**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

** **

**FORM 10-Q**

** **

**ý****QUARTERLY REPORT PURSUANTTO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

** **

**Forthe quarterly period ended: March 31, 2003**

** **

**or**

** **

**o****TRANSITION REPORT PURSUANTTO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

** **

**Forthe transition period from                to                **

** **

**CommissionFile Number: 0-10196**

** **

**INDEPENDENT BANKSHARES, INC.**

(Exact name ofregistrant as specified in its charter)

 

| **Texas**                                                        |   | **75-1717279**                     |
|------------------------------------------------------------------|--------|------------------------------------|
| (State or other  jurisdiction of  Incorporation or organization) |   | (IRS Employer  Identification No.) |
|                                                             |   |                               |
| **1617  Broadway  Lubbock, Texas**                               |   | **79408**                          |
| (Address of  principal executive offices)                        |   | (Zip Code)                         |
|                                                             |   |                               |
| **(806)  749-1850**                                              |
| (Registrant’s  telephone number, including area code)       |

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports) and (2) has been subject to such filing requirements for the past90 days.

 

YES ý    NO o

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12-b-2 ofthe Exchange Act.

 

YES o    NO ý

 

Indicate thenumber of shares outstanding of each ofthe issuer’s classes of common stock at March 31, 2003.

 

Class:  Common Stock, par value $0.25 per shareOutstanding at March 31, 2003: 2,273,674 shares

 

 

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**PART I**

 

**FINANCIAL INFORMATION**

 

Item 1. FinancialStatements.

 

2

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**INDEPENDENTBANKSHARES, INC.**

**A WHOLLYOWNED SUBSIDIARY OF STATE NATIONAL BANCSHARES, INC.**

**CONSOLIDATEDBALANCE SHEETS**

**MARCH 31,2003 AND DECEMBER 31, 2002**

**(Unaudited)**

 
|                                                                                     |   | **March 31,  2003** |       | **December  31,  2002** |       |
|------------------------------------------------------------------------------------------|--------|---------------------|------------|-------------------------|------------|
| **ASSETS**                                                                               |   | **(in  thousands)** |       |
| Cash and Cash Equivalents:                                                               |   |                |       |                    |       |
| Cash and Due from Banks                                                                  |   | $                   | 46,640     |                    | $          | 54,119 |   |
| Interest-earning Time Deposits in Other Banks                                            |   | 15                  |       | 14,482                  |       |
| Federal Funds Sold                                                                       |   | 18,320              |       | 15,623                  |       |
| Total Cash and Cash Equivalents                                                          |   | 64,975              |       | 84,224                  |       |
| Available-For-Sale Securities                                                            |   | 272,717             |       | 274,342                 |       |
| Loans Held-For-Sale                                                                      |   | 13,428              |       | 15,475                  |       |
| Loans Held-For-Investment:                                                               |   | 661,391             |       | 658,870                 |       |
| Less:                                                                                    |   |                |       |                    |       |
| Unearned Income on Installment Loans                                                     |   | 2                   |       | 3                       |       |
| Allowance for Loan Losses                                                                |   | 11,096              |       | 10,914                  |       |
| Net Loans                                                                                |   | 650,293             |       | 647,953                 |       |
| Goodwill                                                                                 |   | 37,934              |       | 37,934                  |       |
| Other Intangible Assets                                                                  |   | 15,611              |       | 16,327                  |       |
| Premises and Equipment                                                                   |   | 26,884              |       | 24,944                  |       |
| Accrued Interest Receivable                                                              |   | 6,144               |       | 7,044                   |       |
| Other Real Estate and Other Repossessed Assets                                           |   | 3,641               |       | 3,703                   |       |
| Assets Related to Discontinued Operations                                                |   | —              |       | 480                     |       |
| Other Assets                                                                             |   | 29,372              |       | 29,251                  |       |
| Total Assets                                                                             |   | 1,120,999           |       | $                       | 1,141,677  |   |
|                                                                                     |   |                | ** ** |                    | ** ** |
| **LIABILITIES AND STOCKHOLDER’S EQUITY**                                            |   |                |       |                    |       |
| Liabilities:                                                                             |   |                |       |                    |       |
| Deposits:                                                                                |   |                |       |                    |       |
| Noninterest-bearing Demand Deposits                                                      |   | $                   | 242,346    |                    | $          | 241,179 |   |
| Interest-bearing Demand Deposits                                                         |   | 343,433             |       | 350,975                 |       |
| Interest-bearing Time Deposits                                                           |   | 352,477             |       | 372,560                 |       |
| Total Deposits                                                                           |   | 938,256             |       | 964,714                 |       |
| Federal Funds Purchased and Securities Sold under  Agreements to Repurchase              |   | 27,850              |       | 20,762                  |       |
| Accrued Interest Payable                                                                 |   | 828                 |       | 1,009                   |       |
| Note Payable                                                                             |   | 1,043               |       | 789                     |       |
| Liabilities Related to Discontinued Operations                                           |   | —              |       | 3,954                   |       |
| Other Liabilities                                                                        |   | 10,474              |       | 9,525                   |       |
| Total Liabilities                                                                        |   | 978,451             |       | 1,000,753               |       |
|                                                                                     |   |                |       |                    |       |
| Guaranteed Preferred Beneficial Interests in the  Company’s Subordinated Debentures |   | 10,938              |       | 10,934                  |       |
|                                                                                     |   |                |       |                    |       |
| Stockholder’s Equity:                                                               |   |                |       |                    |       |
| Common Stock                                                                             |   | 568                 |       | 568                     |       |
| Additional Paid-in Capital                                                               |   | 144,134             |       | 144,134                 |       |
| Retained Earnings (Deficit)                                                              |   | (17,772             | )          | (20,028                 | )          |
| Unrealized Gain on Available-for-sale Securities                                         |   | 4,680               |       | 5,316                   |       |
| Total Stockholder’s Equity                                                          |   | 131,610             |       | 129,990                 |       |
| Total Liabilities and Stockholder’s Equity                                          |   | $                   | 1,120,999  |                    | $          | 1,141,677 |   |

 

See Accompanying Notes to Consolidated Financial Statements.

 

3

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**INDEPENDENTBANKSHARES, INC.**

**A WHOLLYOWNED SUBSIDIARY OF STATE NATIONAL BANCSHARES, INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**QUARTERSENDED MARCH 31, 2003 AND 2002**

**(Unaudited)**

** **
|                                                                                                                     |   | **Quarter Ended  March 31,** |   |
|--------------------------------------------------------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                                                                     |   | **2003**                     |   | **2002** |   |
|                                                                                                                     |   | **(in  thousands)**          |   |
| Interest  Income:                                                                                                        |   |                         |   |
| Interest and Fees on Loans                                                                                               |   | $                            | 11,341 |   | $ | 11,770 |   |
| Interest on Securities                                                                                                   |   | 3,002                        |   | 4,546 |   |
| Interest on Deposits in Other Banks                                                                                      |   | 21                           |   | 63 |   |
| Interest on Federal Funds Sold                                                                                           |   | 66                           |   | 120 |   |
| Total Interest Income                                                                                                    |   | 14,430                       |   | 16,499 |   |
| Interest Expense:                                                                                                        |   |                         |   |   |   |
| Interest on Deposits                                                                                                     |   | 2,505                        |   | 4,309 |   |
| Interest on Securities Sold Under Agreement to  Repurchase                                                               |   | 36                           |   | 38 |   |
| Interest on Federal Funds Purchased                                                                                      |   | —                       |   | 2 |   |
| Interest on Notes Payable                                                                                                |   | 12                           |   | 9 |   |
| Total Interest Expense                                                                                                   |   | 2,553                        |   | 4,358 |   |
| Net Interest Income                                                                                                      |   | 11,877                       |   | 12,141 |   |
| Provision for Loan Losses                                                                                                |   | 118                          |   | 455 |   |
| Net Interest Income After Provision for Loan Losses                                                                      |   | 11,759                       |   | 11,686 |   |
| Noninterest Income:                                                                                                      |   |                         |   |   |   |
| Service Charges                                                                                                          |   | 2,024                        |   | 1,822 |   |
| Trust Fees                                                                                                               |   | 144                          |   | 129 |   |
| Gain on Sale of Loans                                                                                                    |   | 774                          |   | 376 |   |
| Gain on Sale of Securities                                                                                               |   | 10                           |   | 72 |   |
| Other Income                                                                                                             |   | 792                          |   | 816 |   |
| Total Noninterest Income                                                                                                 |   | 3,744                        |   | 3,215 |   |
| Noninterest Expenses:                                                                                                    |   |                         |   |   |   |
| Salaries and Employee Benefits                                                                                           |   | 5,471                        |   | 4,874 |   |
| Net Occupancy and Equipment Expense                                                                                      |   | 1,987                        |   | 1,891 |   |
| Amortization of Intangible Assets                                                                                        |   | 673                          |   | 761 |   |
| Data Processing Expense                                                                                                  |   | 424                          |   | 474 |   |
| Professional Fees                                                                                                        |   | 373                          |   | 317 |   |
| Communication Expense                                                                                                    |   | 350                          |   | 413 |   |
| Net Costs Applicable to Other Real Estate and Other  Repossessed Assets                                                  |   | 129                          |   | 19 |   |
| Distributions on Guaranteed Preferred Beneficial  Interests in the Company’s Subordinated Debentures                |   | 281                          |   | 280 |   |
| Merger-related Expense                                                                                                   |   | 632                          |   | — |   |
| Other Expenses                                                                                                           |   | 1,784                        |   | 2,065 |   |
| Total Noninterest Expenses                                                                                               |   | 12,104                       |   | 11,094 |   |
| Income From Continuing Operations Before Federal  Income Taxes and Cumulative Effect of a Change in Accounting Principle |   | 3,399                        |   | 3,807 |   |
| Federal Income Tax Expense                                                                                               |   | 1,121                        |   | 1,394 |   |
| Income From Continuing Operations Before Cumulative  Effect of a Change in Accounting Principle                          |   | 2,278                        |   | 2,413 |   |
| Discontinued Operations                                                                                                  |   |                         |   |   |   |
| (Loss) Gain from Branches Held-for-Sale                                                                                  |   | (33                          | )      | 58 |   |
| Federal Income Tax (Benefit) Expense                                                                                     |   | (11                          | )      | 20 |   |
| Net (Loss) Gain from Branches Held-for-Sale                                                                              |   | (22                          | )      | 38 |   |
| Income Before Cumulative Effect of a Change in  Accounting Principle                                                     |   | 2,256                        |   | 2,451 |   |
| Cumulative Effect of a Change in Accounting  Principle                                                                   |   | —                       |   | 15,642 |   |
| Net Income (Loss)                                                                                                        |   | $                            | 2,256  |   | $ | (13,191 | ) |

 

See Accompanying Notes to Consolidated Financial Statements.

