**Exhibit 13**

** **

**Management Discussion and Analysis andConsolidated Financial Statements included in 2002 Financial**

**Information distributed to shareholders withthe 2002 Annual Report**

 

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**MANAGEMENTDISCUSSION AND ANALYSIS**

 

***Forward-LookingStatements***

* *

*This document, including information includedwith or incorporated by reference in this document, contains forward-lookingstatements within the meaning of the Private Securities Litigation Reform Actof 1995.  These statements are notguarantees of future performance and involve certain risks, uncertainties andassumptions that are difficult to predict. Actual outcomes and results may differ materially from those expressedin, or implied by, our forward-looking statements.  Words such as “expects,” “anticipates,” “believes,” “estimates,”“intends,” “strategy,” other similar expressions or future or conditional verbssuch as “will,” “may,” “should,” “would,” and “could” are intended to identifysuch forward-looking statements. Readers should not rely solely on the forward-looking statements andshould consider all uncertainties and risks throughout this document.  The statements are representative only as ofthe date they are made, and PNWB undertakes no obligation to update anyforward-looking statement.*

* *

*Possible events or factors that could cause results or performance todiffer materially from those expressed in our forward-looking statementsinclude, but are not limited to, the following:  changes in general economic conditions and economic conditions inthe geographic areas  in which PNWBoperates which may affect, among other things, the level of nonperformingloans, charge-offs, and provision expense; changes in the interest rateenvironment which may reduce interest margins and impact funding sources;  litigation liabilities, including costs,expenses, settlements and judgments; changes in tax laws, rules and regulationsas well as Internal Revenue Service (IRS) or other governmental agencies’interpretations thereof; legislative, regulatory and accounting changesaffecting the banking and financial services industry; competition with otherlocal, regional and national banks, thrifts, credit unions and other nonbankfinancial institutions; ability to grow core businesses; ability to develop andintroduce new banking-related products, services and enhancements and gainmarket acceptance of such products; mergers and acquisitions and theirintegration into PNWB;  and management’sability to manage these and other risks.*

 

**OVERVIEW**

 

The following discussion is providedfor the consolidated operations of Pacific Northwest Bancorp (Bancorp), whichincludes its wholly owned subsidiaries (collectively PNWB).  As of December 31, 2002, Bancorp’s whollyowned subsidiaries were Pacific Northwest Bank, InterWest Capital Trust I and Pacific Northwest Statutory Trust I.  The purpose of this discussion is to focuson significant factors concerning PNWB’s financial condition and results ofoperations.  This discussion should beread along with the consolidated financial statements (including notes thereto)for an understanding of the following discussion and analysis.

 

Bancorp is a bank holdingcompany incorporated in the State of Washington.  PNWB is a financial services company providing a variety ofproducts and services for both business and individual customers.  Financial services of PNWB include thebanking activities of accepting deposits from businesses and individuals andoriginating commercial and commercial real estate loans, residential loans,consumer loans, and agricultural loans.

 

On June 20, 2000, the Board ofDirectors approved a change of PNWB’s fiscal year end from September 30 toDecember 31, retroactively to January 1, 2000. EffectiveSeptember 1, 2000, Interwest Bancorp, Inc. changed its name to Pacific NorthwestBancorp.  In conjunction with thischange, the company’s commercial bank subsidiary, Interwest Bank, changed itsname to Pacific Northwest Bank.

 

OnNovember 13, 2002, PNWB completed the acquisition of Bank of the Northwest(BKNW) and merged BKNW into its commercial bank subsidiary, Pacific NorthwestBank.  The acquisition of BKNW expandedPNWB’s market area along the I-5 corridor to the metropolitan Portland, Oregonarea with five additional financial centers. The acquisition added approximately $383.1 million of assets (excludingrecorded goodwill) including approximately $254.1 million of net loansreceivable, and approximately $288.0 million of deposits.  PNWB issued 1,749,882 shares of common stockand paid approximately $25.8 million in cash for all outstanding BKNW sharesresulting a purchase price of $81.7 million, net of $1.6 million of acquisitioncosts.  The financial results of PNWBfor the year ended December 31, 2002 included BKNW operations starting onNovember 13, 2002.  On December 9, 2002,PNWB successfully completed the information systems and operational processesof BKNW and all of the five BKNW branches were renamed Pacific Northwest Bank.

 

During2002, PNWB continued its effort of restructuring its balancesheet that originally started in 2000.  As of December 31, 2002, PNWB’sbalance sheet was in a slightly asset sensitive position.   During the past year, PNWB increased the commercial and commercialreal estate loan balance by $331.3million, which represented 68.3percent of total gross loans as of December 31, 2002 compared to 58.4 percent as of December 31,2001.  Also, the percentage oftransaction deposits and money market accounts in the deposit portfolioincreased while the percentage of higher-cost certificates of deposit decreasedcompared to 2001.  The implementation ofbalance sheet restructuring initiatives contributed to the increase in netinterest income and net interest margin in 2002.

 

In November 2002, PNWBannounced that it wouldoutsource its residential mortgage lending function and discontinue itsinternal mortgage loan operations beginning in the first quarter of 2003.  PNWBwill start to offer a web-based mortgage lending program to its customersthrough a third party, which will underwrite and process the mortgageloans.  The mortgage loans will close inthe name of Pacific Northwest Bank, but will be committed to sell withservicing released to a third party shortly before closing.  Management expects that this willreduce mortgage banking business risk and improve operational efficiencies.

 

A source of future growth may be through mergers andacquisitions.  PNWB’s managementbelieves that many other financial institutions are considering selling theirinstitutions for a variety of reasons, including lack of shareholder liquidity,management succession issues, technology challenges, and increasingcompetition. PNWB actively reviews proposals for various acquisitionopportunities.  PNWB has a due diligencereview process to evaluate potential acquisitions and has establishedparameters for potential acquisitions relating to market factors, financialperformance and certain non-financial factors. Successful completion of acquisitions by PNWB depends on several factorssuch as the availability of suitable acquisition candidates, necessaryregulatory and shareholder approval and compliance with applicable capitalrequirements.  No assurance can be madethat acquisition activity will continue in the future.

 

Currently, PNWB conducts its business through 58 financial centers inthe Pacific Northwest, including the metropolitan areas of Seattle andBellevue, Washington and Portland, Oregon. Investments are available through Pacific Northwest Financial Servicesand insurance products are available through Pacific Northwest InsuranceAgency, both wholly owned subsidiaries of Pacific Northwest Bank.

 

Certain reclassifications havebeen made to prior year financial data to conform to 2002 presentation.  The effects of the reclassifications are notconsidered material.

 

## **CRITICAL ACCOUNTING POLICIES AND ESTIMATES**

 

Our financial statements are based upon the selectionand application of significant accounting policies which require management tomake significant estimates and assumptions (see note 1 to the consolidatedfinancial statements).  We believe thatthe following are the more critical judgment areas in the application of ouraccounting policies that currently affect our financial condition and resultsof operations.

 

1

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*ALLOWANCE FOR LOSSES ON LOANS*| The allowance for loan loss is established through a charge to the provisionfor loan losses.  Provisions are made toreserve for known and inherent risk characteristics within the loan portfolio.  The allowance is a significant estimate andPNWB regularly evaluates it for adequacy by considering factors such as currentloan grades, historical loss rates, change in the nature of the loan portfolio,overall portfolio quality, industry concentrations, delinquency trends, currenteconomic factors and estimated impact of current economic conditions that mayeffect a borrower’s ability to pay.  Theuse of different estimates or assumptions could produce different provisionsfor loan loss.  In addition, theallowance for losses on loans is also subject to regulatory supervision andexamination.

 

*SECURITIES AVAILABLE FOR SALE|*Securities available for sale are carried at estimated fair values. Theestimated fair value of securities available for sale is based on quoted marketrates and dealer quotes.  Unrealizedgains and losses on securities available for sale are excluded from earningsand presented as accumulated other comprehensive income or loss, net of relateddeferred income taxes as a component of shareholders’ equity.  PNWB continually monitors its securitiesportfolio for other than temporary impairment of securities. When an other thantemporary decline in the value below cost or amortized cost is identified, theinvestment is reduced to its fair value, which becomes the new cost basis ofthe investment. The amount of the reduction is reported as a realized loss inthe consolidated statements of income. Any recovery of value in excess of theinvestment’s new cost basis is recognized as a realized gain only on sale,maturity or other disposition of the investment.  Factors that PNWB evaluates in determining the existence of another than temporary decline in value include (1) the length of time and extentto which the fair value has been less than cost or carrying value, (2) thecircumstances contributing to the decline in fair value (including a change ininterest rates or spreads to benchmarks), (3) recent performance of thesecurity, (4) the financial strength of the issuer, and (5) the intent andability of PNWB to retain the investment for a period of time sufficient toallow for anticipated recovery. Additionally, for asset-backed securities, PNWBconsiders the security rating and the amount of credit support available forthe security.

 

**RESULTSOF OPERATIONS**

 

PNWB’s net income was $28.8million for the year ended December 31, 2002 compared to $22.1 million and $6.3million for the years ended December 31, 2001 and 2000, respectively.  Diluted net income per share was $1.80 forthe year ended December 31, 2002 compared to $1.40 and $0.40 for the yearsended December 31, 2001 and 2000, respectively.  Return on average assets was 1.01 percent for the year endedDecember 31, 2002 compared to 0.79 percent and 0.22 percent for the years endedDecember 31, 2001 and 2000, respectively. Return on average shareholders’ equity was 13.62 percent for the yearended December 31, 2002 compared to 11.63 percent and 3.74 percent for theyears ended December 31, 2001 and 2000, respectively.

 

2

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*FIVE-YEARSELECTED CONSOLIDATED FINANCIAL DATA*

 

The following table summarizes financial informationfor the years ended December 31, 2002, 2001 and 2000, and the years endedSeptember 30, 1999, and 1998. Historical results are not necessarily indicative of future results.

 
| **As of and for the year ended,**                        |   | **December  31,  2002(1)** |       | **December  31,  2001(2)** |       | **December  31,  2000(3)** |       | **September  30,  1999** |       | **September  30,  1998(4)** |       |
|----------------------------------------------------------|--------|----------------------------|------------|----------------------------|------------|----------------------------|------------|--------------------------|------------|-----------------------------|------------|
|                                                     |   |                       |       |                       |       |                       |       |                     |       |                        |       |
| **SUMMARY  OF OPERATIONS**                               |   |                       | ** ** |                       | ** ** |                       | ** ** |                     | ** ** |                        | ** ** |
| Interest income                                          |   | $                          | 178,132    |                       | $          | 205,653                    |       | $                        | 218,188    |                        | $          | 179,659 |   | $ | 180,279 |   |
| Interest expense                                         |   | 69,745                     |       | 103,841                    |       | 128,655                    |       | 95,480                   |       | 101,483                     |       |
| Net interest income                                      |   | 108,387                    |       | 101,812                    |       | 89,533                     |       | 84,179                   |       | 78,796                      |       |
| Provision for losses on loans                            |   | 6,350                      |       | 6,050                      |       | 4,750                      |       | 2,000                    |       | 2,807                       |       |
| Net interest income after provision for  losses on loans |   | 102,037                    |       | 95,762                     |       | 84,783                     |       | 82,179                   |       | 75,989                      |       |
| Gain (loss) on sale of securities available  for sale    |   | (1,425                     | )          | 1,709                      |       | (6,113                     | )          | 72                       |       | 813                         |       |
| Other non-interest income                                |   | 20,685                     |       | 18,976                     |       | 18,226                     |       | 27,975                   |       | 25,371                      |       |
| Non-interest expense(5)                                  |   | 77,513                     |       | 81,152                     |       | 86,265                     |       | 67,786                   |       | 66,683                      |       |
| Income tax expense                                       |   | 15,024                     |       | 13,203                     |       | 4,362                      |       | 14,585                   |       | 12,848                      |       |
| Net income                                               |   | $                          | 28,760     |                       | $          | 22,092                     |       | $                        | 6,269      |                        | $          | 27,855 |   | $ | 22,642 |   |
|                                                     |   |                       |       |                       |       |                       |       |                     |       |                        |       |
| Basic net income per share                               |   | $                          | 1.85       |                       | $          | 1.42                       |       | $                        | 0.40       |                        | $          | 1.78 |   | $ | 1.45 |   |
| Diluted net income per share                             |   | 1.80                       |       | 1.40                       |       | 0.40                       |       | 1.74                     |       | 1.40                        |       |
| Cash dividends declared per share                        |   | 0.56                       |       | 0.56                       |       | 0.56                       |       | 0.56                     |       | 0.50                        |       |

 
| **STATEMENT  OF FINANCIAL CONDITION**    |   |      |      |      |   |      |   |      |
|------------------------------------------|--------|-----------|-----------|-----------|--------|-----------|--------|-----------|
| Total assets                             |   | $         | 3,127,009 |      | $      | 2,741,508 |   | $         | 2,882,870 |   | $ | 2,579,539 |   | $ | 2,448,386 |   |
| Loans receivable and loans held for sale |   | 2,028,434 |      | 1,832,189 |   | 1,771,701 |   | 1,584,722 |   | 1,452,175 |   |
| Deposits                                 |   | 2,054,310 |      | 1,604,855 |   | 1,717,108 |   | 1,578,949 |   | 1,564,825 |   |
| Borrowings                               |   | 788,359   |      | 914,151   |   | 959,873   |   | 817,910   |   | 682,390 |   |
| Shareholders’ equity                |   | 261,613   |      | 200,486   |   | 178,736   |   | 165,306   |   | 171,652 |   |
| Book  value per share                    |   | $         | 15.57     |      | $      | 12.86     |   | $         | 11.54 |   | $ | 10.71 |   | $ | 10.97 |   |

 
| **KEY OPERATING RATIOS**                               |   |   | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
|--------------------------------------------------------|--------|--------|------------|--------|------------|--------|------------|--------|------------|--------|------------|
| Return on average assets                               |   | 1.01   | %          | 0.79   | %          | 0.22   | %          | 1.12   | %          | 0.95   | %          |
| Return on average shareholders’ equity            |   | 13.62  | %          | 11.63  | %          | 3.74   | %          | 16.00  | %          | 13.58  | %          |
| Average shareholders’ equity to average  assets   |   | 7.41   | %          | 6.77   | %          | 5.92   | %          | 7.02   | %          | 6.99   | %          |
| Net interest margin                                    |   | 4.10   | %          | 3.86   | %          | 3.41   | %          | 3.64   | %          | 3.52   | %          |
| Ratio of non-performing assets to total  assets**(6)** |   | 0.61   | %          | 0.80   | %          | 0.83   | %          | 0.56   | %          | 0.64   | %          |
| Dividend payout ratio                                  |   | 30.55  | %          | 39.55  | %          | 138.76 | %          | 31.62  | %          | 33.98  | %          |

 

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(1)        2002 results include merger, conversion andintegration expenses of $0.7 million (net of tax), expenses for severance andemployment agreements of $0.6 million (net of tax), mortgage banking exit costsof $0.2 million (net of tax), and branch consolidation expense of $0.2 million(net of tax).

 

(2)        2001 results include conversion and integrationexpenses of $0.8 million (net of tax), and expenses for severance andemployment agreements of $0.1 million (net of tax).

 

(3)        2000 results include conversion and integrationexpenses of $4.8 million (net of tax), expenses for severance and employmentagreements of $2.2 million (net of tax), and impairment of goodwill of $0.7million.

 

(4)        1998 results include merger-related charges of$4.4 million (net of tax) and a merger-related provision for losses on loans of$0.7 million (net of tax).

 

(5)        2002 non-interest expense does not include $1.1million of goodwill amortization expense as a result of adoption of SFAS No.142 on January 1, 2002.

 

(6)        Non-performing assets consist of non-performingloans (including non-accrual loans and certain other delinquent loans identifiedat the discretion of management) and other real estate.

 

3

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*NETINTEREST INCOME* | PNWB’s net income is significantly affectedby changes in net interest income, which is the difference between interestincome received on loans receivable and other interest-earning assets andinterest paid on deposits and borrowings. PNWB’s operations are sensitive to changes in interest rates and theresulting impact on net interest income. Net interest income before the provision for losses on loans was $108.4 million for the year endedDecember 31, 2002 compared to $101.8 million and $89.5 million for the yearsended December 31, 2001 and 2000,respectively.  The increases in net interest income from 2001 to2002 and from 2000 to 2001 reflectedthe benefits of declining rate environment in 2001 and changes in the mix inloans and deposits during the past two years.  Interest rates decreased in 2001 and resulted in a greaterreduction in funding costs in comparison to reduction in earnings on loans andinvestments due to PNWB’s liability sensitive position at that time.  As of December 31, 2002, PNWB was in aslightly asset sensitive position.  Assuch, management does not expect that net interest income and net interestmargin will continue to improve if there were decreases in market interestrates.

 

Net interest margin, which is net interest incomedivided by average interest-earning assets, increased to 4.10 percent in 2002, compared to3.86 percent and 3.41 percent for the year ended December 31, 2001 and 2000, respectively.  Theincreases in net interestmargin for 2002 and 2001 were primarily due to the repositioning of the balance sheet thatresulted in a more favorable loan and deposit mix and a lower cost of fundsthat resulted from reductions in market interest rates during 2001. Thegrowth in higher yielding commercial loans, lower-cost checking and moneymarket account deposits, as well as a decline in average balance of borrowingsduring 2002 and 2001 contributed to the improvement of net interestmargin.  The cost of funds was 2.95 percent for the year ended December 31,2002, compared to 4.40 percent and 5.33 percent for the year endedDecember 31, 2001 and2000.  The improvements in net interestmargin was partially offset by decreases in the yield earned on loans,securities and other interest-earning assets. The yield on interest-earning assets decreased from 8.32 percent for theyear ended December 31, 2000 to 7.80 percent for the year ended December 31,2001, and 6.73 percent for the year ended December 31, 2002.  The decreases were primarily due todecreases in market interest rates in 2001 and the fourth quarter of 2002.

 

Interest income was $178.1million for the year ended December 31, 2002, compared to $205.7 million and$218.2 million for the years ended December 31, 2001 and 2000,respectively.  The decreases in interestincome on interest-earning assets in 2002 and 2001 were primarily due todecreases in the yield earned which were partially offset by increases involume in both 2002 and 2001.

 

Interest expense was $69.7 million for the year endedDecember 31, 2002, compared to $103.8 million and $128.7 million for the yearsended December 31, 2001 and 2000, respectively.  The decreases in interest expense in 2002 and 2001were primarilydue to decreases in both the cost of funds and the average balance of highercosting borrowings, partially offset by increases in the balances of depositsduring both 2002 and 2001.

 

The following table presents, for the periodsindicated, information regarding average balances of assets and liabilities aswell as the total amounts of interest income from average interest-earningassets and interest expense on average interest-bearing liabilities, resultingyield and cost ratios, interest rate spread, ratio of interest-earning assetsto interest-bearing liabilities and net interest margin for PNWB.

 

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| **Year ended**                                                                      |   | **December  31,  2002** |      | **December  31,  2001** |    | **December  31,  2000** |   |
|-------------------------------------------------------------------------------------|--------|-------------------------|-----------|-------------------------|---------|-------------------------|--------|
| **Dollars in thousands**                                                            |   | **Average  Balance**    |      | **Interest**            |    | **Average  Yield/Cost** |   | **Average  Balance** |   | **Interest** |   | **Average  Yield/Cost** |   | **Average  Balance** |   | **Interest** |   | **Average  Yield/Cost** |   |
|                                                                                |   |                    |      |                    |    |                    |   |   |   |   |   |   |   |   |   |   |   |   |   |
| *Assets:*                                                                           |   |                    |      |                    |    |                    |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans receivable and loans held for sale(1)                                         |   | $                       | 1,864,167 |                    | $       | 137,750                 |   | 7.39 | % | $ | 1,812,352 |   | $ | 153,936 |   | 8.49 | % | $ | 1,755,144 |   | $ | 159,870 |   | 9.11 | % |
| Securities available for sale and securities held  to maturity                      |   | 771,506                 |      | 40,211                  |    | 5.21                    |   | 816,240 |   | 51,116 |   | 6.27 |   | 841,380 |   | 56,747 |   | 6.74 |   |
| Other interest-earning assets                                                       |   | 9,528                   |      | 171                     |    | 1.79                    |   | 9,091 |   | 601 |   | 6.61 |   | 25,971 |   | 1,571 |   | 6.05 |   |
| Total interest-earning assets                                                       |   | 2,645,201               |      | 178,132                 |    | 6.73                    |   | 2,637,683 |   | 205,653 |   | 7.80 |   | 2,622,495 |   | 218,188 |   | 8.32 |   |
|                                                                                |   |                    |      |                    |    |                    |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Non-interest-earning assets                                                         |   | 204,518                 |      |                    |    |                    |   | 170,863 |   |   |   |   |   | 204,196 |   |   |   |   |   |
|                                                                                |   |                    |      |                    |    |                    |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total assets                                                                        |   | $                       | 2,849,719 |                    |    |                    |   |   | $ | 2,808,546 |   |   |   |   |   | $ | 2,826,691 |   |   |   |   |   |
|                                                                                |   |                    |      |                    |    |                    |   |   |   |   |   |   |   |   |   |   |   |   |   |
| *Liabilities and Shareholders’ Equity:*                                        |   |                    |      |                    |    |                    |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings accounts and money market accounts                                          |   | $                       | 526,387   |                    | $       | 8,701                   |   | 1.65 | % | $ | 388,947 |   | $ | 10,978 |   | 2.82 | % | $ | 386,869 |   | $ | 13,285 |   | 3.43 | % |
| Checking accounts                                                                   |   | 226,324                 |      | 1,033                   |    | 0.46                    |   | 199,856 |   | 1,723 |   | 0.86 |   | 182,208 |   | 2,017 |   | 1.11 |   |
| Certificates of deposit                                                             |   | 802,088                 |      | 27,258                  |    | 3.40                    |   | 879,021 |   | 45,774 |   | 5.21 |   | 823,764 |   | 48,503 |   | 5.89 |   |
| Total interest-bearing deposits                                                     |   | 1,554,799               |      | 36,992                  |    | 2.38                    |   | 1,467,824 |   | 58,475 |   | 3.98 |   | 1,392,841 |   | 63,805 |   | 4.58 |   |
|                                                                                |   |                    |      |                    |    |                    |   |   |   |   |   |   |   |   |   |   |   |   |   |
| FHLB advances, securities sold under agreements to  repurchase and other borrowings |   | 807,265                 |      | 32,753                  |    | 4.06                    |   | 892,786 |   | 45,366 |   | 5.08 |   | 1,019,612 |   | 64,850 |   | 6.36 |   |
| Total interest-bearing liabilities                                                  |   | 2,362,064               |      | 69,745                  |    | 2.95                    |   | 2,360,610 |   | 103,841 |   | 4.40 |   | 2,412,453 |   | 128,655 |   | 5.33 |   |
|                                                                                |   |                    |      |                    |    |                    |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Non-interest-bearing deposits                                                       |   | 246,768                 |      |                    |    |                    |   | 230,131 |   |   |   |   |   | 218,887 |   |   |   |   |   |
| Other non-interest-bearing liabilities                                              |   | 29,763                  |      |                    |    |                    |   | 27,786 |   |   |   |   |   | 27,871 |   |   |   |   |   |
| Total liabilities                                                                   |   | 2,638,595               |      |                    |    |                    |   | 2,618,527 |   |   |   |   |   | 2,659,211 |   |   |   |   |   |
|                                                                                |   |                    |      |                    |    |                    |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Shareholders’ equity                                                           |   | 211,124                 |      |                    |    |                    |   | 190,019 |   |   |   |   |   | 167,480 |   |   |   |   |   |
| Total liabilities and shareholders’ equity                                     |   | $                       | 2,849,719 |                    |    |                    |   |   | $ | 2,808,546 |   |   |   |   |   | $ | 2,826,691 |   |   |   |   |   |
|                                                                                |   |                    |      |                    |    |                    |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income                                                                 |   |                    |      | $                       | 108,387 |                    |   |   |   |   | $ | 101,812 |   |   |   |   |   | $ | 89,533 |   |   |   |
| Interest rate spread                                                                |   |                    |      |                    |    | 3.78                    |   |   |   |   |   | 3.40 |   |   |   |   |   | 2.99 |   |
| Net interest margin                                                                 |   |                    |      |                    |    | 4.10                    |   |   |   |   |   | 3.86 |   |   |   |   |   | 3.41 |   |
|                                                                                |   |                    |      |                    |    |                    |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Ratio of average interest-earning assets to  average interest- bearing liabilities  |   |                    |      |                    |    | 111.99                  | %      |   |   |   |   | 111.74 | % |   |   |   |   | 108.74 | % |

 

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(1) Average balances do not includenon-accrual loans.

 

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The following table provides information on changes innet interest income for the periods indicated that are attributable to changesin interest rates and changes in volume.

 
|                                                                                          |   | **December  31, 2001 to  December 31, 2002  Increase (Decrease)  Due to Changes in** |    | **December  31, 2000 to  December 31, 2001  Increase (Decrease)  Due to Changes in** |   |
|-----------------------------------------------------------------------------------------------|--------|--------------------------------------------------------------------------------------|---------|--------------------------------------------------------------------------------------|--------|
| **Dollars in thousands**                                                                      |   | **Rate**                                                                             |    | **Volume**                                                                           |   | **Total** |   | **Rate** |   | **Volume** |   | **Total** |   |
|                                                                                          |   |                                                                                 |    |                                                                                 |   |   |   |   |   |   |   |   |   |
| *Interest-Earning Assets*                                                                     |   |                                                                                 |    |                                                                                 |   |   |   |   |   |   |   |   |   |
|                                                                                          |   |                                                                                 |    |                                                                                 |   |   |   |   |   |   |   |   |   |
| Loans receivable and loans held for sale                                                      |   | $                                                                                    | (20,484 | )                                                                                    | $      | 4,298 |   | $ | (16,186 | ) | $ | (10,746 | ) | $ | 4,812 |   | $ | (5,934 | ) |
| Securities available for sale, securities  held to maturity and other interest-earning assets |   | (8,673                                                                               | )       | (2,662                                                                               | )      | (11,335 | ) | (3,856 | ) | (2,745 | ) | (6,601 | ) |
| Total net change in interest income on interest-earning assets                                |   | (29,157                                                                              | )       | 1,636                                                                                |   | (27,521 | ) | (14,602 | ) | 2,067 |   | (12,535 | ) |
|                                                                                          |   |                                                                                 |    |                                                                                 |   |   |   |   |   |   |   |   |   |
| *Interest-Bearing Liabilities*                                                                |   |                                                                                 |    |                                                                                 |   |   |   |   |   |   |   |   |   |
|                                                                                          |   |                                                                                 |    |                                                                                 |   |   |   |   |   |   |   |   |   |
| Interest-bearing deposits                                                                     |   | 24,768                                                                               |    | (3,285                                                                               | )      | 21,483 |   | 8,681 |   | (3,351 | ) | 5,330 |   |
| FHLB advances, securities sold under agreements  to repurchase and other borrowings           |   | 8,550                                                                                |    | 4,063                                                                                |   | 12,613 |   | 12,085 |   | 7,399 |   | 19,484 |   |
| Total net change in interest expense on  interest-bearing liabilities                         |   | 33,318                                                                               |    | 778                                                                                  |   | 34,096 |   | 20,766 |   | 4,048 |   | 24,814 |   |
| Net change  in net interest income                                                            |   | $                                                                                    | 4,161   |                                                                                 | $      | 2,414 |   | $ | 6,575 |   | $ | 6,164 |   | $ | 6,115 |   | $ | 12,279 |   |

 

*PROVISION FOR LOSSES ON LOANS*| The provision for losses on loans was $6.4 million for the year endedDecember 31, 2002 compared to $6.1 million and $4.8 million for the years endedDecember 31, 2001 and 2000.  The levelof provision was based on management’s evaluation of the Pacific Northwesteconomy and its resulting impact on the known and inherent risk characteristicsin the loan portfolio.  These riskcharacteristics include changes in the size and composition of the loanportfolio, delinquency levels, actual loan loss experience, detailed analysisof individual loans for which full collectibility may not be assured andcurrent economic conditions in the geographical area where we lend.   Management believes that the allowance forlosses on loans was adequate as of December 31, 2002.

 

*NON-INTEREST INCOME*| Non-interest income was $19.3 million for the year ended December 31, 2002,compared to $20.7 million and $12.1 million for the years ended December 31,2001 and 2000. Excluding the $1.4 million loss from sale of securities in 2002,the $1.7 million gain from sale of securities in 2001, and the $6.1 millionloss from sale of securities in 2000, non-interest income was $20.7 million,$19.0 million, and $18.2 million for 2002, 2001 and 2000, respectively.  This increase from 2001 was primarily due tothe $1.7 million tax-exempt income from bank owned life insurance (BOLI) thatmanagement obtained in April of 2002. The increase in non-interest income in 2001 from 2000 was primarily dueto a $1.4 million increase in the gain on sale of loans in 2001, partiallyoffset by a decrease of $0.6 million in investment product fees and insurancecommissions.

 

During the second quarter of 2002, PNWBimplemented the financial strategy to purchase $50.0 million of BOLI on certainkey employees. PNWB is the beneficiary of these BOLI contracts and the proceedsfrom the death benefit payments will be used to offset the cost of employeebenefits.  In addition, PNWB addedanother $5.3 million of BOLI through the BKNW acquisition in November 2002. The$1.7 million of income from BOLI represented tax-exempt increases in the cashsurrender value of BOLI contracts for the year ended December 31, 2002.

 

Gains on the sale of loans were $2.6 millionfor the year ended December 31, 2002, compared to $2.3 million and $0.9 millionfor the years ended December 31, 2001 and 2000, respectively.  In mid-2001, as part of PNWB’s transition toa commercial bank, management changed its strategy on the origination andretention of single-family residential mortgage loans.  As a result, the majority of PNWB’ssingle-family mortgage loan originations were sold in the secondary market withservicing released.  During 2002 and2001, the decline in long-term interest rates resulted in increases infixed-rate single-family mortgage loan refinances and opportunities to sellthese loans on the secondary market for a fee. In addition to the lower interest rate environment, the increases ingains on sale of loans in 2002 and 2001 were also due to PNWB’s focus oninitiatives to improve the mortgage banking activities.  During the fourth quarter of 2002, PNWBannounced that it would outsource its residential mortgage lending function anddiscontinue its internal mortgage loan operations beginning in the firstquarter of 2003.  As a result, PNWBexpects gains on sale of loans to decrease significantly in 2003. On the otherhand, management expects that the reduction in non-interest expensespecifically related to mortgage banking operations to more than offset thedecrease expected in gains on sale of loans resulting from the elimination ofmortgage banking revenue.

