**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, 2005****or****(
      )**
    **Transition
      Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of
      1934****For
      the transition period from ______________________ to
      ______________________**
 
 
 **Commission
File Number 000-18166**
 
 
 
 **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 Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period the Registrant was required to
file such reports), and (2) has been subject to such filing requirements for the
past 90 days. Yes [X] No [ ]
 
 Indicate
by check mark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Exchange Act).
 Yes [X]
No [ ]
 
 As of
August 8, 2005 , there were
7 ,018,849
shares of Registrant's $0.10 Par Value Common Stock
outstanding.
  1
  
 **FORM
      10-Q****STATE
      FINANCIAL SERVICES CORPORATION****INDEX****PART
      I - FINANCIAL INFORMATION**Page
      No.Item
      1.
    Financial
      Statements. (unaudited)Consolidated
      Statements of Financial Condition as of
      June
      30, 2005 (unaudited) and December 31, 2004 (audited)
    3Consolidated
      Statements of Income for the
      Three
      Months ended June 30, 2005 and June 30, 2004
    4Consolidated
      Statements of Income for the
      Six
      Months ended June 30, 2005 and June 30, 2004
    5Consolidated
      Statements of Cash Flows for the
      Six
      Months ended June 30, 2005 and June 30, 2004
    6Notes
      to Unaudited Consolidated Financial Statements
    7Item
      2.
    Management’s
      Discussion and Analysis of
      Financial
      Condition and Results of Operations.
    10Item
      3.
    Quantitative
      and Qualitative Disclosures****About
      Market Risk.
    19Item
      4.
    Controls
      and Procedures.
    20**PART
      II - OTHER INFORMATION**Item
      1.
    Legal
      Proceedings.
    21Item
      6.
    Exhibits.
    21Signatures
    
    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,**
      **2005**
      **(unaudited)**
    
    **December
      31, 2004**
      **(audited)****Assets**Cash
      and due from banks
    
    $
    39,975,432
    
    $
    34,864,395Interest-bearing
      bank balances
    
    
    5,766,426
    
    
    5,170,383Federal
      funds sold
    
    
    994,662
    
    
    14,968,937Cash
      and cash equivalents
    
    
    46,736,520
    
    
    55,003,715Investment
      securities:Available-for-sale
      (at fair value)
    
    
    360,619,037
    
    
    387,077,866Held-to-maturity
      (fair value of $277,868-2005
      and $279,511-2004)
    
    
    274,892
    
    
    274,947Loans
      and leases (net of allowance for loan and lease losses of $13,809,579-2005
      and $12,347,154-2004)
    
    
    1,016,169,371
    
    
    922,668,520Loans
      held for sale
    
    
    4,952,290
    
    
    3,129,775Premises
      and equipment
    
    
    32,607,789
    
    
    32,941,598Accrued
      interest receivable
    
    
    5,763,248
    
    
    5,690,553Goodwill
    
    
    36,815,156
    
    
    35,354,252Core
      deposit intangible
    
    
    4,384,780
    
    
    4,642,708Bank
      owned life insurance
    
    
    22,375,975
    
    
    21,920,248Other
      assets
    
    
    6,309,989
    
    
    7,178,719**Total
      Assets**
    
    $
    1,537,009,047
    
    $
    1,475,882,901**Liabilities
      and Shareholders’ Equity**Deposits
    
    
    1,068,457,783
    
    
    1,083,866,755Securities
      sold under agreement to repurchase
    
    
    159,083,121
    
    
    143,723,944Federal
      Home Loan Bank advances
    
    
    67,300,000
    
    
    67,300,000Note
      payable
    
    
    44,122,678
    
    
    15,790,000Subordinated
      debt
    
    
    14,000,000
    
    
    14,000,000Junior
      subordinated debentures owed to unconsolidated subsidiary
      trust
    
    
    30,000,000
    
    
    30,000,000Federal
      funds purchased
    
    
    24,000,000
    
    
    -Accrued
      expenses and other liabilities
    
    
    7,466,185
    
    
    4,137,478Accrued
      interest payable
    
    
    2,760,802
    
    
    2,182,398**Total
      Liabilities**
    
    
    1,417,190,569
    
    
    1,361,000,575Minority
      interest in consolidated subsidiary
    
    
    644,697
    
    
    -**Shareholders’
      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; issued9,697,837
      shares in 2005 and 9,623,301 shares in 2004, outstanding
      6,974,997and
      6,900,461shares in 2005 and 2004, respectively
    
    
    969,784
    
    
    962,330Additional
      paid-in capital
    
    
    88,226,942
    
    
    86,885,929Retained
      earnings
    
    
    77,891,392
    
    
    73,313,612Accumulated
      other comprehensive (loss) income
    
    
    (579,844
    )
    
    1,054,948Unearned
      shares held by ESOP
    
    
    (3,981,303
    )
    
    (3,981,303
    )Treasurystock-2,722,840shares in 2005 and 2004
    
    
    (43,353,190
    )
    
    (43,353,190
    )**Total
      Shareholders’ Equity**
    
    
    119,173,781
    
    
    114,882,326**Total
      Liabilities and Shareholders’ Equity**
    
    $
    1,537,009,047
    
    $
    1,475,882,901
 
 See notes
to unaudited consolidated financial statements.
  3
  **State
Financial Services Corporation And Subsidiaries**
 **Consolidated
Statements of Income (unaudited)**
 
 **Three
      Months Ended June 30,****2005**
    
    **2004****Interest
      income:**Loans
      and leases
    
    $
    17,227,038
    
    $
    12,917,564Investment
      securities:Taxable
    
    
    3,524,874
    
    
    3,867,596Tax-exempt
    
    
    541,254
    
    
    548,895Federal
      funds sold and other short-term investments
    
    
    41,811
    
    
    28,729**Total
      interest income**
    
    
    21,334,977
    
    
    17,362,784**Interest
      expense:**Deposits
    
    
    4,543,658
    
    
    3,321,840Securities
      sold under agreements to repurchase
    
    
    1,015,639
    
    
    613,640Federal
      Home Loan Bank advances
    
    
    684,413
    
    
    787,903Other
      borrowings
    
    
    976,486
    
    
    587,829**Total
      interest expense**
    
    
    7,220,196
    
    
    5,311,212**Net
      interest income**
    
    
    14,114,781
    
    
    12,051,572Provision
      for loan and lease losses
    
    
    689,248
    
    
    600,000**Net
      interest income after provision for loan and lease
      losses**
    
    
    13,425,533
    
    
    11,451,572**Other
      income:**Service
      charges on deposit accounts
    
    
    754,260
    
    
    766,586ATM
      and merchant service fees
    
    
    282,361
    
    
    259,070Security
      commissions and management fees
    
    
    137,865
    
    
    192,659Investment
      securities gains, net
    
    
    161,275
    
    
    198,899Gain
      on sale of loans
    
    
    379,883
    
    
    516,824Bank
      owned life insurance income
    
    
    223,589
    
    
    223,343Other
    
    
    681,161
    
    
    817,875**Total
      other income**
    
    
    2,620,394
    
    
    2,975,256**Other
      expenses:**Salaries
      and employee benefits
    
    
    5,006,343
    
    
    4,520,763Net
      occupancy expense
    
    
    735,216
    
    
    762,237Equipment
      rentals, depreciation and maintenance
    
    
    1,015,043
    
    
    1,070,919Data
      processing
    
    
    620,216
    
    
    598,693Legal
      and professional
    
    
    446,170
    
    
    198,517Advertising
    
    
    414,284
    
    
    329,424Delivery
      and postage
    
    
    189,979
    
    
    283,998Telephone
    
    
    154,473
    
    
    168,890Merger
      related expenses
    
    
    850,462
    
    
    -Other
    
    
    1,226,671
    
    
    1,429,120**Total
      other expenses**
    
    
    10,658,857
    
    
    9,362,561Minority
      interest in income of consolidated subsidiary
    
    
    66,960
    
    
    -**Income
      before income taxes**
    
    
    5,320,110
    
    
    5,064,267Income
      taxes
    
    
    2,153,405
    
    
    1,626,895**Net
      income**
    
    $
    3,166,705
    
    $
    3,437,372**Basic
      earnings per common share**
    
    $
    0.47
    
    $
    0.52**Diluted
      earnings per common share**
    
    
    0.46
    
    
    0.50**Dividends
      per common share**
    
    
    0.17
    
    
    0.15
 
 See notes
to unaudited consolidated financial statements.
  4
  **State
Financial Services Corporation And Subsidiaries**
 **Consolidated
Statements of Income (unaudited)**
 
