content: UNITED STATES
  
                         SECURITIES AND EXCHANGE COMMISSION
  
                               Washington, D.C. 20549
  
                                      Form 10-Q
  
  
       Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange
  Act of 1934
  
  For the period ended    June 30, 1997
  
  Commission File Number:  0-13775
  
  
  
                            KEYSTONE HERITAGE GROUP, INC.
                                    (Registrant)
  
  
       PENNSYLVANIA                                               23-2219740
  (State of incorporation)                                     (I.R.S. Employer
                                                               Identification No.)
  
                555 WILLOW STREET, LEBANON, PENNSYLVANIA     17046
               (Address of principal executive offices)    (Zip Code)
  
  
                                    717-274-6800
                (Registrant's telephone number, including area code)
  
  
       Indicate  by check mark  whether the  registrant  (1) has filed all reports
  required to be filed by Section 13 or 15(d) of the  Securities  Exchange  Act of
  1934  during  the  preceding  12 months  (or for such  shorter  period  that the
  registrant was required to file such reports),  and (2) has been subject to such
  filing requirements for the past 90 days. Yes X No
  
           Indicate  the  number of  shares  outstanding  of each of the  issuer's
  classes of common stock, as of the latest practicable date.
  
  
  
            Class                                 Outstanding at August 8, 1997
  Common Stock ($5.00 par value)                               3,951,583 shares
  
  <PAGE>
  
                            KEYSTONE HERITAGE GROUP, INC.
  
                                        Index
  
  
  PART I - FINANCIAL INFORMATION                                          Page
  
  
  Item 1 - Financial Statements
  
           Consolidated Balance Sheets as of
           June 30, 1997 and December 31, 1996 (Unaudited)                  3
  
           Consolidated Statements of Income for the
           Three and Six Months ended June 30, 1997 and
           1996 (Unaudited)                                                 4
  
           Consolidated Statements of Stockholders' Equity
           for the Six Months ended June 30, 1997 and
           1996 (Unaudited)                                                 5
  
           Consolidated Statements of Cash Flows for the
           Six Months ended June 30, 1997 and
           1996 (Unaudited)                                                 6
  
           Notes to Consolidated Financial Statements                       7
  
  
  Item 2 - Management's Discussion and Analysis of
           Financial Condition and Results of Operations                    8
  
  
  PART II - OTHER INFORMATION
  
  Item 4 - Submission of Matters To A Vote of Security Holders             17
  
  Signature Page                                                           19
  
                                         -2-
  
  <PAGE>
  
                            KEYSTONE HERITAGE GROUP, INC.
  
                             CONSOLIDATED BALANCE SHEETS
  
                               (Dollars In Thousands)
  
  <TABLE>
  <CAPTION>
                                                            June 30      December 31
                                                              1997           1996
  <S>                                                       <C>            <C>    
  ASSETS
        Cash and due from banks                             $22,008        $22,832
        Interest bearing deposits with banks                    341            181
        Federal funds sold                                    2,100              0
        Investment securities available for sale             68,171         62,596
        Investment securities held to maturity
             (fair value of $93,472 and $92,079
             for 1997 and 1996, respectively)                93,274         91,652
        Loans held for sale                                   1,280          6,019
        Loans, net of unearned income of
           $1,627 for 1997 and $1,812 for 1996              436,988        422,534
        Allowance for loan losses                            (8,681)        (7,736)
                                                          ---------      ---------
  
             Loans, net                                     428,307        414,798
  
        Premises and equipment, net                           8,537          8,132
        Accrued interest receivable                           3,720          3,677
        Other real estate owned                                 192            695
        Deferred tax asset, net                               2,665          2,604
        Other assets                                          3,517          3,121
                                                          ---------      ---------
  
             Total assets                                  $634,112       $616,307
                                                          =========      =========
  
  LIABILITIES
        Non-interest bearing deposits                       $70,569        $72,683
        Interest bearing deposits                           472,188        454,150
                                                          ---------      ---------
  
             Total deposits                                 542,757        526,833
  
        Short-term borrowings                                12,086         12,478
        Other borrowings                                      6,113          6,438
        Accrued interest payable                              4,794          5,184
        Other liabilities                                     3,007          3,135
                                                          ---------      ---------
  
             Total liabilities                              568,757        554,068
  
  STOCKHOLDERS' EQUITY
  
        Common stock - $5 par value; 10,000,000
             shares authorized; 4,071,683 outstanding
             at June 30, 1997 and December 31, 1996          20,358         20,358
        Capital surplus                                      22,078         22,078
        Retained earnings                                    24,881         21,418
        Treasury stock - 120,100 shares at June 30,
             1997 and 93,700 at December 31, 1996            (2,826)        (2,123)
        Net unrealized gain on investment securities
             available for sale, net of taxes                   864            508
                                                          ---------      ---------
  
             Total stockholders' equity                      65,355         62,239
  
             Total liabilities and stockholders'
               equity                                      $634,112       $616,307
                                                          =========      =========
  </TABLE>
  
  See accompanying notes to financial statements.
  
                                         -3-
  
  <PAGE>
  
                            KEYSTONE HERITAGE GROUP, INC.
                          CONSOLIDATED STATEMENTS OF INCOME
  
                    (Dollars in thousands, except per share data)
  <TABLE>
  <CAPTION>
                                                              Three Months Ended     Six Months Ended
                                                                  June 30                 June 30
                                                              1997       1996        1997         1996
  <S>                                                        <C>         <C>        <C>         <C>    
  INTEREST INCOME
                Interest and fees on loans                   $9,785      $8,977     $19,234     $17,730
                Interest and dividends on investment
                  securities available for sale:
                    Taxable investment securities               922         696       1,751       1,433
                    Equity investments                           67          49         130         104
                Interest and dividends on investment
                  securities held to maturity:
                    Taxable investment securities             1,073       1,074       2,182       2,219
                    Non-taxable investment securities           186         126         359         251
                                                            -------     -------     -------     -------
                      Total interest and dividends on
                       investment securities                  2,248       1,945       4,422       4,007
                Interest on money market investments            123          30         182          67
                                                            -------     -------     -------     -------
                    Total interest income                    12,156      10,952      23,838      21,804
  
  INTEREST EXPENSE
                Interest on deposits                          5,084       4,451       9,990       8,954
                Interest on short-term borrowings               127         113         249         234
                Interest on other borrowings                     95         160         192         322
                                                            -------     -------     -------     -------
                    Total interest expense                    5,306       4,724      10,431       9,510
  
                    Net interest income                       6,850       6,228      13,407      12,294
  
                Provision for loan losses                         0           0           0           0
                                                            -------     -------     -------     -------
                    Net interest income after provision
                     for possible loan losses                 6,850       6,228      13,407      12,294
  
  OTHER OPERATING INCOME
                Trust income                                    331         292         648         609
                Service charges on deposits                     359         331         701         637
                Net realized gain on investment
                    securities available for sale                28           0         202          23
                Net gain on sale of mortgage loans              211         249         425         323
                Net gain on sale of credit card loans
                    and merchant processing activity            618           0         618           0
                Other income                                    649         582       1,254       1,065
                                                            -------     -------     -------     -------
                    Total other operating income              2,196       1,454       3,848       2,657
  
  OTHER OPERATING EXPENSE
                Salaries and employee benefits                2,697       2,486       5,441       4,850
                Occupancy expense, net                          374         299         735         627
                Equipment expense                               484         546         938       1,052
                Deposit insurance expense                        17           0          32           1
                Other expense                                   970       1,350       2,245       2,626
                                                            -------     -------     -------     -------
                    Total other operating expense             4,542       4,681       9,391       9,156
  
                    Income before income taxes                4,504       3,001       7,864       5,795
                Income taxes                                  1,397         923       2,420       1,794
                                                            -------     -------     -------     -------
  
                    Net income                               $3,107      $2,078      $5,444      $4,001
                                                            =======     =======     =======     =======
  
  PER COMMON SHARE
                    Net income                                 $.78        $.51       $1.37        $.98
                                                            =======     =======     =======     =======
  
                    Cash dividends paid                        $.25        $.20        $.50        $.40
  </TABLE>
  
                                         -4-
  
  <PAGE>
  
                            KEYSTONE HERITAGE GROUP, INC.
                   CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                              Six Months Ended June 30
  
                               (Dollars in thousands)
  <TABLE>
  <CAPTION>
  
                                                                                                         Net Unrealized
                                                                                                         Gain (Loss) On
                                                          Common       Capital    Retained     Treasury  Securities Available
                                                           Stock       Surplus    Earnings       Stock   for Sale           Total
  <S>                                                    <C>          <C>         <C>               <C>         <C>       <C>    
  Balance, December 31, 1995                              $20,358      $22,078     $16,107           $0          $336      $58,879
                                                                                                                          --------
   Net Income                                                 -0-          -0-       4,001          -0-           -0-        4,001
                                                                                                                          --------
   Cash dividends ($.40 per share)                            -0-          -0-      (1,629)         -0-           -0-       (1,629)
                                                                                                                          --------
   Change in unrealized gain (loss)
    on investment securities
    available for sale, net of taxes                          -0-          -0-         -0-          -0-         (124)         (124)
                                                          -------      -------     -------      -------      --------      -------
  
  Balance, June 30, 1996                                  $20,358      $22,078     $18,479           $0          $212      $61,127
                                                         ========      =======     =======     ========      ========     ========
  
  Balance, December 31, 1996                              $20,358      $22,078     $21,418      ($2,123)         $508      $62,239
                                                          -------      -------     -------      -------      --------      -------
   Net income                                                 -0-          -0-       5,444           -0-           -0-       5,444
                                                          -------      -------     -------      -------      --------      -------
   Cash dividends ($.50 per share)                            -0-          -0-      (1,981)          -0-           -0-      (1,981)
                                                          -------      -------     -------      -------      --------      -------
   Acquisition of 43,300 shares of
    treasury stock at cost                                    -0-          -0-         -0-         (703)           -0-        (703)
                                                          -------      -------     -------      -------      --------      -------
   Change in unrealized gain
    (loss) on investment securities
    available for sale, net of taxes                          -0-          -0-         -0-          -0-           356          356
                                                          -------      -------     -------      -------      --------      -------
  
  Balance, June 30, 1997                                  $20,358      $22,078     $24,881      ($2,826)         $864      $65,355
                                                         ========      =======     =======     ========      ========     ========
  </TABLE>
  
                                         -5-
  <PAGE>
  
                            KEYSTONE HERITAGE GROUP, INC.
                        CONSOLIDATED STATEMENTS OF CASH FLOWS
                               (Dollars in thousands)
  <TABLE>
  <CAPTION>
                                                                      Six Months Ended
                                                                          June 30
                                                                     1997          1996
  <S>                                                              <C>           <C>   
  CASH FLOW FROM OPERATING ACTIVITIES:
      Net income                                                   $5,444        $4,001
      Adjustments to reconcile net income to cash:
          Depreciation and amortization                               631           816
          (Increase) decrease in deferred income taxes               (250)          249
          (Increase) decrease in accrued interest receivable          (43)          196
          Decrease in accrued interest payable                       (390)       (1,278)
          Net gain on sale or credit card loans
           and merchant card processing                              (618)            0
          Net gain on sale of other real estate owned                 (60)            0
          Net gain on sale of loans                                  (425)         (323)
          Originations of residential mortgage loans sold         (16,206)      (20,763)
          Proceeds from sale of residential mortgage loans         17,432        18,900
          Net realized gain on investment securities
           available for sale                                        (202)          (23)
          Other, net                                                 (850)         (796)
                                                                 --------      --------
              Net cash provided by operating activities             4,463           979
  
  CASH FLOWS FROM INVESTING ACTIVITIES:
      Net increase in money market investments                     (2,260)       (3,512)
      Maturities of investment securities
        held to maturity                                           15,118        12,447
      Maturities of investment securities
        available for sale                                          9,257        13,375
      Sale of investment securities available for sale              2,406            63
      Funds invested in investment securities
        held to maturity                                          (16,667)       (9,393)
      Funds invested in investment securities
        available for sale                                        (16,395)       (3,236)
      Proceeds from sale of credit card loans and
        merchant processing activity                                3,051             0
      Net increase in loans made to customers                     (11,894)      (15,584)
      Net expenditures for premises and equipment                  (1,036)         (600)
      Proceeds from sale of other real estate owned                   609           206
                                                                 --------      --------
          Net cash used in investing activities                   (17,811)       (6,234)
  
  
  CASH FLOWS FROM FINANCING ACTIVITIES:
      Net increase in deposits                                     15,924         4,905
      Net (decrease) increase in short-term borrowings               (392)        2,708
      Net increase (decrease) in other borrowings                    (324)       (5,479)
      Acquisition of treasury stock                                  (703)            0
      Cash dividends paid                                          (1,981)       (1,629)
                                                                 --------      --------
          Net cash used by financing activities                    12,524           505
  
      Net decrease in cash and due from banks                        (824)       (4,750)
  
      Cash and due from banks at beginning of period               22,832        23,766
      Cash and due from banks at end of period                    $22,008       $19,016
  
  SUPPLEMENTAL DISCLOSURES:
      Interest paid                                                $5,558        $4,826
      Income taxes paid                                             2,450         1,683
  
  NON-CASH INVESTING AND FINANCING ACTIVITIES:
      Loans charged-off                                               308           575
  </TABLE>
  
                                         -6-
  <PAGE>
  
                            KEYSTONE HERITAGE GROUP, INC.
  
