<PAGE>
 
                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20429

                                  FORM 10-KSB
(MARK ONE)


                  ANNUAL REPORT UNDER SECTION 13 OR 15(D) OF
     [X]              THE SECURITIES EXCHANGE ACT OF 1934
                 For the fiscal year ended December 31, 1998

             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: 0-25465
                                        
                           CORNERSTONE BANCORP, INC.
--------------------------------------------------------------------------------
                (Name of small business issuer in its charter)

<TABLE> 
<S>                                                                    <C> 
                     CONNECTICUT                                                    06-1170335
     --------------------------------------------------                ------------------------------------
(State or other jurisdiction of incorporation or organization)         ( I.R.S. Employer Identification No.)

         550 SUMMER ST.,  STAMFORD, CONNECTICUT                                        06901
        -----------------------------------------                                    -----------
            (Address of principal office)                                            ( Zip Code) 
</TABLE> 

                  Issuer's telephone number:  (203) 356-0111
                                              --------------

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

<TABLE> 
       <S>                                                <C>   
       Title of Each Class                                Name of each exchange on which registered 
       --------------------                               -----------------------------------------
       Common Stock, par value $0.01 per share            American Stock Exchange
</TABLE> 

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

              None
       --------------------
         (Title of Class)

Check whether the issuer (1) filed all reports to be filed by Section 13 or
15(d) of the Securities Exchange Act of 1934 during the past 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_____
    ---    

Check if there is no disclosure of delinquent filers in response to Item 405 of
Regulation S-B contained herein, and no disclosure will be contained, to the
best of the issuer's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-KSB or any amendment of
this Form 10-KSB. (X)

The issuer's revenues for the fiscal year ended December 31, 1998 were
$11,266,000.

The aggregate market value of the issuer's Common Stock held  by non-affiliates
of the issuer as of March 2, 1999, was $15,808,310 based on the closing price of
$17.875 per share.

The number of shares outstanding of the issuer's common stock as of March 2,
1999 was 1,122,837.

DOCUMENTS INCORPORATED BY REFERENCE
Proxy Statement for Annual Meeting of Shareholders to be held on May 19, 1999 -
Part III.

Transitional Small Business Disclosure Format (check one):  Yes____  No X
                                                                       ---
<PAGE>
 
                               TABLE OF CONTENTS

<TABLE>
<CAPTION>
PART I                                                                          PAGE
------                                                                          ----
<S>                                                                             <C>
     Item 1  -  Description of Business........................................     1

     Item 2  -  Description of Property........................................    11

     Item 3  -  Legal Proceedings..............................................    12

     Item 4  -  Submission of Matters to a Vote of Security Holders............    12
 
     Item 4A -  Executive Officers of the Issuer...............................    13
 
PART II
-------
 
     Item 5  - Market for Common Equity and
               Related Stockholder Matters....................................    13
 
     Item 6  - Management's Discussion and Analysis of Financial
               Condition and Results of Operations............................    14
 
     Item 7  - Financial Statements...........................................    26
 
     Item 8  - Changes in and Disagreements With Accountants
               on Accounting and Financial Disclosure.........................    27
 
PART III
--------
 
     Item 9  - Directors, Executive Officers, Promoters and Control Persons;
               Compliance with Section 16(a) of the Exchange Act..............    27
 
     Item 10 - Executive Compensation.........................................    27
 
     Item 11 - Security Ownership of Certain Beneficial Owners and Management     27
 
     Item 12 - Certain Relationships and Related Transactions.................    27
</TABLE>

                                      (i)
<PAGE>
 
<TABLE> 
<S>                                                                               <C> 
PART IV
-------

  Item 13 - Exhibits and Reports on Form 8-K..................................    27

SIGNATURES....................................................................    30
</TABLE> 

                                     (ii)
<PAGE>
 
ITEM 1.   DESCRIPTION OF BUSINESS
          -----------------------

                                    GENERAL

     Cornerstone Bancorp, Inc. (the "Bancorp") is a Connecticut corporation,
incorporated in 1998 to serve as a bank holding company to provide executive,
financial and administrative functions for its subsidiaries.  The Bancorp is the
successor registrant to Cornerstone Bank (the "Bank").  The Bancorp completed
the acquisition of the Bank on March 1, 1999 pursuant to a reorganization
whereby the Bancorp acquired all of the issued and outstanding shares of common
stock of the Bank in a one-for-one share exchange.  As a result of this
reorganization, the Bank is now a wholly-owned subsidiary of the Bancorp. The
holding company formation was accounted for in a manner similar to a pooling of
interests and, accordingly, it had no effect on the Bank's financial statements.
The Bank will continue its operations at the same locations and with the same
management it had prior to the reorganization.  References to the "Bancorp" in
this report include references to Cornerstone Bancorp, Inc. and Cornerstone
Bank, unless the context indicates otherwise.

     The Bank is a Connecticut corporation incorporated in 1985. The Bank's
business consists primarily of attracting deposits from the general public and
local businesses and investing or loaning these deposits. The Bank originates
loans collateralized by liens on commercial and residential properties and
engages in making secured and unsecured consumer installment and commercial
loans.

     The Bank engages in a full service commercial and consumer banking
business. The Bank offers retail banking services including demand, savings and
time deposits and commercial mortgage and consumer/installment loans. Since its
inception, the Bank's primary mission has been to serve the banking needs of its
community, the businesses in Fairfield County, Connecticut (including minority-
owned businesses in low and moderate income areas) and its citizens (including
low and moderate income areas) while focusing on its surrounding community towns
and cities of Stamford, Greenwich, Darien and New Canaan. The Bank conducts its
operations through its main office located on 550 Summer Street in Stamford,
Connecticut; its branch offices located on Hope Street, West Broad Street and
High Ridge Road in Stamford, Connecticut; and a fourth branch located in Cos
Cob, Connecticut. The Bank anticipates that it will open a fifth branch in
Norwalk, Connecticut on or about April 30, 1999. The Bank also offers limited
service mobile branches which operate within a five mile radius of the offices
located on Summer Street in Stamford, Cos Cob and Norwalk, Connecticut.

                          FORWARD-LOOKING STATEMENTS

     The statements contained in this report which are not historical are
"forward-looking statements" within the meaning of Section 27A of the Securities
Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934,
as amended.  Examples of such forward-looking statements include, without
limitation, statements by the Bancorp regarding expectations for earnings,
credit quality, other financial and business matters and efforts to achieve Year
2000 compliance.  In addition, when used in this report, the words "anticipate,"
"plan," "believe," "estimate," "expect" and similar expressions as they relate
to the Bancorp or its management are intended to identify forward-looking
statements.  All forward-looking statements involve risks and uncertainties.
Actual results may differ materially from those discussed in, or implied by, the

                                      -1-
<PAGE>
 
forward-looking statements as a result of certain factors, including but not
limited to, competitive pressures on loan and deposit product pricing, other
actions of competitors, changes in economic conditions, the extent and timing of
actions of the Federal Reserve Board, customer deposit disintermediation,
changes in customers' acceptance of the Bank's products and services, the extent
and timing of legislative and regulatory actions and reforms, and unanticipated
internal and/or third party delays or failures in achieving Year 2000
compliance.

     The forward-looking statements contained in this report speak only as of
the date on which such statements are made.  By making any forward-looking
statements, the Bancorp assumes no duty to update them to reflect new, changing
or unanticipated events or circumstances.

                          MARKET AREA AND COMPETITION

     The primary market area of the Bank consists of the town of Stamford and
the surrounding communities of Greenwich, Darien and New Canaan.  The balance of
Fairfield County forms a secondary market.  Stamford is 37.71 square miles and
is located in the Southwest corner of Connecticut.  It is located 40 miles north
of New York City and is adjacent to Greenwich, Darien, and New Canaan,
Connecticut and Pound Ridge, New York.

     Competition in the financial services industry and in the Bank's market
area is strong. Numerous commercial banks, savings banks and savings
associations maintain offices in the area. Commercial banks, savings banks,
savings associations, money market funds, mortgage brokers, finance companies,
credit unions, insurance companies, investment firms and private lenders compete
with the Bank for various segments of the Bank's business.  These competitors,
which are located both inside and outside the  Bank's market area, often have
far greater resources than the Bank and are able to conduct more intensive and
broader based promotional efforts to reach both commercial and individual
customers.  The Bank has emphasized personalized banking services and the
advantage of local decision-making in its banking business, and this emphasis
has been well received by the public in the Bank's market area.

     Changes in the financial services industry resulting from fluctuating
interest rates, technological changes and deregulation have resulted in an
increase in competition, cost of funds, merger activity,  and customer awareness
of product and service differences among competitors.

     Connecticut has enacted legislation which liberalized banking powers and
has put thrift institutions on equal footing with other banks, thereby improving
their competitive position.  In addition, Connecticut's Interstate Banking Act
permits mergers or acquisitions of Connecticut banks and bank holding companies
in other states, so long as such states have reciprocal legislation.  Many of
these states currently have such legislation.  Connecticut banking law also
permits non-Connecticut bank holding companies to open offices in Connecticut
that may engage in a banking business, other than the provision of deposit
services, and several New York and other out-of-state bank holding companies
have done so.  Such legislative authority has also increased the size of
financial institutions competing with the Bank for deposits and loans in its
market place.

     The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994
(the "Interstate Banking Act") became federal law in October 1994.  The
Interstate Banking Act authorizes a number of interstate banking transactions
and activities, including, among others, the following: (i) since October 1995,
a bank holding company has been allowed to acquire banks in states outside of
the 

                                      -2-
<PAGE>
 
holding company's home state; (ii) beginning on June 1, 1997 (or earlier, if
allowed by state law), an insured bank may acquire a bank outside of the
acquiring bank's home state, unless the home state of such bank involved in the
transaction passes a law before June 1, 1997 prohibiting such transactions with
out-of-state banks; (iii) an insured bank may acquire a branch of a bank located
outside of the acquiring bank's home state if the law of the state where the
branch is located allows such out-of-state acquisitions; and (iv) an insured
bank will be able to establish new branches in states outside of the bank's home
state if the state in which the bank desires to establish a branch has a law
permitting out-of-state banks to establish branches. The effect of the
Interstate Banking Act has increased competition for the Bank.

     The business of the Bank also may be affected by governmental and
regulatory actions and policies.  Monetary and fiscal policies of the United
States Government and its instrumentalities, including the Board of Governors of
the Federal Reserve System, significantly influence the growth of loans,
investments and deposits.  The present bank regulatory environment may undergo
further change which will affect the banking industry itself and competition
between banks and non-bank financial institutions.


                              LENDING ACTIVITIES

     At December 31, 1998, the Bank's loan portfolio totaled approximately $69
million.  The portfolio represented approximately  49% of total assets and
approximately 57% of total deposits. Approximately 66% of the loan portfolio
consisted of loans collateralized by residential construction, residential real
estate or nonfarm nonresidential properties; approximately 30% of the portfolio
consisted of commercial loans; and approximately 4% of the portfolio consisted
of consumer installment, auto and other loans.   The Bank's lending limit to one
borrower under applicable law was approximately $2.5 million at December 31,
1998.  The Bank's lending limit to one borrower is equal to 15% of its
unimpaired capital  (approximately $15.0 million) plus loan and lease loss
reserves (approximately $1.7 million) at December 31, 1998.  Sources to fund the
Bank's loans are derived primarily from deposits and stockholders' equity.

     Loans are generated through the Bank's marketing efforts, its present
customers, walk-in customers and referrals from professionals including
certified public accountants, attorneys, real estate brokers, builders and local
businesses.  The Bank's lending activities are also impacted by economic trends
which affect the availability of funds, the demand for loans, and the level of
interest rates.   Loan demand throughout the Bank's market generally is expected
to be moderate in 1999. The Bank is well positioned in terms of capital and
liquidity and looks forward to extending credit opportunities to qualified
borrowers.

                                      -3-
<PAGE>
 
ANALYSIS OF LOAN PORTFOLIO
 
The following table sets forth an analysis of the composition of the loan
portfolio as of December 31, 1998, 1997 and 1996:

<TABLE>
<CAPTION>
                                                  December 31,       
                                       ----------------------------------
                                         1998          1997        1996  
                                       ---------      -------     -------
                                              (in thousands)      
<S>                                    <C>           <C>         <C>    
Loans secured by real estate:                                     
   Construction                        $   5,089     $  6,780    $  9,489
   Residential                            23,645       23,598      23,493
   Nonfarm nonresidential                 16,859       14,686      11,867
Commercial loans                          20,576       31,800      25,650
Consumer loans                             2,750        1,865       2,607
Lease financing receivables                  202          127           0
Other loans                                  248           99         146
                                       ---------     --------    -------- 
Total principal balances                  69,369       78,955      73,252
Net deferred loan costs                       15            3           7
                                       ---------     --------    -------- 
Total loans                            $  69,384     $ 78,958    $ 73,259
                                       =========     ========    ======== 
</TABLE>

INTEREST RATES

     Interest rates charged by the Bank on its loans are determined by
competitive conditions in its market area, the cost of funds, the demand for
funds and the availability of loanable funds.  The average yield on the loan
portfolio was 10.19% in 1998, as compared to 9.40% in 1997.  One large loan
carried on nonaccrual at the end of 1997 was fully recovered in the second
quarter of 1998, contributing significantly to the higher portfolio yield in
1998.  Interest income and fees totalling $454,000 were recognized at the time
of recovery, including approximately $325,000 in prior year interest which had
not been accrued.

PROBLEM LOANS

     It is the Bank's policy to manage its loan portfolio so as to recognize
problem loans at an early point.  The Bank commences internal collection efforts
once a loan payment is more than 15 days past due.  Loans are classified as
nonaccrual and placed on a cash basis for purposes of income recognition when
the collectibility of interest and principal become uncertain, generally  90
days after becoming past due.  Once a residential or commercial mortgage loan is
90 days past due, the Bank reviews the loan, including the appraisal of the
collateral, and may request an updated appraisal.  If the value of the
collateral, based on such appraisal, is not sufficient to cover the loan
obligation, such loans will be classified as nonaccrual.  Commercial loans are
generally classified as nonaccrual after being 90 days past due.  Construction
loans 90 days past due are subject to a present value analysis,  utilizing
current appraisal data, to determine whether or not they will be classified as
nonaccrual.  Generally, any uncollected but previously accrued interest is
charged against current income when a loan is placed on nonaccrual status.  The
Bank's data processing system generates delinquency reports on all of the Bank's
loans weekly and management reviews the loan portfolio on a weekly basis to
determine if past due loans should be placed on nonaccrual status.  Unless the
customer is working with the Bank toward repayment, once a loan payment is 90
days past due, the Bank generally initiates appropriate collection action.
Reinstatement of the loan to accrual status is done on a case-by-case basis and
only after the loan has been brought current and the borrower has demonstrated
adequate performance.

                                      -4-
<PAGE>
 
     Loans classified as nonperforming include nonaccrual loans, loans that are
ninety days or more past due and restructured loans.  Nonperforming loans
aggregated approximately $812,000 at December 31, 1998, compared to
approximately $3,330,000 at December 31, 1997.  The decrease in nonperforming
loans was primarily due to one loan being placed on nonaccrual status in 1997
which was subsequently paid off in 1998.  Management is not aware of any
characteristics of groups of loans not classified as nonperforming that would
give rise to other than normal collectibility concerns.  Information concerning
nonperforming loans is provided in the following table:

<TABLE>
<CAPTION>
                                    1998     1997      1996      1995     1994
                                   ------  --------  --------  --------  ------
                                              (dollars in thousands)
<S>                                <C>     <C>       <C>       <C>       <C>
Loans on nonaccrual status:
   Real estate loans (1)           $  370  $  2,708  $    573  $    477  $  425
   Commercial loans                   154       293       314       298
    Installment and other loans                  16         1         4
                                   ------  --------  --------  --------  ------ 
                                      524     3,017       888       779     425
                                   ------  --------  --------  --------  ------
Accruing loans past due
 90 days or more:
  Real estate loans                   288       295        81       374     181
  Commercial loans                               15         4        13
   Installment and other loans                    3         4         7
                                   ------  --------  --------  --------  ------
                                      288       313        89       394     181
                                   ------  --------  --------  --------  ------ 
 
Restructured loans                                        290       293     294

Total nonperforming loans          $  812  $  3,330  $  1,267  $  1,466  $  900
Total nonperforming loans as a     ======  ========  ========  ========  ======

percentage of total loans            1.17%     4.22%     1.73%     2.28%   1.74%
                                   ======  ========  ========  ========  ======
</TABLE>

(1) The amount at December 31, 1997 includes a loan with a balance of $2,050,000
which was fully collected during 1998.

                                      -5-
<PAGE>
 
ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES

<TABLE>
<CAPTION>
                                       1998     1997     1996     1995     1994
                                      -------  -------  -------  -------  -------
                                                (dollars in thousands)
<S>                                   <C>      <C>      <C>      <C>      <C> 
Balance at beginning of period        $ 1,529  $ 1,660  $ 1,384  $ 1,177  $ 1,151
Charge-offs: 
  Commercial                              105      188       51        1       11
  Real estate mortgage                     26      102       81                64
  Installment loans to individuals         37        4       16
                                      -------  -------  -------  -------  -------  
                                          168      294      148        1       75
                                      -------  -------  -------  -------  -------
 
Recoveries:
  Commercial                               74       33       10        2       10
  Real estate mortgage                     14
  Installment loans to individuals         12       14
                                      -------  -------  -------  -------  -------  
                                          100       47       10        2       10
                                      -------  -------  -------  -------  -------  
 
Net charge-offs                            68      247      138       (1)      65
                                      -------  -------  -------  -------  -------  
 Provisions charged to income             272      116      414      206       91
                                      -------  -------  -------  -------  -------  
 Balance at end of period             $ 1,733  $ 1,529  $ 1,660  $ 1,384  $ 1,177
                                      =======  =======  =======  =======  =======
 
Ratio of net charge-offs
to average loans outstanding             0.09%    0.33%    0.20%    0.00%    0.13%
                                      =======  =======  =======  =======  =======
</TABLE>


                             INVESTMENT ACTIVITIES

     The Bank has authority  to  invest in a number of investment products
deemed prudent by the Board of Directors.  Subject to various restrictions, the
Bank may own obligations of the United States Government, Federal Agencies,
certain obligations of municipalities, certificates of deposit, banker's
acceptances, commercial paper and corporate bonds.

     The Bank has established a written securities policy which is approved
annually by its Board of Directors.  The policy states specific objectives
relating to interest rate sensitivity and contribution to Bank profitability.
The Bank emphasizes the quality and term of the securities acquired for its
portfolio.  The Bank does not engage in the practice of trading securities for
the purpose of generating portfolio gains.

