UNITED STATES
 SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 
 
 Form 10 - Q
 
 (X)
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended June 30, 2004or( )
Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934For the transition period from ______________________ to ______________________ 
 
 Commission File Number 1-018166
 
 
 
 STATE FINANCIAL SERVICES CORPORATION
 (Exact name of registrant as specified in its charter)
 
 
 WISCONSIN
(State or other jurisdiction of
incorporation or organization)
39-1489983
(I.R.S. Employer identification No.) 
 
 815 NORTH WATER STREET, MILWAUKEE, WISCONSIN 53202-3526
 (Address and Zip Code of principal executive offices)
 
 
 
 (414) 223-8400
 (Registrant's telephone number, including area code)
 
 
 
 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [X]
 
 Indicate by check mark whether the registrant is an accelerated filer (as defined by Rule 12b-2 of the Exchange Act).
 Yes [X] No [ ]
 
 As of August 6 , 2004 , there were 6,889,253 shares of Registrant's $0.10 Par Value Common Stock outstanding.
 1 
 FORM 10-QSTATE FINANCIAL SERVICES CORPORATIONINDEXPART I - FINANCIAL INFORMATIONPage No.Item 1.
Financial Statements. (Unaudited)Consolidated Statements of Financial Condition as of
June 30, 2004 (unaudited) and December 31, 2003 (audited)
3Consolidated Statements of Income for the
Three Months ended June 30, 2004 and June 30, 2003
4Consolidated Statements of Income for the
Six Months ended June 30, 2004 and June 30, 2003
5Consolidated Statements of Cash Flows for the
Six Months ended June 30, 2004 and June 30, 2003
6Notes to Consolidated Financial Statements
7Item 2.
Management's Discussion and Analysis of
Financial Condition and Results of Operations.
10Item 3.
Quantitative and Qualitative DisclosuresAbout Market Risk.
19Item 4.
Controls and Procedures.
19PART II - OTHER INFORMATIONItem 1.
Legal Proceedings.
20Item 2.
Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities.
20Item 3.
Default Upon Senior Securities.
20Item 4.
Submission of Matters to a Vote of Security Holders.
20Item 5.
Other Information.
20Item 6.
Exhibits and Reports on Form 8-K.
20Signatures

22Exhibit Index

23 2 Part I.  Financial Information
 Item 1.  Financial Statements.
 
 State Financial Services Corporation And Subsidiaries
 Consolidated Statements of Financial Condition
 June 30,
2004
(unaudited)
December 31,
2003
(audited)AssetsCash and due from banks

$
60,675,756

$
55,824,050Interest-bearing bank balances


4,605,989


4,399,723Federal funds sold


9,451,521


18,144,353Cash and cash equivalents


74,733,266


78,368,126Investment securitiesAvailable-for-sale (at fair value)


538,139,392


397,061,108Held-to-maturity (fair value of$697,395 -2004 and $988,006 - 2003)


684,639


964,662Loans (net of allowance for loan losses of $11,803,467-2004 and $10,706,350-2003)


880,892,266


863,323,685Loans held for sale


3,393,403


1,900,438Premises and equipment


33,180,006


32,918,853Accrued interest receivable


5,708,824


5,246,660Goodwill


37,646,354


37,626,045Core deposit intangible


4,900,637


5,158,565Bank owned life insurance


21,468,078


21,029,985Other assets


5,132,114


9,331,295Total Assets

$
1,605,878,979

$
1,452,929,422Liabilities And Shareholders' EquityDeposits:Demand


179,505,191


180,872,397Savings


264,726,008


253,202,071Money market


251,869,875


233,003,329Time deposits in excess of $100,000


150,585,564


126,127,203Other time deposits


220,073,818


235,908,124Total deposits


1,066,760,456


1,029,113,124Federal Home Loan Bank advances


67,800,000


67,800,000Notes payable


31,500,000


30,200,000Trust preferred securities


30,000,000


15,000,000Securities sold under agreements to repurchase


294,407,908


175,592,887Federal funds purchased


-


-Accrued expenses and other liabilities


3,611,315


21,071,418Accrued interest payable


2,326,372


1,957,473Total Liabilities


1,496,406,051


1,340,734,902Shareholders' Equity:Preferred stock, $1 par value; authorized-100,000 shares; issued and outstanding-none


-


-Common stock, $0.10 par value; authorized-25,000,000 shares; issued 9,569,378 shares in 2004 and 9,527,489 shares in 2003, outstanding 6,941,538 shares in 2004 and 7,043,149 shares in 2003


956,938


952,749Additional paid in capital


85,302,983


84,739,420Retained earnings


67,834,747


63,152,966Accumulated other comprehensive income


(48,940
)

3,763,835Unearned shares held by ESOP


(3,981,360
)

(3,981,360
)TreasuryStock - 2,627,840shares in 2004 and 2,484,340 in 2003


(40,591,440
)

(36,433,090
)Total Shareholders' Equity


109,472,928


112,194,520Total Liabilities And Shareholders' Equity

$
1,605,878,979

$
1,452,929,422 
 See notes to unaudited consolidated financial statements.
 3 State Financial Services Corporation And Subsidiaries
 Consolidated Statements of Income (Unaudited)
 
 Three Months Ended June 30,2004
2003Interest income:Loans

$
12,917,564

$
11,901,126Investment securities:Taxable


3,867,596


3,269,171Tax-exempt


548,895


572,049Federal funds sold and other short-term investments


28,729


41,847Total interest income


17,362,784


15,784,193Interest expense:Deposits


3,787,688


3,394,689Notes payable and other borrowings


1,523,524


1,563,119Total interest expense


5,311,212


4,957,808Net interest income


12,051,572


10,826,385Provision for loan losses


600,000


825,000Net interest income after provision for loan losses


11,451,572


10,001,385Other income:Service charges on deposit accounts


766,586


680,540ATM and merchant service fees


259,070


759,238Security commissions and management fees


192,659


101,923Investment securities gains, net


198,899


80,274Gain on sale of loans


516,824


1,323,429Gain on sale of merchant processing


-


1,300,000Other


1,041,218


1,056,222Total other income


2,975,256


5,301,626Other expenses:Salaries and employee benefits


4,520,763


5,023,928Net occupancy expense


762,237


702,127Equipment rentals, depreciation and maintenance


1,070,919


1,004,452Data processing


598,693


540,012Legal and professional


198,517


411,188ATM and merchant services


68,370


504,430Advertising


329,424


267,567Provision for merchant chargebacks


-


300,000Merchant processing exit fee


-


150,000Efficiency consulting expense


-


570,000Severance charges


-


180,114Other


1,813,638


1,450,540Total other expenses


9,362,561


11,104,358Income before income taxes


5,064,267


4,198,653Income tax expense


1,626,895


1,162,008Net income

$
3,437,372

$
3,036,645Basic earnings per common share

$
0.52

$
0.46Diluted earnings per common share


0.50


0.44Dividends per common share


0.15


0.13 
 
 See notes to unaudited consolidated financial statements.
 4 State Financial Services Corporation And Subsidiaries
 Consolidated Statements of Income (Unaudited)
 
