SAL Salisbury Bancorp, Inc.

Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Management's Discussion and Analysis of Financial Condition and Results of Operations of Salisbury and its subsidiary should be read in conjunction with Salisbury's Annual Report on Form 10-K for the year ended December 31, 2011.

BUSINESS

Salisbury Bancorp, Inc. ("Salisbury"), a Connecticut corporation, formed in 1998, is a bank holding company for Salisbury Bank and Trust Company ("Bank"), a Connecticut-chartered and Federal Deposit Insurance Corporation (the "FDIC") insured commercial bank headquartered in Lakeville, Connecticut. Salisbury's principal business consists of the business of the Bank. The Bank, formed in 1848, is engaged in customary banking activities, including general deposit taking and lending activities to both retail and commercial markets, and trust and wealth advisory services. The Bank conducts its banking business from eight full-service offices in the towns of Canaan, Lakeville, Salisbury and Sharon, Connecticut, South Egremont and Sheffield, Massachusetts, Millerton and Dover Plains, New York, and operates its trust and wealth advisory services from offices in Lakeville, Connecticut.

Critical Accounting Policies and Estimates

Salisbury’s consolidated financial statements follow GAAP as applied to the banking industry in which it operates. Application of these principles requires management to make estimates, assumptions and judgments that affect the amounts reported in the financial statements. These estimates, assumptions and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event.

Salisbury’s significant accounting policies are presented in Note 1 of Notes to Consolidated Financial Statements in Salisbury's 2011 Annual Report on Form 10-K for the year ended December 31, 2011 and, along with this Management’s Discussion and Analysis, provide information on how significant assets are valued in the financial statements and how those values are determined. Management believes that the following accounting estimates are the most critical to aid in fully understanding and evaluating Salisbury’s reported financial results, and they require management’s most difficult, subjective or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain.

The allowance for loan losses represents management’s estimate of credit losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the balance sheet. Note 1 of Notes to Consolidated Financial Statements in Salisbury's 2011 Annual Report on Form 10-K for the period ended December 31, 2011 describes the methodology used to determine the allowance for loan losses. In addition, a discussion of the factors driving changes in the amount of the allowance for loan losses are included in the “Provision and Allowance for Loan Losses” section of Management’s Discussion and Analysis of this Quarterly Report.

Management evaluates goodwill and identifiable intangible assets for impairment annually using valuation techniques that involve estimates for discount rates, projected future cash flows and time period calculations, all of which are susceptible to change based on changes in economic conditions and other factors. Future events or changes in the estimates, which are used to determine the carrying value of goodwill and identifiable intangible assets or which otherwise adversely affects their value or estimated lives, could have a material adverse impact on the results of operations.

Management evaluates securities for other-than-temporary impairment giving consideration to the extent to which the fair value has been less than cost, estimates of future cash flows, delinquencies and default severity, and the intent and ability of Salisbury to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. The consideration of the above factors is subjective and involves estimates and assumptions about matters that are inherently uncertain. Should actual factors and conditions differ materially from those used by management, the actual realization of gains or losses on investment securities could differ materially from the amounts recorded in the financial statements.

The determination of the obligation and expense for pension and other postretirement benefits is dependent on certain assumptions used in calculating such amounts. Key assumptions used in the actuarial valuations include the discount rate, expected long-term rate of return on plan assets and rates of increase in compensation and health care costs.

Actual results could differ from the assumptions and market driven rates may fluctuate. Significant differences in actual experience or significant changes in the assumptions may materially affect the future pension and other postretirement obligations and expense.

RESULTS OF OPERATIONS

For the three month periods ended September 30, 2012 and 2011

Overview

Net income available to common shareholders was $1,094,000, or $0.65 per common share, for the quarter ended September 30, 2012 (third quarter 2012), versus $1,069,000, or $0.63 per common share, for the quarter ended June 30, 2012 (second quarter 2012), and $865,000, or $0.51 per common share, for the quarter ended September 30, 2011 (third quarter 2011).

Net Interest Income

Tax equivalent net interest income decreased $121,000, or 2.5%, versus second quarter 2012, and decreased $80,000, or 1.6%, versus third quarter 2011. Average total interest bearing deposits increased $14.0 million as compared with second quarter 2012 and increased $14.4 million, or 3.7%, as compared with third quarter 2011. Average earning assets increased $14.3 million as compared with second quarter 2012 and increased $4.6 million, or 0.8%, as compared with third quarter 2011. The net interest margin decreased 18 basis points versus second quarter 2012 and decreased 8 basis points versus third quarter 2011 to 3.35% for third quarter 2012.

