**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 September 30, 2004****or****o**
**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 1-018166**
 
 
 **STATE FINANCIAL SERVICES CORPORATION**
 **(Exact name of registrant as specified in its charter)**
  **WISCONSIN**
(State or other jurisdiction ofincorporation 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 November 8 , 2004 , there were 6,891,822 shares of Registrant's $0.10 Par Value Common Stock outstanding.
     ****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 ofSeptember 30, 2004 (unaudited) and December 31, 2003 (audited)
3Consolidated Statements of Income for theThree Months ended September 30, 2004 and September 30, 2003
4Consolidated Statements of Income for theNine Months ended September 30, 2004 and September 30, 2003
5Consolidated Statements of Cash Flows for theNine Months ended September 30, 2004 and September 30, 2003
6Notes to Consolidated Financial Statements
7Item 2.
Management's Discussion and Analysis ofFinancial Condition and Results of Operations.
11Item 3.
Quantitative and Qualitative Disclosures About Market Risk.
20Item 4.
Controls and Procedures.
20**PART II - OTHER INFORMATION**Item 1.
Legal Proceedings.
21Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds.
21Item 3.
Default Upon Senior Securities.
22Item 4.
Submission of Matters to a Vote of Security Holders.
22Item 5.
Other Information.
22Item 6.
Exhibits.
22Signatures

23Exhibit Index

24
  2 Table of Contents  **Part I.** **Financial Information**
 ****Item 1.****Financial Statements**** **.**
 
 ****State Financial**Services Corporation And Subsidiaries**
 **Consolidated Statements of Financial Condition**
 **September 30,**
**2004**
**(unaudited)**

**December 31,**
**2003**
**(audited)****Assets**Cash and due from banks

$
39,734,936

$
55,824,050Interest-bearing bank balances


3,554,914


4,399,723Federal funds sold


3,241,517


18,144,353Cash and cash equivalents


46,531,367


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


564,863,070


397,061,108Held-to-maturity (fair value of$594,393 -2004 and $988,006 - 2003)


584,656


964,662Loans (net of allowance for loan losses of $12,277,817-2004 and $10,706,350-2003)


913,960,585


863,323,685Loans held for sale


3,513,102


1,900,438Premises and equipment


33,121,822


32,918,853Accrued interest receivable


5,816,811


5,246,660Goodwill


37,646,354


37,626,045Core deposit intangible


4,771,673


5,158,565Bank owned life insurance


21,694,279


21,029,985Other assets


4,944,736


9,331,295**Total Assets**

$
1,637,448,455

$
1,452,929,422**Liabilities And Shareholders' Equity**Deposits:Demand


184,072,935


180,872,397Savings


257,082,200


253,202,071Money market


266,875,567


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


143,272,049


126,127,203Other time deposits


211,192,170


235,908,124Total deposits


1,062,494,921


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


67,300,000


67,800,000Notes payable


32,258,000


30,200,000Trust preferred securities


30,000,000


15,000,000Securities sold under agreements to repurchase


325,071,456


175,592,887Federal funds purchased


-


-Accrued expenses and other liabilities


5,688,562


21,071,418Accrued interest payable


2,154,936


1,957,473**Total Liabilities**


1,524,967,875


1,340,734,902**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; issued 9,610,492 shares in 2004 and 9,527,489 shares in 2003, outstanding 6,887,652 shares in 2004 and 7,043,149 shares in 2003


961,049


952,749Additional paid in capital


85,922,123


84,739,420Retained earnings


70,568,141


63,152,966Accumulated other comprehensive income


2,150,067


3,763,835Unearned shares held by ESOP


(3,767,610
)

(3,981,360
)TreasuryStock - 2,722,840shares in 2004 and 2,484,340 in 2003


(43,353,190
)

(36,433,090
)**Total Shareholders' Equity**


112,480,580


112,194,520**Total Liabilities And Shareholders' Equity**

$
1,637,448,455

$
1,452,929,422 
 See notes to unaudited consolidated financial statements.
  3 Table of Contents  ****State Financial**Services Corporation And Subsidiaries**
 **Consolidated Statements of Income (Unaudited)**
 