 Six Months Ended June 30,2004
2003Interest income:Loans

$
25,781,330

$
23,664,366Investment securities:Taxable


7,328,775


7,033,438Tax-exempt


1,093,232


1,185,826Federal funds sold and other short-term investments


76,874


62,066Total interest income


34,280,211


31,945,696Interest expense:Deposits


6,507,236


6,589,250Notes payable and other borrowings


4,093,020


3,491,290Total interest expense


10,600,256


10,080,540Net interest income


23,679,955


21,865,156Provision for loan losses


1,200,000


1,425,000Net interest income after provision for loan losses


22,479,955


20,440,156Other income:Service charges on deposit accounts


1,629,106


1,379,880ATM and merchant service fees


474,133


1,450,846Security commissions and management fees


365,798


195,311Investment securities gains, net


418,279


135,470Gain on sale of loans


929,410


2,647,200Gain on sale of merchant processing


-


1,300,000Other


1,902,177


1,745,753Total other income


5,718,903


8,854,460Other expenses:Salaries and employee benefits


8,887,374


10,139,997Net occupancy expense


1,534,023


1,389,171Equipment rentals, depreciation and maintenance


2,066,128


1,956,781Data processing


1,192,852


1,069,733Legal and professional


603,376


814,186ATM and merchant services


143,893


965,436Advertising


650,001


617,917Provision for merchant chargebacks


-


300,000Merchant processing exit fee


-


150,000Efficiency consulting expense


-


570,000Severance charges


-


180,114Other


3,280,139


2,982,836Total other expenses


18,357,786


21,136,171Income before income taxes


9,841,072


8,158,445Income tax expense


3,161,946


2,269,646Net income

$
6,679,126

$
5,888,799Basic earnings per common share

$
1.00

$
0.89Diluted earnings per common share


0.97


0.87Dividends per common share


0.30


0.26 
 
 See notes to unaudited consolidated financial statements.
 5 
 State Financial Services Corporation And Subsidiaries
 Consolidated Statements of Cash Flows (Unaudited)
 Six Months Ended
June 30,2004


2003Operating ActivitiesNet income

$
6,679,126

$
5,888,799Adjustments to reconcile net income to net cash provided by (used in) operating activities:Provision for loan losses


1,200,000


1,425,000Depreciation


1,503,488


1,398,325Amortization of premiums and accretion of discounts on investment securities


337,675


742,192Income from bank owned life insurance


(438,093
)

(309,756
)Decrease (increase) in accrued interest receivable


(462,164
)

2,190,551Increase (decrease) in accrued interest payable


368,899


(301,814
)Realized investment securities gains


(418,279
)

(135,470
)Payment to Lakes Region Bancorps shareholders for acquisition


(13,416,729
)

0Other


2,357,580


(285,397
)Net cash provided by (used in) operating activities


(2,288,497
)

10,612,430Investing ActivitiesProceeds from maturities or principal payments of investment securities held-to-maturity


280,000


190,000Purchases of securities available-for-sale


(390,394,283
)

(366,371,246
)Proceeds from maturities and sales of investment securities available-for-sale


243,619,695


415,763,291Net increase in loans


(20,261,546
)

(55,548,829
)Net purchases of premises and equipment


(1,764,641
)

(1,024,755
)Net cash provided by (used in) investing activities


(168,520,775
)

(6,991,539
)Financing ActivitiesNet (decrease) increase in deposits


37,647,332


(15,430,654
)Repayment of notes payable


(19,000,000
)

(6,750,000
)Proceeds of notes payable


20,300,000


5,230,000Proceeds from trust preferred securities offering


15,000,000


0Increase in securities sold under agreements to repurchase


118,815,021


27,100,876Repayment of Federal Home Loan Bank advances


0


(15,000,000
)Cash dividends


(1,997,345
)

(1,729,211
)Repayment of federal funds purchased


0


500,000Purchase of treasury stock


(4,158,350
)

(92,000
)Proceeds from exercise of stock options


567,754


661,410Net cash provided by (used in) financing activities


167,174,412


(5,509,579
)Decrease in cash and cash equivalents


(3,634,860
)

(1,888,688
)Cash and cash equivalents at beginning of period


78,368,126


67,516,805Cash and cash equivalents at end of period

$
74,733,266

$
65,628,117Supplemental information:Interest paid

$
10,231,357

$
10,403,267Income taxes paid


4,161,843


2,618,092
 See notes to unaudited consolidated financial statements.
 6 State Financial Services Corporation And Subsidiaries
 Notes to Unaudited Consolidated Financial Statements
 June 30, 2004
 
 NOTE A - BASIS OF PRESENTATION
 
 The accompanying unaudited consolidated financial statements include the accounts of State Financial Services Corporation (the "Company" or State) and its subsidiaries. The Company owns State Financial Bank, National Association (the Bank). All significant intercompany balances and transactions have been eliminated. The unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (GAAP) for interim financial information and with the rules and regulations of the Securities and Exchange Commission (SEC). Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP for complete financial statements have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation have been included. Interim operating results are not necessarily indicative of the results that may be expected for the year. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2003.
 
 NOTE B - ACCOUNTING CHANGES
 
 On March 9, 2004, the SEC issued Staff Accounting Bulletin (SAB) 105, "Application of Accounting Principles to Loan Commitments" to advise registrants of the staff's view that fair value of the recorded loan commitments, that are required to follow derivative accounting under Statement of Financial Accounting Standards (SFAS) 133, Accounting for Derivative Instruments and Hedging Activities, should not take into consideration the expected future cash flows related to the associated servicing of the future loan. The staff indicated its belief that incorporating expected future cash flows related to the associated servicing of the loan essentially results in the immediate recognition of a servicing asset, which is only appropriate once the servicing asset has been contractually separated from the underlying loan by sale or by securitization of the loan with servicing retained. Furthermore, no other internally-developed intangible assets, such as customer relationship intangibles, should be recorded as part of the loan commitment derivative. The staff noted that recognition of such assets is only appropriate in the event of a third-party transaction, such as the purchase of a loan commitment either individually, in a portfolio, or in a business combination.
 
 In addition, SAB 105 requires registrants to disclose their accounting policy for loan commitments pursuant to Accounting Principles Board (APB) Opinion No. 22, including methods and assumptions used to estimate fair value and any associated hedging strategies, as required by SFAS 107, SFAS 133 and Item 305 of Regulation S-K ( Quantitative and Qualitative Disclosures About Market Risk) .
 
 SAB 105 does not explicitly  require banks that apply derivative accounting to their loan commitments to treat the loan commitments only as liabilities. Rather, the staff appears to be deferring to the Financial Accounting Standards Board (FASB) to address this aspect of the fair value issue in its loan commitment project.
 
 The provisions of SAB 105 must be applied to loan commitments accounted for as derivatives that are entered into after March 31, 2004. The staff will not object to the application of existing accounting practices to loan commitments accounted for as derivatives that are entered into on or before March 31, 2004, with appropriate disclosures.
 
 The issuance of SAB 105 has not had a material impact on the Company as the loan commitments are generally not accounted for as derivatives.
 
 In January 2003, the FASB issued FASB Interpretation No 46 (FIN 46), which provides guidance on how to identify a variable interest entity (VIE) and determine when the assets, liabilities, noncontrolling interests, and results of operations of a VIE are to be included in an entity's consolidated financial statements. A VIE exists when either the total equity investment at risk is not sufficient to permit the entity to finance its activities by itself, or the equity investors lack one of three characteristics associated with owning a controlling financial interest. Those characteristics include the direct or indirect ability to make decisions about an entity's activities through voting rights or similar rights, the obligation to absorb the expected losses of an entity if they occur, or the right to receive the expected residual returns of the entity if they occur.
 
