<PAGE>   1
                                                                      EXHIBIT 13

                                      1998
                                        
                                       -
                                        
                                     ANNUAL
                                        
                                       -
                                        
                                     REPORT
                                        
                                    [PHOTOS]
                                        
                                    SOUTHERN
                                        
                                       -
                                        
                                    MICHIGAN
                                        
                                       -
                                        
                                 BANCORP, INC.
<PAGE>   2
                                  RETIREMENTS

Southern Michigan Bank & Trust had two long-time employees retire in 1998. Jerry
L. Towns, chairman and CEO, retired 26 years with SMB&T, and Jane Gillette
retired after 20 years in the data processing department at SMB&T.

[Jerry Towns photo]

Jerry Towns, whose banking career began in 1958 in Toledo, Ohio and featured a
stop in Chicago before he became a fixture in Coldwater beginning in 1972,
announced his intention to retire from day-to-day banking, effective Dec. 31.

Jerry joined Southern Michigan Bank & Trust as a vice president in the 
commercial lending department in 1972. He subsequently served six years as 
executive vice president before becoming president in 1979. For the past 15 
years he has been chairman & CEO of Southern Michigan Bancorp. After his 
retirement, Jerry will continue to serve as the holding company's board 
chairman.

A native of nearby Hillsdale and a 1948 graduate of Hillsdale College, Jerry 
served two years in the U.S. Marine Corp. He is a 1964 graduate of the Graduate 
School of Banking at the University of Wisconsin.

Active in banking trade association matters for much of his career, Jerry holds 
the distinction of being the only banker to serve two terms (1987-89) as 
president of the Michigan Association of Community Bankers. He also served as 
state director to the IBAA, was active in the Ohio Bankers Association and has 
held committee assignments with the ABA. Beginning in 1982, he moved through 
the chairs of elected office in the MACB, concluding with the two terms as that 
association's president. On two separate occasions, Jerry served as a member of 
the MBA's executive and legislative committees in Lansing.

He has been active in community organizations such as the Rotary, the Coldwater 
Industrial Growth Corp., the local Chamber of Commerce, the Branch County 
Economic Growth Alliance and the Branch County Community Foundation. Many of 
these responsibilities have been passed along to others. He remains on the 
board of the Kellogg Community College Foundation of Battle Creek.

Jerry, an avid golfer, plans to play golf "at least four times per week" now
that he is retired. He will spend winters in Florida and the remainder of the
year here in Coldwater.

[Jane Gillette photo]

Jane Gillette, a dedicated employee for 20 years, also retired on December 31, 
1998. In her 20 years, Jane missed only one day of work due to illness. She was 
always helpful, cheerful and able to get to the bottom of a problem and solve 
it. One word describes Jane, "stic-to-it-tiveness."

Jane went to college to study data processing, a field she worked in all of her 
working years.

Married to Carl for 42 years this May, Jane has 3 sons, one daughter and 12 
grandchildren. During her retirement she intends to pursue her hobby of 
gardening, enjoy her grandchildren and her mother with whom she was recently 
reunited.

Southern Michigan Bank & Trust will miss both Jerry and Jane tremendously and 
wish them both all the best for many happy retirement years.
<PAGE>   3
TABLE OF CONTENTS



SELECTED FINANCIAL DATA                                               2
FIVE YEAR FINANCIAL PERFORMANCE                                       3
LETTER TO SHAREHOLDERS                                                4
MANAGEMENT'S REPORT                                                   5
MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL INFORMATION                12
CONSOLIDATED BALANCE SHEETS                                          13
CONSOLIDATED STATEMENTS OF SHAREHOLDER'S EQUITY                      14
CONSOLIDATED STATEMENTS OF INCOME                                    15
CONSOLIDATED STATEMENTS OF CASH FLOWS                                16
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                           17
REPORT OF INDEPENDENT AUDITORS                                       29
BOARD OF DIRECTORS AND STRATEGIC MANAGEMENT TEAM                     30
OFFICERS                                                             31
EMPLOYEES                                                            32








FACTS ABOUT SOUTHERN MICHIGAN BANCORP, INC. STOCK
Registrar and Transfer Company acts as transfer agent for the Company's stock.
For information concerning the transfer of the Company's stock, call Ms. Pamela
Green, Corporate Relations, at (800) 456-0596, extension 2510.

The Coldwater, Michigan office of Hilliard Lyons "makes the market" for the
Company's stock. For more information call (517) 278-4333 or (800) 211-5257.

Southern Michigan Bancorp, Inc. provides an automatic dividend reinvestment plan
that allows shareholders to increase their holdings without brokerage fees. For
more information call Mr. Nick Giancaspro of Registrar and Transfer Company at
(800) 456-0596, extension 2526.

ANNUAL MEETING
The Annual Meeting of Southern Michigan Bancorp, Inc. will be held on April 19,
1999 at 4:00 p.m. at Southern Michigan Bank & Trust, 51 W. Pearl Street,
Coldwater, Michigan.

10-K INFORMATION
To order Form 10-K, the Annual Report for 1998 to the Securities and Exchange
Commission, address request to Southern Michigan Bancorp, Inc., 51 West Pearl
Street, Coldwater, Michigan 49036, Attention: Secretary.


                                       1
<PAGE>   4
SELECTED FINANCIAL DATA


<TABLE>
<CAPTION>
                                                           Year Ended December  31
                                            1998         1997       1996        1995         1994
                                          ---------------------------------------------------------
                                                  (In thousands, except per share amounts)
<S>                                       <C>         <C>         <C>         <C>         <C>
Total interest income                     $ 19,446    $ 18,669    $ 16,787    $ 15,476    $ 12,680
Net interest income                         11,414      11,226      10,183       9,096       7,738
Provision for loan losses                      600         460         267         222         180
Net income                                   3,549       3,032       3,058       2,615       2,018
Per share data:
   Basic and diluted earnings per share       1.87        1.59        1.62        1.41        1.11
   Cash dividends                              .67         .58         .53         .50         .38
Balance sheet data:
   Long-term borrowings                      5,000       3,000           0           0           0
   Capital note                                  0           0           0       1,000       1,000
   Common stock subject to repurchase        6,029       4,899       3,555       2,232       1,464
   Equity                                   19,933      20,590      19,616      18,497      16,855
   Total assets                            266,851     238,531     235,562     209,977     195,625
Return on average assets                     1.42%       1.30%       1.45%       1.31%       1.11%
Return on average equity                    17.48%      14.96%      16.09%      14.64%      12.36%
</TABLE>

COMMON STOCK MARKET PRICES AND DIVIDENDS
The Company's common stock, for which there is no established public trading
market, is traded infrequently in the local over-the-counter market. Market
prices are based on information provided by an established securities dealer.
There were 465 shareholders of record at December 31, 1998.

High and low market prices and dividends for the last two years were:

<TABLE>
<CAPTION>
                                1998                               1997
                  --------------------------------   ---------------------------------
                      MARKET PRICE         CASH          Market Price         Cash
                     -------------       DIVIDENDS   --------------------    Dividends
                  HIGH BID    LOW BID    DECLARED    High Bid     Low Bid    Declared
Quarter Ended
--------------------------------------------------------------------------------------
<S>               <C>         <C>        <C>         <C>          <C>        <C>
March 31          $42.00      $34.00      $ .15       $23.50      $21.50      $ .12
June 30            51.25       41.25        .15        24.63       22.50        .13
September 30       45.00       41.25        .16        28.00       24.13        .13
December 31        42.00       32.75        .21        34.00       28.00        .20
</TABLE>

There are restrictions that currently limit the Company's ability to pay cash
dividends. Information regarding dividend payment restrictions is described in
Note K to the consolidated financial statements for the year ended December 31,
1998.

All per share amounts have been adjusted for a 1997 stock split effected in the
form of a 100% stock dividend, and a 2 for 1 stock split in 1995.


                                        2
        
                                  Southern Michigan Bancorp, Inc. and Subsidiary
<PAGE>   5
FIVE YEAR FINANCIAL PERFORMANCE


Net income and dividends per share

                                  [LINE GRAPH]
                             [PLOT POINTS TO COME]

Per share amounts have been adjusted for a 2 for 1 stock split in 1995 and a
1997 stock split effected in the form of a 100% stock dividend.


Return on assets
(net income divided by average assets)

                                  [LINE GRAPH]
                             [PLOT POINTS TO COME]

Return on assets is a standard measure of financial performance in the banking
industry.


Net interest margin
(fully taxable equivalent basis)

                                  [LINE GRAPH]
                             [PLOT POINTS TO COME]

Net interest margin is the difference between the yield on earning assets and
the interest cost of funding those assets.


Capital ratios
(at year end)

                                  [LINE GRAPH]
                             [PLOT POINTS TO COME]

Capital as a percentage of risk-weighted assets indicates the Company's ability
to continue growing while ensuring that it has resources to absorb the risk
inherent in the business.


Ratio of average equity to average assets

                                  [LINE GRAPH]
                             [PLOT POINTS TO COME]

Average equity to average assets measures the extent to which the shareholders'
investment has been leveraged.


                                       3

1998 Annual Report to Shareholders
<PAGE>   6
LETTER TO SHAREHOLDERS


To Our Shareholders:

Last year we told you that "every organization that is committed to growth and
independence must, first of all, be prepared and willing to adapt to change".

Southern Michigan Bancorp seized the opportunity, provided by years of
increasing profits, to invest in changes that will greatly strengthen long-term
shareholder value.

As you read the 1998 Annual Report of Southern Michigan Bancorp, Inc. you will
see that the investment in change made in 1997 already is starting to bear
fruit. You will note, for example, that we had substantial growth in 1998 to go
along with record profits. These changes will continue to strengthen long-term
shareholder value.


                 [PHOTO OF JERRY L. TOWNS & JAMES T. GROHALSKI]


The opening of our new Hillsdale branch office was a very exciting event that
took place in the fourth quarter. This new facility serves as a prototype of the
financial services office that we will open in the future. The "centers" within
are available for customers to receive advice and assistance in obtaining
mortgages, financial services for business, and non-deposit investment products,
such as stocks, bonds and mutual funds. The office also is uniquely equipped and
staffed to handle traditional banking transactions, such as teller services,
drive-through banking and ATM's.

Almost everyone that we talked to lately has had some concerns about the Year
2000 problem, or Y2K, and how Southern Michigan Bank & Trust is addressing the
problem.

Before we address that concern, a short definition of the Y2K is required.
Simply put, computers cannot tell the difference between the year 1900 and 2000.
Initially, programmers dropped off the first two digits of the 19XX year in
order to save memory space in the computer. Consequently, the year 2000 might be
read as 1900.

How is Southern Michigan Bank & Trust addressing the problem? All computers and
software the Bank utilizes are purchased from third party vendors. What does
this mean? The Bank continuously monitors our vendors for their progress towards
Y2K compliance. This process will continue until we receive certification from
each critical hardware and software provider. Initial communication with these
vendors has not resulted in any Y2K concerns.

We began testing procedures on all hardware and software used by the Bank months
ago. This was done to determine past and current Y2K conditions and to validate
the statements made by our third party vendors. While this is going on,
alternate vendors will be contacted as part of our overall contingency plan and
these vendors will be asked for their Y2K compliance plans, as well.

Be assured that Southern Michigan Bank & Trust is doing everything possible to
address all questions concerning the Y2K problem. We are confident that the
transition to the Year 2000 will be a smooth one for our customers and
shareholders alike.

Creating profit and increasing shareholder value will continue to be our goal as
we approach the new Millennium.


/s/ Jerry L. Towns                        /s/ James T. Grohalski

Jerry L. Towns                            James T. Grohalski
Chairman                                  President & C.E.O.


                                       4        
 
                                  Southern Michigan Bancorp, Inc. and Subsidiary
<PAGE>   7
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS

The following discussion provides information about the Company's financial
condition which supplements the Consolidated Financial Statements included
elsewhere in this Annual Report. The analysis should be read in conjunction with
such financial statements and Five Year Performance and Selected Financial Data
presented in other sections of this Annual Report.

FINANCIAL CONDITION

The Company functions as a financial intermediary and, as such, its financial
condition should be examined in terms of trends in its sources and uses of
funds.

The Company uses its funds primarily to support its lending activities. Loans
increased by 2.9% in 1998 and 4.0% in 1997. Commercial loans increased by 10.3%
in 1998 as local businesses expanded and took advantage of lower interest rates.
Installment loans declined as the result of competition from both financial and
non-financial companies which offer borrowers other low cost financing options.
The real estate mortgage portfolio increased primarily due to the offering of
competitive home equity products. The Bank's real estate mortgage loan sales to
the secondary market continued to increase in 1998. Gains of $1,085,000 (after
the capitalization of mortgage servicing rights) were recognized in 1998 and
gains of $550,000 were recognized in 1997. There were no loans held for sale at
December 31, 1998. The real estate portfolio largely consists of residential
mortgages within the local area with a low risk of loss. The Bank anticipates
that the sale of loans in the secondary market will continue to increase subject
to the impact of economic factors and levels of interest rates.

The loan growth in 1997 occurred in all loan categories and is the result of
continued good economic conditions within the Company's market area. Despite a
significant increase in secondary market loan sales, the Bank's mortgage
portfolio increased in 1997 due to the offering of some attractive adjustable
rate mortgage products and the Bank's continued efforts to become a market
leader in the consumer lending area.