     At December 31, 1998, the Bank's held-to-maturity portfolio consisted of
debt securities carried at a total amortized cost of approximately $9,661,000.
The fair value of these securities was approximately $9,744,000.  At December
31, 1998, the Bank's available-for-sale portfolio was carried at a total fair
value of approximately $30,003,000 (or $222,000 more than amortized cost of
$29,781,000).  The after-tax unrealized gain on available for sale securities of
$131,000 is included in stockholders' equity at December 31, 1998.  The Bank
also maintained an investment of $22,544,000  in Federal funds sold at December
31, 1998.  See Note 3 to the Bank's Financial Statements for additional
information on the securities portfolio.

                                    DEPOSITS

          Deposits are the primary source of funds for the Bank.  The Bank's
deposits consist of checking accounts, preferred savings accounts, regular
savings deposits, NOW accounts, money 

                                      -6-
<PAGE>
 
market accounts, and certificates of deposit. Deposits are obtained from
individuals, partnerships, small and medium size businesses and professionals in
the Bank's market area. The Bank does not accept brokered deposits.

     The following table shows, by maturity, the dollar amount of certificates
of deposit  of $100,000 or more at December 31, 1998.

<TABLE>
<CAPTION>
                                                                      Rate
               Maturity                                  Amount       Paid
     --------------------------------------------       ---------    --------
                                                        (dollars in thousands)
     <S>                                                <C>          <C>
     Less than 3 months                                 $   2,851        4.95%
     Greater than 3 months and less than 6 months           1,361        5.51
     Greater than 6 months and less than 1 year             3,331        5.15
     Greater than 1 year                                    2,947        5.57
                                                        ---------    --------
        Total                                           $  10,490        5.26%
                                                        =========    ========
</TABLE>

     The following table summarizes the average amount and the average rate paid
on the Bank's deposits for the years ended December 31, 1998 and 1997.

<TABLE>
<CAPTION>
                                                 1998                        1997                            
                                         ----------------------      ---------------------
                                          Average       Rate          Average       Rate         
Type of Account                           Balance       Paid          Balance       Paid 
---------------                          ----------   ---------      ----------   -------- 
                                                        (dollars in thousands)
<S>                                      <C>          <C>            <C>          <C>
NOW Accounts                             $   15,187      1.41%       $   13,213      1.42%
Money Market Accounts                         2,866      2.33             2,923      2.40
Regular, Club, Cash Management                4,922      2.50             4,042      2.47
Preferred Rate Savings                       19,678      3.00            17,891      3.04
Certificates of Deposit                      48,349      5.40            46,242      5.41
                                         ----------   -------        ----------   -------
      Total                              $   91,002      3.96%       $   84,311      4.04%
                                         ==========   =======        ==========   =======
</TABLE>

See Note 6 to the Bank's Financial Statements for additional information on time
deposits.

                                   REGULATION

     As a Connecticut-chartered bank whose deposits are insured by the Bank
Insurance Fund of the Federal Deposit Insurance Corporation ("FDIC"), the Bank
is subject to regulation and supervision by both the Connecticut Banking
Commissioner (the "Banking Commissioner") and the FDIC.  The Bank also is
subject to the laws and regulations of the Federal Reserve Board that are
applicable to FDIC-insured financial institutions.  The Bancorp is also subject
to certain regulations of the Federal Reserve Board and the Banking
Commissioner.  This governmental regulation and supervision is primarily
intended to protect depositors, not shareholders.

     This structure also gives the regulatory authorities 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.  Any
change in such regulation, whether by the Banking Commissioner, the FDIC or
through legislation, could have a material adverse impact on the Bancorp and its
operations.  Until February 1998, the Bank was operating under a supervisory
agreement, a Memorandum of Understanding, issued by the FDIC with regard to
certain compliance aspects of the Bank's operations.  The Memorandum of
Understanding

                                      -7-
<PAGE>
 
was issued early in 1997. The regulators removed the Memorandum of Understanding
in February 1998 in light of the significant steps taken by the Bank to improve
the compliance personnel and policies of the Bank.

CONNECTICUT REGULATION

     The Banking Commissioner regulates the Bank's internal organization as well
as its deposit, lending and investment activities.  The approval of the Banking
Commissioner is required for, among other things, certain amendments to the
Bank's Articles of Incorporation and Bylaws, as well as for the establishment of
branch offices and business combination transactions.  The Banking Commissioner
conducts periodic examinations of the Bank.  Many of the areas regulated by the
Banking Commissioner are subject to similar regulation by the FDIC.

     Connecticut banking laws grant banks broad lending authority.  Subject to
certain limited exceptions, however, total secured and unsecured loans made to
any one obligor pursuant to this statutory authority may not exceed 25% of the
bank's equity capital and reserves for loan and lease losses.

     Subject to certain limited exceptions, state-chartered banks are prohibited
from engaging as a principal in any activity that is not permissible for
national banks.  State-chartered banks, for example, are prohibited from
acquiring equity investments of a type, or in an amount, not permissible for a
national bank.

     The Connecticut Interstate Banking Act permits Connecticut banks and bank
holding companies to engage in stock acquisitions with depository institutions
in other states with reciprocal legislation. A majority of states have enacted
such legislation.  Several interstate mergers and acquisitions involving
Connecticut bank holding companies or banks with offices in the Bank's service
area and bank holding companies or banks headquartered in other states recently
have been completed.

FDIC REGULATION

     The Bank's deposit accounts are insured by the Bank Insurance Fund of the
FDIC to a maximum of $100,000 for each insured depositor.  FDIC insurance of
deposits may be terminated by the FDIC, after notice and hearing, upon a finding
by the FDIC that the insured institution has engaged in unsafe or unsound
practices, or is in an unsafe or unsound condition to continue operations, or
has violated any applicable law, regulation, rule or order, or conditions
imposed by the FDIC.

     As a FDIC-insured, state-chartered bank, the Bank is subject to supervision
and examination by the FDIC and also is subject to FDIC regulations regarding
many aspects of its business, including types of deposit instruments offered,
permissible methods for acquisition of funds, and activities of subsidiaries and
affiliates of the Bank.  The FDIC periodically makes its own examination of
insured institutions.

     Federal law requires each federal banking agency to prescribe for
depository institutions under its jurisdiction standards relating to, among
other things: internal controls; information systems and audit systems; loan
documentation; credit underwriting; interest rate risk exposure; asset growth;
compensation, fees and benefits; and such other operational and  managerial
standards as the agency deems appropriate.  The federal banking agencies adopted
final regulations and Interagency Guidelines 

                                      -8-
<PAGE>
 
Establishing Standards for Safety and Soundness (the "Guidelines") to implement
these safety and soundness standards. The Guidelines set forth the safety and
soundness standards that the federal banking agencies use to identify and
address problems at insured depository institutions before capital becomes
impaired. The Guidelines address internal controls and information systems;
internal audit system; credit underwriting; loan documentation; interest rate
risk exposure; asset quality; earnings; and compensation, fees and benefits.
If the appropriate federal banking agency determines that an institution fails
to meet any standard prescribed by the Guidelines, the agency may require the
institution to submit to the agency an acceptable plan to achieve compliance
with the standard by the Federal Deposit Insurance Act, as amended. The final
regulations establish deadlines for the submission and review of such safety and
soundness compliance programs.

     Under the Community Reinvestment Act, as amended ("CRA"), as implemented by
FDIC regulations, the Bank has a continuing and affirmative obligation
consistent with its safe and sound operation to help meet the credit needs of
its entire community, including low and moderate income neighborhoods.  The CRA
does not prescribe specific lending requirements or programs for financial
institutions nor does it limit an institution's discretion to develop the types
of products and services that it believes are best suited to its particular
community, consistent with the CRA.  The CRA requires the FDIC, in connection
with its examination of an institution, to assess the institution's record of
meeting the credit needs of its community and to take such record into account
in its evaluation of certain applications by such institution.  The Financial
Institutions Reform, Recovery and Enforcement Act of 1989 amended the CRA to
require public disclosure of an institution's CRA rating and requires the FDIC
to provide a written evaluation of an institution's CRA performance utilizing a
four-tiered descriptive rating system.  The Bank's latest CRA rating, received
from the FDIC, was "satisfactory."

     The FDIC has adopted risk-based capital guidelines to which FDIC-insured,
state-chartered banks that are not members of the Federal Reserve System, such
as the Bank, are subject.  The guidelines establish a systematic analytical
framework that makes regulatory capital requirements more sensitive to
differences in risk profiles among banking organizations.  Banks are required to
maintain minimum levels of capital based upon their total assets and total
"risk-weighted assets."  For purposes of these requirements, capital is
comprised both of Tier 1 and Tier 2 capital.  Tier 1 capital consists primarily
of common stock and retained earnings.  Tier 2 capital consists primarily of
loan loss reserves, subordinated debt, and convertible securities.  In
determining total capital, the amount of Tier 2 capital may not exceed the
amount of Tier 1 capital.  A bank's total "risk-based assets" are determined by
assigning the bank's assets and off-balance sheet items (e.g., letters of
credit) to one of four risk categories based upon their relative credit risks.
The greater the risk associated with an assets, the greater the amount of such
asset that will be subject to the capital requirements.  Banks must satisfy the
following three minimum capital standards: (1) Tier 1 capital in an amount equal
to between 4% and 5% of total assets (the "leverage ratio"); (2) Tier 1 capital
in an amount equal to 4% of risk-weighted assets; and (3) total Tier 1 and Tier
2 capital in an amount equal to 8% of risk-weighted assets.

     The Federal Deposit Insurance Corporation Improvement Act of 1991
("FDICIA") defines specific capital categories based upon an institution's
capital ratios.  The capital categories, in declining order, are: (i) well
capitalized; (ii) adequately capitalized; (iii) undercapitalized; (iv)
significantly undercapitalized; and (v) critically undercapitalized.  Under
FDICIA and the FDIC's prompt correction action rules, the FDIC may take any one
or more of the following actions against an undercapitalized bank: restrict
dividends and management fees; restrict asset growth; and prohibit new
acquisitions, new branches or new lines of business without prior FDIC approval.
If a bank is significantly undercapitalized, the FDIC may also require the bank
to raise capital, restrict interest rates a bank may 

                                      -9-
<PAGE>
 
pay on deposits, require a reduction in assets, restrict any activities that
might cause risk to a bank, require improved management, prohibit the acceptance
of deposits from correspondent banks and restrict compensation to any senior
executive officer. When a bank becomes critically undercapitalized, (i.e., the
ratio of tangible equity to total assets is equal to or less than 2%), the FDIC
must, within 90 days thereafter, appoint a receiver for the bank or take such
other action as the FDIC determines would better achieve the purposes of the
law. Even where such other action is taken, the FDIC generally must appoint a
receiver for a bank if the bank remains critically undercapitalized during the
calendar quarter beginning 270 days after the date on which the bank became
critically undercapitalized.

     To be considered "adequately capitalized," an institution must generally
have a leverage ratio of at least 4%, a Tier 1 capital to risk-weighted assets
ratio of at least 4%, and a total (Tier 1 and Tier 2) capital to risk-weighted
assets ratio of at least 8%.  As of December 31, 1998, the Bank was in full
compliance with all three minimum capital standards and was categorized as "well
capitalized" under the provisions of FDICIA.  See Note 14 to the Bank's
Financial Statements for an analysis of the Bank's actual and required
regulatory capital.


FEDERAL RESERVE SYSTEM REGULATION

     Under the regulations of the Federal Reserve Board, banking institutions
are required to maintain reserves with respect to transaction accounts
(primarily NOW and regular checking accounts), which allow payments or transfers
to third parties.  These regulations generally require the maintenance of
reserves of 3% against net transaction accounts of $47.8 million or less and,
for net transaction accounts over $47.8 million, $1,434,000 plus 10% of the
amount of such accounts in excess of $47.8 million.  There is no reserve
requirement for transaction account balances of $4.7 million or less. These
amounts and percentages are subject to adjustment by the Federal Reserve Board.

     In addition, the Bancorp is subject to regulation by the Federal Reserve
Board as a bank holding company.  The Federal Reserve Board has established
capital adequacy guidelines for bank holding companies that are similar to the
FDIC capital guidelines described above.  The Federal Bank Holding Company Act
of 1956, as amended (the "Federal BHC Act"), limits the types of companies that
a bank holding company may acquire or organize and the activities in which it or
they may engage.  In general, the Bancorp and its subsidiaries are prohibited
from engaging in or acquiring direct control of any company engaged in non-
banking activities unless such activities are so closely related to banking or
managing or controlling banks as to be proper incident thereto.  State-chartered
banks forming holding companies generally are allowed those powers, with certain
restrictions, granted to them by applicable state law.  The Bancorp believes
that it may continue to engage in those activities in which the Bank engages.

     Under the Federal BHC Act, the Bancorp is required to file annually with
the Federal Reserve Board a report of its operations, and the Bancorp, the Bank
and any other subsidiaries is subject to examination by the Federal Reserve
Board.  In addition, the Bancorp is required to obtain the prior approval of the
Board of Governors of the Federal Reserve System to acquire, with certain
exceptions, more than 5% of the outstanding voting stock of any bank or bank
holding company, to acquire all or substantially all of the assets of a bank or
to merge or consolidate with another bank holding company. Moreover, the
Bancorp, the Bank and any other subsidiaries is prohibited from engaging in
certain tying arrangements in connection with any extension of credit or
provision of any property or services.  The Bank also is subject to certain
restrictions imposed by the Federal Reserve Act on issuing any extension of
credit to the Bancorp or any of its subsidiaries, or making any investments in
the stock or other 

                                      -10-
<PAGE>
 
securities thereof, and on the taking of such stock or securities as collateral
for loans to any borrower.

     The Federal Reserve Board has issued a policy statement on the payment of
cash dividends by bank holding companies, which expresses the Federal Reserve
Board's view that a bank holding company should pay cash dividends only to the
extent that a bank 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 a bank 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 prompt corrective action
regulations adopted by the Federal Reserve Board pursuant to FDICIA, the Federal
Reserve Board may prohibit a bank holding company from paying any dividends if
the holding company's bank subsidiary is classified as "undercapitalized".

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


                                   PERSONNEL

     As of December 31, 1998 the Bank had 43 employees, 38 of whom are full-time
and 5 of whom are part-time.  The employees are not represented by a collective
bargaining unit and the Bank considers its relationship with its employees to be
good.

ITEM 2.  DESCRIPTION OF PROPERTY
         -----------------------

     The following table sets forth the location of the Bank's main office and
branches, as well as certain additional information relating to those offices.

<TABLE> 
<CAPTION> 
                                    Year Facility       Owned or          
                                       Opened            Leased           
                                    --------------     ----------          
<S>                                 <C>                <C>  
Main office (1)
550 Summer Street
Stamford, Connecticut                     1988            Owned

Springdale office (2)
1042 Hope Street
Stamford, Connecticut                     1989            Leased

High Ridge office(3)
1117 High Ridge Road
Stamford, Connecticut                     1994            Leased
</TABLE> 

                                      -11-
<PAGE>
 
<TABLE>
<CAPTION>
                                     Year Facility        Owned or
                                        Opened             Leased
                                     -------------        --------
<S>                                  <C>                  <C>
Cos Cob office (4)
211 East Putnam Avenue
Cos Cob, Connecticut                      1995             Leased
 
West Broad office (5)
56 West Broad Street
Stamford, Connecticut                     1997             Leased
 
Norwalk office (6)
79 New Canaan Avenue
Norwalk, Connecticut                     Pending           Leased
</TABLE>


(1) The main office provides 11,000 square feet of interior space and has
offstreet parking facilities.

(2) The Springdale facility is a full-service branch.  The office lease provides
for 1,500 square feet of interior space with an initial term of approximately 3
years, and renewal options for six additional 5 year terms.  The lease has been
renewed through 2002.

(3) The High Ridge facility is a full-service branch. The office lease provides
for approximately 1,763 square feet of interior space with an initial term of 5
years, expiring 1999, and renewal options for three additional 5 year periods.

(4) The Cos Cob facility is a full-service branch. The office lease provides for
approximately 900 square feet of interior space with an initial term of 5 years,
expiring 2000, and renewal options for two additional 5 year periods.

(5) The West Broad facility is a full-service branch. The office lease provides
for approximately 2,000 square feet of interior space with an initial term of 5
years, expiring 2001, and renewal options for three additional 5 year periods.

(6) The Norwalk  facility will be a full-service branch, expected to open on or
about April 30, 1999.  The office lease provides for approximately 2,200 square
feet of interior space with an initial term of 5 years commencing the day the
branch opens for business, and renewal options for three additional 5 year
periods.

ITEM 3.  LEGAL PROCEEDINGS
         -----------------

         There are no material legal proceedings, other than ordinary routine
litigation incidental to the business, to which the Bancorp is a party or of
which any of its property is the subject.

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
         ---------------------------------------------------

         A Special Meeting of Shareholders of the Bank was held on October 21,
1998. At the special meeting, the shareholders of the Bank approved the
formation of a bank holding company by approving an Agreement and Plan of
Reorganization dated as of August 19, 1998 between the Bank and the Bancorp.
There were 816,729 votes cast for, 14,961 votes cast against, and 2,371
abstentions with respect to the Agreement and Plan of Reorganization.

                                      -12-
<PAGE>
 
ITEM 4A.  EXECUTIVE OFFICERS OF THE ISSUER
          --------------------------------

          The following table shows the name, age, positions held with the
Bancorp, and the principal occupations during the past five years of the
Bancorp's executive officers.

<TABLE>
<CAPTION>
                                Positions Held with the Bancorp and Principal
Name                   Age      Occupations During the Past Five Years
----                  -----     --------------------------------------
<S>                   <C>       <C>
Norman H. Reader*       74      President and Chief Executive Officer
                                (1985 - present)
                               
James P. Jakubek        49      Executive Vice President and Chief
                                Operating Officer (1991 - present)
                               
Paul H. Reader          40      Senior Vice President (1993 - Present)
                                Vice President (1988 - 1993)
                               
Leigh A. Hardisty       41      Vice President, Chief Financial Officer
                                and Corporate Secretary (1999 - present)
                                Vice President & Comptroller and
                                Corporate Secretary (1993 - 1999)
                                Comptroller and Corporate           
                                Secretary (1988 - 1993)
</TABLE> 

* Norman H. Reader is the father of Paul H. Reader.


                                    PART II

ITEM 5.  MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
         --------------------------------------------------------

         The common stock of the Bancorp has traded on the American Stock
Exchange under the symbol CBN since March 2, 1999, and prior thereto, the common
stock of the Bank was traded on the American Stock Exchange from January 1996
under the same symbol. The following table sets forth, for the periods
indicated, the actual high and low sales prices for the common stock as reported
by the American Stock Exchange.

