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

[X]      Annual Report pursuant to Section 13 or 15(d) of the Securities
         Exchange Act of 1934 for the fiscal year ended December 31, 2003.

                                       OR

[ ]      Transition Report pursuant to Section 13 or 15(d) of the Securities
         Exchange Act of 1934 for the transition period from _______ to _______.

                        Commission File Number 000-50426

                               KNBT Bancorp, Inc.
       -----------------------------------------------------------------
                (Name of Registrant as specified in its charter)

            Pennsylvania                              38-3681905
----------------------------------       ---------------------------------------
  (State or other jurisdiction of          (I.R.S. Employer Identification No.)
   incorporation or organization)

        90 Highland Avenue, Bethlehem, Pennsylvania          18017
--------------------------------------------------------------------------------
         (Address of principal executive offices)         (Zip Code)

         Registrant's telephone number, including area code 610-861-5000

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

                                      None

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

                          Common Stock, $0.01 Par Value
                          -----------------------------
                                (Title of Class)

                     --------------------------------------

     Indicate  by check mark  whether the  registrant  (1) has filed all reports
required  to be filed by Section  13 or 15 (d) of the  Securities  Exchange  Act
during the preceding 12 months (or for such shorter  period that the  registrant
was  required  to file such  reports),  and (2) has been  subject to such filing
requirements for the past 90 days.

                             Yes _X         No ____

     Indicate 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. [ ]

     Indicate by check mark whether the registrant is an  accelerated  filer (as
defined in Rule 12b-2 of the Exchange Act).

                             Yes ____       No __X__


     The  registrant  had no  shares of common  equity  outstanding  on the last
business day of the registrant's most recently  completed second fiscal quarter.
The registrant completed its initial public offering on October 31, 2003.

     The number of shares of the  Issuer's  common  stock,  par value  $0.01 per
share, outstanding as of March 19, 2004 was 30,529,450.

                     --------------------------------------

                      DOCUMENTS INCORPORATED BY REFERENCE:
     Certain  portions  of  KNBT  Bancorp's  proxy  statement  to  be  filed  in
connection  with its 2004 Annual Meeting of  Shareholders  are  incorporated  by
reference in Part III of this Report. Other documents  incorporated by reference
are listed in the Exhibit Index.



<PAGE>


<TABLE>
<CAPTION>
                               KNBT BANCORP, INC.
                           Form 10-K Table of Contents


                                                                                                                         Page
                                                                                                                         ----
                                     PART I

<S>  <C>                                                                                                                  <C>
Item 1.         Business...........................................................................................       1

Item 2.         Properties.........................................................................................      31

Item 3.         Legal Proceedings..................................................................................      31

Item 4.         Submission of Matters to a Vote of Security Holders................................................      31



                                     PART II

Item 5.         Market for Registrant's Common Equity, Related Stockholder Matters and Issuer
                Repurchases of Equity Securities...................................................................      32

Item 6.         Selected Consolidated Financial Data...............................................................      33

Item 7.         Management's Discussion and Analysis of Financial Condition and Results of Operations..............      34

Item 7A.        Quantitative and Qualitative Disclosures About Market Risk.........................................      47

Item 8.         Financial Statements and Supplementary Data........................................................      48

Item 9.         Changes in and Disagreements with Accountants on Accounting and Financial Disclosure...............      82

Item 9A.        Controls and Procedures............................................................................      82



                                    PART III

Item 10.        Directors and Executive Officers of the Registrant.................................................      83

Item 11.        Executive Compensation.............................................................................      83

Item 12.        Security Ownership of Certain Beneficial Owners and Management and
                Related Stockholder Matters........................................................................      83

Item 13.        Certain Relationships and Related Transactions.....................................................      83

Item 14.        Principal Accounting Fees and Services.............................................................      83



                                     PART IV

Item 15.        Exhibits, Financial Statement Schedules and Reports on Form 8-K....................................      84

Signatures ........................................................................................................      86


</TABLE>


<PAGE>


                               KNBT BANCORP, INC.

           CAUTIONARY STATEMENT REGARDING FORWARD LOOKING INFORMATION

         In addition to historical information,  this Annual Report on Form 10-K
includes certain "forward-looking  statements," as defined in the Securities Act
of 1933 and the  Securities  Exchange Act of 1934,  based on current  management
expectations.   KNBT's  actual  results  could  differ   materially  from  those
management  expectations.  Such  forward-looking  statements  include statements
regarding  KNBT's  intentions,  beliefs or current  expectations  as well as the
assumptions  on which such  statements  are based.  Stockholders  and  potential
stockholders  are cautioned  that any such  forward-looking  statements  are not
guarantees of future performance and involve risks and  uncertainties,  and that
actual  results  may  differ   materially   from  those   contemplated  by  such
forward-looking statements. Factors that could cause future results to vary from
current  management  expectations  include,  but are  not  limited  to,  general
economic  conditions,   legislative  and  regulatory  changes,  monetary  fiscal
policies  of  the  federal  government,  changes  in  tax  policies,  rates  and
regulations  of federal,  state and local tax  authorities,  changes in interest
rates,  deposit  flows,  cost of funds,  demand  for loan  products,  demand for
financial  services,  difficulties  in integrating  the data processing or other
systems at its subsidiary savings bank,  competition,  changes in the quality or
composition  of KNBT's loan and  investment  portfolios,  changes in  accounting
principles, policies or guidelines and other economic, competitive, governmental
and  technological  factors  affecting  KNBT's  operations,  markets,  products,
services  and fees.  KNBT  undertakes  no  obligation  to  update or revise  any
forward-looking  statements to reflect  changed  assumptions,  the occurrence of
unanticipated events or changes to future operating results over time.

PART I

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

General
-------

         KNBT Bancorp,  Inc. is a Pennsylvania  corporation  and registered bank
holding company organized in 2003.  KNBT's business consists  primarily of being
the parent  holding  company  for  Keystone  Nazareth  Bank & Trust  Company,  a
Pennsylvania  chartered  savings  bank.  Keystone  Nazareth Bank & Trust Company
(which we also refer to as the "Bank") is the  stock-form  successor to Keystone
Savings Bank upon the mutual-to-stock  conversion of Keystone Savings Bank which
was  completed  on  October  31,  2003.  Concurrently  with the  mutual-to-stock
conversion,  KNBT acquired,  through a merger,  First Colonial Group,  Inc., the
parent bank holding  company for Nazareth  National Bank and Trust  Company.  On
October 31 2003, First Colonial Group was merged with and into KNBT and Nazareth
National Bank was merged with and into Keystone  Nazareth Bank & Trust  Company.
The  mutual-to-stock  conversion  of Keystone  Savings Bank and the mergers with
First Colonial and Nazareth  National Bank also coincided with the completion of
the initial public offering of KNBT. KNBT sold approximately 20.2 million shares
of its common  stock for an aggregate of $202.0  million to  subscribers  in its
offering,  contributed  approximately  1.6 million shares of common stock to the
recently  created  Keystone  Nazareth  Charitable  Foundation,   and  issued  an
additional  8.5  million  shares to former  shareholders  of First  Colonial  in
exchange for their First Colonial shares.

Available Information
---------------------

         KNBT is a public  company  and  files  annual,  quarterly  and  current
reports, proxy statements and other information with the Securities and Exchange
Commission.  KNBT's  filings are available to the public at the SEC's website at
HTTP://www.sec.gov.  Members of the  public may also read and copy any  document
that KNBT files at the SEC's Public  Reference  Room at 450 Fifth Street,  N.W.,
Washington,  D.C. 20549. You can request copies of these documents by writing to
the  SEC  and  paying  a fee  for  the  copying  cost.  Please  call  the SEC at
1-800-SEC-0330  for more information about the operation of the public reference
room.  In  addition  to the  foregoing,  the  Company  maintains  a  website  of
www.KNBT.com.  KNBT makes available on its Internet website copies of its Annual
Reports on Form 10-K,  Quarterly  Reports on Form 10-Q,  Current Reports on Form
8-K and any amendments to such documents as soon as reasonably practicable after
KNBT  electronically  files such material  with, or furnishes such documents to,
the SEC.


                                      -1-
<PAGE>


Keystone Nazareth Bank & Trust Company
--------------------------------------

         The Bank is a stock savings bank incorporated in 2003 under the laws of
Pennsylvania and is a wholly-owned subsidiary of KNBT. The Bank is the successor
to Keystone Savings Bank, a Pennsylvania  mutual savings bank that was organized
in 1925.  The Bank has 41 full service  offices  with 19 located in  Northampton
County, Pennsylvania, 16 in Lehigh County, Pennsylvania,  five in Monroe County,
Pennsylvania and one in Carbon County,  Pennsylvania.  The Bank's office network
includes 14 full service in-store  supermarket branch offices. The Bank has ATMs
in all but one of its banking offices and also maintains six off-site ATMs.

         The Bank is primarily  engaged in attracting  deposits from the general
public  and using  those  funds to invest in loans and  securities.  The  Bank's
principal sources of funds are deposits, repayments of loans and mortgage-backed
securities,  maturation of investments, funds provided from operations and funds
borrowed  from outside  sources  such as the Federal Home Loan Bank  ("FHLB") of
Pittsburgh.   The  Bank's  deposit   products   include   interest-bearing   and
non-interest-bearing  checking  accounts,  statement savings accounts,  passbook
savings accounts,  money-market accounts,  club accounts,  individual retirement
accounts and  certificates  of deposit.  These funds are primarily  used for the
origination of various loan types including  single-family  residential mortgage
loans,  non-residential  or commercial  real estate  mortgage  loans,  direct or
indirect consumer loans, such as home equity loans,  automobile and recreational
vehicle loans and  commercial  business  lines of credit,  letters of credit and
term loans. Most of the Bank's commercial  customers are small to medium in size
businesses operating in the Bank's market area.

         The Bank also offers trust and wealth  management  services through its
trust department under the name KNBT Financial Advisors.  These services include
acting as executor and trustee under wills and deeds, as guardian, custodian and
as trustee and agent for  pension,  profit  sharing and other  employee  benefit
trusts as well as various investment,  pension and estate planning services. The
market  value of the funds held by the trust  department  was $312.4  million at
December 31, 2003.

         The Bank offers a  selection  of  investment  and  insurance  products,
including equity securities, mutual funds and annuities, to its customers in its
branch offices.  The Bank conducts such activities under the name KNBT Financial
Advisors.  Such  products are sold by  registered  representatives  who are dual
employees  of both the Bank and a  third-party,  registered  broker-dealer.  The
revenues  received  through the sale of these  products  amounted  to  $465,000,
$420,000 and $100,000 in 2003, 2002 and 2001, respectively.

         The Bank has two  wholly-owned  subsidiaries,  KLV, Inc. and KLVI, Inc.
KLV, Inc. is inactive.  KLVI,  Inc., a Delaware  corporation,  is a wholly-owned
subsidiary  of the Bank  formed in 1997 to hold and  manage  certain  investment
securities.

         The Bank is also a majority  owner of Traditions  Settlement  Services,
LLC.  Traditions  was  organized in May 2002 and provides  real estate title and
settlement services.

Subsidiaries
-------------

         In addition to the Bank, KNBT's subsidiaries  include KNBT Inv. I, KNBT
Inv. II and First Colonial Statutory Trust I.

         In December 2003, KNBT established a wholly-owned subsidiary, KNBT Inv.
I, a Delaware  corporation  for the  purpose of  investing  in various  types of
securities.  As of December  31,  2003,  KNBT Inv. I, Inc.  had total  assets of
$10,000 of which all were in a non-interest bearing checking account.

         KNBT Inv. II, Inc.,  formerly  known as First C. G. Company,  Inc., was
acquired  on October 31, 2003 as part of KNBT's  acquisition  of First  Colonial
Group,  KNBT Inv. II, Inc. is a wholly-owned  subsidiary of KNBT.  KNBT Inv. II,
Inc.  is a Delaware  corporation  established  for the purpose of  investing  in
various




                                      -2-
<PAGE>

types of  securities.  As of December  31,  2003,  KNBT Inv.  II, Inc. had total
assets of $5.5 million of which $4.9  million was invested in equity  securities
with most of the remaining assets in interest-bearing money market accounts.

         First  Colonial  Statutory  Trust I was acquired by KNBT on October 31,
2003 as a part of the merger with First  Colonial  Group,  Inc.  First  Colonial
Statutory  Trust I, a wholly-owned  subsidiary of KNBT, was  established in June
2002 and is a Connecticut  business trust.  This company was established for the
purpose of issuing $15.0 million of trust preferred  securities.  First Colonial
Statutory Trust I had total assets of $15.5 million at December 31, 2003.

Market Area and Competition
---------------------------

         The Bank's  market  area  consists of Lehigh,  Northampton,  Carbon and
Monroe  counties,  Pennsylvania.  The greater  Lehigh  Valley area,  which is in
eastern Pennsylvania  approximately 60 miles north of Philadelphia,  is anchored
by the cities of  Bethlehem,  Allentown and Easton.  The combined  population of
Lehigh and Northampton  Counties is in excess of 600,000 and the market includes
a mix of urban,  suburban and rural areas.  Between 1990 and 2002,  the combined
population  of  Lehigh  and  Northampton  Counties  grew by  approximately  8.3%
compared  to 3.4% for  Pennsylvania  as a  whole.  Major  employers  in the area
include  Federal,  State  and local  governments,  local  healthcare  providers,
including  Lehigh  Valley  Hospital  and St.  Luke's  Hospital,  Air  Products &
Chemicals, PPL, Binney & Smith, Agere Systems and Mack Trucks.

         The  Bank  faces  significant  competition  in  originating  loans  and
attracting  deposits.  This competition  stems primarily from commercial  banks,
other savings banks and savings  associations  and  mortgage-banking  companies.
Within the Bank's market area,  more than 50 other banks,  savings  institutions
and  credit  unions  are  operating.  Many of the  financial  service  providers
operating in the Bank's market area are significantly  larger,  and have greater
financial  resources,  than the Bank. The Bank faces additional  competition for
deposits from money market and other mutual funds, and from other non-depository
financial institutions such as brokerage firms and insurance companies.

Lending Activities
------------------

         KNBT  primarily  extends  loans to  individuals  and  businesses in the
counties of Northampton, Lehigh, Monroe and Carbon, Pennsylvania.  Historically,
KNBT's   principal   lending   activity  has  been  the   origination  of  loans
collateralized by one-to four-family, or single-family,  residential real estate
located in its market area. In addition,  KNBT  traditionally  has been actively
involved  in  construction  and land  development  loans,  with an  emphasis  on
construction/permanent  single-family  residential  mortgage  loans and loans to
local homebuilders, and consumer loans, primarily home equity loans and lines of
credit.  The securitization of some of its residential real estate loans and the
continuing  sale of such loans has been a factor in reducing  KNBT's  historical
concentration in these types of loans. KNBT has increased its commercial lending
activities as a result of the merger and the additions to the commercial lending
staff.

         KNBT's one-to  four-family  residential  real estate loans  amounted to
$332.0  million or 36.0% of the total loan  portfolio at December  31, 2003.  At
such date,  commercial  real estate loans amounted to $156.5 million or 17.0% of
the total portfolio, construction and land development loans were $112.7 million
or 12.2% of the total portfolio, commercial business loans were $39.0 million or
4.23% of the portfolio and consumer loans were $265.5 million or 28.8% of KNBT's
total loan portfolio.




                                      -3-
<PAGE>


         Loan Portfolio  Composition.  The following table shows the composition
of the loan portfolio by type of loan at the dates indicated.


<TABLE>
<CAPTION>



<S>           <C>         <C>         <C>     <C>          <C>     <C>            <C>       <C>          <C>      <C>         <C>

------------------------------------------------------------------------------------------------------------------------------------

                                                                    At December 31,
                          ----------------------------------------------------------------------------------------------------------
                                  2003                 2002                  2001                   2000                 1999
                          ----------------------------------------------------------------------------------------------------------
                           Amount       %       Amount       %        Amount        %          Amount      %       Amount       %
                          --------- --------   --------- ---------   ---------  ----------    -------- --------- --------- ---------
                                                                   (dollars in thousands)
Real estate loans:
One-to four-family
  residential (1) .....   $ 332,024   36.00%  $ 361,842    59.34%  $ 513,352      73.27%    $ 509,188    73.20% $ 472,874     72.52%
  Multi-family
    residential .......      14,197    1.54       5,377     0.88       3,823       0.55         4,020     0.58      3,607      0.55
  Commercial real
    estate ............     156,563   16.97      29,385     4.82      12,839       1.83         6,715     0.97      3,442      0.54
  Construction and
    land development ..     112,684   12.22      59,363     9.74      54,092       7.72        59,687     8.58     63,404      9.72
                          --------- --------   --------- ---------   ---------  ----------    -------- --------- --------- ---------
Total real estate
  loans ...............     615,468   66.73     455,967    74.78     584,106      83.36       579,610    83.33    543,327     83.33

Commercial
  business loans ......      38,978    4.23      10,050     1.65       4,399       0.63         4,166     0.60      3,535      0.54
State and political
  subdivision loans ...       2,334    0.25        --         --          --         --            --       --         --         --
Consumer loans:
  Home equity loans
    and lines of credit     151,603   16.44     102,275    16.77      96,702      13.80        94,317    13.56     90,867     13.94
  Automobile and other
    vehicles ..........     102,256   11.09      31,956     5.24       5,887       0.84         8,901     1.28      7,906      1.21
  Other ...............      11,682    1.26       9,500     1.56       9,572       1.37         8,585     1.23      6,407      0.98
                          --------- --------   --------- ---------   ---------  ----------    -------- --------- --------- ---------
Total consumer
  loans ...............     265,541   28.79     143,731    23.57     112,161      16.00       111,803    16.07    105,180     16.13
                          --------- --------   --------- ---------   ---------  ----------    -------- --------- --------- ---------

  Total loans .........     922,321  100.00%    609,748   100.00%    700,666     100.00%      695,579   100.00%   652,042    100.00%
                          --------- ========   --------- =========   ---------  ==========    -------- ========= --------- =========
Less:
Undisbursed portion
    of construction
    loans in process ..     (27,099)            (24,263)             (23,552)                 (28,972)            (31,743)
Deferred loan fees ....        (469)             (3,236)              (5,682)                  (6,163)             (6,090)
Allowance for loan
  losses ..............      (7,910)             (2,927)              (3,386)                  (3,337)             (3,101)
                          ---------             ---------            ---------                --------           ---------
Net loans .............   $ 886,843           $ 579,322            $ 668,046                $ 657,107         $   611,108
                          =========             =========            =========                ========           =========

------------------------------------------------------------------------------------------------------------------------------------

</TABLE>


(1) Includes mortgage loans held-for-sale of $4.7 million at December 31, 2003
and $23.8 million at December 31, 2002. There were no mortgage loans
held-for-sale at December 31, 2001, 2000 or 1999.




                                      -4-
<PAGE>



         Contractual  Terms to Final  Maturities.  The following table shows the
scheduled contractual maturities of KNBT's loans as of December 31, 2003, before
giving  effect to net items.  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 amounts shown below do not take into account loan prepayments.


<TABLE>
<CAPTION>

<S>                                  <C>        <C>          <C>          <C>          <C>          <C>          <C>        <C>
------------------------------------------------------------------------------------------------------------------------------------

                                                                                                  State and
                                     One-to                              Construction Commercial  Political
                                   Four-Family Multi-family Commercial    and Land     Business   Subdivision  Consumer
                                   Residential  Residential Real Estate  Development    Loans       Loans        Loans        Total
                                   ------------ ----------- ------------ ------------ ----------- ----------- ------------ ---------
                                                                            (dollars in thousands)
 Amounts due after
     December 31, 2003 in:
     One year or less ........       $  1,526   $    326     $  9,691     $ 87,858     $ 18,336     $   --       $ 15,946   $133,683
     After one year through
        three years ..........          3,152        728        7,919       23,259        3,452         --         30,546     69,056
     After three years through
         five years ..........         14,493        101       16,013          148        3,315          443       94,786    129,299
     After five years through
        fifteen years ........        103,948      6,090       67,489        1,419        7,797        1,891      122,307    310,941
     After fifteen years .....        208,905      6,952       55,451         --          6,078         --          1,956    279,342
                                     --------   --------     --------     --------     --------     --------     --------   --------
        Total ................       $332,024   $ 14,197     $156,563     $112,684     $ 38,978     $  2,334     $265,541   $922,321
                                     ========   ========     ========     ========     ========     ========     ========   ========

------------------------------------------------------------------------------------------------------------------------------------

</TABLE>


         The  following  table shows the amount of KNBT's  loans at December 31,
2003,  which are due after  December  31, 2004 and  indicates  whether they have
fixed-rates of interest or which are floating or adjustable rates.

<TABLE>
<CAPTION>

<S>                                             <C>                    <C>                  <C>
-----------------------------------------------------------------------------------------------------

                                                                   Floating or
                                               Fixed-Rate         Adjustable Rate           Total
                                             ---------------     -----------------     --------------
                                                                 (dollars in thousands)
One-to four-family residential ............     $ 303,741              $ 26,757             $ 330,498
Multi-family residential ..................         6,223                 7,648                13,871
Commercial real estate ....................        83,259                63,613               146,872
Construction and land development .........         4,473                20,353                24,826
Commercial business .......................        12,219                 8,423                20,642
State and political subdivisions ..........         2,152                   182                 2,334
Consumer ..................................       208,542                41,053               249,595
                                             ---------------     -----------------     --------------
   Total ..................................     $ 620,609             $ 168,029             $ 788,638
                                             ===============     =================     ==============

-----------------------------------------------------------------------------------------------------

</TABLE>

         Loan Originations,  Sales and Servicing.  KNBT's lending activities are
subject to underwriting standards and loan origination procedures established by
its board of directors and  management.  KNBT relies on its staff of retail loan
representatives  and commercial  lenders to originate new loans. These employees
travel  throughout  KNBT's  market area and meet with  customers at their homes,
place of business or in the Bank's offices, to take loan applications.  KNBT has
designated certain employees at each of its branch offices to take consumer loan
applications.  KNBT has  centralized  its consumer and  residential  real estate
lending underwriting function and all new loans are received and underwritten by
staff at KNBT's main office.

         KNBT's  single-family  residential mortgage loans generally are written
on  standardized  documents used by the Federal  National  Mortgage  Association
("FNMA" or "Fannie Mae").  Historically,  in its efforts to manage interest rate
risk,  KNBT  sells  into  the  secondary  market  most of its  newly  originated
single-family  residential mortgage loans which are agency eligible.  KNBT sells
such  newly  originated  loans on a  loan-


                                      -5-
<PAGE>

by-loan or "flow"  basis as the loans  close.  Excluding  the effect of two loan
securitizations,  KNBT sold an aggregate of $50.3  million and $37.2  million of
its newly originated single-family residential mortgage loans in the years ended
December 31, 2003 and 2002, respectively. At the time of sale, KNBT recognizes a
gain or loss on the  sale  based  on the  difference  between  the net  proceeds
received and the carrying value of the loans sold.  KNBT's net gains on sales of
residential  mortgage loans were $246,000,  $900,000 and $108,000 in 2003,  2002
and 2001,  respectively.  These gains are included in total non-interest income.
KNBT retains the right to continue to provide  servicing for all loans sold. The
income from servicing is included in non-interest income as service fees.

         At December 31, 2003, KNBT was servicing  $228.0 million of residential
real estate loans it had  previously  sold.  Due to the  continuing low interest
rate  environment  and  a  higher  level  of  loan  repayments  than  originally
estimated,  KNBT recognized impairments of its mortgage servicing rights of $1.1
million  and  $676,000  during  the  years  ended  December  31,  2003 and 2002,
respectively. Such impairments are recorded as non-interest expense.

         In addition to loan sales, KNBT "securitized"  $47.3 million and $115.3
million of seasoned, single-family residential mortgage loans in the years ended
December 31, 2003 and 2002, respectively. In such transactions,  loans which did
not meet Fannie Mae's eligibility  standards at the time of origination,  due to
the lack of  private  mortgage  insurance  or other  criteria,  were  able to be
securitized  after being in KNBT's portfolio for certain  stipulated  periods of
time, generally 18 to 24 months.  Securitization is the process of packaging and
transferring   residential   mortgage   loans  to  issuers  of   mortgage-backed
securities,  such as Fannie Mae, in return for mortgage-backed securities backed
by the mortgage  loans which are  transferred.  As there is an active market for
mortgage-backed  securities,  they  generally  can be sold more readily than the
underlying loans in response to changes in interest rates or other factors. KNBT
retained all of the securities  from its 2003  securitization  and it sold $61.4
million of the $115.3 million securitization in 2002.

         KNBT is  limited  in the  amount  of loans  that it can make to any one
borrower.  This  amount  is  equal  to 15% of  Keystone  Nazareth  Bank &  Trust
Company's  unimpaired  capital and surplus,  or  approximately  $38.8 million at
December 31, 2003.  KNBT has established a house limit of $25.0 million in loans
to any one borrower. KNBT's loans to one borrower have been within these limits.



                                      -6-
<PAGE>


         The following table shows total loans originated, securitized, sold and
repaid at KNBT during the periods indicated.

<TABLE>
<CAPTION>

<S>                                 <C>                  <C>               <C>               <C>
------------------------------------------------------------------------------------------------------

                                                                    Year Ended December 31,
                                                         ---------------------------------------------
                                                           2003              2002               2001
                                                         ---------         ---------         ---------
                                                                      (dollars in thousands)
 Loan originations:
     One-to four-family residential (1) ..............   $ 135,325         $ 109,029         $ 100,204
     Consumer ........................................     131,989           114,188            58,784
     Other (2) .......................................     192,864            73,605            17,291
                                                         ---------         ---------         ---------
         Total loan originations .....................     460,178           296,822           176,279

 Sales, securitizations and loan principal repayments:
     Loans sold:
       One-to four-family residential ................      50,286            37,178            12,127
                                                         ---------         ---------         ---------
         Total sold ..................................      50,286            37,178            12,127

     Loans securitized:
       Securitized and retained ......................      47,251            53,897              --
       Securitized and sold ..........................        --              61,438              --
                                                         ---------         ---------         ---------
         Total securitized ...........................      47,251           115,335              --
                                                         ---------         ---------         ---------

     Loans principal repayments ......................     298,760           205,534           123,979
                                                         ---------         ---------         ---------
     Total loans sold, securitized and
       principal repayments ..........................     396,297           358,047           136,106
 Decrease due to other items, net (3) ................      27,568            27,499            29,234
 Loans received in merger with First Colonial ........     271,208              --                --
                                                         ---------         ---------         ---------
 Net increase (decrease) in loans receivable .........   $ 307,521         $ (88,724)        $  10,939
                                                         =========         =========         =========

------------------------------------------------------------------------------------------------------
</TABLE>

(1)  Includes loans  originated for sale of $29.0 million in 2003, $61.0 million
     in 2002 and $12.2 million in 2001.

(2)  Consists of commercial real estate, construction and land development loans
     and commercial business loans.

(3)  Other items  consist of loans in process,  deferred  fees and the allowance
     for loan losses.

         Single-Family  Residential Mortgage Lending. A primary lending activity
of KNBT is the  origination  of loans  secured  by  first  mortgages  on  one-to
four-family  residences  in its  market  area.  Traditionally,  KNBT  has been a
leading  originator of  single-family  residential  mortgage loans in Lehigh and
Northampton  Counties,  and the Bank expects to continue its single-family  loan
origination  efforts. At December 31, 2003,  single-family  residential mortgage
loans amounted to $332.0 million or 36.0% of KNBT's total loan portfolio  which,
compares  to $361.8  million  of  single-family  residential  mortgage  loans at
December 31, 2002.



                                      -7-
<PAGE>


         KNBT  originates  fixed-rate,  fully  amortizing  mortgage  loans  with
maturities  ranging  between 10 and 30 years.  Management  establishes  interest
rates   charged  on  loans  based  on  market   conditions.   KNBT  also  offers
adjustable-rate  mortgage  loans with terms of up to 30 years,  with an interest
rate based on the one year Constant Maturity  Treasury Bill index,  which adjust
annually from the outset of the loan or which adjust  manually  after a three or
five year initial fixed  period.  Interest  rate  adjustments  on such loans are
typically limited to no more than 2% during any adjustment period or 6% over the
life of the loan. Due to local market  conditions and the current  interest rate
environment,  KNBT has originated few ARM loans during the past three years.  At
December 31, 2003,  91.9% of KNBT's  single-family  residential  mortgage  loans
maturing  after  December  31,  2004 had fixed  rates of  interest  and 8.1% had
adjustable interest rates.

         KNBT underwrites  one-to  four-family  residential  mortgage loans with
loan-to-value  ratios of up to 95%,  provided  that a borrower  obtains  private
mortgage  insurance  on loans that  exceed 85% of the  appraised  value or sales
price, whichever is less, of the secured property. KNBT also requires that title
insurance,  hazard insurance and, if appropriate,  flood insurance be maintained
on all properties securing real estate loans. A licensed appraiser appraises all
properties  securing one-to  four-family  first mortgage  loans.  Mortgage loans
originated  by KNBT  generally  include a  due-on-sale  clause which provide the
contractual  right to deem the loan immediately due and payable in the event the
borrower transfers ownership of the property without KNBT's consent. Due-on-sale
clauses are an important  means of adjusting the yields of  fixed-rate  mortgage
loans in a  portfolio  and KNBT  generally  exercises  its  rights  under  these
clauses.

         During  2003,  KNBT's  practice  was to sell to Fannie  Mae most of its
newly originated,  agency eligible single-family residential mortgage loans with
interest rates of 6.5% or less. Such loans are sold on a non-recourse basis with
servicing  retained.  During the year ended December 31, 2003,  KNBT,  excluding
sales made as a part of its  securitization,  sold an aggregate of $50.3 million
and $37.2 million, respectively, of single-family residential mortgage loans.

         Consumer Loans. At December 31, 2003, KNBT's consumer loans amounted to
$265.5 million or 28.8% of the total loan  portfolio.  KNBT's consumer loans are
comprised  primarily of home equity loans and lines of credit and automobile and
recreational  vehicle loans.  KNBT also offers a variety of other consumer loans
including personal loans and lines of credit,  home improvement loans and credit
card loans.  At December 31, 2003,  KNBT's home equity loans and lines of credit
amounted to $151.6 million or 16.4% of the total loan portfolio. Of such amount,
$112.8  million were loans and $38.8 million were lines of credit.  In addition,
at such date the  unadvanced  portion of home  equity  lines of credit was $45.3
million.  Home equity loans and lines of credit, like single-family  residential
mortgage loans, are secured by the equity in the borrower's residence.  However,
the Bank generally  obtains a second mortgage  position on a home equity loan or
line of credit.  KNBT's home equity loans typically are structured as fixed-rate
fully  amortizing loans with terms of up to 15 years and  loan-to-value  ratios,
when combined with any senior liens, of up to 100%. KNBT charges higher interest
rates for loan-to-value ratios exceeding 80%. KNBT's home equity lines of credit
have  adjustable  rates of  interest  which are  indexed  to the  prime  rate as
reported in The Wall Street Journal.  Generally, the maximum loan-to-value ratio
on home equity lines of credit,  including the  outstanding  amount of any first
mortgage loan, is 80%, however,  larger  loan-to-value loans are granted. A home
equity  line of credit  may be drawn down by the  borrower  for a period of five
years from the date of the loan agreement.  During this period, the borrower has
the option of paying, on a monthly basis,  either principal and interest or only
the interest.

         KNBT's automobile and other vehicle loans amounted to $102.2 million at
December 31, 2003 and have increased  significantly since the Bank commenced its
indirect  automobile  lending function in January 2002. The total automobile and
other  vehicle  loans  includes,   at  December  31,  2003,   $24.9  million  of
recreational vehicle loans that were acquired from First Colonial in the merger.
Keystone  originates  indirect  auto and  recreational  vehicle  loans through a
network of dealers  located in its market area and was actively  doing  business
with approximately 78 dealers at December 31, 2003. KNBT employed an experienced
indirect  lender  to head its  program  and has  grown  its  dealer  network  by
emphasizing  quality service and the development of long term relationships with
the owners and managers of dealerships.

         KNBT makes indirect  loans to purchase both new and used vehicles.  The
loans have terms up to six years for loans  secured by new and used autos and 15
years for loans  secured by  recreational  vehicles.  As of December  31,  2003,
approximately  20.0% of KNBT's  indirect  auto loans  were  secured by new cars,
54.0% were secured by used cars and 26.0% were secured by recreational vehicles.
KNBT  originated  $56.5 million and $32.9 million of indirect  loans during 2003
and 2002, respectively.

         To underwrite  its indirect  loans,  KNBT reviews the credit history of
applicants and determines  appropriate  debt to income and loan to value ratios.
KNBT also believes that the quality of its indirect loan




                                      -8-
<PAGE>


portfolio  is  positively   affected  by  its  efforts  to  build  and  maintain
relationships  with dealers who attract  creditworthy  customers.  KNBT tries to
identify such dealers based on KNBT's knowledge of dealers in its market area.

         Indirect auto and  recreational  vehicle  lending entails greater risks
than  owner-occupied   residential  mortgage  lending.  Although  KNBT  has  not
experienced  significant  delinquencies in this portfolio to date, borrowers are
more  likely to  default  on those  loans than on a  residential  mortgage  loan
secured by their  primary  residence.  Moreover,  automobiles  and  recreational
vehicles depreciate rapidly and, in the event of a default,  principal loss as a
percentage  of the loan balance  depends  upon the mileage and  condition of the
vehicle at the time of repossession, over which KNBT has no control.

         Consumer loans entail  greater risk than  residential  mortgage  loans,
particularly  in the case of loans  that are  unsecured  or  secured  by rapidly
depreciating  assets such as automobiles  and  recreational  vehicles.  In these
cases, any 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  beyond  obtaining a deficiency  judgment.  In addition,  consumer loan
collections depend on the borrower's  continuing financial  stability,  and thus
are more  likely to be  adversely  affected  by job loss,  divorce,  illness  or
personal bankruptcy.

         Construction  and Land  Development  Loans.  KNBT  has  been an  active
originator of  construction  and land  development  loans in its market area for
many years. At December 31, 2003, KNBT's construction and land development loans
amounted  to  $112.7  million  or  12.2% of the  total  loan  portfolio.  KNBT's
construction   lending  includes  both  construction  loans  to  individuals  to
construct personal residences,  which amounted to approximately $63.8 million at
December 31,  2003,  and loans to building  contractors  and  developers,  which
amounted  to  approximately  $13.0  million at  December  31, 2003 and loans for
commercial  real estate  construction,  which  amounted to  approximately  $35.9
million at December 31, 2003. At December 31, 2003,  the  unadvanced  portion of
construction loans in process amounted to $76.2 million.

         KNBT's  construction  loans to  individuals  to build their  residences
typically are  structured as  construction/permanent  loans whereby there is one
closing for both the construction loan and the permanent  financing.  During the
construction  phase, which typically lasts for six to nine months,  employees of
KNBT make periodic  inspections of the  construction  site and loan proceeds are
disbursed  directly to the  contractors as construction  progresses.  Typically,
disbursements   are  made  in  five  draws  during  the   construction   period.
Construction  loans  require  payment of interest  only during the  construction
phase and are  structured to be converted to fixed-rate  permanent  loans at the
end  of  the  construction  phase.  Prior  to  making  a  commitment  to  fund a
construction loan, KNBT requires an appraisal of the property by independent fee
appraisers or the Bank's in-house appraisers.  The Bank's staff also reviews and
inspects  each project prior to every  disbursement  of funds during the term of
the  construction  loan.  Loan proceeds are  disbursed  based on a percentage of
completion.