 

4

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**INDEPENDENT BANKSHARES, INC.**

**A WHOLLY OWNED SUBSIDIARY OF STATENATIONAL BANCSHARES, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**QUARTERS ENDED MARCH 31, 2003 and2002**

**(Unaudited)**

 
|                                                                                      |   | **Quarter  Ended March 31,** |   |
|-------------------------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                                      |   | **2003**                     |   | **2002** |   |
|                                                                                      |   | **(in  thousands)**          |   |
| Cash  Flows from Operating Activities:                                                    |   |                         |   |   |   |
| Net Income (Loss)                                                                         |   | $                            | 2,256  |   | $ | (13,191 | ) |
| Adjustments to Reconcile Net Income (Loss) to Net  Cash Provided by Operating Activities: |   |                         |   |   |   |
| Depreciation and Amortization                                                             |   | 1,513                        |   | 1,604 |   |
| Net Amortization of Premium/Discount                                                      |   | 376                          |   | 264 |   |
| Net Gain on Sales of Available-For-Sale Securities                                        |   | —                       |   | (72 | ) |
| Provision for Loan Losses                                                                 |   | 118                          |   | 455 |   |
| Cumulative Effect of a Change in Accounting  Principle                                    |   | —                       |   | 15,642 |   |
| Net Loss on Sales of Premises and Equipment                                               |   | —                       |   | 2 |   |
| Gain on Branch Sale                                                                       |   | (50                          | )      | — |   |
| Writedown of Premises and Equipment                                                       |   | 139                          |   | 14 |   |
| Net Loss (Gain) on Sales of Other Real Estate and  Other Repossessed Assets               |   | 10                           |   | (3 | ) |
| Writedown of Other Real Estate and Other  Repossessed Assets                              |   | —                       |   | 3 |   |
| Loans Originated for Sale                                                                 |   | (30,107                      | )      | (19,506 | ) |
| Proceeds from Sales of Loans Held-for-Sale                                                |   | 32,928                       |   | 19,497 |   |
| Gain on Sale of Loans                                                                     |   | (774                         | )      | (376 | ) |
| Decrease in Accrued Interest Receivable                                                   |   | 901                          |   | 1,081 |   |
| Increase in Other Assets                                                                  |   | (121                         | )      | (240 | ) |
| Decrease in Accrued Interest Payable                                                      |   | (181                         | )      | (579 | ) |
| Increase in Other Liabilities                                                             |   | 1,272                        |   | 1,737 |   |
| Net Cash Provided by Operating Activities                                                 |   | 8,280                        |   | 6,332 |   |
|                                                                                      |   |                         |   |   |   |
| Cash Flows from Investing Activities:                                                     |   |                         |   |   |   |
| Proceeds from Maturities of Available-for-sale Securities                                 |   | 31,483                       |   | 28,601 |   |
| Purchases of Available-for-sale Securities                                                |   | (31,962                      | )      | (46,147 | ) |
| Proceeds from Sales of Available-for-sale  Securities                                     |   | 765                          |   | 6,868 |   |
| Net Cash Used in Branch Sale                                                              |   | (2,434                       | )      | (686 | ) |
| Net (Increase) Decrease in Loans                                                          |   | (2,279                       | )      | 19,370 |   |
| Proceeds from Sales of Premises and Equipment                                             |   | —                       |   | 28 |   |
| Additions to Premises and Equipment                                                       |   | (2,910                       | )      | (150 | ) |
| Proceeds from Sales of Other Real Estate and Other  Repossessed Assets                    |   | 75                           |   | 122 |   |
| Net Cash (Used in) Provided by Investing Activities                                       |   | (7,262                       | )      | 8,006 |   |
|                                                                                      |   |                         |   |   |   |
| Cash Flows from Financing Activities:                                                     |   |                         |   |   |   |
| Decrease in Deposits                                                                      |   | (27,609                      | )      | (34,625 | ) |
| Increase in Federal Funds Purchased and Securities  Sold under Agreements to Repurchase   |   | 7,088                        |   | 1,871 |   |
| Advances on Note Payable                                                                  |   | 268                          |   | — |   |
| Paydown of Note Payable                                                                   |   | (14                          | )      | (10 | ) |
| Payment of Cash Dividends                                                                 |   | —                       |   | (1,000 | ) |
| Net Cash Used in Financing Activities                                                     |   | (20,267                      | )      | (33,764 | ) |
| Net Decrease in Cash and Cash Equivalents                                                 |   | (19,249                      | )      | (19,426 | ) |
| Cash and Cash Equivalents at Beginning of Period                                          |   | 84,224                       |   | 90,707 |   |
| Cash and Cash Equivalents at End of Period                                                |   | $                            | 64,975 |   | $ | 71,281 |   |
|                                                                                      |   |                         |   |   |   |
| Noncash Investing Activities:                                                             |   |                         |   |   |   |
| Additions to Other Real Estate and Other  Repossessed Assets through Foreclosures         |   | $                            | 31     |   | $ | 417 |   |

 

See AccompanyingNotes to Consolidated Financial Statements.

 

5

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**INDEPENDENT BANKSHARES, INC.**

**A WHOLLY OWNED SUBSIDIARY OF STATENATIONAL BANCSHARES, INC.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

**(1)**                                 **Summary of Significant AccountingPolicies**

 

For information regarding significant accountingpolicies, reference is made to Notes to Consolidated Financial Statementsincluded in the Annual Report of Independent Bankshares Inc. (the “Company”) onForm 10-K for the year ended December 31, 2002, which was filed with theSecurities and Exchange Commission pursuant to Section 13 of theSecurities and Exchange Act of 1934, as amended.

 

The accompanying financial statements reflect alladjustments necessary to present a fair statement of the results for theinterim periods presented, and all adjustments are of a normal, recurringnature.

 

**(2)**                                 **Bank Mergers**

 

On February 14, 2003, State National Bancshares,Inc.  (“State National”), the Company’ssole shareholder, contributed its ownership interest in State National Bank, ElPaso, Texas (“SNB El Paso”), an indirect wholly owned subsidiary of StateNational, to the Company.  The Company,in turn, contributed to Independent Financial Corp., a Delaware subsidiary ofthe Company, all of the capital stock of SNB El Paso. After the contribution,SNB El Paso was then merged with and into State National Bank, Lubbock, Texas(the “Bank”), (the “Merger”).  The Bankcontinued as the surviving entity and is an indirect wholly owned subsidiary ofthe Company. There was no merger consideration paid as, prior to the Merger,SNB El Paso and the Bank were both direct or indirect subsidiaries of StateNational.

 

As a result of theMerger, the balance sheet and results of operations of the SNB El Paso havebeen included in the Company’s consolidated financial statements since August11, 2000, the date of the acquisition of the Company by State National.

 

**(3)**                                 **Accumulated Other Comprehensive Income**

 

An analysis of accumulated other comprehensive incomefor the quarter ended March 31, 2003, is as follows:

 

|                          |   | **Accumulated  Other  Comprehensive Income (Loss)** |   |
|-------------------------------|--------|-----------------------------------------------------|--------|
|                          |   | **Quarter  Ended March 31,**                        |   |
|                          |   | **2003**                                            |   | **2002** |   |
|                          |   | **(In  thousands)**                                 |   |
| Balance,  beginning of period |   | $                                                   | 5,316  |   | $ | 4,309 |   |
| Current  period change        |   | (636                                                | )      | (1,351 | ) |
| Balance,  at March 31         |   | $                                                   | 4,680  |   | $ | 2,958 |   |

 

**(4)**                                 **Adoption ofAccounting Standards**

 

In June 2001 the FASBissued SFAS No. 142, “Goodwill and Other Intangible Assets”*,*which addresses theaccounting for goodwill and other intangible assets.  SFAS No. 142 prohibits the amortization of goodwill andintangible assets with indefinite useful lives.  SFAS No. 142 requires that these assets be reviewed forimpairment at least annually. Intangible assets with finite lives will continue to be amortized overtheir estimated useful lives. Additionally, SFAS No. 142 requires that goodwill included in thecarrying value of equity method investments no longer be amortized.

 

6

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SFAS No. 142 waseffective for the Company’s fiscal year beginning January 1, 2002.  The implementation of SFAS No. 142 resultedin the Company recording a non-cash goodwill impairment charge of $15,642,000during the first quarter of 2002.  Thischarge reflects the cumulative effect of adopting the accounting change in thestatement of operations, but does not affect the Company’s operations and hasno impact on cash flows.  The Company’sassets were reviewed again for impairment as of October 1, 2002.  The results of this review determined thatan impairment did not need to be recorded in 2003.

 

In August 2001 the FASBissued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-LivedAssets”.  SFAS No. 144 addressesfinancial accounting and reporting for the impairment of long-lived assets andfor long-lived assets to be disposed of. More specifically, this statement broadens the presentation ofdiscontinued operations to include a component of an entity whose operationsand cash flows can be clearly distinguished, operationally and for financialreporting purposes, from the rest of the entity.  It supersedes, with exceptions, SFAS No. 121, “Accounting for theImpairment of Long-Lived Assets and Long-Lived Assets to be Disposed of”, andwas adopted January 1, 2002.

 

In 2002 the Company soldthree branches located in Bangs and Trent, Texas and Belen, New Mexico.  In 2003 the Company sold one branch locatedin Socorro, New Mexico  Accordingly, theoperating results of the deposed properties have been reclassified and reportedas discontinued operations in the Consolidated Statements of operations and theassets and liabilities of the branch held-for-sale have been reclassified andreported as such on the consolidated balance sheets.

 

**(5)**                                 **Branch Sale**

 

On February 10, 2003, theBank sold its branch in Socorro, New Mexico to an unrelated financialinstitution.  A pre tax gain of $50,000was recorded related to this transaction. Net loss for the period ended March 31, 2003 for this branch was$22,000.

 

7

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**Item 2.**  **Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

*ThisQuarterly Report on Form 10-Q contains certain forward-looking statements andinformation relating to Independent Bankshares, Inc. (the “Company”, and at orprior to the date of the Acquisition, “IBK”) and its subsidiaries that arebased on the beliefs of the Company’s management as well as assumptions made byand information currently available to the Company’s management. When used inthis report, the words “anticipate,” “believe,” “estimate,” “expect” and“intend” and words or phrases of similar import, as they relate to the Companyor its subsidiaries or Company management, are intended to identifyforward-looking statements. Such statements are intended to be covered by thesafe-harbor provisions for forward-looking statements contained in the PrivateSecurities Litigation Reform Act of 1995 and we are including this statementfor purposes of invoking those safe- harbor provisions.  These forward-looking statements reflect thecurrent view of the Company with respect to future events and are subject tocertain risks, uncertainties and assumptions, many of which are beyond theCompany’s control, related to certain factors including, without limitation,competitive factors, general economic conditions nationally and within theState of Texas, customer relations, the interest rate environment, governmentalregulation and supervision, nonperforming asset levels, loan concentrations,changes in industry practices, acts of terrorism and war, one time events andother factors described herein. Based upon changing conditions, should any oneor more of these risks or uncertainties materialize, or should any underlyingassumptions prove incorrect, actual results may vary materially from thosedescribed herein as anticipated, believed, estimated, expected or intended. TheCompany does not intend to update these forward-looking statements.*

 

**The Company**

 

The Company is a bank holding company headquartered inLubbock, Texas. The Company is an indirect wholly owned subsidiary of StateNational Bancshares, Inc., Lubbock, Texas (“State National”). At March 31,2003, the Company owned all of the common securities of Independent CapitalTrust (“Independent Capital”) and indirectly owned, through a Delawaresubsidiary, Independent Financial Corp. (“Independent Financial”), 100% of thestock of State National Bank, Lubbock, Texas (the “Bank”). At March 31, 2003,the Bank operated full-service banking locations in the Texas cities of Abilene(four locations), Azle (two locations), Big Spring, El Paso, (seven locations),Lubbock (three locations), Odessa (two locations), Plainview, San Angelo,Stamford and Winters and in the New Mexico cities of Alamogordo, Deming,Elephant Butte, Las Cruces (two locations), Ruidoso (three locations), SunlandPark, and T or C.

 

**Results of Operations**

 

*General*

 

The following discussion and analysis presents themore significant factors affecting the Company’s financial condition at March31, 2003 and December 31, 2002 and results of operations for the quarters endedMarch 31, 2003 and 2002. This discussion and analysis should be read inconjunction with the Consolidated Financial Statements, notes thereto and otherfinancial information appearing elsewhere in this quarterly report.

 

*Net Income*

 

Net income for thequarter ended March 31, 2003, amounted to $2,256,000, compared to net loss of$13,191,000 for the quarter ended March 31, 2002. The loss was primarily due toa $15,642,000 impairment recorded in the first quarter of 2002 as a cumulativeeffect of a change in accounting principle, related to the adoption of SFAS No.142.  The net income before cumulativeeffect of a change in accounting principle for the quarter ended March 31, 2003was $2,256,000, compared to the net income before cumulative effect of a changein accounting principle for the quarter ended March 31, 2002 of$2,451,000.  The decrease in incomebefore cumulative effect of a change in accounting principle was primarily dueto merger-related expenses, caused by the Merger, and recorded in the firstquarter of 2003.

 

8

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*Net Interest Income*

 

Net interest income represents the amount by whichinterest income on interest-earning assets, including loans and securitiesexceeds interest paid on interest-bearing liabilities, including deposits andother borrowed funds. Net interest income is the principal source of theCompany’s earnings. Interest rate fluctuations, as well as changes in theamount and type of interest-earning assets and interest-bearing liabilities,combine to affect net interest income.