 

6

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Losses on the sale ofsecurities available for sale were $1.4 million for the year ended December 31,2002, compared to gains of $1.7 million and losses of $6.1 million for theyears ended December 31, 2001 and 2000, respectively.  The $1.4 million of losses in 2002 primarily resulted from thesale of $51.9 million mortgage-backed securities as a result of PNWB’s assetliability management strategies.  The$1.7 million gains during 2001 were primarily from the sale of mortgage-backedsecurities that were securitized from PNWB’s single family mortgage loanportfolio in prior years.  As part ofits strategic plan to become a commercial bank, PNWB partially restructured itsinvestment portfolio during the first half of 2000 and sold approximately $130million of securities available for sale, which resulted in a $6.8 millionloss, offset by a gain of $0.7 million during the second half of 2000.

 

*NON-INTEREST EXPENSE*| Non-interest expense was $77.5 million for the year ended December 31, 2002,compared to $81.2 million and $86.3 million for the years ended December 31,2001and 2000, respectively.  Excludingcosts associated with merger, conversion and integration activities, severanceagreements and goodwill impairment, non-interest expense was $75.5 million,$79.7 million and $74.8 million for the years ended December 31, 2002, 2001 and2000, respectively.

 

General and administrative(G&A) expense was $17.6 million for the year ended December 31, 2002, adecrease from the $20.7 million for the year ended December 31, 2001.  Apart from the $1.1 million of goodwillamortization expense eliminated due to the adoption of SFAS No. 142 “Accountingfor Goodwill and Other Intangible Assets” on January 1, 2002, the decrease inG&A expense was primarily attributable to management’s on-going initiativesto improve operational efficiencies. G&A, occupancy and equipment and data processing expenses increasedduring the year ended December 31, 2001 compared to the year ended December 31,2000 primarily due to increased costs associated with operations such as dataservices, supplies and courier expenses as we transitioned to a commercialbank.

 

Expense from other real estateowned, net of gains from the sale of other real estate owned, was $0.2 millionfor each of the years ended December 31, 2002 and 2001, compared to $2.3million for the year ended December 31, 2000. PNWB recorded write-downs of approximately $2.2 million during 2001primarily to one land development project as a result of new management’sintent with regard to the development and sale of the project as well aschanging economic conditions.

 

The amortization of goodwill was $0 for the year endedDecember 31, 2002 compared to $1.1 million each for the years ended December31, 2001 and 2000, respectively.   Asdiscussed previously and in the financial statements, goodwill is no longeramortized but is reviewed annually for impairment or more frequently ifimpairment indicators arise effective January 1, 2002.  The amortization of core deposit intangibleincreased slightly from $0.2 million each for the years ended December 31, 2001and 2000 to $0.3 million for the year ended December 31, 2002.  The acquisition of BKNW in November 2002resulted in an addition of $9.5 million of core deposit intangible; and as such,PNWB expects that the amortization expense of core deposit intangible willincrease by approximately $1.0 million on an annual basis starting in 2003.

 

Merger, conversion andintegration expense was $1.0 million for the year ended December 31, 2002,compared to $1.3 million and $7.4 million for the years ended December 31, 2001and 2000, respectively.  The $1.0million expenses for 2002 were primarily related to the acquisition of BKNW andthe subsequent conversion of BKNW’s information systems and operationalprocesses.  The $1.3 million expensesfor 2001 and $7.4 million for 2000 were primarily related to the consolidationof the individual banking systems obtained through acquisitions in 1998 and1999.  Those expenses included thebuyout of previous data processing contracts, consultant fees, accelerateddepreciation of equipment and other costs incurred in conjunction withconversion and integration initiatives. Conversion and integration costs were expensed as incurred.   As of December 31, 2002, PNWB had anaccrued liability for $0.2 million related to merger, conversion andintegration expenses for the BKNW acquisition.

 

In conjunction with the BKNWacquisition and the outsourcing of PNWB’s mortgage lending operations announcedduring the fourth quarter of 2002, PNWB incurred $963,000 in expensesassociated with severance and employment agreements during the year endedDecember 31, 2002.  There wereapproximately 90 employees affected by these severance and employmentagreements.  The entire $963,000expenses were paid out during the year ended December 31, 2002 and as such,PNWB had no accrued liability related to the agreements for the 90 employeesaffected as of December 31, 2002.

 

In conjunction with executivemanagement changes, elimination of duplicate administrative functions and consolidatingoperating systems subsequent to the acquisitions between 1996 and 1999, PNWBincurred $0.2 million and $3.3 million in expenses associated with severanceand employment agreements during the years ended December 31, 2002 and 2001.  There were approximately 40 employeesaffected by these severance and employment agreements.  $0.5 million and $1.2 million of suchexpenses were paid out during 2001 and 2000, respectively.  As of December 31, 2002, PNWB had an accruedliability of $1.4 million related to certain agreements that will be paid outin future periods.

 

As part of the transition to acommercial bank in 2000, PNWB consolidated its mortgage brokerage function intoits wholesale lending function and related processes and changed its strategy tosell its single-family mortgage loan production in the secondary market withservicing released.  This resulted inthe impairment of $0.7 million of goodwill during the year ended December 31,2000, which was previously recorded for the acquisition of a mortgage brokeragesubsidiary in 1996.

 

The efficiency ratio iscomputed by dividing total operating expenses by net interest income andnon-interest income.  An increase in theefficiency ratio indicates that more resources are being utilized to generatethe same volume of income while a decrease would indicate a

 

7

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more efficient allocation ofresources. The efficiency ratio for 2002 improved to 60.72 percent compared to66.25 percent and 84.87 percent for the years ended December 31, 2001 and 2000,respectively.

 

*INCOME TAX EXPENSE* |Income tax expense was $15.0 million for the year ended December 31, 2002,compared to $13.2 million and $4.4 million for the years ended December 31,2001 and 2000, respectively.  Theincreases in income tax expense were consistent with the increases in incomebefore income taxes over the past three years.   The effective tax rates were 34.3 percent for the year endedDecember 31, 2002, compared to 37.4 percent and 41.0 percent for the yearsended December 31, 2001 and 2000, respectively. The decrease of the effectivetax rate in 2002 from 2001 were primarily the result of the tax-exempt BOLIincome and the elimination of non-tax deductible goodwill amortization expensein 2002.  The decrease of effective taxrate in 2001 from 2000 was primarily due to the goodwill impairment expense in2000 that was not deductible for federal income tax purposes.

 

**REVIEWOF FINANCIAL CONDITION**

 

PNWB’s total consolidatedassets were $3.127 billion as of December 31, 2002 compared to $2.742 billionas of December 31, 2001.

 

*SECURITIES AND OTHER INTEREST-EARNING ASSETS* |Securities and other interest-earning assets, including securities availablefor sale, interest-bearing deposits in banks, federal funds sold and securitiespurchased under agreements to resell, were $789.5 million as of December 31,2002, compared to $757.5 million as of December 31, 2001.

 

PNWB maintains liquidity in accordance with aninternal liquidity policy.  Liquiditylevels may be increased or decreased depending upon the yields on investmentalternatives, management’s judgment as to the attractiveness of the yields thenavailable in relation to other opportunities and management’s expectation ofthe yield that will be available in the future.  Management’s projections as to the short-term demand for funds tobe used for loan origination and other activities can also affect liquiditylevels.

 

The followingtable sets forth PNWB’s securities available for sale as of the dates indicated.

 
|                                             |   | **December  31, 2002**     |    | **December  31, 2001**     |   | **December  31, 2000**     |   |
|--------------------------------------------------|--------|----------------------------|---------|----------------------------|--------|----------------------------|--------|
| **Dollars in thousands**                         |   | **Estimated  Fair  Value** |    | **Percent  of  Portfolio** |   | **Estimated  Fair  Value** |   | **Percent  of  Portfolio** |   | **Estimated  Fair  Value** |   | **Percent  of  Portfolio** |   |
|                                             |   |                       |    |                       |   |                       |   |   |   |   |   |   |   |
| U.S. government and agency securities            |   | $                          | 547,039 |                       | 69.3   | %                          | $      | 291,994 |   | 38.6 | % | $ | 510,916 |   | 60.8 | % |
| Obligations of states and political subdivisions |   | 16,213                     |    | 2.1                        |   | 1,161                      |   | 0.2 |   | 1,187 |   | 0.1 |   |
| Private mortgage-backed and related securities   |   | 124,343                    |    | 15.8                       |   | 374,437                    |   | 49.4 |   | 242,062 |   | 28.8 |   |
| FHLB stock                                       |   | 52,566                     |    | 6.7                        |   | 46,084                     |   | 6.1 |   | 42,962 |   | 5.1 |   |
| Other securities                                 |   | 48,385                     |    | 6.1                        |   | 43,342                     |   | 5.7 |   | 43,362 |   | 5.2 |   |
| Total                                            |   | $                          | 788,546 |                       | 100.0  |                       | $      | 757,018 |   | 100.0 |   | $ | 840,489 |   | 100.0 |   |

 

The following table sets forth the contractualmaturities and weighted average yields of PNWB’s securities available for saleas of December 31, 2002.  Securitieswith no stated maturity dates are reported as due within one year.

 
|                                             |   | **Less Than  One Year**    |   | **One to  Five Years** |   | **Five to  Ten Years**     |   | **OverTen  Years** |   |
|--------------------------------------------------|--------|----------------------------|--------|------------------------|--------|----------------------------|--------|--------------------|--------|
| **Dollars in thousands**                         |   | **Estimated  Fair  Value** |   | **Yield**              |   | **Estimated  Fair  Value** |   | **Yield**          |   | **Estimated  Fair  Value** |   | **Yield** |   | **Estimated  Fair  Value** |   | **Yield** |   |
|                                             |   |                       |   |                   |   |                       |   |               |   |   |   |   |   |   |   |   |   |
| U.S. government and agency securities            |   | $                          | 14,636 |                   | 3.0    | %                          | $      | 113,538            |   | 3.4 | % | $ | 91,107 |   | 4.5 | % | $ | 327,758 |   | 5.0 | % |
| Obligations of states and political subdivisions |   | 159                        |   | 4.8                    |   | 678                        |   | 6.4                |   | 2,019 |   | 3.9 |   | 13,357 |   | 5.1 |   |
| Private mortgage-backed and related securities   |   | —                     |   | —                 |   | 1,513                      |   | 6.3                |   | 7,583 |   | 5.4 |   | 115,247 |   | 5.2 |   |
| FHLB Stock                                       |   | 52,566                     |   | —                 |   | —                     |   | —             |   | — |   | — |   | — |   | — |   |
| Other securities                                 |   | 408                        |   | —                 |   | —                     |   | —             |   | — |   | — |   | 47,977 |   | 5.3 |   |
| Total                                            |   | $                          | 67,769 |                   | 3.0    | %                          | $      | 115,729            |   | 3.4 | % | $ | 100,709 |   | 4.5 | % | $ | 504,339 |   | 5.1 | % |

 

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Securities classified as available for saleare reported at estimated fair value, with unrealized gains and losses (net ofincome taxes) reported as accumulated other comprehensive income, a separatecomponent of shareholders’ equity. See Note 4 of the Consolidated FinancialStatements for detail of the gross unrealized gains and losses.

 

The following table stratifiesthe unrealized losses of PNWB’s securities available for sale as of December31, 2002 by credit rating:

 

| **Dollars in thousands** |   | **Carrying  Value** |    | **Unrealized  Losses** |   |
|--------------------------|--------|---------------------|---------|------------------------|--------|
| AAA                      |   | $                   | 130,108 |                   | $      | 1,274 |   |
| AA                       |   | 30,352              |    | 2,571                  |   |
| A                        |   | 14,931              |    | 1,769                  |   |
| BBB                      |   | 957                 |    | 38                     |   |
| BA                       |   | 1,846               |    | 68                     |   |
| Total                    |   | 178,194             |    | 5,720                  |   |
|                          |        |                     |         |                        |        |  |  |

 

The following table stratifies the unrealized lossesof PNWB’s securities available for sale as of December 31, 2002 by length oftime the securities have continuously been in an unrealized loss position:

 

| **Dollars in thousands** |   | **Carrying  Value** |    | **Unrealized  Losses** |   |
|--------------------------|--------|---------------------|---------|------------------------|--------|
| 0-6  months              |   | $                   | 123,169 |                   | $      | 1,889 |   |
| 7-12  months             |   | 10,272              |    | 90                     |   |
| 13-24  months            |   | 15,993              |    | 485                    |   |
| Over  24 months          |   | 28,760              |    | 3,256                  |   |
| Total                    |   | 178,194             |    | 5,720                  |   |
|                          |        |                     |         |                        |        |  |  |

 

PNWB’s gross unrealized losses are primarily relatedto investment grade assets.  Unrealizedlosses relating to the investment grade assets (BBB and higher) are generallydue to changes in interest rates which may include changes in spreads tobenchmarks for a particular sector of the market. To the extent that there areunrealized losses in PWNB’s investment portfolio, the investments are evaluatedfor other than temporary impairment.  Thesecurities that have continuously been in an unrealized loss position consistedof variable rate securities purchased between 1998 and 1999 and were allinvestment grade and continue to be investment grade. In determining whetherthe losses were temporary or other than temporary, PNWB considered (1) recentperformance of the security, (2) the credit rating of the security, (3) theamount of credit support available for the security, if any, (4) circumstancescontributing to the decline in value, (5) the length of time and extent towhich the fair value has been less than cost or carrying value, and (6) theintent and ability of PWNB to retain the investment for a period of timesufficient to allow for anticipated recovery. In consideration of the above items, management has performed an evaluationof the investments with unrealized losses as of December 31, 2002, andconsiders such unrealized losses to be primarily associated with interest raterisk.  Furthermore, PNWB maintains itsintent and ability to retain such investments in consideration of its overallasset-liability management strategy. As a result, management deems theapproximately $5.7 million in unrealized losses as of December 31, 2002 to betemporary.

 

*LOANS HELD FOR SALE*| Loans held for sale totaled $25.6 million as of December 31, 2002 compared to$43.8 million as of December 31, 2001. Loans held for sale are carried at the lower of cost or estimated fairvalue in aggregate.  Net unrealizedlosses are recognized in a valuation allowance by charges to income.  Loans held for sale are generallysingle-family residential mortgage loans, construction loans, and loansoriginated under a Small Business Administration program.  The loans are typically sold to FHLMC andother financial institutions.  Prior to2001, PNWB retained the right to service the loans in connection with loanssales, for which it generally receives a fee based on the difference betweenthe rate paid to the investor and that collected from the borrower.  PNWB capitalized loan-servicing rightseither through the purchase or origination of mortgage loans that weresubsequently sold or securitized with the servicing rights retained.  Loan servicing rights are included inintangible assets and are amortized as an offset to services fees in proportionto and over the period of servicing income, not to exceed 15 years.  Starting in 2001, PNWB released the right toservice the loans for all the single-family mortgage loans sold.

 

*LOANS RECEIVABLE* |Net loans receivable were $2.003 billion as of December 31, 2002, an increasefrom $1.788 billion as of December 31, 2001.

 

Subsequent to the acquisitionsof six commercial banks from 1996 to 1999, PNWB’s banking subsidiary changedits charter from a Washington state savings bank to a Washington statecommercial bank effective July 1, 2001. The acquisitions and charter conversion increased PNWB’s ability tooriginate commercial loans.  Sincemid-2000, management has been focusing on restructuring the loan portfolio sothat it is more reflective of a commercial bank.  The principle balances outstanding for commercial, commercialreal estate, and consumer loans increased during the year ended December 31,2002, while the principle balances for single-family mortgage, real estateconstruction, and agricultural loans outstanding decreased.

 

Commercial loans outstandingtotaled $571.3 million as of December 31, 2002, an increase of $32.0 millionfrom December 31, 2001, which represented an annual growth rate of 6.0 percent.Commercial real estate loans outstanding totaled $770.4 million, an increase of$300.0 million from December 31, 2001, which represented an annual growth rateof 63.8 percent.  The growth incommercial and commercial real estate loans resulted from the acquisition ofBKNW and increases in commercial real estate lending.  Commercial, commercial real estate, and agricultural loansoutstanding represented 68.3 percent of total gross loans as of December 31,2002, an increase from 58.4 percent of total gross loans as of December 31, 2001.

 

Single-family mortgage loansoutstanding totaled $231.2 million, or 11.3 percent of total gross loans, as ofDecember 31, 2002, compared to $321.2 million, or 17.7 percent of total grossloans, as of December 31, 2001. The decrease was primarily due to early payoffsassociated with the current interest rate environment and management’s strategynot to originate single family mortgages that remain on the balance sheet.

 

Real estate construction loansoutstanding totaled $274.6 million, or 13.5 percent of total gross loans, as ofDecember 31, 2002 compared to $319.2 million, or 17.6 percent of total grossloans, as of December 31, 2001.

 

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Consumer loans outstandingtotaled $139.8 million, or 6.9 percent of total gross loans, as of December 31,2002 compared to $115.4 million, or 6.3 percent of total gross loans, as ofDecember 31, 2001.

 

The following table sets forth thecomposition of PNWB’s loan portfolio by type of loan as of the dates indicated.

 
|                             |   | **December  31,  2002** |      | **December  31,  2001** |   | **December  31,  2000** |   | **December  31,  1999** |   | **September  30,  1999** |   | **September  30,  1998** |      |
|----------------------------------|--------|-------------------------|-----------|-------------------------|--------|-------------------------|--------|-------------------------|--------|--------------------------|--------|--------------------------|-----------|
| **Dollars in thousands**         |   | **Amount**              |      | **Percent**             |   | **Amount**              |   | **Percent**             |   | **Amount**               |   | **Percent**              |      | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   |
|                             |   |                    |      |                    |   |                    |   |                    |   |                     |   |                     |      |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial loans:                |   |                    |      |                    |   |                    |   |                    |   |                     |   |                     |      |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial                       |   | $                       | 571,283   |                    | 28.0   | %                       | $      | 539,241                 |   | 29.6                     | %      | $                        | 477,223   |   | 26.7 | % | $ | 392,452 |   | 23.1 | % | $ | 365,853 |   | 23.1 | % | $ | 275,151 |   | 19.9 | % |
| Commercial real estate(1)        |   | 770,413                 |      | 37.8                    |   | 470,408                 |   | 25.9                    |   | 375,699                  |   | 21.1                     |      | 377,976 |   | 22.2 |   | 339,013 |   | 21.4 |   | 240,132 |   | 17.4 |   |
| Agricultural loans               |   | 51,653                  |      | 2.5                     |   | 52,422                  |   | 2.9                     |   | 57,224                   |   | 3.2                      |      | 55,385 |   | 3.3 |   | 53,190 |   | 3.3 |   | 46,763 |   | 3.4 |   |
| Total commercial loans           |   | 1,393,349               |      | 68.3                    |   | 1,062,071               |   | 58.4                    |   | 910,146                  |   | 51.0                     |      | 825,813 |   | 48.6 |   | 758,056 |   | 47.8 |   | 562,046 |   | 40.7 |   |
|                             |   |                    |      |                    |   |                    |   |                    |   |                     |   |                     |      |   |   |   |   |   |   |   |   |   |   |   |   |
| Single-family residential(1)     |   | 231,232                 |      | 11.3                    |   | 321,246                 |   | 17.7                    |   | 415,071                  |   | 23.3                     |      | 449,227 |   | 26.5 |   | 433,133 |   | 27.3 |   | 541,585 |   | 39.2 |   |
| Real estate construction         |   | 274,581                 |      | 13.5                    |   | 319,228                 |   | 17.6                    |   | 330,267                  |   | 18.5                     |      | 318,957 |   | 18.8 |   | 298,134 |   | 18.8 |   | 197,182 |   | 14.3 |   |
| Consumer loans                   |   | 139,784                 |      | 6.9                     |   | 115,440                 |   | 6.3                     |   | 128,346                  |   | 7.2                      |      | 103,640 |   | 6.1 |   | 96,399 |   | 6.1 |   | 80,695 |   | 5.8 |   |
| Total loans                      |   | 2,038,946               |      | 100                     | %      | 1,817,985               |   | 100                     | %      | 1,783,830                |   | 100                      | %         | 1,697,637 |   | 100 | % | 1,585,722 |   | 100 | % | 1,381,508 |   | 100 | % |
| Less:                            |   |                    |      |                    |   |                    |   |                    |   |                     |   |                     |      |   |   |   |   |   |   |   |   |   |   |   |   |
| Allowance for losses on loans    |   | (26,940                 | )         |                    |   | (20,123                 | )      |                    |   | (17,561                  | )      |                     |      | (15,182 | ) |   |   | (14,123 | ) |   |   | (13,224 | ) |   |   |
| Deferred loan fees and discounts |   | (9,193                  | )         |                    |   | (9,430                  | )      |                    |   | (8,755                   | )      |                     |      | (10,140 | ) |   |   | (10,015 | ) |   |   | (9,235 | ) |   |   |
| Net loans receivable             |   | $                       | 2,002,813 |                    |   |                    | $      | 1,788,432               |   |                     |   | $                        | 1,757,514 |   |   |   | $ | 1,672,315 |   |   |   | $ | 1,561,584 |   |   |   | $ | 1,359,050 |   |   |   |

 

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(1)          Includes construction loans converted topermanent loans.

 

The following table indicates the contractualmaturity of PNWB’s gross loans as of December 31, 2002. Loans having no statedschedule of repayments and no stated maturity are reported as due within oneyear.  Loan balances do not includedeferred loan fees and discounts and the allowance for losses on loans.  The table does not reflect any estimate ofprepayments, which significantly shorten the average life of all loans and willcause PNWB’s actual repayment experience to differ significantly from thatindicated below.
| **Dollars in thousands**  |   | **Within  One  Year** |    | **After One  Through  5 Years** |   | **After  5 Years** |   | **Total** |      |
|---------------------------|--------|-----------------------|---------|---------------------------------|--------|--------------------|--------|-----------|-----------|
|                      |   |                  |    |                            |   |               |   |      |      |
| Commercial loans:         |   |                  |    |                            |   |               |   |      |      |
| Commercial                |   | $                     | 251,455 |                            | $      | 154,400            |   | $         | 165,428   |   | $ | 571,283 |   |
| Commercial real estate    |   | 48,422                |    | 147,745                         |   | 574,246            |   | 770,413   |      |
| Agricultural loans        |   | 27,606                |    | 10,616                          |   | 13,431             |   | 51,653    |      |
| Total commercial loans:   |   | 327,483               |    | 312,761                         |   | 753,105            |   | 1,393,349 |      |
|                      |   |                  |    |                            |   |               |   |      |      |
| Single-family residential |   | 8,318                 |    | 29,469                          |   | 193,445            |   | 231,232   |      |
| Real estate construction  |   | 122,198               |    | 79,604                          |   | 72,779             |   | 274,581   |      |
| Consumer loans            |   | 52,615                |    | 31,755                          |   | 55,414             |   | 139,784   |      |
| Total gross loans         |   | $                     | 510,614 |                            | $      | 453,589            |   | $         | 1,074,743 |   | $ | 2,038,946 |   |

 

10

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The following table sets forth the dollaramount of the loans contractually due after one year as of December 31, 2002that have fixed and/or floating or variable interest rates.

 
| **Dollars in thousands**  |   | **Fixed  Rates** |    | **Floating  or  Variable  Rates** |   |
|---------------------------|--------|------------------|---------|-----------------------------------|--------|
|                      |   |             |    |                              |   |
| Commercial loans          |   |             |    |                              |   |
| Commercial                |   | $                | 86,275  |                              | $      | 233,553 |   |
| Commercial real estate    |   | 104,110          |    | 608,700                           |   |
| Agricultural loans        |   | 4,010            |    | 20,621                            |   |
| Total commercial loans:   |   | 194,395          |    | 862,874                           |   |
|                      |   |             |    |                              |   |
| Single-family residential |   | 88,607           |    | 137,845                           |   |
| Real estate construction  |   | 21,035           |    | 131,349                           |   |
| Consumer loans            |   | 50,198           |    | 36,971                            |   |
| Total                     |   | $                | 354,235 |                              | $      | 1,169,039 |   |

 

The principle lending activities of PNWB arethe origination of commercial loans, commercial real estate mortgage loans,real estate construction loans, single-family residential mortgage loans,consumer loans and agricultural loans.

 

*Commercial loans* | Commercial loans include awide range of loan types to small and medium-sized businesses, includingcommercial lines of credit with variable rates and maturities of one year orless, and equipment and operational loans. These loans are primarily secured by liens on real estate, capitalassets, accounts receivable and inventory, although certain loans areunsecured.  Commercial lending hasincreased risks as a result of dependence on income production for future repayment,and in certain circumstances, the lack of tangible collateral.   Commercial loans are underwritten based onthe financial strength and repayment ability of the borrower, as well as thevalue of any collateral securing the loans. Commercial lending operations rely on a strong credit culture thatcombines prudent credit policies and individual lender accountability.

 

*Commercial real estate mortgage loans* | PNWBoriginates mortgage loans on commercial real estate properties with terms of upto 30 years in its primary market area. These loans are secured by property such as apartment buildings,condominium projects, office buildings, small commercial business properties,subdivision developments and shopping centers.

 

Commercial real estate mortgage loansgenerally have larger balances outstanding and involve greater risks thansingle-family residential mortgage loans because payments on loans secured bycommercial properties are dependent on the successful operation or managementof the properties. As a result, repayment of such loans may be subject toconditions in the real estate market or the economy to a greater extent thansingle-family residential mortgage loans. These loans may involve large loanbalances to single borrowers or groups of related borrowers.

 

*Real estate construction* | PNWB originatesreal estate construction loans to residential owner-occupants (customconstruction loans) and to contractors building residential properties forresale, as well as construction loans for condominiums, commercial real estateproperties and land development on properties located within its primary marketarea.  Construction loans toowner-occupants generally are converted to single-family residential mortgageloans.

 

Real estate construction loans may involveadditional risks because loan funds are collateralized by the project underconstruction, which is of uncertain value prior to completion.  Delays may arise from labor problems,material shortages may be experienced and other unpredictable contingencies mayoccur.  It is important to evaluateaccurately the total loan funds required to complete a project and related loan-to-valueratios.  Because of these factors, theanalysis of prospective construction loan projects requires an expertise thatis different in significant respects from the expertise required for realestate mortgage lending.  Constructionlending is generally considered to involve a higher degree of collateral riskthan long-term financing of residential properties.  PNWB’s risk of loss on a construction loan is dependent largelyupon the accuracy of the initial estimate of the property’s value andmarketability at completion of construction or development and the estimatedcost (including interest) of construction. If the estimate of construction costs and the marketability of theproperty upon completion of the project prove to be inaccurate, PNWB may berequired to advance additional funds to complete development of theproject.  PNWB’s underwriting criteriaare designed to evaluate and minimize the risks of each real estateconstruction loan.  Among other things,PNWB considers evidence of the availability of permanent financing for theborrower, the reputation of the borrower, the amount of the borrower’s equityin the project, the independent appraisal and review of cost estimates, thepre-construction sale and leasing information, and the cash flow projections ofthe borrower.

 

*Single-family residential mortgage loans*| In November 2002, PNWB announced that it will outsource its residential mortgage lending function anddiscontinue its internal mortgage loan operations beginning in the firstquarter of 2003.  PNWB will start to offer a web-basedmortgage lending program to its customers through a third party, which willunderwrite and process the mortgage loans. The 

 

11

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mortgageloans will close in PNWB’s name and will be sold with servicing released to athird party shortly after closing.  Managementexpects that this will reduce mortgage banking business risk and improveoperational efficiencies.  PNWB originates both fixed-rate loans andadjustable-rate mortgage loans (“ARMs”) secured by single-family residentialproperties with loan terms of up to 30 years. ARMs have interest rates that adjust based upon changes in apredetermined index for a period matching the repricing period of theloan.  Borrowers’ demand for ARMs versusfixed-rate mortgage loans is a function of the level of interest rates, theexpectations of changes in the level of interest rates and the differencebetween the interest rates and loan fees offered for fixed-rate mortgage loansand the rates and loan fees for ARMs.

 

*Consumer loans* | Consumer loans consist ofautomobile loans, home equity loans, credit card loans and loans for otherconsumer purposes.  Consumer loans alsoinclude both secured and unsecured personal lines of credit.  Consumer lending may involve special risks,including decreases in the value of collateral and transaction costs associatedwith foreclosure and repossession.

 

*Agricultural loans*| Agricultural loans include seasonal production loans secured by crops andequipment.  These loans generally haveadjustable rates that are renewed annually. Agricultural loans also include loans secured by farmland.  The majority of PNWB’s agricultural loanshave terms of less than five years and have variable interest rates.

 

*Off-balance sheet loan commitments*|As of December 31, 2002, PNWB had $231.2million in real estate loan commitments to extend credit.  Other loan commitments to extend credit,which include commercial and consumer lines of credit, totaled $445.2 million as of December 31,2002.  Outstanding commitments to extendcredit under standby letters of credit and commercial letters of credit totaled$64.5 million and $17.8 million as of December 31, 2002.  The following is a summary of PNWB’soff-balance sheet loan commitments and standby letters of credit as of December31, 2002 (dollars in thousands):

 
| Real estate                  |   | $       | 231,203 |   |
|------------------------------|--------|---------|---------|--------|
| Non-real estate commercial   |   | 445,201 |    |
| Standby letters of credit    |   | 64,501  |    |
| Commercial letters of credit |   | 17,816  |    |
| Total                        |   | $       | 758,721 |   |

 

*Non-performing loans*| Loans are generally placed on non-accrual when they become past due over 90days, or 120 days if they are single-family mortgage loans, or when thecollection of interest or principal is considered unlikely.  Loans past due over 90 or 120 days that arenot on non-accrual status must be well secured by tangible collateral and inthe process of collection.  PNWB doesnot return a loan to accrual status until it is brought current with respect toboth principal and interest and future principal and interest payments are nolonger in doubt.  When a loan is placedon non-accrual status, any previously accrued and uncollected interest isreversed from interest income.  As ofDecember 31, 2002, PNWB had $11.9 million of loans on non-accrual statuscompared to $16.1 million as of December 31, 2001.  PNWB performs a review of its loan portfolio for weaknesses incredit quality on an ongoing basis to identify problem loans.  This review results in internal loanclassifications based on risk characteristics and loan performance.  The overall objective of this review processis to identify trends in the credit quality of the loan portfolio and todetermine the level of loss exposure to evaluate the need for an adjustment tothe allowance for losses on loans.