         KNBT  also  originates  construction  and  site  development  loans  to
contractors and builders  primarily to finance the construction of single-family
homes and subdivisions  and, to a lesser extent,  the construction of commercial
development  projects,  and site  development  projects.  Loans to  finance  the
construction of single-family  homes and  subdivisions are generally  offered to
experienced  builders  in the Lehigh  Valley  with whom KNBT has an  established
relationship.  Residential development loans are typically offered with terms of
up to 24 months.  The maximum  loan-to-value  limit applicable to these loans is
80% of the appraised  post-construction  value.  Construction  loan proceeds are
disbursed   periodically  in  increments  as  construction   progresses  and  as
inspection by KNBT's approved appraisers warrants.  At December 31, 2003, KNBT's
largest  construction  and site  development  loan  totaled $2.5 million and was
secured by a first  mortgage  lien.  This loan was  performing  according to its
original  terms at December  31,  2003.  During 2003,  KNBT  estimates  that the
average  balance of its  construction  loans to  contractors  and developers was
approximately $4.7 million.



                                      -9-
<PAGE>


         KNBT also makes construction loans for commercial development projects.
The projects  include  multi-family,  apartment,  industrial,  retail and office
buildings.   These  loans   generally   have  an   interest-only   phase  during
construction,  and generally convert to permanent financing when construction is
completed.  Disbursement of funds is at the sole discretion of KNBT and is based
on the progress of construction.  The maximum  loan-to-value limit applicable to
these loans is 80% of the  appraised  post-construction  value.  KNBT's  largest
commercial  construction  loan commitment to a single borrower was $15.7 million
at December 31, 2003 for a commercial  construction  development project located
within KNBT's primary market area.  While this loan was performing in accordance
with all its terms at December 31, 2003,  management has downgraded this loan on
its  internal  classification  system  and  is  closely  monitoring  it due to a
slowdown  in  the  construction   process  as  a  result  of  inclement  weather
conditions.

         KNBT also originates land loans to local contractors and developers for
the  purpose  of  improving  the  property,  or for the  purpose  of  holding or
developing the land for sale.  Such loans are secured by a lien on the property,
are limited to 65% of the lower of the acquisition  price or the appraised value
of the land,  and have a term of up to two years with a floating  interest  rate
based on KNBT's internal base rate.  KNBT's land loans are generally  secured by
property in its primary  market area.  KNBT  requires  title  insurance  and, if
applicable,  a  hazardous  waste  survey  reporting  that  the  land  is free of
hazardous or toxic waste.

         Construction  financing  is  generally  considered  to involve a higher
degree of credit risk than long-term financing on improved,  owner-occupied real
estate. Risk of loss on a construction loan depends largely upon the accuracy of
the initial  estimate of the  property's  value at  completion  of  construction
compared to the estimated cost,  including  interest,  of construction and other
assumptions.  Additionally,  if the estimate of value  proves to be  inaccurate,
KNBT may be confronted with a project, when completed,  having a value less than
the loan  amount.  KNBT has  attempted  to  minimize  these  risks by  generally
concentrating  on  residential   construction   loans  in  its  market  area  to
contractors with whom it has established relationships.

         Commercial Real Estate Loans and  Multi-Family  Residential Real Estate
Loans.  At December 31, 2003,  KNBT's  commercial  real estate loans amounted to
$156.6  million  or 17.0% of the  total  loan  portfolio.  The  amount of KNBT's
commercial  real estate loans  increased  $127.2 million in 2003 from a total of
$29.4 million at year-end  2002.  The merger with First  Colonial  accounted for
$52.0 million of this increase.  KNBT's commercial real estate loans are secured
by  mortgages  on  various  commercial  income  producing  properties  and owner
occupied commercial buildings including office buildings,  retail and industrial
properties. All of KNBT's commercial real estate loans are secured by properties
in Pennsylvania and  substantially  all are located in the Bank's primary market
area.

         KNBT offers both adjustable-rate and fixed-rate  commercial real estate
loans. Such loans typically have terms of 15 or 20 years with call options every
5 to 7 years.  Loan-to-value  ratios cannot exceed 85%,  although they generally
are 80% or less, and a debt service  coverage of 1.20 times or better  generally
is required. Personal guarantees often are required.

         KNBT performs more extensive diligence in underwriting  commercial real
estate loans than loans secured by owner occupied one-to four-family residential
properties  due to the larger loan amounts and the riskier nature of such loans.
KNBT  attempts to  understand  and control  the risk in several  ways  including
inspection  of all such  properties  and the  review  of the  overall  financial
condition of the  borrower,  which may include,  for example,  the review of the
rent rolls and the  verification of income.  KNBT reviews a minimum of two years
of tax returns and financial  statements of the borrower in its  underwriting of
commercial real estate loans and these documents must be updated and provided to
the  bank on  annual  basis.  KNBT's  commercial  lending  staff  undertakes  an
extensive  credit  review  of each  commercial  real  estate  loan in  excess of
$500,000  at least  annually.  KNBT's  largest  commercial  real  estate loan at
December 31, 2003, was a $7.9 million loan secured by commercial  real estate in
KNBT's  primary  market area.  Such loan was  performing in accordance  with its
terms at December 31, 2003.

         Commercial  real estate loans have  interest  rates which are generally
more sensitive to changes in market interest rates than  residential real estate
loans.  Commercial real estate loans,  however,  entail




                                      -10-
<PAGE>


significant  additional  credit  risk  as  compared  with  one-  to  four-family
residential  mortgage  lending,  as they typically  involve larger loan balances
concentrated with single borrowers or groups of related borrowers.  In addition,
the  payment  experience  on  commercial  real  estate  loans  secured by income
producing  properties is typically dependent on the successful  operation of the
related  real  estate  project  and thus may be more  significantly  impacted by
adverse conditions in the real estate market or in the economy generally.

         At December 31, 2003, KNBT's  multi-family  residential  mortgage loans
amounted to $14.2 million or 1.5% of the loan portfolio.  Such loans are secured
by apartment  buildings  with five or more units.  KNBT has not  emphasized  the
origination of  multi-family  residential  mortgage loans but, when  originated,
they are underwritten pursuant to the same policies and procedures as commercial
real estate loans.

         Commercial Business Loans. KNBT's commercial business loans amounted to
$39.0  million  or 4.2% of the  total  loan  portfolio  at  December  31,  2003.
Commercial  business  loans have  increased by $29.0 million since  December 31,
2002 with $9.5  million of that  increase  resulting  from the merger with First
Colonial. KNBT expects that its commercial loan portfolio will continue to grow.

         KNBT's  commercial  business loans  typically are to small to mid-sized
businesses  with annual  revenues  generally not  exceeding  $100 million in its
market  area and may be for  working  capital,  equipment  financing,  inventory
financing  or  accounts  receivable  financing.  Small  business  loans may have
adjustable or fixed rates and generally have terms of 5 years or less but may go
up to 10 years.  KNBT's  commercial  business  loans  generally  are  secured by
equipment, machinery, real property or other corporate assets. In addition, KNBT
generally  obtains personal  guarantees from the principals of the borrower with
respect to all commercial  business loans. KNBT's commercial loans structured as
advances  are made upon  perfected  security  interests  in accounts  receivable
and/or  inventory.  Generally  KNBT will  advance  amounts up to 75% of accounts
receivable and 50% of the value of inventory.

         At December 31, 2003, KNBT's largest commercial  business loan was $5.8
million  to a business  located in KNBT's  primary  market  area.  Such loan was
performing in accordance with its terms at December 31, 2003.

         Commercial  business  loans  generally  are deemed to involve a greater
degree  of  risk  than  single-family  residential  mortgage  loans.  Commercial
business   lending  is  relatively  new  to  KNBT  and  KNBT  is  attempting  to
aggressively  increase its  originations  of  commercial  business  loans.  KNBT
continues to hire experienced  commercial loan officers and acquired  additional
experienced  commercial  loan  officers  as a  result  of the  merger.  KNBT has
implemented  policies and procedures for commercial  business  lending which are
deemed to be prudent.

         Loan  Approval  Procedures  and  Authority.  KNBT's  Board of Directors
establishes its lending  policies and  procedures.  KNBT's Loan Policy Manual is
reviewed  on at least an  annual  basis by its  Directors'  Loan  Committee  and
management in order to propose  modifications as a result of market  conditions,
regulatory changes and other factors. Most modifications must be approved by the
Board of Directors of KNBT.

         Various officers or combinations of officers of KNBT have the authority
within  specifically  identified  limits  to  approve  new  loans.  The  largest
individual lending authority is $1.0 million.  Amounts in excess of $1.0 million
up to $5.0 million must be approved by the Officers  Loan  Committee and amounts
in excess of $5.0 million up to $15.0  million must be approved by the Directors
Loan  Committee.  Loans in excess of $15.0 million must be approved by the Board
of Directors of KNBT.

Non-Performing Assets

         On loans where the  collection  of  principal  or interest  payments is
doubtful,  the accrual of interest income ceases ("non-accrual" loans). On loans
90 days or more past due, as to principal and interest payments,  KNBT's policy,
with certain limited exceptions,  is to discontinue accruing additional interest
and reverse any interest  currently  accrued.  On  occasion,  this action may be
taken  earlier if the  financial


                                      -11-
<PAGE>


condition  of the  borrower  raises  significant  concern with regard to his/her
ability to service the debt in accordance  with the terms of the loan agreement.
Interest  income is not accrued on these loans  until the  borrower's  financial
condition and payment record demonstrate an ability to service the debt.

         Real estate that is acquired as a result of  foreclosure  is classified
as other real estate owned. Real estate is recorded at the lower of cost or fair
value  less  estimated  selling  costs.  Costs  associated  with  acquiring  and
improving a foreclosed  property are usually  capitalized to the extent that the
carrying values does not exceed fair value less estimated selling costs. Holding
costs are charged to expense.  Gains and losses on the sale of other real estate
owned are credited or charged to operations, as incurred.

         The following table shows the amounts of KNBT's  non-performing  assets
defined as non-accruing loans,  accruing loans 90 days or more past due and real
estate  owned  at  the  dates  indicated.   KNBT  did  not  have  troubled  debt
restructurings at any of the dates indicated.

<TABLE>
<CAPTION>
<S>                                         <C>           <C>            <C>         <C>           <C>
-----------------------------------------------------------------------------------------------------------

                                                                     At December 31,
                                         ------------------------------------------------------------------
                                             2003           2002         2001         2000         1999
                                         -------------  -------------  ----------- ----------  ------------
                                                                (dollars in thousands)

    Non-accruing loans ...............      $1,720        $2,197         $1,752      $  763        $1,103
    Accruing loans 90 days
      or more past due ...............         405           298            938          35           486
                                            ------        ------         ------      ------        ------
         Total non-performing loans ..       2,125         2,495          2,690         798         1,589

    Other real estate owned ..........         173           115            200         151           488
                                            ------        ------         ------      ------        ------
         Total non-performing assets .      $2,298        $2,610         $2,890      $  949        $2,077
                                            ======        ======         ======      ======        ======

    Total non-performing loans
       as a percentage of loans, net .        0.24%         0.43%          0.40%       0.12%         0.26%
    Total non-performing loans
       as a percentage of total assets        0.11%         0.25%          0.29%       0.10%         0.21%
    Total non-performing assets
       as a percentage of total assets        0.12%         0.26%          0.31%       0.12%         0.27%

-----------------------------------------------------------------------------------------------------------


         The  following  table  shows the effect  non-accrual  loans have had on
interest income from each of the periods indicated.



-----------------------------------------------------------------------------------------------------------

                                                               Year ended December 31,
                                         ------------------------------------------------------------------
                                             2003           2002         2001         2000         1999
                                         -------------  -------------  ----------- ----------  ------------
                                                                 (dollars in thousands)
Interest which would have been
   recorded at the original rate              $ 50          $ 66           $ 81        $ 43          $ 69
Interest that was reflected
   in income .........................          60            45             40          26            34
                                            ------        ------         ------      ------        ------

Net impact on interest income ........        $ 10         $ (21)         $ (41)      $ (17)        $ (35)
                                            ======        ======         ======      ======        ======

-----------------------------------------------------------------------------------------------------------

</TABLE>



         KNBT  measures  impairment  of a loan  based  on the  present  value of
expected  future cash flows  discounted at the loan's  effective  interest rate,
except  that as a practical  expedient,  impairment  may be measured  based on a
loan's  observable market price, or the fair value of the collateral if the loan
is collateral  dependent.  Regardless of the measurement method, a creditor must
measure  impairment  based on the fair value of the collateral when the creditor
determines that foreclosure is probable.  SFAS



                                      -12-
<PAGE>



No. 118,  "Accounting by Creditors for Impairment of a Loan - Income Recognition
and  Disclosures,"  allows  creditors  to use existing  methods for  recognizing
interest income on impaired loans.

         KNBT  identifies a loan as impaired  when it is probable  that interest
and principal will not be collected  according to the  contractual  terms of the
loan  agreement.  The accrual of interest is  discontinued  on such loans and no
income is  recognized  until all recorded  amounts of interest and principal are
recovered in full.

         Loan  impairment  is measured by  estimating  the expected  future cash
flows and  discounting  them at the  respective  effective  interest  rate or by
valuing the underlying collateral. The total principal amount of KNBT's impaired
loans was  $217,000  at  December  31,  2003.  There were no  impaired  loans at
December 31, 2002. The recorded  investment in these loans and the valuation for
credit losses related to loan impairment at December 31, 2003 were as follows:


---------------------------------------------------------------
At December 31,                                   2003
---------------------------------------------------------------
                                        (dollars in thousands)
Principal amount of impaired loans ..........    $ 217
Accrued interest ............................        2
Deferred loan costs .........................        -
                                                --------
                                                   219
Less valuation allowance
  at December 31, ............................      33
                                                 --------
                                                 $ 186

---------------------------------------------------------------

         The activity in KNBT's  allowance  account for credit losses related to
impaired loans was as follows for the year ended December 31, 2003:

---------------------------------------------------------------
Year ended December 31,                           2003
---------------------------------------------------------------
                                        (dollars in thousands)
Valuation allowance at January 1, ............      $ -
Received in merger ...........................       33
Provision for loan impairment ................        -
Direct charge-offs ...........................        -
Transfers from (to) unallocated reserve ......        -
                                                 --------
Valuation allowance
  at December 31, ............................     $ 33

---------------------------------------------------------------


         Total cash collected on impaired loans by KNBT during 2003 was $98,000,
of which $64,000 was credited to the principal balance outstanding on such loans
and $38,000 was credited to interest  income.  KNBT's  valuation  allowance  for
impaired loans of $33,000 at December 31, 2003 is included in its "Allowance for
Loan Losses"  which  amounted to $7.9 million at December 31, 2003.  KNBT had no
valuation allowance for impaired loans in 2002.

         Allowance for Loan Losses. The allowance for loan losses is established
through a provision  for loan losses.  KNBT  maintains  the allowance at a level
believed, to the best of management's knowledge, to cover all known and inherent
losses in the  portfolio  that are both  probable and  reasonable to estimate at
each reporting date.  Management  reviews all loans which are delinquent 60 days
or more on a monthly basis and performs regular reviews of the allowance no less
than quarterly in order to identify those inherent losses and assess the overall
collection  probability  for the  loan  portfolio.  Such  reviews  consist  of a
quantitative  analysis by loan category,  using  historical  loss experience and
consideration of a series of qualitative loss factors. KNBT's evaluation process
includes, among other things, an analysis of delinquency trends,  non-performing
loan trends,  the level of charge-offs  and recoveries,  prior loss  experience,
total loans  outstanding,  the volume of loan  originations,  the type, size and
geographic  concentration  of its loans,  the value of  collateral  securing the
loan, the borrower's ability to repay and repayment  performance,  the number of
loans requiring heightened management  oversight,  local


                                      -13-
<PAGE>


economic conditions and industry  experience.  In addition,  in establishing the
allowance  for loan losses,  KNBT's  management  considers a ten point  internal
rating system for all loans originated by the Commercial Lending department.  At
the time of origination,  each commercial loan is assigned a rating based on the
assumed risk elements of the loan. Such risk ratings are  periodically  reviewed
by  management  and  revised  as  deemed  appropriate.  As a result of this risk
assessment,  management  has  identified  $55.5 million of loans at December 31,
2003 which were  performing  in  accordance  with their terms but were deemed to
have certain weaknesses or increased levels of risk.  Included in this amount is
one  commercial  construction  loan in the  amount  of $15.7  million  which was
performing in accordance  with its terms but  management  believes has developed
certain credit  weaknesses and an increased level of risk. The  establishment of
the allowance for loan losses is significantly affected by management's judgment
and  uncertainties  and there is a likelihood  that  different  amounts would be
reported under different conditions or assumptions. Various regulatory agencies,
as an integral part of their  examination  process,  periodically  review KNBT's
allowance  for loan  losses.  Such  agencies  may require it to make  additional
provisions for estimated  loan losses based upon judgments  different from those
of  management.  As of December 31, 2003,  KNBT's  allowance for loan losses was
0.89% of total loans receivable.

         KNBT will continue to monitor and modify its allowances for loan losses
as conditions  dictate.  No assurances  can be given that its level of allowance
for loan  losses  will  cover  all of the  inherent  losses on its loans or that
future  adjustments  to the  allowance  for loan losses will not be necessary if
economic and other conditions differ  substantially  from the economic and other
conditions  used by  management  to determine the current level of the allowance
for loan losses.

         The following  table shows changes in KNBT's  allowance for loan losses
during the periods presented.

<TABLE>
<CAPTION>

<S>                                                         <C>           <C>             <C>             <C>           <C>
------------------------------------------------------------------------------------------------------------------------------------

                                                                              At or For the Year ended December 31,
                                                        ----------------------------------------------------------------------
                                                            2003            2002         2001            2000           1999
                                                        -------------   -----------  -------------   -------------    ---------
                                                                                     (dollars in thousands)
       Allowance for loan losses, beginning of period       $2,927        $3,386          $3,337          $3,101        $2,986
       Reserve received in merger ...................        3,548            --              --              --            --
       Provision for loan losses ....................        2,951           111             391             442           421
       Charge-offs:
             One-to four-family residential .........          242           229             154             100            88
             Multi-family ...........................           --            --              --              --           115
             Commercial real estate .................           --            --              --              --            --
             Construction and land development ......           --            --              --              --            --
             Commercial business ....................          154            --              --              --            --
             Consumer ...............................        1,207           394             224             146           108
                                                            ------        ------          ------          ------        ------
                Total charge-offs ...................        1,603           623             378             246           311
                                                            ------        ------          ------          ------        ------
       Recoveries on loans previously charged-off ...           87            53              36              40             5
                                                            ------        ------          ------          ------        ------
       Net loans charged-off ........................        1,516           570             342             206           306
       Allowance for loan losses, at December 31, ...       $7,910        $2,927          $3,386          $3,337        $3,101
                                                        ----------------------------------------------------------------------
       Allowance for loan losses at year-end to:
             Average loans ..........................         1.27%         0.47%           0.50%           0.52%         0.53%
             Loans at year-end ......................         0.89%         0.52%           0.50%           0.51%         0.50%
             Non-performing loans ...................       388.28%       117.31%         125.87%         418.17%       195.15%
                                                        ----------------------------------------------------------------------
</TABLE>

                                      -14-
<PAGE>


                  The following table shows how KNBT's allowance for loan losses
         has been allocated by type of loan at each of the dates indicated.

<TABLE>
<CAPTION>



<S>                    <C>        <C>     <C>             <C>     <C>           <C>      <C>          <C>       <C>          <C>
                     ---------------------------------------------------------------------------------------------------------------
                                                                       At December 31,
                     ---------------------------------------------------------------------------------------------------------------
                             2003                   2002                  2001                   2000                   1999
                     --------------------  --------------------- ---------------------  ---------------------  ---------------------
                                  Loan                   Loan                   Loan                   Loan                   Loan
                                Category               Category               Category               Category               Category
                      Amount     as a %      Amount     as a %     Amount      as a %     Amount      as a %     Amount      as a %
                        of      of Total       of      of Total      of       of Total      of       of Total      of       of Total
                     Allowance    Loans    Allowance     Loans    Allowance     Loans    Allowance     Loans   Allowance     Loans
                     ---------- ---------  ----------- --------- ------------ --------  ------------ --------  -----------  --------
                                                                        (dollars in thousands)
 One-to four-family
   residential .....   $  349     36.00%  $   1,086       59.34%  $   2,053     73.27%   $2,291       73.20%    $ 2,128       72.52%
 Multi-family
   residential .....        4      1.54          33        0.88          35      0.55        48        0.58          36        0.55
 Commercial real
   estate ..........    2,745     16.97         145        4.82          39      1.83        43        0.97           5        0.54
 Construction and
   land development       683     12.22         451        9.74         291      7.72       106        8.58         102        9.72
 Commercial
   business ........      712      4.23         500        1.65         464      0.63       115        0.60          22        0.54
 State and political
   subdivisions ....       --      0.25          --          --          --        --       --           --          --          --
 Consumer ..........    2,673     28.79         590       23.57         303     16.00       123       16.07         150       16.13
 Unallocated .......      744        --         122          --         201        --       611          --         658          --
                     ---------- ---------  ----------- --------- ------------ --------  ------------ --------  -----------  --------
     Total .........   $7,910    100.00%     $2,927     100.00%    $  3,386    100.00%  $ 3,337      100.00%    $ 3,101      100.00%
                     ========== =========  =========== ========= ============ ========  ============ ========  ===========  ========

------------------------------------------------------------------------------------------------------------------------------------

</TABLE>

Investment Activities

         KNBT invests in securities  pursuant to its Investment  Policy.  KNBT's
investment  policy is designed  primarily to maintain  liquidity,  to generate a
favorable  return  without  incurring  undue  interest  rate and credit risk, to
complement  its lending  activities,  to manage the interest  sensitivity of its
assets and  liabilities  and  minimize  KNBT's tax  liability.  KNBT also uses a
leverage investment  strategy for the purpose of enhancing returns.  Pursuant to
this  strategy,  KNBT has  increased  the size of its  investment  portfolio  by
utilizing borrowings to support such investments.

         At December 31, 2003, KNBT's investment  securities  amounted to $734.1
million  or 37.8% of total  assets at such date.  At such date,  there were $9.6
million in unrealized gains with respect to the investment  securities portfolio
of KNBT,  resulting in a net of tax unrealized gain of $6.3 million. The largest
component  of  KNBT's   investment   securities  in  recent   periods  has  been
mortgage-backed  securities,  which  amounted to $464.4  million or 63.2% of the
investment securities portfolio at December 31, 2003. In addition,  KNBT invests
in municipal securities,  corporate debt obligations, U.S. government and agency
obligations  and other  securities.  In recent  periods,  KNBT has increased the
amount  of its  investment  in  municipal  securities  due to the tax  advantage
provided.  Under KNBT's investment policy,  municipal bonds must be rated in the
top three investment rating categories at the time of purchase.

         In order to achieve maximum flexibility with its investment securities,
all of KNBT's investment securities have been classified as  available-for-sale,
pursuant to SFAS No. 115,  for more than the past three years.  This  accounting
pronouncement  requires  a  security  to be  classified  as  available-for-sale,
held-to-maturity,  or trading, at the time of acquisition. Securities classified
as  held-to-maturity  must be purchased with the intent and ability to hold that
security until its final maturity,  and can be sold prior to maturity only under
rare circumstances. Held-to-maturity securities are accounted for based upon the
historical  cost of the security.  Available-for-sale  securities can be sold at
any time based upon needs or market  conditions.  Available-for-sale  securities
are  accounted  for at fair  value,  with  unrealized  gains and


                                      -15-
<PAGE>


losses on these securities, net of income tax provisions,  reflected in retained
earnings as accumulated other comprehensive income.

         Currently, KNBT is not participating in hedging programs, interest rate
swaps,  collars  or other  activities  involving  the use of  off-balance  sheet
financial derivatives.  Also, KNBT does not purchase mortgage-backed  derivative
instruments  that  would be  characterized  "high-risk"  under  Federal  banking
regulations at the time of purchase,  nor does it purchase corporate obligations
that are not rated investment grade.

         KNBT's   mortgage-backed   securities  include  mortgage   pass-through
certificates  issued  by the  GNMA,  FNMA and  FHLMC  as well as  collateralized
mortgage  obligations  ("CMOs")  issued by such  agencies  or  private  issuers.
Investments in mortgage-backed securities involve a risk that actual prepayments
will be greater than estimated prepayments over the life of the security,  which
may require  adjustments to the  amortization of any premium or accretion of any
discount  relating to such  instruments  thereby  changing the net yield on such
securities.  There is also  reinvestment  risk associated with the cash flows of
such securities or in the event such  securities are redeemed by the issuer.  In
addition,  the market  value of such  securities  may be  adversely  affected by
changes in interest rates.

         Collateralized   mortgage   obligations  are  typically   issued  by  a
special-purpose  entity, in KNBT's case, private issuers or government agencies,
which  may be  organized  in a  variety  of  legal  forms,  such as a  trust,  a
corporation, or a partnership.  Substantially all of the collateralized mortgage
obligations  held in KNBT's  portfolio  consist of senior  sequential  tranches,
primarily  investments  in the  first  tranche  of the  collateralized  mortgage
obligations.  By purchasing senior sequential  tranches,  management attempts to
ensure  the cash flow  associated  with  such an  investment.  While  non-agency
private issues are somewhat less liquid than collateralized mortgage obligations
issued by GNMA,  Fannie Mae or Freddie Mac, they  generally  have a higher yield
than agency  insured or guaranteed  collateralized  mortgage  obligations,  such
higher yield  reflecting in part to lack of such  guarantee or  protection  and,
thus,  the  potentially  higher  risk of loss or  default  associated  with such
assets.  KNBT's  investment  portfolio policy requires that all privately issued
CMOs be rated AAA by Standard & Poor's at the time of  purchase.




                                      -16-
<PAGE>

         The following table sets forth certain  information  relating to KNBT's
investment securities portfolio and FHLB stock at the dates indicated.

<TABLE>
<CAPTION>
<S>                                   <C>             <C>             <C>          <C>             <C>          <C>

-------------------------------------------------------------------------------------------------------------------------------

                                                                         At December 31,
                                    -------------------------------------------------------------------------------------------
                                                 2003                        2002                            2001
                                    ----------------------------   ----------------------------   -----------------------------
                                     Amortized         Fair         Amortized         Fair         Amortized         Fair
                                        Cost          Value            Cost          Value            Cost           Value
                                    -------------------------------------------------------------------------------------------
   Debt Securities: ..........                                       (dollars in thousands)
   U.S. Government
     and agency obligations ..        $118,037        $120,380        $ 30,677     $ 31,075        $  8,445         $  8,437
   Corporate securities ......          15,068          15,637          34,053       35,172          36,937           38,153
   Municipal obligations .....         112,228         115,655          38,935       41,039          29,040           29,560
   Mortgage-backed securities:
      GNMA ...................           2,124           2,138           3,234        3,327             563              608
      FHLMC ..................          83,737          83,985          17,963       18,348           3,063            3,140
      FNMA ...................         224,802         227,538          73,743       76,101           6,845            6,867
      Other ..................         150,645         150,697          83,449       84,174          64,849           65,101
                                    ----------       ---------        ----------   ---------       ----------      ---------
   Total mortgage-backed
      securities .............         461,308         464,358         178,389      181,950          75,320           75,716
   Other debt securities .....              --              --              --           --              10               10
                                    ----------       ---------        ----------   ---------       ----------      ---------
      Total debt securities ..         706,641         716,030         282,054      289,236         149,752          151,876

   Equity Securities:
   ARM fund ..................           4,939           4,880           4,939        4,914           4,938            4,909
   Other equity securities ...          12,939          13,177              --           --              --               --
                                    ----------       ---------        ----------   ---------       ----------      ---------

      Total equity securities           17,878          18,057           4,939        4,914           4,938            4,909
                                    ----------       ---------        ----------   ---------       ----------      ---------

   Total investment securities        $724,519        $734,087        $286,993     $294,150        $154,690         $156,785
                                    ----------       ---------        ----------   ---------       ----------      ---------

   FHLB stock ................          11,543          11,543           8,011        8,011           6,099            6,099
                                    ----------       ---------        ----------   ---------       ----------      ---------

   Total investment securities
     and FHLB stock ..........        $736,062        $745,630        $295,004     $302,161        $160,789         $162,884
                                    -------------------------------------------------------------------------------------------
</TABLE>

                                      -17-
<PAGE>


         The following table sets forth the amount of investment securities,  at
amortized  cost,  which  mature  during  each of the periods  indicated  and the
weighted average yields for each range of maturities at the dates indicated.  No
tax-exempt yields have been adjusted to a tax-equivalent basis.

<TABLE>
<CAPTION>


<S>                             <C>         <C>    <C>         <C>     <C>         <C>       <C>        <C>     <C>         <C>
------------------------------------------------------------------------------------------------------------------------------------

                                                          Amounts at December 31, 2003, which mature in:
                               -----------------------------------------------------------------------------------------------------
                                                    Over One
                                   One     Weighted   Year    Weighted Over Five  Weighted     Over    Weighted             Weighted
                                  year     Average   Through  Average   Through   Average       Ten     Average             Average
                                 or Less    Yield  Five Years  Yield   Ten Years   Yield       Years     Yield     Total     Yield
                               -----------------------------------------------------------------------------------------------------
                                                                        (dollars in thousands)
Debt securities:
    U.S. Government and
       agency obligations ...   $ 2,020      1.68% $ 61,339     3.04%  $ 16,173     3.67%    $ 38,505    4.13%  $ 118,037     3.65%
    Corporate securities ....     6,008      6.66     9,060     5.64          -        -            -       -      15,068     6.05
    Municipal obligations ...       102      4.85     2,123     3.98     27,745     4.33       82,258    4.63     112,228     4.54
    Mortgage-backed
       securities ...........         -         -    10,348     4.09    116,337     3.74      334,623    4.48     461,308     4.28
                              ---------- --------- --------- --------- ----------- --------- ----------- -------- ----------  ------
       Total debt securities .  $ 8,130      5.40% $ 82,870     3.75%  $160,255     3.84%    $455,386    4.48%  $ 706,641     4.26%



         The  following  table sets  forth the  purchases,  sales and  principal
repayments of  mortgage-backed  securities,  at amortized cost, for KNBT for the
periods indicated.
                                                                              At or For the
                                                                          Year Ended December 31,
                                                                -------------------------------------------
                                                                  2003             2002             2001
                                                                ---------        ---------        ---------
                                                                           (dollars in thousands)
   Mortgage-backed securities at beginning of period .....      $ 178,389        $  75,320        $  44,521
   Mortgage-backed securities acquired through merger
      with First Colonial ................................        151,584               --               --
   Purchase price adjustment of mortgage-backed securities
      acquired through merger with First Colonial ........         (2,309)              --               --
   Purchases .............................................        333,675          140,911           53,160
   Securitized and retained ..............................         47,251           53,897               --
   Securitized and sold ..................................             --           61,438               --
   Repayments ............................................       (218,339)         (88,850)         (22,403)
   Sales .................................................        (25,495)         (63,844)              --
   Amortizations of premiums and discounts, net ..........         (3,448)            (483)              42
                                                                ---------        ---------        ---------
   Mortgage-backed securities at end of period ...........      $ 461,308        $ 178,389        $  75,320
                                                                =========        =========        =========

   Weighted average yield at end of period ...............           4.05%            5.85%            6.09%

-----------------------------------------------------------------------------------------------------------

</TABLE>

Sources of Funds

         Deposits.  Deposits are the primary source of KNBT's funds. KNBT offers
a variety of deposit  accounts with a range of interest rates and terms.  KNBT's
deposits consist of interest-bearing and non-interest-bearing checking accounts,
money market, savings and certificate of deposit accounts.

         Total  deposits  increased to $1.3  billion at December 31, 2003,  from
$771.8  million at December  31, 2002,  a growth of $517.6  million or 67.1%.  A
major factor in this growth was the acquisition of $512.1 million of deposits as
a result of the merger with First Colonial. Also contributing to the increase




                                      -18-
<PAGE>


in deposits were increases in savings, money market and checking products due to
the opening of new branches and KNBT's marketing programs.  Total core deposits,
which are all deposits other than  certificates of deposits  increased by $359.2
million in 2003, $318.0 million of which were acquired through the merger. These
deposits  totaled  $741.7  million at December  31,  2003 and $382.6  million at
December 31, 2002.  KNBT's core deposits were 57.5% and 49.6% of total  deposits
at December 31, 2003 and 2002, respectively.  Certificates of deposits increased
$158.4  million from $389.3  million at December  31, 2002 to $547.7  million at
December 31, 2003.  The merger  accounted for $194.0  million of the increase in
certificates of deposit.

         The following  table shows for KNBT the average balance of each type of
deposit  and the  average  rate paid on each  type of  deposit  for the  periods
indicated.

<TABLE>
<CAPTION>

<S>                      <C>         <C>           <C>        <C>        <C>           <C>         <C>         <C>         <C>
------------------------------------------------------------------------------------------------------------------------------------

                                                                Year Ended December 31,
                      --------------------------------------------------------------------------------------------------------------
                                      2003                                  2002                                  2001
                      ---------------------------------     ----------------------------------    ----------------------------------
                         Average   Interest  Average           Average   Interest   Average          Average  Interest    Average
                         Balance   Expense  Rate Paid          Balance   Expense   Rate Paid         Balance   Expense   Rate Paid
                      ---------------------------------     ----------------------------------    ----------------------------------
                                                                 (dollars in thousands)
Savings ...............  $182,548    $  1,315      0.72%      $111,689   $  1,680      1.50%       $ 97,778    $  2,127    2.18%
Interest-bearing
   checking ...........   102,506         298      0.29         81,609        466      0.57          76,090         846    1.11
Money market ..........   203,978       2,212      1.08        134,456      2,784      2.07         100,327       3,512    3.50
Certificates of deposit   409,003      12,168      2.98        417,073     18,169      4.36         447,171      25,679    5.74
                         --------     -------                  -------     ------                   -------      ------
Total interest-bearing
  deposits ............   898,035      15,993      1.78        744,827     23,099      3.10         721,366      32,164    4.46
Non-interest-bearing
  deposits ............    53,559          --        --         28,881         --        --          19,890          --      --
                         --------     -------                  -------     ------                   -------      ------
   Total deposits .....  $951,594    $ 15,993      1.68%      $773,708   $ 23,099      2.99%       $741,256    $ 32,164    4.34%
                         ========     =======      ====        =======     ======      ====         =======      ======   ======


         The following table shows for KNBT deposit flows during the periods
indicated.


------------------------------------------------------------------------------------------------------------------

                                                                       Year Ended December 31,
                                                ------------------------------------------------------------------
                                                       2003                    2002                    2001
                                                --------------------     ------------------      -----------------
                                                                       (dollars in thousands)
Deposits received in merger ..................       $      512,086            $         -            $         -
Total deposits ...............................           10,938,793              4,352,478              2,616,347
Total withdrawals ............................          (10,947,524)            (4,373,961)            (2,586,937)
Interest credited ............................               14,230                 21,089                 29,397
                                                --------------------     ------------------      -----------------
     Total increase (decrease) in deposits ...       $       517,585           $      (394)           $    58,807
                                                ====================     ==================      =================
</TABLE>


                                      -19-
<PAGE>


         The  following  table  shows  for KNBT the  amount of  certificates  of
deposit,  by various  interest  rate  categories  and  maturities,  at the dates
indicated.

