of cryptography, fraud perpetrated by a customer, employee, or third-party, or other developments could result in a compromise or breach of the algorithms the Bank or our third-party service providers use to protect the confidentiality and integrity of data, including non-public customer information. If any such compromise of security were to occur, it could have a material adverse effect on our business, financial condition, and results of operations.

The Company may not be able to replace key members of management or attract and retain qualified employees in the future.

The Company depends on the services of existing management to carry out its business strategies. As the Company expands, it will need to continue to attract and retain additional management and other qualified staff. In particular, because the Company plans to continue to expand its locations and products and services, it will need to continue to attract and retain qualified banking personnel. Competition for such personnel is significant in the Company’s geographic market areas. The loss of the services of any management personnel, or the inability to recruit and retain qualified personnel in the future, could have an adverse effect on our results of operations, financial conditions, and prospects.

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The Company’s banking operations are subject to extensive government regulation that is expected to become more burdensome, increase its costs and make it less competitive compared to financial services firms that are not subject to the same regulation.

The Company is subject to government regulation that could limit or restrict its activities, which in turn could adversely impact operations. The financial services industry is regulated extensively. Federal and state banking regulation is designed primarily to protect the deposit insurance funds and consumers. These regulations can sometimes impose significant limitations on operations. Moreover, federal and state banking laws and regulations undergo frequent, significant changes. Changes in laws and regulations may affect the cost of doing business, limit permissible activities (including insurance and securities activities), or the Company’s competitive position in relation to credit unions, savings associations and other financial institutions. These changes could also reduce federal deposit insurance coverage, broaden the powers or geographic range of financial holding companies, alter the taxation of financial institutions, and change the structure and jurisdiction of various regulatory agencies. Federal monetary policy, particularly as implemented through the Federal Reserve System, can significantly affect credit availability. Other federal legislation such as the Sarbanes-Oxley Act can dramatically shift resources and costs to ensure adequate compliance. The Dodd-Frank Act, enacted in July 2010, has increased our overall costs of compliance. The Dodd-Frank Act and other recent legislative and regulatory initiatives contain provisions and requirements that could detrimentally affect the Company’s business by increasing capital requirements, subjecting us to more stringent consumer protection laws, increasing reporting obligations and costs, restricting income generating activities and requiring compliance with new corporate governance and executive compensation standards. In addition, increased regulation restricts our ability to conduct business consistent with historical practices, including aspects such as compensation, interest rates, new and inconsistent consumer protection regulations and mortgage regulation, among others. Congress or state legislatures could also adopt laws reducing the amount that borrowers are otherwise contractually required to pay under existing loan contracts, require lenders to extend or restructure certain loans or limit foreclosure and collection remedies. The Company cannot predict the substance or impact of pending or future legislation or regulation, or the application thereof. If we receive less than satisfactory results on regulatory examinations, we could be restricted from making acquisitions, adding branches, developing new lines of business or otherwise continuing our growth strategy.

The financial services industry is highly competitive.

Competition may adversely affect the Company’s performance. The financial services business is becoming increasingly competitive due to changes in regulation, technological advances, and the accelerating pace of consolidation among financial services providers. The Company faces competition both in attracting deposits and in originating loans. Competition for loan’s principally through the pricing of interest rates and loan fees, and the efficiency and quality of services. Increasing levels of competition in the banking and financial services industries may reduce market share or cause the prices charged for services to fall. Results may differ in future periods depending upon the nature or level of competition.

The Company may be required to raise additional capital, which will depend on market conditions and the results of which could have a dilutive effect on existing shareholders.

Our growth strategy may require additional capital. Also, continued elevated levels of nonperforming assets or higher regulatory capital requirements could require us to sell shares of our common stock. Shares of the Company’s common stock eligible for future sale, including those that may be issued in connection with the Company’s various stock option and equity compensation plans, in possible acquisitions, and any other offering of Company’s common stock for cash, could have a dilutive effect on the market for Company’s common stock and could adversely affect its market price. There are 35,000,000 shares of Company’s common stock authorized, of which 15,~~483~~538,~~598~~969 shares were outstanding at December 31, ~~2012~~2013.

At the time the Company needs to raise capital, market conditions may be adverse and it may run the risk of not being able to meet capital requirements set by regulators or necessary for growth.

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If the Company inaccurately determines the fair value of assets acquired, including the FDIC loss-sharing assets, its business, financial condition, results of operations, and future prospects could be materially and adversely affected.

Management makes various assumptions and judgments about the collectability of acquired loans, including the creditworthiness of borrowers and the value of the real estate and other assets serving as collateral for the repayment of secured loans. In FDIC-assisted acquisitions that include loss-sharing agreements, the Company may record a loss-sharing asset that it considers adequate to absorb the indemnified portion of future losses which may occur in the acquired loan portfolio. The FDIC loss-sharing asset is accounted for on the same basis as the related acquired loans and OREO and primarily represents the present value of the cash flows the Company expects to collect from the FDIC under the loss-sharing agreements. If our assumptions are incorrect, significant earnings volatility can occur and the balance of the FDIC loss-sharing asset may at any time be insufficient to cover future loan losses, and credit loss provisions may be needed to respond to different economic conditions or adverse developments in the acquired loan portfolio. Any increase in future loan losses could have a negative effect on our operating results.

FDIC-assisted acquisition opportunities may not become available and increased competition may make it more difficult for us to successfully bid on failed bank transactions.

A part of our growth strategy is to pursue failing banks that the FDIC plans to place in receivership. The FDIC may not place banks that meet our strategic objectives into receivership. The number of troubled institutions has decreased significantly since we acquired the assets of City Bank and North County Bank in 2010 and we anticipate very limited opportunities to grow through such acquisitions. Failed bank transactions are attractive opportunities because of loss-sharing arrangements with the FDIC and our ability to determine the non-deposit liabilities that the Company assumes. The bidding process for failing banks could become very competitive and the FDIC does not provide information about bids until after the failing bank has been closed. The Company may not be able to match or beat the bids of other acquirers unless it bid aggressively by increasing the premium paid on assumed deposits or reducing the discount bid on assets purchased, which could make the acquisition less attractive to us.

If the goodwill the Company has recorded in connection with acquisitions becomes impaired, it could have an adverse impact on our results of operations.

Accounting standards require that the Company account for acquisitions using the acquisition method of accounting. The Company evaluates its goodwill for impairment on an annual basis or more frequently if events or circumstances indicate that a potential impairment exists. Such evaluation is based on a variety of factors, including the quoted price of its common stock, market prices of common stock of other banking organizations, common stock trading multiples, discounted cash flows, and data from comparable acquisitions. There can be no assurance that future evaluations of goodwill will not result in impairment and ensuing write-down, which could be material, resulting in an adverse impact on our earnings and capital.

The FDIC has increased insurance premiums to restore and maintain the federal deposit insurance fund, which has increased our costs and could adversely affect our business.

In 2009, the FDIC imposed a special deposit insurance assessment of five basis points on all insured institutions, and also required insured institutions to prepay estimated quarterly risk-based assessments through 2012. The Dodd-Frank Act established 1.35% as the minimum deposit insurance fund reserve ratio. The FDIC has determined that the fund reserve ratio should be 2.0% and has adopted a plan under which it will meet the statutory minimum fund reserve ratio of 1.35% by the deadline of September 30, 2020. The Dodd-Frank Act requires the FDIC to offset the effect on institutions with assets less than $10 billion of the increase in the statutory minimum fund reserve ratio to 1.35% from the former statutory minimum of 1.15%. The deposit insurance fund will likely suffer additional losses in the future due to failures of insured institutions. There can be no assurance that there will not be additional significant deposit insurance premium increases, special assessments or prepayments. Any significant premium increases or special assessments could have a material adverse effect on the Company’s financial condition and results of operations. Although premiums for 2012 were less than 2011, the Company expects premiums to remain relatively higher than before the Dodd-Frank Act.

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Our ability to receive dividends from our banking subsidiary could affect our liquidity and ability to pay dividends.

The Company is a separate and distinct legal entity from the Bank. It receives substantially all of its revenue from dividends from its banking subsidiary. In addition to capital raised at the holding company level, dividends from the Bank are the principal source of funds to pay dividends on our common stock and principal and interest on its outstanding debt. Federal and state laws and regulations limit the amount of dividends that the Bank may pay to the Company. Limitations on its ability to receive dividends from its subsidiary could have a material adverse effect on its liquidity and on its ability to pay dividends on common stock. Additionally, if the Bank’s earnings are not sufficient to make dividend payments to the Company while maintaining adequate capital levels, it may not be able to make dividend payments to its common shareholders or principal and interest payments on its outstanding debt.

Significant legal or regulatory actions could subject us to substantial uninsured liabilities.

From time to time, the Company is subject to claims and proceedings related to its operations. In addition, the Company could become subject to supervisory or enforcement actions by regulators, or criminal proceedings by prosecutorial authorities. In addition to defense costs, if the Company is subject to large monetary penalties or fines as a result of such claims or proceedings, it would suffer adverse financial consequences and reputational harm. The Company’s insurance coverage does not cover any civil money penalties or fines imposed by government authorities and may not cover all other claims that might be brought against it or continue to be available to it at a reasonable cost.

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Risks related to Proposed Merger

Combining the two companies may be more difficult, costly or time consuming than expected and the anticipated benefits and cost savings of the merger may not be realized.

The Company and Heritage have operated and, until the completion of the proposed merger, will continue to operate, independently. The success of the proposed merger, including anticipated benefits and cost savings, will depend, in part, on the combined company’s ability to successfully combine and integrate the businesses of the two companies and their subsidiary banks in a manner that permits growth opportunities and does not materially disrupt existing customer relations. It is possible that the integration process could result in the loss of key employees, the disruption of either company’s ongoing businesses and the combined company’s ability to maintain relationships with clients, customers, depositors and employees. The loss of key employees could adversely affect our ability to successfully conduct our business, which could have an adverse effect on our financial results and the value of our common stock. If we experience difficulties with the integration process, the anticipated benefits of the merger may not be realized fully or at all, or may take longer to realize than expected. Integration efforts between the two companies will also divert management attention and resources. In addition, the actual cost savings of the proposed merger could be less than anticipated.

Termination of the merger agreement could negatively impact the Company.

The Company’s shareholders will be asked to approve the proposed merger with Heritage and if we fail to obtain two-thirds shareholder approval of the proposal, the merger agreement may be terminated. The merger is subject to satisfaction of additional customary closing conditions and if we cannot satisfy such conditions, the merger agreement may also be terminated. If the merger agreement is terminated, there may be various negative consequences to the Company. We may be adversely impacted by the failure to pursue other opportunities due to management’s focus on the proposed merger with Heritage. We have devoted significant internal resources to the proposed merger, which would be lost if the merger is not completed. Additionally, if the merger agreement is terminated, the market price of the Company’s common stock could decline to the extent that the current market prices reflect a market assumption that the merger will be completed. If the merger agreement is terminated under certain circumstances, the Company may be required to pay to Heritage a termination fee of $7.9 million.

The Company and the Bank will be subject to uncertainties and contractual restrictions while the proposed merger with Heritage is pending.

We may have difficulty attracting, retaining and motivating key personnel until the proposed merger is complete, which could cause customers to seek to change their banking relationship with us. Some of our employees may experience uncertainty about their future roles with the combined company following the proposed merger with Heritage. If key employees depart because of issues relating to the uncertainty and difficulty of integration or a desire not to remain with the Company, our business could be harmed. In addition, subject to certain exceptions, we have agreed to operate our business in the ordinary course prior to closing of the proposed merger with Heritage.

If the proposed merger with Heritage is not completed, we will have incurred substantial expenses.

We have incurred and will continue to incur substantial expenses in connection with the negotiation and completion of the transactions contemplated by the merger agreement with Heritage. If the proposed merger with Heritage is not completed, we would have to recognize these expenses without realizing any expected benefits of the proposed merger.

The merger agreement limits the Company’s ability to pursue acquisition proposals and requires us to pay a termination fee under limited circumstances.

The merger agreement prohibits the Company from soliciting, initiating, knowingly encouraging or knowingly facilitating certain third‑-party acquisition proposals. The merger agreement also provides that the Company must pay a $7.9 million termination fee in the event that the merger agreement is terminated under certain circumstances. These provisions might discourage a potential competing acquirer with an interest in acquiring all or a significant part of the company from considering or proposing such an acquisition.

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Item 1B. Unresolved Staff Comments

The Company has no unresolved staff comments from the Securities and Exchange Commission.

Item 2. Properties

The headquarters of the Company are located at 450 Southwest Bayshore Drive in Oak Harbor, WA in a building that is owned by the Company on leased land. The building also houses the Bank’s Oak Harbor branch. At December 31, ~~2012~~2013, the Bank conducted business at 31 branch locations, 19 of which are owned by the Bank, including the main office in Coupeville, WA, and 12 are leased under various agreements. The Bank’s branches are located in northwest Washington State in the following counties: Island, King, San Juan, Skagit, Snohomish and Whatcom. The Company owns two properties which are used for administrative purposes. The Company leases an additional administrative building.

Item 3. Legal Proceedings

The Company and its directors are named as defendants in two lawsuits pending in the Superior Court for the State of Washington in King County, Washington, which have been consolidated under the caption In Re Washington Banking Company Shareholder Litigation, Lead Case No. 13-2-38689-5 SEA. The consolidated litigation generally alleges that the Company’s directors breached their fiduciary duties to the Company and its shareholders by agreeing to the proposed merger at an unfair price and without an adequate sales process, because they have interests in the merger different from shareholders and by agreeing to deal protection provisions in the merger agreement that are alleged to prevent bids by third parties. The consolidated litigation also alleges that the disclosures in connection with the merger are misleading in various respects. The consolidated litigation seeks, among other things, an order enjoining the defendants from consummating the proposed merger with Heritage Financial Corporation, as well as attorneys’ and experts’ fees and certain other damages. The Company and its directors believe the claims and allegations lack merit. The Company and its directors filed motions to dismiss the claims against them.

The Company and its subsidiaries are, from time to time, defendants in, and are threatened with, various legal proceedings arising from regular business activities. Management believes that its liability for damages, if any, arising from current claims or contingencies will not have a material adverse effect on the Company’s results of operations, financial conditions or cash flows.

Item 4. Mine Safety Disclosures

Not applicable.

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PART II

Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

The Company’s common stock is traded on the Nasdaq Global Select Market System under the symbol “WBCO.”

The Company is aware that blocks of its stock are held in street name by brokerage firms. As a result, the number of shareholders of record does not include the actual number of beneficial owners of the Company’s stock. As of March 7, ~~2013~~2014, the Company’s common stock was held of record by approximately ~~430~~424 shareholders, a number which does not include beneficial owners who hold shares in “street name.”

The following are the high and low ~~adjusted~~sales ~~closing~~ prices for the Company’s stock as reported by Nasdaq and the quarterly cash dividends paid by the Company to its shareholders on a per share basis during ~~2012~~2013 and ~~2011~~2012:

	2012						2011
	2013						2012
	High		Low		Dividend		High		Low		Dividend
First quarter	$	14.3025	$	1113.6749	$	0.~~120~~150	$	14.0348	$	1211.9674	$	0.~~050~~120
Second quarter	14.25	~~14.26~~	12.52	~~13.02~~	0.150	~~0.140~~	14.47	~~13.84~~	12.85	~~12.84~~	0.140	~~0.050~~
Third quarter	15.65	~~14.65~~	13.55	~~13.34~~	0.090	~~0.090~~	15.03	~~13.64~~	13.19	~~9.23~~	0.090	~~0.050~~
Fourth quarter	18.24	~~14.24~~	13.84	~~13.08~~	0.145	~~0.150~~	14.55	~~12.14~~	13.00	~~9.52~~	0.150	~~0.050~~

The Company’s dividend policy requires the Board of Directors to review the Company’s financial performance, capital adequacy, cash resources, regulatory restrictions, economic conditions and other factors, and if such review is favorable, the Board may declare and pay dividends. The ability of the Company to pay dividends will depend on the profitability of the Bank, the need to retain or increase capital, the dividend restrictions imposed upon the Bank by applicable banking law and dividend restrictions imposed upon the Company under applicable corporate and banking law regulation. Although the Company anticipates payment of a regular quarterly cash dividend, future dividends are subject to these limitations and to the discretion of the Board of Directors, and could be reduced or eliminated.16

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Equity Compensation Plan Information

The following table sets forth information about equity compensation plans that provide for the award of securities or the grant of options to purchase securities to employees and directors of the Company, its subsidiaries and its predecessors by merger that were in effect at December 31, ~~2012~~2013.

	Equity Compensation Plan Information
	(A)			(B)	~~(B)~~		(C)	~~(C)~~
Plan category	Number of securities to be issued upon exercise of outstanding options, warrants and rights			Weighted average exercise price of outstanding options, warrants and rights (2)	~~Weighted average exercise price of outstanding options, warrants and rights (2)~~		Number of securities remaining available for future issuance under equity compensation plans excluding securities reflected in column (A)	~~Number of securities remaining available for future issuance under equity compensation plans excluding securities reflected in column (A)~~
Equity compensation plans approved by security holders
2005 stock incentive plan(1)	222,676	~~207,656~~	(3)	$	$4.92	~~6.01~~	361,219		~~431,610~~
Equity compensation plans not approved by security holder	—	—		—		—	—		—
Total	222,676	~~207,656~~		$	$4.92	~~6.01~~	361,219		~~431,610~~


⁽¹⁾	^{The 2005 plan is currently the only stock award plan available for new grants.}


⁽²⁾	^{Weighted average exercise price is based solely on securities with an exercise price.}


⁽³⁾	^{Includes 95,367 outstanding stock options and 127,309 restricted stock units (each unit represents one share), which are subject to issuance upon vesting of the awards. Of the 127,309 RSU awards outstanding at 12/31/13, 57,631 are scheduled to vest during 2014.}

Sales of Unregistered Securities

The Company had no sales of unregistered securities during the fourth quarter of ~~2012~~2013.

Purchases of Equity Securities

The Company had no purchases of its equity securities during the fourth quarter of ~~2012~~2013.

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~~The~~Five-Year following chart, which is furnished not filed, compares the yearly percentage change in the cumulative shareholder return on the Company’s common stock during the five years ended December 31, 2012, with (1) the Total Return for the NASDAQ Stock ~~Market~~Performance Index (which is a broad nationally recognized index of stock performance by companies traded on the NASDAQ Market System and the NASDAQ Small Cap Market) (2) the Total Return Index for SNL Bank NASDAQ (comprised of banks listed on the NASDAQ National Market System) (3) Total Return for SNL Bank $500M to $1 Billion Bank Index (comprised of publicly-traded banks located in the U.S. with total assets between $500 million and $1 billion) and (4) Total Return for SNL Bank $1 Billion to $5 Billion Bank Index (comprised of publicly-traded banks located in the U.S. with total assets between $1 billion and $5 billion).Graph

The ~~graph~~following ~~assumes~~chart, ~~$100~~which ~~was~~is ~~invested~~furnished onnot ~~December 31~~filed, ~~2007,~~compares the yearly percentage change in the cumulative shareholder return on the Company’s common stock ~~and~~during the ~~comparison~~five ~~groups~~years ended December 31, 2013, with (1) the Total Return for the NASDAQ Stock Market Index (which is a broad nationally recognized index of stock performance by companies traded on the NASDAQ Market System and ~~assumes~~the NASDAQ Small Cap Market) (2) the ~~reinvestment~~Total Return Index for SNL Bank NASDAQ (comprised of ~~all~~banks ~~cash~~listed ~~dividends~~on ~~prior~~the toNASDAQ ~~any~~National ~~tax~~Market ~~effect~~System) and ~~retention~~(3) Total Return for SNL Bank $1 Billion to $5 Billion Bank Index (comprised of ~~all~~publicly-traded ~~stock~~banks ~~dividends~~located in the U.S. with total assets between $1 billion and $5 billion).

	Period Ending
Index	12/31/07		12/31/08		12/31/09		12/31/10		12/31/11		12/31/12
Washington Banking Company	$	100.00	$	56.37	$	79.00	$	91.65	$	80.87	$	95.89
NASDAQ Composite		100.00		60.02		87.24		103.08		102.26		120.42
SNL Bank NASDAQ		100.00		72.62		58.91		69.51		61.67		73.51
SNL Bank $500M-$1B		100.00		64.08		61.03		66.62		58.61		75.14
SNL Bank $1B-$5B		100.00		82.94		59.45		67.39		61.46		75.78

The graph assumes $100 was invested on December 31, 2008, in the Company’s common stock and the comparison groups and assumes the reinvestment of all cash dividends prior to any tax effect and retention of all stock dividends.

Source : SNL Financial LC, Charlottesville, VA @ 2013 www.snl.com



	Period Ending
Index	12/31/2008		12/31/2009		12/31/2010		12/31/2011		12/31/2012		12/31/2013
Washington Banking Company	$	100.00	$	140.15	$	162.59	$	14,347.00	$	170.11	$	229.70
NASDAQ Composite	100.00		145.36		171.74		170.38		200.63		281.22
SNL Bank NASDAQ	100.00		81.12		95.71		84.92		101.22		145.48
SNL Bank $1B-$5B	100.00		71.68		81.25		74.10		91.37		132.87

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Item 6. Selected Financial Data

Consolidated Five-Year Statements of Income and Selected Financial Data

The following table sets forth selected audited consolidated financial information and certain financial ratios for the Company. This information is derived in part from the audited consolidated financial statements and notes thereto of the Company set forth in Item 8- Financial Statements and Supplementary Data and should be read in conjunction with the Company’s financial statements and the management discussion set forth in Item 7- Management’s Discussion and Analysis of Financial Condition and Results of Operations.