 **Six
      Months Ended June 30,****2005**
    
    **2004****Interest
      income:**Loans
      and leases
    
    $
    32,933,940
    
    $
    25,781,330Investment
      securities:Taxable
    
    
    7,068,473
    
    
    7,328,775Tax-exempt
    
    
    1,095,282
    
    
    1,093,232Federal
      funds sold and other short-term investments
    
    
    67,392
    
    
    76,874**Total
      interest income**
    
    
    41,165,087
    
    
    34,280,211**Interest
      expense:**Deposits
    
    
    7,969,928
    
    
    6,507,236Securities
      sold under agreements to repurchase
    
    
    1,860,301
    
    
    1,386,918Federal
      Home Loan Bank advances
    
    
    1,414,561
    
    
    1,577,294Other
      borrowings
    
    
    2,504,137
    
    
    1,128,808**Total
      interest expense**
    
    
    13,748,927
    
    
    10,600,256**Net
      interest income**
    
    
    27,416,160
    
    
    23,679,955Provision
      for loan and lease losses
    
    
    1,217,258
    
    
    1,200,000**Net
      interest income after provision for loan and lease
      losses**
    
    
    26,198,902
    
    
    22,479,955**Other
      income:**Service
      charges on deposit accounts
    
    
    1,520,737
    
    
    1,629,106ATM
      and merchant service fees
    
    
    543,333
    
    
    474,133Security
      commissions and management fees
    
    
    278,640
    
    
    365,798Investment
      securities gains, net
    
    
    307,511
    
    
    418,279Gain
      on sale of loans
    
    
    693,687
    
    
    929,410Bank
      owned life insurance income
    
    
    455,727
    
    
    438,093Other
    
    
    1,419,646
    
    
    1,464,084**Total
      other income**
    
    
    5,219,281
    
    
    5,718,903**Other
      expenses:**Salaries
      and employee benefits
    
    
    10,174,769
    
    
    8,887,374Net
      occupancy expense
    
    
    1,527,393
    
    
    1,534,023Equipment
      rentals, depreciation and maintenance
    
    
    1,986,278
    
    
    2,066,128Data
      processing
    
    
    1,229,027
    
    
    1,192,852Legal
      and professional
    
    
    768,291
    
    
    603,376Advertising
    
    
    650,024
    
    
    650,001Delivery
      and postage
    
    
    408,111
    
    
    560,700Telephone
    
    
    329,085
    
    
    343,234Merger
      related expenses
    
    
    850,462
    
    
    -Other
    
    
    2,492,452
    
    
    2,520,098**Total
      other expenses**
    
    
    20,415,892
    
    
    18,357,786Minority
      interest in income of consolidated subsidiary
    
    
    116,985
    
    
    -**Income
      before income taxes**
    
    
    10,885,306
    
    
    9,841,072Income
      taxes
    
    
    4,034,464
    
    
    3,161,946**Net
      income**
    
    $
    6,850,842
    
    $
    6,679,126**Basic
      earnings per common share**
    
    $
    1.03
    
    $
    1.00**Diluted
      earnings per common share**
    
    
    1.00
    
    
    0.97**Dividends
      per common share**
    
    
    0.34
    
    
    0.30
 
 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,****2005**
    
    **2004****Operating
      Activities**Net
      income
    
    $
    6,850,842
    
    $
    6,679,126Adjustments to
      reconcile net income to net cash provided by (used in) operating
      activities:Provision for
      loan and lease losses
    
    
    1,217,258
    
    
    1,200,000Depreciation
    
    
    1,391,163
    
    
    1,503,488Amortization of
      premiums and accretion of discounts on investment
    securities
    
    
    519,920
    
    
    337,675Amortization of
      deferred loan fees
    
    
    (669,219
    )
    
    (310,465
    )Income
      from bank owned life insurance
    
    
    (455,727
    )
    
    (438,093
    )Net
      change in loans held for sale
    
    
    (1,822,515
    )
    
    (1,492,965
    )Increase in
      accrued interest receivable
    
    
    (72,695
    )
    
    (462,164
    )Increase in
      accrued interest payable
    
    
    539,649
    
    
    368,899Realized
      investment securities gains
    
    
    (307,511
    )
    
    (418,279
    )Payment
      to Lakes Region Bancorp’s shareholders for acquisition
    
    
    -
    
    
    (13,416,729
    )Other
    
    
    2,574,390
    
    
    2,657,580Net
      cash provided by (used in) operating activities
    
    
    9,765,555
    
    
    (3,791,927
    )**Investing
      Activities**Proceeds from
      maturities or principal payments of investment securities
      held-to-maturity
    
    
    -
    
    
    280,000Purchases of
      investment securities available-for-sale
    
    
    (336,739,648
    )
    
    (390,394,283
    )Proceeds
      from maturities and sales of investment securities
      available-for-sale
    
    
    360,303,727
    
    
    243,619,695Net
      increase in loans and leases
    
    
    (67,251,730
    )
    
    (18,758,116
    )Business
      acquisitions, net of cash acquired of $483,000 in 2005
    
    
    (3,088,680
    )
    
    -Net
      purchases of premises and equipment
    
    
    (997,155
    )
    
    (1,764,641
    )Net
      cash used in investing activities
    
    
    (47,773,486
    )
    
    (167,017,345
    )**Financing
      Activities**Net
      (decrease) increase in deposits
    
    
    (15,408,972
    )
    
    37,647,332Repayment of
      notes payable
    
    
    (23,959,537
    )
    
    (19,000,000
    )Proceeds of
      notes payable
    
    
    30,557,678
    
    
    20,300,000Proceeds from
      junior subordinated debentures owed to unconsolidated subsidiary
      trust
    
    
    -
    
    
    14,700,000Increase in
      securities sold under agreements to repurchase
    
    
    15,359,177
    
    
    118,815,021Proceeds from
      federal funds purchased
    
    
    24,000,000
    
    
    -Minority
      interest in income of consolidated subsidiary
    
    
    116,985
    
    
    -Cash
      dividends
    
    
    (2,273,062
    )
    
    (1,997,345
    )Purchase of
      treasury stock
    
    
    -
    
    
    (4,158,350
    )Proceeds from
      exercise of stock options
    
    
    1,348,467
    
    
    567,754Net
      cash provided by financing activities
    
    
    29,740,736
    
    
    166,874,412Decrease
      in cash and cash equivalents
    
    
    (8,267,195
    )
    
    (3,934,860
    )Cash
      and cash equivalents at beginning of period
    
    
    55,003,715
    
    
    78,368,126Cash
      and cash equivalents at end of period
    
    $
    46,736,520
    
    $
    74,733,266Supplemental
      information:Interest
      paid
    
    $
    13,170,523
    
    $
    10,231,357Income
      taxes paid
    
    
    4,368,889
    
    
    4,161,843
 
 See notes
to unaudited consolidated financial statements.
  6
  **State
Financial Services Corporation And Subsidiaries**
 **Notes
to Unaudited Consolidated Financial Statements**
 **For
the Quarter Ended June 30, 2005**
 
 **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”) and 80 percent of the equity interests of m2 Lease Funds LLC (“M2”). All
significant intercompany balances and transactions have been eliminated. The
unaudited consolidated financial statements have been prepared in accordance
with United States generally accepted accounting principles (“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,
2004.
 