<TABLE>
<CAPTION>
<S>       <C>                          <C>           <C>          <C>              <C>        <C>          <C>        <C>

                                                                  Balance at December 31, 2003
                                                            Maturing in the 12 Months Ending December 31,
                                     -------------------------------------------------------------------------------------------
Certificates of Deposit:                  2004       2005         2006        2007        2008      Thereafter         Total
-----------------------------------  ------------  -----------  ----------  -----------  ---------  ------------  --------------
                                                                    (dollars in thousands)
Less than 2% ......................    $ 171,421     $ 31,236     $ 2,743     $      -    $     -       $    32       $ 205,432
2.00% - 2.99% .....................       51,152       34,055      14,887        1,138      1,452           107         102,791
3.00% - 3.99% .....................       54,229       34,589      18,305        8,328     12,367           118         127,936
4.00% - 4.99% .....................       12,727       26,199      16,013       27,920        180         1,182          84,221
5.00% - 5.99% .....................        9,364        1,807       2,241       13,543        133            20          27,108
6.00% - 6.99% .....................           70          131           -            4          -             -             205
7.00% or more ....................             1            -           -            -          -             -               1
                                     ------------  -----------  ----------  -----------  ---------  ------------  --------------
   Total certificates of deposit ..    $ 298,964     $128,017     $54,189     $ 50,933    $14,132       $ 1,459       $ 547,694
                                     ============  ===========  ==========  ===========  =========  ============  ==============


</TABLE>


         The  following  table shows the  maturities of KNBT's  certificates  of
deposit of $100,000 or more at December 31, 2003  indicated by time remaining to
maturity.

<TABLE>
<CAPTION>

<S>   <C> <C>                                      <C>                    <C>

                                                                        Weighted
Maturing in Quarter Ending:                     Amount                Average Rate
----------------------------------------    ---------------      ---------------------
                                                      (dollars in thousands)
March 31, 2004 ..........................          $ 5,522                 1.98%
June 30, 2004 ...........................           11,291                 2.27
September 30, 2004 ......................            4,547                 2.78
December 31, 2004 .......................            5,604                 2.16
After December 31, 2004 .................           29,892                 3.47
                                            ---------------      ---------------------
   Total certificates of deposit with
      balances of $100,000 or more ......          $56,856                 2.90%
                                            ===============      =====================


</TABLE>


         Borrowings.  KNBT, as part of its operating strategy, utilizes advances
from the  Federal  Home  Loan Bank of  Pittsburgh  as an  alternative  to retail
deposits  to  fund  its  operations.  These  FHLB  advances  are  collateralized
primarily by certain of KNBT's mortgage loans and mortgage-backed securities and
secondarily  by its investment in capital stock of the Federal Home Loan Bank of
Pittsburgh.  FHLB  advances  are  made  pursuant  to  several  different  credit
programs,  each of which has it own interest rate and range of  maturities.  The
maximum  amount that the Federal  Home Loan Bank of  Pittsburgh  will advance to
member institutions,  including KNBT, fluctuates from time to time in accordance
with the policies of the Federal Home Loan Bank. At December 31, 2003,  KNBT had
$207.2 million in outstanding FHLB advances. At December 31, 2002, FHLB advances
totaled $113.5 million,  which includes $20.0 million in short-term  (overnight)
borrowings. KNBT had no other short-term (overnight) borrowings from the FHLB in
2003, 2002 and 2001.

         The weighted  average  interest rates on KNBT's  advances was 4.21% and
4.69% for the years ended December 31, 2003 and 2002, respectively.



                                      -20-
<PAGE>


         The  principal  payments  due on  KNBT's  long-term  FHLB  advances  at
December 31, 2003 are as follows:



----------------------------------------------------------

FHLB Advances
Due In:                            At December 31, 2003
----------------------------       -----------------------
                                   (dollars in thousands)
2004                                             $ 24,300
2005                                               20,000
2006                                               20,000
2007                                               61,626
2008                                               13,000
2009 and thereafter                                68,227
                                         -----------------
     Total                                      $ 207,153
                                         =================

         In addition to FHLB advances, KNBT's borrowings include securities sold
under agreements to repurchase ("repurchase agreements").  Repurchase agreements
are  contracts  for the sale of  securities  owned or borrowed by KNBT,  with an
agreement to repurchase  those  securities at an agreed upon price and date. The
collateral  for  such  repurchase   agreements  are  U.S.  Treasury  and  Agency
securities and municipal  securities.  At December 31, 2003,  KNBT's  securities
repurchase  agreements amounted to $24.6 million and all of such borrowings were
short-term,  having maturities of one year or less. KNBT's securities sold under
repurchase agreements totaled $8.9 million at December 31, 2002.

         The  following  table  shows  certain   information   regarding  KNBT's
repurchase agreements:

<TABLE>
<CAPTION>


<S>                                                    <C>                <C>               <C>
----------------------------------------------------------------------------------------------------

                                                           At or For the Year Ended December 31,
                                                ----------------------------------------------------
                                                     2003               2002             2001
                                                ----------------   ---------------  ----------------
                                                                (dollars in thousands)
Repurchase Agreements:
      Average balance outstanding ..............       $ 11,931           $ 7,330           $ 2,431
      Maximum amount outstanding at any
         month-end during the period ...........       $ 29,010           $10,051           $ 5,752
      Balance outstanding at end of period .....       $ 24,550           $ 8,904           $ 5,752
      Average interest rate during the period ..          1.10%             2.09%             3.79%
      Weighted average interest rate at
         end of period .........................          0.64%             1.85%             2.49%



</TABLE>


         In conjunction  with the merger with First  Colonial,  KNBT assumed the
$15.0 million of statutory  trust debt held by First  Colonial which were issued
to First Colonial Trust I, a wholly-owned  Connecticut  statutory business trust
subsidiary in June 2002.  The  Statutory  Trust I issued $15.0 million in pooled
trust preferred  securities.  The subordinated  debentures are the sole asset of
the statutory trust. The trust preferred  securities are classified as long-term
debt for the  financial  statements,  but are  included  as Tier I  capital  for
regulatory  purposes.  The interest rate on this security (4.62% at December 31,
2003) is variable,  adjusting  quarterly at  three-month  LIBOR plus 3.45%.  The
interest is payable  quarterly.  The trust preferred  securities  mature in June
2007,  or may be redeemed at any time in the event that the deduction of related
interest  for federal  income tax  purposes is  prohibited,  treatment as Tier I
capital is no longer permitted,  or certain other  contingencies  arise. The net
proceeds  of the  trust  preferred  securities  have been  used to  support  the
Company's growth and other general corporate purposes.



                                      -21-
<PAGE>



Regulation of KNBT Bancorp

         Set forth below is a brief  description of certain laws relating to the
regulation  of KNBT Bancorp and Keystone  Nazareth  Bank & Trust  Company.  This
description  does not purport to be complete and is qualified in its entirety by
reference to applicable laws and regulations.

General

         The Bank as a Pennsylvania-chartered savings bank with deposits insured
by the Savings  Association  Insurance Fund  administered by the Federal Deposit
Insurance Corporation, is subject to extensive regulation and examination by the
Pennsylvania  Department  of  Banking  and  by  the  Federal  Deposit  Insurance
Corporation.  The federal  and state laws and  regulations  applicable  to banks
regulate,  among other things,  the scope of their business,  their investments,
the  reserves  required  to  be  kept  against  deposits,   the  timing  of  the
availability  of deposited funds and the nature and amount of and collateral for
certain  loans.  This  regulatory  structure  also gives the  federal  and state
banking agencies  extensive  discretion in connection with their supervisory and
enforcement activities and examination policies, including policies with respect
to the  classification  of assets and the  establishment  of adequate  loan loss
reserves for regulatory  purposes.  The laws and regulations  governing the Bank
generally have been promulgated to protect depositors and not for the purpose of
protecting shareholders.

         Federal law  provides the federal  banking  regulators,  including  the
Federal  Deposit  Insurance  Corporation  and the Federal  Reserve  Board,  with
substantial enforcement powers. This enforcement authority includes, among other
things, the ability to assess civil money penalties,  to issue  cease-and-desist
or  removal  orders,   and  to  initiate   injunctive  actions  against  banking
organizations and institution-affiliated  parties, as defined. In general, these
enforcement  actions may be initiated for violations of laws and regulations and
unsafe or unsound  practices.  Other  actions or inactions may provide the basis
for  enforcement  action,  including  misleading or untimely  reports filed with
regulatory  authorities.   Any  change  in  such  regulation,   whether  by  the
Pennsylvania  Department of Banking, the Federal Deposit Insurance  Corporation,
the Federal Reserve Board or the United States  Congress,  could have a material
impact on KNBT and its operations.

         KNBT is a bank  holding  company  under the Bank  Holding  Company  Act
subject to regulation and  supervision  by the Federal  Reserve Board and by the
Pennsylvania  Department of Banking.  KNBT is required to file annually a report
of its operations  with, and is subject to examination  by, the Federal  Reserve
Board and the Pennsylvania  Department of Banking. This regulation and oversight
is generally intended to ensure that KNBT limits its activities to those allowed
by law and that it operates in a safe and sound manner without  endangering  the
financial health of its subsidiary bank.

         KNBT has  registered  its common stock with the SEC under Section 12(g)
of the Securities  Exchange Act of 1934. KNBT is subject to the proxy and tender
offer rules,  insider  trading  reporting  requirements  and  restrictions,  and
certain other requirements  under the Securities  Exchange Act of 1934. KNBT has
listed its common stock on the Nasdaq Stock Market national  market system.  The
Nasdaq Stock Market listing requirements impose additional requirements on KNBT,
including,  among other things,  rules relating to corporate  governance and the
composition and independence of its board of directors and various committees of
the board, such as the audit committee.

         Bank Holding  Company Act Activities and Other  Limitations.  Under the
Bank  Holding  Company Act,  KNBT must obtain the prior  approval of the Federal
Reserve  Board  before it may acquire  control of another  bank or bank  holding
company, merge or consolidate with another bank holding company,  acquire all or
substantially  all of the assets of another  bank or bank  holding  company,  or
acquire direct or indirect ownership or control of any voting shares of any bank
or bank  holding  company if,  after such  acquisition,  KNBT would  directly or
indirectly own or control more than 5% of such shares.

         Federal  statutes impose  restrictions on the ability of a bank holding
company and its non-bank  subsidiaries  to obtain  extensions of credit from its
subsidiary bank, on the subsidiary bank's investments in the stock or securities
of the  holding  company,  and on the  subsidiary  bank's  taking of the holding
company's  stock or securities as collateral  for loans to any borrower.  A bank
holding company and its subsidiaries are also prevented




                                      -22-
<PAGE>

from engaging in certain tie-in arrangements in connection with any extension of
credit,  lease or sale of property,  or furnishing of services by the subsidiary
bank.

         A bank  holding  company is required to serve as a source of  financial
and  managerial  strength  to its  subsidiary  banks  and  may not  conduct  its
operations in an unsafe or unsound manner. In addition,  it is the policy of the
Federal  Reserve  Board that a bank  holding  company  should stand ready to use
available  resources to provide  adequate capital to its subsidiary banks during
periods of financial  stress or  adversity  and should  maintain  the  financial
flexibility  and  capital-raising  capacity to obtain  additional  resources for
assisting its  subsidiary  banks. A bank holding  company's  failure to meet its
obligations  to serve as a source  of  strength  to its  subsidiary  banks  will
generally be considered by the Federal Reserve Board to be an unsafe and unsound
banking  practice or a violation of the Federal  Reserve Board  regulations,  or
both.

         Non-Banking  Activities.  The business  activities  of KNBT,  as a bank
holding company,  are restricted by the Bank Holding Company Act. Under the Bank
Holding  Company  Act and the  Federal  Reserve  Board's  bank  holding  company
regulations, KNBT may only engage in, or acquire or control voting securities or
assets of a company engaged in:

     o    banking  or  managing  or  controlling  banks and  other  subsidiaries
          authorized under the Bank Holding Company Act; and

     o    any Bank Holding  Company Act activity the Federal  Reserve  Board has
          determined  to be so closely  related that it is incidental to banking
          or managing or controlling banks.

         The Federal  Reserve  Board has by regulation  determined  that certain
activities  are  closely  related  to  banking  including  operating  a mortgage
company, finance company, credit card company,  factoring company, trust company
or savings association; performing certain data processing operations; providing
limited  securities  brokerage  services;  acting as an  investment or financial
advisor;  acting as an  insurance  agent  for  certain  types of  credit-related
insurance;  leasing  personal  property on a full-payout,  non-operating  basis;
providing tax planning and preparation services;  operating a collection agency;
and providing certain courier  services.  However,  as discussed below,  certain
other  activities  are  permissible  for a bank  holding  company that becomes a
financial holding company.

         Financial  Modernization.  The  Gramm-Leach-Bliley  Act permits greater
affiliation  among  banks,  securities  firms,  insurance  companies,  and other
companies under a new type of financial  services  company known as a "financial
holding  company." A financial  holding  company  essentially  is a bank holding
company with  significantly  expanded powers.  Financial  holding  companies are
authorized by statute to engage in a number of financial  activities  previously
not permissible for bank holding companies,  including securities  underwriting,
dealing and market making;  sponsoring  mutual funds and  investment  companies;
insurance underwriting and agency; and merchant banking activities. The act also
permits the Federal  Reserve  Board and the  Treasury  Department  to  authorize
additional  activities for financial holding companies if they are "financial in
nature" or  "incidental"  to financial  activities.  A bank holding  company may
become a  financial  holding  company  if each of its  subsidiary  banks is well
capitalized,   well  managed,  and  has  at  least  a  "satisfactory"  Community
Reinvestment Act rating. A financial  holding company must provide notice to the
Federal  Reserve  Board within 30 days after  commencing  activities  previously
determined  by statute or by the Federal  Reserve  Board and  Department  of the
Treasury to be permissible. KNBT has not submitted notice to the Federal Reserve
Board of its intent to be deemed a financial holding company. However, it is not
precluded  from  submitting  a notice in the future  should it wish to engage in
activities only permitted to financial holding companies.

         Regulatory Capital Requirements.  The Federal Reserve Board has adopted
capital  adequacy  guidelines  pursuant  to which it  assesses  the  adequacy of
capital in examining  and  supervising  a bank holding  company and in analyzing
applications  to it under the Bank  Holding  Company  Act.  The Federal  Reserve
Board's  capital  adequacy  guidelines  for KNBT, on a consolidated  basis,  are
similar  to  those  imposed  on  the  Bank  by  the  Federal  Deposit  Insurance
Corporation. Prompt corrective action provisions, however, are not applicable to
bank holding companies.



                                      -23-
<PAGE>


         Restrictions on Dividends.  KNBT's ability to declare and pay dividends
may depend in part on dividends received from the Bank. The Pennsylvania Banking
Code  regulates the  distribution  of dividends by savings banks and states,  in
part,  that  dividends  may be  declared  and paid only out of  accumulated  net
earnings and may not be declared or paid unless surplus,  retained earnings,  is
at  least  equal to  contributed  capital.  In  addition,  dividends  may not be
declared or paid if the Bank is in default in payment of any  assessment due the
Federal Deposit Insurance Corporation.

         The Federal  Reserve  Board  issued a policy  statement  in 1985 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  holding  company's  net  income  for the past  year is
sufficient  to cover both the cash  dividends  and a rate of earnings  retention
that is consistent with the holding 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 federal prompt corrective
action  regulations,  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 - "Regulation of the Bank" below.

         Federal  Securities Laws. KNBT is subject to the proxy and tender offer
rules,  insider trading  reporting  requirements and  restrictions,  and certain
other requirements under the Securities Exchange Act of 1934.

         Sarbanes-Oxley Act of 2002. On July 30, 2002, the President signed into
law the Sarbanes-Oxley Act of 2002 implementing  legislative reforms intended to
address  corporate and accounting  fraud. In addition to the  establishment of a
new accounting oversight board which will enforce auditing,  quality control and
independence  standards  and will be  funded by fees  from all  publicly  traded
companies,  the  Sarbanes-Oxley  Act  restricts  provision of both  auditing and
consulting  services by accounting  firms. To ensure auditor  independence,  any
non-audit  services being provided to an audit client  requires  pre-approval by
the company's audit committee members.  In addition,  the audit partners must be
rotated.  The  Sarbanes-Oxley  Act requires chief  executive  officers and chief
financial officers, or their equivalent,  to certify to the accuracy of periodic
reports  filed with the SEC,  subject to civil and  criminal  penalties  if they
knowingly or  willfully  violate this  certification  requirement.  In addition,
under the  Sarbanes-Oxley  Act,  counsel are  required  to report  evidence of a
material  violation of the  securities  laws or a breach of fiduciary  duty by a
company to its chief executive officer or its chief legal officer,  and, if such
officer does not  appropriately  respond,  to report such  evidence to the audit
committee  or other  similar  committee  of the board of  directors or the board
itself.

         Longer  prison  terms now apply to  corporate  executives  who  violate
federal  securities  laws, the period during which certain types of suits can be
brought against a company or its officers has been extended,  and bonuses issued
to top executives prior to restatement of a company's  financial  statements are
now subject to disgorgement if such restatement was due to corporate misconduct.
Executives  are also  prohibited  from insider  trading during  retirement  plan
"blackout" periods, and loans to company executives are restricted. In addition,
a provision  directs that civil  penalties  levied by the SEC as a result of any
judicial or administrative action under the Sarbanes-Oxley Act be deposited to a
fund for the benefit of harmed  investors.  The Federal  Accounts  for  Investor
Restitution  ("FAIR")  provision  also  requires  the SEC to develop  methods of
improving  collection  rates.  The  legislation  accelerates  the time frame for
disclosures by public companies,  as they must immediately disclose any material
changes in their  financial  condition or  operations.  Directors  and executive
officers  must also  provide  information  for most  changes in  ownership  in a
company's securities within two business days of the change.

         The  Sarbanes-Oxley  Act also  increases the oversight of, and codifies
certain  requirements  relating to audit  committees of public companies and how
they interact with the company's  "registered  public accounting firm" ("RPAF").
Audit  Committee  members  must be  independent  and are barred  from  accepting
consulting,  advisory or other  compensatory  fees from the issuer. In addition,
companies  must  disclose  whether  at least one  member of the  committee  is a
"financial  expert,"  as such term is defined by the SEC,  and if not,  why not.
Under the Sarbanes-Oxley  Act, a RPAF is prohibited from performing  statutorily
mandated audit services for a company if such company's chief executive officer,
chief financial  officer,  comptroller,  chief accounting  officer or any person
serving in equivalent  positions has been employed by such firm and participated
in the audit of such company  during the  one-year  period  preceding  the audit
initiation date. The  Sarbanes-Oxley  Act also prohibits any officer or director
of a company or any other person  acting under their  direction  from taking any
action to fraudulently influence,  coerce,


                                      -24-
<PAGE>


manipulate or mislead any independent public or certified  accountant engaged in
the audit of the company's financial statements for the purpose of rendering the
financial  statement's  materially  misleading.   The  Sarbanes-Oxley  Act  also
required the SEC to prescribe rules requiring  inclusion of an internal  control
report and  assessment by management in the annual report to  shareholders.  The
Sarbanes-Oxley  Act  requires the RPAF that issues the audit report to attest to
and report on management's  assessment of the company's  internal  controls.  In
addition, the Sarbanes-Oxley Act requires that each financial report required to
be prepared in accordance with, or reconciled to, generally accepted  accounting
principles  and filed with the SEC reflect all material  correcting  adjustments
that are identified by a RPAF in accordance with generally  accepted  accounting
principles and the rules and regulations of the SEC.

Regulation of The Bank

         Pennsylvania  Savings Bank Law. The Pennsylvania  Banking Code contains
detailed provisions governing the organization,  location of offices, rights and
responsibilities  of directors,  officers,  and employees,  as well as corporate
powers,  savings and investment operations and other aspects of the Bank and its
affairs.  The code  delegates  extensive  rule-making  power and  administrative
discretion to the Pennsylvania Department of Banking so that the supervision and
regulation  of  state-chartered  savings  banks  may  be  flexible  and  readily
responsive  to  changes  in  economic  conditions  and in  savings  and  lending
practices.

         The  Pennsylvania  Banking  Code  also  provides  that  state-chartered
savings  banks may  engage in any  activity  permissible  for a federal  savings
association,  subject to regulation by the  Pennsylvania  Department of Banking.
The Federal Deposit Insurance Act,  however,  will prohibit the Bank from making
new  investments,  loans,  or becoming  involved in  activities as principal and
equity investments which are not permitted for national banks unless:

     o    the Federal Deposit Insurance  Corporation  determines the activity or
          investment  does not pose a  significant  risk of loss to the  Savings
          Association Insurance Fund; and

     o    the Bank meets all applicable capital requirements.

Accordingly,  the  additional  operating  authority  provided to the Bank by the
Pennsylvania  Banking Code is  significantly  restricted by the Federal  Deposit
Insurance Act.

         Insurance  of  Accounts.  The  deposits  of the Bank are insured to the
maximum extent  permitted by the Savings  Association  Insurance Fund,  which is
administered by the Federal Deposit Insurance Corporation, and are backed by the
full faith and credit of the U.S.  Government.  As insurer,  the Federal Deposit
Insurance  Corporation is authorized to conduct  examinations of, and to require
reporting by, insured institutions. It also may prohibit any insured institution
from  engaging  in  any  activity  the  Federal  Deposit  Insurance  Corporation
determines  by  regulation  or order to pose a  serious  threat  to the  Federal
Deposit Insurance  Corporation.  The Federal Deposit Insurance  Corporation also
has the authority to initiate enforcement actions against savings institutions.

         Under  current  Federal  Deposit  Insurance  Corporation   regulations,
Savings Association Insurance  Fund-insured  institutions are assigned to one of
three  capital  groups which are based  solely on the level of an  institution's
capital "well  capitalized,"  "adequately  capitalized"  and  "undercapitalized"
which are defined in the same manner as the regulations  establishing the prompt
corrective  action system discussed  below.  These three groups are then divided
into three subgroups which reflect varying levels of supervisory  concern,  from
those which are  considered to be healthy to those which are considered to be of
substantial   supervisory  concern.  The  matrix  so  created  results  in  nine
assessment risk  classifications,  with rates during the last six months of 2003
ranging from zero for well capitalized,  healthy institutions, such as the Bank,
to  27  basis  points  for   undercapitalized   institutions   with  substantial
supervisory concerns.

         In addition,  all  institutions  with  deposits  insured by the Federal
Deposit  Insurance  Corporation are required to pay assessments to fund interest
payments  on  bonds  issued  by the  Financing  Corporation,  a  mixed-ownership
government  corporation  established  to  recapitalize  the  predecessor  to the
Savings Association  Insurance Fund. The assessment rate for the last quarter of
2003 was 0.152% of insured deposits and is adjusted quarterly. These assessments
will continue until the Financing Corporation bonds mature in 2019.



                                      -25-
<PAGE>


         The Federal  Deposit  Insurance  Corporation  may terminate the deposit
insurance  of any insured  depository  institution,  including  the Bank,  if it
determines  after a hearing that the  institution  has engaged or is engaging in
unsafe or unsound  practices,  is in an unsafe or unsound  condition to continue
operations,  or has  violated  any  applicable  law,  regulation,  order  or any
condition   imposed  by  an  agreement  with  the  Federal   Deposit   Insurance
Corporation.  It also may  suspend  deposit  insurance  temporarily  during  the
hearing process for the permanent  termination of insurance,  if the institution
has no tangible capital. If insurance of accounts is terminated, the accounts at
the institution at the time of the  termination,  less  subsequent  withdrawals,
shall  continue  to be  insured  for a period  of six  months to two  years,  as
determined by the Federal Deposit Insurance Corporation.  Management is aware of
no  existing  circumstances  which  would  result in  termination  of the Bank's
deposit insurance.

         Regulatory   Capital   Requirements.   The  Federal  Deposit  Insurance
Corporation has promulgated  capital adequacy  requirements for  state-chartered
banks that,  like the Bank, are not members of the Federal Reserve Board System.
The  capital  regulations  establish  a  minimum  3%  Tier  1  leverage  capital
requirement for the most highly rated state-chartered, non-member banks, with an
additional  cushion  of  at  least  100  to  200  basis  points  for  all  other
state-chartered,  non-member banks, which effectively increases the minimum Tier
1 leverage  ratio for such other  banks to 4% to 5% or more.  Under the  Federal
Deposit Insurance Corporation's  regulations,  the highest-rated banks are those
that the Federal Deposit Insurance  Corporation  determines are not anticipating
or experiencing  significant growth and have well diversified risk, including no
undue interest rate risk exposure, excellent asset quality, high liquidity, good
earnings and, in general,  which are considered a strong  banking  organization,
rated composite 1 under the Uniform Financial  Institutions  Rating System. Tier
1, or leverage capital,  is defined as the sum of common  shareholders'  equity,
including  retained  earnings,  non-cumulative  perpetual  preferred  stock  and
related surplus, and minority interests in consolidated subsidiaries,  minus all
intangible  assets other than certain  purchased  mortgage  servicing rights and
purchased credit card relationships.

         The Federal Deposit  Insurance  Corporation's  regulations also require
that state-chartered,  non-member banks meet a risk-based capital standard.  The
risk-based  capital standard requires the maintenance of total capital,  defined
as Tier 1 capital and supplementary (Tier 2) capital, to risk weighted assets of
8%. In determining the amount of risk-weighted  assets, all assets, plus certain
off balance sheet assets,  are multiplied by a risk-weight of 0% to 100%,  based
on the risks the Federal Deposit Insurance  Corporation believes are inherent in
the type of asset or item.  The  components of Tier 1 capital for the risk-based
standards  are the same as  those  for the  leverage  capital  requirement.  The
components  of  supplementary  (Tier 2)  capital  include  cumulative  perpetual
preferred stock,  mandatory  subordinated  debt,  perpetual  subordinated  debt,
intermediate-term  preferred  stock,  up to 45% of  unrealized  gains on  equity
securities  and a portion of a bank's  allowance for loan losses.  Allowance for
loan losses includable in supplementary capital is limited to a maximum of 1.25%
of risk-weighted  assets.  Overall, the amount of supplementary capital that may
be included in total capital is limited to 100% of Tier 1 capital.

         A bank that has less than the minimum leverage  capital  requirement is
subject to various  capital plan and activities  restriction  requirements.  The
Federal  Deposit  Insurance  Corporation's  regulations  also  provide  that any
insured  depository  institution  with a ratio of Tier 1 capital to total assets
that is less  than  2.0% is deemed  to be  operating  in an  unsafe  or  unsound
condition  pursuant to Section  8(a) of the Federal  Deposit  Insurance  Act and
could be subject to potential termination of deposit insurance.

         The Bank is also subject to minimum capital requirements imposed by the
Pennsylvania   Department  of  Banking  on  Pennsylvania   chartered  depository
institutions.   Under  the   Pennsylvania   Department   of  Banking's   capital
regulations,  a Pennsylvania bank or savings association must maintain a minimum
leverage ratio of Tier 1 capital, as defined under the Federal Deposit Insurance
Corporation's  capital  regulations,  to total  assets of 4%. In  addition,  the
Pennsylvania  Department of Banking has the supervisory  discretion to require a
higher leverage ratio for any institution or association  based on inadequate or
substandard performance in any of a number of areas. The Pennsylvania Department
of  Banking   incorporates  the  same  Federal  Deposit  Insurance   Corporation
risk-based capital requirements in its regulations.




                                      -26-
<PAGE>



         Prompt  Correction  Action.  The  following  table  shows the amount of
capital associated with the different capital categories set forth in the prompt
correction action regulations.

<TABLE>
<CAPTION>

<S>                                      <C>                    <C>                <C>
-------------------------------------------------------------------------------------------------
                                            Total                 Tier 1             Tier 1
                                          Risk-Based            Risk-Based          Leverage
Capital Category                           Capital                Capital           Capital
--------------------------------   --------------------   -------------------  ------------------

Well capitalized ..................      10% or more            6% or more         5% or more

Adequately capitalized ............       8% or more            4% or more         4% or more

Undercapitalized ..................      Less than 8%          Less than 4%       Less than 4%

Significantly undercapitalized ....      Less than 6%          Less than 3%       Less than 3%

</TABLE>


         In addition, an institution is "critically  undercapitalized" if it has
a ratio of tangible  equity to total  assets that is equal to or less than 2.0%.
Under  specified  circumstances,  a federal banking agency may reclassify a well
capitalized  institution as adequately capitalized and may require an adequately
capitalized  institution  or an  undercapitalized  institution  to  comply  with
supervisory  actions as if it were in the next lower  category,  except that the
Federal  Deposit  Insurance  Corporation  may  not  reclassify  a  significantly
undercapitalized institution as critically undercapitalized.

         An institution  generally must file a written capital  restoration plan
which  meets  specified  requirements  within  45  days  of the  date  that  the
institution   receives   notice  or  is  deemed  to  have   notice  that  it  is
undercapitalized, significantly undercapitalized or critically undercapitalized.
A federal  banking  agency must provide the  institution  with written notice of
approval or  disapproval  within 60 days after  receiving a capital  restoration
plan,  subject to extensions by the agency.  An institution which is required to
submit a  capital  restoration  plan  must  concurrently  submit  a  performance
guaranty  by  each  company  that   controls  the   institution.   In  addition,
undercapitalized  institutions are subject to various  regulatory  restrictions,
and the  appropriate  federal  banking  agency  also  may  take  any  number  of
discretionary supervisory actions.

         At  December  31,  2003,   the  Bank  was  deemed  a   well-capitalized
institution for purposes of the above  regulations and as such is not subject to
the above-mentioned restrictions.



                                      -27-
<PAGE>


         The  following  table  provides a  comparison  of KNBT's and the Bank's
capital amounts,  risk-based  capital ratios and leverage ratios for the periods
indicated.

<TABLE>
<CAPTION>

<S>                                      <C>           <C>             <C>           <C>

-------------------------------------------------------------------------------------------------------------------------------
Capital Ratios                                                           Required                   To Be Well Capitalized
                                                                        For Capital                 Under Prompt Corrective
                                               Actual                Adequacy Purposes                 Action Provisions
                                      ----------------------         ---------------------          -----------------------
at December 31, 2003                  Amount            Ratio          Amount      Ratio            Amount       Ratio
------------------------------------------------------------------------------------------------------------------------------
Total Capital                                                        (dollars in thousands)
(To risk-weighted assets)
   Company, (consolidated) ...........   $359,522      33.24%          $ 86,535      8.00%               N/A         N/A
   Bank ..............................   $258,441      24.01%          $ 86,123      8.00%          $107,654       10.00%

Tier I Capital
(To risk-weighted assets)
   Company, (consolidated) ...........   $351,612      32.51%          $ 43,268      4.00%               N/A         N/A
   Bank ..............................   $250,499      23.27%          $ 43,062      4.00%           $64,593        6.00%

Tier I Capital
(To average assets, leverage)
   Company, (consolidated) ...........   $351,612      19.39%          $ 72,525      4.00%               N/A         N/A
   Bank ..............................   $250,499      13.42%          $ 74,646      4.00%           $93,307        5.00%

------------------------------------------------------------------------------------------------------------------------------
Capital Ratios                                                           Required                   To Be Well Capitalized
                                                                        For Capital                 Under Prompt Corrective
                                               Actual                Adequacy Purposes                 Action Provisions
                                      ----------------------         ---------------------          -----------------------
at December 31, 2002                  Amount            Ratio          Amount      Ratio            Amount       Ratio
------------------------------------------------------------------------------------------------------------------------------

                                                                     (dollars in thousands)
Total Capital
(To risk-weighted assets)
   Bank ..............................   $109,137      18.69%          $ 46,702      8.00%           $58,378       10.00%

Tier I Capital
(To risk-weighted assets)
   Bank ..............................   $106,210      18.19%          $ 23,351      4.00%           $35,027        6.00%

Tier I Capital
(To average assets, leverage)
   Bank ..............................   $106,210      10.78%          $ 39,410      4.00%           $49,263        5.00%

--------------------------------------------------------------------------------------------------------------------------
</TABLE>

         Affiliate  Transaction  Restrictions.  Federal laws strictly  limit the
ability  of banks to engage in  transactions  with their  affiliates,  including
their bank holding  companies.  Such transactions  between a subsidiary bank and
its parent company or the non-bank  subsidiaries of the bank holding company are
limited to 10% of a bank  subsidiary's  capital and surplus and, with respect to
such parent company and all such non-bank  subsidiaries,  to an aggregate of 20%
of the bank subsidiary's capital and surplus.  Further,  loans and extensions of
credit generally are required to be secured by eligible  collateral in specified
amounts.  Federal law also requires that all transactions between a bank and its
affiliates  be  on  terms  as  favorable  to  the  bank  as  transactions   with
non-affiliates.

         Federal Home Loan Bank System. The Bank is a member of the Federal Home
Loan Bank of  Pittsburgh,  which is one of 12 regional  Federal Home Loan Banks.
Each  Federal Home Loan Bank serves as a reserve or central bank for its members
within its  assigned  region.  It is funded  primarily  from funds  deposited by
member  institutions  and proceeds from the sale of consolidated  obligations of
the Federal Home Loan Bank


                                      -28-
<PAGE>


system.  It makes loans to members (i.e.,  advances) in accordance with policies
and  procedures  established  by the board of directors of the Federal Home Loan
Bank.  At December  31, 2003,  the Bank had $207.2  million in Federal Home Loan
Bank advances.

         As a member, the Bank is required to purchase and maintain stock in the
Federal Home Loan Bank of  Pittsburgh in an amount equal to the greater of 1% of
its aggregate  unpaid  residential  mortgage loans,  home purchase  contracts or
similar  obligations  at the  beginning  of each  year or 5% of its  outstanding
advances  from the Federal Home Loan Bank.  At December  31, 2003,  the Bank had
$11.5 million in stock of the Federal Home Loan Bank of Pittsburgh  which was in
compliance with this requirement.

         Federal  Reserve Board System.  The Federal  Reserve Board requires all
depository  institutions to maintain  non-interest bearing reserves at specified
levels against their transaction accounts,  which are primarily checking and NOW
accounts,  and non-personal time deposits.  The balances  maintained to meet the
reserve requirements imposed by the Federal Reserve Board may be used to satisfy
the liquidity  requirements  that are imposed by the Pennsylvania  Department of
Banking.  At December 31, 2003,  the Bank was in  compliance  with these reserve
requirements.

Federal Taxation

         General.  KNBT and the Bank are subject to federal  income  taxation in
the same general manner as other corporations with some exceptions listed below.
The  following  discussion of federal,  state and local income  taxation is only
intended  to  summarize  certain  pertinent  income  tax  matters  and  is not a
comprehensive description of the tax rules applicable to KNBT and the Bank.

         Method of  Accounting.  For federal  income tax purposes,  KNBT reports
income and expenses on the accrual  method of  accounting  and files its federal
income tax return on a calendar year basis.

         Bad Debt  Reserves.  The  Small  Business  Job  Protection  Act of 1996
eliminated  the use of the reserve method of accounting for bad debt reserves by
savings associations, effective for taxable years beginning after 1995. Prior to
that time,  KNBT was  permitted to establish a reserve for bad debts and to make
additions  to the reserve.  These  additions  could,  within  specified  formula
limits,  be deducted in  arriving  at taxable  income.  As a result of the Small
Business Job Protection Act of 1996, savings  associations must use the specific
charge-off  method in computing  their bad debt  deduction  beginning with their
1996 federal tax return. In addition, federal legislation required the recapture
over a six-year  period of the excess of tax bad debt  reserves at December  31,
1995 over those established as of December 31, 1987.