 

Net interest incomeamounted to $11,877,000 for the first quarter of 2003, a decrease of $264,000,or 2.2%, from the first quarter of 2002. Net interest income for the firstquarter of 2002 was $12,141,000. The decrease in net interest income from March31, 2002 to March 31, 2003 was primarily caused by a decrease in the primeinterest rate from 4.75% to 4.25% which occurred on November 7, 2002.  Though net interest income at March 31, 2003decreased from March 31, 2002, the net interest margin on a fullytaxable-equivalent basis increased from 4.82% for the first quarter of 2002, to4.98% for the first quarter of 2003. The increase in net interest margin fromMarch 31, 2002 to March 31, 2003 is primarily caused by the realignment of thedeposit mix.

 

At March 31, 2003,approximately $367,591,000 or 55.58%, of the Company’s total loans, net ofunearned income, were loans with floating interest rates.  During the period from March 31, 2002 toMarch 31, 2003, these floating interest rate loans have been subjected todeclining interest rates which were the primary cause of the decrease in loanyields from 7.53% at March 31, 2002 to 6.89% at March 31, 2003.

 

Security yields decreasedfrom 5.39% at March 31, 2002 to 4.56% at March 31, 2003.  This decrease was primarily caused bydeclines in the bond market during the period ended March 31, 2003.

 

Average overall ratespaid for various types of certificates of deposit decreased from March 31,2002, to March 31, 2003. For example, the average rate paid for certificates ofdeposit less than $100,000 decreased from 3.42% for the first quarter of 2002to 2.26% for the first quarter of 2003, while the average rate paid by the Companyfor certificates of deposit of $100,000 or more also decreased from 3.53%during the first quarter of 2002 to 2.37% during the first quarter of 2003.Rates on other types of deposits, such as interest-bearing demand, savings andmoney market deposits, decreased from an average of 0.83% during the firstquarter of 2002 to an average of 0.48% during the first quarter of 2003. Thesedecreases were primarily caused by the decline in interest rates during thetime period from March 31, 2002 to March 31, 2000.  These changes caused the Company’s overall cost ofinterest-bearing deposits to decrease from 2.22% for the first three months of2002 to 1.39% for the first three months of 2003.

 

The following tablepresents the average balance sheets of the Company for the quarters endedMarch 31, 2003 and 2002, and indicates the interest earned or paid on themajor categories of interest-earning assets and interest-bearing liabilities ona fully taxable-equivalent basis and the average rates earned or paid on eachmajor category. This analysis details the contribution of interest-earningassets and the impact of the cost of funds on overall net interest income.

 

9

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|                                                                                     |   | **Quarter  Ended March 31,** |      |
|------------------------------------------------------------------------------------------|--------|------------------------------|-----------|
|                                                                                     |   | **2003**                     |      | **2002** |   |
|                                                                                     |   | **Average  Balance**         |      | **Interest  Income/  Expense** |   | **Yield/  Rate** |   | **Average  Balance** |   | **Interest  Income/  Expense** |   | **Yield/  Rate** |   |
|                                                                                     |   | **(Dollars  in thousands)**  |      |
| ASSETS                                                                                   |   |                         |      |   |   |   |   |   |   |   |   |   |   |
| Interest-earning  assets:                                                                |   |                         |      |   |   |   |   |   |   |   |   |   |   |
| Loans,  net of unearned income (1)                                                       |   | $                            | 658,391   |   | $ | 11,341 |   | 6.89 | % | $ | 624,998 |   | $ | 11,770 |   | 7.53 | % |
| Securities  (2)                                                                          |   | 265,480                      |      | 3,028 |   | 4.56 | % | 340,870 |   | 4,596 |   | 5.39 | % |
| Interest-earning  time deposits in other banks                                           |   | 7,678                        |      | 21 |   | 1.09 | % | 14,816 |   | 63 |   | 1.70 | % |
| Federal  funds sold                                                                      |   | 25,092                       |      | 66 |   | 1.05 | % | 30,864 |   | 120 |   | 1.56 | % |
| Total  interest-earning assets                                                           |   | 956,641                      |      | 14,456 |   | 6.04 | % | 1,011,548 |   | 16,549 |   | 6.54 | % |
|                                                                                     |   |                         |      |   |   |   |   |   |   |   |   |   |   |
| Noninterest-earning  assets:                                                             |   |                         |      |   |   |   |   |   |   |   |   |   |   |
| Cash  and due from banks                                                                 |   | 46,079                       |      |   |   |   |   | 57,916 |   |   |   |   |   |
| Intangible  assets                                                                       |   | 53,883                       |      |   |   |   |   | 72,527 |   |   |   |   |   |
| Premises  and equipment                                                                  |   | 25,920                       |      |   |   |   |   | 26,759 |   |   |   |   |   |
| Accrued  interest receivable and other assets                                            |   | 50,570                       |      |   |   |   |   | 46,651 |   |   |   |   |   |
| Allowance  for possible loan losses                                                      |   | (11,081                      | )         |   |   |   |   | (11,467 | ) |   |   |   |   |
| Total  noninterest-earning assets                                                        |   | 165,371                      |      |   |   |   |   | 192,386 |   |   |   |   |   |
|                                                                                     |   |                         |      |   |   |   |   |   |   |   |   |   |   |
| Total  assets                                                                            |   | $                            | 1,122,012 |   |   |   |   |   |   | $ | 1,203,934 |   |   |   |   |   |
|                                                                                     |   |                         |      |   |   |   |   |   |   |   |   |   |   |
| LIABILITIES  AND STOCKHOLDER’S EQUITY                                               |   |                         |      |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  liabilities:                                                           |   |                         |      |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing,  savings and money market deposits                                     |   | $                            | 348,551   |   | $ | 418 |   | 0.48 | % | $ | 354,526 |   | $ | 735 |   | 0.83 | % |
| Time  deposits                                                                           |   | 362,568                      |      | 2,087 |   | 2.30 | % | 412,796 |   | 3,574 |   | 3.46 | % |
| Federal  funds purchased and securities sold under agreements to repurchase              |   | 22,687                       |      | 36 |   | 0.63 | % | 16,261 |   | 40 |   | 0.98 | % |
| Note  Payable                                                                            |   | 920                          |      | 12 |   | 5.22 | % | 681 |   | 9 |   | 5.29 | % |
| Total  interest-bearing liabilities                                                      |   | 734,726                      |      | 2,553 |   | 1.39 | % | 784,264 |   | 4,358 |   | 2.22 | % |
| Noninterest-bearing  liabilities:                                                        |   |                         |      |   |   |   |   |   |   |   |   |   |   |
| Demand  deposits                                                                         |   | 233,993                      |      |   |   |   |   | 218,790 |   |   |   |   |   |
| Accrued  interest payable and other liabilities                                          |   | 11,243                       |      |   |   |   |   | 36,325 |   |   |   |   |   |
| Total  noninterest-bearing liabilities                                                   |   | 245,236                      |      |   |   |   |   | 255,115 |   |   |   |   |   |
| Total  liabilities                                                                       |   | 979,962                      |      |   |   |   |   | 1,039,379 |   |   |   |   |   |
| Guaranteed  preferred beneficial interests in the Company’s subordinated debentures |   | 10,938                       |      |   |   |   |   | 10,922 |   |   |   |   |   |
| Stockholder’s  equity                                                               |   | 131,112                      |      |   |   |   |   | 153,633 |   |   |   |   |   |
| Total  liabilities and stockholder’s equity                                         |   | $                            | 1,122,012 |   |   |   |   |   | $ | 1,203,934 |   |   |   |   |   |
| Tax-equivalent  net interest income                                                      |   |                         |      | $ | 11,903 |   |   |   |   |   | $ | 12,191 |   |   |   |
| Interest  rate spread (3)                                                                |   |                         |      |   |   | 4.65 | % |   |   |   |   | 4.32 | % |
| Net  interest margin (4)                                                                 |   |                         |      |   |   | 4.98 | % |   |   |   |   | 4.82 | % |

 

----

(1)             Nonaccrual loans areincluded in the Average Balance columns, and income recognized on these loans,if any, is included in the Interest Income/Expense columns. Interest income onloans includes fees on loans, which are not material in amount.

(2)             Nontaxable interestincome on securities was adjusted to a taxable yield assuming a tax rate of34%.

(3)             The interest ratespread is the difference between the average yield on interest-earning assetsand the average cost of interest-bearing liabilities.

(4)             The net interestmargin is equal to net interest income, on a fully taxable-equivalent basis,divided by average interest-earning assets.

 

10

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The following tablepresents the changes in the components of net interest income and identifiesthe part of each change due to differences in the average volume ofinterest-earning assets and interest-bearing liabilities and the part of eachchange due to the average rate on those assets and liabilities. The changes ininterest due to both rate and volume in the table have been allocated to volumeor rate change in proportion to the absolute amounts of the change in each.

 
|                                                                        |   | **March 31,  2003 vs. 2002**    |   |
|-----------------------------------------------------------------------------|--------|---------------------------------|--------|
|                                                                        |   | **Decrease  Due to Changes in** |   |
|                                                                        |   | **Volume**                      |   | **Rate** |   | **Total** |   |
|                                                                        |   | **(Dollars  in thousands)**     |   |
| Interest-earning  assets:                                                   |   |                            |   |   |   |   |   |
| Loans,  net of unearned income (1)                                          |   | $                               | 629    |   | $ | (1,058 | ) | $ | (429 | ) |
| Securities  (2)                                                             |   | (1,017                          | )      | (551 | ) | (1,568 | ) |
| Interest-earning  time deposits in other banks                              |   | (30                             | )      | (12 | ) | (42 | ) |
| Federal  funds sold                                                         |   | (22                             | )      | (32 | ) | (54 | ) |
| Total  interest income                                                      |   | (440                            | )      | (1,653 | ) | (2,093 | ) |
|                                                                        |   |                            |   |   |   |   |   |
| Interest-bearing  liabilities:                                              |   |                            |   |   |   |   |   |
| Deposits:                                                                   |   |                            |   |   |   |   |   |
| Savings  and money market deposits                                          |   | (12                             | )      | (305 | ) | (317 | ) |
| Time  deposits                                                              |   | (435                            | )      | (1,052 | ) | (1,487 | ) |
| Federal  funds purchased and securities sold under agreements to repurchase |   | 16                              |   | (20 | ) | (4 | ) |
| Note  Payable                                                               |   | 3                               |   | — |   | 3 |   |
| Total  interest expense                                                     |   | (428                            | )      | (1,377 | ) | (1,805 | ) |
|                                                                        |   |                            |   |   |   |   |   |
| Decrease  in net interest income                                            |   | $                               | (12    | ) | $ | (276 | ) | $ | (288 | ) |

 

----

(1)             Nonaccrual loans havebeen included in average assets for the purposes of the computations, therebyreducing yields.

(2)             Information withrespect to tax-exempt securities is provided on a fully taxable-equivalentbasis assuming a tax rate of 34%.

 

# *Provision for Loan Losses*

 

The amount of the provision for loan losses is basedon periodic (not less than quarterly) evaluations of the loan portfolio,especially nonperforming and other probable problem loans. During theseevaluations, consideration is given to such factors as: management’s evaluationof specific loans; the level and composition of nonperforming loans; historicalloss experience; results of examinations by regulatory agencies; an internalasset review process conducted by the Company; expectations of economicconditions and their impact on particular industries and individual borrowers;the market value of collateral; the strength of available guarantees;concentrations of credits; and other judgmental factors. The provision for loanlosses made for the quarter ended March 31, 2003 was $118,000, compared to$455,000 for the quarter ended March 31, 2002. The relatively lowprovision recorded in the first quarter of 2003 is primarily related toimproved loan quality and recoveries received during the year which haveexceeded expectations thereby reducing the need for a provision.

 

*Noninterest Income*

 

Total noninterest income increased $529,000, or 16.5%,from $3,215,000 during the first quarter of 2002 to $3,744,000 during the firstquarter of 2003.

 

Service charges on deposit accounts and on other typesof services are the major source of noninterest income to the Company. Thissource of income increased from $1,822,000 during the first three months of2002 to $2,024,000 during the first three months of 2003, a $202,000, or 11.1%,increase. The increase in service charges on deposit accounts was primarily dueto stricter collection policies enforced by management during 2003.