The following table sets forth the components of Salisbury's tax-equivalent net interest income and yields on average interest-earning assets and interest-bearing funds.

The following table sets forth the changes in tax-equivalent interest due to volume and rate.

Interest Income

Tax equivalent interest income decreased $377,000, or 6.1%, to $5.8 million for third quarter 2012 as compared with third quarter 2011. Loan income decreased $129,000, or 2.8%, primarily due to a 34 basis points decline in the average loan yield offset in part by a $16.3 million, or 4.3%, increase in average loans. Tax equivalent securities income decreased $246,000, or 15.6%, primarily due to a 43 basis points decline in the average yield and by a $9.7 million, or 6.9%, decrease in average volume. Changes in securities yields resulted from the effect of changes in market interest rates on securities purchases, calls of agency bonds and prepayments of mortgage backed securities. Income from short term funds decreased $5,000 as a result of a 3 basis points decline in the average yield and by a $1.7 million decrease in the average balance.

Interest Expense

Interest expense decreased $297,000, or 22.3%, to $1.0 million for third quarter 2012 as compared with third quarter 2011. Interest on deposit accounts and retail repurchase agreements decreased $184,000, or 2.4%, as a result of lower average rates, down 20 and 21 basis points respectively. Lower rates were offset in part by a $2.6 million, or 0.6%, increase in the average balance of deposits and repurchase agreements. The lower average rate resulted from the effect of lower market interest rates on rates paid and changes in product mix. The higher average volume resulted from deposit growth. Interest expense on FHLBB borrowings decreased $113,000 as a result of lower average borrowings, down $12.6 million, offset partially by an average borrowing rate increase of 15 basis points as compared with third quarter 2011. The decline in advances resulted from scheduled maturities that were not replaced with new advances.

Reserve coverage, as measured by the ratio of the allowance for loan losses to gross loans, remained unchanged at 1.10% at September 30, 2012, June 30, 2012 and September 30, 2011.

During the first nine months of 2012, non-performing loans (non-accrual loans and accruing loans past-due 90 days or more) increased $1.2 million to $9.2 million, or 2.43% of gross loans receivable, from 2.16% at December 31, 2011. Compared with a year ago non-performing loans decreased $4.7 from 3.80% of gross loans receivable at September 30, 2011. Accruing loans past due 30-89 days increased $0.8 million to 0.83% of gross loans receivable, from 0.66% at December 31, 2011 and 0.66% at September 30, 2011. See “Financial Condition – Loan Credit Quality” for further discussion and analysis.

The credit quality segments of loans receivable and the allowance for loan losses are as follows:

The allowance for loan losses represents management’s estimate of the probable credit losses inherent in the loan portfolio as of the reporting date. The allowance is increased by provisions charged to earnings and by recoveries of amounts previously charged off, and is reduced by loan charge-offs. Loan charge-offs are recognized when management determines a loan or portion of a loan to be uncollectible. The allowance for loan losses is computed by segregating the portfolio into three components: (1) loans collectively evaluated for impairment: general loss allocation factors for non-impaired loans are segmented into pools of loans based on similar risk characteristics such as loan product, collateral type and loan-to-value, loan risk rating, historical loss experience, delinquency factors and other similar economic indicators, (2) loans individually evaluated for impairment: individual loss allocations for loans deemed to be impaired based on discounted cash flows or collateral value, and (3) unallocated: general loss allocations for other environmental factors.

Impaired loans and certain potential problem loans, where warranted, are individually evaluated for impairment. Impairment is measured for each individual loan, or for a borrower’s aggregate loan exposure, using either the fair value of the collateral if the loan is collateral dependent or the present value of expected future cash flows discounted at the loan’s effective interest rate. An allowance is established when the collateral value or discounted cash flows of the loan is lower than the carrying value of that loan.

The component of the allowance for loan losses for loans collectively evaluated for impairment is estimated by stratifying loans into segments and credit risk ratings and applying management’s general loss allocation factors. The general loss allocation factors are based on expected loss experience adjusted for historical loss experience and other qualitative factors, including levels/trends in delinquencies; trends in volume and terms of loans; effects of changes in risk selection and underwriting standards and other changes in lending policies, procedures and practices; experience/ability/depth of lending management and staff; and national and local economic trends and conditions. The qualitative factors are determined based on the various risk characteristics of each loan segment. There were no significant changes in Salisbury’s policies or methodology pertaining to the general component of the allowance for loan losses during the quarter ended September 30, 2012.