         Taxable  Distributions  and Recapture.  Prior to the Small Business Job
Protection Act of 1996, bad debt reserves  created prior to January 1, 1988 were
subject to recapture  into taxable  income if KNBT failed to meet certain thrift
asset and definitional tests. New federal  legislation  eliminated these savings
association  related  recapture  rules.  However,  under  current law,  pre-1988
reserves remain subject to recapture  should the Bank make certain  non-dividend
distributions or cease to maintain a bank charter.

         At  December  31,  2003,  KNBT's  total  federal  pre-1988  reserve was
approximately  $9.8  million.  The reserve  reflects the  cumulative  effects of
federal tax deductions by KNBT for which no federal  income tax provisions  have
been made.

         Alternative   Minimum  Tax.  The  Internal   Revenue  Code  imposes  an
alternative  minimum  tax at a rate of 20% on a base of regular  taxable  income
plus  certain tax  preferences.  The  alternative  minimum tax is payable to the
extent such alternative  minimum tax income is in excess of an exemption amount.
Net  operating  losses,  of which KNBT has none,  can offset no more than 90% of
alternative minimum taxable income.  Certain payments of alternative minimum tax
may be used as credits against regular tax liabilities in future years. KNBT had
a minimum tax credit carryover of $285,000 at December 31, 2003.

         Net Operating Loss  Carryovers.  For net operating  losses in tax years
beginning before August 6, 1997, KNBT may carry back net operating losses to the
three years  preceding the loss year and then forward to fifteen years following
the loss years.  For net  operating  losses in years  beginning  after August 5,
1997,  net operating


                                      -29-
<PAGE>


losses can be carried back to the two years  preceding the loss year and forward
to the 20 years  following the loss year. At December 31, 2003,  KNBT had no net
operating loss carry-forwards for federal income tax purposes.

         Corporate  Dividends-Received  Deduction.  KNBT  may  exclude  from its
income 100% of dividends  received from KNBT as a member of the same  affiliated
group of corporations.  The corporate dividends received deduction is 80% in the
case of dividends  received from corporations  which a corporate  recipient owns
less than 80%, but at least 20% of the  distribution  corporation.  Corporations
which own less than 20% of the stock of a  corporation  distributing  a dividend
may deduct only 70% of dividends received.

State and Local Taxation

         Pennsylvania  Taxation.  KNBT is subject to the Pennsylvania  Corporate
Net Income Tax,  Capital Stock and Franchise Tax. The Corporation Net Income Tax
rate for 2003 is 9.99% and is  imposed  on  unconsolidated  taxable  income  for
federal  purposes with certain  adjustments.  In general,  the Capital Stock and
Franchise Tax is a property tax imposed on a  corporation's  capital stock value
at a statutorily  defined rate, such value being determined in accordance with a
fixed formula based upon average net income and net worth.

         The  Bank is  subject  to tax  under  the  Pennsylvania  Mutual  Thrift
Institutions Tax Act, as amended to include thrift  institutions  having capital
stock.  Pursuant to the Mutual Thrift  Institutions  Tax, the tax rate is 11.5%.
The Mutual Thrift  Institutions Tax exempts Keystone from other taxes imposed by
the  Commonwealth  of  Pennsylvania  for state  income tax purposes and from all
local taxation  imposed by political  subdivisions,  except taxes on real estate
and real estate transfers.  The Mutual Thrift Institutions Tax is a tax upon net
earnings, determined in accordance with generally accepted accounting principles
with  certain  adjustments.  The Mutual  Thrift  Institutions  Tax, in computing
income according to generally  accepted  accounting  principles,  allows for the
deduction of interest earned on state and federal obligations, while disallowing
a percentage  of a thrift's  interest  expense  deduction in the  proportion  of
interest income on those  securities to the overall interest income of the Bank.
Net operating losses, if any,  thereafter can be carried forward three years for
Mutual Thrift Institutions Tax purposes.

Employees

         As of December 31, 2003, KNBT had  approximately  649 employees of whom
141 were  part-time.  KNBT considers its  relationship  with its employees to be
good.



                                      -30-
<PAGE>


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

         KNBT does not own or lease any  property.  The Bank owns 20  properties
and leases 25 other  properties.  The principal  office of KNBT is located at 90
Highland  Avenue,  Bethlehem,  PA 18017.  The book value of this office was $3.2
million at December 31, 2003.

         The Bank also owns an  operations  and lending  office at 236  Brodhead
Road,  Bethlehem,  PA 18017.  This building was purchased in 2003 and had a book
value of $7.2 million at December 31, 2003. The Bank acquired an office building
at 3864 Adler Place,  Bethlehem,  PA 18017 as a part of the acquisition of First
Colonial.  The Bank will continue to use this facility for general office space.
This building had a book value of $2.9 million at December 31, 2003.

         In addition,  the Bank owns 15 branch banking  facilities and leases 25
other  branch  banking  facilities.  All of which are located  within the Bank's
market area.

         The Bank also owns a garage and parking lot in  Nazareth,  Pennsylvania
and a vacant  lot which is  available  for a possible  future  branch in Easton,
Pennsylvania.

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

         From time-to-time, KNBT and the Bank are parties to routine litigation
incidental to their business.

         Neither KNBT, the Bank nor any of their subsidiaries is subject to any
material legal proceedings, nor are any such proceedings known to be
contemplated by any governmental authorities.


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

         No matter was submitted to a vote of shareholders during the fourth
quarter of the fiscal year covered by this report.


                                      -31-
<PAGE>


PART II

Item 5.   Market for Registrant's Common Equity, Related Stockholder Matters and
          ----------------------------------------------------------------------
          Issuer Purchases of Equity Securities
          -------------------------------------

         KNBT Bancorp.  Inc.  common stock trades on the Nasdaq  National Market
under the trading  symbol "KNBT." At the close of business on December 31, 2003,
there were 3,641 shareholders of record.

         The  declaration  and payment of dividends is at the sole discretion of
the Board of  Directors,  and their timing and amount will depend upon the Board
of Directors  consideration of the earnings,  financial  condition,  and capital
needs of KNBT and the Bank and  certain  other  factors  including  restrictions
arising from  Federal  banking  laws and  regulations  (see "Note P - Regulatory
Matters" in the "Notes to Consolidated  Financial  Statements").  As of December
31, 2003,  no  dividends  had been paid or declared on KNBT common  stock.  KNBT
common  shares were first sold in KNBT's  initial  public  offering as a part of
Keystone  Savings Bank's  mutual-to-stock  conversion on October 31, 2003 at the
offering price of $10.00 per share.  KNBT's common stock began trading on Nasdaq
on November 3, 2003.

         During the period of October 31, 2003 through  December  31, 2003,  bid
prices  reported  for  KNBT's  common  stock was a high of  $17.79  and a low of
$15.87. The last sale price on December 31, 2003 was $17.58.

         KNBT did not sell any of its equity  securities  during  2003 that were
not registered under the Securities Act of 1933.

         For information regarding KNBT's equity compensation plans see item 12.





                                      -32-
<PAGE>


Item 6.   Selected Financial Data

<TABLE>
<CAPTION>


<S>                                                      <C>           <C>             <C>             <C>             <C>

------------------------------------------------------------------------------------------------------------------------------------
(dollars in thousands, except per share data)
As of and For the Year Ended December 31,                  2003 (1)        2002            2001            2000             1999
------------------------------------------------------------------------------------------------------------------------------------
 Consolidated Summary of Income
     Interest income ...............................     $    59,063   $    59,479     $    60,493     $    57,603     $    52,181
     Interest expense ..............................          21,061        26,416          34,064          31,141          26,846
                                                         -----------   -----------     -----------     -----------     -----------
     Net interest income ...........................          38,002        33,063          26,429          26,462          25,335
     Provision for loan losses .....................           2,951           111             391             442             421
     Total non-interest income .....................           9,048         8,814           5,013           3,214           2,955
     Total non-interest expense (2) ................          55,119        24,568          19,613          17,999          16,372
                                                         -----------   -----------     -----------     -----------     -----------

     Income (loss) before income taxes (benefit) ...         (11,020)       17,198          11,438          11,235          11,497
     Income taxes (benefit) ........................          (5,264)        5,188           3,326           3,718           3,898
                                                         -----------   -----------     -----------     -----------     -----------

       Net income (loss) (2) .......................     $    (5,756)  $    12,010     $     8,112     $     7,517     $     7,599
                                                         ===========   ===========     ===========     ===========     ===========


 Consolidated Balance Sheet Data
     Total assets ..................................     $ 1,940,801   $ 1,015,906     $   922,045     $   824,736     $   773,953
     Investment securities available-for-sale (3) ..         734,087       294,150         156,785         114,077         103,092
     Loans receivable, net .........................         882,166       555,526         668,046         657,107         611,108
     Mortgage loans held-for-sale ..................           4,677        23,796              --              --              --
     Deposits ......................................       1,289,410       771,825         772,226         713,520         665,369
     Securities sold under agreements to repurchase           24,550         8,904           5,752              --              --
     FHLB advances .................................         207,153       113,500          40,500          13,000          25,000
     Guaranteed preferred beneficial interest in the
        Company's subordinated debentures ..........          15,000            --              --              --              --
     Shareholders' equity / retained eanings .......         389,080       111,049          95,788          86,204          78,687
     Book value per share ..........................           13.20           N/A             N/A             N/A             N/A
     Full service offices ..........................              41            19              16              16              15

 Selected Consolidated Ratios
     Net income (loss) to:
       Average total assets ........................           (0.46)%        1.25 %          0.92 %          0.94 %          1.02 %
       Average equity ..............................           (3.58)        11.46            8.79            9.27            9.93
     Net interest margin (4) .......................            3.49          3.66            3.21            3.38            3.50
     Efficiency ratio (5) ..........................          117.15         58.67           62.38           60.65           57.87
     Equity to assets (6) ..........................           20.05         10.93           10.39           10.45           10.17
     Tier 1 capital to average assets (leverage) (6)           19.39         10.78           10.50           10.45            9.97
     Tier I risk-based capital ratio (6) ...........           32.51         18.19           17.09           16.99           16.67
     Total risk-based capital ratio (6) ............           32.24         18.19           17.71           17.65           17.34


</TABLE>

(1)  After the close of business on October 31, 2003, the Company  completed the
     mutual-to-stock  conversion of the Bank and the related  subscription stock
     offering and the  acquisition by merger of First Colonial  Group,  Inc. See
     "Business - General" in Item 1.
(2)  Included in the non-interest  expenses for the year ended December 31, 2003
     are a  $16.1  million  contribution  to the  Keystone  Nazareth  Charitable
     Foundation  and $5.7 million of merger and systems  integration  costs as a
     result of the acquisition of First Colonial Group.
(3)  KNBT has classified all of its investment securities as available-for-sale,
     therefore   there   are   no   securities    classified   as   trading   or
     held-to-maturity. (4) Calculated on a tax-equivalent basis.
(5)  The calculation of the efficiency ratio for 2003 includes the effect of the
     $16.1 million  contribution to the Keystone Nazareth Charitable  Foundation
     and $5.7 million of merger and systems integration costs as a result of the
     acquisition of First Colonial Group.
(6)  Ratios  for  2003  are for  KNBT  Bancorp.  Ratios  for 1999 - 2002 are for
     Keystone Nazareth Bank & Trust Company (formerly Keystone Savings Bank).


                                      -33-

<PAGE>


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

General
-------

         The following presents a review of KNBT Bancorp's results of operations
and financial condition. This information should be read in conjunction with the
KNBT's consolidated financial statements and the accompanying notes to financial
statements.   KNBT's  consolidated  earnings  are  derived  primarily  from  the
operations of its wholly owned savings bank subsidiary, Keystone Nazareth Bank &
Trust Company, and its other subsidiaries

         KNBT's results of operations depend, to a large extent, on net interest
income,  which is the  difference  between  the  income  earned  on its loan and
investment  portfolios and interest expense on deposits and borrowings.  Results
of operations  are also affected by fee income from its banking and  non-banking
operations,  provisions for loan losses,  loan servicing and other  non-interest
income.  Non-interest  expense  primarily  consists of compensation and employee
benefits,  office occupancy and equipment expense, data processing,  advertising
and business promotion and other expenses. KNBT's results of operations are also
significantly   affected  by  general   economic  and  competitive   conditions,
particularly  changes in  interest  rates,  government  policies  and actions of
regulatory  authorities.  Future  changes  in  applicable  law,  regulations  or
government policies may materially impact KNBT's financial condition and results
of operations.


Critical Accounting Policies, Judgments and Estimates
-----------------------------------------------------

         The accounting and reporting  policies of KNBT conform with  accounting
principles  generally  accepted  in the  United  States of America  and  general
practices within the financial services  industry.  The preparation of financial
statements in conformity with accounting  principles  generally  accepted in the
United States  requires  management to make estimates and the  assumptions  that
affect the amounts  reported in the financial  statements  and the  accompanying
notes. Actual results could differ from those estimates.

         KNBT considers that the  determination of the allowance for loan losses
involves a higher degree of judgment and complexity  than its other  significant
accounting  policies.  The  allowance  for loan  losses is  calculated  with the
objective of maintaining a reserve level believed by management to be sufficient
to absorb estimated  probable credit losses.  Management's  determination of the
adequacy of the allowance is based on periodic evaluations of the loan portfolio
and other relevant factors. However, this evaluation is inherently subjective as
it requires  material  estimates,  including,  among  others,  expected  default
probabilities,  loss given default,  expected  commitment usage, the amounts and
timing of expected future cash flows on impaired loans,  mortgages,  and general
amounts for historical  loss  experience.  The process also  considers  economic
conditions,  uncertainties  in estimating  losses and inherent risks in the loan
portfolio. All of these factors may be susceptible to significant change. To the
extent actual outcomes differ from management  estimates,  additional provisions
for loan losses may be required that would  adversely  impact earnings in future
periods.

         KNBT  recognizes  deferred  tax assets and  liabilities  for future tax
effects of temporary  differences,  net  operating  loss carry  forwards and tax
credits.  Deferred tax assets are subject to  management's  judgment  based upon
available  evidence  that  future  realization  is  more  likely  than  not.  If
management  determines  that KNBT may be unable  to  realize  all or part of net
deferred tax assets in the future,  a direct charge to income tax expense may be
required  to reduce  the  recorded  value of the net  deferred  tax asset to the
expected  realizable amount. For further  information,  see "Note B - Summary of
Accounting  Policies"  in the  "Notes  to  Consolidated  Financial  Statements",
included in Item 8 of this Form 10-K.

         Goodwill, under SFAS No. 142, is subject to impairment testing at least
annually  to  determine  whether   write-downs  of  the  recorded  balances  are
necessary.  The Company tests for impairment based on the goodwill maintained at
each defined  reporting unit. A fair value is determined for each reporting unit
based on at least one of three various market  valuation  methodologies.  If the
fair values of the  reporting  units exceed their book values,  no write-down of
recorded goodwill is necessary. If the fair value of the reporting unit is less,
an expense  may be  required  on the  Company's  books to write down the related
goodwill to the proper carrying value. The Company


                                      -34-
<PAGE>


recorded  goodwill and other  identifiable  intangible assets as a result of the
acquisition  of First  Colonial in October 2003.  For further  information,  see
"Note B8 -  Summary  of  Accounting  Policies"  in the  "Notes  to  Consolidated
Financial Statements" included in Item 8 of this Form 10-K.

Operating Strategy

         KNBT was  organized  in 2003 by Keystone  Savings Bank as a part of its
mutual-to-stock  conversion  and  to  be  the  holding  company  for  the  Bank.
Historically,  Keystone  Savings  Bank  operated as a  traditional  savings bank
primarily providing  single-family  residential  mortgage loans and a variety of
retail products and services to its customers.

         Concurrent  with the  conversion  on October 31, 2003,  First  Colonial
Group,  Inc. was merged with and into KNBT and Nazareth  National Bank and Trust
Company was merged into the Bank. Historically, Nazareth National Bank and Trust
Company was a full-service  community  commercial bank with full trust services.
Keystone Nazareth Bank & Trust Company is a Pennsylvania chartered stock savings
bank.  Some of the Bank's  key  operating  strategies  and  characteristics  are
described below.

     o    A  current  branch  network  system  with 41  branch  offices  located
          throughout   Lehigh,   Northampton,   Monroe  and   Carbon   Counties,
          Pennsylvania with consideration for additional branches in the future.

     o    Continuing  to enhance  operating  systems  and  customer  service and
          convenience, including new computer software and hardware, an improved
          internet  banking  system and new branch systems which are expected to
          be operational during the second quarter of 2004.

     o    Strong deposit  market share  particularly  in Northampton  and Lehigh
          Counties  in which  the  Bank  has the  largest  and  second  largest,
          respectively,  deposit market share.  Overall, the Bank estimates that
          it has the second largest deposit share in the Lehigh Valley.

     o    Focusing on increased lending to small to mid-sized  businesses in the
          greater Lehigh Valley, which sector is believed to be underserved.

     o    Continuing to develop as a "relationship  bank" offering a broad array
          of deposit  and loan  products  as well as  securities  and  insurance
          products and trust and wealth management services.

     o    Leveraging capital  efficiently  through additional growth of loan and
          investment portfolios.

Financial Performance Summary

         KNBT had a net loss for 2003 of $5.8 million,  which included  one-time
charges  aggregating  $21.8  million  (pre-tax)  resulting  from a $16.1 million
contribution to the Keystone Nazareth Charitable  Foundation and $5.7 million of
merger related and systems  integration  related charges  incurred in connection
with the First Colonial Group, Inc. and KNBT merger. KNBT's net income was $12.0
million and $8.1 million in 2002 and 2001, respectively.

         KNBT's  return on average  assets was  (0.46)% in 2003 as  compared  to
1.25% in 2002 and 0.92% in 2001.  The  return on  average  equity  was  (3.58)%,
11.46% and 8.79% in 2003, 2002 and 2001, respectively.

         Total assets of KNBT were $1.9 billion at December 31, 2003 as compared
to $1.0  billion at  year-end  2002,  an  increase  of $924.9  million or 91.0%.
Included in this increase of total assets are $610.4 million of assets  acquired
as a result of the merger with First Colonial.  During 2003, total deposits grew
by $515.8  million  or 66.8% to a  year-end  total of $1.3  billion.  The merger
accounted for $512.1  million of this  increase.  Total deposits at December 31,
2002 were  $771.8  million.  Total loans  amounted to $890.1  million and $558.5
million at December 31, 2003 and 2002,  respectively.  The loan increase in 2003
was $331.6 million. This increase included $272.2 million of loans acquired from
First Colonial in the merger.

         The  conversion of the Bank to a stock company  resulted in the sale of
an aggregate of  20,201,188  shares of KNBT's  common stock at a price of $10.00
per share for  proceeds of $202.0  million.  The  capitalized  expenses



                                      -35-
<PAGE>




for the  conversion  were  $5.8  million  resulting  in net  proceeds  of $196.2
million.  This sale was the principal  factor in the $278.0 million  increase in
shareholders'  equity during 2003. An additional  primary factor in the increase
in equity was the acquisition of First Colonial Group, Inc. through the issuance
of an  aggregate  of  8,545,855  common  shares in exchange  for the  previously
outstanding  shares of First  Colonial.  Total  shareholders'  equity was $389.1
million and $111.0  million at December  31, 2003 and 2002,  respectively.  Also
affecting the change in equity during 2003 was the  establishment of an employee
stock  ownership  plan (ESOP)  through the purchase of 949,845  shares of common
stock through a loan from KNBT to the ESOP in the amount of $16.1  million,  the
release of 9,723 shares at their fair market value of $165,000, the contribution
of 1,616,095  shares of KNBT common stock to the  Keystone  Nazareth  Charitable
Foundation which had a value of $16.1 million at the time of  contribution,  the
issuance of 56,259 shares of KNBT common stock pursuant to the exercise of stock
options for proceeds of $311,000,  and the net loss of $5.8  million.  The total
common shares  outstanding  at December 31, 2003 were  29,479,275  excluding the
unallocated shares held by the ESOP.

Analysis of Net Interest Income

         Net  interest  income  represents  the  difference  between  income  on
interest-earnings  assets  and  expense  on  interest-bearing  liabilities.  Net
interest  income also  depends  upon the  relative  amounts of  interest-earning
assets and interest-bearing  liabilities and the interest rate earned or paid on
them. Net interest income is the primary source of earnings for KNBT. Therefore,
changes in net  interest  income are  important  factors in KNBT's  overall  net
income.

         Average  Balances,  Net Interest  Income,  and Yields  Earned and Rates
Paid.  The  following  table shows for the periods  indicated  the total  dollar
amount of  interest  from  average  interest-earnings  assets and the  resulting
yields, as well as the interest expense on average interest-bearing liabilities,
expressed  both in dollars and rates,  and the net  interest  margin.  The table
includes  information adjusted to a tax equivalent yield basis for the Company's
tax-exempt investment securities. The presentation on a tax-equivalent basis may
be considered to include non-GAAP information.  Management believes that it is a
standard  industry  practice in the banking industry to present such information
on a fully tax equivalent basis and that such information is useful to investors
in making peer  comparisons.  The tax-exempt  adjustments  and  comparable  GAAP
information also is included in the table.




                                      -36-
<PAGE>

<TABLE>
<CAPTION>


<S>                                          <C>        <C>         <C>     <C>          <C>      <C>    <C>        <C>      <C>
------------------------------------------------------------------------------------------------------------------------------------
Consolidated Comparative Statement Analysis
(dollars in thousands) For the Year Ended December 31,
------------------------------------------------------------------------------------------------------------------------------------
                                                          2003                          2002                         2001
                                          -------------------------------  -----------------------------  --------------------------
                                                     Interest    Average              Interest  Average             Interest Average
                                            Average   Income/    Yield/      Average   Income/  Yield/     Average   Income/ Yield/
                                            Balance   Expense    Rate        Balance   Expense  Rate       Balance   Expense Rate
                                          -------------------------------  -----------------------------  --------------------------
Assets
Interest-Earning Assets
    Interest-bearing balances with banks .   $ 106,395  $ 1,028     0.97%  $ 30,577     $ 408     1.33% $ 30,475   $ 1,011   3.32%
    Investment securities
       Taxable ...........................     345,048   13,334     3.86    241,475    13,272     5.50   113,261     7,332   6.47
       Non-taxable (1) ...................      62,508    4,358     6.97     31,229     2,441     7.82    22,095     1,824   8.26
    Loans receivable (2) (3) .............     622,525   41,833     6.72    627,001    44,188     7.05   679,532    50,946   7.50
    Allowance for loan losses ...........       (3,447)       -              (3,021)        -             (3,676)        -
                                          ------------- --------          ---------- ---------         ---------- ---------
    Net loans ............................     619,078   41,833     6.76    623,980    44,188     7.08   675,856    50,946   7.54
                                          ------------- --------          ---------- ---------         ---------- ---------
      Total interest-earning assets ......   1,133,029   60,553     5.34    927,261    60,309     6.50   841,687    61,113   7.26
    Non-interest earning assets ..........     121,964        -        -     33,531         -        -    35,352         -      -
                                          ------------- -------- -------- ---------- --------- ------- ---------- --------- ------
      Total Assets,
        Interest Income .................. $ 1,254,993   60,553            $960,792    60,309          $ 877,039    61,113
                                          ------------- --------          ---------- ---------         ---------- ---------

Liabilities
Interest-Bearing Liabilities
    Interest-bearing deposits
      Demand deposits ....................   $ 102,506      298     0.29   $ 81,609       466     0.57  $ 76,090       846   1.11
      Money market deposits .............      203,978    2,212     1.08    134,456     2,784     2.07   100,327     3,512   3.50
      Savings deposits ...................     182,548    1,315     0.72    111,689     1,680     1.50    97,778     2,127   2.18
      Certificates of deposit ...........      409,003   12,168     2.98    417,073    18,169     4.36   447,171    25,679   5.74
                                          ------------- -------- -------- --------- ---------- ------------------ --------- ------
        Total interest-bearing deposits ..     898,035   15,993     1.78    744,827    23,099     3.10   721,366    32,164   4.46

    Securities sold under agreements
      to repurchase ......................      11,931      131     1.10      7,330       155     2.11     2,431        94   3.87
    FHLB advances ........................     114,520    4,822     4.21     67,358     3,162     4.69    32,702     1,806   5.53
    Guaranteed preferred beneficial
      interests in Company's subordinated
      debentures .........................       2,507      115     4.59          -         -        -        -         -      -
                                          ------------- --------          --------- ----------         ---------- ---------
      Total interest-bearing liabilitites    1,026,993   21,061     2.05    819,515    26,416     3.22   756,499    34,064   4.50

Non-Interest-Bearing Liabilities
    Non-interest-bearing deposits ........      53,559        -        -     28,881         -        -    19,890         -      -
    Other liabilities ....................      13,832        -        -      7,603         -        -     8,356         -      -
                                          ------------- --------          --------- ----------         ---------- ---------
      Total Liabilities ..................   1,094,384   21,061             855,999    26,416            784,745    34,064
    Shareholders' Equity/ ................                                                                                      -
      Retained Earnings ..................     160,609        -             104,793         -             92,294         -
                                          ------------- --------          --------- ----------         ---------- ---------
    Total Liabilities & Shareholders'
      Equity, Interest Expense ........... $ 1,254,993   21,061            $960,792    26,416          $ 877,039    34,064
                                          ------------- --------          --------- ----------         ---------- ---------

Net interest income tax
   equivalent basis ......................               39,492                        33,893                       27,049
                                                        --------                    ----------                    ---------
    Net interest spread
      Tax equivalent basis (4) ...........                          3.29%                         3.28%                      2.76%
    Effect of interest-free sources
     used to fund earning assets .........                          0.20                          0.37                       0.45
                                                                 --------                      --------                     ------

Net interest margin
   tax equivalent basis (5) ..............                          3.49                          3.66                       3.21
                                                                 --------                      --------                     ------

Tax-exempt adjustment ....................               (1,490)                         (830)                        (620)
                                                      ----------                    ----------                    ---------

Net interest income and margin ...........             $ 38,002     3.35%             $33,063     3.57%           $ 26,429   3.14%
                                                      ========== ========           ========== ========           ========= ======

Average interest-earning assets
   to average interest-bearing
   liabilities ...........................                        110.32%                       113.15%                    111.26%
------------------------------------------------------------------------------------------------------------------------------------





</TABLE>

(1) Includes Federal Home Loan Bank stock.
(2) The indicated interest income and average yields are presented on a taxable
    equivalent basis. The taxable equivalent adjustments included above are $1.5
    million, $830,000 and $620,000 for the years 2003, 2002 and 2001,
    respectively. The effective tax rate used for the taxable equivalent
    adjustment was 34%.
(3) Loan fees of $1.5 million, $1.2 million and $793,000 for the years 2003,
    2002 and 2001, respectively, are included in interest income. Average loan
    balances include non-accruing loans of $1.7 million, $2.2 million and $1.8
    million and average loans held-for-sale of $3.1 million, $4.4 million and
    none for the years 2003, 2002 and 2001, respectively.
(4) Net interest spread is the arithmetic difference between yield on
    interest-earning assets and the rate paid on interest-bearing liabilities.
(5) Tax equivalent net interest margin is computed by dividing tax equivalent
    net interest income by average interest-earning assets.


                                      -37-
<PAGE>


         Rate Volume  Analysis.  The  following  table shows the extent to which
changes in interest rates and changes in volume of  interest-earning  assets and
interest-bearing  liabilities affected KNBT's interest income and expense during
the  periods  indicated.  For  each  category  of  interest-earning  assets  and
interest-bearing liabilities, information is provided on changes attributable to
(1)  changes  in rate,  which is the  change in rate  multiplied  by prior  year
volume,  and (2) changes in volume,  which is the change in volume multiplied by
prior year rate. The combined effect of changes in both rate and volume has been
allocated  proportionately  to the  change  due to rate  and the  change  due to
volume.

<TABLE>
<CAPTION>


<S>                                               <C>           <C>             <C>           <C>           <C>           <C>

------------------------------------------------------------------------------------------------------------------------------------

                                                          2003 Compared to 2002                       2002 Compared to 2001
                                                 ----------------------------------------   ----------------------------------------
                                                     Increase (Decrease)                       Increase (Decrease)
                                                               Due to                                    Due to
                                                 ----------------------------------------   ----------------------------------------
                                                                                Total                                      Total
                                                                                Increase                                   Increase
                                                    Rate        Volume         (Decrease)       Rate         Volume       (Decrease)
                                                 -----------  ------------   ----------------------------  ------------   ----------
                                                                                (dollars in thousands)
     Interest income:
         Cash and cash equivalents ............   $   (392)     $  1,012        $    620      $   (606)     $      3      $   (603)
         Investment securities ................     (5,790)        7,769           1,979        (2,734)        9,291         6,557
         Loans receivables, net ...............     (2,009)         (346)         (2,355)       (2,848)       (3,910)       (6,758)
                                                  --------      --------        --------      --------      --------      --------
             Total interest-earning assets ....     (8,191)        8,435             244        (6,188)        5,384          (804)

     Interest expense:
         Savings deposits .....................       (288)          120            (168)         (441)           61          (380)
         Checking deposits ....................     (2,011)        1,439            (572)       (1,923)        1,195          (728)
         Money market deposits ................     (1,431)        1,066            (365)         (749)          302          (447)
         Certificates of deposit ..............     (5,649)         (352)         (6,001)       (5,782)       (1,728)       (7,510)
                                                  --------      --------        --------      --------      --------      --------
             Total interest-bearing deposits ..     (9,379)        2,273          (7,106)       (8,895)         (170)       (9,065)

     Securities sold under agreements
       to repurchase ..........................       (121)           97             (24)         (122)          183            61
     FHLB advances and other borrowings .......       (554)        2,214           1,660          (562)        1,918         1,356
     Guaranteed preferred beneficial interests
       in company's subordinated debentures ...         --           115             115            --            --            --
                                                  --------      --------        --------      --------      --------      --------
             Total interest-bearing liabilities    (10,054)        4,699          (5,355)       (9,579)        1,931        (7,648)

     Increase (decrease) in net
       interest income ........................   $  1,863      $  3,736        $  5,599      $  3,391      $  3,453      $  6,844
                                                  ========      ========        ========      ========      ========      ========



</TABLE>


         The net interest income, on a fully taxable equivalent basis,  amounted
to $39.5  million  for 2003,  an  increase  of $5.6  million or 16.5% over $33.9
million in 2002. As shown in the  "Rate/Volume  Analysis" table, the increase in
net interest  income in 2003 was  attributable  to higher net interest income of
$3.7  million due to changes in volume and $1.9 million due to changes in rates.
The  volume-related  change  resulted  primarily  from  increases in  investment
securities and  interest-bearing  balances with banks reduced in part by a small
increase in loan  receivables  (see  discussions  on "Lending  Activities"),  an
increase in money market deposits, savings and demand deposits and FHLB advances
and other  deposits.  The  rate-related  change was  primarily the result of the
decrease of interest  earned on investment  securities and loans being less than
the decrease of interest paid on deposits and debt.

         The net interest income,  on a fully taxable  equivalent basis, in 2002
increased  $6.8  million or 25.3% over the 2001  figure of $27.2  million.  This
increase was the result of growth in investments  and loans,  reduced in part by
increases in time  deposits  and debt.  Also  affecting  2002 net income was the
decrease in interest  rates earned on loans and  investments  being greater than
the decrease on the interest rates paid on deposits and debt.

         The net interest margin, a measure of net interest income  performance,
is determined by dividing net interest income by total interest-earning  assets.
The net interest  margin was 3.35% for 2003,  3.57% for 2002 and 3.14% for 2001.
The net interest margin on a tax equivalent  basis was 3.49% for 2003,




                                      -38-
<PAGE>


3.66% for 2002 and 3.21% for 2001. The decrease in 2003 net interest  margin was
primarily due to the non-interest-earning  assets amounting to $124.6 million in
2003 as compared to $33.5 million in 2002. The interest spread is the difference
of interest  earned on assets less the interest  paid on deposits and debt.  The
interest   spread  was  3.29%,   3.28%  and  2.76%  for  2003,  2002  and  2001,
respectively.

Provision for Loan Losses

         The provision for loan losses is determined by management's  review and
analysis of the loan portfolio.  This evaluation  process includes,  among other
things,  an  analysis  of  delinquent  and  non-performing  loans,  the level of
charge-offs  and  recoveries,  the value of  collateral  securing the loan,  the
borrower's   ability  to  repay,   repayment   performance  and  local  economic
conditions.  The valuation also takes into  consideration  performing loans that
may have certain  weaknesses as identified by management in its review of loans.
A primary  factor in the  increased  provision  for 2003 as compared to 2002 was
$156.1  million  or 395.9%  increase  in total  commercial  related  loans.  The
commercial  loans acquired from First Colonial in the merger accounted for $61.5
million of this increase. An additional factor was the decision of management to
downgrade a  performing  $15.7  million  commercial  loan due to certain  credit
weaknesses.  The provision for loan losses amounted to $3.0 million for the year
ended  December  31, 2003 as compared to $111,000 in 2002.  The increase of $2.8
million was the result of  management's  ongoing  evaluation of risk elements in
KNBT's loan portfolio.  The provision in 2001 was $391,000. Net charge-offs were
$1.5 million, $570,000, and $342,000 in 2003, 2002, and 2001, respectively.  For
more information see "Business - Lending Activities - Non-Performing  Assets" in
Item 1.

Non-Interest Income

         Non-interest income increased in 2003 by $234,000 or 2.7% to a total of
$9.0 million from $8.8 million in 2002.  This  increase was primarily the result
of an increase in the fees earned on deposit services of $414,000 or 11.4%. Fees
on deposit  services  amounted to $4.0 million in 2003 and $3.6 million in 2002.
This  increase  was the result of a higher  number of deposit  accounts  and the
acquisition  of new accounts  due to the merger.  Other  non-interest  operating
income  increased  in 2003  over  2002 by $1.5  million  or  123.8%.  The  other
non-interest  operating  income was $2.8  million  and $1.2  million in 2003 and
2002,  respectively.  This increase was the result of higher loan fees including
mortgage  servicing  fees  and  increases  in other  fee  based  services.  Also
contributing  to  higher  non-interest  income  were  increases  of  $45,000  in
brokerage  services  revenues,  and  $80,000  in  earnings  on bank  owned  life
insurance  ("BOLI").  The revenues from brokerage services were $465,000 in 2003
and $420,000 in 2002.  The earnings on the bank owned life  insurance  were $1.5
million  and $1.4  million in 2003 and 2002,  respectively.  KNBT began  earning
revenues from trust  operations in November 2003 when trust powers were obtained
and the trust accounts were acquired due to the merger with First Colonial.  The
trust revenues for the last two months of 2003 amounted to $279,000.

         The  increases  in  non-interest  income  were offset in part by a $1.5
million decrease in the net gains on the sale of investment  securities and by a
$654,000  decrease in the gains on the sale of  residential  real estate  loans.
During 2003, KNBT had total net losses of $249,000 on the sales of $25.5 million
of securities  available-for-sale compared to total net gains of $1.2 million in
2002 on the sales of $63.8 million of securities available-for-sale.  The losses
in 2003 were due to the sale of some lower yielding and longer term  securities.
The gains on the sale of residential real estate loans were $246,000 in 2003 and
$900,000 in 2002.