<TABLE>
<CAPTION>
                                  1998                        1997       
                         ------------------------      --------------------
                           High            Low          High         Low      
                         --------       ---------      -------     -------- 
<S>                      <C>            <C>            <C>         <C>      
First Quarter            $ 21.875       $  19.25       $20.375     $ 16.375 
Second Quarter             22.50           20.50        16.625       14.50 
Third Quarter              25.875*         19.50*       19.50        16.75 
Fourth Quarter             20.50*          17.1875*     21.25        19.0625  
</TABLE>

* A 10% stock dividend was declared in July 1998 and distributed in August 1998.

     As of February 26, 1999, there were approximately 556 holders of record of
the Bancorp's common stock.

                                      -13-
<PAGE>
 
     The transfer agent and registrar for the Bancorp's common stock is American
Stock Transfer & Trust Company.

DIVIDEND POLICY

     The Bancorp's shareholders are entitled to dividends, when and if declared
by the Bancorp's Board of Directors out of funds legally available therefor. The
Bancorp is not directly subject to the restrictions imposed by Connecticut law
regarding the payment of dividends by a Connecticut-chartered capital stock
bank.  For the foreseeable future, however, the sole source of amounts available
to the Bancorp for the declaration of dividends will be dividends declared and
paid by the Bank on the Bank's Common Stock held by the Bancorp.  The Bank is
prohibited by Connecticut banking law from paying dividends, except from its net
profits.  Net profits are defined as the remainder of all earnings from current
operations plus actual recoveries on loans and investments and other assets
after deducting from the total thereof all current operating expenses, actual
losses, accrued dividends on preferred stock, if any, and all federal and state
taxes.  The total of all dividends declared by the Bank in any calendar year may
not, unless specifically approved by the Banking Commissioner, exceed the total
of its net profits for that year combined with its retained net profits of the
preceding two years.  Federal statutes  prohibit FDIC insured depository
institutions from paying dividends or making capital distributions that would
cause the institution to fail to meet minimum capital requirements.  These
dividend limitations can affect the amount of dividends payable to the Bancorp.

      In 1998 and 1997, the Bank declared a total of $357,000 and $298,000 in
quarterly cash dividends on its common stock.  On January 20, 1999 the Bank's
Board of Directors declared a special dividend of $0.18 cents per share payable
February 19, 1999 to shareholders of record on February 8, 1999.

ITEM 6.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
         -----------------------------------------------------------------------
OF OPERATIONS
-------------


         The following discussion and analysis presents a review of  financial
condition as of December 31, 1998 and 1997, and operating results for the years
ended December 31, 1998, 1997 and 1996.


                              FINANCIAL CONDITION
                            (dollars in thousands)

COMPARATIVE ANALYSIS OF 1998 AND 1997

     Total assets increased to $139,733 at December 31, 1998 from $125,408 at
December 31, 1997, an increase of $14,325 (or 11%).  The Bank's net loan
portfolio decreased to $67,651 at December 31, 1998 from $77,429 at December 31,
1997, a decrease of  $9,778 (or 13%).  The decline in the loan portfolio from
December 31, 1997 to December 31, 1998 was primarily attributable to a decrease
in commercial mortgage loans (commercial loans collateralized by real estate),
term loans, aircraft loans, conventional mortgage loans and demand loans.  These
decreases were partially offset by increases in other loans, time loans and
installment loans.  Loan payoffs and competitive pressures on both rates and
terms for various loan types have resulted in a decline in the Bank's loan
portfolio.  Although the Bank cannot predict future economic or competitive
conditions, the Bank's strategically planned expansion in 1999, with the opening
of its fifth branch office in Norwalk, may stimulate loan originations and
lessen any further decline in the loan portfolio.

                                      -14-
<PAGE>
 
     Securities increased to $39,664 at December 31, 1998 from $27,303 at
December 31, 1997, an increase of $12,361 (or 45%).  In 1998, the increase in
the securities portfolio resulted from the influx of deposits and the decline in
the Bank's loan portfolio.

     Deposits increased to $121,879 at December 31, 1998 from $108,904 at
December 31, 1997, an increase of $12,975 (or 12%).  Time deposits contributed
the largest increase, increasing to $52,492 at December 31, 1998 from $45,860 at
December 31, 1997, for an increase of $6,632 (or 14%).  The largest increase in
time deposits occurred in 12-17 month certificates of deposit ("CD's") which
increased by $2,894 (or 13%).  The second largest increase in time deposits
occurred in 36-47 month CD's which increased by $1,663 (or 151%).  The third
largest increase in time deposits occurred in 24-30 month CD's  which increased
by $1,208 (or 47%). Demand deposits increased to $25,746 at December 31, 1998
from $22,627 at December 31, 1997, an increase of $3,119 (or 14%). Money market
and NOW accounts increased to $18,941 at December 31, 1998 from $17,428 at
December 31, 1997, an increase of $1,513 (or 9%). Most of this increase was
attributable to NOW accounts, which increased by $1,420 (or 10%). Regular, club
and money market savings increased to $24,700 at December 31, 1998 from $22,989
at December 31, 1997, an increase of $1,711 (or 7%). This increase included an
increase in regular savings of $1,274 (or 31%).

     In general, the Bank attempts to control the flow of deposits primarily by
pricing its accounts to remain competitive with other financial institutions in
its market area, although the Bank does not necessarily seek to match the
highest rates paid by competing institutions. In particular, during 1998 the
Bank attempted to retain market share by remaining generally competitive with
other financial institutions in its market area in the CD and NOW account
categories.

COMPARATIVE ANALYSIS OF 1997 AND 1996

     Total assets increased to $125,408 at December 31, 1997 from $111,632 at
December 31, 1996, an increase of $13,776 (or 12%).  The Bank's net loan
portfolio increased to $77,429 at December 31, 1997 from $71,599 at December 31,
1996, an increase of  $5,830 (or 8%).  Growth in the loan portfolio from
December 31, 1996 to December 31, 1997 was primarily attributable to an increase
in commercial mortgage loans (commercial loans collateralized by real estate),
demand loans and conventional mortgage loans.  These increases were partially
offset by a decline in the term, time and aircraft loan portfolio.

     Securities increased to $27,303 at December 31, 1997 from $20,558 at
December 31, 1996, an increase of $6,745 (or 33%). In 1997, the increase in the
securities portfolio resulted from the influx of deposits.

     Deposits increased to $108,904 at December 31, 1997 from $96,843 at
December 31, 1996, an increase of $12,061 (or 12%).  Demand deposits contributed
the largest increase, increasing to $22,627 at December 31, 1997 from $18,385 at
December 31, 1996, for an increase of $4,242 (or 23%).   Time deposits
contributed the second largest increase, increasing to $45,860 at December 31,
1997 from $42,142 at December 31, 1996, for an increase of $3,718 (or 9%).  The
largest increase in time deposits occurred in 12-17 month CD's which increased
by $3,903 (or 18%).  Regular, club and money market savings increased to $22,989
at December 31, 1997 from $19,969 at December 31, 1996, an increase of $3,020
(or 15%).  The largest increase was attributable to money market savings which
increased by $2,050 (or 12%).  Regular savings increased $930 (or 29%).  Money
market and NOW accounts increased to $17,428 at December 31, 1997 from $16,347
at December 31, 1996, an increase of $1,081 (or 7%).

                                      -15-
<PAGE>
 
     During 1997 the Bank attempted to retain market share by remaining
generally competitive with other financial institutions in its market area, in
particular in the 12-17 month CD category. The influx of deposits was also a
result of advertising and the opening of a new branch in the Stamford area in
1997.

AVERAGE BALANCES, INTEREST AND AVERAGE YIELDS

     The following table sets forth information relating to the Bank's balance
sheet and reflects average yield on assets and average cost of liabilities for
the periods indicated. Such yields and costs are derived by dividing interest
income or expense by the average daily balance of assets or liabilities,
respectively, for the periods presented.  Fully taxable equivalent ("FTE")
adjustments have been made using a 34% tax rate in calculating income and yields
on tax exempt securities.

<TABLE>
<CAPTION>
                                                                               For the Year Ended December 31,                      
                                               -------------------------------------------------------------------------------------
                                                                  1998                               1997                           
                                               ---------------------------------------   ------------------------------  -----------
                                                 Average                    Yield/     Average                Yield/        Average 
                                                 Balance       Interest      Cost      Balance    Interest     Cost         Balance 
                                               ----------     ----------   -------    ---------  ----------  --------      ---------
                                                                                  (dollars in thousands)                            
<S>                                            <C>            <C>          <C>        <C>        <C>        <C>            <C>      
ASSETS                                                                                                                              
Interest earning assets:                                                                                                            
Loans (1)                                      $  74,229      $ 7,563       10.19%    $  75,348  $    7,082     9.40%      $ 68,881 
Taxable  securities                               32,508        2,123        6.53        25,531       1,658     6.50         18,280 
Tax-exempt  securities                                 0            0        0.00           148           8     5.42            454 
Federal funds sold                                15,697          817        5.20        10,282         551     5.36         11,008 
                                               ---------      -------    --------     ---------  ----------  -------       -------- 
Total interest earning assets                    122,434       10,503        8.58       111,309       9,299     8.35         98,623 
                                               ---------      -------    --------     ---------  ----------  -------       --------

Non-interest earning assets:                                                                                                       
Cash and due from banks                            4,937                                  4,413                               3,494 
Premises and equipment                             2,922                                  2,792                               2,800 
Other assets                                       2,250                                  2,255                               2,530 
Allowance for loan losses                         (1,701)                                (1,782)                             (1,552)
                                               ---------                              ---------                            -------- 
Total Assets                                   $ 130,842                              $ 118,987                            $105,895 
                                               =========                              =========                            ======== 

                                                                                                                           
LIABILITIES AND                                                                                                            
 STOCKHOLDERS'  EQUITY:                                                                                                    
 Interest bearing liabilities:                                                                                             
 NOW accounts                                  $  15,187      $   214        1.41%    $  13,213  $      187     1.42%      $ 12,659
 Money market accounts                             2,866           67        2.33         2,923          70     2.40          3,115 
 Regular, club, cash management                    4,922          123        2.50         4,042         100     2.47          3,192 
 Preferred rate savings                           19,678          591        3.00        17,891         543     3.04         17,032 
 Certificates of deposit                          48,349        2,612        5.40        46,242       2,502     5.41         41,118 
 Borrowed funds                                    2,346           65        2.77         2,110          58     2.73          2,169 
  Other interest bearing deposits                     17            0        1.04            18           0     1.68             19 
                                               ---------      -------    --------     ---------  ----------  -------       --------
 Total interest bearing liabilities               93,365        3,672        3.93%       86,439       3,460     4.00%        79,304 
                                               ---------      -------    --------     ---------  ----------  -------       --------
                                                                                                                           
 Non-interest bearing liabilities:                                                                                                 
 Demand deposits                                  20,745                                 19,192                              16,191
 Other                                             2,508                                    739                               1,378
                                               ---------                              ---------                            --------
 Total non-interest bearing liabilities           23,253                                 19,931                              17,569
                                                                                                                                   
Stockholders' equity                              14,224                                 12,617                               9,022
                                               ---------                              ---------                            --------

Total Liabilities & Stockholders' Equity       $ 130,842                              $ 118,987                            $105,895
                                               =========                              =========                            ========
 
Net interest income (FTE)                                     $ 6,831                            $    5,839                
Less: Fully taxable equivalent adjustment                           0                                    (2)               
                                                              -------                            ----------                
Net interest income (non-FTE)                                 $ 6,831                            $    5,837                
                                                              -------                            ==========                
 
Interest rate spread                                                         4.65%                              4.35%
                                                                         ========                            =======
Net yield on interest earning assets                             5.58%                                 5.25%        
                                                              =======                            ==========
Ratio of average interest earning assets
to average interest bearing liabilities           131.14%                                128.77%                             124.36%
                                               =========                              =========                            ========

<CAPTION> 
                                            ----------------------
                                                   1996   
                                            ----------------------
                                                            Yield/     
                                             Interest       Cost      
                                            ----------     ------     
<S>                                         <C>            <C>        
ASSETS                                                                
Interest earning assets:                                              
Loans (1)                                   $  6,809        9.89%     
Taxable  securities                            1,101        6.02      
Tax-exempt  securities                            27        5.95      
Federal funds sold                               579        5.26      
                                            --------       -----      
Total interest earning assets                                                
                                               8,516        8.63      
                                            --------       -----       
                             
Non-interest earning assets: 
Cash and due from banks      
Premises and equipment       
Other assets                 
Allowance for loan losses    
                             
Total Assets                 
                             
                             
LIABILITIES AND STOCKHOLDERS' EQUITY:      
 Interest bearing liabilities:                          
 NOW accounts                               $    180        1.42%
 Money market accounts                            74        2.38
 Regular, club, cash management                   78        2.46
 Preferred rate savings                          513        3.01
 Certificates of deposit                       2,269        5.52
 Borrowed funds                                   60        2.79  
  Other interest bearing deposits                  1        2.34    
                                            --------       -----    
                                               3,175        4.00%   
 Total interest bearing liabilities         --------       -----     
                                      
 
 Non-interest bearing liabilities:
 Demand deposits                             
 Other                           
                             
 Total non-interest bearing liabilities           

Stockholders' equity           
 
Total Liabilities & Stockholders' Equity         
 
Net interest income (FTE)                   $  5,341
Less: Fully taxable equivalent adjustment         (9)
                                            --------   
Net interest income (non-FTE)               $  5,332
                                            ========               
 
Interest rate spread                                        4.63%
                                                           =====
Net yield on interest earning assets            5.42%
                                            ========                        
</TABLE>

(1) Average balances include loans on non-accrual status.

                                      -16-
<PAGE>
 
     The following table sets forth the dollar amount of changes in interest
income, interest expense and net interest income on a tax equivalent basis for
the periods indicated.

<TABLE>
<CAPTION>
RATE/VOLUME ANALYSIS
                                                                For the Year Ended December 31,
                                      -----------------------------------------------------------------------------------
                                       1998               vs.            1997           1997         vs.            1996
                                       ----               ---            ----           ----         --             ----
                                               Increase (Decrease) Due To                  Increase (Decrease ) Due To
                                              ----------------------------                 ---------------------------
                                       Rate              Volume          Total          Rate       Volume           Total  
                                      ------             ------          -----          ----       ------           -----
                                                                        (in thousands)
<S>                                   <C>                <C>             <C>            <C>        <C>              <C>
INTEREST INCOME:
 
Loans                                 $  588             $ (107)         $  481         $ (348)    $  621           $  273
Taxable securities                         8                457             465             93        464              557
Tax-exempt  securities                     0                 (8)             (8)            (3)       (16)             (19)
Federal funds sold                       (16)               282             266             11        (39)             (28)
                                      ------             ------          ------         ------     ------           ------
Total earning assets                  $  580             $  624          $1,204         $ (247)    $1,030           $  783
                                      ======             ======          ======         ======     ======           ======
 
INTEREST EXPENSE:
 
NOW accounts                          $   (1)                28          $   27         $    0     $    7           $    7
Money market accounts                     (2)                (1)             (3)             1         (5)              (4)
Regular, club, cash management             1                 22              23              0         22               22
Preferred rate savings                    (6)                54              48              5         25               30
Certificates of deposit                   (3)               113             110            (46)       279              233
Borrowed funds                             1                  6               7             (1)        (1)              (2)
Other interest bearing deposits            0                  0               0             (1)         0               (1)
                                      ------             ------          ------         ------     ------           ------
Total interest bearing liabilities    $  (10)            $  222          $  212         $  (42)    $  327           $  285
                                      ======             ======          ======         ======     ======           ======
 
CHANGE IN NET INTEREST INCOME         $  590             $  402          $  992         $ (205)    $  703           $  498
                                      ======             ======          ======         =====      ======           ======
</TABLE>

                               OPERATING RESULTS
                            (dollars in thousands)

COMPARATIVE ANALYSIS OF 1998 AND 1997

NET INCOME

     Net income was $1,874 for the year ended December 31, 1998 compared to
$1,425 for the year ended December 31, 1997, an increase of $449 or 32%.  Basic
earnings per common share was $1.68 for the year ended December 31, 1998 and
$1.29 for the year ended December 31, 1997 based on weighted average shares
outstanding of approximately 1,117,000 and 1,106,000, respectively.  Diluted
earnings per share were $1.60 for the year ended December 31, 1998 and $1.24 for
the year ended December 31, 1997 based on weighted average shares of
approximately 1,170,000 and 1,148,000, respectively.  Return on average common
stockholder's equity was 13.17% and 11.29% for the years ended December 31, 1998
and 1997, respectively.

     The increase in net income for the year ended December 31, 1998 was
primarily due to securities volume and the resolution of a large problem loan.
One large loan carried on nonaccrual status at the end of 1997 was fully
recovered in the second quarter of 1998.  Interest income and fees totalling
$454 were recognized at the time of recovery, including approximately $325 in
prior year interest which had not been accrued.  The average yield on interest
earning assets (FTE) increased 23 basis points in 1998 compared to 1997,
primarily reflecting the impact of this nonaccrual loan, while the average cost
of interest bearing liabilities decreased by 7 basis points for the same period.
This resulted in an interest rate spread of 4.65% in 1998, up 30 basis points
from 4.35% in 1997.  The net interest margin (FTE) increased to 5.58% in 1998
from 5.25% in 1997.


     

                                      -17-
<PAGE>
 
     The return on average assets was 1.43% for the year ended December 31, 1998
and 1.20% for the year ended December 31, 1997.

NET INTEREST INCOME

     Net interest income is the difference between the interest income the Bank
earns on its loans, securities, and other earning assets, and the interest
expense it pays on deposits and other interest-bearing liabilities necessary to
fund these earning assets. Net interest income is the primary component of the
Bank's earnings.

     Net interest income was $6,831 for the year ended December 31, 1998
compared to $5,837 for the year ended December 31, 1997, an increase of $994, or
17%.

INTEREST INCOME

     Average interest earning assets for the year ended December 31, 1998 were
$122,434 compared to $111,309 for the year ended December 31, 1997, an increase
of $11,125, or 10%.  Total interest income, which is a function of the volume of
interest earning assets and their related rates, was $10,503 in 1998 and $9,299
in 1997, representing an increase of  $1,204, or 13%.

     Loans represent the largest component of interest earning assets.  Average
loans outstanding in 1998 were $74,229 compared to $75,348 in 1997, a 1%
decrease.  Interest on loans was $7,563 in 1998 compared to $7,082 in 1997,  a
7% increase.  The average yield on loans increased to 10.19% in 1998 as compared
to 9.40% in 1997.  One large loan carried on nonaccrual at the end of 1997 was
fully recovered in the second quarter of 1998, contributing significantly to the
higher yield in 1998.  Interest income and fees totalling $454 were recognized
at the time of recovery, including approximately $325 in prior year interest
which had not been accrued.  Excluding the decrease in 1997 interest income due
to this loan's nonaccrual status and the increase in 1998 interest income due to
the recovery, the average yield on the loan portfolio would have been 9.75% in
1998 and 9.81% in 1997.

