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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



FORM 10-KSB



(Mark One)



|x | ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ------------------------------------------------------------------------------



For the fiscal year ended December 31, 2003



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



For the transition period from
 to



Commission file number: 0-25465



CORNERSTONE BANCORP, INC./CT

(Name
of small business issuer in its charter)



|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Connecticut                                                    |  | 06-1524044                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)
|                                                               | 
|550 Summer St., Stamford, Connecticut                          |  | 06901                               
|(Address of principal office)                                  |  | (Zip Code)                          



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



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



|                                        |  |                                            
|--------------------------------------- |  | -------------------------------------------
|Common Stock, par value $0.01 per share |  | American Stock Exchange                    
|(Title of Each Class)                   |  | (Name of each exchange on which registered)



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



|                      |  | 
|--------------------- |  | 
|None                 
|(Title of Each Class)



Check whether the issuer (1) has filed
all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the
past 90 days. Yes x No ̈



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



The
issuers revenues for the fiscal year ended December 31, 2003 were $13,351,000.



The aggregate market value of the issuers common stock held by non-affiliates of the issuer was $23,391,751 based on the closing price of $24.65 per share as of March 1, 2004.



The number of shares outstanding of the issuers common stock as of March 1, 2004 was
1,246,640.



DOCUMENTS INCORPORATED BY REFERENCE



Proxy Statement for Annual Meeting of Shareholders to be held on May 26,
2004 - Part III.



Transitional Small Business Disclosure Format (check one):
Yes ̈No x



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##### Table of Contents

TABLE OF CONTENTS



|           |  |                                                                                                                 |  |     
|---------- |  | --------------------------------------------------------------------------------------------------------------- |  | ----
|           |  |                                                                                                                 |  | PAGE
|           |  |                                                                                                                
|PART I     |  |                                                                                                                 |  |     
|           |  |                                                                                                                
|Item 1 -   |  | Description of Business                                                                                         |  | 1   
|           |  |                                                                                                                
|Item 1A -  |  | Executive Officers of the Issuer                                                                                |  | 15  
|           |  |                                                                                                                
|Item 2 -   |  | Description of Property                                                                                         |  | 16  
|           |  |                                                                                                                
|Item 3 -   |  | Legal Proceedings                                                                                               |  | 17  
|           |  |                                                                                                                
|Item 4 -   |  | Submission of Matters to a Vote of Security Holders                                                             |  | 17  
|           |  |                                                                                                                
|PART II    |  |                                                                                                                 |  |     
|           |  |                                                                                                                
|Item 5 -   |  | Market for Common Equity and Related Stockholder Matters                                                        |  | 17  
|           |  |                                                                                                                
|Item 6 -   |  | Managements Discussion and Analysis or Plan of Operation                                                       |  | 18  
|           |  |                                                                                                                
|Item 7 -   |  | Financial Statements                                                                                            |  | 29  
|           |  |                                                                                                                
|Item 8 -   |  | Changes in and Disagreements With Accountants on Accounting and Financial Disclosure                            |  | 29  
|           |  |                                                                                                                
|Item 8A -  |  | Controls and Procedures                                                                                         |  | 29  
|           |  |                                                                                                                
|PART III   |  |                                                                                                                 |  |     
|           |  |                                                                                                                
|Item 9 -   |  | Directors, Executive Officers, Promoters and Control Persons; Compliance with Section 16(a) of the Exchange Act |  | 30  
|           |  |                                                                                                                
|Item 10 -  |  | Executive Compensation                                                                                          |  | 30  
|           |  |                                                                                                                
|Item 11 -  |  | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters                  |  | 30  
|           |  |                                                                                                                
|Item 12 -  |  | Certain Relationships and Related Transactions                                                                  |  | 30  
|           |  |                                                                                                                
|Item 13 -  |  | Exhibits and Reports on Form 8-K                                                                                |  | 30  
|           |  |                                                                                                                
|Item 14 -  |  | Principal Accountant Fees and Services                                                                          |  | 33  
|           | 
|SIGNATURES |  | 34                                                                                                             



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|Item 1. | Description of Business
|------- | -----------------------



General



Cornerstone Bancorp, Inc. (the Bancorp) is a Connecticut corporation, incorporated in 1998 to serve as a bank holding company to provide
executive, financial and administrative functions for its subsidiaries. The Bancorp is the successor registrant to Cornerstone Bank (the Bank), pursuant to a re-organization whereby the Bancorp acquired all of the issued and outstanding
shares of common stock of the Bank in a one-for-one share exchange on March 1, 1999. The Bank is a wholly-owned subsidiary of the Bancorp, engaged in a full-service commercial and consumer banking business. Cornerstone Business Credit, Inc.
(CBC), a wholly-owned subsidiary of the Bank, has engaged since the third quarter of 2001 in the origination of small business loans that qualify for the guaranty of the U.S. Small Business Administration (the SBA).
References to the Company in this report are to the Bancorp, the Bank and CBC, collectively, unless the context indicates otherwise.



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



The Bank engages in a full-service commercial and consumer banking business.
Services include demand, savings and time deposits, and mortgage, commercial and consumer installment loans. Since its inception, the Banks primary mission has been to serve the banking needs of its community, the businesses in Fairfield
County, Connecticut (including minority-owned businesses in low and moderate income areas) and its citizens (including those living in low and moderate income areas), while focusing on its community towns and cities of Stamford, Greenwich, Darien,
New Canaan, Westport and Norwalk. The Bank conducts its operations through its main office located on 550 Summer Street in Stamford, Connecticut and five branch offices in the following locations: Hope Street, and High Ridge Road in Stamford,
Connecticut; East Putnam Avenue in Cos Cob, Connecticut; New Canaan Avenue in Norwalk, Connecticut; and Post Road East in Westport, Connecticut. The Bank also offers limited service mobile branches that operate within a five-mile radius of the
offices located on Summer Street in Stamford, Cos Cob, Norwalk and Westport. In the third quarter of 2002, the Bank leased office space on Chapel Street in New Haven to serve as a work area for SBA lenders.



Forward-Looking Statements



The statements contained in this report that are not historical are
forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Examples of such forward-looking statements include, without
limitation, statements regarding expectations for earnings, credit quality, and other financial and business matters. When used in this report, the words anticipate, plan, believe, estimate,
expect and similar expressions as they relate to the Company or its management are intended to identify forward-looking statements. All forward-looking statements involve risks and uncertainties. Actual results may differ materially from
those discussed in, or implied by, the forward-looking statements as a result of certain factors, including but not limited to, competitive pressures on loan and deposit product pricing; other actions of competitors; changes in economic conditions;
technological changes; the extent and timing of actions of the Federal Reserve Board, including changes in monetary policies and interest rates; customer deposit disintermediation; changes in customers acceptance of the Banks products
and services; and the extent and timing of legislative and regulatory actions and reforms.



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The forward-looking statements contained in this report speak only as of the date on which such
statements are made.



Market Area and Competition



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



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



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



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



The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the Interstate Banking Act) authorizes a number of interstate banking
transactions and activities, including, among others, the following: (i) a bank holding company may acquire banks in states outside of the holding companys home state; (ii) an insured bank may acquire a bank outside of the acquiring
banks home state, unless the home state of such bank involved in the transaction passed a law before June 1, 1997 prohibiting such transactions with out-of-state banks; (iii) an insured bank may acquire a branch of a bank located outside of
the acquiring banks home state if the law of the state where the branch is located allows such out-of-state acquisitions; and (iv) an insured bank is able to establish new branches in states outside of the banks home state if the state
in which the bank desires to establish a branch has a law permitting out-of-state banks to establish branches. The effect of the Interstate Banking Act has been to increase competition in the Banks market area.



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The business of the Bank also may be affected by governmental and regulatory actions and policies.
Monetary and fiscal policies of the United States Government and its instrumentalities, including the Board of Governors of the Federal Reserve System, significantly influence the growth of loans, investments and deposits. The present bank
regulatory environment may undergo further changes that could affect the banking industry itself and competition between banks and non-bank financial companies. See Regulation and Supervision below.



Lending Activities



Loans are generated through the Banks marketing efforts, its present
customers, walk-in customers and referrals from professionals including certified public accountants, attorneys, real estate brokers, builders and local businesses. The Banks lending activities are impacted by economic trends affecting the
availability of funds, the demand for loans, and the level of interest rates. Interest rates charged by the Bank on its loans are determined by competitive conditions in its market area, the cost of funds, the demand for loans and the availability
of loanable funds.



Loan Portfolio
Composition. At December 31, 2003, the principal balance of the Banks loan portfolio (excluding loans held for sale) totaled $121.5 million, before deducting the allowance for loan losses. The net portfolio represented approximately
53% of total assets and approximately 60% of total deposits at that date. Approximately 86% of the loan portfolio consisted of loans secured by residential or non-residential real estate properties, including construction loans; approximately 12% of
the portfolio consisted of commercial loans; and approximately 2% of the portfolio consisted of consumer installment and other loans. Funding for the Banks loans is derived primarily from deposits, stockholders equity and, to a much
lesser extent, borrowings.



The following is an analysis
of the composition of the loan portfolio (excluding loans held for sale) at December 31:



|                                |  |                        |         |      |   |      |        |      |         |      |  |        |  |   |         |        |     |   |   |         |  |     |  |   |        |  |    
|------------------------------- |  | ---------------------- | ------- | ---- | - | ---- | ------ | ---- | ------- | ---- |  | ------ |  | - | ------- | ------ | --- | - | - | ------- |  | --- |  | - | ------ |  | ---
|                                |  | 2003                   |         | 2002 |   | 2001 |        | 2000 |         | 1999
|                                |  | Amount                 |         |      | % |      | Amount |      |         | %    |  | Amount |  | % |         | Amount |     | % |   | Amount  |  | %  
|                                |  | (dollars in thousands)
|Loans secured by real estate:   |  |                        |         |      |   |      |        |      |         |      |  |        |  |   |         |        |     |   |   |         |  |     |  |   |        |  |    
|Residential                     |  | $                      | 36,473  |      |   | 30   |        | $    | 46,085  |      |  | 37     |  | $ | 42,740  |        | 40  |   | $ | 45,630  |  | 45  |  | $ | 35,501 |  | 45 
|Non-residential                 |  |                        | 52,945  |      |   | 44   |        |      | 49,977  |      |  | 41     |  |   | 43,956  |        | 42  |   |   | 39,754  |  | 40  |  |   | 25,470 |  | 32 
|Construction                    |  |                        | 14,920  |      |   | 12   |        |      | 11,429  |      |  | 9      |  |   | 5,479   |        | 5   |   |   | 2,375   |  | 2   |  |   | 6,022  |  | 8  
|Commercial loans                |  |                        | 15,077  |      |   | 12   |        |      | 14,024  |      |  | 11     |  |   | 12,039  |        | 11  |   |   | 10,711  |  | 11  |  |   | 9,604  |  | 12 
|Consumer and other loans        |  |                        | 2,116   |      |   | 2    |        |      | 2,259   |      |  | 2      |  |   | 2,368   |        | 2   |   |   | 2,316   |  | 2   |  |   | 3,026  |  | 3  
|                                |  |                        |         |      |   |      |        |      |         |      |  |        |  |   |         |        |     |   |   |         |  |     |  |   |        |  |    
|Total loans                     |  |                        | 121,531 |      |   | 100  |        |      | 123,774 |      |  | 100    |  |   | 106,582 |        | 100 |   |   | 100,786 |  | 100 |  |   | 79,623 |  | 100
|                                |  |                        |         |      |   |      |        |      |         |      |  |        |  |   |         |        |     |   |   |         |  |     |  |   |        |  |    
|Deferred loan (fees) costs, net |  |                        | (55     | )    |   |      |        |      | (65     | )    |  |        |  |   | 50      |        |     |   |   | 8       |  |     |  |   | 41     |  |    
|                                |  |                        |         |      |   |      |        |      |         |      |  |        |  |   |         |        |     |   |   |         |  |     |  |   |        |  |    
|Total loans                     |  | $                      | 121,476 |      |   |      |        | $    | 123,709 |      |  |        |  | $ | 106,632 |        |     |   | $ | 100,794 |  |     |  | $ | 79,664 |  |    
|                                |  |                        |         |      |   |      |        |      |         |      |  |        |  |   |         |        |     |   |   |         |  |     |  |   |        |  |    



Loans held for sale at
December 31, 2003 consisted of residential mortgage and SBA loans of $595,000 and $184,000, respectively ($7,057,000 and $187,000, respectively, at December 31, 2002). SBA loans held for sale were $755,000 at December 31, 2001. There were no loans
held for sale at December 31, 2000 and 1999.



The Banks
lending limit to one borrower under applicable federal regulations was approximately $3.4 million at December 31, 2003, representing 15% of the sum of its unimpaired capital (approximately $20.5 million) and the allowance for loan losses
(approximately $2.4 million). Subject to certain limitations, the Bank may lend an additional 10% above the 15% lending limitation to one borrower. The Banks largest lending relationship with a single borrower at December 31, 2003 amounted to
$2.9 million.



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Loan Portfolio Maturities. The following table presents loan principal balances at December
31, 2003 based upon their interest rate repricing frequency and remaining period to maturity. Adjustable rate loans are included based on the period to next repricing date, while fixed rate loans are included based on the period in which payments
are contractually due.



|                                  |  |                              |        |                 |   |              |  |            |        |                   |   |        |  |   |       |  |   |         |  |    
|--------------------------------- |  | ---------------------------- | ------ | --------------- | - | ------------ |  | ---------- | ------ | ----------------- | - | ------ |  | - | ----- |  | - | ------- |  | ---
|                                  |  | Loans Secured by Real Estate |        |                 |   |              |  |            |        |                  
|                                  |  | Residential                  |        | Non-residential |   | Construction |  | Commercial |        | Consumerand Other |   | Total  |  | %
|                                  |  | (dollars in thousands)      
|One year or less                  |  | $                            | 18,068 |                 | $ | 17,375       |  | $          | 13,359 |                   | $ | 10,636 |  | $ | 1,330 |  | $ | 60,768  |  | 50 
|After one year through five years |  |                              | 13,279 |                 |   | 11,376       |  |            | 736    |                   |   | 3,047  |  |   | 748   |  |   | 29,186  |  | 24 
|After five years                  |  |                              | 5,126  |                 |   | 24,194       |  |            | 825    |                   |   | 1,394  |  |   | 38    |  |   | 31,577  |  | 26 
|                                  |  |                              |        |                 |   |              |  |            |        |                   |   |        |  |   |       |  |   |         |  |    
|Total                             |  | $                            | 36,473 |                 | $ | 52,945       |  | $          | 14,920 |                   | $ | 15,077 |  | $ | 2,116 |  | $ | 121,531 |  | 100
|                                  |  |                              |        |                 |   |              |  |            |        |                   |   |        |  |   |       |  |   |         |  |    



Loan Portfolio
Delinquencies. It is the Banks policy to manage its loan portfolio to facilitate early recognition of problem loans. The Bank commences internal collection efforts once a loan payment is more than 15 days past due. The
Banks data processing system generates delinquency reports on all of the Banks loans weekly, and management reviews the loan portfolio to determine if past due loans should be placed on non-accrual status. Unless the customer is working
with the Bank toward repayment, once a loan payment is 90 days past due, the Bank generally initiates appropriate collection or legal action.



Loans are classified as non-accrual for purposes of income recognition when the collectibility of interest and principal become uncertain, which is
generally when a loan becomes 90 days past due. Accrual of interest may continue, however, if management believes the loan is well secured and collection is probable. When a residential or commercial mortgage loan becomes 90 days past due, the Bank
reviews the loan, including the appraisal of the collateral, and may request an updated appraisal. The value of the collateral, based on such appraisal, is one of the factors considered in determining whether the loan should be classified as
non-accrual. Commercial loans are generally classified as non-accrual after becoming 90 days past due. Construction loans 90 days past due are subject to a present value analysis, utilizing current appraisal data, to determine whether or not they
will be classified as non-accrual. Generally, any uncollected but previously accrued interest is charged against current income when a loan is placed on non-accrual status. Application of payments received on non-accrual loans, as principal and/or
interest due, depends on managements expectation regarding ultimate repayment. Loans are returned to accrual status when they demonstrate a period of payment performance and are expected to be fully collectible as to principal and
interest.



The following table summarizes loan portfolio
delinquencies at December 31:



|                      |  |                        |       |                      |      |   |         |      |                      |  |      |         |  |                      |       |  |         |   |                      |   |       |         |     |                      |  |   |     |  |     |  
|--------------------- |  | ---------------------- | ----- | -------------------- | ---- | - | ------- | ---- | -------------------- |  | ---- | ------- |  | -------------------- | ----- |  | ------- | - | -------------------- | - | ----- | ------- | --- | -------------------- |  | - | --- |  | --- | -
|                      |  | 2003                   |       |                      | 2002 |   |         | 2001 |                      |  | 2000 |         |  | 1999                 |      
|                      |  | Balance                |       | Percentof TotalLoans |      |   | Balance |      | Percentof TotalLoans |  |      | Balance |  | Percentof TotalLoans |       |  | Balance |   | Percentof TotalLoans |   |       | Balance |     | Percentof TotalLoans | 
|                      |  | (dollars in thousands) |      
|Loans delinquent for: |  |                        |       |                      |      |   |         |      |                      |  |      |         |  |                      |       |  |         |   |                      |   |       |         |     |                      |  |   |     |  |     |  
|30 to 59 days         |  | $                      | 2,551 |                      | 2.1  | % |         | $    | 2,297                |  | 1.9  | %       |  | $                    | 477   |  | 0.4     | % |                      | $ | 897   |         | 0.9 | %                    |  | $ | 487 |  | 0.6 | %
|60 to 89 days         |  |                        | 180   |                      | 0.1  |   |         |      | 88                   |  |     |         |  |                      | 53    |  | 0.1     |   |                      |   | 11    |         |    |                      |  |   | 21  |  |    |  
|90 days or more       |  |                        | 921   |                      | 0.8  |   |         |      | 1,758                |  | 1.4  |         |  |                      | 1,106 |  | 1.0     |   |                      |   | 456   |         | 0.5 |                      |  |   | 460 |  | 0.6 |  
|                      |  |                        |       |                      |      |   |         |      |                      |  |      |         |  |                      |       |  |         |   |                      |   |       |         |     |                      |  |   |     |  |     |  
|Total                 |  | $                      | 3,652 |                      | 3.0  | % |         | $    | 4,143                |  | 3.3  | %       |  | $                    | 1,636 |  | 1.5     | % |                      | $ | 1,364 |         | 1.4 | %                    |  | $ | 968 |  | 1.2 | %
|                      |  |                        |       |                      |      |   |         |      |                      |  |      |         |  |                      |       |  |         |   |                      |   |       |         |     |                      |  |   |     |  |     |  



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The following table summarizes, by type of loan, the recorded investment in non-performing loans at
December 31, 2003, 2002, 2001, 2000 and 1999. Amounts are shown for (i) loans that were past due 90 days or more, segregated between those on non-accrual status and those that were still accruing interest, and (ii) loans that were current or past
due less than 90 days for which interest payments were being applied to reduce principal balances.



|                                                                                                                         |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |      |   |  |   |       |  
|------------------------------------------------------------------------------------------------------------------------ |  | ---------------------- | ----- | - | ---- | - | ----- | ---- |  | - | ----- | - |  | ---- | ---- | - |  | - | ----- | -
|                                                                                                                         |  | 2003                   |       |   | 2002 |   |       | 2001 |  |   | 2000  |   |  | 1999 |     
|                                                                                                                         |  | (dollars in thousands) |      
|Loans on non-accrual status:                                                                                             |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |      |   |  |   |       |  
|Loans secured by real estate                                                                                             |  | $                      | 9     |   |      | $ | 149   |      |  | $ | 202   |   |  | $    | 455  |   |  | $ | 388   |  
|                                                                                                                         |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |      |   |  |   |       |  
|Loans on accrual status:                                                                                                 |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |      |   |  |   |       |  
|Loans secured by real estate                                                                                             |  |                        | 777   |   |      |   | 1,480 |      |  |   | 737   |   |  |      |     |   |  |   | 50    |  
|Commercial loans                                                                                                         |  |                        | 91    |   |      |   | 122   |      |  |   | 133   |   |  |      |     |   |  |   | 9     |  
|Consumer and other loans                                                                                                 |  |                        | 44    |   |      |   | 7     |      |  |   | 34    |   |  |      | 1    |   |  |   | 13    |  
|                                                                                                                         |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |      |   |  |   |       |  
|                                                                                                                         |  |                        | 912   |   |      |   | 1,609 |      |  |   | 904   |   |  |      | 1    |   |  |   | 72    |  
|                                                                                                                         |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |      |   |  |   |       |  
|Total loans past due 90 days or more                                                                                     |  |                        | 921   |   |      |   | 1,758 |      |  |   | 1,106 |   |  |      | 456  |   |  |   | 460   |  
|                                                                                                                         |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |      |   |  |   |       |  
|Loans current or past due less than 90 days for which interest payments were being applied to reduce principal balances: |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |      |   |  |   |       |  
|Loans secured by real estate                                                                                             |  |                        |      |   |      |   | 11    |      |  |   | 308   |   |  |      | 198  |   |  |   | 846   |  
|Commercial loans                                                                                                         |  |                        | 218   |   |      |   |      |      |  |   |      |   |  |      | 9    |   |  |   |      |  
|                                                                                                                         |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |      |   |  |   |       |  
|                                                                                                                         |  |                        | 218   |   |      |   | 11    |      |  |   | 308   |   |  |      | 207  |   |  |   | 846   |  
|                                                                                                                         |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |      |   |  |   |       |  
|Total non-performing loans                                                                                               |  | $                      | 1,139 |   |      | $ | 1,769 |      |  | $ | 1,414 |   |  | $    | 663  |   |  | $ | 1,306 |  
|                                                                                                                         |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |      |   |  |   |       |  
|Ratio of total non-performing loans to total loans outstanding                                                           |  |                        | 0.94  | % |      |   | 1.43  | %    |  |   | 1.33  | % |  |      | 0.66 | % |  |   | 1.64  | %
|                                                                                                                         |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |      |   |  |   |       |  



Repayments of
approximately $673,000 on loans past due 90 days or more on accrual status at December 31, 2003 were received in January 2004.



During the year ended December 31, 2003, collections of $111,000 were recognized in interest income due to the payoff of former non-accrual loans and
$69,000 was recognized in interest income due to the payoff of a loan which had been on non-accrual status.



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Allowance for Loan Losses. The following table summarizes changes in the allowance for loan
losses for the years ended December 31:



|                                                                  |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |       |    |  |   |       |   
|----------------------------------------------------------------- |  | ---------------------- | ----- | - | ---- | - | ----- | ---- |  | - | ----- | - |  | ---- | ----- | -- |  | - | ----- | --
|                                                                  |  | 2003                   |       |   | 2002 |   |       | 2001 |  |   | 2000  |   |  | 1999 |      
|                                                                  |  | (dollars in thousands) |      
|Balance at beginning of year                                      |  | $                      | 2,234 |   |      | $ | 1,848 |      |  | $ | 1,589 |   |  | $    | 1,626 |    |  | $ | 1,733 |   
|Charge-offs:                                                      |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |       |    |  |   |       |   
|Commercial                                                        |  |                        |      |   |      |   | (2    | )    |  |   | (19   | ) |  |      | (470  | )  |  |   | (81   | ) 
|Real estate mortgage                                              |  |                        |      |   |      |   |      |      |  |   |      |   |  |      |      |    |  |   | (14   | ) 
|All other loans                                                   |  |                        | (8    | ) |      |   | (47   | )    |  |   | (6    | ) |  |      | (10   | )  |  |   | (8    | ) 
|                                                                  |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |       |    |  |   |       |   
|                                                                  |  |                        | (8    | ) |      |   | (49   | )    |  |   | (25   | ) |  |      | (480  | )  |  |   | (103  | ) 
|                                                                  |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |       |    |  |   |       |   
|Recoveries:                                                       |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |       |    |  |   |       |   
|Commercial                                                        |  |                        | 26    |   |      |   | 43    |      |  |   | 7     |   |  |      | 53    |    |  |   | 44    |   
|Real estate mortgage                                              |  |                        |      |   |      |   |      |      |  |   | 90    |   |  |      |      |    |  |   | 26    |   
|All other loans                                                   |  |                        | 39    |   |      |   | 29    |      |  |   | 96    |   |  |      | 6     |    |  |   | 6     |   
|                                                                  |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |       |    |  |   |       |   
|                                                                  |  |                        | 65    |   |      |   | 72    |      |  |   | 193   |   |  |      | 59    |    |  |   | 76    |   
|                                                                  |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |       |    |  |   |       |   
|Net recoveries (charge-offs)                                      |  |                        | 57    |   |      |   | 23    |      |  |   | 168   |   |  |      | (421  | )  |  |   | (27   | ) 
|                                                                  |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |       |    |  |   |       |   
|Provision for loan losses                                         |  |                        | 96    |   |      |   | 363   |      |  |   | 91    |   |  |      | 384   |    |  |   | (80   | ) 
|                                                                  |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |       |    |  |   |       |   
|Balance at end of year                                            |  | $                      | 2,387 |   |      | $ | 2,234 |      |  | $ | 1,848 |   |  | $    | 1,589 |    |  | $ | 1,626 |   
|                                                                  |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |       |    |  |   |       |   
|Ratio of net recoveries (charge-offs)to average loans outstanding |  |                        | 0.05  | % |      |   | 0.02  | %    |  |   | 0.16  | % |  |      | (0.46 | %) |  |   | (0.04 | %)
|                                                                  |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |       |    |  |   |       |   
|Ratio of allowance for loan losses to total loans                 |  |                        | 1.96  | % |      |   | 1.81  | %    |  |   | 1.73  | % |  |      | 1.58  | %  |  |   | 2.04  | % 
|                                                                  |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |       |    |  |   |       |   
|Ratio of allowance for loan losses to total non-performing loans  |  |                        | 210   | % |      |   | 126   | %    |  |   | 131   | % |  |      | 240   | %  |  |   | 125   | % 
|                                                                  |  |                        |       |   |      |   |       |      |  |   |       |   |  |      |       |    |  |   |       |   



Recoveries credited to
the allowance for loan losses during the year ended December 31, 2003 included $12,000 with respect to a commercial loan that had been charged off in 1998.