(dollars in thousands, except per share amounts)	As of or for the Years Ended December 31,
	2012		2011		2010		2009		2008
	2013		2012		2011		2010		2009
Operating data:
Total interest income	$	8975,~~710~~359	$	89,~~707~~710	$	7589,~~949~~707	$	5475,~~392~~949	$	5854,~~782~~392
Total interest expense	5,420	~~7,113~~	7,113	~~9,981~~	9,981	~~11,830~~	11,830	~~14,019~~	14,019	~~20,834~~
Net interest income	69,939	~~82,597~~	82,597	~~79,726~~	79,726	~~64,119~~	64,119	~~40,373~~	40,373	~~37,948~~
Provision for loan losses	14,615	~~9,744~~	9,744	~~10,050~~	10,050	~~13,486~~	13,486	~~10,200~~	10,200	~~5,050~~
Net interest income after provision	55,324	~~72,853~~	72,853	~~69,676~~	69,676	~~50,633~~	50,633	~~30,173~~	30,173	~~32,898~~
Service charges on deposits	3,401	~~3,560~~	3,560	~~3,818~~	3,818	~~3,346~~	3,346	~~3,426~~	3,426	~~2,987~~
Other noninterest income	18,944	~~4,686~~	4,686	~~5,394~~	5,394	~~30,185~~	30,185	~~4,235~~	4,235	~~3,899~~
Total noninterest income	22,345	~~8,246~~	8,246	~~9,212~~	9,212	~~33,531~~	33,531	~~7,661~~	7,661	~~6,886~~
Noninterest expense	56,301	~~56,399~~	56,399	~~55,825~~	55,825	~~46,797~~	46,797	~~28,734~~	28,734	~~27,523~~
Income before income taxes	21,368	~~24,700~~	24,700	~~23,063~~	23,063	~~37,367~~	37,367	~~9,100~~	9,100	~~12,261~~
Provision for income taxes	6,872	~~7,856~~	7,856	~~7,111~~	7,111	~~11,797~~	11,797	~~2,886~~	2,886	~~3,929~~
Net income before preferred dividends	14,496	~~16,844~~	16,844	~~15,952~~	15,952	~~25,570~~	25,570	~~6,214~~	6,214	~~8,332~~
Preferred dividends	—	-	—	~~1,084~~	1,084	~~1,659~~	1,659	~~1,600~~	1,600	-
Net income available to common
Net income available to common shareholders	$	14,496	$	16,844	$	14,868	$	23,911	$	4,614
shareholders	$	16,844	$	14,868	$	23,911	$	4,614	$	8,332
Average number of shares outstanding, basic	15,495,000		15,422,000		15,329,000		15,307,000		10,011,000
Average number of shares outstanding, basic		15,422,000		15,329,000		15,307,000		10,011,000		9,465,000
Average number of shares outstanding, diluted	15,551,000		15,455,000		15,393,000		15,465,000		10,079,000
Average number of shares outstanding, diluted		15,455,000		15,393,000		15,465,000		10,079,000		9,513,000
Per share data:
Net income per common share, basic	$	10.0994	$	01.9709	$	10.5697	$	01.4656	$	0.8846
Net income per common share, diluted	0.93	~~1.09~~	1.09	~~0.97~~	0.97	~~1.55~~	1.55	~~0.46~~	0.46	~~0.88~~
Tangible book value per common share	11.22	~~11.41~~	11.41	~~10.67~~	10.67	~~9.76~~	9.76	~~8.79~~	8.79	~~8.47~~
Dividends per common share	0.54	~~0.50~~	0.50	~~0.20~~	0.20	~~0.14~~	0.14	~~0.18~~	0.18	~~0.26~~
Balance sheet data:
Total assets	$	1,~~687~~683,~~677~~988	$	1,~~670~~687,~~682~~677	$	1,~~704~~670,~~939~~682	$	1,~~045~~704,~~871~~939	$	~~899~~1,~~631~~045,871
Non-covered loans	888,686	~~853,134~~	853,134	~~812,830~~	812,830	~~834,293~~	834,293	~~813,852~~	813,852	~~823,068~~
Covered loans	151,955	~~217,339~~	217,339	~~269,081~~	269,081	~~366,153~~	366,153	-	—	-
Allowance for loan losses, non-covered loans	17,093	~~17,147~~	17,147	~~18,032~~	18,032	~~18,812~~	18,812	~~16,212~~	16,212	~~12,250~~
Allowance for loan losses, covered loans	14,622	~~3,252~~	3,252	~~870~~	870	~~1,336~~	1,336	-	—	-
Non-covered OREO	3,067	~~3,023~~	3,023	~~1,976~~	1,976	~~4,122~~	4,122	~~4,549~~	4,549	~~2,226~~
Covered OREO	5,980	~~13,460~~	13,460	~~26,622~~	26,622	~~29,766~~	29,766	-	—	-
Deposits	1,467,492	~~1,462,973~~	1,462,973	~~1,466,344~~	1,466,344	~~1,492,220~~	1,492,220	~~846,671~~	846,671	~~747,159~~
Overnight borrowings		-		-		-		-		11,640
Other borrowed funds	—		—		—		—		10,000
Other borrowed funds		-		-		-		10,000		30,000
Junior subordinated debentures	25,774		25,774		25,774		25,774		25,774
Junior subordinated debentures		25,774		25,774		25,774		25,774		25,774
Preferred securities	—		—		—		25,334		24,995
Preferred securities		-		-		25,334		24,995		-
Total shareholders' equity	179,930		182,624		170,820		182,098		159,521
Total shareholders' equity		182,624		170,820		182,098		159,521		80,560

~~-24-~~19

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(dollars in thousands, except per share amounts)	As of or for the Years Ended December 31,
	2012				2011				2010			2009			2008
	2013			2012			2011			2010		2009
Selected performance ratios:
Return on average assets	0.88	~~1.01~~%	%	1.01	%	~~0.95~~	%0.95	%		1.72	%	0.66	~~0.66~~%	%		~~0.94~~	%
Return on average common equity	7.99	~~9.56~~%	%	9.56	%	~~9.17~~	%9.17	%		16.87	%	7.11	~~7.11~~%	%		~~10.82~~	%
Net interest margin (fully tax-equivalent)	4.65	~~5.54~~%	%	5.54	%	~~5.47~~	%5.47	%		4.90	%	4.63	~~4.63~~%	%		~~4.60~~	%
Net interest spread	4.56	~~5.45~~%	%	5.45	%	~~5.39~~	%5.39	%		4.76	%	4.28	~~4.28~~%	%		~~4.18~~	%
Noninterest expense to average assets	3.41	~~3.37~~%	%	3.37	%	~~3.32~~	%3.32	%		3.16	%	3.05	~~3.05~~%	%		~~3.09~~	%
Efficiency ratio (fully tax-equivalent)	60.43	~~61.31~~%	%	61.31	%	~~62.06~~	%62.06	%		47.48	%	59.01	~~59.01~~%	%		~~60.63~~	%
Dividend payout ratio	57.25	~~45.81~~%	%	45.81	%	~~20.63~~	%20.63	%		8.64	%	37.23	~~37.23~~%	%		~~29.01~~	%
Asset quality ratios:
Nonperforming non-covered loans to
period end non-covered loans	0.95	~~1.82~~%	%	1.82	%	~~2.72~~	%2.72	%		3.10	%	0.42	~~0.42~~%	%		~~0.23~~	%
Allowance for loan losses, non-covered
loans to period end non-covered loans	1.92	~~2.01~~%	%	2.01	%	~~2.22~~	%2.22	%		2.25	%	1.99	~~1.99~~%	%		~~1.49~~	%
Allowance for loan losses, covered loans
to period end covered loans	9.62	~~1.50~~%	%	1.50	%	~~0.32~~	%0.32	%		0.36	%	—	-			-
Allowance for loan losses, non-covered
loans to nonperforming non-covered loans	203.27	~~110.26~~%	%	110.26	%	~~81.59~~	%81.59	%		72.79	%	477.53	~~477.53~~%	%		~~638.69~~	%
Nonperforming non-covered assets to
total assets	0.68	~~1.10~~%	%	1.10	%	~~1.44~~	%1.44	%		1.76	%	0.76	~~0.76~~%	%		~~0.46~~	%
Net loan charge-offs to average non-covered
loans outstanding	0.22	~~0.97~~%	%	0.97	%	~~1.37~~	%1.37	%		1.15	%	0.76	~~0.76~~%	%		~~0.48~~	%
Total risk-based capital	19.76	~~19.39~~%	%	19.39	%	~~19.73~~	%19.73	%		20.96	%	22.15	~~22.15~~%	%		~~13.23~~	%
Tier 1 risk-based capital	18.49	~~18.13~~%	%	18.13	%	~~18.47~~	%18.47	%		19.70	%	20.89	~~20.89~~%	%		~~11.98~~	%
Leverage ratio	12.41	~~11.78~~%	%	11.78	%	~~11.16~~	%11.16	%		11.42	%	18.73	~~18.73~~%	%		~~11.68~~	%
Average equity to average assets	11.01	~~10.54~~%	%	10.54	%	~~9.64~~	%9.64	%		11.26	%	11.86	~~8.44~~%	%		~~8.65~~	%
Other data:
Number of banking offices	31	31		31		30	30			30		18	18			19
Number of full time equivalent employees	464	~~467~~		467		~~450~~	450			448		281	~~281~~			~~258~~

Summary of Quarterly Financial Information

See Item 8- Financial Statements and Supplementary Data, Note (24) Selected Quarterly Financial Data (Unaudited) in the consolidated financial statements.

~~-25-~~20

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis should be read in conjunction with Item 8- Financial Statements and Supplementary Data.

Executive Overview

Significant items for the year ended December 31, ~~2012~~2013 were as follows:

§• Net income ~~per~~available ~~diluted~~to common shareholders per diluted share was $10.0993 for the year ended December 31, ~~2012~~2013, compared to $01.9709 for the year ended December 31, ~~2011~~2012.

§• ~~Total~~Net ~~assets~~interest ~~and~~margin, ~~deposits~~on ~~were~~a ~~relatively~~tax ~~stable~~equivalent atbasis, $1was 4.765% ~~billion~~for ~~and~~the ~~$1.5~~year ~~billion~~ended December 31, ~~respectively~~2013, compared to 5.54% a year ago.

§• ~~Allowance~~Non-covered loans, net of allowance for loan losses, tototaled ~~total~~$871.6 ~~non-covered~~million ~~loans~~at ~~decreased~~December 31, 2013, compared to 2$836.~~01%~~0 million at ~~year~~December ~~end~~31, 2012 ~~from 2~~.~~22% a year ago.~~

§• ~~Net~~Nonperforming ~~charge~~non-~~offs~~covered assets to ~~average~~total ~~non-covered~~assets ~~loans~~improved ~~was~~to 0.9768% ~~for~~at ~~2012~~December 31, 2013, compared to 1.3710% ~~for~~at ~~2011~~December 31, 2012.

§• ~~Nonperforming~~Continued ~~non-covered~~progress ~~assets~~in toresolving ~~total~~acquired ~~assets~~loans ~~was~~which 1declined to $137.~~10%~~3 million at ~~year~~December ~~end~~31, ~~2012~~2013, compared to 1$214.~~44%~~1 atmillion a year ~~end 2011~~ago.

§• ~~Continued~~Total ~~progress~~risk-based incapital ~~resolving~~for ~~acquired~~the ~~loans~~Company ~~which~~was ~~declined~~19.76% byat ~~$54.1~~December ~~million~~31, 2013, compared to ~~$214~~19.139% ~~million~~ at December 31, 2012. The FDIC requires a minimum total risk-based capital ratio of 10% to be considered “well-capitalized.”

§• ~~The~~Tangible ~~Company’s~~book ~~net~~value ~~interest~~per ~~margin,~~common onshare atotaled ~~tax-equivalent~~$11.22 ~~basis,~~at ~~increased~~December to31, ~~5.54% for 2012~~2013, compared to 5$11.~~47%~~41 ~~for~~at ~~2011~~December 31, 2012.

§ The Bank opened its 31st full-service branch in Woodinville in December 2012.

Summary of Critical Accounting Policies

Significant accounting policies are described in the consolidated financial statements in Note (1) Summary of Significant Accounting Policies. Several of these accounting policies require management to make difficult, subjective or complex judgments or estimates. Management believes that the following accounting policies could be considered critical under the SEC’s definition.

Allowance for Loan Losses: The allowance for loan losses is established to absorb known and inherent losses attributable to loans outstanding. The adequacy of the allowance is monitored on a regular basis and is based on management’s evaluation of numerous quantitative and qualitative factors. Quantitative factors include our historical loss experience, delinquency and charge-off trends, estimates of, and changes in, collateral values, changes in risk ratings on loans and other factors. Qualitative factors include the general economic environment in our markets and, in particular, the state of the real estate market and specific relevant industries. Other qualitative factors that are considered in our methodology include, size and complexity of individual loans in relation to the lending officer’s background and experience levels, loan structure, extent and nature of waivers of existing loan policies, and pace of loan portfolio growth.

As the Company adds new products, increases the complexity of the loan portfolio, and expands its geographic coverage, the Company intends to enhance and adapt its methodology to keep pace with the size and complexity of the loan portfolio. Changes in any of the above factors could have a significant effect on the calculation of the allowance for credit losses in any given period. The Company believes that its systematic methodology continues to be appropriate given our size and level of complexity.

~~-26-~~21

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~~Acquired~~Covered Loans: InCovered ~~accordance with FASB ASC 310-30, acquired~~ loans are aggregated into pools, based on individually evaluated common risk characteristics, and aggregate expected cash flows were estimated for each pool. A pool is accounted for as a single asset with a single interest rate, cumulative loss rate and cash flow expectation. The Bank aggregated all of the loans acquired in the FDIC-assisted acquisitions of City Bank and North County Bank into 18 and 14 pools, respectively. A loan will be removed from a pool of loans only if the loan is sold, foreclosed, assets are received in satisfaction of the loan, or the loan is written off, and will be removed from the pool at the carrying value. If an individual loan is removed from a pool of loans due to a payoff, the difference between its carrying amount and the cash received will be recognized in income immediately and would not affect the effective yield used to recognize the accretable difference on the remaining pool. Loans originally placed into a performing pool will not be reported individually as 30-89 days past due, non-performing (90+ days past due or nonaccrual) or accounted for as a troubled debt restructuring as the pool is the unit of accounting. Rather, these metrics related to the underlying loans within a performing pool will be considered in our ongoing assessment and estimates of future cash flows. If, at acquisition, the loans are collateral dependent and acquired primarily for the rewards of ownership of the underlying collateral, or if cash flows expected to be collected cannot be reasonably estimated, accrual of income is inappropriate. Such loans will be placed into nonperforming (nonaccrual) loan pools.

The cash flows expected to be received over the life of the pool were estimated by management with the assistance of a third party valuation specialist. These cash flows were input into an ~~ASC 310-30 compliant~~ accounting loan system which calculates the carrying values of the pools and underlying loans, book yields, effective interest income and impairment, if any, based on actual and projected events. Default rates, loss severity and prepayment speed assumptions will be periodically reassessed and updated within the accounting model to update the expectation of future cash flows. The excess of the cash flows expected to be collected over the pool’s carrying value is considered to be the accretable yield and is recognized as interest income over the estimated life of the loan or pool using the effective yield method. The accretable yield will change due to changes in the timing and amounts of expected cash flows. For the performing loan pools, a prepayment assumption as documented by the valuation specialist is initially applied. Changes in the accretable yield will be disclosed quarterly.

The excess of the contractual balances due over the cash flows expected to be collected is considered to be the nonaccretable difference. The nonaccretable difference represents the estimate of the credit losses expected to occur and was considered in determining the fair value of the loans as of the acquisition date. Subsequent to the acquisition date, any increases in expected cash flows over those expected at purchase date in excess of fair value are adjusted through the accretable difference on a prospective basis. Any subsequent decreases in expected cash flows over those expected at purchase date are recognized by recording ana ~~impairment~~provision for loan losses. Any disposals of loans, including sales of loans, payments in full or foreclosures, result in the removal of the loan from the pool at its carrying amount.

~~-27-~~FDIC Indemnification Asset: The Company has elected to account for amounts receivable under the loss share agreement as an indemnification asset. The FDIC indemnification asset is initially recorded at fair value, based on the discounted value of expected future cash flows under the loss share agreement. The difference between the present value and the undiscounted cash flows the Company expects to collect from the FDIC will be accreted into noninterest income over the life of the FDIC indemnification asset.

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FDIC Indemnification Asset: The Company has elected to account for amounts receivable under the loss share agreement as an indemnification asset in accordance with FASB ASC 805, Business Combinations. The FDIC indemnification asset is initially recorded at fair value, based on the discounted value of expected future cash flows under the loss share agreement. The difference between the present value and the undiscounted cash flows the Company expects to collect from the FDIC will be accreted into noninterest income over the life of the FDIC indemnification asset.

The FDIC indemnification asset is reviewed periodically and adjusted for any changes in expected cash flows based on recent performance and expectations for future performance of the covered portfolio. These adjustments are measured on the same basis as the related covered loans and covered other real estate owned. Any increases in cash flow of the covered assets over those expected will reduce the FDIC indemnification asset and any decreases in cash flow of the covered assets under those expected will increase the FDIC indemnification asset. Increases and decreases to the FDIC indemnification asset are recorded as adjustments to noninterest income.

Fair Value: FASB ASC 820, Fair Value Measurements and Disclosures, establishes a hierarchical disclosure framework associated with the level of pricing observability utilized in measuring financial instruments at fair value. The degree of judgment utilized in measuring the fair value of financial instruments generally correlates to the level of pricing observability. Financial instruments with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of pricing observability and a lesser degree of judgment utilized in measuring fair value. Conversely, financial instruments rarely traded or not quoted will generally have little or no pricing observability and a higher degree of judgment utilized in measuring fair value. Pricing observability is impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and not yet established and the characteristics specific to the transaction.

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Results of Operations Overview

For ~~the~~ year ended December 31, ~~2012~~2013, net income available to common shareholders ~~was~~totaled $1614.85 million, or $10.0993 per diluted common share, compared to net income available to common shareholders of $1416.98 million, or $01.9709 per diluted common share, for the year ended December 31, ~~2011~~2012, and $2314.9 million, or $10.5597 per diluted common share, for the year ended December 31, ~~2010~~2011.

Net income available to common shareholders for the year ended December 31, 2010, included a $19.9 million pre-tax bargain purchase gain related to the September 24, 2010 FDIC-assisted acquisition of North County Bank.

In addition to results presented in accordance with generally accepted accounting principles in the United States of America (“GAAP”), this filing presents certain non-GAAP financial measures. Management believes that certain non-GAAP financial measures provide investors with information useful in understanding the Company's financial performance; however, readers of this report are urged to review these non-GAAP measures in conjunction with the GAAP results, as reported.

Operating earnings are not a measure of performance calculated in accordance with GAAP. However, management believes that operating earnings are an important indication of the ability to generate earnings through the Company's fundamental banking business. Since operating earnings exclude the effects of certain items that are unusual and/or difficult to predict, management believes that operating earnings provide useful supplemental information to both management and investors in evaluating the Company's financial results.

Operating earnings should not be considered in isolation or as a substitute for net income, cash flows from operating activities or other income or cash flow statement data calculated in accordance with GAAP. Moreover, the manner in which the Company calculates operating earnings may differ from that of other companies reporting measures with similar names.

The following table provides the reconciliation of the Company's GAAP earnings to operating earnings (non-~~28-~~GAAP) for the periods presented:



(dollars in thousands)	For the Year Ended December 31,
	2013		2012		2011
GAAP earnings available to common shareholders	$	14,496	$	16,844	$	14,868
Provision for income tax	6,872		7,856		7,111
GAAP earnings available to common shareholders
before provision for income tax	21,368		24,700		21,979
Adjustments to GAAP earnings available to common shareholders:
Merger related expenses	652		—		324
Accelerated accretion of remaining preferred stock discount	—		—		1,046
Operating earnings before tax	22,020		24,700		23,349
Provision for income tax	7,100		7,856		7,224
Net operating earnings	$	14,920	$	16,844	$	16,125
Diluted GAAP earnings per common share	$	0.93	$	1.09	0.97
Diluted operating earnings per common share	$	0.96	$	1.09	1.05

Fully tax-equivalent net interest income and fully tax-equivalent net interest margin are non-GAAP performance measurements that management believes provide investors with a more accurate picture of the Company's operational performance and are consistent with industry practice. The calculation for both measurements involves grossing up interest income on tax-exempt loans and investments by an amount that makes it comparable to taxable income.

Neither fully tax-equivalent net interest income nor fully tax-equivalent net interest margin should be considered in isolation nor as a substitute for net interest income or net interest margin or any other measure calculated in accordance with GAAP. Moreover, the manner in which the Company calculates fully tax-equivalent net interest income and fully tax-equivalent net interest margin may differ from that of other companies reporting measures with similar names.