 

*ALLOWANCE FOR LOSSES ON LOANS* | PNWB’sallowance for losses on loans was $26.9 million or 1.33 percent of loans receivableas of December 31, 2002, compared to $20.1 million, or 1.11 percent of loans asof December 31, 2001.  Net loancharge-offs for the year ended December 31, 2002 were $3.2 million or 0.17percent of the average balance of loans outstanding for the year.  Net loan charge-offs were $3.5 million or0.19 percent for the year ended December 31, 2001 and $2.4 million or 0.14percent for the year ended December 31, 2000. The increase in net charge-offs in 2001 was primarily due to an increasein charge-offs related to foreclosed single-family residential loans.

 

When available informationconfirms that specific loans or portions thereof are uncollectible, theseamounts are charged off against the allowance for losses on loans.  The existence of some or all of thefollowing criteria will generally confirm that a loss has been incurred: theloan is significantly delinquent and the borrower has not evidenced the abilityor intent to bring the loan current; there is no recourse to the borrower, orif there is recourse, the borrower has insufficient assets to pay the debt; thefair value of the loan 

 

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collateral is significantlybelow the current loan balance, and there is little or no near-term prospectfor improvement.  A provision for losseson loans, which is a charge against income, is added to the allowance forlosses on loans based on ongoing assessments of credit risk in the loanportfolio.

 

The allowance for losses on loans is maintained at an amount to sufficientlyprovide for estimated losses based on evaluating known and inherent risks inthe loan portfolio.  Management analyzescertain factors underlying the quality of the loan portfolio.  These factors include changes in the sizeand composition of the loan portfolio, delinquency levels, actual loan lossexperience, current economic conditions, and detailed analysis of individualloans for which full collectibility may not be assured.  The appropriate level of the allowance forlosses on loans is estimated based upon factors and trends identified bymanagement at the time financial statements are prepared.

 

Management has assessed, and will continue to assesson an on-going basis, the impact of the slowdown of Pacific Northwest economyon the credit risk in the loan portfolio. Currently, management is not aware of any unusually large loanconcentrations in industries negatively impacted by the slowdown in theeconomy.  As a result of management’scontinued emphasis on credit quality, delinquency trends and classified loanlevels have shown improvement in 2002 relative to prior periods.  Management continues to closely monitorPNWB’s credit quality and focus on identifying potential problem credits andany loss exposure in a timely manner. Industry concentration and related limits will continue to be subject toon-going assessments.

 

PNWB believes it has established itsallowance for losses on loans in accordance with accounting principlesgenerally accepted in the United States. However, there can be no assurance that in the future, regulators, whenreviewing PNWB’s loan portfolio, will not request PNWB to increase itsallowance for losses on loans, thereby affecting PNWB’s financial condition andresults of operations.  Substantialincreases may be necessary should the quality of loans deteriorate as a resultof the factors discussed above.

 

The following table sets forth activity inthe allowance for losses on loans during the periods indicated.

 
| **Year ended**                                                                              |   | **December  31,** |   | **September  30,** |   |
|---------------------------------------------------------------------------------------------|--------|-------------------|--------|--------------------|--------|
| **Dollars in thousands**                                                                    |   | **2002**          |   | **2001**           |   | **2000** |   | **1999** |   | **1998** |   |
|                                                                                        |   |              |   |               |   |   |   |   |   |   |   |
| Allowance as of beginning of year                                                           |   | $                 | 20,123 |               | $      | 17,561 |   | $ | 15,182 |   | $ | 13,224 |   | $ | 11,104 |   |
| Provision for losses on loans                                                               |   | 6,350             |   | 6,050              |   | 4,750 |   | 2,000 |   | 1,707 |   |
| *Merger and acquisition activity:*                                                          |   |              |   |               |   |   |   |   |   |   |   |
| Allowance acquired                                                                          |   | 3,688             |   | —             |   | — |   | — |   | 295 |   |
| Provision pursuant to acquisition                                                           |   | —            |   | —             |   | — |   | — |   | 1,100 |   |
| Pooling accounting adjustment                                                               |   | —            |   | —             |   | — |   | — |   | (76 | ) |
|                                                                                        |   |              |   |               |   |   |   |   |   |   |   |
| *Charge-offs:*                                                                              |   |              |   |               |   |   |   |   |   |   |   |
| Commercial loans                                                                            |   | 659               |   | 1,518              |   | 1,300 |   | 405 |   | 194 |   |
| Commercial real estate                                                                      |   | 77                |   | 326                |   | 5 |   | — |   | 119 |   |
| Single-family residential                                                                   |   | 1,446             |   | 1,723              |   | 750 |   | 727 |   | 413 |   |
| Real estate construction                                                                    |   | 174               |   | 47                 |   | 283 |   | — |   | 134 |   |
| Consumer loans                                                                              |   | 793               |   | 922                |   | 464 |   | 337 |   | 428 |   |
| Agricultural loans                                                                          |   | 607               |   | 210                |   | 154 |   | 84 |   | 2 |   |
| Total charge-offs                                                                           |   | 3,756             |   | 4,746              |   | 2,956 |   | 1,553 |   | 1,290 |   |
|                                                                                        |   |              |   |               |   |   |   |   |   |   |   |
| *Recoveries:*                                                                               |   |              |   |               |   |   |   |   |   |   |   |
| Commercial loans                                                                            |   | 84                |   | 629                |   | 280 |   | 86 |   | 88 |   |
| Commercial real estate                                                                      |   | —            |   | 126                |   | 29 |   | 38 |   | 55 |   |
| Real estate mortgage loans:                                                                 |   |              |   |               |   |   |   |   |   |   |   |
| Single-family residential                                                                   |   | 170               |   | 330                |   | 175 |   | 245 |   | 61 |   |
| Consumer loans                                                                              |   | 193               |   | 173                |   | 100 |   | 83 |   | 176 |   |
| Agricultural loans                                                                          |   | 88                |   | —             |   | 1 |   | — |   | 4 |   |
| Total recoveries                                                                            |   | 535               |   | 1,258              |   | 585 |   | 452 |   | 384 |   |
| Net charge-offs                                                                             |   | (3,221            | )      | (3,488             | )      | (2,371 | ) | (1,101 | ) | (906 | ) |
| Allowance as of end of year                                                                 |   | $                 | 26,940 |               | $      | 20,123 |   | $ | 17,561 |   | $ | 14,123 |   | $ | 13,224 |   |
| Ratio of allowance for losses on loans to  total loans receivable as of the end of the year |   | 1.33              | %      | 1.11               | %      | 0.99 | % | 0.90 | % | 0.82 | % |
| Ratio of net charge-offs to average loans  outstanding during the year                      |   | 0.17              | %      | 0.19               | %      | 0.14 | % | 0.08 | % | 0.05 | % |

 

PNWB maintains an estimated allowance forlosses on loans based on the analyses conducted by management and creditpersonnel.  The allowance for losses onloans is allocated to certain loan categories based on the relative riskcharacteristics, asset classifications and

 

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actual loss experience of the loanportfolio.  Management has reviewed theallocations in the various loan categories and believes the allowance forlosses on loans was adequate at all times during the five-year period endedDecember 31, 2002.

 

PNWB updated its methodology for allocatingthe allowance for losses on loans during 2000, with a greater emphasis on currentrisk characteristics and asset classifications and less emphasis on historicalloss experience compared to years prior to 2001.  Management believes this approach is more appropriate andreflective of the changing nature of the loan portfolio with a greater emphasison commercial lending that is also expanding into new markets andproducts.  As such, portfolio riskcharacteristics and internal asset classification assessments are morereflective of the current loan portfolio than historical loss experience.

 

Theallocation of the allowance for losses on loans to commercial and commercialreal estate loans increased from prior years primarily due to growth incommercial loans, allowance acquired from the BKNW acquisition and a greateremphasis on the current risk characteristics inherent in the commercial andcommercial real estate loan portfolio.

 

Theincreased allocation to real estate construction loans and agricultural loansin 2002, 2001 and 2000 compared to prior years is due to a greater emphasis on riskcharacteristics inherent in real estate construction lending and greateremphasis on internal asset classifications. Prior year allocations were based more heavily on historical lossexperience and PNWB had not experienced significant losses in the real estateconstruction and agricultural loan portfolios. The allocation to agriculturalloans has also increased due to an increase in non-performing and adverselyclassified agricultural loans based on the state of the agricultural economy incentral Washington.

 

Thedecreased allocation to single-family residential mortgage loans is primarilydue to a decrease in the balances outstanding in the portfolio compared toprior years.

 

The lower level of the allocation to theconsumer loans in 2002, 2001 and 2000 compared to prior years reflects thechange in the methodology of allocating the allowance for losses on loans tothe consumer portfolio.  The increase inallocation to consumer loans in 2002 compared to 2001 was due to an increase inthe consumer loan balance and historical loss experience.

 

Although theallocation of the allowance for losses on loans is an important creditmanagement tool, the entire allowance for losses on loans is available for theentire loan portfolio.  The followingtable sets forth the allocation of the allowance for losses on loans by loancategory as of the dates indicated.

 
| **Dollars in thousands**  |   | **December  31,  2002** |   | **December  31,  2001** |   | **December  31,  2000** |   | **December  31,  1999** |   | **September  30,  1999** |   | **September  30,  1998** |   |
|---------------------------|--------|-------------------------|--------|-------------------------|--------|-------------------------|--------|-------------------------|--------|--------------------------|--------|--------------------------|--------|
|                      |   |                    |   |                    |   |                    |   |                    |   |                     |   |                     |   |
| Commercial loans:         |   |                    |   |                    |   |                    |   |                    |   |                     |   |                     |   |
| Commercial loans          |   | $                       | 9,620  |                    | $      | 6,105                   |   | $                       | 4,448  |                     | $      | 3,632                    |   | $ | 2,785 |   | 2,454 |   |
| Commercial real estate    |   | 7,525                   |   | 3,265                   |   | 2,862                   |   | 1,342                   |   | 1,525                    |   | 1,878                    |   |
| Agricultural loans        |   | 2,316                   |   | 1,999                   |   | 1,921                   |   | 394                     |   | 334                      |   | 285                      |   |
| Total commercial loans:   |   | 19,461                  |   | 11,369                  |   | 9,231                   |   | 5,368                   |   | 4,644                    |   | 4,617                    |   |
|                      |   |                    |   |                    |   |                    |   |                    |   |                     |   |                     |   |
| Single-family residential |   | 551                     |   | 1,798                   |   | 2,076                   |   | 3,265                   |   | 2,471                    |   | 3,288                    |   |
| Real estate construction  |   | 2,666                   |   | 2,752                   |   | 2,804                   |   | 301                     |   | 302                      |   | 424                      |   |
| Consumer loans            |   | 772                     |   | 448                     |   | 311                     |   | 1,376                   |   | 1,441                    |   | 996                      |   |
| Unallocated               |   | 3,490                   |   | 3,756                   |   | 3,139                   |   | 4,872                   |   | 5,265                    |   | 3,899                    |   |
|                      |   |                    |   |                    |   |                    |   |                    |   |                     |   |                     |   |
| Total                     |   | $                       | 26,940 |                    | $      | 20,123                  |   | $                       | 17,561 |                     | $      | 15,182                   |   | $ | 14,123 |   | $ | 13,224 |   |
|                           |        |                         |        |                         |        |                         |        |                         |        |                          |        |                          |        |  |  |  |  |  |  |

 

*OTHER REAL ESTATE* |Other real estate includes property acquired by PNWB through foreclosure andreal estate held for development.  Otherreal estate is carried at the lower of the estimated fair value or theprincipal balance of the foreclosed loans. The real estate held for developmentportfolio primarily consists of one land development project.  PNWB had other real estate totaling $7.2million as of December 31, 2002 compared to $5.8 million as of December 31,2001.

 

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*NON-PERFORMING ASSETS |*PNWB’s non-performing assets as of December 31, 2002, consisting ofnon-performing loans and other real estate, totaled $19.1 million or 0.61percent of total assets.  This is adecrease from $21.9 million or 0.80 percent of total assets as of December 31,2001.  Non-performing loans decreased to$11.9 million as of December 31, 2002 from $16.1 million as of December 31,2001.  The decrease in non-performingloans was primarily attributable to loans being brought current in non-performingsingle-family residential and real estate construction loan categories.  Management believes that the allowance forlosses on loans is adequate to provide for losses that may be incurred onnon-performing loans.  Non-performingother real estate was $7.2 million as of December 31, 2002, as compared to $5.8million as of December 31, 2001.  Thisincrease resulted primarily from the foreclosure of a $1.5 million non-accrualcommercial loan during the third quarter of 2002. The following table presents informationwith respect to PNWB’s non-performing assets and restructured loans as of thedates indicated.

 
| **Dollars in thousands**                        |   | **December  31,  2002** |   | **December  31,  2001** |   | **December  31,  2000** |   | **December  31,  1999** |   | **September  30,  1999** |   | **September  30,  1998** |   |
|-------------------------------------------------|--------|-------------------------|--------|-------------------------|--------|-------------------------|--------|-------------------------|--------|--------------------------|--------|--------------------------|--------|
|                                            |   |                    |   |                    |   |                    |   |                    |   |                     |   |                     |   |
| Non-performing loans:                           |   |                    |   |                    |   |                    |   |                    |   |                     |   |                     |   |
| Commercial loans:                               |   |                    |   |                    |   |                    |   |                    |   |                     |   |                     |   |
| Commercial                                      |   | $                       | 5,562  |                    | $      | 5,434                   |   | $                       | 2,455  |                     | $      | 5,038                    |   | $ | 3,943 |   | $ | 1,682 |   |
| Commercial real estate                          |   | 657                     |   | 1,100                   |   | 991                     |   | 1,371                   |   | 792                      |   | 557                      |   |
| Agricultural loans                              |   | 1,658                   |   | 2,685                   |   | 1,272                   |   | 88                      |   | 652                      |   | 127                      |   |
| Total Commercial Loans                          |   | 7,877                   |   | 6,534                   |   | 3,446                   |   | 6,409                   |   | 4,735                    |   | 2,239                    |   |
|                                            |   |                    |   |                    |   |                    |   |                    |   |                     |   |                     |   |
| Single-family residential                       |   | 3,733                   |   | 5,425                   |   | 5,020                   |   | 3,207                   |   | 4,125                    |   | 5,036                    |   |
| Real estate construction                        |   | 130                     |   | 1,199                   |   | 3,920                   |   | 880                     |   | 880                      |   | 634                      |   |
| Consumer loans                                  |   | 173                     |   | 245                     |   | 225                     |   | 366                     |   | 507                      |   | 174                      |   |
| Total                                           |   | 11,913                  |   | 16,088                  |   | 13,883                  |   | 10,950                  |   | 10,899                   |   | 8,210                    |   |
| Other real estate                               |   | 7,152                   |   | 5,762                   |   | 9,909                   |   | 4,313                   |   | 3,560                    |   | 7,553                    |   |
| Total non-performing assets                     |   | $                       | 19,065 |                    | $      | 21,850                  |   | $                       | 23,792 |                     | $      | 15,263                   |   | $ | 14,459 |   | $ | 15,763 |   |
|                                            |   |                    |   |                    |   |                    |   |                    |   |                     |   |                     |   |
| Restructured loans                              |   | $                       | 434    |                    | $      | 570                     |   | $                       | 687    |                     | $      | 777                      |   | $ | 798 |   | $ | 883 |   |
| Total non-performing loans to loans  receivable |   | 0.59                    | %      | 0.90                    | %      | 0.79                    | %      | 0.65                    | %      | 0.70                     | %      | 0.60                     | %      |
| Total non-performing loans to total assets      |   | 0.38                    | %      | 0.59                    | %      | 0.48                    | %      | 0.39                    | %      | 0.42                     | %      | 0.34                     | %      |
| Total non-performing assets to total assets     |   | 0.61                    | %      | 0.80                    | %      | 0.83                    | %      | 0.55                    | %      | 0.56                     | %      | 0.64                     | %      |

 

*Goodwill and Other Intangible Assets*|Goodwill and other intangible assets totaled $78.2 million, or 2.50 percent of total assets and 29.9percent of total shareholders’ equity as of December 31, 2002.   Goodwill and other intangible assetstotaled $18.1 million, or 0.66percent of total assets and 9.04percent of total shareholders’ equity as of December 31, 2001. This increase in thebalance of goodwill and other intangible assets was due to the BKNW acquisition in 2002, whichresulted in the recording of approximately $51.6 million of goodwill and $9.5million of core deposit intangible.

 

Prior to 2002, goodwill arising from acquisitions represents the excessof the purchase price over the estimated fair value of net assetsacquired.  Goodwill was amortized usingthe straight-line methods over periods not exceeding twenty years.  Effective January 1, 2002, upon adoption ofSFAS No. 142 “Accounting for Goodwill and Other Intangible Assets”, PNWB nolonger amortizes the goodwill, and instead, reviews the goodwill for impairmenton an annual basis or more frequently if impairment indicators arise.  PNWB’s annual goodwill impairment evaluationin the fourth quarter of 2002 indicated no impairment of goodwill.

 

Other intangible assets consistof core deposit intangibles and mortgage servicing rights, and are amortizedusing straight-line and accelerated methods over periods not exceeding twentyyears.  Mortgage servicing rights arecapitalized when acquired either through the purchase or origination of loansthat are subsequently sold or securitized with the servicing rightsretained.  The estimated fair value ofmortgage servicing rights at the date of the sale of loans is determined basedon the discounted present value of expected future cash flows using keyassumptions for servicing income and costs and prepayment rates on theunderlying loans. The estimated fair value is periodically evaluated forimpairment by comparing actual cash flows and estimated future cash flows fromthe servicing assets to those estimated at the time servicing assets wereoriginated.  Mortgage servicing rightsare amortized as an offset to service fees in proportion to and over the periodof estimated net servicing income.  Theamortization and write-down of mortgage servicing rights was $0.8 million, $1.3million and $0.8 million for the years ended December 31, 2002, 2001 and 2000,respectively.  The higher amortizationand write-down level during 2001 compared to 2002 and 2000 was primarily due todecreases in interest rates, which resulted in higher prepayment rates on theunderlying loans.

 

*DEPOSITS* | PNWBoffers various types of deposit accounts, including checking accounts, savingsaccounts, money market accounts and certificate of deposit accounts.  Deposit accounts vary as to terms, theprincipal differences are the minimum balance required, the time period thefunds must remain on deposit, the interest rate, and the deposit or withdrawaloption.  PNWB relies on generatingdeposits through a marketing strategy that employs a sales staff responsiblefor retaining and generating new customer relationships.

 

15

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Non-interest-bearing depositswere $345.6 million as of December 31, 2002, compared to $241.7 million as ofDecember 31, 2001.  Non-interest-bearing deposits represented 16.8 percent of total depositsas of December 31, 2002, compared to 15.1 percent as of December 31, 2001.  Interest-bearing transaction accounts, whichincludes interest-bearing checking, money market and savings accounts, totaled$904.0 million as of December 31, 2002 compared to $632.0 million as ofDecember 31, 2001.  Interest-bearingtransaction accounts represented 44.0 percent of total deposits as of December31, 2002, compared to 39.4 percent as of December 31, 2001.  The increases in non-interest-bearing andinterest-bearing deposits were due to the BKNW acquisition as well as growth indeposit accounts during 2002.

 

Certificates of deposit were$804.7 million as of December 31, 2002, compared to $731.1 million as ofDecember 31, 2001.  Certificates ofdeposit represented 39.2 percent of total deposits as of December 31, 2002, comparedto 45.6 percent as of December 31, 2001.

 

During 2002, managementcontinued to focus on initiatives to restructure the deposit portfolio in aneffort to decrease funding costs and better manage interest rate risk whilebuilding customer relationships.  As ofDecember 31, 2002, 60.8 percent of total deposits were transaction accounts,compared to 54.4 percent as of December 31, 2001.  The increase in the percentage of non-interest-bearing depositsand interest-bearing transaction deposits (core deposits) relative tocertificates of deposit reflected the progress made on those initiatives andwas also attributable to the BKNW acquisition.   The increase in core deposits positively contributed to thenoticeable decrease in the cost of funds in 2002.  It is management’s intention to continue to increase coredeposits as a percentage of the total deposit portfolio in the future.

 

The following table indicatesthe amount of PNWB’s certificates of deposit with balances equal to or greaterthan $100,000 classified by time remaining until maturity as of December 31,2002.

 
| **Dollars in thousands**   |   |       |    |
|----------------------------|--------|------------|---------|
| **Maturity Period**        |   | **Amount** |    |
|                       |   |       |    |
| Three months or less       |   | $          | 168,720 |   |
| Three through six months   |   | 75,755     |    |
| Six through twelve months  |   | 127,248    |    |
| Greater than twelve months |   | 87,343     |    |
| Total                      |   | $          | 459,066 |   |

 

The following table sets forth the balancesof deposits by account type as of the dates indicated.

 
|                               |   | **December  31, 2002** |      | **December  31, 2001** |   | **December  31, 2000** |   |
|------------------------------------|--------|------------------------|-----------|------------------------|--------|------------------------|--------|
| **Dollars in thousands**           |   | **Amount**             |      | **Percent  of  Total** |   | **Amount**             |   | **Percent  of  Total** |   | **Amount** |   | **Percent  of  Total** |   |
|                               |   |                   |      |                   |   |                   |   |   |   |   |   |   |   |
| Non-interest-bearing deposits      |   | $                      | 345,571   |                   | 16.8   | %                      | $      | 241,674 |   | 15.1 | % | $ | 244,100 |   | 14.2 | % |
| Interest-bearing checking accounts |   | 263,591                |      | 12.8                   |   | 214,098                |   | 13.3 |   | 201,894 |   | 11.8 |   |
| Money market accounts              |   | 531,698                |      | 25.9                   |   | 322,552                |   | 20.1 |   | 266,933 |   | 15.5 |   |
| Savings accounts                   |   | 108,721                |      | 5.3                    |   | 95,390                 |   | 5.9 |   | 100,831 |   | 5.9 |   |
| Certificates of deposit            |   | 804,729                |      | 39.2                   |   | 731,141                |   | 45.6 |   | 903,350 |   | 52.6 |   |
|                               |   |                   |      |                   |   |                   |   |   |   |   |   |   |   |
| Total                              |   | $                      | 2,054,310 |                   | 100.0  | %                      | $      | 1,604,855 |   | 100.0 | % | $ | 1,717,108 |   | 100.0 | % |

 

*FHLB ADVANCES AND SECURITIES SOLD UNDERAGREEMENT TO REPURCHASE* | PNWB borrows throughadvances from the Federal Home Loan Bank (FHLB) and securities sold underagreements to repurchase with third parties. These borrowing sources totaled $730.3 million as of December 31, 2002compared to $864.0 million as of December 31, 2001.  The need for this type of borrowings decreased as a result of theincreases in deposits.

 

The FHLB provides credit formember financial institutions.  Asmembers, financial institutions are required to own capital stock in the FHLB,and are authorized to apply for advances on the security of such stock, certainhome mortgages, commercial real estate loans and other assets such assecurities that are obligations of, or guaranteed by, the United States.  Advances are made to member financialinstitutions pursuant to several different programs.  These programs are generally designed to meet the financialinstitution’s needs while still reflecting market terms and conditions.  Interest rates on these advances vary inresponse to general economic conditions.

 

PNWB also uses the securitiesmarket for borrowings by utilizing its securities available for sale ascollateral.  These borrowings arecollateralized by securities with an estimated fair value exceeding the facevalue of the borrowings.

 

16

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The following table sets forthcertain information with respect to FHLB advances and securities sold underagreements to repurchase during the periods indicated:

 
| **As of or  for the year ended  Dollars in thousands**          |   | **December  31,  2002** |    | **December  31,  2001** |   | **December  31,  2000** |   |
|-----------------------------------------------------------------|--------|-------------------------|---------|-------------------------|--------|-------------------------|--------|
|                                                            |   |                    |    |                    |   |                    |   |
| Maximum amount outstanding at any month end  during the period: |   |                    |    |                    |   |                    |   |
| FHLB advances                                                   |   | $                       | 740,727 |                    | $      | 721,200                 |   | $ | 787,526 |   |
| Securities sold under agreements to  repurchase                 |   | 126,939                 |    | 279,176                 |   | 286,807                 |   |
|                                                            |   |                    |    |                    |   |                    |   |
| Approximate average amount outstanding  during the period:      |   |                    |    |                    |   |                    |   |
| FHLB advances                                                   |   | 640,111                 |    | 651,824                 |   | 707,814                 |   |
| Securities sold under agreements to  repurchase                 |   | 117,108                 |    | 193,607                 |   | 267,570                 |   |
| Balance outstanding at end of period:                           |   |                    |    |                    |   |                    |   |
| FHLB advances                                                   |   | 609,581                 |    | 714,526                 |   | 643,200                 |   |
| Securities sold under agreements to  repurchase                 |   | 120,706                 |    | 149,504                 |   | 274,920                 |   |
|                                                            |   |                    |    |                    |   |                    |   |
| Weighted average rate paid during the  period:                  |   |                    |    |                    |   |                    |   |
| FHLB advances                                                   |   | 3.81                    | %       | 4.63                    | %      | 6.07                    | %      |
| Securities sold under agreements to  repurchase                 |   | 3.32                    |    | 5.49                    |   | 6.66                    |   |
|                                                            |   |                    |    |                    |   |                    |   |
| Weighted average rate paid at end of  period:                   |   |                    |    |                    |   |                    |   |
| FHLB advances                                                   |   | 3.95                    |    | 3.23                    |   | 6.37                    |   |
| Securities sold under agreements to  repurchase                 |   | 2.54                    |    | 3.63                    |   | 6.88                    |   |
|                                                                 |        |                         |         |                         |        |                         |        |  |  |  |

 

*GUARANTEED PREFERRED BENEFICIAL INTERESTS INSUBORDINATED DEBT* | On September 26, 2002, $12.0 million of Capital Securities were issuedby Pacific Northwest Statutory Trust I (the Trust).  The Trust is a business trust organized in September 2002, andBancorp owns 100 percent of the common equity of the Trust.  The proceeds of the offering were investedby the Trust in junior subordinated debentures of Bancorp.  The debentures held by the Trust are thesole assets of Pacific Northwest Statutory Trust I.  The Capital Securities are subject to mandatory redemption, inwhole or in part, upon repayment of the debentures.  The debentures will not mature earlier than September 26, 2007,and not later than September 26, 2012. The interest rate on the CapitalSecurities is based upon Three-Month LIBOR plus 3.55 percent and adjusts on aquarterly basis.  As of December 31,2002, the interest rate on the Capital Securities was 4.95 percent. Bancorpentered into agreements which, taken collectively, fully and unconditionallyguarantee the capital securities subject to the terms of each of theguarantees.

 

On November 15, 1999, $40.0 million of 9.875percent Capital Securities were issued by InterWest Capital Trust I (the TrustI).  The Trust I is a business trustorganized in November 1999, and Bancorp owns 100 percent of the common equityof the Trust I.  The proceeds of theoffering were invested by the Trust I in junior subordinated debentures ofBancorp.  The debentures held by theTrust I are the sole assets of the Trust I. Distributions on the capital securities issued by the Trust I arepayable semi-annually at 9.875 percent per annum, which is equal to theinterest rate being earned by the Trust I on the debentures that it held.  The capital securities are subject tomandatory redemption, in whole or in part, upon repayment of thedebentures.  The debentures will notmature earlier than November 15, 2009, and not later than November 15, 2029.Bancorp entered into agreements which, taken collectively, fully andunconditionally guarantee the capital securities subject to the terms of eachof the guarantees.  During 2002 and2001, Bancorp purchased $1.5 million and $2.5 million of the Trust I capitalsecurities in an effort to reduce funding costs.

 

PNWB used the proceeds forgeneral corporate purposes including stock repurchases and investment in thesubsidiary bank.  The capital securitiesqualify as Tier I capital under the capital guidelines of the Federal ReserveBoard.

 

**CAPITAL**

 

Bancorp is committed to managing capital for maximumshareholder benefit and maintaining strong protection for depositors andcreditors.  PNWB manages various capitallevels at both the holding company and subsidiary bank level to maintainadequate capital ratios and levels in accordance with external regulations andcapital guidelines established by the Board of Directors of eachinstitution.  See Note 18 of theConsolidated Financial Statements for detail of regulatory capital ratios forBancorp and Pacific Northwest Bank.

 

On January 22, 2002, the Boardof Directors approved a stock repurchase plan of up to five percent ofBancorp’s outstanding shares of common stock in the open market for thefollowing twelve-month period.  On September16, 2002, Bancorp completed the stock repurchase plan.  Under this plan, Bancorp repurchased andretired a total of 780,825 shares at an average price of $27.85.  On January 28, 2003, the Board of Directorsapproved another stock repurchase plan of up to five percent of Bancorp’soutstanding shares of common stock in the open market over the next twelvemonths.

 

17

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During the fourth quarter of2002, Bancorp issued approximately 1.7 million shares of Bancorp common stockas part of the Northwest merger consideration and this increased Bancorp’sshareholders’ equity by approximately 57.0 million.

 

PNWB’s total shareholders’equity was $261.6 million and book value per share was $15.57 as of December31, 2002.  PNWB’s total shareholders’equity was $200.5 million and book value per share was $12.86 as of December31, 2001.  In addition to the stockrepurchases and the stock issued for the BKNW acquisition, the increase inshareholders’ equity was also attributable to net income of $28.8 million,other comprehensive income of $2.4 million, the issuance of $3.0 million ofcommon stock through exercise of stock options, an increase in the estimatedfair value of securities available for sale (net of tax) of $2.4 million, andthe ESOP debt repayment of $0.5 million, partially offset by $8.8 million individends paid to shareholders.