 **Three Months Ended September 30,****2004**

**2003****Interest income:**Loans

$
13,580,148

$
11,427,984Investment securities:Taxable


3,913,152


3,293,913Tax-exempt


554,508


553,689Federal funds sold and other short-term investments


24,653


38,714**Total interest income**


18,072,461


15,314,300**Interest expense:**Deposits


3,804,915


3,003,273Notes payable and other borrowings


1,676,064


1,623,110**Total interest expense**


5,480,979


4,626,383**Net interest income**


12,591,482


10,687,917Provision for loan losses


656,000


600,000**Net interest income after provision for loan losses**


11,935,482


10,087,917**Other income:**Service charges on deposit accounts


801,610


730,450ATM and merchant service fees


260,698


406,395Security commissions and management fees


130,797


131,986Investment securities gains, net


161,580


187,210Gain on sale of loans


350,482


1,406,750Other


758,182


722,209**Total other income**


2,463,349


3,585,000**Other expenses:**Salaries and employee benefits


4,514,327


4,918,055Net occupancy expense


777,565


663,356Equipment rentals, depreciation and maintenance


1,037,948


982,621Data processing


606,097


505,097Legal and professional


243,364


398,603ATM and merchant services


70,351


219,837Advertising


327,107


224,738Other


1,731,842


1,233,426**Total other expenses**


9,308,601


9,145,733**Income before income taxes**


5,090,230


4,527,184Income tax expense


1,366,891


1,406,104**Net income**

$
3,723,339

$
3,121,080**Basic earnings per common share**

$
0.56

$
0.47**Diluted earnings per common share**


0.55


0.46**Dividends per common share**


0.15


0.13 See notes to unaudited consolidated financial statements.
  4 Table of Contents  ****State Financial**Services Corporation And Subsidiaries**
 **Consolidated Statements of Income (Unaudited)**
 
 **Nine Months Ended September 30,****2004**

**2003****Interest income:**Loans

$
39,361,478

$
35,092,350Investment securities:Taxable


11,241,927


10,327,351Tax-exempt


1,647,740


1,739,515Federal funds sold and other short-term investments


101,527


100,780**Total interest income**


52,352,672


47,259,996**Interest expense:**Deposits


9,797,638


9,415,102Notes payable and other borrowings


6,283,597


5,291,821**Total interest expense**


16,081,235


14,706,923**Net interest income**


36,271,437


32,553,073Provision for loan losses


1,856,000


2,025,000**Net interest income after provision for loan losses**


34,415,437


30,528,073**Other income:**Service charges on deposit accounts


2,448,229


2,121,757ATM and merchant service fees


734,831


1,857,241Security commissions and management fees


496,595


327,297Investment securities gains, net


684,368


322,680Gain on sale of loans


1,279,892


4,053,950Gain on sale of merchant processing


-


1,300,000Other


2,538,336


2,456,535**Total other income**


8,182,251


12,439,460**Other expenses:**Salaries and employee benefits


13,401,701


15,058,052Net occupancy expense


2,311,587


2,052,527Equipment rentals, depreciation and maintenance


3,104,076


2,939,402Data processing


1,798,949


1,424,830Legal and professional


930,471


1,212,789ATM and merchant services


214,244


1,185,273Advertising


977,108


842,655Provision for merchant chargebacks


-


300,000Merchant processing exit fee


-


150,000Efficiency consulting expense


-


570,000Severance charges


-


180,114Other


4,928,250


4,366,262**Total other expenses**


27,666,386


30,281,904**Income before income taxes**


14,931,302


12,685,629Income tax expense


4,528,837


3,675,750**Net income**

$
10,402,465

$
9,009,879**Basic earnings per common share**

$
1.56

$
1.35**Diluted earnings per common share**


1.52


1.33**Dividends per common share**


0.45


0.39 See notes to unaudited consolidated financial statements.
  5 Table of Contents  ****State Financial**Services Corporation And Subsidiaries**
 **Consolidated Statements of Cash Flows (Unaudited)**
 **Nine Months Ended**
**September 30,****2004**

**2003****Operating Activities**Net income

$
10,402,465

$
9,009,879Adjustments to reconcile net income to net cash provided by (used in) operating activities:Provision for loan losses


1,856,000


2,025,000Depreciation


2,237,124


2,114,838Amortization of premiums and accretion of discounts on investment securities


555,162


934,318Income from bank owned life insurance


(664,294
)

(546,145
)Decrease (increase) in accrued interest receivable


(570,151
)

2,372,542Increase (decrease) in accrued interest payable


197,463


(408,001
)Realized investment securities gains


(684,368
)

(322,680
)Payment to Lakes Region Bancorps shareholders for acquisition


(13,416,729
)

0Other, net


3,618,348


(5,546,485
)Net cash provided by operating activities


3,531,020


9,633,266**Investing Activities**Proceeds from maturities of investment securities held-to-maturity


380,000


390,000Purchases of securities available-for-sale


(695,609,690
)