During the year ended December 31, 2002, recoveries credited to the allowance for loan losses included $20,000 with respect to a consumer loan that had
been charged off in 1991 and $39,000 with respect to two commercial loans that had been charged off in 1999.



During the year ended December 31, 2001, the Bank recovered $90,000 with respect to a consumer loan that had been charged off in November 1990. Also in
2001, $149,000 was received on a non-residential real estate loan that had been charged off in December 1997, of which $81,000 was a recovery of previously charged-off principal and $68,000 was a payment for interest that had been applied against
principal and was subsequently applied to income.



Approximately $460,000 of the commercial loan charge-offs for the year ended December 31, 2000 represented loans to a borrower who filed for bankruptcy. This amount was recovered in February 2004 and credited to the allowance for loan
losses. An additional $216,000 was recovered from this borrower in February 2004, principally representing interest that the Bank had not accrued as income subsequent to the charge-off in 2000.



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An allocation of the allowance for loan losses at December 31, 2003, 2002, 2001, 2000 and 1999 is
presented below. No portion of the allowance is restricted to any loan or group of loans, and the entire allowance is available to absorb credit losses. The amount and timing of actual charge-offs and future allowance allocations may vary from
current estimates. The table indicates the allowance for loan losses allocable to real estate secured loans and other loan types, as well as the percent of the total loan portfolio represented by balances within each loan type.



|                              |  |                         |       |                               |       |   |                         |      |                               |  |       |                         |  |                               |       |  |                         |   |                               |   |       |                         |       |                               |  |   |       |  |       |  
|----------------------------- |  | ----------------------- | ----- | ----------------------------- | ----- | - | ----------------------- | ---- | ----------------------------- |  | ----- | ----------------------- |  | ----------------------------- | ----- |  | ----------------------- | - | ----------------------------- | - | ----- | ----------------------- | ----- | ----------------------------- |  | - | ----- |  | ----- | -
|                              |  | 2003                    |       |                               | 2002  |   |                         | 2001 |                               |  | 2000  |                         |  | 1999                          |      
|                              |  | Allowancefor LoanLosses |       | % ofLoans byType toTotalLoans |       |   | Allowancefor LoanLosses |      | % ofLoans byType toTotalLoans |  |       | Allowancefor LoanLosses |  | % ofLoans byType toTotalLoans |       |  | Allowancefor LoanLosses |   | % ofLoans byType toTotalLoans |   |       | Allowancefor LoanLosses |       | % ofLoans byType toTotalLoans | 
|                              |  | (dollars in thousands)  |      
|Loans secured by real estate: |  |                         |       |                               |       |   |                         |      |                               |  |       |                         |  |                               |       |  |                         |   |                               |   |       |                         |       |                               |  |   |       |  |       |  
|Residential                   |  | $                       | 571   |                               | 30.1  | % |                         | $    | 704                           |  | 37.3  | %                       |  | $                             | 660   |  | 29.8                    | % |                               | $ | 681   |                         | 45.3  | %                             |  | $ | 566   |  | 44.6  | %
|Non-residential               |  |                         | 829   |                               | 43.5  |   |                         |      | 781                           |  | 40.4  |                         |  |                               | 689   |  | 41.6                    |   |                               |   | 593   |                         | 39.4  |                               |  |   | 495   |  | 32.0  |  
|Construction                  |  |                         | 234   |                               | 12.3  |   |                         |      | 171                           |  | 9.2   |                         |  |                               | 85    |  | 5.1                     |   |                               |   | 35    |                         | 2.4   |                               |  |   | 93    |  | 2.4   |  
|Commercial                    |  |                         | 237   |                               | 12.4  |   |                         |      | 210                           |  | 11.3  |                         |  |                               | 187   |  | 11.3                    |   |                               |   | 160   |                         | 10.6  |                               |  |   | 192   |  | 10.6  |  
|Consumer and other            |  |                         | 33    |                               | 1.7   |   |                         |      | 38                            |  | 1.8   |                         |  |                               | 36    |  | 2.2                     |   |                               |   | 35    |                         | 2.3   |                               |  |   | 105   |  | 2.3   |  
|Unallocated                   |  |                         | 483   |                               |      |   |                         |      | 330                           |  |      |                         |  |                               | 191   |  |                        |   |                               |   | 85    |                         |      |                               |  |   | 175   |  |      |  
|                              |  |                         |       |                               |       |   |                         |      |                               |  |       |                         |  |                               |       |  |                         |   |                               |   |       |                         |       |                               |  |   |       |  |       |  
|Total                         |  | $                       | 2,387 |                               | 100.0 | % |                         | $    | 2,234                         |  | 100.0 | %                       |  | $                             | 1,848 |  | 100.0                   | % |                               | $ | 1,589 |                         | 100.0 | %                             |  | $ | 1,626 |  | 100.0 | %
|                              |  |                         |       |                               |       |   |                         |      |                               |  |       |                         |  |                               |       |  |                         |   |                               |   |       |                         |       |                               |  |   |       |  |       |  



Investment
Activities



The Bank has authority to invest in a variety
of security types deemed prudent by the Board of Directors. Subject to various restrictions, the Bank may own obligations of the United States Government, federal agencies, certain obligations of municipalities, certificates of deposit,
bankers acceptances, commercial paper and corporate bonds.



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



Investment Portfolio Composition. At December 31, 2003, the
Banks securities held to maturity consisted of debt securities reported at an amortized cost of $20.5 million (or $509,000 less than fair value). At December 31, 2003, the Banks available for sale securities portfolio consisted of debt
securities reported at a total fair value of $11.1 million (or $42,000 more than amortized cost). The after-tax net unrealized gain of $26,000 on available for sale securities has been recorded as a component of stockholders equity at December
31, 2003. The Bank also held an investment of $613,000 in Federal Home Loan Bank (FHLB) stock at December 31, 2003, which is a non-marketable equity security reported at cost.



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The amortized cost and fair value of debt securities are summarized as follows at December 31:



|                                   |  |                |        |           |   |               |  |           |        |               |   |           |  |   |        |  |   |       
|---------------------------------- |  | -------------- | ------ | --------- | - | ------------- |  | --------- | ------ | ------------- | - | --------- |  | - | ------ |  | - | ------
|                                   |  | 2003           |        | 2002      |   | 2001         
|                                   |  | AmortizedCost  |        | FairValue |   | AmortizedCost |  | FairValue |        | AmortizedCost |   | FairValue
|                                   |  | (in thousands)
|Securities available for sale:     |  |                |        |           |   |               |  |           |        |               |   |           |  |   |        |  |   |       
|U. S. Government Agency securities |  | $              | 9,535  |           | $ | 9,578         |  | $         | 9,082  |               | $ | 9,242     |  | $ | 9,541  |  | $ | 9,779 
|Mortgage-backed securities         |  |                | 1,502  |           |   | 1,501         |  |           | 2,152  |               |   | 2,150     |  |   |       |  |   |      
|                                   |  |                |        |           |   |               |  |           |        |               |   |           |  |   |        |  |   |       
|                                   |  |                | 11,037 |           |   | 11,079        |  |           | 11,234 |               |   | 11,392    |  |   | 9,541  |  |   | 9,779 
|                                   |  |                |        |           |   |               |  |           |        |               |   |           |  |   |        |  |   |       
|Securities held to maturity:       |  |                |        |           |   |               |  |           |        |               |   |           |  |   |        |  |   |       
|U. S. Government Agency securities |  |                | 15,090 |           |   | 15,519        |  |           | 20,746 |               |   | 21,637    |  |   | 25,918 |  |   | 26,373
|Mortgage-backed securities         |  |                | 2,354  |           |   | 2,413         |  |           | 5,937  |               |   | 6,079     |  |   | 9,356  |  |   | 9,509 
|State and municipal bonds          |  |                | 2,991  |           |   | 3,012         |  |           |       |               |   |          |  |   |       |  |   |      
|Other securities                   |  |                | 75     |           |   | 75            |  |           | 75     |               |   | 75        |  |   | 75     |  |   | 75    
|                                   |  |                |        |           |   |               |  |           |        |               |   |           |  |   |        |  |   |       
|                                   |  |                | 20,510 |           |   | 21,019        |  |           | 26,758 |               |   | 27,811    |  |   | 35,349 |  |   | 35,957
|                                   |  |                |        |           |   |               |  |           |        |               |   |           |  |   |        |  |   |       
|Total debt securities              |  | $              | 31,547 |           | $ | 32,098        |  | $         | 37,992 |               | $ | 39,203    |  | $ | 44,890 |  | $ | 45,736
|                                   |  |                |        |           |   |               |  |           |        |               |   |           |  |   |        |  |   |       



Investment
Portfolio Maturities. The following table summarizes the amortized cost and the weighted average tax equivalent yield of the securities portfolio (excluding mortgage-backed securities), by remaining period to contractual maturity, at
December 31, 2003:



|                                   |  |                        |        |   |                       |   |        |                       |  |   |       |   |  |   |        |  
|---------------------------------- |  | ---------------------- | ------ | - | --------------------- | - | ------ | --------------------- |  | - | ----- | - |  | - | ------ | -
|                                   |  | One Yearor Less        |        |   | One ThroughFive Years |   |        | Five ThroughTen Years |  |   | Total |  
|                                   |  | (dollars in thousands) |       
|Securities available for sale:     |  |                        |        |   |                       |   |        |                       |  |   |       |   |  |   |        |  
|U.S. Government Agency securities  |  | $                      | 2,501  |   |                       | $ | 7,034  |                       |  | $ |      |   |  | $ | 9,535  |  
|                                   |  |                        |        |   |                       |   |        |                       |  |   |       |   |  |   |        |  
|Securities held to maturity:       |  |                        |        |   |                       |   |        |                       |  |   |       |   |  |   |        |  
|U. S. Government Agency securities |  |                        | 8,522  |   |                       |   | 6,568  |                       |  |   |      |   |  |   | 15,090 |  
|State and municipal bonds          |  |                        |       |   |                       |   |       |                       |  |   | 2,991 |   |  |   | 2,991  |  
|Other securities                   |  |                        | 25     |   |                       |   | 25     |                       |  |   | 25    |   |  |   | 75     |  
|                                   |  |                        |        |   |                       |   |        |                       |  |   |       |   |  |   |        |  
|                                   |  |                        | 8,547  |   |                       |   | 6,593  |                       |  |   | 3,016 |   |  |   | 18,156 |  
|                                   |  |                        |        |   |                       |   |        |                       |  |   |       |   |  |   |        |  
|Total amortized cost               |  | $                      | 11,048 |   |                       | $ | 13,627 |                       |  | $ | 3,016 |   |  | $ | 27,691 |  
|                                   |  |                        |        |   |                       |   |        |                       |  |   |       |   |  |   |        |  
|Weighted average yield             |  |                        | 5.15   | % |                       |   | 4.22   | %                     |  |   | 4.44  | % |  |   | 4.61   | %
|                                   |  |                        |        |   |                       |   |        |                       |  |   |       |   |  |   |        |  



Sources of Funds



Deposits. Deposits are the primary source of
funds for the Bank. The Banks deposits consist of checking accounts, preferred savings accounts, regular savings deposits, NOW accounts, money market accounts and certificates of deposit. Deposits are obtained from individuals, partnerships,
small and medium size businesses and professionals in the Banks market area. The Bank does not accept brokered deposits.



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##### Table of Contents

The following table summarizes the average balance and the average rate paid on each type of
interest-bearing deposit for the years ended December 31:



|                               |  |                        |         |                 |      |   |                |      |                 |  |      |                |  |                 |         |  |      |  
|------------------------------ |  | ---------------------- | ------- | --------------- | ---- | - | -------------- | ---- | --------------- |  | ---- | -------------- |  | --------------- | ------- |  | ---- | -
|                               |  | 2003                   |         |                 | 2002 |   |                | 2001 |                
|Type of Account                |  | AverageBalance         |         | AverageRatePaid |      |   | AverageBalance |      | AverageRatePaid |  |      | AverageBalance |  | AverageRatePaid |        
|                               |  | (dollars in thousands) |        
|NOW accounts                   |  | $                      | 27,513  |                 | 0.27 | % |                | $    | 27,123          |  | 0.27 | %              |  | $               | 23,994  |  | 0.81 | %
|Money market accounts          |  |                        | 4,019   |                 | 1.08 |   |                |      | 4,063           |  | 1.13 |                |  |                 | 7,080   |  | 1.65 |  
|Regular, club, cash management |  |                        | 8,141   |                 | 1.05 |   |                |      | 7,146           |  | 1.15 |                |  |                 | 6,400   |  | 1.80 |  
|Preferred rate savings         |  |                        | 29,284  |                 | 1.32 |   |                |      | 26,103          |  | 1.49 |                |  |                 | 21,868  |  | 2.30 |  
|Time certificates of deposit   |  |                        | 77,465  |                 | 3.04 |   |                |      | 59,663          |  | 4.06 |                |  |                 | 51,918  |  | 5.32 |  
|                               |  |                        |         |                 |      |   |                |      |                 |  |      |                |  |                 |         |  |      |  
|Total                          |  | $                      | 146,422 |                 | 2.01 | % |                | $    | 124,098         |  | 2.43 | %              |  | $               | 111,260 |  | 3.32 | %
|                               |  |                        |         |                 |      |   |                |      |                 |  |      |                |  |                 |         |  |      |  



The following table
shows, by maturity, the balance of time certificates of deposit of $100,000 or more and the average rate paid at December 31, 2003. See Note 6 to the Consolidated Financial Statements for additional information concerning time deposits.



|                                             |  |                        |        |                  |      |  
|-------------------------------------------- |  | ---------------------- | ------ | ---------------- | ---- | -
|Remaining Period to Maturity                 |  | Balance                |        | AverageRate Paid |     
|                                             |  | (dollars in thousands) |       
|Less than 3 months                           |  | $                      | 6,898  |                  | 2.29 | %
|Greater than 3 months and less than 6 months |  |                        | 3,437  |                  | 2.03 |  
|Greater than 6 months and less than 1 year   |  |                        | 4,337  |                  | 2.37 |  
|Greater than 1 year                          |  |                        | 3,446  |                  | 5.23 |  
|                                             |  |                        |        |                  |      |  
|Total                                        |  | $                      | 18,118 |                  | 2.82 | %
|                                             |  |                        |        |                  |      |  



Borrowings. The Bank uses borrowings as a secondary source of funds, in the form of securities repurchase agreements and advances from the FHLB of Boston. Securities repurchase agreements represent transactions with certain
commercial customers in which the Bank borrows funds from the customers and pledges U.S. Treasury and Government Agency securities as collateral. The identical securities are repurchased from the customer when the borrowing matures, generally within
three months.



The following table summarizes information
concerning borrowings under securities repurchase agreements as of and for the years ended December 31:



|                                               |  |                        |       |   |      |   |       |      |  |   |       |  
|---------------------------------------------- |  | ---------------------- | ----- | - | ---- | - | ----- | ---- |  | - | ----- | -
|                                               |  | 2003                   |       |   | 2002 |   |       | 2001 | 
|                                               |  | (dollars in thousands) |      
|Repurchase agreement borrowings:               |  |                        |       |   |      |   |       |      |  |   |       |  
|At December 31                                 |  | $                      | 4,540 |   |      | $ | 5,723 |      |  | $ | 8,041 |  
|Average for the year                           |  |                        | 5,778 |   |      |   | 5,889 |      |  |   | 7,721 |  
|Maximum at any month end                       |  |                        | 6,754 |   |      |   | 6,149 |      |  |   | 9,086 |  
|Weighted average interest rates on borrowings: |  |                        |       |   |      |   |       |      |  |   |       |  
|At December 31                                 |  |                        | 1.05  | % |      |   | 1.42  | %    |  |   | 1.34  | %
|Average for the year                           |  |                        | 1.19  | % |      |   | 1.34  | %    |  |   | 1.78  | %



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##### Table of Contents

Securities with a fair value of $4.6 million, $5.8 million and $8.1 million were pledged as collateral
for repurchase agreement borrowings at December 31, 2003, 2002 and 2001, respectively. The agreements at December 31, 2003 mature within three months.



As a member of the FHLB of Boston, the Bank is required to own capital stock in the FHLB and is authorized to apply for advances from the FHLB. Each FHLB
credit program has its own interest rate, which may be fixed or variable, and range of maturities. The FHLB of Boston may prescribe the acceptable uses for these advances, as well as limitations on the size of the advances and repayment provisions.
At December 31, 2003, the Banks FHLB borrowing capacity was $12.3 million. On such date, there were no FHLB advances outstanding.



Regulation and Supervision



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



This structure also gives the regulatory
authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets for regulatory purposes and the establishment of an adequate
allowance for loan losses. Any change in such regulation, whether by the Banking Commissioner, the FDIC, the Federal Reserve Board or through legislation, could have a material adverse impact on the Company and its operations.



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



Connecticut banking laws grant banks broad lending
authority. Subject to certain limited exceptions, however, total secured and unsecured loans made to any one obligor pursuant to this statutory authority generally may not exceed 25% and 15%, respectively, of a banks equity capital plus the
allowance for loan losses.



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



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



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



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



Federal law requires
each federal banking agency, such as the FDIC, to prescribe for depository institutions under its jurisdiction standards relating to, among other things: internal controls; information systems and audit systems; loan documentation; credit
underwriting; interest rate risk exposure; asset growth; compensation, fees and benefits; and such other operational and managerial standards as the agency deems appropriate. The federal banking agencies adopted final regulations and Interagency
Guidelines Establishing Standards for Safety and Soundness (the Guidelines) to implement these safety and soundness standards. The Guidelines set forth the safety and soundness standards that the federal banking agencies use to identify
and address problems at insured depository institutions before capital becomes impaired. The Guidelines address internal controls and information systems; internal audit systems; credit underwriting; loan documentation; interest rate risk exposure;
asset quality; earnings; compensation, fees and benefits; and standards for safeguarding customer information. If the FDIC determines that an institution fails to meet any standard prescribed by the Guidelines, the FDIC may require the institution
to submit to it an acceptable plan to achieve compliance with those Guidelines. The Guidelines establish time frames for the submission and review of such safety and soundness compliance programs.



Under the Community Reinvestment Act, as amended (CRA), the Bank
has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not prescribe specific lending requirements
or programs for financial institutions nor does it limit an institutions discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The CRA requires the FDIC,
in connection with its examination of an institution, to assess the institutions record of meeting the credit needs of its community and to take such record into account in its evaluation of certain applications by such institution. The CRA
requires public disclosure of an institutions CRA rating and requires the FDIC to provide a written evaluation of an institutions CRA performance utilizing a four-tiered descriptive rating system. The Banks latest CRA rating,
received from the FDIC on January 19, 1999, was satisfactory, which is second to the highest rating of outstanding.



The FDIC has adopted risk-based capital guidelines applicable to FDIC-insured, state-chartered banks that are not members of the Federal Reserve System,
such as the Bank. The guidelines establish a systematic analytical framework that makes regulatory capital requirements more sensitive to differences in risk profiles among banking organizations. Banks are required to maintain minimum levels of
capital based upon their total assets and total risk-weighted assets. For purposes of these requirements, capital is comprised both of Tier 1 and Tier 2 capital. Tier 1 capital consists primarily of common stock and retained earnings.
Subject to certain limitations, Tier 2 capital consists primarily of the allowance for loan losses, subordinated debt, and convertible securities. In determining total capital, the amount of Tier 2 capital may not exceed the amount of Tier 1
capital. A banks total risk-weighted assets are determined by assigning the banks assets and off-balance sheet items (e.g., letters of credit) to one of four risk categories based upon their relative credit risks. The greater the credit
risk associated with an asset, the greater the amount of such asset that will be subject to the capital requirements.



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The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) defines specific
capital categories based upon an institutions capital ratios. The capital categories, in declining order, are: (i) well capitalized, (ii) adequately capitalized, (iii) undercapitalized, (iv) significantly undercapitalized, and (v) critically
undercapitalized. Under FDICIA and the FDICs prompt corrective action rules, the FDIC may take any one or more of the following actions against an undercapitalized bank: restrict dividends and management fees; restrict asset growth; and
prohibit new acquisitions, new branches or new lines of business without prior FDIC approval. If a bank is significantly undercapitalized, the FDIC may also require the bank to raise capital, restrict interest rates a bank may pay on deposits,
require a reduction in assets, restrict any activities that might cause risk to a bank, require improved management, prohibit the acceptance of deposits from correspondent banks and restrict compensation to any senior executive officer. When a bank
becomes critically undercapitalized (i.e., the ratio of tangible equity to total assets is equal to or less than 2%), the FDIC must, within 90 days thereafter, appoint a receiver for the bank or take such other action as the FDIC determines would
better achieve the purposes of the law. Even where such other action is taken, the FDIC generally must appoint a receiver for a bank if the bank remains critically undercapitalized during the calendar quarter beginning 270 days after the date on
which the bank became critically undercapitalized.



To be
considered adequately capitalized, an institution must generally have a leverage ratio of Tier 1 capital to total adjusted assets of at least 4%, a Tier 1 capital to risk-weighted assets ratio of at least 4%, and a total (Tier 1 and Tier
2) capital to risk-weighted assets ratio of at least 8%. Generally, a bank is considered to be well capitalized if it has a leverage (Tier 1) capital ratio of at least 5%, a Tier 1 risk-based capital ratio of at least 6%, and a total
risk-based capital ratio of at least 10%. As of December 31, 2003, the Bank was in full compliance with all three minimum capital standards and was categorized as well capitalized under the provisions of FDICIA. See Capital
Resources and Note 10 to the Consolidated Financial Statements for an analysis of the Banks actual and required regulatory capital.



Federal Reserve System Regulation. Under the Federal Reserve Act and Regulation D issued thereunder by the Federal Reserve Board, banking
institutions are required to maintain reserves with respect to transaction accounts (primarily NOW and regular checking accounts) which allow payments or transfers to third parties. These regulations generally require the maintenance of reserves of
3% against net transaction accounts of $42.1 million or less and, for net transaction accounts over $45.4 million, $1,362,000 plus 10% of the amount of such accounts in excess of $45.4 million. These amounts and percentages are subject to adjustment
by the Federal Reserve Board. At December 31, 2003, the Banks net transaction accounts exceeded $45.4 million. The Banks required average reserve balances were approximately $2,372,000 at December 31, 2003.



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



Under the Federal BHC Act, the Bancorp is required to file annually with the
Federal Reserve Board a report of its operations, and the Bancorp, the Bank and any other subsidiaries are subject to examination by the Federal Reserve Board. In addition, the Bancorp is required to obtain the prior approval of the Board of
Governors of the Federal Reserve System to acquire, with certain exceptions, more than 5% of the outstanding



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voting stock of any bank or bank holding company, to acquire all or substantially all of the assets of a bank or to merge or consolidate with another bank
holding company. Moreover, the Bancorp, the Bank and any other subsidiaries are prohibited from engaging in certain tying arrangements in connection with any extension of credit or provision of any property or services. The Bank also is subject to
certain restrictions imposed by the Federal Reserve Act on issuing any extension of credit to the Bancorp or any of its subsidiaries, or making any investments in the stock or other securities thereof, and on the taking of such stock or securities
as collateral for loans to any borrower.



In 1999, the
Gramm-Leach-Bliley (GLB) Act was enacted, authorizing affiliations between banking, securities and insurance firms, and permitting bank holding companies and banks to engage in a variety of new financial activities. Among the new
activities that are permitted to bank holding companies are securities and insurance brokerage, securities underwriting, insurance underwriting and merchant banking. The Federal Reserve Board, in consultation with the Secretary of the Treasury, may
approve additional financial activities. The GLB Act also imposes new requirements on financial institutions with respect to customer privacy. It generally prohibits disclosure of customer information to nonaffiliated third parties unless the
disclosure is made pursuant to certain exceptions or the customer has been given the opportunity to object and has not objected to such disclosure. Financial institutions are further required to disclose their privacy policies to customers annually.
Financial institutions, however, will be required to comply with state law if it is more protective of customer privacy than the GLB Act. The Board of Directors approved the Banks privacy policy in October 2000.



The Federal Reserve Board has issued a policy statement on the payment of
cash dividends by bank holding companies, which expresses the Federal Reserve Boards view that a bank holding company should pay cash dividends only to the extent that a bank holding companys net income for the past year is sufficient to
cover both the cash dividends and a rate of earnings retention that is consistent with a bank holding companys capital needs, asset quality and overall financial condition. This policy statement has had no operative effect upon the dividends
paid by the Bancorp through December 31, 2003, and is not expected to have an operative effect in 2004. The Federal Reserve Board also indicated that it would be inappropriate for a company experiencing serious financial problems to borrow funds to
pay dividends. Furthermore, under the prompt corrective action regulations adopted by the Federal Reserve Board pursuant to FDICIA, the Federal Reserve Board may prohibit a bank holding company from paying any dividends if the holding companys
bank subsidiary is classified as undercapitalized.