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(dollars in thousands)	For the Year Ended
	December 31,
	2012		2011		2010
GAAP earnings available to common shareholders	$	16,844	$	14,868	$	23,911
Provision for income tax		7,856		7,111		11,797
GAAP earnings available to common shareholders
before provision for income tax		24,700		21,979		35,708
Adjustments to GAAP earnings available to common shareholders
Bargain purchase gain on acquisition		-		-		(19,925	)
Merger related expenses		-		324		2,113
Accelerated accretion of remaining preferred stock discount		-		1,046		-
Operating earnings before tax		24,700		23,349		17,896
Provision for income tax		7,856		7,224		5,563
Net operating earnings	$	16,844	$	16,125	$	12,333
Diluted GAAP earnings per common share	$	1.09	$	0.97	$	1.55
Diluted operating earnings per common share	$	1.09	$	1.05	$	0.80

The following table provides the reconciliation of the Company's net interest income (GAAP) to a fully tax-equivalent net interest income (non-GAAP) and net interest margin (GAAP) to a fully tax-equivalent net interest margin (non-GAAP) for the periods presented:

Tangible common equity, tangible assets and tangible book value per common share are not measures that are calculated in accordance with GAAP. However, management uses these non-GAAP measures in their analysis of the Company's performance. Management believes that these non-GAAP measures are an important indication of the Company's ability to grow both organically and through business combinations, and with respect to tangible common equity, the Company's ability to pay dividends and to engage in various capital management strategies.



(dollars in thousands)	For the Year Ended December 31,
	2013			2012			2011
GAAP net interest income	$	69,939		$	82,597		$	79,726
Tax-equivalent adjustment	881			1,144			1,021
Tax-equivalent net interest income	$	70,820		$	83,741		$	80,747
Average interest earning assets	$	1,522,068		$	1,510,471		$	1,475,834
Net interest margin	4.59		%	5.47		%	5.40		%
Tax-equivalent net interest margin	4.65		%	5.54		%	5.47		%

Tangible common equity, tangible assets and tangible book value per common share are measures that are not calculated in accordance with GAAP. However, management uses these non-GAAP measures in their analysis of the Company's performance. Management believes that these non-GAAP measures are an important indication of the Company's ability to grow both organically and through business combinations, and with respect to tangible common equity, the Company's ability to pay dividends and to engage in various capital management strategies.

Neither tangible common equity, tangible assets nor tangible book value per common share should be considered in isolation or as a substitute for common shareholders' equity or book value per common share or any other measure calculated in accordance with GAAP. Moreover, the manner in which the Company calculates tangible common equity, tangible assets and tangible book value per share may differ from that of other companies reporting measures with similar names.

The following table provides the reconciliation of the Company's shareholders' equity (GAAP) to tangible common equity (non-29GAAP) and total assets (GAAP) to tangible assets (non-GAAP) for the periods presented:

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(dollars in thousands)	December 31, 2013			December 31, 2012
Total shareholders' equity	$	179,930		$	182,624
Adjustments to shareholders' equity
Goodwill and other intangible assets, net	(5,588		)	(6,027		)
Tangible common equity	$	174,342		$	176,597
Total assets	$	1,683,988		$	1,687,677
Adjustments to total assets
Goodwill and other intangible assets, net	(5,588		)	(6,027		)
Total tangible assets	$	1,678,400		$	1,681,650
Common shares outstanding at end of period	15,538,969			15,483,598
Tangible common equity ratio	10.39		%	10.50		%
Tangible book value per common share	$	11.22		$	11.41

(dolars in thousands)	December 31, 2012			December 31, 2011
Total shareholders' equity	$	182,624		$	170,820
Adjustments to shareholders' equity
Goodwill and other intangible assets, net		(6,027	)		(6,539	)
Tangible common equity	$	176,597		$	164,281
Total assets	$	1,687,677		$	1,670,682
Adjustments to total assets
Goodwill and other intangible assets, net		(6,027	)		(6,539	)
Tangible assets	$	1,681,650		$	1,664,143
Common shares outstanding at end of period		15,483,598			15,398,197
Tangible common equity ratio		10.50	%		9.87	%
Tangible book value per common share	$	11.41		$	10.67

Net Interest Income: One of the Company’s key sources of earnings is net interest income. To make it easier to compare results among several periods and the yields on various types of earning assets (some of which are taxable and others which are not), net interest income is presented in this discussion on a “taxable-equivalent basis” (i.e., as if it were all taxable at the same rate). There are several factors that affect net interest income including:

§• The volume, pricing, mix and maturity of interest-earning assets and interest-bearing liabilities;

§• The volume of free funds (consisting of noninterest-bearing deposits and other liabilities and shareholders’ equity); ~~and,~~

§• The volume of noninterest-earning assets~~, market interest rate fluctuations, and asset quality.~~;

~~-30-~~• Market interest rate fluctuations; and


•	Asset quality.

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The following tables set forth various components of the balance sheet that affect interest income and expense and their respective yields or rates:

(dollars in thousands)	For the Year Ended December 31,	~~Years Ended December 31,~~
		2012										2011											2010
	2013									2012											2011
				Interest	~~Interest~~			~~Average~~						Interest		~~Interest~~				~~Average~~				Interest		~~Interest~~			~~Average~~
	Average	~~Average~~		earned/	~~earned/~~		Average	~~yield/~~		Average		~~Average~~		earned/		~~earned/~~		Average		~~yield/~~	Average		~~Average~~	earned/		~~earned/~~	Average		~~yield/~~
	balance	~~balance~~		paid	~~paid~~		yield/rate	~~rate~~		balance		~~balance~~		paid		~~paid~~		yield/rate		~~rate~~	balance		~~balance~~	paid		~~paid~~	yield/rate		~~rate~~
Assets
Non-covered loans (1)(2)	$	$864,049	~~831,179~~	$	$44,234	~~47,061~~	5.12	%	~~5.66~~	%$	831,179	$	~~831,997~~	$	47,061	$	~~50,313~~	5.66	%		~~6.05~~$	%831,997	$	~~834,668~~$	50,313	$	~~53,963~~6.05	%		~~6.47~~	%
Covered loans	176,611		~~242,552~~	23,710		~~36,418~~	13.43	%	~~15.01~~	%242,552			~~307,836~~	36,418			~~34,819~~	15.01	%		~~11.31~~307,836	%		~~226~~34,~~852~~819			~~19,173~~11.31	%		~~8.45~~	%
Federal funds sold	—		8	—		-	—	%	-	8			~~519~~	—			1	—	%		~~0.20~~519	%		~~5,669~~1			70.20	%		~~0.11~~	%
Interest-bearing deposits	80,554		~~98,169~~	206		~~251~~	0.26	%	~~0.26~~	%98,169			~~101,683~~	251			~~258~~	0.26	%		~~0.25~~101,683	%		~~107,664~~258			~~291~~0.25	%		~~0.27~~	%
Investments
Investments:
Taxable	328,911		~~291,836~~	5,720		~~5,333~~	1.74	%	~~1.83~~	%291,836			~~205,426~~	5,333			~~3,967~~	1.83	%		~~1.93~~205,426	%		~~134~~3,~~100~~967			~~2,348~~1.93	%		~~1.75~~	%
Non-taxable (2)	71,943		~~46,727~~	2,370		~~1,791~~	3.29	%	~~3.83~~	%46,727			~~28,373~~	1,791			~~1,370~~	3.83	%		~~4.83~~28,373	%		181,~~918~~370			~~1,085~~4.83	%		~~5.74~~	%
Interest-earning assets	1,522,068		~~1,510,471~~	76,240		~~90,854~~	5.01	%	~~6.02~~	%1,510,471			~~1,475,834~~	90,854			~~90,728~~	6.02	%		~~6.15~~1,475,834	%		190,~~327,871~~728			~~76,867~~6.15	%		~~5.79~~	%
Noninterest-earning assets	126,692		~~161,432~~							161,432			~~205,420~~								205,420			~~155,213~~
Total assets	$	$1,648,760	~~1,671,903~~							$	1,671,903	$	~~1,681,254~~								$	1,681,254	$	~~1,483,084~~
Liabilities and shareholders' equity
Deposits:
NOW accounts and MMA	$	$647,965	~~611,477~~	$	$1,052	~~1,352~~	0.16	%	~~0.22~~	%$	611,477	$	~~581,189~~	$	1,352	$	~~2,394~~	0.22	%		~~0.41~~$	%581,189	$	~~439,302~~$	2,394	$	~~2,611~~0.41	%		~~0.59~~	%
Savings	119,518		~~105,085~~	60		~~105~~	0.05	%	~~0.10~~	%105,085			~~96,892~~	105			~~199~~	0.10	%		~~0.21~~96,892	%		~~74,922~~199			~~189~~0.21	%		~~0.25~~	%
Time deposits	403,478		~~497,812~~	3,830		~~5,124~~	0.95	%	~~1.03~~	%497,812			~~606,771~~	5,124			~~6,899~~	1.03	%		~~1.14~~606,771	%		~~599~~6,~~673~~899			~~8,291~~1.14	%		~~1.38~~	%
Total interest-bearing deposits	1,170,961		~~1,214,374~~	4,942		~~6,581~~	0.42	%	~~0.54~~	%1,214,374			~~1,284,852~~	6,581			~~9,492~~	0.54	%		~~0.74~~1,284,852	%		19,~~113,897~~492			~~11,091~~0.74	%		~~1.00~~	%
Federal funds purchased	11		61	—		-			-	61			3	—			-	—	%		-3			~~279~~—			-—	%		~~0.04~~	%
Junior subordinated debentures	25,774		~~25,774~~	478		~~532~~	1.85	%	~~2.06~~	%25,774			~~25,774~~	532			~~489~~	2.06	%		~~1.90~~25,774	%		~~25,774~~489			~~496~~1.90	%		~~1.92~~	%
Other interest-bearing liabilities			-			-			-				-				-				-			6,521			243			3.73	%
Total interest-bearing liabilities	1,196,746			5,420			0.45	%		1,240,209				7,113				0.57	%		1,310,629			9,981			0.76	%
Total interest-bearing liabilities			1,240,209			7,113			0.57	%			1,310,629				9,981				0.76	%		1,146,471			11,830			1.03	%
Noninterest-bearing deposits	257,314									243,522											202,297
Noninterest-bearing deposits			243,522										202,297											158,399
Other liabilities	13,240									12,035											6,263
Other liabilities			12,035										6,263											11,158
Total liabilities	1,467,300									1,495,766											1,519,189
Total liabilities			1,495,766										1,519,189											1,316,028
Total shareholders' equity	181,460									176,137											162,065
Total shareholders' equity			176,137										162,065											167,056
Total liabilities and
Total liabilities and
shareholders' equity	$	1,648,760								$	1,671,903										$	1,681,254
shareholders' equity		$	1,671,903									$	1,681,254										$	1,483,084
Net interest income/spread				$	70,820		4.56	%						$	83,741			5.45	%					$	80,747		5.39	%
Net interest income/spread					$	83,741			5.45	%						$	80,747				5.39	%				$	65,037			4.76	%
Credit for interest-bearing funds							0.09	%										0.09	%								0.08	%
Credit for interest-bearing funds									0.09	%											0.08	%								0.14	%
Net interest margin (2)							4.65	%										5.54	%								5.47	%
Net interest margin (2)									5.54	%											5.47	%								4.90	%
(1) Average balance includes nonaccrual loans.
(2) Interest income on non-taxable investments and loans is presented on a taxable-equivalent basis using the federal statutory rate of 35%. These adjustments totaled $1.1 million, $1.0 million and $918 thousand for the years ended December 31, 2012, 2011 and 2010, respectively. Taxable-equivalent is a non-GAAP performance measurement that managment believes provides investors with a more
accurate picture of the net interest margin and efficiency ratio for comparative purposes.

~~-31-~~(1) Average balance includes nonaccrual loans.

⁽²⁾ Interest income on non-taxable investments and loans is presented on a taxable-equivalent basis using the federal statutory rate of 35%. These adjustments totaled $881 thousand, $1.1 million and $1.0 million for the years ended December 31, 2013, 2012 and 2011, respectively. Taxable-equivalent is a non-GAAP performance measurement that management believes provides investors with a more accurate picture of the net interest margin and efficiency ratio for comparative purposes.

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Net interest income on a taxable-equivalent basis increased $15.7 million for the year ended December 31, 2011 compared to the same period in 2010. The increase was primarily attributable to increases in the average balance and average yield earned on covered loans. For the period, average covered loans increased $81.0 million and the average yield increased 286 basis points. Also contributing to the increase was the $164 thousand decrease in average interest-bearing liabilities and the 27 basis point decrease in the average rate paid on those liabilities. Net interest margin on a taxable-equilavent basis was 5.47% for 2011, an increase of 57 basis points as compared to 2010.

Due to the current low interest rate environment, together with the projected principal reduction in higher yielding covered loans, management expects net interest income and net interest margin will decline in future periods.

The following table details the effects of changes in rates and volume on interest income and expense for the periods indicated:

(dollars in thousands)	2013 compared to 2012	~~2012 compared to 2011~~											2012 compared to 2011	~~2011 compared to 2010~~
		Increase (decrease) in interest income and expense due to changes in (2):												Increase (decrease) in interest income and expense due to changes in (2):
	Increase (decrease) in interest income and expense due to changes in (2)												Increase (decrease) in interest income and expense due to changes in (2)
	Volume	~~Volume~~			Rate	~~Rate~~			Total	~~Total~~			Volume	~~Volume~~			Rate	~~Rate~~			Total	~~Total~~
Assets
Non-covered loans (1)(3)	$	$1,987	~~(48~~	)	$	$(4,814	~~(3,204~~)	)	$	$(2,827	~~(3,252~~)	)	$	$(48	~~(172~~)	)	$	$(3,204	~~(3,478~~)	)	$	$(3,252	~~(3,650~~)	)
Covered loans	(9,146		~~(2,940~~)	)	(3,562		~~4,539~~)		(12,708		~~1,599~~)		(2,940		~~8,033~~)		4,539		~~7,613~~		1,599		~~15,646~~
Federal funds sold	—		(1	)	—		-		—		(1	)	(1		~~(90~~)	)	—		84		(1		(6)	)
Interest-bearing deposits	(45		(9)	)	—		2		(45		(7)	)	(9		~~(15~~)	)	2		~~(18~~	)	(7		~~(33~~)	)
Investments (1)
Investments: (1)
Taxable	625		~~1,566~~		(238		~~(200~~)	)	387		~~1,366~~		1,566		~~1,356~~		(200		~~263~~)		1,366		~~1,619~~
Non-taxable	783		~~618~~		(204		~~(197~~)	)	579		~~421~~		618		~~417~~		(197		~~(132~~)	)	421		~~285~~
Interest-earning assets	$	$(5,796	~~(814~~)	)	$	$(8,818	~~940~~)		$	$(14,614	~~126~~)		$	$(814	~~9,529~~)		$	$940	~~4,332~~		$	$126	~~13,861~~
Liabilities
Deposits:
NOW accounts and money market	$	$77	~~119~~		$	$(377	~~(1,161~~)	)	$	$(300	~~(1,042~~)	)	$	$119	~~711~~		$	$(1,161	~~(928~~)	)	$	$(1,042	~~(217~~)	)
Savings	13		16		(58		~~(110~~)	)	(45		~~(94~~)	)	16		49		(110		~~(39~~)	)	(94		10)
Time deposits	(917		~~(1,162~~)	)	(377		~~(613~~)	)	(1,294		~~(1,775~~)	)	(1,162		98)		(613		~~(1,490~~)	)	(1,775		~~(1,392~~)	)
Total interest-bearing deposits	(827		~~(1,027~~)	)	(812		~~(1,884~~)	)	(1,639		~~(2,911~~)	)	(1,027		~~858~~)		(1,884		~~(2,457~~)	)	(2,911		~~(1,599~~)	)
Junior subordinated debentures	—		-		(54		43)		(54		43)		—		-		43		(7	)	43		(7	)
Other interest-bearing liabilities			-				-				-				(122	)			(121	)			(243	)
Total interest-bearing liabilities	$	(827	)		$	(866	)		$	(1,693	)		$	(1,027	)		$	(1,841	)		$	(2,868	)
Total interest-bearing liabilities		$	(1,027	)		$	(1,841	)		$	(2,868	)		$	736			$	(2,585	)		$	(1,849	)

(1) Interest income on non-taxable investments and loans are presented on a fully tax-equivalent basis using the federal statutory rate of 35.0% for the years ended December 31, ~~2012~~2013, ~~2011~~2012 and ~~2010~~2011.

⁽²⁾ The changes attributable to the combined effect of volume and interest rates have been allocated proportionately.

⁽³⁾Interest income previously accrued on nonaccrual loans is reversed in the period the loan is placed on nonaccrual status.

Net interest income on a taxable-32equivalent basis totaled $70.8 million for the year ended December 31, 2013, compared to $83.7 million for the same period in 2012. The $12.9 million year-over-year decrease was primarily related to decreases in volume and in the yield earned on covered loans and decreases in the yield earned on non-covered loans. Net interest margin (net interest income as a percentage of average interest-earning assets) on a taxable-equivalent basis was 4.65% for 2013, compared to 5.54% for 2012, a decrease of 89 basis points.

Net interest income on a taxable-equivalent basis totaled $83.7 million for the year ended December 31, 2012, compared to $80.7 million for the same period in 2011. The $3.0 million year-over-year increase was primarily attributable to decreases in the average balance and the average rate paid on interest-bearing deposits. For the period, average interest-bearing deposits decreased $70.5 million and the average rate decreased 20 basis points. For the period, interest earned on interest-earning assets remaining relatively flat. Net interest margin (net interest income as a percentage of average interest-earning assets) on a taxable-equivalent basis was 5.54% for 2012, an increase of 7 basis points as compared to 2011.

Due to the current low interest rate environment, together with the projected principal reduction in higher yielding covered loans, management expects the net interest margin will decline in future periods.

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Provision for Loan Losses: The provision for loan losses is highly dependent on the Company’s ability to manage asset quality and control the level of net charge-offs through prudent underwriting standards. In addition, decline in general economic conditions could increase future provisions for loan ~~loss~~losses and materially impact the Company’s net income. For further discussion of the Company’s asset quality see the Credit Risks and Asset Quality section found in Item 72- Management’s Discussion and Analysis of Financial Condition and Results of Operations.

~~The~~For ~~provision~~the ~~for~~year ~~loan~~ended ~~losses~~December 31, 2013, the Company recorded a provision for non-covered ~~loans~~loan ~~totaled~~losses of $1.9 million compared to $7.1 million and $10.5 million for the years ended December 31, 2012 and 2011, respectively. Net charge-offs for the year ended December 31, 2013 were $1.9 million, compared to $108.50 million and $1211.23 million for ~~2011~~the years ended December 31, 2012 and ~~2010~~2011, respectively. At December 31, 2013 and 2012, the allowance for non-covered loan losses, as a percent of total non-covered loans, was 21.0192%, ~~compared to 2.22% at December 31, 2011~~ and 2.2501% ~~at December 31~~, ~~2010~~respectively.

~~Noninterest~~The ~~Income:~~Company ~~Noninterest~~recorded ~~income~~a ~~remains~~$12.7 million provision for covered loan losses for the year ended December 31, 2013, compared to a ~~key~~provision ~~focus~~for covered loan losses of $2.6 million for the ~~Company.~~year ~~The~~ended ~~Company~~December ~~has~~31, ~~focused~~2012, onand ~~diversifying~~a ~~the~~recovery ~~noninterest~~for ~~income~~covered ~~mix~~loan ~~through~~losses of $450 thousand for the ~~sale~~year ofended ~~mortgage~~December ~~loans~~31, ~~and~~2011. For ~~through~~the year ended December 31, 2013, the ~~introduction~~provision offor ~~nondeposit~~covered ~~investment~~loan ~~products~~losses ~~consisting~~was primarily attributable to the deterioration of ~~annuity~~cash ~~sales~~flows ~~and~~associated ~~investment~~with ~~service~~several ~~fees~~covered ~~and~~loan ~~income~~pools acquired from ~~the~~City ~~Company’s~~ Bank, ~~Owned~~particularly ~~Life~~those ~~Insurance~~in ~~policies~~the hospitality portfolio. This ~~The~~provision, ~~following~~however, ~~table~~was ~~presents~~partially offset by a significantly greater change in the ~~key~~FDIC ~~components~~indemnification ofasset, included in noninterest income:, as noted in the table on the next page.

(dollars in thousands)	Years Ended December 31,								Change			Change
	2012			2011			2010		2012 vs. 2011			2011 vs. 2010
Service charges and fees	$	3,560		$	3,818		$	3,346	$	(258	)	$	472
Electronic banking income		3,666			3,197			2,306		469			891
Investment products		1,295			1,072			522		223			550
Gain on sale of investment securities, net		931			-			-		931			-
Bank owned life insurance income		191			311			226		(120	)		85
Income from the sale of mortgage loans		3,848			1,197			1,134		2,651			63
SBA premium income		602			444			578		158			(134	)
Change in FDIC indemnification asset		(9,126	)		(9,232	)		1,884		106			(11,116	)
Gain on disposition of covered assets		1,877			6,312			1,840		(4,435	)		4,472
Bargain purchase gain on acquisition		-			-			19,925		-			(19,925	)
Other		1,402			2,093			1,770		(691	)		323
Total noninterest income	$	8,246		$	9,212		$	33,531	$	(966	)	$	(24,319	)

The decrease in service charges and fees in 2012 compared to 2011 was principally attributable to continued reductions in non-sufficient funds and overdraft fee income resulting from regulatory reform changes, which went into effect during the third quarter of 2010. The increase in service charges and fees in 2011 compared to 2010 was primarily attributable to the increased volume of transaction deposit accounts gained through the acquisitions of City Bank and North County Bank in 2010 and an increase in NSF fees.