The unallocated component of the allowance is maintained to cover uncertainties that could affect management’s estimate of probable losses. It reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating allocated and general reserves in the portfolio.

Determining the adequacy of the allowance at any given period is difficult, particularly during deteriorating or uncertain economic periods, and management must make estimates using assumptions and information that are often subjective and changing rapidly. The review of the loan portfolio is a continuing event in light of a changing economy and the dynamics of the banking and regulatory environment. Should the economic climate deteriorate, borrowers could experience difficulty and the level of non-performing loans, charge-offs and delinquencies could rise and require increased provisions. In management's judgment, Salisbury remains adequately reserved both against total loans and non-performing loans at September 30, 2012.

Management’s loan risk rating assignments, loss percentages and specific reserves are subjected annually to an independent credit review by an external firm. In addition, the bank is examined annually on a rotational process by one of its two primary regulatory agencies, the FDIC and State of Connecticut Department of Banking (“CTDOB”). As an integral part of their examination process, the FDIC and CTDOB review the Bank's credit risk ratings and allowance for loan losses. The Bank was examined by the CTDOB in July 2012 and by the FDIC in May 2011.

Non-interest income

The following table details the principal categories of non-interest income.

Non-interest income for third quarter 2012 increased $553,000 versus third quarter 2011. Trust and Wealth Advisory revenues increased $84,000 due primarily from growth in managed assets. Service charges and fees increased $25,000 mainly due to increased debit card interchange fees. Income from sales and servicing of mortgage loans increased $416,000 due to interest rate driven fluctuations in the volume of fixed rate residential mortgage loan sales and mortgage servicing valuations. Mortgage loans sales totaled $18.3 million for third quarter 2012 versus $7.6 million for third quarter 2011. Third quarter 2012 and third quarter 2011 included a mortgage servicing valuation impairment benefit of $12,000 and charge of $65,000 respectively. The increase in other income consisted primarily of bank owned life insurance income.

Non-interest expense

The following table details the principal categories of non-interest expense.

Non-interest expense for third quarter 2012 increased $158,000 versus third quarter 2011. Compensation and employee benefits decreased $45,000 due to changes in staffing levels and mix. Premises and equipment increased $21,000 due primarily to increased machine and software maintenance, due to replaced and upgraded equipment and software, offset slightly by an expense for disposed assets in third quarter 2011.

  Data processing increased $3,000. Higher volume of debit card and ATM transactions was partially offset by lower core processing expenses. Professional fees decreased $8,000. Lower usage of legal and consulting fees was partially offset by higher investment management fees due to increased assets under management in the Trust and Wealth Advisory division. Collections and OREO increased $149,000 versus third quarter 2011 due primarily to increased litigation expenses. FDIC insurance decreased $21,000 due to a decrease in the assessment base. Marketing and other operating expenses increased $59,000 due to higher administrative and operational expenses.

Income taxes

The effective income tax rates for third quarter 2012, second quarter 2012 and third quarter 2011 were 20.63%, 18.54% and 16.43%, respectively. Fluctuations in the effective tax rate result from changes in the mix of taxable and tax exempt income. Salisbury’s effective tax rate is generally less than the 34% federal statutory rate due to holdings of tax-exempt municipal bonds, some tax-exempt loans and bank owned life insurance.

Salisbury did not incur Connecticut income tax in 2012 or 2011, other than minimum state income tax, as a result of its utilization of Connecticut tax legislation that permits banks to shelter certain mortgage income from the Connecticut corporation business tax through the use of a special purpose entity called a Passive Investment Company (“PIC”). In accordance with this legislation, in 2004 the Bank formed a PIC, SBT Mortgage Service Corporation. Salisbury's income tax provision reflects the full impact of the Connecticut legislation. Salisbury does not expect to pay other than minimum state income tax in the foreseeable future unless there is a change in the State of Connecticut corporate tax law.

For the nine month periods ended September 30, 2012 and 2011

Overview

Net income available to common shareholders was $3,328,000, or $1.97 per common share, for the nine month period ended September 30, 2012 (nine month period 2012), compared with $2,459,000, or $1.46 per common share, for the nine month period ended September 30, 2011 (nine month period 2011).

The following table sets forth the changes in tax-equivalent interest due to volume and rate.

Interest Income

Tax equivalent interest income decreased $845,000, or 4.5%, to $17.9 million for nine month period 2012 versus nine month period 2011.

