**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-Q**

 

**(MarkOne)**

 

**ý****                                ****QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934.**

 

**For the quarterly period ended June 30,2005**

 

**OR**

 

**o****                                ****TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934.**

 

**Commission File Number 0-18832**

 

**FirstFinancial Service Corporation**

(Exact Name of Registrant as specified in its charter)

 
| **Kentucky**                                                    |   | **61-1168311**                    |
|-----------------------------------------------------------------|--------|-----------------------------------|
| (State or other jurisdiction  of incorporation or organization) |   | (IRS Employer Identification No.) |

 

**2323 Ring Road**

**Elizabethtown, Kentucky  42701**

(Address of principal executive offices)

(Zip Code)

 

**(270) 765-2131**

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.

 

Yes    ý     No  o

 

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

 

Yes    ý     No  o

 

Indicate the number of shares outstanding of each ofthe issuer’s classes of common stock, as of the latest practicable date.

 
| **Class**    | ** ** | **Outstanding as of July 31,  2005** |
|--------------|------------|-------------------------------------------|
|         |       |                                      |
| Common Stock |       | 3,626,188 shares                          |

 

 

----

 

## **FIRST FINANCIAL SERVICE CORPORATION**

 

**TABLE OF CONTENTS**

 
| **PART I**  – FINANCIAL INFORMATION |                                                                                                                        |
|-----------------------------------------------|-----------------------------------------------------------------------------------------------------------------------------|
|                                          |                                                                                                                        |
| **Item 1.**                                   | Consolidated Financial  Statements and Notes to Consolidated Financial Statements                                           |   |
|                                          |                                                                                                                        |   |
| **Item 2.**                                   | Management’s Discussion and  Analysis of the Consolidated Statements of Financial Condition and Results of  Operations |   |
|                                          |                                                                                                                        |   |
| **Item 3.**                                   | Quantitative and Qualitative  Disclosures about Market Risk                                                                 |   |
|                                          |                                                                                                                        |   |
| **Item 4.**                                   | Controls and Procedures                                                                                                     |   |
|                                          |                                                                                                                        |
| **PART II – OTHER  INFORMATION**    |                                                                                                                        |
|                                          |                                                                                                                        |
| **Item 1.**                                   | Legal Proceedings                                                                                                           |   |
|                                          |                                                                                                                        |   |
| **Item 2.**                                   | Changes In Securities, Use of Proceeds and Issuer Purchases of Equity Securities                                            |   |
|                                          |                                                                                                                        |   |
| **Item 3.**                                   | Defaults upon Senior Securities                                                                                             |   |
|                                          |                                                                                                                        |   |
| **Item 4.**                                   | Submission of Matters to a Vote of Security Holders                                                                         |   |
|                                          |                                                                                                                        |   |
| **Item 5.**                                   | Other Information                                                                                                           |   |
|                                          |                                                                                                                        |   |
| **Item 6.**                                   | Exhibits                                                                                                                    |   |
|                                          |                                                                                                                        |   |
|                                          | SIGNATURES                                                                                                                  |   |
|                                          |                                                                                                                        |   |
|                                          | CERTIFICATIONS                                                                                                              |   |

 

2

----

 

**Item1.**

 

**FIRSTFINANCIAL SERVICE CORPORATION**

**ConsolidatedStatements of Financial Condition**

 
| ** **                                                                                                                                                 | ** ** | **(Unaudited)**   | ** ** | ** **            | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                 | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
| **(Dollars In thousands, except share data)**                                                                                                              | ** ** | **2005**          | ** ** | **2004**              | ** ** |
| **ASSETS**                                                                                                                                                 |       |              |       |                  |       |
| Cash and due from banks                                                                                                                                    |       | $                 | 18,139     |                  | $          | 27,910 |   |
| Federal funds sold                                                                                                                                         |       | 8,000             |       | 8,000                 |       |
| Cash and cash equivalents                                                                                                                                  |       | 26,139            |       | 35,910                |       |
|                                                                                                                                                       |       |              |       |                  |       |
| Securities available-for-sale                                                                                                                              |       | 42,124            |       | 21,928                |       |
| Securities held-to-maturity, fair value of $33,578  Jun (2005) and $34,557 Dec (2004)                                                                      |       | 34,102            |       | 34,915                |       |
| Total securities                                                                                                                                           |       | 76,226            |       | 56,843                |       |
|                                                                                                                                                       |       |              |       |                  |       |
| Loans held for sale                                                                                                                                        |       | 763               |       | 1,219                 |       |
| Loans receivable, net of unearned fees                                                                                                                     |       | 608,168           |       | 604,698               |       |
| Allowance for loan losses                                                                                                                                  |       | (6,714            | )          | (6,489                | )          |
| Net loans receivable                                                                                                                                       |       | 602,217           |       | 599,428               |       |
|                                                                                                                                                       |       |              |       |                  |       |
| Federal Home Loan Bank stock                                                                                                                               |       | 7,005             |       | 6,845                 |       |
| Cash surrender value of life insurance                                                                                                                     |       | 7,494             |       | 7,353                 |       |
| Premises and equipment, net                                                                                                                                |       | 18,568            |       | 17,469                |       |
| Real estate owned:                                                                                                                                         |       |              |       |                  |       |
| Acquired through foreclosure                                                                                                                               |       | 1,034             |       | 681                   |       |
| Held for development                                                                                                                                       |       | 337               |       | 389                   |       |
| Other repossessed assets                                                                                                                                   |       | 38                |       | 40                    |       |
| Goodwill                                                                                                                                                   |       | 8,384             |       | 8,384                 |       |
| Accrued interest receivable                                                                                                                                |       | 2,529             |       | 2,487                 |       |
| Other assets                                                                                                                                               |       | 1,878             |       | 1,817                 |       |
|                                                                                                                                                       |       |              |       |                  |       |
| **TOTAL ASSETS**                                                                                                                                           |       | $                 | 751,849    |                  | $          | 737,646 |   |
|                                                                                                                                                       |       |              |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                              |       |              |       |                  |       |
| **LIABILITIES:**                                                                                                                                           |       |              |       |                  |       |
| Deposits:                                                                                                                                                  |       |              |       |                  |       |
| Non-interest bearing                                                                                                                                       |       | $                 | 43,239     |                  | $          | 38,441 |   |
| Interest bearing                                                                                                                                           |       | 555,262           |       | 547,945               |       |
| Total deposits                                                                                                                                             |       | 598,501           |       | 586,386               |       |
|                                                                                                                                                       |       |              |       |                  |       |
| Advances from Federal Home Loan Bank                                                                                                                       |       | 78,452            |       | 78,904                |       |
| Subordinated debentures                                                                                                                                    |       | 10,000            |       | 10,000                |       |
| Accrued interest payable                                                                                                                                   |       | 378               |       | 413                   |       |
| Accounts payable and other liabilities                                                                                                                     |       | 1,159             |       | 637                   |       |
| Deferred income taxes                                                                                                                                      |       | 1,325             |       | 1,505                 |       |
|                                                                                                                                                       |       |              |       |                  |       |
| **TOTAL LIABILITIES**                                                                                                                                      |       | 689,815           |       | 677,845               |       |
|                                                                                                                                                       |       |              |       |                  |       |
| **STOCKHOLDERS’ EQUITY:**                                                                                                                             |       |              |       |                  |       |
| Serial preferred stock, 5,000,000 shares authorized  and unissued                                                                                          |       | —            |       | —                |       |
| Common stock, $1 par value per share; authorized  10,000,000 shares; issued and outstanding, 3,626,188 shares Jun (2005), and  3,645,438 shares Dec (2004) |       | 3,626             |       | 3,645                 |       |
| Additional paid-in capital                                                                                                                                 |       | 7,730             |       | 8,226                 |       |
| Retained earnings                                                                                                                                          |       | 50,272            |       | 47,174                |       |
| Accumulated other comprehensive income, net of tax                                                                                                         |       | 406               |       | 756                   |       |
|                                                                                                                                                       |       |              |       |                  |       |
| **TOTAL STOCKHOLDERS’ EQUITY**                                                                                                                        |       | 62,034            |       | 59,801                |       |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                        |       | $                 | 751,849    |                  | $          | 737,646 |   |

 

***Seenotes to the unaudited consolidated financial statements.***

 

3

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**FIRSTFINANCIAL SERVICE CORPORATION**

**ConsolidatedStatements of Income**

**(Unaudited)**

 
| ** **                                          | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                          | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| **(Dollars in thousands, except per share data)**   | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Interest Income:**                                |       |                   |       |                 |       |   |   |   |   |
| Interest and fees on loans                          |       | $                      | 10,272     |                 | $          | 9,021 |   | $ | 20,226 |   | $ | 18,129 |   |
| Interest and dividends on investments and deposits  |       | 755                    |       | 419                  |       | 1,431 |   | 862 |   |
| Total interest income                               |       | 11,027                 |       | 9,440                |       | 21,657 |   | 18,991 |   |
|                                                |       |                   |       |                 |       |   |   |   |   |
| **Interest Expense:**                               |       |                   |       |                 |       |   |   |   |   |
| Deposits                                            |       | 3,146                  |       | 2,528                |       | 6,039 |   | 5,253 |   |
| Federal Home Loan Bank advances                     |       | 951                    |       | 923                  |       | 1,895 |   | 1,851 |   |
| Subordinated debentures                             |       | 175                    |       | 124                  |       | 332 |   | 248 |   |
| Total interest expense                              |       | 4,272                  |       | 3,575                |       | 8,266 |   | 7,352 |   |
|                                                |       |                   |       |                 |       |   |   |   |   |
| Net interest income                                 |       | 6,755                  |       | 5,865                |       | 13,391 |   | 11,639 |   |
| Provision for loan losses                           |       | 41                     |       | 259                  |       | 316 |   | 648 |   |
| Net interest income after provision for loan losses |       | 6,714                  |       | 5,606                |       | 13,075 |   | 10,991 |   |
|                                                |       |                   |       |                 |       |   |   |   |   |
| **Non-interest Income:**                            |       |                   |       |                 |       |   |   |   |   |
| Customer service fees on deposit accounts           |       | 1,319                  |       | 1,268                |       | 2,439 |   | 2,403 |   |
| Gain on sale of mortgage loans                      |       | 168                    |       | 244                  |       | 351 |   | 462 |   |
| Brokerage commissions                               |       | 78                     |       | 92                   |       | 157 |   | 186 |   |
| Gain on sale of real estate held for development    |       | 143                    |       | 371                  |       | 143 |   | 376 |   |
| Gain on sale of investments                         |       | —                 |       | —               |       | 381 |   | — |   |
| Other income                                        |       | 268                    |       | 286                  |       | 527 |   | 605 |   |
| Total non-interest income                           |       | 1,976                  |       | 2,261                |       | 3,998 |   | 4,032 |   |
|                                                |       |                   |       |                 |       |   |   |   |   |
| **Non-interest Expense:**                           |       |                   |       |                 |       |   |   |   |   |
| Employee compensation and benefits                  |       | 2,856                  |       | 2,657                |       | 5,634 |   | 5,055 |   |
| Office occupancy expense and equipment              |       | 503                    |       | 482                  |       | 998 |   | 891 |   |
| Marketing and advertising                           |       | 195                    |       | 213                  |       | 383 |   | 352 |   |
| Outside services and data processing                |       | 630                    |       | 551                  |       | 1,227 |   | 1,065 |   |
| Bank franchise tax                                  |       | 195                    |       | 207                  |       | 398 |   | 419 |   |
| Other expense                                       |       | 897                    |       | 906                  |       | 1,781 |   | 1,673 |   |
| Total non-interest expense                          |       | 5,276                  |       | 5,016                |       | 10,421 |   | 9,455 |   |
|                                                |       |                   |       |                 |       |   |   |   |   |
| Income before income taxes                          |       | 3,414                  |       | 2,851                |       | 6,652 |   | 5,568 |   |
| Income taxes                                        |       | 1,120                  |       | 925                  |       | 2,172 |   | 1,803 |   |
| **Net Income**                                      |       | $                      | 2,294      |                 | $          | 1,926 |   | $ | 4,480 |   | $ | 3,765 |   |
|                                                |       |                   |       |                 |       |   |   |   |   |
| Shares applicable to basic income per share         |       | 3,641,688              |       | 3,645,438            |       | 3,644,081 |   | 3,671,152 |   |
| **Basic income per share**                          |       | $                      | 0.63       |                 | $          | 0.53 |   | $ | 1.23 |   | $ | 1.03 |   |
|                                                |       |                   |       |                 |       |   |   |   |   |
| Shares applicable to diluted income per share       |       | 3,658,611              |       | 3,659,274            |       | 3,662,276 |   | 3,688,193 |   |
| **Diluted income per share**                        |       | $                      | 0.63       |                 | $          | 0.53 |   | $ | 1.22 |   | $ | 1.02 |   |

 

***Seenotes to the unaudited consolidated financial statements.***

 

4

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**FIRSTFINANCIAL SERVICE CORPORATION**

**ConsolidatedStatements of Comprehensive Income**

**(Unaudited)**

 
| ** **                                                     | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                     | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| **(Dollars in thousands)**                                     | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                           |       |                   |       |                 |       |   |   |   |   |
| **Net Income**                                                 |       | $                      | 2,294      |                 | $          | 1,926 |   | $ | 4,480 |   | $ | 3,765 |   |
| Other comprehensive income (loss):                             |       |                   |       |                 |       |   |   |   |   |
| Change in unrealized gain (loss) on securities                 |       | 98                     |       | (27                  | )          | (149 | ) | 14 |   |
| Reclassification of realized amount                            |       | —                 |       | —               |       | (381 | ) | — |   |
| Net unrealized gain (loss) recognized in  comprehensive income |       | 98                     |       | (27                  | )          | (530 | ) | 14 |   |
| Tax effect                                                     |       | (33                    | )          | 9                    |       | 180 |   | (5 | ) |
| Total other comphrehensive income (loss)                       |       | 65                     |       | (18                  | )          | (350 | ) | 9 |   |
|                                                           |       |                   |       |                 |       |   |   |   |   |
| **Comphrehensive Income**                                      |       | $                      | 2,359      |                 | $          | 1,908 |   | $ | 4,130 |   | $ | 3,774 |   |