Loan commitments, consisting of unused credit card and home equity lines,
available amounts on revolving lines of credit and other approved loans which
have not been funded, were $31,175,000 and $23,049,000 at December 31, 1998 and
1997, respectively. All of these commitments, with the exception of unused
credit cards ($1,616,000 in 1998 and $2,539,000 in 1997), are priced at a
variable interest rate thus minimizing the Bank's risk in a changing interest
rate environment.

There were no significant concentrations in any loan category as to borrower,
industry or location.

Another significant use of funds is the investment securities portfolio.
Investments increased by 50.6% in 1998 and decreased by 20.4% in 1997. The 1998
increase is the result of a significant increase in deposits. The funds received
from maturing investments were used to fund the 1997 loan growth since the Bank
was not able to fund this growth with deposits.

The available for sale portfolio had net unrealized gains of $394,000 in 1998
and $39,000 in 1997. Net unrealized gains in the investment portfolio classified
as held to maturity totaled $937,000 in 1998 and $351,000 in 1997. It is the
Company's intent to hold these investment securities to maturity with the
available for sale securities being available to sell should the Company require
additional liquidity. There is no concentration of investments in the portfolio
which would constitute an unusual risk.

Deposits traditionally represent the Company's principal source of funds. Total
deposits increased 12.7% in 1998 and decreased 1.1% in 1997. A complete overhaul
of the Bank's personal checking accounts at the beginning of 1998 allowed the
Bank to increase the number of deposit accounts. The Bank experienced an
increase not only in demand deposit accounts, but in other deposit accounts as
well as customers opening secondary accounts to supplement their new checking
accounts. The 1997 decrease is the result of the maturing of short-term
municipal and school deposits that were acquired late in 1996.

Attracting and keeping traditional deposit relationships will continue to be a
challenge for the Bank, particularly with the increased competition from
non-deposit products. In order to have an alternate funding source, the Bank
obtained a $3,000,000 putable advance from the Federal Home Loan Bank (FHLB) in
December 1997. This advance carries a five year maturity and is secured by a
blanket collateral agreement with the FHLB giving the FHLB an unperfected
security interest in the Bank's one-to-four family whole mortgage loans,
government and agency securities and highly rated mortgage-backed securities.
The Bank obtained an additional $2,000,000 advance in February 1998. FHLB
advances have been a less expensive way to obtain longer term funds rather than
paying a premium for long term deposits.

Premises and equipment increased by 25.9% in 1998 and 6.9% in 1997. The Bank
opened a new branch office in Hillsdale in October 1998 at an approximate cost
of $2,000,000. The Bank made this significant investment because of the growth
potential in Hillsdale. The 1997 increase was due to the continued upgrading of
the Bank's technology.

CAPITAL RESOURCES

The Company maintains a strong capital base to take advantage of business
opportunities while ensuring that it has resources to absorb the risk inherent
in the business.


                                       5

1998 Annual Report to Shareholders
<PAGE>   8
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)


The Federal Reserve Board (FRB) has imposed risk-based capital guidelines
applicable to the Company. These guidelines require that bank holding companies
maintain capital commensurate with both on and off balance sheet credit risks of
their operations. Under the guidelines, a bank holding company must have a
minimum ratio of total capital to risk-weighted assets of 8 percent. In
addition, a bank holding company must maintain a minimum ratio of Tier 1 capital
equal to 4 percent of risk-weighted assets. Tier 1 capital includes common
shareholders' equity, qualifying perpetual preferred stock and minority
interests in equity accounts of consolidated subsidiaries less goodwill.

As a supplement to the risk-based capital requirements, the FRB has also adopted
leverage capital ratio requirements. The leverage ratio requirements are
intended to insure that adequate capital is maintained against risk other than
credit risk. The leverage ratio requirements establish a minimum ratio of Tier 1
capital to total assets of 3 percent for the most highly rated bank holding
companies and banks that do not anticipate and are not experiencing significant
growth. All other bank holding companies are required to maintain a ratio of
Tier 1 capital to assets of 4 to 5 percent, depending on the particular
circumstances and risk profile of the institution.

Regulatory agencies have determined that the capital component created by the
adoption of Financial Accounting Standards Board (FASB) Statement No. 115 should
not be included in Tier 1 capital. As such, the net unrealized appreciation or
depreciation on available-for-sale securities is not included in the ratios
listed in Note N to the financial statements. The ratios include the common
stock subject to repurchase obligation in the Company's employee stock ownership
plan (ESOP). As seen in Note N, the Company exceeds the well capitalized
requirements.

In addition to these regulatory requirements, a certain level of capital growth
must be achieved to maintain appropriate levels of equity to total assets.
During 1998 and 1997, total average assets grew 7.2% and 10.8%. At the same
time, average equity (including common stock held by the ESOP) increased 5.2% in
1998 and 11.9% in 1997. Equity grew at a lower level than assets in 1998 because
of the repurchase and retirement of 51,079 shares of common stock. Future growth
opportunities will focus on maintaining the existing customer base and growing
within the Calhoun and Hillsdale county markets.

LIQUIDITY AND INTEREST RATE SENSITIVITY

The primary functions of asset/liability management are to assure adequate
liquidity and maintain an appropriate balance between interest-earning assets
and interest-bearing liabilities. Liquidity management involves the ability to
meet the cash flow requirements of customers who may be either depositors
wanting to withdraw funds or borrowers needing assurance that sufficient funds
will be available to meet their credit needs. Interest rate sensitivity
management seeks to avoid fluctuating net interest margins and enhance
consistent growth of net interest income through periods of changing interest
rates.

Maturing loans and investment securities are the principal sources of asset
liquidity. Securities maturing or callable within 1 year were $29,286,000 at
December 31, 1998 representing 43.4% of the amortized cost of the investment
securities portfolio, an increase from the 30.4% level of 1997. Loans maturing
within 1 year were $37,963,000 at December 31, 1998 representing 23.2% of the
loan portfolio, a slight increase from the 20.6% level of 1997.

Financial institutions are subject to prepayment risk in falling rate
environments. Prepayments of assets carrying higher rates reduce the Company's
interest income and overall asset yields. Certain portions of an institution's
liabilities may be short-term or due on demand, while most of its assets may be
invested in long-term loans or investments. Accordingly, the Company seeks to
have in place sources of cash to meet short-term demands. These funds can be
obtained by increasing deposits, borrowing, or selling assets. Also, Federal
Home Loan Bank advances and short-term borrowings provide additional sources of
liquidity for the Company.

During the year ended December 31, 1998, there was a net decrease in cash and
cash equivalents of $620,000. The major source of cash in 1998 was the increase
in deposits. The major use of cash in 1998 was the purchase of investment
securities.

During the year ended December 31, 1997, there was a net increase in cash and
cash equivalents of $3,328,000. The major sources of cash in 1997 were loan
sales and maturing securities. The major uses of cash in 1997 were loan growth
and loans originated for sale.

During the year ended December 31, 1996, there was a net decrease in cash and
cash equivalents of $3,660,000. The major source of cash in 1996 was the
increase in deposits resulting from growth in the existing deposit base and the
acquisition of two branches. The major use of cash in 1996 was the increase
in loans.

Federal law places restrictions on extensions of credit from banks to their
parent holding company and, with certain exceptions, to other affiliates, on
investments in stock or other securities thereof, and on taking of such
securities as collateral for loans. Note K to the Consolidated Financial
Statements discusses these limitations between the Company and its banking
subsidiary.

Interest rate risk arises when the maturity or repricing characteristics of
assets differ significantly from the maturity or the repricing characteristics
of liabilities. Accepting this risk can be an important source of profitability
and shareholder value, however excessive levels of interest rate risk could pose
a significant threat to the Company's earnings and capital base. Accordingly,
effective risk management that maintains interest rate risk at prudent levels is
essential to the Company's safety and soundness.


                                       6         

                                  Southern Michigan Bancorp, Inc. and Subsidiary
<PAGE>   9
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)


The Company measures the impact of changes in interest rates on net interest
income through a comprehensive analysis of the Bank's interest rate sensitive
assets and liabilities. Interest rate sensitivity varies with different types of
interest-earning assets and interest-bearing liabilities. Overnight federal
funds and mutual funds on which rates change daily and loans which are tied to
the prime rate or a comparable index differ considerably from long-term
investment securities and fixed-rate loans. Similarly, certificates of deposit
and money market investment accounts are much more interest sensitive than
passbook savings accounts. The shorter term interest rate sensitivities are key
to measuring the interest sensitivity gap, or excess interest-earning assets
over interest-bearing liabilities. In addition to reviewing the interest
sensitivity gap, the Company also analyzes projected changes in market interest
rates and the resulting effect on net interest income.

The following table shows the interest sensitivity gaps for five different time
intervals as of December 31, 1998:

<TABLE>
<CAPTION>
                                 0-30     31-90      91-365      1-5      Over 5
                                 Days      Days       Days      Years     Years
                               -------------------------------------------------
<S>                            <C>       <C>         <C>       <C>       <C>
Interest-earning assets        $61,675   $  9,101    $54,303   $88,058   $24,670
Interest-bearing liabilities    51,976     81,005     39,236    31,366
                               -------------------------------------------------
Interest sensitivity gap       $ 9,699   $(71,904)   $15,067   $56,692   $24,670
                               =================================================
</TABLE>

The primary interest sensitive assets in the one year repricing range are
commercial loans and adjustable rate mortgage loans. The primary interest
sensitive liabilities in the one year repricing range are money market
investment accounts, certificates of deposit and interest bearing checking
accounts. This analysis indicates that growth in rate sensitive liabilities has
outpaced the growth in rate sensitive assets in the one year range. This has
occurred primarily as a result of the inclusion of interest bearing checking
accounts and savings accounts in a repricing period of one year or less as these
accounts have become rate sensitive as interest rates have fluctuated. The
long-term interest sensitivity gap indicates that the Company's net interest
margin would improve with an increase in interest rates and decline with further
declines in interest rates. Trying to minimize the interest sensitivity gap is a
continual challenge in a changing rate environment and one of the objectives of
the Company's asset/liability strategy.

RESULTS OF OPERATIONS

Net interest income is an effective measurement of how well management has
balanced the Company's interest rate sensitive assets and liabilities. Net
interest income increased by 1.7% in 1998, 10.2% in 1997 and 12.0% in 1996. The
1998 increase is due to the reinvestment of funds held in overnight federal
funds accounts into higher yielding investment securities. The 1997 and 1996 net
interest income increased as a result of the reinvestment of funds received from
maturing investment securities into the higher yielding loan portfolio, along
with the stability of the Company's cost of funds.

The uncertain economic environment and potential fluctuations in interest rates
are expected to continue to impact the Company and the industry in 1999.
Depending on these interest rate fluctuations, there may be market pressure to
raise deposit rates in 1999 and to lower loan rates. The Company monitors
deposit rates on a weekly basis and adjusts deposit rates as the market
dictates. Loan rates are subject to change as the national prime rate changes
and are also influenced by competitor's rates. An increase in deposit rates
occurring at the same time as loan rates decrease would cause the Company's net
interest income to decline.

The provision for loan losses is based on an analysis of the required additions
to the allowance for loan losses. The allowance for loan losses is maintained at
a level believed adequate by management to absorb probable losses in the loan
portfolio. Some factors considered by management in determining the level at
which the allowance is maintained include specific credit reviews, past loan
loss experience, current economic conditions and trends, results of examinations
by regulatory agencies and the volume, growth and composition of the loan
portfolio.

The provision for loan losses was $600,000 in 1998, $460,000 in 1997 and
$267,000 in 1996. The 1998 provision was increased to provide for increased
charge-offs and delinquencies, primarily as a result of increased customer
bankruptcies. The 1997 provision was increased to provide for loan growth and
the increase in charge-offs and delinquencies. Several customers, including a
large commercial borrower, declared bankruptcy, during 1997 resulting in
increased charge-offs. Net charge-offs were $431,000 in 1998, $411,000 in 1997
and $62,000 in 1996. The provision in 1996 was increased to provide for
significant loan growth. It is anticipated that the Company will continue to
experience higher than normal losses in 1999 . The provision will be adjusted
quarterly, if necessary, to reflect actual charge-off experience and any known
future losses.

Non-interest income, excluding security gains and losses, increased by 30.2% in
1998, 15.2% in 1997 and 28.8% in 1996. The 1998 increase is due to increased
service charge income, increased gains recognized on the sale of secondary
market real estate mortgage loans and increased income from the Bank's automatic
teller machines (ATMs). The Bank increased its deposit base by 12.7% in 1998 and
generated additional service charges as a result of the growth. In order to
reduce the risk associated with changing interest rates, the Bank regularly
sells fixed rate real estate mortgage loans on the secondary market. The Bank
recognizes a profit at the



                                       7

1998 Annual Report to Shareholders
<PAGE>   10
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)


time of the sale and receives a fee in order to service the loans. During this
period of relatively low interest rates, the Bank has generated large volumes of
fixed rate mortgage loans. During 1998, the Bank began assessing a fee to
noncustomers who use the Bank's ATMs and thus increased fees generated.