Loan income decreased $311,000, or 2.2%, primarily due to a 32 basis points decline in the average loan yield offset in part by a $15.2 million, or 4.2%, increase in average loans. Tax equivalent securities income decreased $496,000, or 10.6%, primarily due to a 42 basis points decline in the average yield and by a $1.5 million, or 1.1%, decrease in average volume. Changes in securities yields resulted from the effect of changes in market interest rates on securities purchases, calls and sales of agency bonds and prepayments of mortgage backed securities. Income from short term funds decreased $43,000 as a result of a 15 basis points decline in the average yield and by a $1.3 million decrease in the average balance.

Interest Expense

Interest expense decreased $978,000, or 22.9%, to $3.3 million for nine month period 2012 versus nine month period 2011.

Interest on deposit accounts and retail repurchase agreements decreased $604,000, or 24.2%, as a result of lower average rates, down 23 and 9 basis points respectively, along with an average balance decrease of $5.5 million in repurchase agreements. Lower rates were offset in part by a $15.5 million, or 4.1%, increase in the average balance of deposits. The lower average rate resulted from the effect of lower market interest rates on rates paid and changes in product mix. The higher average volume resulted from deposit growth.

Interest expense on FHLBB borrowings decreased $374,000 as a result of lower average borrowings, down $13.8 million, offset in part by a higher average borrowing rate, up 13 basis points, due to scheduled maturities that were not replaced with new advances.

Provision and Allowance for Loan Losses

The provision for loan losses was $690,000 for nine month period 2012 and $860,000 for nine month period 2011. Net loan charge-offs were $587,000 and $753,000, for the respective periods.

Reserve coverage at September 30, 2012, as measured by the ratio of allowance for loan losses to gross loans, remained stable at 1.10%, as compared with 1.10% a year ago at September 30, 2011. During the first nine months of 2012, non-performing loans (non-accrual loans and accruing loans past-due 90 days or more) increased $1.2 million to $9.2 million, or 2.43% of gross loans receivable, from 2.16% at December 31, 2011 while accruing loans past due 30-89 days increased $0.7 million to $3.2 million, or 0.83% of gross loans receivable from 0.66% at December 31, 2011. See “Financial Condition – Loan Credit Quality” for further discussion and analysis.

Non-interest income

The following table details the principal categories of non-interest income.

Non-interest income for the nine month period 2012 increased $1,472,000 versus nine month period 2011. Trust and Wealth Advisory revenues increased $312,000 from growth in managed assets and higher estate fees collected in 2012. Service charges and fees increased $73,000 due primarily to higher interchange fees resulting from increased volume. Income from sales and servicing of mortgage loans increased $743,000 due to interest rate driven fluctuations in the volume of fixed rate residential mortgage loan sales and mortgage servicing valuations. Mortgage loans sales totaled $46.8 million for nine month period 2012 and $16.1 million for nine month period 2011. Nine month period 2012 and 2011 included mortgage servicing valuation impairment charges of $90,000 and $80,000, respectively. Nine month period 2012 gains on securities resulted from the sale of $2.5 million of US Treasury bonds, while nine month period 2011 gains on securities represent accretion of discounts on called securities. Other income consisted of bank owned life insurance income and rental income.

Non-interest expense

The following table details the principal categories of non-interest expense.

Non-interest expense for nine month period 2012 increased $830,000 versus nine month period 2011. Salaries increased $66,000 due to changes in staffing levels and mix. Employee benefits increased $325,000 due primarily to a 2012 pension plan curtailment expense of $341,000 from retiree lump-sum withdrawals. Premises and equipment increased $66,000 due primarily to higher depreciation and increased machine and software maintenance due to replaced and upgraded equipment and software. The increase was offset slightly by lower building maintenance and repairs (snow removal) and utilities due to the mild winter experienced in the Northeast. Data processing increased $162,000 due primarily to a 2011 vendor rebate and a higher volume of debit card and ATM transactions in 2012. Professional fees increased $28,000 due primarily to higher investment management fees associated with the growth in trust and wealth advisory assets under management and offset partially by lower usage of legal and consulting services. Collections and OREO expense increased $226,000 due primarily to higher litigation expenses, up $413,000, and payment of delinquent real estate taxes in connection with foreclosed properties, up $65,000. These increases were offset in part by lower foreclosed property expenses, which was down $217,000. Salisbury had $641,000 in foreclosed property at September 30, 2012 as compared with $2.7 million at September 30, 2011. FDIC insurance expense decreased $156,000 for the nine month period ended September 30, 2012, due primarily to a change in the basis of assessment effective July 1, 2011 that lowered the overall assessment rate for subsequent periods. Other operating expenses increased $113,000 due to higher other administrative and operational expenses.