(698,147,945
)Proceeds from maturities and sales of investment securities available-for-sale


525,491,836


719,693,474Net increase in loans


(54,105,564
)

(42,804,075
)Net purchases of premises and equipment


(2,440,093
)

(1,255,666
)Net cash used in investing activities


(226,283,511
)

(22,124,212
)**Financing Activities**Net (decrease) increase in deposits


33,381,797


(34,092,325
)Repayment of notes payable


(21,600,000
)

(10,710,000
)Proceeds of notes payable


23,658,000


11,110,000Proceeds from trust preferred securities offering


15,000,000


0Increase in securities sold under agreements to repurchase


149,478,569


51,180,745Repayment of Federal Home Loan Bank advances


(500,000
)

(15,000,000
)Decrease in guaranteed ESOP obligation


213,750


213,750Cash dividends


(2,987,290
)

(2,600,586
)Repayment of federal funds purchased


0


(6,500,000
)Purchase of treasury stock


(6,920,100
)

(92,000
)Proceeds from exercise of stock options


1,191,006


1,090,501Net cash provided by (used in) financing activities


190,915,732


(5,399,915
)Decrease in cash and cash equivalents


(31,836,759
)

(17,890,861
)Cash and cash equivalents at beginning of period


78,368,126


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

$
46,531,367

$
49,625,944Supplemental information:Interest paid

$
15,883,772

$
15,114,924Income taxes paid


4,631,843


3,318,092 
 See notes to unaudited consolidated financial statements.
  6 Table of Contents  **State Financial Services Corporation And Subsidiaries**
 ****Notes to Unaudited**Consolidated Financial Statements**
 **September 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 has stated that it 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 March 2004, the Financial Accounting Standards Board (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 that impairment is other-than-temporary, and measurement of an impairment loss. 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 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. The guidance also includes 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.
 7 Table of Contents
 
 With the release of EITF Issue 03-1-1on 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 (FSP) providing implementation guidance is issued. The final FSP providing implementation guidance is expected to be issued early in December 2004. 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.
 
 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.
 
 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 Employee Stock Option 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**
**September 30,**

**Nine months ended**
**September 30,****2004**

**2003**

**2004**

**2003****Basic:**Weighted-average number of shares outstanding


6,896,307


7,014,434


6,954,418


6,978,545Less: weighted-average number of unearned ESOP shares


(281,288
)

(322,599
)

(285,668
)

(322,599
)Denominator for basic earnings per share


6,615,019


6,691,835


6,668,750


6,655,946**Fully diluted:**Denominator for basic earnings per share


6,615,019


6,691,835


6,668,750


6,655,946Add: assumed conversion of stock options using treasury stock method


169,642


147,066


190,431


121,357Denominator for fully diluted earnings per share


6,784,661


6,838,901


6,859,181


6,777,303 
 **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.
  8 Table of Contents  **Three months ended**
**September 30,**

**Nine months ended**
**September 30,****2004**

**2003**

**2004**

**2003**Net Income

$
3,723,339

$
3,121,080

$
10,402,465

$
9,009,879Other comprehensive income:Change in unrealized securities gains (losses), net of tax


2,297,231


(1,842,117
)

(1,197,741
)

(2,370,232
)Reclassification adjustment for realized gains included in net income, net of tax


(98,224
)

(113,805
)

(416,027
)

(196,157
)Total comprehensive income (loss)

$
5,922,346

$
1,165,158

$
8,788,697

$
6,443,490 
 
 **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 September 30, 2004, 238,500 shares have been repurchased at an average price of $29.02 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.
 
 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 nine months ended September 30, 2004 and September 30, 2003.
  **Three months ended**
**September 30,**
**Nine months ended**
**September 30,****2004**
**2003**
**2004**
**2003**Expected life of options
4.44 years
6.75 years
4.44 years
6.75 yearsRisk-free interest rate
3.11%
3.60%
3.11%
3.60%Expected dividend yield
2.19%
2.20%
2.19%
2.20%Expected volatility factor
35.36%
26.90%
35.36%
26.90% 
 
 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:
  9 Table of Contents  **Three months ended**
**September 30,**

**Nine months ended**
**September 30,***(Thousands, except per share data)*

**2004**

**2003**

**2004**

**2003**Net income, as reported

$
3,723

$
3,121

$
10,402

$
9,010Compensation expense, net of taxes, as reported


3,302


3,391


9,337


10,695Pro forma compensation expense in accordance with SFAS No. 123, net of tax


(3,456
)

(3,444
)

(9,670
)

(10,832
)Pro forma net income

$
3,569

$
3,068

$
10,069

$
8,873Net income per common share, as reported:Basic

$
0.56

$
0.47

$
1.56

$
1.35Diluted

$
0.55

$
0.46

$
1.52

$
1.33Pro forma net income per common share:Basic

$
0.54

$
0.46

$
1.51

$
1.33Diluted

$
0.53

$
0.45

$
1.47

$
1.31 
 ****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 September 30, 2004 are included in the Companys unaudited consolidated statements of income for three and nine months ended September 30, 2004. Hawthorns and Lakes Regions financial condition is included in the Companys consolidated statements of financial condition as of September 30, 2004 (unaudited) and December 31, 2003.
 