 

***Seenotes to the unaudited consolidated financial statements.***

 

5

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**FIRSTFINANCIAL SERVICE CORPORATION**

**ConsolidatedStatements of Changes in Stockholders’ Equity**

**SixMonths Ended June 30, 2005**

**(DollarsIn Thousands, Except Per Share Amounts)**

**(Unaudited)**

 
| ** **                                                                            | ** ** | ** ** | ** ** | ** ** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Retained  Earnings** | ** ** | **Accumulated  Other  Comprehensive  Income, Net of  Tax** | ** ** | **Total** | ** ** |
|---------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|----------------------------------|------------|------------------------|------------|------------------------------------------------------------|------------|-----------|------------|
| ** **                                                                            | ** ** | ** ** |
| ** **                                                                            | ** ** | ** ** |
| **Common Stock**                                                                      |
| **Shares**                                                                            | ** ** | **Amount** |
|                                                                                  |       |       |       |       |       |                             |       |                   |       |                                                       |       |      |       |
| **Balance, December 31, 2004**                                                   |       | 3,645      |       | $          | 3,645      |                             | $          | 8,226                  |       | $                                                          | 47,174     |      | $          | 756 |   | $ | 59,801 |   |
| Net income                                                                            |       |       |       |       |       |                             |       | 4,480                  |       |                                                       |       | 4,480     |       |
| Exercise of stock options                                                             |       | 3          |       | 3          |       | 54                               |       |                   |       |                                                       |       | 57        |       |
| Net change in unrealized gains (losses) on  securities available-for-sale, net of tax |       |       |       |       |       |                             |       |                   |       | (350                                                       | )          | (350      | )          |
| Cash dividends declared ($.38 per share)                                              |       |       |       |       |       |                             |       | (1,382                 | )          |                                                       |       | (1,382    | )          |
| Stock repurchased                                                                     |       | (22        | )          | (22        | )          | (550                             | )          | —                 |       | —                                                     |       | (572      | )          |
|                                                                                  |       |       |       |       |       |                             |       |                   |       |                                                       |       |      |       |
| **Balance, June 30, 2005**                                                       |       | 3,626      |       | $          | 3,626      |                             | $          | 7,730                  |       | $                                                          | 50,272     |      | $          | 406 |   | $ | 62,034 |   |

 

***Seenotes to the unaudited consolidated financial statements.***

 

6

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**FIRSTFINANCIAL SERVICE CORPORATION**

**ConsolidatedStatements of Cash Flows**

**(DollarsIn Thousands)**

**(Unaudited)**

 
| ** **                                                                         | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                         | ** ** | **June 30,**    | ** ** |
| ** **                                                                         | ** ** | **2005**             | ** ** | **2004** | ** ** |
| **Operating Activities:**                                                          |       |                 |       |   |   |
| Net income                                                                         |       | $                    | 4,480      |   | $ | 3,765 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |       |                 |       |   |   |
| Provision for loan losses                                                          |       | 316                  |       | 648 |   |
| Depreciation on premises and equipment                                             |       | 624                  |       | 524 |   |
| Federal Home Loan Bank stock dividends                                             |       | (160                 | )          | (132 | ) |
| Net amortization (accretion)                                                       |       | (23                  | )          | 20 |   |
| Gain on sale of investments available-for-sale                                     |       | (381                 | )          | — |   |
| Gain on sale of mortgage loans                                                     |       | (351                 | )          | (462 | ) |
| Gain on sale of real estate held for development                                   |       | (143                 | )          | (376 | ) |
| Origination of loans held for sale                                                 |       | (19,644              | )          | (29,060 | ) |
| Proceeds on sale of loans held for sale                                            |       | 20,451               |       | 29,312 |   |
| Changes in:                                                                        |       |                 |       |   |   |
| Cash surrender value of life insurance                                             |       | (141                 | )          | — |   |
| Interest receivable                                                                |       | (42                  | )          | (17 | ) |
| Other assets                                                                       |       | (61                  | )          | 267 |   |
| Interest payable                                                                   |       | (35                  | )          | (26 | ) |
| Accounts payable and other liabilities                                             |       | 522                  |       | (23 | ) |
| Net cash from operating activities                                                 |       | 5,412                |       | 4,440 |   |
|                                                                               |       |                 |       |   |   |
| **Investing Activities:**                                                          |       |                 |       |   |   |
| Sales of securities available-for-sale                                             |       | 1,431                |       | — |   |
| Purchases of securities available-for-sale                                         |       | (27,158              | )          | — |   |
| Maturities of securities available-for-sale                                        |       | 5,435                |       | — |   |
| Purchases of securities held-to-maturity                                           |       | —               |       | (28,100 | ) |
| Maturities of securities held-to-maturity                                          |       | 783                  |       | 17,101 |   |
| Net change in loans                                                                |       | (3,912               | )          | (26,089 | ) |
| Net purchases of premises and equipment                                            |       | (1,723               | )          | (2,027 | ) |
| Sales of real estate held for development                                          |       | 195                  |       | — |   |
| Net cash from investing activities                                                 |       | (24,949              | )          | (39,115 | ) |
|                                                                               |       |                 |       |   |   |
| **Financing Activities**                                                           |       |                 |       |   |   |
| Net change in deposits                                                             |       | 12,115               |       | (2,835 | ) |
| Advances from Federal Home Loan Bank                                               |       | —               |       | 57,100 |   |
| Repayments to Federal Home Loan Bank                                               |       | (452                 | )          | (39,518 | ) |
| Proceeds from stock options exercised                                              |       | 57                   |       | — |   |
| Dividends paid                                                                     |       | (1,382               | )          | (1,323 | ) |
| Common stock repurchased                                                           |       | (572                 | )          | (1,560 | ) |
| Net cash from financing activities                                                 |       | 9,766                |       | 11,864 |   |
|                                                                               |       |                 |       |   |   |
| **(Decrease) in cash and cash equivalents**                                        |       | (9,771               | )          | (22,811 | ) |
| **Cash and cash equivalents, beginning of period**                                 |       | 35,910               |       | 48,030 |   |
| **Cash and cash equivalents, end of period**                                       |       | $                    | 26,139     |   | $ | 25,219 |   |

 

***Seenotes to the unaudited consolidated financial statements.***

 

7

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**Notes To Unaudited ConsolidatedFinancial Statements**

 

**1.****                                      BASISOF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

***Basis of Presentation*** – The accompanying unaudited consolidated financial statements include the accounts of First Financial Service Corporation and its wholly owned subsidiary, First Federal Savings Bank.  First Federal Savings Bank has three wholly owned subsidiaries, First Service Corporation of Elizabethtown, First Heartland Mortgage Company and First Federal Office Park, LLC.  Unless the text clearly suggests otherwise, references to “us,” “we,” or “our” include First Financial Service Corporation and its wholly-owned subsidiary.  All significant intercompany transactions and balances have been eliminated.

 

The accompanyingunaudited consolidated financial statements have been prepared in accordancewith accounting principles generally accepted in the United States of Americafor interim financial information and with the instructions to Form 10-Qand Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotesrequired by accounting principles generally accepted in the United States ofAmerica for complete financial statements. In the opinion of management, all adjustments (consisting of normalrecurring accruals) considered necessary for a fair presentation have beenincluded.  Operating results for the sixmonth period ending June 30, 2005 are not necessarily indicative of theresults that may occur for the year ending December 31, 2005.  For further information, refer to theconsolidated financial statements and footnotes thereto included in theCorporation’s annual report on Form 10-K for the period ended December 31,2004.

 

***Stock Option Plans*** – Employee compensation expense under stock optionplans is reported using the intrinsic value method.  No stock-based compensation cost is reflectedin net income, as all options granted had an exercise price equal to the marketprice of the underlying common stock at date of grant.  The following table illustrates the effect onnet income and earnings per share if expense was measured using the fair valuerecognition provisions of FASB Statement No. 123, Accounting forStock-Based Compensation.

 
| ** **                                                                         | ** **  | **Three Months Ended**                             | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------------|-------------|----------------------------------------------------|------------|----------------------|------------|
| ** **                                                                         | ** **  | **June 30,**                                  | ** ** | **June 30,**    | ** ** |
| ** **                                                                         | ** **  | **2005**                                           | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                         | ** **  | **(Dollars In Thousands, Except  Per Share Data)** | ** ** |
| Net income:                                                                        |        |                                               |       |                 |       |   |   |   |   |
| As reported                                                                        |        | $                                                  | 2,294      |                 | $          | 1,926 |   | $ | 4,480 |   | $ | 3,765 |   |
| Deduct: Stock-based compensation expense determined  under fair value based method |        | (23                                                | )          | (30                  | )          | (56 | ) | (62 | ) |
| Pro-forma                                                                          |        | $                                                  | 2,271      |                 | $          | 1,896 |   | $ | 4,424 |   | $ | 3,703 |   |
|                                                                               |        |                                               |       |                 |       |   |   |   |   |
| Earnings per share:                                                                |        |                                               |       |                 |       |   |   |   |   |
| Basic                                                                              | As Reported |                                               | $          | 0.63                 |       | $ | 0.53 |   | $ | 1.23 |   | $ | 1.03 |   |
|                                                                               | Pro-forma   |                                               | 0.62       |                 | 0.52       |   | 1.21 |   | 1.01 |   |
| Diluted                                                                            | As Reported |                                               | $          | 0.63                 |       | $ | 0.53 |   | $ | 1.22 |   | $ | 1.02 |   |
|                                                                               | Pro-forma   |                                               | 0.62       |                 | 0.52       |   | 1.21 |   | 1.01 |   |

 

**Effect of Newly Issued But Not Yet Effective AccountingStandards** – In December 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”)No. 123 (Revised 2004) (“SFAS No. 123R”), “Share-Based Payment.”  SFAS No. 123R is a revision of FASBStatement 123, “Accounting for Stock-Based Compensation” and supersedes APBOpinion No. 25, “Accounting for Stock Issued to Employees,” and itsrelated implementation guidance.  SFAS No. 123Rrequires all public companies to record compensation cost for stock optionsprovided to employees in return for employee service. The cost is measured atthe fair value of the options when granted, and this cost is expensed over theemployee service period, which is normally the vesting period of theoptions.  This will apply to awardsgranted or modified for the year beginning January 1, 2006.** **Compensationcost will also be recorded for prior option grants that vest after the date ofadoption.  The effect on results ofoperations will depend on the level of future option grants and the calculationof the fair value of the options granted at such future date, as well as thevesting periods provided, and so they cannot currently be predicted. ** **Existingoptions that will vest after adoption date are expected to result in additionalcompensation expense of approximately $66,000 in 2006, $60,000 in 2007, $60,000in 2008 and $45,000 in 2009.  There willbe no significant effect on financial position as total equity will not change.

 

8

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***Reclassifications*** –Certain amounts have been reclassified in the prior period financial statementsto conform to the current period classifications.

 

**2.**                                      **SECURITIES**

 

Theamortized cost basis and fair values of securities are as follows:

 
| ** **                         | ** ** | ** **    | ** ** | **Gross**        | ** ** | **Gross**        | ** ** | ** **     | ** ** |
|------------------------------------|------------|---------------|------------|------------------|------------|------------------|------------|----------------|------------|
| ** **                         | ** ** | **Amortized** | ** ** | **Unrealized**   | ** ** | **Unrealized**   | ** ** | ** **     | ** ** |
| **(Dollars in thousands)**         | ** ** | **Cost**      | ** ** | **Gains**        | ** ** | **Losses**       | ** ** | **Fair Value** | ** ** |
| **Securities available-for-sale:** |       |          |       |             |       |             |       |           |       |
| **June 30, 2005:**            |       |          |       |             |       |             |       |           |       |
| U. S. Treasury and agencies        |       | $             | 27,463     |             | $          | —           |       | $              | (73        | ) | $ | 27,390 |   |
| Mortgage-backed                    |       | 9,966         |       | —           |       | (27              | )          | 9,939          |       |
| Equity                             |       | 1,127         |       | 690              |       | —           |       | 1,817          |       |
| State and municipal                |       | 924           |       | 26               |       | —           |       | 950            |       |
| Corporate                          |       | 2,028         |       | —           |       | —           |       | 2,028          |       |
|                               |       |          |       |             |       |             |       |           |       |
| Total                              |       | $             | 41,508     |             | $          | 716              |       | $              | (100       | ) | $ | 42,124 |   |
|                               |       |          |       |             |       |             |       |           |       |
| **December 31, 2004:**        |       |          |       |             |       |             |       |           |       |
| U. S. Treasury and agencies        |       | $             | 15,985     |             | $          | —           |       | $              | (56        | ) | $ | 15,929 |   |
| Mortgage-backed                    |       | 1,901         |       | —           |       | (22              | )          | 1,879          |       |
| Equity                             |       | 1,898         |       | 1,181            |       | —           |       | 3,079          |       |
| State and municipal                |       | 999           |       | 42               |       | —           |       | 1,041          |       |
|                               |       |          |       |             |       |             |       |           |       |
| Total                              |       | $             | 20,783     |             | $          | 1,223            |       | $              | (78        | ) | $ | 21,928 |   |
|                               |       |          |       |             |       |             |       |           |       |
| ** **                         | ** ** | ** **    | ** ** | **Gross**        | ** ** | **Gross**        | ** ** | ** **     | ** ** |
| ** **                         | ** ** | **Amortized** | ** ** | **Unrecognized** | ** ** | **Unrecognized** | ** ** | ** **     | ** ** |
| ** **                         | ** ** | **Cost**      | ** ** | **Gains**        | ** ** | **Losses**       | ** ** | **Fair Value** | ** ** |
| **Securities held-to-maturity:**   |       |          |       |             |       |             |       |           |       |
| **June 30, 2005:**            |       |          |       |             |       |             |       |           |       |
| U.S. Treasury and agencies         |       | $             | 26,095     |             | $          | 1                |       | $              | (382       | ) | $ | 25,714 |   |
| Mortgage-backed                    |       | 6,007         |       | 5                |       | (148             | )          | 5,864          |       |
| Corporate                          |       | 2,000         |       | —           |       | —           |       | 2,000          |       |
|                               |       |          |       |             |       |             |       |           |       |
| Total                              |       | $             | 34,102     |             | $          | 6                |       | $              | (530       | ) | $ | 33,578 |   |
|                               |       |          |       |             |       |             |       |           |       |
| **December 31, 2004:**        |       |          |       |             |       |             |       |           |       |
| U.S. Treasury and agencies         |       | $             | 26,095     |             | $          | 3                |       | $              | (244       | ) | $ | 25,854 |   |
| Mortgage-backed                    |       | 6,820         |       | 7                |       | (124             | )          | 6,703          |       |
| Corporate                          |       | 2,000         |       | —           |       | —           |       | 2,000          |       |
|                               |       |          |       |             |       |             |       |           |       |
| Total                              |       | $             | 34,915     |             | $          | 10               |       | $              | (368       | ) | $ | 34,557 |   |