 **NOTE
B - ACCOUNTING CHANGES**
 
 On
December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued FASB
Statement No. 123 (revised 2004), *Share-Based
Payment* (“123(R)”), which is a revision of FASB Statement No. 123, *Accounting
for Stock-Based Compensation* (“Statement
123”). 123(R) supersedes Accounting Principles Board (“APB”) Opinion No. 25, *Accounting
for Stock Issued to Employees* , and
amends FASB Statement No. 95, *Statement
of Cash Flows* .
Generally, the approach in 123(R) is similar to the approach described in
Statement 123. However, 123(R) requires all share-based payments to employees,
including grants of employee stock options, to be recognized in the income
statement based on their fair values. 123(R) is effective for annual reporting
periods beginning after December 15, 2005. The Company expects to adopt 123(R)
beginning on January 1, 2006.
 
 123(R)
permits public companies to adopt its requirements using one of two methods: a
“modified prospective” method, pursuant to which compensation cost is recognized
beginning with the effective date based on the requirements of 123(R) for all
share-based payments granted after the effective date and all awards granted to
employees prior to the effective date of 123(R) that remain unvested on the
effective date, or a “modified retrospective” method, which includes the
requirements of the modified prospective method described above, but also
permits entities to restate based on the amounts previously recognized under
Statement 123 for purposes of pro forma disclosures either (a) all prior periods
presented or (b) prior interim periods of the year of adoption. The Company
plans to adopt 123(R) using the modified-prospective method.
 
 As
permitted by Statement 123, the Company currently accounts for share-based
payments to employees using the intrinsic value method of APB Opinion No. 25
and, as such, generally recognizes no compensation cost for employee stock
options. Accordingly, the adoption of 123(R)’s fair value method will have a
significant impact on the Company’s results of operations, although it will have
no impact on the Company’s overall financial position. The impact of adoption of
Statement 123(R) cannot be determined at this time because it depends on the
levels of share-based awards granted in the future. However, had the Company
adopted Statement 123(R) in prior periods, the impact of such statement would
have approximated the impact of Statement 123 as described in the disclosure of
pro forma net income and earnings per share in Note E to the unaudited
consolidated financial statements.
 
  7
  In March
2004, the FASB ratified the consensus reached by the Emerging Issues Task Force
in Issue 03-1, “The Meaning of Other-Than-Temporary Impairment and Its
Application to Certain Investments” (“EITF 03-1”). EITF 03-1 provides guidance
for determining when an investment is considered impaired, whether an impairment
is other-than-temporary, and measurement of an impairment loss. Under EITF 03-1,
an investment is considered impaired if the fair value of the investment is less
than its cost. Generally, an impairment is considered other-than-temporary
unless: (a) the investor has the ability and intent to hold an investment for a
reasonable period of time sufficient for a forecasted recovery of fair value up
to (or beyond) the cost of the investment; and (b) evidence indicating that the
cost of the investment is recoverable within a reasonable period of time
outweighs evidence to the contrary. If an impairment is determined to be
other-than-temporary, then an impairment loss is recognized equal to the
difference between the investment’s cost and its fair value. EITF 03-1 also
addresses accounting considerations subsequent to recognition of an
other-than-temporary impairment, and requires certain disclosures about
unrealized losses that have not been recognized as other-than-temporary
impairments.
 
 With the
release of EITF 03-1-1 on September 30, 2004, the FASB staff delayed the
effective date of the other-than-temporary impairment evaluation guidance of
EITF 03-1 (which was initially to be applied prospectively to all current and
future investments in interim and annual reporting periods beginning after June
15, 2004). EITF 03-1-1 delays the effective date of the measurement and
recognition guidance until certain implementation issues are addressed and a
final FASB Staff Position providing implementation guidance is issued. The
disclosure requirements of the EITF 03-1 remain in effect. The amount of any
other-than-temporary impairment that may need to be recognized in the future
will be dependent on market conditions, the occurrence of certain events or
changes in circumstances relative to an investee, and the Company’s intent and
ability to hold the impaired investments at the time of the
valuation.
 
 **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 Employee
Stock Ownership Plan (“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**
    
    **Six
      months ended****June
      30,**
      **2005**
    
    **June
      30,**
      **2004**
    
    **June
      30,**
      **2005**
    
    **June
      30,**
      **2004****Basic:**Weighted-average
      number of shares outstanding
    
    
    6,948,503
    
    
    6,939,809
    
    
    6,930,929
    
    
    6,983,792Less:
      weighted-average number of unearned ESOP shares
    
    
    (262,516
    )
    
    (281,288
    )
    
    (262,516
    )
    
    (287,881
    )Denominator
      for basic earnings per share
    
    
    6,685,987
    
    
    6,658,521
    
    
    6,668,413
    
    
    6,695,911**Fully
      diluted:**Denominator
      for basic earnings per share
    
    
    6,685,987
    
    
    6,658,521
    
    
    6,668,413
    
    
    6,695,911Add:
      assumed conversion of stock options using treasury stock
      method
    
    
    170,727
    
    
    196,396
    
    
    171,738
    
    
    200,825Denominator
      for fully diluted earnings per share
    
    
    6,856,714
    
    
    6,854,917
    
    
    6,840,151
    
    
    6,896,736
 
  8
  **NOTE
D - COMPREHENSIVE INCOME**
 
 Comprehensive
income is the total of reported net income and all other revenues, expenses,
gains and losses that under GAAP are not included in reported net income but are
instead reflected directly in shareholders’ equity.
 
 **Three
      months ended**
    
    **Six
      months ended****June
      30,**
      **2005**
    
    **June
      30,**
      **2004**
    
    **June
      30,**
      **2005**
    
    **June
      30,**
      **2004**Net
      income
    
    $
    3,166,705
    
    $
    3,437,372
    
    $
    6,850,842
    
    $
    6,679,126Other
      comprehensive income:Change
      in unrealized securities gains (losses), net of tax
    
    
    1,407,752
    
    
    (4,383,320
    )
    
    (1,410,792
    )
    
    (3,558,503
    )Fair
      market value adjustment on cash flow hedge, net of tax
    
    
    (38,817
    )
    
    -
    
    
    (38,817
    )
    
    -Reclassification
      adjustment for realized gains included in net income, net of
      tax
    
    
    (97,120
    )
    
    (120,911
    )
    
    (185,183
    )
    
    (254,272
    )Total
      comprehensive income (loss)
    
    $
    4,438,520
    
    $
    (1,066,859
    )
    $
    5,216,050
    
    $
    2,866,351
 
 **NOTE
E - 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 in accordance with the
fair value method of Statement 123.
 
 The
Black-Scholes option valuation model is commonly used in estimating the fair
value of traded options that have no vesting restrictions and are fully
transferable. In addition, option valuation models require certain assumptions
to be made, 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 assumptions can materially affect the
fair value estimates, management believes that the existing models do not
necessarily provide a reliable single measure of the fair value of the Company’s
employee stock options.
 
 In
determining compensation expense in accordance with Statement 123, the fair
value of the Company’s employee stock options was estimated at the date of grant
using the Black-Scholes option pricing model with the following weighted average
assumptions for the three months and six months ended June 30, 2005 and June 30,
2004.
 