 

During fiscal year 2002,Bancorp declared cash dividends totaling $0.56 per share, consistent with $0.56per share for the year ended December 31, 2001.

 

**LIQUIDITYRESOURCES**

 

Liquidity management focuses onthe need to meet both short-term funding requirements and PNWB’s long-termstrategies and goals.  Specifically, theobjective of liquidity management is to ensure the continuous availability offunds to meet the demands of depositors, creditors and borrowers.  Management structures the balance sheet tomeet these needs.  PNWB desires toattract and retain business and retail customer relationships with a focus ontransaction accounts and commercial and consumer lending.  PNWB also uses wholesale funds throughadvances from the FHLB and the sale of securities under agreements torepurchase to fund asset growth and meet liquidity needs.  Other sources of funds for liquidity includeloan repayments, loan sales, security sales, mortgage-backed and relatedsecurity repayments as well as wholesale and brokered certificates ofdeposit.  Repayments on loans andmortgage-backed and related securities and deposit inflows and outflows areaffected by changes in interest rates.

 

PNWB has capacity to borrowadditional funds from the FHLB through pre-approved credit lines.  These credit lines have pledge requirementswhereby PNWB must maintain unencumbered collateral with a par value at leastequal to the outstanding balance.  As ofDecember 31, 2002, the additional amount available under credit lines from theFHLB was $444.7 million.  Additionally,PNWB uses the securities market as a vehicle for borrowing by utilizing itssecurities available for sale as collateral. These borrowings are collateralized by securities with an estimated fairvalue exceeding the face value of the borrowings.  If the estimated fair value of the securities were to decline asa result of an increase in interest rates or other factors, PNWB would berequired to pledge additional securities or cash as collateral.  As of December 31, 2002, PNWB had $450.0million of available credit from third parties to sell securities underagreements to repurchase within six months or $150.0 million of availablecredit if the repurchase maturity is greater than six months.

 

The analysis of liquidity alsoincludes a review of PNWB’s consolidated statement of cash flows for 2002.  The consolidated statement of cash flowsdetails PNWB’s operating, investing and financing activities during theyear.  The most significant items underoperating activities include net income of $28.8 million.  Operating activities also include the addback of non-cash depreciation, amortization of intangible assets, provision forlosses on loans, and amortization of premium on investments totaling $15.8million.  Net cash provided by operatingactivities is also adjusted for the net gain on sale of loans and securitiesavailable for sale of $1.2 million and FHLB stock dividends of $3.0million.  Investing activities includedproceeds from the sale of securities available for sale of $53.9 million,proceeds from maturing and principal repayments on securities available forsale of $462.9 million and purchases of securities available for sale of $453.0million. Investing activities also include a $133.5 million increase in loansreceivable, $178.8 million of proceeds from the sale of loans, $50.0 millionpurchase of bank owned life insurance, and $17.8 million cash paid for the BKNWacquisition, net of cash acquired. During 2002, financing activities included $191.8 million in borrowingrepayments, net of borrowing proceeds, a $149.9 million increase in checking,savings and money market account deposits, $21.7 million purchase andretirement of common stock, $12.0 million of proceeds from issuance of PacificNorthwest Statutory Trust I capital securities, $1.5 million paid to purchaseInterwest Capital Trust I capital securities and $8.7 million paid in cashdividends to shareholders.

 

**SUPERVISIONAND REGULATION**

 

Bancorp is a registered bankholding company under the Bank Holding Company Act of 1956 (BHCA) and issubject to the supervision of, and regulation by, the Board of Governors of theFederal Reserve System (FRB).  Under theBHCA, Bancorp files with the FRB annual reports of operations and suchadditional information as the FRB may require. Under the BHCA, a bank holding company may engage in banking, managingor controlling banks, furnishing or performing services for banks it controls,and conducting activities that the FRB has determined to be closely related tobanking.

 

Pacific Northwest Bank is amember of the Federal Deposit Insurance Corporation (FDIC), and as such, issubject to examination thereby.  PacificNorthwest Bank is a state-chartered commercial bank subject to regulation andsupervision by the Washington Department of Financial Institutions Division ofBanks.  In practice, the primaryregulator makes regular examinations of the subsidiary bank subject to itsregulatory review or participates in joint examinations with otherregulators.  Areas subject to regulationby federal or state authorities include the allowance for losses on loans,investments, loans, mergers and acquisitions, issuance of securities, paymentof dividends, establishment of branches and other aspects of operations.

 

18

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The enforcement powersavailable to banking regulators are substantial and include, among otherthings, the ability to assess civil monetary penalties, to issuecease-and-desist or removal orders and to initiate injunctive actions againstbanking organizations and institution-affiliated parties, as defined.  In general, enforcement actions must beinitiated for violations of laws and regulations and unsafe or unsoundpractices.   Other actions, orinactions, may provide the basis for enforcement action, including misleadingor untimely reports filed with regulatory authorities.  Applicable law also requires public disclosureof final enforcement actions.

 

**MARKETRISK**

 

PNWB’s results of operationsare largely dependent upon its ability to manage interest rate risk. Managementconsiders interest rate risk to be a significant market risk that could have amaterial effect on PNWB’s financial condition and results of operations.

 

PNWB is sensitive to thepotential change in interest rates and the resulting impact on net interestincome.  It has been an objective ofmanagement to reduce this sensitivity through the use of adjustable rate loansand short-term commercial and consumer loans. This enables PNWB to better matchthe duration of its deposit base with these types of assets.

 

In addition to adjustable rateloans, PNWB uses a number of additional strategies to minimize the impact onnet income due to significant changes in interest rates. The strategiesutilized by PNWB include sales of long-term, fixed-rate mortgage loans,emphasis on growth in non-interest-bearing deposits, variable rateinterest-bearing checking, savings and money market account deposits as well asadjustable rate commercial lending.

 

Management uses simulationanalysis to measure PNWB’s interest sensitivity position.  This simulation analysis is used to evaluatethe effects of potential interest rate movements on net interest income.  The simulation analysis model is dynamic innature, and incorporates management’s current balance sheet strategy.   Management develops assumptions regardinginterest rate spreads, projected balances, expected maturities, cash flows andprepayment assumptions under different interest rate scenarios.

 

The table on the following pagesets forth the balances of PNWB’s financial instruments at the expectedmaturity dates, as well as the estimated fair value of those financial instrumentsas of December 31, 2002. The expected maturities take into considerationhistorical and estimated principal prepayments for loans and mortgage-backedsecurities.  Principal prepayments arethe amounts of principal reduction, over and above normal amortization.

 

The expected maturities forfinancial liabilities with no stated maturity reflect assumptions based onhistorical and estimated future roll-off rates. The roll-off rate fornon-interest-bearing deposits, interest-bearing checking accounts, money marketaccounts and savings accounts is 20 percent. The weighted average interestrates for financial instruments presented are actual as of December 31,2002.

 

The estimated fair valueamounts have been determined by PNWB using available market information andappropriate valuation methodologies. However, considerable judgment is necessary to interpret market data inthe development of the estimated fair value amounts.  Accordingly, the estimated fair values presented herein are notnecessarily indicative of the amounts PNWB could realize in a current marketexchange.  The use of different marketassumptions and/or estimation methodologies may have a material effect on theestimated fair value amounts. The carrying value of cash and due from banks,federal funds sold, securities purchased under agreements to resell andinterest receivable is a reasonable estimate of the fair value for suchfinancial assets.  The estimated fairvalues of securities available for sale and loans held for sale are based onquoted market rates and dealer quotes. The estimated fair value of loans receivable is based on discounted cashflows, using interest rates currently offered for loans of similarcharacteristics.  The estimated fairvalue of deposits with no stated maturity, such as checking accounts, moneymarket accounts and savings accounts, is equal to the amount payable on demandas of December 31, 2002.  The estimatedfair value of certificates of deposit is based on the present value ofcontractual cash flows using a discount rate based on the current average ratefor deposits with similar characteristics. The estimated fair value of FHLB advances and securities sold underagreements to repurchase is based on the present value of future cash flowsusing a discount rate equal to the rate offered on similar borrowings withsimilar maturities as of December 31, 2002. The estimated fair value of guaranteed preferred beneficial interests insubordinated debt is based on quoted market rates for subordinated debt with similarinterest rates and similar characteristics. The estimated fair values presented are based on information availableas of December 31, 2002.

 

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| **Expected maturity date  year ended December 31,  Dollars in thousands** |   | **2003** |   | **2004** |   | **2005** |   | **2006** |   | **2007** |   | **Thereafter** |   | **Total** |   | **Estimated  Fair Value** |   |
|---------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------------|--------|-----------|--------|---------------------------|--------|
|                                                                      |   |     |   |     |   |     |   |     |   |     |   |           |   |      |   |                      |   |
| MARKET RISK                                                               |   |     |   |     |   |     |   |     |   |     |   |           |   |      |   |                      |   |
|                                                                      |   |     |   |     |   |     |   |     |   |     |   |           |   |      |   |                      |   |
| *Financial Assets*                                                        |   |     |   |     |   |     |   |     |   |     |   |           |   |      |   |                      |   |
| Cash and due from banks                                                   |   |     |   |     |   |     |   |     |   |     |   |           |   |      |   |                      |   |
| Non-interest-bearing                                                      |   | $        | 92,541 |     | $      | —   |   | $        | — |     | $      | —         |   | $         | — |                      | $      | — |   | $ | 92,541 |   | $ | 92,541 |   |
| Interest-bearing                                                          |   | 6,122    |   | 843      |   | 496      |   | —   |   | —   |   | —         |   | 7,461     |   | 7,461                     |   |
| Weighted average interest rate                                            |   | 3.59     | %      | 3.87     | %      | 4.14     | %      | —   |   | —   |   | —         |   | 3.66      | %      |                      |   |
| Federal funds sold                                                        |   | 950      |   | —   |   | —   |   | —   |   | —   |   | —         |   | 950       |   | 950                       |   |
|                                                                      |   | 1.19     | %      | —   |   | —   |   | —   |   | —   |   | —         |   | 1.19      | %      |                      |   |
| Securities  available for sale                                            |   | 362,347  |   | 119,548  |   | 108,932  |   | 73,335   |   | 25,202   |   | 93,548         |   | 782,912   |   | 788,546                   |   |
| Weighted  average interest rate                                           |   | 5.03     | %      | 5.18     | %      | 5.38     | %      | 3.77     | %      | 4.10     | %      | 5.75           | %      | 5.04      | %      |                      |   |
| Loans  receivable, net                                                    |   |     |   |     |   |     |   |     |   |     |   |           |   |      |   |                      |   |
| Fixed  rate                                                               |   | 131,921  |   | 75,822   |   | 47,248   |   | 36,914   |   | 27,475   |   | 105,775        |   | 425,155   |   | 435,071                   |   |
| Weighted  average interest rate                                           |   | 7.32     | %      | 7.51     | %      | 7.72     | %      | 7.56     | %      | 7.20     | %      | 7.52           | %      | 7.46      | %      |                      |   |
| Variable  rate                                                            |   | 659,577  |   | 248,897  |   | 134,121  |   | 93,566   |   | 67,193   |   | 401,244        |   | 1,604,598 |   | 1,643,034                 |   |
| Weighted  average interest rate                                           |   | 6.51     | %      | 6.19     | %      | 6.22     | %      | 6.11     | %      | 5.85     | %      | 5.67           | %      | 6.18      | %      |                      |   |
| Loans  held for sale                                                      |   | 25,621   |   | —   |   | —   |   | —   |   | —   |   | —         |   | 25,621    |   | 26,571                    |   |
| Weighted  average interest rate                                           |   | 7.00     | %      | —   |   | —   |   | —   |   | —   |   | —         |   | 7.00      | %      |                      |   |
| Interest  receivable                                                      |   | 14,306   |   | —   |   | —   |   | —   |   | —   |   | —         |   | 14,306    |   | 14,306                    |   |
|                                                                      |   |     |   |     |   |     |   |     |   |     |   |           |   |      |   |                      |   |
| *Financial Liabilities*                                                   |   |     |   |     |   |     |   |     |   |     |   |           |   |      |   |                      |   |
| Non-interest-bearing deposits                                             |   | $        | 70,803 |     | $      | 68,692   |   | $        | 68,692 |     | $      | 68,692         |   | $         | 68,692 |                      | $      | — |   | $ | 345,571 |   | $ | 345,571 |   |
| Interest-bearing checking accounts                                        |   | 53,031   |   | 52,640   |   | 52,640   |   | 52,640   |   | 52,640   |   | —         |   | 263,591   |   | 263,591                   |   |
| Weighted average interest rate                                            |   | 0.29     | %      | 0.28     | %      | 0.28     | %      | 0.28     | %      | 0.28     | %      | —         |   | 0.28      | %      |                      |   |
| Money market accounts                                                     |   | 177,227  |   | 177,227  |   | 177,227  |   | 17       |   | —   |   | —         |   | 531,698   |   | 531,698                   |   |
| Weighted average interest rate                                            |   | 1.34     | %      | 1.34     | %      | 1.34     | %      | 1.34     | %      | 1.34     | %      | —         |   | 1.34      | %      |                      |   |
| Savings accounts                                                          |   | 21,749   |   | 21,743   |   | 21,743   |   | 21,743   |   | 21,743   |   | —         |   | 108,721   |   | 108,721                   |   |
| Weighted average interest rate                                            |   | 0.50     | %      | 0.50     | %      | 0.50     | %      | 0.50     | %      | 0.50     | %      | —         |   | 0.50      | %      |                      |   |
| Certificates of deposit                                                   |   | 563,307  |   | 101,581  |   | 45,742   |   | 10,071   |   | 82,138   |   | 1,892          |   | 804,729   |   | 823,066                   |   |
| Weighted average interest rate                                            |   | 2.58     | %      | 3.77     | %      | 4.52     | %      | 4.64     | %      | 5.05     | %      | 5.52           | %      | 3.13      | %      |                      |   |
| FHLB advances                                                             |   | 167,500  |   | 140,700  |   | 112,750  |   | 45,234   |   | 52,597   |   | 90,800         |   | 609,581   |   | 640,686                   |   |
| Weighted average interest rate                                            |   | 2.39     | %      | 3.95     | %      | 4.61     | %      | 4.62     | %      | 4.69     | %      | 5.25           | %      | 3.95      | %      |                      |   |
| Securities sold under agreements to  repurchase                           |   | 94,073   |   | 21,682   |   | 4,951    |   | —   |   | —   |   | —         |   | 120,706   |   | 122,558                   |   |
| Weighted  average interest rate                                           |   | 2.20     | %      | 4.11     | %      | 4.82     | %      | —   |   | —   |   | —         |   | 2.65      | %      |                      |   |
| Guaranteed  preferred beneficial interest in subordinated debt            |   | —   |   | —   |   | —   |   | —   |   | —   |   | 48,000         |   | 48,000    |   | 50,095                    |   |
| Weighted  average interest rate                                           |   | —   |   | —   |   | —   |   | —   |   | —   |   | 8.88           | %      | 8.88      | %      |                      |   |

 

While this table provides some information aboutPNWB’s interest sensitivity, it does not predict the trends of futureearnings.  For this reason, PNWB usesfinancial modeling to forecast earnings under different interest rateprojections.  While this modeling ishelpful in managing interest rate risk, it does require significant assumptionsfor the projection of loan prepayment rates, loan origination volumes andliability funding sources that may prove to be inaccurate.

 

**ACCOUNTINGCHANGES**

 

In January 2003, the FASBissued SFAS No. 148 “Accounting for Stock-Based Compensation-Transition andDisclosure”. SFAS No. 148 amends FASB Statement No. 123 “**Accounting for Stock-Based Compensation” and**providesalternative methods of transition for a voluntary change to the fair valuebased method of accounting for stock-based employee compensation. In addition,SFAS No. 148 amends the disclosure requirements of Statement 123 to requiremore prominent and quarterly disclosures in financial statements about theeffects of stock-based compensation. SFAS No. 148 became effective immediately for fiscal years ending afterDecember 15, 2002.  The adoption ofthis statement affected the disclosures in PNWB’s consolidated financial statements;however, it had no material impact on PNWB’s financial condition or results ofoperations.

 

In November 2002, the FASBissued Interpretation No. 45, “Guarantor’s Accounting and DisclosureRequirements for Guarantees, Including Indirect Guarantees of Indebtedness ofOthers” (FIN 45).  FIN 45 changescurrent practice in accounting for, and disclosure of, guarantees.  Guarantees meeting the characteristicsdescribed in FIN 45, which are not included in a list of exceptions, arerequired to be initially recorded at fair value.  FIN 45 also requires a guarantor to make new disclosures forguarantees even when the likelihood of the guarantor’s having to make paymentsunder the guarantee is remote.  FIN 45applies to PNWB’s accounting and disclosure of Standby 

 

20

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Letters of Credit.  FIN 45 became effective on a prospectivebasis to guarantees issued or modified after December 31, 2002.  The disclosure requirements in FIN 45 becameeffective for financial statements of periods ending after December 15,2002.   The adoption of FIN 45 had nomaterial impact on PNWB’s financial condition or results of operations.

 

In October 2002, the FASB issued SFAS No.147, *Acquisitionsof Certain Financial Institutions (SFAS 147)*. SFAS 147 addresses theaccounting for the acquisition of a financial institution, which had previouslybeen addressed in SFAS No. 72, *Accounting for Certain Acquisitions of Banking orThrift Institutions*. SFAS 72 required that the excess of the fair valueof liabilities assumed over the fair value of tangible and identifiableintangible assets be recognized as an unidentifiable intangible asset. SFAS 147amends SFAS 72 and states that this excess, if acquired in a businesscombination, represents goodwill that should be accounted for in accordancewith SFAS No. 142, *Goodwill and Other Intangible Assets*. PNWBadopted the provisions of SFAS 147 effective October 1, 2002 and applied theprovisions to the BKNW acquisition as well as historical acquisitions.  Such adoption had no impact on PNWB’sfinancial condition or statement of income.

 

In July 2002, the FASB issued SFAS No. 146“Accounting for Costs Associated with Exit or Disposal Activities”.  SFAS No. 146 addresses financial accountingand reporting for costs associated with exit or disposal activities andnullifies EITF Issue No. 94-3 “Liability Recognition for Certain EmployeeTermination Benefits and Other Costs to Exit an Activity (including CertainCosts Incurred in a Restructuring)”. SFAS No. 146 requires that a liability for a cost associated with anexit or disposal activity initiated after December 31, 2002 be recognized whenthe liability is incurred as opposed to when a plan is developed as required byEITF Issue No. 94-3.  SFAS No. 146 willbecome effective on January 1, 2003. Management does not expect the adoption of SFAS No. 146 to have amaterial impact on PNWB’s financial condition or results of operations.

 

In April 2002, the FASB issued SFAS No. 145“Rescission of FASB Statements No. 4, 44, and 62, Amendment of FASB StatementNo. 13, and Technical Corrections”. SFAS No. 145 rescinds the classification of extinguishment of debt asextraordinary as previously required under SFAS No. 4 and establishes newcriteria for the classification of gains and losses on extinguishment ofdebt.  SFAS No. 145 also amends SFAS No.13 to require certain modifications to capital leases be treated as asale-leaseback and modifies the accounting for sub-leases when the originallessee remains a secondary obligor. SFAS No. 145 will become effective onJanuary 1, 2003 with the exception of the amendment and technical correctionsrelated to SFAS No. 13, which were effective on May 15, 2002.  Management does not expect the adoption ofSFAS No. 145 to have a material impact on PNWB’s financial condition or resultsof operations.

 

In July 2001, the FASB issued SFAS No. 142 “Accountingfor Goodwill and Other Intangible Assets”. Under SFAS No. 142, goodwill and indefinite lived intangible assets areno longer amortized but are reviewed annually for impairment or more frequentlyif impairment indicators arise. Separable intangible assets that are not deemed to have an indefinitelife will continue to be amortized over their useful lives.  This Statement became effective on January1, 2002.  PNWB performed thetransitional impairment assessment of its goodwill as of January 1, 2002 andnoted that such assessment did not indicate any impairment of goodwill.  The adoption of SFAS No. 142 reduces PNWB’sgoodwill amortization expense by approximately $1.1 million on an annualbasis.  A reconciliation of reported netincome to net income adjusted to exclude goodwill amortization for the yearsended December 31, 2002, 2001 and 2000 is as follows:

 
| **Dollars in thousands, except per share amount** |   | **Year ended  December 31,  2002** |   | **Year ended  December 31,  2001** |   | **Year ended  December 31,  2000** |   |
|---------------------------------------------------|--------|------------------------------------|--------|------------------------------------|--------|------------------------------------|--------|
|                                              |   |                               |   |                               |   |                               |   |
| Income statement:                                 |   |                               |   |                               |   |                               |   |
| Reported net income                               |   | $                                  | 28,760 |                               | $      | 22,092                             |   | $ | 6,269 |   |
| Adjustment for goodwill amortization              |   | —                             |   | 1,121                              |   | 1,115                              |   |
| Adjusted net income                               |   | $                                  | 28,760 |                               | $      | 23,213                             |   | $ | 7,384 |   |
|                                              |   |                               |   |                               |   |                               |   |
| Basic net income per share:                       |   |                               |   |                               |   |                               |   |
| Reported basic net income per share               |   | $                                  | 1.85   |                               | $      | 1.42                               |   | $ | 0.40 |   |
| Adjustment for goodwill amortization              |   | —                             |   | 0.07                               |   | 0.08                               |   |
| Adjusted basic net income per share               |   | $                                  | 1.85   |                               | $      | 1.49                               |   | $ | 0.48 |   |
|                                              |   |                               |   |                               |   |                               |   |
| Diluted net income per share:                     |   |                               |   |                               |   |                               |   |
| Reported diluted net income per share             |   | $                                  | 1.80   |                               | $      | 1.40                               |   | $ | 0.40 |   |
| Adjustment for goodwill amortization              |   | —                             |   | 0.08                               |   | 0.07                               |   |
| Adjusted diluted net income per share             |   | $                                  | 1.80   |                               | $      | 1.48                               |   | $ | 0.47 |   |

 

In June 1998, the FinancialAccounting and Standards Board (FASB) issued SFAS No. 133 “Accounting forDerivative Instruments and Hedging Activities.”  In June 2000, the FASB issued SFAS No. 138, which amended certainprovisions of SFAS No. 133 to clarify specific areas presenting difficulties inimplementation.  SFAS No. 133, asamended by SFAS No. 138, establishes accounting and reporting standards forderivative instruments, including certain derivative instruments imbedded inother contracts, and for hedging activities. It requires the recognition of all derivatives as either assets orliabilities in the statement of financial condition and the measurement ofthose instruments at estimated fair value. In certain defined conditions, a derivative may be specificallydesignated as a hedge for a particular exposure. The accounting for derivativesdepends on the intended use of the derivatives and the resulting 

 

21

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designation.  This statement was adopted by PNWB onJanuary 1, 2001. The adoption of this statement did not have a material impacton PNWB’s financial condition or results of operations.  As permitted by the provisions of thisstatement, PNWB transferred all securities held to maturity to securitiesavailable for sale on January 1, 2001. This transfer resulted in a decrease ofother comprehensive income of $597,000, net of income taxes of $321,000.

 

22

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**REPORTOF MANAGEMENT TO SHAREHOLDERS**

 

Management of Pacific NorthwestBancorp is responsible for the preparation, integrity and fair presentation ofits published financial statements.  Theconsolidated financial statements have been prepared in accordance with accountingprinciples generally accepted in the United States and include judgments andestimates of management.  PacificNorthwest Bancorp’s management also prepared the other information included inthis report and is responsible for its accuracy and consistency with theconsolidated financial statements.

 

Management is responsible forestablishing and maintaining an effective internal control structure overfinancial reporting.  The internalcontrol system is supported by written policies and procedures and by auditsperformed by an internal audit staff that reports to the Audit Committee of theBoard of Directors.  Internal auditorsmonitor the operation of the internal control system and report findings tomanagement and the Audit Committee, and corrective actions are taken to addressidentified control deficiencies and other opportunities for improving thesystem.  The Audit Committee providesoversight to the financial reporting process. There are inherent limitations in the effectiveness of any system of internalcontrol, including the possibility of human error and circumvention oroverriding of controls.  Accordingly,even an effective internal control system can provide only reasonable assurancewith respect to financial statement preparation.  The concept of reasonable assurance is based on the recognitionthat the costs of such a system should not exceed the benefits to bereceived.  Management believes thesystem provides an appropriate cost/benefit balance.

 

Management assesses PacificNorthwest Bancorp’s internal control structure over financial reporting.  Based on these assessments, managementbelieves that Pacific Northwest Bancorp maintains an effective internal controlsystem over financial reporting.

 
| Patrick M.  Fahey                      | Bette J.  Floray                                      |
|----------------------------------------|-------------------------------------------------------|
| President and  Chief Executive Officer | Executive  Vice President and Chief Financial Officer |

 

**REPORTOF ERNST & YOUNG LLP, INDEPENDENT AUDITORS**

 

To the Board of Directors andShareholders

Pacific Northwest Bancorp

 

We have audited theaccompanying consolidated statements of financial condition of PacificNorthwest Bancorp as of December 31, 2002 and 2001, and the related consolidated statements of income,shareholders’ equity, and cash flows for each of the three years in the periodended December 31, 2002.  These consolidated financial statements arethe responsibility of Pacific Northwest Bancorp’s management.  Our responsibility is to express an opinionon these consolidated financial statements based on our audits.

 

We conducted our audits inaccordance with auditing standards generally accepted in the UnitedStates.  Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the consolidated financial position of Pacific Northwest Bancorpat December 31, 2002and 2001, and the consolidatedresults of their operations and their cash flows for the each of the threeyears in the period ended December 31, 2002in conformity with accounting principles generally accepted in the UnitedStates.