 

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**3.****                                      LOANSRECEIVABLE**

 

Loansreceivable are summarized as follows:

 
| ** **                         | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------|------------|-------------------|------------|-----------------------|------------|
| **(Dollars in thousands)**         | ** ** | **2005**          | ** ** | **2004**              | ** ** |
|                               |       |              |       |                  |       |
| Commercial                         |       | $                 | 34,025     |                  | $          | 32,228 |   |
| Real estate commercial             |       | 314,534           |       | 302,567               |       |
| Real estate construction           |       | 11,176            |       | 10,850                |       |
| Residential mortgage               |       | 149,787           |       | 159,550               |       |
| Consumer and home equity           |       | 68,511            |       | 70,143                |       |
| Indirect consumer                  |       | 31,353            |       | 30,798                |       |
| Loans held for sale                |       | 763               |       | 1,219                 |       |
|                               |       | 610,149           |       | 607,355               |       |
| Less:                              |       |              |       |                  |       |
| Net deferred loan origination fees |       | (1,218            | )          | (1,438                | )          |
| Allowance for loan losses          |       | (6,714            | )          | (6,489                | )          |
|                               |       | (7,932            | )          | (7,927                | )          |
|                               |       |              |       |                  |       |
| Loans Receivable                   |       | $                 | 602,217    |                  | $          | 599,428 |   |

 

Theallowance for losses on loans is summarized as follows:

 
| ** **                   | ** ** | **As of and For the**  | ** ** | **As of and For the** | ** ** |
|------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                   | ** ** | **Three Months Ended** | ** ** | **Six Months Ended**  | ** ** |
| ** **                   | ** ** | **June 30,**      | ** ** | **June 30,**     | ** ** |
| **(Dollars in thousands)**   | ** ** | **2005**               | ** ** | **2004**              | ** ** | **2005** | ** ** | **2004** | ** ** |
|                         |       |                   |       |                  |       |   |   |   |   |
| Balance, beginning of period |       | $                      | 6,701      |                  | $          | 5,733 |   | $ | 6,489 |   | $ | 5,568 |   |
| Provision for loan losses    |       | 41                     |       | 259                   |       | 316 |   | 648 |   |
| Charge-offs                  |       | (106                   | )          | (219                  | )          | (246 | ) | (490 | ) |
| Recoveries                   |       | 78                     |       | 49                    |       | 155 |   | 96 |   |
| Balance, end of period       |       | $                      | 6,714      |                  | $          | 5,822 |   | $ | 6,714 |   | $ | 5,822 |   |

 

Investmentin impaired loans is summarized below. There were no impaired loans for the periods presented without anallowance allocation.

 
| ** **                                  | ** ** | **As of and For the** | ** ** | **As of and For the** | ** ** |
|---------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                  | ** ** | **Six Months Ended**  | ** ** | **Year Ended**        | ** ** |
| ** **                                  | ** ** | **June 30,**     | ** ** | **December 31,** | ** ** |
| **(Dollars in thousands)**                  | ** ** | **2005**              | ** ** | **2004**              | ** ** |
|                                        |       |                  |       |                  |       |
| End of period impaired loans                |       | $                     | 4,891      |                  | $          | 5,240 |   |
| Amount of allowance for loan loss allocated |       | 1,210                 |       | 928                   |       |
|                                             |            |                       |            |                       |            |  |  |

 

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Wereport non-performing loans as impaired. Our non-performing loans are as follows:

 
| ** **                                   | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| **(Dollars in thousands)**                   | ** ** | **2005**          | ** ** | **2004**              | ** ** |
|                                         |       |              |       |                  |       |
| Restructured                                 |       | $                 | 3,166      |                  | $          | 3,218 |   |
| Loans past due over 90 days still on accrual | ** ** | **—**        |       | —                |       |
| Non accrual loans                            |       | 1,725             |       | 2,022                 |       |
| Total                                        |       | $                 | 4,891      |                  | $          | 5,240 |   |

 

**4.****                                     ****EARNINGS PER SHARE**

 

Thereconciliation of the numerators and denominators of the basic and diluted EPSis as follows:

 
| ** **                                     | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| **(Dollars in thousands,**                     | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| **except per share data)**                     | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                           |       |                   |       |                 |       |   |   |   |   |
| Net income available to common shareholders    |       | $                      | 2,294      |                 | $          | 1,926 |   | $ | 4,480 |   | $ | 3,765 |   |
| Basic EPS:                                     |       |                   |       |                 |       |   |   |   |   |
| Weighted average common shares                 |       | 3,642                  |       | 3,645                |       | 3,644 |   | 3,671 |   |
| Diluted EPS:                                   |       |                   |       |                 |       |   |   |   |   |
| Weighted average common shares                 |       | 3,642                  |       | 3,645                |       | 3,644 |   | 3,671 |   |
| Dilutive effect of stock options               |       | 17                     |       | 14                   |       | 18 |   | 17 |   |
| Weighted average common and incremental shares |       | 3,659                  |       | 3,659                |       | 3,662 |   | 3,688 |   |
| Earnings Per Share:                            |       |                   |       |                 |       |   |   |   |   |
| Basic                                          |       | $                      | 0.63       |                 | $          | 0.53 |   | $ | 1.23 |   | $ | 1.03 |   |
| Diluted                                        |       | $                      | 0.63       |                 | $          | 0.53 |   | $ | 1.22 |   | $ | 1.02 |   |

 

Stock options for 10,000 shares of common stock werenot included in the 2005 and 2004 computations of diluted earnings per sharebecause their impact was anti-dilutive.

 

**Item 2.**

 

**MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITIONAND RESULTS OF OPERATIONS**

 

##### **GENERAL**

 

We conduct operations in14 full-service banking centers in six contiguous counties in Central Kentuckyalong the Interstate 65 corridor.  Ourmarket presence ranges from the major metropolitan market of Louisville inJefferson County, Kentucky approximately 40 miles north of our headquarters inElizabethtown, Kentucky to Hart County, Kentucky, approximately 30 miles southof Elizabethtown.  Our market issupported by a diversified industry base and consists of a regional populationof over 1 million.

 

Weserve the needs and cater to the economic strengths of the local communities inwhich we operate and strive to provide a high level of personal andprofessional customer service. We offer a variety of financial services to ourretail and commercial banking customers. These services include personal andcorporate banking services and personal investment financial counselingservices.

 

Through****our personal investment financialcounseling services, we offer a wide variety of mutual funds, equityinvestments, and fixed and variable annuities.

 

We invest in the wholesale capital markets throughthe management of our security portfolio and use various forms of wholesalefunding. The security portfolio contains a variety of instruments, includingcallable

 

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debentures, taxable and non-taxable debentures,fixed and adjustable rate mortgage backed securities, and collateralizedmortgage obligations.

 

Ourresults of operations depend primarily on net interest income, which is thedifference between interest income we earn on loans, investment securities andother interest-earning assets and interest expense we pay on deposits and otherinterest-bearing liabilities. Our operations are also affected by non-interestincome, such as service charges, insurance agency revenue, loan fees, gains andlosses from the sale of mortgage loans and gains from the sale of real estateheld for development. Our principal operating expenses, aside from interestexpense, consist of compensation and employee benefits, occupancy costs, dataprocessing expense and provisions for loan losses.

 

This discussion and analysis covers material changesin the financial condition since December 31, 2004 and material changes inthe results of operations for the three and six-month periods ending, June 30,2005 as compared to 2004.  It should beread in conjunction with “Management Discussion and Analysis of FinancialCondition and Results of Operations” included in the Annual Report on Form 10-Kfor the period ended December 31, 2004.

 

# **Business Risk**

 

We, like other financial companies, are subject to anumber of risks, many of which are outside of management’s control, though westrive to manage those risks while optimizing returns.  Among the risks assumed are: (a) creditrisk, which is the risk that loan and lease customers or other counter partieswill be unable to perform their contractual obligations, (b) market risk,which is the risk that changes in market rates and prices will adversely affectour financial condition or results of operation, (c) liquidity risk, whichis the risk that we will have insufficient cash or access to cash to meet ouroperating needs, and (d) operational risk, which is the risk of lossresulting from inadequate or failed internal processes, people, and systems, orfrom external events.

 

In addition to the other information included orincorporated by reference into this report, readers should consider that thefollowing important factors, among others, could materially impact ourbusiness, future results of operations, and future cash flows.

 

**(a)****         ****Credit Risk**

 

We extend credit to a variety of customers based oninternally set standards and the judgment of management.  We manage the credit risk by maintaining aprogram of underwriting standards that we update periodically, the review of certaincredit decisions, and an on-going process of assessment of the quality of thecredit we have already extended.  Despiteour credit standards and our on-going process of credit assessment we may incursignificant credit losses.

 

Our loans and deposits are focused in centralKentucky and adverse economic conditions in that state, in particular, couldnegatively impact results from operations, cash flows, and financialcondition.  Adverse economic conditionsand other factors, such as political or business development or natural hazardsthat may affect Kentucky, may reduce demand for credit or fee-based productsand could negatively affect real estate and other collateral values, interestrate levels, and the availability of credit to refinance loans at or prior tomaturity.

 

**(b)****         ****Market Risk**

 

Changes in interest rates could negatively impactour financial condition or results of operations.

 

Our results of operations depend substantially onnet interest income, the difference between interest earned on interest-earningassets (such as investments and loans) and interest paid on interest-bearingliabilities (such as deposits and borrowings). Interest rates are highly sensitive to many factors, includinggovernmental monetary policies and domestic and international economic andpolitical conditions.  Conditions such asinflation, recession, unemployment, money supply, and other factors beyond ourcontrol may also affect interest rates. If our interest-earning assets mature or reprice more quickly thaninterest-bearing liabilities in a given period, a decrease in market ratescould adversely affect net interest income. Likewise, if interest-bearing liabilities mature or reprice more quicklythan interest-earning assets in a given period, an increase in market ratescould adversely affect net interest income.

 

Fixed-rate loans increase our exposure to interestrate risk in a rising rate environment because interest-bearing liabilitieswould be subject to repricing before assets become subject to repricing.  Adjustable-rate loans decrease the riskassociated with changes in interest rates but involve other risks, such as theinability of borrowers to make higher payments in an increasing interest rateenvironment.  At the same time, forsecured loans, the marketability of the

 

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underlying collateral may be adversely affected byhigher interests rates.  In a declininginterest rate environment, there may be an increase in prepayments on loans asthe borrowers refinance their loans at lower interest rates.  Under these circumstances, our results ofoperations could be negatively impacted.

 

When evaluating short-term interest rate riskexposure, the primary measurement represents scenarios that model a 200 basispoint increasing (decreasing) parallel shift in rates over the nexttwelve-month period.  For the periodended June 30, 2005, that scenario modeled net interest income to beapproximately 13.7% lower than the internal forecast of net interest incomeusing the baseline scenario if rates were to decrease 200 basis points in aparallel shift and 10.8% higher than the internal forecast of net interestincome using the baseline scenario if rates were to increase 200 basis pointsin a parallel shift.

 

Although fluctuations in market interest rates areneither completely predictable nor controllable, our Asset Liability Committeemeets periodically to monitor our interest rate sensitivity position andoversee its financial risk management by establishing policies and operatinglimits.  For further discussion, see the “Asset/LiabilityManagement and Market Risk” section of Management’s Discussion andAnalysis of Financial Condition and Results of Operations.

 

**(c)****         ****Liquidity Risk**

 

If we are unable to borrow funds through access tothe capital markets, we may not be able to meet the cash flow requirements ofour depositors and borrowers, or meet the operating cash needs of theCorporation to fund corporate expansion or other activities.

 

Liquidity policies and limits are established by theboard of directors, with operating limits set by the Asset Liability Committee(“ALCO”), based upon analyses of the ratio of loans to deposits, the percentageof assets funded with non-core or wholesale funding.  ALCO regularly monitors the overall liquidityposition of the Bank and holding company to ensure that various alternativestrategies exist to cover unanticipated events that could affectliquidity.  Liquidity is the ability tomeet cash flow needs on a timely basis at a reasonable cost.  The liquidity of the Bank is used to makeloans and to repay deposit liabilities as they become due or are demanded bycustomers.  The ALCO establishes boardapproved policies and monitors guidelines to diversify our wholesale fundingsources to avoid concentrations in any one-market source.  Wholesale funding sources include Federalfunds purchased, securities sold under repurchase agreements, non-core brokereddeposits, and medium and long-term debt, which includes Federal Home Loan Bank(FHLB) advances that are collateralized with mortgage-related assets.