         Non-interest  income  increased $3.8 million or 75.8% from $5.0 million
in 2001 to $8.8 million in 2002. Non-interest income increased from 2001 to 2002
as a result of increases in the net gains on the sales of investment  securities
of $1.2 million, increases in earnings on bank owned life insurance of $536,000,
increases in the net gains on the sale of loans of $792,000,  increased fees for
deposit  services of $923,000 and  increased  non-interest  operating  income of
$63,000.

Non-Interest Expense

         Non-interest  expense  increased  to $55.1  million  in 2003 from $24.6
million in 2002, a $30.5 million or 124.4%  increase.  The major factors in this
increase were the $16.1 million contribution to KNBT's new


                                      -39-
<PAGE>

charitable  foundation  and $5.7  million of expenses  related to the merger and
subsequent  integration  of systems and  operations at the Bank.  The merger and
integration  expenses  included  such items as severance  agreements,  supplies,
customer communication,  data processing upgrades and other costs.  Compensation
and benefits  expense  increased by $5.4 million or 41.0%.  These  expenses were
$18.6 million and $13.2 million in 2003 and 2002, respectively.  Contributing to
the increase in  compensation  and employee  benefit  expense were normal salary
increases,  additional  staff  required for the new branches  added in 2003, the
addition of 245 employees as a result of the merger with First  Colonial,  staff
increases in the lending and trust  divisions and a benefit  expense of $165,000
for the ESOP.  Occupancy  expense  increased  from $3.1  million in 2002 to $4.6
million in 2003,  an increase  of $1.5  million or 48.0%.  The higher  occupancy
expense  was the  result of the  addition  of new  branches,  the  purchase  and
renovation of a new operations center and additional  facilities acquired in the
merger.  All  other  expense  items  including  advertising,   data  processing,
professional services, supplies, postage, FDIC insurance premiums, impairment of
mortgage  servicing  rights and all other items totaled $10.1 million in 2003 as
compared to $8.3 million in 2002. This was an increase of $1.8 million or 21.9%.
These  increases  were  principally  due to the  growth of the  Company  and the
merger.

         Non-interest expense in 2002 increased $5.0 million or 25.3% over 2001.
Total  non-interest  expenses  were $24.6  million in 2002 and $19.6  million in
2001. The increase in  compensation  and employee  benefit  expense from 2001 to
2002 was $2.8  million or 26.9%.  Occupancy  expenses  in 2002 were  $467,000 or
17.8%  higher  than in 2001.  All other  non-interest  expenses  grew in 2002 as
compared  to 2001 by $1.7  million or 25.6% in 2002 over 2001.  In  addition  to
normal salary increases, compensation increased as the result of the addition of
new branches in 2002.  Also in 2002,  compared to 2001,  the  Company's  benefit
expense increased due to a $793,000  increase in retirement  expenses related to
the multiple  employer defined benefit pension plan,  matching  contributions to
the Company's 401k plan and the funding of the supplemental executive retirement
plans for certain executive officers.

Income Tax Expense (Benefit)

         KNBT had an income  tax  benefit  of $5.3  million  for the year  ended
December 31, 2003. The income tax expense in 2002 amounted to $5.2 million.  The
tax  benefit in 2003 was the result of a net  operating  loss for the year.  The
income tax expense in 2001 was $3.3 million.  KNBT's effective  Federal tax rate
was a benefit of (47.8)% for the year ended  December  31,  2003  compared to an
effective  tax rate of 30.2% for the year ended  December 31, 2002 and 29.1% for
the year ended December 31, 2001.

Market Risk

         Market risk is the risk of loss from adverse  changes in market  prices
and rates. KNBT's market risk arises primarily from the interest rate risk which
is  inherent  in its  lending  and  deposit  taking  activities.  To  that  end,
management  actively  monitors  and  manages  interest  rate risk  exposure.  In
addition  to  market  risk,  KNBT's  primary  risk is  credit  risk on its  loan
portfolio. KNBT attempts to manage credit risk through its loan underwriting and
oversight policies. See "Lending Activities".

         KNBT and the Bank operate as a community banking institution  primarily
in the counties of Northampton,  Lehigh, Monroe and Carbon,  Pennsylvania.  As a
result of its location and nature of  operations,  the Company is not subject to
foreign  currency  exchange or commodity  price risk. The Bank makes real estate
and other loans primarily in the counties adjacent to its operations and thus is
subject  to risks  associated  with  those  local  economies.  The Bank  holds a
concentration  of one-to  four-family  residential  real estate  loans (36.0% of
total loans) and  consumer/installment  loans (28.8% of total loans) in its loan
portfolio.  Loans for  automobiles  and other  vehicles  represent  38.5% of the
consumer/installment  loans  and  11.1% of total  loans.  The  Bank's  loans are
subject to interest and economic  risks.  The Bank also  originates  residential
real estate loans for sale in the secondary market. Such loans are identified as
"Mortgage Loans Held-for-Sale" on the Company's balance sheet and are subject to
interest rate risk (see discussion on "Loan Origination,  Sales and Servicing").
The  Company  does not own any  trading  assets  and  does not have any  hedging
transactions  in  place  such  as  interest  rate  swaps  (see   discussions  on
"Investment Activities").








                                      -40-
<PAGE>


Interest Rate Sensitivity

         Interest  rate  sensitivity  is a  measure  of the  extent to which net
interest income would change due to changes in the level of interest rates.

         The  principal  objective  of  KNBT's  interest  rate  risk  management
function is to evaluate the interest rate risk embedded in certain balance sheet
accounts, determine the level of risk appropriate,  given its business strategy,
operating  environment,  capital  and  liquidity  requirements  and  performance
objectives,  and manage the risk  consistent with approved  guidelines.  Through
such management,  KNBT seeks to reduce the exposure of its operations to changes
in interest rates.  KNBT monitors interest rate risk as such risk relates to its
operating  strategies.   KNBT  has  established  an  Asset/Liability  Committee,
responsible  for reviewing its  asset/liability  policies and interest rate risk
position.  The Asset/Liability  Committee meets on a quarterly basis. The extent
of the movement of interest rates is an  uncertainty  that could have a negative
impact on future earnings of KNBT.

         KNBT primarily has utilized the following  strategies in its efforts to
manage interest rate risk:

     o    It has  emphasized  originations  for portfolio of shorter term loans,
          particularly construction loans, commercial loans and consumer loans;

     o    It has been an  active  seller  in the  secondary  market of its newly
          originated,  agency eligible long-term fixed-rate residential mortgage
          loans  and  it   securitized   an  aggregate   of  $47.3   million  of
          single-family residential mortgage loans in 2003 and $115.3 million in
          2002;

     o    It has invested in securities with relatively short anticipated lives,
          generally three to five years.

         Gap Analysis. The matching of assets and liabilities may be analyzed by
examining the extent to which such assets and  liabilities  are  "interest  rate
sensitive" and by monitoring a bank's interest rate sensitivity  "gap." An asset
and  liability  is said to be interest  rate  sensitive  within a specific  time
period if it will mature or reprice  within that time period.  The interest rate
sensitivity   gap  is  defined  as  the   difference   between   the  amount  of
interest-earning  assets maturing or repricing within a specific time period and
the amount of  interest-bearing  liabilities  maturing or repricing  within that
same time period. At December 31, 2003, KNBT's cumulative one-year interest rate
gap,  which is the  difference  between  the amount of  interest-earning  assets
maturing or repricing within one year and interest-bearing  liabilities maturing
or repricing  within one year, as a percentage  of total assets,  was a positive
13.77%. A gap is considered  positive when the amount of interest rate sensitive
assets  exceeds  the amount of interest  rate  sensitive  liabilities.  A gap is
considered  negative  when the amount of  interest  rate  sensitive  liabilities
exceeds the amount of interest rate sensitive assets.  During a period of rising
interest  rates,  a negative  gap would tend to affect  adversely  net  interest
income  while a positive gap would tend to result in an increase in net interest
income.  Conversely,  during a period of falling  interest rates, a negative gap
would tend to result in an increase in net interest  income while a positive gap
would tend to affect adversely net interest income.

         The following  table sets forth the amounts of KNBT's  interest-earning
assets and interest-bearing  liabilities outstanding at December 31, 2003, which
are expected,  based upon certain  assumptions,  to reprice or mature in each of
the future time periods shown,  commonly termed, the GAP Table. Except as stated
below, the amount of assets and liabilities shown which reprice or mature during
a particular  period were  determined in accordance  with the earlier of term to
repricing or the contractual maturity of the asset or liability.  The table sets
forth an approximation  of the projected  repricing of assets and liabilities at
December  31,  2003,  on  the  basis  of  contractual  maturities,   anticipated
prepayments,  and scheduled  rate  adjustments  within a three-month  period and
subsequent  selected  time  intervals.  The loan  amounts  in the table  reflect
principal  balances  expected  to be  repaid  and/or  repriced  as a  result  of
contractual  amortization and anticipated  prepayments of adjustable-rate  loans
and  fixed-rate  loans,  and as a result  of  contractual  rate  adjustments  on
adjustable-rate   loans.   Annual  prepayment  rates  for   adjustable-rate  and
fixed-rate  single-family  and multi-family  mortgage loans are assumed to range
from 14% to 32%. The annual  prepayment rate for  mortgage-backed  securities is
assumed  to range  from  14% to 32%.  Money  market  deposit  accounts,  savings
accounts and interest-bearing checking accounts are assumed to have annual rates
of withdrawal, or "decay rates," of 20%, 15% and 15%, respectively.


                                      -41-
<PAGE>

<TABLE>
<CAPTION>


<S>                                 <C>          <C>          <C>            <C>          <C>             <C>            <C>
------------------------------------------------------------------------------------------------------------------------------------

                                                                          At December 31, 2003
------------------------------------------------------------------------------------------------------------------------------------
                                                  More than     More than    More than        More than
                                       3 Months    3 Months     6 Months       1 Year          3 Years      More than
                                        or Less  to 6 Months    to 1 Year    to 3 Years       to 5 Years     5 Years       Total
                                    -----------  -----------  -----------    -----------  -----------     -----------    -----------

                                                                            (dollars in thousands)
Interest-earning assets (1):
   Deposits at other institutions   $    85,422  $      --    $      --      $      --    $      --       $      --      $    85,422
   Debt investment securities ...        31,515       40,677       85,379        224,021      140,991         193,626        716,209
   Loans receivable (2) .........       287,766       76,607      139,187        292,449      114,979          11,333        922,321
   Equity securities ............          --           --           --             --           --            29,421         29,421
                                    -----------  -----------  -----------    -----------  -----------     -----------    -----------
      Total interest-earning
        assets ..................   $   404,703  $   117,284  $   224,566    $   516,470  $   255,970     $   234,380    $ 1,753,373
                                    ===========  ===========  ===========    ===========  ===========     ===========    ===========
   Cumulative total interest-
     earning assets .............   $   404,703  $   521,987  $   746,553    $ 1,263,023  $ 1,518,993     $ 1,753,373    $ 1,753,373
                                    ===========  ===========  ===========    ===========  ===========     ===========    ===========
Interest-bearing
   liabilities:
   Savings deposits .............   $     8,847  $     8,847  $    17,694    $    66,352  $    66,353     $    53,083    $   221,176
   Interest-bearing
      checking deposits .........         6,550        6,550       13,100         49,126       49,126          39,297        163,749
   Money market deposits ........        11,976       11,976       23,953         95,808       95,808            --          239,521
   Certificates of deposit ......        82,521       72,871      145,742        181,254       37,285          28,021        547,694
   FHLB advances and other
        borrowings ..............        47,708        6,458       14,316         49,266       64,823          64,132        246,703
                                    -----------  -----------  -----------    -----------  -----------     -----------    -----------
        Total interest-bearing
          liabilities ...........   $   157,602  $   106,702  $   214,805    $   441,806  $   313,395     $   184,533    $ 1,418,843
                                    ===========  ===========  ===========    ===========  ===========     ===========    ===========

Cumulative total interest-
   bearing liabilities ..........   $   157,602  $   264,304  $   479,109    $   920,915  $ 1,234,310     $ 1,418,843    $ 1,418,843
                                    ===========  ===========  ===========    ===========  ===========     ===========    ===========

Interest-earning assets
   less interest-bearing
   liabilities ..................   $   247,101  $    10,582  $     9,761    $    74,664  $   (57,425)    $    49,847    $   334,530
                                    ===========  ===========  ===========    ===========  ===========     ===========    ===========

Cumulative interest-rate
   sensitivity gap (3) ..........   $   247,101  $   257,683  $   267,444    $   342,108  $   284,683     $   334,530
                                    ===========  ===========  ===========    ===========  ===========     ===========
Cumulative interest-rate
   gap as a percentage
   of total assets at
   December 31, 2003 ............         12.73%       13.27%       13.77%         17.62%       14.66%         17.23%

Cumulative interest-
   earning assets as a
   percentage of
   cumulative interest-
   bearing liabilities at
   December 31, 2003 ............        256.79%      197.49%      155.82%        137.15%      123.06%         123.58%

------------------------------------------------------------------------------------------------------------------------------------

</TABLE>

(1)  Interest-earning assets are included in the period in which the balances
     are expected to be redeployed and/or repriced as a result of anticipated
     prepayments, scheduled rate adjustment and contractual maturities.
(2)  For purposes of the gap analysis, loans receivable includes non-performing
     loans, gross of the allowance for loan losses, undisbursed loan funds and
     deferred loan fees.
(3)  Interest-rate sensitivity gap represents the difference between net
     interest-earning assets and interest-bearing liabilities.


                                      -42-
<PAGE>



                               KNBT BANCORP, INC.


         Certain  shortcomings are inherent in the method of analysis  presented
in the foregoing table. For example, although certain assets and liabilities may
have similar  maturities  or periods to  repricing,  they may react in different
degrees to changes in market interest rates. Also, the interest rates on certain
types of assets and  liabilities  may  fluctuate in advance of changes in market
interest  rates,  while  interest rates on other types may lag behind changes in
market rates. Additionally,  certain assets, such as adjustable-rate loans, have
features which restrict changes in interest rates both on a short-term basis and
over the life of the asset. Further, in the event of a change in interest rates,
prepayment and early withdrawal levels would likely deviate  significantly  from
those assumed in calculating the table.  Finally,  the ability of many borrowers
to service their  adjustable-rate loans may decrease in the event of an interest
rate increase.

         KNBT's interest rate sensitivity is monitored by management through the
use of models that generate  estimates of the change in its net portfolio  value
("NPV") and net interest income ("NII") over a range of interest rate scenarios.
NPV is the present  value of expected cash flows from assets,  liabilities,  and
off-balance sheet contracts. The NPV ratio, under any interest rate scenario, is
defined as the NPV in that scenario divided by the market value of assets in the
same scenario.  KNBT also analyzes  potential  changes to NII for a twelve-month
period under rising and falling  interest rate  scenarios.  The following  table
sets forth  KNBT's NPV and NII as of December  31, 2003 and reflects the changes
to NPV and NII as a result of immediate and sustained  changes in interest rates
as indicated.

<TABLE>
<CAPTION>



<S>                                        <C>                 <C>                 <C>                  <C>
------------------------------------------------------------------------------------------------------------
                                        Net Portfolio Value
                                        at December 31, 2003               Net Interest Income for 2004
                                -------------------------------------  -------------------------------------
                                                   Percent Change                        Percent Change
                                                        from                                   from
Rate Scenario                      Amount             Base Case           Amount             Base Case
------------------------------  --------------   --------------------  -------------------------------------
                                                          (dollars in thousands)
+300 basis point rate shock ....    $ 366,674           (13.5%)             $ 69,110             4.7%
+200 basis point rate shock ....      390,100            (8.0%)               68,850             4.3%
+100 basis point rate shock ....      409,860            (3.3%)               68,298             3.5%
Static - base case ............       423,908               --                66,010              --
-100 basis point rate shock ...       410,745            (3.1%)               59,448            (9.9%)
-200 basis point rate shock ...       398,318            (6.0%)               53,119           (19.5%)
-300 basis point rate shock ...       387,533            (8.6%)               48,424           (26.6%)

------------------------------------------------------------------------------------------------------------

</TABLE>



Liquidity

         KNBT's  primary  sources of funds are from  deposits,  amortization  of
loans,  loan prepayments and the maturity of loans,  mortgage-backed  securities
and other investments, and other funds provided from operations. While scheduled
payments  from the  amortization  of loans and  mortgage-backed  securities  and
maturing  investment  securities  are relatively  predictable  sources of funds,
deposit flows and loan prepayments can be greatly influenced by general interest
rates, economic conditions and competition.  KNBT also maintains excess funds in
short-term,  interest-bearing  assets that provide additional liquidity and also
utilizes  outside  borrowings,  primarily  from the  Federal  Home  Loan Bank of
Pittsburgh, as an additional funding source.

         KNBT uses its liquidity to fund  existing and future loan  commitments,
to fund maturing  certificates  of deposit and demand  deposit  withdrawals,  to
invest in other  interest-earning  assets,  and to meet operating  expenses.  In
addition to cash flow from loan and securities  payments and prepayments as well
as from sales of  available-for-sale  securities  and mortgage  loans,  KNBT has
significant  borrowing  capacity  available to fund  liquidity  needs.  KNBT has
increased its utilization of FHLB borrowings in recent years as a cost efficient
addition  to  deposits  as a  source  of  funds.  The  average  balance  of FHLB
borrowings  was $114.5  million,  $67.4  million and $32.7 million for the years
ended December 31, 2003, 2002, and 2001,  respectively.  To date KNBT borrowings
have  consisted  primarily  of  advances  from the  Federal  Home  Loan  Bank of
Pittsburgh.



                                      -43-
<PAGE>


         KNBT  has not  used,  and has no  intention  to  use,  any  significant
off-balance  sheet financing  arrangements for liquidity  purposes.  Its primary
financial  instruments with off-balance sheet risk are limited to loan servicing
for  others,  obligations  to fund  loans  to  customers  pursuant  to  existing
commitments and  commitments to sell mortgage  loans. In addition,  KNBT had not
had, and has no intention to have, any significant transactions, arrangements or
other relationships with any unconsolidated, limited purpose entities that could
materially affect its liquidity or capital resources. KNBT has not, and does not
intend to, trade in commodity contracts.

         KNBT  anticipates  that it will continue to have  sufficient  funds and
alternative funding sources to meet its current commitments.

         KNBT's contractual obligations as of December 31, 2003 are as follows:
<TABLE>
<CAPTION>





<S>                                        <C>                <C>             <C>               <C>              <C>
Contractual Obligations
At December 31, 2003
--------------------------------------------------------------------------------------------------------------------------
                                                                           Payments Due by Period:
                                                       -------------------------------------------------------------------
                                                          Less Than                                          More Than
                                           Total           1 Year         1-3 Years         3-5 Years         5 Years
-------------------------------------- --------------  ---------------- ---------------  ----------------  ---------------
                                                                         (dollars in thousands)
Federal Home Loan Bank debt ...........    $ 207,153          $ 24,300        $ 40,000          $ 74,626         $ 68,227
Trust preferred securities ............       15,000                 -               -                 -           15,000
Operating leases ......................       10,545             1,317           2,166             1,361            5,701
Severance agreements ..................        1,220             1,028             192                 -                -
Deferred directors' fees and
  officer compensation ...............         2,691                98             104               112            2,377
                                       --------------  ---------------- ---------------  ----------------  ---------------

Total obligations .....................    $ 236,609          $ 26,743        $ 42,462          $ 76,099         $ 91,305
                                       ==============  ================ ===============  ================  ===============

Off-Balance-Sheet Obligations

         KNBT is a party to financial instruments with off-balance-sheet risk in
the normal  course of business  to meet the  financing  needs of its  customers.
These  financial  instruments  include  commitments to extend credit and standby
letters of credit.  Those instruments  involve, to varying degrees,  elements of
credit  risk in excess of the amount  recognized  in the balance  sheet.  KNBT's
exposure  to credit loss in the event of  non-performance  by the other party to
the financial instrument for commitments to extend credit and standby letters of
credit is represented by the contractual  notional amount of those  instruments.
KNBT  uses the same  credit  policies  in  making  commitments  and  conditional
obligations  as it does  for  on-balance-sheet  instruments  (see  Note N of the
"Notes to Consolidated Financial Statements").

         KNBT's contingent liabilities and commitments as of December 31, 2003
are as follows:


--------------------------------------------------------------------------------------------------------------------------
Contingent Liabilities and Commitments
At December 31, 2003
--------------------------------------------------------------------------------------------------------------------------
                                                          Less Than                                          More Than
                                           Total           1 Year         1-3 Years         3-5 Years         5 Years
-------------------------------------- --------------  ---------------- ---------------  ----------------  ---------------
                                                                         (dollars in thousands)
Lines of credit .......................    $ 139,105          $ 71,364        $ 12,230          $ 29,450         $ 26,061
Standby letters of credit .............       15,297             7,795           7,448                54               --
Other commitments to make loans .......      130,802           110,848           5,251               456           14,247
                                       --------------  ---------------- ---------------  ----------------  ---------------
Total .................................    $ 285,204         $ 190,007        $ 24,929          $ 29,960         $ 40,308
                                       ==============  ================ ===============  ================  ===============


</TABLE>


                                      -44-
<PAGE>


         Impact of Inflation  and Changing  Prices.  The  financial  statements,
accompanying  notes,  and related  financial data of KNBT presented  herein have
been prepared in accordance with generally accepted accounting principals, which
require the measurement of financial  position and operating results in terms of
historical dollars without  considering the changes in purchasing power of money
over  time due to  inflation.  The  impact  of  inflation  is  reflected  in the
increased cost of operations. Most of KNBT's assets and liabilities are monetary
in nature:  therefore,  the impact of interest rates has a greater impact on its
performance  than the effects of general levels of inflation.  Interest rates do
not  necessarily  move in the same direction or to the same extent as the prices
of goods and services.

Conversion from Mutual to Stock Form and Capital Resources

         On October 31, 2003 KNBT completed its sale of common stock.  KNBT sold
20,201,188  shares  of  common  stock at a price of  $10.00  per share for total
proceeds of $202.0  million.  The  capitalized  expenses for the conversion were
$5.8 million  resulting in net proceeds of $196.2  million.  Concurrent with the
conversion KNBT established the Keystone Nazareth  Charitable  Foundation with a
contribution of 1,616,095 shares of KNBT common stock to the Foundation.

         Also concurrent  with the  conversion,  KNBT acquired First Colonial on
October  31,  2003.  KNBT  issued  8,545,855  shares  of  common  stock  to  the
shareholders  of First Colonial in exchange for their First Colonial shares (see
"Merger with First Colonial Group").

         In connection with the conversion,  KNBT also established the ESOP. The
ESOP  purchased  949,845  shares in the market at an average price of $17.01 per
share for a total cost of $16.1 million.  In December,  2003,  9,723 KNBT common
shares were allocated to the plan participants at their fair value of $164,000.

         At  December  31,  2003  KNBT  had   29,479,275   total  common  shares
outstanding. This number does not include 940,122 unallocated shares held in the
ESOP. The average shares  outstanding for 2003 (months of November and December,
only) excluding unallocated ESOP shares, was 28,502,462.

         KNBT's total  shareholders'  equity was $389.1  million at December 31,
2003 as compared to $111.0 million at December 31, 2002. This was an increase of
$278.1 million or 250.4%. The increase in shareholders' equity was the result of
net proceeds from the stock  offering of $196.2  million,  the issuance of $85.5
million  of KNBT  common  stock to former  First  Colonial  shareholders  in the
merger,  the  contribution of $16.1 million of KNBT common stock to the Keystone
Nazareth  Charitable  Foundation,  the change in  unrealized  gain on investment
securities,  net of  deferred  taxes  of $1.6  million,  net  proceeds  from the
exercise of stock options of $311,000 and the allocation in KNBT's ESOP of 9,723
shares of stock with a fair  market  value of  $165,000.  These  increases  were
partially  offset by KNBT's net loss from operations in 2003 of $5.8 million and
the purchase of shares of common stock for the ESOP of $16.1 million.

         The  Company  and the Bank are  subject to various  regulatory  capital
requirements  administered  by the  Federal  banking  agencies.  Failure  to met
minimum  capital  requirements  can  initiate  certain  mandatory  and  possible
additional discretionary actions by regulators that, if undertaken, could have a
direct  material  effect  on  the  Company's  financial  statements.  Additional
information  relating  to the  Company's  and Bank's  capital  requirements  and
capital  ratios can be found in Note P of the "Notes to  Consolidated  Financial
Statements."

Merger with First Colonial Group

         On October 31, 2003,  KNBT acquired First Colonial  Group,  Inc. (First
Colonial) and its subsidiaries,  Nazareth National Bank and Trust Company, First
C.G.  Company,  Inc. and First Colonial  Statutory Trust I. First Colonial Group
was merged into KNBT and  Nazareth  National  Bank and Trust  Company was merged
into the Bank to form Keystone Nazareth Bank & Trust Company.



                                      -45-
<PAGE>


         At October 31, 2003 First Colonial had $610.4 million in assets.  Under
the terms of the merger,  each outstanding  share of First Colonial common stock
was converted to 3.7 shares of KNBT common  stock,  resulting in the issuance of
8,545,855  shares of KNBT's  common  stock in the merger.  First  Colonial had a
stock  option  plan  which  had  options  to  acquire  218,417  shares  of First
Colonial's common stock at October 31, 2003. Pursuant to the terms of the merger
agreement,  these options were  converted at the 3.7 exchange rate to options to
acquire 808,157 shares of KNBT's common stock.

         The merger  transaction  was accounted for under the purchase method of
accounting.  The results of operations include the operation acquired from First
Colonial  for the period  October 31,  2003  through  December  31,  2003.  More
information  is available in KNBT's  reports on Form 8-K dated January 14, 2004,
December  23, 2003 and  November 3, 2003 each filed with the SEC,  and in KNBT's
registration statement on Form S-1 filed with the SEC on June 6, 2003.

New Accounting Pronouncements

         The  Bank  adopted  FIN  45,  "Guarantor's  Accounting  and  Disclosure
Requirements  for Guarantees  including  Indirect  Guarantees of Indebtedness of
Others,"  on  January 1,  2003.  FIN 45  requires  a  guarantor  entity,  at the
inception  of  a  guarantee  covered  by  the  measurement   provisions  of  the
interpretation,  to  record a  liability  for the fair  value of the  obligation
undertaken in issuing the  guarantee.  The Bank has  financial  and  performance
letters of credit.  Financial letters of credit require the Bank to make payment
if  the  customer's  financial  condition   deteriorates,   as  defined  in  the
agreements.  FIN 45  applies  prospectively  to  guarantees  the Bank  issues or
modifies subsequent to December 31, 2002. The required  disclosures are included
in these financial statements.

         In January  2003,  the FASB  issued  FASB  Interpretation  46 (FIN 46),
"Consolidation of Variable Interest  Entities." FIN 46 clarifies the application
of  Accounting  Research  Bulletin 51,  Consolidated  Financial  Statements,  to
certain  entities in which voting  rights are not effective in  identifying  the
investor  with the  controlling  financial  interest.  An entity is  subject  to
consolidation under FIN 46 if the investors either do not have sufficient equity
at risk for the entity to finance its activities without additional subordinated
financial  support,  are unable to direct the  entity's  activities,  or are not
exposed to the entity's  losses or entitled to its residual  returns  ("variable
interest entities").  Variable interest entities within the scope of FIN 46 will
be  required  to be  consolidated  by their  primary  beneficiary.  The  primary
beneficiary  of a variable  interest  entity is  determined to be the party that
absorbs a majority of the entity's  expected losses,  receives a majority of its
expected  returns,  or both.  Management  has  determined  that  First  Colonial
Statutory  Trust I qualifies as a variable  interest  entity under FIN 46. First
Colonial  Statutory  Trust I issued  mandatorily  redeemable  preferred stock to
investors and loaned the proceeds to the Company. First Colonial Statutory Trust
I holds,  as its sole asset,  subordinated  debentures  issued by the Company in
2002.  First Colonial  Statutory Trust I is currently  included in the Company's
consolidated  balance  sheet and  statements  of  operations.  The  Company  has
evaluated the impact of FIN 46 and concluded it should  continue to  consolidate
First  Colonial  Statutory  Trust I as of December 31, 2003,  in part due to its
ability to call the preferred  stock prior to the mandatory  redemption date and
thereby benefit from a decline in required dividend yields.

         Subsequent  to the  issuance  of FIN 46,  the  FASB  issued  a  revised
interpretation,  FIN 46(R),  the  provisions of which must be applied to certain
variable  interest  entities by March 31, 2004.  The Company  plans to adopt the
provisions  under the revised  interpretation  in the first quarter of 2004. FIN
46(R) will require KNBT to deconsolidate  First Colonial Statutory Trust I as of
March 31, 2004. FIN 46(R) precludes consideration of the call option embedded in
the preferred stock when  determining if the Company has the right to a majority
of First Colonial Statutory Trust I expected residual returns.  Accordingly, the
Company will  deconsolidate  First Colonial  Statutory Trust I at the end of the
first quarter, which will result in an increase in outstanding debt by $464,000.
The banking  regulatory  agencies have not issued any guidance that would change
the regulatory  capital treatment for the  trust-preferred  securities issued by
First Colonial Statutory Trust I based on the adoption of FIN 46(R). However, as
additional  interpretations from the banking regulators related to entities such
as First Colonial Statutory Trust I become available, management will reevaluate
its   potential   impact  to  its  Tier  I  capital   calculation   under   such
interpretations.




                                      -46-
<PAGE>


         In October 2003,  the AICPA issued SOP 03-3,  "Accounting  for Loans or
Certain Debt Securities Acquired in a Transfer." SOP 03-3 applies to a loan with
the evidence of  deterioration of credit quality since  origination  acquired by
completion of a transfer for which it is probable at acquisition,  that the Bank
will be unable to collect all contractually  required payments  receivable.  SOP
03-3 is effective for loans  acquired in fiscal years  beginning  after December
31, 2004.  Early adoption is permitted.  Management is currently  evaluating the
provisions of SOP 03-3 and does not  anticipate  its adoption to have a material
affect on the Bank's financial position or results of operations.

         The Bank  adopted  EITF 03-1,  "The  Meaning  of Other  than  Temporary
Impairment and Its Application to Certain Investments," as of December 31, 2003.
EITF 03-1 includes certain  disclosures  regarding  quantitative and qualitative
disclosures for investment  securities  accounted for under FAS 115,  Accounting
for Certain Investments in Debt and Equity Securities,  that are impaired at the
balance  sheet  date,  but  an  other-than-temporary  impairment  has  not  been
recognized. The disclosure under EITF 03-1 are required for financial statements
for years  ending after  December  15, 2003 and are included in these  financial
statements.


Item 7.A   Quantitative and Qualitative Disclosure About Market Risks
--------   ----------------------------------------------------------

         Information with respect to quantitative and qualitative  disclosure is
contained in Item 7 "Management's Discussion and Analysis of Financial Condition
and Results of Operations."



                                      -47-
<PAGE>



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



REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS

Board of Directors
KNBT Bancorp, Inc.


         We have audited the  accompanying  consolidated  balance sheets of KNBT
Bancorp,  Inc. (and  previously  Keystone  Savings Bank) and  subsidiaries as of
December 31, 2003 and 2002, and the related  consolidated  statements of income,
changes in  shareholders'  equity and cash flows for each of the three  years in
the  period  ended  December  31,  2003.  These  financial  statements  are  the
responsibility of the Company's management.  Our responsibility is to express an
opinion on these financial statements based on our audits.

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

         In our opinion,  the  financial  statements  referred to above  present
fairly, in all material  respects,  the consolidated  financial position of KNBT
Bancorp,  Inc.  and  subsidiaries  as of  December  31,  2003 and 2002,  and the
consolidated  results of their operations and their  consolidated cash flows for
each of the three years in the period ended  December 31,  2003,  in  conformity
with accounting principles generally accepted in the United States of America.



/s/ Grant Thornton LLP

Philadelphia, Pennsylvania
January 31, 2004



                                      -48-
<PAGE>

<TABLE>
<CAPTION>



<S>                                                            <C>                  <C>
KNBT BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
----------------------------------------------------------------------------------------------------
(dollars in thousands)                                                  At December 31,
                                                             ---------------------------------------
                                                                   2003                 2002
----------------------------------------------------------------------------------------------------
      ASSETS
          Cash and Due From Banks ..........................   $    53,555          $    33,535
          Interest-Bearing Deposits With Banks .............        85,422               52,758
                                                               -----------          -----------
            Cash and Cash Equivalents ......................       138,977               86,293
          Investment Securities Available-for-Sale .........       734,087              294,150
          Federal Home Loan Bank of Pittsburgh Stock .......        11,543                8,011
          Mortgage Loans Held-for-Sale .....................         4,677               23,796
          Loans ............................................       890,076              558,453
          Less:  Allowance for Loan Losses .................        (7,910)              (2,927)
                                                               -----------          -----------
            Net Loans ......................................       882,166              555,526
          Bank Owned Life Insurance ........................        57,849               26,334
          Premises and Equipment, Net ......................        35,867               12,178
          Accrued Interest Receivable ......................         7,645                4,964
          Goodwill and Other Intangible Assets .............        47,448                  912
          Other Assets .....................................        20,542                3,742
                                                               -----------          -----------
            TOTAL ASSETS ...................................   $ 1,940,801          $ 1,015,906
                                                               ===========          ===========

      LIABILITIES
          Deposits .........................................   $ 1,289,410          $   771,825
          Securities Sold Under Agreements to Repurchase ...        24,550                8,904
          Advances from the Federal Home Loan Bank .........       207,153              113,500
          Guaranteed Preferred Beneficial Interest in the
            Company's Subordinated Debentures ..............        15,000                   --
          Accrued Interest Payable .........................         3,218                  711
          Other Liabilities ................................        12,390                9,917
                                                               -----------          -----------
            TOTAL LIABILITIES ..............................     1,551,721              904,857
                                                               -----------          -----------

      SHAREHOLDERS' EQUITY
          Preferred Stock, no par
            Authorized:  20,000,000 shares .................            --                   --
          Common Stock, Par Value $0.01 a share ............           295                   --
            Authorized:  100,000,000 shares
             Issued and Outstanding:
              29,479,275 shares at Dec. 31, 2003 and None at
              Dec. 31, 2002
          Additional Paid-In Capital .......................       297,887                   --
          Retained Earnings ................................       100,570              106,326
          Unallocated Common Stock Held
            by Employee Stock Ownership Plan ...............       (15,987)                  --
          Accumulated Other Comprehensive Income ...........         6,315                4,723
                                                               -----------          -----------
          TOTAL SHAREHOLDERS' EQUITY .......................       389,080              111,049
                                                               -----------          -----------

          TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY .......   $ 1,940,801          $ 1,015,906
                                                               ===========          ===========

</TABLE>

          See accompanying notes to consolidated financial statements.