The increases in electronic banking income for the periods presented were primarily attributable to an increase in interchange fees on new deposit accounts gained through the acquisitions of City Bank and North County Bank in 2010.

Investment products increased due to increased sales of annuity products. In addition, at December 31, 2012, the Company had 25 licensed branch investment sales representatives, compared to 24 and 10 at December 31, 2011 and 2010, respectively.

Gain on sale of investment securities, net represents the net gain recognized on the sale of available for sale investment securities for the year ended December 31, 2012. Management reviews the investment securities portfolio regularly for opportunities to adjust the portfolio and expects additional sales in future periods.

Income from the sale of mortgage loans increased due to the increase in sales volume of loans held for sale, primarily related to significant mortgage activity as a result of historically low interest rates. For the year ended December 31, 2012, proceeds from the sale of loans held for sale totaled $211.8 million, compared to $129.0 million and $127.4 million for the years ended December 31, 2011 and 2010, respectively.

-33-

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~~The~~Noninterest ~~gain~~Income: Noninterest onincome ~~disposition~~remains ofa ~~covered~~key ~~assets~~focus isof the ~~income~~Company. ~~the~~The Company ~~recognizes~~has ~~when~~focused aon ~~covered~~diversifying ~~asset~~the isnoninterest ~~paid~~income ~~off~~mix orthrough ~~sold and~~ the ~~proceeds~~sale ~~exceed~~of ~~its~~mortgage ~~carrying~~loans ~~value. The~~and ~~gain~~the onguaranteed ~~disposition~~portion of ~~covered~~SBA ~~assets~~loans isand ~~expected~~through tothe ~~continue~~introduction toof ~~decline~~nondeposit asinvestment ~~the~~products ~~balance~~consisting primarily of ~~covered~~annuity ~~assets~~sales ~~decrease. At~~and ~~December~~investment ~~31,~~service ~~2012,~~fees ~~covered~~and ~~assets~~income ~~totaled~~from ~~$227.5~~the ~~million,~~Company's ~~compared~~Bank toOwned ~~$294.8~~Life ~~million~~Insurance atpolicies. ~~December~~The ~~31,~~following ~~2011~~table ~~and~~presents ~~$394.6~~the ~~million~~key atcomponents ~~December~~of ~~31,~~noninterest ~~2010.~~income:

The bargain purchase gain on acquisition for the year ended December 31, 2010, represents the excess of the estimated fair value of the assets acquired over the estimated fair value of the liabilities assumed for the 2010 North County Bank acquisition.



(dollars in thousands)	Years Ended December 31,								Change			Change
	2013		2012			2011			2013 vs. 2012			2012 vs. 2011
Service charges and fees	$	3,401	$	3,560		$	3,818		$	(159	)	$	(258	)
Electronic banking income	4,101		3,666			3,197			435			469
Investment products	771		1,295			1,072			(524		)	223
Gain on sale of investment securities, net	556		931			—			(375		)	931
Bank owned life insurance income	132		191			311			(59		)	(120		)
Income from the sale of mortgage loans	3,267		3,848			1,197			(581		)	2,651
SBA premium income	894		602			444			292			158
Change in FDIC indemnification asset	5,735		(9,126		)	(9,232		)	14,861			106
Gain on disposition of covered assets	2,315		1,877			6,312			438			(4,435		)
Other	1,173		1,402			2,093			(229		)	(691		)
Total noninterest income	$	22,345	$	8,246		$	9,212		$	14,099		$	(966	)

The increases in electronic banking income for the periods presented were primarily attributable to increases in interchange fees on new deposit accounts and increases in ATM fee income. Additionally, the Company received a fee from Visa during 2013 for its exclusive branding of the Company's debit and credit cards.

The decrease in investment products income for 2013 compared to 2012 was primarily attributable to a change in the mix of investment products sold. For the year ended December 31, 2013, the Company sold $24.5 million in annuities and $17.5 million in mutual funds, compared to $40.7 million in annuities and $1.5 million in mutual funds a year ago. Typically, the Company earns a one-time fee on annuities at the time of sale, compared to a lesser and recurring annual fee on mutual funds.

Gain on sale of investment securities, net represents the net gain recognized on the sale of available for sale investment securities. Management reviews the investment securities portfolio regularly for opportunities to adjust the portfolio and may have additional sales in future periods.

The decrease in income from the sale of mortgage loans in 2013 compared to 2012 was primarily attributable to a decline in sales volume of loans held for sale due to a decline in mortgage activity. The increase in income from the sale of mortgage loans in 2012 compared to 2011 was primarily attributable to the increase in sales volume of loans held for sale due to significant mortgage activity as a result of historically low interest rates. For the years ended December 31, 2013, 2012 and 2011, proceeds from the sale of loans held for sale totaled $155.5 million, $211.8 million and $129.0 million, respectively.

SBA premium income is the income the Company recognizes when it sells the guaranteed portion of each SBA loan to investors in the secondary market. For the year ended December 31, 2013, the Company sold total guaranteed portions of SBA loans in the amounts of $7.8 million, compared to $5.0 million for the year ended December 31, 2012 and $1.7 million for the year ended December 31, 2011.

The change in FDIC indemnification asset for the year ended December 31, 2013 represents the accretion of income on the FDIC indemnification asset, compared to the amortization of expense for the years ended December 31, 2012 and 2011. Based upon the collections made on the indemnification asset and the subsequent quarterly revaluations of the estimated remaining cash flows of covered loans, accretion was required to increase the asset in order to match the projected cashflows over the remaining term of the asset. For the year ended December 31, 2013, the Company recorded a $12.7 million impairment charge related to the credit deterioration in the covered loan portfolio. Related to the impairment charge, the Company also recorded a $10.2 million write up of the indemnification asset and a $626 thousand reversal of a portion of the FDIC clawback liability.

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The gain on disposition of covered assets is the income the Company recognizes when a covered asset is paid off or sold and the proceeds exceed its carrying value. The gain on disposition of covered assets is expected to continue to decline as the balance of covered assets decrease. At December 31, 2013, covered assets totaled $143.3 million, compared to $227.5 million at December 31, 2012 and $294.8 million at December 31, 2011.

The decrease in other noninterest income in 2012 compared to 2011 was primarily attributable to a $670 thousand gain generated from the sale of the merchant card processing portfolio to a new provider in the second quarter of 2011.

Noninterest Expense: The Company continues to focus on controlling noninterest ~~expenses~~expense and addressing long term operating expenses. The following table presents the key ~~components~~elements of noninterest expense:

(dollars in thousands)	Years Ended December 31,	~~Years Ended December 31,~~								Change	~~Change~~			Change	~~Change~~
		2012			2011			2010			2012 vs. 2011				2011 vs. 2010
	2013			2012			2011			2013 vs. 2012				2012 vs. 2011
Salaries and benefits	$	$30,909	~~29,944~~	$	$29,944	~~27,496~~	$	$27,496	~~23,527~~	$	$965	~~2,448~~		$	$2,448	~~3,969~~
Occupancy and equipment	7,287		~~6,883~~	6,883		~~6,553~~	6,553		~~5,631~~	404		~~330~~		330		~~922~~
Office supplies and printing	1,501		~~1,643~~	1,643		~~1,665~~	1,665		~~1,594~~	(142		~~(22~~)	)	(22		71)
Data processing	2,185		~~2,134~~	2,134		~~1,916~~	1,916		~~1,434~~	51		~~218~~		218		~~482~~
Consulting and professional fees	849		~~904~~	904		~~1,152~~	1,152		~~891~~	(55		~~(248~~)	)	(248		~~261~~)
Intangible amortization	439		~~512~~	512		~~622~~	622		~~672~~	(73		~~(110~~)	)	(110		~~(50~~)	)
Merger related expenses	652		-	—		~~324~~	324		~~2,113~~	652		~~(324~~	)	(324		~~(1,789~~)	)
FDIC premiums	1,091		~~1,281~~	1,281		~~1,818~~	1,818		~~1,609~~	(190		~~(537~~)	)	(537		~~209~~)
FDIC clawback liability			1,680			1,576			-			104				1,576
FDIC clawback liability adjustment	(88		)	1,680			1,576			(1,768		)		104
Non-covered OREO and repossession expenses, net	2,227		~~1,841~~	1,841		~~1,358~~	1,358		~~1,196~~	386		~~483~~		483		~~162~~
Covered OREO and repossession expenses, net	1,696		~~1,699~~	1,699		~~2,192~~	2,192		~~1,240~~	(3		~~(493~~)	)	(493		~~952~~)
Other	7,553		~~7,878~~	7,878		~~9,153~~	9,153		~~6,890~~	(325		~~(1,275~~)	)	(1,275		~~2,263~~)
Total noninterest expense	$	$56,301	~~56,399~~	$	$56,399	~~55,825~~	$	$55,825	~~46,797~~	$	$(98	~~574~~)		$	$574	~~9,028~~

The increase in salaries and benefits in 2013 compared to 2012 was primarily attributable to an increase in salaries due to annual merit increases. The increase in salaries and benefits in 2012 compared to 2011 was primarily due to increases in real estate loan commissions, employee health insurance expense and stock-based compensation expense. Additionally, the Company paid year -end bonuses of $1.2 million and $1.1 million in 2013 and 2012, respectively. The Company did not pay any bonuses in 2011. The increase in salaries and benefits in 2011 compared to 2010 was primarily due to the recognition of a full year of salary expense related to the additional full-time equivalents acquired from City Bank and North County Bank in the second and third quarters of 2010, respectively.

The ~~increase~~increases in occupancy and equipment inwere ~~2012 compared to 2011 was~~ primarily attributable to additional depreciation expense on furniture and equipment and computer software ~~purchased during 2012~~ and additional building lease expense. The increase in expense in 2011 compared to 2010 was primarily due to additional depreciation expense related to the acquisition of facilities and furnishing of the eight City Bank locations acquired from the FDIC in the third quarter of 2010.

~~-34-~~Merger related expenses incurred in 2013 relate to the proposed merger with Heritage Financial Corporation and consisted primarily of professional and consulting services. Merger related expenses incurred in 2011 relate to the City Bank and North County Bank acquisitions and consisted primarily of conversion expense, severance and professional and consulting services.

FDIC clawback liability expense represents the Bank’s provision for the estimated liabilities under the loss sharing arrangements entered into with the FDIC for the acquisitions of City Bank on April 16, 2010 and North County Bank on September 24, 2010. Approximately ten years following the respective acquisition dates, the Bank is required to make a payment to the FDIC in the event that losses on covered assets under the loss share agreements have been less than the stated thresholds in the agreements.

Non-covered and covered OREO and repossession expense represents costs the Company incurs in reclaiming, repairing and selling real estate properties and automobiles, as well as any write-downs or losses on the sale of non-covered and covered OREO properties. The expense on covered OREO is expected to continue to decline as the balance of covered OREO decreases and credit quality and economic conditions improve. At December 31, 2013, covered OREO totaled $6.0 million, down from $13.5 million at December 31, 2012.

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~~Data~~The ~~processing~~decrease ~~expense~~in ~~increased~~other noninterest expense in ~~2012~~2013 compared to ~~2011,~~2012 ~~and~~was primarily attributable to a decrease in ~~2011~~advertising expense. The decrease in other noninterest expense in 2012 compared to ~~2010,~~2011 was primarily asattributable ato ~~result~~the ofdecreases ~~the~~in ~~Company’s~~advertising, ~~continued~~sales ~~growth~~development, telephone and ~~expansion. The~~ ~~Bank~~Business ~~opened~~and ~~its~~Occupation ~~31st~~(B&O) ~~branch~~tax. During inthe ~~Woodinville~~first inquarter ~~December~~of ~~2012~~2011, ~~and~~the ~~acquired~~Bank 11paid ~~branches~~the ~~through~~B&O ~~its~~tax ~~FDIC-assisted~~on ~~acquisitions~~the ofbargain ~~City~~purchase ~~Bank~~gain ~~and~~on ~~North~~acquisition ~~County~~recognized ~~Bank~~during inthe third quarter of 2010.

~~Merger~~Income ~~related~~Taxes: ~~expenses~~The ~~relate~~Company’s toconsolidated ~~non-recurring~~effective ~~expenses~~tax ofrate for the ~~City~~year ~~Bank~~ended ~~and~~December 31, ~~North~~2013, ~~County~~was ~~Banks~~32.2%, ~~acquisitions~~compared to 31.8% ~~Merger~~and ~~related~~30.8% for ~~expenses~~the ~~include~~years ~~conversion~~ended ~~expense~~December 31, ~~severance~~2012 and ~~professional~~2011, ~~and~~respectively. The ~~consulting~~annual ~~services~~effective tax rates are below the federal statutory rate of 35% principally due to nontaxable income generated from investments in bank owned life insurance, tax-exempt municipal bonds and loans. ~~The~~Additionally, the Company’s ~~did~~tax ~~not~~rate ~~incur~~for ~~any~~the ~~merger~~years ~~related~~ended ~~expense~~December 31, ~~during~~ 2012 and ~~does~~2011 ~~not~~reflect ~~anticipate~~a ~~incurring~~benefit ~~any~~from ~~future~~the ~~merger~~New ~~related~~Market ~~expenses~~Tax Credit Program. The tax benefits related to these ~~acquisitions~~credits were recognized in the same periods that the credits were recognized on the Company’s income tax returns and expired at the ended of 2012. Additional information on income taxes is provided in Item 8- Financial Statements and Supplementary Data, Note (14) Income Taxes of the consolidated financial statements.

The decrease in FDIC premiums in 2012 compared to 2011 was attributable to the new assessment rate and assessment base instituted by the FDIC during the third quarter of 2011. The increase in FDIC premiums in 2011 compared to 2010 was primarily due to an increase in deposits held at the measurement date related to the City Bank and North County Bank acquisitions.

FDIC clawback liability expense represents the Bank’s provision for the estimated liability under the provisions of the loss sharing arrangements under the Purchase and Assumption Agreements entered into with the FDIC for the 2010 acquisitions of City Bank and North County Bank. Additional information regarding the FDIC clawback liability can be found in Note (2), Business Combinations of the consolidated financial statements.

Non-covered and covered OREO and repossession expense represents costs the Company incurs in reclaiming, repairing and selling real estate properties and automobiles, as well as any write-downs or losses on the sale of non-covered and covered OREO properties. The expense on covered OREO is expected to continue to decline as the balance of covered OREO decreases and credit quality and economic conditions improve. At December 31, 2012, covered OREO totaled $13.5 million, down from $26.6 million at December 31, 2011 and $29.8 million at December 31, 2010.

The decrease in other noninterest expense in 2012 compared to 2011 was primarily attributable to the decreases in advertising, sales development, telephone and Business and Occupation (B&O) tax. During the first quarter of 2011, the Bank paid the B&O tax on the bargain purchase gain on acquisition recognized during the third quarter of 2010. The increase in other noninterest expense in 2011 compared to 2010 was primarily affected by the recognition of a full year of additional expenses related to the increase in branches due to the FDIC-assisted acquisitions in the second and third quarters of 2010.

Income Tax: The Company’s consolidated effective tax rate, as a percentage of pre-tax income from continuing operations, was 31.8% in 2012, compared to an effective tax rate of 30.8% and 31.6% for 2011 and 2010, respectively. The effective tax rate is lower than the federal statutory rate of 35.0% due to nontaxable income generated from investments in BOLI, tax-exempt municipal bonds and loans. Additionally, the Company’s tax rates reflect a benefit from the New Market Tax Credit Program whereby a subsidiary of the Bank has utilized approximately $3.1 million in total federal tax credits. The tax benefits related to these credits will be recognized in the same periods that the credits are recognized on the Company’s income tax returns. Additional information on income taxes is provided in Item 8- Financial Statements and Supplementary Data, Note (14) Income Taxes of the consolidated financial statements.

Financial Condition Overview

AtTotal ~~December~~assets at December 31, ~~2012~~2013, ~~non-covered~~were ~~loans totaled~~ $~~853.~~1.68 ~~million~~billion, compared to $~~812~~1.869 ~~million~~billion at December 31, ~~2011~~2012. ~~Deposits~~For ~~remained~~the ~~relatively~~period, ~~flat~~net ~~totaling~~covered loans decreased $176.8 million, investment securities increased $59.5 ~~billion~~million atand ~~December~~total 31non-covered loans, ~~2012~~net ~~and~~of ~~2011. Shareholders’~~allowance ~~equity~~for loan losses, increased $1135.86 million,. Total orshareholders’ ~~6.9%,~~equity towas $~~182~~179.69 million at December 31, ~~2012~~2013, compared to $~~170~~182.86 million ~~a year ago. Tangible book value was $11.41 per share~~ at December 31, 2012, ~~compared~~a todecrease of $102.677 ~~a year ago~~million. The ~~Company~~decrease in shareholders’s ~~ability~~equity towas ~~sustain~~primarily ~~continued~~attributable ~~loan~~to ~~and~~net ~~deposit~~income ~~growth~~of is$14.5 ~~dependent~~million onreduced ~~many~~by ~~factors,~~a ~~including~~$9.9 ~~the~~million ~~effects~~other ofcomprehensive ~~competition,~~loss ~~economic~~related ~~conditions,~~to ~~retention~~the ofinvestment ~~key~~securities ~~personnel~~portfolio and ~~valued~~$8.3 ~~customers,~~million ~~and~~in ~~the~~cash ~~Company’s~~dividends ~~ability~~paid toon ~~close~~common ~~loans~~stock during the year.

~~-35-~~Investment Securities: The composition of the Company's investment portfolio reflects management's investment strategy of maintaining an appropriate level of liquidity while providing a relatively stable source of investment income. The investment securities portfolio provides a vehicle for the investment of available funds and a source of liquidity. At December 31, 2013, total investment securities increased $59.5 million to $432.5 million, compared to $373.0 million at December 31, 2012. The increase was a result of the Company actively purchasing investment securities during the year as it continued to deploy funds generated through the resolution of acquired assets and the reinvestment of funds generated from maturities and principal payments of investment securities.

~~Table~~At December 31, 2013, net unrealized losses on investment securities totaled $8.0 million, compared to unrealized gains of ~~Contents~~$7.2 million at December 31, 2012. The increase in net unrealized losses for the period can be attributed to the increase in interest rates during 2013.

Investment Securities: The composition of the Company’s investment portfolio reflects management’s investment strategy of maintaining an appropriate level of liquidity while providing a relatively stable source of investment income. The investment securities portfolio provides a vehicle for the investment of available funds and a source of liquidity. In 2012, total investment securities increased $77.0 million to $373.0 million at December 31, 2012. The increase was a result of the Company actively purchasing investment securities during 2012 as it continued to deploy funds acquired from the City Bank and North County Bank acquisitions, as well as, funds generated through the resolution of acquired assets.

The Company’s investment portfolio mix, based upon fair value, is outlined in the table below:

(dollars in thousands)	December 31, 2013	~~Years Ended December 31,~~		December 31, 2012
		2012			2011
U.S. government agencies	$	85,672		$	88,586
U.S. government agencies		$	88,586		$	76,574
Residential pass-through securities	180,809			168,423
U.S. Treasuries			-			42,597
State and political subdivisions	77,275			64,297
Residential pass-through securities			168,423			117,398
Corporate obligations	10,933			10,435
State and political subdivisions			64,297			47,093
Agency-issued collateralized mortgage obligations	54,145			14,046
Corporate obligations			10,435			10,287
Asset-backed securities	21,816			25,188
Agency-issued collateralized mortgage obligations			14,046			-
Investments in mutual funds and other equity securities	1,892			1,993
Asset-backed securities			25,188			-
Total investment securities available for sale (1)	$	432,542		$	372,968
Investments in mutual funds and other equity securities			1,993			2,006
Total investment securities available for sale (1)		$	372,968		$	295,955

^{(1) Other than securities issued by the U.S. Government and U.S Government agencies and corporations, no investment in aggregate, in a single issuer, exceeds 10% of shareholders’ equity.}

~~-36-~~30

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The weighted average ~~contractual~~ life of the Company’s investment portfolio in ~~2012~~2013 increased to 5.37 years from 45.93 years in ~~2011~~2012. The following table further details the contractual maturities of the Company’s investment portfolio, based upon fair value at December 31, ~~2012~~2013. Expected maturities may differ from contractual maturities because issuers may have the right to call or repay obligations with or without prepayment penalties. Additional information about the investment portfolio is provided in Item 8- Financial Statements and Supplementary Data, Note (4) Investment Securities of the consolidated financial statements.

