SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549
                                   ---------
                                   FORM 10-K

(Mark One)
[X]  ANNUAL REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES  EXCHANGE
     ACT OF 1934

For the fiscal year ended September 30, 1997

                                       OR

[ ]  TRANSITIONAL  REPORT  PURSUANT  TO  SECTION  13 OR 15(d) OF THE  SECURITIES
     EXCHANGE ACT OF 1934

For the transition period from                to
                               --------------     ---------------

                           Commission File No. 0-22219

                             NEWSOUTH BANCORP, INC.
             ------------------------------------------------------
             (Exact name of registrant as specified in its charter)

           Delaware                                              56-1999749
-------------------------------                               ----------------
(State or other jurisdiction of                               (I.R.S. employer
incorporation or organization)                               identification no.)

1311 Carolina Avenue, Washington, North Carolina                    27889-2047
------------------------------------------------                    ----------
    (Address of principal executive offices)                        (Zip Code)

       Registrant's telephone number, including area code: (919) 946-4178

           Securities registered pursuant to Section 12(b) of the Act:
                                 Not Applicable

           Securities registered pursuant to Section 12(g) of the Act:

                     Common stock, par value $.01 per share
                     --------------------------------------
                                (Title of Class)

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

Indicate by check mark if disclosure of delinquent  filers  pursuant to Item 405
of Regulation  S-K is not contained  herein,  and will not be contained,  to the
best of registrant's  knowledge,  in definitive proxy or information  statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]

As of December 9, 1997,  the aggregate  market value of the 2,329,993  shares of
Common Stock of the registrant  issued and outstanding held by non-affiliates on
such date was  approximately  $67.6  million  based on the closing sale price of
$29.00  per share of the  registrant's  Common  Stock as  listed  on the  Nasdaq
National  Market System.  For purposes of this  calculation,  it is assumed that
directors,  executive  officers  and  beneficial  owners  of more than 5% of the
registrant's outstanding voting stock are affiliates.

Number of shares of Common Stock outstanding as of December 9, 1997:  2,909,500.

                       DOCUMENTS INCORPORATED BY REFERENCE

     The following lists the documents incorporated by reference and the Part of
the Form 10-K into which the document is incorporated:

     1.   Portions  of the Annual  Report to  Stockholders  for the fiscal  year
          ended September 30, 1997. (Parts I, II and IV)
     2.   Portions of Proxy  Statement for 1998 Annual Meeting of  Stockholders.
          (Part III)

<PAGE>

                                     PART I

Item 1.  Business
-----------------

General

     NewSouth Bancorp,  Inc. (the "Company") was incorporated  under the laws of
the State of Delaware in October 1996 at the direction of the Board of Directors
of Home Savings Bank, SSB (the "Savings Bank") for the purpose of serving as the
holding  company of the Savings  Bank upon  completion  of its  conversion  from
mutual  to stock  form  (the  "Stock  Conversion"),  and then as a bank  holding
company of NewSouth Bank (the "Bank")  following  the  conversion of the Savings
Bank from a North  Carolina-chartered  savings  bank to a  commercial  bank (the
"Bank Conversion").  The Stock Conversion and the Bank Conversion were completed
in April  1997 and the  Company is now the  holding  company  for the Bank.  The
Company's  principal  business  is  overseeing  the  business  of the  Bank  and
investing the portion of the net Stock Conversion proceeds retained by it.

     NewSouth  Bank.  The  Bank is a North  Carolina-chartered  commercial  bank
headquartered  in Washington,  North Carolina and serves eastern North Carolina.
The Bank was chartered by the State of North Carolina in 1902 under the name The
Home Building and Loan  Association.  The Bank received federal insurance of its
deposits in 1959.  In 1992,  the Bank  converted  to a North  Carolina-chartered
savings  bank,  at which time it adopted the name Home Savings  Bank,  SSB. Upon
completion  of the Bank  Conversion  in  April  1997,  the  Bank  became a North
Carolina-chartered commercial bank and adopted its present name.

     The Bank's  principal  business  consists of  attracting  deposits from the
general public and investing  these funds in loans secured by first mortgages on
owner-occupied,  single-family  residences in the Bank's market area, commercial
real estate loans, commercial business loans and consumer loans.

     The Bank derives its income  principally  from interest earned on loans and
investments and, to a lesser extent,  loan servicing and other fees and gains on
the sale of loans and investments.  The Bank's  principal  expenses are interest
expense on deposits and borrowings and noninterest  expense such as compensation
and  employee  benefits,  office  occupancy  expenses  and  other  miscellaneous
expenses.  Funds for these  activities  are  provided  principally  by deposits,
repayments of outstanding loans and investments and operating revenues.

Market Area

     Although the Company makes loans and obtains  deposits  throughout  eastern
North Carolina, the Company's primary market area consists of Beaufort,  Craven,
Lenoir,  Nash,  Pasquotank  and Pitt Counties in North  Carolina,  which are the
counties in which the Bank's  offices are  located.  As of  September  30, 1997,
management  estimates  that more than 95% of deposits and 90% of loans came from
its primary market area.

     The  economy of the  Company's  primary  market area is  diversified,  with
employment  distributed among manufacturing,  agriculture and  non-manufacturing
activities.  Major employers in the area include Weyerhaeuser  Company,  Dupont,
Abbott  Laboratories,  East Carolina University and Pitt Memorial Hospital.  The
unemployment  rate in the Company's  market area is below the national  average,
though higher than the unemployment rate for the State of North Carolina.

     According  to data  provided  by a  private  marketing  firm,  the  Company
estimates the population of its primary market area to be approximately 430,000.
This  compares to a  population  of  approximately  400,000 in 1990.  The median
household income of the Company's primary market area is $23,256, as compared to
$26,647 for North Carolina as a whole.

                                        2
<PAGE>

Lending Activities

     General.  The Company's  gross loan  portfolio  totaled  $214.5  million at
September 30, 1997,  representing  86.0% of total assets at that date. It is the
Company's policy to concentrate its lending within its market area. At September
30,  1997,  $68.0  million,  or 31.7% of the  Company's  gross  loan  portfolio,
consisted  of   single-family,   residential   mortgage  loans.   The  Company's
construction  loans totaled $33.2 million,  or 15.5% of the Company's gross loan
portfolio,  at September  30, 1997.  The Company also  originates a  significant
amount of commercial real estate loans.  At September 30, 1997,  commercial real
estate loans  amounted to $46.0  million,  or 21.4% of the Company's  gross loan
portfolio.  In recent years, the Company has sought to increase  originations of
commercial business loans and consumer loans. At September 30, 1997,  commercial
business  loans  totaled  $16.4  million,  or 7.7% of the  Company's  gross loan
portfolio,  and consumer loans totaled $49.9 million,  or 23.3% of the Company's
gross  loan  portfolio.   To  a  lesser  extent,  the  Company  also  originates
multi-family  residential real estate loans and commercial real estate loans. At
September  30, 1997,  multi-family  residential  real estate  loans  amounted to
$946,000, or .4% of the Company's gross loan portfolio.

                                        3
<PAGE>

     Loan Portfolio  Composition.  The following  table sets forth selected data
relating to the  composition  of the Company's loan portfolio by type of loan at
the dates indicated. At September 30, 1997, the Company had no concentrations of
loans exceeding 10% of gross loans other than as disclosed below.

<TABLE>
<CAPTION>
                                                                            At September 30,
                                             1997              1996               1995               1994                1993
                                        -------------------------------------------------------------------------------------------
                                        Amount     %      Amount      %      Amount      %      Amount       %      Amount      %
                                        ------  ------    ------   ------    ------   ------    ------    ------    ------   ------
                                                                                           (Dollars in thousands)           
                                                                                                                            
Residential mortgage loans:                                                                                                 
<S>                                   <C>         <C>    <C>         <C>    <C>         <C>    <C>          <C>    <C>         <C>  
  Single-family residential.......... $ 67,959    31.7%  $ 58,576    33.7%  $ 67,736    43.0%  $ 74,364     49.8%  $ 76,692    58.0%
  Multi-family residential...........      946      .4        998      .6      2,315     1.5      2,412      1.6      2,508     1.9
  Construction.......................   33,249    15.5     35,240    20.3     32,062    20.4     31,663     21.2     23,723    17.9
                                      --------  ------   --------  ------   --------  ------   --------   ------   --------  ------
    Total residential mortgage loans.  102,154    47.6     94,814    54.6    102,113    64.9    108,439     72.6    102,923    77.8
                                      --------  ------   --------  ------   --------  ------   --------   ------   --------  ------

Commercial loans:                                                                                                           
  Commercial real estate.............   45,990    21.4     31,168    17.9     21,890    13.9     17,098     11.4      8,157     6.2
  Commercial business................   16,449     7.7     10,328     6.0      3,698     2.4      1,777      1.2        162      .1
                                      --------  ------   --------  ------   --------  ------   --------   ------   --------  ------
    Total commercial loans...........   62,439    29.1     41,496    23.9     25,588    16.3     18,875     12.6      8,319     6.3
                                      --------  ------   --------  ------   --------  ------   --------   ------   --------  ------
                                                                                                                            
Consumer loans:                                                                                                             
  Automobile.........................    4,611     2.2      4,185     2.4      2,532     1.6      1,986      1.3      2,148     1.6
  Savings account loans..............      617      .3        549      .3        661      .4        454       .3        389      .3
  Home equity loans..................   21,665    10.1     17,949    10.3     15,514     9.9     11,930      8.0     10,231     7.7
  Other..............................   22,996    10.7     14,740     8.5     10,977     6.9      7,767      5.2      8,323     6.3
                                      --------  ------   --------  ------   --------  ------   --------   ------   --------  ------
    Total consumer loans.............   49,889    23.3     37,423    21.5     29,684    18.8     22,137     14.8     21,091    15.9
                                      --------  ------   --------  ------   --------  ------   --------   ------   --------  ------
      Total..........................  214,482  100.00%   173,733  100.00%   157,385  100.00%   149,451   100.00%   132,333  100.00%
                                      --------  ======   --------  ======   --------  ======   --------   ======   --------  ======
                                                                                                                            
Less:                                                                                                                       
  Loans in process...................   12,717             15,245             10,626             11,506              11,766 
  Deferred fees and discounts........      731                456                341                289                 188 
  Allowance for loan losses..........    3,249              2,351              1,877              1,977               1,843 
                                      --------           --------           --------           --------            -------- 
    Total............................ $197,785           $155,681           $144,541           $135,679            $118,536 
                                      ========           ========           ========           ========            ======== 
</TABLE>
                                           
                                        4
<PAGE>

     Loan  Maturities.  The following  table sets forth certain  information  at
September  30,  1997  regarding  the  dollar  amount  of loans  maturing  in the
Company's  portfolio  based on their  contractual  terms to maturity,  including
scheduled repayments of principal. Demand loans, loans having no stated schedule
of repayments and no stated maturity,  and overdrafts are reported as due in one
year or less.  The table does not include  any  estimate  of  prepayments  which
significantly  shorten  the  average  life of  mortgage  loans and may cause the
Company's  repayment  experience to differ from that shown below.  Loan balances
are net of loans in process.

<TABLE>
<CAPTION>
                                                              Due After             Due After
                                                              1 Through             5 or More
                                      Due One Year          5 Years After          Years After
                                        or Less,         September 30, 1997    September 30, 1997      Total
                                   ------------------    ------------------    ------------------     ------
                                                                      (In thousands)

<S>                                    <C>                   <C>                   <C>              <C>       
Residential mortgage loans..........   $   21,539            $   11,692            $   58,531       $   91,762
Commercial (1)......................        9,540                46,053                 4,756           60,349
Consumer............................        5,230                21,969                22,456           49,655
                                       ----------            ----------            ----------       ----------
     Total..........................   $   36,309            $   79,714            $   85,743       $  201,766
                                       ==========            ==========            ==========       ==========
</TABLE>
---------------
(1)  Includes commercial real estate and commercial business loans.

     The  following  table sets forth at September 30, 1997 the dollar amount of
all loans due one year or more after September 30, 1997 which have predetermined
interest rates and have floating or adjustable interest rates.

<TABLE>
<CAPTION>
                                                          Predetermined              Floating or
                                                               Rate               Adjustable Rates
                                                          -------------           ----------------
                                                                      (In thousands)

<S>                                                        <C>                       <C>        
      Residential mortgage loans.........................  $    35,182               $    35,041
      Commercial (1).....................................       19,642                    31,167
      Consumer...........................................       18,526                    25,899
                                                           -----------               -----------
          Total..........................................  $    73,350               $    92,107
                                                           ===========               ===========
</TABLE>
--------------
(1)  Includes commercial real estate and commercial business loans.

     Scheduled  contractual  principal  repayments  of loans do not  reflect the
actual life of such assets.  The average life of loans can be substantially less
than their  contractual terms because of prepayments.  In addition,  due-on-sale
clauses on loans generally give the Bank the right to declare a loan immediately
due and payable in the event,  among other things,  that the borrower  sells the
real  property  subject to the mortgage and the loan is not repaid.  The average
life of mortgage loans tends to increase when current mortgage loan market rates
are substantially  higher than rates on existing mortgage loans and, conversely,
decrease when current  mortgage loan market rates are  substantially  lower than
rates on existing mortgage loans.

     Originations,  Purchases  and  Sales  of  Loans.  The  Bank  generally  has
authority  to  originate  and  purchase  loans  secured by real  estate  located
throughout  the  United  States.   Consistent  with  its  emphasis  on  being  a
community-oriented  financial  institution,  the Bank  concentrates  its lending
activities in its market area.

     The  Bank's  loan  originations  are  derived  from a  number  of  sources,
including   referrals  from   depositors  and   borrowers,   repeat   customers,
advertising,   calling  officers  as  well  as  walk-in  customers.  The  Bank's
solicitation  programs consist of  advertisements in local media, in addition to
participation in various community  organizations and events.  Real estate loans
are  originated by the Bank's loan  personnel.  All of the Bank's loan personnel
are  salaried,  and  though the Bank does not  compensate  loan  personnel  on a
commission basis for loans  originated,  it does pay an incentive  percentage of
closed  mortgage  loan volume once a defined  threshold has been achieved by the
participant. With the

                                        5
<PAGE>

exception of applications for boat or recreational  vehicle loans,  which may be
originated  on an indirect  basis  through an  arrangement  with  dealers,  loan
applications  are  accepted at the Bank's  offices.  In  addition,  the Bank has
several salaried loan  originators who travel to meet prospective  borrowers and
take applications. In all cases, the Bank has final approval of the application.
Historically,  the Bank generally has not purchased loans. However, the Bank may
in the future  consider making limited loan  purchases,  including  purchases of
commercial loans.

     In  recent  years,  the  Bank  has sold or  exchanged  for  mortgage-backed
securities a significant amount of fixed-rate, single-family mortgage loans that
it originated.  During the years ended September 30, 1997, 1996 and 1995,  these
transactions   totaled  $31.7   million,   $53.2  million  and  $43.9   million,
respectively.  Such loans are sold to or  exchanged  with the Federal  Home Loan
Mortgage  Corporation  ("FHLMC").  The Bank generally retains servicing on loans
sold or exchanged.