                                      -49-
<PAGE>

<TABLE>
<CAPTION>



<S>                                                               <C>           <C>          <C>

KNBT BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS

-----------------------------------------------------------------------------------------------------
(dollars in thousands)
                                                                          Year Ended December 31,
                                                                  -----------------------------------
                                                                    2003          2002          2001
                                                                  --------      --------     --------
     INTEREST INCOME
        Loans, including fees ...............................     $ 41,823      $ 44,188     $ 50,946
        Investment Securities ...............................       16,212        14,883        8,536
        Other Interest ......................................        1,028           408        1,011
                                                                  --------      --------     --------
            Total Interest Income ...........................       59,063        59,479       60,493
                                                                  --------      --------     --------

     INTEREST EXPENSE
        Deposits ............................................       15,993        23,099       32,164
        Securities Sold Under Agreements to Repurchase ......          131           155           94
        Advances from the Federal Home Loan Bank ............        4,822         3,162        1,806
        Trust-Preferred Securities ..........................          115            --           --
                                                                  --------      --------     --------
            Total Interest Expense ..........................       21,061        26,416       34,064
                                                                  --------      --------     --------

     NET INTEREST INCOME ....................................       38,002        33,063       26,429
        Provision for Loan Losses ...........................        2,951           111          391
                                                                  --------      --------     --------

        Net Interest Income After Provision
          for Loan Losses ...................................       35,051        32,952       26,038
                                                                  --------      --------     --------

     NON-INTEREST INCOME
        Trust Revenue .......................................          279            --           --
        Brokerage Services Revenue ..........................          465           420          100
        Deposit Service Charges .............................        4,042         3,628        2,705
        Bank Owned Life Insurance ...........................        1,515         1,435          899
        Net Gains ( Losses) on Sales of Investment Securities         (249)        1,202           35
        Net Gains on Sales of Residential Mortgage Loans ....          246           900          108
        Non-Interest Operating Income .......................        2,750         1,229        1,166
                                                                  --------      --------     --------

            Total Non-Interest Income .......................        9,048         8,814        5,013
                                                                  --------      --------     --------

     NON-INTEREST EXPENSES
        Compensation and Employee Benefits ..................       18,633        13,217       10,414
        Net Occupancy and Equipment Expense .................        4,599         3,086        2,619
        Professional Fees ...................................        1,083           868          419
        Advertising .........................................          350           840          728
        Data Processing .....................................        2,124         1,712        1,603
        Impairment of Mortgage Servicing Rights .............        1,068           676          236
        Contributions to Charitable Foundation ..............       16,161            --           --
        Merger-Related Expenses .............................        5,652            --           --
        Other Operating Expenses ............................        5,449         4,169        3,594
                                                                  --------      --------     --------

            Total Non-Interest Expenses .....................       55,119        24,568       19,613
                                                                  --------      --------     --------

     Income (Loss) Before Income Taxes (Benefit) ............      (11,020)       17,198       11,438
     Income Taxes (Benefit) .................................       (5,264)        5,188        3,326
                                                                  --------      --------     --------

     NET INCOME (LOSS) ......................................     $ (5,756)     $ 12,010     $  8,112
                                                                  ========      ========     ========

     PER SHARE DATA
        Net Income - Basic ..................................        N/M           N/A          N/A
                                                                  ========      ========     ========
        Net Income - Diluted ................................        N/M           N/A          N/A
                                                                  ========      ========     ========


          See accompanying notes to consolidated financial statements.

</TABLE>


                                      -50-
<PAGE>

<TABLE>
<CAPTION>

<S>                <C>                                       <C>       <C>           <C>       <C>            <C>         <C>

KNBT BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY

------------------------------------------------------------------------------------------------------------------------------------
(dollars in thousands)                                                                                       Accumulated
                                                               Common     Additional            Unallocated     Other
                                               Common          Stock       Paid-In    Retained     ESOP     Comprehensive
                                               Shares          Value       Capital    Earnings    Shares       Income       Total
-----------------------------------------------------------------------------------------------------------------------------------
Balance at January 1, 2000 ...................            -     $   -       $    -    $ 86,204  $       -      $ 732       $ 86,936
                         2001
Comprehensive Income
   Net Income ................................                                           8,112                                8,112
   Other Comprehensive Income Net of Taxes ...                                                                   740            740
                                                                                                                     --------------
Total Comprehensive Income ...................                                                                                8,852
                                               ------------------------------------------------------------------------------------
Balance at December 31, 2001 .................            -         -            -      94,316          -      1,472         95,788
                         2002
Comprehensive Income
   Net Income ................................                                          12,010                               12,010
   Other Comprehensive Income Net of Taxes ...                                                                 3,251          3,251
                                                                                                                     --------------
Total Comprehensive Income ...................                                                                               15,261
                                               ------------------------------------------------------------------------------------
Balance at December 31, 2002 .................            -         -            -    106,326           -      4,723       111,049
                         2003
Comprehensive Loss
   Net Loss ..................................                                         (5,756)                               (5,756)
   Other Comprehensive Income Net of Taxes
      and Reclassification Adjustments .......                                                                 1,592          1,592
                                                                                                                     --------------
Total Comprehensive Loss                                                                                                     (4,164)
Proceeds from Sale of Common Stock, Net ......   20,201,188       202      196,059                                          196,261
Shares in merger with First Colonial .........    8,545,855        85       85,374                                           85,459
Issuance of Common Stock
   to Charitable Foundation ..................    1,616,095        16       16,145                                           16,161
Purchase of Shares for ESOP ..................     (949,845)       (9)                            (16,152)                  (16,161)
Unallocated ESOP Shares Committed to Employees        9,723                     (1)                   165                       164
Shares Issued upon Exercise of Stock Options .       56,259         1          310                                              311
                                               ------------------------------------------------------------------------------------
Balance at December 31, 2003 .................   29,479,275     $ 295    $ 297,887  $ 100,570   $ (15,987)  $ 6,315       $ 389,080

-----------------------------------------------------------------------------------------------------------------------------------

See accompanying notes to consolidated financial statements.




</TABLE>



                                      -51-
<PAGE>

<TABLE>
<CAPTION>



<S>                                                                               <C>            <C>            <C>

KNBT BANCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
--------------------------------------------------------------------------------------------------------------------------
(dollars in thousands)                                                                     Year Ended December 31,
                                                                              --------------------------------------------
                                                                                      2003           2002          2001
--------------------------------------------------------------------------------------------------------------------------

OPERATING ACTIVITIES
  Net (Loss) Income .........................................................     $  (5,756)     $  12,010      $   8,112
  Adjustments to Reconcile Net Income (Loss) to Net Cash
     Provided by (Used in) Operating Activities:
        Provision for Loan Losses ...........................................         2,951            111            391
        Depreciation and Amortization .......................................         3,180          1,317          1,137
        Amortization (Accretion) of Security Premiums and Discounts, Net ....         3,630           (521)            82
        Loss on Disposition of Fixed Assets .................................            --             99             --
        Gain (Loss) on Sale of Other Real Estate Owned ......................            31             28             10
        Loss (Gain) on Sales of Investment Securities .......................           249         (1,202)           (35)
        Gains on the Sales of Mortgage Loans ................................          (246)          (900)          (108)
        Mortgage Loans Originated for Sale ..................................       (29,043)       (60,974)       (12,127)
        Mortgage Loan Sales .................................................        50,286         37,178         12,127
        Contribution to Charitable Foundation ...............................        16,161             --             --
   Changes in Assets and Liabilities:
        Decrease (Increase) in Accrued Interest Receivable ..................           283         (1,805)        (1,063)
        (Increase) Decrease in Other Assets .................................        (5,849)        (4,113)         1,667
        Increase (Decrease) in Other Liabilities and Accrued Interest Payable         5,760          2,842         (1,973)
                                                                                  ---------      ---------      ---------
Net Cash Provided by (Used in) Operating Activities .........................        41,637        (15,930)         8,220
                                                                                  ---------      ---------      ---------

INVESTING ACTIVITIES
Proceeds from Calls and Maturities of Securities Available-for-Sale .........       264,030        104,037         46,102
Proceeds from Sales of Securities Available-for-Sale ........................        28,540         63,844          1,625
Purchase of Securities Available-for-Sale ...................................      (462,963)      (184,848)       (89,818)
Purchase of Federal Home Loan Bank of Pittsburgh Stock ......................        (3,531)        (1,912)          (394)
Purchase of Bank Owned Life Insurance .......................................       (31,515)        (4,000)       (20,000)
Net Increase in Loans .......................................................       (62,542)        (1,915)       (11,330)
Purchase of Premises and Equipment ..........................................       (13,138)        (1,376)        (2,208)
Proceeds from Sale of Other Real Estate Owned ...............................           556            791            337
Cash and Cash Equivalents Acquired through Merger ...........................        45,616             --             --
                                                                                  ---------      ---------      ---------
Net Cash Used in Investing Activities .......................................      (234,947)       (25,379)       (75,686)
                                                                                  ---------      ---------      ---------

FINANCING ACTIVITIES
Net Increase (Decrease) in Deposits .........................................         5,499           (394)        58,807
Net (Decrease) Increase in Repurchase Agreements ............................        (2,113)         3,152          4,123
Proceeds from Long-Term Debt ................................................        92,300         73,000         30,500
Payments on Long-Term Debt ..................................................       (30,103)            --         (3,000)
Purchase of ESOP Shares .....................................................       (16,161)            --             --
Proceeds from Issuance of Common Stock ......................................       196,261             --             --
Proceeds from the Exercise of Stock Options .................................           311             --             --
                                                                                  ---------      ---------      ---------
Net Cash Provided by Financing Activities ...................................       245,994         75,758         90,430
                                                                                  ---------      ---------      ---------

Increase in Cash and Cash Equivalents .......................................        52,684         34,449         22,964
Cash and Cash Equivalents, January 1, .......................................        86,293         51,844         28,880
                                                                                  ---------      ---------      ---------
Cash and Cash Equivalents, December 31, .....................................     $ 138,977      $  86,293      $  51,844
                                                                                  =========      =========      =========

Supplemental Disclosure of Cash Flow Information
   Cash Paid During the Year for
        Income Taxes ........................................................     $   3,165      $   4,075      $   3,450
                                                                                  =========      =========      =========

        Interest on Deposits, Advances and Other Borrowed Money .............     $  18,554      $  26,344      $  33,956
                                                                                  =========      =========      =========

Supplemental Disclosure of Non-cash Activities
        Mortgage Loan Securitizations .......................................     $  47,250      $ 115,335      $      --
                                                                                  =========      =========      =========

        Reclassification of Loans Receivable to Other Real Estate Owned .....     $     473      $     998      $     342
                                                                                  =========      =========      =========
See accompanying notes to consolidated financial statements


</TABLE>



                                      -52-
<PAGE>


                               KNBT BANCORP, INC.


KNBT BANCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(All dollar amounts presented in the tables are in thousands, except per share
data.)


NOTE A - ORGANIZATION

         KNBT Bancorp,  Inc. ("KNBT" or the "Company") is the holding company of
Keystone  Nazareth Bank & Trust  Company  ("the Bank"),  KNBT Inv. I, Inc ("Inv.
I"),  KNBT Inv. II, Inc.  ("Inv.  II"),  and First  Colonial  Statutory  Trust I
("Statutory  Trust  I").  The  Bank  is an  independent  community  Pennsylvania
chartered  stock savings bank. The Bank provides  retail and commercial  banking
and trust and brokerage services through its 41 offices in Northampton,  Lehigh,
Monroe and Carbon counties in northeastern Pennsylvania.

         On October 31, 2003,  Keystone  Savings Bank converted and  reorganized
from a  Pennsylvania  mutual  savings bank into a stock  chartered  savings bank
holding company structure  pursuant to a Plan of Conversion (the "Plan").  Under
the  terms of the Plan,  Keystone  Savings  Bank  changed  its name to  Keystone
Nazareth Bank & Trust Company, became a wholly-owned subsidiary of KNBT Bancorp,
Inc. and received 50% of the net proceeds  from the initial  public  offering of
KNBT  Bancorp,  Inc.'s  common  stock.  KNBT  Bancorp,  Inc.  is a  Pennsylvania
corporation and a registered bank holding company.

         KNBT Bancorp,  Inc. sold  20,201,188  shares of its common stock to the
public  at $10.00  per  share.  In  addition,  KNBT  Bancorp,  Inc.  contributed
1,616,095 shares to Keystone Nazareth Charitable Foundation.  KNBT Bancorp, Inc.
received  net proceeds of $196.2  million.  The number of shares of common stock
sold and the price for such  shares  was  determined  by the Board of  Directors
based  upon an  appraisal  of  Keystone  Savings  Bank  made  by an  independent
appraisal firm.

         Upon completion of the Plan, a "liquidation account" was established in
an amount  equal to the total  equity of Keystone  Savings Bank as of the latest
practicable  date  prior  to  the  conversion.   The  liquidation   account  was
established  to  provide  a limited  priority  claim to the  assets of  Keystone
Savings  Bank to eligible  account  holders and  supplemental  eligible  account
holders,  as defined in the Plan, who continue to maintain  deposits in Keystone
Savings  Bank  after the  Reorganization.  In the  unlikely  event of a complete
liquidation  of Keystone  Savings  Bank,  and only in such event,  each eligible
account  holder  and  supplemental  eligible  account  holder  would  receive  a
liquidation  distribution,  prior to any  payment  to the  holder of the  Bank's
common  stock.  This  distribution  would be based  upon each  eligible  account
holder's and supplemental account holders  proportionate share of the then total
remaining qualifying deposits.

         The Bank competes with other banking and financial  institutions in its
primary market  communities,  including  financial  institutions  with resources
substantially greater than its own. Commercial banks, savings banks, savings and
loan  associations,  credit unions and money market funds  actively  compete for
savings and time deposits and for various types of loans. Such institutions,  as
well as consumer finance and insurance companies,  may be considered competitors
of the Bank with respect to one or more of the services it renders.

         KNBT and the Bank are  subject  to  regulations  of  certain  state and
Federal  agencies  and,  accordingly,  they are  periodically  examined by those
regulatory agencies.  As a consequence of the extensive regulation of commercial
banking  activities,  the Bank's business is  particularly  susceptible to being
affected  by state and Federal  legislation  and  regulation  which may have the
effect of increasing the cost of doing business.



                                      -53-
<PAGE>


NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

1. Basis of Financial Statement Presentation

         The  accounting  and  reporting  policies of KNBT conform to accounting
principles  generally  accepted in the United States of America and  predominant
practices within the banking industry.  The accompanying  consolidated financial
statements include the accounts of KNBT and its wholly-owned  subsidiaries,  the
Bank,  Inv. I, Inv. II,  Statutory Trust I, the Bank's  wholly-owned  subsidiary
KLVI and the Bank's majority-owned subsidiary, Traditions Settlement Services.

         In preparing  the  consolidated  financial  statements,  management  is
required to make estimates and assumptions  that affect the reported  amounts of
assets and  liabilities  as of the dates of the balance  sheets and revenues and
expenditures   for  the  periods.   Therefore,   actual   results  could  differ
significantly from those estimates.

         The  principal   estimates   that  are   particularly   susceptible  to
significant  change in the near term relate to the allowance for loan losses and
the evaluation of impairment of goodwill.  The evaluation of the adequacy of the
allowance  for loan losses  includes an  analysis  of the  individual  loans and
overall risk  characteristics  and size of the different  loan  portfolios,  and
takes into consideration current economic and market conditions,  the capability
of specific borrowers to pay specific loan obligations,  as well as current loan
collateral  values.  However,  actual losses on specific  loans,  which also are
encompassed in the analysis, may vary from estimated losses.

2. Cash and Cash Equivalents

         For reporting cash flows,  cash and cash  equivalents  include cash and
due from banks and  interest-bearing  deposits with banks. The Company maintains
cash deposits in other  depository  institutions  that  occasionally  exceed the
amount of deposit  insurance  available.  Management  periodically  assesses the
financial  condition of these  institutions  and  believes  that the risk of any
possible  credit loss is minimal.  Interest-bearing  deposits in other financial
institutions  consist of short-term  investments  generally having maturities of
less than 30 days.

3. Investment Securities

         KNBT accounts for its investment securities in accordance with SFAS No.
115,  "Accounting for Certain Investments in Debt and Equity  Securities".  This
standard  requires,   among  other  things,  that  debt  and  equity  securities
classified  as  available  for sale be reported at fair value,  with  unrealized
gains and losses excluded from earnings and reported in a separate  component of
shareholders' equity, net of income taxes and reclassification adjustments.

         Investment  securities  expected to be held for an indefinite period of
time are classified as available for sale and are stated at fair value. Gains or
losses  on the  sales of  securities  available  for sale  are  recognized  upon
realization utilizing the specific identification method.

         KNBT  follows SFAS No. 133 as amended by SFAS No 138,  "Accounting  for
Certain Derivative Instruments and Certain Hedging Activities." SFAS No. 133, as
amended  requires that entities  recognize all  derivatives  as either assets or
liabilities   in  the  statement  of  financial   condition  and  measure  those
instruments at fair value.  KNBT did not have any  derivative  instruments as of
December 31, 2003 and 2002.

         KNBT adopted EITF 03-1, "The Meaning of Other than Temporary Impairment
and Its  Application to Certain  Investments" as of December 31, 2003. EITF 03-1
includes certain disclosures regarding quantitative and qualitative  disclosures
for investment securities accounted for under SFAS 115, that are impaired at the
balance  sheet  date,  but  an  other-than-temporary  impairment  has  not  been
recognized.   The  disclosures  under  EITF  03-1  are  required  for  financial
statements  for years ending  after  December 15, 2003 and are included in these
financial statements.



                                      -54-
<PAGE>


4. Mortgage Loans Held-for-Sale

         Mortgage loans originated and intended for sale in the secondary market
are carried at the lower of aggregate  cost or estimated  fair value.  Gains and
losses on the sales of loans are also accounted for in accordance  with SFAS No.
134,  "Accounting for Mortgage  Securities Retained after the Securitizations of
Mortgage Loans Held-for-Sale by a Mortgage Banking  Enterprise".  This statement
requires  that an entity  engaged in mortgage  banking  activities  classify the
retained  mortgage-backed  security or other  interest,  which resulted from the
securitizations  of a mortgage  loan  held-for-sale  based upon its  ability and
intent to sell or hold these investments.

         KNBT follows SFAS No. 140,  "Accounting  for Transfers and Servicing of
Financial  Assets  and   Extinguishments  of  Liabilities,"  which  revised  the
standards  for  accounting  for  the  securitizations  and  other  transfers  of
financial  assets and collateral.  Transfers of financial  assets for which KNBT
has  surrendered  control of the financial  assets are accounted for as sales to
the extent that consideration other than beneficial interests in the transferred
assets is received in exchange. Retained interest in a sale or securitization of
financial assets are measured at the date of transfer by allocating the previous
carrying  amount  between  the  assets  transferred  and  based on the  relative
estimated fair values. The fair values of retained debt securities are generally
determined through reference to independent pricing information. The fair values
of retained  servicing  rights and any other  retained  interests are determined
based on the present value of expected  future cash flows  associated with those
interests and by reference to market prices for similar assets.

         KNBT adopted SFAS No. 149,  "Amendment  of Statement  133 on Derivative
Instruments and Hedging Activities," on July 1, 2003.  Implementation issue C13,
"When a Loan  Commitment Is Included in the Scope of Statement  133" is included
in SFAS No. 149.  SFAS No. 149 amends SFAS No. 133 to add a scope  exception for
borrowers (all  commitments) and lenders (all commitments  except those relating
to  mortgage  loans  that  will be held for  sale).  Statement  149 also  amends
paragraph  SFAS No.  133 to  require a lender to  account  for loan  commitments
related to mortgage  loans that will be held for sale as  derivatives.  SFAS No.
149 is effective  for  contracts  entered into or modified  after June 30, 2003.
KNBT periodically  enters into commitments with its customers,  which it intends
to sell in the future.  KNBT's  commitments  to extend credit for loans intended
for resale were not material at December 31, 2003.

5. Loans and Allowance for Loan Losses

         Loans  that  management  has the  intent  and  ability  to hold for the
foreseeable  future or until  maturity  or payoff  are  stated at the  amount of
unpaid principal and reduced by an allowance for loan losses.  Interest on loans
accrues  and  is  credited  to  operations  based  upon  the  principal  amounts
outstanding.  The allowance for loan losses is  established  through a provision
for loan losses charged to operations.  Loans are charged  against the allowance
for  loan  losses  when  management  believes  that  the  collectibility  of the
principal is unlikely.

         Interest  is  discontinued  when,  in the  opinion of  management,  the
collectibility of such interest becomes doubtful. A loan is generally classified
as nonaccrual when the loan is 90 days or more delinquent. Loan origination fees
and certain direct origination costs are deferred and amortized over the life of
the related loans as an adjustment to the yield on loans  receivable in a manner
which approximates the interest method.

         The allowance  for loan losses is  maintained  at an amount  management
deems  adequate  to cover  estimated  losses.  In  determining  the  level to be
maintained,  management  evaluates  many  factors,  including  current  economic
trends,   industry  experience,   historical  loss  experience,   industry  loan
concentrations,  the borrowers' ability to repay and repayment performance,  and
estimated collateral values. In the opinion of management, the present allowance
is adequate to absorb future loan losses which are  foreseeable  and  reasonably
estimable.  While  management uses the best  information  available to make such
evaluations,  future  adjustments  to the  allowance  may be necessary  based on
changes in economic  conditions or any of the other factors used in management's
determination.  In addition, various




                                      -55-
<PAGE>


regulatory  agencies,   as  an  integral  part  of  their  examination  process,
periodically  review  KNBT's  allowance  for losses on loans.  Such agencies may
require KNBT to recognize  additions to the allowance  based on their  judgments
about  information   available  to  them  at  the  time  of  their  examination.
Charge-offs  to the  allowance  are made  when the loan is  transferred  to real
estate owned or some other determination of impairment is made.

         KNBT accounts for its impaired  loans in accordance  with SFAS No. 114,
"Accounting  by Creditors for Impairment of a Loan," as amended by SFAS No. 118,
"Accounting by Creditors of a Loan - Income  Recognition and Disclosures."  This
standard requires that a creditor measure  impairment based on the present value
of expected future cash flows discounted at the loan's  observable market price,
or the  fair  value  of the  collateral  if the  loan is  collateral  dependent.
Regardless of the measurement  method, a creditor must measure  impairment based
on  the  fair  value  of  the  collateral  when  the  creditor  determines  that
foreclosure is probable.

         FASB Interpretation FIN No. 45, "Guarantor's  Accounting and Disclosure
Requirements  for Guarantee,  Including  Indirect  Guarantees of Indebtedness of
Others," requires certain disclosures  effective for the year ended December 31,
2002  regarding the nature of the  guarantee,  the maximum  potential  amount of
future  payments  that  the  guarantor  could  be  required  to make  under  the
guarantee,  and the current amount of the liability, if any, for the guarantor's
obligations under the guarantee.  Significant  guarantees that have been entered
into by KNBT include standby and performance  letters of credit. The adoption of
FIN  No.  45 did  not  have a  material  impact  on the  consolidated  financial
statements.

         In October 2003,  the AICPA issued SOP 03-3,  "Accounting  for Loans or
Certain Debt Securities Acquired in a Transfer". SOP 03-3 applies to a loan with
the evidence of  deterioration of credit quality since  origination  acquired by
completion of a transfer for which it is probable at acquisition,  that the Bank
will be unable to collect all contractually  required payments  receivable.  SOP
03-3 is effective for loans  acquired in fiscal years  beginning  after December
31, 2004.  Early adoption is permitted.  Management is currently  evaluating the
provisions of SOP 03-3 and does not anticipate its adoption will have a material
affect on KNBT's consolidated financial position or results of operations.

6. Premises and Equipment

         Premises   and   equipment   are  carried  at  cost  less   accumulated
depreciation, and include expenditures for new facilities, major betterments and
renewals.  Expenditures  of  maintenance  and  repairs are charged to expense as
incurred. Depreciation is computed using the straight-line method based upon the
estimated useful lives of the related assets.

         On January 1, 2002,  KNBT  adopted  SFAS No. 144,  "Accounting  for the
Impairment or Disposal of Long-Lived  Assets." SFAS No. 144 retains the existing
requirements to recognize and measure the impairment of long-lived  assets to be
held and used or to be disposed of by sale.  The adoption of this  statement did
not have an impact on the  financial  condition or results of  operations of the
Company.

7. Other Real Estate Owned

         Real estate  acquired  through  foreclosure is classified as other real
estate  owned  ("OREO").  OREO is carried at the lower cost  (lesser of carrying
value of loan or fair value at date of acquisition) or fair value less estimated
costs to sell. Any reductions in value, at or prior to the dates the real estate
is  considered  foreclosed,  is charged to the  allowance  for loan losses.  Any
subsequent  reductions in value are charged through earnings.  Costs relating to
the  development or improvement of the property are  capitalized;  holding costs
are charged to expense.

8. Goodwill and Intangible Assets

         KNBT adopted SFAS No. 142,  "Goodwill and Intangible Assets" on January
1, 2002. This statement  modifies the accounting for all purchased  goodwill and
intangible  assets.  SFAS No. 142


                                      -56-
<PAGE>


includes  requirements to test goodwill and indefinite lived  intangible  assets
for impairment  rather than amortize them. KNBT has tested the goodwill included
on its  consolidated  balance  sheet as of December 31, 2003 and has  determined
that it was not impaired as of such date.

         Intangible  assets  are  comprised  of  core  deposit  intangibles  and
goodwill acquired in business combinations. KNBT's goodwill is the result of its
acquisition  of First Colonial Group in October 2003. The balance of goodwill at
December 31, 2003 was $28.8 million.  Core deposit  intangibles of $17.1 million
(net of  accumulated  amortization  of  $364,000) at December 31, 2003 are being
amortized  over the  estimated  useful lives of the  existing  deposit base of 8
years using a method which approximates the interest method.

9. Income Taxes

         Under the  liability  method  deferred tax assets and  liabilities  are
determined based on the difference between the financial statement and tax bases
of assets and  liabilities as measured by the enacted tax rates which will be in
effect when these temporary  differences are estimated to reverse.  Deferred tax
expense is the result of changes in deferred tax assets and liabilities.

10. Advertising

         The Company expenses advertising costs as incurred.

11. Stock Based Compensation

         KNBT  acquired the stock option plans  previously  maintained  by First
Colonial  Group,  Inc. as a part of the merger.  KNBT's  stock  option plans are
accounted for under SFAS No. 123,  "Accounting  for  Stock-Based  Compensation."
This  standard  contains  a fair  value-based  method  for  valuing  stock-based
compensation  which  measures  compensation  cost at the grant date based on the
fair  value of the  award.  Compensation  is then  recognized  over the  service
period, which is usually the vesting period. Alternatively, the standard permits
entities  to  continue   accounting  for  employee  stock  options  and  similar
instruments  under APB Opinion  No. 25.  Entities  that  continue to account for
stock  options  using  APB  Opinion  No.  25 are  required  to  make  pro  forma
disclosures  of net income and  earnings per share,  as if the fair  value-based
method of  accounting  defined in SFAS No. 123 had been  applied.  KNBT's  stock
option plans are  accounted  for under APB Opinion No. 25. KNBT did not have any
unvested stock options at December 31, 2003.

12. Employee Benefit Plans

         KNBT has certain  employee  benefit plans  covering  substantially  all
employees.  KNBT expenses such costs as incurred.  KNBT follows SFAS No. 132, as
revised in December  2003,  "Employers'  Disclosures  about  Pensions  and Other
Post-retirement  Benefits." SFAS No. 132 revised  employers'  disclosures  about
pension  and  other  post-retirement   benefit  plans.  It  requires  additional
information about changes in the benefit  obligation and the fair values of plan
assets.   It  also   standardized   the  requirements  for  pensions  and  other
post-retirement  benefit plans to the extent possible,  and illustrates combined
formats for the presentation of pension plan and other  post-retirement  benefit
plan disclosures.

         In November 2003,  KNBT  established  an Employee Stock  Ownership Plan
("ESOP")  covering all eligible  employees as defined by the ESOP. The ESOP is a
tax-qualified  plan  designed to invest  primarily  in KNBT's  common stock that
provides  employees  with the  opportunity  to receive a KNBT-funded  retirement
benefit based  primarily on the value of KNBT's common stock.  KNBT accounts for
its ESOP in accordance  with  Statement of Position  ("SOP")  93-6,  "Employer's
Accounting  for  Employee  Stock  Ownership  Plans",  issued  by the  Accounting
Standards  Division of the American  Institute of Certified  Public  Accountants
("AICPA").

         To purchase  KNBT's common stock,  the ESOP borrowed $16.1 million from
KNBT to purchase  949,845  shares of KNBT common  stock in the market.  The ESOP
loan is being repaid principally from the




                                      -57-
<PAGE>

Bank's  contributions  to the ESOP over a period  of up to 30  years.  Dividends
declared on common stock held by the ESOP and not  allocated to the account of a
participant can be used to repay the loan. Compensation expense is recognized in
accordance with SOP 93-6. The number of shares  released  annually is based upon
the ratio that the current  principal and interest  payment bears to the current
and all remaining scheduled future principal and interest payments.

         All shares that have not been released for  allocation to  participants
are held in a suspense account by the ESOP for future  allocation as the loan is
repaid.  Unallocated  common  stock  purchased  by the  ESOP  is  recorded  as a
reduction of stockholders' equity at cost.

13. Bank Owned Life Insurance (BOLI)

         KNBT has purchased Bank Owned Life Insurance  policies  ("BOLI").  BOLI
involves the purchasing of life  insurance by the  corporation on a chosen group
of employees.  The proceeds are used to help defray employee benefit costs. KNBT
is the owner and beneficiary of the policies.  The Company  originally  invested
$20.0  million  in BOLI in 2001 and made  additional  BOLI  investments  of $4.0
million in 2002 and $30.0 million in 2003. BOLI is recorded on the  consolidated
balance  sheets at its cash  surrender  value and changes in the cash  surrender
value are recorded in non-interest income. BOLI income is tax-exempt.

14. Trust Assets and Revenue

         Assets held by the Trust  Department of the Bank in fiduciary or agency
capacities for its customers are not included in the  accompanying  consolidated
balance sheets since such assets are not assets of KNBT.  Operating  revenue and
expenses of the Trust Department are included under their respective captions in
the  accompanying  consolidated  statements  of income and are  recorded  on the
accrual basis.

15. Per Share Information

         KNBT  follows the  provisions  of SFAS No. 128,  "Earnings  Per Share".
Basic  earnings per share excludes  dilution and is computed by dividing  income
available  to  common  shareholders  by  the   weighted-average   common  shares
outstanding during the period. Diluted earnings per share takes into account the
potential  dilution that could occur if  securities or other  contracts to issue
common stock were exercised and converted into common stock.  Earnings per share
were  not  meaningful  in 2003,  as KNBT did not  complete  its  initial  public
offering  until October 31, 2003.  KNBT did not have any shares  outstanding  in
2002 and 2001.

16. Financial Instruments

         SFAS No. 107, "Disclosures about Fair Value of Financial  Instruments,"
requires  KNBT to  disclose  the  estimated  fair  value  of  their  assets  and
liabilities  considered  to  be  financial  instruments.  Financial  instruments
requiring disclosure consist primarily of cash and cash equivalents,  investment
securities, loans, deposits and borrowings.

17. Segment Information

         SFAS No. 131, "Disclosures About Segments of an Enterprise and Related
Information," defines how operating segments are determined and requires
disclosures of certain financial and descriptive information about KNBT's
operating segments. Management has determined that KNBT has one operating
segment and, accordingly, one reportable segment, "Community Banking." All of
KNBT's activities are interrelated, and each activity is dependent and assessed
based on how each of the activities of KNBT supports the others. For example,
consumer and residential mortgage lending is dependent upon the ability of KNBT
to fund itself with retail deposits and other borrowings and to manage interest
rate and credit risk. All significant operating decisions are based upon
analysis of KNBT as one operating segment.


                                      -58-
<PAGE>


18. Comprehensive Income

         SFAS No. 130, "Reporting  Comprehensive Income," includes net income as
well as  certain  other  items  which  result in a change to equity  during  the
period.

         The income tax effects allocated to comprehensive  income for the years
ended December 31, 2003, 2002, 2001 were as follows:

<TABLE>
<CAPTION>



<S>                                                   <C>                <C>              <C>
--------------------------------------------------------------------------------------------------
                                                         Year ended December 31, 2003
                                              ----------------------------------------------------
                                                                      Tax
                                                Before tax          benefit          Net of tax
                                                  amount           (expense)           amount
--------------------------------------------------------------------------------------------------
                                                           (dollars in thousands)
Unrealized Gains on Securities:
  Unrealized holding gains arising
    during period ............................        $ 2,162            $ (734)          $ 1,428
  Less reclassification adjustment for
    net realized losses ......................            249                85               154
                                              ----------------  ----------------   ---------------

Other comprehensive income, net ..............        $ 2,411            $ (819)          $ 1,592

--------------------------------------------------------------------------------------------------
                                                         Year ended December 31, 2002
                                              ----------------------------------------------------
                                                                      Tax
                                                Before tax          benefit          Net of tax
                                                  amount           (expense)           amount
--------------------------------------------------------------------------------------------------
                                                           (dollars in thousands)
Unrealized Gains on Securities:
  Unrealized holding gains arising
    during period ............................        $ 6,266          $ (2,222)          $ 4,044
  Less reclassification adjustment for
    net realized gains .......................         (1,202)             (409)             (793)
                                              ----------------  ----------------   ---------------

Other comprehensive income, net .............         $ 5,064          $ (1,813)          $ 3,251

--------------------------------------------------------------------------------------------------
                                                         Year ended December 31, 2001
                                              ----------------------------------------------------
                                                                      Tax
                                                Before tax          benefit          Net of tax
                                                  amount           (expense)           amount
--------------------------------------------------------------------------------------------------
                                                           (dollars in thousands)
Unrealized Gains on Securities:
  Unrealized holding gains arising
    during period ............................          $ 938            $ (174)            $ 764
  Less reclassification adjustment for
    net realized gains .......................            (35)              (11)              (24)
                                              ----------------  ----------------   ---------------

Other comprehensive income, net ..............          $ 903            $ (163)            $ 740
--------------------------------------------------------------------------------------------------
</TABLE>


19. Statement of Cash Flows

         KNBT  considers  cash,  due from banks and  Federal  funds sold as cash
equivalents for the purposes of the Consolidated Statements of Cash Flows.



                                      -59-
<PAGE>


20. Variable Interest Entities

         In January 2003, FASB  Interpretation 46 ("FIN 46"),  "Consolidation of
Variable  Interest  Entities" was issued.  FIN 46 clarifies the  application  of
Accounting Research Bulletin 51, "Consolidated Financial Statements", to certain
entities in which voting  rights are not effective in  identifying  the investor
with the controlling  financial interest.  An entity is subject to consolidation
under FIN 46 if the investors  either do not have sufficient  equity at risk for
the entity to finance its activities without additional  subordinated  financial
support, are unable to direct the entity's activities, or are not exposed to the
entity's  losses  or  entitled  to  its  residual  returns  ("variable  interest
entities").  Variable interest entities within the scope of FIN 46 were required
to be consolidated by their primary  beneficiary.  The primary  beneficiary of a
variable  interest  entity is determined to be the party that absorbs a majority
of the entity's expected losses, receives a majority of its expected returns, or
both.

         Management  has  determined  that  First  Colonial  Statutory  Trust  I
qualifies as a variable  interest entity under FIN 46. First Colonial  Statutory
Trust I issued  mandatorily  redeemable  preferred stock to investors and loaned
the proceeds to KNBT. First Colonial Statutory Trust I holds, as its sole asset,
subordinated debentures issued by KNBT in 2002. First Colonial Statutory Trust I
is currently  included in KNBT's  consolidated  balance sheet and  statements of
income. KNBT has evaluated the impact of FIN 46 and concluded it should continue
to consolidate First Colonial Statutory Trust I as of December 31, 2003, in part
due to its ability to call the preferred stock prior to the mandatory redemption
date and thereby benefit from a decline in required dividend yields.