     Average investments in debt securities and Federal funds sold were $48,205
for the year ended December 31, 1998 compared to $35,961 for the year ended
December 31, 1997, an increase of $12,244, or 34%. Related income increased to
$2,940 for the year ended December 31, 1998 from $2,217 for the year ended
December 31, 1997, an increase of $723, or 33%. The increased income resulted
primarily from a larger portion of excess funds (generated by increased deposits
and decreased loans) being invested in taxable securities. Average investments
in debt securities, not including Federal funds, increased by $6,829, or 27% in
the year ended December 31,1998 and average Federal funds sold increased by
$5,415, or 53%. The average rate earned on federal funds decreased to 5.20% for
the year ended December 31, 1998 compared to 5.36% for the year ended December
31, 1997.

     Average interest bearing liabilities increased by $6,926 during 1998, while
average loans decreased by $1,119 and average debt securities and Federal funds
sold increased by $12,244. In 1998, the Bank attempted to retain market share by
remaining generally competitive with other financial institutions in its market
area in the CD category. Loan payoffs and competitive pressures on both rates
and terms for various loan types resulted in a decline in the Bank's loan
portfolio. Although the Bank cannot predict future economic or competitive
conditions, the Bank's strategically planned expansion in 1999 (Norwalk branch)
may stimulate loan originations and lessen any further decline in the loan
portfolio.

                                      -18-
<PAGE>
 
INTEREST EXPENSE

     Interest expense was $3,672 for the year ended December 31,  1998 compared
to $3,460 for the year ended December 31,  1997,  a 6%  increase.  Interest
expense is a function of interest bearing liabilities and their related rates.
Average interest bearing liabilities were $93,365 in 1998 compared to $86,439 in
1997, an increase of $6,926, or 8%.  The growth in average interest bearing
liabilities was primarily due to growth in time deposits, as well as NOW and
regular savings accounts.

PROVISION FOR LOAN LOSSES

     The provision for loan losses is based upon the size and composition of the
loan portfolio, and management's estimate of losses inherent in the loan
portfolio based upon an evaluation of portfolio risk and economic factors. A
review of the quality of the loan portfolio is conducted internally by
management on a quarterly basis with the results presented to the Bank's Board
of Directors for approval. The evaluation considers individual borrowers whose
aggregate loans are greater than $100, as well as all Bank classified assets.
Consideration is also given to several factors including, but not limited to,
economic conditions, delinquency, charge off history, growth and composition of
the loan portfolio, and other relevant factors. The provision for loan losses
was $272 for the year ended December 31, 1998 and $116 for the year ended
December 31, 1997. As of December 31, 1998, the allowance for loan losses was
$1,733 or 2.50% of gross loans, compared to $1,529 or 1.94% of gross loans at
December 31, 1997, and $1,660 or 2.27% of gross loans at December 31, 1996.

     At December 31, 1998, the Bank had $812 of nonperforming loans, of which
$524 were non-accrual loans and $288 were accruing loans greater than 90 days
past due. At December 31, 1997, the Bank had $3,330 of nonperforming loans of
which $3,017 were non-accrual loans and $313 were accruing loans greater than 90
days past due. The decrease in nonperforming loans in 1998 is primarily due to
the payoff of a loan in the second quarter of 1998 which was carried on
nonaccrual status at the end of 1997.

NONINTEREST INCOME

     Noninterest income was $763 for the year ended December 31,  1998, compared
to $624 for the year ended December 31,  1997, an increase of $139, or 22%.
Approximately  72% of the increase was due to increased late payment charges and
fees collected on the payoff of a few large loans.

                                      -19-
<PAGE>
 
NONINTEREST EXPENSE

     Total noninterest expenses were $4,143 for the year ended December 31,
1998 and $3,874 for the year ended December 31, 1997,  an increase of $269, or
7%.

     A table summarizing the dollar amounts for each category and percent
changes is as follows:

<TABLE>
<CAPTION>
                                                                               Increase        
                                          Year  ended December 31,            1998 vs 1997   
                                          ------------------------            ------------   
CATEGORY                                   1998              1997              $        %   
                                          ------            ------             -        -   
<S>                                       <C>               <C>               <C>     <C> 
Salaries and employee benefits            $ 2,015           $ 1,884           $ 131      7%
Occupancy                                     461               451              10      2
Furniture and equipment                       412               371              41     11
Other                                       1,255             1,168              87      7
                                          -------           -------           -----   ----  
 
Total noninterest expense                 $ 4,143           $ 3,874           $ 269      7%
                                          =======           =======           =====   ====
</TABLE>

     The increase in salaries and employee benefits was due to increased
personnel, salary increases and bonuses.  The increase in occupancy expenses
primarily resulted from the renewal of the lease for the Springdale branch.  The
increase in furniture and equipment expenses resulted from additional equipment
purchases as well as ancillary service contracts in 1998.  The increase in other
noninterest expense was due to increased data processing charges as well as
legal, accounting and miscellaneous fees relating to the formation of the bank
holding company.

     The following table summarizes dollar amounts for each major category of
noninterest expense as a percentage of total operating income (interest income
plus noninterest income):

<TABLE>
<CAPTION>
 
                                                  Year ended December 31,
                                             --------------------------------
CATEGORY                                      1998                      1997
                                             ------                    ------
<S>                                          <C>                       <C>
Salaries and employee benefits               17.89%                    18.99%
Occupancy                                     4.09                      4.55
Furniture and equipment                       3.65                      3.74
Other                                        11.14                     11.77
                                             -----                     -----  
Total noninterest expense                    36.77%                    39.05%
                                             =====                     =====
</TABLE>

COMPARATIVE ANALYSIS OF 1997 AND 1996

NET INCOME

     Net income was $1,425 for the year ended December 31, 1997 compared to
$1,252 for the year ended December 31, 1996, an increase of $173 or 14%.  Basic
earnings per common share was $1.29 for the year ended December 31, 1997 and
$1.33 for the year ended December 31, 1996 based on weighted average shares
outstanding of approximately 1,106,000 and 944,000, respectively.  Diluted
earnings per share were $1.24 for the year ended December 31, 1997 and $1.30 for
the year ended December 31, 1996 based on weighted average shares of
approximately 1,148,000 and 962,000, respectively.  Return on average common
stockholder's equity was 11.29% and 13.88% for the years ended December 31, 1997
and  1996, respectively.

                                      -20-
<PAGE>
 
     The increase in net income for the year ended December 31, 1997 was
primarily due to increased loan volume and securities volume. The average yield
on interest earning assets (FTE) decreased 28 basis points in 1997 while the
average yield on interest bearing liabilities remained unchanged for the same
period. This resulted in an interest rate spread (FTE) of 4.35% in 1997 compared
to 4.63% in 1996. The net interest margin (FTE) decreased to 5.25% in 1997 from
5.42% in 1996.

     The return on average assets was 1.20% for the year ended December 31, 1997
and 1.18% for the year ended December 31, 1996.

NET INTEREST INCOME

     Net interest income was $5,837 for the year ended December 31, 1997
compared to $5,332 for the year ended December 31, 1996, an increase of $505, or
9%.

INTEREST INCOME

     Average interest earning assets for the year ended December 31, 1997 were
$111,309 compared to $98,623 for the year ended December 31, 1996, an increase
of $12,686, or 13%. Total interest income, which is a function of the volume of
interest earning assets and their related rates, was $9,297 in 1997 and $8,507
in 1996, representing an increase of $790, or 9%.

     Loans represent the largest component of interest earning assets. Average
loans outstanding in 1997 were $75,348 compared to $68,881 in 1996, a 9%
increase. Loan growth was funded by an increase in deposits and the growth in
retained earnings both of which were aided by the opening of new branches in
1994, 1995 and 1997. Interest on loans was $7,082 for 1997 compared to $6,809 in
1996, a 4% increase. The increase in loan income in 1997 was primarily due to
increased loan volume. The average yield on loans decreased to 9.40% for the
year ended December 31, 1997 as compared to 9.89% for the year ended December
31, 1996. The decrease in loan yield in 1997 was primarily due to one large loan
placed on nonaccrual status in 1997. Had the loan remained on accrual status,
the average yield on loans in 1997 would have been 9.81%.

     Average investments in debt securities and Federal funds sold were $35,961
for the year ended December 31, 1997 compared to $29,742 for the year ended
December 31, 1996, an increase of $6,219, or 21%. Related income increased to
$2,215 for the year ended December 31, 1997 from $1,698 for the year ended
December 31, 1996, an increase of $517, or 30%. The increased income resulted
primarily from a larger portion of excess funds being invested in taxable
securities. Average investments in debt securities, not including Federal funds,
increased by $6,945, or 37% in the year ended December 31, 1997 while average
Federal funds sold decreased by $726, or 7%. The average rate paid on federal
funds increased to 5.36% for the year ended December 31, 1997 compared to 5.26%
for the year ended December 31, 1996.

     Average interest bearing liabilities increased by $7,135 during 1997, while
average loans increased by $6,467 and average debt securities and Federal funds
sold increased $6,219. In 1997, the Bank attempted to retain market share by
remaining generally competitive with other financial institutions in its market
area in the 12-17 month CD category. The influx of deposits is also a result of
advertising and the opening of a new branch in the Stamford area in 1997.

                                      -21-
<PAGE>
 
INTEREST EXPENSE

     Interest expense was $3,460 for the year ended December 31,  1997 compared
to $3,175 for the year ended December 31,  1996,  a 9%  increase.  Interest
expense is a function of interest bearing liabilities and their related rates.
Average interest bearing liabilities  were $86,439 in 1997 compared to $79,304
in 1996, an increase of $7,135, or 9%.  The growth in average interest bearing
liabilities was primarily due to growth in time deposits as well as regular,
club and money market savings.

PROVISION FOR LOAN LOSSES

     The provision for loan losses was $116 for the year ended December 31,
1997 and $414 for the year ended December 31,  1996.  As of December 31, 1997,
the allowance for loan losses was $1,529 or 1.94% of gross loans, compared to
$1,660 or 2.27% of gross loans at December 31, 1996 and $1,384 or 2.15% of gross
loans at December 31, 1995.

     At December 31, 1997, the Bank had $3,330 of nonperforming loans, of which
$3,017 were non-accrual loans and $313 were accruing loans greater than 90 days
past due.  At December 31, 1996, the Bank had $1,267 of nonperforming loans of
which $888 were non-accrual loans, $89 were accruing loans greater than 90 days
past due and $290 were restructured loans.  Although the ratio of nonperforming
loans to total loans at December 31, 1997 increased to 4.22% from 1.73% at the
previous year end, the increase was due primarily to one loan which was resolved
in 1998.

NONINTEREST INCOME

     Noninterest income was $624 for the year ended December 31,  1997, compared
to $585 for the year ended December 31,  1996, an increase of $39, or 7%.
Approximately  96% of the increase was due to increased late payment charges and
other service charges on loans.  Income from late charges and service charges on
loans increased to $87 in 1997 from $38 in 1996, an increase of $49 or 129%.

NONINTEREST EXPENSE

     Total noninterest expenses were $3,874 for the year ended December 31,
1997 and $3,350 for the year ended December 31, 1996,  an increase of $524, or
16%.

     A table summarizing the dollar amounts for each category and percent
changes is as follows:

<TABLE>
<CAPTION>
                                                                                Increase              
                                          Year  ended December 31,            1997 vs 1996            
                                          ------------------------            ------------            
CATEGORY                                   1997              1996              $        %             
                                           ----              ----              -        -             
<S>                                       <C>                <C>              <C>       <C>        
Salaries and employee benefits            $ 1,884            $ 1,603          $ 281     18%       
Occupancy                                     451                388             63     16        
Furniture and  equipment                      371                311             60     19        
Other                                       1,168              1,048            120     11        
                                          -------            -------          -----   ----        
                                                                                              
Total noninterest expense                 $ 3,874            $ 3,350          $ 524     16%       
                                          =======            =======          =====     ==         
</TABLE>

     The increase in salaries and employee benefits was due to salary increases,
bonuses and the addition of branch personnel in the fourth quarter of 1996.  The
increase in occupancy expenses 

                                      -22-
<PAGE>
 
primarily resulted from the renewal of the lease for the Springdale branch. The
increase in furniture and equipment expense resulted from additional equipment
purchases at the main office and the West Broad street branch which opened in
1997, as well as ancillary service contracts. The increase in other noninterest
expense was due to increased data processing charges, legal fees, insurance
costs and donations.

     The following table summarizes dollar amounts for each major category of
noninterest expense as a percentage of total operating income:

<TABLE>
<CAPTION>
                                        Year ended December 31,
                                        -----------------------
CATEGORY                                 1997             1996
                                        ------           ------
<S>                                     <C>              <C>
Salaries and employee benefits          18.99%           17.63%
Occupancy                                4.55             4.27
Furniture and equipment                  3.74             3.42
Other                                   11.77            11.53
                                        -----            -----
Total noninterest expense               39.05%           36.85%
                                        =====            =====
</TABLE>


                    LIQUIDITY AND INTEREST RATE SENSITIVITY

     At December 31, 1998, total short term investments, which are made up of
Federal funds sold, all available-for-sale securities, and held-to-maturity
securities maturing in one year or less, totalled $55,552.  The liquidity of the
Bank is measured by the ratio of net cash, short term, and marketable assets to
net deposits and short term  liabilities. The Bank's liquidity ratio at
December 31, 1998 was 52.57%. The Bank's internal guideline is to maintain a
liquidity ratio of at least 20%.

     As reported in the statements of cash flows, the Bank's cash flows are
classified as operating, investing, or financing.  The  $883 increase in net
cash provided by operating activities in 1998, compared to 1997, was primarily
due to the $449 increase in net income.  Approximately $309 of the increase in
net income was a result of the recovery of  all  previously  nonaccrued interest
and certain loan fees on a nonaccrual loan.  Net cash used in investing
activities declined by $10,172 in 1998, compared to 1997, due to the higher
levels of loan repayments and maturities of available-for-sale securities.
Compared to 1997, net cash provided by financing activities increased by $81,
and cash and cash equivalents increased by $11,870 during 1998.

     Management anticipates that the Norwalk branch will commence operations on
or about April 30, 1999.  Construction costs are projected to be $120,000 and
furniture, equipment and signs are projected to cost $130,000.  General
corporate funds will be used to support the renovation and ancillary purchases.

     At December 31, 1998, the Bank had outstanding loan commitments under
unused lines of credit approximating $8,955 and outstanding letters of credit
approximating $225.

     The following table sets forth the maturity or repricing distribution of
the Bank's interest earning assets and interest bearing liabilities as of
December 31, 1998, the Bank's interest rate sensitivity gap (i.e., interest-
sensitive assets less interest-sensitive liabilities), the Bank's cumulative
interest rate sensitivity gap, the ratio of cumulative total interest-earning
assets to cumulative total interest-bearing liabilities, and the Bank's
cumulative interest rate sensitivity gap ratio.  For purposes of the table, an
asset or liability is considered rate sensitive within a specified period when
it matures or  could be repriced within such period in accordance with its
contractual terms.  Debt securities are placed in maturity periods based upon
their projected call date, where applicable.  Regular savings, preferred rate

                                      -23-
<PAGE>
 
savings, NOW and money market demand accounts totaling $43,546 have been
included in the column for liabilities repricing within 6 months. Regular
savings, preferred rate savings, NOW and money market demand accounts are
believed to be sensitive to changes in interest rates in a rising rate
environment. Management believes such deposits would move into higher yielding
deposit products in a rising rate environment.

<TABLE>
<CAPTION>
                                                       Interest Sensitivity
                                        ---------------------------------------------------

                                         Within 6      6 Months-     1-5        Over 5                      
                                          Months        1 Year      Years        Years         Total 
                                        ----------    ----------  ---------   -----------    ---------
                                                             (dollars in thousands)
<S>                                     <C>           <C>         <C>         <C>            <C>
Interest earning assets:
Federal funds sold and securities       $  29,397     $    5,537  $  27,274   $       0      $   62,208
 
Loans (1)
 Adjustable rate                           21,293             12          0           0          21,305
 Fixed rate                                 6,209          2,894     22,037      16,152          47,292
                                        ---------     ----------  ---------   ---------      ----------
 
   Total interest earning assets           56,899          8,443     49,311      16,152         130,805
                                        ---------     ----------  ---------   ---------      ---------- 
 
Interest bearing liabilities:
Money market demand and
  NOW accounts                             18,941              0          0           0          18,941
Regular, club, and preferred
  rate savings accounts                    24,605             95          0           0          24,700
Time                                       21,210         14,993     16,185         104          52,492
                                        ---------     ----------  ---------   ---------      ---------- 
 
   Total deposits                          64,756         15,088     16,185         104          96,133
 
Repurchase agreements                       2,198              0          0           0           2,198
Other interest-bearing liabilities              0              3          0           0               3
                                        ---------     ----------  ---------   ---------      ---------- 
 
   Total interest bearing liabilities      66,954         15,091     16,185         104          98,334
                                        ---------     ----------  ---------   ---------      ---------- 
 
Total interest earning assets
less interest bearing liabilities
for the period                          $ (10,055)    $   (6,648) $  33,126   $  16,048
 
Cumulative total
interest earning assets less
interest bearing liabilities            $ (10,055)    $  (16,703) $  16,423   $  32,471
 
Cumulative total interest earning
assets less interest bearing
liabilities as a percentage of
total interest earning assets               (7.64)%       (12.69)%    12.48%      24.68%
</TABLE>

(1)  Excludes loans on nonaccrual status and overdrafts.

                                      -24-
<PAGE>
 
     The tabular presentation of the Bank's interest sensitivity position
indicates that for the period up to one year following December 31, 1998
cumulative total interest earning assets are less than cumulative total interest
bearing liabilities. If interest rates were to decline during this period, more
liabilities would be repricing than assets and therefore the Bank would
experience an increase in its net interest margin. If interest rates were to
increase during this period, more liabilities would be repricing than assets for
that period and therefore the Bank would experience a decline in its net
interest margin. Periods of one through five years and over five years indicate
that more interest earning assets will be repricing than interest bearing
liabilities, therefore the Bank would experience an increase in its net interest
margin in a rising rate environment while in a declining rate environment the
Bank would experience a decrease in its net interest margin.

     The tabular presentation only represents repricing of interest earning
assets and interest bearing liabilities at a point in time and is not indicative
of when and how the interest earning assets and interest bearing liabilities
will actually reprice.