The 1997 increase is due to increased service charges on deposit accounts as a
result of the additional deposits purchased in connection with the acquisition
of two branches late in 1996, increased gains recognized on the sale of
secondary market real estate mortgage loans in 1997 due to an increase in
activity, increased fees from the sale of non-depository investment products in
1997 due to an increase in activity and unrecognized losses on real estate
mortgage loans held for sale recorded in 1996. These increases were partially
offset by a decline in trust income due to a decline in trust assets and a
decline in earnings on Bank owned life insurance policies due to an increase in
premium payments.

The increase in 1996 was due to an increase in trust income, as a result of
increased trust assets, increased secondary market gains due to an increase in
activity and the capitalization of mortgage servicing rights, increased earnings
in Bank-owned life insurance policies and increased rental income. These
increases were partially offset by a $61,000 unrealized loss on $1,200,000 in
real estate mortgage loans previously classified as held for sale and
transferred to the Bank's loan portfolio. This loss will be amortized through
the maturity dates of the loans.

Security gains of $0 in 1998, $5,000 in 1997 and $10,000 in 1996 were
recognized.

Non-interest expense increased by 1.8% in 1998, 16.0% in 1997 and 10.6% in 1996.
The primary expense categories that increased in 1998 were occupancy, equipment
and marketing. Occupancy and equipment costs increased as a result of the
opening or the new Hillsdale branch and continued upgrades to the Bank's
technology base. Marketing expenditures increased as the Bank revamped its
checking account products.

The 1997 increase is due to additional personnel costs, occupancy costs,
marketing and advertising expenditures, training costs and intangible asset
amortization as a result of the acquisition of two branches late in 1996. Trust
department expenses also increased in 1997 as professional consultants and new
trust administrators were added in order to increase the trust department's
market share. Equipment costs increased in 1997 as the Company invested in
significant technological upgrades.

The 1996 increase was due to increased salary and benefit costs associated with
an increase in the number of employees, increased occupancy and equipment costs
associated with the new retail loan centers and technology improvements made
throughout the Bank, increased training expenditures and increased marketing and
advertising expenditures to promote the new retail loan centers and the branches
acquired from First of America. These increases were partially offset by a
decline in legal fees and FDIC premiums.

Income tax expense was $1,185,000 in 1998, $1,085,000 in 1997 and $1,150,000 in
1996. Tax-exempt income continues to have a major impact on the Company's tax
expense. The benefit offsetting lower coupon rates on municipal instruments is
the nontaxable feature of the income earned on such instruments. This resulted
in a lower effective tax rate and reduced federal income tax expense by
approximately $350,000 in 1998, $254,000 in 1997 and $227,000 in 1996.

Results of operations can be measured by various ratio analyses. Two widely
recognized performance indicators are the return on equity and the return on
assets. The Company's return on equity was 17.48% in 1998, 14.96% in 1997 and
16.09% in 1996. The return on average assets was 1.42% in 1998, 1.30% in 1997
and 1.45% in 1996.

The majority of assets and liabilities of a financial institution are monetary
in nature and therefore differ greatly from most commercial and industrial
companies that have significant investments in fixed assets or inventories.
However, inflation does have an important impact on the growth of total assets
in the banking industry and the resulting need to increase equity capital at
higher than normal rates in order to maintain an appropriate equity-to-assets
ratio. Another significant effect of inflation is on other expenses, which tend
to rise during periods of general inflation.

Management believes the most significant impact on financial results is the
Company's ability to react to changes in interest rates. As discussed
previously, management is attempting to maintain an essentially balanced
position between interest sensitive assets and liabilities in order to protect
against wide interest rate fluctuations.

YEAR 2000

The Company has developed a plan to assess Year 2000 issues. The concern is
whether or not computers, elevators, telephone systems and other electronic
items will recognize the Year 2000 as a valid date. For banks, this is a concern
not only for the bank's operations, but for those of their customers and
vendors. As part of the Year 2000 plan, the Company has identified all critical
business processes and established a priority schedule for assessment of each
process.


                                       8
         
                                  Southern Michigan Bancorp, Inc. and Subsidiary
<PAGE>   11
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)


The first step in the plan is the testing of the Company's critical hardware
systems to verify that the systems are Year 2000 compliant. The critical
hardware systems include the mainframe computer system and some personal
computers. The testing of all critical hardware will be completed by March 31,
1999.

The next step in the Company's plan is to perform testing on all critical
software. The Company has no software that is internally programmed; all
software is purchased from external vendors. The Company has implemented a
verification process to establish that critical software purchased from software
vendors is Year 2000 compliant. Critical software includes mainframe operating
software, trust systems, Microsoft operating systems and systems providing
connectivity of network hardware. The testing of critical software will be
substantially completed by March 31, 1999.

As part of its Year 2000 plan, the Company has initiated formal communications
with its critical service providers to determine the extent to which the Company
is vulnerable to any failure of those third parties to remedy their own Year
2000 issues. Critical service providers include phone companies and energy
providers. This review of service providers will be completed by June 30, 1999.
There can be no assurance that the systems of other companies on which the
Company's systems rely will be remedied in a timely manner or that there will be
no adverse effect on the Company's systems. Therefore, the Company could be
negatively impacted to the extent that other entities not affiliated with the
Company are unsuccessful in properly addressing Year 2000 issues.

A key step in the Company's Year 2000 plan is the development of a Remediation
Contingency Plan to mitigate risks associated with a failure to successfully
complete renovation, validation and implementation of the Company's Year 2000
plan. The Remediation Contingency Plan will provide for alternate service
providers and software vendors in the event that the Company's current service
providers and software vendors are not fully Year 2000 compliant by March 31,
1999, in the case of software vendors, and June 30, 1999, in the case of service
providers. The Remediation Contingency Plan will be developed by mid March 1999.
Also by June 30, 1999, the Company will have in place an expanded Business
Resumption Plan. This Plan will be an addition to the Company's current Business
Resumption Plan and will specifically address Year 2000 issues and the
interruption of the Company's business operations by such things as a power
outage. The Business Resumption Plan will include the identification of the
Company's core business processes and a specific recovery plan for the possible
failure of each core business process. A sustained power outage or similar
disruption will have an adverse effect on the Company's operations; however,
management is not aware of any facts which would indicate that such disruptions
are likely.

Another important step in the Company's Year 2000 plan is the identification of
all significant customers whose own Year 2000 compliance status may pose a risk
to the Company. As part of this step, the Company will determine the actions
these customers are taking to avoid significant disruptions that could result
from the Year 2000 date change. This step will be completed by mid March 1999.

The Company's Board of Directors reviews the status of the Year 2000 issues on a
monthly basis. The Company will incur remediation and testing costs relating to
Year 2000 issues through the Year 2000, but does not anticipate that material
incremental costs will be incurred in any single period. The costs of the
project and the date on which the Company plans to complete Year 2000
modifications are based upon management's best estimates.

The Company has been engaged in activities addressing Year 2000 issues since mid
1997. In January, 1999, the Bank entered into discussions with the Federal
Deposit Insurance Corporation ("FDIC") regarding the Bank's Year 2000
preparedness. As a result of such discussions, the Board of Directors entered
into an agreement with the FDIC describing certain actions to be taken by the
Bank to address Year 2000 issues. The Company is actively pursuing all such
actions (which actions are summarized above) and anticipates that it will
complete all such actions in a timely manner.

NONPERFORMING ASSETS

Nonperforming assets include nonaccrual loans, accruing loans past due 90 days
or more, and other real estate which includes foreclosures and deeds in lieu of
foreclosure.

A loan generally is classified as nonaccrual when full collectibility of
principal or interest is doubtful or a loan becomes 90 days past due as to
principal or interest, unless management determines that the estimated net
realizable value of the collateral is sufficient to cover the principal balance
and accrued interest. When interest accruals are discontinued, unpaid interest
credited to income in the current year is reversed, and unpaid interest accrued
in prior years is charged to the allowance for loan losses. Nonperforming loans
are returned to performing status when the loan is brought current and has
performed in accordance with contract terms for a period of time.


                                       9

1998 Annual Report to Shareholders
<PAGE>   12
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)


The following table sets forth the aggregate amount of nonperforming loans in
each of the following categories:

<TABLE>
<CAPTION>
                                                       December 31
                                                 1998      1997     1996
                                                -------------------------
                                                  (Dollars in thousands)
<S>                                             <C>       <C>       <C>
Nonaccrual loans:
  Commercial, financial and agricultural        $  343    $1,026    $448
  Real estate mortgage                               0         0       0
  Installment                                        0        61       2
                                                -------------------------
                                                   343     1,087     450
Loans contractually past due 90 days or more:
  Commercial, financial and agricultural        $  807    $1,067      82
  Real estate mortgage                             161       630     129
  Installment                                      120       966     165
                                                -------------------------
                                                 1,088     2,663     376
                                                -------------------------
Total nonperforming loans                        1,431     3,750     826
Other real estate owned                            166       103      76
                                                -------------------------
Total nonperforming assets                      $1,597    $3,853    $902
                                                =========================
Nonperforming loans to year-end loans             .88%     2.36%    .54%
Nonperforming assets to year-end loans
  and other real estate owned                     .98%     2.43%    .59%
</TABLE>

Nonperforming loans decreased in 1998 as some of 1997's problem loans were
charged off and the Company accelerated its collection activities. Some increase
in nonperforming loans was expected in 1997 due to the significant loan growth
that occurred in recent years. Customers experienced heavier debt loads due to
the ease of obtaining credit and this is resulted in an increase in bankruptcy
filings and delinquencies. Nonperforming loans are subject to continuous
monitoring by management and are specifically reserved for in the allowance for
loan losses where appropriate.

At December 31, 1998, the Company had approximately $3,931,000 in commercial,
financial and agricultural loans for which payments are presently current but
the borrowers are experiencing certain financial and/or operational
difficulties. These loans are subject to frequent management review and their
classification is reviewed on a monthly basis.

In management's evaluation of the loan portfolio risks, any significant future
increases in nonperforming loans is dependent to a large extent on the economic
environment. In a deteriorating or uncertain economy, management applies more
conservative assumptions when assessing the future prospects of borrowers and
when estimating collateral values. This may result in a higher number of loans
being classified as nonperforming.

REGULATORY MATTERS

Representatives of the FDIC completed an examination at the Company's subsidiary
bank using financial information as of December 31, 1997. The purpose of the
examination was to determine the safety and soundness of the bank.

Examination procedures require individual judgments about a borrower's ability
to repay loans, sufficiency of collateral values and the effects of changing
economic circumstances. These procedures are similar to those employed by the
Company in determining the adequacy of the allowance for loan losses and in
classifying loans. Judgments made by regulatory examiners may differ from those
made by management. The Company's level and classification of identified
potential problem loans was not revised significantly as a result of this
regulatory examination process.

Management and the Board of Directors evaluate existing practices and procedures
on an ongoing basis. In addition, regulators often make recommendations during
the course of their examination that relate to the operations of the Company and
the Bank. As a matter of practice, management and the Board of Directors
consider such recommendations promptly.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company's primary market risk exposure is interest rate risk and to a lesser
extent liquidity risk. See Liquidity and Interest Rate Sensitivity, above.
Business is transacted in U.S. dollars with no foreign exchange rate risk or any
exposure to changes in commodity prices.

The following tables provide information about the Company's financial
instruments that are sensitive to changes in interest rates as of December 31,
1998 and 1997. The Company had no derivative financial instruments, or trading
portfolio, at either date.


                                      10         

                                  Southern Michigan Bancorp, Inc. and Subsidiary
<PAGE>   13
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)


The expected maturity date values for loans receivable, mortgage-backed
securities and investment securities were calculated without adjusting the
instrument's contractual maturity date for expectations of prepayments. Expected
maturity date values for interest-bearing core deposits were not based upon
estimates of the period over which the deposits would be outstanding, but rather
the opportunity for repricing. Similarly, with respect to its variable rate
instruments, the Company believes that repricing dates, as opposed to expected
maturity dates may be more relevant in analyzing the value of such instruments
and are reported as such in the following table. Company borrowings are also
reported based on conversion or repricing dates.