(dollars in thousands)	Dates of Maturities
	Under 1 year			1 - 5 years			5 - 10 years			Over 10 years			Total
U.S. government agencies	$	124,~~067~~050		$	7181,~~444~~622		$	~~5,075~~—		$	-—		$	8885,~~586~~672
Weighted average yield	2.83	~~1.96~~	%	1.15	~~1.39~~	%	—	~~0.99~~	%	—	-		1.22	~~1.45~~	%
Residential pass-through securities	5,431	~~7,427~~		21	37		19,480	~~21,133~~		155,877	~~139,826~~		180,809	~~168,423~~
Weighted average yield	1.51	~~1.70~~	%	2.07	~~2.32~~	%	2.06	~~1.89~~	%	2.14	~~1.90~~	%	2.11	~~1.89~~	%
Taxable state and political subdivisions	—	-		1,098	-		1,370	~~3,143~~		—	~~2,169~~		2,468	~~5,312~~
Weighted average yield	—	-	%	4.38	-	%	4.26	~~4.25~~	%	—	~~4.80~~	%	4.31	~~4.48~~	%
Tax exempt state and political subdivisions	—	~~1,440~~		2,280	~~9,983~~		51,869	~~25,871~~		20,658	~~21,691~~		74,807	~~58,985~~
Weighted average yield	—	~~3.39~~	%	4.71	~~3.57~~	%	3.15	~~3.46~~	%	3.72	~~4.19~~	%	3.37	~~3.75~~	%
Corporate obligations	—	-		10,933	~~7,735~~		—	~~2,700~~		—	-		10,933	~~10,435~~
Weighted average yield	—	-		1.14	~~1.12~~	%	—	~~1.26~~	%	—	-		1.14	~~1.20~~	%
Agency-issued collateralized mortgage obligations	—	-		—	-		—	-		54,145	~~14,046~~		54,145	~~14,046~~
Weighted average yield	—	-		—	-		—	-		2.05	~~1.55~~	%	2.05	~~1.55~~	%
Asset-backed securities	—	-		—	-		—	-		21,816	~~25,188~~		21,816	~~25,188~~
Weighted average yield	—	-		—	-		—	-		2.01	~~2.05~~	%	2.01	~~2.05~~	%
Investments in mutual funds and other equities	—	-		—	-		—	-		1,892	~~1,993~~		1,892	~~1,993~~
Weighted average yield	—	-		—	-		—	-		3.41	~~4.16~~	%	3.41	~~4.16~~	%
Total	$	209,~~934~~481		$	8995,~~199~~954		$	5772,~~922~~719		$	~~204~~254,~~913~~388		$	~~372~~432,~~968~~542
Weighted average yield	2.08		%	1.38		%	2.88		%	2.22		%	2.13	~~2.11~~	%

Residential pass-through securities in the table above include both pooled mortgage-backed securities and high quality collateralized mortgage obligation structures, with a weighted average life of 34.59 years. These mortgage-related securities provide yield spread comparable to U.S. Treasuries or U.S. government agencies; however, the cash flows arising from them can be volatile due to prepayments of the underlying mortgage loans.

~~-37-~~Federal Home Loan Bank (FHLB) stock: FHLB stock totaled $7.2 million at December 31, 2013 and $7.4 million at December 31, 2012.

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Federal Home Loan Bank (FHLB) stock: FHLB stock totaled $7.4 million at December 31, 2012 and $7.6 million at December 31, 2011.

FHLB stock is carried at par and does not have a readily determinable fair value. Ownership of FHLB stock is restricted to the FHLB and member institutions, and can only be purchased and redeemed at par. The remaining restricted equity securities primarily represent investments in Pacific Coast Bankers’ Bancshares stock.

In September 2012, the FHLB of Seattle was notified by the Federal Housing Finance Agency (“Finance Agency”) that it is now classified as “adequately capitalized” as compared to the prior classification of “undercapitalized.” Under Finance Agency regulations, the FHLB of Seattle may repurchase excess capital stock under certain conditions, however they may not redeem stock or pay a dividend without Finance Agency approval. Based on the above, the Company has determined there is not an other-than-temporary impairment on the FHLB stock investment as of December 31, 2013.

Management periodically evaluates FHLB stock for other-than-temporary or permanent impairment. Management’s determination of whether these investments are impaired is based on its assessment of the ultimate recoverability of cost rather than by recognizing temporary declines in value. The determination of whether a decline affects the ultimate recoverability of the cost is influenced by criteria such as (1) the significance of any decline in net assets of the FHLB as compared to the capital stock amount of the FHLB and the length of time this situation has persisted, (2) the compliance with the minimum financial metrics required as part of the Consent Arrangement the FHLB has with the Finance Agency, (3) the impact of legislative and regulatory changes on institutions and, accordingly, the customer base of the FHLB and (4) the liquidity position of the FHLB.

Moody’s Investors Services rating of the FHLB of Seattle as Aaa was confirmed in August 2011, but a negative outlook was assigned as Moody’s revised the rating outlook to negative for U.S. government debt and all issuers Moody’s considers directly-linked to the U.S. government. Standard and Poors’ rating is AA+, but it also issued a negative outlook with the action reflecting the downgrade of the long-term sovereign credit rating of the U.S. in 2011. Based on the above, the Company has determined there is not an other-than-temporary impairment on the FHLB stock investment as of December 31~~, 2012.~~

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Non-Covered Loans: Interest and fees earned on the Company’s loan portfolio is the primary source of revenue. The Company attempts to balance the diversity of its portfolio, believing that this provides a good means of minimizing risk. Active portfolio management has resulted in solid loan growth and a diversified portfolio that is not heavily concentrated in any one industry or in any one community. The composition of the Company’s non-covered loan portfolio is as follows:

(dollars in thousands)		December 31,
	December 31,
		2012								2011								2010						2009								2008
(dollars in thousands)	2013							2012							2011						2010						2009
	Balance	~~Balance~~			% of total	~~% of total~~		Balance		~~Balance~~		% of total		~~% of total~~	Balance			~~Balance~~	% of total		~~% of total~~Balance			~~Balance~~% of total			Balance	~~% of total~~			% of total	~~Balance~~			~~% of total~~
Commercial	$	$179,914	~~162,481~~		20.3	%	~~19.1~~	%$	162,481	$	~~150,386~~	19.1	%		~~18.5~~$	%150,386		$	~~145,319~~18.5	%	$	~~17.5~~145,319	%	$17.5	~~93,295~~%		$	93,295	~~11.5~~	%	11.5	$%	~~94,490~~			~~11.5~~	%
Real estate mortgages:
One-to-four family residential	41,811		~~36,873~~		4.7	%	~~4.3~~	%36,873			~~40,331~~	4.3	%		~~5.0~~40,331	%			~~46,717~~5.0	%	46,717	~~5.6~~	%	5.6	~~53,313~~%		53,313		~~6.5~~	%	6.5	%	~~58,099~~			~~7.2~~	%
Multi-family and commercial	447,337		~~415,754~~		50.4	%	~~48.8~~	%415,754			~~370,782~~	48.8	%		~~45.7~~370,782	%			~~348,548~~45.7	%	348,548	~~41.9~~	%	41.9	~~360,745~~%		360,745		~~44.5~~	%	44.5	%	~~327,704~~			~~39.9~~	%
Total real estate mortgages	489,148		~~452,627~~		55.1	%	~~53.1~~	%452,627			~~411,113~~	53.1	%		~~50.7~~411,113	%			~~395,265~~50.7	%	395,265	~~47.5~~	%	47.5	~~414,058~~%		414,058		~~51.0~~	%	51.0	%	~~385,803~~			~~47.1~~	%
Real estate construction:
One-to-four family residential	33,928		~~46,472~~		3.8	%	~~5.5~~	%46,472			~~58,810~~	5.5	%		~~7.3~~58,810	%			~~72,945~~7.3	%	72,945	~~8.8~~	%	8.8	~~76,046~~%		76,046		~~9.4~~	%	9.4	%	~~100,170~~			~~12.2~~	%
Multi-family and commercial	22,320		~~34,926~~		2.6	%	~~4.1~~	%34,926			~~31,546~~	4.1	%		~~3.9~~31,546	%			~~42,664~~3.9	%	42,664	~~5.1~~	%	5.1	~~34,231~~%		34,231		~~4.2~~	%	4.2	%	~~45,285~~			~~5.5~~	%
Total real estate construction	56,248		~~81,398~~		6.4	%	~~9.6~~	%81,398			~~90,356~~	9.6	%		~~11.2~~90,356	%			~~115,609~~11.2	%	115,609	~~13.9~~	%	13.9	~~110,277~~%		110,277		~~13.6~~	%	13.6	%	~~145,455~~			~~17.7~~	%
Consumer:
Indirect	79,900		~~77,596~~		9.0	%	~~9.1~~	%77,596			~~80,396~~	9.1	%		~~9.9~~80,396	%			~~90,231~~9.9	%	90,231	~~10.8~~	%	10.8	~~100,697~~%		100,697		~~12.4~~	%	12.4	%	~~108,266~~			~~13.2~~	%
Direct	81,773		~~77,294~~		9.2	%	~~9.1~~	%77,294			~~78,726~~	9.1	%		~~9.7~~78,726	%			~~85,665~~9.7	%	85,665	~~10.3~~	%	10.3	~~93,051~~%		93,051		~~11.5~~	%	11.5	%	~~86,364~~			~~10.5~~	%
Total consumer	161,673		~~154,890~~		18.2	%	~~18.2~~	%154,890			~~159,122~~	18.2	%		~~19.6~~159,122	%			~~175,896~~19.6	%	175,896	~~21.1~~	%	21.1	~~193,748~~%		193,748		~~23.9~~	%	23.9	%	~~194,630~~			~~23.7~~	%
Subtotal	886,983		~~851,396~~		100.0	%	~~100.0~~	%851,396			~~810,977~~	100.0	%		~~100.0~~810,977	%			~~832,089~~100.0	%	832,089	~~100.0~~	%	100.0	~~811,378~~%		811,378		~~100.0~~	%	100.0	%	~~820,378~~			~~100.0~~	%
Deferred loan costs, net	1,703		~~1,738~~					1,738			~~1,853~~				1,853				~~2,204~~		2,204				~~2,474~~		2,474						~~2,690~~
Allowance for loan losses	(17,093		~~(17,147~~)	)				(17,147		)	~~(18,032~~	)			(18,032		)		~~(18,812~~	)	(18,812		)		~~(16,212~~	)	(16,212		)				~~(12,250~~	)
Total non-covered loans	$	$871,593	~~835,987~~					$	835,987	$	~~794,798~~				$	794,798		$	~~815,481~~		$	815,481		$	~~797,640~~		$	797,640				$	~~810,818~~

The Company’s loan portfolio is comprised of the following loan types:

§• Commercial Loans: Commercial loans include both secured and unsecured loans for working capital and expansion. Short-term working capital loans generally are secured by accounts receivable, inventory and/or equipment, while longer-term commercial loans are usually secured by equipment.

§• Real Estate Mortgage Loans: Real estate loans consist of two types: one-to-four family residential and commercial properties.

o◦ One-to-Four Family Residential Loans: One-to-four family residential loans are secured principally by 1st deeds of trust on residential properties principally located within the Company’s market area.

o◦ Commercial Real Estate Loans: Commercial real estate loans are secured principally by manufacturing facilities, apartment buildings and commercial buildings for office, storage and warehouse space. Loans secured by commercial real estate may involve a greater degree of risk than one-to-four family residential loans. Payments on such loans are often dependent on business cash flows or third party lease payments.

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The composition of the commercial real estate loan portfolio by loan type is as follows:

(dollars in thousands)	2012						2011							2010							2009						2008
	December 31,
	Balance		% of total				Balance			% of total				Balance				% of total			Balance			% of total			Balance		% of total
(dollars in thousands)	2013					2012						2011							2010					2009
Commercial real estate:
	Balance		% of total			Balance			% of total			Balance				% of total			Balance			% of total		Balance			% of total
Office	$	109,152		26.3	%		$	103,470			27.9	%		$	90,875				26.1	%	$	113,694			31.5	%	$	109,917		33.5	%
Commercial real estate:
Retail		138,356		33.3	%			133,949			36.1	%			135,191				38.8	%		144,102			39.9	%		127,687		39.0	%
Office	$	131,396	29.4	%		$	109,152		26.3	%		$	103,470			27.9	%		$	90,875		26.1	%	$	113,694		31.5	%
Industrial		98,295		23.6	%			73,003			19.7	%			58,520				16.8	%		57,545			16.0	%		41,871		12.8	%
Retail	141,049		31.5	%		138,356			33.3	%		133,949				36.1	%		135,191			38.8	%	144,102			39.9	%
Hospitality		29,880		7.2	%			22,090			6.0	%			22,208				6.4	%		21,659			6.0	%		21,502		6.6	%
Industrial	96,984		21.7	%		98,295			23.6	%		73,003				19.7	%		58,520			16.8	%	57,545			16.0	%
Other		40,071		9.6	%			38,270			10.3	%			41,754				11.9	%		23,745			6.6	%		26,727		8.1	%
Hospitality	31,966		7.1	%		29,880			7.2	%		22,090				6.0	%		22,208			6.4	%	21,659			6.0	%
Total commerical
Other	45,942		10.3	%		40,071			9.6	%		38,270				10.3	%		41,754			11.9	%	23,745			6.6	%
real estate	$	415,754		100.0	%		$	370,782			100.0	%		$	348,548				100.0	%	$	360,745			100.0	%	$	327,704		100.0	%
Total commercial real estate	$	447,337	100.0	%		$	415,754		100.0	%		$	370,782			100.0	%		$	348,548		100.0	%	$	360,745		100.0	%

The composition of the commercial real estate loan portfolio by occupancy type is as follows:

(dollars in thousands)	2012						2011							2010							2009						2008
	December 31,
	Balance		% of total				Balance			% of total				Balance				% of total			Balance			% of total			Balance		% of total
(dollars in thousands)	2013					2012						2011							2010					2009
Commercial real estate:
	Balance		% of total			Balance			% of total			Balance				% of total			Balance			% of total		Balance			% of total
Owner occupied	$	210,149		50.5	%		$	210,681			56.8	%		$	190,351				54.6	%	$	183,137			50.8	%	$	172,258		52.6	%
Commercial real estate:
Non-owner occupied		205,605		49.5	%			160,101			43.2	%			158,197				45.4	%		177,608			49.2	%		155,446		47.4	%
Owner occupied	$	240,721	53.8	%		$	210,149		50.5	%		$	210,681			56.8	%		$	190,351		54.6	%	$	183,137		50.8	%
Total commerical
Non-owner occupied	206,616		46.2	%		205,605			49.5	%		160,101				43.2	%		158,197			45.4	%	177,608			49.2	%
real estate	$	415,754		100.0	%		$	370,782			100.0	%		$	348,548				100.0	%	$	360,745			100.0	%	$	327,704		100.0	%
Total commercial real estate	$	447,337	100.0	%		$	415,754		100.0	%		$	370,782			100.0	%		$	348,548		100.0	%	$	360,745		100.0	%

§• Real Estate Construction Loans: Real estate construction loans consist of four types: 1) commercial real estate, 2) one-to-four family residential construction, 3) land development and 4) raw land.

o◦ Commercial Real Estate: Commercial real estate construction loans are primarily for owner-occupied properties.

o◦ One-to-Four Family Residential: One-to-four family residential construction loans are for the construction of custom homes, where the homeowner is the borrower.

o◦ Land Development: Land development loans are principally secured by land, which has been improved with the installation of utilities and infrastructure, to support building construction.

o◦ Raw Land: Raw land loans are principally secured by unimproved land where the borrower intends future development of the property.

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The composition of the real estate construction loan portfolio is as follows:

(dollars in thousands)	2012						2011							2010							2009						2008
	December 31,
	Balance		% of total				Balance			% of total				Balance				% of total			Balance			% of total			Balance		% of total
(dollars in thousands)	2013					2012						2011							2010					2009
Real estate construction:
	Balance		% of total			Balance			% of total			Balance				% of total			Balance			% of total		Balance			% of total
Commerical	$	25,693		31.6	%		$	16,252			18.0	%		$	26,134				22.6	%	$	13,805			12.5	%	$	22,344		15.4	%
Real estate construction:
Residential		8,027		9.9	%			10,805			12.0	%			11,900				10.3	%		11,867			10.8	%		26,315		18.1	%
Commercial	$	7,471	13.3	%		$	25,693		31.6	%		$	16,252			18.0	%		$	26,134		22.6	%	$	13,805		12.5	%
Land development
Residential	6,925		12.3	%		8,027			9.9	%		10,805				12.0	%		11,900			10.3	%	11,867			10.8	%
commercial		1,603		1.9	%			5,043			5.6	%			5,876				5.1	%		6,608			6.0	%		8,965		6.2	%
Land development commercial	3,680		6.5	%		1,603			1.9	%		5,043				5.6	%		5,876			5.1	%	6,608			6.0	%
Land development
Land development residential	17,752		31.6	%		25,230			31.0	%		29,358				32.5	%		37,467			32.4	%	37,623			34.1	%
residential		25,230		31.0	%			29,358			32.5	%			37,467				32.4	%		37,623			34.1	%		35,767		24.6	%
Raw land commercial	11,169		19.9	%		7,631			9.4	%		10,251				11.3	%		10,653			9.2	%	13,087			11.9	%
Raw land commercial		7,631		9.4	%			10,251			11.3	%			10,653				9.2	%		13,087			11.9	%		12,343		8.5	%
Raw land residential	9,251		16.4	%		13,214			16.2	%		18,647				20.6	%		23,579			20.4	%	27,287			24.7	%
Raw land residential		13,214		16.2	%			18,647			20.6	%			23,579				20.4	%		27,287			24.7	%		38,088		26.2	%
Total real estate construction	$	56,248	100.0	%		$	81,398		100	%		$	90,356			100	%		$	115,609		100	%	$	110,277		100	%
Other		-		-				-			-				-				-			-			-			1,633		1.0	%
Total real estate
construction	$	81,398		100.0	%		$	90,356			100.0	%		$	115,609				100.0	%	$	110,277			100.0	%	$	145,455		100.0	%

§• Consumer Loans: The Company’s consumer loan portfolio consists of automobile loans, boat and recreational vehicle financing, home equity and home improvement loans, and miscellaneous secured and unsecured personal loans.

o◦ Direct Consumer Loans: Direct consumer loans consist of automobile loans, boat and recreational vehicle financing, home equity and home improvement loans, and miscellaneous secured and unsecured personal loans originated directly by the Bank’s loan officers.

o◦ Indirect Consumer Loans: The Company makes loans for new and used automobile and recreational vehicles that are originated indirectly by selected dealers located in the Company’s market areas. The Company has limited its indirect loan purchases primarily to dealerships that are established and well known in their market areas and to applicants that are not classified as sub-prime.

The Company makes certain loans which are guaranteed by the SBA. The SBA, an independent agency of the federal government, provides loan guarantees to qualifying small and medium sized businesses for up to 85% of the principal loan amount. The Company generally sells the guaranteed portion of each loan to investors in the secondary market. The guaranteed portion of an SBA loan is generally sold at a premium. In ~~2012~~2013, the Company sold total guaranteed portions of SBA loans in the amount of $57.08 million, compared with $15.70 million in ~~2011~~2012. The Company retains the unguaranteed portion of the loan. The retained portion of the SBA loan is classified within the portfolio by loan type.

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Specific types of loans within the Company’s portfolio are more sensitive to interest rate changes. Commercial and real estate construction loan interest rates are primarily based upon current market rates plus a basis point spread charged by the Company. To better understand the Company’s risk associated with these loans, the following table sets forth the maturities by loan type at December 31, 2013:

(dollars in thousands)	Maturing
	Within 1 year		1 - 5 years		After 5 years		Total
Commercial	$	54,~~264~~426	$	5960,~~957~~017	$	4865,~~260~~471	$	~~162~~179,~~481~~914
Real estate construction:
One-to-four family residential	17,327	~~25,410~~	14,765	~~20,084~~	1,836	~~978~~	33,928	~~46,472~~
Multi-family and commercial	1,271	~~12,276~~	4,418	~~1,380~~	16,631	~~21,270~~	22,320	~~34,926~~
Total real estate construction	18,598	~~37,686~~	19,183	~~21,464~~	18,467	~~22,248~~	56,248	~~81,398~~
Total	$	9173,~~950~~024	$	8179,~~421~~200	$	7083,~~508~~938	$	~~243~~236,~~879~~162
Fixed-rate loans	$	2313,~~237~~564	$	4742,~~787~~043	$	812,~~576~~369	$	7967,~~600~~976
Variable-rate loans	59,460	~~68,713~~	37,157	~~33,634~~	71,569	~~61,932~~	168,186	~~164,279~~
Total	$	9173,~~950~~024	$	8179,~~421~~200	$	7083,~~508~~938	$	~~243~~236,~~879~~162

At December 31, ~~2012~~2013, approximately 6973% of these variable rate loans had an interest rate floor in place.