The USA Patriot Act.The terrorist attacks in September, 2001 have impacted the financial services industry and led to federal legislation that attempts to address certain issues involving financial institutions. On October
26, 2001, President Bush signed into law the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001.



Part of the USA Patriot Act is the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001
(IMLA). IMLA authorizes the Secretary of the Treasury, in consultation with the heads of other government agencies, to adopt special measures applicable to banks, bank holding companies, and/or other financial institutions. These
measures may include enhanced recordkeeping and reporting requirements for certain financial transactions that are of primary money laundering concern, due diligence requirements concerning the beneficial ownership of certain types of accounts, and
restrictions or prohibitions on certain types of accounts with foreign financial institutions.



Among its other provisions, IMLA requires each financial institution to: (i) establish an anti-money laundering program; (ii) establish due diligence policies, procedures and controls with respect to its private
banking accounts and correspondent banking accounts involving foreign individuals and certain foreign banks; and (iii) avoid establishing, maintaining, administering, or managing correspondent accounts in the United States for, or on behalf of, a
foreign bank that does not have a physical presence in any country. In addition, IMLA contains a provision encouraging cooperation among financial institutions, regulatory authorities and law enforcement authorities with respect to individuals,
entities and organizations engaged in, or reasonably suspected of engaging in, terrorist acts or money laundering activities. IMLA expands the circumstances under which funds in a bank account may be forfeited and requires covered financial
institutions to respond under certain circumstances to requests for information from federal banking agencies within 120 hours. IMLA also amends the BHCA and the Bank Merger Act to require the federal banking agencies to consider the effectiveness
of a financial institutions anti-money laundering activities when reviewing an application under these acts.



Federal Securities Law. The common stock of the Company is registered with the Securities and Exchange Commission (SEC) under
the Securities Exchange Act of 1934 (the Exchange Act). The Company is subject to the information, proxy solicitation, insider trading restrictions and other requirements of the SEC under the Exchange Act. Common stock of the Company
held by persons who are affiliates (generally officers, directors and principal stockholders) of the Company may not be resold without registration or unless sold in accordance with certain resale restrictions. If the Company meets specified current
public information requirements, each affiliate of the Company is able to sell in the public market, without registration, a limited number of shares in any three-month period.



The Sarbanes-Oxley Act of 2002. In July, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002.
The purpose of the Sarbanes-Oxley Act is to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes.



The Sarbanes-Oxley Act amends the Securities Exchange Act of 1934 to prohibit
a registered public accounting firm from performing specified nonaudit services contemporaneously with a mandatory audit. The Sarbanes-Oxley Act also vests the audit committee of an issuer with responsibility for the appointment, compensation, and
oversight of any registered public accounting firm employed to perform audit services. It requires each committee member to be a member of the board of directors of the issuer, and to be otherwise independent. The Sarbanes-Oxley Act further requires
the chief executive officer and chief financial officer of an issuer to make certain certifications as to each annual or quarterly report.



In addition, the Sarbanes-Oxley Act requires officers to forfeit certain bonuses and profits under certain circumstances. Specifically, if an issuer is
required to prepare an accounting restatement due to the material noncompliance of the issuer as a result of misconduct with any financial reporting requirements under the securities laws, the chief executive officer and chief financial officer of
the issuer shall be required to reimburse the issuer for (1) any bonus or other incentive-based or equity based compensation received by that person from the issuer during the 12-month period following the first public issuance or filing with the
SEC of the financial document embodying such financial reporting requirement; and (2) any profits realized from the sale of securities of the issuer during that 12-month period.



The Sarbanes-Oxley Act also instructs the SEC to require by rule:



| |  | disclosure of all material off-balance sheet transactions and relationship that may have a material effect upon the financial status of an issuer; and
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | the presentation of pro forma financial information in a manner that is not misleading, and which is reconcilable with the financial condition of the issuer under generally accepted
accounting principles.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The Sarbanes-Oxley Act
also prohibits insider transactions in the Corporations stock during a lock out period of Corporations pension plans, and any profits of such insider transactions are to be disgorged. In addition, there is a prohibition of corporation
loans to its executives, except in certain circumstances. The Sarbanes-Oxley Act also provides for mandated internal control report and assessment with the annual report and an attestation and a report on such report by Corporations auditor.
The SEC also requires an issuer to institute a code of ethics for senior financial officers of the corporation. Furthermore, the Sarbanes-Oxley Act adds a criminal penalty of fines and imprisonment of up to 10 years for securities fraud.





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Personnel



As of December 31, 2003, the Bank had 64 employees (57 of whom are full-time and 7 of whom are part-time). The employees are not represented by a
collective bargaining unit and the Bank considers its relationship with its employees to be good.



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##### Table of Contents

|Item 1A. | Executive Officers of the Issuer
|-------- | --------------------------------



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





|                       |  |     |  |                                                                                                                                                                                                            
|---------------------- |  | --- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Name                   |  | Age |  | Positions Held with the Bancorp and Principal Occupations During the Past Five Years                                                                                                                       
|                       |  |    
|Norman H. Reader*      |  | 79  |  | Vice Chairman (2000  January 2004)
President and Chief Executive Officer (1985 - 2000)                                                                                                                    
|                       |  |    
|Merrill J. Forgotson*  |  | 61  |  | President and Chief Executive Officer (2000 -
present) Senior Vice President Peoples Bank (1990-2000)                                                                                                     
|                       |  |    
|James P. Jakubek       |  | 54  |  | Executive Vice President and Chief Operating Officer
(1991 - present)                                                                                                                                      
|                       |  |    
|Paul H. Reader*        |  | 45  |  | Senior Vice President (1993 - Present)                                                                                                                                                                     
|                       |  |    
|Ernest J. Verrico, Sr. |  | 48  |  | Vice President and Chief Financial Officer (2001 - present) Senior Vice President and Controller (CT/NY Region) First Union National Bank (1982-2001)                                                      
|                       |  |    
|Leigh A. Hardisty      |  | 46  |  | Vice President and Corporate Secretary (2001 -
present) Vice President, Chief Financial Officer and Corporate
Secretary (1999 - 2001) Vice President and Comptroller, and Corporate Secretary (1993 - 1999)



|* | Norman H. Reader passed away on January 8, 2004. He was the father of Paul H. Reader and the father-in-law of Merrill J. Forgotson. Merrill J. Forgotson and Paul H. Reader are
brothers-in-law.
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

|Item 2. | Description of Property
|------- | -----------------------



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



|                                                                 |  |                      |  |                
|---------------------------------------------------------------- |  | -------------------- |  | ---------------
|                                                                 |  | Year Facility Opened |  | Owned or Leased
|Main office(1) 550 Summer Street Stamford, Connecticut           |  | 1988                 |  | Owned          
|                                                                 |  |                     
|Springdale office(2) 1042 Hope Street Stamford, Connecticut      |  | 1989                 |  | Leased         
|                                                                 |  |                     
|High Ridge office(3) 1117 High Ridge Road Stamford, Connecticut  |  | 1994                 |  | Leased         
|                                                                 |  |                     
|Cos Cob office(4) 211 East Putnam Avenue Cos Cob, Connecticut    |  | 1995                 |  | Leased         
|                                                                 |  |                     
|Norwalk office(5) 79 New Canaan Avenue Norwalk, Connecticut      |  | 1999                 |  | Leased         
|                                                                 |  |                     
|East Norwalk office(6) 128 East Avenue Norwalk, Connecticut      |  | 2001                 |  | Leased         
|                                                                 |  |                     
|Westport office(7) 1071 Post Road East Westport, Connecticut     |  | 2001                 |  | Leased         
|                                                                 |  |                     
|New Haven Office(8) 742-756 Chapel Street New Haven, Connecticut |  | 2002                 |  | Leased         



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



|(2) | The Springdale facility is a full-service branch. The office lease provides for 1,500 square
feet of interior space with a term expiring in 2007, and renewal options for three additional 5 year terms.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(3) | The High Ridge facility is a full-service branch. The office lease provides for approximately
1,763 square feet of interior space, with a term expiring in 2005, and renewal options for two additional 5 year periods.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(4) | The Cos Cob facility is a full-service branch. The office lease provides for approximately
900 square feet of interior space with a term of 5 years expiring in 2005, and a renewal option for one additional 5 year period.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

|(5) | The Norwalk facility is a full-service branch. The office lease provides for approximately
2,200 square feet of interior space with an initial term of 5 years expiring in 2004, and renewal options for three additional 5 year periods.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(6) | The East Avenue facility is a business development office. The office lease provides for
approximately 2,800 square feet of interior space with an initial term of 5 years expiring in 2006, and a renewal option for one additional 5 year period.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(7) | The Westport facility is a full-service branch. The office lease provides for approximately
1,700 square feet of interior space with an initial term of 5 years expiring in 2006, and a renewal option for one additional 5 year period.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(8) | The New Haven facility is leased office space. The office lease provides for approximately
790 square feet of interior space with an initial term of 5 years which expires in 2007, and a renewal option for one additional 5 year period.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



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



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



No matters were submitted to a vote of security holders during the fourth quarter of 2003.



PART II



|Item 5. | Market for Common Equity and Related Stockholder Matters
|------- | --------------------------------------------------------



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



|               |  |      |       |      |   |       |  |     |       |  |   |      
|-------------- |  | ---- | ----- | ---- | - | ----- |  | --- | ----- |  | - | -----
|               |  | 2003 |       | 2002
|               |  | High |       | Low  |   | High  |  | Low
|First Quarter  |  | $    | 17.80 |      | $ | 16.27 |  | $   | 16.09 |  | $ | 14.33
|Second Quarter |  |      | 19.57 |      |   | 16.95 |  |     | 19.09 |  |   | 19.09
|Third Quarter  |  |      | 25.75 |      |   | 19.25 |  |     | 17.98 |  |   | 17.98
|Fourth Quarter |  |      | 22.25 |      |   | 19.70 |  |     | 17.00 |  |   | 17.00



As of March 1, 2004,
there were approximately 434 holders of record of the Bancorps common stock.



The transfer agent and registrar for the Bancorps common stock is American Stock Transfer & Trust Company.



Dividend Policy



The Bancorps shareholders are entitled to dividends, when and if declared by the Bancorps Board of Directors out of funds legally available
therefor. The Bancorp is not directly subject to the restrictions imposed by Connecticut law regarding the payment of dividends by a Connecticut-chartered capital stock bank. For the foreseeable future, however, the sole source of amounts available
to the Bancorp for the declaration of dividends will be dividends declared and paid by the Bank on the Banks common stock held by the Bancorp. The Bank is prohibited by Connecticut banking law from paying dividends, except from its net
profits. Net profits are defined as the remainder of all earnings from current operations plus actual recoveries on loans and



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##### Table of Contents

investments and other assets after deducting from the total thereof all current operating expenses, actual losses, accrued dividends on preferred stock, if
any, and all federal and state taxes. The total of all dividends declared by the Bank in any calendar year may not, unless specifically approved by the Banking Commissioner, exceed the total of its net profits for that year combined with its
retained net profits of the preceding two years. The Banks net profits retained in 2003 and 2002 (after cash dividends paid to the Bancorp) totaled $2,543,000. Federal statutes prohibit FDIC insured depository institutions from paying
dividends or making capital distributions that would cause the institution to fail to meet minimum capital requirements. These dividend limitations can affect the amount of dividends payable by the Bank to the Bancorp. During 2002 and 2003,
quarterly cash dividends of $530,000 and $554,000, respectively, were declared.



Equity Compensation Plan Information



|                                         |  |                                                                                        |     |  |                                                                          |       |     |                                                            |        |    
|---------------------------------------- |  | -------------------------------------------------------------------------------------- | --- |  | ------------------------------------------------------------------------ | ----- | --- | ---------------------------------------------------------- | ------ | ---
|Plan Category                            |  | Number ofsecuritiesto be issuedupon exercise ofoutstanding options,warrants and rights |     |  | Weighted averageexercise price ofoutstanding options,warrants and rights |       |     | Number ofsecurities remainingavailable for future issuance |       
|Equity plans approved by shareholders(1) |  | 185,016                                                                                | (2) |  | $                                                                        | 12.05 | (2) |                                                            | 76,789 | (3)



|(1) | As of December 31, 2003, the Company had no equity compensation plans that had not been
approved by its shareholders.
|--- | ---------------------------------------------------------------------------------------------------------------------



|(2) | Represents the number of outstanding options and the related weighted average exercise price
at December 31, 2003 for grants under the 1986 Incentive and Non-Qualified Stock Plan and the 1996 Stock Option Plan. Does not include unvested awards under the 2001 Restricted Stock Plan.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(3) | No shares are available pursuant to the 1986 Incentive and Non-Qualified Stock Plan; 24,728
shares are available for issuance under the 1996 Stock Option Plan and 52,061 shares are available for issuance under the 2001 Restricted Stock Plan. (See Note 12 to the Consolidated Financial Statements and the discussion of Executive
Compensation in the 2004 Proxy Statement.) The table does not include shares available under the Directors Compensation Plan which does not include a specific reservation of shares.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|Item 6. | Managements Discussion and Analysis or Plan of Operation
|------- | ---------------------------------------------------------



The following managements discussion and analysis presents a review of financial condition as of December 31, 2003 and 2002 and operating results
for the years then ended. All dollar amounts in this section are in thousands, except per share amounts.



CRITICAL ACCOUNTING POLICIES



In the course of the Companys normal business activity, management must select and apply many accounting policies and methodologies that lead to the financial results presented in the consolidated financial
statements. Some of these policies are more critical than others. Management considers the determination of the allowance for loan losses to be a critical accounting policy because of the uncertainty and subjectivity inherent in estimating the
levels of allowance needed to cover probable credit losses within the loan portfolio and the material effect that these estimates can have on the Companys results of operations. Estimates by management are based upon individual analysis of
credits above an internally defined threshold taking into account the industry in which the borrower operates, the financial condition of the borrower, the value of the collateral and the borrowers repayment history. While management uses the
best available information to determine the allowance for loan losses, future adjustments to the allowance may be necessary based on a variety of factors, including changes in economic and real estate market conditions, particularly in Southwestern
Fairfield County, Connecticut.



All accounting policies are
important and readers of this report should review these policies, as included in Note 1 to the Consolidated Financial Statements, to gain a greater understanding of how the Companys financial performance is reported.



FINANCIAL CONDITION



Total assets increased to $225,867 at December 31, 2003 from $212,054 at
December 31, 2002, an increase of $13,813 (or 7%). The increase in cash and cash equivalents of $28,625 was funded principally by an increase in deposits of $15,697, a decrease in loans held for sale of $6,465, net proceeds from the maturity/call of
securities of $3,712 and a decrease in net loans of $2,386.



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The Banks net loan portfolio (excluding loans held for sale) decreased to $119,089 at December 31,
2003 from $121,475 at December 31, 2002, a decrease of $2,386 (or 2%). The net decrease in the loan portfolio included decreases of $9,612 (or 21%) in loans secured by residential real estate and $143 (or 6%) in consumer and other loans. These
declines were partially offset by increases of $3,491 (or 31%) in construction loans, $2,923 (or 6%) in non-residential (commercial) real estate loans, and $1,098 (or 8%) in commercial loans. The decrease in residential loans reflects general loan
refinancing activity in addition to the payoff of five loans totaling approximately $5,400 during 2003. The increase in construction loans is primarily attributable to the origination of three new loans totaling approximately $3,200. The increase in
non-residential loans is primarily attributable to the origination of four loans totaling approximately $2,900 during 2003. Increases in commercial loans primarily reflect new loan growth.



Securities decreased to $31,589 at December 31, 2003 from $38,150 at December
31, 2002, a decrease of $6,561 (or 17%). The decrease in the securities portfolio was primarily due to cash flows from security maturities and securities called prior to maturity in the available for sale and the held to maturity portfolios, the
proceeds of which were ultimately reinvested in cash and cash equivalents. Securities held to maturity decreased to $20,510 (representing 65% of total securities) at December 31, 2003 from $26,758 (or 70%) a year earlier. Securities available for
sale decreased to $11,079 (or 35% of total securities) at December 31, 2003 from $11,392 (or 30%) at December 31, 2002. The overall portfolio continues to be comprised mostly of U.S. Government Agency securities with maturities and repricing of less
than five years. It is expected that near-term cash flows from the securities portfolio as well as a portion of cash and cash equivalents, will be used to fill in the Banks ladder of maturing securities to meet future liquidity needs.



Deposits increased to $198,718 at December 31, 2003 from
$183,021 at December 31, 2002, an increase of $15,697 (or 9%). Demand deposits decreased to $44,142 at December 31, 2003 from $46,610 at December 31, 2002, a decrease of $2,468 (or 5%). The increase of $8,065 (or 24%) in regular, club and money
market savings to $42,171 at December 31, 2003 represented a general increase in the number and balance of preferred rate savings accounts, which also pay a higher level of interest relative to regular savings accounts. The increase of $4,428 (or
13%) in money market, demand and NOW accounts to $37,233 at December 31, 2003 was primarily due to one account, which increased $3,500. Approximately $3,500 was withdrawn from the depositors account in January 2004. The decrease of $2,468 (or
5%) in non-interest bearing demand deposits to $44,142 at December 31, 2003 includes a decrease of $10,800 attributable to one account, largely offset by increased balances in internal checking accounts, which are used to fund in-clearing cashiers
checks. Time deposits increased to $75,172 at December 31, 2003 from $69,500 at December 31, 2002, an increase of $5,672 (or 8%). The largest dollar increase in time deposits occurred in 18-23 month certificates of deposit (CDs) which
increased by $8,821, followed by 12-17 month CDs which increased by $5,213, and 181-364 day CDs which increased by $622. The increases were partially offset by decreases in 91-180 day CDs which decreased $5,892; 60 month CDs
which decreased $987; and 36-47 month CDs which decreased $512.



Borrowings under securities repurchase agreements decreased by $1,183 to $4,540 at December 31, 2003, from $5,723 a year earlier.



Stockholders equity increased to $20,487 at December 31, 2003 from $19,338 at December 31, 2002, a net increase of $1,149 (or 6%). The increase
reflects net income of $1,602 for the year and $173 for shares issued in connection with stock option exercises and the Dividend Reinvestment Plan, partially offset by $554 in cash dividends declared. The ratio of stockholders equity to total
assets was 9.1% at both December 31, 2003 and 2002. Book value per common share outstanding increased to $16.55 at December 31, 2002 from $16.01 at December 31, 2002.



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##### Table of Contents

RESULTS OF OPERATIONS



General



The Companys results of operations depend primarily on its net interest income, which is the difference between the interest income on earning
assets, such as loans and securities, and the interest expense paid on deposits and borrowings. Results of operations are also affected by non-interest income and expense, the provision for loan losses and income tax expense. Non-interest income
consists primarily of gains and losses on sales of loans held for sale, banking service fees and charges, and income on bank-owned life insurance. The Companys non-interest expense consists primarily of salaries and employee benefits,
occupancy and equipment expenses, data processing expenses, professional fees, and advertising and promotion. Results of operations are also significantly affected by general economic and competitive conditions, particularly changes in market
interest rates, government policies and actions of regulatory authorities.



Net Income



Net income was $1,602 for 2003
compared to $1,820 for 2002, a decrease of $218 or 12%. Basic earnings per common share was $1.33 for 2003 compared to $1.53 for 2002 based on weighted average shares outstanding of approximately 1,202,000 and 1,191,000, respectively. Diluted
earnings per common share was $1.28 for 2003 compared to $1.48 for 2002 based on weighted average shares of approximately 1,251,000 and 1,232,000, respectively.



The most significant cause of the lower net income in 2003 was a decrease of $656 in net interest income and an increase of $395 in non-interest
expense. These factors were partially offset by an increase in noninterest income of $454, a reduction in the provision for loans losses of $267 and a reduction in income tax expense of $112.



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##### Table of Contents

The following summarizes selected statistical information for the years ended December 31:



|                                          |  |       |   |  |       |  
|----------------------------------------- |  | ----- | - |  | ----- | -
|                                          |  | 2003  |   |  | 2002  |  
|Return on average assets                  |  | 0.73  | % |  | 0.95  | %
|Return on average equity                  |  | 8.04  |   |  | 9.77  |  
|Cash dividend payout ratio                |  | 34.58 |   |  | 29.12 |  
|Ratio of average equity to average assets |  | 9.02  |   |  | 9.74  |  



Net Interest Income



Net interest income was $7,822 for 2003 compared to $8,478 for 2002, a
decrease of $656 (or 8%), driven primarily by the continuing low level of interest rates in 2003. The lower average yield on the loan and securities portfolio was partially offset by declining rates on interest bearing deposits and a higher volume
of federal funds. Total average interest-earning assets increased by $27,488 (or 16%) to $201,331 in 2003 from $173,843 in 2002. Included in the total increase in average interest-earning assets was an increase of $26,773 in comparatively lower
yielding federal funds. The increase in interest income from the higher volume of federal funds was more than offset by the effect of a decline in yield on the loan and securities portfolios from 7.83% and 4.91%, respectively, in 2002 to 7.26% and
4.15%, respectively, in 2003. Average interest-bearing liabilities increased to $152,578 in 2003 compared to $130,044 in 2002, an increase of $22,534 (or 17%). Consistent with the trend in average asset yields, the average cost of interest-bearing
liabilities continued to decline in 2003. The trend to lower rates on both assets and liabilities reflects the continuing effect of the current low interest rate environment.



The average yield on interest-earning assets decreased 125 basis points to 5.40% in 2003 from 6.65% in 2002. The continued
general decline in the level of market interest rates during 2003 also directly impacted yields on the Companys time deposits and other interest-bearing deposits, as the average rate paid on interest-bearing liabilities dropped 40 basis points
from 2.38% in 2002 to 1.98% in 2003. The interest rate spread, which is the yield rate on interest-earning assets minus the rate paid on interest-bearing liabilities, decreased by 85 basis points to 3.42% in 2003 from 4.27% in 2002. The net interest
margin, representing the net yield on earning assets (net interest income as a percent of total interest-earning assets), decreased by 98 basis points to 3.90% in 2003 from 4.88% in 2002.