 

As described in note 2 to theconsolidated financial statements, Pacific Northwest Bancorp adopted certainnew accounting standards in fiscal 2002 as required by the Financial AccountingStandards Board.

 
| **Seattle,  Washington** | ***Ernst &  Young LLP*** |
|--------------------------|------------------------------|
| **January  31, 2003**    |                         |

 

23

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**CONSOLIDATEDSTATEMENTS OF FINANCIAL CONDITION**

 
| **Dollars in thousands  As of December 31,**                                                                                                     |   | **2002**  |      | **2001**  |   |
|--------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------|-----------|-----------|--------|
|                                                                                                                                             |   |      |      |      |   |
| *Assets*                                                                                                                                         |   |      |      |      |   |
|                                                                                                                                             |   |      |      |      |   |
| Cash and due from banks                                                                                                                          |   |      |      |      |   |
| Non-interest-bearing                                                                                                                             |   | $         | 92,541    |      | $      | 58,134 |   |
| Interest-bearing                                                                                                                                 |   | 7,461     |      | 491       |   |
| Federal funds sold and securities purchased  under agreements to resell                                                                          |   | 950       |      | —    |   |
| Securities available for sale, at estimated  fair value                                                                                          |   | 788,546   |      | 757,018   |   |
| Loans held for sale (estimated fair value:  2002-$26,571 and 2001-$43,872)                                                                       |   | 25,621    |      | 43,757    |   |
| Loans  receivable                                                                                                                                |   | 2,029,753 |      | 1,808,555 |   |
| Allowance for losses on loans                                                                                                                    |   | (26,940   | )         | (20,123   | )      |
|                                                                                                                                             |   |      |      |      |   |
| Net loans receivable                                                                                                                             |   | 2,002,813 |      | 1,788,432 |   |
|                                                                                                                                             |   |      |      |      |   |
| Interest  receivable                                                                                                                             |   | 14,306    |      | 14,808    |   |
| Other real  estate                                                                                                                               |   | 7,152     |      | 5,762     |   |
| Premises and  equipment, net                                                                                                                     |   | 48,082    |      | 50,837    |   |
| Goodwill                                                                                                                                         |   | 67,732    |      | 16,137    |   |
| Other  intangible assets                                                                                                                         |   | 10,505    |      | 1,985     |   |
| Bank owned  life insurance                                                                                                                       |   | 56,995    |      | —    |   |
| Other assets                                                                                                                                     |   | 4,305     |      | 4,147     |   |
|                                                                                                                                             |   |      |      |      |   |
| Total assets                                                                                                                                     |   | $         | 3,127,009 |      | $      | 2,741,508 |   |
|                                                                                                                                             |   |      |      |      |   |
| *Liabilities*                                                                                                                                    |   |      |      |      |   |
|                                                                                                                                             |   |      |      |      |   |
| Deposits                                                                                                                                         |   |      |      |      |   |
| Non-interest-bearing                                                                                                                             |   | $         | 345,571   |      | $      | 241,674 |   |
| Interest-bearing                                                                                                                                 |   | 1,708,739 |      | 1,363,181 |   |
| Total deposits                                                                                                                                   |   | 2,054,310 |      | 1,604,855 |   |
|                                                                                                                                             |   |      |      |      |   |
| Federal Home Loan Bank (FHLB) advances                                                                                                           |   | 609,581   |      | 714,526   |   |
| Securities sold under agreements to  repurchase                                                                                                  |   | 120,706   |      | 149,504   |   |
| Guaranteed preferred beneficial interests  in subordinated debt                                                                                  |   | 48,000    |      | 37,500    |   |
| Other borrowings                                                                                                                                 |   | 10,072    |      | 12,621    |   |
| Other liabilities                                                                                                                                |   | 22,727    |      | 22,016    |   |
|                                                                                                                                             |   |      |      |      |   |
| Total liabilities                                                                                                                                |   | 2,865,396 |      | 2,541,022 |   |
|                                                                                                                                             |   |      |      |      |   |
| *Shareholders’ Equity*                                                                                                                      |   |      |      |      |   |
| Common stock, no par  value   Authorized shares 30,000,000   Issued and outstanding: 2002—16,799,472 shares and 2001—15,595,204 shares |   | —    |      | —    |   |
| Paid-in capital                                                                                                                                  |   | 64,995    |      | 26,757    |   |
| Retained earnings                                                                                                                                |   | 192,942   |      | 172,967   |   |
| Debt  related to employee stock ownership plan (ESOP)                                                                                            |   | —    |      | (543      | )      |
| Accumulated other comprehensive income:                                                                                                          |   |      |      |      |   |
| Unrealized gain on securities available for  sale, net of tax                                                                                    |   | 3,676     |      | 1,305     |   |
| Total  shareholders’ equity                                                                                                                 |   | 261,613   |      | 200,486   |   |
| Total  liabilities and shareholders’ equity                                                                                                 |   | $         | 3,127,009 |      | $      | 2,741,508 |   |

 

*See Notes to Consolidated Financial Statements*

 

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**CONSOLIDATEDSTATEMENTS OF INCOME**
| **Dollars in thousands, except per share amounts**              |   | **Year ended  December 31,  2002** |     | **Year ended  December 31,  2001** |     | **Year ended  December 31,  2000** |     |
|-----------------------------------------------------------------|--------|------------------------------------|----------|------------------------------------|----------|------------------------------------|----------|
|                                                            |   |                               |     |                               |     |                               |     |
| *Interest Income*                                               |   |                               | * * |                               | * * |                               | * * |
|                                                            |   |                               |     |                               |     |                               |     |
| Loans receivable and loans held for sale                        |   | $                                  | 137,750  |                               | $        | 153,936                            |     | $ | 159,870 |   |
| Securities available for sale                                   |   | 40,211                             |     | 51,116                             |     | 52,402                             |     |
| Securities held to maturity                                     |   | —                             |     | —                             |     | 4,345                              |     |
| Other                                                           |   | 171                                |     | 601                                |     | 1,571                              |     |
|                                                            |   | 178,132                            |     | 205,653                            |     | 218,188                            |     |
| *Interest Expense*                                              |   |                               |     |                               |     |                               |     |
|                                                            |   |                               |     |                               |     |                               |     |
| Deposits                                                        |   | 36,992                             |     | 58,475                             |     | 63,805                             |     |
| FHLB advances and other borrowings                              |   | 25,279                             |     | 30,972                             |     | 43,113                             |     |
| Securities sold under agreements to  repurchase                 |   | 3,704                              |     | 10,498                             |     | 17,787                             |     |
| Guaranteed preferred beneficial interests  in subordinated debt |   | 3,770                              |     | 3,896                              |     | 3,950                              |     |
|                                                            |   | 69,745                             |     | 103,841                            |     | 128,655                            |     |
|                                                            |   |                               |     |                               |     |                               |     |
| Net interest income                                             |   | 108,387                            |     | 101,812                            |     | 89,533                             |     |
| Provision for losses on loans                                   |   | 6,350                              |     | 6,050                              |     | 4,750                              |     |
| Net interest income after provision for  losses on loans        |   | 102,037                            |     | 95,762                             |     | 84,783                             |     |
|                                                            |   |                               |     |                               |     |                               |     |
| *Non-Interest Income*                                           |   |                               | * * |                               | * * |                               | * * |
|                                                            |   |                               |     |                               |     |                               |     |
| Service fees                                                    |   | 13,443                             |     | 11,669                             |     | 11,871                             |     |
| Gain on sale of loans                                           |   | 2,601                              |     | 2,312                              |     | 905                                |     |
| Investment product fees and insurance  commissions              |   | 1,665                              |     | 2,294                              |     | 2,869                              |     |
| Bank owned life insurance                                       |   | 1,685                              |     | —                             |     | —                             |     |
| Gain (loss) on sale of securities available  for sale           |   | (1,425                             | )        | 1,709                              |     | (6,113                             | )        |
| Other                                                           |   | 1,291                              |     | 2,701                              |     | 2,581                              |     |
|                                                            |   | 19,260                             |     | 20,685                             |     | 12,113                             |     |
| *Non-Interest Expense*                                          |   |                               | * * |                               | * * |                               | * * |
|                                                            |   |                               |     |                               |     |                               |     |
| Compensation and employee benefits                              |   | 39,300                             |     | 39,018                             |     | 39,398                             |     |
| General and administrative                                      |   | 17,592                             |     | 20,716                             |     | 15,679                             |     |
| Occupancy and equipment                                         |   | 12,471                             |     | 12,217                             |     | 10,626                             |     |
| Data processing                                                 |   | 5,724                              |     | 6,208                              |     | 5,510                              |     |
| Other real estate owned                                         |   | 184                                |     | 207                                |     | 2,327                              |     |
| Amortization of goodwill                                        |   | —                             |     | 1,121                              |     | 1,115                              |     |
| Amortization of core deposit intangible                         |   | 254                                |     | 175                                |     | 175                                |     |
| Merger, conversion and integration                              |   | 1,025                              |     | 1,290                              |     | 7,361                              |     |
| Severance and employment agreements                             |   | 963                                |     | 200                                |     | 3,325                              |     |
| Impairment of goodwill                                          |   | —                             |     | —                             |     | 749                                |     |
|                                                            |   | 77,513                             |     | 81,152                             |     | 86,265                             |     |
|                                                            |   |                               |     |                               |     |                               |     |
| Income before income taxes                                      |   | 43,784                             |     | 35,295                             |     | 10,631                             |     |
| Income tax expense                                              |   | 15,024                             |     | 13,203                             |     | 4,362                              |     |
|                                                            |   |                               |     |                               |     |                               |     |
| Net income                                                      |   | $                                  | 28,760   |                               | $        | 22,092                             |     | $ | 6,269 |   |
|                                                            |   |                               |     |                               |     |                               |     |
| Basic net income per share                                      |   | $                                  | 1.85     |                               | $        | 1.42                               |     | $ | 0.40 |   |
|                                                            |   |                               |     |                               |     |                               |     |
| Diluted net income per share                                    |   | $                                  | 1.80     |                               | $        | 1.40                               |     | $ | 0.40 |   |

 

*See Notes to Consolidated FinancialStatements*

 

25

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**CONSOLIDATEDSTATEMENTS OF SHAREHOLDERS’ EQUITY**

 
|                                                                                                                                              |   | **Common  Stock,  No Par Value  Shares** |       | **Paid-In  Capital** |       | **Retained  Earnings** |   | **Debt  Related  to ESOP** |       | **Accumulated  Other  Comprehensive  Income (Loss)** |       | **Total**  |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------------------|------------|----------------------|------------|------------------------|--------|----------------------------|------------|------------------------------------------------------|------------|------------|--------|
| **Dollars in thousands, except share data**                                                                                                       |   |                                     |       |                 |       |                   |   |                       |       |                                                 |       |       |   |
| **January 1, 2000**                                                                                                                               |   | 15,800,377                               |       | $                    | 33,297     |                   | $      | 162,043                    |       | $                                                    | (2,980     | )          | $      | (20,640 | ) | $ | 171,720 |   |
| Dividends declared, $0.56 per share                                                                                                               |   |                                     |       |                 |       | (8,699                 | )      |                       |       |                                                 |       | (8,699     | )      |
| Issuance of common stock:                                                                                                                         |   |                                     |       |                 |       |                   |   |                       |       |                                                 |       |       |   |
| Stock option plans                                                                                                                                |   | 111,964                                  |       | 779                  |       |                   |   |                       |       |                                                 |       | 779        |   |
| Stock grants                                                                                                                                      |   | 2,455                                    |       | 75                   |       |                   |   |                       |       |                                                 |       | 75         |   |
| Purchase and retirement of common stock                                                                                                           |   | (468,000                                 | )          | (7,860               | )          |                   |   |                       |       |                                                 |       | (7,860     | )      |
| ESOP debt repayment                                                                                                                               |   | 47,561                                   |       |                 |       |                   |   | 1,312                      |       |                                                 |       | 1,312      |   |
| Comprehensive income:                                                                                                                             |   |                                     |       |                 |       |                   |   |                       |       |                                                 |       |       |   |
| Net income                                                                                                                                        |   |                                     |       |                 |       | 6,269                  |   |                       |       |                                                 |       | 6,269      |   |
| Other comprehensive income -                                                                                                                      |   |                                     |       |                 |       |                   |   |                       |       |                                                 |       |       |   |
| Unrealized gain on securities available for  sale, net of taxes of $6,013                                                                         |   |                                     |       |                 |       |                   |   |                       |       | 11,167                                               |       | 11,167     |   |
| Reclassification adjustment for losses  included in net income, net of taxes of $2,140                                                            |   |                                     |       |                 |       |                   |   |                       |       | 3,973                                                |       | 3,973      |   |
| Total comprehensive income                                                                                                                        |   |                                     |       |                 |       |                   |   |                       |       |                                                 |       | 21,409     |   |
| **December 31, 2000**                                                                                                                             |   | 15,494,357                               |       | $                    | 26,291     |                   | $      | 159,613                    |       | $                                                    | (1,668     | )          | $      | (5,500 | ) | $ | 178,736 |   |
|                                                                                                                                              |   |                                     |       |                 |       |                   |   |                       |       |                                                 |       |       |   |
| Dividends declared, $0.56 per share                                                                                                               |   |                                     |       |                 |       | (8,738                 | )      |                       |       |                                                 |       | (8,738     | )      |
| Issuance of common stock:                                                                                                                         |   |                                     |       |                 |       |                   |   |                       |       |                                                 |       |       |   |
| Stock option plans                                                                                                                                |   | 77,597                                   |       | 808                  |       |                   |   |                       |       |                                                 |       | 808        |   |
| Purchase and retirement of common stock                                                                                                           |   | (15,921                                  | )          | (342                 | )          |                   |   |                       |       |                                                 |       | (342       | )      |
| ESOP debt repayment                                                                                                                               |   | 39,171                                   |       |                 |       |                   |   | 1,125                      |       |                                                 |       | 1,125      |   |
| Comprehensive income:                                                                                                                             |   |                                     |       |                 |       |                   |   |                       |       |                                                 |       |       |   |
| Net income                                                                                                                                        |   |                                     |       |                 |       | 22,092                 |   |                       |       |                                                 |       | 22,092     |   |
| Other comprehensive income (loss) -                                                                                                               |   |                                     |       |                 |       |                   |   |                       |       |                                                 |       |       |   |
| Cumulative effect of adoption of SFAS No.  133, Transfer of securities held to maturity to securities available for  sale, net of taxes of $(321) |   |                                     |       |                 |       |                   |   |                       |       | (597                                                 | )          | (597       | )      |
| Unrealized gain on securities available for  sale, net of taxes of $4,584                                                                         |   |                                     |       |                 |       |                   |   |                       |       | 8,513                                                |       | 8,513      |   |
| Reclassification adjustment for gains  included in net income, net of taxes of $(598)                                                             |   |                                     |       |                 |       |                   |   |                       |       | (1,111                                               | )          | (1,111     | )      |
| Total comprehensive income                                                                                                                        |   |                                     |       |                 |       |                   |   |                       |       |                                                 |       | 28,895     |   |
| **December 31, 2001**                                                                                                                             |   | **15,595,204**                           | ** ** | **$**                | **26,757** | ** **             | **$**  | **172,967**                | ** ** | **$**                                                | **(543**   | **)**      | **$**  | **1,305** | ** ** | **$** | **200,486** | ** ** |
|                                                                                                                                              |   |                                     |       |                 |       |                   |   |                       |       |                                                 |       |       |   |
| Dividends declared, $0.56 per share                                                                                                               |   |                                     |       |                 |       | (8,785                 | )      |                       |       |                                                 |       | (8,785     | )      |
| Issuance of common stock:                                                                                                                         |   |                                     |       |                 |       |                   |   |                       |       |                                                 |       |       |   |
| Acquisition                                                                                                                                       |   | 1,749,882                                |       | 56,960               |       |                   |   |                       |       |                                                 |       | 56,960     |   |
| Stock option plans                                                                                                                                |   | 217,547                                  |       | 3,024                |       |                   |   |                       |       |                                                 |       | 3,024      |   |
| Purchase and retirement of common stock                                                                                                           |   | (780,825                                 | )          | (21,746              | )          |                   |   |                       |       |                                                 |       | (21,746    | )      |
| ESOP debt repayment                                                                                                                               |   | 17,664                                   |       |                 |       |                   |   | 543                        |       |                                                 |       | 543        |   |
| Comprehensive income:                                                                                                                             |   |                                     |       |                 |       |                   |   |                       |       |                                                 |       |       |   |
| Net income                                                                                                                                        |   |                                     |       |                 |       | 28,760                 |   |                       |       |                                                 |       | 28,760     |   |
| Other comprehensive income -                                                                                                                      |   |                                     |       |                 |       |                   |   |                       |       |                                                 |       |       |   |
| Unrealized gain on securities available for  sale, net of taxes of $778                                                                           |   |                                     |       |                 |       |                   |   |                       |       | 1,444                                                |       | 1,444      |   |
| Reclassification adjustment for losses  included in net income, net of taxes of $499                                                              |   |                                     |       |                 |       |                   |   |                       |       | 927                                                  |       | 927        |   |
| Total comprehensive income                                                                                                                        |   |                                     |       |                 |       |                   |   |                       |       |                                                 |       | 31,131     |   |
| **December 31, 2002**                                                                                                                             |   | **16,799,472**                           | ** ** | **$**                | **64,995** | ** **             | **$**  | **192,942**                | ** ** | **$**                                                | **—** | ** ** | **$**  | **3,676** | ** ** | **$** | **261,613** | ** ** |

 

*See Notes to Consolidated Financial Statements*

 

26

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**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

 
| **Dollars in thousands**                                                                            |   | **Year ended  December 31,  2002** |   | **Year ended  December 31,  2001** |   | **Year ended  December 31,  2000** |   |
|-----------------------------------------------------------------------------------------------------|--------|------------------------------------|--------|------------------------------------|--------|------------------------------------|--------|
| *Operating Activities*                                                                              |   |                               |   |                               |   |                               |   |
|                                                                                                |   |                               |   |                               |   |                               |   |
| Net  income                                                                                         |   | $                                  | 28,760 |                               | $      | 22,092                             |   | $ | 6,269 |   |
| Adjustments  to reconcile net income to net cash provided by operating activities:                  |   |                               |   |                               |   |                               |   |
| Depreciation                                                                                        |   | 5,249                              |   | 6,157                              |   | 5,544                              |   |
| Amortization  of goodwill                                                                           |   | —                             |   | 1,121                              |   | 1,115                              |   |
| Amortization  of other intangible assets                                                            |   | 981                                |   | 1,459                              |   | 927                                |   |
| Impairment  of goodwill                                                                             |   | —                             |   | —                             |   | 749                                |   |
| Provision  for losses on loans                                                                      |   | 6,350                              |   | 6,050                              |   | 4,750                              |   |
| Gain  on sale of other real estate                                                                  |   | (200                               | )      | (607                               | )      | (177                               | )      |
| Loss  from real estate write-downs                                                                  |   | 311                                |   | 592                                |   | 2,168                              |   |
| Amortization  (accretion) of premiums and discounts, net                                            |   | 3,229                              |   | (180                               | )      | (76                                | )      |
| Gain  on sale of loans                                                                              |   | (2,601                             | )      | (2,312                             | )      | (905                               | )      |
| (Gain)  loss on sale of securities available for sale                                               |   | 1,425                              |   | (1,709                             | )      | 6,113                              |   |
| Loss  on disposal of premises and equipment                                                         |   | 240                                |   | 239                                |   | —                             |   |
| Loan  fees deferred, net of amortization                                                            |   | 474                                |   | 2,121                              |   | 630                                |   |
| FHLB  stock dividends                                                                               |   | (2,978                             | )      | (3,126                             | )      | (2,846                             | )      |
| Income  from bank owned life insurance                                                              |   | (1,685                             | )      | —                             |   | —                             |   |
| Deferred  income tax expense (benefit)                                                              |   | 1,190                              |   | (678                               | )      | (2,984                             | )      |
|                                                                                                |   |                               |   |                               |   |                               |   |
| Changes  in operating assets and liabilities:                                                       |   |                               |   |                               |   |                               |   |
| (Increase)  decrease in interest receivable                                                         |   | 2,702                              |   | 4,879                              |   | (2,981                             | )      |
| (Increase)  decrease in other assets                                                                |   | 7,186                              |   | 5,582                              |   | (5,059                             | )      |
| Increase  (decrease) in other liabilities                                                           |   | (8,136                             | )      | (8,041                             | )      | 13,924                             |   |
|                                                                                                |   |                               |   |                               |   |                               |   |
| Net  cash provided by operating activities                                                          |   | $                                  | 42,497 |                               | $      | 33,638                             |   | $ | 27,161 |   |
|                                                                                                |   |                               |   |                               |   |                               |   |
| *Investing Activities*                                                                              |   |                               |   |                               |   |                               |   |
|                                                                                                |   |                               |   |                               |   |                               |   |
| Proceeds  from sale of securities available for sale                                                |   | 53,912                             |   | 151,402                            |   | 156,540                            |   |
| Purchases  of securities available for sale                                                         |   | (453,012                           | )      | (373,172                           | )      | (156,891                           | )      |
| Proceeds  from maturing and principal repayments on securities available for sale                   |   | 462,901                            |   | 385,443                            |   | 87,320                             |   |
| Proceeds  from maturing and principal repayments on securities held to maturity                     |   | —                             |   | —                             |   | 4,094                              |   |
| Proceeds  from sale of loans                                                                        |   | 178,838                            |   | 143,289                            |   | 160,524                            |   |
| Net  increase in loans receivable                                                                   |   | (133,506                           | )      | (212,839                           | )      | (371,793                           | )      |
| Proceeds  from sale of other real estate                                                            |   | 7,432                              |   | 9,653                              |   | 7,654                              |   |
| Purchases  of premises and equipment                                                                |   | (3,519                             | )      | (4,889                             | )      | (10,452                            | )      |
| Proceeds  from sale of premises and equipment                                                       |   | 1,481                              |   | 5,200                              |   | —                             |   |
| Purchases  of bank owned life insurance                                                             |   | (50,000                            | )      | —                             |   | —                             |   |
| Purchases  of FHLB stock                                                                            |   | —                             |   | —                             |   | (770                               | )      |
| Redemption  of FHLB stock                                                                           |   | —                             |   | —                             |   | 5,000                              |   |
| Cash  paid for acquisition, net of cash received                                                    |   | (17,806                            | )      | —                             |   | —                             |   |
| Improvements  capitalized to other real estate                                                      |   | (641                               | )      | (1,367                             | )      | (2,081                             | )      |
| Net  decrease (increase) in federal funds sold and securities purchased under  agreements to resell |   | (5                                 | )      | 7,467                              |   | (7,467                             | )      |
|                                                                                                |   |                               |   |                               |   |                               |   |
| Net  cash provided by (used in) investing activities                                                |   | $                                  | 46,075 |                               | $      | 110,187                            |   | $ | (128,322 | ) |

 

*See Notes to Consolidated Financial Statements*

 

27

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**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

 
| **Dollars in thousands**                                                                            |   | **Year ended  December 31,  2002** |    | **Year ended  December 31,  2001** |   | **Year ended  December 31,  2000** |   |
|-----------------------------------------------------------------------------------------------------|--------|------------------------------------|---------|------------------------------------|--------|------------------------------------|--------|
| *Financing Activities*                                                                              |   |                               |    |                               |   |                               |   |
|                                                                                                |   |                               |    |                               |   |                               |   |
| Net  increase in deposits                                                                           |   | $                                  | 149,891 |                               | $      | 50,626                             |   | $ | 29,825 |   |
| Net  increase (decrease) in certificates of deposit                                                 |   | 11,566                             |    | (162,878                           | )      | 89,093                             |   |
| Proceeds  from FHLB advances, securities sold under agreements to repurchase, and other  borrowings |   | 5,021,871                          |    | 3,803,363                          |   | 1,753,541                          |   |
| Repayment  of FHLB advances, securities sold under agreements to repurchase, and other  borrowings  |   | (5,213,670                         | )       | (3,857,459                         | )      | (1,789,615                         | )      |
| Proceeds  from issuance of notes payable                                                            |   | —                             |    | 12,000                             |   | —                             |   |
| Proceeds  from issuance of Pacific Northwest Statutory Trust I - capital  securities                |   | 12,000                             |    | —                             |   | —                             |   |
| Purchase  of InterWest Capital Trust I - capital securities                                         |   | (1,500                             | )       | (2,500                             | )      | —                             |   |
| Dividends  paid to shareholders                                                                     |   | (8,631                             | )       | (8,712                             | )      | (8,770                             | )      |
| Issuance  of common stock from exercise of stock options                                            |   | 3,024                              |    | 808                                |   | 779                                |   |
| Purchase  and retirement of common stock                                                            |   | (21,746                            | )       | (342                               | )      | (7,860                             | )      |
|                                                                                                |   |                               |    |                               |   |                               |   |
| Net  cash provided by (used in) financing activities                                                |   | (47,195                            | )       | (165,094                           | )      | 66,993                             |   |
|                                                                                                |   |                               |    |                               |   |                               |   |
| Net  increase (decrease) in cash and cash equivalents                                               |   | 41,377                             |    | (21,269                            | )      | (34,168                            | )      |
|                                                                                                |   |                               |    |                               |   |                               |   |
| Cash and due  from banks:                                                                           |   |                               |    |                               |   |                               |   |
|                                                                                                |   |                               |    |                               |   |                               |   |
| Beginning  of year                                                                                  |   | 58,625                             |    | 79,894                             |   | 114,062                            |   |
|                                                                                                |   |                               |    |                               |   |                               |   |
| End  of year                                                                                        |   | $                                  | 100,002 |                               | $      | 58,625                             |   | $ | 79,894 |   |
|                                                                                                |   |                               |    |                               |   |                               |   |
| *Supplemental Disclosures of Cash Flow Information*                                                 |   |                               |    |                               |   |                               |   |
|                                                                                                |   |                               |    |                               |   |                               |   |
| Cash  paid during the year for:                                                                     |   |                               |    |                               |   |                               |   |
| Interest                                                                                            |   | $                                  | 75,684  |                               | $      | 108,594                            |   | $ | 122,465 |   |
| Income  taxes                                                                                       |   | 18,500                             |    | 10,800                             |   | 9,630                              |   |
|                                                                                                |   |                               |    |                               |   |                               |   |
| Non-cash  investing and financing activities:                                                       |   |                               |    |                               |   |                               |   |
| Fair  value of assets acquired, net                                                                 |   | 33,300                             |    | —                             |   | —                             |   |
| Loans  receivable transferred to other real estate                                                  |   | 8,292                              |    | 3,202                              |   | 8,214                              |   |
| Premises  and equipment transferred to other real estate                                            |   | —                             |    | 923                                |   | 279                                |   |
| Loans  receivable securitized as securities available for sale                                      |   | —                             |    | —                             |   | 120,169                            |   |
| Transfer  of securities from held to maturity to available for sale                                 |   | —                             |    | 64,741                             |   | —                             |   |
| ESOP  debt repayment                                                                                |   | 543                                |    | 1,125                              |   | 1,312                              |   |
|                                                                                                |   |                               |    |                               |   |                               |   |

 

*See Notes to Consolidated FinancialStatements*

 

28

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**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

 

**NOTE 1**SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES

 

*NATURE OF BUSINESS*|Pacific Northwest Bancorp is a bank holding company incorporated in Washingtonstate.  Through its commercial banksubsidiary, Pacific Northwest Bank, a wide range of financial services areoffered to individuals and businesses throughout the Pacific Northwestincluding the metropolitan areas of Seattle and Bellevue, Washington andPortland, Oregon. Financial services of PNWB include the banking activities ofaccepting deposits from businesses and individuals and originating commercialand commercial real estate loans, residential loans, consumer loans, andagricultural loans.

 

Investment products are available through Pacific Northwest FinancialServices, Inc. and insurance products are available through Pacific NorthwestInsurance Agency, Inc., both subsidiaries of Pacific Northwest Bank.

 

*BASIS OFPRESENTATION* | The consolidated financial statementsinclude the accounts of Pacific Northwest Bancorp (Bancorp) and its whollyowned subsidiaries (collectively, PNWB). As of December 31, 2002, Bancorp’s wholly owned subsidiaries werePacific Northwest Bank, InterWest Capital Trust I and Pacific NorthwestStatutory Trust I.   All materialintercompany transactions and balances have been eliminated.

 

*USE OF ESTIMATES*| The preparation of the consolidated financial statements in conformity withaccounting principles generally accepted in the United States requiresmanagement to make estimates and assumptions that affect amounts reported inthe consolidated financial statements. Changes in these estimates and assumptions are considered reasonablypossible and may have a material impact on the consolidated financialstatements and thus actual results could differ from the amounts reported anddisclosed herein.

 

*SECURITIES AVAILABLEFOR SALE AND SECURITIES HELD TO MATURITY*| Securitiesheld to maturity are carried at amortized cost, and are adjusted to the lowerof cost or estimated fair value only when an other than temporary impairment invalue occurs.  Effective January 1,2001, PNWB adopted SFAS No. 133 “Accounting for Derivative Instruments andHedging Activities” and as a result, PNWB transferred all securities held tomaturity to securities available for sale.

 

Those securities not classified as held to maturity are classified asavailable for sale, and are carried at estimated fair value. The estimated fairvalue of securities available for sale is based on quoted market rates anddealer quotes. Unrealized gains and losses on available-for-sale securities areexcluded from earnings and presented as accumulated other comprehensive incomeor loss, net of related deferred income taxes. PNWB continually monitors its investment portfolio for other thantemporary impairment of securities. When an other than a temporary decline inthe value below cost or amortized cost is identified, the investment is reducedto its fair value, which becomes the new cost basis of the investment. Theamount of the reduction is reported as a realized loss in the statement ofoperations. Any recovery of value in excess of the investment’s new cost basisis recognized as a realized gain only on sale, maturity or other disposition ofthe investment.  Factors that PNWBevaluates in determining the existence of an other than temporary decline invalue include (1) the length of time and extent to which the fair value hasbeen less than cost or carrying value, (2) the circumstances contributing tothe decline in fair value (including a change in interest rates or spreads tobenchmarks), (3) recent performance of the security, (4) the financial strengthof the issuer, and (5) the intent and ability of PNWB to retain the investmentfor a period of time sufficient to allow for anticipated recovery.Additionally, for asset-backed securities, PNWB considers the security ratingand the amount of credit support available for the security.

 

The carrying value ofsecurities available for sale is adjusted for unaccreted discounts andunamortized premiums over the estimated average life of the security, or in thecase of callable securities, through the first call date using the effectiveyield method.  Such accretion andamortization is included as interest income on securities.

 

*LOANSRECEIVABLE *|Loans receivable are stated at the principal amount outstanding, net ofdeferred loan fees and discounts. Commercial loans are generally secured by liens on real estate, capitalassets, accounts receivable and inventory, although certain loans areunsecured.  Real estate mortgage loansare generally secured by first liens on single-family residences, land,developed lots or commercial property. Agricultural loans are generally securedby farmland, crops, dairy, and/or equipment. Consumer loans consist of automobile loans, home equity loans, creditcard loans and loans for other consumer purposes.  Consumer loans include both secured and unsecured personal linesof credit.

 

*LOANS HELD FOR SALE*|Loans held for sale are carried at the lower of cost or estimated fair value inaggregate. Net unrealized losses are recognized in a valuation allowance bycharges to income.  Managementdetermines the appropriate classification of loans held for sale at the time oforigination.

 

29

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*LOAN FEE INCOME,INTEREST INCOME ON LOANS RECEIVABLE AND UNEARNED INTEREST*|Loan origination fees and direct costs related to loan origination activitiesare deferred and amortized into interest income over contractual or actual loanlives as an adjustment to the loan yield. Deferred fees and costs related to loans sold are recognized into incomeat the time the loans are sold. Interest is accrued on loans receivable until the loan is 90 daysdelinquent or 120 days delinquent if the loan is a single family mortgage loan,or management doubts the collectibility of the loan or the unpaid interest, atwhich time PNWB establishes a reserve for any accrued interest. If managementdetermines the ultimate collectibility of principal is in doubt, all cashreceipts on non-accrual loans are applied to reduce the principal balance.

 

*ALLOWANCE FOR LOSSESON LOANS*| The allowance for losses on loans ismaintained at an amount to sufficiently provide for estimated losses based onevaluating known and inherent risks in the loan portfolio.   Management analyzes the factors underlyingthe quality of the loan portfolio. These factors include changes in the size andcomposition of the loan portfolio, delinquency levels, actual loan lossexperience, current economic conditions, and detailed analysis of individualloans for which full collectibility may not be assured. The appropriateness ofthe allowance for losses on loans is estimated based upon these factors andtrends identified by management at the time financial statements are preparedin accordance with accounting principles generally accepted in the UnitedStates.   However, these factors andtrends may change in the future, which may result in a material impact on theconsolidated financial statements.

 

When available information confirms that specific loans or portionsthereof are uncollectible, identified amounts are charged off against theallowance for losses on loans. The existence of some or all of the followingcriteria will generally confirm that a loss has been incurred: the loan issignificantly delinquent and the borrower has not evidenced the ability orintent to bring the loan current; PNWB has no recourse to the borrower, or ifit does, the borrower has insufficient assets to pay the debt; the estimatedfair value of the loan collateral is significantly below the current loanbalance, and there is little or no near-term prospect for improvement.

 

All loans are periodicallyevaluated for impairment, except large groups of homogenous loans that arecollectively evaluated for impairment, and loans that are measured at estimatedfair value or at the lower of cost or estimated fair value. PNWB considers allsingle-family residential and consumer loans to be homogenous loans.  A loan is considered impaired when it isdeemed probable that a creditor will be unable to collect all amounts dueaccording to the contractual terms of the loan agreement. The valuation ofimpaired loans is based on the present value of expected future cash flowsdiscounted at the loans effective interest rate or, as a practical expedient,at the loan’s observable market price or the estimated fair value of thecollateral if the loan is collateral dependent.  Generally, PNWB evaluates a loan for impairment when it is placedon non-accrual status or if a loan is internally risk rated as substandard ordoubtful.

 

A provision for losses on loans, which is a charge against income, isadded to the allowance for losses on loans based on quarterly assessments ofthe loan portfolio. The allowance for losses on loans is allocated to certainloan categories based on the relative risk characteristics, assetclassifications and actual loss experience of the loan portfolio.  While management has allocated the allowancefor losses on loans to various loan portfolio segments, the allowance isgeneral in nature and is available for the loan portfolio in its entirety.