Covered Loans: The composition of the Company’s covered loan portfolio is as follows:



(dollars in thousands)	December 31,
	2013			2012			2011			2010
Commercial	$	17,285		$	29,011		$	43,588		$	32,837
Real estate mortgages:
One-to-four family residential	10,969			14,195			15,753			17,724
Multi-family residential and commercial	122,072			184,583			230,310			282,034
Total real estate mortgages	133,041			198,778			246,063			299,758
Real estate construction:
One-to-four family residential	1,327			7,764			11,875			70,885
Multi-family and commercial	9,243			18,743			34,470			78,679
Total real estate construction	10,570			26,507			46,345			149,564
Consumer - direct	6,796			10,219			14,768			22,626
Subtotal	167,692			264,515			350,764			504,785
Fair value discount	(15,737		)	(47,176		)	(81,683		)	(138,632		)
Total covered loans	151,955			217,339			269,081			366,153
Allowance for loan losses	(14,622		)	(3,252		)	(870		)	(1,336		)
Total covered loans, net	$	137,333		$	214,087		$	268,211		$	364,817

On April 16, 2010, the Bank acquired certain assets and assumed certain liabilities of City Bank, Lynnwood, Washington, from the Federal Deposit Insurance Corporation (“FDIC”), as receiver of City Bank, in an FDIC-assisted transaction. As part of the Purchase and Assumption Agreement, the Bank and the FDIC entered into loss share agreements (each, a “loss share agreement” and collectively, the “loss share agreements”). The Bank will share in the losses, which begins with the Bank incurring the first 2% of losses, on the covered assets. After the first 2% of losses on covered assets, the FDIC will absorb 80% of losses and share in 80% of loss recoveries on 100% of the covered loan portfolio. The loss share agreement for commercial and single family residential mortgage loans are in effect for five years and ten years, respectively, from the April 16, 2010 acquisition date and the loss recovery provisions for such loans are in effect for eight years and ten years, respectively, from the acquisition date.

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In April 2020, approximately ten years following the acquisition date, the Bank is required to make a payment to the FDIC in the event that losses on covered assets under the loss share agreements have been less than the stated threshold level. The payment amount will be 50% of the excess, if any, of (i) 20% of the intrinsic loss estimate ($111.0 million) minus (ii) the sum of (a) 25% of the asset discount (or 25% of the asset discount of ($50.7 million)), plus (b) 25% of cumulative loss share payments (as defined in the Agreement), plus (c) the cumulative servicing amount received by the Bank from the FDIC on covered assets. The Bank recorded an estimated liability of $913 thousand under this provision at December 31, 2013.

On September 24, 2010, the Bank assumed certain deposit liabilities and acquired certain assets of North County Bank, Arlington, Washington from the FDIC as receiver for North County Bank and entered into a Purchase and Assumption Agreement with the FDIC. As part of the Agreement, the Bank and the FDIC entered into a loss sharing arrangement covering future losses incurred on acquired or “covered” loans and other real estate owned (“OREO”). On single family loans and OREO, the FDIC will absorb: (i) 80% of losses on the first $7.8 million of losses incurred; (ii) 0% of losses on $7.8 million to $12.3 million of losses incurred; and (iii) 80% of losses above $12.3 million of losses incurred. On commercial and non-single family loans and OREO, the FDIC will absorb: (i) 80% of losses on the first $33.9 million of losses incurred; (ii) 0% of losses on $33.9 million to $47.9 million of losses incurred; and (iii) 80% of losses above $47.9 million of losses incurred. The FDIC will share in loss recoveries on the covered loan and OREO portfolio.

In September 2020, approximately ten years following the acquisition date, the Bank is required to make a payment to the FDIC in the event that losses on covered assets under the loss share agreements have been less than the stated threshold level. The payment amount will be 50% of the excess, if any, of (i) 20% of the intrinsic loss estimate ($46.9 million) minus (ii) the sum of (a) 20% of the net loss amount, plus (b) 25% of the asset discount bid ($62.5 million), plus (c) 3.5% of total loss share assets at acquisition. The Bank recorded an estimated liability of $4.2 million under this provision at December 31, 2013.

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Credit Risks and Asset Quality

Credit Risks: The extension of credit, in the form of loans or other credit substitutes, to individuals and businesses is a major portion of the Company’s principal business activity. Company policies and applicable laws and regulations require risk analysis as well as ongoing portfolio and credit management.

The Company manages its credit risk through lending limits, credit review, approval policies and extensive, ongoing internal monitoring. Through this monitoring process, nonperforming loans are identified. Nonperforming assets consist of nonaccrual loans, nonaccruing restructured loans, past due loans and other real estate owned. Additional information on nonperforming assets is provided in Item 8- Financial Statements and Supplementary Data, Note (1) Significant Accounting Policies of the consolidated financial statements. Nonperforming assets are assessed for potential loss exposure on an individual or homogeneous group basis. Further details on the loss analysis are provided in the Allowance for Loan Losses section.

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The following table summarizes the Company’s nonperforming non-covered assets for the past five years:

(dollars in thousands)		December 31,
	December 31,
		2012				2011				2010				2009				2008
(dollars in thousands)	2013				2012				2011				2010				2009
Non-covered nonperforming loans	$	$8,409	~~15,551~~		$	$15,551	~~22,100~~		$	$22,100	~~25,846~~		$	$25,846	~~3,395~~		$	$3,395	~~1,918~~
Non-covered other real estate owned	3,067		~~3,023~~		3,023		~~1,976~~		1,976		~~4,122~~		4,122		~~4,549~~		4,549		~~2,226~~
Total non-covered nonperforming assets	$	$11,476	~~18,574~~		$	$18,574	~~24,076~~		$	$24,076	~~29,968~~		$	$29,968	~~7,944~~		$	$7,944	~~4,144~~
Restructured loans (1)		$	26,303			$	26,493			$	19,936			$	-			$	-
Restructured Loans (1)	$	24,409			$	26,303			$	26,493			$	19,936			$	—
Total non-covered impaired loans	$	$32,818	~~41,854~~		$	$41,854	~~48,593~~		$	$48,593	~~45,782~~		$	$45,782	~~3,395~~		$	$3,395	~~1,918~~
Non-covered accruing loans past due 90
Non-covered accruing loans past due 90 days or more	$	—			$	—			$	—			$	—			$	—
days or more		$	-			$	-			$	-			$	-			$	1
Non-covered potential problem loans (2)	$	798			$	2,601			$	2,179			$	5,178			$	4,586
Non-covered potential problem loans (2)		$	2,601			$	2,179			$	5,178			$	4,586			$	5,168
Allowance for loan losses	$	17,093			$	17,147			$	18,032			$	18,812			$	16,212
Allowance for loan losses		$	17,147			$	18,032			$	18,812			$	16,212			$	12,250
Non-covered nonperforming loans to total gross
Non-covered nonperforming loans to total
non-covered loans	0.95		%		1.82		%		2.72		%		3.10		%		0.42		%
non-covered loans			1.82	%			2.72	%			3.10	%			0.42	%			0.23	%
Allowance for loan losses to total gross non-covered loans	1.92		%		2.01		%		2.22		%		2.25		%		1.99		%
Allowance for loan losses to total non-covered loans			2.01	%			2.22	%			2.25	%			1.99	%			1.49	%
Allowance for loan losses to total non-covered
Allowance for loan losses to non-covered
nonperforming loans	203.27		%		110.26		%		81.59		%		72.79		%		477.53		%
nonperfoming loans			110.26	%			81.59	%			72.79	%			477.53	%			638.69	%
Non-covered nonperforming assets to total assets	0.68		%		1.10		%		1.44		%		1.76		%		0.76		%
Non-covered nonperforming assets to total assets			1.10	%			1.44	%			1.76	%			0.76	%			0.46	%

^{(1) Represents accruing restructured loans performing according to their restructured terms.}

^{(2) Potential problem loans represent loans where known information about possible credit problems of borrowers causes management to have serious doubts about the ability of such borrowers to comply with the present loan repayment terms but the loans do not presently meet the criteria to be classified as impaired.}

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Asset Quality: The following table sets forth historical information regarding the Company's net charge-offs and average non-covered loans for the past five years:

(dollars in thousands)	December 31,
	2012			2011			2010			2009			2008
	2013			2012			2011			2010			2009
Indirect net charge-offs	$	~~391~~325		$	~~626~~391		$	~~954~~626		$	~~1,574~~954		$	1,~~440~~574
Other net charge-offs	1,604	~~7,594~~		7,594	~~10,654~~		10,654	~~8,596~~		8,596	~~4,664~~		4,664	~~2,486~~
Total net charge-offs	$	71,~~985~~929		$	117,~~280~~985		$	911,~~550~~280		$	69,~~238~~550		$	36,~~926~~238
Average indirect loans	$	8180,~~043~~118		$	8881,~~054~~043		$	9888,~~360~~054		$	~~104~~98,~~871~~360		$	~~110~~104,~~536~~871
Average other loans	777,329	~~738,335~~		738,335	~~737,574~~		737,574	~~730,800~~		730,800	~~714,830~~		714,830	~~708,038~~
Total average loans (1)	$	~~819~~857,~~378~~447		$	~~825~~819,~~628~~378		$	~~829~~825,~~160~~628		$	~~819~~829,~~701~~160		$	~~818~~819,~~574~~701
Indirect net charge-offs to average
Indirect net charge-offs to average indirect loans	0.41		%	0.48		%	0.71		%	0.97		%	1.50		%
indirect loans		0.48	%		0.71	%		0.97	%		1.50	%		1.30	%
Other net charge-offs to average other loans	0.21		%	1.03		%	1.44		%	1.18		%	0.65		%
Other net charge-offs to average
Net charge-offs to average loans	0.22		%	0.97		%	1.37		%	1.15		%	0.76		%
other loans		1.03	%		1.44	%		1.18	%		0.65	%		0.35	%
Net charge-offs to average loans		0.97	%		1.37	%		1.15	%		0.76	%		0.48	%

^{(1) Excludes average loans held for sale.}

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Allowance for Loan Losses

The allowance for loan losses is maintained at a level considered adequate by management to provide for potential loan losses inherent in the portfolio. The Company assesses the allowance for loan losses on a quarterly basis. The Company's methodology for making such assessments and determining the adequacy of the allowance includes the following key elements:

·• Specific Allowances: A specific allowance is established when management has identified unique or particular risks that are related to a specific loan that demonstrate risk characteristics consistent with impairment. Specific allowances may also be established to address the unique risks associated with a group of loans or particular type of credit exposure.

·• Formula Allowance: The calculations of expected loss rates are determined utilizing a two factor approach; loss given default (“LGD”) and probability of default (“PD”). Taken together, these two factors produce the expected loss rate.

§◦ LGD is defined as the rate of loss as determined by dividing the expected net charge-off by defaulted loans, where defaulted loans are defined as loans that have 30 days or greater payment delinquency plus non-accrual and gross loans charged off. LGD rates utilized reflect industry experience as determined by state and loan type, and are based upon banks with total assets below $1 billion. Banks falling into these size and state groupings will better capture state/geographic differences that occur in LGD rates, as well as provide a sufficient number of observations to be statistically meaningful. LGD rates are based upon industry experience starting in 1992 and applied at a two standard deviation level. Bank specific LGD rates are utilized when there are sufficient observations to generate a meaningful result, and these observations should include at least three observations as observed over a minimum of at least one full economic cycle for each type/sector/subsector/geographic combination to be considered meaningful.

§◦ PD is defined as the actual payment default rate (defined as the number of times a loan has been delinquent 30 or more days divided by the number of months the loan has been outstanding from the origination date to the valuation date), or for loans which have not generated an actual payment default rate, the rate applied is based upon industry experience for such loans as applied by loan type and state in which the loan applies to (in the case of real estate loans, the state determination is based upon were the collateral resides), where the expected payment default rate is defined as the sum loans where payment delinquencies are 30 or more days delinquent, plus non-accrual and gross loans charged off divided by total loans for each group. Expected payment default rates are then scaled against the bank’s loan risk grades with the bank’s lowest pass/non-watch grade set to equal the industry PD and then scaled lower or higher against the bank’s remaining loan grades.

Management believes that the allowance for loan losses was adequate as of December 31, 2012. There is, however, no assurance that future loan losses will not exceed the levels provided for in the allowance for loan losses and could possibly result in additional charges to the provision for loan and lease losses. In addition, bank regulatory authorities, as part of their periodic examination of the Bank, may require additional charges to the provision for loan and lease losses in future periods if warranted as a result of their review. Approximately 87% of our loan portfolio is secured by real estate, and a significant decline in real estate market values may require an increase in the allowance for loan and lease losses. The U.S. recession, the housing market downturn and declining real estate values in our markets have negatively impacted aspects of our residential development, commercial real estate, commercial construction and commercial loan portfolios. A continued deterioration in our markets may adversely affect our loan portfolio and may lead to additional charges to the provision for loan losses.38

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Management believes that the allowance for loan losses was adequate as of December 31, 2013. There is, however, no assurance that future loan losses will not exceed the levels provided for in the allowance for loan losses and could possibly result in additional charges to the provision for loan and lease losses. In addition, bank regulatory authorities, as part of their periodic examination of the Bank, may require additional charges to the provision for loan and lease losses in future periods if warranted as a result of their review. Approximately 82% of our loan portfolio is secured by real estate, and a significant decline in real estate market values may require an increase in the allowance for loan and lease losses. The U.S. recession, the housing market downturn and declining real estate values in our markets have negatively impacted aspects of our residential development, commercial real estate, commercial construction and commercial loan portfolios. A continued deterioration in our markets may adversely affect our loan portfolio and may lead to additional charges to the provision for loan losses.

The following table sets forth historical information regarding changes in the Company's allowance for loan losses:

(dollars in thousands)	December 31,	~~Years Ended December 31,~~
		2012				2011				2010				2009				2008
	2013				2012				2011				2010				2009
Balance at beginning of period	$	$17,147	~~18,032~~		$	$18,032	~~18,812~~		$	$18,812	~~16,212~~		$	$16,212	~~12,250~~		$	$12,250	~~11,126~~
Provision for non-covered loan losses	1,875		~~7,100~~		7,100		~~10,500~~		10,500		~~12,150~~		12,150		~~10,200~~		10,200		~~5,050~~
Charge-offs:
Commercial	(562		~~(1,640~~)	)	(1,640		~~(1,707~~)	)	(1,707		~~(2,071~~)	)	(2,071		~~(964~~)	)	(964		~~(1,902~~)	)
Real estate mortgage	(225		~~(3,311~~)	)	(3,311		~~(8,547~~)	)	(8,547		~~(2,868~~)	)	(2,868		~~(1,640~~)	)	(1,640		~~(392~~)	)
Real estate construction	(70		~~(2,706~~)	)	(2,706		~~(144~~)	)	(144		~~(3,516~~)	)	(3,516		~~(2,600~~)	)	(2,600		~~(163~~)	)
Consumer
Consumer:
Direct	(1,766		~~(725~~)	)	(725		~~(1,335~~)	)	(1,335		~~(632~~)	)	(632		~~(650~~)	)	(650		~~(925~~)	)
Indirect	(673		~~(801~~)	)	(801		~~(1,208~~)	)	(1,208		~~(1,691~~)	)	(1,691		~~(2,416~~)	)	(2,416		~~(2,022~~)	)
Total charge-offs	(3,296		~~(9,183~~)	)	(9,183		~~(12,941~~)	)	(12,941		~~(10,778~~)	)	(10,778		~~(8,270~~)	)	(8,270		~~(5,404~~)	)
Recoveries:
Commercial	235		~~248~~		248		~~269~~		269		~~214~~		214		~~655~~		655		~~553~~
Real estate mortgage	183		~~438~~		438		~~688~~		688		47		47		~~359~~		359		61
Real estate construction	442		11		11		2		2		~~131~~		131		48		48		~~121~~
Consumer
Consumer:
Direct	159		91		91		~~120~~		120		99		99		~~128~~		128		~~161~~
Indirect	348		~~410~~		410		~~582~~		582		~~737~~		737		~~842~~		842		~~582~~
Total recoveries	1,367		~~1,198~~		1,198		~~1,661~~		1,661		~~1,228~~		1,228		~~2,032~~		2,032		~~1,478~~
Net charge-offs	(1,929		~~(7,985~~)	)	(7,985		~~(11,280~~)	)	(11,280		~~(9,550~~)	)	(9,550		~~(6,238~~)	)	(6,238		~~(3,926~~)	)
Balance at end of period	$	$17,093	~~17,147~~		$	$17,147	~~18,032~~		$	$18,032	~~18,812~~		$	$18,812	~~16,212~~		$	$16,212	~~12,250~~

The following table shows the allocation of the allowance for loan losses, by loan type, for the past five years:

(dollars in thousands)	December 31,	~~December 31,~~
		2012							2011							2010						2009							2008
	2013						2012							2011					2010					2009
	Amount	~~Amount~~		% of Loans (1)	~~% of Loans (1)~~		Amount		~~Amount~~		% of Loans (1)		~~% of Loans (1)~~	Amount		~~Amount~~	% of Loans (1)		~~% of Loans (1)~~Amount			~~Amount~~% of Loans (1)		Amount	~~% of Loans (1)~~			% of Loans (1)	~~Amount~~		~~% of Loans (1)~~
Commercial	$	$4,323	~~4,405~~	20.3	%	~~19.1~~	%$	4,405	$	~~4,034~~	19.1	%		~~18.5~~$	%4,034	$	~~3,915~~18.5	%	$	~~17.5~~3,915	%	$17.5	~~1,515~~%	$	1,515	~~11.5~~	%	11.5	$%	~~1,124~~		~~11.5~~	%
Real estate mortgage	6,827		~~6,516~~	55.1	%	~~53.1~~	%6,516			~~6,500~~	53.1	%		~~50.7~~6,500	%		~~6,507~~50.7	%	6,507	~~47.5~~	%	47.5	~~8,060~~%	8,060		~~51.0~~	%	51.0	%	~~5,426~~		~~47.1~~	%
Real estate construction	3,050		~~3,050~~	6.4	%	~~9.6~~	%3,050			~~4,046~~	9.6	%		~~11.2~~4,046	%		~~4,947~~11.2	%	4,947	~~13.9~~	%	13.9	~~2,330~~%	2,330		~~13.6~~	%	13.6	%	~~2,258~~		~~17.7~~	%
Consumer	2,893		~~3,176~~	18.2	%	~~18.2~~	%3,176			~~3,452~~	18.2	%		~~19.6~~3,452	%		~~3,443~~19.6	%	3,443	~~21.1~~	%	21.1	~~4,307~~%	4,307		~~23.9~~	%	23.9	%	~~3,313~~		~~23.7~~	%
Unallocated			-			-				-				-			-			-			-			-				129		-
Total	$	17,093		100.0	%		$	17,147			100.0	%		$	18,032		100.0	%	$	18,812		100.0	%	$	16,212			100.0	%
Total		$	17,147			100.0	%		$	18,032				100.0	%	$	18,812			100.0	%	$	16,212			100.0	%		$	12,250		100.0	%

^{(1) Represents the total of outstanding loans in each category as a percent of total loans outstanding.}

~~The allocation of the allowance for loan losses should not be interpreted as an indication of specific amounts or loan categories in which future charge-offs may occur.~~39

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(dollars in thousands)	December 31,
	2012					2011					2010
	Average balance		Average rate			Average balance		Average rate			Average balance		Average rate
Interest-bearing demand and MMA deposits	$	611,477		0.22	%	$	581,189		0.41	%	$	439,302		0.59	%
Savings deposits		105,085		0.10	%		96,892		0.21	%		74,922		0.25	%
Time deposits		497,812		1.03	%		606,771		1.14	%		599,673		1.38	%
Total interest-bearing deposits		1,214,374		0.54	%		1,284,852		0.74	%		1,113,897		1.00	%
Demand and other noninterest-bearing deposits		243,522					202,297					158,399
Total average deposits	$	1,457,896				$	1,487,149				$	1,272,296

The allocation of the allowance for loan losses should not be interpreted as an indication of specific amounts or loan categories in which future charge-offs may occur.

Deposits: In 2013, the Company focused its efforts on maintaining its deposit base through competitive pricing and delivery of quality service. Additional information regarding deposits is provided in Item 8- Financial Statements and Supplementary Data, Note (11) Deposits.



(dollars in thousands)	December 31,
	2013				2012				2011
	Average balance		Average rate		Average balance		Average rate		Average balance		Average rate
Interest-bearing demand and MMA deposits	$	647,965	0.16	%	$	611,477	0.22	%	$	581,189	0.41	%
Savings deposits	119,518		0.05	%	105,085		0.10	%	96,892		0.21	%
Time deposits	403,478		0.95	%	497,812		1.03	%	606,771		1.14	%
Total interest-bearing deposits	1,170,961		0.42	%	1,214,374		0.54	%	1,284,852		0.74	%
Demand and other noninterest-bearing deposits	257,314				243,522				202,297
Total average deposits	$	1,428,275			$	1,457,896			$	1,487,149

Wholesale Deposits: The following table further details wholesale deposits, which are included in total deposits shown above:

(dollars in thousands)	December 31,
	2012							2011								2010
	2013						2012							2011
	Balance			% of total			Balance	~~Balance~~			% of total	~~% of total~~		Balance		~~Balance~~		% of total		~~% of total~~
Mutual fund money market deposits	14,704	~~14,704~~		97.8	~~53.9~~%	%	14,704		~~24,704~~		53.9	%	~~75.1~~	%24,704			~~24,704~~	75.1	%		~~72.9~~	%
CDARS deposits	327	~~12,579~~		2.2	~~46.1~~%	%	12,579		~~8,174~~		46.1	%	~~24.9~~	%8,174			~~9,206~~	24.9	%		~~27.1~~	%
Total wholesale deposits	$	2715,~~283~~031		100.0	~~100.0~~%	%	$	$27,283	~~32,878~~		100.0	%	~~100.0~~	%$	32,878	$	~~33,910~~	100.0	%		~~100.0~~	%
Wholesale deposits to total deposits	1.0	~~1.9~~	%				1.9		~~2.2~~%	%				2.2		%	~~2.3~~	%

Mutual fund money market deposits are obtained from an intermediary that provides cash sweep services to broker-dealers and clearing firms. Currently, the Company anticipates limiting the growth of these types of deposits. The deposits are payable upon demand.