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##### Table of Contents

The following table sets forth average balance sheet amounts for 2003 and 2002, together with the average
yield on interest-earning assets and the average cost of interest-bearing liabilities for the periods. Yields and costs were derived by dividing interest income or expense by the average daily balance of assets or liabilities, respectively.
Non-accrual loans were included in the computation of average balances, but have been reflected in the table as loans carrying a zero yield. The yield rates include the effect of deferred loan fees and costs, and securities discounts and premiums,
which are included in interest income. Average balances of securities are based on amortized cost. Yields on tax-exempt securities are stated on a fully taxable-equivalent (FTE) basis using a tax rate of 38.5%.



|                                                                                 |  |                        |         |   |          |   |        |            |  |      |                |  |   |          |   |            |   |        |  |      |  
|-------------------------------------------------------------------------------- |  | ---------------------- | ------- | - | -------- | - | ------ | ---------- |  | ---- | -------------- |  | - | -------- | - | ---------- | - | ------ |  | ---- | -
|                                                                                 |  | 2003                   |         |   | 2002     |  
|                                                                                 |  | AverageBalance         |         |   | Interest |   |        | Yield/Cost |  |      | AverageBalance |  |   | Interest |   | Yield/Cost |  
|                                                                                 |  | (dollars in thousands) |        
|Assets                                                                           |  |                        |         |   |          |   |        |            |  |      |                |  |   |          |   |            |   |        |  |      |  
|Interest-earning assets:                                                         |  |                        |         |   |          |   |        |            |  |      |                |  |   |          |   |            |   |        |  |      |  
|Loans                                                                            |  | $                      | 121,624 |   |          | $ | 8,831  |            |  | 7.26 | %              |  | $ | 120,309  |   |            | $ | 9,423  |  | 7.83 | %
|Securities                                                                       |  |                        | 38,497  |   |          |   | 1,597  |            |  | 4.15 |                |  |   | 39,096   |   |            |   | 1,921  |  | 4.91 |  
|Federal funds sold                                                               |  |                        | 41,210  |   |          |   | 443    |            |  | 1.07 |                |  |   | 14,438   |   |            |   | 224    |  | 1.55 |  
|                                                                                 |  |                        |         |   |          |   |        |            |  |      |                |  |   |          |   |            |   |        |  |      |  
|Total interest-earning assets                                                    |  |                        | 201,331 |   |          |   | 10,871 |            |  | 5.40 |                |  |   | 173,843  |   |            |   | 11,568 |  | 6.65 |  
|                                                                                 |  |                        |         |   |          |   |        |            |  |      |                |  |   |          |   |            |   |        |  |      |  
|Non-interest earning assets:                                                     |  |                        |         |   |          |   |        |            |  |      |                |  |   |          |   |            |   |        |  |      |  
|Cash and due from banks                                                          |  |                        | 9,645   |   |          |   |        |            |  |      |                |  |   | 10,206   |   |            |   |        |  |      |  
|Premises and equipment                                                           |  |                        | 2,992   |   |          |   |        |            |  |      |                |  |   | 2,936    |   |            |   |        |  |      |  
|Other assets                                                                     |  |                        | 9,178   |   |          |   |        |            |  |      |                |  |   | 6,148    |   |            |   |        |  |      |  
|Allowance for loan losses                                                        |  |                        | (2,402  | ) |          |   |        |            |  |      |                |  |   | (1,987   | ) |            |   |        |  |      |  
|                                                                                 |  |                        |         |   |          |   |        |            |  |      |                |  |   |          |   |            |   |        |  |      |  
|Total assets                                                                     |  | $                      | 220,744 |   |          |   |        |            |  |      |                |  | $ | 191,146  |   |            |   |        |  |      |  
|                                                                                 |  |                        |         |   |          |   |        |            |  |      |                |  |   |          |   |            |   |        |  |      |  
|Liabilities and Stockholders Equity:                                            |  |                        |         |   |          |   |        |            |  |      |                |  |   |          |   |            |   |        |  |      |  
|Interest-bearing liabilities:                                                    |  |                        |         |   |          |   |        |            |  |      |                |  |   |          |   |            |   |        |  |      |  
|NOW accounts                                                                     |  | $                      | 27,513  |   |          | $ | 76     |            |  | 0.27 | %              |  | $ | 27,123   |   |            | $ | 73     |  | 0.27 | %
|Money market accounts                                                            |  |                        | 4,019   |   |          |   | 43     |            |  | 1.08 |                |  |   | 4,063    |   |            |   | 46     |  | 1.13 |  
|Regular, club, cash management                                                   |  |                        | 8,141   |   |          |   | 86     |            |  | 1.05 |                |  |   | 7,146    |   |            |   | 82     |  | 1.15 |  
|Preferred rate savings                                                           |  |                        | 29,284  |   |          |   | 387    |            |  | 1.32 |                |  |   | 26,103   |   |            |   | 389    |  | 1.49 |  
|Time deposits                                                                    |  |                        | 77,465  |   |          |   | 2,351  |            |  | 3.04 |                |  |   | 59,663   |   |            |   | 2,420  |  | 4.06 |  
|Repurchase agreements                                                            |  |                        | 6,122   |   |          |   | 72     |            |  | 1.17 |                |  |   | 5,889    |   |            |   | 79     |  | 1.34 |  
|Other                                                                            |  |                        | 34      |   |          |   |       |            |  | 0.50 |                |  |   | 57       |   |            |   | 1      |  | 1.75 |  
|                                                                                 |  |                        |         |   |          |   |        |            |  |      |                |  |   |          |   |            |   |        |  |      |  
|Total interest-bearing liabilities                                               |  |                        | 152,578 |   |          |   | 3,015  |            |  | 1.98 |                |  |   | 130,044  |   |            |   | 3,090  |  | 2.38 |  
|                                                                                 |  |                        |         |   |          |   |        |            |  |      |                |  |   |          |   |            |   |        |  |      |  
|Non-interest bearing liabilities:                                                |  |                        |         |   |          |   |        |            |  |      |                |  |   |          |   |            |   |        |  |      |  
|Demand deposits                                                                  |  |                        | 46,145  |   |          |   |        |            |  |      |                |  |   | 40,919   |   |            |   |        |  |      |  
|Other                                                                            |  |                        | 2,108   |   |          |   |        |            |  |      |                |  |   | 1,559    |   |            |   |        |  |      |  
|                                                                                 |  |                        |         |   |          |   |        |            |  |      |                |  |   |          |   |            |   |        |  |      |  
|Total non-interest bearing liabilities                                           |  |                        | 48,253  |   |          |   |        |            |  |      |                |  |   | 42,478   |   |            |   |        |  |      |  
|                                                                                 |  |                        |         |   |          |   |        |            |  |      |                |  |   |          |   |            |   |        |  |      |  
|Stockholders equity                                                             |  |                        | 19,913  |   |          |   |        |            |  |      |                |  |   | 18,624   |   |            |   |        |  |      |  
|                                                                                 |  |                        |         |   |          |   |        |            |  |      |                |  |   |          |   |            |   |        |  |      |  
|Total liabilities & stockholders equity                                         |  | $                      | 220,744 |   |          |   |        |            |  |      |                |  | $ | 191,146  |   |            |   |        |  |      |  
|                                                                                 |  |                        |         |   |          |   |        |            |  |      |                |  |   |          |   |            |   |        |  |      |  
|Net interest income (FTE basis)                                                  |  |                        |         |   |          |   | 7,856  |            |  |      |                |  |   |          |   |            |   | 8,478  |  |      |  
|Less: Fully taxable equivalent adjustment                                        |  |                        |         |   |          |   | (34    | )          |  |      |                |  |   |          |   |            |   |       |  |      |  
|                                                                                 |  |                        |         |   |          |   |        |            |  |      |                |  |   |          |   |            |   |        |  |      |  
|Net interest income (reported in the consolidated statements of income)          |  |                        |         |   |          | $ | 7,822  |            |  |      |                |  |   |          |   |            | $ | 8,478  |  |      |  
|                                                                                 |  |                        |         |   |          |   |        |            |  |      |                |  |   |          |   |            |   |        |  |      |  
|Interest rate spread                                                             |  |                        |         |   |          |   |        |            |  | 3.42 | %              |  |   |          |   |            |   |        |  | 4.27 | %
|                                                                                 |  |                        |         |   |          |   |        |            |  |      |                |  |   |          |   |            |   |        |  |      |  
|Net interest margin                                                              |  |                        |         |   |          |   |        |            |  | 3.90 | %              |  |   |          |   |            |   |        |  | 4.88 | %
|                                                                                 |  |                        |         |   |          |   |        |            |  |      |                |  |   |          |   |            |   |        |  |      |  
|Ratio of average interest-earning assets to average interest-bearing liabilities |  |                        | 131.95  | % |          |   |        |            |  |      |                |  |   | 133.68   | % |            |   |        |  |      |  
|                                                                                 |  |                        |         |   |          |   |        |            |  |      |                |  |   |          |   |            |   |        |  |      |  



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##### Table of Contents

The following table sets forth the dollar amount of changes in interest income, interest expense and net
interest income for 2003 compared to 2002. Information is provided for each category of interest-earning assets and interest-bearing liabilities, with respect to (i) changes attributable to rate (i.e., changes in rate multiplied by prior-period
balances) and (ii) changes attributable to changes in volume (i.e., changes in balances multiplied by the prior-period rate). Changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately to the change
due to volume and the change due to rate, based on the relative dollar amounts of the volume and rate changes.



|                                          |  |                            |        |   |        |   |      |       |  |   |      |  
|----------------------------------------- |  | -------------------------- | ------ | - | ------ | - | ---- | ----- |  | - | ---- | -
|                                          |  | Increase (Decrease) Due To |       
|                                          |  | Rate                       |        |   | Volume |   |      | Total | 
|                                          |  | (in thousands)             |       
|Interest Income (FTE Basis):              |  |                            |        |   |        |   |      |       |  |   |      |  
|Loans                                     |  | $                          | (694   | ) |        | $ | 102  |       |  | $ | (592 | )
|Securities                                |  |                            | (290   | ) |        |   | (34  | )     |  |   | (324 | )
|Federal funds sold                        |  |                            | (87    | ) |        |   | 306  |       |  |   | 219  |  
|                                          |  |                            |        |   |        |   |      |       |  |   |      |  
|Total interest-earning assets             |  | $                          | (1,071 | ) |        | $ | 374  |       |  | $ | (697 | )
|                                          |  |                            |        |   |        |   |      |       |  |   |      |  
|Interest Expense:                         |  |                            |        |   |        |   |      |       |  |   |      |  
|NOW accounts                              |  | $                          | 1      |   |        | $ | 2    |       |  | $ | 3    |  
|Money market accounts                     |  |                            | (2     | ) |        |   | (1   | )     |  |   | (3   | )
|Regular, club, cash management            |  |                            | (7     | ) |        |   | 11   |       |  |   | 4    |  
|Preferred rate savings                    |  |                            | (47    | ) |        |   | 45   |       |  |   | (2   | )
|Time deposits                             |  |                            | (692   | ) |        |   | 623  |       |  |   | (69  | )
|Repurchase agreements                     |  |                            | (10    | ) |        |   | 3    |       |  |   | (7   | )
|Other                                     |  |                            |       |   |        |   | (1   | )     |  |   | (1   | )
|                                          |  |                            |        |   |        |   |      |       |  |   |      |  
|Total interest-bearing liabilities        |  | $                          | (757   | ) |        | $ | 682  |       |  | $ | (75  | )
|                                          |  |                            |        |   |        |   |      |       |  |   |      |  
|Change in Net Interest Income (FTE Basis) |  | $                          | (314   | ) |        | $ | (308 | )     |  | $ | (622 | )
|                                          |  |                            |        |   |        |   |      |       |  |   |      |  



Interest Income



Average interest-earning assets for 2003 were $201,331 compared to $173,843
for 2002, an increase of $27,488 (or 16%). Total interest income, which is a function of the volume of interest-earning assets and their related rates, was $10,871 (FTE basis) in 2003 and $11,568 in 2002, representing a decrease of $697 (or 6%).



Loans represent the largest component of interest-earning
assets. Average loans outstanding in 2003 were $121,624 compared to $120,309 in 2002, a 1% increase. Interest on loans was $8,831 in 2003 compared to $9,423 in 2002, a 6% decrease. The average yield on loans decreased to 7.26% in 2003 as compared to
7.83% in 2002, primarily reflecting the effect of the continued low interest rates in 2003.



Average investments in securities and Federal funds sold totaled $79,707 for 2003 compared to $53,534 for 2002, an increase of $26,173 (or 49%). Average
securities decreased by $599 (or 2%) in 2003, and average Federal funds sold increased by $26,772 (or 185%). Interest income on securities and Federal funds sold decreased to a total of $2,040 (FTE basis) for 2003 from $2,145 for 2002, a net
decrease of $105 (or 5%), consisting of a $324 decrease in income on securities and a $219 increase in income on Federal funds. The increased income on Federal funds sold primarily resulted from higher average balances attributable to an increase of
$22,534 in average deposits. This increase in income attributable to the higher volume of Federal funds was partially offset by the decline in the average yield from 1.55% in 2002 to 1.07% in 2003. The average yield on securities decreased to 4.15%
in 2003 from 4.91% in 2002, also reflecting continued low market interest rates.



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##### Table of Contents

Interest Expense



Interest expense was $3,015 for 2003 compared to $3,090 for 2002, a 2% decrease. Interest expense is a function of the volume of interest-bearing
liabilities and their related rates. Average interest-bearing liabilities were $152,578 in 2003 compared to $130,044 in 2002, an increase of $22,534 (or 17%). The average cost of total interest-bearing liabilities decreased by 40 basis points, to
1.98% in 2003 from 2.38% in 2002, reflecting the continued low market interest rates.



The growth in average interest-bearing liabilities in 2003 compared to 2002 was primarily due to time deposits (growth of $17,802) and, to a lesser extent, preferred rate savings accounts (growth of $3,181). The 30%
increase in average time deposits reflects the competitive rates offered by the Bank during 2003.



Provision for Loan Losses



The periodic provision for loan losses represents the amount necessary to adjust the allowance for loan losses to managements estimate of probable credit losses inherent in the existing loan portfolio at the reporting date.
Managements determination of the allowance for loan losses is based on the results of continuing reviews of individual loans and borrower relationships, particularly in the commercial and commercial real estate loan portfolios. A review of the
quality of the loan portfolio is conducted internally by management on a quarterly basis, using a consistently-applied methodology, and the results are presented to the Board of Directors for approval. The evaluation covers individual borrowers
whose aggregate loans are greater than $100, as well as all adversely-classified loans. Management also considers factors such as the borrowers financial condition, historical and expected ability to make loan payments, and underlying
collateral values. The determination of the allowance for loan losses also considers the level of past due loans, the Banks historical loan loss experience, changes in loan portfolio mix, geographic and borrower concentrations, and current
economic conditions. The allowance for loan losses is also adjusted for charge-offs and recoveries.



The allowance for loan losses was $2,387 at December 31, 2003 and $2,234 at December 31, 2002, and the provision for loan losses was $96 and $363 for the
years then ended. Net recoveries credited to the allowance were $57 in 2003 and $23 in 2002. The allowance for loan losses represented 1.95% and 1.81% of total loans at December 31, 2003 and 2002, respectively. The percentage of the allowance to
total non-performing loans increased to 210% at December 31, 2003 from 126% at December 31, 2002. The lower provision for loan losses in 2003 compared to 2002 reflects the slowdown in loan growth and continuation of favorable asset quality trends,
particularly the low levels of charge-offs and non-performing loans, as well as improving economic conditions in the Companys market area. Refer to footnote 4 of the Consolidated Statements of Condition of Cornerstone Bancorp, Inc. and
subsidiary as of December 31, 2003 and 2002.



While management
uses the best available information to determine the allowance for loan losses, future adjustments to the allowance may be necessary based on changes in economic and real estate market conditions, particularly in the Banks service area of
Southwestern Fairfield County, Connecticut. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Banks allowance for loan losses. Such agencies may require the Bank to recognize
adjustments to the allowance based on their judgments of information available at the time of their examination.



Non-interest Income



Total non-interest income was $2,514 for 2003, compared to $2,060 for 2002, an increase of $454 or 22%. The $1,144 gain on sale of loans and loan
servicing in 2003 relates principally to the sale of participating interests in SBA loans and, to a lesser extent, the sale of newly originated residential mortgage loans. Income from deposit service charges decreased by $60 (12%) to $447 in 2003
from $507 in 2002, primarily due to a



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##### Table of Contents

decline in customer overdraft activity. Income from bank-owned life insurance rose to $198 in 2003 from $153 in 2002, reflecting a full year of income in
2003 on the policies purchased in March 2002.



Non-interest Expense



Total non-interest expenses were $7,635 for 2003 and
$7,240 for 2002, an increase of $395, or 5%. The following table summarizes the dollar amounts for each category of non-interest expense, and the dollar and percent changes in 2003 compared to 2002.



|                               |  |                        |       |      |   |                                |  |   |     |   |  |     |  
|------------------------------ |  | ---------------------- | ----- | ---- | - | ------------------------------ |  | - | --- | - |  | --- | -
|                               |  |                        |       |      |   | Increase(Decrease)2003 vs.2002 | 
|                               |  | 2003                   |       | 2002 |   | $                              |  |   | %   |  
|                               |  | (dollars in thousands) |      
|Salaries and employee benefits |  | $                      | 4,381 |      | $ | 4,009                          |  | $ | 372 |   |  | 9   | %
|Occupancy                      |  |                        | 680   |      |   | 768                            |  |   | (88 | ) |  | (11 | )
|Furniture and equipment        |  |                        | 431   |      |   | 390                            |  |   | 41  |   |  | 11  |  
|Data processing                |  |                        | 549   |      |   | 564                            |  |   | (15 | ) |  | (3  | )
|Professional fees              |  |                        | 393   |      |   | 304                            |  |   | 89  |   |  | 29  |  
|Advertising and promotion      |  |                        | 176   |      |   | 204                            |  |   | (28 | ) |  | (14 | )
|Other                          |  |                        | 1,025 |      |   | 1,001                          |  |   | 24  |   |  | 2   |  
|                               |  |                        |       |      |   |                                |  |   |     |   |  |     |  
|Total non-interest expense     |  | $                      | 7,635 |      | $ | 7,240                          |  | $ | 395 |   |  | 5   | %
|                               |  |                        |       |      |   |                                |  |   |     |   |  |     |  



The increase in
salaries and employee benefits includes the addition of two employees, salary increases, staff and executive bonuses, and a combined increase of $258 in expenses related to the salary continuation plan and restricted stock plan for executive
officers. The increase in professional fees is primarily due to increased consulting expense. These increases were partially offset by a decrease in occupancy due to the reduction in rent expense resulting from the closure of the West Broad Street
office in November 2002, and a decrease in advertising and promotion expense.



The following is an analysis of the major categories of non-interest expense as a percentage of total operating income (interest income plus non-interest income):



|                               |  |       |   |  |       |  
|------------------------------ |  | ----- | - |  | ----- | -
|                               |  | 2003  |   |  | 2002  |  
|Salaries and employee benefits |  | 32.81 | % |  | 29.42 | %
|Occupancy                      |  | 5.09  |   |  | 5.64  |  
|Furniture and equipment        |  | 3.23  |   |  | 2.86  |  
|Data processing                |  | 4.11  |   |  | 4.14  |  
|Professional fees              |  | 2.94  |   |  | 2.23  |  
|Advertising and promotion      |  | 1.32  |   |  | 1.50  |  
|Other                          |  | 7.68  |   |  | 7.34  |  
|                               |  |       |   |  |       |  
|Total non-interest expense     |  | 57.19 | % |  | 53.13 | %
|                               |  |       |   |  |       |  



LIQUIDITY, INTEREST
RATE SENSITIVITY AND CAPITAL RESOURCES



Liquidity



The objective of the Companys liquidity management is to ensure the
availability of sufficient cash flows to meet all financial commitments and to capitalize on opportunities for expansion. Liquidity management addresses the Companys ability to meet deposit withdrawals on demand or at contractual maturity, to
repay borrowings as they mature, and to fund new loans and investments as opportunities arise.



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##### Table of Contents

The Companys liquidity sources described below are anticipated to be sufficient to fund deposit
withdrawals, loan commitments and other obligations existing as of December 31, 2003.



At December 31, 2003, short term investments, which are made up of federal funds sold, available for sale securities and held to maturity securities due or callable in one year or less, totaled $67,165. Primary
liquidity of the Company is measured by the ratio of net cash, short term investments and other marketable assets to deposits and short term liabilities. The primary liquidity ratio at December 31, 2003 was 37.29%, compared to 17.89% at December 31,
2002. The Bank also calculates a secondary liquidity ratio which contemplates loan payoffs for the forthcoming year and the maturity of available for sale securities and held to maturity securities beyond one year. The Banks secondary
liquidity ratio at December 31, 2002 was 51.63%, compared to 34.92% at December 31, 2002. The Banks internal guideline is to generally maintain a primary liquidity ratio of 10 to 15% and a secondary liquidity ratio of 20% or more. The
Banks actual primary and secondary liquidity ratios have recently been higher than these guidelines due to the high level of federal funds. Management anticipates lower ratios as lending and investment opportunities arise.



The Companys funding at December 31, 2003 consisted of deposit
liabilities and, to a much lesser extent, short-term borrowings. If the Bank requires funds beyond its internal funding capabilities, advances are available from the FHLB of Boston. At December 31, 2003, the Banks available FHLB borrowing
capacity in the form of advances and a short-term line of credit was $12,264. At December 31, 2003, certificates of deposit scheduled to mature within one year totaled $57,348. The Banks experience has been that a majority of its maturing
certificate of deposit accounts are renewed.



The
following table shows the contractual obligations of the Company by contractual payment period as of December 31, 2003. Further discussions of the borrowings and operating leases are included in Notes 7 and 9 to the Consolidated Financial Statements
included in Item 7 of this report.



|                                               |  |                  |        |                    |   |                     |  |                 |     |       |   |       |  |   |       
|---------------------------------------------- |  | ---------------- | ------ | ------------------ | - | ------------------- |  | --------------- | --- | ----- | - | ----- |  | - | ------
|                                               |  | One year or less |        | One to three years |   | Three to five Years |  | Over five years |     | Total
|Securities sold under agreements to repurchase |  | $                | 4,540  |                    | $ |                    |  | $               |    |       | $ |      |  | $ | 4,540 
|Obligations under operating leases             |  |                  | 346    |                    |   | 385                 |  |                 | 32  |       |   |      |  |   | 763   
|Commitments to originate loans                 |  |                  | 1,280  |                    |   |                    |  |                 |    |       |   |      |  |   | 1,280 
|Commitments to fund unused lines of credit     |  |                  | 8,922  |                    |   | 4,881               |  |                 | 439 |       |   | 1,255 |  |   | 15,497
|Purchased services                             |  |                  | 372    |                    |   | 488                 |  |                 |    |       |   |      |  |   | 860   
|                                               |  |                  |        |                    |   |                     |  |                 |     |       |   |       |  |   |       
|Total                                          |  | $                | 15,460 |                    | $ | 5,754               |  | $               | 471 |       | $ | 1,255 |  | $ | 22,940
|                                               |  |                  |        |                    |   |                     |  |                 |     |       |   |       |  |   |       



The obligations under
operating leases relate to banking facilities that are leased by the Company. These leases are generally for five year terms with renewal clauses. See Item 2, Description of Property, for additional information.



In the normal course of business, the Company enters into various data
processing services and other service agreements, which are included as purchased services in the above table. These agreements specify both fixed fees and variable fees based upon usage. The agreements generally have initial terms
ranging from three to five years and are cancelable with notice to the vendors.



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As reported in the Consolidated Statements of Cash Flows, the Companys cash flows are classified as
operating, investing, or financing. Net cash provided by (used in) operating activities was $9,220 for the year ended December 31, 2003 compared to ($2,856) for the year ended December 31, 2002, primarily due to the net effect of originations and
sales of loans held for sale, which provided cash of $7,783 in 2003 but used cash of $5,264 in 2002. Investing activities provided cash of $5,268 in 2003 and used cash of $13,093 in 2002, a differential of $18,361. Cash used to fund net loan
disbursements and bank-owned life insurance decreased $20,151 and $3,894, respectively, in 2003 compared to 2002. Cash used to purchase securities increased $11,836 for the year ended December 31, 2003 compared to the year ended December 31, 2002.
These factors were partially offset by the effect of the proceeds from maturities and calls of securities which increased from $11,919 in 2002 to $18,231 in 2003. The decrease of $11,717 in net cash provided by financing activities for the year
ended December 31, 2003 primarily resulted from a decrease of $12,851 in cash provided by deposits. Cash and cash equivalents increased $28,625 during 2003 to $62,829 at year end, principally in Federal funds sold which increased by $24,100 to
$47,000.



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##### Table of Contents

Interest Rate Sensitivity



The following table sets forth (i) the maturity or repricing distribution of interest-earning assets and interest-bearing
liabilities as of December 31, 2003, (ii) the interest rate sensitivity gap (i.e., interest-sensitive assets less interest-sensitive liabilities), (iii) the cumulative interest rate sensitivity gap, (iv) the ratio of cumulative total
interest-earning assets to cumulative total interest-bearing liabilities, and (iv) the cumulative interest rate sensitivity gap ratio. For purposes of the table, an asset or liability is considered rate sensitive within a specified period when it
matures or could be repriced within such period in accordance with its contractual terms. Debt securities are placed in maturity periods based upon their projected call date, where applicable. Adjustable rate loans are included based on the period
to next repricing date, while principal payments on fixed rate loans are factored into monthly maturity data or at final maturity. Based on managements evaluation of the interest rate sensitivity of regular savings, preferred rate savings, NOW
and money market demand accounts, such balances have been included in the column for liabilities repricing after 1 but within 5 years.



|                                                                                                                             |  |                           |         |   |                  |   |        |           |  |   |             |   |  |       |        |   |  |   |        
|---------------------------------------------------------------------------------------------------------------------------- |  | ------------------------- | ------- | - | ---------------- | - | ------ | --------- |  | - | ----------- | - |  | ----- | ------ | - |  | - | -------
|                                                                                                                             |  | Interest Rate Sensitivity
|                                                                                                                             |  | Within 6Months            |         |   | 6 Months -1 Year |   |        | 1-5 Years |  |   | Over 5Years |   |  | Total
|Interest-earning assets:                                                                                                     |  |                           |         |   |                  |   |        |           |  |   |             |   |  |       |        |   |  |   |        
|Federal funds sold and securities                                                                                            |  | $                         | 55,254  |   |                  | $ | 4,228  |           |  | $ | 15,139      |   |  | $     | 3,968  |   |  | $ | 78,589 
|Loans(1):                                                                                                                    |  |                           |         |   |                  |   |        |           |  |   |             |   |  |       |        |   |  |   |        
|Adjustable rate                                                                                                              |  |                           | 53,179  |   |                  |   |       |           |  |   |            |   |  |       |       |   |  |   | 53,179 
|Fixed rate                                                                                                                   |  |                           | 7,654   |   |                  |   | 7,881  |           |  |   | 37,880      |   |  |       | 14,621 |   |  |   | 68,036 
|                                                                                                                             |  |                           |         |   |                  |   |        |           |  |   |             |   |  |       |        |   |  |   |        
|Total interest-earning assets                                                                                                |  |                           | 116,087 |   |                  |   | 12,109 |           |  |   | 53,019      |   |  |       | 18,589 |   |  |   | 199,804
|                                                                                                                             |  |                           |         |   |                  |   |        |           |  |   |             |   |  |       |        |   |  |   |        
|Interest-bearing liabilities:                                                                                                |  |                           |         |   |                  |   |        |           |  |   |             |   |  |       |        |   |  |   |        
|Money market demand and NOW accounts                                                                                         |  |                           |        |   |                  |   |       |           |  |   | 37,233      |   |  |       |       |   |  |   | 37,233 
|Regular, club and preferred rate savings accounts                                                                            |  |                           |        |   |                  |   | 46     |           |  |   | 42,125      |   |  |       |       |   |  |   | 42,171 
|Time accounts                                                                                                                |  |                           | 38,143  |   |                  |   | 19,205 |           |  |   | 17,814      |   |  |       | 10     |   |  |   | 75,172 
|                                                                                                                             |  |                           |         |   |                  |   |        |           |  |   |             |   |  |       |        |   |  |   |        
|Total interest-bearing deposits                                                                                              |  |                           | 38,143  |   |                  |   | 19,251 |           |  |   | 97,172      |   |  |       | 10     |   |  |   | 154,576
|Repurchase agreements                                                                                                        |  |                           | 4,540   |   |                  |   |       |           |  |   |            |   |  |       |       |   |  |   | 4,540  
|                                                                                                                             |  |                           |         |   |                  |   |        |           |  |   |             |   |  |       |        |   |  |   |        
|Total interest-bearing liabilities                                                                                           |  |                           | 42,683  |   |                  |   | 19,251 |           |  |   | 97,172      |   |  |       | 10     |   |  |   | 159,116
|                                                                                                                             |  |                           |         |   |                  |   |        |           |  |   |             |   |  |       |        |   |  |   |        
|Total interest-earning assets less interest-bearing liabilities for the period                                               |  | $                         | 73,404  |   |                  | $ | (7,142 | )         |  | $ | (44,153     | ) |  | $     | 18,579 |   |  | $ | 40,688 
|                                                                                                                             |  |                           |         |   |                  |   |        |           |  |   |             |   |  |       |        |   |  |   |        
|Cumulative total Interest-earning assets less Interest-bearing liabilities                                                   |  | $                         | 73,404  |   |                  | $ | 66,262 |           |  | $ | 22,109      |   |  | $     | 40,688 |   |  |   |        
|                                                                                                                             |  |                           |         |   |                  |   |        |           |  |   |             |   |  |       |        |   |  |   |        
|Cumulative total interest-earning assets less interest-bearing liabilities, as a percentage of total interest-earning assets |  |                           | 36.74   | % |                  |   | 33.16  | %         |  |   | 11.07       | % |  |       | 20.36  | % |  |   |        
|                                                                                                                             |  |                           |         |   |                  |   |        |           |  |   |             |   |  |       |        |   |  |   |        



|(1) | Excludes loans on non-accrual status, overdrafts and loans held for sale.
|--- | -------------------------------------------------------------------------



The tabular presentation of the Companys interest sensitivity position indicates that for the period up to one year
following December 31, 2003, the cumulative amount of interest-earning assets expected to reprice is greater than the cumulative amount of interest-bearing liabilities expected to reprice. Accordingly, the Company may experience a decrease in its
net interest margin if interest rates were to decline during this period, and an increase in net interest margin if interest rates were to increase. From greater than six months through one year and greater than one year through five years, more
interest-bearing liabilities are expected to reprice than interest-earning assets; therefore, the Company would experience a decrease in its net interest margin in a rising rate environment and an increase in its net interest margin in a declining
rate environment.