 

We maintain a portfolio of securities that can beused as a secondary source of liquidity. There are other sources of liquidityshould they be needed.  These include thesale or securitization of loans, the ability to acquire additional non-corebrokered deposits, additional collateralized borrowings such as FHLB advances,the issuance of debt securities, and the issuance of preferred or commonsecurities in public or private transactions.

 

If we were unable to access any of these fundingsources when needed, we might be unable to meet the needs of our customers,which could adversely impact our financial condition, our results ofoperations, cash flows, and our level of regulatory-qualifying capital.  For further discussion, see the “Liquidity” section ofManagement’s Discussion and Analysis of Financial Condition and Results ofOperations.

 

**(d)****         ****Operational Risk**

 

We have significant competition in both attractingand retaining deposits and in originating loans.

 

Competition is intense in most of the markets weserve.  We compete on price and servicewith other banks and financial companies such as savings and loans, creditunions, finance companies, mortgage banking companies, and brokeragefirms.  Competition could intensify inthe future as a result of industry consolidation, the increasing availabilityof products and services from non-banks, greater technological developments inthe industry, and banking reform.

 

Management maintains internal operational controlsand we have invested in technology to help us process large volumes oftransactions.  However, there can be noassurance that we will be able to continue processing at the same or higherlevels of transactions.  If our systemsof internal controls should fail to work as expected, if our systems were to beused in an unauthorized manner, or if employees were to subvert the system ofinternal controls, significant losses could occur.

 

We process large volumes of transactions on a dailybasis and are exposed to numerous types of operation risk.  Operational risk resulting from inadequate orfailed internal processes, people, and systems includes the risk of fraud

 

13

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by employees or persons outside of our company, theexecution of unauthorized transactions by employees, errors relating totransaction processing and systems, and breaches of the internal control systemand compliance requirements.  This riskof loss also includes potential legal actions that could arise as a result ofthe operational deficiency or as a result of noncompliance with applicableregulatory standards.

 

We establish and maintain systems of internaloperational controls that provide management with timely and accurate informationabout our level of operational risk. While not foolproof, these systems have been designed to manageoperational risk at appropriate, cost effective levels.  We have also established procedures that aredesigned to ensure that policies relating to conduct, ethics, and businesspractices are followed.  From time totime, we experience loss from operational risk, including the effects ofoperational errors.

 

While management continually monitors and improvesour system of internal controls, data processing systems, and corporate wideprocesses and procedures, there can be no assurance that we will not suffersuch losses in the future.  New, orchanges in existing tax, accounting, are regulatory laws, regulations, rules,standards, policies, and interpretations could significantly impact strategicinitiatives, results of operations, cash flows, and financial condition.

 

The financial servicesindustry is extensively regulated. Federal and state banking regulations are designed primarily to protectdeposit insurance funds and consumers, not to benefit a financial company’sshareholders.  These regulations maysometimes impose significant limitations on operations.  The significant federal and state bankingregulations that affect us are described in this report under the heading “Regulation”.  These regulations, along with currentlyexisting tax, accounting, and monetary laws, regulations, rules, standards,policies and interpretations control the methods by which financialinstitutions conduct business, implement strategic initiatives and taxcompliance, and govern financial reporting and disclosures.  These laws, regulations, rules, standards,policies, and interpretations are constantly evolving and may change significantlyover time.  Events that may not have adirect impact on us, such as the bankruptcy of U.S. companies, have resulted inlegislators, regulators, and authoritative bodies, such as the FinancialAccounting Standards Board, the Securities and Exchange Commission, the PublicCompany Accounting Oversight Board, and other various taxing authoritiesresponding by adopting and or proposing substantive revisions to laws,regulations, rules, standards, policies, and interpretations.  The nature, extent, and timing of theadoption of significant new laws and regulations, or changes in or repeal ofexisting laws and regulations may have a material impact on our business andresults of operations.  However, it isimpossible to predict at this time, the extent to which any such adoption,change, or repeal would impact us.

 

##### **OVERVIEW**

 

During the first half of 2005, we completed theredesign of our Mt. Washington facility in Bullitt County.  This follows the redesign of one of ourHardin County facilities and the opening of two new full-service facilities inthe growing Louisville market.  We intendto start construction on a new full-service banking center in Elizabethtownduring the second half of 2005 with plans of opening in early 2006.  The design of the new and enhanced facilitiesrepresents our state of the art prototype branch with a retail focused design,complimenting our commitment to providing superior customer service. We believethese facilities will allow us to more effectively support our lendingrelationships and to develop a larger presence within these markets.  While we anticipate these facilities willsignificantly enhance the value of our franchise in the near future, theadditional expense in operating these new facilities will continue to place pressureon earnings for a period of time.  We areoptimistic that our expansion strategy will minimize this period and thelong-term benefits will outweigh the initial investment.

 

Our emphasis oncommercial lending generated a 4% compound annual growth rate in the total loanportfolio and a 35% compound annual growth rate in commercial loans over thepast four years.  Commercial loans were$360 million at June 30, 2005, an increase of $50 million from June 30,2004, and an increase of $13.6 million from December 31, 2004.  The loan growth in the first six months of2005 has been slower than recent quarters due to scheduled and acceleratedpayoffs in our portfolio in conjunction with aggressive fixed rate pricingamong market participants. While we expect the recent loan growth trends tocontinue, the commercial loan growth for 2005 is expected to slow from the 27%growth in the commercial portfolio experienced during 2004.

 

The growth in ourcommercial loan portfolio, coupled with the rising interest rate environment,has favorably impacted the level of interest income generated.  Net interest margin increased to 3.88% forthe six months ended June 30, 2005, compared to 3.67% for the same sixmonths ended a year ago.  This hasresulted in an $890,000 increase in net interest income to $6.8 million for thesecond quarter ended June 30, 2005 and a $1.8 million increase in netinterest income to $13.4 million for the six months ended June 30, 2005,compared to the respective periods in 2004. The increasing interest rate environment positively impacted netinterest margin due

 

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to the growth in theadjustable rate commercial loans coupled with the decrease in residential fixedrate loans in the loan portfolio.  Netinterest margin has increased in each of the last six quarters and is likely tocontinue to benefit from continued increases in the prime-lending rate.  However, the increase in the cost of depositswill likely slow the increases in net interest margin over future quarters.

 

Our asset quality remainsfavorable.  Net charge-offs as a percentof total loans was 0.03% for the six months ended June 30, 2005, comparedto 0.06% for the same period year ago. The allowance for loan losses as a percent of total loans, increased to1.10% at June 30, 2005 compared to 1.07% at December 31, 2004.  The percentage of non-performing loans tototal loans was 0.80% at June 30, 2005, compared to 0.87% at December 31,2004.

 

Provision for loan loss expense decreased $218,000to $41,000 for the quarter ended June 30, 2005, compared to $259,000 forthe quarter ended June 30, 2004. For the six months ended June 30, 2005, provision for loan lossexpense decreased $332,000 to $316,000, compared to $648,000 for the same sixmonths ended a year ago.  The decrease inthe provision was related to the softer expansion in the commercial loanportfolio for the year, as compared to a year ago, as well as a decrease in netcharge offs of $304,000 to $90,000 for the six months ended June 30, 2005compared to the prior year.

 

Non-interest incomedecreased $285,000 to $2.0 million for the quarter ended June 30,2005.  For the six months ended,non-interest income decreased $34,000 to $4.0 million. Non-interest expenseincreased $260,000, to $5.3 million for the quarter ended June 30, 2005,and $966,000 to $10.4 million for the six months ended June 30, 2005,compared to the same periods a year ago. The primary contributing factors to this increase were the additionaloperating and employee compensation expenses related to the recent expansionefforts.  Twenty-one retail staffpositions were added for the expansion into the Louisville metropolitan market,coupled with expanded facilities in Hardin County and Bullitt County, Kentucky.  Additional increases in staff have takenplace during 2004 and 2005 to continue the transformation towards a strongerretail sales culture and to provide expanded products and services to ourretail and commercial customers. Non-interest expense levels are often measured using an efficiency ratio(non-interest expense divided by the sum of net interest income andnon-interest income).  Our efficiencyratio was 60% for the six months ended June 30, 2005 and 2004, indicatingan operationally efficient financial institution.

 

###### **CRITICALACCOUNTING POLICIES**

 

Our accounting andreporting policies comply with accounting principles generally accepted in theUnited States of America and conform to general practices within the bankingindustry.  The accounting policy relatingto the allowance for loan losses is critical to the understanding of ourresults of operations since the application of this policy requires significantmanagement assumptions and estimates that could result in materially differentamounts to be reported if conditions or underlying circumstances were tochange.

 

**Allowance for Loan Losses –**We maintain an allowance sufficient to absorb probableincurred credit losses existing in the loan portfolio, and our Executive LoanCommittee evaluates the adequacy of the allowance for loan losses on a quarterlybasis.  We estimate the allowance required using past loan lossexperience, known and inherent risks in the portfolio, adverse situations thatmay affect the borrower’s ability to repay, estimated value of the underlyingcollateral, and current economic conditions.  While we estimate theallowance for loan losses, in part, based on historical losses within each loancategory, estimates for losses within the commercial real estate portfoliodepend more on credit analysis and recent payment performance. Allocations ofthe allowance may be made for specific loans or loan categories, but the entireallowance is available for any loan that, in management’s judgment, should becharged off.

 

The allowance consists of specific and generalcomponents.  The specific componentrelates to loans that are individually classified as impaired or loansotherwise classified as substandard or doubtful.  The general component covers non-classifiedloans and is based on historical loss experience adjusted for current factors.The methodology for allocating the allowance for loan and lease losses takesinto account our strategic plan to increase our emphasis on commercial andconsumer lending. We increase the amount of the allowance allocated tocommercial loans and consumer loans in response to the growth of the commercialand consumer loan portfolios and management’s recognition of the higher risksand loan losses in these lending areas. Allowance estimates are developed inconsultation with regulatory authorities and actual loss experience adjustedfor current economic conditions. Allowance estimates are considered a prudent measurement of the risk inthe loan portfolio and are applied to individual loans based on loan type.

 

Basedon our calculation, an allowance of $6.7 million or 1.10% of total loans wasreserved for potential losses within the loan portfolio as of June 30,2005.** **This estimate resultedin a provision for loan losses on the income

 

15

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statementof $316,000 for the 2005 six-month period.** **If the mix and amount of future charge off percentages differsignificantly from those assumptions used by management in making itsdetermination, the allowance for loan losses and provision for loan losses onthe income statement could be materially and adversely affected.

 

##### **RESULTS OF OPERATIONS**

Net income for the quarter ended June 30, 2005was $2.3 million or $0.63 per share diluted compared to $1.9 million or $0.53per share diluted for the same period in 2004. Net income for the six-month period ended June 30, 2005 was $4.5million or $1.22 per share diluted compared to $3.8 million or $1.02 per sharediluted for the same period a year ago. The increase in diluted earnings per share for the three and six-monthperiods were primarily the result of an increase in net interest income of$890,000 and $1.7 million and a decrease in provision for loan loss expense of$218,000 and $332,000 for the 2005 respective periods compared to 2004.** **Ourbook value per common share increased from $15.69 at June 30, 2004 to$17.11 at June 30, 2005.  Annualizednet income for 2005 generated a return on average assets****of 1.20% and a return on average equity of14.58%.  These compare with a return onaverage assets of 1.10% and a return on average equity of 13.27% for the 2004period also annualized.

 

***Net Interest Income***-On an annualizedbasis, the net interest margin as a percent of average earning assets increased15 basis points to 3.86% for the quarter ended June 30, 2005 and 21 basispoints to 3.88% for the six months ended June 30, 2005 compared to 3.71%and 3.67% for the respective three-month and six-month periods ended June 30,2004. ** **Theincreasing interest rate environment positively impacted net interest margindue to the growth in our adjustable rate commercial loans coupled with thedecrease in our residential fixed rated mortgage loans. ** **Theyield on earning assets averaged 6.30% and 6.27% for the respective three-monthand six-month 2005 periods compared to an average yield on earning assets of5.97% and 5.99% for the same periods in 2004.The prime-lending rate increased225 basis points since the Federal Open Market Committee began increasingshort-term interest rates in June 2004. ** **Management expects its yield onloans to improve with additional increases in the prime-lending rate.

 

Our cost of fundsaveraged 2.65% and 2.59% for the respective three-month and six-month 2005periods compared to an average cost of funds of 2.42% and 2.49% for the sameperiods in 2004. ** **The increase in our cost of fundsis due to the re-pricing of certificate of deposit maturities rolling off atlower rates into current higher interest rates, as well as our new PriorityRate money market product, which generated $37.5 million for the quarter ended June 30,2005.  Going forward, our cost of fundsis expected to increase as the general market deposit rates have becomeincreasingly competitive with the recent upward trend in interest rates.

 

Net interest margin has increased in each of thelast six quarters and is likely to continue to benefit from continued increasesin the prime-lending rate.  However, theflattening of the yield curve will likely slow the increases in net interestmargin over future quarters.

 

Thenet result of the above factors was an increase in net interest income of$890,000 for the quarter ended and $1.7 million for the six months ended June 30,2005 compared to the same three and six month periods a year ago.