Income taxes

The effective income tax rates for nine month periods 2012 and 2011 were 21.54% and 17.27%, respectively. Fluctuations in the effective tax rate result from changes in the mix of taxable and tax exempt income. Salisbury’s effective tax rate is generally less than the 34% federal statutory rate due to holdings of tax-exempt municipal bonds, some tax-exempt loans and bank owned life insurance.

FINANCIAL CONDITION

Overview

Total assets were $611 million at September 30, 2012, up $2 million from December 31, 2011. Loans receivable, net, were $377 million at September 30, 2012, up $6.6 million, or 1.8%, from December 31, 2011. Non-performing assets were $9.9 million at September 30, 2012, down $0.9 million from $10.8 million at December 31, 2011. Reserve coverage, as measured by the ratio of the allowance for loan losses to gross loans, was 1.10%, 1.09% and 1.10%, at September 30, 2012, December 31, 2011 and September 30, 2011, respectively. Deposits were $490 million, up $19 million from $471 million at December 31, 2011.

At September 30, 2012, book value and tangible book value per common share were $32.18 and $25.86, respectively as compared with $30.12 and $23.69, respectively, at December 31, 2011 and $30.36 and $23.91, respectively, at September 30, 2011. Salisbury’s Tier 1 leverage and total risk-based capital ratios were 9.78% and 17.00%, respectively, and above the “well capitalized” limits as defined by the FRB.

Securities and Short Term Funds

During third quarter 2012, securities decreased $30.5 million to $131 million, while cash and cash-equivalents (interest-bearing deposits with other banks, money market funds and federal funds sold) increased $28.5 million to $65 million. Salisbury continued to maintain a relatively high level of cash and cash-equivalents in response to historically low market interest rates and a higher level of volatile deposits.

Salisbury evaluates securities for OTTI where the fair value of a security is less than its amortized cost basis at the balance sheet date. As part of this process, Salisbury considers its intent to sell each debt security and whether it is more likely than not that it will be required to sell the security before its anticipated recovery. If either of these conditions is met, Salisbury recognizes an OTTI charge to earnings equal to the entire difference between the security’s amortized cost basis and its fair value at the balance sheet date. For securities that meet neither of these conditions, an analysis is performed to determine if any of these securities are at risk for OTTI.

Salisbury does not intend to sell any of its securities and it is not more likely than not that Salisbury will be required to sell any of its securities before recovery of their cost basis, which may be maturity. Therefore, management does not consider any of its securities, other than four non-agency CMO securities reflecting OTTI, to be OTTI at September 30, 2012.

In 2009 Salisbury determined that five non-agency CMO securities reflected OTTI and recognized losses for deterioration in credit quality of $1.1 million. Salisbury judged the four remaining securities not to have additional OTTI and all other CMO securities not to be OTTI as of September 30, 2012. It is possible that future loss assumptions could change necessitating Salisbury to recognize future OTTI for further deterioration in credit quality. Salisbury does not intend to sell these securities and it is not more likely than not that Salisbury will be required to sell these securities before recovery of their cost basis.

Accumulated other comprehensive income of $0.9 million at September 30, 2012 included net unrealized securities gains, net of tax, of $3.0 million, mostly offset by unrecognized pension plan expense, net of tax, of $2.1 million.

Loan Credit Quality

The persistent weakness in the local and regional economies continues to impact the credit quality of Salisbury’s loans receivable. During the first nine months of 2012, while non-performing assets decreased $0.9 million, total impaired and potential problem loans increased $1.4 million to $28.1 million, or 7.4% of gross loans receivable at September 30, 2012, from $26.7 million, or 7.2% of gross loans receivable at December 31, 2011.

The credit quality segments of loans receivable and their credit risk ratings are as follows:

Changes in impaired and potential problem loans are as follows:

During the first nine months of 2012 Salisbury downgraded risk ratings on $1.7 million of loans, placed $3.9 million of loans on non-accrual status as a result of deteriorated payment and financial performance and charged-off $556,000 of losses primarily as a result of collateral deficiencies. Offsetting these deteriorations were loan risk rating upgrades resulting from improved performance, loans returned to accrual status as a result of sustained performance, and loan repayments.