 **Three
      months ended**
    
    **Six
      months ended****June
      30,**
      **2005**
    
    **June
      30,**
      **2004**
    
    **June
      30,**
      **2005**
    
    **June
      30,**
      **2004**Expected
      life of options
    
    
    6.27
      years
    
    
    6.45
      years
    
    
    6.27
      years
    
    
    6.45
      yearsRisk-free
      interest rate
    
    
    3.65
    %
    
    3.51
    %
    
    3.65
    %
    
    3.51
    %Expected
      dividend yield
    
    
    2.14
    %
    
    2.21
    %
    
    2.14
    %
    
    2.21
    %Expected
      volatility factor
    
    
    20.68
    %
    
    21.73
    %
    
    20.68
    %
    
    21.73
    %
 
  9
  For
purposes of pro forma disclosures, the estimated fair value of the Company’s
employee stock options is amortized to expense over the options’ vesting period,
which is generally three years. The Company’s pro forma information (including
stock based compensation expense) is as follows:
 
 **Three
      months ended**
    
    **Six
      months ended***(In
      thousands, except per share data)*
    
    **June
      30,**
      **2005**
    
    **June
      30,**
      **2004**
    
    **June
      30,**
      **2005**
    
    **June
      30,**
      **2004**Net
      income, as reported
    
    $
    3,167
    
    $
    3,437
    
    $
    6,851
    
    $
    6,679Compensation
      expense, net of taxes, as reported
    
    
    2,978
    
    
    3,070
    
    
    6,400
    
    
    6,032Pro
      forma compensation expense in accordance with Statement 123, net of
      tax
    
    
    (3,128
    )
    
    (3,148
    )
    
    (6,686
    )
    
    (6,211
    )Pro
      forma net income
    
    $
    3,017
    
    $
    3,359
    
    $
    6,565
    
    $
    6,500Net
      income per common share, as reported:Basic
    
    $
    0.47
    
    $
    0.52
    
    $
    1.03
    
    $
    1.00Diluted
    
    $
    0.46
    
    $
    0.50
    
    $
    1.00
    
    $
    0.97Pro
      forma net income per common share:Basic
    
    $
    0.45
    
    $
    0.50
    
    $
    0.98
    
    $
    0.97Diluted
    
    $
    0.44
    
    $
    0.49
    
    $
    0.96
    
    $
    0.94
 
 **NOTE
F - ACQUISITIONS**
 
 On March
21, 2005, the Company entered into a definitive agreement to be acquired by
Associated Banc-Corp (“Associated”), headquartered in Green Bay, Wisconsin. The
stock merger transaction is valued at $278 million based on the closing share
price of Associated’s common stock on March 18, 2005. According to the terms of
the agreement, the Company will merge into Associated, with the Company’s
shareholders exchanging each share of their State common stock for 1.20 shares
of Associated common stock.
 
 The
merger with Associated is expected to close during the third quarter of 2005,
subject to approval by State’s shareholders, regulatory approvals, and various
other conditions to closing. The Company’s Board of Directors has set August 24,
2005 as the date of the special meeting of the Company’s shareholders to approve
the merger. The record date for determining the shareholders entitled to receive
notice of, and to vote at, the special meeting is July 6, 2005.
 
 On
January 13, 2005, the Company acquired an 80% interest in m2 Lease Funds, LLC
(“M2”) for $3.6 million in cash, resulting in approximately $1.5 million in
goodwill. M2 is engaged in the business of leasing, primarily machinery and
equipment, to commercial and industrial businesses accounted for as direct
financing lease contracts. M2’s operating results are included in the Company’s
Consolidated Statements of Income from January 13, 2005 through June 30,
2005.
 
 **Item
2. Management’s Discussion and Analysis of Financial Condition and Results of
Operations.**
 
 **Application
of Critical Accounting Policies**
 
 The
Company’s unaudited consolidated financial statements included in this Quarterly
Report on Form 10-Q are prepared in accordance with United States GAAP 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 consolidated financial statements and
accompanying notes. These estimates, assumptions, and judgments are based on
information available to the Company 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 unaudited
consolidated financial statements.
 
 All of
the Company’s significant accounting policies are presented in Note 1 to the
Company’s consolidated financial statements in its Annual Report on Form 10-K
for the year ended December 31, 2004. These policies, along with the disclosures
presented in the other financial statement notes contained in this Quarterly
Report on Form 10-Q and in this discussion, provide information on how
significant assets and liabilities are valued in the unaudited consolidated
financial statements and how those values are determined.
 
 10
 The
Company’s management has determined that its accounting policies with respect to
the allowance for loan and lease losses (“allowance”) require subjective or
complex judgments relating to the Company’s financial position and results of
operations, and therefore, are its most important critical accounting policies.
The allowance represents management’s estimate of probable credit losses
inherent in the loan and lease portfolio. Determining the amount of the
allowance 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 and leases, 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 and lease portfolio also represents the largest asset category included
in the Consolidated Statements of Financial Condition. Note 1 to the
consolidated financial statements in the Company’s Annual Report on Form 10-K
for the year ended December 31, 2004 describes the methodology used to determine
the allowance. In addition, a discussion of the factors driving changes in the
amount of the allowance is included in the Provision for Loan Losses at Risk
Elements in the Loan Portfolio sections of management’s discussion and analysis
included in such Annual Report.
 
 **Changes
in Financial Condition**
 
 At June
30, 2005 and December 31, 2004, the Company’s total assets were approximately
$1.5 billion. During the first six months of 2005, significant uses of funds by
the Company consisted of a $67.3 million increase in loans and leases
receivable, $15.4 million decrease in deposits, $3.1 million in business
acquisitions, a $2.3 million payment for cash dividends, and $1.0 million in net
purchases of premises and equipment. Significant funding sources for the first
six months of 2005 came from a $23.6 million net decrease in investment
securities, $15.4 million increase in securities sold under agreement to
repurchase, $9.8 million in cash from operating activities, a $6.6 million net
increase in notes payable, $24.0 million increase in federal funds purchased,
and $1.3 million from the exercise of stock options.
 
 **Asset
Quality**
 
 At June
30, 2005, the Company’s non-performing assets were $7.1 million, a decrease of
$0.6 million from December 31, 2004 due to a decrease of $0.8 million in other
real estate owned offset by an increase of $0.2 million in non-accrual loans and
leases. Total non-performing assets as a percentage of total assets were 0.46%
at June 30, 2005 and 0.52% at December 31, 2004. As a percentage of total loans
and leases outstanding, the level of non-performing loans and leases was 0.68%
at June 30, 2005 compared to 0.72% at December 31, 2004. This percentage
decrease was primarily due to total loans and leases increasing at a faster rate
than non-performing loans and leases.
 
 When, in
the opinion of the Company’s management, serious doubt exists as to the
collectibility of a loan or lease, it is placed on non-accrual status. In all
cases, however, when a loan or lease reaches 90 days delinquent on the payment
of principal or interest, it is placed on non-accrual status. At the time a loan
or lease 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. The following table summarizes non-performing assets
on the dates indicated (dollars in thousands).
 