                     NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
  
  
  1.    The accompanying  consolidated  financial  statements of Keystone Heritage
        Group,  Inc.  have not  been  reviewed  by  independent  certified  public
        accountants.  However, in management's opinion, the statements reflect all
        adjustments  and  disclosures  necessary  for a fair  presentation  of the
        consolidated balance sheet of the Company as of June 30, 1997 and December
        31,  1996,  the  consolidated  statements  of income for the three and six
        month periods ended June 30, 1997 and 1996 and the consolidated statements
        of cash  flows  for the six  months  ended  June 30,  1997 and  1996.  The
        accounting  policies  followed in the  presentation  of interim  financial
        results are the same as those followed on an annual basis or those adopted
        during the first quarter of 1997. The consolidated financial statements of
        Keystone Heritage Group, Inc. and subsidiaries include the accounts of the
        Company and its wholly owned  subsidiaries,  Lebanon Valley  National Bank
        and Keystone Heritage Life Insurance Company. All significant intercompany
        balances  and  transactions  have  been  eliminated  in  the  consolidated
        financial  statements.  For purposes of comparability,  certain prior year
        amounts have been reclassified.
  
  2.    Earnings per common share are based upon the  weighted  average  number of
        shares outstanding.  The weighted average number of shares outstanding was
        3,955,121  and  4,071,683  for the three month periods ended June 30, 1997
        and 1996,  respectively,  and  3,962,576  and 4,071,683 for the six months
        ended June 30, 1997 and 1996, respectively.
  
  
  3.    During the second  quarter of 1997 the Company  completed  the sale of its
        $3.1  million  portfolio  of credit  card  receivables,  and in a separate
        transaction,  completed  the sale of its  merchant  credit card  processor
        portfolio.  The combined effect of these  transactions  resulted in a $618
        thousand pre-tax gain.
  
  
                                         -7-
  
  <PAGE>
  
                        MANAGEMENT'S DISCUSSION AND ANALYSIS
                  OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
  
        Keystone  Heritage  Group,  Inc. (the "Company") is a bank holding company
  organized under the laws of Pennsylvania  and registered  under the Federal Bank
  Holding  Company Act of 1956.  The  Company's  principal  subsidiary  is Lebanon
  Valley National Bank (the "Bank").
  
  Results of Operations
        Net income for the  Company for the three  months  ended June 30, 1997 was
  $3.107  million or $.78 per share,  compared to $2.078 million or $.51 per share
  for the three months ended June 30, 1996. Return on average stockholders' equity
  and return on average  assets for the 1997  period  were 19.61  percent and 2.00
  percent, respectively.
  
        During the second  quarter,  the Company sold its $3.1 million credit card
  receivables  portfolio and its merchant  credit card  processor  portfolio at an
  after-tax net gain of approximately  $400 thousand or $.10 per share. Net income
  was also improved as a result of receiving  interest income and recovering legal
  expenses previously expended on a charged-off commercial loan. The net after-tax
  effect of these commercial loan related items was approximately $320 thousand or
  $.08 per share.  As part of the  settlement,  the Company  also  recovered  $500
  thousand of loans previously  charged-off  which  contributed to the increase in
  the Allowance for Loan Losses to $8.7 million.
  
        Net income for the six months  ended June 30,  1997 was $5.444  million or
  $1.37 per share,  compared to net income of $4.001 million or $.98 per share for
  1996.  Return on average  stockholders'  equity and return on average assets for
  the 1997 period were 17.41 percent and 1.78 percent, respectively.
  
  Net Interest Income
        Net interest  income is the primary source of income for the Company.  Net
  interest  income  is  the  difference  between  interest  earned  on  loans  and
  investments  and interest paid on deposits and other funding  sources.  Deposits
  are the primary source of funds for the Company. The factors which influence net
  interest  income  include  changes in  interest  rates and  changes in asset and
  liability balances.
  
        For purposes of this  discussion,  interest  income and the average  yield
  earned on loans and  investments  are presented on a taxable  equivalent  basis.
  This provides a basis for  comparison of tax exempt loans and  investments  with
  taxable loans and  investments by giving effect to interest earned on tax exempt
  loans and  investments  by an amount  equivalent  to federal  income taxes which
  would have been paid on the assumption  that the interest earned on those assets
  was taxable at the Company's statutory tax rate of 35 percent.
  
        The tables  presented  on pages 15 and 16 are  comparative  statements  of
  average balances of interest  earning assets and interest  bearing  liabilities,
  interest  income and interest  expense,  and interest rates for the three months
  ended June 30,  1997 and 1996,  and for the six months  ended June 30,  1997 and
  1996.
  
        Net  interest  income for the three  months  ended June 30,  1997 was $7.0
  million,  a $660 thousand or 10.4 percent increase from the same period of 1996.
  The net interest margin for the second quarter of 1997 was 4.76 percent compared
  to 4.71  percent for the same  period of 1996.  Average  earning  assets for the
  three month period ended June 30, 1997 were $592.4  million,  a $47.8 million or
  an 8.8  percent  increase  from the same  period of 1996.  For the  three  month
  comparative  periods,  net interest income and the net interest margin increased
  in 1997  primarily as a result of an increase in average  loans  outstanding  of
  $28.2  million or 7.0 percent and increases in the  investment  and money market
  investment balances of $19.6 million or 14.0 percent.  This growth was primarily
  funded by  increases  in average  interest  bearing  deposit  balances  of $44.9
  million, or 10.7 percent and an increase in average  non-interest bearing demand
  deposits of $3.4 million or 5.4 percent.
  
                                         -8-
  
  <PAGE>
  
        Net  interest  income  for the six months  ended  June 30,  1997 was $13.8
  million,  a $1.2 million or 9.4 percent  increase  from the same period of 1996.
  The net interest  margin for the six months ended June 30, 1997 was 4.74 percent
  compared to 4.68 percent for the same period of 1996. Average earning assets for
  the six month period ended June 30, 1997 were $585.5 million, a $44.4 million or
  a 8.2 percent increase from the same period of 1996.
  
  Provision and Allowance for Loan Losses
        There was no provision  for loan losses  charged to net income  during the
  six month period ended June 30, 1997 or 1996.
  
        Net  recoveries  of $782 thousand were recorded for the three months ended
  June 30, 1997 compared to net  charge-offs  of $122 thousand for the same period
  of  1996.  For the  six  month  comparative  period  the  Company  recorded  net
  recoveries  of $945  thousand  for 1997 and  recorded  net  charge-offs  of $371
  thousand for 1996.  During the second quarter or 1997,  the Company  recovered a
  total of $885  thousand on three  unrelated  commercial  loans.  A total of $500
  thousand  which  was  previously  charged  off  in  1992  was  recovered  on one
  commercial  loan though a  litigation  process.  In  addition  to the  recovered
  principal  balance on this loan,  the Company also  recovered  $490  thousand in
  interest income and legal expenses  associated  with this loan.  Commercial loan
  charge-offs for the six months ended June 30, 1997 were $339 thousand lower than
  the same period of 1996 while  charge-offs in loans to individuals  increased by
  $68 thousand for the same comparative periods.
  
        The  allowance  for loan losses was $8.7  million or 1.99 percent of total
  loans  outstanding at June 30, 1997 and $7.7 million or 1.83 percent at June 30,
  1996.  The allowance for loan losses is a reserve for estimated  potential  loan
  losses in the loan  portfolio.  Losses occur  primarily from the loan portfolio,
  but may also be derived from commitments to extend credit and standby letters of
  credit.  Loan losses and recoveries of previously  charged-off loans are charged
  or credited  directly to the allowance  for loan losses.  The allowance for loan
  losses is an amount which, in management's  judgement, is considered adequate to
  absorb  potential losses inherent in the loan portfolio.  Management  performs a
  quarterly  assessment of the Bank's loan portfolio to determine the  appropriate
  level  of the  allowance  for  loan  losses.  The  factors  considered  in  this
  evaluation  include,  but are not necessarily  limited to, estimated loan losses
  identified  through  the  review of loans by the  Company's  personnel;  general
  economic conditions; deterioration in loan concentrations or pledged collateral;
  historic  loss  experience;   and  trends  in  portfolio  volume,   composition,
  delinquencies, and non-accruals. In addition, various regulatory agencies, as an
  integral  part of their  examination  process,  periodically  review  the Bank's
  allowance for loan losses.
  
  
                                         -9-
  
  <PAGE>
  
        The  following  is a summary of the  activity  in the  allowance  for loan
  losses for the three and six month periods ended June 30, 1997 and 1996:
  <TABLE>
  <CAPTION>
                                                                          Three Months Ended                Six Months Ended
                                                                                June 30                         June 30
  (Dollars in thousands)                                                   1997             1996             1997      1996
  <S>                                                                     <C>              <C>              <C>        <C>
   Allowance for loan losses
    at beginning of period                                               $7,899           $7,776            $7,736    $8,025
   Loans charged-off:
    Commercial                                                               67              142                67       406
    Agriculture                                                               0                0                 0         0
    Real estate construction                                                  0                0                 0         0
    Loans to individuals                                                    138               88               237       169
    Real estate - residential mortgage                                        4                0                 4         0
                                                                         ------           ------            ------    ------
   Total loans charged-off                                                  209              230               308       575
  
   Recoveries of loans previously charged-off:
    Commercial                                                              964               90             1,210       171
    Agriculture                                                               0                0                 0         0
    Real estate construction                                                  0                8                 0        12
    Loans to individuals                                                     26               10                42        21
    Real estate - residential mortgage                                        1                0                 1         0
                                                                         ------           ------            ------    ------
    Total recoveries of loans previously
                             charged-off                                    991              108             1,253       204
  
    Net loans charged-off                                                  (782)             122              (945)      371
    Current period's provision for
    loan losses                                                               0                0                 0         0
                                                                         ------           ------            ------    ------
  
    Allowance for loan
    losses at end of period                                              $8,681           $7,654            $8,861    $7,654
                                                                         ======           ======            ======    ======
  </TABLE>
  
  Other Operating Income and Expense
       Other  operating  income was $2.2  million  and $1.5  million for the three
  months ended June 30, 1997 and 1996,  respectively.  Other operating  income was
  $3.9  million and $2.7  million for the six months ended June 30, 1997 and 1996,
  respectively.  During the second quarter of 1997 the Company  completed the sale
  of its $3.1  million  portfolio  of credit card  receivables,  and in a separate
  transaction, completed the sale of our merchant credit card processor portfolio.
  The combined effect of these  transactions  resulted in a $618 thousand  pre-tax
  gain.  The  gain on the sale of the  credit  card  portfolio  along  with  gains
  recognized on the sale of certain  equity  investments  recorded as  investments
  available  for sale were the primary  reasons for the growth in other  operating
  income  during the six month period of 1997 compared to the same period of 1996.
  In addition,  the Company recognized $425 thousand from selling $16.2 million of
  mortgages in the  secondary  market in the six month period of 1997  compared to
  recognizing  $323 thousand from selling $20.8 million in the secondary market in
  the same period of 1996. The increase in the gain on sale of mortgage loans is a
  result of an increase in the the amount of government (FHA and VA) loans sold in
  1997 compared to 1996.  Although  total  mortgage loan sales have decreased from
  1996 the profit margin attributable to FHA and VA loans is significantly  higher
  than the  conventional  loans which the Company  sold  exclusively  prior to the
  acquisition of Central Mortgage Company during the first quarter of 1996.
  