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##### Table of Contents

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



Capital Resources



At December 31, 2003 and 2002, the Banks leverage capital ratio was 9.7% and 9.2%, respectively. At December 31, 2003 and 2002, the Banks Tier
1 risk-based capital ratio was 13.7% and 13.0%, respectively, and its total-risk based capital ratio was 15.0% and 14.2%, respectively. These ratios exceeded the stated minimum regulatory requirements for capital adequacy and for classification as a
well-capitalized institution. The Bancorps consolidated capital ratios at December 31, 2003 and 2002 were substantially the same as the Banks ratios.



IMPACT OF INFLATION AND CHANGING PRICES



The Consolidated Financial Statements and related Notes have been prepared in conformity with accounting principles
generally accepted in the United States of America, which generally require the measurement of financial position and operating results in terms of historical dollars without considering the change in the relative purchasing power of money over time
due to inflation. The impact of inflation is reflected in the increased cost of the Companys operations. Unlike industrial companies, nearly all the assets and liabilities of the Company are financial. As a result, the Companys net
income is directly impacted by changes in interest rates, which are influenced by inflationary expectations. Changes in interest rates do not necessarily move to the same extent as changes in prices of goods and services. The Companys ability
to match the interest sensitivity of its financial assets to the interest sensitivity of its financial liabilities as part of its interest rate risk management program may reduce the effect which changes in interest rates have on net income.
Liquidity and maturity structure of the Companys assets and liabilities are critical to the maintenance of acceptable levels of net income and there is no assurance the Company will be successful in doing so.



|Item 7. | Financial Statements
|------- | --------------------



The Consolidated Statements of Condition of Cornerstone Bancorp, Inc. and subsidiary as of December 31, 2003 and 2002, and the related Consolidated Statements of Income, Stockholders Equity, and Cash Flows for the years then ended,
together with the related notes and the report of KPMG LLP, independent auditors, are included herein on pages F-1 through F-28.



|Item 8. | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
|------- | ------------------------------------------------------------------------------------



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



|Item 8A. | Controls and Procedures
|-------- | -----------------------



An evaluation of the effectiveness of the design and operation of the Companys disclosure controls and procedures was conducted as of December 31, 2003 under the supervision and with the participation of the Chief Executive Officer
and Chief Financial Officer. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that the Companys disclosure controls and procedures were adequate and designed to ensure that information required
to be disclosed by the Company in this report is recorded, processed, summarized and reported in a timely manner, including that such information is accumulated and



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---

##### Table of Contents

communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required
disclosure.



During the fourth quarter of 2003, there were no
changes in internal control over financial reporting that materially affected, or are reasonably likely to materially affect, the Companys internal control over financial reporting.



Reference is made to the Certifications of the Chief Executive Officer and Chief Financial Officer about these and other
matters included as exhibits to this report.



PART III



|Item 9. | Directors, Executive Officers, Promoters and Control Persons; Compliance with Section 16(a) of the Exchange Act
|------- | ---------------------------------------------------------------------------------------------------------------



Information regarding the Bancorps directors is incorporated by reference herein to the Bancorps Proxy Statement for its Annual Meeting of
Shareholders to be held on May 26, 2004 (the 2004 Proxy Statement). Information regarding the Bancorps executive officers is included as Item 1A in Part I of this Form 10-KSB.



|Item 10. | Executive Compensation
|-------- | ----------------------



Information regarding the compensation of the Bancorps executive officers is incorporated by reference herein to the 2004 Proxy Statement.



|Item 11. | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
|-------- | ----------------------------------------------------------------------------------------------



Information regarding the beneficial ownership of the Bancorps common stock by certain persons is incorporated by reference herein to the 2004 Proxy
Statement. Equity Compensation Plan information is provided in Item 5 to this Form 10-KSB.



|Item 12. | Certain Relationships and Related Transactions
|-------- | ----------------------------------------------



Information regarding certain transactions involving the Bancorp is incorporated by reference herein to the 2004 Proxy Statement.



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



(a) Exhibits



|            |  |                                                                                                                                                                                                                 
|----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                                                     
|            | 
|2.1         |  | Agreement and Plan of Reorganization dated as of August 19, 1998 between Cornerstone Bank and Cornerstone Bancorp, Inc. (Exhibit 2.1 to Form 8-K12G3 dated March 1, 1999, File No. 0-25465
(Form 8-K12G3)) (1)
|            | 
|3.1         |  | Certificate of Incorporation of Cornerstone Bancorp, Inc. (Exhibit 4.1 to Form 8-K12G3) (1)                                                                                                                     
|            | 
|3.2         |  | Bylaws of Cornerstone Bancorp, Inc. (Exhibit 4.2 to Form 8-K12G3) (1)                                                                                                                                           



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|       |  |                                                                                                                                                                                                                                                             
|------ |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|       | 
|4.1    |  | Form of Specimen Common Stock Certificate of Cornerstone Bancorp, Inc. (Exhibit 4.3 to Form 8-K12G3) (1)                                                                                                                                                    
|       | 
|10.1   |  | Lease agreement dated as of January 19, 1989 between First National Bank of Stamford and Joseph F. Calve Family Trust (Exhibit 2 to Cornerstone Banks Registration Statement on Form F-1
filed with the FDIC) (1)                                          
|       | 
|10.2   |  | Lease agreement dated as of May 16, 1995 between Cornerstone Bank and Mill Pond Company (Exhibit 3(ii) to Cornerstone Banks Form F-2 for the year ended December 31, 1994 filed with the
FDIC) (1)                                                         
|       | 
|10.3   |  | Lease agreement dated as of November 29, 1996 between Cornerstone Bank and John P. Rossi (Exhibit 3(vii) to Cornerstone Banks Form F-2 for the year ended December 31, 1996 filed with
the FDIC) (1)                                                       
|       | 
|10.4   |  | Lease agreement dated as of December 22, 1998 between Cornerstone Bank and Ralph Sandolo (Exhibit 10.4 to Cornerstone Bancorp, Inc.s Form 10-KSB for the year ended December 31, 1998)
(1)                                                                 
|       | 
|10.5   |  | Cornerstone Bancorp, Inc. 1986 Incentive and Non-Qualified Stock Option Plan (Exhibit 99.1 to Registration Statement on Form S-8 Registration No. 333-73129)(Form S-8)
(1)                                                                                
|       | 
|10.6   |  | Cornerstone Bancorp, Inc. 1996 Stock Plan (Exhibit 99.1 to Registration statement on Form S-8 Registration No. 333-67298) (1)                                                                                                                               
|       | 
|10.7   |  | Cornerstone Bancorp, Inc. Director Compensation Plan (Exhibit 99.3 to Form S-8) (1)                                                                                                                                                                         
|       | 
|10.7.1 |  | Cornerstone Bancorp, Inc. 2001 Restricted Stock Plan (Exhibit 99.1 to Registration Statement on Form S-8 Registration No. 333-67302) (1)                                                                                                                    
|       | 
|10.8   |  | Employment agreement dated as of May 17, 2001 between Cornerstone Bank and Norman H. Reader (Exhibit 10.8 to Cornerstone Bancorp, Inc.s Form 10-KSB for the year ended December 31, 1998)
(1)                                                              
|       | 
|10.9   |  | Employment agreement dated as of May 17, 2001 between Cornerstone Bank and James P. Jakubek (Exhibit 10.9 to Cornerstone Bancorp, Inc.s Form 10-KSB for the year ended December 31, 1998)
(1)                                                              
|       | 
|10.10  |  | Employment agreement dated as of November 27, 2000 between Cornerstone Bancorp, Inc. and Merrill J. Forgotson (Exhibit 10.10 to Cornerstone Bancorp, Inc.s Form 10-KSB for the year ended
December 31, 2001) (1)                                           
|       | 
|10.11  |  | Employment agreement dated as of May 17, 2001 between Cornerstone Bank and Paul H. Reader (Exhibit 10.11 to Cornerstone Bancorp, Inc.s Form 10-KSB for the year ended December 31, 2001)
(1)                                                               
|       | 
|10.12  |  | Lease agreement dated as of June 28, 1994 between Cornerstone Bank and Samuel Lotstein Realty (Exhibit 2 to Cornerstone Banks Registration Statement on Form F-1 filed with the FDIC and
amendment to original lease agreement dated November 24, 1999) (1)



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##### Table of Contents

|      |  |                                                                                                                                                                                                                                                                             
|----- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|      | 
|10.13 |  | Lease agreement dated as of November 24, 1999 amending original lease agreement dated as of June 28, 1994 between Cornerstone Bank and the Samuel Lotstein Realty Company (Exhibit 11.0 to
Cornerstone Bancorp, Inc.s Form 10-KSB for the year ended December 31, 1999) (1)
|      | 
|10.14 |  | Lease agreement dated as of February 28, 2001 between Cornerstone Bancorp, Inc/Cornerstone Bank and Fyber Properties 128 LLC (Exhibit 10.14 to Cornerstone Bancorp, Inc.s Form 10-KSB for
the year ended December 31, 2001) (1)                                            
|      | 
|10.15 |  | Lease agreement dated as of June 6, 2001 between Cornerstone Bancorp, Inc. and Gesa B. Vogt (Exhibit 10.15 to Cornerstone Bancorp, Inc.s Form 10-KSB for the year ended December 31,
2001) (1)                                                                             
|      | 
|10.16 |  | Change in control agreement dated as of October 22, 2001 between Cornerstone Bank and Ernest J. Verrico (Exhibit 10.16 to Cornerstone Bancorp, Inc.s Form 10-KSB for the year ended
December 31, 2002) (1)                                                                 
|      | 
|10.17 |  | Lease agreement dated as of June 4, 2002 between Cornerstone Business Credit, Inc/Cornerstone Bank and Chapel and State, LLC (Exhibit 10.17 to Cornerstone Bancorp, Inc.s Form 10-KSB for
the year ended December 31, 2002) (1)                                            
|      | 
|10.18 |  | Salary continuation agreement dated as of April 1, 2002 between Cornerstone Bank and Merrill J. Forgotson (Exhibit 10.18 to Cornerstone Bancorp, Inc.s Form 10-KSB for the year ended
December 31, 2002) (1)                                                               
|      | 
|10.19 |  | Salary continuation agreement dated as of April 1, 2002 between Cornerstone Bank and Paul H. Reader (Exhibit 10.19 to Cornerstone Bancorp, Inc.s Form 10-KSB for the year ended December
31, 2002) (1)                                                                     
|      | 
|10.20 |  | Salary continuation agreement dated as of April 1, 2002 between Cornerstone Bank and James P. Jakubek (Exhibit 10.20 to Cornerstone Bancorp, Inc.s Form 10-KSB for the year ended
December 31, 2002) (1)                                                                   
|      | 
|10.21 |  | Salary continuation agreement dated as of April 1, 2002 between Cornerstone Bank and Ernest J. Verrico (Exhibit 10.21 to Cornerstone Bancorp, Inc.s Form 10-KSB for the year ended
December 31, 2002) (1)                                                                  
|      | 
|10.22 |  | Board vote January 8, 2004 amending the employment agreement dated as of May 17, 2001 between Cornerstone Bank and Norman H. Reader (2)                                                                                                                                     
|      | 
|21.1  |  | Subsidiaries of Cornerstone Bancorp, Inc. (Exhibit 21.1 to Cornerstone Bancorp, Inc.s Form 10-KSB for the year ended December 31, 2001) (1)                                                                                                                                
|      | 
|23.1  |  | Consent of KPMG LLP (2)                                                                                                                                                                                                                                                     
|      | 
|31.1  |  | Rule 13a-14(a)/15d-14(a) Certification (2)                                                                                                                                                                                                                                  
|      | 
|31.2  |  | Rule 13a-14(a)/15d-14(a) Certification (2)                                                                                                                                                                                                                                  



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|     |  |                                                                                                                          
|---- |  | -------------------------------------------------------------------------------------------------------------------------
|     | 
|32.1 |  | Certification pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (2)



|(1) | Incorporated by reference from referenced filing.
|--- | -------------------------------------------------



|(2) | Filed herewith.
|--- | ---------------



(b) Reports on Form 8-K



The Company filed the
following reports on Form 8-K during the quarter ended December 31, 2003:



1.
Form 8-K filed on October 27, 2003 reporting earnings for the quarter and nine months ended September 30, 2003.



2. Form 8-K filed on December 17, 2003 reporting cash dividend.



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



Information regarding fees paid to and services rendered by the Companys independent auditors is incorporated by reference herein to the 2004 Proxy Statement.



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##### Table of Contents

SIGNATURES



In accordance with the
requirements of the Exchange Act, the Registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized



CORNERSTONE BANCORP, INC.

(Registrant)



|                     |  |  |  |                                                           
|-------------------- |  |  |  | ----------------------------------------------------------
|                     |  |  |  |                                                           
|                     |  | 
|Date: March 24, 2004 |  |  |  | /s/ Merrill J. Forgotson                                  
|                     |  |  |  |                                                           
|                     |  | 
|                     |  |  |  | Merrill J. Forgotson President and Chief Executive Officer



|                     |  |  |  |                                                             
|-------------------- |  |  |  | ------------------------------------------------------------
|                     |  |  |  |                                                             
|                     |  | 
|Date: March 24, 2004 |  |  |  | /s/ Ernest J. Verrico                                       
|                     |  |  |  |                                                             
|                     |  | 
|                     |  |  |  | Ernest J. Verrico Vice President and Chief Financial Officer



**************



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



|                           |  |                                                                                                        |  |               
|-------------------------- |  | ------------------------------------------------------------------------------------------------------ |  | --------------
|Signature                  |  | Title                                                                                                  |  | Date          
|                           |  |                                                                                                       
|/s/ Melvin L. Maisel       |  | Chairman of the Board                                                                                  |  | March 24, 2004
|                           |  |                                                                                                        |  |               
|Melvin L. Maisel           |  |                                                                                                        |  |               
|                           |  |                                                                                                       
|/s/ Merrill J. Forgotson   |  | Director, President and Chief Executive Officer                                                        |  | March 24, 2004
|                           |  |                                                                                                        | 
|Merrill J. Forgotson       |  |                                                                                                        | 
|                           |  |                                                                                                       
|/s/ James P. Jakubek       |  | Director, Executive Vice President                                                                     |  | March 24, 2004
|                           |  |                                                                                                        | 
|James P. Jakubek           |  |                                                                                                        | 
|                           |  |                                                                                                       
|/s/ Paul H. Reader         |  | Director, Senior Vice President                                                                        |  | March 24, 2004
|                           |  |                                                                                                        | 
|Paul H. Reader             |  |                                                                                                        | 
|                           |  |                                                                                                       
|/s/ Ernest J. Verrico, Sr. |  | Vice President, Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer) |  | March 24, 2004
|                           |  |                                                                                                        | 
|Ernest J. Verrico          |  |                                                                                                        | 
|                           |  |                                                                                                       
|/s/ Joseph Field           |  | Director                                                                                               |  | March 24, 2004
|                           |  |                                                                                                        |  |               
|Joseph Field               |  |                                                                                                        |  |               
|                           |  |                                                                                                       
|/s/ J. James Gordon        |  | Director                                                                                               |  | March 24, 2004
|                           |  |                                                                                                        |  |               
|J. James Gordon            |  |                                                                                                        |  |               



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|                            |  |          |  |               
|--------------------------- |  | -------- |  | --------------
|Signature                   |  | Title    |  | Date          
|                            |  |         
|/s/ Stanley A. Levine       |  | Director |  | March 24, 2004
|                            |  |          |  |               
|Stanley A. Levine           |  |          |  |               
|                            |  |         
|/s/ Joseph A. Maida         |  | Director |  | March 24, 2004
|                            |  |          |  |               
|Joseph A. Maida             |  |          |  |               
|                            |  |         
|/s/ Ronald C. Miller        |  | Director |  | March 24, 2004
|                            |  |          |  |               
|Ronald C. Miller            |  |          |  |               
|                            |  |         
|/s/ Courtney A. Nelthropp   |  | Director |  | March 24, 2004
|                            |  |          |  |               
|Courtney A. Nelthropp       |  |          |  |               
|                            |  |         
|/s/ Martin Prince           |  | Director |  | March 24, 2004
|                            |  |          |  |               
|Martin Prince               |  |          |  |               
|                            |  |         
|/s/ Donald Sappern          |  | Director |  | March 24, 2004
|                            |  |          |  |               
|Donald Sappern              |  |          |  |               
|                            |  |         
|/s/ Joseph D. Waxberg, M.D. |  | Director |  | March 24, 2004
|                            |  |          |  |               
|Joseph D. Waxberg, M.D.     |  |          |  |               



-35-



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##### Table of Contents

Cornerstone Bancorp, Inc.



Consolidated Financial Statements as of

December 31, 2003 and 2002, and for

the Years Then Ended, With

Independent Auditors Report





---

##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Consolidated Financial Statements



Table of Contents



|                                                                                               |  |            
|---------------------------------------------------------------------------------------------- |  | -----------
|                                                                                               |  | Page       
|Independent Auditors Report                                                                   |  | F1        
|                                                                                               | 
|Consolidated Financial Statements:                                                             |  |            
|                                                                                               | 
|Consolidated Statements of Condition as of December 31, 2003 and 2002                          |  | F2        
|                                                                                               | 
|Consolidated Statements of Income for the Years Ended December 31, 2003 and 2002               |  | F3        
|                                                                                               | 
|Consolidated Statements of Stockholders Equity for the Years Ended December 31, 2003 and 2002 |  | F4        
|                                                                                               | 
|Consolidated Statements of Cash Flows for the Years Ended December 31, 2003 and 2002           |  | F5        
|                                                                                               | 
|Notes to Consolidated Financial Statements                                                     |  | F6 to F28





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##### Table of Contents

Independent Auditors Report



The Board of
Directors and Stockholders

Cornerstone Bancorp, Inc.:



We have audited the accompanying consolidated statements of condition of Cornerstone Bancorp, Inc. and subsidiary (the Company) as of December 31, 2003 and
2002, and the related consolidated statements of income, stockholders equity, and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Companys management. Our responsibility is to
express an opinion on these consolidated financial statements based on our audits.



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



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





/s/    KPMG LLP



Stamford, Connecticut

February 20, 2004



F-1



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##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Consolidated Statements of Condition



December 31, 2003 and 2002



(Dollars in thousands,
except per share data)



|                                                                                                                                                                                                      |  |      |         |   |      |   |         |  
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | -
|                                                                                                                                                                                                      |  | 2003 |         |   | 2002 |  
|Assets                                                                                                                                                                                                |  |      |         |   |      |   |         |  
|Cash and cash equivalents:                                                                                                                                                                            |  |      |         |   |      |   |         |  
|Cash and due from banks (note 2)                                                                                                                                                                      |  | $    | 15,829  |   |      | $ | 11,304  |  
|Federal funds sold                                                                                                                                                                                    |  |      | 47,000  |   |      |   | 22,900  |  
|                                                                                                                                                                                                      |  |      |         |   |      |   |         |  
|Total cash and cash equivalents                                                                                                                                                                       |  |      | 62,829  |   |      |   | 34,204  |  
|                                                                                                                                                                                                      |  |      |         |   |      |   |         |  
|Securities, including collateral of $4,587 in 2003 and $5,815 in 2002 for borrowings under securities repurchase agreements (note
3):                                                                 |  |      |         |   |      |   |         |  
|Available for sale, at fair value                                                                                                                                                                     |  |      | 11,079  |   |      |   | 11,392  |  
|Held to maturity, at amortized cost (fair value of $21,019 in 2003 and $27,811 in 2002)                                                                                                               |  |      | 20,510  |   |      |   | 26,758  |  
|                                                                                                                                                                                                      |  |      |         |   |      |   |         |  
|Total securities                                                                                                                                                                                      |  |      | 31,589  |   |      |   | 38,150  |  
|                                                                                                                                                                                                      |  |      |         |   |      |   |         |  
|Loans held for sale (note 4)                                                                                                                                                                          |  |      | 779     |   |      |   | 7,244   |  
|Loans, net of allowance for loan losses (note 4)                                                                                                                                                      |  |      | 119,089 |   |      |   | 121,475 |  
|Accrued interest receivable                                                                                                                                                                           |  |      | 956     |   |      |   | 1,081   |  
|Federal Home Loan Bank stock, at cost                                                                                                                                                                 |  |      | 613     |   |      |   | 521     |  
|Premises and equipment, net (note 5)                                                                                                                                                                  |  |      | 3,103   |   |      |   | 2,962   |  
|Bank-owned life insurance                                                                                                                                                                             |  |      | 5,340   |   |      |   | 5,113   |  
|Deferred income taxes (note 8)                                                                                                                                                                        |  |      | 941     |   |      |   | 781     |  
|Other assets                                                                                                                                                                                          |  |      | 628     |   |      |   | 523     |  
|                                                                                                                                                                                                      |  |      |         |   |      |   |         |  
|Total assets                                                                                                                                                                                          |  | $    | 225,867 |   |      | $ | 212,054 |  
|                                                                                                                                                                                                      |  |      |         |   |      |   |         |  
|Liabilities and Stockholders Equity                                                                                                                                                                  |  |      |         |   |      |   |         |  
|Liabilities:                                                                                                                                                                                          |  |      |         |   |      |   |         |  
|Deposits:                                                                                                                                                                                             |  |      |         |   |      |   |         |  
|Demand (non-interest bearing)                                                                                                                                                                         |  | $    | 44,142  |   |      | $ | 46,610  |  
|Money market demand and NOW                                                                                                                                                                           |  |      | 37,233  |   |      |   | 32,805  |  
|Regular, club and preferred rate savings                                                                                                                                                              |  |      | 42,171  |   |      |   | 34,106  |  
|Time (note 6)                                                                                                                                                                                         |  |      | 75,172  |   |      |   | 69,500  |  
|                                                                                                                                                                                                      |  |      |         |   |      |   |         |  
|Total deposits                                                                                                                                                                                        |  |      | 198,718 |   |      |   | 183,021 |  
|Borrowings under securities repurchase agreements (note 7)                                                                                                                                            |  |      | 4,540   |   |      |   | 5,723   |  
|Accrued interest payable                                                                                                                                                                              |  |      | 108     |   |      |   | 126     |  
|Securities purchased, not yet settled                                                                                                                                                                 |  |      |        |   |      |   | 2,529   |  
|Other liabilities (note 14)                                                                                                                                                                           |  |      | 2,014   |   |      |   | 1,317   |  
|                                                                                                                                                                                                      |  |      |         |   |      |   |         |  
|Total liabilities                                                                                                                                                                                     |  |      | 205,380 |   |      |   | 192,716 |  
|                                                                                                                                                                                                      |  |      |         |   |      |   |         |  
|Commitments and contingencies (note 9) Stockholders equity (notes 10 and 12):                                                                                                                        |  |      |         |   |      |   |         |  
|Common stock, par value $0.01 per share. Authorized 5,000,000 shares; issued 1,289,735 shares in 2003 and 1,279,365 shares in 2002;
outstanding 1,237,674 shares in 2003 and 1,207,904 shares in 2002 |  |      | 13      |   |      |   | 13      |  
|Additional paid-in capital                                                                                                                                                                            |  |      | 14,298  |   |      |   | 13,954  |  
|Retained earnings                                                                                                                                                                                     |  |      | 7,253   |   |      |   | 6,205   |  
|Treasury stock, at cost (52,061 shares in 2003 and 71,461 shares in 2002)                                                                                                                             |  |      | (545    | ) |      |   | (749    | )
|Unearned restricted stock awards                                                                                                                                                                      |  |      | (558    | ) |      |   | (183    | )
|Accumulated other comprehensive income, net of taxes (note 11)                                                                                                                                        |  |      | 26      |   |      |   | 98      |  
|                                                                                                                                                                                                      |  |      |         |   |      |   |         |  
|Total stockholders equity                                                                                                                                                                            |  |      | 20,487  |   |      |   | 19,338  |  
|                                                                                                                                                                                                      |  |      |         |   |      |   |         |  
|Total liabilities and stockholders equity                                                                                                                                                            |  | $    | 225,867 |   |      | $ | 212,054 |  
|                                                                                                                                                                                                      |  |      |         |   |      |   |         |  



See
accompanying notes to consolidated financial statements.