     Loan Underwriting  Policies.  The Bank's lending  activities are subject to
the  Bank's  written,  non-discriminatory  underwriting  standards  and to  loan
origination  procedures  prescribed  by the Bank's  Board of  Directors  and its
management.  Detailed loan applications are obtained to determine the borrower's
ability  to repay,  and the more  significant  items on these  applications  are
verified   through  the  use  of  credit  reports,   financial   statements  and
confirmations.  All mortgage  loans are presented  weekly to a loan committee of
the Board of Directors of the Bank made up of three outside  directors who serve
on a rotating basis.  Neither the President nor the Chairman of the Board serves
on the loan  committee.  Individual  officers  of the  Bank  have  been  granted
authority by the Board of Directors to approve  consumer and commercial loans up
to  varying  specified  dollar  amounts,  depending  upon the  type of loan.  In
addition,  committees  of loan  officers  have  loan  authorities  greater  than
individual  authorities.  These authorities are based on aggregate borrowings of
an individual or entity. All loans to a single borrower aggregating in excess of
$500,000  must be approved by the full Board of Directors.  On a monthly  basis,
the full Board of Directors reviews the actions taken by the loan committee.

     Applications  for  single-family  real estate  loans are  underwritten  and
closed in accordance with the standards of FHLMC.  Generally,  upon receipt of a
loan application from a prospective  borrower, a credit report and verifications
are ordered to verify  specific  information  relating  to the loan  applicant's
employment, income and credit standing. If a proposed loan is to be secured by a
mortgage on real estate,  an appraisal of the real estate is usually  undertaken
either by an  appraiser  approved by the Bank and licensed by the State of North
Carolina  or  by  qualified  Bank  personnel.   In  the  case  of  single-family
residential  mortgage loans,  except when the Bank becomes aware of a particular
risk of environmental contamination, the Bank generally does not obtain a formal
environmental  report on the real  estate  at the time a loan is made.  A formal
environmental  report may be required in  connection  with  nonresidential  real
estate loans.

     It is the Bank's policy to record a lien on the real estate securing a loan
and to obtain title  insurance  which insures that the property is free of prior
encumbrances and other possible title defects. Borrowers must also obtain hazard
insurance  policies  prior to closing and, when the property is in a flood plain
as designated  by the  Department  of Housing and Urban  Development,  pay flood
insurance policy premiums.

     With respect to single-family  residential mortgage loans, the Bank makes a
loan  commitment  of  between  15 and 30 days for  each  loan  approved.  If the
borrower  desires a longer  commitment,  the commitment may be extended for good
cause and upon  written  approval.  Fees of between $175 and $425 are charged in
connection  with the  issuance of a  commitment  letter.  The  interest  rate is
guaranteed for the commitment period.

     If the amount of a residential loan originated or refinanced exceeds 80% of
the lessor of the appraised value or contract price, the Bank's policy generally
is to obtain  private  mortgage  insurance  at the  borrower's  expense  on that
portion of the principal amount of the loan that exceeds 80%. The Bank will make
a single-family  residential  mortgage loan with up to a 95% loan-to-value ratio
if the required  private  mortgage  insurance is  obtained.  The Bank  generally
limits the loan-to-value  ratio on commercial real estate mortgage loans to 80%,
although  the  loan-to-value  ratio on  commercial  real estate loans in limited
circumstances has been as high as 85%. The Bank limits the  loan-to-value  ratio
on multi-family residential real estate loans to 80%.

                                        6
<PAGE>

     The Bank is subject to regulation which limits the amount the Bank can lend
to one borrower.  See " -- Regulation -- Limits on Loans to One Borrower." Under
these limits,  the Bank's  loan-to-one-borrower  were limited to $6.0 million at
September 30, 1997. At that date the Bank had no lending relationships in excess
of the loans-to-one-borrower limit.

     Interest  rates  charged by the Bank on loans are affected  principally  by
competitive factors, the demand for such loans and the supply of funds available
for lending purposes.  These factors are, in turn,  affected by general economic
conditions,  monetary policies of the federal government,  including the Federal
Reserve Board, legislative tax policies and government budgetary matters.

     Single-Family  Residential Real Estate Lending.  The Bank  historically has
been and continues to be an originator of single-family, residential real estate
loans in its market area.  At September  30,  1997,  single-family,  residential
mortgage loans,  excluding home  improvement  loans,  totaled $67.9 million,  or
31.7% of the Company's gross loan portfolio.

     The Bank  originates  fixed-rate  mortgage  loans at  competitive  interest
rates.  At September 30, 1997,  $41.4 million,  or 19.3%, of the Company's gross
loan  portfolio was  comprised of  fixed-rate  mortgage  loans.  Generally,  the
Company  retains  fixed-rate  mortgages  with  maturities 15 years or less while
fixed-rate loans with longer  maturities may be retained in portfolio or sold in
the  secondary  market.  The Bank also offers FHA and VA  mortgage  loans in its
market area, which are underwritten and closed by a correspondent lender.

     The Bank  also  offers  adjustable-rate  residential  mortgage  loans.  The
adjustable-rate  loans  currently  offered by the Bank have interest rates which
adjust every one, three or five years from the closing date of the loan or on an
annual basis commencing after an initial fixed-rate period of one, three or five
years in accordance  with a designated  index (the primary index utilized by the
Bank is the weekly  average  yield on U.S.  Treasury  securities  adjusted  to a
constant  comparable  maturity  equal to the  loan  adjustment  period,  as made
available by the Federal Reserve Board (the "Treasury Rate")), plus a stipulated
margin. The Bank offers adjustable-rate loans that meet FHLMC standards, as well
as  loans  that  do  not  meet  such  standards.   The  Bank's   adjustable-rate
single-family  residential  real estate  loans that do not meet FHLMC  standards
have  a cap of  generally  2% on  any  increase  in  the  interest  rate  at any
adjustment date, and include a cap on the maximum interest rate over the life of
the loan,  which cap  generally is 3% to 4.5% above the initial  rate. In return
for providing a relatively  low cap on interest rate  increases over the life of
the loan,  the Bank's  adjustable-rate  loans provide for a floor on the minimum
interest  rate over the life of the loan,  which floor  generally is .125% below
the initial rate.  Further,  the Bank  generally  does not offer  "teaser" rates
i.e.,   initial  rates  below  the  fully  indexed  rate,  on  such  loans.  The
adjustable-rate  mortgage  loans  offered  by the Bank that do  conform to FHLMC
standards have a cap of 6% above the initial rate over the life of a loan but do
not include a floor, may be offered with a teaser rate and have a 25 basis point
lower  margin above the index on which the  interest  rate is based.  All of the
Bank's  adjustable-rate loans require that any payment adjustment resulting from
a change in the interest rate of an adjustable-rate loan be sufficient to result
in full  amortization  of the loan by the end of the loan term and, thus, do not
permit any of the increased  payment to be added to the principal  amount of the
loan, or so-called negative amortization.  At September 30, 1997, $50.4 million,
or 23.5%,  of the  Company's  residential  mortgage  loans were  adjustable-rate
loans.

     The retention of  adjustable-rate  loans in the Company's  portfolio  helps
reduce the  Company's  exposure to increases or decreases in  prevailing  market
interest rates.  However,  there are unquantifiable  credit risks resulting from
potential  increases in costs to  borrowers in the event of upward  repricing of
adjustable-rate  loans.  It is possible that during  periods of rising  interest
rates,  the  risk of  default  on  adjustable-rate  loans  may  increase  due to
increases in interest  costs to  borrowers.  Further,  although  adjustable-rate
loans allow the  Company to increase  the  sensitivity  of its  interest-earning
assets to changes in interest rates, the extent of this interest  sensitivity is
limited by the initial  fixed-rate  period before the first  adjustment  and the
lifetime  interest rate  adjustment  limitations.  Accordingly,  there can be no
assurance that yields on the Company's  adjustable-rate  loans will fully adjust
to compensate for increases in the Company's cost of funds.

                                        7
<PAGE>

     Construction  Lending.  The Bank also  offers  residential  and  commercial
construction  loans, with a substantial portion of such loans originated to date
being for the  construction of  owner-occupied,  single-family  dwellings in the
Bank's primary market area. Residential construction loans are offered primarily
to  individuals  building  their primary or secondary  residence,  as well as to
selected local developers to build single-family dwellings.  Generally, loans to
owner/occupants   for  the   construction   of   owner-occupied,   single-family
residential  properties are originated in connection  with the permanent loan on
the property and have a  construction  term of six to 18 months.  Such loans are
offered on a fixed-rate or adjustable-rate  basis. Interest rates on residential
construction  loans made to the  owner/occupant  have interest  rates during the
construction  period of 1% above the rate  offered by the Bank on the  permanent
loan product  selected by the borrower.  Upon  completion of  construction,  the
permanent  loan rate will be set at the rate  then  offered  by the Bank on that
permanent  loan product,  except that if the permanent  loan rate would be above
the  construction  loan rate then the  borrower can maintain the same rate as on
the  construction  loan.  Interest  rates on residential  construction  loans to
builders  are set at the prime rate plus a margin of  between  .50% and 1% or at
the  Treasury  Rate plus a margin of between 3% and 4.5%,  and adjust  annually.
Interest rates on commercial construction loans are based on the prime rate plus
a negotiated margin of between 0% and 1% and adjust annually,  with construction
terms  generally not  exceeding 18 months.  Advances are made on a percentage of
completed  basis.  At  September  30,  1997,  $33.2  million,  or 15.5%,  of the
Company's gross loan portfolio consisted of construction loans, virtually all of
which was secured by single-family residences.

     Prior to making a  commitment  to fund a loan,  the Bank  requires  both an
appraisal of the property by appraisers approved by the Board of Directors and a
study of the  feasibility  of the  proposed  project.  The Bank also reviews and
inspects each project at the  commencement of construction  and either weekly or
biweekly during the term of the construction  loan. The Bank generally charges a
 .50% to 1% construction loan fee for speculative builder loans. For construction
loans to owner-occupants,  the Bank generally charges a 1% construction loan fee
and a $425 commitment fee.

     Construction  financing  generally is considered to involve a higher degree
of risk of loss than long-term financing on improved, occupied real estate. Risk
of loss on a  construction  loan is  dependent  largely upon the accuracy of the
initial  estimate of the  property's  value at  completion  of  construction  or
development and the estimated cost (including interest) of construction.  During
the  construction  phase,  a number of factors  could  result in delays and cost
overruns.  If the estimate of construction costs proves to be inaccurate and the
borrower  is unable to meet the Bank's  requirements  of  putting up  additional
funds to cover extra costs or change orders,  then the Bank will demand that the
loan be paid  off and,  if  necessary,  institute  foreclosure  proceedings,  or
refinance the loan. If the estimate of value proves to be  inaccurate,  the Bank
may be  confronted,  at or prior to the  maturity of the loan,  with  collateral
having a value  which is  insufficient  to assure full  repayment.  The Bank has
sought to  minimize  this risk by  limiting  construction  lending to  qualified
borrowers (i.e.,  borrowers who satisfy all credit  requirements and whose loans
satisfy  all  other  underwriting  standards  which  would  apply to the  Bank's
permanent mortgage loan financing for the subject property) in the Bank's market
area. On loans to builders, the Bank works only with selected builders with whom
it has experience and carefully monitors the creditworthiness of the builders.

     Multi-Family  Residential  and  Commercial  Real Estate  Lending.  The Bank
originates  commercial  real  estate  loans,  as well  as a  limited  amount  of
multi-family residential real estate loans, generally limiting such originations
to loans secured by properties in its primary  market area and to borrowers with
whom it has other loan  relationships.  The Company's  multi-family  residential
loan portfolio consists primarily of loans secured by small apartment buildings,
and the  commercial  real estate loan  portfolio  includes  loans to finance the
acquisition of small office  buildings and commercial and industrial  buildings.
Such  loans  generally  range in size  from $1.0  million  to $3.4  million.  At
September 30, 1997,  multi-family  residential  and commercial real estate loans
totaled $1.0 million and $46.0 million, respectively,  which amounted to .5% and
21.4%,  respectively,  of the Company's gross loan portfolio.  Multi-family  and
commercial  real  estate  loans are  originated  either  for 15 year  terms with
interest  rates that adjust  every one,  three or five years based on either the
prime rate as quoted in The Wall  Street  Journal  plus a  negotiated  margin of
between 0% and 1% for  shorter  term loans or, for  longer  term  loans,  or the
Treasury Rate plus a negotiated margin of between 3% and

                                        8
<PAGE>

4.5%,  or  on  a  fixed-rate  basis  with  interest  calculated  on  a  15  year
amortization schedule with a balloon payment due after five years.

     Multi-family   residential  and  commercial  real  estate  lending  entails
significant additional risks as compared with single-family residential property
lending.  Multi-family  residential  and commercial  real estate loans typically
involve larger loan balances to single borrowers or groups of related borrowers.
The payment  experience on such loans  typically is dependent on the  successful
operation of the real estate project,  retail  establishment or business.  These
risks can be  significantly  affected  by supply  and demand  conditions  in the
market for office, retail and residential space, and, as such, may be subject to
a greater  extent to adverse  conditions in the economy  generally.  To minimize
these risks, the Bank generally limits itself to its market area or to borrowers
with which it has prior  experience or who are  otherwise  known to the Bank. It
has been the Bank's policy to obtain annual financial statements of the business
of the borrower or the project for which commercial or multi-family  residential
real estate loans are made.  In  addition,  in the case of  commercial  mortgage
loans made to a partnership or a corporation, the Bank seeks, whenever possible,
to obtain personal guarantees and annual financial  statements of the principals
of the partnership or corporation.

     Commercial Lending. The Company's commercial loans consist of loans secured
by commercial real estate and commercial  business loans,  which are not secured
by real estate. For a discussion of the Company's commercial real estate lending
see "-- Multi-Family and Commercial Real Estate Lending."

     In recent years, the Bank has emphasized  commercial business lending.  The
Bank originates  commercial  business loans to small and medium sized businesses
in its  market  area.  The  Bank's  commercial  borrowers  are  generally  small
businesses engaged in manufacturing, distribution or retailing, or professionals
in healthcare,  accounting and law. Commercial business loans are generally made
to finance the  purchase  of  inventory,  new or used  equipment  or  commercial
vehicles and for short-term working capital. Such loans generally are secured by
equipment and inventory, and, if possible, cross-collateralized by a real estate
mortgage,  although  commercial  business  loans  are  sometimes  granted  on an
unsecured basis.  Such loans generally are made for terms of five years or less,
depending on the purpose of the loan and the  collateral,  with loans to finance
operating expenses made for one year or less, with interest rates that adjust at
least  annually  at a rate equal to the prime rate as stated in The Wall  Street
Journal plus a margin of between 0% and 2%. Generally, commercial loans are made
in  amounts  ranging  between  $5,000  and  $250,000.  At  September  30,  1997,
commercial  business loans totaled $16.4 million, or 7.6% of the Company's gross
loan portfolio.

     The Bank  underwrites  its  commercial  business  loans on the basis of the
borrower's  cash flow and ability to service the debt from earnings  rather than
on the basis of  underlying  collateral  value,  and the Bank seeks to structure
such loans to have more than one source of  repayment.  The borrower is required
to provide the Bank with  sufficient  information  to allow the Bank to make its
lending determination.  In most instances, this information consists of at least
two years of financial statements,  a statement of projected cash flows, current
financial  information  on any guarantor and any  additional  information on the
collateral. For loans with maturities exceeding one year, the Bank requires that
borrowers and guarantors provide updated financial information at least annually
throughout the term of the loan.