       Other  operating  expense for the three months ended June 30, 1997 was $4.5
  million,  a 3.0 percent  decrease  from the $4.7  million  reported for the same
  period of 1996. For the six months ended June 30, 1997 other  operating  expense
  was $9.4 million compared to $9.2 million for the same period of 1996.
  
       Salaries and benefits expense increased by $211 thousand or 8.5 percent and
  by $591  thousand or 12.2  percent  for the three and six months  ended June 30,
  1997  compared to the same  periods of 1996.  The increase in salary and benefit
  expense is primarily  attributable to the opening of five de novo branches since
  September  30, 1996 and the effects of the staffing for Central  Mortgage  being
  present for the full year in 1997,  compared to being present for four months in
  1996. In addition  merit  increases of 3.5 percent were applied to base salaries
  as of January 1, 1997. Other expense  decreased by  approximately  $380 thousand
  for both the three and six month  periods  ended June 30,  1997  compared to the
  same period of 1996. A portion of the reduction in other  operating  expense was
  attributable to the recovery of previously expended legal fees amounting to $458
  thousand for two separate commercial loans.
  
                                        -10-
  
  <PAGE>
  
  Non-Performing Assets
       Loans,  other than consumer loans not secured by real estate, are typically
  classified  as  non-accrual  at the  time  they  reach  90 days  past  due as to
  principal or interest.  Loans may also be placed on non-accrual  status when, in
  management's  opinion,  the collectability of principal or interest is doubtful,
  or should management  believe that circumstances  warrant such action.  Consumer
  loans not secured by residential  real estate are  charged-off  when they become
  120 days past due.
  
       Non-performing loans at June 30, 1997 totalled $966 thousand or .22 percent
  of total loans outstanding, compared to $973 thousand or .23 percent of loans at
  December  31, 1996 and $1.3  million or .31  percent of loans at June 30,  1996.
  Non-performing assets at June 30, 1997 were $1.2 million or .27 percent of loans
  plus other real estate  owned  compared to $1.7  million or .39 percent of loans
  plus  other real  estate  owned at  December  31,  1996 and $2.0  million or .49
  percent of loans plus other real estate owned at June 30, 1996. The  improvement
  in non-performing assets at June 30, 1997 as compared to December 31, 1996 was a
  result of decreased levels of other real estate owned.
  
       The following is a  presentation  of  non-performing  assets as of June 30,
  1997, December 31, 1996, and June 30, 1996:
  
                                          June 30     Dec. 31     June 30
  (Dollars in thousands)                    1997        1996        1996
  
  Non-performing loans                       $966        $973      $1,251
  Other real estate owned, net                192         695         741
                                           ------      ------      ------
  Total non-performing assets              $1,158      $1,668      $1,992
                                           ======      ======      ======
  
  Loans past due 90 days or more as to
    principal or interest                     579         624         303
  
  
  Allowance for loan losses to
    non-performing loans                    8.99x       7.95x       6.12x
  Non-performing loans as a
    percent of loans outstanding              .22%        .23%        .31%
  Non-performing assets as a
    percent of loans outstanding
    plus other real estate owned              .27%        .39%        .49%
  
       Interest income of  approximately  $12 thousand and $23 thousand would have
  been recognized  during the three and six month periods ended June 30, 1997, had
  these  loans been  current in  accordance  with  their  original  terms and been
  outstanding  through the period or since  origination.  Interest income on these
  loans of $1 thousand  and $2 thousand  was  recognized  during the three and six
  months ended June 30, 1997.
  
       Concentrations   of  credit  are   considered  to  exist  if  a  number  of
  counterparties  are  engaged in similar  activities  and have  similar  economic
  characteristics  that would cause their ability to meet contractual  obligations
  to  be  similarly   affected  by  changes  in  economic  or  other   conditions.
  Agriculture-related  borrowings  at June 30, 1997  totalled $115 million or 26.2
  percent of total  loans  outstanding.  These  loans may be  impacted  by adverse
  climate or economic  conditions  not common to other  industries.  The Company's
  exposure to possible loss in the event of  nonperformance  by these borrowers is
  represented by the contractual amount of those instruments. The Company's policy
  is to require  supporting  collateral  for these loans which is generally in the
  form of agriculture real estate, livestock, and farm equipment. At June 30, 1997
  there were no significant  agriculture  related borrowings which were classified
  as  non-performing  assets and there were no charge-offs of agriculture  related
  loans during the three or six months ended June 30, 1997.
  
                                        -11-
  
  <PAGE>
  
  Financial Position
       Total assets at June 30, 1997 were $634 million compared to $616 million at
  December 31, 1996.  Total loans  outstanding  at June 30, 1997 were $431 million
  compared to $423 million at December 31, 1996.  Total deposits at March 31, 1997
  were $543 million compared to $527 million at December 31, 1996.
  
  Capital Adequacy
       The Company's  stockholders'  equity was $65.4 million at June 30, 1997 and
  $62.2 million at December 31, 1996. Total stockholders'  equity increased by 5.0
  percent from  December 31, 1996 which was the net effect of the  recognition  of
  $5.4 million in net income for the three month period, cash dividend payments to
  stockholders  of $1.98 million,  a favorable  change in net unrealized  gains or
  losses on investment securities available for sale of $356 thousand,  and due to
  the  acquisition of treasury  stock at a cost of $703  thousand.  Net unrealized
  gains on  investment  securities  available  for sale of $864  thousand and $508
  thousand were included as a component of  stockholders'  equity at June 30, 1997
  and December 31, 1996, respectively.
  
       The Company  announced  its  intentions  to  repurchase  up to 5 percent or
  203,584 shares of its outstanding  common stock in June, 1996. These repurchased
  shares  will  be  available  for  reissuance   through  the  Company's  Dividend
  Reinvestment or Stock Option Plans or for other general  corporate  purposes.  A
  total of 14,000 shares of common stock were  re-acquired  by the Company  during
  the second  quarter of 1997 with a  cumulative  total of 120,100  acquired as of
  June 30, 1997.
  
       The  maintenance  of an  appropriate  level of capital is a priority of the
  Company's  management.  The Company's  capital  adequacy and dividend policy are
  closely  monitored  by  management  and are  reviewed  regularly by the Board of
  Directors of the Company.  The Company  intends to provide an adequate return to
  its stockholders while retaining a sufficient capital base to provide for future
  growth and to comply with regulatory standards.
  
       Banking  regulators'  risk-based  capital  guidelines  address  the capital
  adequacy of banking  organizations.  These  guidelines  include a definition  of
  capital and a framework for calculating risk-weighted assets by assigning assets
  and off-balance sheet items to broad risk categories,  as well as minimum ratios
  to be maintained by banking  organizations.  The  risk-based  capital ratios are
  calculated by dividing qualifying capital by risk-weighted assets.
  
       Under the risk-based  capital  guidelines,  Total Capital is defined as the
  sum of core or "Tier 1" Capital and "Tier 2" Capital. As the guidelines apply to
  Keystone Heritage Group, Inc., Tier 1 Capital is total stockholders'  equity and
  Tier 2 Capital  includes a portion of the allowance  for loan losses.  The rules
  require  that  banking  organizations  must have ratios of 4.00 percent and 8.00
  percent  for  Tier 1 and  Total  Capital,  respectively.  At June  30,  1997 the
  Company's  Tier 1 and Total Capital ratios were 13.39 percent and 14.72 percent,
  respectively.  Tier 1 and Total  Capital  ratios  were 13.12  percent  and 14.43
  percent  respectively,  at December  31,  1996.  In  addition to the  risk-based
  capital ratio, a bank is also required to maintain a "Leverage  ratio" of Tier 1
  capital to average total assets of 3 percent or higher.  The Company's  Leverage
  ratio was 10.32  percent at June 30, 1997 and was 10.28  percent at December 31,
  1996.
  
  
  Off-Balance Sheet Items
  
       The  Company's  loan   portfolio   consists  of  loans  to  businesses  and
  individuals  primarily  in its  five-county  market area of Lebanon,  Lancaster,
  Berks, Dauphin, and Schuylkill counties.
  
       In the ordinary course of business, the Company enters into agreements with
  customers,  such as commitments  to extend credit and standby  letters of credit
  which involve, to varying degrees,  elements of credit and interest rate risk in
  excess of the amounts presented in the balance sheet. The Company's  exposure to
  possible loss in the event of nonperformance by the other party to the financial
  instruments for commitments to extend credit and financial guarantees written is
  represented by the contractual amount of those instruments.  The Company may not
  be obligated to advance funds if the customer's financial condition deteriorates
  or if the customer fails to meet certain terms.
  
                                        -12-
  
  <PAGE>
  
       Commitments and  conditional  obligations  generally have fixed  expiration
  dates or termination clauses and may require payment of a fee. Since many of the
  commitments  are expected to expire  without  being used,  the total  commitment
  amounts do not  necessarily  represent  future  cash  requirements.  The Company
  evaluates each customer's creditworthiness on a case-by-case basis, applying the
  same  credit   standards  used  in  the  lending   process,   through   periodic
  reassessments  of the  customer's  creditworthiness  and through  ongoing credit
  reviews. The amount of collateral  obtained,  if deemed necessary by the Company
  upon  extension of credit,  is based on  management's  credit  evaluation of the
  counterparty.  Collateral  held  varies  but may  include  accounts  receivable,
  inventory,  property,  plant  and  equipment,  and  income-producing  commercial
  properties.
  
       The Company has entered into  interest  rate swap  contracts as part of its
  asset-liability  management  activities.  These contracts are used primarily for
  the purpose of managing  interest  rate risk in order to minimize  mismatches in
  the Bank's interest rate sensitivity and interest rate risk positions.
  
       Interest rate swap  contracts  generally  involve the exchange of fixed and
  floating-rate   interest  payment   obligations  without  the  exchange  of  the
  underlying  principal  amounts.  Entering  into  interest  rate  swap  contracts
  involves not only the risk of dealing with  counterparties  and their ability to
  meet the terms of the contracts but also the interest rate risk  associated with
  unmatched  positions.  Notional  principal amounts often are used to express the
  volume of these transactions.
  
       The interest  income or interest  expense  differential  from interest rate
  swap  contracts is  recognized  on the accrual  basis as a component of interest
  income or interest  expense over the life of the contract.  Gains or losses from
  early  termination  of interest  rate swap  contracts are deferred and amortized
  over the remaining term of the underlying assets or liabilities.  The Company is
  not exposed to credit risk in terms of the notional  amounts of these contracts,
  however, the receipt of payments representing the interest differential is based
  on the creditworthiness of the counterparty to each contract.
  
           The  Company's  use of these  interest  rate swap  contracts is closely
  monitored by the Company's  Board of Directors  and is closely  controlled as to
  levels  of  exposure.  At June 30,  1997 the  Company  had seven  interest  rate
  agreements  outstanding  having a total  notional  amount of $70 million.  These
  agreements  consisted  of  interest  rate swap  agreements  each with a notional
  amount of $10 million.
  
           The Company  does not obtain  collateral  or other  security to support
  financial instruments subject to credit risk but monitors the credit standing of
  counterparties. The counterparties of the aforementioned interest rate contracts
  are commercial banks having a rating of A1 from Moody's Investor Service.
  