 

16

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**AVERAGEBALANCE SHEETS**

 

The following tables set forth information relatingto the Bank’s average balance sheet and reflect the average yield on assets andaverage cost of liabilities for the periods indicated.  Dividing income or expense by the averagemonthly balance of assets or liabilities, respectively, derives such yields andcosts for the periods presented.

 
| ** **                                          | ** ** | **Quarter Ended June 30,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------|------------|
| ** **                                          | ** ** | ** **                      | ** ** | **2005** | ** ** | ** ** | ** ** | ** ** | ** ** | **2004** | ** ** | ** ** | ** ** |
| ** **                                          | ** ** | **Average**                     | ** ** | ** ** | ** ** | **Average** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| **(Dollars in thousands)**                          | ** ** | **Balance**                     | ** ** | **Interest** | ** ** | **Yield/Cost (5)** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Yield/Cost (5)** | ** ** |
|                                                |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| **ASSETS**                                          |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Interest earning assets:                            |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury and agencies                          |       | $                               | 57,509     |   | $ | 391 |   | 2.73 | % | $ | 26,922 |   | $ | 188 |   | 2.81 | % |
| Mortgage-backed securities                          |       | 8,640                           |       | 84 |   | 3.90 |   | 10,087 |   | 86 |   | 3.43 |   |
| Equity securities                                   |       | 1,747                           |       | 18 |   | 4.13 |   | 2,966 |   | 31 |   | 4.20 |   |
| State and political subdivision securities **(1)**  |       | 956                             |       | 16 |   | 6.71 |   | 1,071 |   | 15 |   | 5.63 |   |
| Corporate bonds                                     |       | 4,031                           |       | 51 |   | 5.08 |   | 2,000 |   | 15 |   | 3.02 |   |
| Loans receivable **(2) (3) (4)**          |       | 605,217                         |       | 10,272 |   | 6.81 |   | 575,987 |   | 9,021 |   | 6.30 |   |
| FHLB stock                                          |       | 6,922                           |       | 84 |   | 4.87 |   | 6,637 |   | 66 |   | 4.00 |   |
| Interest bearing deposits                           |       | 16,922                          |       | 116 |   | 2.75 |   | 11,076 |   | 23 |   | 0.84 |   |
| **Total interest earning assets**                   |       | 701,944                         |       | 11,032 |   | 6.30 |   | 636,746 |   | 9,445 |   | 5.97 |   |
| Less: Allowance for loan losses                     |       | (6,706                          | )          |   |   |   |   | (5,724 | ) |   |   |   |   |
| Non-interest earning assets                         |       | 57,104                          |       |   |   |   |   | 55,884 |   |   |   |   |   |
| **Total assets**                                    |       | $                               | 752,342    |   |   |   |   |   | $ | 686,906 |   |   |   |   |   |
|                                                |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**       |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Interest bearing liabilities:                       |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Savings accounts                                    |       | $                               | 88,010     |   | $ | 350 |   | 1.60 | % | $ | 88,223 |   | $ | 240 |   | 1.09 | % |
| NOW and money market accounts                       |       | 150,649                         |       | 498 |   | 1.33 |   | 127,624 |   | 160 |   | 0.50 |   |
| Certificates of deposit and other time deposits     |       | 318,649                         |       | 2,298 |   | 2.89 |   | 287,292 |   | 2,128 |   | 2.98 |   |
| FHLB advances                                       |       | 78,692                          |       | 952 |   | 4.85 |   | 80,158 |   | 923 |   | 4.63 |   |
| Trust preferred securities                          |       | 10,000                          |       | 174 |   | 6.98 |   | 10,000 |   | 124 |   | 4.99 |   |
| **Total interest bearing liabilities**              |       | 646,000                         |       | 4,272 |   | 2.65 |   | 593,297 |   | 3,575 |   | 2.42 |   |
| Non-interest bearing liabilities:                   |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Non-interest bearing deposits                       |       | 40,792                          |       |   |   |   |   | 33,783 |   |   |   |   |   |
| Other liabilities                                   |       | 3,550                           |       |   |   |   |   | 2,931 |   |   |   |   |   |
| **Total liabilities**                               |       | 690,342                         |       |   |   |   |   | 630,011 |   |   |   |   |   |
|                                                |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Stockholders’ equity                           |       | 62,000                          |       |   |   |   |   | 56,895 |   |   |   |   |   |
| **Total liabilities and stockholders’ equity** |       | $                               | 752,342    |   |   |   |   |   | $ | 686,906 |   |   |   |   |   |
|                                                |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| **Net interest income**                             |       |                            |       | $ | 6,760 |   |   |   |   |   | $ | 5,870 |   |   |   |
| **Net interest spread**                             |       |                            |       |   |   | 3.65 | % |   |   |   |   | 3.54 | % |
| **Net interest margin**                             |       |                            |       |   |   | 3.86 | % |   |   |   |   | 3.71 | % |
|                                                     |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

**(1) **Taxableequivalent yields are calculated assuming a 34% federal income tax rate.

**(2) **Includesloan fees, immaterial in amount, in both interest income and the calculation ofyield on loans.

**(3) **Calculationsinclude non-accruing loans in the average loan amounts outstanding.

**(4) **Includesloans held for sale.

**(5) **Annualized

 

17

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| ** **                                          | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------------------------|------------|------------------------------------|------------|
| ** **                                          | ** ** | ** **                         | ** ** | **2005** | ** ** | ** ** | ** ** | ** ** | ** ** | **2004** | ** ** | ** ** | ** ** |
| ** **                                          | ** ** | **Average**                        | ** ** | ** ** | ** ** | **Average** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| **(Dollars in thousands)**                          | ** ** | **Balance**                        | ** ** | **Interest** | ** ** | **Yield/Cost (5)** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Yield/Cost (5)** | ** ** |
|                                                |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| **ASSETS**                                          |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| Interest earning assets:                            |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury and agencies                          |       | $                                  | 53,566     |   | $ | 715 |   | 2.69 | % | $ | 22,045 |   | $ | 337 |   | 3.07 | % |
| Mortgage-backed securities                          |       | 8,542                              |       | 164 |   | 3.87 |   | 9,419 |   | 170 |   | 3.63 |   |
| Equity securities                                   |       | 2,210                              |       | 58 |   | 5.29 |   | 2,958 |   | 64 |   | 4.35 |   |
| State and political subdivision  securities **(1)** |       | 973                                |       | 31 |   | 6.42 |   | 1,071 |   | 33 |   | 6.20 |   |
| Corporate bonds                                     |       | 3,048                              |       | 74 |   | 4.90 |   | 2,000 |   | 30 |   | 3.02 |   |
| Loans receivable **(2) (3) (4)**          |       | 603,199                            |       | 20,226 |   | 6.76 |   | 569,017 |   | 18,129 |   | 6.41 |   |
| FHLB stock                                          |       | 6,884                              |       | 160 |   | 4.69 |   | 6,604 |   | 131 |   | 3.99 |   |
| Interest bearing deposits                           |       | 18,666                             |       | 239 |   | 2.58 |   | 24,611 |   | 108 |   | 0.88 |   |
| **Total interest earning assets**                   |       | 697,088                            |       | 21,667 |   | 6.27 |   | 637,725 |   | 19,002 |   | 5.99 |   |
| Less: Allowance for loan losses                     |       | (6,604                             | )          |   |   |   |   | (5,653 | ) |   |   |   |   |
| Non-interest earning assets                         |       | 57,405                             |       |   |   |   |   | 54,972 |   |   |   |   |   |
| **Total assets**                                    |       | $                                  | 747,889    |   |   |   |   |   | $ | 687,044 |   |   |   |   |   |
|                                                |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**       |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| Interest bearing liabilities:                       |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| Savings accounts                                    |       | $                                  | 83,066     |   | $ | 572 |   | 1.39 | % | $ | 89,680 |   | $ | 428 |   | 0.96 | % |
| NOW and money market accounts                       |       | 153,293                            |       | 1,010 |   | 1.33 |   | 124,622 |   | 381 |   | 0.61 |   |
| Certificates of deposit and other time deposits     |       | 317,571                            |       | 4,456 |   | 2.83 |   | 290,881 |   | 4,444 |   | 3.07 |   |
| FHLB advances                                       |       | 78,785                             |       | 1,896 |   | 4.85 |   | 79,200 |   | 1,851 |   | 4.70 |   |
| Trust preferred securities                          |       | 10,000                             |       | 332 |   | 6.70 |   | 10,000 |   | 248 |   | 4.99 |   |
| **Total interest bearing liabilities**              |       | 642,715                            |       | 8,266 |   | 2.59 |   | 594,383 |   | 7,352 |   | 2.49 |   |
| Non-interest bearing liabilities:                   |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| Non-interest bearing deposits                       |       | 40,117                             |       |   |   |   |   | 32,851 |   |   |   |   |   |
| Other liabilities                                   |       | 3,584                              |       |   |   |   |   | 3,065 |   |   |   |   |   |
| **Total liabilities**                               |       | 686,416                            |       |   |   |   |   | 630,299 |   |   |   |   |   |
|                                                |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| Stockholders’ equity                           |       | 61,473                             |       |   |   |   |   | 56,745 |   |   |   |   |   |
| **Total liabilities and stockholders’ equity** |       | $                                  | 747,889    |   |   |   |   |   | $ | 687,044 |   |   |   |   |   |
|                                                |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| **Net interest income**                             |       |                               |       | $ | 13,401 |   |   |   |   |   | $ | 11,650 |   |   |   |
| **Net interest spread**                             |       |                               |       |   |   | 3.67 | % |   |   |   |   | 3.50 | % |
| **Net interest margin**                             |       |                               |       |   |   | 3.88 | % |   |   |   |   | 3.67 | % |

 

----

**(1) **Taxableequivalent yields are calculated assuming a 34% federal income tax rate.

**(2) **Includesloan fees, immaterial in amount, in both interest income and the calculation ofyield on loans.

**(3) **Calculationsinclude non-accruing loans in the average loan amounts outstanding.

**(4) **Includesloans held for sale.

**(5) **Annualized

 

18

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**RATE/VOLUMEANALYSIS**

 

The table below sets forthcertain information regarding changes in interest income and interest expenseof the Bank for the periods indicated. For each category of interest-earning assets and interest-bearingliabilities, information is provided on changes attributable to (1) changesin rate (changes in rate multiplied by old volume); (2) changes in volume(change in volume multiplied by old rate); and (3) changes in rate-volume(change in rate multiplied by change in volume).  Changes in rate-volume are proportionatelyallocated between rate and volume variance.

 
| ** **                                      | ** ** | **Three Months Ended**  | ** ** | **Six Months Ended**    | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                      | ** ** | **June 30,**       | ** ** | **June 30,**       | ** ** |
| ** **                                      | ** ** | **2005 vs. 2004**       | ** ** | **2005 vs. 2004**       | ** ** |
| ** **                                      | ** ** | **Increase (decrease)** | ** ** | **Increase (decrease)** | ** ** |
| ** **                                      | ** ** | **Due to change in**    | ** ** | **Due to change in**    | ** ** |
| ** **                                      | ** ** | ** **              | ** ** | ** **              | ** ** | **Net** | ** ** | ** ** | ** ** | ** ** | ** ** | **Net** | ** ** |
| **(Dollars in thousands)**                      | ** ** | **Rate**                | ** ** | **Volume**              | ** ** | **Change** | ** ** | **Rate** | ** ** | **Volume** | ** ** | **Change** | ** ** |
| **Interest income:**                            |       |                    |       |                    |       |   |   |   |   |   |   |   |   |
| U.S. Treasury and agencies                      |       | $                       | (5         | )                       | $          | 208 |   | $ | 203 |   | $ | (47 | ) | $ | 425 |   | $ | 378 |   |
| Mortgage-backed securities                      |       | 11                      |       | (13                     | )          | (2 | ) | 10 |   | (16 | ) | (6 | ) |
| Equity securities                               |       | (1                      | )          | (12                     | )          | (13 | ) | 12 |   | (18 | ) | (6 | ) |
| State and political subdivision securities      |       | 3                       |       | (2                      | )          | 1 |   | 1 |   | (3 | ) | (2 | ) |
| Corporate bonds                                 |       | 36                      |       | —                  |       | 36 |   | 44 |   | — |   | 44 |   |
| Loans                                           |       | 779                     |       | 472                     |       | 1,251 |   | 980 |   | 1,117 |   | 2,097 |   |
| FHLB stock                                      |       | 15                      |       | 3                       |       | 18 |   | 23 |   | 6 |   | 29 |   |
| Interest bearing deposits                       |       | 76                      |       | 17                      |       | 93 |   | 163 |   | (32 | ) | 131 |   |
|                                            |       |                    |       |                    |       |   |   |   |   |   |   |   |   |
| **Total interest earning assets**               |       | 914                     |       | 673                     |       | 1,587 |   | 1,186 |   | 1,479 |   | 2,665 |   |
|                                            |       |                    |       |                    |       |   |   |   |   |   |   |   |   |
| **Interest expense:**                           |       |                    |       |                    |       |   |   |   |   |   |   |   |   |
| Savings accounts                                |       | 110                     |       | —                  |       | 110 |   | 177 |   | (33 | ) | 144 |   |
| NOW and money market accounts                   |       | 304                     |       | 34                      |       | 338 |   | 525 |   | 104 |   | 629 |   |
| Certificates of deposit and other time deposits |       | (57                     | )          | 227                     |       | 170 |   | (377 | ) | 389 |   | 12 |   |
| FHLB advances                                   |       | 46                      |       | (17                     | )          | 29 |   | 55 |   | (10 | ) | 45 |   |
| Trust Preferred Securities                      |       | 50                      |       | —                  |       | 50 |   | 84 |   | — |   | 84 |   |
|                                            |       |                    |       |                    |       |   |   |   |   |   |   |   |   |
| **Total interest bearing liabilities**          |       | 453                     |       | 244                     |       | 697 |   | 464 |   | 450 |   | 914 |   |
|                                            |       |                    |       |                    |       |   |   |   |   |   |   |   |   |
| **Net change in net interest income**           |       | $                       | 461        |                    | $          | 429 |   | $ | 890 |   | $ | 722 |   | $ | 1,029 |   | $ | 1,751 |   |

 

***Non-Interest Income***-Non-interestincome decreased $285,000, or 13% for the quarter ended June 30, 2005 to$2.0 million compared to $2.3 million for the same quarter in 2004.  For the six months ended, non-interest incomedecreased $34,000 to $4.0 million.  Thedecreased level of non-interest income during 2005 was primarily related tolower recorded gains on the sale of real estate held for development anddecreased gains on the sale of mortgage loans. Offsetting these decreases wasan increase in gain on the sale of investment securities.