     The Bank's commercial  business loans may be structured as term loans or as
lines of credit.  Commercial  business term loans are generally  made to finance
the  purchase of assets and have  maturities  of five years or less.  Commercial
business lines of credit are typically made for the purpose of providing working
capital and are usually  approved  with a term of 12 months and are  reviewed at
that time to see if extension is warranted. The Bank also offers both commercial
and standby letters of credit for its commercial  borrowers.  Commercial letters
of credit  are  written  for a maximum  term of one year.  The terms of  standby
letters of credit generally do not exceed one year.

     Commercial  business  loans are often  larger and may involve  greater risk
than other types of lending.  Because payments on such loans are often dependent
on successful operation of the business involved, repayment of such loans may be
subject to a greater extent to adverse conditions in the economy. The Bank seeks
to minimize these risks through its underwriting guidelines,  which require that
the loan be supported by adequate  cash flow of the borrower,  profitability  of
the  business,  collateral  and personal  guarantees of the  individuals  in the
business. In addition, the Bank

                                        9
<PAGE>

limits  this type of lending to its market area and to  borrowers  with which it
has prior experience or who are otherwise well known to the Bank.

     Consumer  Lending.  In recent  years,  the Bank has been  successful in its
strategy of  increasing  its  portfolio of consumer  loans.  The consumer  loans
originated by the Bank include  automobile loans,  certificate of deposit loans,
home equity loans and miscellaneous  other consumer loans,  including  unsecured
loans. At September 30, 1997,  consumer loans totaled $49.9 million, or 23.3% of
the Company's gross loan portfolio.

     The Bank's automobile loans are generally underwritten in amounts up to 90%
of the lesser of the purchase  price of the  automobile or, with respect to used
automobiles,  the loan value as  published by the  National  Automobile  Dealers
Association.  The terms of most such  loans do not  exceed 60  months.  The Bank
requires  that the  vehicles  be insured and the Bank be listed as loss payee on
the insurance policy.

     The  Bank  makes  certificate  of  deposit  loans  for  up to  90%  of  the
depositor's  account balance.  The interest rate is normally 3% above the annual
percentage  yield  paid on the  account  and the  account  must  be  pledged  as
collateral  to secure  the loan.  Interest  generally  is billed on a  quarterly
basis. At September 30, 1997, loans on certificates of deposit totaled $617,000,
or 0.3% of the Company's total loan portfolio.

     At September 30, 1997, the Company had approximately  $21.7 million in home
equity line of credit loans, representing  approximately 10.1% of its gross loan
portfolio.  The Company's home equity lines of credit have  adjustable  interest
rates tied to the prime  interest  rate plus a margin.  The home equity lines of
credit  require  monthly  payments  until the loan is paid in full.  Home equity
lines of credit are generally secured by subordinate  liens against  residential
real  property.  The Bank  requires  that fire and  extended  coverage  casualty
insurance (and, if appropriate,  flood  insurance) be maintained in an amount at
least  sufficient to cover its loan. Home equity loans are generally  limited so
that the amount of such  loans,  along with any  senior  indebtedness,  does not
exceed 85% of the value of the real estate security.

     The Company  offers credit card loans through its  participation  as a Visa
and MasterCard issuer.  Management  believes that providing credit card services
to its  customers  helps the Bank remain  competitive  by offering  customers an
additional service,  and the Bank does not actively solicit credit card business
beyond its customer base and market area. The rate currently charged by the Bank
on its credit card loans  ranges from 11.5% to 17.5%,  and the Bank is permitted
to change the interest rate on 30 days notice.  Processing of bills and payments
is contracted to an outside  servicer.  At September 30, 1997, the Company had a
commitment  to fund an  aggregate  of $2.2  million of credit card loans,  which
represented  the  aggregate  credit limit on credit  cards,  and had $479,000 of
credit card loans  outstanding,  representing  0.2% of its gross loan portfolio.
The Company  intends to continue and expand credit card  lending,  but estimates
that at  current  levels of credit  card  loans,  it makes  little or no monthly
profit net of service expenses and write-offs.

     Consumer  lending affords the Company the opportunity to earn yields higher
than those obtainable on single-family  residential lending.  However,  consumer
loans entail greater risk than do residential  mortgage  loans,  particularly in
the case of loans which are unsecured (as is the case with credit card loans) or
secured  by  rapidly   depreciable  assets  such  as  automobiles.   Repossessed
collateral for a defaulted  consumer loan may not provide an adequate  source of
repayment of the outstanding loan balance as a result of the greater  likelihood
of damage, loss or depreciation. The remaining deficiency often does not warrant
further  substantial  collection  efforts  against the  borrower.  In  addition,
consumer  and credit  card loan  collections  are  dependent  on the  borrower's
continuing  financial  stability,  and  thus  are more  likely  to be  adversely
affected by events such as job loss,  divorce,  illness or personal  bankruptcy.
Further,  the application of various state and federal laws,  including  federal
and state  bankruptcy  and  insolvency  law,  may limit the amount  which may be
recovered.  In underwriting  consumer  loans,  the Bank considers the borrower's
credit  history,  an analysis of the borrower's  income and ability to repay the
loan, and the value of the collateral.

                                       10
<PAGE>

     Loan Fees and  Servicing.  The Bank receives  fees in connection  with late
payments  and for  miscellaneous  services  related to its loans.  The Bank also
charges fees in  connection  with loan  originations.  These fees can consist of
origination,  discount,  construction  and/or commitment fees,  depending on the
type of loan. The Bank generally does not service loans for others except as set
forth below and except for mortgage  loans  originated and sold by the Bank with
servicing retained.

     In  addition,  the Bank has  developed a program to  originate  loans for a
local credit union.  The Bank receives a $600  origination  fee for each loan as
well as an annual servicing fee of .375% of the loan amount.  All of these loans
are funded and closed in the name of the credit union. The Bank has explored the
possibility of developing similar arrangements with other institutions, although
none are currently planned.

     Nonperforming  Loans and Other Problem Assets. It is management's policy to
continually  monitor its loan portfolio to anticipate and address  potential and
actual  delinquencies.  When a borrower  fails to make a payment on a loan,  the
Bank takes immediate  steps to have the delinquency  cured and the loan restored
to current status. Loans which are delinquent more than 15 days incur a late fee
of 4% of the  monthly  payment of  principal  and  interest  due. As a matter of
policy, the Bank will contact the borrower after the loan has been delinquent 15
days. If payment is not promptly received,  the borrower is contacted again, and
efforts  are made to  formulate  an  affirmative  plan to cure the  delinquency.
Generally,  after any loan is  delinquent  45 days or more, a default  letter is
sent to the  borrower.  If the default is not cured after 30 days,  formal legal
proceedings are commenced to collect amounts owed.

     Loans  generally  are placed on nonaccrual  status,  and accrued but unpaid
interest is reversed,  when, in management's judgment, it is determined that the
collectibility  of  interest,  but  not  necessarily  principal,   is  doubtful.
Generally, this occurs when payment is delinquent in excess of 90 days. Consumer
loans are generally  charged off, or any expected  loss is reserved  for,  after
they  become  more than 120 days past due.  All other loans are charged off when
management  concludes  that  they  are  uncollectible.  See  Note 1 of  Notes to
Financial Statements.

     Real estate  acquired by the Bank as a result of  foreclosure is classified
as real estate acquired through foreclosure until such time as it is sold and is
recorded at the lower of the estimated fair value of the underlying  real estate
or the carrying amount of the loan.  Costs relating to holding or improving such
real  estate are charged  against  income in the current  period.  Any  required
write-down  of the loan to its fair  value  less  estimated  selling  costs upon
foreclosure  is charged  against the  allowance  for loan losses.  See Note 1 of
Notes to Financial Statements.

     The  following  table sets  forth  information  with  respect to the Bank's
nonperforming assets at the dates indicated. At the dates shown, the Bank had no
restructured  loans  within the meaning of  Statement  of  Financial  Accounting
Standards No. 15.

<TABLE>
<CAPTION>
                                                                      At September 30,
                                                 ------------------------------------------------------
                                                   1997         1996        1995       1994       1993
                                                 -------      -------     -------    -------    -------
                                                                  (Dollars in thousands)
Loans accounted for on a nonaccrual basis:
<S>                                              <C>          <C>         <C>        <C>        <C>
  Residential mortgage:
    Single-family............................    $   298      $   376     $   413    $   286    $   806
    Construction.............................        916          647         248         --        200
  Commercial real estate.....................         16           --          --         --         --
  Commercial business........................         14            8          --         --         --
  Consumer...................................         18            3          20         53         34
                                                 -------      -------     -------    -------    -------

    Total nonperforming loans................    $ 1,262      $ 1,034     $   681    $   339    $ 1,040
                                                 =======      =======     =======    =======    =======

Percentage of total loans, net...............        .64%         .66%        .47%       .25%       .88%
                                                 =======      =======     =======    =======    =======

Real estate owned............................    $   358      $   179     $    69    $   180    $   115
                                                 =======      =======     =======    =======    =======
</TABLE>

                                       11
<PAGE>

     During  the year  ended  September  30,  1997,  gross  interest  income  of
approximately  $48,000  would have been  recorded  on loans  accounted  for on a
nonaccrual basis if the loans had been current throughout this period.  Interest
on such loans  included in income  during the period  amounted to  approximately
$9,000.

     At September 30, 1997, the Bank had no loans not classified as non-accrual,
90 days past due or restructured  where known  information about possible credit
problems of  borrowers  caused  management  to have  serious  concerns as to the
ability of the  borrowers to comply with present  loan  repayment  terms and may
result in disclosure as non-accrual, 90 days past due or restructured.

     There were no loans accruing interest which were  contractually past due 90
days or more at the end of any reported period.

     At September 30, 1997,  an analysis of the Bank's  portfolio did not reveal
any impaired loans that needed to be classified under SFAS No. 114 or 118.

     At September 30, 1997,  the Company had $1.3 million of  nonaccrual  loans,
which  consisted of six  single-family  residential  real estate loans  totaling
$298,000,  six single-family  residential  construction loans totaling $916,000,
one commercial real estate loan totaling $16,000,  two commercial business loans
totaling $14,000, and three consumer totaling $18,000.

     At September 30, 1997,  the Bank had $358,000 of real estate  owned,  which
consisted of four single-family residences.

     Classified Assets.  Federal  regulations require that the Bank classify its
assets on a regular  basis.  In addition,  in connection  with  examinations  of
insured institutions, examiners have authority to identify problem assets and if
appropriate,  classify  them in their  reports of  examination.  There are three
classifications  for  problem  assets:  "substandard,"  "doubtful"  and  "loss."
Substandard  assets have one or more defined weaknesses and are characterized by
the distinct  possibility that the insured institution will sustain some loss if
the  deficiencies  are not  corrected.  Doubtful  assets have the  weaknesses of
substandard assets with the additional  characteristic  that the weaknesses make
collection or  liquidation  in full, on the basis of currently  existing  facts,
conditions and values, questionable, and there is a high possibility of loss. An
asset classified loss is considered  uncollectible and of such little value that
continuance as an asset of the institution is not warranted.  Assets  classified
as substandard or doubtful  require a bank to establish  general  allowances for
loan  losses.  If an asset or portion  thereof is  classified  loss, a bank must
either  establish a specific  allowance for loss in the amount of the portion of
the asset classified loss, or charge off such amount. The Bank regularly reviews
its  assets  to  determine   whether  any  assets  require   classification   or
re-classification.  At  September  30,  1997,  the Company  had $2.2  million in
classified  assets,  including  $1.2  million  in assets  classified  as special
mention,  $937,000  million  in  assets  classified  as  substandard,  no assets
classified as doubtful and $36,000 in assets classified as loss.

     Allowance for Loan Losses.  The Company's  policy is to establish  reserves
for  estimated  losses on delinquent  loans when it  determines  that losses are
expected  to be incurred on such  loans.  The  allowance  for losses on loans is
maintained at a level believed adequate by management to absorb potential losses
in the portfolio. Management's determination of the adequacy of the allowance is
based on an evaluation of the portfolio, past loss experience,  current economic
conditions,  volume, growth and composition of the portfolio, and other relevant
factors.  The  allowance is increased  by  provisions  for loan losses which are
charged against income.

     Although management believes it uses the best information available to make
determinations  with  respect to the  allowances  for losses and  believes  such
allowances  are  adequate,  future  adjustments  may be  necessary  if  economic
conditions differ  substantially from the economic conditions in the assumptions
used in making  the  initial  determinations.  Management  anticipates  that the
Company's allowance for loan losses will increase in the future as it implements
the Board of Directors'  strategy of continuing existing lines of business while
gradually expanding

                                       12
<PAGE>

commercial  business and consumer lending,  which loans generally entail greater
risks than single-family residential mortgage loans.

     The following  table sets forth an analysis of the Company's  allowance for
loan losses for the periods indicated.

<TABLE>
<CAPTION>
                                                                 Year Ended September 30,
                                        ----------------------------------------------------------------------
                                           1997           1996            1995           1994           1993
                                        ---------      ---------       ---------      ---------      ---------
                                                                (Dollars in thousands)

<S>                                     <C>            <C>             <C>            <C>            <C>      
Balance at beginning of period........  $   2,351      $   1,877       $   1,977      $   1,843      $   1,350
                                        ---------      ---------       ---------      ---------      ---------

Loans charged-off:
  Residential mortgage:
    Single-family.....................  $      --      $      44       $      20      $      10      $      --
  Commercial real estate..............         --             --              76             --             --
  Consumer............................         72             19              26             68             56
                                        ---------      ---------       ---------      ---------      ---------
Total charge-offs.....................         72             63             122             78             56
                                        ---------      ---------       ---------      ---------      ---------

Recoveries:
  Residential real estate mortgage:
    Single-family residential.........         33             25              --             --             --
  Consumer............................          6              1               2              2              1
                                        ---------      ---------       ---------      ---------      ---------
Total recoveries......................         39             26               2              2              1
                                        ---------      ---------       ---------      ---------      ---------

Net loans charged-off.................         33             37             120             76             55
                                        ---------      ---------       ---------      ---------      ---------

Provision for loan losses.............        931            511              20            210            548
                                        ---------      ---------       ---------      ---------      ---------

Balance at end of period..............  $   3,249      $   2,351       $   1,877      $   1,977      $   1,843
                                        =========      =========       =========      =========      =========

Ratio of net charge-offs to average
  loans outstanding during the period.        .02%           .02%            .09%           .06%           .02%
                                        =========      =========       =========      =========      =========
</TABLE>

                                       13
<PAGE>

     The  following  table  allocates  the  allowance  for loan  losses  by loan
category  at the  dates  indicated.  The  allocation  of the  allowance  to each
category is not  necessarily  indicative  of future losses and does not restrict
the use of the allowance to absorb losses in any category.