<TABLE>
<CAPTION>
                                                           Principal Amount Maturing in:                                 Fair Value
                                     -----------------------------------------------------------------------------------------------
                                       1999        2000         2001        2002        2003     Thereafter    Total     12/31/98
                                     -----------------------------------------------------------------------------------------------
                                                                      (Dollars in thousands)
<S>                                  <C>         <C>          <C>         <C>         <C>        <C>         <C>         <C>
Rate sensitive assets:
   Fixed interest rate loans         $  9,887    $  6,679     $  8,478    $ 10,259    $ 11,483    $ 11,582   $ 58,368    $ 58,653
      Average interest rate            10.81%       9.98%       10.25%      10.50%       9.79%       9.01%     10.02%
   Variable interest rate loans        28,076       1,848        3,728       3,032       5,541      62,710    104,935     104,935
      Average interest rate             8.75%       8.63%        8.65%       8.79%       9.00%       8.72%      8.70%
   Fixed interest rate securities      21,933      11,304        7,962       5,327       2,971      18,397     67,894      68,831
      Average interest rate             4.71%       4.62%        4.59%       4.64%       4.58%       4.71%      4.60%
   Other interest bearing assets        6,610                                                                   6,610       6,610
      Average interest rate             4.84%                                                                   4.84%

Rate sensitive liabilities:
   Interest bearing demand deposits    79,255                                                                  79,255      79,255
      Average interest rate             3.05%                                                                   3.05%
   Savings deposits                    37,037       2,825        1,282         235       4,289          0      45,668      46,704
      Average interest rate             2.30%       5.81%        5.72%       5.65%       5.60%                  3.30%
   Time deposits                       55,925      10,774        5,164       1,797           0          0      73,660      74,201
      Average interest rate             5.46%       4.83%        4.74%       4.81%                              4.97%
   Fixed interest rate borrowings                                                        5,000                  5,000       5,000
      Average interest rate                                                              5.47%                  5.47%
</TABLE>

<TABLE>
<CAPTION>
                                                         Principal Amount Maturing in:                                    Fair Value
                                     -----------------------------------------------------------------------------------------------
                                        1998        1999         2000        2001        2002     Thereafter    Total      12/31/97
                                     -----------------------------------------------------------------------------------------------
                                                                      (Dollars in thousands)
<S>                                   <C>         <C>           <C>         <C>         <C>       <C>          <C>         <C>
Rate sensitive assets:
   Fixed interest rate loans          $20,230     $12,383       $9,288      $7,163      $4,843      $4,414     $58,321     $57,958
      Average interest rate             9.88%      10.03%       10.15%      10.18%      10.23%      10.04%      10.09%
   Variable interest rate loans        12,543         564          449       9,443      11,029      66,392     100,420     100,420
      Average interest rate             9.17%       9.28%        9.59%       9.55%       9.63%       9.87%       9.52%
   Fixed interest rate securities      13,490      13,919        7,107       3,448       2,738       4,372      45,074      45,425
      Average interest rate             5.85%       5.72%        5.98%       6.50%       4.98%       6.19%       5.75%
   Other interest bearing assets        4,500                                                                    4,500       4,500
      Average interest rate             5.43%                                                                    5.43%

Rate sensitive liabilities:
   Interest bearing demand deposits    67,032                                                                   67,032      67,032
      Average interest rate             3.39%                                                                    3.39%
   Savings deposits                    34,416       5,332        2,174       1,330         140                  43,392      43,397
      Average interest rate             2.78%       5.89%        5.58%       5.31%       5.74%                   3.41%
   Time deposits                       51,701       7,802        5,481         683          12          39      65,718      65,705
      Average interest rate             5.43%       5.66%        5.72%       5.70%       5.70%       5.70%       5.46%
   Fixed interest rate borrowings                                            3,000                               3,000       3,000
      Average interest rate                                                  5.71%                               5.71%
</TABLE>


                                       11

1998 Annual Report to Shareholders
<PAGE>   14

MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL INFORMATION


Management of Southern Michigan Bancorp, Inc. has prepared and is responsible
for the accompanying financial statements and for their integrity and
objectivity. In the opinion of management, the financial statements, which
necessarily include amounts based on management's estimates and judgments, have
been prepared in conformity with generally accepted accounting principles on a
consistent basis. Management also prepared the other information in the Annual
Report and is responsible for its accuracy and consistency with the financial
statements.

The Company maintains a system of internal accounting controls designed to
provide reasonable assurance that assets are safeguarded and that transactions
are executed in accordance with the Company's authorizations and policies.
Further, such a system provides reasonable assurances as to the integrity and
reliability of the financial statements which fairly present financial position
and results of operations in conformity with generally accepted accounting
principles. Internal accounting controls are augmented by written policies
covering standards of personal and business conduct and an organizational
structure providing for division of responsibility and authority.

Management monitors the effectiveness of and compliance with established control
systems through a continuous program of internal audit and credit examinations
and recommends possible improvements thereto. In addition, as part of their
audit of the Company's financial statements, Crowe, Chizek and Company LLP,
independent auditors, completed an evaluation of selected internal accounting
controls to establish a basis for reliance thereon in determining the nature,
timing, and extent of audit tests to be applied. Management has considered the
recommendations from the examination of controls concerning the Company's system
of internal controls and has taken actions that we believe are cost-effective in
the circumstances to respond appropriately to these recommendations. Management
believes that, as of December 31, 1998, the Company's system of internal
controls is adequate to accomplish the objectives discussed herein. Further,
management believes the system of controls has prevented or detected on a timely
basis any occurrences that could be material to the financial statements and
that timely corrective actions have been initiated when appropriate.

The Board of Directors exercises its responsibility for the financial statements
and related information through the Audit Committee, which is composed entirely
of outside directors. The Audit Committee meets regularly with management and
Crowe, Chizek and Company LLP, to assess the scope of the annual audit plan and
to review the status and results of audits, including major changes in
accounting policies and reporting practices. Crowe, Chizek and Company LLP has
direct and confidential access to the Audit Committee at all times to discuss
the results of their audits.


/s/ Jerry L. Towns                      /s/ James T. Grohalski

Jerry L. Towns                          James T. Grohalski
Chairman                                President & C.E.O.


                                       12 


                                  Southern Michigan Bancorp, Inc. and Subsidiary
<PAGE>   15
CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                                         December 31
                                                                                      1998           1997
                                                                                      ----           ----
<S>                                                                                 <C>            <C>
ASSETS                                                                                  (In thousands)
Cash                                                                                $  3,021       $  3,057
Due from banks                                                                        13,207         13,791
                                                                                    --------       --------
   Cash and cash equivalents                                                          16,228         16,848
Federal funds sold                                                                     4,000          4,500
Investment securities available for sale                                              36,138         12,853
Investment securities held to maturity
   (fair value of $32,693 in 1998 and $32,572 in 1997)                                31,756         32,221
Loans, net                                                                           161,277        156,878
Premises and equipment                                                                 7,036          5,588
Other assets                                                                          10,416          9,643
                                                                                    --------       --------
TOTAL ASSETS                                                                        $266,851       $238,531
                                                                                    ========       ========

LIABILITIES AND SHAREHOLDERS' EQUITY
Deposits
   Non-interest bearing                                                             $ 34,778       $ 30,923
   Interest bearing                                                                  198,583        176,142
                                                                                    --------       --------
Total deposits                                                                       233,361        207,065
Accounts payable and other liabilities                                                 2,528          2,977
Other borrowings                                                                       5,000          3,000
                                                                                    --------       --------
TOTAL LIABILITIES                                                                    240,889        213,042

Common stock subject to repurchase obligation in ESOP                                  6,029          4,899

Shareholders' equity:
Preferred stock, 100,000 shares authorized; none issued or outstanding 
Common stock, $2.50 par value:
   Authorized - 4,000,000 shares
   Issued - 1,872,677 shares (1,916,921 in 1997)
   Outstanding - 1,721,950 shares (1,772,839 in 1997)                                  4,305          4,432
Capital surplus                                                                        3,863          1,914
Retained earnings                                                                     11,505         14,218
Net unrealized gain on available-for-sale
   securities, net of tax of $134 in 1998 and $13 in 1997                                260             26
                                                                                    --------       --------
TOTAL SHAREHOLDERS' EQUITY                                                            19,933         20,590
                                                                                    --------       --------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY                                          $266,851       $238,531
                                                                                    ========       ========
</TABLE>


See accompanying notes.


                                       13

1998 Annual Report to Shareholders
<PAGE>   16

CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY


In thousands

<TABLE>
<CAPTION>
                                                                                                  Net Unrealized
                                                                                                     Gain (Loss)
                                                                                                   On Available-
                                                    Common          Capital          Retained           For-Sale
                                                     Stock          Surplus          Earnings         Securities             TOTAL
                                                     -----          -------          --------         ----------             -----
<S>                                              <C>              <C>              <C>            <C>                    <C>
BALANCE AT JANUARY 1, 1996                       $   2,145        $   3,511         $  12,630           $    211         $  18,497

Net income for 1996                                                                     3,058                                3,058
Cash dividends declared - $.53 per share                                               (1,001)                              (1,001)
Common stock issued under
   dividend reinvestment plan (14,146 shares)           35              440                                                    475
Change in common stock subject to repurchase            (6)          (1,217)                                                (1,223)
Net change in unrealized gain (loss)
   on available-for-sale securities, net of tax                                                             (190)             (190)
                                                 ---------        ---------        ----------          ---------        ----------
BALANCE AT DECEMBER 31, 1996                         2,174            2,734            14,687                 21            19,616

Net income for 1997                                                                     3,032                                3,032
Cash dividends declared - $ .58 per share                                              (1,109)                              (1,109)
Common stock issued under dividend
   reinvestment plan (9,879 shares)                     25              365                                                    390
100% stock dividend issued (956,695 shares)          2,392                             (2,392)
Change in common stock subject to repurchase          (159)          (1,185)                                                (1,344)
Net change in unrealized gain (loss)
   on available-for-sale securities, net of tax                                                                5                 5
                                                 ---------        ---------        ----------          ---------        ----------
BALANCE AT DECEMBER 31, 1997                         4,432            1,914            14,218                 26            20,590

Net income for 1998                                                                     3,549                                3,549
Cash dividends declared - $ .67 per share                                              (1,262)                              (1,262)
Common stock issued under dividend
   reinvestment plan (6,835 shares)                     18              233                                                    251
Common stock repurchased and
   retired (51,079 shares)                            (128)          (2,171)                                                (2,299)
Transfer from retained earnings to surplus                            5,000            (5,000)
Change in common stock subject to repurchase           (17)          (1,113)                                                (1,130)
Net change in unrealized gain (loss)
   on available-for-sale securities, net of tax                                                              234               234
                                                 ---------        ---------        ----------          ---------        ----------
BALANCE AT DECEMBER 31, 1998                     $   4,305        $   3,863        $   11,505          $     260        $   19,933
                                                 =========        =========        ==========          =========        ==========
</TABLE>


See accompanying notes.


                                       14

                                  Southern Michigan Bancorp, Inc. and Subsidiary
<PAGE>   17

CONSOLIDATED STATEMENTS OF INCOME


<TABLE>
<CAPTION>
                                                                                 Year ended December 31
                                                                           1998            1997            1996
                                                                           ----            ----            ----
<S>                                                                    <C>             <C>             <C>
Interest income:                                                                     (In thousands)
   Loans, including fees                                               $ 15,781        $ 15,545        $ 13,500
   Investment securities:
      Taxable                                                             2,305           2,189           2,443
      Tax-exempt                                                          1,094             861             775
                                                                       --------        --------        --------
                                                                          3,399           3,050           3,218
   Other                                                                    266              74              69
                                                                       --------        --------        --------
Total interest income                                                    19,446          18,669          16,787
Interest expense:
   Deposits                                                               7,622           7,260           6,427
   Capital notes                                                              9
   Other                                                                    410             183             168
                                                                       --------        --------        --------
Total interest expense                                                    8,032           7,443           6,604
                                                                       --------        --------        --------
NET INTEREST INCOME                                                      11,414          11,226          10,183
Provision for loan losses                                                   600             460             267
                                                                       --------        --------        --------
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES                      10,814          10,766           9,916
Non-interest income:
   Service charges on deposit accounts                                      978             835             727
   Trust fees                                                               500             528             545
   Securities gains                                                                           5              10

   Gain on sales of loans                                                 1,085             550             343
   Earnings on life insurance policies                                      220             181             203
   Other                                                                    413             360             313
                                                                       --------        --------        --------
                                                                          3,196           2,459           2,141
                                                                       --------        --------        --------
                                                                         14,010          13,225          12,057
Non-interest expenses:
   Salaries and employee benefits                                         4,528           4,508           4,048
   Occupancy                                                                781             697             605
   Equipment                                                                872             762             712
   Advertising                                                              219             253             175
   Other                                                                  2,876           2,888           2,309
                                                                       --------        --------        --------
                                                                          9,276           9,108           7,849
                                                                       --------        --------        --------
Income before income taxes                                                4,734           4,117           4,208
Federal income taxes                                                      1,185           1,085           1,150
                                                                       --------        --------        --------
NET INCOME                                                                3,549           3,032           3,058
Other comprehensive income:
   Unrealized gains/losses on securities arising during the year            355              13            (279)
   Reclassification adjustment for accumulated gains/losses
      included in net income                                                  0               5              10
   Tax effect                                                              (121)             (3)            (99)
                                                                       --------        --------        --------
   Other comprehensive income                                               234               5            (190)
                                                                       --------        --------        --------
COMPREHENSIVE INCOME                                                   $  3,783        $  3,037        $  2,868
                                                                       ========        ========        ========
BASIC AND DILUTED EARNINGS PER SHARE                                   $   1.87        $   1.59        $   1.62
                                                                       ========        ========        ========
</TABLE>


See accompanying notes.