F-2



---

##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Consolidated Statements of Income



Years Ended December 31, 2003 and 2002



(Dollars in
thousands, except per share data)



|                                                       |  |      |        |      |   |       
|------------------------------------------------------ |  | ---- | ------ | ---- | - | ------
|                                                       |  | 2003 |        | 2002
|Interest income:                                       |  |      |        |      |   |       
|Loans                                                  |  | $    | 8,831  |      | $ | 9,423 
|Securities                                             |  |      | 1,563  |      |   | 1,921 
|Federal funds sold                                     |  |      | 443    |      |   | 224   
|                                                       |  |      |        |      |   |       
|Total interest income                                  |  |      | 10,837 |      |   | 11,568
|                                                       |  |      |        |      |   |       
|Interest expense:                                      |  |      |        |      |   |       
|Deposits                                               |  |      | 2,943  |      |   | 3,010 
|Borrowings (note 7)                                    |  |      | 72     |      |   | 80    
|                                                       |  |      |        |      |   |       
|Total interest expense                                 |  |      | 3,015  |      |   | 3,090 
|                                                       |  |      |        |      |   |       
|Net interest income                                    |  |      | 7,822  |      |   | 8,478 
|Provision for loan losses (note 4)                     |  |      | 96     |      |   | 363   
|                                                       |  |      |        |      |   |       
|Net interest income after provision for loan losses    |  |      | 7,726  |      |   | 8,115 
|                                                       |  |      |        |      |   |       
|Non-interest income:                                   |  |      |        |      |   |       
|Gain on sale of loans and loan servicing, net (note 4) |  |      | 1,144  |      |   | 630   
|Deposit service charges                                |  |      | 447    |      |   | 507   
|Bank-owned life insurance                              |  |      | 198    |      |   | 153   
|Other                                                  |  |      | 725    |      |   | 770   
|                                                       |  |      |        |      |   |       
|Total non-interest income                              |  |      | 2,514  |      |   | 2,060 
|                                                       |  |      |        |      |   |       
|Non-interest expense:                                  |  |      |        |      |   |       
|Salaries and employee benefits (notes 12 and 14)       |  |      | 4,381  |      |   | 4,009 
|Occupancy (note 9)                                     |  |      | 680    |      |   | 768   
|Furniture and equipment                                |  |      | 431    |      |   | 390   
|Data processing                                        |  |      | 549    |      |   | 564   
|Professional fees                                      |  |      | 393    |      |   | 304   
|Advertising and promotion                              |  |      | 176    |      |   | 204   
|Other                                                  |  |      | 1,025  |      |   | 1,001 
|                                                       |  |      |        |      |   |       
|Total non-interest expense                             |  |      | 7,635  |      |   | 7,240 
|                                                       |  |      |        |      |   |       
|Income before income tax expense                       |  |      | 2,605  |      |   | 2,935 
|Income tax expense (note 8)                            |  |      | 1,003  |      |   | 1,115 
|                                                       |  |      |        |      |   |       
|Net income                                             |  | $    | 1,602  |      | $ | 1,820 
|                                                       |  |      |        |      |   |       
|Earnings per common share (note 13):                   |  |      |        |      |   |       
|Basic                                                  |  | $    | 1.33   |      | $ | 1.53  
|Diluted                                                |  |      | 1.28   |      |   | 1.48  
|                                                       |  |      |        |      |   |       



See
accompanying notes to consolidated financial statements.



F-3



---

##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Consolidated Statements of Stockholders Equity



Years Ended December 31, 2003 and 2002



(Dollars in thousands, except per share data)



|                                            |  |                            |  |                          |    |                  |   |        |               |   |        |                               |  |   |                                     |   |  |                          |      |   |  |   |     |   |  |   |        |  
|------------------------------------------- |  | -------------------------- |  | ------------------------ | -- | ---------------- | - | ------ | ------------- | - | ------ | ----------------------------- |  | - | ----------------------------------- | - |  | ------------------------ | ---- | - |  | - | --- | - |  | - | ------ | -
|                                            |  | Common Stock               |  | AdditionalPaid-inCapital |    | RetainedEarnings |   |        | TreasuryStock |   |        | UnearnedRestrictedStockAwards |  |   | AccumulatedOtherComprehensiveIncome |   |  | TotalStockholdersEquity |     
|                                            |  | Number ofSharesOutstanding |  | Amount                   |    |                  |   |        |               |  
|Balances at December 31, 2001               |  | 1,076,720                  |  | $                        | 12 |                  | $ | 11,816 |               | $ | 6,848  |                               |  | $ | (880                                | ) |  | $                        |     |   |  | $ | 145 |   |  | $ | 17,941 |  
|Comprehensive income:                       |  |                            |  |                          |    |                  |   |        |               |   |        |                               |  |   |                                     |   |  |                          |      |   |  |   |     |   |  |   |        |  
|Net income                                  |  |                           |  |                          |   |                  |   |       |               |   | 1,820  |                               |  |   |                                    |   |  |                          |     |   |  |   |    |   |  |   | 1,820  |  
|Other comprehensive loss (note 11)          |  |                           |  |                          |   |                  |   |       |               |   |       |                               |  |   |                                    |   |  |                          |     |   |  |   | (47 | ) |  |   | (47    | )
|                                            |  |                            |  |                          |    |                  |   |        |               |   |        |                               |  |   |                                     |   |  |                          |      |   |  |   |     |   |  |   |        |  
|Total comprehensive income                  |  |                            |  |                          |    |                  |   |        |               |   |        |                               |  |   |                                     |   |  |                          |      |   |  |   |     |   |  |   | 1,773  |  
|Cash dividends declared ($0.4398 per share) |  |                           |  |                          |   |                  |   |       |               |   | (530   | )                             |  |   |                                    |   |  |                          |     |   |  |   |    |   |  |   | (530   | )
|Shares issued in connection with:           |  |                            |  |                          |    |                  |   |        |               |   |        |                               |  |   |                                     |   |  |                          |      |   |  |   |     |   |  |   |        |  
|Stock dividend                              |  | 109,123                    |  |                          | 1  |                  |   | 1,932  |               |   | (1,933 | )                             |  |   |                                    |   |  |                          |     |   |  |   |    |   |  |   |       |  
|Restricted stock awards                     |  | 11,450                     |  |                          |   |                  |   | 52     |               |   |       |                               |  |   | 131                                 |   |  |                          | (183 | ) |  |   |    |   |  |   |       |  
|Stock option exercises                      |  | 3,025                      |  |                          |   |                  |   | 27     |               |   |       |                               |  |   |                                    |   |  |                          |     |   |  |   |    |   |  |   | 27     |  
|Dividend Reinvestment Plan                  |  | 6,687                      |  |                          |   |                  |   | 112    |               |   |       |                               |  |   |                                    |   |  |                          |     |   |  |   |    |   |  |   | 112    |  
|Directors Compensation Plan                 |  | 899                        |  |                          |   |                  |   | 15     |               |   |       |                               |  |   |                                    |   |  |                          |     |   |  |   |    |   |  |   | 15     |  
|                                            |  |                            |  |                          |    |                  |   |        |               |   |        |                               |  |   |                                     |   |  |                          |      |   |  |   |     |   |  |   |        |  
|Balances at December 31, 2002               |  | 1,207,904                  |  |                          | 13 |                  |   | 13,954 |               |   | 6,205  |                               |  |   | (749                                | ) |  |                          | (183 | ) |  |   | 98  |   |  |   | 19,338 |  
|Comprehensive income:                       |  |                            |  |                          |    |                  |   |        |               |   |        |                               |  |   |                                     |   |  |                          |      |   |  |   |     |   |  |   |        |  
|Net income                                  |  |                           |  |                          |   |                  |   |       |               |   | 1,602  |                               |  |   |                                    |   |  |                          |     |   |  |   |    |   |  |   | 1,602  |  
|Other comprehensive loss (note 11)          |  |                           |  |                          |   |                  |   |       |               |   |       |                               |  |   |                                    |   |  |                          |     |   |  |   | (72 | ) |  |   | (72    | )
|                                            |  |                            |  |                          |    |                  |   |        |               |   |        |                               |  |   |                                     |   |  |                          |      |   |  |   |     |   |  |   |        |  
|Total comprehensive income                  |  |                            |  |                          |    |                  |   |        |               |   |        |                               |  |   |                                     |   |  |                          |      |   |  |   |     |   |  |   | 1,530  |  
|Cash dividends declared ($0.45 per share)   |  |                           |  |                          |   |                  |   |       |               |   | (554   | )                             |  |   |                                    |   |  |                          |     |   |  |   |    |   |  |   | (554   | )
|Shares issued in connection with:           |  |                            |  |                          |    |                  |   |        |               |   |        |                               |  |   |                                     |   |  |                          |      |   |  |   |     |   |  |   |        |  
|Restricted stock awards                     |  | 19,400                     |  |                          |   |                  |   | 171    |               |   |       |                               |  |   | 204                                 |   |  |                          | (375 | ) |  |   |    |   |  |   |       |  
|Stock option exercises                      |  | 4,731                      |  |                          |   |                  |   | 64     |               |   |       |                               |  |   |                                    |   |  |                          |     |   |  |   |    |   |  |   | 64     |  
|Dividend Reinvestment Plan                  |  | 5,639                      |  |                          |   |                  |   | 109    |               |   |       |                               |  |   |                                    |   |  |                          |     |   |  |   |    |   |  |   | 109    |  
|                                            |  |                            |  |                          |    |                  |   |        |               |   |        |                               |  |   |                                     |   |  |                          |      |   |  |   |     |   |  |   |        |  
|Balances at December 31, 2003               |  | 1,237,674                  |  | $                        | 13 |                  | $ | 14,298 |               | $ | 7,253  |                               |  | $ | (545                                | ) |  | $                        | (558 | ) |  | $ | 26  |   |  | $ | 20,487 |  
|                                            |  |                            |  |                          |    |                  |   |        |               |   |        |                               |  |   |                                     |   |  |                          |      |   |  |   |     |   |  |   |        |  



See
accompanying notes to consolidated financial statements.



F-4



---

##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Consolidated Statements of Cash Flows



Years Ended December 31, 2003 and 2002



(In thousands)



|                                                                                            |  |      |         |   |      |   |         |  
|------------------------------------------------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | -
|                                                                                            |  | 2003 |         |   | 2002 |  
|Operating activities:                                                                       |  |      |         |   |      |   |         |  
|Net income                                                                                  |  | $    | 1,602   |   |      | $ | 1,820   |  
|Adjustments to reconcile net income to net cash provided by (used in) operating activities: |  |      |         |   |      |   |         |  
|Depreciation and amortization                                                               |  |      | 604     |   |      |   | 576     |  
|Gain on sale of loans and loan servicing, net                                               |  |      | (1,144  | ) |      |   | (630    | )
|Provision for loan losses                                                                   |  |      | 96      |   |      |   | 363     |  
|Originations of loans held for sale                                                         |  |      | (26,442 | ) |      |   | (22,578 | )
|Proceeds from sales of loans held for sale                                                  |  |      | 34,225  |   |      |   | 17,314  |  
|Deferred income tax benefit                                                                 |  |      | (115    | ) |      |   | (38     | )
|Decrease (increase) in accrued interest receivable                                          |  |      | 125     |   |      |   | (6      | )
|Increase in other assets                                                                    |  |      | (105    | ) |      |   | (175    | )
|Decrease in accrued interest payable                                                        |  |      | (18     | ) |      |   | (38     | )
|Increase in other liabilities                                                               |  |      | 697     |   |      |   | 419     |  
|Income on bank-owned life insurance                                                         |  |      | (198    | ) |      |   | (153    | )
|Other adjustments, net                                                                      |  |      | (107    | ) |      |   | 270     |  
|                                                                                            |  |      |         |   |      |   |         |  
|Net cash provided by (used in) operating activities                                         |  |      | 9,220   |   |      |   | (2,856  | )
|                                                                                            |  |      |         |   |      |   |         |  
|Investing activities:                                                                       |  |      |         |   |      |   |         |  
|Proceeds from maturities and calls of securities available for sale                         |  |      | 4,133   |   |      |   | 3,497   |  
|Proceeds from maturities and calls of securities held to maturity                           |  |      | 14,098  |   |      |   | 8,422   |  
|Purchases of securities available for sale                                                  |  |      | (6,529  | ) |      |   | (2,683  | )
|Purchases of securities held to maturity                                                    |  |      | (7,990  | ) |      |   |        |  
|Net loan repayments (originations), other than loans held for sale                          |  |      | 2,234   |   |      |   | (17,917 | )
|Purchases of bank-owned life insurance                                                      |  |      | (29     | ) |      |   | (3,923  | )
|Purchases of Federal Home Loan Bank stock                                                   |  |      | (92     | ) |      |   | (55     | )
|Purchases of premises and equipment                                                         |  |      | (557    | ) |      |   | (434    | )
|                                                                                            |  |      |         |   |      |   |         |  
|Net cash provided by (used in) investing activities                                         |  |      | 5,268   |   |      |   | (13,093 | )
|                                                                                            |  |      |         |   |      |   |         |  
|Financing activities:                                                                       |  |      |         |   |      |   |         |  
|Net increase in deposits                                                                    |  |      | 15,697  |   |      |   | 28,548  |  
|Net decrease in borrowings under securities repurchase agreements                           |  |      | (1,183  | ) |      |   | (2,318  | )
|Dividends paid on common stock                                                              |  |      | (550    | ) |      |   | (515    | )
|Proceeds from issuance of common stock                                                      |  |      | 173     |   |      |   | 139     |  
|                                                                                            |  |      |         |   |      |   |         |  
|Net cash provided by financing activities                                                   |  |      | 14,137  |   |      |   | 25,854  |  
|                                                                                            |  |      |         |   |      |   |         |  
|Net increase in cash and cash equivalents                                                   |  |      | 28,625  |   |      |   | 9,905   |  
|Cash and cash equivalents at beginning of year                                              |  |      | 34,204  |   |      |   | 24,299  |  
|                                                                                            |  |      |         |   |      |   |         |  
|Cash and cash equivalents at end of year                                                    |  | $    | 62,829  |   |      | $ | 34,204  |  
|                                                                                            |  |      |         |   |      |   |         |  
|Supplemental information:                                                                   |  |      |         |   |      |   |         |  
|Interest payments                                                                           |  | $    | 3,033   |   |      | $ | 3,128   |  
|Income tax payments                                                                         |  |      | 973     |   |      |   | 1,203   |  
|(Decrease) increase in liability for securities purchased, not yet settled                  |  |      | (2,529  | ) |      |   | 2,529   |  
|Loans transferred to repossessed assets                                                     |  |      |        |   |      |   | 81      |  
|                                                                                            |  |      |         |   |      |   |         |  



See
accompanying notes to consolidated financial statements.



F-5



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##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Notes to Consolidated Financial Statements



December 31, 2003 and 2002



|(1) | Summary of Significant Accounting Policies
|--- | ------------------------------------------



Cornerstone Bancorp, Inc. (the Bancorp) is a bank holding company formed by Cornerstone Bank (the Bank) for the purpose of owning
all of the Banks outstanding common stock. On March 1, 1999, each share of the Banks common stock was exchanged on a one-for-one basis for the Bancorps common stock. The Bank is a state-chartered commercial bank that provides a
variety of loan and deposit services to individuals and businesses primarily in Southwestern Fairfield County, Connecticut. The Bank is subject to regulations of the Federal Deposit Insurance Corporation (the FDIC) and the State of
Connecticut Department of Banking, and undergoes periodic examinations by those regulatory agencies. The Bancorp is subject to regulation and supervision by the Federal Reserve Board (the FRB). The Banks deposit accounts are
insured up to applicable limits by the Bank Insurance Fund of the FDIC.



Basis of Financial Statement Presentation



The consolidated financial statements include the accounts of the Bancorp, the Bank and Cornerstone Business Credit, Inc. (a wholly-owned subsidiary of the Bank engaged in small business lending operations). These entities are referred to
collectively as the Company. Management has prepared the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America. All significant intercompany balances and
transactions have been eliminated in consolidation.



In
preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Actual results could differ significantly from those estimates,
as a result of changing conditions and future events. An estimate that is particularly critical and susceptible to near-term change is the allowance for loan losses, which is discussed below.



For purposes of the consolidated statements of cash flows, cash equivalents
represent federal funds which are generally sold on an overnight basis.



Prior year amounts are reclassified, whenever necessary, to conform to the current year presentation.



Securities



Securities are classified as either available for sale (representing securities that may be sold in the ordinary course of business) or as held to
maturity (representing debt securities for which the Company has the ability and positive intent to hold until maturity). Management determines the classification of securities at the time of purchase. Securities held to maturity are reported at
amortized cost. Securities available for sale are reported at fair value, with unrealized gains and losses reported on a net-of-tax basis in stockholders equity as accumulated other comprehensive income or loss. Securities are not acquired for
trading purposes.



Purchases (sales) of securities are
recorded on the trade date, and the resulting payables (receivables) are reported in the consolidated statements of condition. Gains and losses realized on sales of securities are determined using the specific identification method. Premiums and
discounts on debt securities are amortized to interest income over the term of the security. Unrealized losses on securities are charged to earnings if management determines that the decline in fair value of a security is other than temporary.



F-6



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##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Notes to Consolidated Financial Statements



December 31, 2003 and 2002



As a member of the Federal Home Loan Bank (FHLB) of Boston, the Bank is required to hold
a certain amount of FHLB stock. This stock is a non-marketable equity security and, accordingly, is reported at cost.



Loans



Loans are reported at unpaid principal balances less the allowance for loan losses, except for loans held for sale which are reported at the lower of cost
or estimated market value in the aggregate. Gains and losses on sales of loans are recorded at settlement using the specific identification method. Interest income is accrued based on contractual rates applied to principal amounts outstanding. Loan
origination and commitment fees, and certain direct origination costs, are deferred and amortized to interest income over the life of the related loan.



Loans past due 90 days or more as to principal or interest are placed on non-accrual status except for certain loans which, in managements judgment,
are adequately secured and probable of collection. When a loan is placed on non-accrual status, previously accrued interest that has not been collected is reversed from current interest income. Thereafter, the application of principal or interest
payments received on non-accrual loans is dependent on the expectation of ultimate repayment of the loan. If ultimate repayment is reasonably assured, payments are applied to principal and interest in accordance with the contractual terms. If
ultimate repayment is not reasonably assured or management judges it to be prudent, any payments received are applied to principal until ultimate repayment is reasonably assured. Loans are returned to accrual status when they demonstrate a
sufficient period of payment performance and are expected to be fully collectible as to principal and interest.



Allowance for Loan Losses



The allowance for loan losses represents managements estimate of probable credit losses inherent in the existing loan portfolio. The allowance is
adjusted to the appropriate level through the periodic provision for loan losses, after recording charge-offs and recoveries. When specific loans or portions thereof are judged by management to be uncollectible, those amounts are charged-off to
reduce the allowance for loan losses. Subsequent recoveries of previously charged-off amounts are restored to the allowance when collected in cash.



Managements determination of the allowance for loan losses is based on the results of continuing reviews of individual loans and borrower
relationships, particularly the larger relationships included in the commercial and commercial real estate loan portfolios. These reviews consider factors such as the borrowers financial condition, historical and expected ability to make loan
payments, and underlying collateral values. Managements determination of the allowance for loan losses also considers the level of past due and non-performing loans, the Companys historical loan loss experience, changes in loan portfolio
mix, geographic and borrower concentrations, and current economic conditions. While management uses the best available information to determine the allowance for loan losses, future adjustments to the allowance may be necessary based on changes in
economic and real estate market conditions, particularly in the Companys market area of Southwestern Fairfield County, Connecticut. In addition, regulatory agencies, as an integral part of their examination process, periodically review the
Companys allowance for loan losses. Such agencies may require the Company to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination.



F-7



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##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Notes to Consolidated Financial Statements



December 31, 2003 and 2002



Statement of Financial Accounting Standards (SFAS) No. 114, Accounting by Creditors
for Impairment of a Loan, requires recognition of an impairment loss on a loan within its scope when it is probable that the lender will be unable to collect principal and/or interest payments in accordance with the terms of the loan agreement.
SFAS No. 114 does not apply to large groups of smaller-balance homogeneous loans (such as residential mortgage and consumer loans) that are collectively evaluated for impairment in accordance with SFAS No. 5, Accounting for Contingencies.
Measurement of impairment under SFAS No. 114

may be based on the present value of expected future cash flows discounted at the loans
effective interest rate or, as a practical expedient, based on the loans observable market price or the collaterals fair value if the loan is collateral dependent. If the measure of an impaired loan is less than its recorded amount, an
impairment allowance is established as part of the allowance for loan losses.



Premises and Equipment



Premises and equipment are reported at cost, less accumulated depreciation and amortization. Owned assets are depreciated using the straight-line method over the estimated useful lives of the assets (three to twenty years for equipment and
thirty-five years for buildings). Leasehold improvements are amortized over the shorter of their estimated service lives or the term of the lease.



Bank-Owned Life Insurance



Bank-owned life insurance is reported at the cash surrender value of the underlying policies. Periodic increases in the cash surrender value are recorded
in non-interest income. The amount by which any death benefits received exceeds a policys cash surrender value is recorded in non-interest income at the time of receipt. Certain policies were purchased by the Company in consideration of its
obligations under the salary continuation agreements described in note 14.



Income Taxes



Deferred tax assets and liabilities are recognized for the estimated future tax effects attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their
respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to future taxable income. The effect on deferred tax assets and liabilities of an enacted change in tax rates is recognized in income
tax expense in the period that includes the enactment date of the change.



A deferred tax liability is recognized for all temporary differences that will result in future taxable income. A deferred tax asset is recognized for all temporary differences that will result in future tax
deductions, subject to reduction of the asset by a valuation allowance in certain circumstances. This valuation allowance is recognized if, based on an analysis of available evidence, management determines that it is more likely than not that a
portion or all of the deferred tax asset will not be realized. The valuation allowance is subject to ongoing adjustments based on changes in circumstances that affect managements judgment about the realizability of the deferred tax asset.
Adjustments to increase or decrease the valuation allowance are charged or credited, respectively, to income tax expense.



F-8



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##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Notes to Consolidated Financial Statements



December 31, 2003 and 2002



Earnings Per Common Share



Basic earnings per share (EPS) excludes dilution and is computed
by dividing income available to common shareholders (net income less dividends on preferred stock, if any) by the weighted average number of common shares outstanding during the period. Diluted EPS is computed in a similar manner, except that the
weighted average number of common shares is increased (using the treasury stock method) by additional common shares that would have been outstanding if all potentially dilutive securities (such as stock options and unvested restricted stock awards)
were exercised or vested during the period.



Stock-Based
Compensation



The Company accounts for stock-based
compensation in accordance with Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. Accordingly, compensation expense is not recognized for fixed stock options
if the exercise price of the option equals the fair value of the underlying stock at the grant date. The fair value of restricted stock awards, measured at the grant date, is recognized as unearned compensation (a component of stockholders
equity) and amortized to compensation expense over the vesting period.