                               CAPITAL RESOURCES

     At December 31, 1998 and December 31, 1997, the Bank's leverage capital
ratio was equal to 10.95% and 10.81%, respectively.  At December 31, 1998 and
December 31, 1997, the Bank's Tier 1 risk-based capital ratio was 18.54% and
15.76%, respectively.  The Bank's total-risk based capital ratio at December 31,
1998 and December 31, 1997 was 19.80% and 17.02%, respectively. These ratios
exceeded the stated minimum regulatory requirements.

     During 1998, the Bank declared a total of $357,000 in quarterly and special
cash dividends on its common stock, and on January 20, 1999 the Bank's Board of
Directors declared a special dividend of $0.18 cents per share payable February
19, 1999 to shareholders of record on February 8, 1999.  The Bank also
distributed a 10% stock dividend during 1998, resulting in the issuance of
101,552 additional common shares.


                                   YEAR 2000
                                        
     The Year 2000 Issue is the result of computer programs being written using
two digits rather than four to define the applicable year.  Computer programs
that have date-sensitive software may recognize a date using "00" as the Year
1900 rather than the Year 2000.  This could result in a system failure or
miscalculations  causing disruptions of operations, including among other
things, a temporary inability to process transactions, generate accurate
customer statements, or engage in similar normal business activities.

     While the Bank believes that most of its systems are already Year 2000
compliant, the Bank has in place an action plan to identify, review and test all
of its operating systems.  In addition, the FDIC monitors the Bank's
preparedness for the Year 2000.  The actions being taken by the Bank in response
to the Year 2000 issue are consistent with the guidelines in policy statements
issued by the bank regulatory agencies.

     Management has initiated a Bank-wide program, consistent with guidelines
issued by the Federal Financial Institutions Examination Council, to prepare the
Bank's computer systems and software applications for the Year 2000.  The
program includes the following phases (current status is indicated for each
phase):

                                      -25-
<PAGE>
 
  *  Identification (Completed)
  *  Assessment (Completed)
  *  Remediation (Completed)
  *  Testing (Continuing)
  *  Contingency Planning (Continuing)

     The Bank has tested its mission critical applications, which are those
comprising its "core" data processing system for loans, deposits and the general
ledger maintained by a third-party vendor. Testing of these applications was
completed by December 31, 1998.

     The Bank has initiated formal communications with all of its significant
vendors and has contacted certain of its customers to determine the extent to
which the Bank is vulnerable to those third parties' failures to remediate their
own Year 2000 Issue.  The Bank is in the process of obtaining assurances from
vendors that timely updates will be made available to make all remaining
purchased software Year 2000 compliant.  However, there can be no guarantee that
the systems of other entities on which the Bank's systems rely will be timely
converted, or that a failure to convert by another entity, or a conversion that
is incompatible with the Bank's systems, would not have a material adverse
effect on the Bank.

     The Bank has also initiated dialogue with its loan customers concerning
their Year 2000 preparedness and has incorporated the consideration of Year 2000
readiness into its loan review and credit underwriting processes.  The Bank has
also employed an outside consultant to assist in developing its Year 2000 plan.

     The Bank estimates that its total Year 2000 project costs, including costs
charged to expense, will not exceed $100,000.  As of December 31, 1998, the Bank
had incurred $40,000 of costs relating to Year 2000,  the majority of which are
hardware and software related.    The cost of the project and the date on which
the Bank plans to complete the Year 2000 modifications are based on management's
best estimates, which were derived utilizing numerous assumptions of future
events including the availability of certain resources, third party modification
plans and other factors. There can be no guarantee that these estimates will be
achieved and actual results could differ materially from those plans.  Specific
factors that may cause such material differences include, but are not limited
to, the availability and cost of personnel trained in this area, the ability to
locate and correct all relevant computer codes and similar uncertainties.

     Significant Year 2000 failures in the Bank's systems or in the systems of
third parties, and a significant reduction in liquidity due to high levels of
withdrawals of customer deposits, would have a material adverse  effect on the
Bank's financial  condition and results of operations.  The Bank believes that
its reasonably likely worst case scenario might include a material increase in
credit losses due to Year 2000 problems of borrowers, a significant reduction in
liquidity due to high levels of withdrawals of customer deposits, and a
disruption in financial markets generally.  The magnitude of potential credit
losses, liquidity problems or a disruption in financial markets cannot be
determined at this time; however, the Bank's Year 2000 program described above
is designed to address exposure to risks.  The Bank continues to develop a
business resumption contingency plan to address the possibility of  unplanned
system difficulties or third party  failures.  This plan will entail some type
of manual recordkeeping and reporting procedures in critical operating areas.

ITEM 7.   FINANCIAL STATEMENTS
          --------------------

          The Statements of Condition of Cornerstone Bank as of December 31,
1998 and 1997, and

                                      -26-
<PAGE>
 
the related Statements of Income, Changes in Stockholders' Equity and Cash Flows
for the years ended December 31, 1998, 1997 and 1996, together with the related
notes and the reports of KPMG LLP and Deloitte & Touche LLP, independent
auditors, are included herein on pages F-1 through F-24.

ITEM 8.   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
          ------------------------------------------------
          ACCOUNTING AND FINANCIAL DISCLOSURE
          -----------------------------------

     There have been no changes in or disagreements with accountants required to
be reported herein.
                                    PART III

ITEM 9.   DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
          -------------------------------------------------------------
          COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT
          -------------------------------------------------

     Information regarding the Bancorp's directors is incorporated by reference
herein to the Bancorp's Proxy Statement for its Annual Meeting of Shareholders
to be held on May 19, 1999 (the "1999 Proxy Statement").  Information regarding
the Bancorp's executive officers is included as Item 4A in Part I of this Form
10-KSB.

ITEM 10.  EXECUTIVE COMPENSATION
          ----------------------

     Information regarding the compensation of the Bancorp's executive officers
is incorporated by reference herein to the 1999 Proxy Statement.

ITEM 11.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
          --------------------------------------------------------------

     Information regarding the beneficial ownership of the Bancorp's common
stock by certain persons is incorporated by reference herein to the 1999 Proxy
Statement.

ITEM 12.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
          ----------------------------------------------

     Information regarding certain transactions involving the Bancorp is
incorporated by reference herein to the 1999 Proxy Statement.


                                    PART IV

ITEM 13.  EXHIBITS AND REPORTS ON FORM 8-K
          --------------------------------

(a)  Exhibits

Exhibit No.    Description

2.1            Agreement and Plan of Reorganization dated as of August 19, 1998
               between Cornerstone Bank and Cornerstone Bancorp, Inc. (Exhibit
               2.1 to Form 8-K12G3 dated March 1, 1999, File No. 0-25465 ("Form
               8-K12G3")) (1)

3.1            Certificate of Incorporation of Cornerstone Bancorp, Inc.
               (Exhibit 4.1 to Form 8- K12G3) (1)

                                      -27-
<PAGE>
 
Exhibit No.    Description

3.2            Bylaws of Cornerstone Bancorp, Inc. (Exhibit 4.2 to Form 8-K12G3)
               (1)

4.1            Form of Specimen Common Stock Certificate of Cornerstone Bancorp,
               Inc. (Exhibit 4.3 to Form 8-K12G3)(1)

10.1           Lease agreement dated as of January 19, 1989 between First
               National Bank of Stamford and Joseph F. Calve Family Trust, and
               Lease agreement dated as of June 28, 1994 between Cornerstone
               Bank and The Samuel Lotstein Realty Company (Exhibit 2 to
               Cornerstone Bank's Registration Statement on Form F-1 filed with
               the FDIC) (1)
               
10.2           Lease agreement dated as of May 16, 1995 between Cornerstone Bank
               and Mill Pond Company (Exhibit 3 (ii) to Cornerstone Bank's Form
               F-2 for the year ended December 31, 1994 filed with the FDIC) (1)
 
10.3           Lease agreement dated as of November 29, 1996 between Cornerstone
               Bank and John P. Rossi (Exhibit 3(vii) to Cornerstone Bank's Form
               F-2 for the year ended December 31, 1996 filed with the FDIC) (1)

10.4           Lease agreement dated as of December 22, 1998 between Cornerstone
               Bank and Ralph Sandolo (2)
 
10.5           Cornerstone Bancorp, Inc. 1986 Incentive and Non-Qualified Stock
               Option Plan (Exhibit 99.1 to Registration Statement on Form S-8
               Registration No. 333-73129 ("Form S-8")) (1) 

10.6           Cornerstone Bancorp, Inc. 1996 Incentive and Non-Qualified Stock
               Option Plan (Exhibit 99.2 to Form S-8)(1)
 
10.7           Cornerstone Bancorp, Inc. Director Compensation Plan (Exhibit
               99.3 to Form S-8)(1)
 
10.8           Employment agreement dated as of July 1, 1998 between Cornerstone
               Bank and Norman H. Reader (2)
 
10.9           Employment agreement dated as of July 15, 1998 between
               Cornerstone Bank and James P. Jakubek (2)

21.1           Subsidiaries of Cornerstone Bancorp, Inc. (2)

23.1           Consent of KPMG LLP (2)

                                      -28-
<PAGE>
 
Exhibit No.    Description

27.1           Financial Data Schedule (2)

(1) Incorporated by reference.
(2) Filed herewith.

(b) Reports on Form 8-K

     No reports on Form 8-K were filed during the last quarter of fiscal 1998.

 

                                      -29-
<PAGE>
 
                                  SIGNATURES

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

                           CORNERSTONE BANCORP, INC.

Date:  March 24,1999                   By: /s/ Norman H. Reader
       -------------                       --------------------------------
                                           Norman H. Reader
                                           President and
                                           Chief Executive Officer

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

<TABLE>
<CAPTION>
SIGNATURE                                  TITLE                               DATE         
<S>                                 <C>                                    <C>             
/s/ Melvin L. Maisel                Chairman of the Board                  March 24, 1999  
---------------------------                                                --------------    
Melvin L. Maisel

                                                                                           
/s/ Norman H. Reader                Director, President,                   March 24, 1999
---------------------------                                                --------------                    
Norman H. Reader                    Chief Executive Officer and                            
                                    Principal Financial Officer                            
                                                                                           
/s/ Joseph Field                    Director                               March 24, 1999 
---------------------------                                                --------------    
Joseph Field

 
/s/ J. James Gordon                Director                                March 24, 1999
---------------------------                                                --------------    
J. James Gordon

 
/s/ James P. Jakubek               Director, Executive                     March 24, 1999
---------------------------                                                --------------    
James P. Jakubek                   Vice President
 

/s/ Stanley A. Levine              Director                                March 24, 1999
---------------------------                                                --------------    
Stanley A. Levine
 

/s/ Joseph A. Maida                Director                                March 24, 1999
---------------------------                                                --------------    
Joseph A. Maida
 

/s/ Ronald C. Miller               Director                                March 24, 1999
---------------------------                                                --------------    
Ronald C. Miller 
 

/s/ Courtney A. Nelthropp          Director                                March 24, 1999
---------------------------                                                --------------    
Courtney A. Nelthropp 
</TABLE>

                                      -30-
<PAGE>
 
<TABLE> 
<CAPTION> 
SIGNATURE                                  TITLE                               DATE         
<S>                                  <C>                                   <C>  
/s/ Martin Prince                    Director                              March 24, 1999
---------------------------                                                --------------
Martin Prince                                  
                                               
/s/ Patrick Tisano                   Director                              March 24, 1999
---------------------------                                                --------------
Patrick Tisano                                 
                                               
/s/ Joseph D. Waxberg, M.D.          Director                              March 24, 1999
---------------------------                                                --------------
Joseph D. Waxberg, M.D.


/s/ Leigh A. Hardisty                Senior Vice President, Comptroller    March 24, 1999
-------------------------------                                            --------------
Leigh A. Hardisty                    & Principal Accounting Officer
</TABLE> 

                                      -31-
<PAGE>
 
                                 EXHIBIT INDEX
 
Exhibit No.    Description

2.1         Agreement and Plan of Reorganization dated as of August 19, 1998
            between Cornerstone Bank and Cornerstone Bancorp, Inc. (Exhibit 2.1
            to Form 8-K12G3 dated March 1, 1999, File No. 0-25465 ("Form 8-
            K12G3")) (1)

3.1         Certificate of Incorporation of Cornerstone Bancorp, Inc. (Exhibit
            4.1 to Form 8-K12G3) (1)

3.2         Bylaws of Cornerstone Bancorp, Inc. (Exhibit 4.2 to Form 8-K12G3)
            (1)
 
4.1         Form of Specimen Common Stock Certificate of Cornerstone Bancorp,
            Inc. (Exhibit 4.3 to Form 8-K12G3) (1) 
 
10.1        Lease agreement as of January 19, 1989 between First National Bank
            of Stamford and and Joseph F. Calve Family Trust, Lease agreement as
            of June 28, 1994 between Cornerstone Bank and The Samuel Lotstein
            Realty Company (Exhibit 2 to Cornerstone Bank's Registration
            Statement on Form F-1 filed with the FDIC) (1)
 
10.2        Lease agreement dated as of May 16, 1995 between Cornerstone Bank
            and Mill Pond Company (Exhibit 3(ii) to Cornerstone Bank's Form
            F-2 for the year ended December 31, 1994 filed with the FDIC) (1)

 
10.3        Lease agreement dated as of November 29, 1996 between Cornerstone
            Bank and John P. Rossi (Exhibit 3(vii) to Cornerstone Bank's Form F-
            2 for the year ended December 31, 1996 filed with the FDIC) (1) 
 
10.4        Lease agreement dated as of December 22, 1998 between Cornerstone
            Bank and Ralph Sandolo (2) 
 
10.5        Cornerstone Bancorp, Inc. 1986 Incentive and Non-Qualified Stock
            Option Plan (Exhibit ("Form S-8")) 99.1 to Registration
            Statement on Form S-8 Registration No. 333-73129 (1) 
 
 
10.6        Cornerstone Bancorp, Inc. 1996 Incentive and Non-Qualified Stock
            Option Plan (Exhibit 99.2 to Form S-8) (1) 
 
10.7        Cornerstone Bancorp, Inc. Director Compensation Plan (Exhibit 99.3
            to Form S-8) (1)
 
10.8        Employment agreement dated as of July 1, 1998 between Cornerstone
            Bank and Norman H. Reader (2)
 
10.9        Employment agreement dated as of July 15, 1998 between Cornerstone
            Bank and James P. Jakubek (2) 

21.1        Subsidiaries of Cornerstone Bancorp, Inc. (2)

23.1        Consent of KPMG LLP (2)
<PAGE>
 
Exhibit No.    Description

27.1        Financial Data Schedule (2)

(1) Incorporated by reference.
(2) Filed herewith.
<PAGE>
 
                               CORNERSTONE BANK
                                        
                             FINANCIAL STATEMENTS
                                        
                               TABLE OF CONTENTS

<TABLE>
<CAPTION>
                                                                               PAGE
<S>                                                                          <C>
INDEPENDENT AUDITORS' REPORTS                                                F-1, F-2
 
FINANCIAL STATEMENTS:
 
 Statements of Condition at December 31, 1998 and 1997                           F-3
 
 Statement of Income for the Years Ended December 31, 1998, 1997 and 1996        F-4
 
 Statements of Changes in Stockholders' Equity for the Years Ended
   December 31, 1998, 1997 and 1996                                              F-5
 
 Statements of Cash Flows for the Years Ended December 31, 1998,
   1997 and 1996                                                                 F-6
 
 Notes to Financial Statements                                               F-7 to F-24
</TABLE>
<PAGE>
 
INDEPENDENT AUDITORS' REPORT


The Board of Directors and Stockholders
Cornerstone Bank:


We have audited the statement of condition of Cornerstone Bank (the "Bank") as
of December 31, 1998 and the related statements of income, changes in
stockholders' equity, and cash flows for the year then ended. These financial
statements are the responsibility of the Bank's management. Our responsibility
is to express an opinion on these financial statements based on our audit.

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

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of the Bank as of December 31,
1998, and the results of its operations and its cash flows for the year then
ended in conformity with generally accepted accounting principles.


/s/ KPMG LLP


January 27, 1999 (except as to
 note 18, which is as of
 March 1, 1999)

                                      F-1
<PAGE>
 
INDEPENDENT AUDITORS' REPORT


To the Board of Directors and Stockholders
of Cornerstone Bank


We have audited the statement of condition of Cornerstone Bank (the "Bank") as
of December 31, 1997 and the related statements of income, changes in
stockholders' equity, and cash flows for the years ended December 31, 1997 and
1996. These financial statements are the responsibility of the Bank's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.

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

In our opinion, such financial statements present fairly, in all material
respects, the financial position of the Bank as of December 31, 1997, and the
results of its operations and its cash flows for the years ended December 31,
1997 and 1996 in conformity with generally accepted accounting principles.


/s/ Deloitte & Touche LLP


February 9, 1998

                                      F-2
           
<PAGE>
                               CORNERSTONE BANK

                            Statements of Condition

                          December 31, 1998 and 1997
                       (In thousands, except share data)

<TABLE> 
<CAPTION> 
                                    ASSETS                                             1998               1997
                                                                                  -------------      -------------
<S>                                                                               <C>                <C>    
Cash and due from banks (note 2)                                                  $       4,768      $       4,927   
Federal funds sold                                                                       22,544             10,515   
                                                                                  -------------      -------------
            Cash and cash equivalents                                                    27,312             15,442   

Available-for-sale securities, at fair value (note 3)                                    30,003             22,754   
Held-to-maturity securities (fair value of $9,744 in 1998 and
    $4,585 in 1997) (note 3)                                                              9,661              4,549   
Loans, net of allowance for loan losses of $1,733 in 1998 and
    $1,529 in 1997 (note 4)                                                              67,651             77,429   
Bank premises and equipment, net (note 5)                                                 2,815              2,966   
Accrued interest receivable                                                                 970                850   
Other assets                                                                              1,321              1,418   
                                                                                  -------------      -------------

            Total assets                                                          $     139,733      $     125,408   
                                                                                  =============      =============

                    LIABILITIES AND STOCKHOLDERS' EQUITY

Liabilities:
    Deposits:
       Demand (non-interest bearing)                                              $      25,746      $      22,627   
       Money market demand and NOW                                                       18,941             17,428   
       Regular, club and money market savings                                            24,700             22,989   
       Time (note 6)                                                                     52,492             45,860   
                                                                                  -------------      -------------
            Total deposits                                                              121,879            108,904   

    Securities sold under agreements to repurchase                                        2,198              2,510   
    Accrued interest payable                                                                166                181   
    Other liabilities                                                                       500                503   
                                                                                  -------------      -------------
            Total liabilities                                                           124,743            112,098   
                                                                                  -------------      -------------

Commitments and contingencies (note 8)

Stockholders' equity (notes 10, 12, 13, 14 and 18):
    Common stock, par value $0.01 per share; authorized
       2,000,000 shares; issued and outstanding 1,119,336 shares
       in 1998 and 1,011,947 shares in 1997                                                  11                 10   
    Additional paid-in capital                                                           11,351              9,050   
    Retained earnings                                                                     3,497              4,164   
    Accumulated other comprehensive income, net of taxes
       of $91 in 1998 and $63 in 1997                                                       131                 86   
                                                                                  -------------      -------------
            Total stockholders' equity                                                   14,990             13,310   
                                                                                  -------------      -------------

            Total liabilities and stockholders' equity                            $     139,733      $     125,408   
                                                                                  =============      =============
</TABLE> 

                                      

See accompanying notes to financial statements.