 7
  In December 2003, the FASB reissued FIN 46 with certain modifications and clarifications. Application of this guidance was effective for interests in certain VIEs commonly referred to as special-purpose entities (SPEs) as of December 31, 2003. Application for all other types of entities is required for periods ending after March 15, 2004, unless previously applied. The application of FIN 46 to any of the Companys investments or interests has not had a material impact on the Companys financial condition, results of operations, or liquidity.
 
 NOTE C - EARNINGS PER SHARE
 
 Basic earnings per share is computed by dividing net income by the weighted-average number of common shares outstanding during the period less unearned ESOP shares. Diluted earnings per share is computed by dividing net income by the weighted-average number of common shares outstanding during the period less unallocated ESOP shares plus the assumed conversion of all potentially dilutive securities. The denominators for the earnings per share amounts are as follows:
 
 Three months ended
June 30,
Six months ended
June 30,2004
2003
2004
2003Basic:Weighted-average number of shares outstanding


6,939,809


6,970,527


6,983,792


6,960,303Less: weighted-average number of unearned ESOP shares


(281,288
)

(322,599
)

(287,881
)

(322,599
)Denominator for basic earnings per share


6,658,521


6,647,928


6,695,911


6,637,704Fully diluted:Denominator for basic earnings per share


6,658,521


6,647,928


6,695,911


6,637,704Add: assumed conversion of stock options using treasury stock method


196,396


196,709


200,825


160,764Denominator for fully diluted earnings per share


6,854,917


6,844,637


6,896,736


6,798,468 
 NOTE D - COMPREHENSIVE INCOME
 
 Comprehensive income is the total of reported net income and all other revenues, expenses, gains and losses that under accounting principles generally accepted in the United States are not included in reported net income but are instead reflected directly in shareholders equity.
 
 Three months ended
June 30,
Six months ended
June 30,2004


2003


2004


2003Net Income

$
3,437,372

$
3,036,645

$
6,679,126

$
5,888,799Other comprehensive income:Change in unrealized securities gains (losses), net of tax


(4,383,320
)

907,277


(3,558,503
)

(528,115
)Reclassification adjustment for realized gains included in net income, net of tax


(120,911
)

(48,799
)

(254,272
)

(82,352
)Total comprehensive income (loss)

$
(1,066,859
)
$
3,895,123

$
2,866,351

$
5,278,332 
 NOTE E - STOCK REPURCHASE PROGRAM
 
 On April 28, 2003, the Companys Board of Directors authorized the repurchase of up to 5%, or approximately 348,000 shares, of the Companys Common Stock. As of June 30, 2004, 163,500 shares have been repurchased at an average price of $28.67 per share.
 
 **NOTE F - STOCK-BASED COMPENSATION**
 
 The Company follows APB Opinion No. 25 under which no compensation expense is recorded when the exercise price of the Companys employee stock options equals the market price of the underlying stock on the date of grant. The Companys pro forma information regarding net income and net income per share has been determined as if these options had been accounted for since January 1, 1995, in accordance with the fair value method SFAS No. 123, Accounting for Stock-Based Compensation.
 
 8
  The Black-Scholes option valuation model is commonly used in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Since the Companys employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimates, in managements opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
 
 In determining compensation expense in accordance with SFAS No. 123, the fair value for these options was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions for the six months ended June 30, 2004 and June 30, 2003.
 
 Three months ended
June 30,
Six months ended
June 30,2004
2003
2004
2003Expected life of options


2.706 years


6.75 years


2.706 years


6.75 yearsRisk-free interest rate


2.90
%

3.80
%

2.90
%

3.60
%Expected dividend yield


2.07
%

2.2
%

2.07
%

2.2
%Expected volatility factor


38.79
%

26.40
%

38.79
%

26.40
% 
 For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options vesting period, which is generally six months. The Companys pro forma information is as follows:
 
 Three months ended
June 30,
Six months ended
June 30,(Thousands, except per share data)

2004
2003
2004
2003Net income, as reported

$
3,437

$
3,037

$
6,679

$
5,889Compensation expense, net of taxes, as reported


3,068


3,634


6,032


7,319Pro forma compensation expense in accordance with SFAS No. 123, net of tax


(3,157
)

(3,686
)

(6,211
)

(7,403
)Pro forma net income

$
3,348

$
2,985

$
6,500

$
5,805Net income per common share, as reported:Basic

$
0.52

$
0.46

$
1.00

$
0.89Diluted

$
0.50

$
0.44

$
0.97

$
0.87Pro forma net income per common share:Basic

$
0.50

$
0.45

$
0.97

$
0.87Diluted

$
0.49

$
0.44

$
0.94

$
0.85 
 NOTE G  ACQUISITIONS
 
 On December 6, 2003, the Company acquired Hawthorn Corporation (Hawthorn) and its wholly owned subsidiary Hawthorn Bank, Mundelein, Illinois. The Company purchased all of the outstanding common stock of Hawthorn for $6.4 million in cash. This in-market acquisition increased the Companys share of the Illinois banking market. Hawthorn Bank has been merged into State Financial Bank, N.A.
 
 On December 6, 2003, the Company also acquired Lakes Region Bancorp, Inc. (Lakes Region) and its wholly owned subsidiary Anchor Bank, Grayslake, Illinois. The Company purchased all of the outstanding common stock of Lakes Region for $13.4 million in cash. This in-market acquisition increased the Companys share of the Illinois banking market. Anchor Bank has been merged into State Financial Bank, N.A.
 
 Application of purchase accounting requires the inclusion of Hawthorns and Lake Regions operating results in the consolidated statements of income from the date of acquisition. Accordingly, Hawthorns and Lakes Regions operating results for the period January 1, 2004 through June 30, 2004 are included in the Companys consolidated statements of income for three and six months ended June 30, 2004. Hawthorns and Lakes Regions financial condition is included in the Companys consolidated statements of financial condition as of June 30, 2004 and December 31, 2003.
 
 9
  On a pro forma basis, the Companys total income, net income, basic and fully diluted earnings per share for the three and six months ended June 30, 2004 and June 30, 2003, after giving effect to the acquisition of Hawthorn and Lakes Region as if they had occurred on January 1, 2003 are as follows (dollars in thousands):
 
 Three months ended
June 30,
Six months ended
June 30,2004
2003
2004
2003Interest income

$
17,363

$
17,733

$
34,280

$
35,788Interest expense


5,311


5,665


10,600


11,502Net interest income


12,052


12,068


23,680


24,286Provision for loan losses


600


861


1,200


1,497Other income


2,975


5,420


5,719


9,086Other expense


9,363


12,240


18,358


23,428Net income before tax


5,064


4,387


9,841


8,447Income taxes


1,627


1,485


3,162


2,710Net income

$
3,437


2,902

$
6,679

$
5,737Basic earnings per share

$
0.52

$
0.44

$
1.00

$
0.86Diluted earnings per share

$
0.50

$
0.42

$
0.97

$
0.84 
 Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations.
 