       The following is the amount of financial instruments with off-balance sheet
  risk not  reflected  in the  consolidated  balance  sheets at June 30,  1997 and
  December 31, 1996:
  
                                          Contractual Amounts
                                          June 30    December 31
  (Dollars in thousands)                   1997        1996
  
  Financial instruments whose
  contractual amounts represent
   credit risk:
    Commitments to extend credit         $91,156     $93,811
    Standby letters of credit              8,028       7,335
  Contractual amounts of off-balance
  sheet financial  instruments not
  constituting credit risk:
    Interest rate swap, notional
     value                                70,000      70,000
  
  
  
                                        -13-
  
  <PAGE>
  
  
  Supervision and Regulation
  
       During the latter part of 1996, Congress agreed on a legislative package to
  stabilize the Savings and Loan (S&L) industry's  deposit  insurance fund (SAIF).
  The  legislation  required the S&L industry to  recapitalize  its insurance fund
  with a one-time assessment.  Previous proposals required the bank insurance fund
  (BIF) to contribute a substantial  amount to help  recapitalize  SAIF. Under the
  current legislation,  banks are required to pay an annual rate of 1.29 cents for
  every $100 of domestic  deposits  from 1997  through 1999 and pay 2.43 cents per
  $100 of domestic deposits for the years of 2000 through 2017. The amount of FDIC
  insurance to be paid under this new legislation  will not materially  impact the
  financial  position,  equity or the  results of  operations  for the  Company in
  future periods.
  
     The Bank is a national  bank,  chartered  under the National Bank Act, and is
  subject to the primary  supervision  of, and is examined by, the  Comptroller of
  the Currency.  As a member of the Federal Reserve System, the Bank is subject to
  provisions of the Federal  Reserve Act, which restricts the ability of a bank to
  extend  credit to its parent  holding  company  or to  certain  of the  parent's
  subsidiaries,  or to invest in the Company's  common stock or to take such stock
  as  collateral  for loans to any borrower.  The  operations of the Bank are also
  subject to regulation by the FDIC.
  
  New Accounting Standards
  
       In February 1997, the Financial Accounting Standards Board issued Statement
  of Financial Accounting Standards No. 128 (SFAS 128), "Earnings Per Share". SFAS
  128,  which  supersedes  APB  Opinion  No. 15 (APB 15),  "Earnings  Per  Share",
  specifies  the  computation,   presentation,  and  disclosure  requirements  for
  earnings  per share (EPS) for  entities  with  publicly  held common  stock.  It
  replaces the  presentation  of primary EPS with a presentation  of basic EPS and
  fully  diluted EPS with diluted EPS,  Basic EPS,  unlike  primary EPS,  excludes
  dilution and is computed by dividing income available to common  stockholders by
  the weighted average number of common shares outstanding for the period. Diluted
  EPS is computed  similarly  to fully  diluted EPS under APB 15. The Company will
  adopt SFAS 128 as of December 31, 1997.  Management  does not expect SFAS 128 to
  have a material effect on the EPS of the Company.
  
  
                                        -14-
  
  <PAGE>
  
            AVERAGE BALANCE SHEETS, RATES AND INTEREST INCOME AND EXPENSE
                               (Dollars in thousands)
  <TABLE>
  <CAPTION>
                                                  Three Months Ended June 30, 1997        Three Months Ended June 30, 1996
                                                    Average               Average          Average              Average
                                                    Balance    Interest    Rate            Balance    Interest    Rate
  <S>                                               <C>          <C>        <C>           <C>          <C>         <C>  
  Assets
      Loans                                         $433,412     $9,869     9.13%         $405,215     $9,056      8.99%
      Money market investments:
          Interest bearing deposits with banks           246          4     6.46               189          3      6.37
          Federal funds sold                           8,652        119     5.52             2,012         27      5.45
  
               Total money market investments          8,898        123     5.54             2,201         30      5.54
      Investment securities available for sale
        and held to maturity:
          Taxable investment securities
           available for sale                         66,863        989     5.93            56,202        747      5.35
          Taxable investment securities
           held to maturity                           66,603      1,073     6.46            69,092      1,072      6.24
          Non-taxable investment securities
           held to maturity                           16,630        286     6.91            11,926        193      6.52
                                                     -------    -------     ----           -------    -------      ---- 
               Total investment securities           150,096      2,348     6.27           137,220      2,012      5.90
               Total earning assets                  592,406    $12,340     8.35%          544,636    $11,098      8.20%
                                                                =======     ====                      =======      ==== 
  
      Other assets                                    30,415                                29,240
                                                    --------                              --------
               Total assets                         $622,821                              $573,876
                                                    ========                              ========
  
  Liabilities and stockholders' equity 
  Interest bearing deposits:
          Demand                                    $ 54,429      $ 176     1.29%         $ 55,008      $ 172      1.26%
          Savings                                    129,240      1,030     4.01           130,755      1,014      3.12
          Time                                       282,488      3,878     5.51           235,446      3,265      5.58
                                                     -------    -------     ----           -------    -------      ---- 
               Total interest bearing deposits       466,157      5,084     4.37           421,209      4,451      4.25
  
      Short-term borrowings                           11,913        127     4.28            10,860        113      4.20
      Other Borrowings                                 6,172         95     6.18            10,966        160      5.87
                                                     -------    -------     ----           -------    -------      ---- 
          Total interest bearing liabilities         484,242    $ 5,306     4.39%          443,035    $ 4,724      4.29%
                                                                =======     ====                      =======      ==== 
  
      Non-interest bearing deposits                   67,006                                63,566
      Other liabilities                                8,036                                 6,838
      Stockholders' equity                            63,537                                60,437
                                                    --------                              --------
          Total liabilities and
          stockholders' equity                      $622,821                              $573,876
                                                    ========                              ========
  
      Net interest income                                       $ 7,034                               $6,374
      Total yield on earning assets                                         8.35%                                  8.20%
                                                                            ----                                   ---- 
      Rate on supporting liabilities                                        3.59%                                  3.49%
                                                                            ----                                   ---- 
      Net interest margin                                                   4.76%                                  4.71%
                                                                            ====                                   ==== 
  </TABLE>
  
  Interest and average interest rates are presented on a fully taxable  equivalent
  basis,  using an effective  tax rate of 35%. For  purposes of  calculating  loan
  yields,  average loan balances include non-accrual loans. Loan fees are included
  in interest income.
  
                                        -15-
  
  <PAGE>
  
            AVERAGE BALANCE SHEETS, RATES AND INTEREST INCOME AND EXPENSE
                               (Dollars in thousands)
  <TABLE>
  <CAPTION>
                                                 Six Months Ended June 30, 1997           Six Months Ended June 30, 1996
                                                 Average               Average            Average              Average
                                                 Balance    Interest    Rate              Balance    Interest    Rate
  <S>                                              <C>            <C>             <C>    <C>           <C>            <C>  
  Assets
      Loans                                        $431,066       $19,401         9.08%  $397,782      $17,890        9.04%
      Money market investments:
          Interest bearing deposits with banks          248             8         6.50        236            7        5.96
          Federal funds sold                          6,433           174         5.45      2,229           60        5.41
                                                   --------      --------         ----   --------     --------        ----
               Total money market investments         6,681           182         5.49      2,465           67        5.47
      Investment securities available for sale
       and held to maturity:
          Taxable investment securities
           available for sale                        64,361         1,881         5.89     57,851        1,537        5.34
          Taxable investment securities
           held to maturity                          67,437         2,182         6.52     71,124        2,219        6.27
          Non-taxable investment securities
           held to maturity                          16,004           552         6.95     11,894          386        6.53
                                                   --------      --------         ----   --------     --------        ----
               Total investment securities          147,802         4,615         6.30    140,869        4,142        5.91
               Total earning assets                 585,549       $24,198         8.33%   541,116      $22,099        8.21%
                                                                  =======         ====                 =======        ==== 
  
      Other assets                                   29,982                                28,132
                                                   --------                              --------
               Total assets                        $615,531                              $569,248
                                                   ========                              ========
  
  Liabilities and stockholders' equity
  Interest bearing deposits:
          Demand                                    $54,248          $346         1.28%   $55,035         $362        1.32%
          Savings                                   128,224         2,013         3.17    129,272        1,999        3.11
          Time                                      278,085         7,631         5.53    234,591        6,593        5.65
                                                   --------      --------         ----   --------     --------        ----
               Total interest bearing deposits      460,557         9,990         4.37    418,898        8,954        4.30
  
      Short-term borrowings                          11,990           249         4.18     11,182          234        4.21
      Long-term debt                                  6,255           192         6.19     11,039          322        5.87
                                                   --------      --------         ----   --------     --------        ----
          Total interest bearing liabilities        478,802       $10,431         4.39%   441,119       $9,510        4.34%
                                                                  =======         ====                 =======        ==== 
  
      Non-interest bearing deposits                  65,428                                60,813
      Other liabilities                               8,234                                 7,488
      Stockholders' equity                           63,067                                59,828
                                                   --------                              --------
          Total liabilities and
          stockholders' equity                     $615,531                              $569,248
                                                   ========                              ========
  
      Net interest income                                         $13,767                              $12,589
      Total yield on earning assets                                               8.33%                              8.21%
      Rate on supporting liabilities                                              3.59%                              3.53%
                                                                                  ----                               ---- 
      Net interest margin                                                         4.74%                              4.68%
                                                                                  ====                               ==== 
  </TABLE>
  
  Interest and average interest rates are presented on a fully taxable  equivalent
  basis,  using an effective  tax rate of 35%. For  purposes of  calculating  loan
  yields,  average loan balances include non-accrual loans. Loan fees are included
  in interest income.
  
                                        -16-
  
  <PAGE>
  
  
  PART II.  OTHER INFORMATION
  
  ITEM 1.  LEGAL PROCEEDINGS
  
  None.
  
  ITEM 2.  CHANGES IN SECURITIES
  
  None.
  
  ITEM 3.  DEFAULTS UPON SENIOR SECURITIES
  
  None.
  
  ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
  
  1997 Annual Stockholders' Meeting
  
       The 1997 Annual Meeting of Stockholders'  for the Company was held on April
  15, 1997.  Stockholders' of the Company voted on the following issues:  Election
  of Directors  Raymond M.  Dorsch,  Jr.,  Wendie  DiMatteo  Holsinger,  Donald W.
  Lesher,  Jr. and Mark Randolph  Tice;  and a proposal to ratify the selection of
  KPMG Peat Marwick LLP as the Company's  Independent  Public  Accountants for the
  fiscal year ending  December 31, 1997.  Seventy  eight  percent of the 3,965,583
  shares  eligible  to vote were  voted in either  proxy  form or in person at the
  meeting.
  
       All  matters  subject to a vote at the Annual  Meeting  were  approved as a
  result of the votes cast at the Annual Meeting.  The following is a presentation
  of the voting results from the April 15, 1997 Annual Stockholders' Meeting:
  
  Election of Directors:             FOR           Withheld        Total
  
  Raymond M. Dorsch, Jr.          3,066,368          29,579      3,095,947
  
  Wendie DiMatteo Holsinger       3,053,073          42,874      3,095,947
  
  Donald W. Lesher, Jr.           3,087,036           8,911      3,095,947
  
  Mark Randolph Tice              3,084,994          10,953      3,095,947
  
  
       The term of the Directors  elected at the Annual Meeting expires in 2000 or
  when the director would reach the mandatory  retirement age of 72. The following
  directors  remain on the Company's  Board of Directors  until the  expiration of
  their  terms in 1998 and 1999 or when the  director  would  reach the  mandatory
  retirement age of 72:
  
  Directors Term Expiring in 1998:
  Charles V. Henry, III
  Bruce A. Johnson
  John E. Wengert
  
  Directors Term Expiring in 1999:
  Harry J. Gensemer
  Albert B. Murry
  Thomas I. Siegel
  Brett H. Tennis
  
       Messrs. Lance M. Frehafer and E.D. Williams, Jr., Directors of the Company,
  retired from the Board on April 15, 1997.
  
       The  proposal  to ratify  the  selection  of KPMG Peat  Marwick  LLP as the
  Company's Independent Public Accountants for the fiscal year ending December 31,
  1997 was voted as follows:
  
                  For              Against            Abstain
  
               3,088,774              1,595              5,578
  
  
                                        -17-
  
  <PAGE>
  
  ITEM 5.  OTHER INFORMATION
  
  None
  
  ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K
  
  (a.)  None.
  
  (b.)  The Company did not file any reports on Form 8-K during the quarter ended
  June 30, 1997.
  
  
  
  
                                        -18-
  
  
  <PAGE>
  
                            KEYSTONE HERITAGE GROUP, INC.
  