 On a pro forma basis, the Companys total income, net income, basic and fully diluted earnings per share for the three and nine months ended September 30, 2004 and September 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**
**September 30,**

**Nine months ended**
**September 30,****2004**

**2003**

**2004**

**2003**Interest income

$
18,072

$
17,267

$
52,353

$
53,055Interest expense


5,481


5,324


16,081


16,826Net interest income


12,591


11,943


36,272


36,229Provision for loan losses


656


577


1,856


2,074Other income


2,463


3,706


8,182


12,792Other expense


9,308


10,173


27,667


33,601Net income before tax


5,090


4,899


14,931


13,346Income taxes


1,367


1,529


4,529


4,239Net income

$
3,723

$
3,370

$
10,402

$
9,107Basic earnings per share

$
0.56

$
0.50

$
1.56

$
1.37Diluted earnings per share

$
0.55

$
0.49

$
1.52

$
1.34 10
  ****Item 2. Managements**Discussion and Analysis of Financial Condition and Results of Operations.**
 
 States net interest income increased 17.8% in the third quarter of 2004, compared to the third quarter of 2003. In the third quarter of 2004, States net interest margin was 3.73%, compared to 3.62% in the second quarter of 2004 and 3.56% in the third quarter of 2003. This margin increase occurred despite the continuing effects of a low margin local governmental seasonal tax collection program, which resulted in repurchase agreements (and corresponding short term investments) of $164 million at September 30, 2004. States core commercial/commercial real estate loans grew at an annualized rate of 20.1% in the third quarter of 2004, and total loans grew at an annualized rate of 15.1%. In the twelve-month period ended September 30, 2004, total loans increased by 18.2%.
 
 States asset quality ratios continued to improve. The ratio of nonperforming loans to total loans declined to 0.84% as of September 30, 2004, from 1.40% on September 30, 2003 and 0.94% on June 30, 2004. On September 30, 2004, nonperforming assets equaled 0.53% of total assets, compared to 1.24% on September 30, 2003 and 0.59% as of June 30, 2004.
 
 Revenues from mortgage originations continued to be significantly lower in the three months and nine months ended September 30, 2004 than in the respective three months and nine months ended September 30, 2003. Mortgage origination related revenue in the third quarter of 2004 declined by 75.1% from the third quarter of 2003 and mortgage origination revenue for the first nine months of 2004 is 68.4% lower than in the first nine months of 2003.
 
 Non-interest expenses in the third quarter of 2004 increased 1.8% over the third quarter of 2003, but declined 0.5% from the second quarter of 2004. For the nine months ended September 30, 2004, non-interest expenses were 8.6% lower than in the nine months ended September 30, 2003.
 
 **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.
  11 Table of Contents  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 September 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 September 30, 2004 and $1.5 billion at December 31, 2003. During the first three quarters of 2004, significant uses of funds by the Company consisted of a $54.1 million net increase in loans, $169.7 million net increase in investment securities, $6.9 million purchase of treasury stock, $3.0 million in payment of cash dividends, and $2.4 million in net purchases of premises and equipment. Funding sources for the first three quarters of 2004 came from a $33.4 million net increase in deposits, $149.5 million increase in securities sold under agreement to repurchase, $15.0 million in proceeds from a trust preferred securities offering, $3.5 million increase in net cash provided by operating activities, $2.1 million net increase in notes payable, and $1.2 million in proceeds from the exercise of stock options.
 
 **Asset Quality**
 
 At September 30, 2004, the Companys non-performing assets were $8.7 million, a decrease of $7.1 million from December 31, 2003, primarily due to a decrease of $4.6 million in other real estate owned and $2.5 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 the Company of approximately $300 thousand. Total non-performing assets as a percentage of total assets were 0.53% at September 30, 2004 and 1.09% at December 31, 2003. As a percentage of total loans outstanding, the level of non-performing loans was 0.84% at September 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).
 