SFAS No. 123, Accounting for Stock-Based Compensation, encourages the use of a fair-value-based method of accounting for employee stock compensation plans, but permits the continued use of the intrinsic-value-based method of
accounting prescribed by APB Opinion No. 25. Under SFAS No. 123, the grant date fair value of options is recognized as compensation expense over the vesting period or in full at the grant date if there is no vesting period. The Company has elected
to continue to apply APB Opinion No. 25 and disclose the pro forma information required by SFAS No. 123. Had stock-based compensation expense been recognized in accordance with SFAS No. 123, the Companys net income and earnings per common
share would have been adjusted to the following pro forma amounts for the years ended December 31:



|                                                                                                                          |  |                                      |       |   |      |   |       |  
|------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------------ | ----- | - | ---- | - | ----- | -
|                                                                                                                          |  | 2003                                 |       |   | 2002 |  
|                                                                                                                          |  | (In thousands, exceptper share data) |      
|Net income, as reported                                                                                                   |  | $                                    | 1,602 |   |      | $ | 1,820 |  
|Add restricted stock expense included in reported net income, net of related tax effects                                  |  |                                      | 50    |   |      |   | 23    |  
|Deduct restricted stock and stock option expense determined under the fair-value-based method, net of related tax effects |  |                                      | (55   | ) |      |   | (43   | )
|                                                                                                                          |  |                                      |       |   |      |   |       |  
|Pro forma net income                                                                                                      |  | $                                    | 1,597 |   |      | $ | 1,800 |  
|                                                                                                                          |  |                                      |       |   |      |   |       |  
|Basic earnings per common share:                                                                                          |  |                                      |       |   |      |   |       |  
|As reported                                                                                                               |  | $                                    | 1.33  |   |      | $ | 1.53  |  
|Pro forma                                                                                                                 |  |                                      | 1.33  |   |      |   | 1.51  |  
|                                                                                                                          |  |                                      |       |   |      |   |       |  
|Diluted earnings per common share:                                                                                        |  |                                      |       |   |      |   |       |  
|As reported                                                                                                               |  | $                                    | 1.28  |   |      | $ | 1.48  |  
|Pro forma                                                                                                                 |  |                                      | 1.28  |   |      |   | 1.46  |  
|                                                                                                                          |  |                                      |       |   |      |   |       |  



F-9



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##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Notes to Consolidated Financial Statements



December 31, 2003 and 2002



On a per share basis, the weighted average estimated fair values of options granted during 2003 and
2002 were $3.14 and $2.68, respectively. These fair values were estimated using the Black Scholes option-pricing model and the following weighted average assumptions in 2003 and 2002: dividend yield of 2.3% and 2.6%, respectively; expected
volatility rate of 45% and 46%, respectively; expected option life of eight years; and risk-free interest rate of 3.3% and 3.6%, respectively.



Borrowings Under Securities Repurchase Agreements



The Company enters into transactions with certain of its commercial customers in which it sells U.S. Government Agency securities under an agreement to
repurchase the identical securities from the customer at a later date. These transactions are accounted for as secured borrowings since the Company maintains effective control over the underlying securities that are pledged as collateral. The
transaction proceeds are recorded as borrowings in the consolidated statements of condition, and the collateral securities continue to be carried as assets of the Company.



Segment Information



Public companies are required to report certain financial information about significant revenue-producing segments of the business for which such
information is available and utilized by the chief operating decision maker. As a community-oriented financial institution, substantially all of the Companys operations involve the delivery of loan and deposit services to customers. Management
makes operating decisions and assesses performance based on an ongoing review of the community banking operations of the Bank and its subsidiary, which constitute the Companys only operating segment for financial reporting purposes.



|(2) | Cash Reserve Requirements
|--- | -------------------------



The Bank is required to maintain average reserve balances under the Federal Reserve Act and Regulation D issued thereunder. These reserves were $2,372,000
and $2,885,000 at December 31, 2003 and 2002, respectively, and are included in cash and due from banks in the consolidated statements of condition.



F-10



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##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Notes to Consolidated Financial Statements



December 31, 2003 and 2002



|(3) | Securities
|--- | ----------



The amortized cost, gross unrealized gains and losses, and fair values of securities are summarized below. Mortgage-backed securities consist of
pass-through securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae.



|                                  |  |                |        |                      |   |                       |  |   |           |   |  |   |       
|--------------------------------- |  | -------------- | ------ | -------------------- | - | --------------------- |  | - | --------- | - |  | - | ------
|                                  |  | AmortizedCost  |        | GrossUnrealizedGains |   | GrossUnrealizedLosses |  |   | FairValue
|                                  |  | (In thousands)
|December 31, 2003                 |  |                |        |                      |   |                       |  |   |           |   |  |   |       
|Available for sale:               |  |                |        |                      |   |                       |  |   |           |   |  |   |       
|U.S. Government Agency securities |  | $              | 9,535  |                      | $ | 45                    |  | $ | (2        | ) |  | $ | 9,578 
|Mortgage-backed securities        |  |                | 1,502  |                      |   | 5                     |  |   | (6        | ) |  |   | 1,501 
|                                  |  |                |        |                      |   |                       |  |   |           |   |  |   |       
|Total                             |  | $              | 11,037 |                      | $ | 50                    |  | $ | (8        | ) |  | $ | 11,079
|                                  |  |                |        |                      |   |                       |  |   |           |   |  |   |       
|Held to maturity:                 |  |                |        |                      |   |                       |  |   |           |   |  |   |       
|U.S. Government Agency securities |  | $              | 15,090 |                      | $ | 429                   |  | $ |          |   |  | $ | 15,519
|Mortgage-backed securities        |  |                | 2,354  |                      |   | 59                    |  |   |          |   |  |   | 2,413 
|State and municipal bonds         |  |                | 2,991  |                      |   | 21                    |  |   |          |   |  |   | 3,012 
|Other securities                  |  |                | 75     |                      |   |                      |  |   |          |   |  |   | 75    
|                                  |  |                |        |                      |   |                       |  |   |           |   |  |   |       
|Total                             |  | $              | 20,510 |                      | $ | 509                   |  | $ |          |   |  | $ | 21,019
|                                  |  |                |        |                      |   |                       |  |   |           |   |  |   |       
|December 31, 2002                 |  |                |        |                      |   |                       |  |   |           |   |  |   |       
|Available for sale:               |  |                |        |                      |   |                       |  |   |           |   |  |   |       
|U.S. Government Agency securities |  | $              | 9,082  |                      | $ | 160                   |  | $ |          |   |  | $ | 9,242 
|Mortgage-backed securities        |  |                | 2,152  |                      |   |                      |  |   | (2        | ) |  |   | 2,150 
|                                  |  |                |        |                      |   |                       |  |   |           |   |  |   |       
|Total                             |  | $              | 11,234 |                      | $ | 160                   |  | $ | (2        | ) |  | $ | 11,392
|                                  |  |                |        |                      |   |                       |  |   |           |   |  |   |       
|Held to maturity:                 |  |                |        |                      |   |                       |  |   |           |   |  |   |       
|U.S. Government Agency securities |  | $              | 20,746 |                      | $ | 911                   |  | $ |          |   |  | $ | 21,657
|Mortgage-backed securities        |  |                | 5,937  |                      |   | 142                   |  |   |          |   |  |   | 6,079 
|Other securities                  |  |                | 75     |                      |   |                      |  |   |          |   |  |   | 75    
|                                  |  |                |        |                      |   |                       |  |   |           |   |  |   |       
|Total                             |  | $              | 26,758 |                      | $ | 1,053                 |  | $ |          |   |  | $ | 27,811
|                                  |  |                |        |                      |   |                       |  |   |           |   |  |   |       



F-11



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##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Notes to Consolidated Financial Statements



December 31, 2003 and 2002



The gross unrealized losses totaling $8,000 at December 31, 2003 relate to U.S. Government Agency
securities and mortgage-backed securities with fair values of $1,998,000 and $710,000, respectively. All of these securities had been in a continuous unrealized loss position for less than twelve months at December 31, 2003. The Company has the
ability and intent to hold these securities until a market price recovery, which may be until maturity. The unrealized losses are attributable to changes in market interest rates and, accordingly, were deemed to be temporary impairments in value.



The following is a summary of the amortized cost and fair
value of debt securities (other than mortgage-backed securities) at December 31, 2003, by remaining period to contractual maturity. Actual maturities may differ from contractual maturities because certain issuers have the right to call or prepay
their obligations.



|                                    |  |                    |       |                  |   |               |  |           |        |  |   |       
|----------------------------------- |  | ------------------ | ----- | ---------------- | - | ------------- |  | --------- | ------ |  | - | ------
|                                    |  | Available for Sale |       | Held to Maturity
|                                    |  | AmortizedCost      |       | FairValue        |   | AmortizedCost |  | FairValue
|                                    |  | (In thousands)    
|One year or less                    |  | $                  | 2,501 |                  | $ | 2,533         |  | $         | 8,547  |  | $ | 8,657 
|Over one year, less than five years |  |                    | 7,034 |                  |   | 7,045         |  |           | 6,593  |  |   | 6,912 
|Five through ten years              |  |                    |      |                  |   |              |  |           | 3,016  |  |   | 3,037 
|                                    |  |                    |       |                  |   |               |  |           |        |  |   |       
|Total                               |  | $                  | 9,535 |                  | $ | 9,578         |  | $         | 18,156 |  | $ | 18,606
|                                    |  |                    |       |                  |   |               |  |           |        |  |   |       



Securities pledged as
collateral for purposes other than the repurchase agreement borrowings described in note 7 had total fair values of $2,053,000 and $2,068,000 at December 31, 2003 and 2002, respectively.



There were no sales of securities during the years ended December 31, 2003 and 2002.



|(4) | Loans
|--- | -----



Most of the Companys loans are granted to customers who reside or do business in Southwestern Fairfield County, Connecticut. In addition to this
geographic concentration, loans collateralized by real estate or granted to customers in real estate-related industries comprise the majority of the portfolio. While collateral provides assurance as a secondary source of repayment, the
Companys underwriting standards require that a borrowers present and expected cash flows be adequate to service the debt at loan origination.



F-12



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##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Notes to Consolidated Financial Statements



December 31, 2003 and 2002



The loan portfolio (excluding loans held for sale) consisted of the following at December 31:



|                                   |  |                |         |   |      |   |         |  
|---------------------------------- |  | -------------- | ------- | - | ---- | - | ------- | -
|                                   |  | 2003           |         |   | 2002 |  
|                                   |  | (In thousands) |        
|Loans secured by real estate:      |  |                |         |   |      |   |         |  
|Residential                        |  | $              | 36,473  |   |      | $ | 46,085  |  
|Non-residential                    |  |                | 52,945  |   |      |   | 49,977  |  
|Construction                       |  |                | 14,920  |   |      |   | 11,429  |  
|Commercial loans                   |  |                | 15,077  |   |      |   | 14,024  |  
|Consumer and other loans           |  |                | 2,116   |   |      |   | 2,259   |  
|                                   |  |                |         |   |      |   |         |  
|Total loans                        |  |                | 121,531 |   |      |   | 123,774 |  
|Allowance for loan losses          |  |                | (2,387  | ) |      |   | (2,234  | )
|Net deferred loan origination fees |  |                | (55     | ) |      |   | (65     | )
|                                   |  |                |         |   |      |   |         |  
|Total loans, net                   |  | $              | 119,089 |   |      | $ | 121,475 |  
|                                   |  |                |         |   |      |   |         |  



Loans held for sale
at December 31, 2003 consisted of residential mortgage loans of $595,000 and Small Business Administration (SBA) loans of $184,000 ($7,057,000 and $187,000, respectively, at December 31, 2002). The estimated market value of loans held
for sale at December 31, 2003 and 2002 exceeded cost and, accordingly, a lower-of-cost-or-market adjustment was not required. Proceeds from sales of residential mortgage loans and SBA loans totaled $33,454,000 in 2003 and $16,719,000 in 2002,
resulting in gains on sale of $1,144,000 in 2003 and $630,000 in 2002. Gains on sales of residential mortgage loans include the related loan servicing rights which are released to the purchasers. Servicing rights are retained by the Company for SBA
loans sold. The principal balances of SBA loans serviced for others, which are not included in the Companys consolidated statements of condition, totaled $13,281,000 and $6,796,000 at December 31, 2003 and 2002, respectively.



The following is a summary of changes in the allowance for loan losses for
the years ended December 31:



|                             |  |                |       |   |      |   |       |  
|---------------------------- |  | -------------- | ----- | - | ---- | - | ----- | -
|                             |  | 2003           |       |   | 2002 |  
|                             |  | (In thousands) |      
|Balance at beginning of year |  | $              | 2,234 |   |      | $ | 1,848 |  
|Provision for loan losses    |  |                | 96    |   |      |   | 363   |  
|Loan charge-offs             |  |                | (8    | ) |      |   | (49   | )
|Recoveries                   |  |                | 65    |   |      |   | 72    |  
|                             |  |                |       |   |      |   |       |  
|Balance at end of year       |  | $              | 2,387 |   |      | $ | 2,234 |  
|                             |  |                |       |   |      |   |       |  



F-13



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##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Notes to Consolidated Financial Statements



December 31, 2003 and 2002



The following is a summary of loans past due 90 days or more, segregated between those on non-accrual
status and those that were still accruing interest:



|                             |  |                |     |          |   |       |  |   |      
|---------------------------- |  | -------------- | --- | -------- | - | ----- |  | - | -----
|                             |  | Non-accrual    |     | Accruing |   | Total
|                             |  | (In thousands)
|December 31, 2003:           |  |                |     |          |   |       |  |   |      
|Loans secured by real estate |  | $              | 9   |          | $ | 777   |  | $ | 786  
|Commercial loans             |  |                |    |          |   | 91    |  |   | 91   
|Consumer and other loans     |  |                |    |          |   | 44    |  |   | 44   
|                             |  |                |     |          |   |       |  |   |      
|Totals                       |  | $              | 9   |          | $ | 912   |  | $ | 921  
|                             |  |                |     |          |   |       |  |   |      
|December 31, 2002:           |  |                |     |          |   |       |  |   |      
|Loans secured by real estate |  | $              | 149 |          | $ | 1,480 |  | $ | 1,629
|Commercial loans             |  |                |    |          |   | 122   |  |   | 122  
|Consumer and other loans     |  |                |    |          |   | 7     |  |   | 7    
|                             |  |                |     |          |   |       |  |   |      
|Totals                       |  | $              | 149 |          | $ | 1,609 |  | $ | 1,758
|                             |  |                |     |          |   |       |  |   |      



The total recorded
investment in impaired loans within the scope of SFAS No. 114 was $218,000 and $149,000 at December 31, 2003 and 2002, respectively, including certain loans current or past due less than 90 days for which interest payments were being applied to
reduce principal. These were real estate secured loans with collateral values in excess of the recorded investments and, accordingly, allowances for impairment losses were not required under SFAS No. 114. The Companys average recorded
investment in impaired loans was $275,000 in 2003 and $367,000 in 2002.



Interest contractually due during the respective years on loans considered impaired at December 31 totaled $23,000 in 2003 and $14,000 in 2002. The portion of the 2003 and 2002 amounts actually collected was $19,000
and $3,000, respectively. No interest income was recorded on impaired loans in 2003 and 2002 while such loans were considered to be impaired.



F-14



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##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Notes to Consolidated Financial Statements



December 31, 2003 and 2002



|(5) | Premises and Equipment
|--- | ----------------------



Premises and equipment are summarized as follows at December 31:



|                                               |  |                |       |      |   |      
|---------------------------------------------- |  | -------------- | ----- | ---- | - | -----
|                                               |  | 2003           |       | 2002
|                                               |  | (In thousands)
|Land                                           |  | $              | 999   |      | $ | 695  
|Buildings and improvements                     |  |                | 2,036 |      |   | 2,028
|Furniture and equipment                        |  |                | 3,004 |      |   | 2,929
|Vehicles                                       |  |                | 223   |      |   | 223  
|                                               |  |                |       |      |   |      
|Total                                          |  |                | 6,262 |      |   | 5,875
|Less accumulated depreciation and amortization |  |                | 3,159 |      |   | 2,913
|                                               |  |                |       |      |   |      
|Premises and equipment, net                    |  | $              | 3,103 |      | $ | 2,962
|                                               |  |                |       |      |   |      



|(6) | Time Deposits
|--- | -------------



The following is a summary of time deposits by remaining period to contractual maturity at December 31:



|                                       |  |                |        |      |   |       
|-------------------------------------- |  | -------------- | ------ | ---- | - | ------
|                                       |  | 2003           |        | 2002
|                                       |  | (In thousands)
|90 days or less                        |  | $              | 24,233 |      | $ | 21,461
|91 to 180 days                         |  |                | 13,910 |      |   | 10,110
|181 days to one year                   |  |                | 19,205 |      |   | 21,383
|                                       |  |                |        |      |   |       
|Total one year or less                 |  |                | 57,348 |      |   | 52,954
|Over one year, less than two years     |  |                | 11,095 |      |   | 7,328 
|Over two years, less than three years  |  |                | 6,448  |      |   | 4,966 
|Over three years, less than four years |  |                | 19     |      |   | 4,119 
|Over four years, less than five years  |  |                | 252    |      |   | 123   
|Greater than five years                |  |                | 10     |      |   | 10    
|                                       |  |                |        |      |   |       
|Total                                  |  | $              | 75,172 |      | $ | 69,500
|                                       |  |                |        |      |   |       



Time deposits of
$100,000 or more aggregated $18,118,000 and $18,415,000 at December 31, 2003 and 2002, respectively.



F-15



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##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Notes to Consolidated Financial Statements



December 31, 2003 and 2002



|(7) | Borrowings
|--- | ----------



Information concerning borrowings under securities repurchase agreements follows as of and for the years ended December 31:



|                                                |  |                       |       |   |      |   |       |  
|----------------------------------------------- |  | --------------------- | ----- | - | ---- | - | ----- | -
|                                                |  | 2003                  |       |   | 2002 |  
|                                                |  | (Dollars inthousands) |      
|Repurchase agreement borrowings:                |  |                       |       |   |      |   |       |  
|At December 31                                  |  | $                     | 4,540 |   |      | $ | 5,723 |  
|Average for the year                            |  |                       | 5,778 |   |      |   | 5,889 |  
|Maximum at any month end                        |  |                       | 6,754 |   |      |   | 6,149 |  
|Fair value of collateral securities at year end |  |                       | 4,587 |   |      |   | 5,815 |  
|                                                |  |                       |       |   |      |   |       |  
|Weighted average interest rates on borrowings:  |  |                       |       |   |      |   |       |  
|At December 31                                  |  |                       | 1.05  | % |      |   | 1.42  | %
|Average for the year                            |  |                       | 1.19  |   |      |   | 1.34  |  
|                                                |  |                       |       |   |      |   |       |  



The repurchase
agreement borrowings at December 31, 2003 mature within three months. Interest expense on securities repurchase agreements was $72,000 in 2003 and $79,000 in 2002.



The Bank may borrow funds from the FHLB of Boston subject to certain limitations. Borrowings are secured by the Banks
investment in FHLB stock and a blanket security agreement that requires maintenance of specified levels of qualifying collateral (principally securities and residential mortgage loans) not otherwise pledged. The Banks FHLB borrowing capacity
in the form of advances and borrowings under a short-term line of credit was $12,264,000 at December 31, 2003. There were no FHLB borrowings outstanding at December 31, 2003 and 2002. Interest expense on FHLB borrowings was $1,000 in 2002 (none in
2003).



|(8) | Income Taxes
|--- | ------------



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



|                         |  |                |       |   |      |   |       |  
|------------------------ |  | -------------- | ----- | - | ---- | - | ----- | -
|                         |  | 2003           |       |   | 2002 |  
|                         |  | (In thousands) |      
|Federal:                 |  |                |       |   |      |   |       |  
|Current                  |  | $              | 871   |   |      | $ | 928   |  
|Deferred                 |  |                | (101  | ) |      |   | (33   | )
|                         |  |                |       |   |      |   |       |  
|                         |  |                | 770   |   |      |   | 895   |  
|                         |  |                |       |   |      |   |       |  
|State:                   |  |                |       |   |      |   |       |  
|Current                  |  |                | 247   |   |      |   | 225   |  
|Deferred                 |  |                | (14   | ) |      |   | (5    | )
|                         |  |                |       |   |      |   |       |  
|                         |  |                | 233   |   |      |   | 220   |  
|                         |  |                |       |   |      |   |       |  
|Total income tax expense |  | $              | 1,003 |   |      | $ | 1,115 |  
|                         |  |                |       |   |      |   |       |  



F-16



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##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Notes to Consolidated Financial Statements



December 31, 2003 and 2002



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



|                                             |  |                |       |   |      |   |       |  
|-------------------------------------------- |  | -------------- | ----- | - | ---- | - | ----- | -
|                                             |  | 2003           |       |   | 2002 |  
|                                             |  | (In thousands) |      
|Income tax at federal statutory rate         |  | $              | 885   |   |      | $ | 998   |  
|State income tax, net of federal tax benefit |  |                | 153   |   |      |   | 145   |  
|Bank-owned life insurance and other items    |  |                | (35   | ) |      |   | (28   | )
|                                             |  |                |       |   |      |   |       |  
|Actual income tax expense                    |  | $              | 1,003 |   |      | $ | 1,115 |  
|                                             |  |                |       |   |      |   |       |  



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



|                                                            |  |                |       |      |   |    
|----------------------------------------------------------- |  | -------------- | ----- | ---- | - | ---
|                                                            |  | 2003           |       | 2002
|                                                            |  | (In thousands)
|Deferred tax assets:                                        |  |                |       |      |   |    
|Allowance for loan losses in excess of tax bad debt reserve |  | $              | 758   |      | $ | 720
|Interest on non-accrual loans                               |  |                | 19    |      |   | 101
|Other deductible temporary differences                      |  |                | 270   |      |   | 78 
|                                                            |  |                |       |      |   |    
|Total deferred tax assets                                   |  |                | 1,047 |      |   | 899
|                                                            |  |                |       |      |   |    
|Deferred tax liabilities:                                   |  |                |       |      |   |    
|Net unrealized gain on securities available for sale        |  |                | 16    |      |   | 60 
|Other taxable temporary differences                         |  |                | 90    |      |   | 58 
|                                                            |  |                |       |      |   |    
|Total deferred tax liabilities                              |  |                | 106   |      |   | 118
|                                                            |  |                |       |      |   |    
|Net deferred tax assets                                     |  | $              | 941   |      | $ | 781
|                                                            |  |                |       |      |   |    



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



|(9) | Commitments and Contingencies
|--- | -----------------------------



Financial Instruments with Off-Balance Sheet Risk



The Company is a party to commitments to originate loans, unused lines of credit and standby letters of credit (credit-related financial
instruments) that involve, to varying degrees, elements of credit risk and interest rate risk in addition to the risks associated with loans recognized in the consolidated statements of condition. Substantially all of these credit-related
financial instruments have been entered into with customers in the Companys primary lending area described in note 4.



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##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Notes to Consolidated Financial Statements



December 31, 2003 and 2002



The contract amounts of credit-related financial instruments reflect the extent of the Companys
involvement with those classes of financial instruments. The Companys exposure to credit loss in the event of non-performance by the counterparty is represented by the contract amount. The Company uses the same credit policies in extending
commitments, lines of credit and standby letters of credit as it does for on-balance sheet instruments.



The contract amounts of these off-balance sheet financial instruments at December 31, 2003 and 2002 are summarized below:



|                               |  |                |        |      |   |       
|------------------------------ |  | -------------- | ------ | ---- | - | ------
|                               |  | 2003           |        | 2002
|                               |  | (In thousands)
|Unused lines of credit         |  | $              | 15,497 |      | $ | 14,745
|Commitments to originate loans |  |                | 1,280  |      |   | 1,817 
|Standby letters of credit      |  |                | 1,338  |      |   | 1,650 
|                               |  |                |        |      |   |       



Lines of credit and
commitments to originate loans are agreements to lend to a customer as long as there is no violation of any condition established in the contract. These agreements generally have fixed expiration dates, or other termination clauses, and may require
payment of a fee. Since certain lines of credit and commitments will likely expire without being funded, the contract amounts do not necessarily represent future cash requirements. In extending lines of credit and commitments, the Company evaluates
each customers creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on managements credit evaluation of the customer.



Substantially all of the Companys outstanding standby letters of
credit are performance standby letters of credit within the scope of FASB Interpretation No. 45, Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. These are
irrevocable undertakings by the Company, as guarantor, to make payments in the event a specified third party fails to perform under a non-financial contractual obligation. Most of the Companys performance standby letters of credit arise in
connection with lending relationships and have terms of one year or less. The maximum potential future payments the Company could be required to make equals the contract amount of the standby letters of credit shown in the preceding table. The
Companys recognized liability for performance standby letters of credit was insignificant at December 31, 2003 and 2002.



The Company also enters into forward contracts to sell residential mortgage loans it has closed (loans held for sale) or that it expects to close
(commitments to originate loans held for sale). These forward contracts are used to reduce the Companys market price risk during the period from the commitment date to the sale date. The notional amount of the Companys forward sales
contracts was approximately $1,526,000 and $8,900,000 at December 31, 2003 and 2002, respectively. Changes in the fair value of the forward sales contracts, loan origination commitments and closed loans were insignificant at both December 31, 2003
and 2002.



F-18



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##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Notes to Consolidated Financial Statements



December 31, 2003 and 2002



Operating Lease Commitments



The Company was obligated under various operating leases for its branch
offices and other office space at December 31, 2003. The leases include renewal options and require the Company to pay applicable costs for utilities, maintenance, insurance and real estate taxes. Rent expense under operating leases was $384,000 in
2003 and $433,000 in 2002.



At December 31, 2003, the future
minimum rental payments under operating leases, excluding renewal option periods, were $346,000 for 2004, $263,000 for 2005, $122,000 for 2006 and $32,000 for 2007.



Legal Proceedings



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



|(10) | Stockholders Equity
|---- | --------------------



Regulatory Capital Requirements



The Bank is subject to FDIC regulations that require a minimum leverage ratio of Tier I capital to total adjusted assets of 4.0%, and minimum ratios of
Tier I and total capital to risk-weighted assets of 4.0% and 8.0%, respectively. The Bancorps consolidated regulatory capital must satisfy similar requirements established by the FRB for bank holding companies.