Salisbury has cooperative relationships with the vast majority of its non-performing loan customers. Substantially all non-performing loans are collateralized with real estate and the repayment of such loans is largely dependent on the return of such loans to performing status or the liquidation of the underlying real estate collateral. Salisbury pursues the resolution of non-performing loans through collections, restructures, voluntary liquidation of collateral by the borrower and, where necessary, legal action. When reasonable attempts to work with a customer to return a loan to performing status, including restructuring the loan, are unsuccessful, Salisbury initiates appropriate legal action seeking to acquire property by deed in lieu of foreclosure or through foreclosure, or to liquidate business assets.

The loan portfolio of Salisbury is substantially secured by real estate collateral and during the economic decline which began in 2007, the value and liquidity of real estate collateral in the region was generally negatively impacted. Recently, it appears that the real estate values in the markets in which Salisbury operates have generally stabilized and improvement in the value and liquidity of real estate collateral provides additional support for the adequacy of allowance for loan losses.

Credit Quality Segments

Salisbury categorizes loans receivable into the following credit quality segments.

Credit Risk Ratings

Salisbury assigns credit risk ratings to loans receivable in order to manage credit risk and to determine the allowance for loan losses. Credit risk ratings categorize loans by common financial and structural characteristics that measure the credit strength of a borrower. Salisbury’s rating model has eight risk rating grades, with each grade corresponding to a progressively greater risk of default. Grades 1 through 4 are pass ratings and 5 through 8 are ratings (special mention, substandard, doubtful and loss) defined by the bank’s regulatory agencies, the FDIC and CTDOB. Risk ratings are assigned to differentiate risk within the portfolio and are reviewed on an ongoing basis and revised, if needed, to reflect changes in the borrowers' current financial position and outlook, risk profiles and the related collateral and structural positions.

Management actively reviews and tests its credit risk ratings against actual experience and engages an independent third-party to annually validate its assignment of credit risk ratings. In addition, the Bank’s loan portfolio and risk ratings are examined annually on a rotating basis by its two primary regulatory agencies, the FDIC and CTDOB.

The past due status of non-performing loans is as follows:

At September 30, 2012, 6.14% of non-accrual loans were current with respect to loan payments, compared with 9.09% at December 31, 2011. Loans past due 180 days include a $3.0 million loan secured by vacant land (residential building lots) where Salisbury has initiated a foreclosure action that is referred to in Item 1 of Part II, Legal Proceedings.

The past due status of troubled debt restructured loans is as follows:

At September 30, 2012, 70.38% of troubled debt restructured loans were current with respect to loan payments, as compared with 57.06% at December 31, 2011.

The past due status of potential problem loans is as follows:

At September 30, 2012, 82.77% of potential problem loans were current with respect to loan payments, as compared with 76.72% at December 31, 2011.

Management cannot predict the extent to which economic or other factors may impact such borrowers’ future payment capacity, and there can be no assurance that such loans will not be placed on nonaccrual status, restructured, or require increased provision for loan losses.

Deposits and Borrowings

Deposits increased $12.3 million during third quarter 2012 to $490.2 million at September 30, 2012, versus $477.9 million at June 30, 2012, and increased $11.6 million versus $478.6 million at September 30, 2011. Retail repurchase agreements decreased $3.2 million during third quarter 2012 to $2.9 million at September 30, 2012, versus $6.1 million at June 30, 2012, and decreased $11.9 million versus $14.8 million at September 30, 2011.

Federal Home Loan Bank of Boston (FHLBB) advances decreased $0.4 million during third quarter 2012 to $42.4 million at September 30, 2012, versus $42.8 million at June 30, 2012, and decreased $12.6 million versus $55.0 million at September 30, 2011. The decreases were due to scheduled payments and maturities.

Liquidity

Salisbury manages its liquidity position to ensure it has sufficient funding availability to meet anticipated and unanticipated deposit withdrawals, loan originations and advances, securities purchases and other operating cash outflows. Salisbury's primary sources of liquidity are principal payments and maturities of securities and loans, short-term borrowings through repurchase agreements and FHLBB advances, net deposit growth and funds provided by operations. Liquidity can also be provided through sales of loans and available-for-sale securities.

Salisbury manages its liquidity in accordance with a liquidity funding policy, and also maintains a contingency funding plan that provide for the prompt and comprehensive response to unexpected demands for liquidity. At September 30, 2012, Salisbury's liquidity ratio, as represented by cash, short term available-for-sale securities and marketable assets to net deposits and short term unsecured liabilities, was 35.0%, versus 33.7% at December 31, 2011. Management believes Salisbury’s funding sources will meet its anticipated funding needs.