 **Sep. 30**
**2004**

**Jun. 30**
**2004**

**Mar. 31**
**2004**

**Dec. 31**
**2003**

**Sep. 30**
**2003**Non-accrual loans

$
7,830

$
8,729

$
9,429

$
10,332

$
10,993Accruing loans past due 90 days or more


-


-


-


-


-Restructured loans


-


-


-


-


-Total non-performing and restructured loans


7,830


8,729


9,429


10,332


10,993Other real estate owned


852


988


5,742


5,483


5,381Total non-performing assets

$
8,682

$
9,717

$
15,171

$
15,815

$
16,374Ratios:Non-performing loans to total loans


0.84
%

0.97
%

1.05
%

1.18
%

1.40
%Allowance to total loans


1.32


1.32


1.24


1.22


1.32Allowance to non-performing loans


156.81


135.22


118.53


103.62


94.29Non-performing assets to total assets


0.53


0.61


1.01


1.09


1.24 
 **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 September 30, 2004, the Allowance was $12.3 million, an increase of $1.6 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 September 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.
  12 Table of Contents  As a percentage of total loans outstanding, the Allowance was 1.32% at September 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 September 30, 2004.
 
 The following table sets forth an analysis of the Allowance for loan losses for the periods indicated (dollars in thousands):
 
 **Nine months**
**ended**
**Sept. 30, 2004**

**Year ended**
**Dec. 31, 2003****Balance at beginning of period**

$
10,706

$
8,805**Charge-offs:**Commercial


166


727Commercial Real Estate


116


403Real estate mortgage


114


309Installment


242


390Other


13


31**Total charge-offs**


651


1,860**Recoveries:**Commercial


170


121Commercial Real Estate


128


1Real estate mortgage


20


17Installment


45


75Other


4


3**Total recoveries**


367


217**Net charge-offs**


284


1,643Balance of acquired allowance at date of acquisitions


0


919Additions charged to operations


1,856


2,625**Balance at end of period**

$
12,278

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


0.04
%

0.21
%Net charge-offs to total allowance1


3.09


15.35Allowance to period end loans outstanding


1.32


1.22 
 1. Annualized.
 
 **Results of Operations-Comparison of the Three-Month Periods Ended September 30, 2004 and September 30, 2003.**
 
 **General**
 
 For the quarter ended September 30, 2004, the Company reported net income of $3.7 million and net income per share on a fully diluted basis of $0.55, compared to net income of $3.1 million and net income per share on a fully diluted basis of $0.46 reported for the quarter ended September 30, 2003.
  13 Table of Contents  **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 September 30, 2004 and September 30, 2003 (dollars in thousands):
 
 **Three months ended**
**September 30, 2004**

**Three months ended**
**September 30, 2003****Average Balance**

**Interest**

**Yield/**
**Rate****4**

**Average Balance**

**Interest**

**Yield/**
**Rate**4**Assets**Interest-earning assets:Loans123

$
915,680

$
13,587


5.90
%
$
780,713

$
11,438


5.81
%Taxable investment securities


390,546


3,896


3.97
%

361,133


3,277


3.60
%Tax-exempt investment securities3


57,714


853


5.88
%

58,444


852


5.78
%Interest-earnings deposits


3,514


17


1.94
%

6,463


17


1.06
%Federal funds sold


7,749


25


1.27
%

17,673


39


0.87
%Total interest-earning assets


1,375,203


18,378


5.32
%

1,224,426


15,623


5.06
%Non-interest-earnings assets:Cash and due from banks


49,540








47,845Premises and equipment, net


33,192








27,255Other assets


74,660








62,758Less: Allowance for loan losses


(12,024
)







(10,126
)**Total**

$
1,520,571







$
1,352,158**Liabilities And Stockholders Equity**Interest-bearing liabilities:Now accounts

$
128,057

$
87


0.27
%
$
103,685

$
51


0.20
%Money market accounts


259,164


783


1.20
%

216,469


504


0.92
%Savings deposits


131,086


131


0.40
%

130,124


131


0.40
%Time deposits


358,067


2,290


2.54
%

309,263


2,140


2.75
%Notes payable


62,367


651


4.15
%

33,587


303


3.58
%FHLB borrowings


67,403


789


4.66
%

77,400


785


4.02
%Federal funds purchased


3,180


19


2.38
%

1,402


5


1.41
%Securities sold under agreement to repurchase


212,596


731


1.37
%

202,983


708


1.38
%Total interest-bearing liabilities


1,221,920


5,481


1.79
%

1,074,913


4,626


1.71
%Non-interest-bearings liabilities:Demand deposits


181,191








160,441Other


5,597








7,717Total liabilities


1,408,708








1,243,071Stockholders equity


111,863








109,087**Total**

$
1,520,571







$
1,352,158Net interest earning and interest rate spread




$
12,897


3.53
%



$
10,997


3.35
%Net yield on interest-earning assets








3.73
%







3.56
%
 
 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.
 