 

The ultimate recovery of allloans is susceptible to future market factors beyond PNWB’s control. Thesefactors may result in losses or recoveries differing significantly from thoseprovided in the consolidated financial statements.

 

*OTHER REAL ESTATE*|Other real estate includes properties acquired through foreclosure and propertyacquired for development.  Other realestate is initially recorded at the lower of cost or estimated fair value by acharge against the allowance for losses on loans, if necessary, at the date offoreclosure, and is subsequently evaluated to determine that the carrying valuedoes not exceed the estimated fair value of the real estate. Losses that resultfrom ongoing periodic valuation of other real estate are charged to operationsin the period in which the losses are identified and are included in other realestate owned expense in the consolidated statements of income.

 

*PREMISES ANDEQUIPMENT* | Premises and equipment are stated at costless accumulated depreciation. Depreciation expense is computed using thestraight-line method over estimated useful lives of up to forty years forbuildings and three to twenty years for furniture, equipment and leaseholdimprovements.

 

*GOODWILL AND OTHERINTANGIBLE ASSETS* | Goodwill arising from acquisitionsrepresent the excess of the purchase price over the estimated fair value of netassets acquired.  Prior to January 1,2002, goodwill was amortized using the straight-line methods over periods notexceeding twenty years.  EffectiveJanuary 1, 2002, upon adoption of SFAS No. 142 “Accounting for Goodwill andOther Intangible Assets”, Goodwill is no longer amortized but is reviewedannually for impairment or more frequently if impairment indicators arise.  PNWB evaluates goodwill for impairment bycomparing the carrying value of the reporting unit to its estimated fair value.  The estimated fair value of the reportingunit is based on quoted market price when available or on the present value ofestimated future cash flows.

 

30

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Other intangible assets consistof core deposit intangibles and mortgage servicing rights.  Core deposit intangibles and mortgageservicing rights are amortized using the straight-line and accelerated methodover periods not exceeding twenty years. Mortgage servicing rights are capitalized when acquired either throughthe purchase or origination of loans that are subsequently sold or securitizedwith the servicing rights retained.  Thevalue of mortgage servicing rights at the date of the sale of loans is determinedbased on the discounted present value of expected future cash flows using keyassumptions for servicing income and costs and prepayment rates on theunderlying loans. The estimated fair value is periodically evaluated forimpairment by comparing actual cash flows and estimated future cash flows fromthe servicing assets to those estimated at the time servicing assets wereoriginated.  Mortgage servicing rightsare amortized as an offset to service fees in proportion to and over the periodof estimated net servicing income.

 

The amount of goodwill andother intangible assets recorded as of December 31, 2002 was supported by thevalue attributed to the operations and deposits acquired and mortgage servicingrights retained.

 

*LONG-LIVED ASSETS*|Long-lived assets are reviewed for impairment whenever events or changes incircumstances indicate that the carrying amount may not be recoverable.  Impairment is measured by comparing thecarrying value of the long-lived assets to the estimated undiscounted futurecash flows expected to result from use of the assets and their ultimatedisposition.  In circumstances whereimpairment is determined to exist, PNWB will write down the assets to its fairvalue based on either present value of estimated expected future cash flows oranticipated realizable market value.

 

*BANK OWNED LIFE INSURANCE|*Thecarrying amount of bank owned life insurance approximates its fair value.  Fair value of bank owned life insurance isestimated using the cash surrender value.

 

*ADVERTISING COSTS*|PNWB expenses advertising costs as incurred.  Advertising expenses for the years ended December 31, 2002, 2001and 2000amounted to $1,777,000, $1,986,000, and $2,209,000, respectively.

 

*INCOME TAXES*| PNWB accounts for income taxes using the liability method.  Under the liability method, a deferred taxasset or liability is determined based on the enacted tax rates which will bein effect when the differences between the financial statement carrying amountsand tax basis of existing assets and liabilities are expected to be reported inPNWB’s consolidated income tax return. The deferred tax expense for the period is equal to the net change inthe deferred tax asset and liability accounts from the beginning to the end ofthe period.  The effect on deferredtaxes of a change in tax rates is recognized in income in the period thatincludes the enactment date.

 

*NET INCOME PER SHARE*| Basic net income per share is calculated by dividingnet income by the weighted average number of common shares outstanding duringthe period.  Diluted net income pershare is calculated by dividing net income by diluted weighted average sharesoutstanding, which includes common stock equivalent shares outstanding usingthe treasury stock method, unless such shares are anti-dilutive.  Common stock equivalents include sharesissuable upon exercise of stock options. Unallocated shares relating to the debt-leveraged money purchaseemployee stock ownership plan debt obligation are deducted in the calculationof weighted average shares outstanding.

 

*STOCK BASEDCOMPENSATION* | Employee stock options are accountedfor using the intrinsic value method prescribed in Accounting Principle BoardOpinion (APB) No. 25, “Accounting for Stock Issued to Employees.”   Stock options are granted at exerciseprices not less than the fair value of common stock on the date of grant.  Under APB No. 25, no compensation expense isrecognized pursuant to PNWB’s stock option plans.  PNWB has elected to apply the disclosure only provisions ofStatement of Financial Accounting Standards (SFAS) No. 148, “Accounting forStock-Based Compensation.”

 

*COMPREHENSIVE INCOME*| Comprehensive income includes net income and othercomprehensive income, which refers to unrealized gains and losses that underaccounting principles generally accepted in the United States are excluded fromnet income.

 

*BUSINESSSEGMENTS *| PNWBoperates a single business segment.  Thefinancial information that is used by the chief operating decision maker inallocating resources and assessing performance is only provided for one reportablesegment as of December 31, 2002 and 2001. At the time of the acquisition, Bank of the Northwest was merged intoPacific Northwest Bank and PNWB consolidated the management function of Bank ofthe Northwest into its existing organizational structure.  PNWB also converted Bank of the Northwestinformation systems and operational processes to those of Pacific NorthwestBank.

 

*RECLASSIFICATIONS*| Certain reclassifications have been made to the 2001 and 2000 consolidatedfinancial statements to conform to 2002 presentation.  The effects of the reclassifications are not considered material.

 

31

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**NOTE 2**ACCOUNTINGCHANGES

 

In January 2003, the FASB issued SFAS No. 148 “Accounting forStock-Based Compensation-Transition and Disclosure”. SFAS No. 148 amends FASBStatement No. 123 “**Accounting for Stock-BasedCompensation” and**provides alternative methods of transitionfor a voluntary change to the fair value based method of accounting forstock-based compensation. In addition, SFAS No. 148 amends the disclosurerequirements of Statement 123 to require more prominent and quarterlydisclosures in financial statements about the effects of stock-basedcompensation.  SFAS No. 148 becameeffective immediately for fiscal years ending after December 15, 2002.  The adoption of this statement affected thedisclosures in PNWB’s consolidated financial statements; however, it had nomaterial impact on PNWB’s financial condition or results of operations.

 

In November 2002, the FASB issued Interpretation No. 45, “Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others” (FIN 45).  FIN 45 changes current practice in accounting for, and disclosureof, guarantees.  Guarantees meeting thecharacteristics described in FIN 45, which are not included in a list ofexceptions, are required to be initially recorded at fair value.  FIN 45 also requires a guarantor to make newdisclosures for guarantees even when the likelihood of the guarantor’s havingto make payments under the guarantee is remote.  FIN 45 applies to PNWB’s accounting and disclosure of StandbyLetters of Credit.  FIN 45 became effectiveon a prospective basis to guarantees issued or modified after December 31,2002.  The disclosure requirements inFIN 45 became effective for financial statements of periods ending afterDecember 15, 2002.   The adoption of FIN45 had no material impact on PNWB’s financial condition or results ofoperations.

 

In October 2002, the FASB issued SFAS No. 147, *Acquisitions of Certain FinancialInstitutions (SFAS 147)*. SFAS 147 addresses the accounting for theacquisition of a financial institution, which had previously been addressed inSFAS No. 72, *Accounting for Certain Acquisitions of Banking or Thrift Institutions*.SFAS 72 required that the excess of the fair value of liabilities assumed overthe fair value of tangible and identifiable intangible assets be recognized asan unidentifiable intangible asset. SFAS 147 amends SFAS 72 and states thatthis excess, if acquired in a business combination, represents goodwill thatshould be accounted for in accordance with SFAS No. 142, *Goodwill and Other Intangible Assets*.PNWB adopted the provisions of SFAS 147 effective October 1, 2002 and appliedthe provisions to the BKNW acquisition as well as historical acquisitions.  Such adoption had no impact on PNWB’sfinancial condition or statement of income.

 

In July 2002, the FASB issuedSFAS No. 146 “Accounting for Costs Associated with Exit or DisposalActivities”.  SFAS No. 146 addressesfinancial accounting and reporting for costs associated with exit or disposalactivities initiated after December 31, 2002 and nullifies EITF Issue No. 94-3“Liability Recognition for Certain Employee Termination Benefits and OtherCosts to Exit an Activity (including Certain Costs Incurred in aRestructuring)”.  SFAS No. 146 requiresthat a liability for a cost associated with an exit or disposal activityinitiated after December 31, 2002 be recognized when the liability is incurredas opposed to when a plan is developed as required by EITF Issue No. 94-3.  SFAS No. 146 will become effective onJanuary 1, 2003.  Management does not expectthe adoption of SFAS No. 146 to have a material impact on PNWB’s financial conditionor results of operations. 

 

In April 2002, the FASB issued SFAS No. 145 “Rescission of FASBStatements No. 4, 44, and 62, Amendment of FASB Statement No. 13, and TechnicalCorrections”.  SFAS No. 145 rescinds theclassification of extinguishment of debt as extraordinary as previouslyrequired under SFAS No. 4 and establishes new criteria for the classificationof gains and losses on extinguishment of debt. SFAS No. 145 also amends SFAS No. 13 to require certain modifications tocapital leases be treated as a sale-leaseback and modifies the accounting forsub-leases when the original lessee remains a secondary obligor. SFAS No. 145will become effective on January 1, 2003 with the exception of the amendmentand technical corrections related to SFAS No. 13, which were effective on May15, 2002.  Management does not expectthe adoption of SFAS No. 145 to have a material impact on PNWB’s financialcondition or results of operations.

 

In July 2001, the FASBissued SFAS No. 142 “Accounting for Goodwill and Other Intangible Assets”.  Under SFAS No. 142, goodwill and indefinitelived intangible assets are no longer amortized but are reviewed annually forimpairment or more frequently if impairment indicators arise.  Separable intangible assets that are not deemedto have an indefinite life will continue to be amortized over their usefullives.  This Statement became effectiveon January 1, 2002.  PNWB performed thetransitional impairment assessment of its goodwill as of January 1, 2002 andnoted that such assessment did not indicate any impairment of goodwill.  The adoption of SFAS No. 142 reduces PNWB’sgoodwill amortization expense by approximately $1.1 million on an annualbasis.  A reconciliation of reported netincome to net income adjusted to exclude goodwill amortization for the yearsended December 31, 2002, 2001 and 2000 is as follows:

 

32

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| **Dollars in thousands, except per share amount** |   | **Year ended  December 31,  2002** |   | **Year ended  December 31,  2001** |   | **Year ended  December 31,  2000** |   |
|---------------------------------------------------|--------|------------------------------------|--------|------------------------------------|--------|------------------------------------|--------|
|                                              |   |                               |   |                               |   |                               |   |
| Income statement:                                 |   |                               |   |                               |   |                               |   |
| Reported net income                               |   | $                                  | 28,760 |                               | $      | 22,092                             |   | $ | 6,269 |   |
| Adjustment for goodwill amortization              |   | —                             |   | 1,121                              |   | 1,115                              |   |
| Adjusted net income                               |   | $                                  | 28,760 |                               | $      | 23,213                             |   | $ | 7,384 |   |
|                                              |   |                               |   |                               |   |                               |   |
| Basic net income per share:                       |   |                               |   |                               |   |                               |   |
| Reported basic net income per share               |   | $                                  | 1.85   |                               | $      | 1.42                               |   | $ | 0.40 |   |
| Adjustment for goodwill amortization              |   | —                             |   | 0.07                               |   | 0.08                               |   |
| Adjusted basic net income per share               |   | $                                  | 1.85   |                               | $      | 1.49                               |   | $ | 0.48 |   |
|                                              |   |                               |   |                               |   |                               |   |
| Diluted net income per share:                     |   |                               |   |                               |   |                               |   |
|                                              |   |                               |   |                               |   |                               |   |
| Reported diluted net income per share             |   | $                                  | 1.80   |                               | $      | 1.40                               |   | $ | 0.40 |   |
| Adjustment for goodwill amortization              |   | —                             |   | 0.08                               |   | 0.07                               |   |
| Adjusted diluted net income per share             |   | $                                  | 1.80   |                               | $      | 1.48                               |   | $ | 0.47 |   |

 

In June 1998, the Financial Accounting and Standards Board (FASB)issued SFAS No. 133 “Accounting for Derivative Instruments and HedgingActivities.”  In June 2000, the FASBissued SFAS No. 138, which amended certain provisions of SFAS No. 133 toclarify specific areas presenting difficulties in implementation.  SFAS No. 133, as amended by SFAS No. 138,establishes accounting and reporting standards for derivative instruments,including certain derivative instruments imbedded in other contracts, and forhedging activities.  It requires therecognition of all derivatives as either assets or liabilities in the statementof financial condition and the measurement of those instruments at estimatedfair value.  In certain definedconditions, a derivative may be specifically designated as a hedge for a particularexposure. The accounting for derivatives depends on the intended use of thederivatives and the resulting designation. This statement was adopted by PNWB on January 1, 2001. The adoption ofthis statement did not have a material impact on PNWB’s financial condition orresults of operations.  As permitted bythe provisions of this statement, PNWB transferred all securities held tomaturity to securities available for sale on January 1, 2001. This transfer resultedin a decrease of other comprehensive income of $597,000, net of income taxes of$321,000.

 

33

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**NOTE 3**ACQUISITION

 

On November 13, 2002, PNWBcompleted the acquisition of Bank of the Northwest (BKNW) headquartered inPortland, Oregon.  This is an importantacquisition for PNWB because it gives PNWB an entry into the commercial bankingmarket in Oregon.  PNWB issued 1,749,882shares of common stock and paid approximately $25,800,000 in cash for all the outstandingcommon stock of BKNW.  The totalpurchase price recorded was $81,700,000, net of $1,600,000 of acquisitioncosts.  Upon the completion of theacquisition, BKNW was merged into PNWB’s commercial bank subsidiary, PacificNorthwest Bank.  PNWB now operates fivefull service branch offices in the metropolitan area of Portland, Oregon as aresult of the acquisition of BKNW.

 

The following summaries theestimated fair values of the assets acquired and liabilities assumed at thedate of acquisition.

 

 
| **As of November 13, 2002Dollars in thousands**    |   |    |    |
|----------------------------------------------------|--------|---------|---------|
| Cash and cash equivalents                          |   | $       | 10,000  |   |
| Securities available for sale                      |   | 98,300  |    |
| Loans                                              |   | 254,100 |    |
| Other assets                                       |   | 11,200  |    |
| Intangible assets subject to amortization          |   |    |    |
| Core deposit intangibles (estimated 10 year  life) |   | 9,500   |    |
| Goodwill                                           |   | 51,600  |    |
| Total assets acquired                              |   |    | 434,700 |   |
|                                               |   |    |    |
| Deposits                                           |   |    | 288,000 |   |
| Borrowings                                         |   | 56,100  |    |
| Deferred tax liabilities                           |   | 3,800   |    |
| Other liabilities                                  |   | 1,900   |    |
| Total liabilities assumed                          |   |    | 349,800 |   |
|                                               |   |    |    |
| Net assets acquired                                |   | $       | 84,900  |   |

 

The following summarizes theunaudited pro forma results of operations as if PNWB acquired BKNW as of thebeginning of each of the periods presented. The pro forma information gives effect to certain adjustments, includingamortization of core deposit intangible resulting from the acquisition and theelimination of amortization of goodwill in 2001 because such amortization wouldhave been suspended as a result of the adoption of SFAS No. 142 “Accounting forgoodwill and other intangibles.”

 
| **(Unaudited)  Dollars in thousands, except per share amounts** |   | **Year ended  December 31,  2002** |    | **Year ended  December 31,  2001** |   |
|-----------------------------------------------------------------|--------|------------------------------------|---------|------------------------------------|--------|
|                                                            |   |                               |    |                               |   |
| Pro forma net interest income:                                  |   | $                                  | 120,045 |                               | $      | 113,300 |   |
| Pro forma net income:                                           |   | 29,357                             |    | 24,379                             |   |
| Pro forma basic net income per share:                           |   | 1.72                               |    | $                                  | 1.42   |   |
| Pro forma diluted net income per share:                         |   | 1.65                               |    | 1.39                               |   |
|                                                                 |        |                                    |         |                                    |        |  |  |

 

This unaudited pro forma information is presented for illustrativepurpose only and is not necessarily indicative of the results of futureoperations or results that would have been achieved if PNWB had acquired BKNWat the beginning of the specified years.

 

34

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**NOTE 4**SECURITIESAVAILABLE FOR SALE

 

Securities available for sale are carried at estimated fair value.  The amortized cost and estimated fair valuesof securities available for sale are summarized as follows:

 
| **Dollars in thousands**                          |   | **Amortized  Cost** |       | **Gross  Unrealized  Gains** |       | **Gross  Unrealized  Losses** |       | **Estimated  Fair  Value** |       |
|---------------------------------------------------|--------|---------------------|------------|------------------------------|------------|-------------------------------|------------|----------------------------|------------|
|                                              |   |                |       |                         |       |                          |       |                       |       |
| December  31, 2002                                |   |                | ** ** |                         | ** ** |                          | ** ** |                       | ** ** |
| U.S.  treasury and agency securities              |   | $                   | 95,626     |                         | $          | 1,476                         |       | $                          | 30         |   | $ | 97,072 |   |
| Obligations of states and political  subdivisions |   | 15,734              |       | 479                          |       | —                        |       | 16,213                     |       |
| Mortgage-backed and related securities            |   | 569,631             |       | 7,333                        |       | 2,654                         |       | 574,310                    |       |
| FHLB stock                                        |   | 52,566              |       | —                       |       | —                        |       | 52,566                     |       |
| Other securities                                  |   | 49,355              |       | 2,066                        |       | 3,036                         |       | 48,385                     |       |
|                                              |   |                |       |                         |       |                          |       |                       |       |
| Total                                             |   | $                   | 782,912    |                         | $          | 11,354                        |       | $                          | 5,720      |   | $ | 788,546 |   |
|                                              |   |                |       |                         |       |                          |       |                       |       |
| December 31, 2001                                 |   |                |       |                         |       |                          |       |                       |       |
| U.S. treasury and agency securities               |   | $                   | 79,436     |                         | $          | 780                           |       | $                          | 192        |   | $ | 80,024 |   |
| Obligations of states and political  subdivisions |   | 1,120               |       | 41                           |       | —                        |       | 1,161                      |       |
| Mortgage-backed and related securities            |   | 582,275             |       | 6,019                        |       | 1,887                         |       | 586,407                    |       |
| FHLB stock                                        |   | 46,084              |       | —                       |       | —                        |       | 46,084                     |       |
| Other securities                                  |   | 46,164              |       | 288                          |       | 3,110                         |       | 43,342                     |       |
|                                              |   |                |       |                         |       |                          |       |                       |       |
| Total                                             |   | $                   | 755,079    |                         | $          | 7,128                         |       | $                          | 5,189      |   | $ | 757,018 |   |

 

The amortized cost and estimated fair value of securities available forsale as of December 31, 2002, by contractual maturity are summarized asfollows:

 
| **Dollars in thousands**                  |   | **Amortized  Cost** |       | **Estimated  Fair  Value** |       |
|-------------------------------------------|--------|---------------------|------------|----------------------------|------------|
|                                      |   |                | ** ** |                       | ** ** |
| Due in one year or less                   |   | $                   | 22,601     |                       | $          | 22,835 |   |
| Due after one year but within five years  |   | 81,818              |       | 83,257                     |       |
| Due after five years but within ten years |   | 1,999               |       | 2,019                      |       |
| Due after ten years                       |   | 54,297              |       | 53,559                     |       |
|                                      |   | 160,715             |       | 161,670                    |       |
| FHLB Stock                                |   | 52,566              |       | 52,566                     |       |
| Mortgage-backed and related securities    |   | 569,631             |       | 574,310                    |       |
|                                      |   |                |       |                       |       |
| Total                                     |   | $                   | 782,912    |                       | $          | 788,546 |   |

 

Proceeds from the sale of securities available for sale during theyears ended December 31, 2002, 2001 and 2000 were $53,912,000, $151,402,000 and $156,540,000, respectively. PNWBrealized gains of $40,000,$1,709,000, and $663,000 andlosses of $1,465,000, $0 and $6,776,000 on those sales duringthe years ended December 31, 2002, 2001and 2000, respectively.

 

Securities available for sale include mortgage-backed and related securitieswith estimated fair values of $51,161,000 $79,619,000 and $175,935,000 as of December 31, 2002, 2001 and 2000, respectively that were securitized from PNWB’ssingle-family residential loan portfolio.

 

35

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**NOTE 5**LOANS RECEIVABLE

 

Loans receivable consisted of the following as of December 31:

* *
| **Dollars in thousands**         |   | **200****2** |      | **200****1** |   |
|----------------------------------|--------|--------------|-----------|--------------|--------|
|                             |   |         |      |         |   |
| Commercial loans:                |   |         |      |         |   |
| Commercial                       |   | $            | 622,936   |         | $      | 591,663 |   |
| Commercial real estate           |   | 770,413      |      | 470,408      |   |
| Total commercial loans           |   | 1,393,349    |      | 1,062,070    |   |
|                             |   |         |      |         |   |
| Single-family residential        |   | 231,232      |      | 321,246      |   |
| Real estate construction         |   | 274,581      |      | 319,228      |   |
| Consumer loans                   |   | 139,784      |      | 115,440      |   |
|                             |   | 2,038,946    |      | 1,817,985    |   |
| Less:                            |   |         |      |         |   |
| Allowance for losses on loans    |   | 26,940       |      | 20,123       |   |
| Deferred loan fees and discounts |   | 9,193        |      | 9,430        |   |
| Net loans receivable             |   | $            | 2,002,813 |         | $      | 1,788,432 |   |

 

PNWB serviced loans, owned in whole or in part by others, of$152,879,000, $254,002,000, and $484,110,000 as of December 31, 2002, 2001 and 2000, respectively.

 

As of December 31, 2002, PNWB had $231,203,000 in real estate loancommitments to extend credit.  Otherloan commitments to extend credit, which include commercial and consumer linesof credit, totaled $445,201,000as of December 31, 2002.  Outstandingcommitments to extend credit under standby letters of credit and commercialletters of credit totaled $64,501,000 and $17,816,000 as of December 31, 2002.

 

Non-accrual loans totaled $11,913,000 and $16,088,000 as of December 31, 2002 and 2001, respectively.  Interest income not recognized on theseloans was $1,582,000 and $1,968,000 as of December 31, 2002 and 2001, respectively.

 

PNWB originates loans primarily in the states of Washington and Oregon.Although PNWB has a diversified loan portfolio, a substantial portion of itsdebtors’ ability to honor their contracts is affected by the economies in theseareas.

 

**NOTE 6**ALLOWANCE FOR LOSSES ON LOANS

 

The activity in the allowance for losses on loans for the years endedDecember 31, 2002,2001 and 2000 issummarized as follows:

 
| **Dollars in thousands**               |   | **Year ended  December 31,  2002** |   | **Year ended  December 31,  2001** |   | **Year ended  December 31,****2000** |   |
|----------------------------------------|--------|------------------------------------|--------|------------------------------------|--------|--------------------------------------|--------|
|                                   |   |                               |   |                               |   |                                 |   |
| Balance, beginning of year             |   | $                                  | 20,123 |                               | $      | 17,561                               |   | $ | 15,182 |   |
|                                   |   |                               |   |                               |   |                                 |   |
| Provision for losses on loans          |   | 6,350                              |   | 6,050                              |   | 4,750                                |   |
| Allowance acquired through acquisition |   | 3,688                              |   | —                             |   | —                               |   |
| Charge-offs                            |   | (3,756                             | )      | (4,747                             | )      | (2,956                               | )      |
| Recoveries                             |   | 535                                |   | 1,259                              |   | 585                                  |   |
|                                   |   |                               |   |                               |   |                                 |   |
| Balance, end of year                   |   | $                                  | 26,940 |                               | $      | 20,123                               |   | $ | 17,561 |   |

 

36

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The following is a summary of loans considered impaired and the relatedinterest income as of and for the years ended December 31, 2002, 2001 and 2000:

 
| **Dollars in thousands**                              |   | **Year ended  December 31,  2002** |   | **Year ended  December 31,  2001** |   | **Year ended  December 31,****2000** |   |
|-------------------------------------------------------|--------|------------------------------------|--------|------------------------------------|--------|--------------------------------------|--------|
|                                                  |   |                               |   |                               |   |                                 |   |
| Recorded investment in impaired loans at  end of year |   | $                                  | 2,020  |                               | $      | 2,523                                |   | $ | 3,819 |   |
| Average recorded investment in impaired  loans        |   | 2,272                              |   | 3,171                              |   | 4,339                                |   |
| Interest income recognized on impaired  loans         |   | 57                                 |   | 180                                |   | 282                                  |   |
|                                                       |        |                                    |        |                                    |        |                                      |        |  |  |  |

 

Total allocated reserves forimpaired loans amounted to $303,000 and $583,000 as of December 31, 2002 and 2001, respectively. Interest incomeon impaired loans is normally recognized on the accrual basis, unless the loanis more than 90 days past due, in which case interest income is recorded on acash basis.

 

**NOTE 7** PREMISES ANDEQUIPMENT

 

Premises and equipment consisted of the following as of December 31:

 
| **Dollars in thousands**             |   | **2002** |   | **2001** |   |
|--------------------------------------|--------|----------|--------|----------|--------|
|                                 |   |     |   |     |   |
| Buildings and leasehold improvements |   | $        | 42,437 |     | $      | 41,225 |   |
| Furniture and equipment              |   | 33,466   |   | 32,650   |   |
|                                 |   | 75,903   |   | 73,875   |   |
| Less accumulated depreciation        |   | (37,154  | )      | (32,962  | )      |
|                                 |   | 38,749   |   | 40,913   |   |
| Land                                 |   | 9,333    |   | 9,913    |   |
| Total                                |   | $        | 48,082 |     | $      | 50,826 |   |

 

Depreciation expense for theyears ended December 31, 2002, 2001 and 2000 was$5,249,000, $6,016,000, and $5,544,000 respectively.

 

PNWB leases certain premises under operating leases.  Rental expense for leased premises was$1,757,000, $1,882,000, and $1,582,000 for the years ended December 31, 2002, 2001 and 2000, respectively. Minimum rental commitments under non-cancelable operating leases havingan original or remaining term of more than one year were as follows as ofDecember 31, 2002:

 
| **Dollars in thousands  Year ending December 31:** |   | **200****3** |   | **200****4** |   | **200****5** |   | **200****6** |   | **200****7** |   | **Thereafter** |   | **Total** |   |
|----------------------------------------------------|--------|--------------|--------|--------------|--------|--------------|--------|--------------|--------|--------------|--------|----------------|--------|-----------|--------|
| Minimum rental commitments                         |   | $            | 3,898  |         | $      | 3,103        |   | $            | 1,752  |         | $      | 1,124          |   | $         | 682    |   | $ | 2,327 |   | $ | 12,886 |   |
|                                                    |        |              |        |              |        |              |        |              |        |              |        |                |        |           |        |  |  |  |  |  |  |  |

 

 

**NOTE 8**GOODWILL AND OTHER INTANGIBLE ASSETS

 

Goodwill and other intangible assets consisted of the following:

 
| **Dollars in thousands**     |   | **Goodwill** |   | **Core  Deposit  Intangible** |   | **Mortgage  Servicing Rights** |   | **Total** |   |
|------------------------------|--------|--------------|--------|-------------------------------|--------|--------------------------------|--------|-----------|--------|
|                         |   |         |   |                          |   |                           |   |      |   |
| Balance, December 31, 2001   |   | $            | 16,137 |                          | $      | 423                            |   | $         | 1,562  |   | $ | 18,122 |   |
| Addition through acquisition |   | 51,595       |   | 9,500                         |   | —                         |   | 61,095    |   |
| Amortization                 |   | —       |   | (254                          | )      | (726                           | )      | (980      | )      |
| Balance, December 31, 2002   |   | $            | 67,732 |                          | $      | 9,669                          |   | $         | 836    |   | $ | 78,237 |   |

 

During the year ended December 31, 2000, PNWB consolidated and restructuredits mortgage loan origination functions and related processes, and as a result,recorded an impairment of $749,000 of goodwill related to the acquisition of amortgage brokerage subsidiary in 1996.

 

37

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The changes in mortgage servicing rights for the years ended December31, 2002,2001 and 2000 are summarized asfollows:

 
| **Dollars in thousands**     |   | **Year ended  December 31,  2002** |   | **Year ended  December 31,  2001** |   | **Year ended  December 31,  2000** |   |
|------------------------------|--------|------------------------------------|--------|------------------------------------|--------|------------------------------------|--------|
|                         |   |                               |   |                               |   |                               |   |
| Balance, beginning of year   |   | $                                  | 1,562  |                               | $      | 2,861                              |   | $ | 1,987 |   |
| Additions                    |   | —                             |   | —                             |   | 1,659                              |   |
| Amortization and write-downs |   | (726                               | )      | (1,299                             | )      | (785                               | )      |
|                         |   |                               |   |                               |   |                               |   |
| Balance, end of year         |   | $                                  | 836    |                               | $      | 1,562                              |   | $ | 2,861 |   |

 

The estimated fair value of mortgage servicing rights exceeded the netbook value as of December 31, 2002 and 2001. The estimated fair value was determined by comparing actual cash flowsand estimated future cash flows from the servicing assets to those estimated atthe time servicing assets were originated.