 

11

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Trust fees from the operation of the trust departmentof the Bank increased $15,000, or 11.6%, from $129,000 during the first threemonths of 2002 to $144,000 during the same period in 2003.  The increase is primarily a result of thegrowth of the client base in the trust department.

 

Gain on sale of loans increased $398,000, or 105.9%,from $376,000 during the first quarter of 2002 to $774,000 during the firstquarter of 2003.  The increase is primarilydue to an increase in loans originated and sold during the period ended March31, 2003 as compared to the period ended March 31, 2002.

 

Other income is the sum of several components ofnoninterest income including other customer service fees, brokerage servicefees, credit and debit card income, safe deposit box rental income and othersources of miscellaneous income. Other income decreased $24,000, or 2.9%, from$816,000 during the first quarter of 2002 to $792,000 during the first quarterof 2003.

 

*Noninterest Expenses*

 

Total noninterest expenses increased $1,010,000, or9.1%, from $11,094,000 during the first quarter of 2002 to $12,104,000 duringthe first quarter of 2003.

 

Salaries and employee benefits, the largest singlecomponent of non-interest expense, increased $597,000, or 12.3%, from$4,874,000 for the first quarter of 2002 to $5,471,000 for the correspondingperiod of 2003. The increase was primarily a result of annual raises, increasesin commission based wages generated from non-interest income and increasedcosts related to medical benefits.

 

Net occupancy andequipment expense was $1,987,000 for the first three months of 2003, anincrease of $96,000, or 5.1%, from the $1,891,000 in expense recorded duringthe first three months of 2002. The increase was primarily a result ofadditional facility maintenance and repair expenses incurred in the three monthperiod ended March 31, 2003.

 

Amortization of intangible assets decreased $88,000,or 11.6%, from $761,000 for the first quarter of 2002 to $673,000 for the firstquarter of 2003.  As core depositintangibles are amortized using an accelerated method, the amortization expensewill decrease each year over the first half of the life of the core deposit intangiblebalances.

 

Data processing expense decreased $50,000, or 10.6%,from $474,000 for the first quarter of 2002 to $424,000 for the first quarterof 2003. The decrease is primarily due to the cost savings created by theMerger.

 

Professional fees, which include legal, accounting andother professional fees, increased $56,000, or 17.7%, from $317,000 during thefirst quarter of 2002 to $373,000 during the same period of 2003, due primarilyto an increase in legal and accounting fees in the first quarter of 2003associated with various regulatory filings and contracts that were required asa result of the Merger.

 

Communication expensedecreased $63,000, or 15.3%, from $413,000 for the first quarter of 2002 to$350,000 for the first quarter of 2003. The decrease is primarily due to costsaving measures implemented by management in late 2002.

 

Net costs applicable toother real estate and other repossessed assets consist of expenses associatedwith holding and maintaining repossessed assets, the net gain or loss on thesales of such assets, the write-down of the carrying value of the assets andany rental income that is credited as a reduction in expense. The Companyrecorded net costs of $129,000 during the first quarter of 2003 and $19,000during the first quarter of 2002.  Theincrease is primarily related to large commercial properties that wereforeclosed on in the fourth quarter of 2002 which incur significant month tomonth operating expenses.

 

Distributions onguaranteed preferred beneficial interests in the Company’s subordinateddebentures totaled $280,000 for the first quarter of 2002 and $281,000 for thefirst quarter of 2003.

 

12

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Merger-related expense increased from $0 during thefirst quarter of 2002 to $632,000 during the first quarter of 2003. Themerger-related expenses in the first quarter 2003 were related to the Merger.

 

Other noninterest expense includes, among many otheritems, stationary, printing and supplies expense, advertising and businessdevelopment expense, postage, loan and collection expenses, armored car andcourier fees, travel, insurance, ATM transaction expenses, regulatoryexaminations, franchise taxes, dues and subscriptions, Federal DepositInsurance Corporation (“FDIC”) insurance expense and directors’ fees. Theseexpenses decreased $281,000, or 13.6%, from $2,065,000 for the first quarter of2002 to $1,784,000 for the first quarter of 2003.  The decrease was primarily related to a decrease in regulatoryassessment fees.  In 2002, the Bank’srating was changed, which caused a decrease in the assessment fees.  The remainder of the decrease is related tocost saving measures implemented by management.

 

*Federal Income Taxes*

 

The Company recorded federal income tax expense of$1,121,000 for the first quarter of 2003, compared to $1,394,000 in the firstquarter of 2002.

 

*Impact of Inflation*

 

The effects of inflation on the local economy and onthe Company’s operating results have been relatively modest for the pastseveral years. Because substantially all of the Company’s assets andliabilities are monetary in nature, such as cash, securities, loans anddeposits, their values are less sensitive to the effects of inflation than tochanging interest rates, which do not necessarily change in accordance withinflation rates. The Company tries to control the impact of interest ratefluctuations by managing the relationship between its interest rate-sensitiveassets and liabilities. See “Analysis of Financial Condition—Interest RateSensitivity” herein.

 

**Analysis of Financial Condition**

 

*Assets*

 

Total assets decreased $20,678,000, or 1.8%, from$1,141,677,000 at December 31, 2002 to $1,120,999,000 at March 31, 2003.  The decrease is primarily due to a decreasein deposits resulting from conservative deposit pricing and an overall declinein deposit rates.

 

*Cash and Cash Equivalents*

 

The amount of cash and cash equivalents decreased$19,249,000, or 22.9%, from $84,224,000 at December 31, 2002 to$64,975,000 at March 31, 2003, due primarily to the shrinkage of the depositbalance.

 

*Securities*

 

Securities decreased $1,625,000, or 0.6%, from$274,342,000 at December 31, 2002 to $272,717,000 at March 31, 2003.

 

The Board of Directors of the Bank reviews allsecurities transactions monthly and the securities portfolio periodically. TheCompany’s current investment policy provides for the purchase of U.S. Treasurysecurities, U.S. government agency securities, mortgage-backed securitieshaving average maturities of twelve years or less and for the purchase ofstate, county and municipal agencies’ securities with maximum maturities of 10years. The Company’s policy is to maintain a securities portfolio withstaggered maturities to meet its overall liquidity needs. Municipal securitiesmust be rated A or better. Certain school district issues, however, areacceptable with a Baa rating. All securities are classified asavailable-for-sale and are carried at fair value at March 31, 2003. Thedecision to sell securities classified as available-for-sale is based uponmanagement’s assessment of changes in economic or financial market conditions.

 

13

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Certain of the Company’s securities are pledged tosecure public and trust fund deposits and for other purposes required orpermitted by law. At March 31, 2003, the book value of U.S. Treasury and otherU.S. Government agency securities so pledged amounted to $93,255,000 or 34.2%of the total securities portfolio.

 

The following table summarizes the amounts and thedistribution of the Company’s securities held at the dates indicated.

 
|                                                                                    |   | **March 31,  2003**         |    | **December  31, 2002** |   |
|-----------------------------------------------------------------------------------------|--------|-----------------------------|---------|------------------------|--------|
|                                                                                    |   | **Amount**                  |    | **%**                  |   | **Amount** |   | % |   |
|                                                                                    |   | **(Dollars  in thousands)** |    |
| Carrying  value:                                                                        |   |                        |    |                   |   |   |   |   |   |
| U.S.  Treasury securities and obligations of U.S. Government agencies and  corporations |   | $                           | 181,212 |                   | 66.4   | % | $ | 172,016 |   | 62.7 | % |
| Mortgage-backed  securities and collateralized mortgage obligations                     |   | 79,910                      |    | 29.3                   |   | 89,697 |   | 32.7 |   |
| Obligations  of states and political subdivisions                                       |   | 3,542                       |    | 1.3                    |   | 4,610 |   | 1.7 |   |
| Other  securities                                                                       |   | 8,053                       |    | 3.0                    |   | 8,019 |   | 2.9 |   |
|                                                                                    |   |                        |    |                   |   |   |   |   |   |
| Total  carrying value of securities                                                     |   | $                           | 272,717 |                   | 100.0  | % | $ | 274,342 |   | 100.0 | % |
|                                                                                    |   |                        |    |                   |   |   |   |   |   |
| Total  fair value of securities                                                         |   | $                           | 272,717 |                   |   |   | $ | 274,342 |   |   |   |

 

14

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The following table provides the maturity distributionand weighted average interest rates of the Company’s total securities portfolioat March 31, 2003. The yield has been computed by relating the forward incomestream on the securities, plus or minus the anticipated amortization ofpremiums or accretion of discounts, to the carrying value of the securities.The restatement of the yields on tax-exempt securities to a fullytaxable-equivalent basis has been computed assuming a tax rate of 34%.

 
| **Type and Maturity Grouping at March 31, 2003**                                              |   | **Principal  Amount**       |    | **Carrying  Value** |   | **Estimated  Fair Value** |   | **Weighted  Average  Yield** |    |
|-----------------------------------------------------------------------------------------------|--------|-----------------------------|---------|---------------------|--------|---------------------------|--------|------------------------------|---------|
|                                                                                          |   | **(Dollars  in thousands)** |    |
| U.S.  Treasury securities and obligations of U.S. Government agencies and  corporations:      |   |                        |    |                |   |                      |   |                         |    |
| Within  one year                                                                              |   | $                           | 65,816  |                | $      | 66,706                    |   | $                            | 66,706  |   | 3.64 | % |
| After  one but within five years                                                              |   | 108,330                     |    | 113,504             |   | 113,504                   |   | 5.03                         | %       |
| After  five but within ten years                                                              |   | 995                         |    | 1,002               |   | 1,002                     |   | 6.34                         | %       |
| Total  U.S. Treasury securities and obligations of U.S. Government agencies and  corporations |   | 175,141                     |    | 181,212             |   | 181,212                   |   | 4.52                         | %       |
|                                                                                          |   |                        |    |                |   |                      |   |                         |    |
| Mortgage-backed  securities and collateralized mortgage obligations                           |   | 79,037                      |    | 79,910              |   | 79,910                    |   | 4.26                         | %       |
|                                                                                          |   |                        |    |                |   |                      |   |                         |    |
| Obligations  of states and political subdivisions:                                            |   |                        |    |                |   |                      |   |                         |    |
| Within  one year                                                                              |   | 1,065                       |    | 1,068               |   | 1,068                     |   | 6.16                         | %       |
| After  one but within five years                                                              |   | 1,718                       |    | 1,801               |   | 1,801                     |   | 6.77                         | %       |
| After  five but within ten years                                                              |   | 490                         |    | 539                 |   | 539                       |   | 7.13                         | %       |
| After  ten years                                                                              |   | 120                         |    | 134                 |   | 134                       |   | 8.13                         | %       |
| Total  obligations of states and political subdivisions                                       |   | 3,393                       |    | 3,542               |   | 3,542                     |   | 6.68                         | %       |
|                                                                                          |   |                        |    |                |   |                      |   |                         |    |
| Other  securities:                                                                            |   |                        |    |                |   |                      |   |                         |    |
| Within  one year                                                                              |   | —                      |    | —              |   | —                    |   | 0.00                         | %       |
| After  one but within five years                                                              |   | —                      |    | —              |   | —                    |   | 0.00                         | %       |
| After  five but within ten years                                                              |   | —                      |    | —              |   | —                    |   | 0.00                         | %       |
| After  ten years                                                                              |   | 8,052                       |    | 8,053               |   | 8,053                     |   | 1.25                         | %       |
| Total  other securities                                                                       |   | 8,052                       |    | 8,053               |   | 8,053                     |   | 1.25                         | %       |
|                                                                                          |   |                        |    |                |   |                      |   |                         |    |
| Total  securities                                                                             |   | $                           | 265,623 |                | $      | 272,717                   |   | $                            | 272,717 |   | 4.35 | % |

 

*Loans Held-for-Sale Portfolio*

 

Loans held-for-sale, which primarily consist of homemortgage loans, are those loans which the Company has the intent to sell in theforeseeable future.  They are carried atthe lower of aggregate cost or market value. Gains and losses on sales of loans are recognized a settlement dates andare determined by the difference between the sales proceeds and the carryingvalue of the loans.  All sales are madewithout recourse.  Loans held-for-saledecreased $2,047,000 or 13.2% from $15,475,000 at December 31, 2002 to$13,428,000 at March 31, 2003.  Thedecrease is related to an increase in the turnover rate of the loansheld-for-sale.