Under its prompt corrective action regulations, the FDIC is required to take
certain supervisory actions (and may take additional discretionary actions) with respect to an undercapitalized bank. Such actions could have a direct material effect on a banks financial statements. The regulations establish a framework for
the classification of banks into five categories: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. Generally, a bank is considered well capitalized if it has a leverage (Tier
I) capital ratio of at least 5.0%, a Tier I risk-based capital ratio of at least 6.0%, and a total risk-based capital ratio of at least 10.0%.



The foregoing capital ratios are based in part on specific quantitative measures of assets, liabilities and certain off-balance sheet items as calculated
under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by the regulators about capital components, risk weightings and other factors.



Management believes that, as of December 31, 2003 and 2002, the Bank and the
Bancorp met all capital adequacy requirements to which they are subject. Further, the most recent FDIC notification categorized the Bank as a well-capitalized institution under the prompt corrective action regulations. There have been no conditions
or events since that notification that management believes have changed the Banks capital classification.



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##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Notes to Consolidated Financial Statements



December 31, 2003 and 2002



The following is a summary of the Banks actual capital amounts and ratios as of December 31,
2003 and 2002, compared to the FDIC requirements for minimum capital adequacy and for classification as a well-capitalized institution. The Bancorps consolidated capital ratios at December 31, 2003 and 2002 were substantially the same as the
Banks actual ratios set forth below.



|                          |  |                        |        |       |                        |   |        |                                  |        |  |     |        |  |       |        |  |      |  
|------------------------- |  | ---------------------- | ------ | ----- | ---------------------- | - | ------ | -------------------------------- | ------ |  | --- | ------ |  | ----- | ------ |  | ---- | -
|                          |  |                        |        |       | FDIC Requirements      |  
|                          |  | Bank Actual            |        |       | MinimumCapitalAdequacy |   |        | Classificationas WellCapitalized |       
|                          |  | Amount                 |        | Ratio |                        |   | Amount |                                  | Ratio  |  |     | Amount |  | Ratio |       
|                          |  | (Dollars in thousands) |       
|December 31, 2003         |  |                        |        |       |                        |   |        |                                  |        |  |     |        |  |       |        |  |      |  
|Leverage (Tier I) capital |  | $                      | 20,216 |       | 9.7                    | % |        | $                                | 8,384  |  | 4.0 | %      |  | $     | 10,480 |  | 5.0  | %
|Risk-based capital:       |  |                        |        |       |                        |   |        |                                  |        |  |     |        |  |       |        |  |      |  
|Tier I                    |  |                        | 20,216 |       | 13.7                   |   |        |                                  | 5,893  |  | 4.0 |        |  |       | 8,839  |  | 6.0  |  
|Total                     |  |                        | 22,063 |       | 15.0                   |   |        |                                  | 11,786 |  | 8.0 |        |  |       | 14,732 |  | 10.0 |  
|December 31, 2002         |  |                        |        |       |                        |   |        |                                  |        |  |     |        |  |       |        |  |      |  
|Leverage (Tier I) capital |  | $                      | 18,991 |       | 9.2                    | % |        | $                                | 8,258  |  | 4.0 | %      |  | $     | 10,323 |  | 5.0  | %
|Risk-based capital:       |  |                        |        |       |                        |   |        |                                  |        |  |     |        |  |       |        |  |      |  
|Tier I                    |  |                        | 18,991 |       | 13.0                   |   |        |                                  | 5,861  |  | 4.0 |        |  |       | 8,790  |  | 6.0  |  
|Total                     |  |                        | 20,772 |       | 14.2                   |   |        |                                  | 11,720 |  | 8.0 |        |  |       | 14,650 |  | 10.0 |  



The Banks
actual Tier I capital represents total stockholders equity, excluding the after-tax net unrealized gain or loss on securities available for sale. The Banks actual risk-based capital represents Tier I capital plus the allowance for loan
losses up to 1.25% of risk-weighted assets.



Dividends



On April 2, 2002, the Company announced a 10% stock
dividend which was distributed on June 14, 2002 to shareholders of record as of May 31, 2002. Under the terms of the dividend, stockholders received a dividend of one share of common stock for every ten shares owned as of the record date. A total of
109,123 common shares were issued. An amount equal to the fair value of these shares was charged to retained earnings, with a corresponding combined increase in common stock and additional paid-in capital.



The Bancorps ability to pay cash dividends to its shareholders is
largely dependent on the ability of the Bank to pay cash dividends to the Bancorp. Under Connecticut banking law, the Bank is permitted to pay cash dividends to the Bancorp in any calendar year only to the extent of any net profits of the Bank for
that calendar year combined with its retained net profits for the preceding two years. The Banks net profits retained in 2003 and 2002 (after cash dividends) totaled $2,543,000.



Dividend Reinvestment Plan



The Companys Dividend Reinvestment Plan permits shareholders to automatically reinvest cash dividends in voluntary
purchases of new shares of the Companys common stock at the current market price. A shareholder can invest up to $5,000 in additional shares each quarter. A total of 5,639 and 6,687 common shares were issued under this plan during 2003 and
2002, respectively.



F-20



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##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Notes to Consolidated Financial Statements



December 31, 2003 and 2002



Stock Repurchases



In December 1999, the Companys Board of Directors approved a stock repurchase plan pursuant to which up to 100,000
common shares may be repurchased from time to time in open market and/or privately-negotiated transactions. A total of 76,415 treasury shares were repurchased pursuant to this plan during 2000, at a total cost of $880,000 or an average of $11.52 per
share. There have been no share repurchases since 2000. Certain treasury shares have been appropriated for the restricted stock grants made in 2002 and 2003.



|(11) | Comprehensive Income
|---- | --------------------



Total comprehensive income is reported in the consolidated statements of stockholders equity and represents the sum of net income and items of
other comprehensive income or loss. The Companys other comprehensive income or loss represents the change during the year in after-tax unrealized gains and losses on securities available for sale. Other comprehensive loss consists
of the following for the years ended December 31:



|                                                                                       |  |                |      |   |      |   |     |  
|-------------------------------------------------------------------------------------- |  | -------------- | ---- | - | ---- | - | --- | -
|                                                                                       |  | 2003           |      |   | 2002 |  
|                                                                                       |  | (In thousands) |     
|Net unrealized holding losses arising during the year on securities available for sale |  | $              | (116 | ) |      | $ | (80 | )
|Related deferred income taxes                                                          |  |                | 44   |   |      |   | 33  |  
|                                                                                       |  |                |      |   |      |   |     |  
|Other comprehensive loss                                                               |  | $              | (72  | ) |      | $ | (47 | )
|                                                                                       |  |                |      |   |      |   |     |  



The Companys
accumulated other comprehensive income, which is included as a separate component of stockholders equity, was $26,000 at December 31, 2003 and $98,000 at December 31, 2002. These amounts represent the net unrealized gains of $42,000 and
$158,000 on securities available for sale at December 31, 2003 and 2002, respectively, less related deferred income taxes of $16,000 and $60,000, respectively.



|(12) | Stock Compensation Plans
|---- | ------------------------



Stock Option Plan



The Companys 1996 Incentive and Non-Qualified Stock Plan (the 1996 Plan) provides for the issuance of up to 225,500 shares of the
Companys common stock, including outstanding stock options that were granted under the 1986 Incentive and Non-Qualified Stock Plan (the 1986 Plan). At December 31, 2003, a total of 24,728 options were available for future grants
under the 1996 Plan.



The terms of the 1996 Plan and the 1986
Plan are substantially the same, except that the 1996 Plan also provides for grants of options to directors and for the issuance of Stock Appreciation Rights (SARs). No SARs have been granted as of December 31, 2003. Stock options have a
ten-year term and an exercise price equal to the fair value of the Companys common stock on the grant date. Options vest immediately, except for options granted to those directors who, on the date of grant, have fewer than five years of



F-21



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##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Notes to Consolidated Financial Statements



December 31, 2003 and 2002



service as a director of the Company. Such options become exercisable beginning on the fifth anniversary of the directors initial service date.



Stock option transactions during 2002 and 2003 are summarized
as follows:



|                                 |  |                 |   |  |                              |      
|-------------------------------- |  | --------------- | - |  | ---------------------------- | -----
|                                 |  | Numberofoptions |   |  | Weightedaverageexerciseprice
|Outstanding at December 31, 2001 |  | 178,843         |   |  | $                            | 11.66
|Granted                          |  | 12,155          |   |  |                              | 15.36
|Expired                          |  | (726            | ) |  |                              | 13.61
|Exercised                        |  | (3,025          | ) |  |                              | 8.99 
|                                 |  |                 |   |  |                              |      
|Outstanding at December 31, 2002 |  | 187,247         |   |  |                              | 11.94
|Granted                          |  | 2,500           |   |  |                              | 18.00
|Exercised                        |  | (4,731          | ) |  |                              | 10.85
|                                 |  |                 |   |  |                              |      
|Outstanding at December 31, 2003 |  | 185,016         |   |  |                              | 12.05
|                                 |  |                 |   |  |                              |      



Substantially all
stock options outstanding at December 31, 2003 and 2002 were exercisable at those dates. Outstanding options at December 31, 2002 consisted of 174,731 non-qualified options and 10,285 incentive options with weighted average exercise prices of $12.25
and $8.68, respectively. The weighted average remaining term of outstanding options was 3.9 years at December 31, 2003. Outstanding options at December 31, 2003 had exercise prices in the following ranges: $8.68 to $10.91 (86,542 options); $12.40 to
$13.64 (41,718 options); $14.55 to $16.01 (48,784 options); and $17.25 to $18.00 (7,972 options).



Restricted Stock Plan



Under the terms of the Companys 2001 Restricted Stock Plan, awards of 19,400 shares and 12,595 shares (adjusted for the 2002 stock dividend) were
made in January 2003 and January 2002, respectively. An equal number of treasury shares has been appropriated for distribution upon vesting, which occurs at the rate of 40% in the second year following the award and 20% in each of the three
subsequent years. No shares had become vested at December 31, 2003. The grant-date fair value of the shares awarded, amounting to $375,000 in 2003 and $183,000 in 2002, is being recognized as compensation expense on a straight-line basis over the
respective vesting periods. Expense recognized in 2003 and 2002 was $81,000 and $37,000, respectively. At December 31, 2003, a total of 52,061 shares were available for future awards under this plan.



Directors Compensation Plan



Under the Directors Compensation Plan, non-officer directors are compensated
for their services in Company common stock or cash, based on an annual election made by each qualifying director at the first Board meeting subsequent to each annual meeting. Directors who elect to receive stock are issued a whole number of shares
equal to their compensation amount divided by the market price of the Companys common stock as of the date of each Board meeting. No directors elected to receive stock in lieu of cash compensation in 2003. A total of 899 shares were issued to
directors under this plan during 2002.



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##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Notes to Consolidated Financial Statements



December 31, 2003 and 2002



|(13) | Earnings Per Common Share
|---- | -------------------------



Basic and diluted earnings per share (EPS) were calculated as follows for 2003 and 2002:



|                                 |  |                                       |       |                  |       |                         |   |     
|-------------------------------- |  | ------------------------------------- | ----- | ---------------- | ----- | ----------------------- | - | ----
|                                 |  | NetIncome (1)                         |       | CommonShares (2) |       | Earnings perCommonShare
|                                 |  | (In thousands, except per share data)
|2003                             |  |                                       |       |                  |       |                         |   |     
|Basic EPS                        |  | $                                     | 1,602 |                  | 1,202 |                         | $ | 1.33
|Effect of dilutive securities(3) |  |                                       |      |                  | 49    |                         |   |     
|                                 |  |                                       |       |                  |       |                         |   |     
|Diluted EPS                      |  | $                                     | 1,602 |                  | 1,251 |                         | $ | 1.28
|                                 |  |                                       |       |                  |       |                         |   |     
|2002                             |  |                                       |       |                  |       |                         |   |     
|Basic EPS                        |  | $                                     | 1,820 |                  | 1,191 |                         | $ | 1.53
|Effect of dilutive securities(3) |  |                                       |      |                  | 41    |                         |   |     
|                                 |  |                                       |       |                  |       |                         |   |     
|Diluted EPS                      |  | $                                     | 1,820 |                  | 1,232 |                         | $ | 1.48
|                                 |  |                                       |       |                  |       |                         |   |     



|(1) | Net income applicable to common stock equaled net income for both 2003 and 2002.
|--- | --------------------------------------------------------------------------------



|(2) | Shares in 2002 have been adjusted for the effect of the 10% stock dividend distributed during the year.
|--- | -------------------------------------------------------------------------------------------------------



|(3) | The effect of dilutive securities represents the number of common-equivalent shares issuable from the assumed exercise of stock options or vesting of restricted
stock, computed using the treasury stock method. An average of 9,350 and 6,050 anti-dilutive stock options were excluded from the computation of common-equivalent shares in 2003 and 2002, respectively.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(14) | Employee Savings Plan and Salary Continuation Agreements
|---- | --------------------------------------------------------



The Company maintains a 401(k) Savings Plan covering substantially all employees. The plan provides for matching contributions by the Company based on a
percentage of employee contributions. The Companys expense for matching contributions was $81,000 in 2003 and $74,000 in 2002.



Effective April 1, 2002, the Company entered into salary continuation agreements with certain executive officers, providing for specified benefit payments
for a 15-year period commencing upon the executives normal retirement date. The agreements also provide for specified benefits upon early termination, disability and death. The Companys obligation to pay these benefits is unfunded,
although certain life insurance policies have been purchased in consideration of the benefit obligations. Salaries and employee benefits expense includes accruals of $213,000 for the year ended December 31, 2003 and $145,000 for the period from the
effective date of the agreements through December 31, 2002. No payments have been made under the agreements through December 31, 2003. Other liabilities at December 31, 2003 and 2002 include salary continuation accruals of $358,000 and $145,000,
respectively.



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##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Notes to Consolidated Financial Statements



December 31, 2003 and 2002



|(15) | Related Party Transactions
|---- | --------------------------



Loans made to the Companys officers, employees, directors and their associates and affiliated businesses totaled $4,265,000 and $4,311,000 at
December 31, 2003 and 2002, respectively. During 2003, new loans made directly or indirectly to these related parties were $595,000 and principal repayments were $641,000. These loans were made in the ordinary course of business at prevailing credit
terms (including interest rates, collateral and repayment terms) and do not involve more than a normal risk of collection.



In the ordinary course of business, the Company also engages in transactions with companies in which certain Company directors have a business interest.
Payments to such companies for commissions, services and materials totaled $50,000 in 2003 and $94,000 in 2002. Management believes that the amounts paid by the Company are reasonable and approximate the amounts that would have been paid to
independent third parties.



|(16) | Fair Values of Financial Instruments
|---- | ------------------------------------



SFAS No. 107 requires entities to disclose the fair values of financial instruments for which it is practicable to estimate fair value. The definition of
a financial instrument includes many of the assets and liabilities recognized in the Companys consolidated statements of condition, as well as certain off-balance sheet items. Fair value is defined in SFAS No. 107 as the amount at which a
financial instrument could be exchanged in a current transaction between willing parties, other than in a forced sale or liquidation.



Quoted market prices are used to estimate fair values when those prices are available. However, active markets do not exist for many types of financial
instruments. Consequently, fair values for these instruments must be estimated by management using techniques such as discounted cash flow analysis and comparison to similar instruments. Estimates developed using these methods are highly subjective
and require judgments regarding significant matters such as the amount and timing of future cash flows and the selection of discount rates that appropriately reflect market and credit risks. Changes in these judgments often have a material effect on
the fair value estimates. Since these estimates are made as of a specific point in time, they are susceptible to material near-term changes. Fair values disclosed in accordance with SFAS No. 107 do not reflect any premium or discount that could
result from the sale of a large volume of a particular financial instrument, nor do they reflect possible tax ramifications or estimated transaction costs.



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##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Notes to Consolidated Financial Statements



December 31, 2003 and 2002



The following is a summary of the carrying amounts and estimated fair values of the Companys
financial assets and liabilities (none of which were held for trading purposes) at December 31:



|                                                  |  |                |         |                     |   |                |  |                     |         |  |   |        
|------------------------------------------------- |  | -------------- | ------- | ------------------- | - | -------------- |  | ------------------- | ------- |  | - | -------
|                                                  |  | 2003           |         | 2002               
|                                                  |  | CarryingAmount |         | EstimatedFair Value |   | CarryingAmount |  | EstimatedFair Value
|                                                  |  | (In thousands)
|Financial assets:                                 |  |                |         |                     |   |                |  |                     |         |  |   |        
|Cash and cash equivalents                         |  | $              | 62,829  |                     | $ | 62,829         |  | $                   | 34,204  |  | $ | 34,204 
|Securities                                        |  |                | 31,589  |                     |   | 32,098         |  |                     | 38,150  |  |   | 39,203 
|Loans, including loans held for sale              |  |                | 119,868 |                     |   | 120,353        |  |                     | 128,719 |  |   | 128,929
|Accrued interest receivable                       |  |                | 956     |                     |   | 956            |  |                     | 1,081   |  |   | 1,081  
|FHLB stock                                        |  |                | 613     |                     |   | 613            |  |                     | 521     |  |   | 521    
|                                                  |  |                |         |                     |   |                |  |                     |         |  |   |        
|Financial liabilities:                            |  |                |         |                     |   |                |  |                     |         |  |   |        
|Deposits without stated maturities                |  | $              | 123,546 |                     | $ | 123,546        |  | $                   | 113,521 |  | $ | 113,521
|Time deposits                                     |  |                | 75,172  |                     |   | 75,968         |  |                     | 69,500  |  |   | 70,196 
|Borrowings under securities repurchase agreements |  |                | 4,540   |                     |   | 4,540          |  |                     | 5,723   |  |   | 5,723  
|Accrued interest payable                          |  |                | 108     |                     |   | 108            |  |                     | 126     |  |   | 126    
|                                                  |  |                |         |                     |   |                |  |                     |         |  |   |        



The following is a
description of the valuation methods used by management to estimate the fair values of the Companys financial instruments:



Securities



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



Loans



The fair values of fixed rate
loans were estimated by discounting projected cash flows using current rates for similar loans. For loans that reprice periodically to market rates, the carrying amount represents the estimated fair value.



Deposits



The estimated fair values of deposits without stated maturities (such as
non-interest bearing demand deposits, savings accounts, NOW accounts and money market accounts) are equal to the amounts payable on demand. The fair values of time certificates of deposit were estimated based on the discounted value of contractual
cash flows. The discount rates were based on rates currently offered for time deposits with similar remaining maturities.



In accordance with SFAS No. 107, these fair values do not include the value of core deposit relationships that comprise a significant portion of the
Companys deposit base. Management believes that the Companys core deposit relationships provide a relatively stable, low-cost funding source that has a substantial unrecognized value separate from the deposit balances.



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##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Notes to Consolidated Financial Statements



December 31, 2003 and 2002



Other Financial Instruments



The remaining financial assets and liabilities listed in the preceding table
have fair values that approximate the respective carrying amounts because they are payable on demand or have short-term maturities and present relatively low credit risk and interest rate risk.



Fair values of the lines of credit, loan origination commitments and standby
letters of credit described in note 9 were estimated based on an analysis of the interest rates and fees currently charged by the Company for similar transactions, considering the remaining terms of the instruments and the creditworthiness of the
potential borrowers. At December 31, 2003 and 2002, the fair values of these financial instruments approximated the related carrying amounts, which were insignificant.



|(17) | Recent Accounting Standards
|---- | ---------------------------



In December 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46 (revised), Consolidation of Variable
Interest Entities(FIN 46R), which addresses how a business enterprise should evaluate whether it has a controlling financial interest in an entity through means other than voting rights and, accordingly, should consolidate the
variable interest entity (VIE). FIN 46R replaces FASB Interpretation No. 46 that was issued in January 2003. As a public company that is a small business issuer, as defined in applicable Securities and Exchange Commission
(SEC) regulations, the Company is required to apply FIN 46R to VIEs no later than the end of the first reporting period ending after December 15, 2004. For any VIEs that must be consolidated under FIN 46R that were created before January
1, 2004, the assets, liabilities and non-controlling interest of the VIE initially would be measured at their carrying amounts, and any difference between the net amount added to the balance sheet and any previously recognized interest would be
recorded as the cumulative effect of an accounting change. If determining the carrying amounts is not practicable, fair value at the date FIN 46R first applies may be used to measure the assets, liabilities and non-controlling interest of the VIE.
The Company currently holds no interests in VIEs and, accordingly, does not expect that FIN 46R will have a significant effect on its consolidated financial statements.



SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, was
issued by the FASB in May 2003. This statement establishes standards for the classification and measurement of certain financial instruments with characteristics of both liabilities and equity. Under SFAS No. 150, certain freestanding financial
instruments that embody obligations of the issuer, and that are now classified as equity, must be classified as liabilities (or as assets in some circumstances). SFAS No. 150 also requires certain disclosures for financial instruments within its
scope. For SEC registrants such as the Company, SFAS No. 150 as originally issued was generally effective for financial instruments entered into or modified after May 31, 2003 and otherwise at the beginning of the first interim period beginning
after June 15, 2003 (July 1, 2003 for the Company). The effective date has been deferred indefinitely for certain types of mandatorily redeemable financial instruments. The Company currently does not have any financial instruments that are within
the scope of SFAS No. 150.



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##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Notes to Consolidated Financial Statements



December 31, 2003 and 2002



|(18) | Parent Company Financial Information
|---- | ------------------------------------



Set forth below are the Bancorps condensed statements of condition as of December 31, 2003 and 2002, together with the related condensed statements
of income and cash flows for the years then ended.



|                                                                                 |  |                |        |      |   |       
|-------------------------------------------------------------------------------- |  | -------------- | ------ | ---- | - | ------
|                                                                                 |  | 2003           |        | 2002
|                                                                                 |  | (In thousands)
|Condensed Statements of Condition                                                |  |                |        |      |   |       
|Assets:                                                                          |  |                |        |      |   |       
|Cash                                                                             |  | $              | 131    |      | $ | 213   
|Investment in the Bank                                                           |  |                | 20,242 |      |   | 19,089
|Other                                                                            |  |                | 376    |      |   | 215   
|                                                                                 |  |                |        |      |   |       
|Total assets                                                                     |  | $              | 20,749 |      | $ | 19,517
|                                                                                 |  |                |        |      |   |       
|Liabilities and stockholders equity:                                            |  |                |        |      |   |       
|Liabilities                                                                      |  | $              | 262    |      | $ | 179   
|Stockholders equity                                                             |  |                | 20,487 |      |   | 19,338
|                                                                                 |  |                |        |      |   |       
|Total liabilities and stockholders equity                                       |  | $              | 20,749 |      | $ | 19,517
|                                                                                 |  |                |        |      |   |       
|Condensed Statements of Income                                                   |  |                |        |      |   |       
|Dividends received from the Bank                                                 |  | $              | 612    |      | $ | 700   
|Non-interest expense                                                             |  |                | 384    |      |   | 318   
|                                                                                 |  |                |        |      |   |       
|Income before income tax benefit and equity in the Banks undistributed earnings |  |                | 228    |      |   | 382   
|Income tax benefit                                                               |  |                | 148    |      |   | 121   
|                                                                                 |  |                |        |      |   |       
|Income before equity in the Banks undistributed earnings                        |  |                | 376    |      |   | 503   
|Equity in the Banks undistributed earnings                                      |  |                | 1,226  |      |   | 1,317 
|                                                                                 |  |                |        |      |   |       
|Net income                                                                       |  | $              | 1,602  |      | $ | 1,820 
|                                                                                 |  |                |        |      |   |       



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##### Table of Contents

CORNERSTONE BANCORP, INC.

AND SUBSIDIARY



Notes to Consolidated Financial Statements



December 31, 2003 and 2002



|                                            |  |                |        |   |      |   |        |  
|------------------------------------------- |  | -------------- | ------ | - | ---- | - | ------ | -
|                                            |  | 2003           |        |   | 2002 |  
|                                            |  | (In thousands) |       
|Condensed Statements of Cash Flows          |  |                |        |   |      |   |        |  
|Cash flows from operating activities:       |  |                |        |   |      |   |        |  
|Net income                                  |  | $              | 1,602  |   |      | $ | 1,820  |  
|Equity in the Banks undistributed earnings |  |                | (1,226 | ) |      |   | (1,317 | )
|Other adjustments, net                      |  |                | (81    | ) |      |   | (66    | )
|                                            |  |                |        |   |      |   |        |  
|Net cash provided by operating activities   |  |                | 295    |   |      |   | 437    |  
|                                            |  |                |        |   |      |   |        |  
|Cash flows from financing activities:       |  |                |        |   |      |   |        |  
|Dividends paid on common stock              |  |                | (550   | ) |      |   | (515   | )
|Proceeds from issuance of common stock      |  |                | 173    |   |      |   | 139    |  
|                                            |  |                |        |   |      |   |        |  
|Net cash used in financing activities       |  |                | (377   | ) |      |   | (376   | )
|                                            |  |                |        |   |      |   |        |  
|Net (decrease) increase in cash             |  |                | (82    | ) |      |   | 61     |  
|Cash at beginning of year                   |  |                | 213    |   |      |   | 152    |  
|                                            |  |                |        |   |      |   |        |  
|Cash at end of year                         |  | $              | 131    |   |      | $ | 213    |  
|                                            |  |                |        |   |      |   |        |  



F-28