                                       15

1998 Annual Report to Shareholders
<PAGE>   18
CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                                      Year ended December 31
                                                                                1998            1997            1996
                                                                                ----            ----            ----
OPERATING ACTIVITIES                                                                      (In thousands)
<S>                                                                         <C>             <C>             <C>     
Net income                                                                  $  3,549        $  3,032        $  3,058
Adjustments to reconcile net income to net cash 
   provided by operating activities:
     Provision for loan losses                                                   600             460             267
     Depreciation                                                                599             527             410
     Net amortization of investment securities                                   182             138             166
     Net realized gain on sales of investment securities                                          (5)            (10)
     Loans originated for sale                                               (34,550)        (17,175)        (11,073)
     Proceeds on loans sold                                                   35,167          17,489          11,269
     Realized gain on sale of loans originated for sale                       (1,085)           (550)           (343)
                                                                                                                      
     Net change in:
        Other assets                                                            (894)           (469)         (1,733)
        Accrued expenses and other liabilities                                  (459)            160             262
                                                                            --------        --------        --------
Net cash from operating activities                                             3,109           3,607           2,273

INVESTING ACTIVITIES
Net (increase) decrease in federal funds sold                                    500          (4,500)          4,500
Activity in available-for-sale investment securities:
   Sales                                                                                         255             509
   Maturities and calls                                                        9,522          12,187          15,652
   Purchases                                                                 (32,808)         (1,167)         (9,736)
Activity in held-to-maturity investment securities:
   Maturities and calls                                                        6,852           4,355           6,719
   Purchases                                                                  (6,213)         (4,230)        (14,842)
Loan originations and payments, net                                           (4,531)         (6,230)        (29,564)
Additions to premises and equipment                                           (2,047)           (888)         (1,675)
                                                                            --------        --------        --------
Net cash from investing activities                                           (28,725)           (218)        (28,437)

FINANCING ACTIVITIES
Acquisition of deposits                                                                                       18,635
Net change in deposits                                                        26,296          (2,402)          5,308
Proceeds from long-term borrowings                                             2,000           3,000
Payment of capital note                                                                                       (1,000)
Common stock issued                                                              251             390             575
Cash dividends paid                                                           (1,252)         (1,049)         (1,014)
Repurchase of common stock                                                    (2,299)
                                                                            --------        --------        --------
Net cash from financing activities                                            24,996             (61)         22,504
                                                                            --------        --------        --------
NET CHANGE IN CASH AND CASH EQUIVALENTS                                         (620)          3,328          (3,660)
Beginning cash and cash equivalents                                           16,848          13,520          17,180
                                                                            --------        --------        --------
ENDING CASH AND CASH EQUIVALENTS                                            $ 16,228        $ 16,848        $ 13,520
                                                                            ========        ========        ========
</TABLE>


See accompanying notes.


                                       16


                                  Southern Michigan Bancorp, Inc. and Subsidiary
<PAGE>   19
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


December 31, 1998

NOTE A - NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES

NATURE OF OPERATIONS AND INDUSTRY SEGMENTS: Southern Michigan Bancorp, Inc. is a
bank holding company. The Company's business is concentrated in the commercial
banking industry segment. The business of commercial and retail banking accounts
for more than 90% of its revenues, operating income and assets. Internal
financial information is primarily reported and aggregated in the line of
business of banking. The Bank offers individuals, businesses, institutions and
government agencies a full range of commercial banking services primarily in the
southern Michigan communities in which the Bank is located and in areas
immediately surrounding these communities. The Bank grants commercial, real
estate and consumer loans to customers. The majority of loans are secured by
specific assets and consumer assets. There are no foreign loans. 

PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include the
accounts of Southern Michigan Bancorp, Inc. (the Company) and its wholly owned
subsidiary, Southern Michigan Bank & Trust (the Bank), after elimination of
significant intercompany balances and transactions. 

USE OF ESTIMATES: The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that effect the reported amounts of assets, liabilities and
disclosure of contingent liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates. Estimates that are more
susceptible to change in the near term include the allowance for loan losses,
deferred income tax provisions, fair values of certain securities and other
financial instruments and the actuarial present value of pension benefit
obligations and net periodic pension expense and prepaid pension costs.

INVESTMENT SECURITIES (including mortgage-backed securities): Management
determines the appropriate classification of securities at the time of purchase.
If management has the intent and the Company has the ability at the time of
purchase to hold securities until maturity, they are classified as held to
maturity and carried at amortized historical cost. Securities to be held for
indefinite periods of time and not intended to be held to maturity are
classified as available-for-sale and carried at fair value, with unrealized
gains and losses reported in other comprehensive income. Securities classified
as available-for-sale include securities that management intends to use as part
of its asset/liability management strategy and that may be sold in response to
changes in interest rates, resultant prepayment risk, and other factors. The
Company is not currently involved in trading activities. 

Premiums and discounts on securities are recognized in interest income using the
level yield method over the estimated life of the security. Gains and losses on
the sale of available-for-sale securities are determined using the specific
identification method. 

LOANS: Loans are reported at the principal balance outstanding, net of unearned
interest, deferred loan fees and costs, and an allowance for loan losses. Loans
held for sale are reported at the lower of cost or market, on an aggregate
basis. Interest on loans is credited to income based upon principal amount
outstanding. The accrual of interest income generally is discontinued when a
loan becomes over 90 days past due as to principal or interest. When interest
accruals are discontinued, interest credited to income in the current year is
reversed, and accrued interest from the prior year is charged to the allowance
for loan losses. Management may elect to continue the accrual of interest when
the estimated net realized value of collateral is sufficient to cover the
principal balance and accrued interest. The carrying values of impaired loans
are periodically adjusted to reflect cash payments, revised estimates of future
cash flows and increases in the present value of expected cash flows due to the
passage of time. Cash payments representing interest income are reported as
such. Other cash payments are reported as reductions in carrying value, while
increases or decreases due to changes in estimates of future payments and due to
the passage of time are included in the provision for loan losses. 

ALLOWANCE FOR LOAN LOSSES: The allowance for loan losses is maintained at a
level believed adequate to absorb potential losses in the portfolio. Management
determines the adequacy of the allowance for loan losses based on a continuing
evaluation of the loan portfolio, past loan loss experience, current economic
conditions, composition of the loan portfolio and other relevant factors. The
allowance is increased by provisions charged against income. 

A loan is impaired when full payment under the loan terms is not expected.
Impairment is evaluated in total for smaller-balance loans of similar nature
such as residential mortgage, consumer and credit card loans, and on an
individual loan basis for other loans. If a loan is impaired, a portion of the
allowance is allocated so that the loan is reported, net, at the present value
of estimated future cash flows using the loan's existing rate or at the fair
value of collateral if repayment is expected solely from the collateral.


                                       17


1998 Annual Report to Shareholders
<PAGE>   20
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE A - NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

PREMISES AND EQUIPMENT: Premises and equipment are stated at cost, less
accumulated depreciation. Depreciation is computed principally using accelerated
methods over their estimated useful lives. 

SERVICING RIGHTS: Servicing rights are recognized as assets for the allocated
value of retained servicing rights on loans sold. Servicing rights are expensed
in proportion to, and over the period of, estimated net servicing rights
revenues. Impairment is evaluated based on the fair value of the rights, using
groupings of the underlying loans as to interest rates and then, secondarily, as
to geographic and prepayment characteristics. Any impairment of a grouping is
reported as a valuation allowance. 

GOODWILL AND CORE DEPOSIT INTANGIBLES: Goodwill is the excess of purchase price
over identified net assets in business acquisitions. Goodwill is amortized on
the straight-line method over 15 years. Core deposit intangibles represent the
value of depositor relationships purchased and are amortized on accelerated
methods over 10 years. Goodwill was $807,000 and $870,000 and core deposit
intangibles were $464,000 and $559,000 at December 31, 1998 and 1997
respectively, and these balances are included in other assets. 

OTHER REAL ESTATE: Other real estate ($166,000 and $103,000 at December 31, 1998
and 1997 respectively), which is included in other assets, comprises properties
acquired through a foreclosure proceeding or acceptance of a deed in lieu of
foreclosure. These properties are initially recorded at fair value at the date
of foreclosure, establishing a new cost basis. After foreclosure, valuations are
periodically performed by management and real estate is carried at the lower of
fair value minus estimated cost of disposal or cost. 

INCOME TAXES: Income tax expense is the total of the current year income tax due
or refundable and the change in deferred tax assets and liabilities. Deferred
tax assets and liabilities are the expected future tax amounts for the temporary
differences between carrying amounts and tax bases of assets and liabilities,
computed using enacted tax rates. A valuation allowance, if needed, reduces
deferred tax assets to the amount expected to be realized. 

EARNINGS PER COMMON SHARE: Basic earnings per common share is net income divided
by the weighted average number of common shares outstanding during the period.
ESOP shares are considered outstanding for this calculation unless unearned.
Diluted earnings per common share includes the dilutive effect of additional
potential common shares issuable under stock options. Earnings and dividends per
share are restated for all stock splits and dividends through the date of issue
of the financial statements. The weighted average common shares outstanding for
the years ended December 31, 1998, 1997 and 1996 were 1,895,292, 1,910,449 and
1,886,324, respectively.


                                       18

                                  Southern Michigan Bancorp, Inc. and Subsidiary
<PAGE>   21
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE A - NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

CASH FLOW INFORMATION: For purposes of the consolidated statements of cash
flows, the Company considers cash and due from banks as cash and cash
equivalents. The Company reports net cash flows for customer loan and deposit
transactions.

COMPREHENSIVE INCOME: Comprehensive income consists of net income and other
comprehensive income. Other comprehensive income includes unrealized gains and
losses on securities available for sale which are also recognized as separate
components of equity. The accounting standard that requires reporting
comprehensive income first applies for 1998, with prior information restated to
be comparable. 

FAIR VALUES OF FINANCIAL INSTRUMENTS: Fair values of financial instruments are
estimated using relevant market information and other assumptions, as more fully
disclosed in Note M. Fair value estimates involve uncertainties and matters of
significant judgment regarding interest rates, credit risk, prepayments and
other factors, especially in the absence of broad markets for particular items.
Changes in assumptions or in market conditions could significantly affect such
estimates. 

CONCENTRATIONS OF CREDIT RISK: The Company grants commercial, real estate and
installment loans to customers mainly in Southern Michigan. Commercial loans
include loans collateralized by commercial real estate, business assets and
agricultural loans collateralized by crops and farm equipment. Commercial,
financial and agricultural loans make up approximately 51% of the loan portfolio
and the loans are expected to be repaid from cash flow from operations of
businesses. Residential mortgage loans make up approximately 31% of the loan
portfolio and are collateralized by mortgages on residential real estate.
Consumer loans make up approximately 18% of the loan portfolio and are primarily
collateralized by consumer assets. 

FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK: The Company, in the normal
course of business, makes commitments to extend credit which are not reflected
in the consolidated financial statements. A summary of these commitments is
disclosed in Note J. 

LOSS CONTINGENCIES: Loss contingencies, including claims and legal actions
arising in the ordinary course of business, are recorded as liabilities when the
likelihood of loss is probable and an amount or range of loss can be reasonably
estimated. Management does not believe there now are such matters that will have
a material effect on the financial statements. 

RECLASSIFICATIONS: Some items in the prior consolidated financial statements
have been reclassified to conform with the current presentation. 

NEW ACCOUNTING PRONOUNCEMENTS: Beginning January 1, 2000, a new accounting
standard will require all derivatives to be recorded at fair value. Unless
designated as hedges, changes in these fair values will be recorded in the
income statement. Fair value changes involving hedges will generally be recorded
by offsetting gains and losses on the hedge and on the hedged item, even if the
fair value of the hedged item is not otherwise recorded. This is not expected to
have a material effect but the effect will depend on derivative holdings when
this standard applies.


NOTE B - INVESTMENT SECURITIES

Year end investment securities were as follows (in thousands):

<TABLE>
<CAPTION>
                                                  GROSS        GROSS
                                   AMORTIZED    UNREALIZED   UNREALIZED        FAIR
AVAILABLE FOR SALE, 1998             COST         GAINS        LOSSES         VALUE
                                   -------       -------       -------       -------
<S>                                <C>          <C>          <C>             <C>    
U.S. Treasury and other U.S. 
   Government agencies             $ 9,019       $    68                     $ 9,087
States and political
   subdivisions thereof             20,236           315       $     5        20,546
Corporate securities                 1,302             8                       1,310
Mortgage-backed securities           2,677             8                       2,685
                                   -------       -------       -------       -------
Total debt securities               33,234           399             5        33,628
Equity securities                    2,510                                     2,510
                                   -------       -------       -------       -------
TOTALS                             $35,744       $   399       $     5       $36,138
                                   =======       =======       =======       =======
</TABLE>


                                       19


1998 Annual Report to Shareholders
<PAGE>   22

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE B - INVESTMENT SECURITIES (CONTINUED)

<TABLE>
<CAPTION>
                                                   GROSS        GROSS
                                  AMORTIZED      UNREALIZED   UNREALIZED      FAIR
Available for sale, 1997             COST          GAINS        LOSSES        VALUE
                                   -------       -------       -------       -------
<S>                               <C>            <C>          <C>            <C>    
U.S. Treasury and other U.S. 
   Government agencies             $ 6,259       $    10       $     7       $ 6,262
States and political
   subdivisions thereof              3,464            36                       3,500
Corporate securities                 1,096             4                       1,100
Mortgage-backed securities           1,646             1             5         1,642
                                   -------       -------       -------       -------
Total debt securities               12,465            51            12        12,504
Equity securities                      349                                       349
                                   -------       -------       -------       -------
TOTALS                             $12,814       $    51       $    12       $12,853
                                   =======       =======       =======       =======

HELD TO MATURITY, 1998

States and political
   subdivisions thereof            $16,460       $   897                     $17,357
Corporate securities                14,592            49       $     9        14,632
                                   -------       -------       -------       -------
Total debt securities               31,052           946             9        31,989
Equity securities                      704                                       704
                                   -------       -------       -------       -------
TOTALS                             $31,756       $   946       $     9       $32,693
                                   =======       =======       =======       =======

Held to maturity, 1997

States and political
   subdivisions thereof            $17,060       $   326       $     1       $17,385
Corporate securities                14,464            41            15        14,490
                                   -------       -------       -------       -------
Total debt securities               31,524           367            16        31,875
Equity securities                      697                                       697
                                   -------       -------       -------       -------
TOTALS                             $32,221       $   367       $    16       $32,572
                                   =======       =======       =======       =======
</TABLE>

Sales of available for sale securities were (in thousands):


<TABLE>
<CAPTION>
                   1998       1997       1996
                   ----       ----       ----
<S>                <C>        <C>        <C> 
Proceeds              0       $255       $509
Gross gains           0          5         10
Gross losses          0          0          0
</TABLE>

Contractual maturities of debt securities at year-end 1998 were as follows (in
thousands). Securities not due at a single maturity date, primarily
mortgage-backed securities, are shown separately. Expected maturities may differ
from contractual maturities because borrowers may have the right to call or
prepay obligations with or without call or prepayment penalties.