 

*Loan Held-for-Investment Portfolio*

 

Total loans, net of unearned income, increased$2,522,000, or 0.4%, from $658,867,000 at December 31, 2002 to$661,389,000 at March 31, 2003.

 

The Bank primarily makes commercial loans to small tomedium sized businesses and professionals. The Bank offers a variety of commercial and real estate lending productsincluding revolving lines of credit, letters of 

 

15

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credit, working capital loans and loans to finance accounts receivable,inventory and equipment, commercial real estate purchase loans, constructionloans, refinance loans and various types of agriculture loans. Typically, theBank’s commercial loans have floating rates of interest, are for varying terms(generally not exceeding five years), are personally guaranteed by theprincipal owner and are collateralized by real estate, accounts receivable,inventory or other business assets.  Dueto customer demand, the Bank also makes installment loans to individuals.

 

The following tablepresents the Company’s loan balances at the dates indicated, separated by loantypes.

 

|                           |   | **March 31,  2003** |    | **December  31,  2002** |   |
|--------------------------------|--------|---------------------|---------|-------------------------|--------|
|                           |   | **(In  thousands)** |    |
|                           |   |                |    |                    |   |
| Real  estate loans             |   | $                   | 395,497 |                    | $      | 387,477 |   |
| Commercial  loans              |   | 182,066             |    | 184,963                 |   |
| Loans  to individuals          |   | 40,607              |    | 43,730                  |   |
| Agriculture  and other loans   |   | 43,221              |    | 42,700                  |   |
| Total  loans                   |   | 661,391             |    | 658,870                 |   |
| Less  unearned income          |   | 2                   |    | 3                       |   |
|                           |   |                |    |                    |   |
| Loans,  net of unearned income |   | $                   | 661,389 |                    | $      | 658,867 |   |

 

Loan concentrations are considered to exist when thereare amounts loaned to a multiple number of borrowers engaged in similaractivities that would cause them to be similarly impacted by economic or otherconditions. The Company had no concentrations of loans at March 31, 2003,except for those described above and a geographic concentration of loans inWest and North Texas as well as southern New Mexico. The Bank had loansoutstanding to foreign countries or borrowers headquartered in foreigncountries (primarily Mexican nationals) of $5,689,000 at March 31, 2003 and of$8,959,000 at December 31, 2002.

 

Management may renew loans at maturity when requestedby a customer whose financial strength appears to support such renewal or whensuch renewal appears to be in the Company’s best interest. The Company requirespayment of accrued interest in such instances and may adjust the rate ofinterest, require a principal reduction or modify other terms of the loan atthe time of renewal.

 

The following table presents the distribution of thematurity of the Company’s loans and the interest rate sensitivity of thoseloans, excluding loans to individuals, at March 31, 2003. The table alsopresents the portion of loans that have fixed interest rates or interest ratesthat fluctuate over the life of the loans in accordance with changes in themoney market environment as represented by the prime rate.

 

|                          |   | **One Year  and Less** |    | **One to  Five Years** |   | **Over Five  Years** |   | **Total  Carrying  Value** |   |
|-------------------------------|--------|------------------------|---------|------------------------|--------|----------------------|--------|----------------------------|--------|
|                          |   | **(In  thousands)**    |    |
| Real  estate loans            |   | $                      | 236,061 |                   | $      | 118,822              |   | $                          | 40,614 |   | $ | 395,497 |   |
| Commercial  loans             |   | 143,791                |    | 25,484                 |   | 12,791               |   | 182,066                    |   |
| Agriculture  and other loans  |   | 37,488                 |    | 3,986                  |   | 1,747                |   | 43,221                     |   |
|                          |   |                   |    |                   |   |                 |   |                       |   |
| Total  loans                  |   | $                      | 417,340 |                   | $      | 148,292              |   | $                          | 55,152 |   | $ | 620,784 |   |
|                          |   |                   |    |                   |   |                 |   |                       |   |
| With  fixed interest rates    |   | $                      | 74,492  |                   | $      | 136,525              |   | $                          | 42,176 |   | $ | 253,193 |   |
| With  variable interest rates |   | 342,848                |    | 11,767                 |   | 12,976               |   | 367,591                    |   |
|                          |   |                   |    |                   |   |                 |   |                       |   |
| Total  loans                  |   | $                      | 417,340 |                   | $      | 148,292              |   | $                          | 55,152 |   | $ | 620,784 |   |

 

16

----

 

*Allowance for Loan Losses*

 

Implicit in the Company’s lending activities is thefact that loan losses will be experienced and that the risk of loss will varywith the type of loan being made and the creditworthiness of the borrower overthe term of the loan. To reflect the currently perceived risk of lossassociated with the Company’s loan portfolio, additions are made to theCompany’s allowance for loan losses (the “allowance”). The allowance is createdby direct charges against income (the “provision” for loan losses), and theallowance is available to absorb loan losses. See “Results ofOperations—Provision for Loan Losses” above.

 

The allowance is reduced by loan charge-offs,increased by recoveries of loans previously charged off and increased ordecreased by the loan loss provision necessary to arrive at a balancedetermined by management to be appropriate. The Company’s allowance was $11,096,000, or 1.68% of loans, net ofunearned income, at March 31, 2003, compared to $10,914,000, or 1.66% of loans,net of unearned income, at December 31, 2002.

 

Credit and loan decisions are made by management andthe Board of Directors of the Bank in conformity with loan policies establishedby the Board of Directors of the Company. The Company’s practice is to chargeoff any loan or portion of a loan when it is determined by management to beuncollectible due to the borrower’s failure to meet repayment terms, theborrower’s deteriorating or deteriorated financial condition, the depreciationof the underlying collateral, the loan’s classification as a loss by regulatoryexaminers or for other reasons. The Company charged off $184,000 in loansduring the first quarter of 2003. Recoveries during the first quarter of 2003were $248,000.

 

The following table presents the activity in theallowance and average loans outstanding and certain pertinent ratios for thequarters ended March 31, 2003 and 2002. 

 
|                                                                                                           |   | **March 31,**               |    |
|----------------------------------------------------------------------------------------------------------------|--------|-----------------------------|---------|
|                                                                                                           |   | **2003**                    |    | **2002** |   |
|                                                                                                           |   | **(Dollars  in thousands)** |    |
| Analysis  of allowance for loan losses:                                                                        |   |                        |    |   |   |
| Balance,  at January 1                                                                                         |   | $                           | 10,914  |   | $ | 10,756 |   |
| Provision  for loan losses                                                                                     |   | 118                         |    | 455 |   |
|                                                                                                           |   | 11,032                      |    | 11,211 |   |
| Loans  charged off:                                                                                            |   |                        |    |   |   |
| Real  estate loans                                                                                             |   | 35                          |    | 24 |   |
| Commercial  loans                                                                                              |   | 4                           |    | 100 |   |
| Loans  to individuals                                                                                          |   | 120                         |    | 291 |   |
| Agriculture  other loans                                                                                       |   | 25                          |    | — |   |
| Total  charge-offs                                                                                             |   | 184                         |    | 415 |   |
| Recoveries  of loans previously charged off:                                                                   |   |                        |    |   |   |
| Real  estate loans                                                                                             |   | —                      |    | 14 |   |
| Commercial  loans                                                                                              |   | 197                         |    | 920 |   |
| Loans  to individuals                                                                                          |   | 51                          |    | 96 |   |
| Agriculture  and other loans                                                                                   |   | —                      |    | 51 |   |
| Total  recoveries                                                                                              |   | 248                         |    | 1,081 |   |
| Net  loans charged off (recovered)                                                                             |   | (64                         | )       | (666 | ) |
| Balance,  at March 31                                                                                          |   | $                           | 11,096  |   | $ | 11,877 |   |
|                                                                                                           |   |                        |    |   |   |
| Average  loans outstanding, net of unearned income                                                             |   | $                           | 658,391 |   | $ | 624,998 |   |
| Ratio  of nonperforming loans to total loans, net of unearned income, at March 31                              |   | 1.29                        | %       | 1.53 | % |
| Ratio  of net loan charge-offs (recoveries) to average loans outstanding, net of  unearned income (annualized) |   | (0.01                       | )%      | (0.11 | )% |
| Ratio  of allowance for loan losses to nonperforming loans, at March 31                                        |   | 130.48                      | %       | 126.38 | % |
| Ratio  of allowance for loan losses to total loans, net of unearned income, at March  31                       |   | 1.68                        | %       | 1.94 | % |

 

17

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The amount of the allowance is established bymanagement, based upon estimated risks inherent in the existing loan portfolio.The allowance is comprised of three components: specific reserves on specificproblem loans, historical loss percentages applied to pools of loans withsimilar characteristics, and an unallocated portion. Management reviews theloan portfolio on a continuing basis to evaluate probable problem loans. Thisreview encompasses management’s estimate of current economic conditions and thepotential impact on various industries, prior loan loss experience and thefinancial conditions of individual borrowers. Loans that have been specificallyidentified as problem or nonperforming loans are reviewed on at least aquarterly basis, and management critically evaluates the prospect of ultimatelosses arising from such loans, based on the borrower’s financial condition andthe value of available collateral.  Whena risk can be specifically quantified for a loan, that amount is specificallyallocated in the allowance. In addition, the Company allocates the allowancebased upon the historical loan loss experience of the different types of loans.Despite such allocation, both the allocated and unallocated portions of theallowance are available for charge-offs for all loans.

 

At March 31, 2003 and December 31, 2002, loansidentified as being impaired consisted of non-homogeneous loans placed onnon-accrual status.

 

At March 31, 2003 and December 31, 2002, the recordedinvestment in loans that are considered to impaired under FAS 114 wasapproximately $8,504,000 and $8,529,000, respectively.  Included in this amount at March 31, 2003 andDecember 31, 2002, was approximately $8,381,000 and $8,389,000, respectively,of impaired loans for which the related specific reserve for loan losses wasapproximately $1,808,000 and $1,867,000, respectively.  There were $123,000 of impaired loans at March31, 2003 and $140,000 at December 31, 2002 did not have a specific relatedreserve for loan losses.

 

The following table shows the allocations in theallowance and the respective percentages of each loan category to total loansat March 31, 2003, and December 31, 2002.

 

|                                      |   | **March 31,  2003**                              |   | **December  31, 2002**                                                 |   |
|-------------------------------------------|--------|--------------------------------------------------|--------|------------------------------------------------------------------------|--------|
|                                      |   | **Amount of  Allowance  Allocated to  Category** |   | **Percent of  Loans by  Category to  Loans, Net  of Unearned  Income** |   | **Amount of  Allowance  Allocated to  Category** |   | **Percent of  Loans by  Category to  Loans, Net of   Unearned  Income** |   |
|                                      |   | **(Dollars  in thousands)**                      |   |
| Real  estate loans                        |   | $                                                | 1,848  |                                                                   | 59.9   | % | $ | 1,937 |   | 58.8 | % |
| Commercial  loans                         |   | 1,445                                            |   | 27.5                                                                   |   | 1,566 |   | 28.1 |   |
| Loans  to individuals                     |   | 626                                              |   | 6.1                                                                    |   | 778 |   | 6.6 |   |
| Agriculture  and other loans              |   | 540                                              |   | 6.5                                                                    |   | 263 |   | 6.5 |   |
| Total  allocated                          |   | 4,459                                            |   | 100.0                                                                  | %      | 4,544 |   | 100.0 | % |
| Unallocated                               |   | 6,637                                            |   |                                                                   |   | 6,370 |   |   |   |
| Total  allowance for possible loan losses |   | $                                                | 11,096 |                                                                   |   |   | $ | 10,914 |   |   |   |

 

*Loan Review Process*

 

The Company follows a loan review program to evaluatethe credit risk in its loan portfolio. Through the loan review process, theBank maintains an internally classified loan list that, along with the list ofnonperforming loans discussed below, helps management assess the overallquality of the loan portfolio and the adequacy of the allowance. Loansclassified as “substandard” are those loans with clear and defined weaknessessuch as highly leveraged positions, unfavorable financial ratios, uncertainrepayment sources, involvement in bankruptcy proceedings or poor financialcondition, which may jeopardize recoverability of the loan. Loans classified as“doubtful” are those loans that have characteristics similar to substandardloans, but also have an increased risk that a loss may occur or at least aportion of the loan may require a charge-off if liquidated at present. Althoughloans classified as substandard do not duplicate loans classified as doubtful,both substandard and doubtful loans may

 

18

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include some loans that are past due at least 90 days, are onnonaccrual status or have been restructured. Loans classified as “loss” arethose loans that are usually in the process of being charged off. There were noloans designated as loss at March 31, 2003.