                                      F-3

<PAGE>
                               CORNERSTONE BANK

                             Statements of Income

                 Years Ended December 31, 1998, 1997 and 1996
                     (In thousands, except per share data)

<TABLE> 
<CAPTION> 
                                                             1998              1997            1996
                                                         -------------     -------------    ------------
<S>                                                      <C>               <C>              <C>   
Interest income:
    Loans                                                $     7,563       $       7,082    $      6,809      
    Securities                                                 2,123               1,658           1,119      
    Federal funds sold                                           817                 557             579       
                                                         -----------       -------------    ------------ 
            Total interest income                             10,503               9,297           8,507   
                                                         -----------       -------------    ------------

Interest expense:
    Deposits                                                   3,607               3,402           3,114   
    Other                                                         65                  58              61   
                                                         -----------       -------------    ------------ 
            Total interest expense                             3,672               3,460           3,175   
                                                         -----------       -------------    ------------

Net interest income                                            6,831               5,837           5,332   
                                                                                                   
Provision for loan losses (note 4)                               272                 116             414   
                                                         -----------       -------------    ------------ 

Net interest income after provision for
    loan losses                                                6,559               5,721           4,918   
                                                         -----------       -------------    ------------ 

Non-interest income:
    Deposit service charges                                      403                 357             369   
    Other                                                        360                 267             216   
                                                         -----------       -------------    ------------ 
            Total non-interest income                            763                 624             585   
                                                         -----------       -------------    ------------ 

Non-interest expense:
    Salaries and employee benefits                             2,015               1,884           1,603   
    Occupancy                                                    461                 451             388   
    Furniture and equipment                                      412                 371             311   
    Data processing                                              345                 279             231   
    Professional fees                                            336                 218             182   
    Other                                                        574                 671             635   
                                                         -----------       -------------    ------------ 
            Total non-interest expense                         4,143               3,874           3,350   
                                                         -----------       -------------    ------------ 

Income before income tax expense                               3,179               2,471           2,153   

Income tax expense (note 7)                                    1,305               1,046             901   
                                                         -----------       -------------    ------------ 

Net income                                               $     1,874       $       1,425    $      1,252   
                                                         ===========       =============    ============

Earnings per common share (note 11):
    Basic                                                $      1.68       $        1.29    $       1.33   
    Diluted                                                     1.60                1.24            1.30   
                                                         ===========       =============    ============
</TABLE> 


See accompanying notes to financial statements.

                                      F-4

<PAGE>

                               CORNERSTONE BANK

                 Statements of Changes in Stockholders' Equity

                 Years Ended December 31, 1998, 1997 and 1996
                 (Dollars in thousands, except per share data)

<TABLE> 
<CAPTION> 
                                                                                                  ACCUMULATED
                                                    COMMON STOCK         ADDITIONAL                  OTHER              TOTAL
                                            -------------------------- 
                                                NUMBER                    PAID-IN      RETAINED   COMPREHENSIVE      STOCKHOLDERS'
                                              OF SHARES       AMOUNT      CAPITAL      EARNINGS      INCOME             EQUITY
                                            ------------     ---------   ----------  -----------  --------------  -----------------
<S>                                         <C>              <C>         <C>         <C>          <C>             <C>    
At December 31, 1995                           852,713       $      9    $   7,095   $    1,988   $         13    $        9,105   
                                       
Comprehensive income:                  
    Net income                                      --             --           --        1,252             --             1,252   
    Net change in unrealized gain on   
        available-for-sale securities, 
        net of taxes (note 10)                      --             --           --           --             37                37   
                                                                                                                  --------------
            Total comprehensive income                                                                                     1,289   
                                       
Cash dividends ($0.22 per share)                    --             --           --         (203)            --              (203) 
Shares issued in connection with:      
    Excercise of warrants                      137,379              1        1,647           --             --             1,648   
    Directors' Stock Compensation Plan             944             --           12           --             --                12   
    Dividend Reinvestment Plan                   6,853             --           83           --             --                83   
                                            ----------       --------    ---------   ----------   ------------    -------------- 
                                       
At December 31, 1996                           997,889             10        8,837        3,037             50            11,934   
                                       
Comprehensive income:                  
    Net income                                      --             --           --        1,425             --             1,425   
    Net change in unrealized gain on   
        available-for-sale securities, 
        net of taxes (note 10)                      --             --           --           --             36                36   
                                                                                                                  --------------
            Total comprehensive income                                                                                     1,461   
                                       
Cash dividends ($0.26 per share)                    --             --           --         (298)            --              (298) 
Shares issued in connection with:      
    Stock Option Plans                           7,750             --          102           --             --               102   
    Directors' Stock Compensation Plan             688             --           12           --             --                12   
    Dividend Reinvestment Plan                   5,620             --           99           --             --                99   
                                            ----------       --------    ---------   ----------   ------------    -------------- 
                                       
At December 31, 1997                         1,011,947             10        9,050        4,164             86            13,310   
                                       
Comprehensive income:                  
    Net income                                      --             --           --        1,874             --             1,874   
    Net change in unrealized gain on   
         available-for-sale securities,
         net of taxes (note 10)                     --             --           --           --             45                45   
                                                                                                                  --------------
            Total comprehensive income                                                                                     1,919   
                                       
Cash dividends ($0.32 per share)                    --             --           --         (357)            --              (357) 
Shares issued in connection with:      
    Stock dividend                             101,552              1        2,183       (2,184)            --                --    
    Stock Option Plans                             250             --            4           --             --                 4   
    Directors' Stock Compensation Plan             399             --            8           --             --                 8   
    Dividend Reinvestment Plan                   5,188             --          106           --             --               106   
                                            ----------       --------    ---------   ----------   ------------    -------------- 
                                       
At December 31, 1998                         1,119,336       $     11    $  11,351   $    3,497   $        131    $       14,990   
                                            ==========       ========    =========   ==========   ============    ==============
</TABLE> 

See accompanying notes to financial statements.

                                      F-5

<PAGE>
                               CORNERSTONE BANK

                           Statements of Cash Flows

                 Years Ended December 31, 1998, 1997 and 1996
                                (In thousands)

<TABLE> 
<CAPTION> 
                                                                                     1998           1997          1996
                                                                                  ------------   ------------  ------------
<S>                                                                               <C>            <C>           <C>     
Operating activities:
    Net income                                                                    $  1,874       $  1,425      $  1,252   
    Adjustments to reconcile net income to net cash
       provided by operating activities:
          Provision for loan losses                                                    272            116           414   
          Depreciation and amortization                                                299            254           264   
          Common stock issued under compensation agreements                              8             12            12   
          Increase in accrued interest receivable                                     (120)          (149)          (15) 
          (Increase) decrease in deferred loan costs                                   (12)             4           (25) 
          Decrease (increase) in other assets                                           69           (114)          (93) 
          (Decrease) increase in accrued interest payable                              (15)            (2)           21   
          Decrease in other liabilities                                                 (3)           (57)         (195) 
                                                                                  --------       --------      --------
               Net cash provided by operating activities                             2,372          1,489         1,635   
                                                                                  --------       --------      --------

Investing activities:
    Proceeds from maturities of available-for-sale securities                       11,403          8,474         7,312   
    Proceeds from maturities of held-to-maturity securities                          1,494          2,950         6,910   
    Purchases of available-for-sale securities                                     (18,538)       (14,569)      (17,012) 
    Purchases of held-to-maturity securities                                        (6,609)        (3,489)       (3,487) 
    Net receipts (disbursements) for loan repayments and originations                9,518         (5,950)       (8,956) 
    Purchases of bank premises and equipment                                          (186)          (506)         (209) 
                                                                                  --------       --------      --------
               Net cash used in investing activities                                (2,918)       (13,090)      (15,442) 
                                                                                  --------       --------      --------

Financing activities:
    Net increase in demand, money market and savings deposits                        6,343          3,718         4,209   
    Net increase in time deposits                                                    6,632          8,343         4,869   
    (Decrease) increase in securities sold under agreements
       to repurchase                                                                  (312)           371          (365) 
    Proceeds from issuance of common stock                                             110            201         1,731   
    Dividends paid on common stock                                                    (357)          (298)         (203) 
                                                                                  --------       --------      --------
               Net cash provided by financing activities                            12,416         12,335        10,241   
                                                                                  --------       --------      --------

Increase (decrease) in cash and cash equivalents                                    11,870            734        (3,566) 

Cash and cash equivalents, beginning of year                                        15,442         14,708        18,274   
                                                                                  --------       --------      --------

Cash and cash equivalents, end of year                                            $ 27,312       $ 15,442      $ 14,708   
                                                                                  ========       ========      ========

Supplemental information:
    Interest paid                                                                 $  3,687       $  3,462      $  3,196   
    Income taxes paid                                                                1,153          1,381         1,198   
    Net change in unrealized gain on available-for-sale
       securities, net of tax                                                           45             36            37   
                                                                                  ========       ========      ========
</TABLE> 


See accompanying notes to financial statements.

                                      F-6

<PAGE>
 
                               CORNERSTONE BANK

                         Notes to Financial Statements



(1)  NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

     BASIS OF FINANCIAL STATEMENT PRESENTATION


     The financial statements of Cornerstone Bank (the "Bank") have been
     prepared in conformity with generally accepted accounting principles and
     banking industry practices. The Bank offers a broad range of lending and
     depository services to individual customers and businesses primarily in
     Southwestern Fairfield County, Connecticut. In preparing the financial
     statements, management is required to make estimates and assumptions that
     affect the reported amounts of assets and liabilites as of the date of the
     statement of condition and income and expenses for the year. Actual results
     could differ significantly from those estimates.

     For purposes of the statements of cash flows, cash and cash equivalents
     include amounts due from banks and Federal funds sold.  Generally, Federal
     funds sold have a one-day maturity.

     Certain prior year amounts have been reclassified to conform with the 1998
     presentation. Earnings per share, dividends per share and other per share
     data for all periods has been adjusted for the effect of the 10% stock
     dividend distributed in August 1998.

     SECURITIES

     Securities are classified as either available-for-sale (representing
     securities the Bank may sell in the ordinary course of business) or as 
     held-to-maturity (representing securities the Bank has the ability and
     positive intent to hold until maturity). Securities held-to-maturity are
     stated at amortized cost. Securities available-for-sale are stated at fair
     value with unrealized gains and losses excluded from earnings and reported
     in stockholders' equity as accumulated other comprehensive income.
     Securities are not acquired for purposes of engaging in trading activities.

     Gains and losses realized on sales of securities are determined using the
     specific identification method. Premiums and discounts on debt securities
     are amortized to interest income over the term of the security. Unrealized
     losses on securities are charged to earnings if management determines that
     the decline in fair value of a security is other than temporary.

     LOANS

     Loans are stated at the principal amount outstanding, net of deferred loan
     costs and fees and the allowance for loan losses. Interest income is
     accrued based on contractual rates applied to principal amounts
     outstanding. Loan origination and commitment fees and certain direct costs
     are deferred and amortized to income over the life of the related loan.

     Loans are classified as nonaccrual when, in the opinion of management,
     collectibility of interest or principal becomes uncertain. Generally, loans
     are placed in nonaccrual status when principal or interest is past due for
     a period of 90 days, or for a lesser period if circumstances indicate
     collection of interest or principal is doubtful. When a loan is placed in
     nonaccrual status, previously accrued and uncollected interest is reversed
     against current year interest income. A nonaccrual loan is restored to
     accrual status only when prospects for future payments of interest and
     principal are no longer in doubt due to borrower performance and prospects.
     Interest received on nonaccrual loans, including impaired loans, generally
     is either applied against principal or reported as interest income
     according to management's judgment of the collectibility of principal.

                                      F-7
<PAGE>
 
     ALLOWANCE FOR LOAN LOSSES

     The allowance for loan losses is increased by provisions for losses charged
     to income. When amounts on specific loans are judged to be uncollectible by
     management, those amounts are charged off to reduce the allowance for loan
     losses. Subsequent recoveries, if any, are restored to the allowance when
     realized.

     Statement of Financial Accounting Standards ("SFAS") No. 114, Accounting by
     Creditors for Impairment of a Loan, as amended, requires recognition of an
     impairment loss on a loan within its scope when it is probable that
     principal and/or interest are not collectible in accordance with the terms
     of the loan agreement. SFAS No. 114 does not apply to large groups of
     smaller-balance homogeneous loans that are collectively evaluated for
     impairment, such as the Bank's portfolios of residential mortgage loans and
     installment loans. Measurement of impairment is based on the present value
     of expected future cash flows discounted at the loan's effective interest
     rate, or, as a practical expedient, at the loan's observable market price
     or the fair value of the collateral, if the loan is collateral dependent.
     The evaluation is inherently subjective as it requires material estimates
     that may be susceptible to significant change. If the fair value of the
     impaired loan is less than the recorded amount, a specific valuation
     allowance is established within the allowance for loan losses or the write-
     down is charged against the allowance for loan losses if the impairment is
     considered to be permanent.

     Management believes that the allowance for loan losses is adequate.
     Management uses past loan loss experience, its evaluation of the loan
     portfolio under current economic conditions and other relevant factors to
     recognize loan losses. Future additions to the allowance may be necessary
     based on changes in economic conditions, particularly in the Bank's service
     area of Southwestern Fairfield County, Connecticut. In addition, regulatory
     agencies, as an integral part of their examination process, periodically
     review the Bank's allowance for loan losses. Such agencies may require the
     Bank to recognize additions to the allowance based on their judgments of
     information available to them at the time of their examination.

     PREMISES AND EQUIPMENT

     Premises and equipment are stated at cost, less accumulated depreciation
     and amortization. The provisions for depreciation are made on the basis of
     the estimated useful lives of the assets, which range from three to twenty
     years for equipment and thirty-five years for buildings, using the 
     straight-line method. Leasehold improvements are amortized over the shorter
     of their estimated service lives or the term of the lease.

     INCOME TAXES

     In accordance with the asset and liability method required by SFAS No. 109,
     Accounting for Income Taxes, deferred taxes are recognized for the
     estimated future tax effects attributable to "temporary differences"
     between the financial statement carrying amounts of existing assets and
     liabilities and their respective tax bases. A deferred tax liability is
     recognized for all temporary differences that will result in future taxable
     income. A deferred tax asset is recognized for all temporary differences
     that will result in future tax deductions, subject to reduction of the
     asset by a valuation allowance in certain circumstances. This valuation
     allowance is recognized if, based on an analysis of available evidence,
     management determines that it is more likely than not that a portion or all
     of the deferred tax asset will not be realized. The valuation allowance is
     subject to ongoing adjustments based on changes in circumstances that
     affect management's judgment about the realizability of the deferred tax
     asset. Adjustments to increase or decrease the valuation allowance are
     charged or credited, respectively, to income tax expense.

                                      F-8
<PAGE>
 
     Deferred tax assets and liabilities are measured using enacted tax rates
     expected to apply to future taxable income. The effect on deferred tax
     assets and liabilities of an enacted change in tax rates is recognized in
     income tax expense in the period that includes the enactment date of the
     change.

     EARNINGS PER SHARE

     SFAS No. 128, Earnings per Share, specifies the computation, presentation
     and disclosure requirements for earnings per share ("EPS") for entities
     with publicly-held common stock or potential common stock. SFAS No. 128
     requires the presentation of basic EPS and diluted EPS. Basic EPS is
     computed by dividing income available to common shareholders (net income
     less dividends on preferred stock, if any) by the weighted average number
     of common shares outstanding for the period. Diluted EPS reflects the
     potential dilution that could occur if securities or other contracts to
     issue common stock (such as stock options) were exercised or converted into
     common stock or resulted in the issuance of common stock that then shared
     in the earnings of the entity.

     STOCK-BASED COMPENSATION

     SFAS No. 123, Accounting for Stock-Based Compensation, establishes a fair-
     value-based method of accounting for stock-based compensation plans and
     encourages, but does not require, entities to adopt that method of
     accounting for all employee stock compensation plans. SFAS No. 123 permits
     entities to continue to measure compensation costs for stock-based
     compensation plans using the intrinsic-value-based method of accounting
     prescribed by Accounting Principles Board ("APB") Opinion No. 25,
     Accounting for Stock Issued to Employees. Entities that follow APB Opinion
     No. 25 must make pro forma disclosures of net income and earnings per
     share, as if the fair-value-based method of accounting prescribed by SFAS
     No. 123 had been applied. The Bank has elected to continue to measure
     compensation cost for stock-based compensation plans in accordance with the
     provisions of APB Opinion No. 25 and has provided the pro forma disclosures
     required by SFAS No. 123.

     TRANSFERS AND SERVICING OF FINANCIAL ASSETS

     SFAS No. 125, Accounting for Transfers and Servicing of Financial Assets
     and Extinguishments of Liabilities, specifies accounting and reporting
     standards for transfers and servicing of financial assets and
     extinguishments of liabilities, and for distinguishing whether a transfer
     of financial assets in exchange for cash or other consideration should be
     accounted for as a sale or as a pledge of collateral in a secured
     borrowing. SFAS No. 125 is effective for transfers and servicing of
     financial assets and extinguishments of liabilities occurring after
     December 31, 1996, except for certain provisions relating to the accounting
     for secured borrowings and collateral which became effective on January 1,
     1998. SFAS No. 125 has not had a material impact on the Bank's financial
     statements.

     The Bank enters into transactions with certain of its commercial customers
     in which the Bank sells U.S. Treasury and agency securities under
     agreements to repurchase the identical securities from the customer at a
     later date. These transactions are accounted for as secured borrowings
     under SFAS No. 125 since the Bank maintains effective control over the
     underlying securities. The transaction proceeds are recorded as borrowed
     funds under the caption "Securities sold under agreements to repurchase" in
     the statements of condition, and the collateral securities continue to be
     carried as assets in the Bank's securities portfolio.

                                      F-9
<PAGE>
 
     SEGMENT INFORMATION

     During 1998, the Bank adopted SFAS No. 131, Disclosures about Segments of
     an Enterprise and Related Information. SFAS No. 131 requires public
     companies to report certain financial information about significant 
     revenue-producing segments of the business for which such information is
     available and utilized by the chief operating decision maker. Specific
     information to be reported for individual operating segments includes a
     measure of profit and loss, certain revenue and expense items, and total
     assets. As a community-oriented financial institution, substantially all of
     the Bank's operations involve the delivery of loan and deposit products to
     customers. Management makes operating decisions and assesses performance
     based on an ongoing review of these community banking operations, which
     constitute the Bank's only operating segment for financial reporting
     purposes under SFAS No. 131.