 **Jun.
      30**
      **2005**
    
    **Mar.
      31**
      **2005**
    
    **Dec.
      31**
      **2004**
    
    **Sep.
      30**
      **2004**
    
    **Jun.
      30**
      **2004**Non-accrual
      loans and leases
    
    $
    6,990
    
    $
    7,582
    
    $
    6,767
    
    $
    7,830
    
    $
    8,729Accruing
      loans and leases past due 90 days or more
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -Restructured
      loans and leases
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -Total
      non-performing and restructured loans and leases
    
    
    6,990
    
    
    7,582
    
    
    6,767
    
    
    7,830
    
    
    8,729Other
      real estate owned
    
    
    98
    
    
    1,377
    
    
    872
    
    
    852
    
    
    988Total
      non-performing assets
    
    $
    7,088
    
    $
    8,959
    
    $
    7,639
    
    $
    8,682
    
    $
    9,717Ratios:Non-performing
      loans and leases to total loans and leases
    
    
    0.68
    %
    
    0.76
    %
    
    0.72
    %
    
    0.84
    %
    
    0.97
    %Allowance
      to total loans and leases
    
    
    1.33
    
    
    1.33
    
    
    1.32
    
    
    1.32
    
    
    1.32Allowance
      to non-performing loans and leases
    
    
    197.57
    
    
    175.34
    
    
    182.46
    
    
    156.81
    
    
    135.22Non-performing
      assets to total assets
    
    
    0.46
    
    
    0.59
    
    
    0.52
    
    
    0.53
    
    
    0.61
 
 11
 **Allowance
for Loan and Lease Losses and Net Charge-offs**
 
 Management
maintains the allowance at a level considered adequate to provide for probable
loan and lease losses. The allowance is increased by provisions charged to
earnings and is reduced by charge-offs, net of recoveries. At June 30, 2005, the
allowance was $13.8 million, an increase of $1.5 million from December 31, 2004.
The allowance was increased primarily due to the increased number of commercial
loans, which are generally higher risk, and the $0.4 million acquired allowance
of M2. As of June 30, 2005 and December 31, 2004, commercial and commercial real
estate loans made up 79% of the total loan and lease portfolio.
 
 As a
percentage of total loans and leases outstanding, the allowance was 1.33% at
June 30, 2005 compared to 1.32% at December 31, 2004. The determination of
allowance adequacy is based upon ongoing evaluations of the Company’s loan and
lease portfolio conducted by the Internal Loan Review function of its banking
subsidiary, State Financial Bank, N.A. (the “Bank”), and reviewed by the
Company’s management. These evaluations consider a variety of factors,
including, but not limited to, general economic conditions, loan and lease
portfolio size, type, and composition, previous loss experience, the borrowers’
financial condition, collateral adequacy, and the level of non-performing loans
and leases. Based upon its analyses, management considered the allowance
adequate to recognize the risk inherent in the loan and lease portfolio at June
30, 2005.
 
 The
following table sets forth an analysis of the allowance for the periods
indicated (dollars in thousands):
 
 **Six
      months**
      **ended**
      **June
      30, 2005**
    
    **Year
      ended**
      **Dec.
      31, 2004****Balance
      at beginning of period**
    
    $
    12,347
    
    $
    10,706**Charge-offs:**Commercial
    
    
    207
    
    
    813Real
      estate mortgage
    
    
    30
    
    
    113Consumer
    
    
    51
    
    
    289Leases
    
    
    -
    
    
    -Other
    
    
    12
    
    
    18**Total
      charge-offs**
    
    
    300
    
    
    1,233**Recoveries:**Commercial
    
    
    122
    
    
    408Real
      estate mortgage
    
    
    1
    
    
    29Consumer
    
    
    7
    
    
    51Leases
    
    
    33
    
    
    -Other
    
    
    3
    
    
    5**Total
      recoveries**
    
    
    166
    
    
    493**Net
      charge-offs**
    
    
    134
    
    
    740Balance
      of acquired allowance at date of acquisition
    
    
    380
    
    
    -Additions
      charged to operations
    
    
    1,217
    
    
    2,381**Balance
      at end of period**
    
    $
    13,810
    
    $
    12,347**Ratios:**Net
      charge-offs to average loans and leases outstanding1
    
    
    0.03
    %
    
    0.08
    %Net
      charge-offs to total allowance1
    
    
    1.95
    
    
    5.99Allowance
      to period end loans and leases outstanding
    
    
    1.33
    
    
    1.32
 1.Annualized.
  12
  **Results
of Operations-Comparison of the Three-Month Periods Ended June 30, 2005 and June
30, 2004.**
 
 **General**
 
 For the
three months ended June 30, 2005, the Company reported net income of $3.2
million and net income per share on a fully diluted basis of $0.46, compared to
net income of $3.4 million and net income per share on a fully diluted basis of
$0.50 reported for the three months ended June 30, 2004.
 
 **Net
Interest Income**
 
 The
following table sets forth average balances, related interest income and
expenses, and effective interest yields and rates for the three months ended
June 30, 2005 and June 30, 2004 (dollars in thousands):
 
 **Three
      months ended**
      **June
      30, 2005**
    
    **Three
      months ended**
      **June
      30, 2004****Average
      Balance**
    
    **Interest**
    
    **Yield/**
      **Rate****4**
    
    **Average
      Balance**
    
    **Interest**
    
    **Yield/**
      **Rate****4****Assets**Interest-earning
      assets:Loans
      and leases123
    
    $
    1,019,732
    
    $
    17,232
    
    
    6.78
    %
    $
    894,760
    
    $
    12,926
    
    
    5.81
    %Taxable
      investment securities
    
    
    337,343
    
    
    3,493
    
    
    4.15
    %
    
    402,267
    
    
    3,852
    
    
    3.85
    %Tax-exempt
      investment securities3
    
    
    56,137
    
    
    833
    
    
    5.95
    %
    
    57,647
    
    
    844
    
    
    5.89
    %Interest-earnings
      deposits
    
    
    3,546
    
    
    32
    
    
    3.58
    %
    
    5,694
    
    
    16
    
    
    1.09
    %Federal
      funds sold
    
    
    5,820
    
    
    42
    
    
    2.88
    %
    
    14,136
    
    
    29
    
    
    0.82
    %Total
      interest-earning assets
    
    
    1,422,578
    
    
    21,632
    
    
    6.10
    %
    
    1,374,504
    
    
    17,667
    
    
    5.17
    %Non-interest-earnings
      assets:Cash and due from
      banks
    
    
    31,724
    
    
    
    
    
    
    
    
    56,998Premises
      and equipment, net
    
    
    32,931
    
    
    
    
    
    
    
    
    33,249Other
      assets
    
    
    76,747
    
    
    
    
    
    
    
    
    78,932Less:
      Allowance for loan and lease losses
    
    
    (13,657
    )
    
    
    
    
    
    
    
    (11,385
    )**Total**
    
    $
    1,550,323
    
    
    
    
    
    
    
    $
    1,532,298**Liabilities
      And Stockholders’ Equity**Interest-bearing
      liabilities:Now
      accounts
    
    $
    118,942
    
    $
    102
    
    
    0.34
    %
    $
    123,732
    
    $
    85
    
    
    0.28
    %Money
      market accounts
    
    
    294,166
    
    
    1,218
    
    
    1.66
    %
    
    249,421
    
    
    713
    
    
    1.15
    %Savings
      deposits
    
    
    124,562
    
    
    123
    
    
    0.40
    %
    
    135,692
    
    
    134
    
    
    0.40
    %Time
      deposits
    
    
    367,529
    
    
    2,703
    
    
    2.95
    %
    
    378,538
    
    
    2,390
    
    
    2.54
    %Notes
      payable
    
    
    87,725
    
    
    1,167
    
    
    5.34
    %
    
    62,247
    
    
    579
    
    
    3.74
    %FHLB
      borrowings
    
    
    67,300
    
    
    685
    
    
    4.08
    %
    
    67,800
    
    
    788
    
    
    4.67
    %Federal
      funds purchased
    
    
    19,030
    
    
    206
    
    
    4.34
    %
    
    2,452
    
    
    8
    
    
    1.31
    %Securities
      sold under agreement to repurchase
    
    
    171,338
    
    
    1,016
    
    
    2.38
    %
    
    216,807
    
    
    614
    
    
    1.14
    %Total
      interest-bearing liabilities
    
    
    1,250,592
    
    
    7,220
    
    
    2.32
    %
    
    1,236,689
    
    
    5,311
    
    
    1.73
    %Non-interest-bearings
      liabilities:Demand
      deposits
    
    
    173,261
    
    
    