 

During the second quarterof 2005, we recorded a $143,000 gain from the sale of a lot previously held fordevelopment compared to a $371,000 gain on the sale of land and two lots heldfor development for the same period in 2004, resulting in a $228,000 decreasein non-interest income for the second quarter. Gain on sale of mortgage loans decreased $76,000 for the quarter and$111,000 for the six months ended June 30, 2005 resulting from lowerorigination volume.  Offsetting thesedecreases was a $381,000 increase in gain on the sale of investment securitiesfor the 2005 six-month period.

 

***Non-Interest Expense -*** Non-interestexpense increased $260,000 or 5% during the quarter ended June 30, 2005and $966,000, or 10% for the six months ended June 30, 2005 compared tothe same periods in 2004.

 

The primary factorsimpacting non-interest expense include additional operating and employeecompensation expenses relating to the recent retail expansion efforts.  Employee compensation and benefits, thelargest component of non-interest expense, increased $199,000 and $579,000 forthe respective three and six-month periods. Twenty-one retail staff positions were added for the expansion into theLouisville market, coupled with expanded facilities in Hardin County andBullitt County, Kentucky.  Additionalincreases in staff have taken place during 2004 and 2005 as we strengthen ourretail sales culture and provide expanded products and services to our retailand commercial customers.

 

19

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Weanticipate the increased level on non-interest expense to continue during 2005with continued retail expansion and market share protection efforts.  We intend to start construction on a new fullservice-banking center in Elizabethtown, KY during 2005 with plans of openingin early 2006.  We are also consideringother possible locations within the core market area to protect and grow our21% market share.

 

Despitethe increase in non-interest expense for 2005, we maintained an efficiencyratio of 60% for the six months ended June 30, 2005 and 2004.

 

**ANALYSISOF FINANCIAL CONDITION**

 

Total assets at June 30, 2005 increased to$751.8 million compared to $737.6 million at December 31, 2004, anincrease of $14.2 million.  The increasewas primarily driven by an increase in investment securities of $19.4 millionand an increase in net loans receivable of $2.8 million.  The growth in investment securities and loanswas principally funded with cash and cash equivalents, which decreased by $9.8million, and deposits, which increased by $12.1 million.

 

##### **Loans Receivable**

 

Net loans receivableincreased $2.8 million to $602.2 million at June 30, 2005 compared to$599.4 million at December 31, 2004. Our commercial and commercial real estate portfolios increased $13.6million to $360 million at June 30, 2005. For the 2005 period, these loans comprised 59% of the total loanportfolio compared to 57% at December 31, 2004, and 54% at June 30,2004.  While the loan growth in the firstsix months of 2005 was slower than recent quarters, we expect the favorabletrend, which has generated a 4% compound annual growth rate in the total loanportfolio to continue for 2005.

 

Offsetting this growthwas a $9.8 million, or 6.1% decrease in the residential mortgage loan portfolioto $149.8 million at June 30, 2005, compared to $159.5 million at December 31,2004.  For 2005, the decline in mortgageloans is expected to slow from the decreases experienced in 2003 and early2004.  Also, contributing to the decreasewas a $1.1 million decline in consumer loans.

 

**Allowanceand Provision for Loan Losses**

 

Ourfinancial performance depends on the quality of the loans we originate andmanagement’s ability to assess the degree of risk in existing loans when itdetermines the allowance for loan losses. An increase in loan charge-offs or non-performing loans or an inadequateallowance for loan losses could reduce net interest income, net income andcapital and limit the range of products and services we can offer.

 

TheExecutive Loan Committee evaluates the allowance for loan losses quarterly tomaintain a level sufficient to absorb probable incurred credit losses existingin the loan portfolio.  Periodicprovisions to the allowance are made as needed. The allowance is determined based on the application of loss estimatesto graded loans by categories.  Theamount of the provision for loan losses necessary to maintain an adequateallowance is also based upon an analysis of such factors as changes in lendingpolicies and procedures; underwriting standards; collection; charge-off andrecovery history; changes in national and local economic business conditionsand developments; changes in the characteristics of the portfolio; ability anddepth of lending management and staff; changes in the trend of the volume and severityof past due, non-accrual and classified loans; troubled debt restructuring andother loan modifications; and results of regulatory examinations.

 

The methodology for allocating the allowance forloan and lease losses takes into account our strategic plan to increase ouremphasis on commercial and consumer lending. We increase the amount of the allowance allocated to commercial loansand consumer loans in response to the growth of the commercial and consumer loanportfolios and management’s recognition of the higher risks and loan losses inthese lending areas.  The indirectconsumer loan program is comprised of new and used automobile, motorcycle andall terrain vehicle loans originated on our behalf by a select group of autodealers within our service area.   Theindirect loan program involves a greater degree of risk and is evaluatedquarterly and monitored by the Board of Directors.  In light of the greater charge-offs fromindirect consumer loans compared to direct consumer loans, proportionally moreof the allowance for consumer loans is allocated for indirect loans than directloans.  As the indirect loan program hasevolved, dealer analysis and underwriting standards have been refined toimprove the loan loss experience of the program.  Estimating the allowance is a continuousprocess.  In this regard, the ExecutiveLoan Committee continues to monitor the performance of indirect consumer loansas well as our other loan products and updates estimates as the evidencewarrants.

 

20

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The following table sets forth an analysis of theBank’s loan loss experience for the periods indicated.

 
| ** **                                                                | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| **(Dollars in thousands)**                                                | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                      |       |                   |       |                 |       |   |   |   |   |
| **Balance at beginning of period**                                        |       | $                      | 6,701      |                 | $          | 5,733 |   | $ | 6,489 |   | $ | 5,568 |   |
| Loans charged-off:                                                        |       |                   |       |                 |       |   |   |   |   |
| Real estate mortgage                                                      |       | —                 |       | —               |       | 4 |   | 41 |   |
| Consumer                                                                  |       | 106                    |       | 177                  |       | 242 |   | 407 |   |
| Commercial                                                                |       | —                 |       | 42                   |       | — |   | 42 |   |
| Total charge-offs                                                         |       | 106                    |       | 219                  |       | 246 |   | 490 |   |
| Recoveries:                                                               |       |                   |       |                 |       |   |   |   |   |
| Real estate mortgage                                                      |       | —                 |       | —               |       | 1 |   | — |   |
| Consumer                                                                  |       | 78                     |       | 49                   |       | 154 |   | 96 |   |
| Commercial                                                                |       | —                 |       | —               |       | — |   | — |   |
| Total recoveries                                                          |       | 78                     |       | 49                   |       | 155 |   | 96 |   |
|                                                                      |       |                   |       |                 |       |   |   |   |   |
| **Net loans charged-off**                                                 |       | 28                     |       | 170                  |       | 91 |   | 394 |   |
|                                                                      |       |                   |       |                 |       |   |   |   |   |
| Provision for loan losses                                                 |       | 41                     |       | 259                  |       | 316 |   | 648 |   |
|                                                                      |       |                   |       |                 |       |   |   |   |   |
| **Balance at end of period**                                              |       | $                      | 6,714      |                 | $          | 5,822 |   | $ | 6,714 |   | $ | 5,822 |   |
|                                                                      |       |                   |       |                 |       |   |   |   |   |
| Allowance for loan losses to total loans (excluding  loans held for sale) |       |                   |       |                 |       | 1.10 | % | 1.00 | % |
| Net charge-offs to average loans outstanding                              |       |                   |       |                 |       | 0.02 | % | 0.07 | % |
| Allowance for loan losses to total non-performing  loans                  |       |                   |       |                 |       | 138 | % | 134 | % |

 

Theprovision for loan losses decreased $218,000, or 84% to $41,000 for the quarterended June 30, 2005, and $332,000, or 51% to $316,000 for the six monthsended June 30, 2005 compared to the same periods in 2004.  The decrease in the provision was related toslower loan growth in the commercial loan portfolio for 2005 compared to a yearago, as well as, a decrease in net charge-offs for the same periods. The totalallowance for loan losses increased $892,000 to $6.7 million from June 30,2004 to June 30, 2005. ** **The increase in the allowance wasrelated to a $26.6 million increase in net loans receivable at June 30,2005, compared to June 30, 2004, in conjunction with a $1.4 millionincrease in classified loans for the 2005 period compared to the 2004 period.** **Netloan charge-offs decreased $142,000 and $303,000 during the quarter andsix-month periods ended June 30, 2005, compared to the 2004 respectiveperiods.** **The decrease in charge-offs is primarily related to adecrease in charge-offs of indirect consumer loans during the periods.

 

Federal regulations require insured institutions toclassify their own assets on a regular basis. The regulations provide for three categories of classified loans --substandard, doubtful and loss.  Assetsclassified as substandard or doubtful require the institution to establishgeneral allowances for loan losses. If an asset or portion thereof is classifiedas loss, the insured institution must either establish specified allowances forloan losses in the amount of 100% of the portion of the asset classified loss,or charge off such amount.  At June 30,2005, on the basis of management’s review of the loan portfolio, we had****$6.8 million of assets classifiedsubstandard, $948,000 classified as doubtful, and $53,000 of assets classifiedas loss.** **At June 30, 2004, on the basis of management’s review ofthe loan portfolio, we had $5.2 million assets classified substandard, $1.1million classified as doubtful, and $66,000 of assets classified as loss.

 

Loans are classifiedaccording to estimated loss as follows: Substandard-2.5% to 35%; Doubtful-5% to 75%; and Loss-100%;. Weadditionally provide a reserve estimate for probable incurred losses innon-classified loans ranging from .20% to 6.00%.  Although we may allocate a portion of theallowance to specific loans or loan categories, the entire allowance isavailable for active charge-offs. Allowance estimates are developed in consultation with regulatoryauthorities and actual loss experience adjusted for current economicconditions.  Allowance estimates areconsidered a prudent measurement of the risk in the loan portfolio and areapplied to individual loans based on loan type.

 

21

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##### **Non-Performing Assets**

 

Non-performing assets consist of certainrestructured loans for which interest rate or other terms have beenrenegotiated, loans on which interest is no longer accrued, real estateacquired through foreclosure and repossessed assets.   We do not have any loans greater than 90days past due still on accrual.  Loans,including impaired loans under SFAS 114, are placed on non-accrual status whenthey become past due 90 days or more as to principal or interest, unless theyare adequately secured and in the process of collection.  Loans are considered impaired if fullprincipal or interest payments are not anticipated in accordance with thecontractual loan terms.  Impaired loansare carried at the present value of expected future cash flows discounted atthe loan’s effective interest rate or at the fair value of the collateral ifthe loan is collateral dependent.

 

Loans are reviewed on a regular basis and normalcollection procedures are implemented when a borrower fails to make a requiredpayment on a loan.  If the delinquency ona mortgage loan exceeds 90 days and is not cured through normal collectionprocedures or an acceptable arrangement is not worked out with the borrower, weinstitute measures to remedy the default, including commencing a foreclosureaction.  Consumer loans generally arecharged off when a loan is deemed uncollectible by management and any availablecollateral has been disposed of. Commercial business and real estate loan delinquencies are handled on anindividual basis by management with the advice of legal counsel.

 

Interest income on loansis recognized on the accrual basis except for those loans in a non-accrual ofincome status. The accrual of interest on impaired loans is discontinued whenmanagement believes, after consideration of economic and business conditionsand collection efforts that the borrowers’ financial condition is such thatcollection of interest is doubtful, typically after the loan becomes 90 daysdelinquent.  When interest accrual isdiscontinued, existing accrued interest is reversed and interest income issubsequently recognized only to the extent cash payments are received.

 

Realestate acquired as a result of foreclosure or by deed in lieu of foreclosure isclassified as real estate owned until such time as it is sold. New and usedautomobile, motorcycle and all terrain vehicles acquired as a result offoreclosure are classified as repossessed assets until they are sold. When suchproperty is acquired it is recorded at the lower of the unpaid principalbalance of the related loan or its fair market value.  Any write-down of the property at the time ofacquisition is charged to the allowance for loan losses.  Subsequent gains and losses are included innon-interest income and non-interest expense.

 

The following table setsforth information with respect to non-performing assets for the periodsindicated.

 
| ** **                                                           | ** **                                                            | **June 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------|-----------------------------------------------------------------------|-------------------|------------|-----------------------|------------|
| **(Dollar in thousands)**                                            | ** **                                                            | **2005**          | ** ** | **2004**              | ** ** |
| ** **                                                           | ** **                                                            | ** **        | ** ** | ** **            | ** ** |
| Restructured                                                         |                                                                  | $                 | 3,166      |                  | $          | 3,218 |   |
| Past due 90 days still on accrual                                    |                                                                  | —            |       | —                |       |
| Loans on non-accrual status                                          |                                                                  | 1,725             |       | 2,022                 |       |
|                                                                 |                                                                  |              |       |                  |       |
| Total non-performing loans                                           |                                                                  | 4,891             |       | 5,240                 |       |
| Real estate acquired through foreclosure                             |                                                                  | 1,034             |       | 681                   |       |
| Other repossessed assets                                             |                                                                  | 38                |       | 40                    |       |
| Total non-performing assets                                          |                                                                  | $                 | 5,963      |                  | $          | 5,961 |   |
|                                                                 |                                                                  |              |       |                  |       |
| Interest income that would have been earned on  non-performing loans |                                                                  | $                 | 331        |                  | $          | 336 |   |
| Interest income recognized on non-performing loans                   |                                                                  | 212               |       | 197                   |       |
| Ratios:                                                              | Non-performing loans to total loans (excluding loans  held for sale)  |              | 0.80       | %                     | 0.87       | % |
|                                                                 | Non-performing assets to total loans (excluding  loans held for sale) |              | 0.98       | %                     | 0.99       | % |

 

Included innon-performing assets for the 2005 period is $3.2 million in restructuredcommercial and residential mortgage loans.** **The restructured loans primarilyconsist of three credit relationships aggregating $2.9 million, including a$2.2 million commercial relationship, a $213,000 commercial relationship****and a $456,000 residential mortgagerelationship.****  The terms of these loans have beenrenegotiated to reduce the rate of interest and extend the term thus reducingthe amount of cash flow required from the borrower to service the loans.  The terms of the restructured loans arecurrently being met.