 Application of Critical Accounting Policies
 
 The Companys consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States and follow general practices within the banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements. Future changes in information may affect these estimates, assumptions, and judgments, which, in turn, may affect amounts reported in the consolidated financial statements.
 
 All significant accounting policies are presented in Note 1 to the consolidated financial statements in the Companys 2003 Annual Report on Form 10-K. These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets and liabilities are valued in the consolidated financial statements and how those values are determined.
 
 Management has determined that its accounting policies with respect to the allowance for loan losses is the accounting area requiring subjective or complex judgments to the Companys financial position and results of operations, and therefore, is its most important critical accounting policy. The allowance for loan losses represents managements estimate of probable credit losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated statements of financial condition. Note 1 to the consolidated financial statements in the Companys 2003 Annual Report on Form 10-K describes the methodology used to determine the allowance for loan losses. In addition, a discussion of the factors driving changes in the amount of the allowance for loan losses is included in the Provision for Loan Losses section of managements discussion.
 
 Effective January 1, 2002, the Company adopted SFAS No. 142, Goodwill and Other Intangible Assets. Under SFAS 142, the Company is required to perform annual impairment tests of its goodwill and intangible assets and more frequently in certain circumstances. The Company has elected to test for goodwill impairment in the fourth quarter of each year. The goodwill impairment test is a two-step process, which requires management to make judgments in determining what assumptions to use in the calculation. The first step of the process consists of estimating the fair value of each reporting unit based on a discounted cash flow model using revenue and profit forecasts and comparing those estimated fair values with the carrying values, which includes the allocated goodwill. If the estimated fair value is less than the carrying value, a second step is performed to compute the amount of the impairment by determining an implied fair value of goodwill. The determination of a reporting units implied fair value of goodwill requires the Company to allocate the estimated fair value of the reporting unit to the assets and liabilities of the reporting unit. Any unallocated fair value represents the implied fair value of goodwill, which is compared to its corresponding carrying value.
 
 10
  The Company cannot predict the occurrence of certain future events that might adversely affect the reported value of goodwill that totaled $37.6 million at June 30, 2004. Such events include, but are not limited to, strategic decisions made in response to economic and competitive conditions, the impact of the economic environment on the Companys customer base, or a material negative change in its relationships with significant customers.
 
 Changes in Financial Condition
 
 The Companys total assets were $1.6 billion at June 30, 2004 and $1.5 billion at December 31, 2003. During the first half of 2004, significant uses of funds by the Company consisted of a $20.3 million increase in loans, $146.5 million net increase in investment securities, $2.3 million decrease in net cash provided by operating activities, $4.2 million purchase of treasury stock, $2.0 million in payment of cash dividends, and $1.8 million in net purchases of premises and equipment. Funding sources for the first half of 2004 came from a $37.6 million increase in deposits, $118.8 million increase in securities sold under agreement to repurchase, $15.0 million in proceeds from trust preferred securities offering, $1.3 million net increase in notes payable, and $568 thousand in proceeds from the exercise of stock options.
 
 Asset Quality
 
 At June 30, 2004, the Companys non-performing assets were $9.4 million, a decrease of $6.4 million from December 31, 2003 primarily due to a decrease of $4.5 million in other real estate owned and $1.9 million in non-accrual loans. The decrease in other real estate owned was mainly due to the sale of one large parcel of real property with a carrying value of $5.2 million which closed during the second quarter of 2004 at a price resulting in a gain to State of approximately $300 thousand. Total non-performing assets as a percentage of total assets were 0.59% at June 30, 2004 and 1.09% at December 31, 2003. As a percentage of total loans outstanding, the level of non-performing loans was 0.94% at June 30, 2004 compared to 1.18% at December 31, 2003. This percentage decrease was due to the decrease in non-performing loans and the increase in average loans outstanding.
 
 When, in the opinion of management, serious doubt exists as to the collectibility of a loan, the loan is placed on non-accrual status. In all cases, however, when a loan reaches 90 days delinquent on the payment of principal or interest the loan is placed on non-accrual status. At the time a loan is classified as non-accrual, interest credited to income in the current year is reversed and interest income accrued in the prior year is charged to the allowance for loan losses. The following table summarizes non-performing assets on the dates indicated (dollars in thousands).
 
 Jun. 30
2004
Mar. 31
2004
Dec. 31
2003
Sep. 30
2003
Jun. 30
2003Non-accrual loans

$
8,729

$
9,429

$
10,332

$
10,993

$
10,731Accruing loans past due 90 days or more


-


-


-


-


-Restructured loans


-


-


-


-


-Total non-performing and restructured loans


8,729


9,429


10,332


10,993


10,731Other real estate owned


988


5,742


5,483


5,381


371Total non-performing assets

$
9,416

$
15,171

$
15,815

$
16,374

$
11,102Ratios:Non-performing loans to total loans


0.97
%

1.05
%

1.18
%

1.40
%

1.34
%Allowance to total loans


1.32


1.24


1.22


1.32


1.23Allowance to non-performing loans


135.22


118.53


103.62


94.29


91.50Non-performing assets to total assets


0.61


1.01


1.09


1.24


0.84 
 Allowance for Loan Losses and Net Charge-offs
 
 Management maintains the allowance for loan losses (the "Allowance") at a level considered adequate to provide for probable loan losses. The Allowance is increased by provisions charged to earnings and is reduced by charge-offs, net of recoveries. At June 30, 2004, the Allowance was $11.8 million, an increase of $1.1 million from the balance at December 31, 2003. The Allowance was increased primarily due to the increased number of commercial loans, which are generally higher risk, particularly during a weak economic period. As of June 30, 2004 and December 31, 2003 commercial and commercial real estate loans made up 77% of the total loan portfolio. As the commercial loan portfolio has grown in size, the complexity of the commercial relationship has also increased.
 
 11
  As a percentage of total loans outstanding, the Allowance was 1.32% at June 30, 2004 compared to 1.22% at December 31, 2003. The determination of Allowance adequacy is based upon on-going evaluations of the Companys loan portfolio conducted by the Internal Loan Review function of its banking subsidiary, State Financial Bank, N.A. (the Bank), and reviewed by management. These evaluations consider a variety of factors, including, but not limited to, general economic conditions, loan portfolio size, type, and composition, previous loss experience, the borrowers financial condition, collateral adequacy, and the level of non-performing loans. Based upon its analyses, management considered the Allowance adequate to recognize the risk inherent in the loan portfolio at June 30, 2004.
 
 The following table sets forth an analysis of the Allowance for loan losses for the periods indicated (dollars in thousands):
 
 Six months
ended
June. 30, 2004
Year ended
Dec. 31, 2003Balance at beginning of period

$
10,706

$
8,805Charge-offs:Commercial


58


727Real estate mortgage


205


712Installment


153


390Other


9


31Total charge-offs


424


1,860Recoveries:Commercial


151


121Real estate mortgage


145


18Installment


24


75Other


1


3Total recoveries


321


217Net charge-offs


103


1,643Balance of acquired allowance at date of acquisitions


0


919Additions charged to operations


1,200


2,625Balance at end of period

$
11,803

$
10,706Ratios:Net charge-offs to average loans outstanding1


0.02
%

0.21
%Net charge-offs to total allowance1


1.75


15.35Allowance to period end loans outstanding


1.32


1.22 1.Annualized.
 