<TABLE>
<CAPTION>
                                                                             At September 30,
                                      ----------------------------------------------------------------------------------------------
                                             1997               1996               1995               1994               1993
                                      ------------------ ------------------ ------------------ ------------------ ------------------
                                             Percent of         Percent of         Percent of         Percent of         Percent of
                                              Loans in           Loans in           Loans in           Loans in           Loans in
                                             Category to        Category to        Category to        Category to        Category to
                                                Total              Total              Total              Total              Total
                                      Amount    Loans    Amount    Loans    Amount    Loans    Amount    Loans    Amount    Loans
                                      ------    -----    ------    -----    ------    -----    ------    -----    ------    -----
                                                        (Dollars in thousands)

<S>                                   <C>      <C>       <C>      <C>       <C>      <C>       <C>      <C>       <C>      <C>  
Residential mortgage................  $1,070     47.6%   $1,037     54.6%   $1,041     64.9%   $1,137     72.6%   $1,147     82.3%
Commercial (1)......................   1,456     23.3       879     23.9       517     16.3       497     12.6       417     15.9
Consumer............................     723     29.1       435     21.5       319     18.8       343     14.8       279      1.8
                                      ------   ------    ------   ------    ------   ------    ------   ------    ------   ------
    Total allowance for loan losses   $3,249   100.00%   $2,351   100.00%   $1,877   100.00%   $1,977   100.00%   $1,843   100.00%
                                      ======   ======    ======   =======   ======   ======    ======   ======    ======   ======
</TABLE>
---------------
(1)  Includes commercial real estate and commercial business loans.

                                       14
<PAGE>

Investment Activities

     General.  Interest  income from  mortgage-backed  securities and investment
securities generally provides the second largest source of income to the Company
after interest on loans. The Bank's Board of Directors has authorized investment
in  U.S.  Government  and  agency  securities,   state  government  obligations,
municipal  securities,  obligations  of the  Federal  Home Loan  Bank  ("FHLB"),
mortgage-backed  securities.  The Bank's objective is to use such investments to
reduce interest rate risk,  enhance yields on assets and provide  liquidity.  At
September 30, 1997,  the Company's  mortgage-backed  securities  and  investment
securities  portfolio amounted to $24.8 million and $3.1 million,  respectively.
At such date,  the Company had an unrealized  gain of $300,318,  net of deferred
taxes, with respect to its securities,  all of which are classified as available
for sale.

     Investment  and  aggregate   investment   limitations  and  credit  quality
parameters of each class of investment are  prescribed in the Bank's  investment
policy. The Bank performs analyses on mortgage-backed  securities and investment
securities  prior to forming mortgage pools and on an ongoing basis to determine
the  impact on  earnings  and  market  value  under  various  interest  rate and
prepayment conditions.  Securities purchases are subject to the oversight of the
Bank's Investment Committee consisting of four directors and are reviewed by the
Board of Directors on a monthly  basis.  The Bank's  President  has authority to
make specific investment decisions within the parameters determined by the Board
of Directors.

     Mortgage-Backed   Securities.   At  September   30,  1997,   the  Company's
mortgage-backed  securities amounted to $24.8 million, or 10.0% of total assets.
Mortgage-backed  securities  represent  a  participation  interest  in a pool of
single-family or multi-family mortgages,  the principal and interest payments on
which are passed from the mortgage originators through  intermediaries that pool
and repackage the participation  interest in the form of securities to investors
such as the Bank. Such  intermediaries may include  quasi-governmental  agencies
such as FHLMC,  FNMA and GNMA  which  guarantee  the  payment of  principal  and
interest to investors. Mortgage-backed securities generally increase the quality
of the Bank's assets by virtue of the guarantees that back them, are more liquid
than  individual  mortgage  loans and may be used to  collaterize  borrowings or
other  obligations  of the Bank.  At September  30, 1997,  all of the  Company's
mortgage-backed  securities  were  backed  by loans  originated  by the Bank and
swapped with the FHLMC in exchange for such mortgage-backed securities.

     The FHLMC is a public  corporation  chartered  by the U.S.  Government  and
owned by the 12 FHLBs and  federally  insured  savings  institutions.  The FHLMC
issues  participation  certificates backed principally by conventional  mortgage
loans.  The FHLMC  guarantees  the timely  payment of interest  and the ultimate
return of principal on  participation  certificates.  FHLMC  securities  are not
backed by the full faith and credit of the United States,  but because the FHLMC
is not a U.S.  Government-sponsored  enterprise, these securities are considered
to be among the highest  quality  investments  with minimal  credit  risks.  The
maximum loan limit for FNMA and FHLMC currently is $207,000.

     Mortgage-backed  securities  typically  are issued  with  stated  principal
amounts,  and the  securities  are backed by pools of mortgages  that have loans
with interest rates that are within a range and having varying  maturities.  The
underlying   pool  of  mortgages  can  be  composed  of  either   fixed-rate  or
adjustable-rate  loans. As a result, the risk  characteristics of the underlying
pool of mortgages,  (i.e.,  fixed-rate or adjustable-rate) as well as prepayment
risk, are passed on to the  certificate  holder.  The life of a  mortgage-backed
pass-through security thus approximates the life of the underlying mortgages.

     Mortgage-backed  securities  generally  yield  less  than the  loans  which
underlie  such  securities   because  of  their  payment  guarantees  or  credit
enhancements  which offer  nominal  credit risk.  In  addition,  mortgage-backed
securities  are more liquid than  individual  mortgage  loans and may be used to
collateralize  borrowings  of the Bank in the event that the Bank  determined to
utilize  borrowings as a source of funds.  Mortgage-backed  securities issued or
guaranteed  by the  FHLMC  (except  interest-only  securities  or  the  residual
interests  in CMOs)  are  weighted  at no more than 20% for  risk-based  capital
purposes,  compared  to a  weight  of 50% to 100%  for  residential  loans.  See
"Regulation -- Regulation of the Bank -- Capital Requirements."

                                       15
<PAGE>

     At September 30, 1997, mortgage-backed securities with an amortized cost of
$24.4  million and a carrying  value of $24.8 million were held as available for
sale, and no  mortgage-backed  securities  were  classified as held to maturity.
Mortgage-backed  securities  which are held to  maturity  are  carried  at cost,
adjusted for the amortization of premiums and the accretion of discounts using a
method which approximates a level yield.  Mortgage-backed  securities classified
as available for sale are carried at fair value.  Unrealized gains and losses on
available for sale mortgage-backed securities are recognized as direct increases
or decreases in equity, net of applicable income taxes. See Notes 1 and 4 of the
Notes to Consolidated  Financial  Statements.  At September 30, 1997, the Bank's
mortgage-backed securities had a weighted average yield of 7.37%.

     At September 30, 1997,  the average  contractual  maturity of the Company's
fixed-rate  mortgage-backed  securities was  approximately  19 years. The actual
maturity of a mortgage-backed  security varies, depending on when the mortgagors
prepay  or  repay  the  underlying  mortgages.  Prepayments  of  the  underlying
mortgages may shorten the life of the investment,  thereby  adversely  affecting
its  yield to  maturity  and the  related  market  value of the  mortgage-backed
security.  The yield is based upon the interest  income and the  amortization of
the  premium  or  accretion  of the  discount  related  to  the  mortgage-backed
security.  Premiums and discounts on mortgage-backed securities are amortized or
accreted over the estimated term of the  securities  using a level yield method.
The  prepayment  assumptions  used to  determine  the  amortization  period  for
premiums and discounts can significantly affect the yield of the mortgage-backed
security,  and these assumptions are reviewed periodically to reflect the actual
prepayment.  The actual  prepayments of the underlying  mortgages depend on many
factors,  including  the  type of  mortgage,  the  coupon  rate,  the age of the
mortgages,   the   geographical   location   of  the   underlying   real  estate
collateralizing  the mortgages and general levels of market interest rates.  The
difference  between  the  interest  rates on the  underlying  mortgages  and the
prevailing  mortgage  interest rates is an important  determinant in the rate of
prepayments.  During periods of falling  mortgage  interest  rates,  prepayments
generally increase, and, conversely,  during periods of rising mortgage interest
rates,  prepayments  generally  decrease.  If the coupon rate of the  underlying
mortgage  significantly exceeds the prevailing market interest rates offered for
mortgage loans,  refinancing  generally increases and accelerates the prepayment
of the underlying mortgages. Prepayment experience is more difficult to estimate
for adjustable-rate mortgage-backed securities.

     Investment   Securities.   The  Company's  investment   securities  consist
primarily  of  securities  issued by the U.S.  Treasury  and  federal  and state
government  agency  obligations.  At September 30, 1997,  the  Company's  entire
portfolio  of  investment  securities  was  classified  available  for  sale and
amounted to $3.1  million,  including  gross  unrealized  gains of $83,000.  The
Company  attempts  to  maintain a high  degree of  liquidity  in its  investment
securities  portfolio  by  choosing  those that are  readily  marketable.  As of
September  30, 1997,  the  estimated  average life of the  Company's  investment
securities  portfolio was  approximately 2 years. In addition,  at September 30,
1997, the Company had $1.3 million of FHLB stock.

                                       16
<PAGE>

     The following table sets forth the scheduled  maturities,  carrying values,
amortized  cost and average yields for the Company's  investment  securities and
mortgage-backed securities portfolio at September 30, 1997.

<TABLE>
<CAPTION>
                               One Year or Less    One to Five Years   Five to Ten Years   More than Ten Years
                               ----------------    -----------------   -----------------   -------------------
                               Carrying  Average   Carrying  Average   Carrying  Average    Carrying  Average
                                 Value    Yield      Value    Yield      Value    Yield       Value    Yield   
                                -------   -----     -------   -----     -------   -----      -------   -----   
                                                            (Dollars in thousands)
Securities available for sale:                                                            
<S>                             <C>       <C>       <C>      <C>        <C>       <C>        <C>       <S>
   U.S. government and agency                                                             
      securities............... $    --      --%    $ 3,083   7.13%     $    --      --%     $    --      --%  
   Mortgage-backed securities..      --      --          --     --        4,270    7.10       20,548    7.42   
                                                                                                              
Securities held to maturity:                                                                                  
   FHLB stock (1)..............      --      --          --     --           --      --        1,288    7.25   
                                -------   -----     -------  -----      --------  -----      -------   -----   
      Total.................... $    --      --%    $ 3,083   7.13%     $ 4,270    7.10%     $21,836    7.41%  
                                =======   =====     =======  =====      =======   =====      =======   =====   
</TABLE>

                                   Total Investment Portfolio
                                   --------------------------
                                  Carrying   Amortized  Average
                                    Value       Cost     Yield 
                                   -------    -------    ----- 
                                       (Dollars in thousands)
Securities available for sale:                              
   U.S. government and agency                               
      securities...............    $ 3,083    $ 3,001     7.13% 
   Mortgage-backed securities..     24,818     24,407     7.37  
                                                            
Securities held to maturity:                                
   FHLB stock (1)..............      1,288      1,288     7.25  
                                   -------    -------    -----  
      Total....................    $29,189    $28,696     7.34% 
                                   =======    =======    =====  

---------------
(1)  As a member of the FHLB of  Atlanta,  the Bank is  required  to maintain an
     investment in FHLB stock, which has no stated maturity.

                                       17
<PAGE>

     The  following  table  sets  forth  the  carrying  value  of the  Company's
investment  securities  and  mortgage-backed  securities  portfolio at the dates
indicated.

<TABLE>
<CAPTION>
                                                                               At September 30,
                                                                  ------------------------------------------
                                                                   1997              1996              1995
                                                                  ------            ------            ------
                                                                                (In thousands)
Securities available for sale:
<S>                                                              <C>               <C>               <C>     
   U.S. government and agency securities.......................  $  3,083          $  5,107          $     --
   State government obligations................................        --             3,000                --
   Mortgage-backed securities..................................    24,818            14,797             9,072
                                                                 --------          --------          --------
      Total                                                        27,901            22,904             9,072

Securities held to maturity:
   U.S. government and agency securities and other.............        --                --             3,002
   FHLB stock..................................................     1,288             1,288             1,288
   Mortgage-backed securities..................................        --                --            13,213
                                                                 --------          --------          --------
      Total....................................................     1,288             1,288            17,503
                                                                 --------          --------          --------

        Total..................................................  $ 29,189          $ 24,192          $ 26,575
                                                                 ========          ========          ========
</TABLE>

Deposit Activity and Other Sources of Funds

     General.  Deposits are the primary  source of the Bank's funds for lending,
investment activities and general operational purposes. In addition to deposits,
the Bank derives funds from loan principal and interest  repayments,  maturities
of investment  securities and  mortgage-backed  securities and interest payments
thereon.  Although  loan  repayments  are a relatively  stable  source of funds,
deposit inflows and outflows are  significantly  influenced by general  interest
rates and money market conditions.  Borrowings may be used on a short-term basis
to compensate for reductions in the  availability  of funds, or on a longer term
basis for general operational  purposes.  The Bank has access to borrow from the
FHLB of Atlanta.

     Deposits.  The Bank attracts  deposits  principally  from within its market
area by offering a variety of deposit instruments,  including checking accounts,
money market  accounts,  statement  and passbook  savings  accounts,  Individual
Retirement  Accounts,  and  certificates of deposit which range in maturity from
seven days to five years.  Deposit terms vary  according to the minimum  balance
required,  the length of time the funds must remain on deposit and the  interest
rate.  Maturities,  terms, service fees and withdrawal penalties for its deposit
accounts are established by the Bank on a periodic  basis.  The Bank reviews its
deposit  pricing on a weekly basis. In determining  the  characteristics  of its
deposit   accounts,   the  Bank   considers   the  rates  offered  by  competing
institutions,  lending  and  liquidity  requirements,  growth  goals and federal
regulations.  Management  believes it prices its  deposits  comparably  to rates
offered by its competitors. The Bank does not accept brokered deposits.

     The Bank  attempts to compete for deposits with other  institutions  in its
market  area by  offering  competitively  priced  deposit  instruments  that are
tailored  to the needs of its  customers.  Additionally,  the Bank seeks to meet
customers'  needs by providing  convenient  customer  service to the  community,
efficient  staff and  convenient  hours of  service.  Substantially,  all of the
Bank's  depositors  are  North  Carolina   residents.   To  provide   additional
convenience, the Bank participates in the HONOR Automatic Teller Machine network
at locations  throughout  the United  States,  through which  customers can gain
access to their  accounts at any time. To better serve its  customers,  the Bank
has installed automatic teller machines at four office locations.

                                       18
<PAGE>

     The  following  tables set forth the  distribution  of the  Bank's  deposit
accounts at the dates  indicated,  the weighted  average  interest rates and the
change in dollar  amounts for each  category of deposits  presented.  Management
does not believe that the use of year-end  balances  instead of average balances
resulted in any material difference in the information presented.

<TABLE>
<CAPTION>
                                                                           For the Year Ended  September 30,
                                                     ------------------------------------------------------------------------------
                                                              1997                       1996                        1995
                                                     ----------------------     -----------------------     -----------------------
                                                                   Weighted                    Weighted                    Weighted
                                                                    Average                     Average                     Average
                                                      Amount         Rate        Amount          Rate        Amount          Rate
                                                      ------         ----        ------          ----        ------          ----
                                                                                (Dollars in thousands)
Demand accounts:
<S>                                                 <C>            <C>         <C>             <C>         <C>             <C> 
  Checking.......................................   $  22,788         .61%     $  17,079          .61%     $  11,752          .93%
  Money market...................................      14,712        4.19         10,256         4.20          4,201         2.87
Savings accounts.................................       6,456        2.00          7,020         2.00          6,890         2.43
                                                    ---------      ------      ---------       ------      ---------       ------
     Total.......................................      43,956        2.01         34,355         1.96         22,843         1.74

Certificate accounts:
  Less than 12 months (1)........................      41,814        5.28         52,962         5.32         41,397         5.81
  12 - 14 months (1).............................      27,384        5.14         39,525         5.29         53,004         6.05
  14 - 72 months (1).............................      61,962        5.89         44,371         6.02         36,213         6.06
                                                    ---------      ------      ---------       ------      ---------       ------
     Total.......................................     131,160        5.53        136,858         5.54        130,614         5.98
                                                    ---------      ------      ---------       ------      ---------       ------

Total deposits...................................   $ 175,116        4.65%     $ 171,213         4.82%     $ 153,457         5.35%
                                                    =========      ======      =========       ======      =========       ======
</TABLE>
---------------
(1)  Original term.