Operating activities for the nine month period 2012 provided net cash of $5.5 million. Investing activities provided net cash of $27.2 million, primarily $32.4 million from securities available-for-sale and $1.7 million from sales of other real estate owned, offset in part by $7.0 million in net loan advances. Financing activities utilized net cash of $4.1 million, primarily for FHLBB advance repayments of $12.2 million, dividends paid of $1.6 million, and a decrease of $16.3 million in time deposits and repurchase agreements, offset in part by a $26.0 million increase in deposit transaction accounts.

At September 30, 2012, Salisbury had outstanding commitments to fund new loan originations of $7.5 million and unused lines of credit of $52.2 million. Salisbury believes that these commitments can be met in the normal course of business. Salisbury believes that its liquidity sources will continue to provide funding sufficient to support operating activities, loan originations and commitments, and deposit withdrawals.

CAPITAL RESOURCES

Shareholders’ equity was $70.4 million at September 30, 2012, up $3.5 million from December 31, 2011. Book value and tangible book value per common share were $32.18 and $25.86, respectively, compared with $30.12 and $23.69, respectively, at December 31, 2011. Contributing to the increase in shareholders’ equity for nine month period 2012 was net income of $3.5 million, other comprehensive income of $1.6 million, less common and preferred stock dividends of $1.4 million and $0.2 million, respectively. Other comprehensive income included unrealized gains on securities available-for-sale, net of tax, of $3.0 million and unrealized losses on the pension plan income, net of tax, of $2.1 million.

In August 2011, Salisbury issued to the U.S. Secretary of the Treasury (the “Treasury”) $16.0 million of its Series B Preferred Stock under the Small Business Lending Fund (the “SBLF”) program. The SBLF program is a $30 billion fund established under the Small Business Jobs Act of 2010 to encourage lending to small businesses by providing Tier 1 capital to qualified community banks with assets of less than $10 billion. The Preferred Stock qualifies as Tier 1 capital for regulatory purposes and ranks senior to the Common Stock.

The Series B Preferred Stock pays noncumulative dividends. The dividend rate on the Series B Preferred Stock for the initial quarterly dividend period ending June 30, 2011 and each of the next nine quarterly dividend periods the Series B Preferred Stock is outstanding is determined each quarter based on the increase in the Bank’s Qualified Small Business Lending. The dividend rates for the quarters ended September 30, 2012 and December 31, 2011 were 1.15625% and 1.51925%, respectively. For the tenth quarterly dividend period through four and one-half years after its issuance, the dividend rate on the Series B Preferred Stock will be fixed at the rate in effect at the end of the ninth quarterly dividend period and after four and one-half years from its issuance the dividend rate will be fixed at 9 percent per annum. On September 28, 2012, Salisbury declared a Series B Preferred Stock dividend of $46,250, payable on October 1, 2012. The Series B Preferred Stock is non-voting, other than voting rights on matters that could adversely affect the Series B Preferred Stock. The Series B Preferred Stock is redeemable at any time at one hundred percent of the issue price plus any accrued and unpaid dividends.

Simultaneously with the receipt of the SBLF capital, Salisbury repurchased for $8,816,000 all of its Series A Preferred Stock sold to the Treasury in 2009 under the Capital Purchase Program (“CPP”), a part of the Troubled Asset Relief Program of the Emergency Economic Stabilization Act of 2008, and made a payment for accrued dividends. The transaction resulted in net capital proceeds to Salisbury of $7,184,000, of which Salisbury invested $6,465,600, or 90%, in the Bank as Tier 1 Capital.

In 2009, as part of the CPP, Salisbury issued to the Treasury a 10-year Warrant to purchase 57,671 shares of Common Stock at an exercise price of $22.93 per share. The Warrant was repurchased for $205,000 on November 2, 2011.

A well-capitalized institution, which is the highest capital category for an institution as defined by the Prompt Corrective Action Regulations issued by the FDIC and the FRB, is one which maintains a Total Risk-Based ratio of 10% or above, a Tier 1 Risk-Based ratio of 6% or above and a Leverage ratio of 5% or above, and is not subject to any written order, written agreement, capital directive, or prompt corrective action directive to meet and maintain a specific capital level. Maintaining strong capital is essential to Salisbury’s and the Bank’s safety and soundness. However, the effective management of capital resources requires generating attractive returns on equity to build value for shareholders while maintaining appropriate levels of capital to fund growth, meet regulatory requirements and be consistent with prudent industry practices.