 Results of Operations-Comparison of the Three-Month Periods Ended June 30, 2004 and June 30, 2003.
 
 General
 
 For the quarter ended June 30, 2004, the Company reported net income of $3.4 million and net income per share on a fully diluted basis of $0.50, compared to net income of $3.0 million and net income per share on a fully diluted basis of $0.44 reported for the quarter ended June 30, 2003.
 
 Net Interest Income
 
 The following table sets forth average balances, related interest income and expenses, and effective interest yields and rates for the three-month periods ended June 30, 2004 and June 30, 2003 (dollars in thousands):
 
 12
  Three months ended
June 30, 2004
Three months ended
June 30, 2003Average Balance
Interest
Yield/
Rate4
Average Balance
Interest
Yield/
Rate4AssetsInterest-earning assets:Loans123

$
894,760

$
12,926


5.81
%
$
777,927

$
11,911


6.14
%Taxable investment securities


402,267


3,852


3.85
%

365,900


3,260


3.57
%Tax-exempt investment securities3


57,647


844


5.89
%

61,084


880


5.78
%Interest-earnings deposits


5,694


16


1.09
%

3,060


10


1.31
%Federal funds sold


14,136


29


0.82
%

15,677


42


1.07
%Total interest-earning assets


1,374,504


17,667


5.17
%

1,223,648


16,103


5.28
%Non-interest-earnings assets:Cash and due from banks


56,998








24,117Premises and equipment, net


33,249








27,486Other assets


78,932








60,331Less: Allowance for loan losses


(11,385
)







(9,495
)Total

$
1,532,298







$
1,326,087Liabilities And Stockholders EquityInterest-bearing liabilities:Now accounts

$
123,732

$
85


0.28
%
$
126,191

$
125


0.40
%Money market accounts


249,421


713


1.15
%

212,339


593


1.12
%Savings deposits


135,692


134


0.40
%

129,455


155


0.48
%Time deposits


378,538


2,390


2.54
%

319,998


2,334


2.93
%Notes payable


62,247


579


3.74
%

27,480


275


4.01
%FHLB borrowings


67,800


788


4.67
%

77,400


784


4.06
%Federal funds purchased


2,452


8


1.31
%

923


4


1.74
%Securities sold under agreement to repurchase


216,807


614


1.14
%

156,006


688


1.77
%Total interest-bearing liabilities


1,236,689


5,311


1.73
%

1,049,792


4,958


1.89
%Non-interest-bearings liabilities:Demand deposits


178,119








158,704Other


6,096








8,475Total liabilities


1,420,904








1,216,971Stockholders equity


111,394








109,116Total

$
1,532,298







$
1,326,087Net interest earning and interest rate spread




$
12,356


3.44
%



$
11,145


3.39
%Net yield on interest-earning assets








3.62
%







3.65
% 
 1. For the purposes of these computations, non-accrual loans are included in the daily average loan amounts outstanding.
 
 2. Interest earned on loans includes loan fees, which are not material in amount.
 
 3. Tax equivalent adjusted
 
 4 . Annualized.
 
 In accordance with new SEC rules required by the Sarbanes-Oxley Act of 2002 regarding the use of financial measures and ratios not calculated in accordance with GAAP, a reconciliation must be provided that shows these measures and ratios calculated according to GAAP and a statement why management believes these measures and ratios provide a more accurate view of performance.
 
 Certain non-GAAP performance measures and ratios are used by management to evaluate and measure the Company's performance. These include taxable-equivalent net interest income (including its individual components) and net interest margin (including its individual components). Management believes that these measures and ratios provide users of the Company's financial information with a more accurate view of the performance of the interest-earning assets and interest-bearing liabilities for comparative purposes. Other financial holding companies may define or calculate these measures and ratios differently. See the table below for supplemental data and the corresponding reconciliation to GAAP financial measures for the three months ended June 30, 2004 and June 30, 2003.
 
 Management reviews yields on certain asset categories and the net interest margin of the Company, and its banking subsidiaries, on a fully taxable-equivalent basis ("FTE"). In this non-GAAP presentation, net interest income is adjusted to reflect tax-exempt interest income on an equivalent before-tax basis. This measures comparability of net interest income arising from both taxable and tax-exempt sources (dollars in thousands).
 
 13
  Three months ended
June 30,2004
2003(A) Interest income (GAAP)

$
17,363

$
15,784Taxable equivalent adjustment-loans


9


10Taxable equivalent adjustment-Tax-exempt securities


295


309Interest income-FTE


17,667


16,103(B) Interest expense (GAAP)


5,311


4,958(C) Net interest income (GAAP) (A minus B)


12,052


10,826Net interest income-FTE


12,356


11,145(D) Net interest margin (GAAP)(annualized)


3.52
%

3.55
%Net interest margin-FTE (annualized)


3.62
%

3.65
% 
 Taxable-equivalent adjustments to interest income involve the conversion of tax-exempt sources of interest income to the equivalent amounts of interest income that would be necessary to derive the same net return if the investments had been subject to income taxes. A 35% incremental income tax rate is used in the conversion of tax-exempt interest income to a taxable-equivalent basis.
 
 For the quarter ended June 30, 2004, the Company reported taxable-equivalent net interest income of $12.4 million, an increase of $1.2 million, or 10.9%, from the $11.1 million reported for the quarter ended June 30, 2003. This increase reflects the Companys interest rate risk management policy, which is designed to minimize the impact of interest rate changes on net interest income. The taxable-equivalent yield on interest-earning assets (net interest margin) decreased to 3.62% in the second quarter of 2004 from 3.65% in the second quarter of 2003.
 
 The Companys taxable-equivalent total interest income increased $1.6 million for the quarter ended June 30, 2004 compared to the same period of 2003 due to the increase in average loans outstanding, partially offset by a lower rate environment. Average loans outstanding increased by $116.8 million, or 15.0%, in the second quarter of 2004 over the second quarter of 2003. For the quarter ended June 30, 2004, the taxable-equivalent yield on interest-earning assets was 5.17% compared to 5.28% for the quarter ended June 30, 2003. The second quarter 2004 loan yield was 5.81% compared to 6.14% in the second quarter of 2003. The Company experienced increased yields earned on its investment securities as cash flows from maturities and repayments were reinvested at higher rates. For the quarter ended June 30, 2004, the yield earned on taxable investment securities increased to 3.85% from 3.57% for the quarter ended June 30, 2003. The taxable equivalent yields earned on tax-exempt investment securities increased to 5.89% for the quarter ended June 30, 2004 from 5.78% for the quarter ended June 30, 2003. The increase in these yields for the second quarter of 2004 compared to the second quarter of 2003 is the result of matured or repaid securities replaced by higher yielding securities in a higher interest rate environment.
 
 The Companys funding costs were also impacted by the lower interest rate environment prevalent over the preceding twelve months. The cost of interest-bearing liabilities decreased to 1.73% for the second quarter of 2004 from 1.89% for the second quarter of 2003. The Company uses wholesale funding sources, such as the Federal Home Loan Bank (FHLB), to balance the timing differences between its various business funding sources and to support loan origination. In the second quarter of 2004, notes payable, FHLB borrowings, federal funds purchased, and securities sold under agreements to repurchase comprised 28.2% of the Companys interest-bearing liabilities compared to 24.9% in the second quarter 2003 due to loan growth exceeding deposit growth in the period.
 