(2)  CASH RESERVE REQUIREMENTS

     The Bank is required to maintain average reserve balances under the Federal
     Reserve Act and Regulation D issued thereunder. Such reserves totaled
     approximately $247,000 and $317,000 at December 31, 1998 and 1997,
     respectively.

(3)  SECURITIES

     The amortized cost, gross unrealized gains and losses, and estimated fair
     values of securities are summarized as follows:

<TABLE>
<CAPTION> 
                                                                                GROSS               GROSS       ESTIMATED         
                                                        AMORTIZED            UNREALIZED          UNREALIZED       FAIR            
                                                          COST                  GAINS              LOSSES         VALUE           
                                                        ----------         ----------         ----------    ------------          
                                                                                     (IN THOUSANDS)                               
    <S>                                                 <C>                <C>                  <C>           <C>                 
    DECEMBER 31, 1998                                                                                                             
    -----------------                                                                                                             
    AVAILABLE-FOR-SALE SECURITIES:                                                                                                
         U.S. Treasury                                     $     501          $       4           $     --          $     505     
         U.S. Agency securities                               29,280                253                 35             29,498     
                                                           ---------          ---------           --------          ---------     
                                                                                                                                 
         Total                                             $  29,781          $     257           $     35          $  30,003     
                                                           =========          =========           ========          =========     
                                                                                                                                  
    HELD-TO-MATURITY SECURITIES:                                                                                                  
         U.S. Treasury                                     $   5,003          $      46           $     --          $   5,049     
         U.S. Agency securities                                4,583                 54                 17              4,620     
         Other                                                    75                 --                 --                 75     
                                                           ---------          ---------           --------          ---------     
                                                                                                                                 
         Total                                             $   9,661          $     100           $     17          $   9,744     
                                                           =========          =========           ========          =========     
                                                                                                                                  
    DECEMBER 31, 1997                                                                                                             
    -----------------                                                                                                             
    AVAILABLE-FOR-SALE SECURITIES:                                                                                                
         U.S. Treasury                                     $   2,499          $       6           $     --          $   2,505     
         U.S. Agency securities                               20,106                148                  5             20,249     
                                                           ---------          ---------           --------          ---------     
                                                                                                                                 
         Total                                             $  22,605          $     154           $      5          $  22,754     
                                                           =========          =========           ========          =========     
                                                                                                                                  
    HELD-TO-MATURITY SECURITIES:                                                                                                  
         U.S. Treasury                                     $   4,005          $      30           $     --          $   4,035     
         U.S. Agency securities                                  494                  6                 --                500     
         Other                                                    50                 --                 --                 50     
                                                           ---------          ---------           --------          ---------     
                                                                                                                                 
         Total                                             $   4,549          $      36           $     --          $   4,585     
                                                           =========          =========           ========          =========     
</TABLE>

                                      F-10
<PAGE>
 
     The following is a summary of the amortized cost and estimated fair value
     of debt securities at December 31, 1998, by remaining period to contractual
     maturity. Expected maturities will differ from contractual maturities
     because issuers may have the right to call or prepay obligations with or
     without call or prepayment penalties.

<TABLE> 
<CAPTION> 
       
                                                           AVAILABLE-FOR-SALE            HELD-TO-MATURITY
                                                               SECURITIES                   SECURITIES          
                                                       -------------------------      ------------------------
                                                                       ESTIMATED                     ESTIMATED
                                                       AMORTIZED         FAIR         AMORTIZED        FAIR
                                                         COST            VALUE          COST           VALUE   
                                                       ---------       ---------      ---------      ---------
                                                                             (IN THOUSANDS)
       <S>                                           <C>             <C>             <C>            <C> 
       Due in one year or less                       $    1,000      $    1,005      $     3,005    $    3,029      
       Due after one year through five years             23,771          23,928            6,606         6,665      
       Due after five years                               5,010           5,070               50            50      
                                                       ---------       ---------       ----------      -------      
                                                                                                                    
       Total                                         $   29,781      $   30,003      $     9,661    $    9,744      
                                                       =========       =========       ==========      =======       
</TABLE> 

     At December 31, 1998 and 1997, securities carried at approximately
     $2,701,000 and $3,016,000, respectively, were pledged as collateral for
     repurchase agreements with customers. No securities were sold in 1998, 1997
     or 1996.

(4)  LOANS AND CONCENTRATION OF CREDIT RISK

     Most of the Bank's lending activity is with customers located within
     Southwestern Fairfield County, Connecticut. At December 31, 1998 and 1997,
     loans collateralized by real estate or granted to customers in real estate
     related industries aggregated approximately $45,593,000 and $45,063,000,
     respectively. While collateral provides assurance as a secondary source of
     repayment, the Bank's underwriting standards require that cash flow of the
     borrowers be adequate to service their debt at loan origination.

     The loan portfolio consisted of the following at December 31:

<TABLE> 
<CAPTION> 
                                                              1998              1997
                                                     ----------------  ---------------
                                                                (IN THOUSANDS)
       <S>                                           <C>               <C>                                                      
       Demand, time and term loans                   $       18,046    $       21,656 
       Commercial mortgage loans                             38,728            44,044 
       Residential mortgage loans                             8,647             8,901 
       Aircraft loans                                         2,698             3,424 
       Installment loans                                        662               650 
       Other loans                                              588               280  
                                                       --------------    --------------
       Total loans                                           69,369            78,955 
                                                                                      
       Allowance for loan losses                             (1,733)           (1,529)
       Deferred loan costs, net                                  15                 3  
                                                       --------------    --------------
                                                                                       
       Total loans, net                              $       67,651    $       77,429  
                                                       ==============    ============== 
</TABLE> 

                                     F-11
<PAGE>
 
     A summary of changes in the allowance for loan losses follows for the years
ended December 31:

<TABLE> 
<CAPTION> 
                                                           1998             1997           1996     
                                                        ----------    --------------   -----------
                                                                      (IN THOUSANDS)    
       <S>                                            <C>            <C>             <C> 
       Balance, beginning of year                     $   1,529      $     1,660     $    1,384
       Provisions charged to income                         272              116            414
       Loans charged off                                   (168)            (294)          (148)
       Recoveries                                           100               47             10   
                                                        ----------     -----------     -----------
                                                                                        
       Balance, end of year                           $   1,733      $     1,529     $    1,660   
                                                        ==========      ==========     ===========
</TABLE> 

     The Bank's recorded investment in impaired loans, as defined by SFAS No.
114, is summarized as follows at December 31:

<TABLE> 
<CAPTION> 
                                                                                   1998             1997     
                                                                            ----------------  ---------------
                                                                                      (IN THOUSANDS)
       <S>                                                                 <C>               <C>   
       Impaired loans for which impairment allowances of
         $43 thousand and $280 thousand were recorded
         at December 31, 1998 and 1997, respectively                       $        351      $          486
       Impaired loans for which no impairment allowance
         or writedown has been recorded                                             173               2,531   
                                                                            ----------------  ---------------
       
       Total impaired loans                                                $        524      $        3,017   
                                                                            ================  ===============
</TABLE> 

     Substantially all of these impaired loans were collateral-dependent loans
     measured based on the fair value of the collateral in accordance with SFAS
     No. 114. The Bank's average recorded investment in impaired loans was
     $1,103,000 in 1998, $2,659,000 in 1997 and $1,136,000 in 1996. Interest
     income recorded on impaired loans (while such loans were impaired) amounted
     to $10,000 in 1998, $13,000 in 1997 and $6,000 in 1996.

     Nonaccrual loans (all of which were also classified as impaired loans under
     SFAS No. 114) and related interest income data are summarized as follows:

<TABLE> 
<CAPTION> 
                                                                  1998              1997            1996     
                                                            --------------    --------------  ---------------
                                                                               (IN THOUSANDS)
       <S>                                                 <C>              <C>              <C> 
       Nonaccrual loans at year-end                        $       524      $      3,017     $       888
       Interest income recorded during the year                     10                13               6
       Interest income that would have been
         recorded during the year under the
         original contractual terms                                 74               313             114   
                                                              ==========       ==========       ==========
</TABLE> 

     The increase in nonaccrual loans during 1997 was due primarily to one loan
     which was fully recovered in the second quarter of 1998. Interest and fee
     income of $454,000 was recognized at the time of recovery, including
     approximately $325,000 in prior year interest which had not been accrued.

                                     F-12
<PAGE>
 
(5)  BANK PREMISES AND EQUIPMENT


     Bank premises and equipment are summarized as follows at December 31:

<TABLE>
<CAPTION>
 
                                                              1998       1997   
                                                            --------   -------- 
                                                               (IN THOUSANDS)   
          <S>                                               <C>        <C>      
          Land                                              $    695   $    695 
          Buildings and improvements                           1,953      1,941 
          Furniture and equipment                              2,176      2,165 
          Vehicles                                               146        137 
                                                            --------   -------- 
          Total                                                4,970      4,938 
                                                                                
          Less accumulated depreciation and amortization       2,155      1,972 
                                                            --------   -------- 
                                                                                
          Bank premises and equipment, net                  $  2,815   $  2,966 
                                                            ========   ========  
 
</TABLE>

(6)  TIME DEPOSITS


     Maturities of time deposits at December 31 are as follows:

<TABLE> 
<CAPTION> 
                                                              1998       1997
                                                            --------   --------
                                                                (IN THOUSANDS)
          <S>                                               <C>        <C> 
          Up to 90 days                                     $ 12,062   $ 11,476
          91 to 180 days                                       9,148      7,961
          181 days to 1 year                                  14,993     14,782
          Over 1 year, less than 2 years                       8,945      5,677
          Over 2 years, less than 5 years                      7,240      5,854
          Greater than 5 years                                   104        110
                                                            --------   --------
        
          Total                                             $ 52,492   $ 45,860
                                                            ========   ========
</TABLE>

     Time deposits of $100,000 or more aggregated approximately $10,490,000 and
     $8,458,000 at December 31, 1998 and 1997, respectively.

                                     F-13
<PAGE>
 
(7)  INCOME TAXES

     The components of income tax expense are as follows for the years ended
     December 31:

<TABLE>
<CAPTION>
 
                                                        1998       1997       1996  
                                                      --------   --------   --------
                                                              (IN THOUSANDS)        
          <S>                                         <C>        <C>        <C>     
          Federal:                                                                  
           Current                                    $    955   $    805   $    818
           Deferred                                         44        (45)      (174)
                                                      --------   --------   --------
                                                           999        760        644
                                                      --------   --------   --------
                                                                                    
          State:                                                                    
           Current                                         295        274        282
           Deferred                                         11         12        (25)
                                                      --------   --------   --------
                                                           306        286        257
                                                      --------   --------   --------
                                                                                    
          Total income tax expense                    $  1,305   $  1,046   $    901
                                                      ========   ========   ======== 
</TABLE>

     The following is a reconciliation of income taxes computed using the
     Federal statutory rate of 34% to the actual income tax expense for the
     years ended December 31:

<TABLE>
<CAPTION>
                                                        1998       1997      1996    
                                                      --------   --------  --------  
                                                                (IN THOUSANDS) 
          <S>                                         <C>        <C>       <C> 
          Income tax at Federal statutory rate        $  1,081   $    840  $    732  
          State income tax, net of Federal benefit         202        185       170  
          Other                                             22         21        (1) 
                                                      --------   --------  --------  
                                                                                     
          Actual income tax expense                   $  1,305   $  1,046  $    901  
                                                      ========   ========  ========   
</TABLE>

     The tax effects of temporary differences that give rise to deferred tax
     assets and liabilities are as follows at December 31:

<TABLE>
<CAPTION>
                                                                                      
                                                                     1998      1997   
                                                                   --------  -------- 
                                                                      (IN THOUSANDS)  
          <S>                                                      <C>       <C>      
          Deferred tax assets:                                                        
           Allowance for loan losses                               $    585  $    505 
           Interest on nonaccrual loans                                 123       270 
                                                                   --------  -------- 
                                                                        708       775 
                                                                   --------  -------- 
                                                                                      
          Deferred tax liabilities:                                                   
           Net unrealized gain on available-for-sale securities          91        63 
           Depreciation of premises and equipment                        40        43 
           Other                                                         15        24 
                                                                   --------  -------- 
                                                                        146       130 
                                                                   --------  --------
                                                                                      
          Net deferred tax asset                                   $    562  $    645 
                                                                   ========  ========  
</TABLE>

     Based on the Bank's historical and anticipated future pre-tax earnings,
     management believes that it is more likely than not that the Bank's
     deferred tax assets will be realized.

                                     F-14
<PAGE>
 
(8)  COMMITMENTS AND CONTINGENCIES


     FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK

     The Bank is a party to credit-related financial instruments that involve,
     to varying degrees, elements of credit risk and interest rate risk in
     addition to the risks associated with loan amounts recognized in the
     statements of condition. At December 31, 1998 and 1997, outstanding loan
     commitments under unused lines of credit were approximately $8,955,000 and
     $7,377,000, respectively, and outstanding letters of credit were
     approximately $225,000 and $179,000, respectively. Unused lines of credit
     are legally binding agreements to lend a customer as long as there is no
     violation of any condition established in the contract. Lines of credit
     generally have fixed expiration dates or other termination clauses. The
     amount of collateral obtained, if deemed necessary by the Bank, is based on
     management's credit evaluation of the borrower.

     Although the foregoing contractual amounts represent the Bank's maximum
     potential exposure to credit loss, they do not necessarily represent future
     cash requirements since certain of these instruments may expire without
     being funded and others may not be fully drawn upon. Substantially all of
     these commitments and letters of credit have been provided to customers
     within the Bank's primary lending area described in note 4.

     LEASE COMMITMENTS

     At December 31, 1998, the Bank was obligated under operating leases for its
     four existing branch offices. The leases include various renewal options
     and require the Bank to pay applicable costs for utilities, maintenance,
     insurance and real estate taxes. Rent expense under branch operating leases
     was approximately $215,000, $207,000 and $127,000 for 1998, 1997 and 1996,
     respectively. At December 31, 1998, the future minimum rental payments
     under operating leases, excluding renewal option periods, were $177,000 for
     1999; $146,000 for 2000; $78,000 for 2001; and $24,000 for 2002.

     LEGAL PROCEEDINGS

     In the normal course of business, the Bank is involved in various
     outstanding legal proceedings. In the opinion of management, after
     consultation with legal counsel, the outcome of such legal proceedings
     should not have a material effect on the Bank's financial condition,
     results of operations or liquidity.

(9)  RELATED PARTY TRANSACTIONS

     Loans made directly or indirectly to the Bank's employees, directors or
     principal shareholders were approximately $3,890,000 and $2,900,000 at
     December 31, 1998 and 1997, respectively. These amounts include loans
     totaling $3,118,000 and $1,721,000 at December 31, 1998 and 1997,
     respectively, with balances that exceeded 2.5% of the equity capital
     accounts of the Bank (or $375,000 and $333,000, respectively). During 1998,
     new loans made directly or indirectly to employees, directors or principal
     shareholders totaled $1,855,000 and payments totaled $865,000. These loans
     were made in the ordinary course of business at normal credit terms, and do
     not represent more than a normal risk of collection.

                                     F-15
<PAGE>
 
      During 1998 and 1997, payments aggregating approximately $128,000 and
      $156,000, respectively, were made for materials and services to companies
      in which certain Bank directors had an interest. Management believes that
      the amounts paid by the Bank are reasonable in relation to the value of
      the materials and services provided.

(10)  COMPREHENSIVE INCOME

      The Bank has adopted SFAS No. 130, Reporting Comprehensive Income, which
      establishes standards for the reporting and display of comprehensive
      income (and its components) in financial statements. Comprehensive income
      represents the sum of net income and items of "other comprehensive income"
      which are reported directly in stockholders' equity, such as the change
      during the period in the after-tax net unrealized gain or loss on
      securities available for sale. In accordance with SFAS No. 130, the Bank
      has reported its comprehensive income for 1998, 1997 and 1996 in the
      statements of changes in stockholders' equity.


      The Bank's accumulated other comprehensive income, which is included in
      stockholders' equity, represents the after-tax net unrealized gain on
      available-for-sale securities at the end of the year. The Bank's other
      comprehensive income for the years ended December 31, 1998, 1997 and 1996
      is summarized as follows:

<TABLE>
<CAPTION>
                                                       1998       1997       1996   
                                                      -------    -------    ------- 
                                                               (IN THOUSANDS)       
          <S>                                         <C>        <C>        <C>     
          Net unrealized holding gains arising                                      
           during the year on available-for-                                        
           sale securities                            $    73    $    62    $    74 
          Related income tax effect                       (28)       (26)       (37)
                                                      -------    -------    ------- 
                                                                                    
          Other comprehensive income                  $    45    $    36    $    37 
                                                      =======    =======    =======  
</TABLE>

                                     F-16
<PAGE>
 
(11)   EARNINGS PER SHARE

       A summary of the basic and diluted earnings per share calculations for
       1998, 1997 and 1996 is as follows:


<TABLE>
<CAPTION>
                                                                   INCOME/(1)/           SHARES/(2)/          PER SHARE        
                                                                   (NUMERATOR)          (DENOMINATOR)           AMOUNT         
                                                                 ---------------      -----------------     -------------      
                                                                           (IN THOUSANDS, EXCEPT PER SHARE DATA)               
       <S>                                                       <C>                  <C>                   <C>                
       1998                                                                                                                    
       ----                                                                                                                    
       Basic EPS                                                 $         1,874                  1,117           $1.68        
       Effect of dilutive stock options                                       --                     53                        
                                                                 ---------------      -----------------                        
       Diluted EPS                                               $         1,874                  1,170           $1.60        
                                                                 ===============      =================                        
                                                                                                                               
       1997                                                                                                                    
       ----                                                                                                                    
       Basic EPS                                                 $         1,425                  1,106           $1.29        
       Effect of dilutive stock options                                       --                     42                        
                                                                 ---------------      -----------------                         
       Diluted EPS                                               $         1,425                  1,148           $1.24        
                                                                 ===============      =================                        
                                                                                                                               
       1996                                                                                                                    
       ----                                                                                                                    
       Basic EPS                                                 $         1,252                    944           $1.33        
       Effect of dilutive stock options                                       --                     18                        
                                                                 ---------------      -----------------                         
       Diluted EPS                                               $         1,252                    962           $1.30        
                                                                 ===============      =================                         
</TABLE>

       /(1)/ Net income applicable to common stock equaled net income for each
             of the periods presented.

       /(2)/ The effect of dilutive stock options represents the number of
             common-equivalent shares issuable from the assumed exercise of
             stock options, computed using the treasury stock method.