                                       19
<PAGE>

     The following table  indicates the amount of the Company's  certificates of
deposit of $100,000 or more (in thousands) by time  remaining  until maturity as
of September 30, 1997. At such date,  such  deposits  represented  9.8% of total
deposits and had a weighted average rate of 5.83%.

            Maturity Period
            ---------------
            Three months or less.......................  $    6,328
            Over three through six months..............       2,852
            Over six through 12 months.................       6,206
            Over 12 months.............................       1,711
                                                         ----------
                Total..................................  $   17,097
                                                         ==========

     At September 30, 1997,  mortgage-backed securities with a carrying value of
$1.6 million were pledged as collateral for deposits from public entities.

     Borrowings.  Savings deposits  historically have been the primary source of
funds for the Bank's lending,  investment and general operating activities.  The
Bank is  authorized,  however,  to use  advances  from  the FHLB of  Atlanta  to
supplement  its  supply  of  lendable  funds  and  to  meet  deposit  withdrawal
requirements.  The FHLB of Atlanta functions as a central reserve bank providing
credit for savings institutions and certain other member financial institutions.
As a member of the FHLB System, the Bank is required to own stock in the FHLB of
Atlanta  and is  authorized  to apply for  advances.  Advances  are  pursuant to
several different programs, each of which has its own interest rate and range of
maturities.  The Bank has a Blanket  Agreement  for advances with the FHLB under
which the Bank may borrow up to 25% of assets  subject to normal  collateral and
underwriting requirements.  Advances from the FHLB of Atlanta are secured by the
Bank's stock in the FHLB of Atlanta and other eligible assets.  During the years
ended September 30, 1997, 1996 and 1995, the Bank's borrowings consisted of FHLB
advances  and,  during the year ended  September  30,  1997,  retail  repurchase
agreements.

     The Bank also utilized  retail  repurchase  agreements to a limited  extent
during fiscal 1996 and 1997. Retail repurchase  agreements  represent agreements
to sell securities  under terms which require the Bank to repurchase the same or
substantially  similar securities by a specified date. The Bank did not have any
such  agreements at September 30, 1995. The Bank did not utilize such agreements
during fiscal 1995.

         The following table sets forth certain information regarding short-term
borrowings by the Company at the dates and for the periods indicated:

<TABLE>
<CAPTION>
                                                                                  At or for the
                                                                             Year Ended September 30,
                                                                -----------------------------------------------
                                                                   1997                1996              1995
                                                                ---------           ---------          --------
                                                                                 (In thousands)
Amounts outstanding at end of period:
<S>                                                             <C>                 <C>                <C>     
  FHLB advances..............................................   $  11,000           $      --          $  4,000
  Federal funds purchased and securities
    sold under repurchase agreements.........................   $   1,621           $   1,040                --
Weighted average rate paid on:
  FHLB advances..............................................        6.17%                --               7.27%
  Federal funds purchased and securities  sold under
    agreements to repurchase.................................        4.67%               4.31%               --
Maximum amount of borrowings outstanding  at any month end:
  FHLB advances..............................................   $  13,000           $   7,000          $ 21,000
  Federal funds purchased and securities
    sold under repurchased agreements........................       1,645               1,040                --
</TABLE>

                                       20
<PAGE>

<TABLE>
<CAPTION>
                                                                          At or for the
                                                                     Year Ended September 30,
                                                        -----------------------------------------------
                                                           1997                1996              1995
                                                        ---------           ---------          --------
                                                                         (In thousands)
Approximate average short-term borrowings
 outstanding with respect to:
<S>                                                     <C>                 <C>                <C>     
  FHLB advances......................................   $   3,400           $   2,250          $ 11,833
  Federal funds purchased and securities
    sold under repurchase agreements.................       1,218                 582                --
Approximate weighted average rate paid on: (1)
  FHLB advances......................................        5.78%               6.83%             6.54%
  Federal funds purchased and securities
    sold under agreements to repurchase..............        4.56%               4.44%               --%
</TABLE>

-------------------
(1)  Based on month-end balances.

Subsidiary Activities

     In prior years, the Bank had one subsidiary,  Tidewater  Financial Services
Corporation,  a North Carolina  corporation,  which had been inactive during the
past three years. This subsidiary was dissolved effective September 30, 1996.

Competition

     The Company faces strong competition in originating real estate, commercial
business and consumer  loans and in attracting  deposits.  The Bank competes for
real estate and other loans  principally  on the basis of  interest  rates,  the
types of loans it originates,  the deposit products it offers and the quality of
services it provides to borrowers.  The Bank also competes by offering  products
which are tailored to the local  community.  Its competition in originating real
estate loans comes primarily from other commercial banks, savings  institutions,
mortgage  bankers and mortgage  brokers.  Commercial  banks,  credit  unions and
finance companies provide vigorous competition in consumer lending.  Competition
may  increase  as a  result  of the  recent  reduction  of  restrictions  on the
interstate operations of financial institutions.

     The Bank attracts its deposits  through its branch  offices  primarily from
the local  communities.  Consequently,  competition  for deposits is principally
from other commercial banks, savings institutions,  credit unions and brokers in
the Bank's  primary  market  area.  The Bank  competes for deposits and loans by
offering  what it  believes to be a variety of deposit  accounts at  competitive
rates,  convenient business hours, a commitment to outstanding  customer service
and  a  well-trained   staff.   The  Bank  believes  it  has  developed   strong
relationships with local realtors and the community in general.

     Management  considers its primary  market area for  gathering  deposits and
originating  loans to be Beaufort,  Craven,  Lenoir,  Nash,  Pasquotank and Pitt
Counties in eastern North  Carolina,  which are the counties in which the Bank's
offices  are  located.  The  Bank  originates  loans  throughout  eastern  North
Carolina.

Employees

     As of  September  30,  1997,  the Bank had 113  full-time  and 7  part-time
employees,  none of whom were represented by a collective  bargaining agreement.
Management considers the Bank's relationships with its employees to be good.

                                       21
<PAGE>

                                   REGULATION

Depository Institution Regulation

     General.  The Bank is a North  Carolina-chartered  commercial  bank and its
deposit accounts are insured by the Savings Association  Insurance Fund ("SAIF")
of the FDIC. The Bank is subject to  supervision,  examination and regulation by
the  Commissioner  and the FDIC and to North Carolina and federal  statutory and
regulatory  provisions  governing  such matters as capital  standards,  mergers,
subsidiary  investments and  establishment of branch offices.  The FDIC also has
the  authority  to conduct  special  examinations.  The Bank is required to file
reports  with  the  Commissioner  and the FDIC  concerning  its  activities  and
financial  condition and will be required to obtain regulatory approval prior to
entering into certain transactions,  including mergers with, or acquisitions of,
other depository institutions.

     As a  federally  insured  depository  institution,  the Bank is  subject to
various regulations promulgated by the Board of Governors of the Federal Reserve
System  ("Federal  Reserve  Board"),   including   Regulation  B  (Equal  Credit
Opportunity),  Regulation D (Reserve  Requirements),  Regulations  E (Electronic
Fund Transfers), Regulation Z (Truth in Lending), Regulation CC (Availability of
Funds and Collection of Checks) and Regulation DD (Truth in Savings).

     The system of regulation and supervision applicable to the Bank establishes
a  comprehensive  framework  for the  operations  of the Bank,  and is  intended
primarily for the protection of the FDIC and the depositors of the Bank. Changes
in the  regulatory  framework  could have a material  effect on the Bank that in
turn, could have a material effect on the Company.

     Capital  Requirements.   The  Federal  Reserve  Board  and  the  FDIC  have
established  guidelines with respect to the maintenance of appropriate levels of
capital by bank holding  companies with  consolidated  assets of $150 million or
more and state non-member banks,  respectively.  The regulations impose two sets
of capital adequacy  requirements:  minimum  leverage rules,  which require bank
holding  companies and state  non-member  banks to maintain a specified  minimum
ratio of capital to total assets,  and risk-based  capital rules,  which require
the  maintenance  of  specified  minimum  ratios of capital  to  "risk-weighted"
assets.  The  regulations of the FDIC and the Federal Reserve Board require bank
holding  companies  and state  non-member  banks,  respectively,  to  maintain a
minimum  leverage  ratio of "Tier 1  capital"  to total  assets of 3.0%.  Tier 1
capital is the sum of common stockholders'  equity,  certain perpetual preferred
stock (which must be noncumulative with respect to banks), including any related
surplus,  and  minority  interests  in  consolidated  subsidiaries;   minus  all
intangible  assets (other than certain purchased  mortgage  servicing rights and
purchased credit card receivables), identified losses and investments in certain
subsidiaries. As a SAIF-insured, state-chartered bank, the Bank must also deduct
from Tier 1 capital an amount equal to its  investments  in, and  extensions  of
credit to,  subsidiaries  engaged in  activities  that are not  permissible  for
national banks, other than debt and equity  investments in subsidiaries  engaged
in  activities  undertaken  as  agent  for  customers  or  in  mortgage  banking
activities or in subsidiary depository  institutions or their holding companies.
Although  setting a minimum 3.0% leverage ratio, the capital  regulations  state
that only the  strongest  bank  holding  companies  and  banks,  with  composite
examination  ratings  of 1 under the  rating  system  used by the  federal  bank
regulators,  would be  permitted  to  operate at or near such  minimum  level of
capital.  All other bank holding  companies and banks are expected to maintain a
leverage  ratio of at least 1% to 2% above the minimum  ratio,  depending on the
assessment  of an  individual  organization's  capital  adequacy  by its primary
regulator.  Any bank or bank  holding  companies  experiencing  or  anticipating
significant  growth would be expected to maintain capital well above the minimum
levels.  In addition,  the Federal  Reserve  Board has  indicated  that whenever
appropriate,  and in  particular  when a bank  holding  company  is  undertaking
expansion,  seeking to engage in new  activities or otherwise  facing unusual or
abnormal  risks,  it will  consider,  on a case-by-case  basis,  the level of an
organization's  ratio of  tangible  Tier 1 capital to total  assets in making an
overall assessment of capital.

     In addition to the leverage  ratio,  the regulations of the Federal Reserve
Board and the FDIC require bank holding companies and state-chartered  nonmember
banks to maintain a minimum ratio of qualifying  total capital to  risk-weighted
assets of at least 8.0% of which at least four percentage  points must be Tier 1
capital.  Qualifying  total  capital  consists of Tier 1 capital  plus Tier 2 or
supplementary  capital  items  which  include  allowances  for loan losses in an
amount of up to 1.25% of risk-weighted  assets,  cumulative  preferred stock and
preferred  stock with a maturity of 20 years or more and certain  other  capital
instruments. The includible amount of Tier 2 capital cannot exceed the

                                       22
<PAGE>

institution's Tier 1 capital. Qualifying total capital is further reduced by the
amount of the bank's  investments in banking and finance  subsidiaries  that are
not consolidated for regulatory capital purposes,  reciprocal  cross-holdings of
capital  securities  issued by other banks and  certain  other  deductions.  The
risk-based  capital  regulations  assign  balance  sheet  assets  and the credit
equivalent amounts of certain  off-balance sheet items to one of four broad risk
weight categories. The aggregate dollar amount of each category is multiplied by
the risk weight  assigned to that category  based  principally  on the degree of
credit risk associated with the obligor. The sum of these weighted values equals
the bank holding company or the bank's risk-weighted assets.

     The federal bank  regulators,  including the FDIC,  have proposed to revise
their risk-based capital  requirements to ensure that such requirements  provide
for explicit  consideration  of interest rate risk.  Under the proposed  rule, a
bank's  interest  rate  risk  exposure  would be  quantified  using  either  the
measurement  system set forth in the proposal or the bank's  internal  model for
measuring  such  exposure,  if such model is  determined  to be  adequate by the
bank's  examiner.  If the dollar amount of a bank's interest rate risk exposure,
as measured  under  either  measurement  system,  exceeds 1% of the bank's total
assets,  the bank would be required  under the proposed rule to hold  additional
capital equal to the dollar amount of the excess.  Management has not determined
what effect, if any, the proposed interest rate risk component would have on the
Bank's  capital if adopted as proposed.  The FDIC has adopted a regulation  that
provides  that the FDIC may take into  account  whether  a bank has  significant
risks from concentrations of credit or nontraditional  activities in determining
the  adequacy  of its  capital.  The Bank has not been  advised  that it will be
required to maintain any additional capital under this regulation.  The proposed
interest  rate risk  component  would not apply to bank  holding  companies on a
consolidated basis.

     In addition to FDIC  regulatory  capital  requirements,  the North Carolina
Bank Commissioner  requires that the Bank have adequate  capitalization which is
determined based upon each Bank's particular set of  circumstances.  The Bank is
subject  to  the  Commissioner's   capital  surplus  regulation  which  requires
commercial  banks to  maintain  a  capital  surplus  of at least  50% of  common
capital. Common capital is defined as the total of the par value of shares times
the number of shares outstanding.

     Prompt Corrective  Regulatory  Action.  Under the Federal Deposit Insurance
Corporation  Improvement Act of 1991 ("FDICIA"),  the federal banking regulators
are  required  to  take  prompt  corrective  action  if  an  insured  depository
institution  fails  to  satisfy  certain  minimum  capital   requirements.   All
institutions, regardless of their capital levels, are restricted from making any
capital  distribution  or paying any management  fees if the  institution  would
thereafter   fail  to  satisfy  the  minimum  levels  for  any  of  its  capital
requirements.  An  institution  that  fails to meet the  minimum  level  for any
relevant capital measure (an "undercapitalized institution") may be: (i) subject
to increased  monitoring by the  appropriate  federal  banking  regulator;  (ii)
required to submit an acceptable capital  restoration plan within 45 days; (iii)
subject to asset growth  limits;  and (iv)  required to obtain prior  regulatory
approval  for   acquisitions,   branching  and  new  lines  of   businesses.   A
"significantly  undercapitalized"  institution  may  be  subject  to  regulatory
demands  for   recapitalization,   broader   application  of   restrictions   on
transactions  with  affiliates,  limitations on interest rates paid on deposits,
asset  growth  and other  activities,  possible  replacement  of  directors  and
officers,  and restrictions on capital distributions by any bank holding company
controlling the institution.  Any company controlling the institution could also
be required to divest the  institution or the  institution  could be required to
divest   subsidiaries.   The  senior  executive   officers  of  a  significantly
undercapitalized   institution   may  not  receive   bonuses  or   increases  in
compensation without prior regulatory approval and the institution is prohibited
from making  payments of principal or interest on its  subordinated  debt. If an
institution's  ratio of tangible capital to total assets falls below a "critical
capital  level,"  the  institution  will  be  subject  to   conservatorship   or
receivership  within  90 days  unless  periodic  determinations  are  made  that
forbearance from such action would better protect the deposit insurance fund.