 

In addition to the internally classified loans, theBank also has a “watch list” of loans that further assists management inmonitoring its loan portfolio. A loan is included on the watch list if itdemonstrates one or more deficiencies requiring attention in the near term orif the loan’s ratios have weakened to a point where more frequent monitoring iswarranted. These loans do not have all the characteristics of a classified loan(substandard, doubtful or loss), but do have weakened elements as compared withthose of a satisfactory credit. Management of the Bank reviews these loans toassist in assessing the adequacy of the allowance. Substantially all of theloans on the watch list at March 31, 2003 were current and paying in accordancewith loan terms. See “Nonperforming Assets” below.

 

*Nonperforming Assets*

 

Nonperforming loans consist of nonaccrual, past dueand restructured loans. A past due loan is an accruing loan that iscontractually past due 90 days or more as to principal or interest payments.Loans on which management does not expect to collect interest in the normalcourse of business are placed on nonaccrual or are restructured. When a loan isplaced on nonaccrual status, any interest previously accrued but not yetcollected is reversed against current income unless, in the opinion ofmanagement, the outstanding interest remains collectible. Thereafter, interestis included in income only to the extent of cash received. A loan is restoredto accrual status when all interest and principal payments are current and theborrower has demonstrated to management the ability to make payments ofprincipal and interest as scheduled.

 

A “troubled debt restructuring” is a restructured loanupon which interest accrues at a below market rate or upon which certainprincipal has been forgiven so as to aid the borrower in the final repayment ofthe loan, with any interest previously accrued, but not yet collected, beingreversed against current income. Interest is accrued based upon the new loanterms.

 

Nonperforming loans are fully or substantiallycollateralized by assets, with any excess of loan balances over collateralvalues allocated in the allowance. Assets acquired through foreclosure arecarried at the lower of cost or estimated fair value, net of estimated costs ofdisposal, if any. See “Other Real Estate and Other Repossessed Assets” below.

 

Foreclosures on defaulted loans result in the Companyacquiring other real estate and other repossessed assets. Accordingly, theCompany incurs other expenses, specifically net costs applicable to other realestate and other repossessed assets, in maintaining, insuring and selling suchassets. The Company attempts to convert nonperforming loans intointerest-earning assets, although usually at a lower dollar amount than theface value of such loans, either through liquidation of the collateral securingthe loan or through intensified collection efforts.

 

The following table lists nonaccrual, past due andrestructured loans and other real estate and other repossessed assets at March31, 2003, and December 31, 2002.

 

|                                                |   | **March 31,  2003** |   | **December  31,  2002** |   |
|-----------------------------------------------------|--------|---------------------|--------|-------------------------|--------|
|                                                |   | **(In  thousands)** |   |
|                                                |   |                |   |                    |   |
| Nonaccrual  loans                                   |   | $                   | 8,504  |                    | $      | 8,529 |   |
| Accruing  loans contractually past due over 90 days |   | 410                 |   | 151                     |   |
| Restructured  loans                                 |   | 789                 |   | 848                     |   |
| Other  real estate and other repossessed assets     |   | 3,641               |   | 3,703                   |   |
|                                                |   |                |   |                    |   |
| Total  nonperforming assets                         |   | $                   | 13,344 |                    | $      | 13,231 |   |

 

19

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The gross interest incomethat would have been recorded during the first quarter of 2003 on the Company’snonaccrual loans if such loans had been current, in accordance with theoriginal terms thereof and outstanding throughout the period or, if shorter,since origination, was approximately $162,000. No interest income was actuallyrecorded (received) on loans that were on nonaccrual during the first quarterof 2003.

 

A probable problem loanis defined as a loan where information about possible credit problems of theborrower is known, causing management to have serious doubts as to the abilityof the borrower to comply with the present loan repayment terms and which mayresult in the inclusion of such loan in one of the nonperforming assetcategories. The Company does not believe it has any probable problem loansother than those reported in the above table or those included on the watchlist as discussed above.

 

*Goodwill and Other Intangible Assets*

 

Amortizable intangiblesassets at March 31, 2003 and December 31, 2002:

 

|                                 |   | **March 31,  2003** |   | **December  31,  2002** |   |
|--------------------------------------|--------|---------------------|--------|-------------------------|--------|
|                                 |   | **(in  thousands)** |   |
| Core  deposit intangible             |   | $                   | 28,246 |                    | $      | 28,342 |   |
| Less:  Accumulated amortization |   | 12,635              |   | 12,015                  |   |
|                                 |   |                |   |                    |   |
| Amortizable  intangible assets       |   | $                   | 15,611 |                    | $      | 16,327 |   |

 

Core deposit intangibleamortization expense was $673,000 for the quarter ended March 31, 2003.

 

Aggregate amortizationexpense is anticipated to be as follows for the years ended December 31 (inthousands):

 

| Remaining  in 2003     |   | $     | 2,009  |   |
|------------------------|--------|-------|--------|--------|
| 2004                   |   | 2,514 |   |
| 2005                   |   | 2,469 |   |
| 2006                   |   | 2,421 |   |
| 2007  & Thereafter |   | 6,198 |   |
| Total                  |   | $     | 15,611 |   |

 

The change in thecarrying amount of goodwill for the quarter ended March 31, 2003 is as follows(in thousands):

 

| Balance  as of January 1, 2003       |   | $      | 37,934 |   |
|--------------------------------------|--------|--------|--------|--------|
| Reductions  or increases to Goodwill |   | — |   |
| Balance  as of March 31, 2003        |   | $      | 37,934 |   |

 

Each October, the fair value of the Company iscalculated through a combination of the market comparison, asset value,earnings value and acquisition analysis methods by a third party to determineif an impairment should be recorded.  Asof October 1, 2002, based on the fair value assessment of the Company by athird party, the Company’s fair value exceeded the book value and as such animpairment was not recorded.

 

*Premises and Equipment*

 

Premises and equipment increased $1,940,000, or 7.8%,during the first quarter of 2003, from $24,944,000 at December 31, 2002 to$26,884,000 at March 31, 2003. The increase was primarily due to the purchaseof the building in Lubbock which houses the Bank’s operations as well as theupgrade of the Company’s computer system. These additions were partially offset by depreciation recorded duringthe first quarter of 2003 of $835,000.

 

20

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*Accrued Interest Receivable*

 

Accrued interest receivable consists of interest thathas accrued on securities and loans, but is not yet payable under the terms ofthe related agreements. The balance of accrued interest receivable decreased$900,000, or 12.8%, from $7,044,000 at December 31, 2002, to $6,144,000 atMarch 31, 2003. The decrease was primarily a result of the seasonal paydown ofinterest on loans.  Of the total balanceat March 31, 2003, $3,362,000, or 54.7%, was interest accrued on loans and$2,782,000, or 45.3%, was interest accrued on securities. The amounts ofaccrued interest receivable and percentages attributable to loans andsecurities at December 31, 2002, were $3,934,000, or 55.9%, and $3,110,000, or44.1%, respectively.

 

*Other Real Estate and Other Repossessed Assets*

 

Other real estate and other repossessed assets consistof real property and other assets unrelated to banking premises or facilities. Incomederived from other real estate and other repossessed assets, if any, isgenerally less than that which would have been earned as interest at theoriginal contract rates on the related loans. At March 31, 2003 and December31, 2002 other real estate and other repossessed assets had an aggregate bookvalue of $3,641,000 and $3,703,000, respectively. Other real estate and otherrepossessed assets decreased $62,000, or 1.7%, during the first three months of2003, due primarily to the sale of two residential properties. Of theMarch 31, 2003 balance, $2,957,000 represented eleven commercial andagricultural properties, $626,000 represented four residential properties and$58,000 represented thirteen repossessed vehicles and other equipment.

 

*Other Assets*

 

The balance of other assets increased $121,000, or0.4%, to $29,372,000 at March 31, 2003, from $29,25,000 at December 31, 2002.

 

*Deposits*

 

The Bank’s lending and investing activities are fundedalmost entirely by core deposits, 62.4% of which are demand, savings and moneymarket deposits at March 31, 2003. Total deposits decreased $26,458,000, or2.7%, from $964,714,000 at December 31, 2002, to $938,256,000 at March 31,2003. The decrease was due primarily to decreases in interest rates paid ontime deposit accounts causing a lower demand for these accounts.  The reduction was one which managementplanned, specifically in an effort to realign the deposit mix.  The Company does not have any brokereddeposits.

 

The following table presents the average amounts of,and the average rates paid on, deposits of the Company for the quarters endedMarch 31, 2003 and 2002.

 

|                                                        |   | **Quarter  Ended March 31,** |    |
|-------------------------------------------------------------|--------|------------------------------|---------|
|                                                        |   | **2003**                     |    | **2002** |   |
|                                                        |   | **Average  Amount**          |    | **Average  Rate** |   | **Average  Amount** |   | **Average  Rate** |   |
|                                                        |   | **(Dollars  in thousands)**  |    |
| Noninterest-bearing  demand deposits                        |   | $                            | 233,993 |   | — | % | $ | 218,790 |   | — | % |
| Interest-bearing  demand, savings and money market deposits |   | 348,551                      |    | 0.48 | % | 354,526 |   | 0.83 | % |
| Time  deposits of less than $100,000                        |   | 213,298                      |    | 2.26 | % | 255,832 |   | 3.42 | % |
| Time  deposits of $100,000 or more                          |   | 149,270                      |    | 2.37 | % | 156,964 |   | 3.53 | % |
|                                                        |   |                         |    |   |   |   |   |   |   |
| Total  deposits                                             |   | $                            | 945,112 |   | 1.06 | % | $ | 986,112 |   | 1.75 | % |

 

Time deposits of $100,000 or more are a more volatile and costly sourceof funds than other deposits and are most likely to affect the Company’s futureearnings because of interest rate sensitivity. At March 31, 2003, and December 31, 2002, deposits of $100,000 or morerepresented approximately 15.7% and 16.1% of the Company’s total deposits,respectively.

 

 

21

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The maturity distributionof time deposits of $100,000 or more at March 31, 2003 is presented below.

 

|                                     |   | **At March  31, 2003** |    |
|------------------------------------------|--------|------------------------|---------|
|                                     |   | **(In  thousands)**    |    |
| 3  months or less                        |   | $                      | 49,057  |   |
| Over  3 through 6 months                 |   | 40,073                 |    |
| Over  6 through 12 months                |   | 35,678                 |    |
| Over  12 months                          |   | 22,057                 |    |
|                                     |   |                   |    |
| Total  time deposits of $100,000 or more |   | $                      | 146,865 |   |

 

Deposits from non-U.S. citizens (primarily Mexicannationals) amounted to approximately $48,468,000 and $45,773,000 at March 31,2003 and December 31, 2002, respectively.

 

# *Fed Funds Purchased and Securities Sold UnderAgreement to Repurchase*

 

The balance of fed fundspurchased and securities sold under agreement to repurchase increased$7,088,000, or 34.1%, from $20,762,000 at December 31, 2002 to $27,850,000 atMarch 31, 2003.  The increase isprimarily related to the promotion of this product to the Bank’s customers aswell as seasonal variation of the balance.

 

*Accrued Interest Payable*

 

Accrued interest payable consists of interest that hasaccrued on deposits, but is not yet payable under the terms of the relatedagreements. The balance of accrued interest payable decreased $181,000, or17.9%, from $1,009,000 at December 31, 2002, to $828,000 at March 31, 2003, dueto a decrease in interest-bearing deposit balances as well as decreases ininterest rates being paid on interest-bearing deposits during the first quarterof 2003.