 

22

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**Investment Securities**

 

Interest on securitiesprovides us our largest source of interest income after interest on loans,constituting 6.6% of the total interest income for the six-months ended June 30,2005.  The securities portfolio serves asa source of liquidity and earnings and contributes to the management ofinterest rate risk.  We have theauthority to invest in various types of liquid assets, including short-termUnited States Treasury obligations and securities of various federal agencies,obligations of states and political subdivisions, corporate bonds, certificatesof deposit at insured savings and loans and banks, bankers’ acceptances, andfederal funds.  We may also invest aportion of our assets in certain commercial paper and corporate debtsecurities.  We are also authorized toinvest in mutual funds and stocks whose assets conform to the investments thatwe are authorized to make directly. The available-for-sale and held-to-maturityinvestment portfolios increased by $19.4 million or 34% during the 2005 perioddue to investments in U.S. agencies, mortgage-backed securities and a corporatebond.  We also sold $1.4 million insecurities available-for-sale during the 2005 period due to one of our equityinvestments de-listing from the NASDAQ National Market System.

 

###### **Deposits**

 

Werely primarily on customer service and long-standing relationships withcustomers to attract and retain deposits. Market interest rates and rates ondeposit products offered by competing financial institutions can significantlyaffect our ability to attract and retain deposits. During the period ended June 30,2005, total deposits increased by $12.1 million compared to December 31,2004. The increase in retail deposits was primarily in non-interest bearingdemand accounts, savings accounts and certificate of deposit balances.  A new money market promotion generated $37.5million for the June 2005 quarter. However, we also experienced a shifting of certain deposits from a moneymarket account to a savings account during the quarter, which reduced thebalance in money market accounts. We plan to continue our deposit gatheringinitiatives by utilizing pricing strategies and offering competitive productsin our existing markets.

 

The following table breaks down our deposits.

 
| ** **              | ** ** | **June 30,**  | ** ** | **December 31,** | ** ** |
|-------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **              | ** ** | **2005**           | ** ** | **2004**              | ** ** |
| ** **              | ** ** | **(In Thousands)** | ** ** |
|                    |       |               |       |                  |       |
| Non-interest bearing    |       | $                  | 43,239     |                  | $          | 38,441 |   |
| NOW demand              |       | 71,897             |       | 73,801                |       |
| Savings                 |       | 100,485            |       | 78,499                |       |
| Money market            |       | 69,070             |       | 85,418                |       |
| Certificates of deposit |       | 313,810            |       | 310,227               |       |
|                    |       | $                  | 598,501    |                  | $          | 586,386 |   |
|                         |            |                    |            |                       |            |  |  |  |  |

 

##### **LIQUIDITY**

 

Liquidity risk arisesfrom the possibility we may not be able to satisfy current or future financialcommitments, or may become unduly reliant on alternative funding sources. Theobjective of liquidity risk management is to ensure that the cash flowrequirements of depositors and borrowers, as well as our operating cash needs,are met, taking into account all on- and off-balance sheet funding demands.Liquidity risk management also includes ensuring cash flow needs are met at areasonable cost. We maintain an investment and funds management policy, whichidentifies the primary sources of liquidity, establishes procedures formonitoring and measuring liquidity, and establishes minimum liquidityrequirements in compliance with regulatory guidance. The liquidity position iscontinually monitored and reviewed by the Asset Liability Committee.

 

Funds are available froma number of sources, including the sale of securities in the available-for-saleportion of the investment portfolio, principal paydowns on loans andmortgage-backed securities, proceeds realized from loans held for sale,brokered deposits and other wholesale funding. ** **At June 30, 2005,we had brokered deposits totaling $500,000. We also have secured federal funds borrowing lines from two of ourcorrespondent banks totaling $10 million and $15 million respectively.** **Ourbanking centers also provide access to retail deposit markets.** **Iflarge certificate depositors shift to our competitors or the stock market inresponse to interest rate changes, we have the ability to replenish thosedeposits through alternative funding sources.** **Traditionally, we have alsoutilized borrowings from the FHLB to supplement our funding requirements.  At June 30, 2005, we had an unusedapproved line of credit in the amount of $94.1 million****and sufficient collateral available to

 

23

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borrow, approximately, anadditional****$30****million in advances from the FHLB.** **Webelieve our sources of liquidity are adequate to meet expected cash needs forthe foreseeable future.

 

At the holding company level, the Corporation uses cash to pay dividends to stockholders, repurchase common stock, make selected investments and acquisitions, and service debt. The main sources of funding for the holding company include dividends and returns of investment from the Bank, a revolving credit agreement with an unaffiliated bank, and access to the capital markets.

 

##### **CAPITAL**

 

Stockholders’equity increased $2.2 million for the period ended June 30, 2005 comparedto December 31, 2004.**** The increase in capital was primarilyattributable to net income during the period. This increase was offset by a decline in additional paid-in-capital dueto the purchase of 22,000 shares of our own common stock and accumulated othercomprehensive income, a result of temporary unrealized losses recorded onsecurities. ** **Average stockholders’ equity toaverage assets ratio declined to 8.22% for the six-months ended June 30,2005 compared to 8.26% for 2004.

 

InMarch 2002, a trust formed by First Financial Service Corporationcompleted the private placement of 10,000 shares of cumulative trust preferredsecurities with a liquidation preference of $1,000 per security.  The proceeds of the offering were loaned tous in exchange for floating rate junior subordinated deferrable interestdebentures.  Distributions on thesecurities are payable quarterly at a rate per annum equal to the 3-month LIBORplus 3.60%.  We undertook the issuance ofthese securities to enhance our regulatory capital position, as the securitiesare considered as Tier I capital under current regulatory guidelines.

 

###### **Kentuckybanking laws limit the amount of dividends that may be paid to First FinancialService Corporation by First Federal Savings Bank without prior approval of theKentucky Office of Financial Institutions. Under these laws, the amount of dividends that may be paid in anycalendar year is limited to current year’s net income, as defined in the laws,combined with the retained net income of the preceding two years, less anydividends declared during those periods.**  At June 30, 2005,without prior regulatory approval, we had approximately $9.0 million ofretained earnings that could be utilized for payment of dividends if authorizedby our board of directors.

 

Each of the federal bank regulatory agencies hasestablished minimum leverage capital requirements for banking organizations.Banking organizations must maintain a minimum ratio of Tier 1 capital toadjusted average quarterly assets equal to 3% to 5% subject to federal bankregulatory evaluation of an organization’s overall safety and soundness.  We intend to maintain a capital position thatmeets or exceeds the “well capitalized” requirements as defined by theFDIC.  The following table shows theratios of Tier 1 capital and total capital to risk-adjusted assets and theleverage ratios for the Corporation and the Bank as of June 30, 2005.

 

24

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| ** **                                          | ** ** | ** ** | ** ** | ** **            | ** ** | ** **            | ** ** | ** **     | ** ** | **To Be Considered** | ** ** |
|-----------------------------------------------------|------------|------------|------------|-----------------------|------------|-----------------------|------------|----------------|------------|----------------------|------------|
| ** **                                          | ** ** | ** ** | ** ** | ** **            | ** ** | ** **            | ** ** | ** **     | ** ** | **Well Capitalized** | ** ** |
| ** **                                          | ** ** | ** ** | ** ** | ** **            | ** ** | ** **            | ** ** | ** **     | ** ** | **Under Prompt**     | ** ** |
| ** **                                          | ** ** | ** ** | ** ** | ** **            | ** ** | **For Capital**       | ** ** | **Correction** | ** ** |
| ** **                                          | ** ** | **Actual** | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| **(Dollars in thousands)**                          | ** ** | **Amount** | ** ** | **Ratio**             | ** ** | **Amount**            | ** ** | **Ratio**      | ** ** | **Amount**           | ** ** | **Ratio** | ** ** |
| **As of June 30, 2005:**                       |       |       |       |                  |       |                  |       |           |       |                 |       |   |   |
| Total risk-based capital (to risk- weighted assets) |       |       |       |                  |       |                  |       |           |       |                 |       |   |   |
| Consolidated                                        |       | $          | 70,206     |                  | 11.7       | %                     | $          | 47,935         |       | 8.0                  | %          | $ | 59,919 |   | 10.0 | % |
| Bank                                                |       | 68,683     |       | 11.5                  |       | 47,805                |       | 8.0            |       | 59,756               |       | 10.0 |   |
| Tier I capital (to risk-weighted assets)            | ** ** | ** ** | ** ** | ** **            | ** ** | ** **            | ** ** | ** **     | ** ** | ** **           | ** ** | ** ** | ** ** |
| Consolidated                                        |       | 63,244     |       | 10.6                  |       | 23,967                |       | 4.0            |       | 35,951               |       | 6.0 |   |
| Bank                                                |       | 61,721     |       | 10.3                  |       | 23,902                |       | 4.0            |       | 35,853               |       | 6.0 |   |
| Tier I capital (to average assets)                  | ** ** | ** ** | ** ** | ** **            | ** ** | ** **            | ** ** | ** **     | ** ** | ** **           | ** ** | ** ** | ** ** |
| Consolidated                                        |       | 63,244     |       | 8.5                   |       | 29,765                |       | 4.0            |       | 37,206               |       | 5.0 |   |
| Bank                                                |       | 61,721     |       | 8.3                   |       | 29,708                |       | 4.0            |       | 37,135               |       | 5.0 |   |
|                                                     |            |            |            |                       |            |                       |            |                |            |                      |            |  |  |  |  |  |

 
| ** **                                          | ** ** | ** ** | ** ** | ** **            | ** ** | ** **            | ** ** | ** **     | ** ** | **To Be Considered** | ** ** |
|-----------------------------------------------------|------------|------------|------------|-----------------------|------------|-----------------------|------------|----------------|------------|----------------------|------------|
| ** **                                          | ** ** | ** ** | ** ** | ** **            | ** ** | ** **            | ** ** | ** **     | ** ** | **Well Capitalized** | ** ** |
| ** **                                          | ** ** | ** ** | ** ** | ** **            | ** ** | ** **            | ** ** | ** **     | ** ** | **Under Prompt**     | ** ** |
| ** **                                          | ** ** | ** ** | ** ** | ** **            | ** ** | **For Capital**       | ** ** | **Correction** | ** ** |
| ** **                                          | ** ** | **Actual** | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| **(Dollars in thousands)**                          | ** ** | **Amount** | ** ** | **Ratio**             | ** ** | **Amount**            | ** ** | **Ratio**      | ** ** | **Amount**           | ** ** | **Ratio** | ** ** |
| **As of December 31, 2004:**                   |       |       |       |                  |       |                  |       |           |       |                 |       |   |   |
| Total risk-based capital (to risk- weighted assets) |       |       |       |                  |       |                  |       |           |       |                 |       |   |   |
| Consolidated                                        |       | $          | 67,798     |                  | 11.6       | %                     | $          | 46,793         |       | 8.0                  | %          | $ | 58,492 |   | 10.0 | % |
| Bank                                                |       | 65,087     |       | 11.2                  |       | 46,600                |       | 8.0            |       | 58,250               |       | 10.0 |   |
| Tier I capital (to risk-weighted assets)            |       |       |       |                  |       |                  |       |           |       |                 |       |   |   |
| Consolidated                                        |       | 61,029     |       | 10.4                  |       | 23,397                |       | 4.0            |       | 35,095               |       | 6.0 |   |
| Bank                                                |       | 58,318     |       | 10.0                  |       | 23,300                |       | 4.0            |       | 34,950               |       | 6.0 |   |
| Tier I capital (to average assets)                  |       |       |       |                  |       |                  |       |           |       |                 |       |   |   |
| Consolidated                                        |       | 61,029     |       | 8.5                   |       | 28,860                |       | 4.0            |       | 36,075               |       | 5.0 |   |
| Bank                                                |       | 58,318     |       | 8.1                   |       | 28,762                |       | 4.0            |       | 35,953               |       | 5.0 |   |
|                                                     |            |            |            |                       |            |                       |            |                |            |                      |            |  |  |  |  |  |

 

**FORWARD-LOOKING STATEMENTS**

 

Statements contained inthis report that are not statements of historical fact constituteforward-looking statements within the meaning of Section 21E of theSecurities Exchange Act of 1934, as amended. In addition, the Corporation may make forward-looking statements infuture filings with the Securities and Exchange Commission, in press releases,and in oral and written statements made by or with the approval of theCorporation.  Forward-looking statementsinclude, but are not limited to: (1) projections of revenues, income orloss, earnings or loss per share, capital structure and other financial items; (2) statementsof plans and objectives of the Corporation or its management or Board ofDirectors; (3) statements regarding future events, actions or economicperformance; and (4) statements of assumptions underlying suchstatements.  Words such as “estimate,” “strategy,”“believes,” “anticipates,” “expects,” “intends,” “plans,” “targeted,” andsimilar expressions are intended to identify forward-looking statements, butare not the exclusive means of identifying such statements.

 

Forward-looking statements involve risks and uncertaintiesthat may cause actual results to differ materially from those indicated by theforward-looking statements.  See “BusinessRisks” above for an analysis of some of these risks and uncertainties.  Some of the events or circumstances thatcould cause such differences include the following: changes in general economicconditions and economic conditions in Kentucky and the markets served by theCorporation any of which may affect, among other things, the level ofnon-performing assets, charge-offs, and provision expense; changes in theinterest rate environment which may reduce interest margins and impact fundingsources; changes in market rates and prices which may adversely impact thevalue of financial products including securities, loans and deposit; changes intax laws, rules and regulations; various monetary and fiscal policies andregulations, including those determined by the Federal Reserve Board, theFederal Deposit Insurance Corporation and the Kentucky Office of FinancialInstitutions; competition with other local and

 

25

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regional commercial banks, savings banks, creditunions and other non-bank financial institutions; ability to grow corebusinesses; ability to develop and introduce new banking-related products,services and enhancements and gain market acceptance of such products; andmanagement’s ability to manage these and other risks.