 The foregoing table includes certain non-GAAP performance measures and ratios that 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 use these or similar measures and ratios, but 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 September 30, 2004 and September 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).
  14 Table of Contents  **Three months ended**
**September 30,****2004**

**2003**(A) Interest income (GAAP)

$
18,072

$
15,314Taxable equivalent adjustment-loans


7


10Taxable equivalent adjustment-Tax-exempt securities


299


299Interest income-FTE


18,378


15,623(B) Interest expense (GAAP)


5,481


4,626(C) Net interest income (GAAP) (A minus B)


12,591


10,688Net interest income-FTE


12,897


10,997(D) Net interest margin (GAAP)(annualized)


3.64
%

3.46
%Net interest margin-FTE (annualized)


3.73
%

3.56
% 
 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 September 30, 2004, the Company reported taxable-equivalent net interest income of $12.9 million, an increase of $1.9 million, or 17.3%, from the $11.0 million reported for the quarter ended September 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) increased to 3.73% in the third quarter of 2004 from 3.56% in the third quarter of 2003.
 
 The Companys taxable-equivalent total interest income increased $2.8 million for the quarter ended September 30, 2004 compared to the same period of 2003 due to the increase in average loans outstanding, and by an increased rate environment. Average loans outstanding increased by $135.0 million, or 17.3%, in the third quarter of 2004 over the third quarter of 2003. For the quarter ended September 30, 2004, the taxable-equivalent yield on interest-earning assets was 5.32% compared to 5.06% for the quarter ended September 30, 2003. The third quarter 2004 loan yield was 5.90% compared to 5.81% in the third 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 September 30, 2004, the yield earned on taxable investment securities increased to 3.97% from 3.60% for the quarter ended September 30, 2003. The taxable equivalent yields earned on tax-exempt investment securities increased to 5.88% for the quarter ended September 30, 2004 from 5.78% for the quarter ended September 30, 2003. The increase in these yields for the third quarter of 2004 compared to the third 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 increased interest rate environment prevalent over the preceding twelve months. The cost of interest-bearing liabilities increased to 1.79% for the third quarter of 2004 from 1.71% for the third 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 third quarter of 2004, notes payable, FHLB borrowings, federal funds purchased, and securities sold under agreements to repurchase comprised 28.3% of the Companys interest-bearing liabilities compared to 29.3% in the third quarter 2003.
 
 **Provision for Loan Losses**
 
 The provision for loan losses was $656 thousand in the third quarter of 2004 and $600 thousand in the third 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.
 15 Table of Contents  **Other Income**
 
 Total other income decreased $1.1 million in the third quarter of 2004 over the third quarter of 2003. The decrease was mainly the result of a $1.1 million decrease in gains on the sale of mortgage loans due to decreased refinancing activity.
 
 **Other Expenses**
 
 Other expenses increased $163 thousand in the third quarter of 2004 over the third quarter of 2003. The increase was due to increases in net occupancy and equipment expense, data processing, advertising and other expense. These increases were offset by decreases in personnel costs, legal and professional fees, and automated teller machine (ATM) and merchant services. Personnel costs decreased $404 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 $170 thousand and data processing increased $101 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 $155 thousand. ATM and merchant services decreased $149 thousand mainly due to the sale of the merchant credit card processing business. Other expense increased $498 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 tax-exempt interest income on investment securities, loans, and nondeductible merger related expenses. The effective tax rate for the three months ended September 30, 2004 was 26.9% compared to 31.1% for the three months ended September 30, 2003. Provisions for income tax were $1.4 million for the third quarter of 2004 compared to $1.4 million for the third quarter of 2003.
  16 Table of Contents  **Results of Operations-Comparison of the Nine-Month Periods Ended September 30, 2004 and September 30, 2003.**
 
 **General**
 
 For the nine months ended September 30, 2004, the Company reported net income of $10.4 million and net income per share on a fully diluted basis of $1.52, compared to net income of $9.0 million and net income per share on a fully diluted basis of $1.33 reported for the nine months ended September 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 nine-month periods ended September 30, 2004 and September 30, 2003 (dollars in thousands):
 