Certificate Deposit Account Registry System (“CDARS”) deposits are obtained through a broker and represent a reciprocal agreement, whereby the Company obtains a portion of time deposits from another financial institution, not to exceed $250,000 per customer. In return, the other financial institution obtains a portion of the Company’s time deposits. All CDARS deposits represent direct customer relationships with the Company, but for regulatory purposes are required to be classified as brokered deposits. Deposit maturities range between four weeks and twenty four months.

Although a significant amount of time deposits will mature and reprice in the next twelve months, the Company expects to retain the majority of such deposits. In the short term, time deposits have limited impact on the liquidity of the Company and these deposits can generally be retained and expanded with increases in rates paid which might, however, increase the cost of funds more than anticipated.

~~-46-~~The following table sets forth the amounts and maturities of time deposits:



(dollars in thousands)	December 31, 2013
	Less than 3 months		3 - 6 months		6 to 12 months		Over 12 months		Total
Time deposits of $100,000 or more	$	24,180	$	21,578	$	63,701	$	47,083	$	156,542
All other time deposits	30,570		35,917		87,874		48,747		203,108
Total	$	54,750	$	57,495	$	151,575	$	95,830	$	359,650

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~~The~~Borrowings: ~~following~~Total ~~table~~borrowings ~~sets~~outstanding ~~forth~~totaled ~~the~~$25.8 ~~amounts~~million at December 31, 2013 and ~~maturities~~2012, and represents junior subordinated debentures. The Company’s sources of ~~time~~funds ~~deposits~~from atborrowings ~~December~~consist 31of borrowings from correspondent banks, ~~2012:~~the FHLB, the Federal Reserve Bank and junior subordinated debentures.

(dollars in thousands)	December 31, 2012
	Less than 3 months		3 - 6 months		6 to 12 months		Over 12 months		Total
Time deposits of $100,000 or more	$	42,693	$	29,403	$	48,861	$	79,632	$	200,589
All other time deposits		40,040		43,457		59,348		104,464		247,309
Total	$	82,733	$	72,860	$	108,209	$	184,096	$	447,898

•

FHLB Overnight Borrowings and Other Borrowed Funds: The Company can use advances from the FHLB to supplement funding needs. The FHLB provides credit for member financial institutions in the form of overnight borrowings, short term and long term advances. As a member, the Bank is required to own capital stock in the FHLB and is authorized to apply for advances on the pledge of certain of its mortgage loans and other assets (principally, securities which are obligations of, or guaranteed by, the United States) provided certain standards related to creditworthiness have been met.

~~Borrowings:~~At ~~Total~~December ~~borrowings~~31, ~~outstanding~~2013 ~~totaled~~and ~~$25.8~~2012, ~~million~~the atCompany had no outstanding overnight borrowings. At December 31, ~~2012~~2013, ~~and~~the ~~2011,~~Company ~~and~~had ~~represents~~an ~~junior~~unused ~~subordinated~~line ~~debentures~~of credit of $201. ~~The~~2 ~~Company’s~~million, ~~sources~~subject ofto ~~funds~~certain ~~from~~collateral ~~borrowings~~and ~~consist~~stock ofrequirements. Additional information regarding FHLB borrowings ~~from~~is ~~correspondent~~provided ~~banks,~~in ~~the~~Item ~~FHLB~~8- Financial Statements and Supplementary Data, ~~the~~Note ~~Federal~~(12) ~~Reserve~~FHLB ~~Bank~~Borrowings and ~~junior~~Fed ~~subordinated~~Funds ~~debentures~~Purchased.

§• ~~FHLB~~Federal ~~Overnight Borrowings and Other Borrowed~~ Funds Purchased: The Company ~~can~~also ~~use~~uses ~~advances~~lines ~~from~~of ~~the~~credit ~~FHLB~~at tocorrespondent ~~supplement~~banks ~~funding~~to ~~needs.~~purchase ~~The~~federal ~~FHLB~~funds ~~provides credit~~ for ~~member financial institutions in the form of overnight borrowings,~~ short -term ~~and long term advances~~funding. AsThere awere ~~member,~~no ~~the~~outstanding ~~Bank~~borrowings isat ~~required~~December to31, ~~own~~2013 ~~capital stock in the FHLB~~ and is2012. ~~authorized~~Available toborrowings ~~apply~~under ~~for~~these ~~advances~~lines ~~on the pledge~~ of ~~certain~~credit oftotaled ~~its~~$45.0 ~~mortgage~~million ~~loans~~at ~~and~~December ~~other assets (principally~~31, ~~securities which are obligations of, or guaranteed by, the United States) provided certain standards related to creditworthiness have been met~~2013.

At• ~~December~~Federal ~~31,~~Reserve ~~2012~~Bank ~~and~~Overnight ~~2011,~~Borrowings: ~~the~~The Company ~~had~~can nouse ~~outstanding~~advances ~~overnight~~from ~~borrowings. At~~the ~~December~~Federal ~~31,~~Reserve ~~2012,~~Bank ~~the~~(“FRB”) ~~Company~~of ~~had~~San anFrancisco ~~unused~~to ~~line~~supplement offunding needs. The FRB provides credit for financial institutions in the form of ~~$153~~overnight borrowings.0 ~~million,~~The ~~subject~~Bank is required to pledge certain ~~collateral~~of its loans and ~~stock~~other ~~requirements.~~assets ~~Additional~~(principally, ~~information~~securities ~~regarding~~which ~~FHLB~~are ~~borrowings~~obligations isof, or guaranteed by, the United States) provided incertain ~~Item~~standards 8-related ~~Financial~~to ~~Statements~~creditworthiness ~~and~~have ~~Supplementary~~been ~~Data,~~met. ~~Note~~There ~~(12)~~were ~~FHLB~~no ~~Borrowings~~outstanding overnight borrowings at December 31, 2013 and ~~Fed~~2012. ~~Funds~~Available ~~Purchased~~overnight borrowings under these lines of credit totaled $17.2 million at December 31, 2013.

§Junior ~~Federal~~Subordinated ~~Funds Purchased~~Debentures: ~~The~~On April 2, 2007, a newly created wholly-owned subsidiary of the Company ~~also~~issued ~~uses~~$10.3 ~~lines~~million of ~~credit~~trust atpreferred ~~correspondent~~securities ~~banks~~with toa ~~purchase~~quarterly ~~federal~~adjustable ~~funds~~rate ~~for~~based ~~short-term~~upon ~~funding~~the London Interbank Offered Rate (“LIBOR”) plus 1.56%. ~~There~~Additionally, ~~were~~on noJune 29, 2007, the Company prepaid $15.0 million of outstanding ~~borrowings~~trust atpreferred ~~December~~securities 31with a quarterly adjustable rate of LIBOR plus 3.65%. On the same day, ~~2012~~the ~~and~~Company ~~2011~~replaced the called securities with another issuance of $15.5 ~~Available~~million ~~borrowings~~of ~~under~~trust ~~these~~preferred ~~lines~~securities with a quarterly adjustable rate of ~~credit~~LIBOR plus 1.56%. Junior subordinated debentures totaled $3525.08 million at ~~Decmber~~December 31, 2013 and 2012. At December 31, 2013 and 2012, $25.0 million of the debentures were considered Tier 1 capital for regulatory capital requirements.

§ Federal Reserve Bank Overnight Borrowings: The Company can use advances from the Federal Reserve Bank (“FRB”) of San Francisco to supplement funding needs. The FRB provides credit for financial institutions in the form of overnight borrowings. The Bank is required to pledge certain of its loans and other assets (principally, securities which are obligations of, or guaranteed by, the United States) provided certain standards related to creditworthiness have been met. There were no outstanding overnight borrowings at December 31, 2012 and 2011. Available overnight borrowings under these lines of credit totaled $17.6 million at December 31, 2012.

Junior Subordinated Debentures: On April 2, 2007, a newly created wholly-owned subsidiary of the Company issued $10.3 million of trust preferred securities with a quarterly adjustable rate based upon the London Interbank Offered Rate (“LIBOR”) plus 1.56%. Additionally, on June 29, 2007, the Company prepaid $15.0 million of outstanding trust preferred securities with a quarterly adjustable rate of LIBOR plus 3.65%. On the same day, the Company replaced the called securities with another issuance of $15.5 million of trust preferred securities with a quarterly adjustable rate of LIBOR plus 1.56%. Junior subordinated debentures totaled $25.8 million at December 31, 2012 and 2011. At December 31, 2012 and 2011, $25.0 million of the debentures were considered Tier 1 capital for regulatory capital requirements.

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Capital

Shareholders’ Equity: Shareholders’ equity ~~increased~~decreased $112.87 million to $~~182~~179.69 million at December 31, ~~2012~~2013 from $~~170~~182.86 million at December 31, ~~2011~~2012. The ~~increase~~decrease in shareholders’ equity was ~~primarly~~primarily due to net income available to common shareholders of $1614.85 million ~~partially~~ reduced by a $79.79 million other comprehensive loss related to the investment securities portfolio and $8.3 million in cash dividends paid on common stock for the year ended December 31, ~~2012~~2013.

TARP-CPP Capital: On January 16, 2009, in exchange for an aggregate purchase price of $26.4 million, the Company issued and sold to the United States Department of the Treasury pursuant to the Troubled Asset Relief Program Capital Purchase Program the following: (i) 26,380 shares of the Company’s newly designated Fixed Rate Cumulative Perpetual Preferred Stock, Series A, no par value per share, and liquidation preference $1,000 per share ($26.4 million liquidation preference in the aggregate) and (ii) a warrant to purchase up to 492,164 shares of the Company’s common stock, no par value per share, at an exercise price of $8.04 per share, subject to certain anti-dilution and other adjustments.

In connection with the issuance and sale of the Company’s securities, the Company entered into a Letter Agreement including the Securities Purchase Agreement - Standard Terms, dated January 16, 2009, with the United States Department of the Treasury (the “Agreement”). The Agreement contained limitations on the payment of quarterly cash dividends on the Company’s common stock in excess of $0.065 per share and on the Company’s ability to repurchase its common stock.

The Series A Preferred Stock paid cumulative dividends at a rate of 5% per annum, applied to the $1,000 per share liquidation preference, as and if declared by the Company’s Board of Directors out of funds legally available. The Series A Preferred Stock had no maturity date and ranked senior to common stock with respect to the payment of dividends and distributions and amounts payable upon liquidation, dissolution and winding up of the Company.

On January 12, 2011, the Company redeemed all 26,380 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A. The Company paid a total of $26.6 million to the Treasury, consisting of $26.4 million in principal and $209 thousand in accrued and unpaid dividends. The Company's redemption of the shares was not subject to additional conditions.41

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On March 2, 2011, the Company completed the repurchase of Warrant to Purchase Common Stock issued to the U.S. Department of the Treasury pursuant to the Troubled Asset Relief Program Capital Purchase Program. The Company repurchased the Warrant for $1.6 million. The Warrant repurchase, together with the Company’s earlier redemption of the entire amount of Fixed Rate Cumulative Perpetual Preferred Stock, Series A, issued to the U.S. Treasury, represents full repayment of all TARP obligations and cancellation of all equity interests in the Company held by the U.S. Treasury.

Common Stock Capital: The Company entered into an Underwriting Agreement dated November 24, 2009 with RBC Capital Markets Corporation, as representative of the underwriters listed therein (collectively the “Underwriters”), providing for the offer and sale in a firm commitment offering of 5,000,000 shares of the Company’s common stock, no par value per share, sold by the Company at a price of $9.00 per share ($8.55 per share, net of underwriting discounts).

In addition, pursuant to the terms of the Underwriting Agreement, the Company granted the Underwriters a 30-day option to purchase up to 750,000 additional shares of the Company’s common stock to cover over-allotments.

On November 30, 2009, the Company completed the public sale of a total of 5,750,000 shares of common stock at a price of $9.00 per share, after giving effect to the sale of the shares being sold pursuant to the over-allotment option, for gross proceeds of approximately $51.8 million. The Company received net proceeds, after underwriting, legal and accounting expenses, of $49.0 million. In connection with the Company’s public offering in the fourth quarter of 2009, the number of shares of common stock underlying the warrant held by the U.S. Treasury was reduced by 50%, to 246,082 shares.

The following table represents the common stock cash dividends declared and the dividend payout ratio for the past three years:

	Years Ended December 31,
	2012			2011			2010
	2013			2012			2011
Dividends declared per share	$	0.50535		$	0.2050		$	0.1420
Dividend payout ratio	57.25	~~45.81~~	%	45.81	~~20.63~~	%	20.63	~~8.64~~	%

Cash dividends are approved by the Board of Directors in connection with its review of the Company’s capital plan. The cash dividend is subject to regulatory ~~limitiation~~limitation as described in Item 1- Business, Supervision and Regulation Section. There is no assurance that future cash dividends will be declared or increased. For further information on shareholders’ equity, see Item 8- Financial Statements and Supplementary Data, Consolidated Statements of Shareholders’ Equity.

Regulatory Capital Requirements: The Company (on a consolidated basis) and the Bank are subject to minimum capital requirements, under which risk percentages are assigned to various categories of assets and off-49balance sheet items to calculate a risk-adjusted capital ratio. The Federal Reserve and FDIC regulations set forth the qualifications necessary for bank holding companies and banks to be classified as “well capitalized,” primarily for assignment of insurance premium rates. Failure to qualify as “well capitalized” can: (a) negatively impact a bank’s ability to expand and to engage in certain activities, (b) cause an increase in insurance premium rates, and (c) impact a bank holding company’s ability to utilize certain expedited filing procedures, among other things. The Company’s and Bank’s current capital ratios are located in Item 8- Financial Statements and Supplementary Data, Note (19) Regulatory Capital Matters of the consolidated financial statements.

On July 2, 2013, the Federal Reserve Board approved the final rules implementing the Basel Committee on Banking Supervision's capital guidelines for U.S. banks. Under the final rules, minimum requirements will increase for both the quantity and quality of capital held by the Bank. The rules include a new common equity Tier 1 capital to risk-weighted assets ratio of 4.5% and a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets. The final rules also raise the minimum ratio of Tier 1 capital to risk-weighted assets from 4.0% to 6.0% and require a minimum leverage ratio of 4.0%. The final rules also implement strict eligibility criteria for regulatory capital instruments. On July 9, 2013, the FDIC also approved, as an interim final rule, the regulatory capital requirements for U.S. banks, following the actions of the Federal Reserve Board. The FDIC's rule is identical in substance to the final rules issued by the FRB. The phase-in period for the final rules will begin for us on January 1, 2015, with full compliance with all of the final rule's requirements phased in over a multi-year schedule. We are currently evaluating the provisions of the final rules and their expected impact on us. Based on a preliminary analysis of the new rules, management believes that it would be fully compliant with the revised standards as of December 31, 2013 if they were effective on that date.

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Liquidity and Cash ~~Flow~~Flows

Whidbey Island Bank: The principal objective of the Bank’s liquidity management program is to maintain the ability to meet day-to-day cash flow requirements of its customers who either wish to withdraw funds or to draw upon credit facilities to meet their cash needs. The Bank monitors the sources and uses of funds on a daily basis to maintain an acceptable liquidity position. In addition to liquidity from core deposits and the repayment and maturities of loans, the Bank can utilize established lines of credit with correspondent banks, sale of investment securities or borrowings from the FHLB.

Washington Banking Company: The Company is a separate legal entity from the Bank and must provide for its own liquidity. Substantially all of the Company’s revenues are obtained from dividends declared and paid by the Bank. There are statutory and regulatory provisions that could limit the ability of the Bank to pay or increase the level of dividends to the Company. However, management believes that such restrictions will not have an adverse impact on the ability of the Company to meets its ongoing cash obligations, which consist principally of debt service on the $25.8 million of outstanding junior subordinated debentures, which totaled approximately $~~532~~478 thousand in ~~2012~~2013. Further information on the Company’s ~~cashflows~~cash flows can be found in Item 8- Financial Statements and Supplementary Data, Note (21) Washington Banking Company Information of the consolidated financial statements.

Consolidated Cash Flows: The consolidated cash flows of the Company and its subsidiary the Bank are disclosed in the Consolidated Statement of Cash Flows found in Item 8- Financial Statements and Supplementary Data. Net cash provided by operating activities was $7063.96 million for the year ended December 31, ~~2012~~2013. The principal source of cash provided by operating activities was net income from continuing operations and proceeds from the sale of loans held for sale. For ~~2012~~2013, $5836.52 million was used in investing activities of the Company, primarily net purchases of available for sale investment securities partially offset by proceeds from the sale of covered other real estate owned. Financing activities used $103.87 million in net cash, primarily due to the cash dividends paid on common stock ~~and~~partially aoffset ~~decrease~~by an increase in deposits.

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Capital Resources

Off-Balance Sheet Commitments: Standby letters of credit, commercial letters of credit, and financial guarantees written, are conditional commitments issued by the Company to guarantee the performance of a customer to a third party or payment by a customer to a third party. Those guarantees are primarily issued in international trade or to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. Except for certain long-term guarantees, the majority of guarantees expire in one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral supporting those commitments, for which collateral is deemed necessary, generally amounts to one hundred percent of the commitment. The Company routinely charges a fee for these credit facilities. The Company was not required to perform on any financial guarantees in ~~2012~~2013.

The following table summarizes the Company’s commitments to extend credit:

(dollars in thousands)	December 31, ~~2012~~2013
Loan commitments
Loan commitments:
Fixed rate	$	1710,~~304~~380
Variable rate	183,344	~~163,210~~
Standby letters of credit		1,114
Total loan commitments	193,724
Total commitments	$	181,628
Standby letters of credit	1,114
Total commitments	$	194,838

Contractual Commitments: The Company is party to many contractual financial obligations, including repayment of borrowings and operating lease payments. The following table summarizes the contractual obligations of the Company as of December 31, 2012:43

(dollars in thousands)	Future Contractual Obligations
	Within 1 year		1 - 3 years		3 - 5 years		Over 5 years		Total
Operating leases	$	1,177	$	1,963	$	1,656	$	2,287	$	7,083
Junior subordinated debentures		-		-		-		25,774		25,774
Total	$	1,177	$	1,963	$	1,656	$	28,061	$	32,857

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(dollars in thousands)	Future Contractual Obligations
	Within 1 year		1 - 3 years		3 - 5 years		Over 5 years		Total
Operating leases	$	1,392	$	2,467	$	2,029	$	1,683	$	7,571
Junior subordinated debentures	—		—		—		25,774		25,774
Total	$	1,392	$	2,467	$	2,029	$	27,457	$	33,345

Item 7A. Quantitative and Qualitative Disclosures about Market Risk

Asset/Liability Management

The purpose of asset/liability management is to provide stable net interest income by protecting the Company’s earnings from undue interest rate risk that arises from volatile interest rates and changes in the balance sheet mix, and by managing the risk/return relationships between liquidity, interest rate risk, market risk, and capital adequacy. The Company maintains an asset/liability management policy that provides guidelines for controlling exposure to interest rate risk by utilizing the following ratios and trend ~~analyses~~analysis: liquidity, equity, volatile liability dependence, portfolio maturities, maturing assets and maturing liabilities. The Company’s policy is to control the exposure of its earnings to changing interest rates by generally endeavoring to maintain a position within a narrow range around an “earnings neutral position,” which is defined as the mix of assets and liabilities that generate a net interest margin that is least affected by interest rate changes.

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Market Risk

Interest Rate Risk: The Company is exposed to interest rate risk. Interest rate risk is the risk that financial performance will decline over time due to changes in prevailing interest rates and resulting yields on interest-earning assets and costs of interest-bearing liabilities. Generally, there are three sources of interest rate risk as described below:

§• Re-pricing Risk: Generally, re-pricing risk is the risk of adverse consequences from a change in interest rates that arises because of differences in the timing of when those interest rate changes affect an institution’s assets and liabilities.

§• Basis Risk: Basis risk is the risk of adverse consequences resulting from unequal changes in the spread between two or more rates for different instruments with the same maturity.

§• Option Risk: In banking, option risks are known as borrower options to prepay loans and depositor options to make deposits, withdrawals, and early redemptions. Option risk arises whenever bank products give customers the right, but not the obligation, to alter the quantity of the timing of cash flows.

A number of measures are used to monitor and manage interest rate risk, including income simulations and interest sensitivity (gap) ~~analyses~~analysis. An income simulation model is the primary tool used to assess the direction and magnitude of changes in net interest income resulting from changes in interest rates. Key assumptions in the model include prepayment speeds on fixed rate assets, cash flows and maturities of other investment securities, and loan and deposit volumes and pricing. These assumptions are inherently uncertain and, as a result, the model cannot precisely estimate net interest income or precisely predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes, changes in market conditions and management strategies, among other factors.