 

###### **Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

###### **Asset/LiabilityManagement and Market Risk**

 

Tominimize the volatility of net interest income and exposure to economic lossthat may result from fluctuating interest rates, we manage our exposure toadverse changes in interest rates through asset and liability managementactivities within guidelines established by our Asset Liability Committee (“ALCO”).  The ALCO, which includes senior managementrepresentatives, has the responsibility for approving and ensuring compliancewith asset/liability management polices. Interest rate risk is the exposure to adverse changes in the netinterest income as a result of market fluctuations in interest rates.  The ALCO, on an ongoing basis, monitorsinterest rate and liquidity risk in order to implement appropriate funding andbalance sheet strategies.  Managementconsiders interest rate risk to be our most significant market risk.

 

We utilize an earnings simulation model to analyzenet interest income sensitivity. Potential changes in market interest rates and their subsequent effectson net interest income are then evaluated. The model projects the effect of instantaneous movements in interestrates of both 100 and 200 basis points. Assumptions based on the historical behavior of our deposit rates andbalances in relation to changes in interest rates are also incorporated intothe model.  These assumptions areinherently uncertain and, as a result, the model cannot precisely measurefuture net interest income or precisely predict the impact of fluctuations inmarket interest rates on net interest income.  Actual results will differ from the model’ssimulated results due to timing, magnitude and frequency of interest ratechanges as well as changes in market conditions and the application and timingof various management strategies.

 

Our interest sensitivity profile was asset sensitiveat both June 30, 2005 and December 31, 2004.  Given a sustained 100 basis point decrease inrates, our base net interest income would decrease by an estimated 6.11% at June 30,2005 compared to a decrease of 2.38% at December 31, 2004.  Given a 100 basis point increase in interestrates our base net interest income would increase by an estimated 5.54% at June 30,2005 compared to an increase of 2.19% at December 31, 2004.

 

Our interest sensitivity at any point in time willbe affected by a number of factors. These factors include the mix of interest sensitive assets andliabilities as well as their relative pricing schedules.  It is also influenced by market interestrates, deposit growth, loan growth, decay rates and prepayment speedassumptions.

 

As demonstrated by the June 30, 2005 and December 31,2004 sensitivity tables presented below, we are continuing to transition awayfrom a liability sensitive to an asset sensitive position as compared to priorperiods in anticipation of rising interest rates for the next several months.The change in our asset sensitivity is a result of changes in the loanportfolio to a greater extent than changes in the investment portfolio.  While lending practices have shifted toshorter term, variable rate commercial and consumer loans, that impact will beevidenced in smaller degrees over time.

 

Our sensitivity to interest rate changes ispresented based on data as of June 30, 2005 and December 31, 2004annualized to a one year period.

 

26

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| ** **                     | ** ** | **June 30, 2005** | ** ** |
|--------------------------------|------------|------------------------|------------|
| ** **                     | ** ** | **Decrease in Rates**  | ** ** | ** ** | ** ** | **Increase in Rates** | ** ** |
| ** **                     | ** ** | **200**                | ** ** | **100** | ** ** | ** ** | ** ** | **100** | ** ** | **200** | ** ** |
| **(Dollars in thousands)**     | ** ** | **Basis Points**       | ** ** | **Basis Points** | ** ** | **Base** | ** ** | **Basis Points** | ** ** | **Basis Points** | ** ** |
|                           |       |                   |       |   |   |   |   |   |   |   |   |
| **Projected interest income**  |       |                   |       |   |   |   |   |   |   |   |   |
| Loans                          |       | $                      | 39,189     |   | $ | 41,970 |   | $ | 44,608 |   | $ | 47,175 |   | $ | 49,660 |   |
| Investments                    |       | 2,466                  |       | 3,340 |   | 3,955 |   | 4,461 |   | 4,971 |   |
| **Total interest income**      |       | 41,655                 |       | 45,310 |   | 48,563 |   | 51,636 |   | 54,631 |   |
|                           |       |                   |       |   |   |   |   |   |   |   |   |
| **Projected interest expense** |       |                   |       |   |   |   |   |   |   |   |   |
| Deposits                       |       | 9,973                  |       | 11,148 |   | 12,382 |   | 13,616 |   | 14,850 |   |
| Borrowed funds                 |       | 4,271                  |       | 4,351 |   | 4,431 |   | 4,511 |   | 4,591 |   |
| **Total interest expense**     |       | 14,244                 |       | 15,499 |   | 16,813 |   | 18,127 |   | 19,441 |   |
|                           |       |                   |       |   |   |   |   |   |   |   |   |
| **Net interest income**        |       | $                      | 27,411     |   | $ | 29,811 |   | $ | 31,750 |   | $ | 33,509 |   | $ | 35,190 |   |
| Change from base               |       | $                      | (4,339     | ) | $ | (1,939 | ) |   |   | $ | 1,759 |   | $ | 3,440 |   |
| % Change from base             |       | (13.67                 | )%         | (6.11 | )% |   |   | 5.54 | % | 10.83 | % |

 
| ** **                     | ** ** | **December 31, 2004** | ** ** |
|--------------------------------|------------|----------------------------|------------|
| ** **                     | ** ** | **Decrease in Rates**      | ** ** | ** ** | ** ** | **Increase in Rates** | ** ** |
| ** **                     | ** ** | **200**                    | ** ** | **100** | ** ** | ** ** | ** ** | **100** | ** ** | **200** | ** ** |
| **(Dollars in thousands)**     | ** ** | **Basis Points**           | ** ** | **Basis Points** | ** ** | **Base** | ** ** | **Basis Points** | ** ** | **Basis Points** | ** ** |
|                           |       |                       |       |   |   |   |   |   |   |   |   |
| **Projected interest income**  |       |                       |       |   |   |   |   |   |   |   |   |
| Loans                          |       | $                          | 38,503     |   | $ | 39,834 |   | $ | 40,943 |   | $ | 41,960 |   | $ | 42,995 |   |
| Investments                    |       | 1,963                      |       | 2,332 |   | 2,517 |   | 2,667 |   | 2,820 |   |
| **Total interest income**      |       | 40,466                     |       | 42,166 |   | 43,460 |   | 44,627 |   | 45,815 |   |
|                           |       |                       |       |   |   |   |   |   |   |   |   |
| **Projected interest expense** |       |                       |       |   |   |   |   |   |   |   |   |
| Deposits                       |       | 10,215                     |       | 10,805 |   | 11,395 |   | 11,914 |   | 12,433 |   |
| Borrowed funds                 |       | 4,262                      |       | 4,307 |   | 4,352 |   | 4,393 |   | 4,434 |   |
| **Total interest expense**     |       | 14,477                     |       | 15,112 |   | 15,747 |   | 16,307 |   | 16,867 |   |
|                           |       |                       |       |   |   |   |   |   |   |   |   |
| **Net interest income**        |       | $                          | 25,989     |   | $ | 27,054 |   | $ | 27,713 |   | $ | 28,320 |   | $ | 28,948 |   |
| Change from base               |       | $                          | (1,724     | ) | $ | (659 | ) |   |   | $ | 607 |   | $ | 1,235 |   |
| % Change from base             |       | (6.22                      | )%         | (2.38 | )% |   |   | 2.19 | % | 4.46 | % |

 

###### **Item 4. CONTROLS AND PROCEDURES**

 

*Evaluation of disclosure controls and procedures*

 

Ourmanagement evaluated, with the participation of our Chief Executive Officer andour Chief Financial Officer, the effectiveness of our disclosure controls and proceduresas of the end of the period covered by this Quarterly Report on Form 10-Q.Based on this evaluation, our Chief Executive Officer and our Chief FinancialOfficer have concluded that our disclosure controls and procedures areeffective as of the end of the period covered by this Quarterly Report on Form 10-Qto ensure that information we are required to disclose in reports that we fileor submit under the Securities Exchange Act of 1934 is recorded, processed,summarized and reported within the time periods specified in Securities andExchange Commission rules and forms.

 

*Changes in internal control over financial reporting*

 

Therewas no change in our internal control over financial reporting that occurredduring the period covered by this Quarterly Report on Form 10-Q that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

27

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##### **Part II-  OTHER INFORMATION**

 

**Item 1.****                                   LegalProceedings**

 

Although,from time to time, we are involved in various legal proceedings in the normalcourse of business, there are no material pending legal proceedings to which weare a party, or to which any of our property is subject.

 

**Item 2.****                                   Changesin Securities, Use of Proceeds and Issuer Purchases of Equity Securities**

 

(e) Issuer Purchases of Equity Securities

 

Thefollowing table provides information as of June 30, 2005 with respect toshares of Common Stock repurchased by the Company during the quarter then ended:

 
| ** **        | ** ** | ** **       | ** ** | ** **         | ** ** | **Total number of**     | ** ** | **Maximum number**       | ** ** |
|-------------------|------------|------------------|------------|--------------------|------------|-------------------------|------------|--------------------------|------------|
| ** **        | ** ** | ** **       | ** ** | ** **         | ** ** | **shares purchased**    | ** ** | **of shares that**       | ** ** |
| ** **        | ** ** | **Total number** | ** ** | **Average**        | ** ** | **as part of publicly** | ** ** | **may yet be purchased** | ** ** |
| ** **        | ** ** | **of shares**    | ** ** | **price paid per** | ** ** | **announced plans**     | ** ** | **under the plans or**   | ** ** |
| **Period**        | ** ** | **purchased**    | ** ** | **share**          | ** ** | **or programs**         | ** ** | **programs**             | ** ** |
|              |       |             |       |               |       |                    |       |                     |       |
| 04/01/05-04/30/05 |       | —           |       | —             |       | —                  |       | 193,645                  |       |
| 05/01/05-04/31/05 |       | 4,000            |       | $                  | 26.15      |                    | 4,000      |                     | 189,645    |   |
| 06/01/05-06/30/05 |       | 18,000           |       | $                  | 25.95      |                    | 18,000     |                     | 171,645    |   |
|              |       |             |       |               |       |                    |       |                     |       |
| Total             |       | 22,000           |       | $                  | 25.99      |                    | 22,000     |                     | 171,645    |   |

 

**Item 3.****                                   DefaultsUpon Senior Securities**

 

NotApplicable

 

**Item 4.****                                   Submissionof Matters to a Vote of Security Holders**

 

Our2005 Annual Meeting of Shareholders was held on May 11, 2005.  At the meeting, the directors listed belowwere elected as directors of the Corporation for terms expiring at the annualmeeting in the year set forth to each of their names.  The voting results for the matters broughtbefore the 2005 Annual Meeting are as follows:

 

1.  Election of Directors.

 
| **Name**             | ** ** | **Term Expires** | ** ** | **Votes For** | ** ** | **Abstentions** | ** ** | **Broker  Non-Votes** | ** ** |
|----------------------|------------|------------------|------------|---------------|------------|-----------------|------------|-----------------------|------------|
| Wreno M. Hall        |       | 2008             |       | 2,414,351     |       | 15,605          |       | -                     |       |
| Walter D. Huddleston |       | 2008             |       | 2,452,821     |       | 15,440          |       | -                     |       |
| J. Stephen Mouser    |       | 2008             |       | 2,439,165     |       | 16,640          |       | -                     |       |
| Michael L. Thomas    |       | 2008             |       | 2,438,885     |       | 15,440          |       | -                     |       |

 

Inaddition, the following directors will continue in office until the annualmeeting of the year set forth beside each of their names.

 
| **Name**             | ** ** | **Term Expires** |
|----------------------|------------|------------------|
| Robert  M. Brown     |       | 2007             |
| B.  Keith Johnson    |       | 2006             |
| Diane  E. Logsdon    |       | 2006             |
| John  L. Newcomb, Jr |       | 2006             |
| Donald  Scheer       |       | 2006             |
| Gail  L. Schomp      |       | 2007             |
| J.  Alton Rider      |       | 2007             |

 

28

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**Item 5.****                                   OtherInformation**

 

None

 

**Item 6.****                                   Exhibits:**

 

31.1 Certification of Chief Executive Officer Pursuant to Section 302 ofSarbanes-Oxley Act

 

31.2 Certification of Chief Financial Officer Pursuant to Section 302 ofSarbanes-Oxley Act

 

32    Certification of Chief Executive Officer and Chief Financial OfficerPursuant to Section 18 U.S.C. Section 1350 (As Adopted Pursuant to Section 906of the Sarbanes-  Oxley Act of 2002)

 

29

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## **FIRST FINANCIAL SERVICE CORPORATION**

 

## **SIGNATURES**

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 

 
| DATE: August 9,  2005 | BY: (S) | B. Keith Johnson                       |   |
|----------------------------|---------|----------------------------------------|--------|
|                       |    | B. Keith Johnson                       |
|                       |    | President and  Chief Executive Officer |
|                       |    |                                   |
|                       |    |                                   |
| DATE: August 9,  2005 | BY: (S) | Gregory S.  Schreacke                  |   |
|                       |    | Gregory S. Schreacke                   |
|                       |    | Chief Financial  Officer               |
|                       |    | Principal  Accounting Officer          |

 

30

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## **INDEX TO EXHIBITS**

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                            |
|----------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                 |       |                                                                                                                                                                                       |
| 31.1                 |       | Certification of Chief Executive Officer Pursuant to  Section 302 of Sarbanes-Oxley Act                                                                                               |
|                 |       |                                                                                                                                                                                       |
| 31.2                 |       | Certification of Chief Financial Officer Pursuant to  Section 302 of Sarbanes-Oxley Act                                                                                               |
|                 |       |                                                                                                                                                                                       |
| 32                   |       | Certification of Chief Executive Officer and Chief  Financial Officer Pursuant to 18 U.S.C. Section 1350 (As Adopted  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002) |

 

31

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