 **Nine months ended**
**September 30, 2004**

**Nine months ended**
**September 30, 2003****Average Balance**

**Interest**

**Yield/**
**Rate**4

**Average Balance**

**Interest**

**Yield/**
**Rate**4**Assets**Interest-earning assets:Loans123

$
898,788

$
39,385


5.85
%
$
768,380

$
35,131


6.11
%Taxable investment securities


378,078


11,180


3.95
%

354,916


10,291


3.88
%Tax-exempt investment securities3


57,610


2,535


5.88
%

61,332


2,676


5.83
%Interest-earnings deposits


6,384


62


1.29
%

2,401


37


2.04
%Federal funds sold


13,791


102


0.98
%

13,629


101


0.99
%Total interest-earning assets


1,354,651


53,264


5.25
%

1,200,658


48,236


5.37
%Non-interest-earnings assets:Cash and due from banks


51,937








39,303Premises and equipment, net


33,124








27,524Other assets


77,674








61,594Less: Allowance for loan losses


(11,444
)







(9,554
)**Total**

$
1,505,942







$
1,319,525**Liabilities And Stockholders Equity**Interest-bearing liabilities:Now accounts

$
124,008

$
250


0.27
%
$
111,466

$
276


0.33
%Money market accounts


247,924


2,099


1.13
%

214,285


1,744


1.09
%Savings deposits


134,137


399


0.40
%

128,645


492


0.51
%Time deposits


367,658


7,049


2.56
%

317,270


6,903


2.91
%Notes payable


60,986


1,761


3.86
%

30,403


850


3.74
%FHLB borrowings


67,667


2,366


4.67
%

77,583


2,354


4.06
%Federal funds purchased


2,706


39


1.93
%

1,491


18


1.61
%Securities sold under agreement to repurchase


205,279


2,118


1.38
%

163,246


2,070


1.70
%Total interest-bearing liabilities


1,210,365


16,081


1.77
%

1,044,389


14,707


1.88
%Non-interest-bearings liabilities:Demand deposits


175,944








157,944Other


7,281








9,029Total liabilities


1,393,590








1,211,362Stockholders equity


112,352








108,163**Total**

$
1,505,942







$
1,319,525Net interest earning and interest rate spread




$
37,183


3.48
%



$
33,529


3.49
%Net yield on interest-earning assets








3.67
%







3.73
%
 
 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.
 
 The foregoing table includes certain non-GAAP performance measures and ratios that 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 use these or similar measures and ratios, but 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 nine months ended September 30, 2004 and September 30, 2003.
  17 Table of Contents  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).
 
 
 **Nine months ended**
**September 30,****2004**

**2003**(A) Interest income (GAAP)

$
52,352

$
47,260Taxable equivalent adjustment-loans


25


39Taxable equivalent adjustment-Tax-exempt securities


887


937Interest income-FTE


53,264


48,236(B) Interest expense (GAAP)


16,081


14,707(C) Net interest income (GAAP) (A minus B)


36,271


32,553Net interest income-FTE


37,183


33,529(D) Net interest margin (GAAP)(annualized)


3.58
%

3.62
%Net interest margin-FTE (annualized)


3.67
%

3.73
% 
 
 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 nine months ended September 30, 2004, the Company reported taxable-equivalent net interest income of $37.2 million, an increase of $3.7 million, or 10.9%, from the $33.5 million reported for the nine months ended September 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 3.67% in the first three quarters of 2004 from 3.73% in the first three quarters of 2003, reflecting repricing of assets in a low rate environment.
 
 The Companys taxable-equivalent total interest income increased $5.0 million for the nine months ended September 30, 2004 compared to the same period of 2003 due to the increase in average loans outstanding. Average loans outstanding increased by $130.4 million, or 17.0%, in the first three quarters of 2004 over the first three quarters of 2003. For the nine months ended September 30, 2004, the taxable-equivalent yield on interest-earning assets was 5.25% compared to 5.37% for the nine months ended September 30, 2003. The first three quarters of 2004 loan yield was 5.85% compared to 6.11% in the first three quarters 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 nine months ended September 30, 2004, the yield earned on taxable investment securities increased to 3.95% from 3.88% for the nine months ended September 30, 2003. The taxable equivalent yields earned on tax-exempt investment securities increased to 5.88% for the nine months ended September 30, 2004 from 5.83% for the nine month ended September 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 three quarters of 2004 from 1.88% for the first three quarters 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 three quarters of 2004, notes payable, FHLB borrowings, federal funds purchased, and securities sold under agreements to repurchase comprised 27.8% of the Companys interest-bearing liabilities compared to 26.1% in the first three quarters of.
 