     The federal banking  regulators has adopted  regulations  implementing  the
prompt  corrective  action provisions of FDICIA.  Under these  regulations,  the
federal  banking  regulators will generally  measure a depository  institution's
capital  adequacy on the basis of the  institution's  total  risk-based  capital
ratio  (the  ratio  of  its  total  capital  to  risk-weighted  assets),  Tier 1
risk-based capital ratio (the ratio of its core capital to risk-weighted assets)
and  leverage  ratio (the ratio of its core capital to adjusted  total  assets).
Under the regulations, an institution that is not subject to an order or written
directive  by its  primary  federal  regulator  to meet or  maintain  a specific
capital  level will be deemed  "well  capitalized"  if it also has:  (i) a total
risk-based  capital  ratio of 10% or greater;  (ii) a Tier 1 risk-based  capital
ratio of 6.0% or greater;

                                       23
<PAGE>

and (iii) a  leverage  ratio of 5.0% or  greater.  An  "adequately  capitalized"
depository  institution is an  institution  that does not meet the definition of
well  capitalized  and  has:  (i) a total  risk-based  capital  ratio of 8.0% or
greater;  (ii) a Tier 1 risk-based capital ratio of 4.0% or greater; and (iii) a
leverage  ratio  of 4.0%  or  greater  (or  3.0% or  greater  if the  depository
institution has a composite 1 CAMEL rating). An  "undercapitalized  institution"
is a depository  institution that has (i) a total risk-based  capital ratio less
than 8.0%; or (ii) a Tier 1 risk-based capital ratio of less than 4.0%; or (iii)
a leverage ratio of less than 4.0% (or less than 3.0% if the  institution  has a
composite 1 CAMEL rating).  A  "significantly  undercapitalized"  institution is
defined as a depository  institution  that has: (i) a total  risk-based  capital
ratio of less than 6.0%; or (ii) a Tier 1 risk-based  capital ratio of less than
3.0%;   or  (iii)  a   leverage   ratio  of  less  than  3.0%.   A   "critically
undercapitalized"  institution is defined as a depository institution that has a
ratio of "tangible equity" to total assets of less than 2.0%. Tangible equity is
defined as core capital plus cumulative  perpetual  preferred stock (and related
surplus) less all  intangibles  other than qualifying  supervisory  goodwill and
certain  purchased  mortgage  servicing  rights.  The FDIC may reclassify a well
capitalized  depository institution as adequately capitalized and may require an
adequately  capitalized  or  undercapitalized  institution  to  comply  with the
supervisory  actions  applicable  to  institutions  in the  next  lower  capital
category (but may not reclassify a significantly undercapitalized institution as
critically  under-capitalized) if it determines, after notice and an opportunity
for a hearing, that the institution is in an unsafe or unsound condition or that
the institution has received and not corrected a  less-than-satisfactory  rating
for any CAMEL rating category. As of September 30, 1997, the Bank was classified
as "well capitalized" under FDIC regulations.

     Safety and Soundness  Guidelines.  Under  FDICIA,  as amended by the Riegle
Community  Development and Regulatory  Improvement Act of 1994 (the "CDRI Act"),
each  federal  banking  agency was required to  establish  safety and  soundness
standards for  institutions  under its  authority.  The  interagency  guidelines
require  depository  institutions to maintain  internal controls and information
systems and internal audit systems that are appropriate for the size, nature and
scope of the institution's business. The guidelines also establish certain basic
standards  for loan  documentation,  credit  underwriting,  interest  rate  risk
exposure,  and asset growth.  The  guidelines  further  provide that  depository
institutions  should maintain safeguards to prevent the payment of compensation,
fees and benefits  that are  excessive or that could lead to material  financial
loss,  and should take into  account  factors  such as  comparable  compensation
practices at comparable institutions.  If the appropriate federal banking agency
determines  that a depository  institution is not in compliance  with the safety
and soundness guidelines, it may require the institution to submit an acceptable
plan to achieve  compliance with the guidelines.  A depository  institution must
submit an acceptable  compliance plan to its primary federal regulator within 30
days of receipt of a request for such a plan.  Failure to submit or  implement a
compliance plan may subject the institution to regulatory sanctions.  Management
believes that the Bank already  substantially meets all the standards adopted in
the interagency guidelines.

     Community Reinvestment Act. The Bank, like other financial institutions, is
subject to the Community  Reinvestment Act ("CRA"). The purpose of the CRA is to
encourage  financial  institutions to help meet the credit needs of their entire
communities,  including  the  needs of  low-and  moderate-income  neighborhoods.
During  the  Bank's  last   compliance   examination,   the  Bank   received  an
"outstanding"  rating with  respect to CRA  compliance.  The Bank's  rating with
respect to CRA  compliance  would be a factor to be  considered  by the  Federal
Reserve Board and the FDIC in considering  applications submitted by the Bank to
acquire branches or to acquire or combine with other financial  institutions and
take other  actions  and,  if such  rating was less than  "satisfactory,"  could
result in the denial of such applications.

     The federal banking  regulatory  agencies have issued a revision of the CRA
regulations,  which  became  effective  on January 1, 1996,  to  implement a new
evaluation system that rates  institutions  based on their actual performance in
meeting  community  credit needs.  Under the  regulations,  a bank will first be
evaluated and rated under three  categories:  a lending test, an investment test
and a service  test.  For each of these three  tests,  the savings  bank will be
given a rating of either "outstanding," "high satisfactory," "low satisfactory,"
"needs to improve," or "substantial  non-compliance." A set of criteria for each
rating has been developed and is included in the  regulation.  If an institution
disagrees with a particular  rating, the institution has the burden of rebutting
the presumption by clearly  establishing  that the quantitative  measures do not
accurately present its actual  performance,  or that  demographics,  competitive
conditions or economic or legal limitations  peculiar to its service area should
be  considered.  The  ratings  received  under the three  tests  will be used to
determine the overall  composite CRA rating.  The composite  ratings will be the
same as those that are currently given: "outstanding," "satisfactory," "needs to
improve" or "substantial non-compliance."

                                       24
<PAGE>

     Federal  Home Loan Bank  System.  The FHLB  System  consists of 12 district
FHLBs subject to supervision and regulation by the Federal Housing Finance Board
("FHFB").  The FHLBs  provide a central  credit  facility  primarily  for member
institutions.  As a member  of the FHLB of  Atlanta,  the  Bank is  required  to
acquire and hold shares of capital  stock in the FHLB of Atlanta in an amount at
least equal to 1% of the aggregate  unpaid principal of its home mortgage loans,
home purchase contracts,  and similar obligations at the beginning of each year,
or 1/20 of its  advances  (borrowings)  from the FHLB of Atlanta,  whichever  is
greater.  The Bank was in compliance  with this  requirement  with investment in
FHLB of Atlanta  stock at  September  30,  1997,  of $1.3  million.  The FHLB of
Atlanta serves as a reserve or central bank for its member  institutions  within
its assigned  district.  It is funded  primarily from proceeds  derived from the
sale of  consolidated  obligations  of the FHLB  System.  It offers  advances to
members in accordance  with policies and procedures  established by the FHFB and
the Board of  Directors of the FHLB of Atlanta.  Long-term  advances may only be
made for the purpose of providing funds for residential housing finance.

     Reserves.  Pursuant to regulations of the Federal  Reserve Board,  the Bank
must maintain  average daily reserves  against their  transaction  accounts.  No
reserves are required to be maintained on the first $4.3 million of  transaction
accounts,  reserves  equal to 3% must be maintained on the next $52.0 million of
transaction accounts,  plus 10% on the remainder.  This percentage is subject to
adjustment  by the Federal  Reserve  Board.  Because  required  reserves must be
maintained  in the form of vault cash or in a noninterest  bearing  account at a
Federal  Reserve Bank,  the effect of the reserve  requirement  is to reduce the
amount of the institution's  interest-earning  assets. As of September 30, 1997,
the Bank met its reserve requirements.

     The Bank is also  subject to the  reserve  requirements  of North  Carolina
commercial  banks.  North  Carolina  law  requires  state  non-member  banks  to
maintain, at all times, a reserve fund in an amount set by the State Commission.

     Deposit  Insurance.  The Bank is  required  to pay  assessments  based on a
percentage of its insured  deposits to the FDIC for insurance of its deposits by
the SAIF. Under the FDIC's risk-based  deposit insurance  assessment system, the
assessment rate for an insured depository  institution depends on the assessment
risk classification assigned to the institution by the FDIC, which is determined
by the  institution's  capital level and supervisory  evaluations.  Based on the
data reported to regulators  for the date closest to the last day of the seventh
month preceding the semi-annual assessment period,  institutions are assigned to
one of three  capital  groups -- well  capitalized,  adequately  capitalized  or
undercapitalized  --  using  the  same  percentage  criteria  as in  the  prompt
corrective action  regulations.  See "-- Prompt Corrective  Regulatory  Action."
Within each capital group,  institutions  are assigned to one of three subgroups
on the basis of supervisory evaluations by the institution's primary supervisory
authority and such other  information  as the FDIC  determines to be relevant to
the  institution's  financial  condition  and  the  risk  posed  to the  deposit
insurance fund.  Subgroup A consists of financially sound institutions with only
a few minor  weaknesses.  Subgroup B consists of institutions  that  demonstrate
weaknesses which, if not corrected, could result in significant deterioration of
the  institution  and  increased  risk of loss to the  deposit  insurance  fund.
Subgroup C consists of institutions that pose a substantial  probability of loss
to the deposit  insurance fund unless effective  corrective action is taken. The
assessment  rate for SAIF  members had ranged  from 0.23% of  deposits  for well
capitalized institutions in Subgroup A to 0.31% of deposits for undercapitalized
institutions in Subgroup C while  assessments for over 90% of the Bank Insurance
Fund ("BIF") members had been the statutory minimum of $2,000.  Recently enacted
legislation  provided for a one-time  assessment of 65.7 basis points of insured
deposits  as of March 31,  1995,  that  fully  capitalized  the SAIF and had the
effect of reducing future SAIF  assessments.  Accordingly,  although the special
assessment  resulted in a one-time charge to the Bank of approximately  $946,000
pre-tax,   accrued   during  the  quarter   ended   September   30,  1997,   the
recapitalization  of the SAIF had the  effect  of  reducing  the  Bank's  future
deposit insurance premiums to the SAIF. Under the recently enacted  legislation,
both BIF and SAIF members will be assessed an amount for  Financing  Corporation
Bond payments. BIF members will be assessed approximately 1.3 basis points while
the SAIF rate will be  approximately  6.4 basis points until January 1, 2000. At
that time, BIF and SAIF members will begin pro rata sharing of the payment at an
expected rate of 2.43 basis points.

     Although the Bank, as a North Carolina  commercial  bank, would qualify for
insurance of deposits by the BIF of the FDIC, substantial entrance and exit fees
apply to conversions from SAIF to BIF insurance. Accordingly, following the Bank
Conversion,  the Bank remained a member of the SAIF,  which insures the deposits
of the Bank to a maximum of $100,000 for each depositor.

                                       25
<PAGE>

     Liquidity Requirements. FDIC policy requires that banks maintain an average
daily  balance  of  liquid  assets  (cash,   certain  time  deposits,   bankers'
acceptances  and specified  United States  government,  state, or federal agency
obligations)  in an  amount  which it  deems  adequate  to  protect  safety  and
soundness  of the  bank.  The FDIC  currently  has no  specific  level  which it
requires. Under the FDIC's calculation method,  management calculated the Bank's
liquidity ratio as 16.0% of total assets at September 30, 1997, which management
believes is adequate.

     North Carolina banks must maintain a reserve fund in an amount and/or ratio
set by the Banking Commission to account for the level of liquidity necessary to
assure the safety and soundness of the State banking system. As of September 30,
1997,  the  Bank's   liquidity  ratio  was  in  excess  of  the  North  Carolina
regulations.

     Dividend Restrictions.  Under FDIC regulations, the Bank is prohibited from
making any capital  distributions  if after  making the  distribution,  the Bank
would have: (i) a total risk-based  capital ratio of less than 8.0%; (ii) a Tier
1 risk-based  capital ratio of less than 4.0%; or (iii) a leverage ratio of less
than 4.0%.

     Earnings of the Bank  appropriated  to bad debt  reserves  and deducted for
Federal  income tax purposes are not available for payment of cash  dividends or
other distributions to stockholders without payment of taxes at the then current
tax  rate by the Bank on the  amount  of  earnings  removed  from  the  pre-1988
reserves  for such  distributions.  The Bank  intends  to make  full use of this
favorable tax treatment and does not contemplate use of any earnings in a manner
which would create federal tax liabilities.

     Limits on Loans to One Borrower. The Bank generally is subject to both FDIC
regulations  and  North  Carolina  law  regarding  loans  to any  one  borrower,
including  related   entities.   Under  applicable  law,  with  certain  limited
exceptions,  loans and extensions of credit by a state chartered non-member bank
to a person outstanding at one time and not fully secured by collateral having a
market  value at least  equal to the amount of the loan or  extension  of credit
shall not exceed 15% of the unimpaired capital of the bank. Loans and extensions
of credit fully secured by readily  marketable  collateral having a market value
may comprise  shall not exceed 10% of the  unimpaired  capital fund of the bank.
Under  these  limits,  the Bank's  loans to one  borrower  were  limited to $6.0
million  at  September  30,  1997.  At  that  date,  the  Bank  had  no  lending
relationships in excess of the loans-to-one-borrower  limit. Notwithstanding the
statutory  loans-to-one-borrower  limitations,  the  Bank  has  a  self  imposed
loans-to-one-borrower  limit, which currently is $3.5 million.  At September 30,
1997, the Bank's largest lending  relationship  was a $3.3 million  relationship
consisting  of  four  commercial  real  estate  loans.  All  loans  within  this
relationship  were  current and  performing  in  accordance  with their terms at
September 30, 1997.

     Transactions with Related Parties.  Transactions between a state non-member
bank and any  affiliate  are  governed  by  Sections  23A and 23B of the Federal
Reserve Act. An affiliate  of a state  non-member  bank is any company or entity
which  controls,  is  controlled  by or is under  common  control with the state
non-member bank. In a holding company  context,  the parent holding company of a
state  non-member  bank  (such  as the  Company)  and any  companies  which  are
controlled  by  such  parent  holding  company  are  affiliates  of the  savings
institution or state non-member bank. Generally,  Sections 23A and 23B (i) limit
the extent to which an  institution or its  subsidiaries  may engage in "covered
transactions"  with  any  one  affiliate  to an  amount  equal  to 10%  of  such
institution's  capital stock and surplus,  and contain an aggregate limit on all
such  transactions with all affiliates to an amount equal to 20% of such capital
stock  and  surplus  and (ii)  require  that all such  transactions  be on terms
substantially  the  same,  or at  least  as  favorable,  to the  institution  or
subsidiary as those provided to a non-affiliate.  The term "covered transaction"
includes the making of loans,  purchase of assets,  issuance of a guarantee  and
similar other types of transactions.  In addition to the restrictions imposed by
Sections 23A and 23B, no state  non-member bank may (i) loan or otherwise extend
credit  to an  affiliate,  except  for  any  affiliate  which  engages  only  in
activities which are permissible for bank holding companies, or (ii) purchase or
invest in any stocks,  bonds,  debentures,  notes or similar  obligations of any
affiliate,  except for affiliates which are subsidiaries of the state non-member
bank.