                                     SIGNATURES
  
  
       Pursuant to the  requirements  of the Securities  Exchange Act of 1934, the
  registrant  has duly  caused  this  report  to be  signed  on its  behalf by the
  undersigned thereunto duly authorized.
  
  
  
                                           Keystone Heritage Group, Inc.
                                           (Registrant)
  
  
  Date  July 31, 1997                 By /s/ Kurt A. Phillips
                                         Kurt A. Phillips
                                         Chief Financial and Accounting Officer
  
  
  
  
  
                                        -19-
metadata_documents: [{"type": "10-Q", "sequence": "1", "secsgml_size_bytes": 65890}]
metadata_filer: {"company-data": {"conformed-name": "KEYSTONE HERITAGE GROUP INC", "cik": "0000715366", "assigned-sic": "6021", "irs-number": "232219740", "state-of-incorporation": "PA", "fiscal-year-end": "1231"}, "filing-values": {"form-type": "10-Q", "act": "34", "file-number": "001-13744", "film-number": "97657207"}, "business-address": {"street1": "55 WILLOW ST", "street2": "P O BOX 1285", "city": "LEBANON", "state": "PA", "zip": "17042-1285", "phone": "7172746800"}, "mail-address": {"street1": "55 WILLOW ST", "street2": "555 WILLOW ST P O BOX 1285", "city": "LEBANON", "state": "PA", "zip": "17042-1285"}}
text: UNITED STATES
  
                         SECURITIES AND EXCHANGE COMMISSION
  
                               Washington, D.C. 20549
  
                                      Form 10-Q
  
       Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange
  Act of 1934
  
  For the period ended    June 30, 1997
  
  Commission File Number:  0-13775
  
                            KEYSTONE HERITAGE GROUP, INC.
                                    (Registrant)
  
       PENNSYLVANIA                                               23-2219740
  (State of incorporation)                                     (I.R.S. Employer
                                                               Identification No.)
  
                555 WILLOW STREET, LEBANON, PENNSYLVANIA     17046
               (Address of principal executive offices)    (Zip Code)
  
                                    717-274-6800
                (Registrant's telephone number, including area code)
  
       Indicate  by check mark  whether the  registrant  (1) has filed all reports
  required to be filed by Section 13 or 15(d) of the  Securities  Exchange  Act of
  1934  during  the  preceding  12 months  (or for such  shorter  period  that the
  registrant was required to file such reports),  and (2) has been subject to such
  filing requirements for the past 90 days. Yes X No
  
           Indicate  the  number of  shares  outstanding  of each of the  issuer's
  classes of common stock, as of the latest practicable date.
  
            Class                                 Outstanding at August 8, 1997
  Common Stock ($5.00 par value)                               3,951,583 shares
  KEYSTONE HERITAGE GROUP, INC.
  
                                        Index
  
  PART I - FINANCIAL INFORMATION                                          Page
  
  Item 1 - Financial Statements
  
           Consolidated Balance Sheets as of
           June 30, 1997 and December 31, 1996 (Unaudited)                  3
  
           Consolidated Statements of Income for the
           Three and Six Months ended June 30, 1997 and
           1996 (Unaudited)                                                 4
  
           Consolidated Statements of Stockholders' Equity
           for the Six Months ended June 30, 1997 and
           1996 (Unaudited)                                                 5
  
           Consolidated Statements of Cash Flows for the
           Six Months ended June 30, 1997 and
           1996 (Unaudited)                                                 6
  
           Notes to Consolidated Financial Statements                       7
  
  Item 2 - Management's Discussion and Analysis of
           Financial Condition and Results of Operations                    8
  
  PART II - OTHER INFORMATION
  
  Item 4 - Submission of Matters To A Vote of Security Holders             17
  
  Signature Page                                                           19
  
                                         -2-
  KEYSTONE HERITAGE GROUP, INC.
  
                             CONSOLIDATED BALANCE SHEETS
  
                               (Dollars In Thousands)
  June 30      December 31
                                                              1997           1996
  ASSETS
        Cash and due from banks                             $22,008        $22,832
        Interest bearing deposits with banks                    341            181
        Federal funds sold                                    2,100              0
        Investment securities available for sale             68,171         62,596
        Investment securities held to maturity
             (fair value of $93,472 and $92,079
             for 1997 and 1996, respectively)                93,274         91,652
        Loans held for sale                                   1,280          6,019
        Loans, net of unearned income of
           $1,627 for 1997 and $1,812 for 1996              436,988        422,534
        Allowance for loan losses                            (8,681)        (7,736)
                                                          ---------      ---------
  
             Loans, net                                     428,307        414,798
  
        Premises and equipment, net                           8,537          8,132
        Accrued interest receivable                           3,720          3,677
        Other real estate owned                                 192            695
        Deferred tax asset, net                               2,665          2,604
        Other assets                                          3,517          3,121
                                                          ---------      ---------
  
             Total assets                                  $634,112       $616,307
                                                          =========      =========
  
  LIABILITIES
        Non-interest bearing deposits                       $70,569        $72,683
        Interest bearing deposits                           472,188        454,150
                                                          ---------      ---------
  
             Total deposits                                 542,757        526,833
  
        Short-term borrowings                                12,086         12,478
        Other borrowings                                      6,113          6,438
        Accrued interest payable                              4,794          5,184
        Other liabilities                                     3,007          3,135
                                                          ---------      ---------
  
             Total liabilities                              568,757        554,068
  
  STOCKHOLDERS' EQUITY
  
        Common stock - $5 par value; 10,000,000
             shares authorized; 4,071,683 outstanding
             at June 30, 1997 and December 31, 1996          20,358         20,358
        Capital surplus                                      22,078         22,078
        Retained earnings                                    24,881         21,418
        Treasury stock - 120,100 shares at June 30,
             1997 and 93,700 at December 31, 1996            (2,826)        (2,123)
        Net unrealized gain on investment securities
             available for sale, net of taxes                   864            508
                                                          ---------      ---------
  
             Total stockholders' equity                      65,355         62,239
  
             Total liabilities and stockholders'
               equity                                      $634,112       $616,307
                                                          =========      =========
  See accompanying notes to financial statements.
  
                                         -3-
  KEYSTONE HERITAGE GROUP, INC.
                          CONSOLIDATED STATEMENTS OF INCOME
  
                    (Dollars in thousands, except per share data)
  Three Months Ended     Six Months Ended
                                                                  June 30                 June 30
                                                              1997       1996        1997         1996
  INTEREST INCOME
                Interest and fees on loans                   $9,785      $8,977     $19,234     $17,730
                Interest and dividends on investment
                  securities available for sale:
                    Taxable investment securities               922         696       1,751       1,433
                    Equity investments                           67          49         130         104
                Interest and dividends on investment
                  securities held to maturity:
                    Taxable investment securities             1,073       1,074       2,182       2,219
                    Non-taxable investment securities           186         126         359         251
                                                            -------     -------     -------     -------
                      Total interest and dividends on
                       investment securities                  2,248       1,945       4,422       4,007
                Interest on money market investments            123          30         182          67
                                                            -------     -------     -------     -------
                    Total interest income                    12,156      10,952      23,838      21,804
  
  INTEREST EXPENSE
                Interest on deposits                          5,084       4,451       9,990       8,954
                Interest on short-term borrowings               127         113         249         234
                Interest on other borrowings                     95         160         192         322
                                                            -------     -------     -------     -------
                    Total interest expense                    5,306       4,724      10,431       9,510
  
                    Net interest income                       6,850       6,228      13,407      12,294
  
                Provision for loan losses                         0           0           0           0
                                                            -------     -------     -------     -------
                    Net interest income after provision
                     for possible loan losses                 6,850       6,228      13,407      12,294
  
  OTHER OPERATING INCOME
                Trust income                                    331         292         648         609
                Service charges on deposits                     359         331         701         637
                Net realized gain on investment
                    securities available for sale                28           0         202          23
                Net gain on sale of mortgage loans              211         249         425         323
                Net gain on sale of credit card loans
                    and merchant processing activity            618           0         618           0
                Other income                                    649         582       1,254       1,065
                                                            -------     -------     -------     -------
                    Total other operating income              2,196       1,454       3,848       2,657
  
  OTHER OPERATING EXPENSE
                Salaries and employee benefits                2,697       2,486       5,441       4,850
                Occupancy expense, net                          374         299         735         627
                Equipment expense                               484         546         938       1,052
                Deposit insurance expense                        17           0          32           1
                Other expense                                   970       1,350       2,245       2,626
                                                            -------     -------     -------     -------
                    Total other operating expense             4,542       4,681       9,391       9,156
  
                    Income before income taxes                4,504       3,001       7,864       5,795
                Income taxes                                  1,397         923       2,420       1,794
                                                            -------     -------     -------     -------
  
                    Net income                               $3,107      $2,078      $5,444      $4,001
                                                            =======     =======     =======     =======
  
  PER COMMON SHARE
                    Net income                                 $.78        $.51       $1.37        $.98
                                                            =======     =======     =======     =======
  
                    Cash dividends paid                        $.25        $.20        $.50        $.40
  -4-
  KEYSTONE HERITAGE GROUP, INC.
                   CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                              Six Months Ended June 30
  
                               (Dollars in thousands)
  Net Unrealized
                                                                                                         Gain (Loss) On
                                                          Common       Capital    Retained     Treasury  Securities Available
                                                           Stock       Surplus    Earnings       Stock   for Sale           Total
  Balance, December 31, 1995                              $20,358      $22,078     $16,107           $0          $336      $58,879
                                                                                                                          --------
   Net Income                                                 -0-          -0-       4,001          -0-           -0-        4,001
                                                                                                                          --------
   Cash dividends ($.40 per share)                            -0-          -0-      (1,629)         -0-           -0-       (1,629)
                                                                                                                          --------
   Change in unrealized gain (loss)
    on investment securities
    available for sale, net of taxes                          -0-          -0-         -0-          -0-         (124)         (124)
                                                          -------      -------     -------      -------      --------      -------
  
  Balance, June 30, 1996                                  $20,358      $22,078     $18,479           $0          $212      $61,127
                                                         ========      =======     =======     ========      ========     ========
  
  Balance, December 31, 1996                              $20,358      $22,078     $21,418      ($2,123)         $508      $62,239
                                                          -------      -------     -------      -------      --------      -------
   Net income                                                 -0-          -0-       5,444           -0-           -0-       5,444
                                                          -------      -------     -------      -------      --------      -------
   Cash dividends ($.50 per share)                            -0-          -0-      (1,981)          -0-           -0-      (1,981)
                                                          -------      -------     -------      -------      --------      -------
   Acquisition of 43,300 shares of
    treasury stock at cost                                    -0-          -0-         -0-         (703)           -0-        (703)
                                                          -------      -------     -------      -------      --------      -------
   Change in unrealized gain
    (loss) on investment securities
    available for sale, net of taxes                          -0-          -0-         -0-          -0-           356          356
                                                          -------      -------     -------      -------      --------      -------
  
  Balance, June 30, 1997                                  $20,358      $22,078     $24,881      ($2,826)         $864      $65,355
                                                         ========      =======     =======     ========      ========     ========
  -5-
  KEYSTONE HERITAGE GROUP, INC.
                        CONSOLIDATED STATEMENTS OF CASH FLOWS
                               (Dollars in thousands)
  Six Months Ended
                                                                          June 30
                                                                     1997          1996
  CASH FLOW FROM OPERATING ACTIVITIES:
      Net income                                                   $5,444        $4,001
      Adjustments to reconcile net income to cash:
          Depreciation and amortization                               631           816
          (Increase) decrease in deferred income taxes               (250)          249
          (Increase) decrease in accrued interest receivable          (43)          196
          Decrease in accrued interest payable                       (390)       (1,278)
          Net gain on sale or credit card loans
           and merchant card processing                              (618)            0
          Net gain on sale of other real estate owned                 (60)            0
          Net gain on sale of loans                                  (425)         (323)
          Originations of residential mortgage loans sold         (16,206)      (20,763)
          Proceeds from sale of residential mortgage loans         17,432        18,900
          Net realized gain on investment securities
           available for sale                                        (202)          (23)
          Other, net                                                 (850)         (796)
                                                                 --------      --------
              Net cash provided by operating activities             4,463           979
  
  CASH FLOWS FROM INVESTING ACTIVITIES:
      Net increase in money market investments                     (2,260)       (3,512)
      Maturities of investment securities
        held to maturity                                           15,118        12,447
      Maturities of investment securities
        available for sale                                          9,257        13,375
      Sale of investment securities available for sale              2,406            63
      Funds invested in investment securities
        held to maturity                                          (16,667)       (9,393)
      Funds invested in investment securities
        available for sale                                        (16,395)       (3,236)
      Proceeds from sale of credit card loans and
        merchant processing activity                                3,051             0
      Net increase in loans made to customers                     (11,894)      (15,584)
      Net expenditures for premises and equipment                  (1,036)         (600)
      Proceeds from sale of other real estate owned                   609           206
                                                                 --------      --------
          Net cash used in investing activities                   (17,811)       (6,234)
  
  CASH FLOWS FROM FINANCING ACTIVITIES:
      Net increase in deposits                                     15,924         4,905
      Net (decrease) increase in short-term borrowings               (392)        2,708
      Net increase (decrease) in other borrowings                    (324)       (5,479)
      Acquisition of treasury stock                                  (703)            0
      Cash dividends paid                                          (1,981)       (1,629)
                                                                 --------      --------
          Net cash used by financing activities                    12,524           505
  
      Net decrease in cash and due from banks                        (824)       (4,750)
  
      Cash and due from banks at beginning of period               22,832        23,766
      Cash and due from banks at end of period                    $22,008       $19,016
  
  SUPPLEMENTAL DISCLOSURES:
      Interest paid                                                $5,558        $4,826
      Income taxes paid                                             2,450         1,683
  
  NON-CASH INVESTING AND FINANCING ACTIVITIES:
      Loans charged-off                                               308           575
  -6-
  KEYSTONE HERITAGE GROUP, INC.
  