    
    
    
    
    
    178,119Other
    
    
    8,431
    
    
    
    
    
    
    
    
    6,096Total
      liabilities
    
    
    1,432,284
    
    
    
    
    
    
    
    
    1,420,904Minority
      interest in consolidated subsidiary
    
    
    597
    
    
    
    
    
    
    
    
    -Stockholders’
      equity
    
    
    117,442
    
    
    
    
    
    
    
    
    111,394**Total**
    
    $
    1,550,323
    
    
    
    
    
    
    
    $
    1,532,298Net
      interest earning and interest rate spread
    
    
    
    
    $
    14,412
    
    
    3.78
    %
    
    
    
    $
    12,356
    
    
    3.44
    %Net
      yield on interest-earning assets
    
    
    
    
    
    
    
    
    4.06
    %
    
    
    
    
    
    
    
    3.62
    %
 
 **Footnotes**
 1 . For the
purposes of these computations, non-accrual loans and leases are included in the
daily average loan and lease amounts outstanding.
 
 2 .
Interest earned on loans and leases includes loan and lease fees, which are not
material in amount.
 
 3 . In
accordance with 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.
  13
  Certain
non-GAAP financial measures and ratios are used by management to evaluate and
measure the Company’s performance. These measures and ratios 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 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 a reconciliation of
these non-GAAP measures and ratios to their most directly comparable GAAP
financial measures for the three months ended June 30, 2005 and June 30,
2004.
 
 Management
reviews yields on certain asset categories and the net interest margin of the
Company and its banking subsidiaries on a fully taxable-equivalent (“FTE”)
basis. In this non-GAAP presentation, net interest income is adjusted to reflect
tax-exempt interest income on an equivalent before-tax basis, which measures
comparability of net interest income arising from both taxable and tax-exempt
sources (dollars in thousands).
 
 Three
      months endedJune
      30, 2005
    
    June
      30, 2004(A)
      Interest income (GAAP)
    
    $
    21,335
    
    $
    17,363Taxable
      equivalent adjustment-loans
    
    
    5
    
    
    9Taxable
      equivalent adjustment-Tax-exempt securities
    
    
    292
    
    
    295Interest
      income-FTE
    
    
    21,632
    
    
    17,667(B)
      Interest expense (GAAP)
    
    
    7,220
    
    
    5,311(C)
      Net interest income (GAAP) (A minus B)
    
    
    14,115
    
    
    12,052Net
      interest income-FTE
    
    
    14,412
    
    
    12,356(D)
      Net interest margin (GAAP)
    
    
    3.98
    %
    
    3.53
    %Net
      interest margin-FTE
    
    
    4.06
    %
    
    3.62
    %
 
 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.
 
 4 .
Annualized.
 
 For the
three months ended June 30, 2005, the Company reported taxable-equivalent net
interest income of $14.4 million, an increase of $2.1 million, or 16.6%, from
the $12.4 million reported for the three months ended June 30, 2004. This
increase reflects the Company’s interest rate risk management policy, which is
currently positioned to benefit from rising interest rates. The
taxable-equivalent yield on interest-earning assets (net interest margin)
increased to 4.06% in the second quarter of 2005 from 3.62% in the second
quarter of 2004.
 
 The
Company’s taxable-equivalent total interest income increased $4.0 million for
the three months ended June 30, 2005 compared to the same period of 2004 due to
the increase in average loans and leases outstanding, enhanced by a higher
interest rate environment. Average loans and leases outstanding increased by
$125.0 million, or 14.0%, in the second quarter of 2005 over the second quarter
of 2004. For the three months ended June 30, 2005, the taxable-equivalent yield
on interest-earning assets was 6.10% compared to 5.17% for the three months
ended June 30, 2004. The second quarter 2005 loan and lease yield was 6.78%
compared to 5.81% in the second quarter of 2004. The Company also experienced
increases in the yields earned on its investment securities as cash flows from
maturities and repayments were reinvested at higher interest rates. For the
three months ended June 30, 2005, the yield earned on taxable investment
securities increased to 4.15% from 3.85% for the three months ended June 30,
2004. The taxable equivalent yields earned on tax-exempt investment securities
increased to 5.95% for the three months ended June 30, 2005 from 5.89% for the
three months ended June 30, 2004. The increase in these yields for the second
quarter of 2005 compared to the second quarter of 2004 is the result of matured
or repaid securities replaced by higher yielding securities in an increasing
interest rate environment.
  14
  The
Company’s funding costs were also impacted by the higher interest rate
environment prevalent over the preceding twelve months. The cost of
interest-bearing liabilities increased to 2.32% for the second quarter of 2005
from 1.73% for the second quarter of 2004. 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 2005, 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 28.2%
in the second quarter 2004 due to loan and lease growth exceeding deposit growth
in the period. Additionally, interest expense on other borrowings increased $1.1
million, or 54.55%, primarily due to the additional notes payable related to the
acquisition of M2.
 
 **Provision
for Loan and Lease Losses**
 
 The
provision for loan and lease losses was $0.7 million in the second quarter of
2005 and $0.6 million in the second quarter of 2004. The provision is adjusted
to reflect loan and lease growth and management’s assessment of asset quality
and risk inherent in the loan and lease portfolio. This growth has been
primarily concentrated in the commercial real estate loan category. These loans
inherently involve more risk than exists in the remaining loan and lease
portfolio.
 
 **Other
Income**
 
 Total
other income decreased $355,000, or 11.9%, in the second quarter of 2005
compared to the second quarter of 2004. The decrease was primarily the result of
decreases in gains on sale of residential mortgage loans of $137,000, security
commissions and management fees of $55,000, other income of $137,000, and
investment securities gains of $38,000, offset by increases in automated teller
machine (“ATM”) and merchant service fees of $23,000. Gains on sale of
residential mortgage loans decreased due to a reduction in mortgage origination
volumes. Service charges on deposit accounts decreased due to fewer fees on
business accounts. ATM and merchant services increased mainly due to increased
transactional volumes. Other income decreased primarily due to decreased gain on
sale of other real estate of $172,000, offset by lease income of $59,000 from M2
that was not included in the second quarter of 2004.
 
 **Other
Expenses**
 
 Other
expenses increased $1,296,000, or 13.8%, in the second quarter of 2005 over the
second quarter of 2004. The increase was primarily due to increases in salaries
and employee benefits of $486,000, legal and professional fees of $248,000,
merger related expense of $850,000, and advertising of $85,000, offset by
decreases in delivery and postage of $94,000, net occupancy and equipment of
$83,000, and other expense of $202,000. Salaries and employee benefits increased
due to higher salaries resulting from annual merit increases, additional
salaries from the acquisition of M2, higher employee insurance costs and higher
performance incentive accruals. Legal and professional expense increased due to
acquisition-related expenditures and higher audit expenses. Advertising expenses
increased due to a change in the long-term advertising strategy relating to the
pending merger with Associated. The merger related expenses are the result of
the pending merger with Associated. Delivery and postage decreased due to timing
of the related expenditures. Other expense decreased primarily due to M2’s
Initial Direct Cost contra expense.
 
 **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, 2005 was 40.5% compared to 32.1% for
the three months ended June 30, 2004. Provisions for income tax were $2.2
million for the second quarter of 2005 compared to $1.6 million for the second
quarter of 2004. The increase in the effective tax rate for the second quarter
2005 compared to the second quarter of 2004 was mainly due to approximately
$653,000 of nondeductible merger expenses.
 