     State non-member  banks also are subject to the  restrictions  contained in
Section 22(h) of the Federal Reserve Act and the Federal Reserve's  Regulation O
thereunder on loans to executive officers, directors and principal stockholders.
Under Section  22(h),  loans to a director,  executive  officer and to a greater
than 10% stockholder of a state non-member bank and certain affiliated interests
of such persons, may not exceed, together with all other outstanding

                                       26
<PAGE>

loans   to   such   person   and   affiliated   interests,   the   institution's
loans-to-one-borrower  limit and all loans to such  persons  may not  exceed the
institution's  unimpaired  capital and  unimpaired  surplus.  Section 22(h) also
prohibits  loans,  above amounts  prescribed by the appropriate  federal banking
agency, to directors,  executive officers and greater than 10% stockholders of a
savings  institution,  and  their  respective  affiliates,  unless  such loan is
approved in advance by a majority of the board of directors  of the  institution
with any "interested"  director not  participating  in the voting.  Regulation O
prescribes the loan amount (which includes all other  outstanding  loans to such
person) as to which such prior board of  director  approval is required as being
the greater of $25,000 or 5% of capital and surplus (up to  $500,000).  Further,
Section 22(h) requires that loans to directors, executive officers and principal
stockholders  be made on terms  substantially  the same as offered in comparable
transactions  to  other  persons.  Section  22(h)  also  generally  prohibits  a
depository  institution  from  paying  the  overdrafts  of any of its  executive
officers or directors.

     State   non-member   banks  also  are  subject  to  the   requirements  and
restrictions  of Section 22(g) of the Federal  Reserve Act on loans to executive
officers  and  the   restrictions  of  12  U.S.C.  ss.  1972  on  certain  tying
arrangements and extensions of credit by correspondent  banks.  Section 22(g) of
the Federal  Reserve Act  requires  loans to  executive  officers of  depository
institutions  not be made on terms more  favorable  than those afforded to other
borrowers,  requires  approval  by  the  board  of  directors  of  a  depository
institution  for extension of credit to executive  officers of the  institution,
and imposes reporting requirements for and additional  restrictions on the type,
amount and terms of credits  to such  officers.  Section  1972 (i)  prohibits  a
depository  institution from extending credit to or offering any other services,
or fixing or varying the  consideration for such extension of credit or service,
on the  condition  that the  customer  obtain some  additional  service from the
institution or certain of its affiliates or not obtain  services of a competitor
of the institution, subject to certain exceptions, and (ii) prohibits extensions
of credit to executive officers, directors, and greater than 10% stockholders of
a depository  institution  by any other  institution  which has a  correspondent
banking relationship with the institution, unless such extension of credit is on
substantially  the same  terms as those  prevailing  at the time for  comparable
transactions  with other  persons and does not involve more than the normal risk
of repayment or present other unfavorable features.

     Additionally,  North Carolina  statutes set forth  restrictions on loans to
executive  officers of  state-chartered  banks,  which  provide that no bank may
extend  credit to any of its  executive  officers nor a firm or  partnership  of
which such executive officers is a member, nor a company in which such executive
officer owns a controlling  interest,  unless the extension of credit is made on
substantially the same terms, including interest rates and collateral,  as those
prevailing at the time for comparable  transactions by the bank with persons who
are not employed by the bank, and provided  further that the extension of credit
does not involve more than the normal risk of repayment.

     Restrictions   on  Certain   Activities.   Under  FDICIA,   state-chartered
non-member banks with deposits insured by the FDIC are generally prohibited from
acquiring or retaining  any equity  investment of a type or in an amount that is
not permissible for a national bank. The foregoing limitation, however, does not
prohibit  FDIC-insured  state  banks  from  acquiring  or  retaining  an  equity
investment   in  a   subsidiary   in  which  the  bank  is  a  majority   owner.
State-chartered banks are also prohibited from engaging as principal in any type
of activity  that is not  permissible  for a national bank and  subsidiaries  of
state-chartered,  FDIC-insured  state banks may not engage as  principal  in any
type of activity  that is not  permissible  for a subsidiary  of a national bank
unless  in either  case the FDIC  determines  that the  activity  would  pose no
significant risk to the appropriate  deposit insurance fund and the bank is, and
continues to be, in compliance with applicable capital standards.

     The FDIC has adopted  regulations to clarify the foregoing  restrictions on
activities of FDIC-insured  state-chartered banks and their subsidiaries.  Under
the regulations,  the term activity refers to the authorized conduct of business
by an insured  state bank and includes  acquiring or  retaining  any  investment
other than an equity  investment.  An activity  permissible  for a national bank
includes  any activity  expressly  authorized  for national  banks by statute or
recognized as permissible in regulations,  official circulars or bulletins or in
any order or written  interpretation  issued by the Office of the Comptroller of
the Currency  ("OCC").  In its regulations,  the FDIC indicates that it will not
permit  state banks to  directly  engage in  commercial  ventures or directly or
indirectly  engage in any  insurance  underwriting  activity  other  than to the
extent such  activities are  permissible  for a national bank or a national bank
subsidiary or except for certain  other limited forms of insurance  underwriting
permitted under the regulations. Under the regulations, the

                                       27
<PAGE>

FDIC permits state banks that meet applicable  minimum  capital  requirements to
engage as principal in certain  activities  that are not permissible to national
banks including guaranteeing obligations of others, activities which the Federal
Reserve Board has found by regulation or order to be closely  related to banking
and certain securities activities conducted through subsidiaries.

Regulation of the Company

     General.  The  Company,  as the sole  shareholder  of the  Bank,  is a bank
holding company and is registered  with the Federal Reserve Board.  Bank holding
companies are subject to  comprehensive  regulation by the Federal Reserve Board
under the Bank Holding  Company Act of 1956,  as amended (the  "BHCA"),  and the
regulations of the Federal Reserve Board. As a bank holding company, the Company
is required  to file with the  Federal  Reserve  Board  annual  reports and such
additional  information as the Federal Reserve Board may require, and is subject
to regular  examinations by the Federal Reserve Board. The Federal Reserve Board
also has extensive enforcement authority over bank holding companies, including,
among other things, the ability to assess civil money penalties,  to issue cease
and  desist or  removal  orders and to  require  that a holding  company  divest
subsidiaries (including its bank subsidiaries).  In general, enforcement actions
may be initiated  for  violations of law and  regulations  and unsafe or unsound
practices.

     Under the BHCA, a bank holding  company must obtain  Federal  Reserve Board
approval before: (i) acquiring, directly or indirectly,  ownership or control of
any  voting  shares of  another  bank or bank  holding  company  if,  after such
acquisition,  it would own or  control  more than 5% of such  shares  (unless it
already owns or controls the majority of such  shares);  (ii)  acquiring  all or
substantially  all of the assets of another  bank or bank  holding  company;  or
(iii) merging or consolidating with another bank holding company,  (satisfactory
financial  condition,  particularly  with  respect  to capital  adequacy,  and a
satisfactory  CRA  rating  generally  are  prerequisites  to  obtaining  federal
regulatory approval to make acquisitions).

     The BHCA also prohibits a bank holding  company,  with certain  exceptions,
from  acquiring  direct or indirect  ownership or control of more than 5% of the
voting  shares of any company  which is not a bank or bank holding  company,  or
from engaging  directly or indirectly in activities other than those of banking,
managing or controlling banks, or providing  services for its subsidiaries.  The
principal  exceptions to these prohibitions  involve certain non-bank activities
which,  by statute or by Federal  Reserve Board  regulation or order,  have been
identified as activities  closely related to the business of banking or managing
or controlling  banks.  The list of activities  permitted by the Federal Reserve
Board includes,  among other things,  operating a savings institution,  mortgage
company,  finance company, credit card company or factoring company;  performing
certain data processing  operations;  providing certain investment and financial
advice;  underwriting  and acting as an  insurance  agent for  certain  types of
credit-related  insurance;  leasing  property  on a  full-payout,  non-operating
basis; selling money orders,  travelers' checks and United States Savings Bonds;
real  estate and  personal  property  appraising;  providing  tax  planning  and
preparation services; and, subject to certain limitations,  providing securities
brokerage services for customers.  The Company has no present plans to engage in
any of these activities.

     The Federal  Reserve  Board has adopted  guidelines  regarding  the capital
adequacy of bank holding  companies,  which  require  bank holding  companies to
maintain  specified  minimum  ratios of capital to total  assets and  capital to
risk-weighted  assets.  See " --  Depository  Institution  Regulation -- Capital
Requirements."

     Acquisition  of Bank  Holding  Companies  and  Banks.  Under the BHCA,  any
company  must obtain  approval of the Federal  Reserve  Board prior to acquiring
control of the  Company or the Bank.  For  purposes  of the BHCA,  "control"  is
defined as ownership of more than 25% of any class of voting  securities  of the
Company or the Bank,  the ability to control  the  election of a majority of the
directors,  or the  exercise  of a  controlling  influence  over  management  or
policies of the Company or the Bank. In addition, the Change in Bank Control Act
and the related  regulations of the Federal  Reserve Board require any person or
persons  acting in concert  (except for companies  required to make  application
under the BHCA),  to file a written notice with the Federal Reserve Board before
such  person or persons  may  acquire  control of the  Company or the Bank.  The
Change  in  Bank  Control  Act  defines  "control"  as the  power,  directly  or
indirectly,  to vote  25% or more of any  voting  securities  or to  direct  the
management or policies of a bank holding company or an insured bank.

                                       28
<PAGE>

     Interstate  Banking.  The  Riegle-Neal  Interstate  Banking  and  Branching
Efficiency  Act of  1994  (the  "Act")  was  enacted  to  ease  restrictions  on
interstate  banking.  Effective  September 29, 1995,  the Act allows the Federal
Reserve  Board to  approve  an  application  of an  adequately  capitalized  and
adequately managed bank holding company to acquire control of, or acquire all or
substantially  all of the assets of, a bank  located in a state  other than such
holding  company's  home state,  without  regard to whether the  transaction  is
prohibited by the laws of any state.  The Federal  Reserve Board may not approve
the  acquisition  of bank that has not been in  existence  for the minimum  time
period (not  exceeding  five years)  specified by the  statutory law of the host
state.  The Act also  prohibits  the Federal  Reserve  Board from  approving  an
application  if  the  applicant  (and  its  depository  institution  affiliates)
controls or would  control  more than 10% of the insured  deposits in the United
States or 30% or more of the deposits in the target  bank's home state or in any
state in which the target bank  maintains a branch.  The Act does not affect the
authority of states to limit the  percentage  of total  insured  deposits in the
state which may be held or controlled  by a bank or bank holding  company to the
extent such limitation does not discriminate  against out-of-state banks or bank
holding  companies.   Individual  states  may  also  waive  the  30%  state-wide
concentration limit contained in the Act.

     Additionally,  the Act authorizes the federal  banking  agencies to approve
interstate  merger  transactions  without regard to whether such  transaction is
prohibited  by the law of any  state,  unless the home state of one of the banks
opts out of the Act by adopting a law after the date of enactment of the Act and
prior to June 1,  1997  that  applies  equally  to all  out-of-state  banks  and
expressly  prohibits merger  transactions  involving  out-of-state  banks. North
Carolina has enacted  legislation  permitting  interstate banking  transactions.
Interstate  acquisitions  of branches  will be permitted  only if the law of the
state in which the  branch is  located  permits  such  acquisitions.  Interstate
mergers  and branch  acquisitions  will also be subject  to the  nationwide  and
statewide insured deposit concentration amounts described above.

     The Act  authorizes  the FDIC to approve  interstate  branching  de novo by
state banks only in states  which  specifically  allow for such  branching.  The
Riegle-Neal  Act also  requires  the  appropriate  federal  banking  agencies to
prescribe  regulations by June 1, 1997 which prohibit any out-of-state bank from
using the interstate  branching  authority  primarily for the purpose of deposit
production.  These regulations must include guidelines to ensure that interstate
branches operated by an out-of-state bank in a host state are reasonably helping
to meet the credit needs of the communities which they serve.

     Dividends.  The Federal Reserve Board has issued a policy  statement on the
payment of cash dividends by bank holding companies, which expresses the Federal
Reserve  Board's view that a bank holding company should pay cash dividends only
to the extent that the  company's  net income for the past year is sufficient to
cover both the cash dividends and a rate of earning retention that is consistent
with the company's capital needs, asset quality and overall financial condition.
The Federal  Reserve Board also indicated that it would be  inappropriate  for a
company   experiencing  serious  financial  problems  to  borrow  funds  to  pay
dividends.  Furthermore,  under the prompt corrective action regulations adopted
by the Federal  Reserve Board pursuant to FDICIA,  the Federal Reserve Board may
prohibit a bank  holding  company  from  paying  any  dividends  if the  holding
company's  bank  subsidiary  is  classified  as   "undercapitalized".   See  "--
Depository Institution Regulation -- Prompt Corrective Regulatory Action."

     Bank holding companies are required to give the Federal Reserve Board prior
written  notice  of  any  purchase  or  redemption  of  its  outstanding  equity
securities  if the gross  consideration  for the  purchase or  redemption,  when
combined with the net  consideration  paid for all such purchases or redemptions
during  the  preceding  12  months,  is  equal  to 10%  or  more  of  the  their
consolidated retained earnings.  The Federal Reserve Board may disapprove such a
purchase or redemption if it determines  that the proposal  would  constitute an
unsafe or unsound practice or would violate any law, regulation, Federal Reserve
Board order, or any condition imposed by, or written agreement with, the Federal
Reserve Board.

     The Federal  Reserve  Board has adopted  guidelines  regarding  the capital
adequacy of bank holding  companies,  which  require  bank holding  companies to
maintain  specified  minimum  ratios of capital to total  assets and  capital to
risk-weighted  assets.  See " --  Depository  Institution  Regulation -- Capital
Requirements."

                                       29
<PAGE>

                                    TAXATION

General

     The Bank files a federal  income tax return  based on a fiscal  year ending
September 30.

Federal Income Taxation

     The Bank is subject to the provisions of the Internal Revenue Code of 1986,
as amended (the  "Internal  Revenue  Code") in the same general  manner as other
corporations.  In its form as a savings bank until April 1997, through tax years
beginning  before  December  31, 1995,  institutions  such as the Bank which met
certain  definitional  tests and other  conditions  prescribed  by the  Internal
Revenue  Code  benefitted  from certain  favorable  provisions  regarding  their
deductions  from taxable income for annual  additions to their bad debt reserve.
For  purposes  of the bad debt  reserve  deduction,  loans  are  separated  into
"qualifying real property loans," which generally are loans secured by interests
in certain real property,  and "nonqualifying loans", which are all other loans.
The bad debt reserve deduction with respect to nonqualifying loans must be based
on actual loss  experience.  The amount of the bad debt reserve  deduction  with
respect  to  qualifying  real  property  loans  may be based  upon  actual  loss
experience  (the  "experience   method")  or  a  percentage  of  taxable  income
determined  without regard to such deduction (the  "percentage of taxable income
method"). Under the experience method, the bad debt deduction for an addition to
the reserve for qualifying real property loans was an amount  determined under a
formula  based  generally  on the bad  debts  actually  sustained  by a  savings
institution  over a period of years.  Under the  percentage  of  taxable  income
method,  the bad debt reserve  deduction for qualifying  real property loans was
computed  as  8%  of  a  savings  institution's  taxable  income,  with  certain
adjustments.  The Bank generally elected to use the method which has resulted in
the greatest deductions for federal income tax purposes in any given year.