                     NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
  
  1.    The accompanying  consolidated  financial  statements of Keystone Heritage
        Group,  Inc.  have not  been  reviewed  by  independent  certified  public
        accountants.  However, in management's opinion, the statements reflect all
        adjustments  and  disclosures  necessary  for a fair  presentation  of the
        consolidated balance sheet of the Company as of June 30, 1997 and December
        31,  1996,  the  consolidated  statements  of income for the three and six
        month periods ended June 30, 1997 and 1996 and the consolidated statements
        of cash  flows  for the six  months  ended  June 30,  1997 and  1996.  The
        accounting  policies  followed in the  presentation  of interim  financial
        results are the same as those followed on an annual basis or those adopted
        during the first quarter of 1997. The consolidated financial statements of
        Keystone Heritage Group, Inc. and subsidiaries include the accounts of the
        Company and its wholly owned  subsidiaries,  Lebanon Valley  National Bank
        and Keystone Heritage Life Insurance Company. All significant intercompany
        balances  and  transactions  have  been  eliminated  in  the  consolidated
        financial  statements.  For purposes of comparability,  certain prior year
        amounts have been reclassified.
  
  2.    Earnings per common share are based upon the  weighted  average  number of
        shares outstanding.  The weighted average number of shares outstanding was
        3,955,121  and  4,071,683  for the three month periods ended June 30, 1997
        and 1996,  respectively,  and  3,962,576  and 4,071,683 for the six months
        ended June 30, 1997 and 1996, respectively.
  
  3.    During the second  quarter of 1997 the Company  completed  the sale of its
        $3.1  million  portfolio  of credit  card  receivables,  and in a separate
        transaction,  completed  the sale of its  merchant  credit card  processor
        portfolio.  The combined effect of these  transactions  resulted in a $618
        thousand pre-tax gain.
  
                                         -7-
  MANAGEMENT'S DISCUSSION AND ANALYSIS
                  OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
  
        Keystone  Heritage  Group,  Inc. (the "Company") is a bank holding company
  organized under the laws of Pennsylvania  and registered  under the Federal Bank
  Holding  Company Act of 1956.  The  Company's  principal  subsidiary  is Lebanon
  Valley National Bank (the "Bank").
  
  Results of Operations
        Net income for the  Company for the three  months  ended June 30, 1997 was
  $3.107  million or $.78 per share,  compared to $2.078 million or $.51 per share
  for the three months ended June 30, 1996. Return on average stockholders' equity
  and return on average  assets for the 1997  period  were 19.61  percent and 2.00
  percent, respectively.
  
        During the second  quarter,  the Company sold its $3.1 million credit card
  receivables  portfolio and its merchant  credit card  processor  portfolio at an
  after-tax net gain of approximately  $400 thousand or $.10 per share. Net income
  was also improved as a result of receiving  interest income and recovering legal
  expenses previously expended on a charged-off commercial loan. The net after-tax
  effect of these commercial loan related items was approximately $320 thousand or
  $.08 per share.  As part of the  settlement,  the Company  also  recovered  $500
  thousand of loans previously  charged-off  which  contributed to the increase in
  the Allowance for Loan Losses to $8.7 million.
  
        Net income for the six months  ended June 30,  1997 was $5.444  million or
  $1.37 per share,  compared to net income of $4.001 million or $.98 per share for
  1996.  Return on average  stockholders'  equity and return on average assets for
  the 1997 period were 17.41 percent and 1.78 percent, respectively.
  
  Net Interest Income
        Net interest  income is the primary source of income for the Company.  Net
  interest  income  is  the  difference  between  interest  earned  on  loans  and
  investments  and interest paid on deposits and other funding  sources.  Deposits
  are the primary source of funds for the Company. The factors which influence net
  interest  income  include  changes in  interest  rates and  changes in asset and
  liability balances.
  
        For purposes of this  discussion,  interest  income and the average  yield
  earned on loans and  investments  are presented on a taxable  equivalent  basis.
  This provides a basis for  comparison of tax exempt loans and  investments  with
  taxable loans and  investments by giving effect to interest earned on tax exempt
  loans and  investments  by an amount  equivalent  to federal  income taxes which
  would have been paid on the assumption  that the interest earned on those assets
  was taxable at the Company's statutory tax rate of 35 percent.
  
        The tables  presented  on pages 15 and 16 are  comparative  statements  of
  average balances of interest  earning assets and interest  bearing  liabilities,
  interest  income and interest  expense,  and interest rates for the three months
  ended June 30,  1997 and 1996,  and for the six months  ended June 30,  1997 and
  1996.
  
        Net  interest  income for the three  months  ended June 30,  1997 was $7.0
  million,  a $660 thousand or 10.4 percent increase from the same period of 1996.
  The net interest margin for the second quarter of 1997 was 4.76 percent compared
  to 4.71  percent for the same  period of 1996.  Average  earning  assets for the
  three month period ended June 30, 1997 were $592.4  million,  a $47.8 million or
  an 8.8  percent  increase  from the same  period of 1996.  For the  three  month
  comparative  periods,  net interest income and the net interest margin increased
  in 1997  primarily as a result of an increase in average  loans  outstanding  of
  $28.2  million or 7.0 percent and increases in the  investment  and money market
  investment balances of $19.6 million or 14.0 percent.  This growth was primarily
  funded by  increases  in average  interest  bearing  deposit  balances  of $44.9
  million, or 10.7 percent and an increase in average  non-interest bearing demand
  deposits of $3.4 million or 5.4 percent.
  
                                         -8-
  Net  interest  income  for the six months  ended  June 30,  1997 was $13.8
  million,  a $1.2 million or 9.4 percent  increase  from the same period of 1996.
  The net interest  margin for the six months ended June 30, 1997 was 4.74 percent
  compared to 4.68 percent for the same period of 1996. Average earning assets for
  the six month period ended June 30, 1997 were $585.5 million, a $44.4 million or
  a 8.2 percent increase from the same period of 1996.
  
  Provision and Allowance for Loan Losses
        There was no provision  for loan losses  charged to net income  during the
  six month period ended June 30, 1997 or 1996.
  
        Net  recoveries  of $782 thousand were recorded for the three months ended
  June 30, 1997 compared to net  charge-offs  of $122 thousand for the same period
  of  1996.  For the  six  month  comparative  period  the  Company  recorded  net
  recoveries  of $945  thousand  for 1997 and  recorded  net  charge-offs  of $371
  thousand for 1996.  During the second quarter or 1997,  the Company  recovered a
  total of $885  thousand on three  unrelated  commercial  loans.  A total of $500
  thousand  which  was  previously  charged  off  in  1992  was  recovered  on one
  commercial  loan though a  litigation  process.  In  addition  to the  recovered
  principal  balance on this loan,  the Company also  recovered  $490  thousand in
  interest income and legal expenses  associated  with this loan.  Commercial loan
  charge-offs for the six months ended June 30, 1997 were $339 thousand lower than
  the same period of 1996 while  charge-offs in loans to individuals  increased by
  $68 thousand for the same comparative periods.
  
        The  allowance  for loan losses was $8.7  million or 1.99 percent of total
  loans  outstanding at June 30, 1997 and $7.7 million or 1.83 percent at June 30,
  1996.  The allowance for loan losses is a reserve for estimated  potential  loan
  losses in the loan  portfolio.  Losses occur  primarily from the loan portfolio,
  but may also be derived from commitments to extend credit and standby letters of
  credit.  Loan losses and recoveries of previously  charged-off loans are charged
  or credited  directly to the allowance  for loan losses.  The allowance for loan
  losses is an amount which, in management's  judgement, is considered adequate to
  absorb  potential losses inherent in the loan portfolio.  Management  performs a
  quarterly  assessment of the Bank's loan portfolio to determine the  appropriate
  level  of the  allowance  for  loan  losses.  The  factors  considered  in  this
  evaluation  include,  but are not necessarily  limited to, estimated loan losses
  identified  through  the  review of loans by the  Company's  personnel;  general
  economic conditions; deterioration in loan concentrations or pledged collateral;
  historic  loss  experience;   and  trends  in  portfolio  volume,   composition,
  delinquencies, and non-accruals. In addition, various regulatory agencies, as an
  integral  part of their  examination  process,  periodically  review  the Bank's
  allowance for loan losses.
  
                                         -9-
  The  following  is a summary of the  activity  in the  allowance  for loan
  losses for the three and six month periods ended June 30, 1997 and 1996:
  Three Months Ended                Six Months Ended
                                                                                June 30                         June 30
  (Dollars in thousands)                                                   1997             1996             1997      1996
  Allowance for loan losses
    at beginning of period                                               $7,899           $7,776            $7,736    $8,025
   Loans charged-off:
    Commercial                                                               67              142                67       406
    Agriculture                                                               0                0                 0         0
    Real estate construction                                                  0                0                 0         0
    Loans to individuals                                                    138               88               237       169
    Real estate - residential mortgage                                        4                0                 4         0
                                                                         ------           ------            ------    ------
   Total loans charged-off                                                  209              230               308       575
  
   Recoveries of loans previously charged-off:
    Commercial                                                              964               90             1,210       171
    Agriculture                                                               0                0                 0         0
    Real estate construction                                                  0                8                 0        12
    Loans to individuals                                                     26               10                42        21
    Real estate - residential mortgage                                        1                0                 1         0
                                                                         ------           ------            ------    ------
    Total recoveries of loans previously
                             charged-off                                    991              108             1,253       204
  
    Net loans charged-off                                                  (782)             122              (945)      371
    Current period's provision for
    loan losses                                                               0                0                 0         0
                                                                         ------           ------            ------    ------
  
    Allowance for loan
    losses at end of period                                              $8,681           $7,654            $8,861    $7,654
                                                                         ======           ======            ======    ======
  Other Operating Income and Expense
       Other  operating  income was $2.2  million  and $1.5  million for the three
  months ended June 30, 1997 and 1996,  respectively.  Other operating  income was
  $3.9  million and $2.7  million for the six months ended June 30, 1997 and 1996,
  respectively.  During the second quarter of 1997 the Company  completed the sale
  of its $3.1  million  portfolio  of credit card  receivables,  and in a separate
  transaction, completed the sale of our merchant credit card processor portfolio.
  The combined effect of these  transactions  resulted in a $618 thousand  pre-tax
  gain.  The  gain on the sale of the  credit  card  portfolio  along  with  gains
  recognized on the sale of certain  equity  investments  recorded as  investments
  available  for sale were the primary  reasons for the growth in other  operating
  income  during the six month period of 1997 compared to the same period of 1996.
  In addition,  the Company recognized $425 thousand from selling $16.2 million of
  mortgages in the  secondary  market in the six month period of 1997  compared to
  recognizing  $323 thousand from selling $20.8 million in the secondary market in
  the same period of 1996. The increase in the gain on sale of mortgage loans is a
  result of an increase in the the amount of government (FHA and VA) loans sold in
  1997 compared to 1996.  Although  total  mortgage loan sales have decreased from
  1996 the profit margin attributable to FHA and VA loans is significantly  higher
  than the  conventional  loans which the Company  sold  exclusively  prior to the
  acquisition of Central Mortgage Company during the first quarter of 1996.
  