 

*Note Payable*

 

The note payable balance consists of advances ofapproximately $1,043,000 and $789,000, at March 31, 2003 and December 31, 2002,respectively, from the Federal Home Loan Bank of Dallas (the “FHLB”).  These advances represent six separate noteswith interest rates ranging from 2.69% to 5.45%, maturities ranging fromJanuary 21, 2008 to February 1, 2018, and are collateralized by a blanketfloating lien on all securities held in safekeeping by the FHLB, the FHLBcapital stock owned by the Bank, and any funds on deposit with the FHLB.

 

*Other Liabilities*

 

The most significant components of other liabilitiesare amounts accrued for various types of expenses and current and deferredfederal income taxes payable. The balance of other liabilities increased$949,000, or 10.0%, from $9,525,000 at December 31, 2002, to $10,474,000 atMarch 31, 2003, primarily due to increases in benefit claims payable andincreases in the payable to State National.

 

*Interest Rate Sensitivity*

 

Interest rate risk arises when an interest-earningasset matures or when its rate of interest changes in a time frame differentfrom that of the supporting interest-bearing liability. The Company seeks tominimize the difference between the amount of interest-earning assets and theamount of interest-bearing liabilities that could change interest rates in thesame time frame in an attempt to reduce the risk of significant adverse effectson the Company’s net interest income caused by interest rate changes. TheCompany does not attempt to match each interest-earning asset with a specificinterest-bearing liability. Instead, as shown in the following table, itaggregates all of its interest-

 

22

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earning assets and interest-bearing liabilities to determine thedifference between the two in specific time frames. This difference is known asthe rate-sensitivity gap. A company is considered to be asset sensitive, orhaving a positive gap, when the amount of interest earning-assets maturing orrepricing within a given period exceeds the amount of its interest-bearingliabilities also maturing or repricing within that time period.  Conversely, a company is considered to beliability sensitive, or having a negative gap, when the amount of itsinterest-bearing liabilities maturing or repricing within a given time periodexceeds the amount of its interest-earning assets also maturing or repricingwithin that time period.  During aperiod of rising interest rates, a negative gap would tend to affect net incomeadversely, while a positive gap would tend to result in an increase in netinterest income.  During a period offalling interest rates, a negative gap would tend to result in an increase innet interest income, while a positive gap would tend to affect net interestincome adversely.  Maintaining abalanced position will reduce risk associated with interest rate changes, butit will not guarantee a stable interest rate spread because the various rateswithin a time frame may change by differing amounts and occasionally change indifferent directions. Management regularly monitors the interest sensitivityposition and considers this position in its decisions in regard to interestrates and maturities for interest-earning assets acquired and interest-bearingliabilities accepted.

 

In adjusting the Company’s asset/liability position,management attempts to manage the Company’s interest rate risk while enhancingnet interest margins.  The rates, termsand interest rate indices of the Company’s interest-earning assets resultprimarily from the Company’s strategy of investing in loans and securities,which permit the Company to limit its exposure to interest rate risk, togetherwith credit risk, while at the same time achieving a positive and relativelystable interest rate spread from the difference between the income earned oninterest-earning assets and the cost of interest-bearing liabilities.

 

The Company’s ratios of interest-sensitive assets tointerest-sensitive liabilities, as shown in the following tables, are 81.1% atthe 90-day interval, 79.0% at the 180-day interval and 85.4% at the 365-dayinterval at March 31, 2003. Currently, the Company is in aliability-sensitive position at the three intervals. However, the Company had$343,433,000 of interest-bearing demand, savings and money market deposits atMarch 31, 2003, for which, from the Company’s experience, interest rates changemore slowly. Therefore, excluding these types of deposits, the Company’sinterest-sensitive assets to interest-sensitive liabilities ratio at the365-day interval would have been 176.4% at March 31, 2003. The interestsensitivity position is presented as of a point in time and can be modified tosome extent by management as changing conditions dictate.

 

23

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The following table showsthe interest rate sensitivity position of the Bank at March 31, 2003.

 
|                                           |   | **Cumulative  Volumes   Subject to Repricing Within** |    | **Volumes  Subject to   Repricing   After** |   |         |   |
|------------------------------------------------|--------|-------------------------------------------------------|---------|---------------------------------------------|--------|--------------|--------|
|                                           |   | **90 Days**                                           |    | **180 Days**                                |   | **365 Days** |   | **1 Year** |   | **Total** |   |
|                                           |   | **(Dollars  in thousands)**                           |    |
| Interest-earning  assets:                      |   |                                                  |    |                                        |   |         |   |   |   |   |   |
| Federal  funds sold                            |   | $                                                     | 18,320  |                                        | $      | 18,320       |   | $ | 18,320 |   | $ | — |   | $ | 18,320 |   |
| Securities                                     |   | 46,276                                                |    | 75,052                                      |   | 117,407      |   | 155,310 |   | 272,717 |   |
| Loans,  net of unearned income                 |   | 333,758                                               |    | 364,315                                     |   | 433,257      |   | 228,132 |   | 661,389 |   |
| Total  interest-earning assets                 |   | 398,354                                               |    | 457,687                                     |   | 568,984      |   | 383,442 |   | 952,426 |   |
|                                           |   |                                                  |    |                                        |   |         |   |   |   |   |   |
| Interest-bearing  liabilities:                 |   |                                                  |    |                                        |   |         |   |   |   |   |   |
| Demand,  savings and money market deposits     |   | 343,433                                               |    | 343,433                                     |   | 343,433      |   | — |   | 343,433 |   |
| Securities  Sold Under Agreement to Repurchase |   | 27,850                                                |    | 27,850                                      |   | 27,850       |   | — |   | 27,850 |   |
| Time  deposits                                 |   | 119,725                                               |    | 208,350                                     |   | 294,717      |   | 57,760 |   | 352,477 |   |
| Total  interest-bearing liabilities            |   | 491,008                                               |    | 579,633                                     |   | 666,000      |   | 57,760 |   | 723,760 |   |
|                                           |   |                                                  |    |                                        |   |         |   |   |   |   |   |
| Rate-sensitivity  gap (1)                      |   | $                                                     | (92,654 | )                                           | $      | (121,946     | )      | $ | (97,016 | ) | $ | 325,682 |   | $ | 228,666 |   |
|                                           |   |                                                  |    |                                        |   |         |   |   |   |   |   |
| Rate-sensitivity  ratio (2)                    |   | 81.1                                                  | %       | 79.0                                        | %      | 85.4         | %      |   |   |   |   |

 

----

(1)             Rate-sensitiveinterest-earning assets less rate-sensitive interest-bearing liabilities.

(2)             Rate-sensitiveinterest-earning assets divided by rate-sensitive interest-bearing liabilities.

 

24

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###  

### *Selected Financial Ratios*

 

The following table presents selected financial ratios(annualized) for the quarters ended March 31, 2003 and 2002.

 
|                                                                                  |   | **Quarter  Ended March 31,** |   |
|---------------------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                                  |   | **2003**                     |   | **2002** |   |
| Income  (loss) Before Cumulative Effect of a Change in Accounting  Principle to: |   |                         |   |   |   |
| Average  assets                                                                       |   | 0.80                         | %      | 0.81 | % |
| Average  interest-earning assets                                                      |   | 0.94                         | %      | 0.97 | % |
| Average  stockholder’s equity                                                    |   | 6.88                         | %      | 6.38 | % |
| Net  income (loss) to:                                                                |   |                         |   |   |   |
| Average  assets                                                                       |   | 0.80                         | %      | (4.38 | )% |
| Average  interest-earning assets                                                      |   | 0.94                         | %      | (5.22 | )% |
| Average  stockholder’s equity                                                    |   | 6.88                         | %      | (34.34 | )% |
| Dividend  payout (1) to:                                                              |   |                         |   |   |   |
| Net  income                                                                           |   | N/A                          |   | N/A |   |
| Average  stockholder’s equity                                                    |   | N/A                          |   | N/A |   |
| Average  stockholder’s equity to:                                                |   |                         |   |   |   |
| Average  total assets                                                                 |   | 11.69                        | %      | 12.76 | % |
| Average  loans (2)                                                                    |   | 19.91                        | %      | 24.58 | % |
| Average  total deposits                                                               |   | 13.87                        | %      | 15.58 | % |
| Average  interest-earning assets to:                                                  |   |                         |   |   |   |
| Average  total assets                                                                 |   | 85.26                        | %      | 84.02 | % |
| Average  total deposits                                                               |   | 101.22                       | %      | 102.58 | % |
| Average  total liabilities                                                            |   | 97.62                        | %      | 97.32 | % |
| Ratio  to total average deposits of:                                                  |   |                         |   |   |   |
| Average  loans (2)                                                                    |   | 69.66                        | %      | 63.38 | % |
| Average  noninterest bearing deposits                                                 |   | 24.76                        | %      | 22.19 | % |
| Average  interest-bearing deposits                                                    |   | 75.24                        | %      | 77.81 | % |
| Total  interest expense to total interest income                                      |   | 17.66                        | %      | 26.33 | % |
| Efficiency  Ratio (3)                                                                 |   | 77.54                        | %      | 72.59 | % |

 

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(1)             Dividends on CommonStock only.

(2)             Before allowance forpossible loan losses.

(3)             Calculated as a totalnoninterest expense divided by the sum of net interest income before provisionfor loan losses and total noninterest income, excluding securities gains andlosses.

 

**Liquidity**

 

*The Bank*

 

Liquidity with respect to a financial institution isthe ability to meet its short-term needs for cash without suffering anunfavorable impact on its on-going operations. The need for the Bank tomaintain funds on hand arises principally from maturities of short-termborrowings, deposit withdrawals, customers’ borrowing needs and the maintenanceof reserve requirements. Liquidity with respect to a financial institution canbe met from either assets or liabilities. On the asset side, the primarysources of liquidity are cash and due from banks, federal funds sold,maturities of securities and scheduled repayments and maturities of loans. TheBank maintains adequate levels of cash and near-cash investments to meet itsday-to-day needs. Cash and due from banks averaged $46,079,000 during the firstquarter of 2003 and $57,916,000 during the first quarter of 2002. These amountscomprised 4.1% and 4.8% of average total assets during the first three monthsof 2003 and 2002, respectively. The average level of securities,interest-earning time deposits in other banks and federal funds sold was$298,250,000 during the first quarter of 2003 and $386,550,000 during the firstquarter of 2002.

 

25

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Securities totaling $765,000 and $6,868,000 were soldduring the first three months of 2003 and 2002, respectively.  At March 31, 2003, $67,774,000, or 24.9%, ofthe Company’s securities portfolio, excluding mortgage-backed securities,matured within one year and $115,305,000, or 42.3%, excluding mortgage-backedsecurities, matured after one but within five years. The Bank’s commercial andreal estate lending activities are concentrated in loans with maturities ofless than five years with both fixed and adjustable interest rates, while itsinstallment lending activities are concentrated in loans with maturities ofthree to five years and with primarily fixed interest rates. At March 31, 2003,approximately $433,257,000, or 65.5%, of the Company’s loans, net of unearnedincome, matured within one year and/or had adjustable interest rates.Approximately $417,340,000, or 67.2%, of the Company’s loans (excluding loansto individuals) matured within one year and/or had adjustable interest rates.See “Analysis of Financial Condition—Loan Portfolio” above.

 

On the liability side, the principal sources ofliquidity are deposits, borrowed funds and the accessibility to money andcapital markets. Customer deposits are by far the largest source of funds.During the first quarter of 2003, the Company’s average deposits were$945,112,000 or 84.2% of average total assets, compared to $986,112,000, or81.9% of average total assets, during the first quarter of 2002. The Company attractsits deposits primarily from individuals and businesses located within themarket areas served by the Bank. See “Analysis of Financial Condition—Deposits”above.

 

*The Company*

 

The Company depends on the Bank for liquidity in theform of cash flow, primarily to meet distribution requirements on the Company’ssubordinated debentures, which payments, in turn, are used to meet distributionrequirements on Independent Capital Trust’s Trust Preferred Securities, and tocover other operating expenses.  The Company’simmediate liquidity needs have been and can continue to be satisfied byadvances from the Company’s parent company.