  18 Table of Contents  **Provision for Loan Losses**
 
 The provision for loan losses was $1.9 million in the first three quarters of 2004 and $2.0 million in the first three quarters 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 $4.3 million for the first three quarters of 2004 over the first three quarters 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 $2.8 million in gains on sale of mortgage loans due to decreased refinancing activity, and a decrease of $1.1 million in 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 $326 thousand, security commissions and management fees of $169 thousand, investment securities gains of $362 thousand, and other income of $82 thousand.
 
 **Other Expenses**
 
 Other expenses decreased $2.6 million in the first three quarters of 2004 over the first three quarters 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 $1.7 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 $424 thousand and data processing increased $374 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 $282 thousand. ATM and merchant services decreased $971 thousand mainly due to the sale of the merchant credit card processing business during 2003. Other expense increased $562 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 tax-exempt interest income on investment securities, loans, and nondeductible merger related expenses. The effective tax rate for the nine months ended September 30, 2004 was 30.3% compared to 29.0% for the nine months ended September 30, 2003. Provisions for income tax were $4.5 million for the first three quarters of 2004 compared to $3.7 million for the first three quarters 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 $46.5 million and $78.4 million at September 30, 2004 and December 31, 2003, respectively.
  19 Table of Contents  
 **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 September 30, 2004 (dollars in thousands):
 
 **Actual**

**Regulatory**
**Minimum**
**Requirement**

**Regulatory**
**Well-capitalized**
**Requirement****Amount**

**Percent**

**Amount**

**Percent**

**Amount**

**Percent**Tier 1 leverage

$
97,910


6.6
%
$
59,102


4.0
%
$
73,878


5.0
%Tier 1 risk-based capital

$
97,910


8.6
%
$
43,322


4.0
%
$
67,982


6.0
%Risk-based capital

$
124,188


11.0
%
$
90,643


8.0
%
$
113,304


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.
 
 **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 September 30, 2004 (dollars in thousands):
 
 **Hedged Item**

**Hedging Instrument**

**Notional Amount**

**Fair Value**

**Remaining Term (Years)**Fixed Rate Loan

Receive Variable Swap

$3,878

$ (35)


8.25
 
 ****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.
  20 Table of Contents  **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.
 
 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.   Unregistered**Sales of Equity Securities and Use of Proceeds.**
 
 Period

Total Number of SharesPurchased

Average Price Paid per Share

Total Number of Shares Purchased as Part of Publicly AnnouncedProgram

Maximum Number of Shares that May Yet Be Purchased Under the ProgramJuly 1, 2004 - July 31, 2004


45,000


$29.05


45,000


139,500August 1, 2004 - August 31, 2004


50,000


$ 29.09


50,000


89,500September 1, 2004 - September 30, 2004


0


$        0


0


89,500Total


95,000


$ 29.07


95,000


89,500
 
  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 in open market or privately negotiated transactions. Through September 30, 2004, 238,500 shares had been repurchased at an average price of $29.02 per share, and the Company had authority to repurchase approximately 89,500 additional shares under this authorization. There is no specific expiration date for the Companys share repurchase authorization.
  21 Table of Contents  ****Item 3.   Default**Upon Senior Securities.**
 
 None.
 
 **Item 4.   Submission of Matters to Vote of Security Holders.**
 
 None.
 
 **Item 5.   Other Information.**
 
 None.
 
 ****Item 6.    Exhibits****
 
 10.1
ISO Option Agreement State Financial Services Corporation 1998 Stock Incentive Plan. 
 10.2
NQO Option Agreement State Financial Services Corporation 1998 Stock Incentive Plan. 
 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
Certification Statement of the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350.  22 Table of Contents  ****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:November 9, 2004
By/s/ Michael J. FalboMichael J. Falbo
President and Chief Executive OfficerDate :November 9,2004
By/s/ Daniel L. WestropeDaniel L. Westrope
Senior Vice President and
Chief Financial Officer  23 Table of Contents  ****STATE FINANCIAL**SERVICES CORPORATION**
 EXHIBIT INDEX TO FORM 10-Q
 For The Quarter Ended September 30, 2004
 
 
 Exhibit Number10.1

ISO Option Agreement State Financial Services Corporation 1998 Stock Incentive Plan.10.2

NQO Option Agreement State Financial Services Corporation 1998 Stock Incentive Plan.31.1

Certification by the Chief Executive Officer pursuant to Rule 13a-14(a) or 15d-14(a) under the Securities Exchange Act of 193431.2

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.
 
  24