 

38

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**NOTE 9**INTEREST-BEARING DEPOSITS

 

Interest-bearing deposits consisted of the following as of December 31:

 
| **Dollars in thousands**                |   | **Weighted  Average  Interest Rate as of  December 31,** |       | **2002** |       | **2001** |       |
|-----------------------------------------|--------|----------------------------------------------------------|------------|----------|------------|----------|------------|
|                                    |   |                                                     | ** ** |     | ** ** |     | ** ** |
| Interest-bearing checking  accounts     |   | 0.37                                                     | %          | $        | 263,591    |     | $          | 214,098 |   |
| Money market accounts                   |   | 1.34                                                     | %          | 531,698  |       | 322,554  |       |
| Savings accounts                        |   | 0.50                                                     | %          | 108,721  |       | 95,390   |       |
|                                    |   |                                                     |       |     |       |     |       |
|                                    |   | 0.96                                                     | %     | 904,010  |       | 632,042  |       |
| Certificates of deposit:                |   |                                                     |       |     |       |     |       |
| Due within one year                     |   |                                                     |       | 562,660  |       | 606,659  |       |
| After one year but within two years     |   |                                                     |       | 102,815  |       | 86,135   |       |
| After two years but within three years  |   |                                                     |       | 41,608   |       | 16,856   |       |
| After three years but within four years |   |                                                     |       | 14,781   |       | 15,082   |       |
| After four years but within five years  |   |                                                     |       | 82,138   |       | 4,240    |       |
| After five years                        |   |                                                     |       | 727      |       | 2,167    |       |
| Total certificates of deposit           |   | 3.13                                                     | %          | 804,729  |       | 731,139  |       |
|                                    |   |                                                     |       |     |       |     |       |
| Total                                   |   | 1.98                                                     | %          | $        | 1,708,739  |     | $          | 1,363,181 |   |

 

Deposits as of December 31,2002 and 2001 included $171,404,000 and $159,051,000, respectively, in publicfund deposits.  Securities with bookvalues of $31,806,000 and $33,566,000 were pledged as collateral on thesedeposits as of December 31, 2002 and 2001, respectively, which exceeds theminimum collateral requirements established by the Washington Public DepositProtection Commission.

 

Certificates of deposit greaterthan or equal to $100,000 totaled $459,066,000 and $393,830,000 as of December31, 2002 and 2001, respectively.

 

Deposit interest expense byaccount type for the years ended December 31, 2002, 2001 and 2000 were asfollows:

 
| **Dollars in thousands**                                   |   | **Year ended  December 31,  2002** |   | **Year ended  December 31,  2001** |   | **Year ended  December 31,  2000** |   |
|------------------------------------------------------------|--------|------------------------------------|--------|------------------------------------|--------|------------------------------------|--------|
|                                                       |   |                               |   |                               |   |                               |   |
| Certificates of deposit greater than or  equal to $100,000 |   | $                                  | 14,676 |                               | $      | 24,762                             |   | $ | 24,897 |   |
| Other certificates of deposit                              |   | 12,582                             |   | 21,011                             |   | 23,606                             |   |
| Money market accounts                                      |   | 7,857                              |   | 9,786                              |   | 11,563                             |   |
| Interest-bearing checking accounts                         |   | 1,033                              |   | 1,723                              |   | 2,017                              |   |
| Savings accounts                                           |   | 844                                |   | 1,193                              |   | 1,722                              |   |
|                                                       |   |                               |   |                               |   |                               |   |
| Total                                                      |   | $                                  | 36,992 |                               | $      | 58,475                             |   | $ | 63,805 |   |

 

39

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**NOTE 10**FEDERALHOME LOAN BANK ADVANCES

 

As of December 31, FHLB advances were scheduled to mature as follows:

 
|                                    |   | **2002**   |    | **2001**            |          |
|-----------------------------------------|--------|------------|---------|---------------------|---------------|
| **Dollars in thousands**                |   | **Amount** |    | **Interest  Rates** |          | **Amount** |   | **Interest  Rates** |   |
|                                    |   |       |    |                |          |   |   |   |   |
| Due within one year                     |   | $          | 167,500 |                | 1.10% - 4.92% |   | $ | 464,625 |   | 1.80% - 7.70% |   |
| After one year but within two years     |   | 140,700    |    | 2.57% - 4.51%       |          | 40,000 |   | 3.04% - 4.92% |   |
| After two years but within three years  |   | 112,750    |    | 3.98% - 6.12%       |          | 85,000 |   | 3.65% - 4.51% |   |
| After three years but within four years |   | 45,151     |    | 3.70% - 4.87%       |          | 45,000 |   | 4.50% - 5.05% |   |
| After four years but within five years  |   | 52,680     |    | 1.23% - 6.04%       |          | 4,901 |   | 3.97% |   |
| After six years but within seven years  |   | 90,800     |    | 3.41% - 5.62%       |          | 75,000 |   | 5.08% - 5.56% |   |
|                                    |   |       |    |                |          |   |   |   |   |
| Total                                   |   | $          | 609,581 |                | —        |   | $ | 714,526 |   | — |   |

 

FHLB advances are collateralized by FHLB stock owned by PNWB, depositswith the FHLB and certain mortgages or deeds of trust securing suchproperties.  As of December 31, 2002,the minimum book value of eligible collateral pledged for these borrowings was$731,497,000.  As of December 31, 2002,the additional amount available under credit lines from the FHLB was$444,714,000.   Certain FHLB advancescontractually due beyond one year have an option whereby the FHLB can call theadvance due prior to the contractual maturity. The amount of such advances with call dates within one year was$75,000,000 as of December 31, 2002.

 

The maximum and average amount outstanding and weighted averageinterest rates on FHLB advances were as follows during the years ended December31, 2002, 2001 and 2000:

 
| **Dollars in thousands**             |   | **Year ended  December 31,  2002** |    | **Year ended  December 31,  2001** |   | **Year ended  December 31,  2000** |   |
|--------------------------------------|--------|------------------------------------|---------|------------------------------------|--------|------------------------------------|--------|
|                                 |   |                               |    |                               |   |                               |   |
| Maximum outstanding at any month end |   | $                                  | 740,727 |                               | $      | 721,200                            |   | $ | 787,526 |   |
| Average outstanding                  |   | 640,111                            |    | 651,824                            |   | 707,814                            |   |
| Weighted average interest rates:     |   |                               |    |                               |   |                               |   |
| For the year                         |   | 3.81                               | %       | 4.63                               | %      | 6.07                               | %      |
| End of year                          |   | 3.95                               | %       | 3.23                               | %      | 6.36                               | %      |
|                                      |        |                                    |         |                                    |        |                                    |        |  |  |  |

 

**NOTE 11**SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE

 

PNWB has sold certain securities of the U.S. government and itsagencies and other approved investments under agreements to repurchase.  The securities sold were classified assecurities available for sale with a carrying value of $79,235,000 and anestimated fair value of $82,192,000 as of December 31, 2002.  As of December 31, 2002, PNWB had$450,000,000 of available credit from third parties to sell securities underagreements to repurchase within six months. This available credit amount would be $150,000,000 if the terms of therepurchase agreements were greater than six months.

 

As of December 31, securities sold under agreements torepurchase were scheduled to mature as follows:

 
|                             |   | **2002**   |    | **2001**            |          |
|----------------------------------|--------|------------|---------|---------------------|---------------|
| **Dollars in thousands**         |   | **Amount** |    | **Interest  Rates** |          | **Amount** |   | **Interest  Rates** |   |
|                             |   |       |    |                |          |   |   |   |   |
| Within 30 days                   |   | $          | 53,821  |                | 0.25% - 1.83% |   | $ | 67,119 |   | 1.75% - 6.00% |   |
| After 30 days but within 90 days |   | 6,700      |    | 1.77%               |          | 22,200 |   | 7.40% |   |
| After 90 days                    |   | 60,185     |    | 3.42% - 4.82%       |          | 60,185 |   | 3.42% - 4.82% |   |
|                             |   |       |    |                |          |   |   |   |   |
| Total                            |   | $          | 120,706 |                | —        |   | $ | 149,504 |   | — |   |

 

40

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The maximum and average amountoutstanding and weighted average interest rates on securities sold underagreements to repurchase were as follows during the years ended December 31,2002, 2001 and 2000:

 
| **Dollars in thousands**             |   | **Year ended  December 31,  2002** |    | **Year ended  December 31,   2001** |   | **Year ended  December 31,  2000** |   |
|--------------------------------------|--------|------------------------------------|---------|-------------------------------------|--------|------------------------------------|--------|
|                                 |   |                               |    |                                |   |                               |   |
| Maximum outstanding at any month end |   | $                                  | 126,939 |                                | $      | 279,176                            |   | $ | 286,807 |   |
| Average outstanding                  |   | 117,108                            |    | 193,607                             |   | 267,570                            |   |
| Weighted average interest rates      |   |                               |    |                                |   |                               |   |
| For the year                         |   | 3.32                               | %       | 5.49                                | %      | 6.66                               | %      |
| End of year                          |   | 2.54                               | %       | 3.63                                | %      | 6.88                               | %      |
|                                      |        |                                    |         |                                     |        |                                    |        |  |  |  |

 

**NOTE 12**GUARANTEEDPREFERRED BENEFICIAL INTEREST IN SUBORDINATED DEBT

 

As of December 31, 2002 and 2001, PNWB had guaranteed preferredbeneficial interest in subordinated debt totaling $48,000,000 and $37,500,000,respectively.

 

On September 26, 2002, $12,000,000 of Capital Securities were issued byPacific Northwest Statutory Trust I (the Trust).  The Trust is a business trust organized in September 2002, andBancorp owns 100 percent of the common equity of the Trust.  The proceeds of the offering were investedby the Trust in junior subordinated debentures of Pacific NorthwestBancorp.  The debentures held by theTrust are the sole assets of Pacific Northwest Statutory Trust I.  The Capital Securities are subject tomandatory redemption, in whole or in part, upon repayment of thedebentures.  The debentures will notmature earlier than September 26, 2007, and not later than September 26, 2012.The interest rate on the Capital Securities is based upon Three-Month LIBORplus 3.55 percent and adjusts on a quarterly basis.  As of December 31, 2002, the interest rate on the CapitalSecurities was 4.95 percent.  PacificNorthwest Bancorp entered into agreements which, taken collectively, fully andunconditionally guarantee the capital securities subject to the terms of eachof the guarantees.  The CapitalSecurities qualify as Tier I capital under the capital guidelines of theFederal Reserve Board.

 

On November 15, 1999, $40,000,000 of 9.875 percent Capital Securitieswere issued by InterWest Capital Trust I (the Trust I).  The Trust I is a business trust organized inNovember 1999, and Bancorp owns 100 percent of the common equity of the TrustI.  The proceeds of the offering wereinvested by the Trust I in junior subordinated debentures of Bancorp.  The debentures held by the Trust I are thesole assets of the Trust I. Distributions on the capital securities issued by the Trust I are payablesemiannually at 9.875 percent per annum, which is equal to the interest ratebeing earned by the Trust I on the debentures it held.  The capital securities are subject tomandatory redemption, in whole or in part, upon repayment of the debentures.Bancorp has entered into agreements which, taken collectively, fully andunconditionally guarantee the capital securities subject to the terms of eachof the guarantees. The capital securities qualify as Tier I capital under thecapital guidelines of the Federal Reserve Board.  During the years ended December 31, 2002 and 2001, Bancorp purchased$1,500,000 and $2,500,000 of the Trust I capital securities, respectively.  At Bancorp’s option, the debentures will notmature earlier than November 15, 2009, and not later than November 15, 2029.  After November 15, 2019, the debentures canbe redeemed at par value. If Bancorp elects to redeem the debentures prior toNovember 15, 2019, an adjusted prepayment price will be paid as follows duringeach of the respective years ending November 15:

 
| **Year** |   | **Price** |   |
|----------|--------|-----------|--------|
| 2009     |   | 104.938   | %      |
| 2010     |   | 104.444   | %      |
| 2011     |   | 103.950   | %      |
| 2012     |   | 103.457   | %      |
| 2013     |   | 102.963   | %      |
| 2014     |   | 102.469   | %      |
| 2015     |   | 101.975   | %      |
| 2016     |   | 101.481   | %      |
| 2017     |   | 100.988   | %      |
| 2018     |   | 100.494   | %      |

 

**NOTE 13**OTHERBORROWINGS

 

As of December 31, 2002and 2001, PNWB had other borrowings totaling $10,072,000 and $12,621,000,respectively.

 

41

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On March 14, 2001,Bancorp entered into an agreement with an unaffiliated lender for a $10,000,000promissory note.  The note accruesinterest at the lender’s base lending rate, which is set at the lender’s solediscretion, plus a margin of 0.75 percent. The interest rate on the note was 5.25% as of December 31, 2002.  The principle of the promissory note is dueon April 1, 2008.

 

On September 26, 2001, Bancorp entered into an agreement with anunaffiliated lender for a $2,000,000 promissory note. Bancorp paid off thisnote in October 2002.  The note accruedinterest at the lender’s base lending rate, which was set at the lender’s solediscretion, plus a margin of one percent.

 

**NOTE 14**SHAREHOLDERS’EQUITY

 

On January 22, 2002, the Board of Directors approved a stock repurchaseplan of up to five percent of Bancorp’s outstanding shares of common stock overthe next twelve months.  On September16, 2002, Pacific Northwest Bancorp completed the stock repurchase plan.  Under this plan, PNWB repurchased, on theopen market, and retired a total of 780,825 shares at an average price of$27.85.

 

During the year ended December 31, 2000, PNWB repurchased and retired468,000 shares of its common stock under two stock repurchase plans approved bythe Board of Directors in 1999.  Thetotal price was $7,860,000, which represented an average price of $16.79 percommon share repurchased.  As ofDecember 31, 2001, no stock repurchases associated with these Board approvedplans remained outstanding.

 

On January 28, 2003, the Boardof Directors approved a stock repurchase plan of up to five percent ofBancorp’s outstanding shares of common stock over the next twelve months.

 

**NOTE 15**SEVERANCEAND EMPLOYMENT AGREEMENTS

 

In conjunction with the BKNW acquisition and the outsourcing of PNWB’smortgage lending operations, PNWB incurred $963,000 in expenses associated withseverance and employment agreements during the year ended December 31, 2002.  There were approximately 90 employeesaffected by these severance and employment agreements.  The entire $963,000 expenses were paid outduring the year ended December 31, 2002 and as such, PNWB had no accruedliability related to these agreements as of December 31, 2002.

 

In conjunction with executive management changes and elimination ofduplicate administrative functions, PNWB incurred $200,000 and $3,325,000 inexpenses associated with severance and employment agreements during the yearsended December 31, 2001 and 2000, respectively.   There were approximately 40 employees affected by theseseverance and employment agreements. During the years ended December 31, 2001 and 2000, $515,000 and $1,154,000of such expenses were paid out, respectively. As of December 31, 2002 and 2001, PNWB had an accrued liability of$1,356,000 related to these agreements recorded in other liabilities that willbe paid out in future periods.

 

42

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**NOTE16**INCOME TAXES

 

A reconciliation of income tax expense based on the statutory corporatetax rate on pre-tax income and the amount of expense shown in the accompanyingconsolidated statements of income for the years ended December 31, 2002,2001and 2000 is as follows:

 
|                                     |   | **2002**   |   | **2001**                                |   | **2000**   |   |
|------------------------------------------|--------|------------|--------|-----------------------------------------|--------|------------|--------|
| **Dollars in thousands**                 |   | **Amount** |   | **As a  percentage  of pretax  income** |   | **Amount** |   | **As a  percentage  of pretax  income** |   | **Amount** |   | **As a  percentage  of pretax  income** |   |
| Federal  income taxes at statutory rates |   | $          | 15,324 |                                    | 35.0   | %          | $      | 12,353 |   | 35.0 | % | $ | 3,721 |   | 35.0 | % |
|                                     |   |       |   |                                    |   |       |   |   |   |   |   |   |   |
| Tax effect  of:                          |   |       |   |                                    |   |       |   |   |   |   |   |   |   |
| Bank  owned life insurance               |   | (590       | )      | (1.3                                    | )      | —     |   | — |   | — |   | — |   |
| Goodwill  amortization                   |   | —     |   | —                                  |   | 455        |   | 1.3 |   | 714 |   | 6.7 |   |
| Tax-exempt  interest                     |   | (56        | )      | (0.1                                    | )      | (36        | )      | (0.1 | ) | (52 | ) | (0.5 | ) |
| Other,  net                              |   | 346        |   | 0.8                                     |   | 431        |   | 1.2 |   | (21 | ) | (0.2 | ) |
|                                     |   |       |   |                                    |   |       |   |   |   |   |   |   |   |
| Total                                    |   | $          | 15,024 |                                    | 34.3   | %          | $      | 13,203 |   | 37.4 | % | $ | 4,362 |   | 41.0 | % |
|                                     |   |       |   |                                    |   |       |   |   |   |   |   |   |   |
| Current  income tax expense              |   | $          | 13,834 |                                    | 31.6   |       | $      | 13,881 |   | 39.3 |   | $ | 7,346 |   | 69.1 |   |
| Deferred  income tax expense (benefit)   |   | 1,190      |   | 2.7                                     |   | (678       | )      | (1.9 | ) | (2,984 | ) | (28.1 | ) |
|                                     |   |       |   |                                    |   |       |   |   |   |   |   |   |   |
| Total                                    |   | $          | 15,024 |                                    | 34.3   | %          | $      | 13,203 |   | 37.4 | % | $ | 4,362 |   | 41.0 | % |

 

 

Tax effects of temporary differences that give rise to elements ofdeferred tax assets (liabilities) consisted of the following as of December 31:

 
| **Dollars in thousands**                              |   | **2002** |   | **2001** |   |
|-------------------------------------------------------|--------|----------|--------|----------|--------|
|                                                  |   |     |   |     |   |
| Deferred  tax assets:                                 |   |     |   |     |   |
| Allowance  for losses on loans                        |   | $        | 7,904  |     | $      | 6,650 |   |
| Deferred  compensation                                |   | 586      |   | 566      |   |
| Other  real estate                                    |   | 278      |   | 1,242    |   |
| Accrued  expenses                                     |   | 1,277    |   | 1,064    |   |
| Other                                                 |   | 1,380    |   | 985      |   |
| Total  deferred tax assets                            |   | 11,425   |   | 10,507   |   |
|                                                  |   |     |   |     |   |
| Deferred  tax liabilities:                            |   |     |   |     |   |
| Loan fees                                             |   | (2,840   | )      | (2,581   | )      |
| FHLB  stock dividends                                 |   | (6,943   | )      | (5,939   | )      |
| Depreciation                                          |   | (2,213   | )      | (1,660   | )      |
| Net  unrealized gain on securities available for sale |   | (1,972   | )      | (678     | )      |
| Purchase  accounting adjustments                      |   | (3,866   | )      | —   |   |
| Other                                                 |   | (351     | )      | (59      | )      |
| Total  deferred tax liabilities                       |   | (18,185  | )      | (10,917  | )      |
|                                                  |   |     |   |     |   |
| Net  deferred tax liability                           |   | $        | (6,760 | )        | $      | (410 | ) |

 

The realization of deferred taxassets is dependent upon the ability to generate taxable income in futureperiods.  PNWB has evaluated availableevidence supporting the realization of its deferred tax assets and determinedit is more likely than not that deferred tax assets will be realized.

 

43

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**NOTE 17**EMPLOYEEBENEFITS

 

*RETIREMENT ANDSAVINGS PLANS* | PNWB had a debt-leveraged employeestock ownership plan (ESOP) for employees. The ESOP is a non-contributory stock ownership plan.  PNWB contributes 5 percent of qualified participants’compensation to the ESOP on a monthly basis.

 

During 1998, the ESOP enteredinto a line of credit agreement with an unrelated third party to borrow up to atotal of $4,000,000 for the purpose of acquiring Bancorp common stock.  Interest on the line of credit is computedat one-month LIBOR plus 1.75 percent. Interest paid was $5,000, $82,000, $205,000 for the years ended December31, 2002, 2001 and 2000 respectively. The obligation is reduced, and shareholders’ equity increased, by theamount of any principal reduction of the line of credit by the ESOP. During theyears ended December 31, 2002, 2001and 2000 the ESOP made principal repaymentsof $543,000, $1,125,000, and $1,312,000 on the ESOP line of credit.  Dividends paid on unallocated shares ofstock may be used to make payments on the loan.  Accordingly, $8,000, $24,000, and $76,000 of dividends wereapplied toward loan payments during the years ended December 31, 2002, 2001 and2000, respectively. The compensation of the leveraged shares is calculated bytaking the difference between the average fair value of the shares released andthe cost of the shares.  Shares arereleased as the loan payments are made on the ESOP line of credit.  On March 15, 2002, ESOP repaid the remainingprinciple and interest due on the line of credit.  As a result, the remaining unallocated shares were allocated tothe plan participants.  Leveraged ESOPshares during the years ended December 31, 2002, 2001and 2000 were as follows:

 
|                                |   | **Year ended  December 31,  2002** |   | **Year ended  December 31,  2001** |   | **Year ended  December 31,  2000** |   |
|-------------------------------------|--------|------------------------------------|--------|------------------------------------|--------|------------------------------------|--------|
|                                |   |                               |   |                               |   |                               |   |
| Leveraged shares, beginning of year |   | 15,900                             |   | 55,071                             |   | 102,632                            |   |
| Shares released for allocation      |   | (15,900                            | )      | (39,171                            | )      | (47,561                            | )      |
|                                |   |                               |   |                               |   |                               |   |
| Unallocated shares, end of year     |   | 0                                  |   | 15,900                             |   | 55,071                             |   |

 

The fair value of unallocated shares was $0, $325,000, and $761,000 asof December 31, 2002, 2001 and 2000, respectively.

 

On April 1, 2002, the ESOP plan converted into the ESOP/Money PurchasePlan.  The plan remains an employeestock ownership plan for all contributions to the plan made prior to March 31,2002.  For all contributions to the Plansubsequent to April 1, 2002, the plan operates as a money purchase pensionplan.  Beginning April 1, 2002, companycontribution and cash dividends from company stock to the plan were invested invarious investment options, including the company stock, based on employeedirectives.

 

PNWB has a salary deferral 401(k) plan that is a defined contributionplan.  Employees can make contributionsto their respective accounts in the 401(k) plan on a pre-tax basis up to themaximum amount permitted by law.  PNWBmatches a portion of the salary deferred by each participant according to theschedule in the plan.  Employees directboth employee’s and PNWB’s contributions to any of the eight investment optionsoffered in the 401(k) plan.  EffectiveJanuary 1, 2002, employees may also direct the contributions to purchaseBancorp common stock.  PNWB’s expenses,including contributions, for the ESOP and 401(k) plan were $2,286,000, $2,063,000,and $2,008,000 for the years ended December 31, 2002, 2001 and 2000,respectively.  Prior to the acquisition,BKNW had a salary deferral 401(k) plan that is a defined contribution plan.  Shortly after the completion of itsacquisition by PNWB, BKNW’s 401(k) plan was merged into PNWB’s salary deferral401(k) plan.

 

PNWB also maintains several non-qualified deferred compensationprograms for certain executive officers.

 

*STOCK OPTION PLANS*| During January 1993, the shareholders of Bancorp approved the addition of aqualified employee stock option plan (1993 incentive plan). The awarding ofstock options to certain employees of PNWB is at the discretion of the Board ofDirectors.  The term of the optionsgranted is generally five or ten years. Substantially all of the options granted under the 1993 incentive planvest over three to five-year periods. The 1993 incentive plan expired on December 31, 2002 and no more optionswere available for futures grants under this plan.

 

In January 1997, theshareholders of Bancorp approved the non-qualified 1996 Outside Directors StockOptions-For-Fees Plan (1996 Director Plan). Under the 1996 Director Plan,non-employee directors may elect to receive stock options in lieu of feesotherwise due for board services and may exercise those options after oneyear.  Each option granted under the1996 Director Plan has a term of five years.

 

44

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Companies acquired by PNWB hadstock option plans that have been assumed by PNWB. The number of stock optionshares and exercise prices were appropriately adjusted to reflect the commonstock exchange ratios for each acquisition. All outstanding stock options of acquired companies became 100 percentvested and exercisable upon the consummation of the respective acquisitionsexcept for 56,990 shares of outstanding stock options assumed from the BKNWacquisition, which will vest between January 2003 and December 2004.  No further awards will be granted under anyof these plans.  BKNW also had a stockwarrant plan that has been assumed by PNWB. The terms of the warrants provided for purchase of 90,950 shares ofPacific Northwest Bancorp common stock at a price of $7.33 by the warrantholders prior to October 15, 2006.

 

The exercise price of options granted under most of these plans wasequal to the fair value of the common stock on the date of the grant. Averageexercise price per share, number of shares authorized, available for grant,granted, exercised, outstanding and currently exercisable reflect adjustmentsfor common stock splits.  Informationwith respect to options granted under all stock option plans is as follows:

 
|                             |   | **Average  Exercise Price** |       | **Options  Outstanding** |       | **Options  Exercisable** |       |
|----------------------------------|--------|-----------------------------|------------|--------------------------|------------|--------------------------|------------|
|                             |   |                        | ** ** |                     | ** ** |                     | ** ** |
| Balance December 31, 1999        |   | 16.40                       |       | 1,005,624                |       | 490,686                  |       |
| Options granted                  |   | 13.45                       |       | 152,875                  |       | —                   |       |
| Options exercised                |   | 6.97                        |       | (111,969                 | )          | (111,969                 | )          |
| Options rescinded/expired        |   | 19.02                       |       | (114,566                 | )          | —                   |       |
| Options vested                   |   | —                      |       | —                   |       | 109,538                  |       |
| Balance December 31, 2000        |   | $                           | 16.73      |                     | 931,964    |                     | 488,255    |   |
| Options granted                  |   | 19.11                       |       | 614,613                  |       | —                   |       |
| Options exercised                |   | 10.24                       |       | (65,343                  | )          | (65,343                  | )          |
| Options rescinded/expired        |   | 19.40                       |       | (80,693                  | )          | —                   |       |
| Options vested                   |   | —                      |       | —                   |       | 154,627                  |       |
| Balance December 31, 2001        |   | $                           | 17.97      |                     | 1,400,541  |                     | 577,539    |   |
| Options assumed from acquisition |   | 9.98                        |       | 511,525                  |       | 454,535                  |       |
| Options granted                  |   | 25.82                       |       | 342,497                  |       | —                   |       |
| Options exercised                |   | 13.85                       |       | (217,547                 | )          | (217,547                 | )          |
| Options rescinded/expired        |   | 18.30                       |       | (88,476                  | )          | —                   |       |
| Options vested                   |   | —                      |       | —                   |       | 375,090                  |       |
| Balance December 31, 2002        |   | $                           | 17.70      |                     | 1,948,540  |                     | 1,189,617  |   |

 

Additional financial data pertaining to outstanding stock options as ofDecember 31, 2002 is as follows:

 
| **Range of  Exercise Prices** |   | **Number of  Option Shares** |       | **Weighted  Average  Remaining  Contractual Life  (in years)** |       | **Weighted  Average  Exercise Price  of Option Shares** |       | **Number of  Exercisable  Option Shares** |       | **Weighted  Average  Exercise Price  of Exercisable  Option Shares** |       |
|-------------------------------|--------|------------------------------|------------|----------------------------------------------------------------|------------|---------------------------------------------------------|------------|-------------------------------------------|------------|----------------------------------------------------------------------|------------|
|                          |   |                         | ** ** |                                                           | ** ** |                                                    | ** ** |                                      | ** ** |                                                                 | ** ** |
| $5.49–$10.28             |   | 345,810                      |       | 3.40                                                           |       | $                                                       | 7.90       |                                      | 332,890    |                                                                 | $          | 7.81 |   |
| $10.48–$17.00            |   | 316,779                      |       | 4.87                                                           |       | 12.99                                                   |       | 253,168                                   |       | 13.02                                                                |       |
| $17.37–$20.66            |   | 456,082                      |       | 6.69                                                           |       | 17.59                                                   |       | 257,267                                   |       | 17.52                                                                |       |
| $20.75–$24.92            |   | 441,044                      |       | 6.09                                                           |       | 21.48                                                   |       | 302,417                                   |       | 21.67                                                                |       |
| $25.33–$27.98            |   | 388,825                      |       | 8.00                                                           |       | 26.11                                                   |       | 43,875                                    |       | 27.40                                                                |       |
|                          |   |                         |       |                                                           |       |                                                    |       |                                      |       |                                                                 |       |
| Total                         |   | 1,948,540                    |       | 5.93                                                           |       | $                                                       | 17.70      |                                      | 1,189,617  |                                                                 | $          | 15.27 |   |

 

As of December 31, 2002, there were a total of 2,911,833 sharesauthorized under all stock option plans and a total of 23,640 shares availablefor future stock option grants.

 

SFAS No. 148, “Accounting for Stock-Based Compensation-Transition andDisclosure,”requires the disclosure of pro forma net income and net income pershare had PNWB adopted the fair value method of accounting for stockoptions.  Under this statement, the fairvalue of stock-based awards is calculated through the use of option pricingmodels.  These models require the use ofsubjective assumptions, including stock price volatility, dividend yield,risk-free interest rate and expected time to exercise. The fair value ofoptions granted under stock option plans is estimated on the date of grantusing the Black-Scholes option-pricing model. Using the assumptions below, the weighted average estimated fair valueof options granted was $5.19, $5.89, and $4.12 during the years ended December31, 2002, 2001 and 2000, respectively. The 

 

45

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following weighted average assumptions were used in the computation ofthe weighted average estimated fair value of stock options for the years endedDecember 31, 2002, 2001 and 2000:

 
|                     |   | **Year ended  December 31,  2002** |   | **Year ended  December 31,  2001** |   | **Year ended  December 31,  2000** |   |
|--------------------------|--------|------------------------------------|--------|------------------------------------|--------|------------------------------------|--------|
|                     |   |                               |   |                               |   |                               |   |
| Expected volatility      |   | 32.3                               | %      | 40.3                               | %      | 40.9                               | %      |
| Expected dividend yield  |   | 2.2                                | %      | 2.7                                | %      | 4.1                                | %      |
| Risk-free interest rate  |   | 3.9                                | %      | 5.1                                | %      | 5.5                                | %      |
| Expected life (in years) |   | 2.7                                |   | 4.7                                |   | 5.8                                |   |

 

If compensation expense forPNWB’s stock option plans had been determined consistent with SFAS No. 148, netincome and net income per share would have been the following pro forma amountsfor the years ended December 31, 2002, 2001 and 2000:
| **Dollars in thousands, except per share amounts** |   | **Year ended  December 31,  2002** |   | **Year ended  December 31,  2001** |   | **Year ended  December 31,  2000** |   |
|----------------------------------------------------|--------|------------------------------------|--------|------------------------------------|--------|------------------------------------|--------|
|                                               |   |                               |   |                               |   |                               |   |
| Net income:                                        |   |                               |   |                               |   |                               |   |
| As reported                                        |   | $                                  | 28,760 |                               | $      | 22,092                             |   | $ | 6,269 |   |
| Pro forma                                          |   | 27,425                             |   | 21,725                             |   | 5,963                              |   |
| Basic net income per share:                        |   |                               |   |                               |   |                               |   |
| As reported                                        |   | $                                  | 1.85   |                               | $      | 1.42                               |   | $ | 0.40 |   |
| Pro forma                                          |   | 1.76                               |   | 1.40                               |   | 0.38                               |   |
| Diluted net income per share:                      |   |                               |   |                               |   |                               |   |
| As reported                                        |   | $                                  | 1.80   |                               | $      | 1.40                               |   | $ | 0.40 |   |
| Pro forma                                          |   | 1.71                               |   | 1.38                               |   | 0.38                               |   |

 

The compensation expenseincluded in the pro forma net income and net income per share is not likely tobe representative of the effect on reported net income for future years becausestock options vest over several years and additional option grants generallyare made each year.