 **Results
of Operations-Comparison of the Six-Month Periods Ended June 30, 2005 and June
30, 2004.**
 
 **General**
 
 For the
six months ended June 30, 2005, the Company reported net income of $6.9 million
and net income per share on a fully diluted basis of $1.00, compared to net
income of $6.7 million and net income per share on a fully diluted basis of
$0.97 reported for the six months ended June 30, 2004.
 
 15
 **Net
Interest Income**
 
 The
following table sets forth average balances related interest income and
expenses, and effective interest yields and rates for the six months ended June
30, 2005 and June 30, 2004 (dollars in thousands):
 
 **Six
      months ended**
      **June
      30, 2005**
    
    **Six
      months ended**
      **June
      30, 2004****Average
      Balance**
    
    **Interest**
    
    **Yield/**
      **Rate****4**
    
    **Average
      Balance**
    
    **Interest**
    
    **Yield/**
      **Rate****4****Assets**Interest-earning
      assets:Loans
      and leases123
    
    $
    1,003,880
    
    $
    32,945
    
    
    6.62
    %
    $
    890,249
    
    $
    25,799
    
    
    5.83
    %Taxable
      investment securities
    
    
    328,550
    
    
    7,009
    
    
    4.30
    %
    
    371,776
    
    
    7,284
    
    
    3.94
    %Tax-exempt
      investment securities3
    
    
    56,584
    
    
    1,685
    
    
    6.01
    %
    
    57,558
    
    
    1,682
    
    
    5.88
    %Interest-earnings
      deposits
    
    
    3,775
    
    
    59
    
    
    3.17
    %
    
    7,835
    
    
    45
    
    
    1.15
    %Federal
      funds sold
    
    
    5,133
    
    
    67
    
    
    2.65
    %
    
    16,845
    
    
    77
    
    
    0.92
    %Total
      interest-earning assets
    
    
    1,397,922
    
    
    41,766
    
    
    6.02
    %
    
    1,344,263
    
    
    34,887
    
    
    5.22
    %Non-interest-earnings
      assets:Cash
      and due from banks
    
    
    35,136
    
    
    
    
    
    
    
    
    53,149Premises
      and equipment, net
    
    
    32,941
    
    
    
    
    
    
    
    
    33,089Other
      assets
    
    
    77,263
    
    
    
    
    
    
    
    
    79,197Less:
      Allowance for loan and lease losses
    
    
    (13,367
    )
    
    
    
    
    
    
    
    (11,151
    )**Total**
    
    $
    1,529,895
    
    
    
    
    
    
    
    $
    1,498,547**Liabilities
      And Stockholders’ Equity**Interest-bearing
      liabilities:Now
      accounts
    
    $
    118,192
    
    $
    191
    
    
    0.33
    %
    $
    121,962
    
    $
    163
    
    
    0.27
    %Money
      market accounts
    
    
    296,797
    
    
    2,298
    
    
    1.56
    %
    
    242,243
    
    
    1,315
    
    
    1.09
    %Savings
      deposits
    
    
    124,135
    
    
    244
    
    
    0.40
    %
    
    135,680
    
    
    268
    
    
    0.40
    %Time
      deposits
    
    
    370,901
    
    
    5,237
    
    
    2.85
    %
    
    372,506
    
    
    4,761
    
    
    2.57
    %Notes
      payable
    
    
    87,630
    
    
    2,231
    
    
    5.13
    %
    
    60,287
    
    
    1,109
    
    
    3.70
    %FHLB
      borrowings
    
    
    67,300
    
    
    1,415
    
    
    4.24
    %
    
    67,800
    
    
    1,577
    
    
    4.68
    %Federal
      funds purchased
    
    
    14,128
    
    
    274
    
    
    3.91
    %
    
    2,466
    
    
    20
    
    
    1.63
    %Securities
      sold under agreement to repurchase
    
    
    154,426
    
    
    1,860
    
    
    2.43
    %
    
    201,581
    
    
    1,387
    
    
    1.38
    %Total
      interest-bearing liabilities
    
    
    1,233,509
    
    
    13,750
    
    
    2.25
    %
    
    1,204,525
    
    
    10,600
    
    
    1.77
    %Non-interest-bearings
      liabilities:Demand
      deposits
    
    
    170,692
    
    
    
    
    
    
    
    
    173,291Other
    
    
    8,929
    
    
    
    
    
    
    
    
    8,130Total
      liabilities
    
    
    1,413,130
    
    
    
    
    
    
    
    
    1,385,946Minority
      interest in consolidated subsidiary
    
    
    568
    
    
    
    
    
    
    
    
    -Stockholders’
      equity
    
    
    116,197
    
    
    
    
    
    
    
    
    112,601**Total**
    
    $
    1,529,895
    
    
    
    
    
    
    
    $
    1,498,547Net
      interest earning and interest rate spread
    
    
    
    
    $
    28,016
    
    
    3.77
    %
    
    
    
    $
    24,287
    
    
    3.45
    %Net
      yield on interest-earning assets
    
    
    
    
    
    
    
    
    4.04
    %
    
    
    
    
    
    
    
    3.63
    %
 
 **Footnotes**
 1 . For the
purposes of these computations, non-accrual loans and leases are included in the
daily average loan and lease amounts outstanding.
 
 2 .
Interest earned on loans and leases includes loan and lease fees, which are not
material in amount.
 
 3 . In
accordance with 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.
  16
  Certain
non-GAAP financial measures and ratios are used by management to evaluate and
measure the Company’s performance. These measures and ratios 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 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 a reconciliation of
these non-GAAP measures and ratios to their most directly comparable GAAP
financial measures for the six months ended June 30, 2005 and June 30,
2004.
 
 Management
reviews yields on certain asset categories and the net interest margin of the
Company, and its banking subsidiaries, on a FTE basis. In this non-GAAP
presentation, net interest income is adjusted to reflect tax-exempt interest
income on an equivalent before-tax basis, which measures comparability of net
interest income arising from both taxable and tax-exempt sources (dollars in
thousands).
 
 Six
      months endedJune
      30, 2005
    
    June
      30, 2004(A)
      Interest income (GAAP)
    
    $
    41,165
    
    $
    34,280Taxable
      equivalent adjustment-loans
    
    
    11
    
    
    18Taxable
      equivalent adjustment-Tax-exempt securities
    
    
    590
    
    
    589Interest
      income-FTE
    
    
    41,766
    
    
    34,887(B)
      Interest expense (GAAP)
    
    
    13,750
    
    
    10,600(C)
      Net interest income (GAAP) (A minus B)
    
    
    27,416
    
    
    23,680Net
      interest income-FTE
    
    
    28,016
    
    
    24,287(D)
      Net interest margin (GAAP)
    
    
    3.95
    %
    
    3.54
    %Net
      interest margin-FTE
    
    
    4.04
    %
    
    3.63
    %
 
 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.
 
 4 .
Annualized.
 
 For the
six-months ended June 30, 2005, the Company reported taxable-equivalent net
interest income of $28.0 million, an increase of $3.7 million, or 15.4%, from
the $24.3 million reported for the six months ended June 30, 2004. This increase
reflects the Company’s interest rate risk management policy, which is currently
positioned to benefit from rising interest rates. The taxable-equivalent yield
on interest-earning assets (net interest margin) increased to 4.04% in the first
half of 2005 from 3.63% in the first half of 2004.
 