         Subsequent  to the  issuance  of FIN 46,  the  FASB  issued  a  revised
interpretation,  FIN 46(R),  the  provisions of which must be applied to certain
variable interest entities by March 31, 2004. KNBT plans to adopt the provisions
under the revised  interpretation  in the first quarter of 2004.  FIN 46(R) will
require KNBT to deconsolidate  First Colonial  Statutory Trust I as of March 31,
2004.  FIN 46(R)  precludes  consideration  of the call  option  embedded in the
preferred  stock when  determining  if KNBT has the right to a majority of First
Colonial Statutory Trust I's expected residual returns.  Accordingly,  KNBT will
deconsolidate  First Colonial Statutory Trust I at the end of the first quarter,
which will result in an increase in  outstanding  debt by $464,000.  The banking
regulatory  agencies  have  not  issued  any  guidance  that  would  change  the
regulatory capital treatment for the trust-preferred  securities issued by First
Colonial  Statutory  Trust I based on the  adoption  of FIN 46(R).  However,  as
additional  interpretations from the banking regulators related to entities such
as First Colonial Statutory Trust I become available, management will reevaluate
its   potential   impact  to  its  Tier  I  capital   calculation   under   such
interpretations.

21. Reclassifications

         Certain  reclassifications  of prior  years'  amounts have been made to
conform to the 2003 presentation.



                                      -60-
<PAGE>

NOTE C - STOCK CONVERSION AND MERGER

     On  October  31,  2003,  KNBT and the Bank  completed  mergers  with  First
Colonial  Group and its  subsidiary  Nazareth  National Bank and Trust  Company,
respectively.  Under the terms of the merger agreement,  which was the result of
arms-length  negotiation,  each  of the  shares  of  First  Colonial  stock  was
exchanged for 3.7 shares of KNBT common stock for a total  issuance of 8,545,855
shares of common stock.  Based on  management's  assessment  of the  anticipated
benefits of the  acquisition,  including  enhanced market share and expansion of
its banking franchise, KNBT entered into the merger agreement and proceeded with
its  acquisition  of  First  Colonial   Group.   First  Colonial  stock  options
outstanding at the date of  acquisitions  were converted into 808,157 options to
purchase  KNBT shares of common  stock and were fully  vested at the time of the
merger.  The  transaction  was  accounted  for  under  the  purchase  method  of
accounting and KNBT's  results of operations  include First  Colonial's  results
from October 31, 2003 (date of  acquisition)  through  December  31,  2003.  The
acquisition resulted in the recording of approximately $45.9 million of goodwill
and other intangible assets.

     The following condensed consolidated balance sheet of First Colonial Group,
Inc. discloses the amounts assigned to each major asset and liability caption at
the acquisition date, October 31, 2003.

<TABLE>
<CAPTION>


<S>                                                                                <C>
--------------------------------------------------------------------------------------------------

                                                                            (dollars in thousands)
 Assets
    Cash and due from banks ....................................................   $  45,616
    Investment securities ......................................................     271,784
    Net loans ..................................................................     272,270
    Fair value allocated to premises and equipment .............................       4,408
    Goodwill and core deposit intangible asset .................................      46,442
    Other assets ...............................................................      26,368
                                                                                   ---------
       Total Assets ............................................................   $ 666,888
                                                                                   =========

 Liabilities
    Total deposits .............................................................   $(512,086)
    Borrowings .................................................................     (64,215)
    Other liabilities ..........................................................      (5,128)
                                                                                   ---------
       Total Liabilities Assumed ...............................................    (581,429)
                                                                                   ---------

       Net assets acquired .....................................................   $  85,459
                                                                                   =========
--------------------------------------------------------------------------------------------------

</TABLE>

     The following  represents the unaudited pro forma financial  information of
KNBT as if the acquisition  occurred on the first date of the periods indicated.
The pro  forma  information  should  be read in  conjunction  with  the  related
historical  information  and is not  necessarily  indicative of the results that
would have been attained had the transaction actually taken place.

--------------------------------------------------------------------------------

                                               For The Year Ended
                                                   December 31,
                             ---------------------------------------------------
                                  2003               2002              2001
                             ---------------    ---------------    -------------
                                               (dollars in thousands)

Interest Income ...........        $ 83,713           $ 89,009          $ 90,528
Interest Expense ..........          33,896             38,826            48,033
                             ---------------    ---------------    -------------
Net Interest Income .......          49,817             50,183            42,495
Provision for Loan Losses .           4,001              1,652               971
Non-interest Income .......          14,761             15,721            10,620
Non-interest Expense ......          77,911             43,834            37,671
Net (Loss) Income .........         $(9,901)          $ 20,333          $ 10,339

--------------------------------------------------------------------------------


                                      -61-
<PAGE>



NOTE D - INVESTMENT SECURITIES

         The  amortized  cost,  unrealized  gains and losses,  and fair value of
KNBT's investment securities available-for-sale are as follows:

<TABLE>
<CAPTION>




<S>                                             <C>                   <C>                    <C>              <C>
------------------------------------------------------------------------------------------------------------------------

                                                                    At December 31, 2003
                                         -------------------------------------------------------------------------------
                                                                   Gross               Gross
                                            Amortized           Unrealized           Unrealized              Fair
                                               Cost                Gains               Losses               Value
                                         -----------------    ----------------    -----------------    -----------------
                                                                        (dollars in thousands)
U. S. Government and agencies ...........       $ 118,037             $ 2,442                $ (99)           $ 120,380
Obligations of states and political
   subdivisions .........................         112,228               3,584                 (157)             115,655

Mortgaged-backed securities
   GNMA .................................           2,124                  14                    -                2,138
   FHLMC ................................          83,737               1,016                 (768)              83,985
   FNMA .................................         224,802               5,597               (2,861)             227,538
   Other CMOs ...........................         150,645                 628                 (576)             150,697
                                         -----------------    ----------------    -----------------    -----------------
      Total mortgage-backed securities ..         461,308               7,255               (4,205)             464,358
Corporate and other debt securities .....          15,068                 569                    -               15,637
ARM fund ................................           4,939                   -                  (59)               4,880
Equity securities .......................          12,939                 272                  (34)              13,177
                                         -----------------    ----------------    -----------------    -----------------
Total investment securities .............       $ 724,519            $ 14,122             $ (4,554)           $ 734,087
                                         =================    ================    =================    =================

------------------------------------------------------------------------------------------------------------------------

</TABLE>

<TABLE>
<CAPTION>


<S>                                             <C>                   <C>                    <C>              <C>


                                                                       At December 31, 2002
                                         -------------------------------------------------------------------------------
                                                                   Gross               Gross
                                            Amortized           Unrealized           Unrealized              Fair
                                               Cost                Gains               Losses               Value
                                         -----------------    ----------------    -----------------    -----------------
                                                                        (dollars in thousands)
U. S. Government and agencies ...........        $ 30,677               $ 398                  $ -             $ 31,075
Obligations of states and political
   subdivisions .........................          38,935               2,148                  (44)              41,039

Mortgaged-backed securities
   GNMA .................................           3,234                  93                    -                3,327
   FHLMC ................................          17,963                 390                   (5)              18,348
   FNMA .................................          73,743               2,382                  (24)              76,101
   Other CMOs ...........................          83,449                 862                 (137)              84,174
                                         -----------------    ----------------    -----------------    -----------------
      Total mortgage-backed securities ..         178,389               3,727                 (166)             181,950
Corporate and other debt securities .....          34,053               1,132                  (13)              35,172
ARM fund                                            4,939                   -                  (25)               4,914
                                         -----------------    ----------------    -----------------    -----------------
Total investment securities .............       $ 286,993             $ 7,405               $ (248)           $ 294,150
                                         =================    ================    =================    =================

------------------------------------------------------------------------------------------------------------------------

</TABLE>



         The   amortized   cost  and  fair  value  of  KNBT's   investment   and
mortgage-backed   securities   available-for-sale   at  December  31,  2003,  by
contractual maturity, are shown in the following table. Expected maturities will
differ from contractual  maturities because borrowers may have the right to call
or prepay obligations with or without call or prepayment penalties.



                                      -62-
<PAGE>

<TABLE>
<CAPTION>



<S>                                                        <C>                       <C>

---------------------------------------------------------------------------------------------

                                                              Available-for-sale
                                                             at December 31, 2003
                                                  -------------------------------------------
                                                     Amortized                   Fair
                                                        Cost                     Value
                                                  -----------------        ------------------
                                                              (dollars in thousands)
Investment Securities
   Due in one year or less .......................         $ 8,130                   $ 8,220
   Due after one year through five years .........          72,522                    73,384
   Due after five years through ten years ........          43,918                    45,102
   Due after ten years ...........................         120,763                   124,966
                                                  -----------------        ------------------
                                                           245,333                   251,672
                                                  -----------------        ------------------
Mortgage-backed securities .......................         461,308                   464,358
ARM fund .........................................           4,939                     4,880
Equity securities ................................          12,939                    13,177
                                                  -----------------        ------------------
   Total .........................................       $ 724,519                 $ 734,087
                                                  =================        ==================

---------------------------------------------------------------------------------------------

</TABLE>

         Gross gains of $146,000 and losses of $395,000  were  realized on sales
of investment securities classified as available-for-sale  during the year ended
December  31,  2003.  Gross  gains of $1.2  million  were  realized  on sales of
investment  securities  classified  as  available-for-sale  for the  year  ended
December 31, 2002. There were no gross losses realized on the sale of investment
securities in 2002. Gross gains of $37,000 and losses of $2,000 were realized on
sales of investment  securities  classified as  available-for-sale  for the year
ended December 31, 2001.

         As of  December  31, 2003 and 2002,  securities  having a book value of
$63.8  million  and  $15.5  million  were  pledged  to secure  public  deposits,
outstanding advances and for other purposes as required by law.

         The following table indicates the length of time individual  securities
have been in a continuous unrealized loss position at December 31, 2003.

<TABLE>
<CAPTION>


<S>                                       <C>             <C>                <C>            <C>           <C>              <C>

----------------------------------------------------------------------------------------------------------------------------------

                                          Less than 12 Months            12 Months or Longer                     Total
                                    ----------------------------   -----------------------------   ------------------------------
                                         Fair        Unrealized        Fair          Unrealized         Fair        Unrealized
Description of Securities               Value          Losses          Value           Losses           Value         Losses
---------------------------------------------------------------------------------------------------------------------------------
                                                                        (dollars in thousands)
U.S. Government & agencies ........       $ 12,100        $ (99)             $ -            $ -           $ 12,100         $ (99)

Obligations of states and
  political subdivisions ..........         17,303         (157)               -              -             17,303          (157)

Total mortgage-backed securities ..        297,021       (4,176)           7,318            (29)           304,339        (4,205)
                                    ---------------  -----------   --------------   ------------   ---------------- -------------

Subtotal, debt securities .........        326,424       (4,432)           7,318            (29)           333,742        (4,461)
                                    ---------------  -----------   --------------   ------------   ---------------- -------------

ARM funds .........................              -            -            4,879            (59)             4,879           (59)

Equity securities .................          1,669          (34)               -              -              1,669           (34)
                                    ---------------  -----------   --------------   ------------   ---------------- -------------

Total temporarily
  impaired securities .............      $ 328,093      $(4,466)        $ 12,197          $ (88)         $ 340,290       $(4,554)
                                    ===============  ===========   ==============   ============   ================ =============

----------------------------------------------------------------------------------------------------------------------------------


</TABLE>



         Management  has reviewed the  securities  listed in the above table and
believes all unrealized  losses to be temporary.  The unrealized  losses are due
primarily to changes in market  interest  rates and


                                      -63-
<PAGE>


other temporary changes in market conditions. As of December 31, 2003, KNBT held
645 different securities of which 186 were in an unrealized loss position.

NOTE E - LOANS

         A summary of KNBT's loans receivable follows:


--------------------------------------------------------------------------------

                                                       At December 31,
                                              -----------------------------
                                                2003                 2002
                                              ---------           ---------
                                                   (dollars in thousands)
   Real Estate
      Residential ..................          $ 346,221           $ 367,219
      Construction .................            112,684              59,363
      Commercial ...................            156,563              29,385
                                              ---------           ---------
         Total real estate .........            615,468             455,967

   Consumer loans ..................            265,541             143,731
   Commercial (non real estate) ....             38,978              10,050
   States and political subdivisions              2,334                  --
                                              ---------           ---------
         Total gross loans .........            922,321             609,748

   Less:
      Mortgage loans held-for-sale .             (4,677)            (23,796)
      Loans in process .............            (27,099)            (24,263)
      Deferred fees ................               (469)             (3,236)
                                              ---------           ---------
         Total loans ...............            890,076             558,453

   Less:  Allowance for loan losses              (7,910)             (2,927)
                                              ---------           ---------
         Total net loans ...........          $ 882,166           $ 555,526
                                              =========           =========

--------------------------------------------------------------------------------


         The Bank makes loans to its  directors and  executive  officers.  These
loans were made in the ordinary course of business and on substantially the same
terms and conditions as those with other borrowers.

         An analysis of the 2003 activity of these loans follows:

---------------------------------------------------------
                                 (dollars in thousands)

Balance, January 1, 2003 ..........         $ 659
     Acquired from merger
        with First Colonial .......         1,728
     New loans ....................         1,631
     Repayments ...................          (411)
                                   ---------------
Balance, December 31, 2003 ........       $ 3,607
---------------------------------------------------------




                                      -64-
<PAGE>


         KNBT's non-performing loans are as follows:

<TABLE>
<CAPTION>



<S>                                                   <C>                  <C>                   <C>
---------------------------------------------------------------------------------------------------------

                                                                    At December 31,
                                             ------------------------------------------------------------
                                                   2003                  2002                  2001
                                             -----------------   ------------------   -------------------
                                                               (dollars in thousands)
Non-accrual loans .........................           $ 1,720              $ 2,197               $ 1,752
Accruing loans 90 days or more past due ...               405                  298                   938
                                             -----------------   ------------------   -------------------
Total non-performing loans ................           $ 2,125              $ 2,495               $ 2,690
                                             =================   ==================   ===================
Interest income not recognized on
  non-accrual loans .......................              $ 50                 $ 66                  $ 81
                                             =================   ==================   ===================






         KNBT's  recorded  investment in impaired loans was $217,000 at December
31, 2003.  KNBT did not have any  impaired  loans at December 31, 2002 and 2001.
The valuation  allowance for loan losses  related to impaired loans is a part of
the allowance for loan losses and was $33,000 at December 31, 2003.  The average
impaired loan balance for the year ended  December 31, 2003 was  $217,000.  KNBT
received  principal  payments  of $64,000 on impaired  loans in 2003.  Income on
impaired loans is recognized by KNBT on a cash basis.  KNBT recognized income of
approximately  $34,000  on  impaired  loans in  2003.  There  were no  principal
payments and no income recognized on impaired loans in 2002 and 2001.

         Activity in the allowance for loan losses is as follows:



                                                              Year ended December 31,
                                             ------------------------------------------------------------
                                                   2003                2002                 2001
                                             -----------------   ------------------   -------------------
                                                               (dollars in thousands)
Balance, beginning of year ................           $ 2,927              $ 3,386               $ 3,337
Acquisition of First Colonial .............             3,548                    -                     -
Provision charged to operations ...........             2,951                  111                   391
Loans charged-off .........................            (1,603)                (623)                 (378)
Recoveries of loans previously charged-off                 87                   53                    36
                                             -----------------   ------------------   -------------------

Balance, end of year ......................           $ 7,910              $ 2,927               $ 3,386
                                             =================   ==================   ===================


</TABLE>


NOTE F - PREMISES AND EQUIPMENT

         KNBT's premises and equipment are summarized as follows:
<TABLE>
<CAPTION>

<S>                                                                       <C>                     <C>


                                                                             At December 31,
                                              Estimated          -----------------------------------------
                                             useful lives              2003                   2002
                                             -----------------   -----------------      ------------------
                                                                          (dollars in thousands)
Land ......................................   Indefinite                  $ 3,624                 $ 1,829
Buildings and leasehold
   improvements ...........................   30-50 years                  25,923                  10,559
Furniture and fixtures ....................   3-10 years                   16,279                  11,210
Purchase accounting adjustment ............    20 years                     4,379                       -
                                                                 -----------------      ------------------
                                                                           50,205                  23,598
Less accumulated depreciation
   and amortization .......................                               (14,338)                (11,420)
                                                                 -----------------      ------------------
                                                                         $ 35,867                $ 12,178
                                                                 =================      ==================

----------------------------------------------------------------------------------------------------------

</TABLE>

                                      -65-
<PAGE>



         Construction  in process of  approximately  $5.9 million is included in
the balances in the previous  table on premises  and  equipment  and will not be
depreciated until it is put in service.

         Depreciation  expense was $1.8  million,  $1.3 million and $1.1 million
for the years ended December 31, 2003,  2002 and 2001. As a result of the merger
with First Colonial, the premises and equipment of First Colonial were marked to
fair value which resulted in an intangible amount of $4.4 million.  Amortization
of $29,000 for this  intangible  asset was recorded for the year ended  December
31, 2003. The intangible related to the buildings and leasehold  improvements is
being amortized over a 20-year period.

NOTE G - ASSET SECURITIZATIONS AND CAPITALIZED SERVICING ASSETS

1.       Asset Securitization

         In  2003,  KNBT  securitized  approximately  $47.3  million  of  one-to
four-family  residential mortgage loans in a guaranteed mortgage  securitization
with the Federal National Mortgage Association ("FNMA"). KNBT recognized no gain
or loss on the transaction as it retained all of the resulting  securities.  All
of  the  resulting   securities   were   classified  as  investment   securities
available-for-sale.  In 2002, KNBT securitized  approximately  $115.3 million of
one-to  four-family   residential   mortgage  loans  in  a  guaranteed  mortgage
securitization  with the FNMA. KNBT sold $61.4 million to various  investors and
recognized  a gain of $1.2  million  on the  transaction.  The  remaining  $53.9
million of loans  securitized were retained by KNBT and classified as investment
securities available-for-sale.  No gain or loss was recognized on the securities
retained. KNBT retained the servicing rights on all of the loans securitized and
allocated  $736,000  of the  carrying  value  of  the  loans  to be  capitalized
servicing assets.

         At December 31, 2003, and December 31, 2002, KNBT's retained securities
had an aggregate  amortized cost of $49.0 million and $44.1 million an aggregate
estimated  fair value of $50.8 million and $46.0  million.  The  estimated  fair
values were obtained from  independent  pricing  sources and management does not
anticipate that a hypothetical  adverse change from expected pricing assumptions
would have a significant  impact on the fair value of the subordinated  retained
securities.  During the years ended  December 31, 2003 and 2002,  KNBT  received
$46.1  million  and $12.2  million,  respectively,  in  principal  and  interest
payments on the retained  securities  and $106,000 and $24,000 in servicing fees
from FNMA.  At  December  31,  2003,  KNBT held  $346.2  million of  residential
mortgage  loans,  $4.2 million of which were past due 30 days or more.  KNBT had
$81,000 in credit  losses on  residential  real estate  loans  during the period
ended  December 31, 2003.  At December  31,  2002,  KNBT held $362.0  million of
residential mortgage loans, $3.5 million of which were past due 30 days or more.
KNBT had $33,000 in credit losses during the period ended December 31, 2002.

2.       Capitalized Servicing Assets

         Changes in capitalized servicing assets were as follows:
<TABLE>
<CAPTION>


<S>                                         <C>                   <C>                   <C>
----------------------------------------------------------------------------------------------

                                                           Year ended December 31,
                                   -----------------------------------------------------------
                                              2003                 2002                  2001
                                   ---------------       ---------------       ---------------
                                                    (dollars in thousands)
Balance, beginning ................         $ 911                 $ 567                 $ 701
Acquired from First Colonial ......           662                     -                     -
Amortizations .....................        (1,068)                 (287)                 (114)
Sales .............................           416                 1,020                   102
Valuation allowance ...............           119                  (389)                 (122)
                                   ---------------       ---------------       ---------------

Ending balance, net ...............       $ 1,040                 $ 911                 $ 567
                                   ===============       ===============       ===============

----------------------------------------------------------------------------------------------


</TABLE>



                                      -66-
<PAGE>




NOTE H - DEPOSITS

         KNBT's deposits are as follows:




                                                    At December 31,
                                        ----------------------------------
                                                 2003                2002
                                        ---------------      -------------
                                               (dollars in thousands)
Non-interest bearing deposits .........      $ 117,270           $ 33,872
Interest-bearing checking deposits ....        163,749             84,164
Savings and club deposits .............        221,176            115,289
Money market deposits .................        239,521            149,225
Time deposits .........................        490,838            343,749
Time deposits $100,000 or more ........         56,856             45,526
                                        ---------------      -------------
                                           $ 1,289,410          $ 771,825
                                        ===============      =============


         Maturities of time deposits at December 31, 2003 are as follows:


---------------------------------------------------

                            (dollars in thousands)
2004 .................           $ 298,964
2005 .................             128,017
2006 .................              54,189
2007 .................              50,933
2008 .................              14,132
2009 and Thereafter ..               1,459
                         ------------------

                                 $ 547,694
                         ==================

---------------------------------------------------


NOTE I - BORROWINGS

1. Federal Home Loan Bank (FHLB) Advances

         Federal  Home Loan Bank  ("FHLB")  advances  at  December  31, 2003 and
December 31, 2002 totaled $207.2 million and $113.5 million,  respectively.  The
December 31, 2002 total of $113.5  million  includes $20.0 million of short-term
(overnight)  borrowings.  KNBT had no short-term (overnight) borrowings from the
FHLB at December 31, 2003.  The  advances are  collateralized  by FHLB stock and
otherwise  unencumbered  qualified assets. The fair value of such collateral for
these  advances  totaled  approximately  $821.7 million at December 31, 2003 and
$547.4  million at December 31,  2002.  These  advances  had a weighted  average
interest rate of 4.21% and 4.69% for the years ended December 31, 2003 and 2002,
respectively.  Advances are made pursuant to several  different  credit programs
offered from time to time by the FHLB.

         KNBT's outstanding FHLB borrowings at December 31, 2003 mature as
follows:


--------------------------------------------------------

                                     (dollars in thousands)
2004 .........................           $ 24,300
2005 .........................             20,000
2006 .........................             20,000
2007 .........................             61,626
2008 ........................              13,000
2009 and Thereafter .........              68,227
                               -------------------

                                        $ 207,153
                               ===================

-------------------------------------------------------



                                      -67-
<PAGE>



2. Securities Sold Under Agreements to Repurchase

         KNBT,  pursuant to a designated  cash  management  agreement,  utilizes
securities sold under  agreements to repurchase as vehicles for customers' sweep
and  term  investment  products.  Securitization  under  these  cash  management
agreements are in U.S.  Treasury and Agency Securities and obligations of states
and political subdivisions securities.

         These  securities  are  held  in a  third  party  custodian's  account,
designated  by the Bank  under a written  custodial  agreement  that  explicitly
recognizes KNBT's interest in the securities.

         KNBT's details of securities sold under agreements to repurchase are as
follows:

<TABLE>
<CAPTION>


<S>                                                     <C>               <C>            <C>
-------------------------------------------------------------------------------------------------

                                                                Year ended December 31,
                                                   ----------------------------------------------
                                                           2003             2002            2001
                                                   -----------------  ---------------  ----------
                                                                 (dollars in thousands)
Average balance outstanding ........................    $ 11,931          $ 7,330        $ 2,431
Maximum amount outstanding any
   month-end during the period .....................    $ 29,010         $ 10,051        $ 5,752
Balance outstanding at end of period ...............    $ 24,550          $ 8,904        $ 5,752
Average interest rate during the period ............       1.10%            2.09%          3.79%
Weighted-average interest rate at end of period ....       0.64%            1.85%          2.49%


</TABLE>

3. Guaranteed Preferred Beneficial Interest in KNBT's Subordinated Debenture

         As a result  of the  merger  with  First  Colonial,  the  Company  also
acquired First Colonial  Statutory Trust I (the "Statutory Trust I") and assumed
its debt.  Statutory Trust I is a wholly-owned  Connecticut  statutory  business
trust subsidiary of the Company  organized for the sole purpose of issuing trust
preferred  securities that are fully and unconditionally  guaranteed by KNBT. On
June 26, 2002, First Colonial issued $15.0 million of subordinated debentures to
Statutory Trust I and the Statutory Trust I issued $15.0 million in pooled trust
preferred  securities.  The  subordinated  debentures  are the sole asset of the
Statutory Trust. The trust preferred securities are classified as long-term debt
for the financial statements,  but are included as Tier I capital for regulatory
purposes.  The interest  rate on this  security  (4.62% at December 31, 2003) is
variable,  adjusting  quarterly at the  three-month  LIBOR rate plus 3.45%.  The
interest is payable  quarterly.  The trust preferred  securities  mature in June
2007,  or may be redeemed at any time in the event that the deduction of related
interest  for federal  income tax  purposes is  prohibited,  treatment as Tier I
capital is no longer  permitted or certain other  contingencies  arise.  The net
proceeds  of the  trust  preferred  securities  have been  used to  support  the
Company's growth and expansion and for other general corporate purposes.



                                      -68-
<PAGE>


NOTE J - INCOME TAXES

         The  components  of KNBT's  income  taxes were as follows for the years
ended:

<TABLE>
<CAPTION>


---------------------------------------------------------------------------

                                    Year ended December 31,
                    -------------------------------------------------------

                            2003                 2002                2001
                    --------------      ---------------     ---------------
                                     (dollars in thousands)
Current:
    Federal ........      $ 1,249              $ 5,232             $ 3,280
    State ..........            -                  128                 (56)
                    --------------      ---------------     ---------------
                            1,249                5,360               3,224

Deferred:
    Federal ........       (6,513)                (172)                102
                    --------------      ---------------     ---------------
                          $(5,264)             $ 5,188             $ 3,326
                    ==============      ===============     ===============



         The  reconciliation  of KNBT's tax computed at the statutory rate is as
follows:

<S>                                        <C>         <C>                  <C>                 <C>
                                                               Year ended December 31,
                                                 -------------------------------------------------------
                                                         2003                 2002                2001
                                                 --------------      ---------------      --------------
                                                                  (dollars in thousands)
Tax (benefit) expense at statutory rate of 35% .       $(3,857)             $ 6,019             $ 3,888
Increase (decrease) resulting from:
   Tax-exempt income ...........................        (1,565)              (1,036)               (657)
   State tax expense, net federal benefit ......             -                   84                  19
   Other, net ..................................           158                  121                  76
                                                 --------------      ---------------      --------------
      Income tax (benefit) expense .............       $(5,264)             $ 5,188             $ 3,326
                                                 ==============      ===============      ==============

</TABLE>


         Deferred tax assets and liabilities consist of the following:

-------------------------------------------------------------------------------

                                                             At December 31,
                                                       ------------------------
                                                         2003             2002
                                                       -------          -------
                                                         (dollars in thousands)
Deferred tax assets:
   Deferred compensation ..........................    $ 1,268          $   773
   Allowance for loan losses ......................      2,344            1,025
   Investment acquisition adjustment ..............      2,081               --
   Charitable contribution ........................      5,540               --
   Other ..........................................        584              286
                                                       -------          -------
                                                        11,817            2,084

Deferred tax liabilitites:
   Fixed assets ...................................      2,057              819
   Core deposit intangible ........................      5,995               --
   Mortgage servicing rights ......................        111              412
   Unrealized gains on securities avalable-for-sale      3,253            2,434
                                                       -------          -------
                                                        11,416            3,665
                                                       -------          -------
      Net deferred tax (liability) ................    $   401          $(1,581)
                                                       =======          =======




                                      -69-
<PAGE>



         As a result of the  acquisition  of First  Colonial,  KNBT  computed  a
deferred tax asset of $9.7 million and deferred tax  liabilities of $7.5 million
for the core deposit  intangible  and the step up of the fixed assets  acquired.
KNBT will not be required to recapture approximately $9.8 million of its tax bad
debt reserve attributable to bad debt deductions taken prior to 1988, as long as
the Bank  continues to operate as a bank under  federal tax law and does not use
the reserve for any other purpose. In accordance with SFAS No. 109, KNBT has not
recorded any deferred tax liability on this portion of its tax bad debt reserve.
The tax that would be paid if KNBT  ultimately  was required to  recapture  that
portion of the reserve would amount to approximately $3.4 million.

NOTE K - RETIREMENT PLANS

1. Defined Benefit Plans

         KNBT  participates in a multiple employer defined benefit pension plan,
which covers  substantially all employees with 1,000 hours of service during the
plan year.  Benefits  are  generally  based on years of service  and the highest
average  compensation  of  five  consecutive  years  of  employment.  It is  the
Company's  policy to fund the amount which satisfies the statutory  requirements
under the Employee  Retirement Income Security Act. KNBT's  contributions to the
multiple  employee pension plan for the years ended December 31, 2003, 2002, and
2001 were  approximately  $816,000,  $529,000  and  $239,000,  respectively.  In
October  2003,  KNBT froze the  future  accrual of  benefits  under the  defined
benefit pension plan. KNBT will continue to contribute to this plan for benefits
accrued prior to October 2003.

2. Defined Contribution Plan

         KNBT also has a 401(k) plan which covers  substantially  all employees.
Employees may elect to defer 1% to 20% of their compensation per year. KNBT will
match  50%  of the  contributions  up to 6% of  compensation  per  year.  KNBT's
contributions to the 401(k) plan totaled  approximately  $306,000,  $222,000 and
$167,000 for the years ended December 31, 2003, 2002, and 2001 respectively.

3. Employee Stock Ownership Plan

         KNBT established an ESOP in November 2003 for all eligible employees as
defined by the ESOP.  KNBT  accounts for its ESOP in  accordance  with SOP 93-6,
"Employers'  Accounting for Employee Stock  Ownership  Plans." The ESOP borrowed
$16.1 million from KNBT to purchase  949,845  shares of KNBT common stock in the
market at an average price of $17.01 per share.

         Under SOP 93-6, unearned ESOP shares are not considered outstanding and
are shown as a  reduction  of  shareholders'  equity as  unearned  compensation.
Dividends on unallocated ESOP shares are considered to be compensation  expense.
KNBT will recognize compensation cost equal to the fair value of the ESOP shares
during the periods in which they become committed to be released.  To the extent
that the fair value of KNBT's ESOP shares  differs from the cost of such shares,
this differential will be credited to equity.  KNBT will receive a tax deduction
equal to the cost of the shares released.  As the loan is internally  leveraged,
the loan receivable from the ESOP to KNBT is not reported as an asset nor is the
debt of the ESOP shown as a Company liability. Dividends on allocated shares are
expected to be used to pay the ESOP debt. The ESOP compensation expense for 2003
was $165,000, which is the fair value of the shares released in 2003 as provided
by SOP 93-6.  At December  31,  2003,  the ESOP had a total of 949,845 of KNBT's
common stock, of which 940,122 were  unallocated  and 9,723 were allocated.  The
fair value of the unreleased ESOP shares,  using the closing quoted market price
of $17.58 per share at year end, was approximately $16.5 million at December 31,
2003.

4. Post-Retirement Benefit

         KNBT, as a part of the merger, assumed First Colonial's post-retirement
benefit plan that covers certain First  Colonial  retired  employees.  This plan
generally provides medical insurance benefits to a group of previously qualified
retirees  and  spouses  who were 60 years of age or older on January 1, 1992 and
who have retired after attaining age 65. This plan is unfunded.  As permitted by
SFAS No. 106, the



                                      -70-
<PAGE>

Company  elected  to delay the  recognition  of this  transition  obligation  by
aggregating  $308,000,  which arose from adopting  SFAS No. 106, and  amortizing
this amount on a straight-line basis over 20 years.

         The components of the net periodic post-retirement benefit cost are as
follows:



-------------------------------------------------------------
Post-Retirement Plan
Year Ended December 31,                      2003
-------------------------------------------------------------
                                     (dollars in thousands)
Interest cost .....................               $ 8
Amortization of transition
  obligation ......................                15
Amortization of unrecognized gain .                (8)
                                     -----------------
Net periodic benefit cost .........              $ 15
                                     =================

-------------------------------------------------------------



         The  assumptions  used  to  develop  the net  periodic  post-retirement
benefit cost are as follows:



--------------------------------------------------------
At December 31, 2003
--------------------------------------------------------

Discount rate .....................               6.50%
Medical care cost
  trend rate ......................               7.00%




         The  medical  care  cost  trend  used  in  the  actuarial   computation
ultimately  is reduced to 7.0% in the year 2003 and 6.0% in 2005 and  subsequent
years.  This was  accomplished  using 0.5% decrements  through the year 2005 and
later.

         The table of actuarially  computed plan assets and benefit  obligations
for KNBT is presented below.


---------------------------------------------------------------------
Post-Retirement Plan
For the Year Ended December 31,                          2003
---------------------------------------------------------------------
                                                 (dollars in thousands)
Change in benefit obligation:
Benefit obligation assumed from merger
  with First Colonial ........................          $ 163
Service cost .................................             --
Interest cost ................................              8
Actual gain ..................................             --
Change due to change in experience ...........            (31)
Change due to change in assumption ...........             --
Benefits paid ................................            (16)
                                                        -----
Benefits obligation at end of year ...........          $ 124
                                                        =====

Change in plan assets:
Fair value of plan assets at beginning of year          $  --
Actual return on plan assets .................             --
Employer contribution ........................             --
Benefits paid ................................             --
                                                        -----
Fair value of plan assets at end of year .....             --

Funded status ................................           (124)
Unrecognized net transition obligation .......            139
Unrecognized net gain ........................            (83)
                                                        -----
Accrued benefit cost .........................          $ (68)
                                                        =====



                                      -71-
<PAGE>


         The effect of a one  percentage  point  increase in each future  year's
assumed medical care cost trend rate,  holding all other  assumptions  constant,
would have been to increase the accumulated  post-retirement  benefit obligation
by $8,224  and the net  post-retirement  benefit  cost by $502.  Decreasing  the
assumed health care cost trend rates by one percentage  point in each year would
decrease the accumulated  post-retirement  benefit  obligation by $7,508 and the
net post-retirement benefit cost by $458.

         Health care  benefits are provided to certain  retired  employees.  The
cost of providing these benefits was approximately $17,000 in 2003.

5. Directors' Deferred Plan

         KNBT,  as part of the  merger,  assumed the First  Colonial  directors'
deferred plan involving  certain former  directors of First  Colonial.  The plan
requires  defined annual  payments for five to fifteen years beginning at age 65
or death.  The annual  benefit is based upon the amount  deferred plus interest.
KNBT has recorded the deferred compensation  liabilities using the present value
method.

         The following  table sets forth the changes in benefit  obligations and
plan assets of the directors' deferred plan.