       Other  operating  expense for the three months ended June 30, 1997 was $4.5
  million,  a 3.0 percent  decrease  from the $4.7  million  reported for the same
  period of 1996. For the six months ended June 30, 1997 other  operating  expense
  was $9.4 million compared to $9.2 million for the same period of 1996.
  
       Salaries and benefits expense increased by $211 thousand or 8.5 percent and
  by $591  thousand or 12.2  percent  for the three and six months  ended June 30,
  1997  compared to the same  periods of 1996.  The increase in salary and benefit
  expense is primarily  attributable to the opening of five de novo branches since
  September  30, 1996 and the effects of the staffing for Central  Mortgage  being
  present for the full year in 1997,  compared to being present for four months in
  1996. In addition  merit  increases of 3.5 percent were applied to base salaries
  as of January 1, 1997. Other expense  decreased by  approximately  $380 thousand
  for both the three and six month  periods  ended June 30,  1997  compared to the
  same period of 1996. A portion of the reduction in other  operating  expense was
  attributable to the recovery of previously expended legal fees amounting to $458
  thousand for two separate commercial loans.
  
                                        -10-
  Non-Performing Assets
       Loans,  other than consumer loans not secured by real estate, are typically
  classified  as  non-accrual  at the  time  they  reach  90 days  past  due as to
  principal or interest.  Loans may also be placed on non-accrual  status when, in
  management's  opinion,  the collectability of principal or interest is doubtful,
  or should management  believe that circumstances  warrant such action.  Consumer
  loans not secured by residential  real estate are  charged-off  when they become
  120 days past due.
  
       Non-performing loans at June 30, 1997 totalled $966 thousand or .22 percent
  of total loans outstanding, compared to $973 thousand or .23 percent of loans at
  December  31, 1996 and $1.3  million or .31  percent of loans at June 30,  1996.
  Non-performing assets at June 30, 1997 were $1.2 million or .27 percent of loans
  plus other real estate  owned  compared to $1.7  million or .39 percent of loans
  plus  other real  estate  owned at  December  31,  1996 and $2.0  million or .49
  percent of loans plus other real estate owned at June 30, 1996. The  improvement
  in non-performing assets at June 30, 1997 as compared to December 31, 1996 was a
  result of decreased levels of other real estate owned.
  
       The following is a  presentation  of  non-performing  assets as of June 30,
  1997, December 31, 1996, and June 30, 1996:
  
                                          June 30     Dec. 31     June 30
  (Dollars in thousands)                    1997        1996        1996
  
  Non-performing loans                       $966        $973      $1,251
  Other real estate owned, net                192         695         741
                                           ------      ------      ------
  Total non-performing assets              $1,158      $1,668      $1,992
                                           ======      ======      ======
  
  Loans past due 90 days or more as to
    principal or interest                     579         624         303
  
  Allowance for loan losses to
    non-performing loans                    8.99x       7.95x       6.12x
  Non-performing loans as a
    percent of loans outstanding              .22%        .23%        .31%
  Non-performing assets as a
    percent of loans outstanding
    plus other real estate owned              .27%        .39%        .49%
  
       Interest income of  approximately  $12 thousand and $23 thousand would have
  been recognized  during the three and six month periods ended June 30, 1997, had
  these  loans been  current in  accordance  with  their  original  terms and been
  outstanding  through the period or since  origination.  Interest income on these
  loans of $1 thousand  and $2 thousand  was  recognized  during the three and six
  months ended June 30, 1997.
  
       Concentrations   of  credit  are   considered  to  exist  if  a  number  of
  counterparties  are  engaged in similar  activities  and have  similar  economic
  characteristics  that would cause their ability to meet contractual  obligations
  to  be  similarly   affected  by  changes  in  economic  or  other   conditions.
  Agriculture-related  borrowings  at June 30, 1997  totalled $115 million or 26.2
  percent of total  loans  outstanding.  These  loans may be  impacted  by adverse
  climate or economic  conditions  not common to other  industries.  The Company's
  exposure to possible loss in the event of  nonperformance  by these borrowers is
  represented by the contractual amount of those instruments. The Company's policy
  is to require  supporting  collateral  for these loans which is generally in the
  form of agriculture real estate, livestock, and farm equipment. At June 30, 1997
  there were no significant  agriculture  related borrowings which were classified
  as  non-performing  assets and there were no charge-offs of agriculture  related
  loans during the three or six months ended June 30, 1997.
  
                                        -11-
  Financial Position
       Total assets at June 30, 1997 were $634 million compared to $616 million at
  December 31, 1996.  Total loans  outstanding  at June 30, 1997 were $431 million
  compared to $423 million at December 31, 1996.  Total deposits at March 31, 1997
  were $543 million compared to $527 million at December 31, 1996.
  
  Capital Adequacy
       The Company's  stockholders'  equity was $65.4 million at June 30, 1997 and
  $62.2 million at December 31, 1996. Total stockholders'  equity increased by 5.0
  percent from  December 31, 1996 which was the net effect of the  recognition  of
  $5.4 million in net income for the three month period, cash dividend payments to
  stockholders  of $1.98 million,  a favorable  change in net unrealized  gains or
  losses on investment securities available for sale of $356 thousand,  and due to
  the  acquisition of treasury  stock at a cost of $703  thousand.  Net unrealized
  gains on  investment  securities  available  for sale of $864  thousand and $508
  thousand were included as a component of  stockholders'  equity at June 30, 1997
  and December 31, 1996, respectively.
  
       The Company  announced  its  intentions  to  repurchase  up to 5 percent or
  203,584 shares of its outstanding  common stock in June, 1996. These repurchased
  shares  will  be  available  for  reissuance   through  the  Company's  Dividend
  Reinvestment or Stock Option Plans or for other general  corporate  purposes.  A
  total of 14,000 shares of common stock were  re-acquired  by the Company  during
  the second  quarter of 1997 with a  cumulative  total of 120,100  acquired as of
  June 30, 1997.
  
       The  maintenance  of an  appropriate  level of capital is a priority of the
  Company's  management.  The Company's  capital  adequacy and dividend policy are
  closely  monitored  by  management  and are  reviewed  regularly by the Board of
  Directors of the Company.  The Company  intends to provide an adequate return to
  its stockholders while retaining a sufficient capital base to provide for future
  growth and to comply with regulatory standards.
  
       Banking  regulators'  risk-based  capital  guidelines  address  the capital
  adequacy of banking  organizations.  These  guidelines  include a definition  of
  capital and a framework for calculating risk-weighted assets by assigning assets
  and off-balance sheet items to broad risk categories,  as well as minimum ratios
  to be maintained by banking  organizations.  The  risk-based  capital ratios are
  calculated by dividing qualifying capital by risk-weighted assets.
  
       Under the risk-based  capital  guidelines,  Total Capital is defined as the
  sum of core or "Tier 1" Capital and "Tier 2" Capital. As the guidelines apply to
  Keystone Heritage Group, Inc., Tier 1 Capital is total stockholders'  equity and
  Tier 2 Capital  includes a portion of the allowance  for loan losses.  The rules
  require  that  banking  organizations  must have ratios of 4.00 percent and 8.00
  percent  for  Tier 1 and  Total  Capital,  respectively.  At June  30,  1997 the
  Company's  Tier 1 and Total Capital ratios were 13.39 percent and 14.72 percent,
  respectively.  Tier 1 and Total  Capital  ratios  were 13.12  percent  and 14.43
  percent  respectively,  at December  31,  1996.  In  addition to the  risk-based
  capital ratio, a bank is also required to maintain a "Leverage  ratio" of Tier 1
  capital to average total assets of 3 percent or higher.  The Company's  Leverage
  ratio was 10.32  percent at June 30, 1997 and was 10.28  percent at December 31,
  1996.
  
  Off-Balance Sheet Items
  
       The  Company's  loan   portfolio   consists  of  loans  to  businesses  and
  individuals  primarily  in its  five-county  market area of Lebanon,  Lancaster,
  Berks, Dauphin, and Schuylkill counties.
  
       In the ordinary course of business, the Company enters into agreements with
  customers,  such as commitments  to extend credit and standby  letters of credit
  which involve, to varying degrees,  elements of credit and interest rate risk in
  excess of the amounts presented in the balance sheet. The Company's  exposure to
  possible loss in the event of nonperformance by the other party to the financial
  instruments for commitments to extend credit and financial guarantees written is
  represented by the contractual amount of those instruments.  The Company may not
  be obligated to advance funds if the customer's financial condition deteriorates
  or if the customer fails to meet certain terms.
  
                                        -12-
  Commitments and  conditional  obligations  generally have fixed  expiration
  dates or termination clauses and may require payment of a fee. Since many of the
  commitments  are expected to expire  without  being used,  the total  commitment
  amounts do not  necessarily  represent  future  cash  requirements.  The Company
  evaluates each customer's creditworthiness on a case-by-case basis, applying the
  same  credit   standards  used  in  the  lending   process,   through   periodic
  reassessments  of the  customer's  creditworthiness  and through  ongoing credit
  reviews. The amount of collateral  obtained,  if deemed necessary by the Company
  upon  extension of credit,  is based on  management's  credit  evaluation of the
  counterparty.  Collateral  held  varies  but may  include  accounts  receivable,
  inventory,  property,  plant  and  equipment,  and  income-producing  commercial
  properties.
  
       The Company has entered into  interest  rate swap  contracts as part of its
  asset-liability  management  activities.  These contracts are used primarily for
  the purpose of managing  interest  rate risk in order to minimize  mismatches in
  the Bank's interest rate sensitivity and interest rate risk positions.
  
       Interest rate swap  contracts  generally  involve the exchange of fixed and
  floating-rate   interest  payment   obligations  without  the  exchange  of  the
  underlying  principal  amounts.  Entering  into  interest  rate  swap  contracts
  involves not only the risk of dealing with  counterparties  and their ability to
  meet the terms of the contracts but also the interest rate risk  associated with
  unmatched  positions.  Notional  principal amounts often are used to express the
  volume of these transactions.
  
       The interest  income or interest  expense  differential  from interest rate
  swap  contracts is  recognized  on the accrual  basis as a component of interest
  income or interest  expense over the life of the contract.  Gains or losses from
  early  termination  of interest  rate swap  contracts are deferred and amortized
  over the remaining term of the underlying assets or liabilities.  The Company is
  not exposed to credit risk in terms of the notional  amounts of these contracts,
  however, the receipt of payments representing the interest differential is based
  on the creditworthiness of the counterparty to each contract.
  
           The  Company's  use of these  interest  rate swap  contracts is closely
  monitored by the Company's  Board of Directors  and is closely  controlled as to
  levels  of  exposure.  At June 30,  1997 the  Company  had seven  interest  rate
  agreements  outstanding  having a total  notional  amount of $70 million.  These
  agreements  consisted  of  interest  rate swap  agreements  each with a notional
  amount of $10 million.
  
           The Company  does not obtain  collateral  or other  security to support
  financial instruments subject to credit risk but monitors the credit standing of
  counterparties. The counterparties of the aforementioned interest rate contracts
  are commercial banks having a rating of A1 from Moody's Investor Service.
  