(12)   STOCK OPTION PLANS AND DIRECTORS' STOCK COMPENSATION PLAN

 
       STOCK OPTION PLANS

       The options outstanding under the terms of the Bank's 1986 Incentive and
       Nonqualified Stock Option Plan (the "1986 Plan") were transferred to the
       1996 Incentive and Nonqualified Stock Option Plan (the "1996 Plan") upon
       adoption of the 1996 Plan.  The 1996 Plan provides for the issuance of up
       to 176,000 shares of the Bank's common stock, reduced by the number of
       shares subject to outstanding stock options granted under the 1986 Plan.
       The number of options available for issuance under the 1996 Plan was
       36,740 as of December 31, 1998.  The terms of the 1996 Plan are
       substantially the same as the 1986 Plan, except that the 1996 Plan also
       provides for the granting of options to directors and the

                                     F-17
<PAGE>
 
       issuance of Stock Appreciation Rights ("SARs"). No SARs have been granted
       as of December 31, 1998. Options have a ten-year term and must be granted
       at exercise prices equal to the fair value of the Bank's common stock on
       the grant date. In addition, all options vest immediately, except for
       options granted to directors who, on the date of grant, have fewer than
       five years of service as a director of the Bank. Such options become
       exercisable beginning on the fifth anniversary of the date on which
       service as a director began.

       Stock option transactions for 1996, 1997 and 1998 are summarized as
       follows:

<TABLE>
<CAPTION>
                                                                      SHARES             WEIGHTED AVERAGE           
                                                                 UNDERLYING OPTIONS       EXERCISE PRICE            
                                                                 ------------------       --------------            
       <S>                                                       <C>                      <C>                       
       Outstanding options as of January 1, 1996                        88,000                $ 9.40              
       Grants:                                                                                                    
          Incentive                                                        275                  9.89              
          Nonqualified                                                  27,775                  9.89              
       Expirations:                                                                                               
          Incentive                                                    (12,375)                 9.09              
          Nonqualified                                                 (11,000)                 9.09              
                                                                       -------                                    
       Outstanding options as of December 31, 1996                      92,675                  9.63              
                                                                                                                  
       Grants:                                                                                                    
          Nonqualified                                                  52,360                 16.61              
       Exercises:                                                                                                 
          Incentive                                                     (4,675)                 9.09              
          Nonqualified                                                  (3,850)                 9.88              
                                                                       -------                                    
       Outstanding options as of December 31, 1997                     136,510                 12.31              
                                                                                                                  
       Grants:                                                                                                    
          Nonqualified                                                   3,025                 18.98              
       Exercises:                                                                                                 
          Nonqualified                                                    (275)                14.97              
                                                                       -------                                    
       Outstanding options as of December 31, 1998                     139,260                $12.47              
                                                                       =======                                       
</TABLE>

       Outstanding options at December 31, 1998 consist of 9,350 incentive
       options and 129,910 nonqualified options with weighted average exercise
       prices of $9.55 and $12.68, respectively.

       The following table summarizes additional information regarding stock
       options outstanding and exercisable at December 31, 1998 and 1997:

<TABLE>
<CAPTION>
                                                     OPTIONS OUTSTANDING                   OPTIONS EXERCISABLE      
                                        --------------------------------------------    ------------------------   
                                                             WEIGHTED       WEIGHTED                   WEIGHTED    
                       RANGE OF                               AVERAGE        AVERAGE                    AVERAGE    
                       EXERCISE              NUMBER         REMAINING       EXERCISE      NUMBER        EXERCISE   
                        PRICES             OUTSTANDING         LIFE          PRICE      EXERCISABLE      PRICE     
                    --------------      -----------------   ----------      --------    -----------    ---------   
          <S>       <C>                 <C>                 <C>             <C>         <C>            <C>         
          1998      $9.55 - $18.98           139,260        7.62 years        $12.47       137,335       $12.45    
                                                                                                                   
          1997      $9.55 - $17.61           136,510        9.35 years        $12.31       132,935       $12.35     
</TABLE>

                                     F-18
<PAGE>
 
       As described in note 1, the Bank measures compensation cost in accordance
       with APB Opinion No. 25 and, accordingly, no compensation cost relating
       to stock options has been recognized in 1998, 1997 or 1996. Had
       compensation cost been determined consistent with the fair-value-based
       method of SFAS No. 123, the Bank's net income and earnings per share for
       the years ended December 31, 1998, 1997 and 1996 would have been reduced
       to the pro forma amounts indicated below.


<TABLE>
<CAPTION>
                                                                    1998               1997             1996      
                                                                -------------     -------------     -------------  
                                                                    (IN THOUSANDS, EXCEPT PER SHARE DATA)         
       <S>                                                      <C>               <C>               <C>            
       Net income:                                                                                                
           As reported                                                  1,874     $       1,425     $       1,252 
           Pro forma                                            $       1,865             1,288             1,219 
                                                                =============     =============     ============= 
                                                                                                                  
        Basic earnings per share:                                                                                 
           As reported                                                   1.68     $        1.29     $        1.33 
           Pro forma                                            $        1.67              1.16              1.25 
                                                                =============     =============     ============= 
                                                                                                                  
        Diluted earnings per share:                                                                               
            As reported                                                  1.60     $        1.24     $        1.30 
            Pro forma                                           $        1.59              1.13              1.23 
                                                                =============     =============     =============  
</TABLE>

       The weighted average estimated fair value of options granted during
       1998, 1997 and 1996 was $5.10, $4.51 and $2.32, respectively. These fair
       values were estimated on the grant dates using the Black-Scholes option-
       pricing model and the following weighted-average assumptions: dividend
       yield of 2.00%, 2.00% and 2.00%; expected volatility of 25%, 23% and 25%;
       expected lives of 5 years; and risk-free interest rates of 4.74%, 5.70%
       and 6.10% for 1998, 1997 and 1996, respectively.

       DIRECTORS' STOCK COMPENSATION PLAN

       Under the Directors' Stock Compensation Plan, nonofficer directors are
       compensated for their services in Bank common stock or cash, based on the
       annual election made by each qualifying director at the first Board
       meeting subsequent to each annual meeting. Under the plan, directors
       accumulate credits for attendance at Board and committee meetings
       throughout the plan year, which ends with each annual meeting, at rates
       set by the Board. Directors who elect to receive stock are issued a whole
       number of shares of stock equal to their accumulated credits divided by
       the fair value of the Bank's common stock as of the date of each Board
       meeting. Such shares are distributed on the last business day of May of
       each year. A total of 399 shares, 688 shares and 944 shares were issued
       to directors during 1998, 1997 and 1996, respectively.

                                     F-19
<PAGE>
 
(13)   STOCKHOLDERS' EQUITY


       DIVIDENDS

       On July 16, 1998, the Bank announced a 10% stock dividend which was
       distributed on August 31, 1998 to shareholders of record as of July 31,
       1998. Under the terms of the dividend, stockholders received a dividend
       of one share of common stock for every ten shares owned as of the record
       date. A total of 101,552 common shares were issued. An amount equal to
       the fair value of these shares was charged to retained earnings, with a
       corresponding combined increase in common stock and additional paid-in
       capital.

       The Bank is statutorily allowed to pay cash dividends in any calendar
       year only to the extent of its net profits for that calendar year, if
       any, combined with its retained net profits for the preceding two years.
       The Bank's net profits retained in 1998 and 1997 (after cash dividends)
       totaled approximately $2,644,000.

       In October 1995, the Bank initiated a Dividend Reinvestment Plan ("DRIP")
       for its shareholders. This plan involves voluntary enrollment by each
       shareholder and entitles them to dividend reinvestment and voluntary
       purchases of common stock without paying any broker's fees. Shareholders
       can invest up to $5,000 in additional shares each quarter. In addition,
       cash dividends are automatically reinvested into new shares of the Bank's
       common stock at the current trading price. The DRIP resulted in the
       issuance of 5,188, 5,620 and 6,853 additional common shares during 1998,
       1997 and 1996, respectively.

       COMMON STOCK OFFERING AND RELATED TRANSACTIONS

       During 1994, the Bank issued an offering circular providing for the sale
       of additional shares of common stock, the conversion of preferred stock
       then outstanding, and the issuance of nontransferable warrants to
       purchase additional common shares. At the conclusion of the offering,
       approximately 269,594 shares of common stock were sold. Approximately
       250,190 shares of common stock were issued to preferred shareholders who
       converted their shares and a conversion incentive payment of
       approximately $237,000 was paid. The Board of Directors redeemed the
       remaining preferred stock in February 1995. In connection with the
       offering, nontransferable warrants were issued to purchase approximately
       170,012 shares of common stock after June 30, 1996 but prior to January
       1, 1997, at the greater of book value per common share at March 31, 1996
       or $12.00 per share. As of December 31, 1996, 137,379 shares of common
       stock were purchased through the exercise of warrants.


(14)   REGULATORY CAPITAL REQUIREMENTS

       The Bank 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 the Bank's financial statements.
       Under capital adequacy guidelines and the regulatory framework for prompt
       corrective action, the Bank must meet or exceed specific capital
       guidelines that involve quantitative measures of the Bank's assets,
       liabilities, and certain off-balance-sheet items as calculated under
       regulatory accounting practices. The Bank's capital amounts and
       classification are also subject to qualitative judgments by the
       regulators about components, risk weightings, and other factors.

                                     F-20
<PAGE>
 
       Quantitative measures established by regulation to ensure capital
       adequacy require the Bank to maintain or exceed the minimum capital
       amounts and ratios set forth in the table below. These requirements
       include ratios of total and Tier 1 capital (as defined in the
       regulations) to risk-weighted assets (as defined), and of Tier 1 capital
       (as defined) to average assets (as defined). Management believes that, as
       of December 31, 1998 and 1997, the Bank met all capital adequacy
       requirements to which it was subject.

       As of December 31, 1998, 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 well capitalized, the Bank must maintain or exceed the
       minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios
       set forth in the table below. There have been no conditions or events
       since the most recent notification that management believes have changed
       the Bank's capital category. The Bank's actual capital amounts and ratios
       are also presented in the table.

<TABLE>
<CAPTION>
                                                                                                    MINIMUM TO BE WELL           
                                                                        MINIMUM FOR CAPITAL       CAPITALIZED UNDER PROMPT       
                                             BANK ACTUAL                ADEQUACY PURPOSES        CORRECTIVE ACTION PROVISIONS    
                                   -----------------------------   ----------------------------  -----------------------------   
                                     AMOUNT              RATIO       AMOUNT             RATIO       AMOUNT            RATIO      
                                   ----------          ---------   ----------         ---------  ------------       ----------   
                                                                       (DOLLARS IN THOUSANDS)                                    
<S>                                <C>                 <C>         <C>                <C>        <C>                <C>          
     AS OF DECEMBER 31, 1998                                                                                                   
     -----------------------                                                                                                   
       Total Capital  (to Risk                                                                                                   
          Weighted Assets)          $ 15,869            19.80%     $   6,411           8.00%        $   8,014       10.00%       
       Tier 1 Capital  (to Risk                                                                                                  
          Weighted Assets)            14,859            18.54          3,205           4.00             4,808        6.00        
       Tier 1 Capital  (to                                                                                                       
          Average Assets)             14,859            10.95          5,426           4.00             6,782        5.00        
                                                                                                                                 
     AS OF DECEMBER 31, 1997                                                                                                   
     -----------------------                                                                                                   
       Total Capital  (to Risk                                                                                                   
          Weighted Assets)            14,279            17.02          6,712           8.00             8,390       10.00        
       Tier 1 Capital  (to Risk                                                                                                  
          Weighted Assets)            13,224            15.76          3,356           4.00             5,035        6.00        
       Tier 1 Capital  (to                                                                                                       
          Average Assets)             13,224            10.81          4,893           4.00             6,117        5.00         
</TABLE>


(15)   EMPLOYEE BENEFIT PLAN

       Effective January 1, 1994, the Bank established a 401(k) Savings Plan
       which covers substantially all employees. The Plan provides for matching
       contributions by the Bank based upon a percentage of employee
       contributions. Total matching contributions by the Bank were $36,000,
       $32,000 and $33,000 for 1998, 1997 and 1996, respectively.

                                     F-21
<PAGE>
 
(16)   ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS


       SFAS No. 107 requires that the Bank disclose estimated fair values for
       certain financial instruments. Estimated fair values have been determined
       by management using available market information and various valuation
       estimation methodologies. Considerable judgment is required to interpret
       the effects on fair value of such items as future expected loss
       experience, current economic conditions, risk characteristics of various
       financial instruments and other factors. The fair value estimates
       presented below are not necessarily indicative of the amounts that the
       Bank could realize in a current market exchange. Also, the use of
       different market assumptions and/or estimation methodologies may have a
       material effect on the estimated fair values.

<TABLE>
<CAPTION>
                                            DECEMBER 31, 1998                DECEMBER 31, 1997       
                                       ---------------------------     ---------------------------   
                                       CARRYING          ESTIMATED     CARRYING          ESTIMATED   
                                        AMOUNT          FAIR VALUE      AMOUNT          FAIR VALUE   
                                       --------         ----------     --------         ----------   
                                                                (IN THOUSANDS)                                                     
       <S>                             <C>              <C>            <C>              <C>          
       Financial assets:                                                                             
        Cash and cash equivalents      $ 27,312         $  27,312      $ 15,442         $  15,442    
        Securities and accrued                                                                       
         interest                        40,249            40,332        27,690            27,726    
        Loans and accrued                                                                            
         interest, net                   68,036            71,449        77,892            76,366    
                                       ========         =========      ========         =========    
                                                                                                     
       Financial liabilities:                                                                        
        Deposits without stated                                                                      
         maturities and accrued                                                                      
         interest                      $ 69,387         $  69,387      $ 63,046         $  63,046    
        Time deposits and accrued                                                                    
         interest                        52,658            53,382        46,039            46,183    
        Securities sold under                                                                        
         agreements to repurchase         2,198             2,198         2,510             2,510        
                                       ========         =========      ========         =========         
</TABLE>

       The fair value estimates presented above are based on pertinent
       information available to management as of December 31, 1998 and 1997.
       Although management is not aware of any factors that would significantly
       affect the estimated fair value amounts, such amounts have not been
       comprehensively revalued since December 31, 1998 and 1997 and, therefore,
       current estimates of fair value may differ significantly from the amounts
       presented above.

       Fair value methods and assumptions are as follows:

       CASH EQUIVALENTS

       The estimated fair values of cash equivalents were based on a comparison
       to current interest rates for similar assets.

       SECURITIES

       The fair values of securities were estimated based on quoted market
       prices or dealer quotes, if available. If a quote was not available, fair
       value was estimated using quoted market prices for similar securities.

                                     F-22
<PAGE>
 
       LOANS

       The fair values of fixed rate loans were estimated by discounting
       projected cash flows using current rates for similar loans. For other
       loans, which reprice frequently to market rates, the carrying amount
       represents the estimated fair value. The total amount of loans included
       has been reduced by specific and general allowances for losses.

       DEPOSITS WITHOUT STATED MATURITIES

       Under the provisions of SFAS No. 107, the estimated fair values of
       deposits without stated maturities (such as non-interest bearing demand
       deposits, savings accounts, NOW accounts and money market accounts) are
       equal to the amounts payable on demand.

       TIME DEPOSITS

       The fair values of time certificates of deposit were estimated based on
       the discounted value of contractual cash flows. The discount rates were
       based on rates currently offered for deposits with similar remaining
       maturities. The excess of the estimated fair value of time deposits over
       their carrying amount represents the discounted value of contractual
       rates as compared to rates currently being offered.

       FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK

       The Bank's financial instruments with off-balance-sheet risk consist of
       the commitments to extend credit and letters of credit described in note
       8. If the options are exercised by the prospective borrowers, these
       financial instruments will become interest-earning assets of the Bank. If
       the options expire, the Bank retains any fees paid by the counterparty in
       order to obtain the commitment or guarantee. The fair values of
       commitments are estimated based upon fees currently charged to enter into
       similar agreements, taking into account the remaining terms of the
       agreements and the present creditworthiness of the counterparties. For
       fixed-rate commitments, the fair value estimates take into consideration
       an interest rate risk factor. The fair values of guarantees and letters
       of credit are based on fees currently charged for similar agreements. The
       fair values of these off-balance-sheet instruments at December 31, 1998
       and 1997 approximated the recorded amounts of the related fees, which
       were not material. The Bank has not engaged in hedging activities through
       the use of instruments such as interest rate futures contracts or
       interest rate swaps.


(17)   RECENT ACCOUNTING STANDARDS

       In June 1998, the Financial Accounting Standards Board ("FASB") issued
       SFAS No. 133, Accounting for Derivative Instruments and Hedging
       Activities, which requires entities to recognize all derivatives as
       either assets or liabilities in the statement of condition at fair value.
       If certain conditions are met, a derivative may be specifically
       designated as a fair value hedge, a cash flow hedge, or a foreign
       currency hedge. A specific accounting treatment applies to each type of
       hedge. Entities may reclassify securities from the held-to-maturity
       category to the available-for-sale category at the time of adopting SFAS
       No. 133. SFAS No. 133 is effective for fiscal years beginning after June
       15, 1999, although early adoption is permitted. The Bank is not presently
       engaged in derivatives and hedging activities covered by the new standard
       and, accordingly, SFAS No. 133 is not expected to have a material impact
       on the Bank's financial statements.

                                     F-23
<PAGE>
 
       In October 1998, the FASB issued SFAS No. 134, Accounting for Mortgage-
       Backed Securities Retained after the Securitization of Mortgage Loans
       Held for Sale by a Mortgage Banking Enterprise. SFAS No. 134 provides for
       the classification of such retained securities as held to maturity,
       available for sale, or trading in accordance with SFAS No. 115. Prior
       accounting standards limited the classification of these securities to
       the trading category. SFAS No. 134 is effective for the fiscal quarter
       beginning after December 15, 1998 and is not expected to affect the
       Bank's financial statements.


(18)   FORMATION OF BANK HOLDING COMPANY

       Under an Agreement and Plan of Reorganization (the "Plan") dated August
       19, 1998 and approved by the Bank's shareholders on October 21, 1998, the
       Bank became a wholly-owned subsidiary of Cornerstone Bancorp, Inc. (the
       "Company") on March 1, 1999. The Company is a newly-formed bank holding
       company incorporated by the Bank for the purpose of owning all of the
       Bank's outstanding common stock. Under the terms of the Plan, each
       outstanding share of the Bank's common stock was exchanged on a one-for-
       one basis for the Company's common stock (par value $0.01 per share). The
       holding company formation was accounted for in a manner similar to a
       pooling of interests and, accordingly, it had no effect on the Bank's
       financial statements.

                                     F-24