<TABLE>
<CAPTION>
                                     HELD TO MATURITY SECURITIES          AVAILABLE FOR SALE SECURITIES
                                     AMORTIZED            FAIR             AMORTIZED            FAIR
                                       COST               VALUE              COST               VALUE
                                       ----               -----              ----               -----
<S>                                  <C>                 <C>              <C>                  <C>    
Due in one year or less               $15,559            $15,592            $10,007            $10,046
Due from one to five years             11,182             11,468             17,663             17,938
Due from five to ten years              1,571              1,641              2,788              2,855
Due after ten years                     2,740              3,287                 99                104
Mortgage-backed securities                                                    2,677              2,685
                                      -------            -------            -------            -------
                                      $31,052            $31,988            $33,234            $33,628
                                      =======            =======            =======            =======
</TABLE>

Investment securities with an amortized cost of $3,303,000 and $3,675,000 were
pledged as collateral for public deposits and for other purposes in 1998 and
1997.


                                       20


                                  Southern Michigan Bancorp, Inc. and Subsidiary
<PAGE>   23
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE C - LOANS

Loans at year-end were as follows:

<TABLE>
<CAPTION>
                                               1998                  1997
                                               ----                  ----
<S>                                       <C>                   <C>      
Commercial                                $  82,533             $  74,819
Consumer                                     29,203                33,865
Real estate mortgage                         51 567                50,057
                                          ---------             ---------
                                            163,303               158,741
Less allowance for loan losses               (2,026)               (1,863)
                                          ---------             ---------
LOANS, NET                                $ 161,277             $ 156,878
                                          =========             =========
</TABLE>

Certain directors and executive officers of the Company and the Bank, including
their associates and companies in which they are principal owners, were loan
customers of the Bank. Loans to these customers are made in the ordinary course
of business at normal credit terms, including interest rates and collateral, and
generally do not involve more than normal risk of collectibility. The following
is a summary of loans (in thousands) exceeding $60,000 in the aggregate to these
individuals and their associates.

<TABLE>
<CAPTION>
                                     1998                1997
                                     ----                ----
<S>                               <C>                 <C>    
Balance at January 1              $ 3,722             $ 2,599
New loans                           7,825               6,974
Repayments                         (7,624)             (5,851)
                                  -------             -------
Balance at December 31            $ 3,923             $ 3,722
                                  =======             =======
</TABLE>

The unpaid principal balance of mortgage loans serviced for others, which are
not included on the consolidated balance sheet, was $51,462,000 and $31,085,000
at December 31, 1998 and 1997, respectively. The balance of loans serviced for
others related to servicing rights that have been capitalized was $49,565,000 in
1998 and $26,214,000 in 1997. The remaining balance of loans serviced for others
also have servicing rights associated with them; however, these servicing rights
arose prior to the adoption of FASB Statement 122, and accordingly, have not
been capitalized on the balance sheet. 

Activity for capitalized mortgage servicing rights was as follows
(in thousands): 

<TABLE>
<CAPTION>
                                   1998              1997
                                   ----              ----
<S>                               <C>               <C>  
Balance at January 1              $ 327             $ 142
Additions                           468               236
Amortized to expense               (200)              (51)
                                  -----             -----
Balance at December 31            $ 595             $ 327
                                  =====             =====
</TABLE>

No valuation allowance was necessary at December 31, 1998 or 1997.

NOTE D - ALLOWANCES FOR LOAN LOSSES

Changes in the allowance for loan losses for the years ended December 31 were as
follows (in thousands):

<TABLE>
<CAPTION>
                                        1998                1997                1996
                                        ----                ----                ----
<S>                                  <C>                 <C>                 <C>    
Balance at January 1                 $ 1,863             $ 1,814             $ 1,609
Provision for loan losses                600                 460                 267
Loans charged off                       (579)               (508)               (170)
Recoveries                               142                  97                 108
                                     -------             -------             -------
Net charge-offs                         (437)               (411)                (62)
                                     -------             -------             -------
Balance at December 31               $ 2,026             $ 1,863             $ 1,814
                                     =======             =======             =======
</TABLE>

<TABLE>
<CAPTION>
                                                                                         1998              1997
                                                                                         ----              ----
<S>                                                                                    <C>               <C>   
Information regarding impaired loans follows:
         Average investment in impaired loans during the year                          $1,566            $1,501
                                                                                       ======            ======
         Interest income recognized on impaired loans on a cash basis
             during the year                                                           $   73            $  118
                                                                                       ======            ======
         Total impaired loans at year end                                              $1,259            $1,328
         Less loans for which no allowance for loan losses is allocated                $    0                68
                                                                                       ------            ------
         Impaired loans for which an allowance for loan losses is allocated            $1,259            $1,260
                                                                                       ======            ======
         Portion of allowance allocated to these loans                                 $  367            $  358
                                                                                       ======            ======
</TABLE>


                                       21

1998 Annual Report to Shareholders
<PAGE>   24
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE E - PREMISES AND EQUIPMENT
Major classes of premises and equipment at December 31 follow (in thousands):

<TABLE>
<CAPTION>
                                            1998               1997
                                            ----               ----
<S>                                      <C>                <C>    
Land                                     $   786            $   540
Buildings and improvements                 7,625              6,525
Equipment                                  3,157              2,534
                                         -------            -------
                                          11,568              9,599
Less accumulated depreciation              4,532              4,011
                                         -------            -------
TOTALS                                   $ 7,036            $ 5,588
                                         =======            =======
</TABLE>

Depreciation and amortization expense charged to operations was approximately
$599,000, $527,000 and $410,000 in 1998, 1997 and 1996, respectively.

NOTE F - DEPOSITS
The carrying amount of domestic deposits at December 31 follows (in thousands):

<TABLE>
<CAPTION>
                                                                 1998                1997
                                                                 ----                ----
<S>                                                          <C>                 <C>     
Non-interest bearing checking                                $ 34,778            $ 30,923
Interest bearing checking                                      37,055              32,085
Passbook savings                                               31,797              29,163
Money market accounts                                          42,200              34,271
Time deposits                                                  72,439              64,301
Individual retirement accounts and other deposits              15,092              16,322
                                                             --------            --------
TOTALS                                                       $233,361            $207,065
                                                             ========            ========
</TABLE>



The carrying amount of time deposits over $100,000 was $21,058,000 and
$16,437,000 at December 31, 1998 and 1997, respectively. Interest expense on
time deposits over $100,000 was $1,084,000, $1,025,000, and $837,000 at December
31, 1998, 1997 and 1996, respectively. 

At December 31, 1998, scheduled maturities of time deposits were as follows:

<TABLE>
<S>                                      <C>     
              1999                       $ 54,704
              2000                         10,774
              2001                          5,164
              2002                          1,797
              2003                              0
              Thereafter                        0
                                         --------
                                         $ 72,439
                                         ========
</TABLE>

The amount of deposits accepted from certain officers and directors was
$1,374,000 and $1,762,000 at December 31, 1998 and 1997, respectively.

NOTE G - OTHER BORROWINGS
Other borrowings represents putable advances obtained by the Bank from the
Federal Home Loan Bank (FHLB) of Indianapolis. The advance matures on December
16, 2002 and bears a fixed interest rate of 5.71% until December 16, 2000. On
that date, the FHLB will have the option to convert the advances to a periodic
adjustable rate and will continue to have this option quarterly thereafter. The
advances may not be prepaid by the Bank prior to the FHLB exercising its option
to convert the advances to an adjustable rate. The advances are secured by a
blanket collateral agreement with the FHLB which gives the FHLB an unperfected
security interest in the Bank's one-to-four family whole mortgage loans,
government and agency securities and highly rated private mortgage-backed
securities.

Interest paid on deposits and other borrowings was $8,054,000 in 1998,
$7,464,000 in 1997 and $6,538,000 in 1996.

NOTE H - INCOME TAXES
The components of federal income taxes for the years ended December 31 were as
follows (in thousands):

<TABLE>
<CAPTION>
                                         1998                1997               1996
                                         ----                ----               ----
<S>                                   <C>                 <C>                <C>    
Currently payable                     $ 1,226             $ 1,066            $ 1,181
Deferred expense (benefit)                (41)                 19                (31)
                                      -------             -------            -------
                                      $ 1,185             $ 1,085            $ 1,150
                                      =======             =======            =======
</TABLE>


                                       22

                                  Southern Michigan Bancorp, Inc. and Subsidiary
<PAGE>   25
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE H - INCOME TAXES (CONTINUED)

A reconciliation of federal income taxes with amounts computed by applying the
statutory federal income tax rate is as follows (in thousands):

<TABLE>
<CAPTION>
                                                                            1998                1997                1996
                                                                            ----                ----                ----
<S>                                                                      <C>                 <C>                 <C>
Statutory tax on pretax income, including tax on security
   gains ($0 in 1998, $2,000 in 1997 and $3,000 in 1996)                 $ 1,610             $ 1,400             $ 1,431
Effect of tax-exempt interest income                                        (350)               (254)               (227)
Effect of life insurance policy cash surrender value increase                (82)                (65)                (75)
Other items-net                                                                7                   4                  21
                                                                         -------             -------             -------
                                                                         $ 1,185             $ 1,085             $ 1,150
                                                                         =======             =======             =======
</TABLE>


The components of deferred tax assets and liabilities are comprised of the
following at December 31 (in thousands):

<TABLE>
<CAPTION>
                                                                          1998              1997
                                                                          ----              ----
<S>                                                                     <C>               <C>   
Deferred tax assets:
Allowance for loan losses                                               $  461            $  405
Deferred compensation liability                                            470               430
Pension liability                                                           65                81
Other                                                                      175               132
                                                                        ------            ------
                                                                         1,171             1,048
Deferred tax liabilities:
Net unrealized appreciation on available-for-sale securities               134                13
Mortgage servicing rights                                                  202               111
Other                                                                       14                23
                                                                        ------            ------
                                                                           350               147
                                                                        ------            ------
Net deferred tax asset                                                  $  821            $  901
                                                                        ======            ======
</TABLE>

The Company made income tax payments of $1,165,000 in 1998, $1,130,000 in 1997
and $1,245,000 in 1996. An allowance against the deferred tax asset was not
considered necessary at December 31, 1998, 1997, or 1996.

NOTE I - RETIREMENT PLANS
The defined benefit pension plan covers substantially all full-time employees.
The benefits are based on years of service and the employee's average highest
compensation during five consecutive years of employment. The funding policy is
to contribute annually an amount sufficient to meet the minimum funding
requirements set forth in the Employee Retirement Income Security Act of 1974,
plus additional amounts as may be appropriate from time to time. Contributions
are intended to provide not only for benefits attributed to service to date but
also for those expected to be earned in the future.

Information about the pension plan was as follows (in thousands).

<TABLE>
<CAPTION>
                                                    1998                1997
                                                    ----                ----
<S>                                              <C>                 <C>     
Change in benefit obligation:
         Beginning benefit obligation            $(1,715)            $(1,853)
         Service cost                               (140)               (130)
         Interest cost                              (115)               (113)
         Actuarial (gain) loss                      (435)                188
         Benefits paid                                79                 193
                                                 -------             ------- 
         Ending benefit obligation                (2,326)             (1,715)

Change in plan assets, at fair value:
         Beginning plan assets                     1,856               1,574
         Actual return                               335                 330
         Employer contribution                       154                 145
         Benefits paid                               (79)               (193)
                                                 -------             ------- 
         Ending plan assets                        2,266               1,856
                                                 -------             ------- 
Funded status                                        (60)                141
Unrecognized net actuarial gain                     (185)               (447)
Unrecognized transition obligation                    17                  21
Unrecognized prior service cost                       49                  61
                                                 -------             ------- 
Accrued pension cost                             $  (179)            $  (224)
                                                 =======             ======= 
</TABLE>


                                       23

1998 Annual Report to Shareholders
<PAGE>   26
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE I - RETIREMENT PLANS (CONTINUED)
The components of pension expense and related actuarial assumptions were as
follows:

<TABLE>
<CAPTION>
                                                             1998               1997               1996
                                                             ----               ----               ----
<S>                                                         <C>                <C>                <C>  
Service cost                                                $ 140              $ 130              $ 139
Interest cost                                                 115                113                112
Actual return on plan assets                                 (345)              (330)              (195)
Net amortization and deferral                                 188                205                 98
                                                            -----              -----              -----
Net                                                         $  98              $ 118              $ 154
                                                            =====              =====              =====
Discount rate on benefit obligation                          7.0%               7.0%               7.0%
Long-term expected rate of return on plan assets             8.0%               8.0%               8.0%
Rate of compensation increase                                3.0%               3.5%               5.0%
</TABLE>

The Company has an employee stock ownership plan (ESOP) for substantially all
full-time employees. The Board of Directors determines the Company's
contribution level annually. Assets of the plan are held in trust by the Bank
and administrative costs of the plan are borne by the plan sponsor. Costs
charged to operations for contributions to the plan totaled $90,000 in 1998,
$66,000 in 1997 and $71,000 in 1996. 