     Legislation  that became  effective for tax years  beginning after December
31, 1995  requiring the Bank to recapture into taxable income over a six taxable
year period the portion of the tax loan  reserve  that  exceeds the pre-1988 tax
loan loss reserve.  The Bank will no longer be allowed to use the reserve method
for tax loan loss provisions,  but would be allowed to use the experience method
of accounting  for bad debts.  There will be no future effect on net income from
the  recapture  because the taxes on these bad debts  reserves  has already been
accrued as a deferred tax liability.

     The Bank's  federal  income tax returns have been audited  through the year
ended September 30, 1992.

State Income Taxation

     Under North  Carolina law, the  corporate  income tax currently is 7.50% of
federal taxable income as computed under the Internal  Revenue Code,  subject to
certain  prescribed  adjustments.  This rate will be  reduced to 7.25% for 1998,
7.00% for 1999 and 6.9% for 2000 and  thereafter.  An annual state franchise tax
is imposed at a rate of .15%  applied to the  greatest of the  institutions  (i)
capital  stock,  surplus and  undivided  profits,  (ii)  investment  in tangible
property in North  Carolina or (iii)  appraised  valuation  of property in North
Carolina.

     For additional  information regarding taxation, see Notes 1 and 10 of Notes
to Consolidated Financial Statements.

                                       30
<PAGE>

Item 2.  Properties
-------------------

         The  following  table sets forth the  location  and certain  additional
information regarding the Bank's offices at September 30, 1997.

<TABLE>
<CAPTION>
                                                                    Book Value at
                                     Year           Owned or        September 30,         Approximate
                                    Opened           Leased             1997            Square Footage
                                    ------          --------        -------------       --------------
                                                                (Dollars in thousands)
<S>                                  <C>              <C>              <C>                 <C>
    Main Office:
    1311 Carolina Avenue
    Washington, NC 27889             1986             Owned            $   627             10,200

    Branch Offices:
    300 North Market Street
    Washington, NC  27889            1959             Owned                117              4,680

    301 E. Arlington Blvd.
    Greenville, NC  27835            1993             Owned                314              2,600

    604 E. Ehringhaus Street
    Elizabeth City, NC  27906        1980             Owned                180              2,500

    827 Hardee Road
    Kinston, NC  28501               1996            Leased                 --              2,000

    1725 Glenburnie Road
    New Bern, NC  28561              1990             Owned                339              2,600

    202 Craven Street
    New Bern, NC  28560              1995            Leased                 34              2,500

    300 Sunset Avenue
    Rocky Mount, NC  27804           1994             Owned                330              4,948

    Loan Production Office:
    6800 Wrightsville Avenue
    Suite 23                         1995            Leased                 --                692
    Wilmington, NC  28406

    Operations Center:
    239 West Main Street
    Washington, NC  27889            1994             Owned                334              7,600

    Future Branch Sites:
    Cypress Landing
    Chocowinity, NC                                   Owned                126

    Taberna
    New Bern, NC                                      Owned                176
</TABLE>

     The book value of the Bank's  investment in premises and equipment was $2.8
million at September 30, 1997. See Note 6 to Consolidated Financial Statements.

                                       31
<PAGE>

Item 3. Legal Proceedings.
--------------------------

     From time to time,  the Company and/or the Bank is a party to various legal
proceedings  incident to their  business.  At September 30, 1997,  there were no
legal  proceedings to which the Company or the Bank was a party, or to which any
of their property was subject,  which were expected by management to result in a
material  loss to the  Company  or the  Bank.  There are no  pending  regulatory
proceedings  to which the  Company or the Bank is a party or to which  either of
their properties is subject which are currently expected to result in a material
loss.

Item 4.  Submission of Matters to Vote of Security Holders.
-----------------------------------------------------------

     Not applicable.

                                     PART II

Item 5.  Market for the Registrant's  Common  Equity and  Related  Stockholders'
--------------------------------------------------------------------------------
         Matters
         -------

     The information contained under the sections captioned "Market Information"
in the  Company's  Annual  Report to  Stockholders  for the  Fiscal  Year  Ended
September  30,  1997  (the  "Annual  Report")  filed as  Exhibit  13  hereto  is
incorporated herein by reference.

Item 6.  Selected Financial Data
--------------------------------

     The  information  contained in the table captioned  "Selected  Consolidated
Financial and Other Data" on page 2 in the Annual Report is incorporated  herein
by reference.

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

     The information contained in the section captioned "Management's Discussion
and  Analysis  of  Financial  Condition  and Results of  Operations"  on pages 3
through 13 in the Annual Report is incorporated herein by reference.

Item 7A.  Quantitative and Qualitative Disclosures About Market Risk
--------------------------------------------------------------------

     The  information  contained  under the sections  captioned  "Interest  Rate
Sensitivity  Analysis" on page 5 in the Annual Report is incorporated  herein be
reference.

Item 8.  Financial Statements and Supplementary Data
----------------------------------------------------

     The  Consolidated  Financial  Statements,  Notes to Consolidated  Financial
Statements,  Independent  Auditors' Report and Selected Financial Data contained
on pages 14  through  30 in the Annual  Report,  which are listed  under Item 14
herein, are incorporated herein by reference.

Item 9.  Changes  in  and  Disagreements  With  Accountants  on  Accounting  and
--------------------------------------------------------------------------------
         Financial Disclosure
         --------------------

     Not applicable.

                                       32
<PAGE>

                                    PART III

Item 10.  Directors and Executive Officers of the Registrant
------------------------------------------------------------

     The  information  contained  under the  sections  captioned  "Proposal I --
Election  of  Directors"  and  "Section  16(a)  Beneficial  Ownership  Reporting
Compliance" in the Company's  definitive  proxy statement for the Company's 1998
Annual Meeting of Stockholders (the "Proxy Statement") is incorporated herein by
reference.

Item 11.  Management Remuneration
---------------------------------

     The  information  contained  under the  sections  captioned  "Proposal I --
Election  of  Directors,"  "--  Compensation  Committee  Interlocks  and Insider
Participation," "-- Compensation Committee Report on Executive  Compensation," "
--  Comparative  Stock  Performance  Graph," " --  Executive  Compensation"  and
"--Director  Compensation" " in the Proxy  Statement is  incorporated  herein by
reference.

Item 12.  Security Ownership of Certain Beneficial Owners and Management
------------------------------------------------------------------------

     (a)  Security Ownership of Certain Beneficial Owners.  Information required
          by this  item is  incorporated  herein  by  reference  to the  section
          captioned  "Voting  Securities  and Security  Ownership"  in the Proxy
          Statement.

     (b)  Security Ownership of Management. Information required by this item is
          incorporated  herein by reference to the  sections  captioned  "Voting
          Securities  and  Security  Ownership"  and  "Proposal I -- Election of
          Directors" in the Proxy Statement.

     (c)  Changes  in  Control.   Management   of  the   Company   knows  of  no
          arrangements,  including any pledge by any person of securities of the
          Company,  the operation of which may at a subsequent  date result in a
          change in control of the registrant.

Item 13.  Certain Relationships and Related Transactions
--------------------------------------------------------

     The information  required by this item is incorporated  herein by reference
to the section  captioned  "Proposal I -- Election of Directors --  Transactions
with Management" in the Proxy Statement.

                                     PART IV

Item 14.  Exhibits, Financial Statement Schedules and Reports on Form 8-K.
--------------------------------------------------------------------------

     (a)  List of Documents Filed as Part of this Report
          ----------------------------------------------

     (1) Financial Statements.  The following  consolidated financial statements
are incorporated by reference from Item 8 hereof (see Exhibit 13):

     Independent Auditors' Report

     Consolidated Statements of Financial Condition as of September 30, 1997 and
     1996

     Consolidated  Statements  of Operations  for the Years Ended  September 30,
     1997, 1996 and 1996

     Consolidated   Statements  of  Stockholders  Equity  for  the  Years  Ended
     September 30, 1997, 1996 and 1995

     Consolidated  Statements  of Cash Flows for the Years Ended  September  30,
     1997, 1996 and 1995

     Notes to Consolidated Financial Statements

                                       33
<PAGE>

     (2) Financial  Statement  Schedules.  All schedules for which  provision is
made in the  applicable  accounting  regulations  of the Securities and Exchange
Commission are omitted because of the absence of conditions under which they are
required or because the  required  information  is included in the  consolidated
financial statements and related notes thereto.

     (3)  Exhibits.  The  following is a list of exhibits  filed as part of this
Annual Report on Form 10-K and is also the Exhibit Index.

      No.         Description
      ---         -----------
      3.1         Certificate  of  Incorporation  of  NewSouth   Bancorp,   Inc.
                  (Incorporated  herein by  reference  from  Exhibit  3.1 to the
                  Company's   Registration  Statement  on  Form  S-1  (File  No.
                  333-16335))
      3.2         Bylaws  of  NewSouth  Bancorp,  Inc.  (Incorporated  herein by
                  reference  from  Exhibit  3.2  to the  Company's  Registration
                  Statement on Form S-1 (File No. 333-16335))
      4           Form of Common Stock  Certificate  of NewSouth  Bancorp,  Inc.
                  (Incorporated  herein  by  reference  from  Exhibit  1 to  the
                  Company's Registration Statement on Form 8-A))
     10.1(a)      Employment Agreement between NewSouth Bancorp, Inc. and Thomas
                  A. Vann (Incorporated herein by reference from Exhibit 10.3(a)
                  to the Company's  Registration Statement on Form S-1 (File No.
                  333-16335))
     10.1(b)      Employment Agreement between Home Savings Bank, SSB and Thomas
                  A. Vann (Incorporated herein by reference from Exhibit 10.3(b)
                  to the Company's  Registration Statement on Form S-1 (File No.
                  333-16335))
     10.2         Change in Control  Protective  Agreements between Home Savings
                  Bank, SSB, NewSouth Bancorp,  Inc. and Mary R. Boyd, Sherry L.
                  Correll,  Kristie W.  Hawkins,  Walter P. House and William R.
                  Outland (Incorporated herein by reference from Exhibit 10.4 to
                  the  Company's  Registration  Statement  on Form S-1 (File No.
                  333-16335))
     10.3         Supplemental   Income   Agreements  as  Amended  and  Restated
                  December 14, 1995 between Home Savings Bank, SSB and Sherry L.
                  Correll,  William R.  Outland  and Thomas A. Vann and the 1996
                  Amendment  Thereto  (Incorporated  herein  by  reference  from
                  Exhibit 10.5 to the Company's  Registration  Statement on Form
                  S-1 (File No. 333-16335))
     10.4         Supplemental  Income Plan  Agreements  as Amended and Restated
                  December 14, 1995 between Home Savings Bank,  SSB and James F.
                  Buckman,  Walter P. House,  Thomas A. Vann and William L. Wall
                  and  the  1996  Amendment  Thereto   (Incorporated  herein  by
                  reference  from  Exhibit  10.6 to the  Company's  Registration
                  Statement on Form S-1 (File No. 333-16335))
     10.5         Home Savings Bank, SSB Director's  Deferred  Compensation Plan
                  Agreements  as Amended  and  Restated  December  14, 1995 with
                  Edmund T. Buckman,  Jr.,  Linley H. Gibbs,  Jr.,  Frederick N.
                  Holscher, Frederick H. Howdy, Charles E. Parker, Jr., Marshall
                  T. Singleton and Thomas A. Vann and the 1996 Amendment Thereto
                  (Incorporated  herein by  reference  from  Exhibit 10.7 to the
                  Company's   Registration  Statement  on  Form  S-1  (File  No.
                  333-16335))
     10.6         Home Savings Bank, SSB Director's  Retirement  Plan Agreements
                  as Amended  and  Restated  December  14,  1995 with  Edmund T.
                  Buckman,  Jr.,  Linley H. Gibbs,  Jr.,  Frederick N. Holscher,
                  Frederick H. Howdy,  Charles E. Parker, Jr. and Thomas A. Vann
                  and  the  1996  Amendment  Thereto   (Incorporated  herein  by
                  reference  from  Exhibit  10.8 to the  Company's  Registration
                  Statement on Form S-1 (File No. 333-16335))
     10.7         Home  Savings  Bank,   SSB   Director's   Retirement   Payment
                  Agreements  as Amended  and  Restated  December  14, 1995 with
                  Edmund T. Buckman,  Jr.,  Linley H. Gibbs,  Jr.,  Frederick N.
                  Holscher,  Frederick  H. Howdy,  Charles E.  Parker,  Jr., and
                  Thomas A. Vann and the 1996  Amendment  Thereto  (Incorporated
                  herein  by  reference  from  Exhibit  10.9  to  the  Company's
                  Registration Statement on Form S-1 (File No. 333-16335))
     10.8         Home Savings Bank,  SSB Directors  Retirement  Plan  Agreement
                  with Marshall Singleton (Incorporated herein by reference from
                  Exhibit 10.10 to the Company's  Registration Statement on Form
                  S-1 (File No. 333-16335))

                                       34
<PAGE>

     13           Annual Report to Stockholders
     21           Subsidiaries of the Registrant
     27           Financial Data Schedule

      (b) Reports on Form 8-K.  During the quarter ended September 30, 1997, the
          --------------------
Registrant did not file any Current Reports on Form 8-K.

      (c)  Exhibits.  The exhibits  required by Item 601 of  Regulation  S-K are
           ---------
either  filed as part of this  Annual  Report  on Form 10-K or  incorporated  by
reference herein.

      (d) Financial  Statements and Schedules Excluded from Annual Report. There
          ----------------------------------------------------------------
are no other financial  statements and financial  statement schedules which were
excluded from the Annual Report to Stockholders  pursuant to Rule 14a-3(b) which
are required to be included herein.

                                       35
<PAGE>

                                   SIGNATURES

     Pursuant  to the  requirements  of  Section  13 or 15(d) of the  Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

                                                NEWSOUTH BANCORP, INC.

December 19, 1997
                                                By:  /s/ Thomas A. Vann
                                                    -------------------------
                                                       Thomas A. Vann
                                                         President

     Pursuant to the  requirements of the Securities  Exchange Act of 1934, this
report  has  been  signed  below  by the  following  persons  on  behalf  of the
registrant and in the capacities and on the dates indicated.


/s/ Thomas A. Vann                                        December 19, 1997
--------------------------------------------
Thomas A. Vann
President and Director
(Principal Executive Officer)


/s/ William L. Wall                                       December 19, 1997
--------------------------------------------
William L. Wall
Executive Vice President, Chief Financial
  Officer and Secretary
(Principal Financial and Accounting Officer)


/s/ Edmund T. Buckman, Jr.                                December 19, 1997
--------------------------------------------
Edmund T. Buckman, Jr.
Director


/s/ Linley H. Gibbs, Jr.                                  December 19, 1997
--------------------------------------------
Linley H. Gibbs, Jr.
Director


/s/ Frederick N. Holscher                                 December 19, 1997
--------------------------------------------
Frederick N. Holscher
Director


/s/ Frederick H. Howdy                                    December 19, 1997
--------------------------------------------
Frederick H. Howdy
Director


/s/ Charles E. Parker, Jr.                                December 19, 1997
--------------------------------------------
Charles E. Parker, Jr.
Director


/s/ Marshall T. Singleton                                 December 19, 1997
--------------------------------------------
Marshall T. Singleton
Director