(dollars in thousands)	~~2012~~2013						2012	~~2011~~
	1 year change in net interest income from scenario			Percentage change			1 year change in net interest income from scenario	~~1 year change in net interest income from scenario~~			Percentage change	~~Percentage change~~
Scenario
Up 100 basis points	$	(~~862~~469	)	(0.7	~~(1.2~~)%	%)	$	$(862	~~(1,968~~)	)	(1.2	)%	~~(2.3~~	%)
Up 200 basis points	$	(~~1,280~~592	)	(0.9	~~(1.7~~)%	%)	$	$(1,280	~~(3,910~~)	)	(1.7	)%	~~(4.6~~	%)
Up 300 basis points	$	(~~1,531~~767	)	(1.2	~~(2.1~~)%	)%	$	$(1,531	~~(5,793~~)	)	(2.1	)%	~~(6.8~~	%)

~~-52-~~45

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~~The~~Interest ~~following~~Rate ~~table~~Sensitivity: ~~sets~~The ~~forth~~analysis ~~the~~of ~~estimated~~an ~~maturity~~institution’s orinterest ~~repricing,~~rate ~~and~~gap (the ~~resulting~~difference ~~interest~~between ~~rate~~the ~~gap~~repricing of ~~the Company’s~~ interest-earning assets and interest-bearing liabilities atduring ~~December~~a ~~31,~~given ~~2012. The~~period ~~interest~~of ~~rate~~time) ~~gaps~~is ~~reported~~another instandard ~~the~~tool ~~table~~for ~~arise~~the ~~when~~measurement ~~assets~~of ~~are~~the ~~funded~~exposure ~~with~~to ~~liabilities~~interest ~~having~~rate ~~different repricing intervals~~risk. The ~~amounts~~Company ~~shown~~believes inthat ~~the~~because ~~following~~interest ~~table~~rate ~~could~~gap beanalysis ~~significantly~~does ~~affected~~not byaddress ~~external~~all factors ~~such~~that ascan ~~changes~~affect earnings performance, it should be used in ~~prepayment~~conjunction ~~assumptions,~~with ~~early~~other ~~withdrawals~~methods of ~~deposits~~evaluating ~~and~~interest ~~competition:~~rate risk.

(dollars in thousands)	0 - 3 months			4 - 12 months			1 - 5 years			Over 5 years			Total
Interest-earning assets:
Interest-earning deposits	$	75,428		$	-		$	-		$	-		$	75,428
Investment securities		10,059			3,447			271,632			87,830			372,968
Investment in subsidiary		-			-			-			774			774
FHLB stock		7,441			-			-			-			7,441
Loans held for sale		18,043			-			-			-			18,043
Total loans		177,699			163,810			359,513			369,451			1,070,473
Total interest-earning assets	$	288,670		$	167,257		$	631,145		$	458,055		$	1,545,127
Percent of interest-earning assets		18.7	%		10.8	%		40.8	%		29.7	%		100.0	%
Interest-bearing liabilities:
Interest-bearing demand deposits	$	345,599		$	-		$	-		$	-		$	345,599
Money market deposits		295,441			-			-			-			295,441
Savings deposits		112,725			-			-			-			112,725
Time deposits		82,733			181,069			184,096			-			447,898
Junior subordinated debentures		25,774			-			-			-			25,774
Total interest-bearing liabilities	$	862,272		$	181,069		$	184,096		$	-		$	1,227,437
Percent of interest-bearing liabilities		70.2	%		14.8	%		15.0	%		0.0	%		100.0	%
Interest sensitivity gap	$	(573,602	)	$	(13,812	)	$	447,049		$	458,055		$	317,690
Interest sensitivity gap, as a
percentage of total assets		-34.0	%		-0.8	%		26.5	%		27.1	%		18.8	%
Cumulative interest sensitivity gap	$	(573,602	)	$	(587,414	)	$	(140,365	)	$	317,690
Cumulative interest sensitivity gap, as a
percentage of total assets		-34.0	%		-34.8	%		-8.3	%		18.8	%

The following table sets forth the estimated maturity or repricing, and the resulting interest rate gap of the Company’s interest-earning assets and interest-bearing liabilities at December 31, 2013. The interest rate gaps reported in the table arise when assets are funded with liabilities having different repricing intervals. The amounts shown in the following table could be significantly affected by external factors such as changes in prepayment assumptions, early withdrawals of deposits and competition:



(dollars in thousands)	0 - 3 months			4 - 12 months			1 - 5 years			Over 5 years			Total
Interest-earning assets:
Interest-earning deposits	$	103,869		$	—		$	—		$	—		$	103,869
Investment securities	2,011			4,320			290,764			135,447			432,542
Investment in subsidiary	—			—			—			774			774
FHLB stock	7,172			—			—			—			7,172
Loans held for sale	3,389			—			—			—			3,389
Total loans	180,814			113,379			336,025			410,423			1,040,641
Total interest-earning assets	$	297,255		$	117,699		$	626,789		$	546,644		$	1,588,387
Percent of interest-earning assets	18.7		%	7.4		%	39.5		%	34.4		%	100.0		%
Interest-bearing liabilities:
Interest-bearing demand deposits	$	370,244		$	—		$	—		$	—		$	370,244
Money market deposits	347,670			—			—			—			347,670
Savings deposits	124,516			—			—			—			124,516
Time deposits	54,750			209,070			95,830			—			359,650
Junior subordinated debentures	25,774			—			—			—			25,774
Total interest-bearing liabilities	$	922,954		$	209,070		$	95,830		$	—		$	1,227,854
Percent of interest-bearing liabilities	75.2		%	17.0		%	7.8		%	—		%	100.0		%
Interest sensitivity gap	$	(625,699	)	$	(91,371	)	$	530,959		$	546,644		$	360,533
Interest sensitivity gap, as a
percentage of total assets	(37.2		)%	(5.4		)%	31.5		%	32.5		%
Cumulative interest sensitivity gap	$	(625,699	)	$	(717,070	)	$	(186,111	)	$	360,533
Cumulative interest sensitivity gap, as a
percentage of total assets	(37.2		)%	(42.6		)%	(11.1		)%	21.4		%

Impact of Inflation and Changing Prices

The primary impact of inflation on the Company’s operations is increased operating costs. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates generally have a more significant impact on a financial institution’s performance than the effects of general levels of inflation. Although interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services, increases in inflation generally have resulted in increased interest rates.

~~-53-~~46

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Item 8. Financial Statements and Supplementary Data

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

	Page	~~Page~~
Management's Report on Internal Control over Financial Reporting	48		55
Report of Independent Registered Public Accounting Firm	49		56
Consolidated Statements of Financial Condition at December 31, 2012 and 2011			57
Consolidated Statements of Financial Condition at December 31, 2013 and 2012	50
Consolidated Statements of Income for the years ended December 31, 2012, 2011 and 2010			58
Consolidated Statements of Income for the years ended December 31, 2013, 2012 and 2011	51
Consolidated Statements of Comprehensive Income for the years ended December 31, 2012, 2011 and 2010			59
Consolidated Statements of Comprehensive Income for the years ended December 31, 2013, 2012 and 2011	52
Consolidated Statements of Shareholders' Equity for the years ended December 31, 2012, 2011 and 2010			60
Consolidated Statements of Shareholders' Equity for the years ended December 31, 2013, 2012 and 2011	53
Consolidated Statements of Cash Flows for the years ended December 31, 2012, 2011 and 2010			61
Consolidated Statements of Cash Flows for the years ended December 31, 2013, 2012 and 2011	53
Notes to Consolidated Financial Statements	55		63

~~-54-~~47

Table of Contents

MANAGEMENT’'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

The Company’s management, including its Chief Executive Officer and its Chief Financial Officer, together with its consolidated subsidiary, is responsible for establishing, maintaining and assessing adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934). The Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company’s financial statements for external reporting purposes in accordance with accounting ~~principals~~principles generally accepted in the United States of America.

The Company’s internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets; provide reasonable assurances that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting ~~principals~~principles generally accepted in the United States of America, and that receipts and expenditures are being made only in accordance with authorizations of management and the directors of the Company; and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the Company’s financial statements.

Management recognizes that there are inherent limitations in the effectiveness of any system of internal control, and accordingly, even effective internal control can provide only reasonable assurance with respect to financial statement preparation and fair presentation. Further, because of changes in conditions, the effectiveness of internal control may vary over time.

The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, ~~2012~~2013. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in the Internal Control-Integrated Framework (1992). Based on this assessment, management believes that, as of December 31, ~~2012~~2013, the Company’s internal control over financial reporting was effective based on those criteria.

The Company’s independent registered public accounting firm has audited the Company’s consolidated financial statements as of and for the year ended December 31, ~~2012~~2013 that are included in this annual report and issued their Report of Independent Registered Public Accounting Firm, appearing under Item 8, which includes an attestation report on the Company’s internal control over financial reporting. The attestation report expresses an unqualified opinion on the effectiveness of the Company’s internal controls over financial reporting as of December 31, ~~2012~~2013.

~~-55-~~48

Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders

Washington Banking Company and Subsidiaries

We have audited the accompanying consolidated statements of financial condition of Washington Banking Company and Subsidiaries (the Company) as of December 31, ~~2012~~2013 and ~~2011~~2012, and the related consolidated statements of income, comprehensive income, shareholders’ equity, and cash flows for each of the three years in the ~~three-year~~ period ended December 31, ~~2012~~2013. We also have audited the Company’s internal control over financial reporting as of December 31, ~~2012~~2013, based on criteria established in Internal Control - Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission ~~(COSO)~~. The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report of Management on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these consolidated financial statements and an opinion on the Company’s internal control over financial reporting based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the consolidated financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall consolidated financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Washington Banking Company and ~~subsidiaries~~Subsidiaries as of December 31, ~~2012~~2013 and ~~2011~~2012, and the consolidated results of their operations and their cash flows for each of the three years in the ~~three-year~~ period ended December 31, ~~2012~~2013, in conformity with generally accepted accounting principles in the United States of America. Also in our opinion, Washington Banking Company and Subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, ~~2012~~2013, based on criteria established in Internal Control - Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission ~~(COSO)~~.

/s/ Moss Adams LLP ~~Everett, Washington~~

~~March 14~~Everett, ~~2013~~Washington

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Table of Contents

WASHINGTON BANKING COMPANY AND ~~SUBSIDIAIRIES~~SUBSIDIARIES

Consolidated Statements of Financial Condition

~~December~~ (Dollars 31in thousands, ~~2012~~except ~~and~~share ~~2011~~data)

(Dollars in thousands)



	December 31, 2013			December 31, 2012
Assets
Cash and due from banks ($3,835 and $3,801, respectively, are restricted)	$	27,489		$	32,145
Interest-bearing deposits	103,869			75,428
Total cash and cash equivalents	131,358			107,573
Investment securities available for sale, at fair value	432,542			372,968
Federal Home Loan Bank stock	7,172			7,441
Loans held for sale	3,389			18,043
Non-covered loans, net of allowance for loan losses	871,593			835,987
Covered loans, net of allowance for loan losses	137,333			214,087
Total loans	1,008,926			1,050,074
Premises and equipment, net	35,038			36,751
Bank owned life insurance	17,836			17,704
Goodwill and other intangible assets, net	5,588			6,027
Non-covered other real estate owned	3,067			3,023
Covered other real estate owned	5,980			13,460
FDIC indemnification asset	14,536			34,571
Other assets	18,556			20,042
Total assets	$	1,683,988		$	1,687,677
Liabilities and Shareholders' Equity
Liabilities:
Deposits
Noninterest-bearing demand	$	265,412		$	261,310
Interest-bearing	1,202,080			1,201,663
Total deposits	1,467,492			1,462,973
Junior subordinated debentures	25,774			25,774
Other liabilities	10,792			16,306
Total liabilities	1,504,058			1,505,053
Commitments and contingencies
Shareholders' Equity:
Common stock, no par value; 35,000,000 shares authorized; 15,538,969 and 15,483,598 shares issued and outstanding at December 31, 2013 and 2012, respectively	86,714			85,707
Retained earnings	98,431			92,234
Accumulated other comprehensive (loss) income, net of tax	(5,215		)	4,683
Total shareholders' equity	179,930			182,624
Total liabilities and shareholders' equity	$	1,683,988		$	1,687,677

	2012		2011
Assets
Cash and due from banks	$	32,145	$	25,399
($3,801 and $653, respectively, are restricted)
Interest-bearing deposits		75,428		80,514
Total cash and cash equivalents		107,573		105,913
Investment securities available for sale, at fair value		372,968		295,955
Federal Home Loan Bank stock		7,441		7,576
Loans held for sale		18,043		22,421
Non-covered loans, net of allowance for loan losses		835,987		794,798
Covered loans, net of allowance for loan losses		214,087		268,211
Total loans		1,050,074		1,063,009
Premises and equipment, net		36,751		37,492
Bank owned life insurance		17,704		17,513
Goodwill and other intangible assets, net		6,027		6,539
Non-covered other real estate owned		3,023		1,976
Covered other real estate owned		13,460		26,622
FDIC indemnification asset		34,571		65,586
Other assets		20,042		20,080
Total assets	$	1,687,677	$	1,670,682
Liabilities and Shareholders' Equity
Liabilities:
Deposits
Noninterest-bearing demand	$	261,310	$	219,250
Interest-bearing		1,201,663		1,247,094
Total deposits		1,462,973		1,466,344
Junior subordinated debentures		25,774		25,774
Other liabilities		16,306		7,744
Total liabilities		1,505,053		1,499,862
Commitments and contingencies
Shareholders' Equity:
Common stock, no par value; 35,000,000 shares authorized; 15,483,598 and
15,398,197 shares issued and outstanding at December 31, 2012 and
December 31, 2011, respectively		85,707		84,564
Retained earnings		92,234		83,107
Accumulated other comprehensive income		4,683		3,149
Total shareholders' equity		182,624		170,820
Total liabilities and shareholders' equity	$	1,687,677	$	1,670,682

See notes to consolidated financial statements

~~-57-~~50

Table of Contents

WASHINGTON BANKING COMPANY AND ~~SUBSIDIAIRIES~~SUBSIDIARIES

Consolidated Statements of Income

(Dollars in thousands, except per share data)

December 31, 2012, 2011 and 2010



	For the Year Ended December 31,
	2013			2012			2011
Interest income:
Interest and fees on non-covered loans	$	44,166		$	46,530		$	49,760
Interest and fees on covered loans	23,710			36,418			34,819
Interest on taxable investment securities	5,720			5,333			3,967
Interest on tax-exempt investment securities	1,557			1,178			902
Other	206			251			259
Total interest income	75,359			89,710			89,707
Interest expense:
Interest on deposits	4,942			6,581			9,492
Interest on junior subordinated debentures	478			532			489
Total interest expense	5,420			7,113			9,981
Net interest income	69,939			82,597			79,726
Provision for loan losses, non-covered loans	1,875			7,100			10,500
Provision (recovery) of loan losses, covered loans	12,740			2,644			(450		)
Net interest income after provision for loan losses	55,324			72,853			69,676
Noninterest income:
Service charges and fees	3,401			3,560			3,818
Electronic banking income	4,101			3,666			3,197
Investment products	771			1,295			1,072
Gain on sale of investment securities, net	556			931			—
Bank owned life insurance income	132			191			311
Income from the sale of mortgage loans	3,267			3,848			1,197
SBA premium income	894			602			444
Change in FDIC indemnification asset	5,735			(9,126		)	(9,232		)
Gain on disposition of covered assets	2,315			1,877			6,312
Other	1,173			1,402			2,093
Total noninterest income	22,345			8,246			9,212
Noninterest expense:
Salaries and benefits	30,909			29,944			27,496
Occupancy and equipment	7,287			6,883			6,553
Office supplies and printing	1,501			1,643			1,665
Data processing	2,185			2,134			1,916
Consulting and professional fees	849			904			1,152
Intangible amortization	439			512			622
Merger related expenses	652			—			324
FDIC premiums	1,091			1,281			1,818
FDIC clawback liability adjustment	(88		)	1,680			1,576
Non-covered OREO and repossession expenses, net	2,227			1,841			1,358
Covered OREO and repossession expenses, net	1,696			1,699			2,192
Other	7,553			7,878			9,153
Total noninterest expense	56,301			56,399			55,825
Income before provision for income tax	21,368			24,700			23,063
Provision for income tax	6,872			7,856			7,111
Net income before preferred dividends	14,496			16,844			15,952
Preferred stock dividends and discount accretion	—			—			1,084
Net income available to common shareholders	$	14,496		$	16,844		$	14,868
Net income available per common share, basic	$	0.94		$	1.09		$	0.97
Net income available per common share, diluted	$	0.93		$	1.09		$	0.97
Average number of common shares outstanding, basic	15,495,000			15,422,000			15,329,000
Average number of common shares outstanding, diluted	15,551,000			15,455,000			15,393,000

See notes to consolidated financial statements

~~(Dollars in thousands, except per share data)~~51

	For the Year Ended December 31,
	2012			2011			2010
Interest income:
Interest and fees on non-covered loans	$	46,530		$	49,760		$	53,414
Interest and fees on covered loans		36,418			34,819			19,173
Interest on taxable investment securities		5,333			3,967			2,348
Interest on tax-exempt investment securities		1,178			902			716
Other		251			259			298
Total interest income		89,710			89,707			75,949
Interest expense:
Interest on deposits		6,581			9,492			11,091
Interest on other borrowed funds		-			-			243
Interest on junior subordinated debentures		532			489			496
Total interest expense		7,113			9,981			11,830
Net interest income		82,597			79,726			64,119
Provision for loan losses, non-covered loans		7,100			10,500			12,150
Provision (recovery) for loan losses, covered loans		2,644			(450	)		1,336
Net interest income after provision for loan losses		72,853			69,676			50,633
Noninterest income:
Service charges and fees		3,560			3,818			3,346
Electronic banking income		3,666			3,197			2,306
Investment products		1,295			1,072			522
Gain on sale of investment securities, net		931			-			-
Bank owned life insurance income		191			311			226
Income from the sale of mortgage loans		3,848			1,197			1,134
SBA premium income		602			444			578
Change in FDIC indemnification asset		(9,126	)		(9,232	)		1,884
Gain on disposition of covered assets		1,877			6,312			1,840
Bargain purchase gain on acquisition		-			-			19,925
Other		1,402			2,093			1,770
Total noninterest income		8,246			9,212			33,531
Noninterest expense:
Salaries and benefits		29,944			27,496			23,527
Occupancy and equipment		6,883			6,553			5,631
Office supplies and printing		1,643			1,665			1,594
Data processing		2,134			1,916			1,434
Consulting and professional fees		904			1,152			891
Intangible amortization		512			622			672
Merger related expenses		-			324			2,113
FDIC premiums		1,281			1,818			1,609
FDIC clawback liability		1,680			1,576			-
Non-covered OREO and repossession expenses, net		1,841			1,358			1,196
Covered OREO and repossession expenses, net		1,699			2,192			1,240
Other		7,878			9,153			6,890
Total noninterest expense		56,399			55,825			46,797
Income before provision for income tax		24,700			23,063			37,367
Provision for income tax		7,856			7,111			11,797
Net income before preferred dividends		16,844			15,952			25,570
Preferred stock dividends and discount accretion		-			1,084			1,659
Net income available to common shareholders	$	16,844		$	14,868		$	23,911
Net income available per common share, basic	$	1.09		$	0.97		$	1.56
Net income available per common share, diluted	$	1.09		$	0.97		$	1.55
Average number of common shares outstanding, basic		15,422,000			15,329,000			15,307,000
Average number of common shares outstanding, diluted		15,455,000			15,393,000			15,465,000

See notes to consolidated financial statements

-58-

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WASHINGTON BANKING COMPANY AND ~~SUBSIDIAIRIES~~SUBSIDIARIES

Consolidated Statements of Comprehensive Income

December 31, 2012, 2011 and 2010

(Dollars in thousands)

	For the Year Ended December 31,
	2012			2011			2010
	2013			2012			2011
Net income before preferred dividends	$	1614,~~844~~496		$	1516,~~952~~844		$	2515,~~570~~952
Investment securities available for sale:
Unrealized gains (losses) arising in period		3,292			4,548			(86	)
Unrealized (losses) gains arising in period	(14,672		)	3,292			4,548
Reclassification adjustment for net gains realized in earnings		(931	)		-			-
Reclassification adjustment for net gains realized in earnings (net of tax expense of $195 and $325 for the years ended December 31, 2013 and 2012, respectively.)	(361		)	(606		)	—
Other comprehensive income (loss) before income tax provision (benefit)		2,361			4,548			(86	)
Income tax (benefit) provision related to unrealized (losses) gains	(5,135		)	1,152			1,592
Income tax provision (benefit)		827			1,592			(30	)
Other comprehensive (loss) income, net of tax	(9,898		)	1,534			2,956
Other comprehensive income (loss), net		1,534			2,956			(56	)
Total comprehensive income	$	4,598		$	18,378		$	18,908
Total comprehensive income	$	18,378		$	18,908		$	25,514

See notes to consolidated financial statements

~~-59-~~52

Table of Contents

WASHINGTON BANKING COMPANY AND ~~SUBSIDIAIRIES~~SUBSIDIARIES

Consolidated Statements of Shareholders’ Equity

~~December~~ (Dollars ~~31,~~and ~~2012~~shares in thousands, ~~2011~~except ~~and~~per ~~2010~~share data)

(Dollars in thousands, except per share data)

Common stock

Accumulated other comprehensive income (loss)

Filing Compare · WASHINGTON BANKING CO