 Provision for Loan Losses
 
 The provision for loan losses was $600 thousand in the second quarter of 2004 and $825 in the second quarter of 2003. The provision is adjusted to reflect loan growth and managements assessment of asset quality and risk inherent in the loan portfolio. This loan growth has been primarily concentrated in the commercial and commercial real estate loan categories. These loans inherently involve more risk than exists in residential mortgage and consumer loans.
 
 Other Income
 
 Total other income decreased $2.3 million in the second quarter of 2004 over the second quarter of 2003. The decrease was the result of a $1.3 million gain in the second quarter 2003 on the sale of the merchant credit card processing business, a decrease of $807 thousand in gains on the sale of mortgage loans due to decreased refinancing activity, and a decrease of $500 thousand in automated teller machine (ATM) and merchant services due to the sale of the merchant processing business. The decreases were offset by increases in service charges on deposit accounts, security commissions and management fees, and investment securities gains.
 
 14
  Other Expenses
 
 Other expenses decreased $1.7 million in the second quarter of 2004 over the second quarter of 2003. The decrease was due to non-recurring expenses in the second quarter 2003 of $450 thousand related to the sale of the merchant credit card processing business, efficiency consulting expense of $570 thousand, and severance charges of $180 thousand. The decrease was also the result of decreases in personnel costs, legal and professional fees, and ATM and merchant services. These decreases were offset by increases in net occupancy and equipment expense, data processing, advertising and other expense. Personnel costs decreased $503 thousand partially due to decreased sales commissions as a result of the decreased volume of refinancing activity on residential mortgages and lower staffing levels offset by the acquisition of Anchor Bank and Hawthorn Bank. Net occupancy and equipment expense increased $127 thousand and data processing increased $59 thousand. Both increases are mainly due to the three additional locations as a result of the acquisitions in December 2003. Legal and professional expense decreased $213 thousand. ATM and merchant services decreased $436 thousand mainly due to the sale of the merchant credit card processing business. Other expense increased $363 thousand mainly due to increased amortization of core deposit intangible as a result of the acquisition of Anchor Bank and Hawthorn Bank.
 
 Income Taxes
 
 The Company's consolidated income tax rate varies from statutory rates principally due to nondeductible goodwill, tax-exempt interest income on investment securities, loans, and nondeductible merger related expenses. The effective tax rate for the three months ended June 30, 2004 was 32.1% compared to 27.7% for the three months ended June 30, 2003. Provisions for income tax were $1.6 million for the second quarter of 2004 compared to $1.2 million for the second quarter of 2003.
 
 Results of Operations-Comparison of the Six-Month Periods Ended June 30, 2004 and June 30, 2003.
 
 General
 
 For the six months ended June 30, 2004, the Company reported net income of $6.7 million and net income per share on a fully diluted basis of $0.97, compared to net income of $5.9 million and net income per share on a fully diluted basis of $0.87 reported for the six months ended June 30, 2003.
 
 Net Interest Income
 
 The following table sets forth average balances, related interest income and expenses, and effective interest yields and rates for the six-month periods ended June 30, 2004 and June 30, 2003 (dollars in thousands):
 15 
 Six months ended
June 30, 2004
Six months ended
June 30, 2003Average Balance
Interest
Yield/
Rate4
Average Balance
Interest
Yield/
Rate4AssetsInterest-earning assets:Loans123

$
890,249

$
25,799


5.83
%
$
762,089

$
23,693


6.27
%Taxable investment securities


371,776


7,284


3.94
%

350,378


7,014


4.04
%Tax-exempt investment securities3


57,558


1,682


5.88
%

62,799


1,824


5.86
%Interest-earnings deposits


7,835


45


1.15
%

2,874


19


1.36
%Federal funds sold


16,845


77


0.92
%

11,573


62


1.08
%Total interest-earning assets


1,344,263


34,887


5.22
%

1,189,713


32,612


5.53
%Non-interest-earnings assets:Cash and due from banks


53,149








33,801Premises and equipment, net


33,089








27,666Other assets


79,197








61,015Less: Allowance for loan losses


(11,151
)







(9,263
)Total

$
1,498,547







$
1,302,932Liabilities And Stockholders EquityInterest-bearing liabilities:Now accounts

$
121,962

$
163


0.27
%
$
115,414

$
224


0.39
%Money market accounts


242,243


1,315


1.09
%

213,303


1,239


1.17
%Savings deposits


135,680


268


0.40
%

127,765


361


0.57
%Time deposits


372,506


4,761


2.57
%

321,340


4,765


2.99
%Notes payable


60,287


1,109


3.70
%

28,785


547


3.83
%FHLB borrowings


67,800


1,577


4.68
%

77,676


1,569


4.07
%Federal funds purchased


2,466


20


1.63
%

1,536


13


1.71
%Securities sold under agreement to repurchase


201,581


1,387


1.38
%

143,048


1,363


1.92
%Total interest-bearing liabilities


1,204,525


10,600


1.77
%

1,028,867


10,081


1.98
%Non-interest-bearings liabilities:Demand deposits


173,291








156,674Other


8,130








9,702Total liabilities


1,385,946








1,195,243Stockholders equity


112,601








107,689Total

$
1,498,547







$
1,302,932Net interest earning and interest rate spread




$
24,287


3.45
%



$
22,531


3.55
%Net yield on interest-earning assets








3.63
%







3.82
% 
 1. For the purposes of these computations, non-accrual loans are included in the daily average loan amounts outstanding.
 
 2. Interest earned on loans includes loan fees, which are not material in amount.
 
 3. Tax equivalent adjusted
 
 4. Annualized .
 
 In accordance with new SEC rules required by the Sarbanes-Oxley Act of 2002 regarding the use of financial measures and ratios not calculated in accordance with GAAP, a reconciliation must be provided that shows these measures and ratios calculated according to GAAP and a statement why management believes these measures and ratios provide a more accurate view of performance.
 
 Certain non-GAAP performance measures and ratios are used by management to evaluate and measure the Company's performance. These include taxable-equivalent net interest income (including its individual components) and net interest margin (including its individual components). Management believes that these measures and ratios provide users of the Company's financial information with a more accurate view of the performance of the interest-earning assets and interest-bearing liabilities for comparative purposes. Other financial holding companies may define or calculate these measures and ratios differently. See the table below for supplemental data and the corresponding reconciliation to GAAP financial measures for the six months ended June 30, 2004 and June 30, 2003.
 
 Management reviews yields on certain asset categories and the net interest margin of the Company, and its banking subsidiaries, on a fully taxable-equivalent basis ("FTE"). In this non-GAAP presentation, net interest income is adjusted to reflect tax-exempt interest income on an equivalent before-tax basis. This measures comparability of net interest income arising from both taxable and tax-exempt sources (dollars in thousands).
 