As of December 31, 1998 and 1997, the ESOP held 150,727 and 144,082 shares of
the Company's stock all of which is allocated to employees. The fair value of
the shares held by the ESOP approximated $6,029,000 and $4,899,000 at December
31, 1998 and 1997, respectively. Upon distribution of shares to a participant,
the participant has the right to require the Company to purchase shares at their
fair value in accordance with terms and conditions of the plan. As such these
shares are not classified in shareholders' equity as permanent equity.

As an incentive to retain key members of management and directors, the Bank has
a deferred compensation plan whereby participants defer a portion of current
compensation. Benefits are based on salary and length of service and are vested
as service is provided from the date of participation through age 65. A
liability is recorded on a present value basis and discounted at current
interest rates. This liability may change depending upon changes in long-term
interest rates. Deferred compensation expense was $229,000 in 1998, $206,000 in
1997 and $189,000 in 1996. The liability for vested benefits was $1,382,000 at
December 31, 1998 and $1,264,000 at December 31, 1997. The Bank holds life
insurance contracts on the plan's participants. The cash surrender value of
these policies was $4,309,000 at December 31, 1998 and $3,725,000 at December
31, 1997 and is included in other assets in the accompanying consolidated
financial statements.

NOTE J - COMMITMENTS

There are various commitments which arise in the normal course of business, such
as commitments under commercial letters of credit, standby letters of credit and
commitments to extend credit. Generally accepted accounting principles recognize
these transactions as contingent liabilities and accordingly, they are not
reflected in the accompanying financial statements. These arrangements have
credit risk essentially the same as that involved in extending loans to
customers and are subject to the Bank's normal credit policies. Collateral
generally consists of receivables, inventory and equipment and is obtained based
on management's credit assessment of the customer. 

At December 31, 1998, the Bank had commitments under commercial letters of
credit, used to facilitate customers' trade transactions, of $133,000 (1997 -
$136,000).

Under standby letter of credit agreements, the Bank agrees to honor certain
commitments in the event that its customers are unable to do so. At December 31,
1998 commitments under outstanding standby letters of credit were $385,000 (1997
- $347,000).

Loan commitments outstanding to extend credit at December 31 are detailed below:

<TABLE>
<CAPTION>
                                1998                   1997
                                ----                   ----
<S>                      <C>                    <C>        
Fixed rate               $ 1,616,000            $ 2,539,000
Variable rate             29,559,000             20,510,000
                         -----------            -----------
                         $31,175,000            $23,049,000
                         ===========            ===========
</TABLE>

The fixed rate commitments have stated interest rates ranging from 6.9% to
18.0%. The terms of the above commitments range from 1 to 60 months.

Management does not anticipate any losses as a result of the above related
transactions; however, the above amount represents the maximum exposure to
credit loss for loan commitments and commercial and standby letters of credit.


                                       24

                                  Southern Michigan Bancorp, Inc. and Subsidiary
<PAGE>   27

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE K - RESTRICTIONS ON TRANSFERS FROM SUBSIDIARY

Banking laws and regulations restrict the amount the Bank may transfer to the
Company in the form of cash dividends, loans and advances. In 1999, the Bank is
permitted to pay the Company approximately $1,410,000 in addition to 1999 net
income as dividends without prior regulatory approval. Substantially all of the
remaining net assets of the Bank are restricted from transfer to the Company
under Federal Reserve regulations.

NOTE L - SOUTHERN MICHIGAN BANCORP, INC. (PARENT COMPANY ONLY) FINANCIAL
INFORMATION

Condensed financial statements of Southern Michigan Bancorp, Inc. follow (in
thousands):

Balance Sheets

<TABLE>
<CAPTION>
                                                                           December 31
                                                                    1998               1997
                                                                    ----               ----
<S>                                                              <C>                <C>    
ASSETS
Cash                                                             $    16            $    19
Investment securities available for sale                           3,170              3,096
Investment securities held to maturity                               250
Investment in subsidiary                                          21,010             21,141
Premises and equipment                                             1,231              1,202
Other                                                                700                414
                                                                 -------            -------
TOTAL ASSETS                                                     $26,377            $25,872
                                                                 =======            =======

LIABILITIES AND SHAREHOLDERS' EQUITY
Dividends payable                                                $   393            $   383
Other liabilities                                                     22
Common stock subject to repurchase obligation in ESOP              6,029              4,899
Shareholders' equity                                              19,933             20,590
                                                                 -------            -------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY                       $26,377            $25,872
                                                                 =======            =======
</TABLE>

Statements of Income

<TABLE>
<CAPTION>
                                                                                 Year ended December 31
                                                                      1998                1997                1996
                                                                      ----                ----                ----
<S>                                                                <C>                 <C>                 <C>    
Dividends from Bank                                                $ 3,620             $ 1,109             $ 1,001
Interest income                                                        167                 137                 113
Other income                                                           226                 206                 205
Other expenses                                                         (33)                (49)                (31)
                                                                   -------             -------             -------
                                                                     3,980               1,403               1,288
Federal income tax expense                                             (85)                (68)                (98)
                                                                   -------             -------             -------
                                                                     3,895               1,335               1,190
Equity in undistributed net income (loss) of subsidiary               (346)              1,697               1,868
                                                                   -------             -------             -------
NET INCOME                                                         $ 3,549             $ 3,032             $ 3,058
                                                                   =======             =======             =======
</TABLE>

<TABLE>
<CAPTION>

Statements of Cash Flows                                                        Year ended December 31
                                                                     1998                1997                1996
                                                                     ----                ----                ----
<S>                                                               <C>                 <C>                 <C>    
OPERATING ACTIVITIES
Net income                                                        $ 3,549             $ 3,032             $ 3,058
Adjustments to reconcile net income to net cash
   provided by operating activities:
      Equity in undistributed net income of subsidiary                346              (1,697)             (1,868)
      Depreciation                                                     31                  31                  29
      Net amortization of investment securities                        16                  13                  14
      Other                                                          (253)               (146)                 34
                                                                  -------             -------             -------
Net cash from operating activities                                  3,689               1,233               1,267
</TABLE>


                                       25

1998 Annual Report to Shareholders
<PAGE>   28
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE L - SOUTHERN MICHIGAN BANCORP, INC. (PARENT COMPANY ONLY)
         FINANCIAL INFORMATION (CONTINUED)


Statements of Cash Flows (continued)

<TABLE>
<CAPTION>
                                                                              Year ended December 31
                                                                    1998                1997                1996
                                                                    ----                ----                ----
<S>                                                              <C>                 <C>                 <C>
INVESTING ACTIVITIES
Activity in available for sale investment securities:
   Maturities and calls                                            1,977                 734               2,614
   Purchases                                                      (2,059)             (1,248)             (4,110)
Activity in held to maturity investment securities:
   Maturities and calls                                                                                      780
   Purchases                                                        (250)
Additions to premises and equipment                                  (60)                (62)               (116)
                                                                 -------             -------             -------
Net cash from investing activities                                  (392)               (576)               (832)
FINANCING ACTIVITIES
Common stock issued                                                  251                 390                 575
Cash dividends paid                                               (1,252)             (1,049)             (1,014)
Repurchase of common stock                                        (2,299)
                                                                 -------             -------             -------
Net cash from financing activities                                (3,300)               (659)               (439)
                                                                 -------             -------             -------
NET CHANGE IN CASH AND CASH EQUIVALENTS                               (3)                 (2)                 (4)
Beginning cash and cash equivalents                                   19                  21                  25
                                                                 -------             -------             -------
ENDING CASH AND CASH EQUIVALENTS                                 $    16             $    19             $    21
                                                                 =======             =======             =======
</TABLE>

NOTE M - FAIR VALUE INFORMATION

FASB Statement 107, "Disclosures about Fair Value of Financial Instruments,"
requires disclosure of fair value information about financial instruments,
whether or not recognized in the balance sheet, for which it is practicable to
estimate that value. In cases where quoted market prices are not available, fair
values are based on estimates using present value or other valuation techniques.
Those techniques are significantly affected by the assumptions used, including
the discount rate and estimates of future cash flows. Statement 107 excludes
certain financial instruments and all nonfinancial instruments from its
disclosure requirements. Accordingly, the aggregate fair value amounts presented
do not represent the underlying value of the Company and represent point-in-time
estimates of value that might not be particularly relevant in predicting the
Company's future earnings or cash flows.

The following methods and assumptions were used by the Company in estimating its
fair value disclosures for financial instruments:

     CASH AND CASH EQUIVALENTS: The carrying amounts reported in the balance
     sheet for cash and due from banks approximate those assets' fair values.

     INVESTMENT SECURITIES (INCLUDING MORTGAGE-BACKED SECURITIES): Fair values
     for investment securities are based on quoted market prices, where
     available. If quoted market prices are not available, fair values are based
     on quoted market prices of comparable instruments. The fair value of
     restricted equity securities approximates amortized cost.

     LOANS: For variable-rate loans that reprice frequently and with no
     significant change in credit risk, fair values are based on carrying
     values. The fair values for other loans are estimated using discounted cash
     flows analyses, using interest rates currently being offered for loans with
     similar terms to borrowers of similar credit quality.

     OFF-BALANCE-SHEET INSTRUMENTS: Fair values for the Bank's letters of credit
     are based on fees currently charged to enter into similar agreements,
     taking into account the remaining terms of the agreements and the
     counterparties' credit standing. It is not practicable to estimate the fair
     value of lending commitments because of the wide variety of the
     instruments.



                                       26

                                  Southern Michigan Bancorp, Inc. and Subsidiary
<PAGE>   29

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE M - FAIR VALUE INFORMATION (CONTINUED)


     DEPOSIT LIABILITIES: The fair values disclosed for demand deposits (e.g.,
     interest and non-interest checking, passbook savings, and certain types of
     money market accounts) are, by definition, equal to the amount payable on
     demand at the reporting date (i.e., their carrying amounts). Fair values
     for fixed-rate certificates of deposit are estimated using a discounted
     cash flow calculation that applies interest rates currently being offered
     on certificates to a schedule of expected monthly maturities on time
     deposits.

     OTHER BORROWINGS: The fair value of the Bank's other borrowings is
     estimated using discounted cash flows analysis based on the Bank's current
     incremental borrowing rate for similar types of borrowing arrangements.

The estimated fair values of the Company's financial instruments at December 31
are as follows (in thousands):

<TABLE>
<CAPTION>
                                                                       1998                                        1997
                                                        ------------------------------              ------------------------------
                                                          CARRYING                FAIR                Carrying                Fair
                                                            AMOUNT               VALUE                  Amount               Value
                                                        ------------------------------              ------------------------------
<S>                                                     <C>                 <C>                     <C>                 <C>
Financial assets:
Cash and cash equivalents                               $   16,228          $   16,228              $   16,848          $   16,848
Federal funds sold                                           4,000               4,000                   4,500               4,500
Investment securities available for sale                    36,138              36,138                  12,853              12,853
Investment securities held to maturity                      31,756              32,693                  32,221              32,572
Loans                                                      163,303             163,588                 158,741             158,378
</TABLE>

<TABLE>
<CAPTION>
                                                                      1998                                         1997
                                                        ------------------------------              ------------------------------
                                                          CARRYING                FAIR                Carrying                Fair
                                                            AMOUNT               VALUE                  Amount               Value
                                                        ------------------------------              ------------------------------
<S>                                                     <C>                 <C>                     <C>                 <C>
Financial liabilities:
Deposits                                                $ (233,361)         $ (234,938)             $ (207,065)         $ (207,057)
Other borrowings                                            (5,000)             (5,000)                 (3,000)             (3,000)

Unrecognized financial instruments:
Commercial letters of credit                                                $       (8)                                 $       (3)
Standby letters of credit                                                           (3)                                         (7)
</TABLE>


                                       27

1998 Annual Report to Shareholders
<PAGE>   30
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE N - REGULATORY MATTERS

The Company and Bank are subject to regulatory capital requirements administered
by federal banking agencies. Capital adequacy guidelines and prompt corrective
action regulations involve quantitative measures of assets, liabilities and
certain off-balance-sheet items calculated under regulatory accounting
practices. Capital amounts and classifications are also subject to qualitative
judgments by regulators about components, risk weightings and other factors, and
the regulators can lower classifications in certain cases. Failure to meet
various capital requirements can initiate regulatory action that could have a
direct material effect on the financial statements.