       The following is the amount of financial instruments with off-balance sheet
  risk not  reflected  in the  consolidated  balance  sheets at June 30,  1997 and
  December 31, 1996:
  
                                          Contractual Amounts
                                          June 30    December 31
  (Dollars in thousands)                   1997        1996
  
  Financial instruments whose
  contractual amounts represent
   credit risk:
    Commitments to extend credit         $91,156     $93,811
    Standby letters of credit              8,028       7,335
  Contractual amounts of off-balance
  sheet financial  instruments not
  constituting credit risk:
    Interest rate swap, notional
     value                                70,000      70,000
  
                                        -13-
  Supervision and Regulation
  
       During the latter part of 1996, Congress agreed on a legislative package to
  stabilize the Savings and Loan (S&L) industry's  deposit  insurance fund (SAIF).
  The  legislation  required the S&L industry to  recapitalize  its insurance fund
  with a one-time assessment.  Previous proposals required the bank insurance fund
  (BIF) to contribute a substantial  amount to help  recapitalize  SAIF. Under the
  current legislation,  banks are required to pay an annual rate of 1.29 cents for
  every $100 of domestic  deposits  from 1997  through 1999 and pay 2.43 cents per
  $100 of domestic deposits for the years of 2000 through 2017. The amount of FDIC
  insurance to be paid under this new legislation  will not materially  impact the
  financial  position,  equity or the  results of  operations  for the  Company in
  future periods.
  
     The Bank is a national  bank,  chartered  under the National Bank Act, and is
  subject to the primary  supervision  of, and is examined by, the  Comptroller of
  the Currency.  As a member of the Federal Reserve System, the Bank is subject to
  provisions of the Federal  Reserve Act, which restricts the ability of a bank to
  extend  credit to its parent  holding  company  or to  certain  of the  parent's
  subsidiaries,  or to invest in the Company's  common stock or to take such stock
  as  collateral  for loans to any borrower.  The  operations of the Bank are also
  subject to regulation by the FDIC.
  
  New Accounting Standards
  
       In February 1997, the Financial Accounting Standards Board issued Statement
  of Financial Accounting Standards No. 128 (SFAS 128), "Earnings Per Share". SFAS
  128,  which  supersedes  APB  Opinion  No. 15 (APB 15),  "Earnings  Per  Share",
  specifies  the  computation,   presentation,  and  disclosure  requirements  for
  earnings  per share (EPS) for  entities  with  publicly  held common  stock.  It
  replaces the  presentation  of primary EPS with a presentation  of basic EPS and
  fully  diluted EPS with diluted EPS,  Basic EPS,  unlike  primary EPS,  excludes
  dilution and is computed by dividing income available to common  stockholders by
  the weighted average number of common shares outstanding for the period. Diluted
  EPS is computed  similarly  to fully  diluted EPS under APB 15. The Company will
  adopt SFAS 128 as of December 31, 1997.  Management  does not expect SFAS 128 to
  have a material effect on the EPS of the Company.
  
                                        -14-
  AVERAGE BALANCE SHEETS, RATES AND INTEREST INCOME AND EXPENSE
                               (Dollars in thousands)
  Three Months Ended June 30, 1997        Three Months Ended June 30, 1996
                                                    Average               Average          Average              Average
                                                    Balance    Interest    Rate            Balance    Interest    Rate
  Assets
      Loans                                         $433,412     $9,869     9.13%         $405,215     $9,056      8.99%
      Money market investments:
          Interest bearing deposits with banks           246          4     6.46               189          3      6.37
          Federal funds sold                           8,652        119     5.52             2,012         27      5.45
  
               Total money market investments          8,898        123     5.54             2,201         30      5.54
      Investment securities available for sale
        and held to maturity:
          Taxable investment securities
           available for sale                         66,863        989     5.93            56,202        747      5.35
          Taxable investment securities
           held to maturity                           66,603      1,073     6.46            69,092      1,072      6.24
          Non-taxable investment securities
           held to maturity                           16,630        286     6.91            11,926        193      6.52
                                                     -------    -------     ----           -------    -------      ---- 
               Total investment securities           150,096      2,348     6.27           137,220      2,012      5.90
               Total earning assets                  592,406    $12,340     8.35%          544,636    $11,098      8.20%
                                                                =======     ====                      =======      ==== 
  
      Other assets                                    30,415                                29,240
                                                    --------                              --------
               Total assets                         $622,821                              $573,876
                                                    ========                              ========
  
  Liabilities and stockholders' equity 
  Interest bearing deposits:
          Demand                                    $ 54,429      $ 176     1.29%         $ 55,008      $ 172      1.26%
          Savings                                    129,240      1,030     4.01           130,755      1,014      3.12
          Time                                       282,488      3,878     5.51           235,446      3,265      5.58
                                                     -------    -------     ----           -------    -------      ---- 
               Total interest bearing deposits       466,157      5,084     4.37           421,209      4,451      4.25
  
      Short-term borrowings                           11,913        127     4.28            10,860        113      4.20
      Other Borrowings                                 6,172         95     6.18            10,966        160      5.87
                                                     -------    -------     ----           -------    -------      ---- 
          Total interest bearing liabilities         484,242    $ 5,306     4.39%          443,035    $ 4,724      4.29%
                                                                =======     ====                      =======      ==== 
  
      Non-interest bearing deposits                   67,006                                63,566
      Other liabilities                                8,036                                 6,838
      Stockholders' equity                            63,537                                60,437
                                                    --------                              --------
          Total liabilities and
          stockholders' equity                      $622,821                              $573,876
                                                    ========                              ========
  
      Net interest income                                       $ 7,034                               $6,374
      Total yield on earning assets                                         8.35%                                  8.20%
                                                                            ----                                   ---- 
      Rate on supporting liabilities                                        3.59%                                  3.49%
                                                                            ----                                   ---- 
      Net interest margin                                                   4.76%                                  4.71%
                                                                            ====                                   ====
  Interest and average interest rates are presented on a fully taxable  equivalent
  basis,  using an effective  tax rate of 35%. For  purposes of  calculating  loan
  yields,  average loan balances include non-accrual loans. Loan fees are included
  in interest income.
  
                                        -15-
  AVERAGE BALANCE SHEETS, RATES AND INTEREST INCOME AND EXPENSE
                               (Dollars in thousands)
  Six Months Ended June 30, 1997           Six Months Ended June 30, 1996
                                                 Average               Average            Average              Average
                                                 Balance    Interest    Rate              Balance    Interest    Rate
  Assets
      Loans                                        $431,066       $19,401         9.08%  $397,782      $17,890        9.04%
      Money market investments:
          Interest bearing deposits with banks          248             8         6.50        236            7        5.96
          Federal funds sold                          6,433           174         5.45      2,229           60        5.41
                                                   --------      --------         ----   --------     --------        ----
               Total money market investments         6,681           182         5.49      2,465           67        5.47
      Investment securities available for sale
       and held to maturity:
          Taxable investment securities
           available for sale                        64,361         1,881         5.89     57,851        1,537        5.34
          Taxable investment securities
           held to maturity                          67,437         2,182         6.52     71,124        2,219        6.27
          Non-taxable investment securities
           held to maturity                          16,004           552         6.95     11,894          386        6.53
                                                   --------      --------         ----   --------     --------        ----
               Total investment securities          147,802         4,615         6.30    140,869        4,142        5.91
               Total earning assets                 585,549       $24,198         8.33%   541,116      $22,099        8.21%
                                                                  =======         ====                 =======        ==== 
  
      Other assets                                   29,982                                28,132
                                                   --------                              --------
               Total assets                        $615,531                              $569,248
                                                   ========                              ========
  
  Liabilities and stockholders' equity
  Interest bearing deposits:
          Demand                                    $54,248          $346         1.28%   $55,035         $362        1.32%
          Savings                                   128,224         2,013         3.17    129,272        1,999        3.11
          Time                                      278,085         7,631         5.53    234,591        6,593        5.65
                                                   --------      --------         ----   --------     --------        ----
               Total interest bearing deposits      460,557         9,990         4.37    418,898        8,954        4.30
  
      Short-term borrowings                          11,990           249         4.18     11,182          234        4.21
      Long-term debt                                  6,255           192         6.19     11,039          322        5.87
                                                   --------      --------         ----   --------     --------        ----
          Total interest bearing liabilities        478,802       $10,431         4.39%   441,119       $9,510        4.34%
                                                                  =======         ====                 =======        ==== 
  
      Non-interest bearing deposits                  65,428                                60,813
      Other liabilities                               8,234                                 7,488
      Stockholders' equity                           63,067                                59,828
                                                   --------                              --------
          Total liabilities and
          stockholders' equity                     $615,531                              $569,248
                                                   ========                              ========
  
      Net interest income                                         $13,767                              $12,589
      Total yield on earning assets                                               8.33%                              8.21%
      Rate on supporting liabilities                                              3.59%                              3.53%
                                                                                  ----                               ---- 
      Net interest margin                                                         4.74%                              4.68%
                                                                                  ====                               ====
  Interest and average interest rates are presented on a fully taxable  equivalent
  basis,  using an effective  tax rate of 35%. For  purposes of  calculating  loan
  yields,  average loan balances include non-accrual loans. Loan fees are included
  in interest income.
  
                                        -16-
  PART II.  OTHER INFORMATION
  
  ITEM 1.  LEGAL PROCEEDINGS
  
  None.
  
  ITEM 2.  CHANGES IN SECURITIES
  
  None.
  
  ITEM 3.  DEFAULTS UPON SENIOR SECURITIES
  
  None.
  
  ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
  
  1997 Annual Stockholders' Meeting
  
       The 1997 Annual Meeting of Stockholders'  for the Company was held on April
  15, 1997.  Stockholders' of the Company voted on the following issues:  Election
  of Directors  Raymond M.  Dorsch,  Jr.,  Wendie  DiMatteo  Holsinger,  Donald W.
  Lesher,  Jr. and Mark Randolph  Tice;  and a proposal to ratify the selection of
  KPMG Peat Marwick LLP as the Company's  Independent  Public  Accountants for the
  fiscal year ending  December 31, 1997.  Seventy  eight  percent of the 3,965,583
  shares  eligible  to vote were  voted in either  proxy  form or in person at the
  meeting.
  
       All  matters  subject to a vote at the Annual  Meeting  were  approved as a
  result of the votes cast at the Annual Meeting.  The following is a presentation
  of the voting results from the April 15, 1997 Annual Stockholders' Meeting:
  
  Election of Directors:             FOR           Withheld        Total
  
  Raymond M. Dorsch, Jr.          3,066,368          29,579      3,095,947
  
  Wendie DiMatteo Holsinger       3,053,073          42,874      3,095,947
  
  Donald W. Lesher, Jr.           3,087,036           8,911      3,095,947
  
  Mark Randolph Tice              3,084,994          10,953      3,095,947
  
       The term of the Directors  elected at the Annual Meeting expires in 2000 or
  when the director would reach the mandatory  retirement age of 72. The following
  directors  remain on the Company's  Board of Directors  until the  expiration of
  their  terms in 1998 and 1999 or when the  director  would  reach the  mandatory
  retirement age of 72:
  
  Directors Term Expiring in 1998:
  Charles V. Henry, III
  Bruce A. Johnson
  John E. Wengert
  
  Directors Term Expiring in 1999:
  Harry J. Gensemer
  Albert B. Murry
  Thomas I. Siegel
  Brett H. Tennis
  
       Messrs. Lance M. Frehafer and E.D. Williams, Jr., Directors of the Company,
  retired from the Board on April 15, 1997.
  
       The  proposal  to ratify  the  selection  of KPMG Peat  Marwick  LLP as the
  Company's Independent Public Accountants for the fiscal year ending December 31,
  1997 was voted as follows:
  
                  For              Against            Abstain
  
               3,088,774              1,595              5,578
  
                                        -17-
  ITEM 5.  OTHER INFORMATION
  
  None
  
  ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K
  
  (a.)  None.
  
  (b.)  The Company did not file any reports on Form 8-K during the quarter ended
  June 30, 1997.
  
                                        -18-
  KEYSTONE HERITAGE GROUP, INC.
  
                                     SIGNATURES
  
       Pursuant to the  requirements  of the Securities  Exchange Act of 1934, the
  registrant  has duly  caused  this  report  to be  signed  on its  behalf by the
  undersigned thereunto duly authorized.
  
                                           Keystone Heritage Group, Inc.
                                           (Registrant)
  
  Date  July 31, 1997                 By /s/ Kurt A. Phillips
                                         Kurt A. Phillips
                                         Chief Financial and Accounting Officer
  
                                        -19-