 16
  Six months ended
June 30,2004
2003(A) Interest income (GAAP)

$
34,280

$
31,946Taxable equivalent adjustment-loans


18


29Taxable equivalent adjustment-Tax-exempt securities


589


637Interest income-FTE


34,887


32,612(B) Interest expense (GAAP)


10,600


10,081(C) Net interest income (GAAP) (A minus B)


23,680


21,865Net interest income-FTE


24,287


22,531(D) Net interest margin (GAAP)(annualized)


3.53
%

3.71
%Net interest margin-FTE (annualized)


3.63
%

3.82
% 
 Taxable-equivalent adjustments to interest income involve the conversion of tax-exempt sources of interest income to the equivalent amounts of interest income that would be necessary to derive the same net return if the investments had been subject to income taxes. A 35% incremental income tax rate is used in the conversion of tax-exempt interest income to a taxable-equivalent basis.
 
 For the six months ended June 30, 2004, the Company reported taxable-equivalent net interest income of $24.3 million, an increase of $1.8 million, or 7.8%, from the $22.5 million reported for the six months ended June 30, 2003. This increase reflects the Companys interest rate risk management policy, which is designed to minimize the impact of interest rate changes on net interest income. The taxable-equivalent yield on interest-earning assets (net interest margin) decreased to 3.63% in the first half of 2004 from 3.82% in the first half of 2003, reflecting repricing of assets in a low rate environment.
 
 The Companys taxable-equivalent total interest income increased $2.3 million for the six months ended June 30, 2004 compared to the same period of 2003 due to the increase in average loans outstanding, partially offset by a lower rate environment. Average loans outstanding increased by $128.2 million, or 16.8%, in the first half of 2004 over the first half of 2003. For the six months ended June 30, 2004, the taxable-equivalent yield on interest-earning assets was 5.22% compared to 5.53% for the six months ended June 30, 2003. The first half of 2004 loan yield was 5.83% compared to 6.27% in the first half of 2003. The Company also experienced decreased yields earned on its investment securities as cash flows from maturities and repayments were reinvested at lower rates. For the six months ended June 30, 2004, the yield earned on taxable investment securities decreased to 3.94% from 4.04% for the six months ended June 30, 2003. The taxable equivalent yields earned on tax-exempt investment securities increased to 5.88% for the six months ended June 30, 2004 from 5.86% for the six month ended June 30, 2003.
 
 The Companys funding costs were also impacted by the lower interest rate environment prevalent over the preceding twelve months. The cost of interest-bearing liabilities decreased to 1.77% for the first half of 2004 from 1.98% for the first half of 2003. The Company uses wholesale funding sources, such as the Federal Home Loan Bank (FHLB), to balance the timing differences between its various business funding sources and to support loan origination. In the first half of 2004, notes payable, FHLB borrowings, federal funds purchased, and securities sold under agreements to repurchase comprised 27.6% of the Companys interest-bearing liabilities compared to 24.4% in the first half of 2003 due to loan growth exceeding deposit growth in the period.
 
 Provision for Loan Losses
 
 The provision for loan losses was $1.2 million in the first half of 2004 and $1.4 million in the first half of 2003. The provision is adjusted to reflect loan growth and managements assessment of asset quality and risk inherent in the loan portfolio. This loan growth has been primarily concentrated in the commercial and commercial real estate loan categories. These loans inherently involve more risk than exists in residential mortgage and consumer loans.
 
 Other Income
 
 Total other income decreased $3.1 million for the first half of 2004 over the first half of 2003. The decrease was the result of a $1.3 million gain in the second quarter 2003 on the sale of the merchant credit card processing business, a decrease of $1.7 million in gains on sale of mortgage loans due to decreased refinancing activity, and a decrease of $977 thousand in automated teller machine (ATM) and merchant services due to the sale of the merchant processing business. The decreases were offset by increases in service charges on deposit accounts of $249 thousand, security commissions and management fees of $170 thousand, investment securities gains of $283 thousand, and other income of $156 thousand.
 
 17
  Other Expenses
 
 Other expenses decreased $2.8 million in the first half of 2004 over the first half of 2003. The decrease was due to expenses in the second quarter 2003 of $450 thousand related to the sale of the merchant credit card processing business, efficiency consulting expense of $570 thousand, and severance charges of $180 thousand. The decrease was also the result of decreases in personnel costs, legal and professional fees, and ATM and merchant services. These decreases were offset by increases in net occupancy and equipment expense, data processing, advertising and other expense. Personnel costs decreased $1.3 million partially due to decreased sales commissions as a result of the decreased volume of refinancing activity on residential mortgages and lower staffing levels offset by the acquisition of Anchor Bank and Hawthorn Bank. Net occupancy and equipment expense increased $254 thousand and data processing increased $123 thousand. Both increases are mainly due to the three additional locations as a result of the acquisitions in December 2003. Legal and professional expense decreased $211 thousand. ATM and merchant services decreased $822 thousand mainly due to the sale of the merchant credit card processing business. Other expense increased $297 thousand mainly due to increased amortization of core deposit intangible as a result of the acquisition of Anchor Bank and Hawthorn Bank.
 
 Income Taxes
 
 The Company's consolidated income tax rate varies from statutory rates principally due to nondeductible goodwill, tax-exempt interest income on investment securities, loans, and nondeductible merger related expenses. The effective tax rate for the six months ended June 30, 2004 was 32.1% compared to 27.8% for the six months ended June 30, 2003. Provisions for income tax were $3.2 million for the first half of 2004 compared to $2.3 million for the first half of 2003.
 
 Liquidity
 
 The primary functions of asset/liability management are to assure adequate liquidity and to maintain an appropriate balance between interest-earning assets and interest-bearing liabilities. Liquidity management involves the ability to meet the cash flow requirements of depositors and borrowers. Liquid assets (including cash deposits with banks, short-term investments, interest-earning deposits, and federal funds sold) are maintained primarily to meet customers current needs. The Company had liquid assets of $74.7 million and $78.4 million at June 30, 2004 and December 31, 2003, respectively.
 
 Capital Resources
 
 There are certain regulatory requirements that affect the Company's level of capital. The following table sets forth these requirements and the Company's capital levels and ratios at June 30, 2004 (dollars in thousands):
 
 Actual
Regulatory
Minimum
Requirement
Regulatory
Well-capitalized
RequirementAmount
Percent
Amount
Percent
Amount
PercentTier 1 leverage

$
96,970


6.5
%
$
59,559


4.0
%
$
74,449


5.0
%Tier 1 risk-based capital

$
96,970


8.9
%
$
43,727


4.0
%
$
65,591


6.0
%Risk-based capital

$
122,774


11.2
%
$
87,454


8.0
%
$
109,318


10.0
% 
 The Company is pursuing a policy of continued asset growth, which requires the maintenance of appropriate ratios of capital to assets. The existing capital levels allow for additional asset growth without further capital infusion. It is the Company's plan to maintain its capital position at or in excess of the "well-capitalized" definition. The Company seeks to obtain additional capital growth through earnings retention and a consistent dividend policy.
 
 18
  Derivative Financial Instruments and Hedging Activities
 
 Interest rate risk, the exposure of the Companys net interest income and net fair value of its assets and liabilities, to adverse movements in interest rates, is a significant market risk exposure that can have a material effect on the Companys financial position, results of operations and cash flows. The Company has policies to ensure that neither earnings nor fair value at risk exceed established guidelines and assesses these risks by continually identifying and monitoring changes in interest rates that may adversely impact expected future earnings and fair values.
 