 

The payment of dividends from the Bank is subject toapplicable law and the scrutiny of regulatory authorities. There were no dividendspaid by the Bank to Independent Financial during the first quarter of 2003 and2002.  SNB El Paso paid dividends of$1,000,000 to State National prior to the Merger.  Independent Financial and Independent Capital paid dividends tothe Company totaling $9,000 during the same time periods of 2003 and 2002,respectively. At March 31, 2003, there were no dividends available for paymentto Independent Financial by the Bank without first obtaining regulatoryapproval.

 

Current tax liabilities totaling $1,248,000 and$1,492,000 were paid by the Bank to the Company during the first three monthsof 2003 and 2002, respectively.

 

**Capital Resources**

 

At March 31, 2003, stockholder’s equity totaled$131,610,000, or 11.7% of total assets, compared to $129,990,000, or 11.4% oftotal assets, at December 31, 2002.

 

Bank regulatory authorities in the United States haverisk-based capital standards by which all bank holding companies and banks areevaluated in terms of capital adequacy. These guidelines relate a banking company’scapital to the risk profile of its assets. The risk-based capital standardsrequire all banking companies to have Tier 1 capital of at least 4% and totalcapital (Tier 1 and Tier 2 capital) of at least 8% of risk-weightedassets, and to be designated as “well-capitalized”, the banking company musthave Tier 1 and total capital ratios of at least 6% and 10%, respectively. Forthe Company, Tier 1 capital includes common stockholders’ equity (net ofavailable for sale fair value adjustment) and qualifying guaranteed preferredbeneficial interests in the Company’s subordinated debentures, reduced byintangible assets, net of the deferred tax liability associated with the coredeposit intangible, and any deferred tax asset disallowed for regulatory capitalpurposes. For the Company, Tier 2 capital is comprised of the remainder of theguaranteed preferred beneficial interests in the Company’s subordinateddebentures not qualifying for Tier 1 capital and the qualifying amount ofthe allowance for loan losses.

 

Banking regulators alsohave leverage ratio requirements. The leverage ratio requirement is measured asthe ratio of Tier 1 capital to adjusted quarterly average assets. The leverageratio standards require all banking 

 

26

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companies to have a minimum leverage ratio of at least 4% and to bedesignated as “well-capitalized”, the banking company must have a leverageratio of at least 5%. The following table provides a calculation of theCompany’s risk-based capital and leverage ratios and a comparison of theCompany’s and the Bank’s risk-based capital ratios and leverage ratios to theminimum regulatory and “well-capitalized” minimum requirements at March 31,2003.

 
|                               |   | **March 31,  2003** |      |
|------------------------------------|--------|---------------------|-----------|
|                               |   | **(In  thousands)** |      |
|                               |   |                |      |
| Tier  1 capital                    |   | $                   | 88,190    |   |
| Tier  2 capital                    |   | 8,843               |      |
|                               |   |                |      |
| Total  capital                     |   | $                   | 97,033    |   |
|                               |   |                |      |
| Net  risk-weighted assets          |   | $                   | 705,211   |   |
|                               |   |                |      |
| Adjusted  quarterly average assets |   | $                   | 1,068,721 |   |

 

 
|                                              |   | **Regulatory  Minimum** |   | **“Well  Capitalized”  Minimum** |   | **Actual  Ratios at  March 31, 2003** |   |
|---------------------------------------------------|--------|-------------------------|--------|--------------------------------------------|--------|---------------------------------------|--------|
|                                              |   |                    |   |                                       |   |                                  |   |
| The Company                                       |   |                    |   |                                       |   |                                  |   |
|                                              |   |                    |   |                                       |   |                                  |   |
| Tier  1 capital to net risk-weighted assets ratio |   | 4.00                    | %      | 6.00                                       | %      | 12.51                                 | %      |
| Total  capital to net risk-weighted assets ratio  |   | 8.00                    |   | 10.00                                      |   | 13.76                                 |   |
| Leverage  ratio                                   |   | 4.00                    |   | 5.00                                       |   | 8.25                                  |   |
|                                              |   |                    |   |                                       |   |                                  |   |
| The  Bank                                         |   |                    |   |                                       |   |                                  |   |
|                                              |   |                    |   |                                       |   |                                  |   |
| Tier  1 capital to net risk-weighted assets ratio |   | 4.00                    | %      | 6.00                                       | %      | 12.50                                 | %      |
| Total  capital to net risk-weighted assets ratio  |   | 8.00                    |   | 10.00                                      |   | 13.75                                 |   |
| Leverage  ratio                                   |   | 4.00                    |   | 5.00                                       |   | 8.29                                  |   |

 

The Federal Deposit Insurance Corporation ImprovementAct of 1991 (“FDICIA”) requires each federal banking agency to revise itsrisk-based capital standards to ensure that those standards take adequateaccount of interest rate risk, concentration of credit risk and the risks ofnon-traditional activities, as well as reflect the actual performance andexpected risk of loss on multi-family mortgages. This law also requires eachfederal banking agency to specify the levels at which an insured institutionwould be considered “well capitalized,” “adequately capitalized,”“undercapitalized,” “significantly undercapitalized” and “criticallyundercapitalized.” Under the FDIC’s regulations, the Company and the Bank wereboth “well capitalized” at March 31, 2003.

 

The Company’s ability to generate capital internallythrough retention of earnings and access to capital markets is essential forsatisfying the capital guidelines for bank holding companies as prescribed bythe Federal Reserve Board.

 

The payment of dividends on the Common Stock isdetermined by the Company’s Board of Directors in light of circumstances andconditions then existing, including the earnings of the Company and the Bank,funding requirements and financial condition and applicable laws andregulations. The Company’s ability to pay cash dividends is restricted by therequirement that it maintain a certain level of capital as discussed above inaccordance with regulatory guidelines. The Federal Reserve Board haspromulgated a policy prohibiting bank holding companies from paying dividends oncommon stock unless such bank holding company can pay such dividends fromcurrent earnings.

 

27

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## **Item 3. Quantitative andQualitative Disclosures About Market Risk**

 

There has been no material change in the Company’smarket risk profile from the information disclosed in the Company’s Form 10-Kfor the year ended December 31, 2002.

 

## **Item 4. Controls andProcedures**

## ** **

Based on the evaluation of the Company’s disclosurecontrols and procedures as of a date within 90 days prior to the filing date ofthis report, each of Tom C. Nichols, the Company’s Chairman, President andChief Executive Officer, and Don E. Cosby, the Company’s Executive VicePresident, Chief Financial Officer and Secretary, have concluded that, in theirjudgment, the Company’s disclosure controls and procedures are effective toensure that material information relating to the registrant, including itsconsolidated subsidiaries, is made known to such officers by others within theCompany or its subsidiaries.

 

There were no significantchanges in the Company’s internal controls or in other factors that couldsignificantly affect these controls subsequent to the date of their evaluation,including any corrective actions with regard to significant deficiencies andmaterial weaknesses.

 

28

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**PART II**

 

**OTHER INFORMATION**

 

Item 1.                     LegalProceedings.

 

None

 

From time to time, the Company is party in litigationproceedings incidental to the normal course of its business.  In the opinion of management, the ultimateliability, if any, resulting from known, current litigation, either singularlyor in the aggregate, would not reasonably be expected to have a materialadverse effect on the Company’s financial position or results of operations.

 

Item 2.                     Changes inSecurities and Use of Proceeds.

 

None

 

Item 3.                     Defaults uponSenior Securities.

 

None

 

Item 4.                     Submission ofMatters to a Vote of Security Holders.

 

None

 

Item 5.                     OtherInformation.

 

Item 6.                     Exhibits andReports on Form 8-K.

 

(a)             Exhibits

 

Exhibits 99.1 Chief Executive Officer and ChiefFinancial Officer Certifications

 

(b)            Reports on Form 8-K

 

None

 

29

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SIGNATURE

 

Pursuant to the requirements of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned thereunto duly authorized.

 

 
| Date: May 14, 2003 |   |   | Independent Bankshares,  Inc.                              |
|--------------------|--------|--------|------------------------------------------------------------|
|               |   |   | (Registrant)                                               |
|               |   |   |                                                       |
|               |   |   |                                                       |
|               |   | By:    | /s/ Don E. Cosby                                           |   |
|               |   |   | Don E. Cosby                                               |
|               |   |   | Executive Vice  President & Chief Financial Officer    |
|               |   |   | (Duly authorized  Officer and Principal Financial Officer) |

 

30

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I, Tom C. Nichols,certify that:

 

1.               Ihave reviewed this quarterly report on Form 10-Q of IndependentBankshares, Inc.;

 

2.               Basedon my knowledge, this quarterly report does not contain any untrue statement ofa material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements weremade, not misleading with respect to the period covered by this quarterlyreport;

 

3.               Basedon my knowledge, the financial statements, and other financial informationincluded in this quarterly report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this quarterly report;

 

4.               Theregistrant’s other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and have:

 

(a)   designed such disclosure controls andprocedures to ensure that material information relating to the  registrant, including its consolidatedsubsidiaries, is made known to us by others within those entities, particularlyduring the period in which this quarterly report is being prepared;

 

(b)  evaluated the effectiveness of theregistrant’s disclosure controls and procedures as of a date within90 days prior to the filing date of this quarterly report (the “EvaluationDate”); and

 

(c)   presented in this quarterly report ourconclusions about the effectiveness of the disclosure controls and proceduresbased on our evaluation as of the Evaluation Date;

 

5.               Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunctions):

 

(a)   all significant deficiencies in the designor operation of internal controls which could adversely affect the registrant’sability to record, process, summarize and report financial data and haveidentified for the registrant’s auditors any material weaknesses in internalcontrols; and

 

(b)   any fraud, whether or not material, thatinvolves management or other employees who have a significant role in theregistrant’s internal controls; and

 

6.               Theregistrant’s other certifying officers and I have indicated in this quarterlyreport whether there were significant changes in internal controls or in otherfactors that could significantly affect the internal controls subsequent to thedate of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 
|   | Date:                                             | May 14, 2003 |
|--------|---------------------------------------------------|--------------|
|   |                                              |
|   | /s/ Tom C. Nichols                                |
|   | Tom C. Nichols                                    |
|   | Chairman, President and  Chief Executive  Officer |

 

31

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I, Don E. Cosby, certifythat:

 

1.               Ihave reviewed this quarterly report on Form 10-Q of IndependentBankshares, Inc.;

 

2.               Basedon my knowledge, this quarterly report does not contain any untrue statement ofa material fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this quarterly report;

 

3.               Basedon my knowledge, the financial statements, and other financial informationincluded in this quarterly report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this quarterly report;

 

4.               Theregistrant’s other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and have:

 

(a)   designed such disclosure controls andprocedures to ensure that material information relating to the  registrant, including its consolidatedsubsidiaries, is made known to us by others within those entities, particularlyduring the period in which this quarterly report is being prepared;

 

(b)   evaluated the effectiveness of the registrant’sdisclosure controls and procedures as of a date within 90 days prior tothe filing date of this quarterly report (the “Evaluation Date”); and

 

(c)   presented in this quarterly report ourconclusions about the effectiveness of the disclosure controls and proceduresbased on our evaluation as of the Evaluation Date;

 

5.               Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunctions):

 

(a)   all significant deficiencies in the designor operation of internal controls which could adversely affect the registrant’sability to record, process, summarize and report financial data and haveidentified for the registrant’s auditors any material weaknesses in internalcontrols; and

 

(b)   any fraud, whether or not material, thatinvolves management or other employees who have a significant role in theregistrant’s internal controls; and

 

6.               Theregistrant’s other certifying officers and I have indicated in this quarterlyreport whether there were significant changes in internal controls or in otherfactors that could significantly affect the internal controls subsequent to thedate of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 

 

 
|   | Date:                                                   | May 14, 2003 |
|--------|---------------------------------------------------------|--------------|
|   |                                                    |
|   | /s/ Don E. Cosby                                        |
|   | Don E. Cosby                                            |
|   | Executive Vice  President and Chief   Financial Officer |

 

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