         Actuarial present value of benefit obligations is as follows:

<TABLE>
<CAPTION>


<S>                                                                         <C>
-------------------------------------------------------------------------------------------
Directors' Deferred Plan
At December 31                                                               2003
-------------------------------------------------------------------------------------------
                                                                     (dollars in thousands)
Change in benefit obligation:
Benefit obligation assumed from merger with First Colonial .......          $ 389
Service cost .....................................................             --
Interest cost ....................................................             25
Change due to change in assumptions ..............................             10
Change due to plan amendment .....................................             --
Actual (gain) loss ...............................................            (11)
Benefits paid ....................................................            (53)
                                                                            -----
Benefits obligation at end of year ...............................          $ 360
                                                                            =====

Change in plan assets:
Fair value of plan assets received from merger with First Colonial          $  --
Actual return on plan assets .....................................             --
Employer contribution ............................................             53
Benefits paid ....................................................            (53)
                                                                            -----
Fair value of plan assets at end of year .........................             --

Funded status ....................................................           (360)
Unrecognized net transition asset ................................             --
Unrecognized net actuarial (gain) loss ...........................             31
Unrecognized prior service cost ..................................             --
Adjustment to recognize
  additional minimum liability ...................................            (31)
                                                                            -----
Accrued benefit cost .............................................          $(360)
                                                                            =====

-------------------------------------------------------------------------------------------


</TABLE>




                                      -72-
<PAGE>



         The  weighted-average  assumed  discount rates used in determining  the
actuarial present value of the projected  benefit  obligation were 6.5% in 2003.
The  weighted-average  expected  long-term rate of return on assets was 9.0% for
2003.


------------------------------------------------------------
Directors' Deferred Plan
Year ended December 31,                           2003
------------------------------------------------------------
                                     (dollars in thousands)
Service cost ............................               $ -
Interest cost ...........................                25
Net amortization and
  deferral of prior service costs .......                 -
                                             ---------------
Net Periodic Benefit Cost ...............              $ 25
                                             ===============


6. Deferred Compensation Plans

         KNBT maintains two deferred  compensation plans. One of these plans was
acquired   through  KNBT's   acquisition  of  First  Colonial.   These  deferred
compensation arrangements permit the directors and certain executive officers to
defer director's fees or salary,  as the case may be, and other  compensation at
the election of the  participants.  At December 31, 2003, there were $223,000 in
accumulated  balances for Keystone's directors (compared to $138,000 at December
31,  2002) and  $224,000  in  accumulated  balances  for former  First  Colonial
directors  under the acquired  First Colonial plan for an aggregate of $467,000.
The  weighted-average  earnings  for  directors  in these plans in 2003 was 4.3%
under the  Keystone  plan and 1.3% under the former  First  Colonial  plan.  The
weighted-average  earnings for  director's  deferred  accounts was 4.7% in 2002.
Deferred  fees will be paid out when the  participant  retires  or as  otherwise
provided by the plan agreements.  Selected executive officers also are permitted
to  defer  compensation.  The plan  includes  all  funds  that  were  previously
identified as the executive  supplemental  retirement plan. At December 31, 2003
and 2002, the balance  accumulated for executive officers was approximately $1.7
million  and  $934,000,  respectively.  The  weighted-average  earnings on these
deferred funds for executive  officers was 2.0% in 2003 and 0.5% in 2002.  These
deferred  amounts  will be paid out when the  executive  retires or as otherwise
provided by the plan agreement.


NOTE L - STOCK OPTIONS

         KNBT assumed the First  Colonial stock option plans on October 31, 2003
pursuant to the merger agreement.  Outstanding options to acquire 218,417 shares
of First  Colonial  common stock were  converted  to options to acquire  808,157
common  shares of the  Company's  stock at the  exchange  ratio of 3.7 shares of
KNBT's stock for each share of First  Colonial's  stock.  All of the outstanding
options  acquired  were fully  vested  prior to the merger  date.  There were no
options awarded after the merger date.



                                      -73-
<PAGE>



         A summary of the stock option plans as of December 31, 2003 and changes
during the year follows:


----------------------------------------------------------------------------
Stock Option Plans
Year Ended December 31, 2003
----------------------------------------------------------------------------
                                                                  Weighted
                                                                  Average
                                                                  Exercise
                                               Shares              Price
                                          ----------------    --------------
Outstanding at beginning of year ..........             -                $ -
Acquired from merger with First Colonial ..       808,157               5.62
Granted ...................................             -                  -
Exercised .................................       (56,259)              5.51
Expired ...................................             -                  -
Outstanding at end of year ................       751,898             $ 5.63



         The following table summarizes information concerning the Company's
stock option plans outstanding at December 31, 2003:

<TABLE>
<CAPTION>


<C>     <C>                        <C>                  <C>                <C>                <C>                    <C>
-------------------------------------------------------------------------------------------------------------------------------
              Options outstanding                                                               Options exercisable
-------------------------------------------------------------------------------------    --------------------------------------

                                                  Weighted
                                                  Average               Weighted                                 Weighted
                                                 Remaining              Average                                   Average
        Range of             Number             Contractual             Exercise           Number                Exercise
     Exercise Price        Outstanding          Life (years)             Price           Exercisable               Price
------------------------------------------    -----------------     -----------------    ---------------     ------------------
$2.35 - $3.14 ......               10,938               0.8                $ 3.07             10,938                 $ 3.07

$3.14 - $3.92 ......               10,930               5.1                $ 3.81             10,930                 $ 3.81

$3.92 - $4.70 ......              115,923               6.6                $ 4.26            115,923                 $ 4.26

$4.70 - $5.49 ......               45,554               4.1                $ 5.02             45,554                 $ 5.02

$5.49 - $6.27 ......              394,816               7.7                $ 5.69            394,816                 $ 5.69

$6.27 - $7.06 ......              125,333               8.3                $ 6.44            125,333                 $ 6.44

$7.06 - $7.84 ......               48,404               2.9                $ 7.84             48,404                 $ 7.84
                        ------------------                                            ---------------
                                  751,898                                                    751,898
                        ==================                                            ===============

</TABLE>


NOTE M - FAIR VALUE OF FINANCIAL INSTRUMENTS

         SFAS No. 107 requires  disclosure of the estimated fair value of assets
and liabilities  considered to be financial  instruments.  For KNBT, as for most
financial  institutions,   the  majority  of  its  assets  and  liabilities  are
considered financial  instruments as defined in SFAS No. 107. However, many such
instruments lack an available trading market as characterized by a willing buyer
and willing seller engaging in an exchange transaction.  Therefore,  KNBT had to
use  significant  estimations  and present  value  calculations  to prepare this
disclosure, as required by SFAS No. 107. Accordingly,  the information presented
below does not purport to represent the aggregate net fair value of KNBT.

         Changes in the  assumptions  or  methodologies  used to  estimate  fair
values  may  materially  affect  the  estimated  amounts.  Also,  management  is
concerned that there may not be reasonable  comparability  between  institutions
due to the wide range of permitted  assumptions and methodologies in the absence
of  active  markets.  This lack of  uniformity  gives  rise to a high  degree of
subjectivity in estimating financial instrument fair values.



                                      -74-
<PAGE>


         Estimated  fair  values  have  been   determined  by  KNBT  using  what
management believes to be the best available data and an estimation  methodology
suitable for each category of financial instruments. The estimated methodologies
used, the estimated fair values, and recorded book balances at December 31, 2003
and 2002 are set forth below.

         For cash and due from banks and  interest-bearing  deposits with banks,
the recorded book values of  approximately  $139.0 million and $86.3 million are
deemed to approximate fair values at December 31, 2003 and 2002, respectively.

         The estimated fair values of investment and mortgage-backed  securities
are based on quoted market prices, if available. If quoted market prices are not
available,  the  estimated  fair  values  are based on quoted  market  prices of
comparable  instruments.  The fair values of loans are estimated on a discounted
cash flow analysis using interest rates currently offered for loans with similar
terms to  borrowers of similar  credit  quality.  The carrying  value of accrued
interest is deemed to approximate fair value.

<TABLE>
<CAPTION>
<S>                                         <C>               <C>                    <C>               <C>

-----------------------------------------------------------------------------------------------------------------
                                                                     At December 31,
                                     ----------------------------------------------------------------------------
                                                   2003                                      2002
                                     -----------------------------------      -----------------------------------
                                        Carrying          Estimated               Carrying         Estimated
                                         Amount          Fair Value                Amount         Fair Value
                                     -----------------------------------      -----------------------------------
                                                              (dollars in thousands)
Investment and mortgage-backed
   securities .......................   $ 734,087         $ 734,087              $ 294,150         $ 294,150
Federal Home Loan Bank
   of Pittsburgh stock ..............   $  11,543         $  11,543              $   8,011         $   8,011
Loans receivable ....................   $ 886,843         $ 889,262              $ 558,453         $ 580,363
Mortgage loans held-for-sale ........   $   4,677         $   4,677              $  23,796         $  23,796

</TABLE>

         The estimated fair values of demand  deposits  (i.e.,  interest-bearing
and non-interest-bearing  checking accounts,  passbook savings and certain types
of money market  accounts)  are, by  definition,  equal to the amount payable on
demand at the  reporting  date (i.e.,  their  carrying  amounts).  The  carrying
amounts of  variable-rate,  fixed-term money market accounts and certificates of
deposit  approximate their fair values at the reporting date. The fair values of
fixed-rate  certificates  of deposit are estimated  using a discounted cash flow
calculation that applies interest rates currently being offered to a schedule of
aggregated  expected  monthly time deposit  maturities.  The carrying  amount of
accrued interest payable approximates its fair value.

<TABLE>
<CAPTION>

<S>                                <C>           <C>                     <C>         <C>

-------------------------------------------------------------------------------------------------
                                                         At December 31,
                                   --------------------------------------------------------------
                                             2003                                 2002
                                   ----------------------------      ----------------------------
                                    Carrying     Estimated               Carrying    Estimated
                                     Amount     Fair Value                Amount    Fair Value
                                   ----------------------------      ----------------------------
                                                        (dollars in thousands)
   Time deposits ............      $547,697      $562,174                $389,179    $393,111
   Securities sold under
     agreements to repurchase      $ 24,550      $ 24,550                $  8,904    $  8,904
   Advances from the
     Federal Home Loan Bank .      $207,153      $212,082                $113,500    $120,334

</TABLE>


         The guaranteed  preferred  beneficial  interest in KNBT's  subordinated
debt had a carrying value of $15.0 million at December 31, 2003. The interest on
this debt is tied to LIBOR and changes  quarterly.  The estimated  fair value at
December 31, 2003 was $15.0 million.



                                      -75-
<PAGE>


         The fair value of  commitments  to extend credit is estimated  based on
the amount of  unamortized  deferred  loan  commitment  fees.  The fair value of
letters of credit is based on the  amount of  unearned  fees plus the  estimated
cost to terminate the letters of credit.  Fair values of unrecognized  financial
instruments including commitments to extend credit and the fair value of letters
of credit are considered immaterial.


NOTE N - FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK

         KNBT is a party to financial instruments with off-balance-sheet risk in
the normal  course of business  to meet the  financing  needs of its  customers.
These  financial  instruments  include  commitments to extend credit and standby
letters of credit.  Those instruments  involve, to varying degrees,  elements of
credit  and  interest  rate  risk in  excess  of the  amount  recognized  in the
consolidated  balance  sheet.  KNBT's  exposure  to credit  loss in the event of
nonperformance by the other party to the financial instrument for commitments to
extend credit and standby  letters of credit is represented  by the  contractual
amount  of those  instruments.  KNBT  uses the same  credit  policies  in making
commitments  and  conditional   obligations  as  it  does  for  on-balance-sheet
instruments.

         KNBT  had  the  following   approximate   off-balance-sheet   financial
instruments whose contract amounts represent credit risk.

<TABLE>
<CAPTION>


<S>                                                             <C>                 <C>
---------------------------------------------------------------------------------------------
                                                                   At December 31,
                                                         -----------------------------------
                                                                 2003               2002
--------------------------------------------------------------------------------------------
                                                                (dollars in thousands)
Commitments to extend credit Lines of credit:
      Commercial loans ..................................       $ 86,664            $48,880
      Home equity secured by mortgage ...................         45,341             26,590
      Unsecured consumer including credit card ..........          7,100              8,712
                                                         ----------------   ----------------
         Total lines of credit ..........................        139,105             84,182
   Letters of credit ....................................         15,297              3,366
   Other loan commitments:
      Commercial loans unsecured ........................         14,580                  -
      Residential mortgages .............................         55,583             19,007
      Other mortgages ...................................         51,758              1,663
      Consumer (auto, personal) .........................          8,881                  -
                                                         ----------------   ----------------
         Total other loan commitments ...................        130,802             20,670
                                                         ----------------   ----------------
Total commitments to extend credit ......................      $ 285,204           $108,218
                                                         ================   ================

--------------------------------------------------------------------------------------------

</TABLE>



         Commitments  to extend  credit are  agreements to lend to a customer as
long as there is no  violation of any  condition  established  in the  contract.
Commitments  generally have fixed expiration dates or other termination  clauses
and may require  payment of a fee. Since many of the commitments are expected to
expire without being drawn upon, the total commitment amounts do not necessarily
represent   future   cash   requirements.   KNBT   evaluates   each   customer's
creditworthiness on a case-by-case basis. The amount of collateral obtained,  if
deemed  necessary  by KNBT upon  extension of credit,  is based on  management's
credit  evaluation  of the  customer.  Collateral  held  varies but may  include
guarantees,  personal or commercial real estate, accounts receivable,  inventory
and equipment.

                                      -76-
<PAGE>


         Standby letters of credit are conditional commitments issued by KNBT to
guarantee the performance of a customer to a third party.  Those  guarantees are
primarily issued to support contracts entered into by customers. Most guarantees
extend for one year.  The credit risk  involved in issuing  letters of credit is
essentially the same as that involved in extending loan facilities to customers.
KNBT holds collateral to support these commitments. The Bank had standby letters
of credit of $15.3  million  and $3.4  million at  December  31,  2003 and 2002,
respectively.  These letters of credit expire as follows:  $7.6 million in 2004,
$7.4 million in 2005 through 2006, and $54,000 in 2007.

         A substantial  amount of KNBT's loans are secured by real estate in the
Northampton,  Lehigh, Monroe, and Carbon counties of northeastern  Pennsylvania.
Loans purchased from other  financial  institutions  or  participation  in loans
originated  by  other  financial  institutions  constitute  less  than 1% of the
Company's loans outstanding. Accordingly, KNBT's primary concentration of credit
risk is  related  to the real  estate  market in the four  county  areas and the
ultimate  collectibility of this portion of KNBT's loan portfolio is susceptible
to changes in economic conditions in that area.

NOTE O - LEASE COMMITMENTS

         The  Bank has  entered  into  several  noncancellable  operating  lease
agreements  for its  branch  banking  facilities.  The Bank is  responsible  for
pro-rata operating expense  escalations.  The approximate  minimum annual rental
payments at December 31, 2003 under these leases are as follows:

-------------------------------------------------

                       (dollars in thousands)
2004 ..................            $ 1,317
2005 ..................              1,177
2006 ..................                989
2007 ..................                734
2008 ..................                627
2009 and Thereafter ...              5,701
                         ------------------

                                  $ 10,545
                         ==================

-------------------------------------------------

         Lease expense for the years ended December 31, 2003,  2002 and 2001 was
$769,000, $474,000, and $339,000, respectively.

NOTE P - REGULATORY MATTERS

         KNBT is subject to various regulatory capital requirements administered
by the federal banking  agencies.  Failure to meet minimum capital  requirements
can initiate certain mandatory - and possibly additional discretionary - actions
by regulators that, if undertaken, could have a direct material effect on KNBT's
financial  statements.  Under capital  adequacy  guidelines  and the  regulatory
framework  for prompt  corrective  action,  KNBT and the Bank must meet specific
capital guidelines that involve  quantitative  measures of KNBT's and the Bank's
assets,  liabilities  and certain  off-balance-sheet  items as calculated  under
regulatory  accounting  practices.  KNBT's and the Bank's  capital  amounts  and
classifications  are also subject to  qualitative  judgments  by the  regulators
about components, risk weightings and other factors.

         KNBT's  ability  to  declare  and pay  dividends  may depend in part on
dividends  received from the Bank. The  Pennsylvania  Banking Code regulates the
distribution  of dividends by savings banks and states,  in part, that dividends
may be declared  and paid only out of  accumulated  net  earnings and may not be
declared  or paid  unless  surplus,  retained  earnings,  is at  least  equal to
contributed  capital. In addition,  dividends may not be declared or paid if the
Bank  is in  default  in  payment  of any  assessment  due the  Federal  Deposit
Insurance Corporation.

         The Federal  Reserve Board issued a policy  statement on the payment of
cash  dividends  by the bank  holding  companies,  which  expresses  the Federal
Reserve  Board's view that a bank holding


                                      -77-
<PAGE>


company should pay cash dividends only to the extent that the holding  company's
net income for the past year is sufficient to cover both the cash  dividends and
a rate of earnings  retention  that is  consistent  with the  holding  company's
capital needs, asset quality and overall financial condition.

         Quantitative  measures  established  by  regulations  to ensure capital
adequacy  require KNBT and the Bank to maintain  minimum amounts and ratios (set
forth in the  table  below)  of total  and Tier I  capital  (as  defined  in the
regulations)  to  risk-weighted  assets (as defined),  and of Tier I capital (as
defined) to average assets (as defined).  As of December 31, 2003,  KNBT and the
Bank met all capital adequacy requirements to which they are subject.

         As of December 31, 2003, the most recent  notification from the Federal
Deposit Insurance Corporation  categorized the Bank as "well-capitalized"  under
the  regulatory  framework for prompt  corrective  action.  To be categorized as
"adequately capitalized" the Bank must maintain minimum total risk-based, Tier I
risk-based  and Tier I leverage  ratios as set forth in the table.  There are no
conditions  or events since that  notification  that  management  believes  have
changed in the institution's category.

         The following  table provides a comparison of KNBT's and Bank's capital
amounts,   risk-based  capital  ratios  and  leverage  ratios  for  the  periods
indicated.

<TABLE>
<CAPTION>


<S>                                <C>                <C>              <C>               <C>

-----------------------------------------------------------------------------------------------------------------------------------
Capital Ratios                                                           Required                      To Be Well Capitalized
                                                                         For Capital                  Under Prompt Corrective
                                           Actual                       Adequacy Purposes                 Action Provisions
                                 ----------------------------    ------------------------------   ---------------------------------
at December 31, 2003             Amount            Ratio            Amount           Ratio            Amount            Ratio

-----------------------------------------------------------------------------------------------------------------------------------
Total Capital                                                         (dollars in thousands)
(To risk-weighted assets)
   KNBT, (consolidated) .........  $ 359,522          33.24%           $86,535           8.00%               N/A              N/A
   Bank .........................  $ 258,441          24.01%           $86,123           8.00%         $ 107,654            10.00%

Tier I Capital
(To risk-weighted assets)
   KNBT, (consolidated) .........  $ 351,612          32.51%           $43,268           4.00%               N/A              N/A
   Bank .........................  $ 250,499          23.27%           $43,062           4.00%          $ 64,593             6.00%

Tier I Capital
(To average assets, leverage)
   KNBT, (consolidated) .........  $ 351,612          19.39%           $72,525           4.00%               N/A              N/A
   Bank .........................  $ 250,499          13.42%           $74,646           4.00%          $ 93,307             5.00%

-----------------------------------------------------------------------------------------------------------------------------------

                                                                         Required                     To Be Well Capitalized
                                                                         For Capital                  Under Prompt Corrective
                                           Actual                      Adequacy Purposes                 Action Provisions
                                 ----------------------------    ------------------------------   ---------------------------------
at December 31, 2002             Amount            Ratio            Amount           Ratio            Amount            Ratio
-----------------------------------------------------------------------------------------------------------------------------------
Total Capital                                                         (dollars in thousands)
(To risk-weighted assets)
   Bank .........................  $ 109,137          18.69%           $46,702           8.00%          $ 58,378            10.00%

Tier I Capital
(To risk-weighted assets)
   Bank .........................  $ 106,210          18.19%           $23,351           4.00%          $ 35,027             6.00%

Tier I Capital
(To average assets, leverage)
   Bank .........................  $ 106,210          10.78%           $39,410           4.00%          $ 49,263             5.00%

-----------------------------------------------------------------------------------------------------------------------------------

</TABLE>

                                      -78-
<PAGE>



NOTE Q - QUARTERLY FINANCIAL DATA (Unaudited)

         The following  represents  summarized quarterly financial data of KNBT,
which, in the opinion of management,  reflects all adjustments  (comprising only
normal recurring accruals) necessary for a fair presentation.  Per share data is
not included because no shares were issued prior to November 2003.


<TABLE>
<CAPTION>

<S>                                              <C>                  <C>                  <C>                   <C>

-------------------------------------------------------------------------------------------------------------------------
Quarterly Financial Data (Unaudited)
                                                                        Three Months Ended

-------------------------------------------------------------------------------------------------------------------------
                              2003             Dec. 31              Sept. 30             June 30              March 31
-------------------------------------------------------------------------------------------------------------------------
                                                                        (dollars in thousands)
Interest income .........................        $18,153              $13,193              $13,578               $14,139
Interest expense ........................          6,110                4,657                4,991                 5,303
Net interest income .....................         12,043                8,536                8,587                 8,836
Provision for loan losses ...............          2,095                  468                  326                    62
Non-interest income .....................          2,447                2,018                2,401                 2,182
Non-interest expense ....................         33,213                7,852                7,148                 6,906
Income (loss) before income taxes .......        (20,819)               2,234                3,514                 4,050
Net income (loss) .......................        (13,087)               1,756                2,626                 2,949

-------------------------------------------------------------------------------------------------------------------------
                               2002             Dec. 31              Sept. 30             June 30              March 31
-------------------------------------------------------------------------------------------------------------------------

Interest income .........................        $14,667              $15,164              $14,721               $14,927
Interest expense ........................          5,821                6,521                6,919                 7,155
Net interest income .....................          8,846                8,643                7,802                 7,772
Provision (recovery) for loan losses ....             58                  301                  197                  (445)
Non-interest income .....................          2,544                1,964                1,663                 2,643
Non-interest expense ....................          7,589                6,079                5,718                 5,182
Income before income taxes ..............          3,743                4,227                3,550                 5,678
Net income ..............................          2,496                3,017                2,601                 3,896

-------------------------------------------------------------------------------------------------------------------------


</TABLE>






                                      -79-
<PAGE>



NOTE R - KNBT BANCORP, INC.
(PARENT COMPANY ONLY)

<TABLE>
<CAPTION>


<S>                                                                                                <C>
-------------------------------------------------------------------------------------------------------
Condensed Balance Sheet
December 31,                                                                            2003
-------------------------------------------------------------------------------------------------------
                                                                                (dollars in thousands)
Assets
   Cash and due from banks ....................................................              $       3
   Interest-bearing deposits with banks .......................................                 94,477
                                                                                  ---------------------
       Total cash and cash equivalents ........................................                 94,480
   Loans receivable ...........................................................                 15,920
   Investment in banking subsidiary ...........................................                302,897
   Investment in other subsidiaries ...........................................                  5,706
   Other assets ...............................................................                  7,380
                                                                                  ---------------------
       Total Assets ...........................................................              $ 426,383
                                                                                  =====================

Liabilities
   Long-term ESOP debt ........................................................              $  15,920
   Guaranteed beneficial interest in the Company's subordinated debentures ....                 15,464
   Other liabilities ..........................................................                  5,919
                                                                                  ---------------------
       Total Liabilities ......................................................                 37,303

Shareholder's Equity ..........................................................                389,080
                                                                                  ---------------------
   Total Liability and Shareholder's Equity ...................................              $ 426,383
                                                                                  =====================

-------------------------------------------------------------------------------------------------------




--------------------------------------------------------------------------------------------------------
Condensed Statement of Operations
For the Year Ended December 31,                                                            2003
--------------------------------------------------------------------------------------------------------
                                                                                   (dollars in thousands)
Income
   Interest on deposits with banks ............................................              $      264
   Interest on ESOP loan ......................................................                      96
   Statutory trust income .....................................................                       5
                                                                                    --------------------
       Total Income ...........................................................                     365
                                                                                    --------------------

Expenses
   Interest on long-term ESOP debt ............................................                      96
   Interest on trust preferred securities .....................................                     120
   Contribution to charitable foundation ......................................                  16,161
   Other expenses .............................................................                      80
                                                                                    --------------------
       Total Expenses .........................................................                  16,457
                                                                                    --------------------

   Loss before tax benefit and equity in undistributed net earnings of subsidiaries             (16,092)
   Income tax benefit .........................................................                  (5,632)
                                                                                    --------------------
   Loss before equity in undistributed net earnings of subsidiaries ...........                 (10,460)
   Equity in undistributed net earnings of subsidiaries .......................                   4,704
                                                                                    --------------------
       Net Loss ...............................................................              $   (5,756)
                                                                                    ====================

--------------------------------------------------------------------------------------------------------

</TABLE>




                                      -80-
<PAGE>
<TABLE>
<CAPTION>


<S>                                                                                                  <C>
---------------------------------------------------------------------------------------------------------------
Condensed Statement of Cash Flows
For the Year Ended December 31,                                                                    2003
---------------------------------------------------------------------------------------------------------------
Operating Activities                                                                     (dollars in thousands)
   Net loss ..........................................................................               $ (5,756)
   Adjustments to reconcile net loss to net cash provided by operating activities:
      Distribution in excess of undistributed net loss of subsidiaries ...............                 (4,704)
      Contribution to charitable foundation ..........................................                 16,161
      Changes in assets and liabilities:
         Increase in other assets ....................................................                 (7,380)
         Increase in other liabilities ...............................................                  5,842
                                                                                           -------------------
Net Cash Provided by Operating Activities ............................................                  4,163
                                                                                           -------------------

Investing Activities
   Investment in subsidiaries ........................................................               (106,225)
                                                                                           -------------------
Net Cash Used In Investing Activities ................................................               (106,225)

Financing Activities
   Net proceeds from issuance of common stock ........................................                196,261
   Proceeds from the exercise of stock options .......................................                    311
                                                                                           -------------------
Net Cash Provided by Financing Activities ............................................                196,572
                                                                                           -------------------

Increase (decrease) in cash and cash equivalents .....................................                 94,480
Cash and cash equivalents, January 1, ................................................                      -
                                                                                           -------------------
Cash and cash equivalents, December 31, ..............................................               $ 94,480
                                                                                           ===================
---------------------------------------------------------------------------------------------------------------

</TABLE>


                                      -81-
<PAGE>



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

                  None


Item 9A.   Controls and Procedures
-------    -----------------------

         Quarterly  evaluation of KNBT's Disclosure Controls and Procedures.  As
of  December  31,  2003,  KNBT  evaluated  the  effectiveness  of the design and
operation of its "disclosure controls and procedures"  ("Disclosure  Controls").
This evaluation ("Controls  Evaluation") was done under the supervision and with
the  participation  of the Chief  Executive  Officer ("CEO") Scott V. Fainor and
Chief Financial Officer ("CFO") Eugene T. Sobol.

         Conclusions.  Based upon the Controls Evaluation,  the CEO and CFO have
concluded that the Disclosure  Controls are effective to timely alert management
of material  information  relating  to KNBT during the period when its  periodic
reports are being prepared.


                                      -82-
<PAGE>


PART III

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

         The  information  required  by Item 10 of Form  10-K  with  respect  to
directors and executive  officers is  incorporated by reference from the section
captioned  "Information  with  Respect  to  Nominees  for  Director,  Continuing
Directors and Executive  Officers" in KNBT's  definitive proxy statement for the
annual  meeting  of  stockholders  to be  held  on  May  6,  2004,  (the  "Proxy
Statement")  to be filed with the Securities  and Exchange  Commission  prior to
April 29, 2004.

         KNBT has  adopted a Code of  Conduct  and  Ethics  that  applies to its
principal  executive officer and principal  financial officer,  as well as other
officers  and  employees of KNBT and the Bank. A copy of the Code of Conduct and
Ethics may be found on KNBT's website at www.KNBT.com.

Item 11.   Executive Compensation
--------   ----------------------

         The  information  required by Item 11 of Form 10-K is  incorporated  by
reference from the sections captioned "Management  Compensation," "Report of the
Human  Resources  Committee of Keystone"  and  "Performance  Graph" in the Proxy
Statement.

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

         The  information  required by Item 12 of Form 10-K is  incorporated  by
reference from the section  captioned  "Beneficial  Ownership of Common Stock by
Certain Beneficial Owners and Management" and "Management  Compensation - Equity
Compensation Plan Information" in the Proxy Statement.

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

         The  information  required by Item 13 of Form 10-K is  incorporated  by
reference from the section captioned "Management  Compensation - Indebtedness of
Management and Related Party Transactions" in the Proxy Statement.


Item 14.   Principal Accountant Fees and Services
-------    --------------------------------------

         The  information  required by Item 14 of Form 10-K is  incorporated  by
reference from the section captioned  "Ratification of Appointment of Auditors -
Audit Fees" in the Proxy Statement.


                                      -83-
<PAGE>



PART IV


Item 15.   Exhibits, Financial Statement Schedules and Reports on Form 8-K
--------   ---------------------------------------------------------------

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

                    Financial Statements: The Consolidated Financial Statements
                    of KNBT Bancorp, Inc. and the Report of Independent
                    Certified Public Accountants thereon, as listed below, have
                    been filed under "Item 8, Financial Statements and
                    Supplementary Data".

                    Report of Independent Certified Public Accountants

                    Consolidated Balance Sheets for the Years Ended
                    12/31/03 and 12/31/02

                    Consolidated Statements of Operations
                    for the Years Ended 12/31/03, 12/31/02 and 12/31/01

                    Consolidated Statement of Changes in Shareholders' Equity
                    for the Years Ended 12/31/03, 12/31/02 and 12/31/01

                    Consolidated Statements of Cash Flows for the Years Ended
                    12/31/03, 12/31/02 and 12/31/01

                    Notes to Consolidated Financial Statements

       (b)    Reports on Form 8-K
              -------------------

          (1)  On October 27, 2003,  KNBT filed a Form 8-K that  included  under
               Items  7  and  9  a  press  release  announcing  the  receipt  of
               regulatory  approvals  required to  complete  the  conversion  of
               Keystone  Savings Bank and the merger with First Colonial  Group,
               Inc.

          (2)  On November 3, 2003,  KNBT filed a Form 8-K that  included  under
               Items 7 and 9 a press release  announcing  the  completion of the
               conversion  of  Keystone  Savings  Bank and the merger with First
               Colonial Group, Inc.

          (3)  On December 23, 2003, KNBT filed a Form 8-K reporting under Items
               2 and 7 the acquisition of First Colonial Group, Inc.



                                      -84-
<PAGE>


         (c)      Exhibits
                  --------

         3.1      Articles of Incorporation of KNBT Bancorp, Inc. (1)

         3.2      Bylaws of KNBT Bancorp, Inc. (1)

         4.0      Form of Stock Certificate of KNBT Bancorp, Inc. (1)

         10.1     Employment  Agreement  between  Keystone  Savings  Bank,  KNBT
                  Bancorp and Scott V. Fainor (1)

         10.2     Employment  Agreement  between  Keystone  Savings  Bank,  KNBT
                  Bancorp and Eugene T. Sobol (1)

         10.3     Supplemental Executive Retirement Plan (1)

         10.4     Trustee and Executive Deferred Compensation Program

         10.5     Senior Management Variable Compensation Program (1)

         10.6     First  Colonial  Group,   Inc.  1994  Stock  Option  Plan  for
                  Non-Employee Directors (2)

         10.7     First Colonial Group, Inc. 1996 Employee Stock Option Plan (3)

         10.8     First Colonial Group, Inc. 2001 Stock Option Plan (4)

         10.9     Nazareth National Bank and Trust Co.  Deferred  Compensation
                  Plan for Directors

         21.0     Subsidiaries of the Registrant - Reference is made to "Item 1.
                  Business" for the required information

         23.0     Consent of Grant Thornton LLP

         31.1     Rule 13a-14(a) Certification of the Chief Executive Officer

         31.2     Rule 13a-14(a) Certification of the Chief Financial Officer

         32.0     Section 1350 Certifications

--------------------------------------------------------------------------------

         (1)      Incorporated by reference from KNBT's  Registration  Statement
                  on Form S-1 filed on June 6, 2003,  as amended,  and  declared
                  effective on August 12, 2003 (Registration No. 333-105899).

         (2)      Incorporated by reference from First Colonial's  Annual Report
                  on Form  10-KSB,  for the fiscal year ended  December 31, 1994
                  (File No. 000-11526).

         (3)      Incorporated by reference from First Colonial's  Annual Report
                  on Form  10-KSB,  for the fiscal year ended  December 31, 1995
                  (File No. 000-11526).

         (4)      Incorporated  by  reference  from First  Colonial's  quarterly
                  report on Form 10-Q, for the quarter ended June 30, 2001 (File
                  No. 000-11526).



                                      -85-
<PAGE>




                                   SIGNATURES

         In  accordance  with  Section  13 or 15(d)  of the  Exchange  Act,  the
registrant  caused  this  report to be signed on its behalf by the  undersigned,
thereunto duly authorized.

                                              KNBT BANCORP, INC.

Dated: March 26, 2004                         By: /s/ Scott V. Fainor
                                                  ------------------------------
                                                  SCOTT V. FAINOR, President and
                                                  Chief Executive Officer


         In accordance with the Exchange Act, this report has been signed below
by the following persons on behalf of the registrant and in the capacities as of
March 26, 2004.


By:       /s/ Jeffrey P. Feather
          -----------------------------------------------------------
          JEFFREY P. FEATHER
          Chairman of the Board
          and Director
          March 26, 2004

By:       /s/ Scott V. Fainor
          -----------------------------------------------------------
          SCOTT V. FAINOR
          President, Chief Executive Officer
          and Director (Principal Executive Officer)
          March 26, 2004

By:       /s/ Eugene T. Sobol
          -----------------------------------------------------------
          EUGENE T. SOBOL
          Senior Executive Vice President and Treasurer
          (Principal Financial Officer and
          Principal Accounting Officer)
          March 26, 2004

By:       /s/ Michael J. Gausling
          -----------------------------------------------------------
          MICHAEL J. GAUSLING
          Director
          March 26, 2004

          By: /s/ Donna D. Holton
          -----------------------------------------------------------
          DONNA D. HOLTON
          Director
          March 26, 2004

By:       /s/ Christian F. Martin, IV
          -----------------------------------------------------------
          CHRISTIAN F. MARTIN, IV
          Director
          March 26, 2004

By:       /s/ John A. Mountain
          -----------------------------------------------------------
          JOHN A. MOUNTAIN
          Director
          March 26, 2004



                                      -86-
<PAGE>


By:       /s/ Daniel B. Mulholland
          -----------------------------------------------------------
          DANIEL B. MULHOLLAND
          Director
          March 26, 2004

By:       /s/ R. Chadwick Paul, Jr.
          -----------------------------------------------------------
          R. CHADWICK PAUL, JR.
          Director
          March 26, 2004

By:       /s/ Charles J. Peischl, Esquire
          -----------------------------------------------------------
          CHARLES J. PEISCHL, ESQUIRE
          Director
          March 26, 2004

By:       /s/ Robert R. Scholl
          -----------------------------------------------------------
          ROBERT R. SCHOLL
          Director
          March 26, 2004

By:       /s/ Kenneth R. Smith
          -----------------------------------------------------------
          KENNETH R. SMITH
          Director
          March 26, 2004

By:       /s/ R. Charles Stehly
          -----------------------------------------------------------
          R. CHARLES STEHLY Director March 26, 2004

By:       /s/ Richard Stevens, III
          -----------------------------------------------------------
          RICHARD STEVENS, III
          Director
          March 26, 2004

By:       /s/ Richard L. Strain
          -----------------------------------------------------------
          RICHARD L. STRAIN
          Director
          March 26, 2004

By:       /s/ Maria Z. Thulin
          -----------------------------------------------------------
          MARIA Z. THULIN
          Director
          March 26, 2004



                                      -87-