The Board of Governors of the Federal Reserve System and the other Federal Bank Supervisory Agencies recently proposed new regulations, which if adopted would restructure the current regulatory capital framework for the banking industry and revise the capital requirements applicable to banks and bank holding companies, including Salisbury and the Bank. These proposed capital rules would revise the risk-based and leverage capital ratios over time to implement the Dodd-Frank Act and to be generally consistent with Basel III Capital Standards established by the Basel Committee on Banking Supervision. The proposed rules would:

• Revise the definition of regulatory capital components and related calculations and revise certain methodologies for calculating risk weighted assets;

• Add a new minimum Common Equity Tier 1 risk based capital ratio of 4.5% of risk-weighted assets;

• Incorporate the revised regulatory capital requirements into the prompt corrective action framework;

• Implement a new capital conservation buffer; and

• Provide a transition period for several aspects of the proposed rule.

While the final provisions of such new capital regulations are uncertain, Salisbury has utilized available tools in an effort to reasonably assess the potential effect of these proposed capital rules on the adequacy of the capital ratios of both Salisbury and the Bank. Based upon such preliminary assessment, management has determined that Salisbury and the Bank have the ability to comply with the proposed capital regulations should they become effective.

Dividends

During the nine month period ended September 30, 2012 Salisbury paid $181,000 in Series B preferred stock dividends to the U.S. Treasury’s SBLF program, and $1,419,000 in common stock dividends.

Salisbury’s Board of Directors declared a $0.28 per common share quarterly cash dividend at their October 26, 2012 meeting. The dividend will be paid on November 30, 2012 to shareholders of record as of November 9, 2012.

Salisbury's ability to pay cash dividends is substantially dependent on the Bank's ability to pay cash dividends to Salisbury. Under Connecticut law a bank cannot declare a cash dividend except from net profits, defined as the remainder of all earnings from current operations. The total of all cash dividends declared by a bank shall not, unless specifically approved by the Commissioner of Banking, exceed the total of its net profits of that year combined with its retained net profits of the preceding two years.

FRB Supervisory Letter SR 09-4, February 24, 2009, revised March 27, 2009, notes that, as a general matter, the board of directors of a bank holding company (“BHC”) should inform the Federal Reserve and should eliminate, defer, or significantly reduce dividends if (1) net income available to shareholders for the past four quarters, net of dividends previously paid during that period, is not sufficient to fully fund the dividends; (2) the prospective rate of earnings retention is not consistent with capital needs and overall current and prospective financial condition; or (3) the BHC will not meet, or is in danger of not meeting, its minimum regulatory capital adequacy ratios. Moreover, a BHC should inform the FRB reasonably in advance of declaring or paying a dividend that exceeds earnings for the period (e.g., quarter) for which the dividend is being paid or that could result in a material adverse change to the BHC capital structure.

Salisbury believes that the payment of common stock cash dividends is appropriate, provided that such payment considers Salisbury's capital needs, asset quality, and overall financial condition and does not adversely affect the financial stability of Salisbury or the Bank. The continued payment of common stock cash dividends by Salisbury will be dependent on Salisbury's and the Bank’s future core earnings, financial condition and capital needs, regulatory restrictions, and other factors deemed relevant by the Board of Directors of Salisbury.

IMPACT OF INFLATION AND CHANGING PRICES

Salisbury’s consolidated financial statements are prepared in conformity with generally accepted accounting principles that require the measurement of financial condition and operating results in terms of historical dollars without considering changes in the relative purchasing power of money, over time, due to inflation. Unlike most industrial companies, virtually all of the assets and liabilities of Salisbury are monetary and as a result, interest rates have a greater impact on Salisbury’s performance than do the effects of general levels of inflation, although interest rates do not necessarily move in the same direction or with the same magnitude as the prices of goods and services. Although not a material factor in recent years, inflation could impact earnings in future periods.

FORWARD-LOOKING STATEMENTS

This Form 10-Q and future filings made by Salisbury with the Securities and Exchange Commission, as well as other filings, reports and press releases made or issued by Salisbury and the Bank, and oral statements made by executive officers of Salisbury and the Bank, may include forward-looking statements relating to such matters as:

Such forward-looking statements are based on assumptions and estimates rather than historical or current facts and, therefore, are inherently uncertain and subject to risk. For those statements, Salisbury claims the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995.

Salisbury notes that a variety of factors could cause the actual results or experience to differ materially from the anticipated results or other expectations described or implied by such forward-looking statements. The risks and uncertainties that may affect the operation, performance, development and results of Salisbury’s and the Bank’s business include the following:

Such developments could have an adverse impact on Salisbury’s and the Bank’s financial position and results of operations.