The prompt corrective action regulations provide five classifications, including
well capitalized, adequately capitalized, under-capitalized, significantly
undercapitalized and critically undercapitalized, although these terms are not
used to represent overall financial condition. If adequately capitalized,
regulatory approval is required to accept brokered deposits. If
undercapitalized, capital distributions are limited, as is asset growth and
expansion, and plans for capital restoration are required. The minimum
requirements are:

<TABLE>
<CAPTION>
                                                 Capital to risk-
                                                 weighted assets
                                             -----------------------         Tier 1 capital 
                                             Total            Tier 1       to average assets
                                             -----------------------       -----------------
<S>                                          <C>                <C>        <C>
         Well capitalized                     10%                6%              5%
         Adequately capitalized               8%                 4%              4%
         Undercapitalized                     6%                 3%              3%
</TABLE>

At year end, actual capital levels (in thousands) and minimum required levels
were:

<TABLE>
<CAPTION>
                                                                                                             Minimum Required
                                                                                                                   To Be
                                                                                Minimum Required             Well Capitalized
                                                                                  For Capital             Under Prompt Corrective
                                                          Actual               Adequacy Purposes            Action Regulations
                                                          ------               -----------------            ------------------
                                                    Amount      Ratio           Amount      Ratio            Amount      Ratio
                                                    ------      -----           ------      -----            ------      -----
<S>                                                <C>          <C>            <C>          <C>           <C>            <C>  
1998
Total capital (to risk weighted assets)
   Consolidated                                    $26,396      13.7%          $15,439       8.0%           $19,298      10.0%
   Bank                                            $21,129      11.1%          $15,238       8.0%           $19,048      10.0%
Tier 1 capital (to risk weighted assets)
   Consolidated                                    $24,370      12.6%           $7,719       4.0%           $11,579       6.0%
   Bank                                            $19,103      10.0%           $7,619       4.0%           $11,428       6.0%
Tier 1 capital (to average assets)
   Consolidated                                    $24,370       9.4%          $10,363       4.0%           $12,954       5.0%
   Bank                                            $19,103       7.8%           $9,845       4.0%           $12,306       5.0%

1997
Total capital (to risk weighted assets)
   Consolidated                                    $25,295      14.3%          $14,143       8.0%           $17,679      10.0%
   Bank                                            $21,002      12.0%          $13,977       8.0%           $17,471      10.0%
Tier 1 capital (to risk weighted assets)
   Consolidated                                    $23,432      13.3%           $7,072       4.0%           $10,607       6.0%
   Bank                                            $19,139      11.0%           $6,988       4.0%           $10,483       6.0%
Tier 1 capital (to average assets)
   Consolidated                                    $23,432      10.1%           $9,250       4.0%           $11,563       5.0%
   Bank                                            $19,139       8.3%           $9,192       4.0%           $11,490       5.0%
</TABLE>

The Company and Bank at year-end 1998 and 1997 were categorized as well
capitalized.


                                       28

                                  Southern Michigan Bancorp, Inc. and Subsidiary

                                       
<PAGE>   31
REPORT OF INDEPENDENT AUDITORS


                              [LOGO CROWE CHIZEK]

Shareholders and Board of Directors
Southern Michigan Bancorp, Inc.
Coldwater, Michigan


We have audited the accompanying consolidated balance sheets of Southern
Michigan Bancorp, Inc. as of December 31, 1998 and 1997 and the related
consolidated statements of income, shareholders' equity and cash flows for each
of the three years in the period ended December 31, 1998. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Southern Michigan
Bancorp, Inc. as of December 31, l998 and 1997 and the results of its operations
and its cash flows for each of the three years in the period ended December 31,
1998 in conformity with generally accepted accounting principles.

                                         /s/ Crowe, Chizek and Company LLP

                                         Crowe, Chizek and Company LLP


Grand Rapids, Michigan
February 17, 1999


                                       29

1998 Annual Report to Shareholders

                                         
<PAGE>   32
BOARD OF DIRECTORS AND STRATEGIC MANAGEMENT TEAM

BOARD OF DIRECTORS:

Jerry L.Towns, Chairman SMB&T
James T.Grohalski, President & Chief Executive Officer SMB&T
Freeman E. Riddle,Spoor-Parlin Farm Equipment
Jane L. Randall, Dally Tire Company
James P. Briskey, Briskey Elevator
Thomas E. Kolassa, The Planning Group
Gregory J.Hull, Farmer
Nolan E. (Rick) Hooker, Hooker Oil
James J. Morrison, Morrison & Associates
William E. (Buzz) Galliers, G & W Display Fixtures
H. Kenneth Cole, Hillsdale College

HONORARY DIRECTORS

John S. Furry
Gerald L. Hensley
James E. Koss
Raymond W. Smith
Howard M. Teeter*
Harvey Randall

STRATEGIC MANAGEMENT TEAM

Jerry L. Towns, Chairman
James T. Grohalski, President & Chief Executive Officer
Jaylen Johnson, Sr. Vice-President/Cashier
Stanley E. Tipton, Sr. Vice-President/Loan Administration
Michael Lammers, Vice-President/Sr. Trust Officer
Julie Waterbury, Vice-President/Controller
Andrew Karr, Vice-President/Human Resources
Mark Lambert, Vice-President/Marketing
Patrick J. Peruchietti, Vice-President/Retail Sales


                                    [PHOTO]

          *It is with great sadness we announce the passing of longtime
          board member and honorary board member, Howard Teeter. Mr. Teeter
          passed away suddenly on December 18, 1998. He will be sadly
          missed by all at Southern Michigan Bank & Trust and in the
          community.


                                       30

                                  Southern Michigan Bancorp, Inc. and Subsidiary

                                       
<PAGE>   33
OFFICERS


SOUTHERN MICHIGAN BANCORP, INC.
Jerry L. Towns, Chairman
James T. Grohalski, President & Chief Executive Officer
Jaylen T. Johnson, Senior Vice-President
Julie A. Waterbury, Vice-President & Controller


SOUTHERN MICHIGAN BANK & TRUST
EXECUTIVE OFFICERS
Jerry L. Towns, Chairman
James T. Grohalski, President & Chief Executive Officer


COMMERCIAL LOANS
Stanley Tipton, Sr. Vice-President/Loan Administrator
Joan Trenary, Vice-President
Craig Binkowski, Vice-President
Merl Grosvenor, Credit Department Manager


CONSUMER LOANS
Patrick Peruchietti, Vice-President/Retail Sales
Jodie Johnson, Vice-President/Loan Center Manager
Scott Galloway, Loan Officer
Valorie Vaughan, Loan Officer


HUMAN RESOURCES
Andrew Karr, Vice-President
Veronica Hannah, *Human Resource Assistant


MARKETING
Mark Lambert, Vice-President
Carol A. Hughes, *Marketing Coordinator


OPERATIONS
Jaylen Johnson, Sr. Vice-President/Cashier
Julie Waterbury, Vice-President/Controller
Barbara Junker, Customer Sales Officer
Ann-Marie Bentley, Coldwater Branch Manager
Leslie Reagle, Operations Officer/Compliance
Jerald VanBlarcom, Asst. Vice-President/
                     Data Processing Officer
Paul Mahle, Asst. Data Processing Officer
Marilyn Lepper, Asst. Vice President/
                     Accounting Dept. Manager


TRUST DEPARTMENT
Michael Lammers, Vice President/Sr. Trust Officer
Margo S. Brush, Asst. Vice-President/
                 Trust Administration Officer
Melissa Kent, Asst. Trust Officer

ATHENS OFFICE
Marcia Carman, Branch Manager

BATTLE CREEK REGION
Ray Killinger, Vice-President/Business Development

BECKLEY ROAD OFFICE
Sharon Warsop, Asst. Vice-President/Branch Manager

CAMDEN OFFICE
Vicki Morris, Asst. Vice-President/Branch Manager

EAST CHICAGO STREET OFFICE
Dawn Wheaton, *Branch Supervisor

HILLSDALE OFFICE
Vicki Morris, Asst. Vice-President/Branch Manager
Carol Teller, Customer Service Manager

HILLSDALE REGION
Robert Stanley, Vice-President/Business Development

KINDERHOOK OFFICE
Nancy Behnke,*Branch Supervisor

NORTH ADAMS OFFICE
Joyce Carpenter, Branch Manager

PENNFIELD OFFICE
Linda McKinney, Asst. Vice-President/Branch Manager

TEKONSHA OFFICE
Anne Walter, Branch Manager

UNION CITY OFFICE
Kenneth Brooks, Vice-President/Branch Manager

*Non-Officer Position


                                       31

1998 Annual Report to Shareholders

                                       
<PAGE>   34
EMPLOYEES


1998 SOUTHERN MICHIGAN BANK & TRUST EMPLOYEES


COLDWATER OFFICE              UNION CITY OFFICE              PENNFIELD OFFICE  
Michelle Archer               Sue Adolph                     Beth Ayers         
Andrea Austin                 Michele Crow                   Talena Hubbard    
Michele Barone                Linda Dormer                   Angela Lawver     
Jerry Brierly                 Dora Fast                      Tracie Williams   
Janet Carpenter               Reba Ludwick                                     
Juanita Carr                  Terri Orris                    ATHENS OFFICE     
Heather Carter                Joanne Parks                   Sharon Cross      
Gary Chrisman                 Tara Powell                    Kris Motz         
Greg Cooper                   Gail Schafer                   Georgia Stafford  
Martha Counterman             Krista Watkins                                   
Deidre Cross                                                 NORTH ADAMS OFFICE
Misty Dempsey                 TEKONSHA OFFICE                Rhonda Baker      
Jane Gillette                 Dawn Copas                     Shelley Reed      
Barbara Godfrey               Cynthia Dora                   Leonce Towers     
Amanda Greenwald              Kay Rice                                         
Linda Grindle                 Sarah Olds                     LOAN  CENTER      
Amy Harmon                    Debra Richar                   Stephanie Arlt    
Debra Hinkley                                                Karen Atkinson    
Ellen Hopkins                 EAST CHICAGO OFFICE            Diana Butler      
Linda Hunnaman                Jennifer Birch                 Dell Cook         
Kelly Kiersey                 Elizabeth Danbury              Regina Holroyd    
Jean Lenon                    Cherie Green                   Carol Root        
Jamie Lepper                                                 Lynn Roper        
Marilyn Malcolm               KINDERHOOK OFFICE              Connie Swain      
Ruth McBride                  Nicole Lowande                 Laurie Tate       
Marcia McClellan              Denise Neusbaum                Diana Tompkins    
Charity Mullen                                                                 
Karan Myers                   CAMDEN OFFICE                  MORTGAGE CENTER   
Brenna Paradine               Amy Dauer                      Lisa Holder       
Janice Rider                  Tere Drake                     Sallie Massa      
Susan Rzepka                  Kolene Dubendorf               
Sophia Shafal                 Constance Grate                
Amy Smale          
Marlana Spaulding             HILLSDALE OFFICE
Nancy Sprow                   Penny Clark
Howard Street                 Chris Hagaman
Betty Supak                   Kathy Miller
Catherine Usher               Marjorie Powell
Patricia VanDyke              Cheryl Zellman
Shirley Vaughan    
Marnell Vincent               BATTLE CREEK OFFICE
Julie Wright                  Valerie Campbell
                              Yvonne Case     
                              Dawn Kenny      
                              Sue O'Connell   
                              Martin Philp     
                              Bronwyn Robb     
                              Jean-Marie Warren


                                       32

                                  Southern Michigan Bancorp, Inc. and Subsidiary


<PAGE>   35
[SOUTHERN MICHIGAN BANK & TRUST PHOTO]
[OPENING DOORS IN THE COMMUNITY]

In October, 1998, the new Hillsdale office of Southern Michigan Bank & Trust 
opened its doors. The office is a portrayal of another way SMB&T has shown its 
commitment to the community of Hillsdale and its citizens, our customers, to 
provide the best service possible. We call it Quality Customer Service - 
Southern Style.

"Our primary goal is to establish an atmosphere that causes our employees to 
routinely deliver high quality service, which reinforces our claim that we are 
the "innovation leader" in customer service. We intend to create a banking 
office that is a 'model' for the bank of the future. It's interior will be 
sales oriented and highly interpersonal. We'll take customer service to a level 
that will differentiate us by its uniqueness - in terms of personal commitment 
and style of presentation."
- SMB&T Marketing Plan - Hillsdale, 1997

One of our goals in constructing the 4,300 square foot building was to make 
financial services more accessible to our customers and community at large. The 
architectural design of the Hillsdale office was created to provide a branch 
environment that encourages relationship banking.

In recognition of our new Hillsdale office, the Hillsdale County Chamber of 
Commerce and Marshburn/Bunkley Architect Associates presented the 1998 
Architectural/Renovation Award to Southern Michigan Bank & Trust "whose efforts 
in design, restoration and beautification enhanced and improved the appearance 
of the community." We are humbled, but proud of the Chamber's recognition and 
our contribution to the Hillsdale community.

As mentioned, the interior is sales oriented and highly interpersonal. The 
implementation of the concept demanded that the staff be proactive in both sales
and service as well as be aware of the functionality of the branch as a whole. 
This meant the Bank needed to commit to a higher level of staffing. To this end,
we added three positions to the staffing level at our new location.

The Hillsdale office provides the full array of banking services including home 
equity loans. Stop by and say hello to our friendly staff. They'll be happy to 
see you.
<PAGE>   36









                     [SOUTHERN MICHIGAN BANCORP, INC. LOGO]
                                51 W. Pearl St.
                              Coldwater, MI 49036
                                 (517) 279-5500