 

**NOTE 18**REGULATORYCAPITAL

 

Bancorp and Pacific NorthwestBank are subject to risk-based capital guidelines requiring minimum capitallevels based on the credit risk of assets. Failure to meet minimum capital requirements can initiate certainmandatory and possibly additional discretionary, actions by regulators that, ifundertaken, could have a material effect on PNWB’s consolidated financialstatements.  Under capital adequacyguidelines and the regulatory framework for prompt corrective action, Bancorpand Pacific Northwest Bank must meet specific capital guidelines that involvequantitative measures of assets, liabilities and certain off-balance-sheetitems as calculated under regulatory accounting practices.  Capital classifications are also subject toqualitative judgments by the regulators about components, risk weightings andother factors.

 

The regulations define therelevant capital levels for the five categories. In general terms, the capitaldefinitions are as follows:

 
|                           |   | **Total  Capital  (to Risk  Weighted Assets)** |   | **Tier  1Capital  (to Risk  Weighted Assets)** |   | **Tier 1  Capital  (to Average  Assets)** |   |
|--------------------------------|--------|------------------------------------------------|--------|------------------------------------------------|--------|-------------------------------------------|--------|
| Well  capitalized              |   | 10                                             | %      | 6                                              | %      | 5                                         | %      |
| Adequately  capitalized        |   | 8                                              | %      | 4                                              | %      | 4                                         | %      |
| Undercapitalized               |   | Below 8                                        | %      | Below 4                                        | %      | Below 4                                   | %      |
| Significantly undercapitalized |   | Below 6                                        | %      | Below 3                                        | %      | Below 3                                   | %      |
| Critically undercapitalized    |   | —                                         |   | —                                         |   | 2 or less                                 | %      |

 

Bancorp is subject torisk-based capital guidelines issued by the Federal Reserve Board (FRB), whichestablish a risk-adjusted ratio relating capital to different categories ofassets.  Tier I capital is comprised ofshareholders’ equity and guaranteed preferred beneficial interests insubordinated debt less certain intangibles, and excludes the equity impact ofadjusting securities available for sale to estimated fair value. Total capitalis Tier I capital and the allowance for losses on loans.  The FRB’s risk-based capital rules aresupplemented by a leverage capital ratio, defined as Tier I capital to adjusted

 

46

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quarterly average total assets.As of December 31, 2002 and 2001, under the FRB’s capital guidelines, Bancorp’sconsolidated regulatory capital exceeded the FRB’s minimum requirements.

 

The capital amounts and ratiosfor Pacific Northwest Bancorp and Pacific Northwest Bank as of December 31,2002 and 2001 are presented in the following table:

 
|                                     |   |       |       |                                |       |       |       |      |       | **To Be Well  Capitalized Under  Prompt   Action Corrective  Provisions** |       |
|------------------------------------------|--------|------------|------------|-------------------------------------|------------|------------|------------|-----------|------------|---------------------------------------------------------------------------|------------|
|                                     |   | **Actual** |       | **For  Capital  Adequacy Purposes** |       |       |
| **Dollars in thousands**                 |   | **Amount** |       | **Ratio**                           |       | **Amount** |       | **Ratio** |       | **Amount**                                                                |       | **Ratio** |   |
|                                     |   |       | ** ** |                                | ** ** |       | ** ** |      | ** ** |                                                                      | ** ** |   | ** ** |
| **December 31, 2002**                    |   |       | ** ** |                                | ** ** |       | ** ** |      | ** ** |                                                                      | ** ** |   | ** ** |
| *Pacific  Northwest Bancorp:*            |   |       | ** ** |                                | ** ** |       | ** ** |      | ** ** |                                                                      | ** ** |   | ** ** |
| Total capital (to risk-weighted assets)  |   | $          | 264,965    |                                | 11.03      | %          | $          | 192,262   |       | 8.0                                                                       | %          | $ | 240,328 |   | 10.0 | % |
| Tier I capital (to risk-weighted assets) |   | 227,653    |       | 9.47                                | %          | 96,131     |       | 4.0       | %          | 144,197                                                                   |       | 6.0 | % |
| Tier I capital (to average assets)       |   | 227,653    |       | 7.77                                | %          | 117,201    |       | 4.0       | %          | 146,502                                                                   |       | 5.0 | % |
|                                     |   |       |       |                                |       |       |       |      |       |                                                                      |       |   |   |
| *Pacific Northwest Bank:*                |   |       |       |                                |       |       |       |      |       |                                                                      |       |   |   |
| Total capital (to risk-weighted assets)  |   | $          | 257,462    |                                | 10.80      | %          | $          | 190,747   |       | 8.0                                                                       | %          | $ | 238,434 |   | 10.0 | % |
| Tier I capital (to risk-weighted assets) |   | 230,150    |       | 9.65                                | %          | 95,374     |       | 4.0       | %          | 143,060                                                                   |       | 6.0 | % |
| Tier I capital (to average assets)       |   | 230,150    |       | 7.87                                | %          | 116,902    |       | 4.0       | %          | 146,128                                                                   |       | 5.0 | % |
|                                     |   |       |       |                                |       |       |       |      |       |                                                                      |       |   |   |
| **December 31, 2001**                    |   |       |       |                                |       |       |       |      |       |                                                                      |       |   |   |
| *Pacific Northwest Bancorp:*             |   |       |       |                                |       |       |       |      |       |                                                                      |       |   |   |
| Total capital (to risk-weighted assets)  |   | $          | 252,089    |                                | 12.09      | %          | $          | 166,802   |       | 8.0                                                                       | %          | $ | 208,502 |   | 10.0 | % |
| Tier I capital (to risk-weighted assets) |   | 219,966    |       | 10.55                               | %          | 83,401     |       | 4.0       | %          | 125,101                                                                   |       | 6.0 | % |
| Tier I capital (to average assets)       |   | 219,966    |       | 8.02                                | %          | 109,692    |       | 4.0       | %          | 137,115                                                                   |       | 5.0 | % |
|                                     |   |       |       |                                |       |       |       |      |       |                                                                      |       |   |   |
| *Pacific Northwest Bank:*                |   |       |       |                                |       |       |       |      |       |                                                                      |       |   |   |
| Total capital (to risk-weighted assets)  |   | $          | 248,486    |                                | 11.96      | %          | $          | 166,274   |       | 8.0                                                                       | %          | $ | 207,842 |   | 10.0 | % |
| Tier I capital (to risk-weighted assets) |   | 228,363    |       | 10.99                               | %          | 83,137     |       | 4.0       | %          | 124,705                                                                   |       | 6.0 | % |
| Tier I capital (to average assets)       |   | 228,363    |       | 8.35                                | %          | 109,427    |       | 4.0       | %          | 136,783                                                                   |       | 5.0 | % |

 

As of December 31, 2002and 2001, Pacific Northwest Bank was in compliance with well-capitalizedcapital requirements. Management believes that under the current regulationsPacific Northwest Bank will continue to meet minimum well-capitalized capitalrequirements in the foreseeable future. However, events beyond the control of Pacific Northwest Bank, such as adownturn in the economy in areas where Pacific Northwest Bank has most of itsloans, could adversely affect future earnings and, consequently, the ability ofPacific Northwest Bank to meet future well-capitalized requirements.

 

Currently, Bancorp paysquarterly dividends, which it intends to continue to do. The funding source fordividends paid to shareholders is dividends received from Pacific NorthwestBank. The payment of dividends to Bancorp from Pacific Northwest Bank will bebased on earnings and financial condition and is subject to ongoing review byregulatory agencies and various statutory limitations.  Generally, PNWB is precluded from payingdividends on its common stock if capital would be reduced to below regulatoryrequirements at either the holding company or subsidiary bank level.  As of December 31, 2002, $66,715,000 ofretained earnings was available for dividend distribution based on the capitallevels and restrictions of Bancorp and Pacific Northwest Bank.

 

In addition to regulatoryrestrictions on the payment of dividends, Pacific Northwest Bank is subject tocertain restrictions imposed by federal law on any extensions of credit toPacific Northwest Bancorp.  As ofDecember 31, 2002, $25,000,000 million of credit was available to PacificNorthwest Bancorp from Pacific Northwest Bank under these limitations.

 

**NOTE 19** DISCLOSUREABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS

 

The estimated fair valueamounts are determined by PNWB using available market information andappropriate valuation methodologies. However, considerable judgment isnecessary to interpret market data in the development of the estimates of fairvalue. Accordingly, the estimates presented herein are not necessarilyindicative of the amounts PNWB could realize in a current market exchange. Theuse of different market assumptions and/or estimation methodologies may have amaterial impact on the estimated fair value amounts. The following methods andassumptions were used to estimate the fair value of each class of PNWB’sfinancial instruments as of December 31, 2002 and 2001:

 

47

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*CASH AND DUE FROM BANKS, FEDERAL FUNDS SOLDAND SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL* |The carrying value is a reasonable estimate of the fair value.

 

*SECURITIES AVAILABLE FOR SALE AND LOANS HELDFOR SALE* | The estimated fair value of securitiesavailable for sale and loans held for sale are based on quoted market rates anddealer quotes.

 

*LOANS RECEIVABLE* |The estimated fair value of loans receivable is based on discounted cash flows,using estimated interest rates currently offered for loans of similarcharacteristics.

 

No adjustment was made to theestimated interest rates for changes in credit of performing loans for which thereare no known credit concerns. Management believes that the risk factor embedded in the estimatedinterest rates, along with the allowance for losses on loans applicable to theloan portfolio, results in a fair valuation of such loans.

 

*DEPOSITS*| The estimatedfair value of deposits with no stated maturity, such as checking accounts,money market and savings accounts, is equal to the amount payable on demand asof December 31, 2002 and 2001, respectively. The estimated fair value of certificates of deposit is based on thediscounted value of contractual cash flows. The discount rate is estimatedusing the current rate for certificates of deposit with similarcharacteristics.

 

*FHLB ADVANCES, SECURITIES SOLD UNDERAGREEMENTS TO REPURCHASE AND OTHER BORROWINGS*| Thefair value of FHLB advances, securities sold under agreements to repurchase andother borrowings are estimated based on the present values using a discountrate equal to the rate currently offered on similar borrowings with similarmaturities.

 

*GUARANTEED PREFERRED BENEFICIAL INTERESTS INSUBORDINATED DEBT*| The estimated fair value isdetermined based on quoted market rates for subordinated debt with similarinterest rates and similar characteristics.

 

*OTHER* | The carryingvalue of other financial instruments has been determined to be a reasonableestimate of their fair value.

 

48

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|                                                                    |   | **December  31, 2002** |    | **December  31, 2001**    |   |
|-------------------------------------------------------------------------|--------|------------------------|---------|---------------------------|--------|
| **Dollars in thousands**                                                |   | **Carrying  Value**    |    | **Estimated  Fair Value** |   | **Carrying  Value** |   | **Estimated  Fair Value** |   |
|                                                                    |   |                   |    |                      |   |   |   |   |   |
| *Financial assets*                                                      |   |                   |    |                      |   |   |   |   |   |
|                                                                    |   |                   |    |                      |   |   |   |   |   |
| Cash and due from banks                                                 |   | $                      | 100,002 |                      | $      | 100,002 |   | $ | 58,625 |   | $ | 58,625 |   |
| Federal funds sold and securities purchased  under agreements to resell |   | 950                    |    | 950                       |   | — |   | — |   |
| Securities available for sale                                           |   | 788,546                |    | 788,546                   |   | 757,018 |   | 757,018 |   |
| Loans receivable                                                        |   | 2,029,753              |    | 2,048,755                 |   | 1,808,555 |   | 1,844,499 |   |
| Loans held for sale                                                     |   | 25,621                 |    | 26,571                    |   | 43,757 |   | 43,872 |   |
|                                                                    |   |                   |    |                      |   |   |   |   |   |
| *Financial liabilities*                                                 |   |                   |    |                      |   |   |   |   |   |
|                                                                    |   |                   |    |                      |   |   |   |   |   |
| Non-interest-bearing deposits                                           |   | $                      | 345,571 |                      | $      | 345,571 |   | $ | 241,674 |   | $ | 241,674 |   |
| Interest-bearing checking accounts                                      |   | 263,591                |    | 263,591                   |   | 214,099 |   | 214,099 |   |
| Money market accounts                                                   |   | 531,698                |    | 531,698                   |   | 322,554 |   | 322,554 |   |
| Savings accounts                                                        |   | 108,721                |    | 108,721                   |   | 95,390 |   | 95,390 |   |
| Certificates of deposit                                                 |   | 804,729                |    | 823,066                   |   | 731,139 |   | 738,857 |   |
| Total deposits                                                          |   | 2,054,310              |    | 2,072,647                 |   | 1,604,855 |   | 1,612,574 |   |
|                                                                    |   |                   |    |                      |   |   |   |   |   |
| FHLB advances and other borrowings                                      |   | 619,653                |    | 640,686                   |   | 727,147 |   | 732,412 |   |
| Securities sold under agreements to  repurchase                         |   | 120,706                |    | 122,558                   |   | 149,504 |   | 149,761 |   |
| Guaranteed preferred beneficial interests  in subordinated debt         |   | 48,000                 |    | 50,095                    |   | 37,500 |   | 35,318 |   |
|                                                                    |   |                   |    |                      |   |   |   |   |   |
| *Off balance sheet loan commitments*                                    |   |                   |    |                      |   |   |   |   |   |
| Real estate                                                             |   | $                      | 231,203 |                      | $      | 231,203 |   | $ | 268,972 |   | $ | 268,972 |   |
| Non-real estate commercial                                              |   | 445,201                |    | 445,201                   |   | 341,258 |   | 341,258 |   |
| Standby letters of credit                                               |   | 64,501                 |    | 64,501                    |   | 51,485 |   | 51,485 |   |
| Commercial letters of credit                                            |   | 17,816                 |    | 17,816                    |   | 16,915 |   | 16,915 |   |

* *

*LIMITATIONS* | Theestimated fair values presented are based on information available tomanagement as of December 31, 2002 and 2001. Since December 31, 2002 and 2001, amounts have not been comprehensivelyrevalued for purposes of these consolidated financial statements and,therefore, current estimates of fair value may differ from the amountsdisclosed above.

 

**NOTE 20**CONTINGENCIES

 

At periodic intervals, theFDIC, the Washington Department of Financial Institutions, Division of Banks,the Federal Reserve Bank (FRB) and other regulatory agencies (collectively theregulators), examine Bancorp and Pacific Northwest Bank as part of theregulatory oversight of the banking industry. Based on their examinations, the regulators may direct Bancorp orPacific Northwest Bank to adjust financial statements in accordance with theirfindings.  A future examination by theregulators could include a review of certain transactions or other amountsreported in PNWB’s 2002 consolidated financial statements.  The regulators have not proposed significantadjustments to PNWB’s consolidated financial statements in prior years andmanagement is not aware of any basis for any such adjustments for 2002.  In view of the uncertain regulatory environmentin which PNWB operates, the extent, if any, to which a forthcoming examinationmay ultimately result in regulatory adjustments to the 2002 consolidatedfinancial statements cannot presently be determined.

 

In the normal course of business, PNWB has various legal claims andother contingent matters outstanding. Management believes that any ultimate liability arising from theseactions will not have a material adverse impact on PNWB’s financial conditionor results of operations.

 

During the year ended September 30, 1998, PNWB sold $26,709,000 ofsingle-family residential mortgage loans with recourse.  As of December 31, 2002, $5,939,000 ofsingle-family mortgage loans sold with recourse were outstanding.

 

49

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**NOTE 21**CONDENSED PARENT COMPANY FINANCIAL INFORMATION PACIFIC NORTHWEST BANCORP

 

Condensed financial information for Pacific Northwest Bancorp (parentcompany only) as of December 31, 2002, 2001 and 2000 is as follows:

 

CONDENSED STATEMENTS OF FINANCIAL CONDITION

 
| **Dollars in thousands  As of December 31,**            |   | **2002** |       | **2001** |       |
|---------------------------------------------------------|--------|----------|------------|----------|------------|
|                                                    |   |     |       |     |       |
| *Assets*                                                |   |     |       |     |       |
|                                                    |   |     |       |     |       |
| Cash and due from banks                                 |   | $        | 5,585      |     | $          | 2,735 |   |
| Securities available for sale, at estimated  fair value |   | 1,106    |       | 984      |       |
| Goodwill                                                |   | 15,487   |       | 15,487   |       |
| Other assets                                            |   | 5,832    |       | 3,326    |       |
| Investment in subsidiaries                              |   | 302,313  |       | 234,757  |       |
|                                                    |   |     |       |     |       |
| Total                                                   |   | $        | 330,323    |     | $          | 257,289 |   |
|                                                    |   |     | ** ** |     | ** ** |
| ***Liabilities and Shareholders’  Equity***        |   |     | ** ** |     | ** ** |
|                                                    |   |     | ** ** |     | ** ** |
| Other liabilities                                       |   | $        | 4,589      |     | $          | 3,022 |   |
| Borrowings from subsidiaries                            |   | 53,610   |       | 41,238   |       |
| Other borrowings                                        |   | 10,511   |       | 12,543   |       |
| Shareholders’ equity                               |   | 261,613  |       | 200,486  |       |
|                                                    |   |     |       |     |       |
| Total                                                   |   | $        | 330,323    |     | $          | 257,289 |   |

 

 

CONDENSED STATEMENTS OF INCOME

 
| **Dollars in thousands**                                                                   |   | **Year ended  December 31,  2002** |   | **Year ended  December 31,  2001** |   | **Year ended  December 31,  2000** |   |
|--------------------------------------------------------------------------------------------|--------|------------------------------------|--------|------------------------------------|--------|------------------------------------|--------|
|                                                                                       |   |                               |   |                               |   |                               |   |
| Dividend income received from subsidiaries                                                 |   | $                                  | 54,500 |                               | $      | 9,900                              |   | $ | 17,000 |   |
| Interest income                                                                            |   | 561                                |   | 194                                |   | 122                                |   |
| Non-interest income                                                                        |   | 1                                  |   | 25                                 |   | 88                                 |   |
| Total income                                                                               |   | 55,062                             |   | 10,119                             |   | 17,210                             |   |
|                                                                                       |   |                               |   |                               |   |                               |   |
| Interest expense                                                                           |   | 4,919                              |   | 4,698                              |   | 4,072                              |   |
| Non-interest expense                                                                       |   | 2,323                              |   | 2,366                              |   | 11,779                             |   |
| Total expenses                                                                             |   | 7,242                              |   | 7,064                              |   | 15,851                             |   |
| Income before income tax benefit and equity  in undistributed net income from subsidiaries |   | 47,819                             |   | 3,055                              |   | 1,359                              |   |
| Income tax benefit                                                                         |   | (2,350                             | )      | (1,678                             | )      | (5,039                             | )      |
| Net income before equity in undistributed  net income from subsidiaries                    |   | 50,169                             |   | 4,733                              |   | 6,398                              |   |
| Equity (deficit) in undistributed net  income from subsidiaries                            |   | (21,409                            | )      | 17,359                             |   | (129                               | )      |
| Net income                                                                                 |   | $                                  | 28,760 |                               | $      | 22,092                             |   | $ | 6,269 |   |

 

50

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CONDENSED STATEMENTS OF CASHFLOWS

 
| **Dollars in thousands**                                                                 |   | **Year ended  December 31,  2002** |   | **Year ended  December 31,  2001** |   | **Year ended  December 31,  2000** |   |
|------------------------------------------------------------------------------------------|--------|------------------------------------|--------|------------------------------------|--------|------------------------------------|--------|
|                                                                                     |   |                               |   |                               |   |                               |   |
| Cash flows from operating activities:                                                    |   |                               |   |                               |   |                               |   |
| Net income                                                                               |   | $                                  | 28,760 |                               | $      | 22,092                             |   | $ | 6,269 |   |
|                                                                                     |   |                               |   |                               |   |                               |   |
| Adjustments to reconcile net income to net  cash provided by operating activities:       |   |                               |   |                               |   |                               |   |
| Equity in net income from subsidiaries                                                   |   | (33,091                            | )      | (27,260                            | )      | (16,871                            | )      |
| Cash dividends received from subsidiaries                                                |   | 54,500                             |   | 9,900                              |   | 17,000                             |   |
| Change in other assets and liabilities, net                                              |   | (629                               | )      | 352                                |   | (1,634                             | )      |
| Amortization of goodwill                                                                 |   | —                             |   | 1,046                              |   | 1,028                              |   |
| Net cash provided by operating activities                                                |   | 49,540                             |   | 6,130                              |   | 5,792                              |   |
|                                                                                     |   |                               |   |                               |   |                               |   |
| Cash flows from investing activities:                                                    |   |                               |   |                               |   |                               |   |
| Cash paid for acquisition, including $1,538  acquisition costs                           |   | (27,837                            | )      | —                             |   | —                             |   |
| Investments in subsidiaries                                                              |   | —                             |   | (6,000                             | )      | —                             |   |
| Purchase of securities available for sale                                                |   | —                             |   | (706                               | )      | —                             |   |
| Net cash used in investing activities                                                    |   | (27,837                            | )      | (6,706                             | )      | —                             |   |
|                                                                                     |   |                               |   |                               |   |                               |   |
| Cash flows from financing activities:                                                    |   |                               |   |                               |   |                               |   |
| Issuance (repayment) of notes payable                                                    |   | (2,000                             | )      | 12,000                             |   | —                             |   |
| Payment of dividends                                                                     |   | (8,631                             | )      | (8,712                             | )      | (8,770                             | )      |
| Purchase and retirement of treasury stock                                                |   | (21,746                            | )      | (342                               | )      | (7,860                             | )      |
| Proceeds from stock option exercises                                                     |   | 3,024                              |   | 808                                |   | 779                                |   |
| Proceeds from issuance of Pacific Northwest

Statutory Trust I – capital securities |   | 12,000                             |   | —                             |   | —                             |   |
| Purchase of InterWest Capital Trust I –  Capital securities                         |   | (1,500                             | )      | (2,500                             | )      | —                             |   |
| Net cash provided by (used in) financing  activities                                     |   | (18,853                            | )      | 1,254                              |   | (15,851                            | )      |
|                                                                                     |   |                               |   |                               |   |                               |   |
| Net increase (decrease) in cash and cash  equivalents                                    |   | 2,850                              |   | 678                                |   | (10,059                            | )      |
|                                                                                     |   |                               |   |                               |   |                               |   |
| Cash and due from banks at beginning of  year                                            |   | 2,735                              |   | 2,057                              |   | 12,116                             |   |
|                                                                                     |   |                               |   |                               |   |                               |   |
| Cash and due from banks at end of year                                                   |   | $                                  | 5,585  |                               | $      | 2,735                              |   | $ | 2,057 |   |

 

51

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**NOTE 22**NET INCOMEPER SHARE

 

The following table presents the computation of basic and diluted netincome per share for the years ended December 31, 2002, 2001 and 2000:

 
| **Dollars in thousands, except  share and per share data**                |   | **Year ended  December 31,2002** |   | **Year ended  December 31,2001** |   | **Year ended  December 31,2000** |   |
|---------------------------------------------------------------------------|--------|----------------------------------|--------|----------------------------------|--------|----------------------------------|--------|
| Numerator                                                                 |   |                             |   |                             |   |                             |   |
| Net income                                                                |   | $                                | 28,760 |                             | $      | 22,092                           |   | $ | 6,269 |   |
|                                                                      |   |                             |   |                             |   |                             |   |
| Denominator                                                               |   |                             |   |                             |   |                             |   |
| Denominator for basic net income per share-  Weighted average shares      |   | 15,569,297                       |   | 15,557,237                       |   | 15,504,759                       |   |
| Effect of dilutive securities:                                            |   |                             |   |                             |   |                             |   |
| Stock options                                                             |   | 438,353                          |   | 175,586                          |   | 106,323                          |   |
| Denominator for diluted net income per  share-                            |   |                             |   |                             |   |                             |   |
| Weighted average shares and assumed  conversion of dilutive stock options |   | 16,007,650                       |   | 15,732,823                       |   | 15,611,082                       |   |
|                                                                      |   |                             |   |                             |   |                             |   |
| Basic net income per share                                                |   | $                                | 1.85   |                             | $      | 1.42                             |   | $ | 0.40 |   |
|                                                                      |   |                             |   |                             |   |                             |   |
| Diluted net income per share                                              |   | $                                | 1.80   |                             | $      | 1.40                             |   | $ | 0.40 |   |

 

**NOTE 23** SELECTEDQUARTERLY FINANCIAL DATA (UNAUDITED)

 
| **Dollars in thousands except per share data**           |   | **Fourth  Quarter** |       | **Third  Quarter** |       | **Second  Quarter** |       | **First  Quarter** |       |
|----------------------------------------------------------|--------|---------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|
|                                                     |   |                | ** ** |               | ** ** |                | ** ** |               | ** ** |
| Year ended December 31, 2002                             |   |                |       |               |       |                |       |               |       |
| Interest income                                          |   | $                   | 44,015     |               | $          | 44,194              |       | $                  | 45,006     |   | $ | 44,916 |   |
| Interest expense                                         |   | 16,948              |       | 17,253             |       | 17,972              |       | 17,572             |       |
| Net interest income                                      |   | 27,067              |       | 26,941             |       | 27,034              |       | 27,344             |       |
| Provision for losses on loans                            |   | 1,250               |       | 1,700              |       | 1,700               |       | 1,700              |       |
| Net interest income after provision for  losses on loans |   | 25,817              |       | 25,241             |       | 25,334              |       | 25,644             |       |
| Gain (loss) on sale of securities available  for sale    |   | (1,465              | )          | —             |       | 40                  |       | —             |       |
| Other non-interest income                                |   | 5,606               |       | 5,170              |       | 5,324               |       | 4,585              |       |
| Non-interest expense                                     |   | 21,803              |       | 18,402             |       | 18,716              |       | 18,592             |       |
| Income before income taxes                               |   | 8,155               |       | 12,009             |       | 11,982              |       | 11,637             |       |
| Income tax expense                                       |   | 2,824               |       | 4,056              |       | 4,070               |       | 4,073              |       |
| Net income                                               |   | $                   | 5,331      |               | $          | 7,953               |       | $                  | 7,912      |   | $ | 7,564 |   |
| Basic net income per share                               |   | $                   | 0.33       |               | $          | 0.53                |       | $                  | 0.52       |   | $ | 0.49 |   |
| Diluted net income per share                             |   | $                   | 0.32       |               | $          | 0.51                |       | $                  | 0.50       |   | $ | 0.48 |   |
|                                                     |   |                |       |               |       |                |       |               |       |
| Year ended December 31, 2001                             |   |                |       |               |       |                |       |               |       |
| Interest income                                          |   | $                   | 48,163     |               | $          | 50,663              |       | $                  | 52,780     |   | $ | 54,047 |   |
| Interest expense                                         |   | 19,095              |       | 24,038             |       | 28,265              |       | 32,443             |       |
| Net interest income                                      |   | 29,068              |       | 26,625             |       | 24,515              |       | 21,604             |       |
| Provision for losses on loans                            |   | 1,700               |       | 1,550              |       | 1,400               |       | 1,400              |       |
| Net interest income after provision for  losses on loans |   | 27,368              |       | 25,075             |       | 23,115              |       | 20,204             |       |
| Gain on sale of securities available for  sale           |   | 51                  |       | 514                |       | 446                 |       | 698                |       |
| Other non-interest income                                |   | 4,772               |       | 4,596              |       | 4,664               |       | 4,944              |       |
| Non-interest expense                                     |   | 21,025              |       | 20,427             |       | 20,434              |       | 19,266             |       |
| Income before income taxes                               |   | 11,166              |       | 9,758              |       | 7,791               |       | 6,580              |       |
| Income tax expense                                       |   | 4,179               |       | 3,651              |       | 2,916               |       | 2,457              |       |
| Net income                                               |   | $                   | 6,987      |               | $          | 6,107               |       | $                  | 4,875      |   | $ | 4,123 |   |
| Basic net income per share                               |   | $                   | 0.45       |               | $          | 0.39                |       | $                  | 0.31       |   | $ | 0.27 |   |
| Diluted net income per share                             |   | $                   | 0.44       |               | $          | 0.39                |       | $                  | 0.31       |   | $ | 0.26 |   |

 

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Non-interest expense for thequarter ended December 31, 2002 includes merger, conversion and integrationexpenses of $1,025,000, expenses associated with severance and employmentagreements of $963,000, mortgage banking exit costs of $272,000, and branchconsolidation expense of $260,000.

 

Non-interest expense for thequarter ended March 31, 2001 includes conversion and integration expenses of$856,000.  Non-interest expense for thequarter ended June 30, 2001 includes conversion and integration expenses of$434,000, and expenses associated with severance and employment agreements of$200,000.

 

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