 The Company has designed strategies to confine these risks within the established limits and identify appropriate risk/reward trade-offs in the financial structure of its balance sheet. These strategies include the use of interest rate swap agreements to manage fluctuations in cash flows or fair values resulting from interest rate risk.
 
 The Company designated the current interest swap outstanding as a fair value hedge of an existing loan that qualifies for short-cut treatment.  Accordingly, the Company does not anticipate ineffectiveness arising from differences between the fair value of the loan and the fair value of the swap.
 
 The following table summarizes the Companys fair value hedges at June 30, 2004 (dollars in thousands):
 
 Hedged Item
Hedging Instrument
Notional Amount
Fair Value
Remaining Term (Years)Fixed Rate Loan
Receive Variable Swap
$3,905
$3,806
8.50 
 Item 3. Quantitative and Qualitative Disclosures About Market Risk.
 
 Refer to the Companys annual report on Form 10-K for the year ended December 31, 2003 for a complete discussion of the Companys market risk. There have been no material changes to the market risk information included in the Companys 2003 Annual Report on Form 10-K.
 
 Item 4. Controls and Procedures.
 
 Disclosure Controls and Procedures
 
 The Companys management, with the participation of the Companys Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Companys disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange Act)) as of the end of the period covered by this report. Based on such evaluation, the Companys Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Companys disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act.
 
 Internal Controls Over Financial Reporting
 
 There have not been any changes in the Companys internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Companys internal control over financial reporting.
 
 Forward Looking Statements
 
 Certain matters discussed in this Report are forward-looking statements that are intended to qualify for the safe harbor from liability established by the Private Securities Litigation Reform Act of 1995. These forward-looking statements can be identified as such because the statements generally will include words such as believes, anticipates, expects, or words of similar meaning. Similarly, statements that describe future plans, objectives, outlooks, targets or goals are also forward-looking statements. Such forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated as of the date of this Report. Factors that could cause such a variance include, but are not limited to, changes in interest rates, local market competition, customer loan and deposit preferences, governmental regulations, and other general economic conditions. Shareholders, potential investors, and other readers are urged to consider these factors in evaluating the forward-looking statements and cautioned not to place undue reliance on such forward-looking statements. The forward-looking statements included in this Report are only made as of the date of this Report, and the Company undertakes no obligation to publicly update such forward-looking statements to reflect subsequent events or circumstances.
 
 19
  Assumptions regarding interest rate sensitivity of some deposits also require significant judgment based on historical patterns relative to the industry and the Companys own experience. Actual sensitivity may vary from the assumptions made, and have an impact on the Companys net interest margin.
 
 Part II.  Other Information
 
 Item 1. Legal Proceedings.
 
 From time to time, the Company and the Bank, are party to legal proceedings arising out of their general lending activities and other operations. Currently there are no material proceedings.
 
 Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities.
 
 None.
 
 Item 3. Default Upon Senior Securities.
 
 None.
 
 Item 4. Submission of Matters to Vote of Security Holders.
 
 Annual Meeting of Shareholders . On May 5, 2004, at the Annual Meeting of the shareholders of the Company, the Company's shareholders reelected Michael J. Falbo and Ulice Payne Jr. and elected Richard A. Meeusen, and Kristine A. Rappe as directors for three-year terms expiring on the date of the annual shareholders' meeting to be held in 2007. The other directors of the Company whose terms of office continued after the 2004 annual meeting of shareholders are as follows: terms expiring at the 2005 annual meeting Jerome J. Holz, Thomas S. Rakow, and David M. Stamm; and terms expiring at the 2006 annual meeting Robert J. Cera, Richard A. Horn, and Barbara E. Weis. The Companys shareholders also approved the proposed amendment to the State Financial Services Corporation 1998 Stock Incentive Plan.
 
 Shareholder Vote with Respect to Matters Acted Upon at the Annual Meeting Election of Directors . Under Wisconsin law, the number of persons corresponding to the number of director positions to be filled at the Annual Meeting who received the highest number of votes are elected as directors. Michael J. Falbo, Ulice Payne Jr., Richard A. Meeusen, and Kristine A. Rappe stood for reelection and election as directors of the Company at the Annual Meeting. The votes with respect to the reelection and election of each were as follows:
 
 Michael J. Falbo5,933,073
votes were cast "FOR" the reelection of Mr. Falbo.0
votes were withheld for the reelection of Mr. Falbo.344,638
votes abstained or were broker non-votes.Ulice Payne Jr.5,814,229
votes were cast "FOR" the reelection of Mr. Payne.0
votes were withheld for the reelection of Mr. Payne.463,482
votes abstained or were broker non-votes.Richard A. Meeusen5,820,829
votes were cast "FOR" the election of Mr. Meeusen.0
votes were withheld for the election of Mr. Meeusen.456,882
votes abstained or were broker non-votes.Kristine A. Rappe5,819,003
votes were cast "FOR" the election of Ms. Rappe.0
votes were withheld for the election of Ms. Rappe.458,708
votes abstained or were broker non-votes. 
 20
  Amendment of State Financial Services Corporation 1998 Stock Incentive Plan. Under Wisconsin law, the amendment of the State Financial Services Corporation 1998 Stock Incentive Plan would be approved if, at the Annual Meeting, a greater number of votes were cast FOR the proposal than were cast AGAINST the proposal. Abstentions and brokers non-votes were not counted except for purposes of establishing a quorum. The vote on the amendment of the State Financial Services Corporation 1998 Stock Incentive Plan was as follows:
 
 2,992,442
votes were cast FOR the amendment of the State Financial Services Corporation 1998 Stock Incentive Plan.2,117,021
votes were cast AGAINST the amendment of the State Financial Services Corporation 1998 Stock Incentive Plan.1,168,248
votes abstained or were broker non-votes. 
 Item 5. Other Information.
 
 None.
 
 Item 6. Exhibits and Reports on Form 8-K.
 
 (a)  Exhibits
 
 31.1  Certification by the Chief Executive Officer pursuant to Rule 13a-14(a) or 15d-14(a) under the Securities Exchange Act of 1934.
 
 31.2  Certification by the Chief Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a) under the Securities Exchange Act of 1934.
 
 32  Certification Statement of the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350.
 
 (b)  Reports on Form 8-K
 
 The Company filed a Current Report on Form 8-K, dated April 23, 2004, furnishing under Item 12 the Companys press release dated April 20, 2004, with respect to financial results for the quarter ended March 31, 2004.
 21 SIGNATURES
 
 
 Pursuant to the requirement of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
 STATE FINANCIAL SERVICES CORPORATION
 (Registrant)
 
 
 Date: August 9, 2004  By /s/ Michael J. Falbo
 Michael J. Falbo
 President and Chief Executive Officer
 
 
 
 Date: August 9, 2004  By /s/ Daniel L. Westrope
 Daniel L. Westrope
 Senior Vice President and
 Chief Financial Officer
 
 22 STATE FINANCIAL SERVICES CORPORATION
 EXHIBIT INDEX TO FORM 10-Q
 For The Quarter Ended June 30, 2004
 
 
 Exhibit Number
 
 31.1   Certification by the Chief Executive Officer pursuant to Rule 13a-14(a) or 15d-14(a) under the Securities Exchange Act of 1934.
 
 31.2   Certification by the Chief Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a) under the Securities Exchange Act of 1934.
 
 32  Certification Statement of the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350.