 The
Company’s taxable-equivalent total interest income increased $6.9 million for
the six months ended June 30, 2005 compared to the same period of 2004 due to
the increase in average loans and leases outstanding, enhanced by a higher
interest rate environment. Average loans and leases outstanding increased by
$113.6 million, or 12.8%, in the first half of 2005 over the first half of 2004.
For the six months ended June 30, 2005, the taxable-equivalent yield on
interest-earning assets was 6.02% compared to 5.22% for the six months ended
June 30, 2004. The first half of 2005 loan and lease yield was 6.62% compared to
5.83% in the first half of 2004. The Company also experienced increases in the
yields earned on its investment securities as cash flows from maturities and
repayments were reinvested at higher interest rates. For the six months ended
June 30, 2005, the yield earned on taxable investment securities increased to
4.30% from 3.94% for the six months ended June 30, 2004. The taxable equivalent
yields earned on tax-exempt investment securities increased to 6.01% for the six
months ended June 30, 2005 from 5.88% for the six months ended June 30, 2004.
The increase in these yields for the first half of 2005 compared to the first
half of 2004 is the result of matured or repaid securities replaced by higher
yielding securities in an increasing interest rate environment.
  17
  The
Company’s funding costs were also impacted by the higher interest rate
environment prevalent over the preceding twelve months. The cost of
interest-bearing liabilities increased to 2.25% for the first half of 2005 from
1.77% for the first half of 2004. The Company uses wholesale funding sources,
such as the FHLB, to balance the timing differences between its various business
funding sources and to support loan origination. In the first half of 2005,
notes payable, FHLB borrowings, federal funds purchased, and securities sold
under agreements to repurchase comprised 26.2% of the Company’s interest-bearing
liabilities compared to 27.6% in the first half 2004 due to loan and lease
growth exceeding deposit growth in the period. Additionally, interest expense on
other borrowings increased $1.7 million, or 41.2%, primarily due to the
additional notes payable related to the acquisition of M2.
 
 **Provision
for Loan and Lease Losses**
 
 The
provision for loan and lease losses was $1.2 million in the first half of 2005
and the first half of 2004. The provision is adjusted to reflect loan and lease
growth and management’s assessment of asset quality and risk inherent in the
loan and lease portfolio. This growth has been primarily concentrated in the
commercial real estate loan category. These loans inherently involve more risk
than exists in the remaining loan and lease portfolio.
 
 **Other
Income**
 
 Total
other income decreased $500,000, or 8.7%, in the first half of 2005 compared to
the first half of 2004. The decrease was primarily the result of decreases in
gains on sale of residential mortgage loans of $236,000, service charges on
deposits of $108,000, investment securities gains of $111,000, and security
commissions and management fees of $87,000, offset by increases in ATM and
merchant service fees of $69,000, bank owned life insurance of $18,000, and
other income of $44,000. Gains on sale of residential mortgage loans decreased
due to a reduction in mortgage origination volumes. Service charges on deposit
accounts decreased due to fewer fees on business accounts. ATM and merchant
services increased mainly due to increased transactional volumes.
 
 **Other
Expenses**
 
 Other
expenses increased $2,100,000, or 11.2%, in the first half of 2005 over the
first half of 2004. The increase was primarily due to increases in salaries and
employee benefits of $1,287,000, legal and professional fees of $165,000, and
merger related expense of $850,000, and data processing of $36,000, offset by
decreases in delivery and postage of $153,000, net occupancy and equipment of
$86,000, telephone of $14,000, and other expense of $28,000. Salaries and
employee benefits increased due to higher salaries resulting from annual merit
increases, additional salaries from the acquisition of M2, higher employee
insurance costs and higher performance incentive accruals. Legal and
professional expense increased due to acquisition-related expenditures and
higher audit expenses. The merger related expenses are the result of the pending
merger with Associated. Delivery and postage decreased due to timing of the
related expenditures.
 
 **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, 2005 was 37.1% compared to 32.1% for the
six months ended June 30, 2004. Provisions for income tax were $4.0 million for
the first half of 2005 compared to $3.2 million for the first half of 2004. The
increase in the effective tax rate for the first half of 2005 compared to the
first half of 2004 was mainly due to approximately $653,000 of nondeductible
merger expenses.
 
 **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 $46.7 million and $55.0 million at June 30,
2005 and December 31, 2004, respectively.
 
  18
  **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, 2005 (dollars in thousands):
 
 **Actual**
    
    **Regulatory**
      **Minimum**
      **Requirement**
    
    **Regulatory**
      **Well-capitalized**
      **Requirement****Amount**
    
    **Percent**
    
    **Amount**
    
    **Percent**
    
    **Amount**
    
    **Percent**Tier
      1 leverage
    
    $
    108,554
    
    
    7.2
    %
    $
    60,369
    
    
    4.0
    %
    $
    75,461
    
    
    5.0
    %Tier
      1 risk-based capital
    
    $
    108,554
    
    
    9.0
    %
    $
    48,055
    
    
    4.0
    %
    $
    72,082
    
    
    6.0
    %Risk-based
      capital
    
    $
    136,363
    
    
    11.4
    %
    $
    96,109
    
    
    8.0
    %
    $
    120,137
    
    
    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. The
Company intends 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.
 
 **Derivative
Financial Instruments and Hedging Activities**
 
 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 it 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 its interest rate swaps currently outstanding as fair value
and cash flow hedges that qualify for “short-cut” treatment.  Accordingly,
the Company does not anticipate ineffectiveness arising from differences between
the fair value of the hedged item and the fair value of the swap.
 
 The
following table summarizes the Company’s fair value and cash flow hedges at June
30, 2005 (dollars in thousands):
 
 **Hedged
      Item**
    
    **Hedging
      Instrument**
    
    **Notional
      Amount**
    
    **Fair
      Value**
    
    **Remaining
      Term (Years)**Fixed
      Rate Loan
    
    
    Receive
      Variable Swap
    
    $
    3,739
    
    $
    (34
    )
    
    7.50Variable
      Rate Borrowing
    
    
    Pay
      Fixed Swap
    
    $
    15,000
    
    $
    (65
    )
    
    3.75
 
 **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, 2004
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 Annual
Report on Form 10-K for the year ended December 31, 2004.
 
  19
  **Item
4. Controls and Procedures.**
 
 **Evaluation
of Disclosure Controls and Procedures**
 
 The
Company’s management, with the participation of the Company’s Chief Executive
Officer and Chief Financial Officer, evaluated the effectiveness of the design
and operation 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 were 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.
 
 **Changes
in Internal Controls Over Financial Reporting**
 
 There was
no change 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) that
occurred during the fiscal quarter to which this report relates that has
materially affected, or is 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, unanticipated issues negatively impacting
the ability of State and Associated to complete the proposed merger in a timely
manner, 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.
 
 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.
 
  20
  **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
6. Exhibits.**
 
 
 31.1
    Certification
      by the Chief Executive Officer pursuant toRule
      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.
 
 32.1
    Certification
      of the Chief Executive Officer and Chief Financial Officer pursuant to 18
      U.S.C. Section 1350.
 
 
  21
  **SIGNATURES**
 
 
 Pursuant
to the requirements 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, 2005  By /s/
Michael J. Falbo
 Michael
J. Falbo
 Chairman
and Chief Executive Officer
 
 
 
 Date: August
9, 2005  By /s/
Daniel L. Westrope
 Daniel L.
Westrope
 Executive
Vice President, Chief Financial Officer,
 Treasurer,
and Corporate Secretary
  22
  **STATE
FINANCIAL SERVICES CORPORATION**
 EXHIBIT
INDEX TO FORM 10-Q
 For The
Quarter Ended June 30, 2005
 
 
 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.
 
 32.1
    Certification
      of the Chief Executive Officer and Chief Financial Officer pursuant to 18
      U.S.C. Section 1350.
  23