**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-Q**

 

**ý****QUARTERLY REPORTPURSUANT TO SECTION 13 OR 15(d)**

**OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended: June 30, 2003**

 

**OR**

 

**o****TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d)**

**OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

**For the transition periodfrom              to              **

 

**Commission File Number: 0-10196**

 

**INDEPENDENT BANKSHARES, INC.**

(Exact name of registrant as specified in itscharter)

 

| **Texas**                                                       |   | **75-1717279**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
|                                                            |   |                                  |
| **1617 Broadway  P. O. Box 5240  Lubbock, Texas**               |   | **79408**                             |
| (Address of principal executive offices)                        |   | (Zip Code)                            |

 

**(806) 749-1850**

(Registrant’s telephone number, includingarea code)

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that the registrantwas required to file such reports) and (2) has been subject to such filingrequirements for the past 90 days.

 

YES ý    NO o

 

Indicate the number of shares outstanding ofeach of the issuer’s classes of common stock at June 30, 2003. Class:  Common Stock, par value $0.25 per shareOutstanding at June 30, 2003: 2,273,647 shares

 

 

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**PART I**

 

**FINANCIALINFORMATION**

 

Item1. Financial Statements.

 

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**INDEPENDENTBANKSHARES, INC.**

**A WHOLLY OWNED SUBSIDIARY OF STATE NATIONALBANCSHARES, INC.**

**CONSOLIDATEDBALANCE SHEETS**

**JUNE 30,2003 AND DECEMBER 31, 2002**

**(Unaudited)**

**(InThousands)**

 
|                                                                                     |   | **June 30,  2003** |       | **December 31,  2002** |       |
|------------------------------------------------------------------------------------------|--------|--------------------|------------|------------------------|------------|
| **ASSETS**                                                                               |   |               |       |                   |       |
| Cash, due from banks and interest-earning time deposits                                  |   | $                  | 50,582     |                   | $          | 54,119 |   |
| Interest-earning time deposits in other banks                                            |   | 16,032             |       | 14,482                 |       |
| Federal funds sold                                                                       |   | 15,225             |       | 15,623                 |       |
| Total cash and cash equivalents                                                          |   | 81,839             |       | 84,224                 |       |
| Available-for-sale securities                                                            |   | 238,242            |       | 274,342                |       |
| Loans held-for-sale                                                                      |   | 8,698              |       | 15,475                 |       |
| Loans held for investment                                                                |   | 687,352            |       | 658,870                |       |
| Unearned  Income                                                                    |   | (1                 | )          | (3                     | )          |
| Allowance for loan losses                                                                |   | (10,854            | )          | (10,914                | )          |
| Net loans                                                                                |   | 676,497            |       | 647,953                |       |
| Goodwill                                                                                 |   | 37,934             |       | 37,934                 |       |
| Other intangible assets                                                                  |   | 14,938             |       | 16,327                 |       |
| Premises and equipment                                                                   |   | 26,543             |       | 24,944                 |       |
| Accrued interest receivable                                                              |   | 6,075              |       | 7,044                  |       |
| Other real estate and other repossessed assets                                           |   | 4,096              |       | 3,703                  |       |
| Assets related to discontinued operations                                                |   | —             |       | 480                    |       |
| Other assets                                                                             |   | 29,043             |       | 29,251                 |       |
| Total assets                                                                             |   | $                  | 1,123,905  |                   | $          | 1,141,677 |   |
|                                                                                     |   |               | ** ** |                   | ** ** |
| **LIABILITIES AND STOCKHOLDER’S EQUITY**                                            |   |               |       |                   |       |
| Deposits:                                                                                |   |               |       |                   |       |
| Noninterest-bearing demand deposits                                                      |   | $                  | 278,667    |                   | $          | 241,179 |   |
| Interest-bearing demand deposits                                                         |   | 342,050            |       | 350,975                |       |
| Interest-bearing time deposits                                                           |   | 333,033            |       | 372,560                |       |
| Total deposits                                                                           |   | 953,750            |       | 964,714                |       |
| Federal funds purchased and securities sold under agreements to  repurchase              |   | 23,010             |       | 20,762                 |       |
| Accrued interest payable                                                                 |   | 769                |       | 1,009                  |       |
| Note payable                                                                             |   | 1,068              |       | 789                    |       |
| Liabilities related to discontinued operations                                           |   | —             |       | 3,954                  |       |
| Other liabilities                                                                        |   | 9,512              |       | 9,525                  |       |
| Total liabilities                                                                        |   | 988,109            |       | 1,000,753              |       |
| Guaranteed preferred beneficial interests in the company’s  subordinated debentures |   | 10,943             |       | 10,934                 |       |
| Stockholder’s equity:                                                               |   |               |       |                   |       |
| Common stock                                                                             |   | 568                |       | 568                    |       |
| Additional paid-in capital                                                               |   | 144,134            |       | 144,134                |       |
| Retained earnings (deficit)                                                              |   | (24,317            | )          | (20,028                | )          |
| Accumulated other comprehensive income                                                   |   | 4,468              |       | 5,316                  |       |
| Total stockholder’s equity                                                          |   | 124,853            |       | 129,990                |       |
| Total liabilities and stockholder’s equity                                          |   | $                  | 1,123,905  |                   | $          | 1,141,677 |   |

 

See Accompanying Notes to InterimConsolidated Financial Statements.

 

3

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**INDEPENDENTBANKSHARES, INC.**

**A WHOLLY OWNED SUBSIDIARY OF STATE NATIONALBANCSHARES, INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)**

**FOR THEQUARTERS AND SIX MONTH PERIOD ENDED JUNE 30, 2003 AND 2002**

**(Unaudited)**

** **
|                                                                                                                     |   | **Quarter Ended  June 30,** |       | **Six Month Period  Ended June 30,** |       |
|--------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|------------|--------------------------------------|------------|
|                                                                                                                     |   | **2003**                    |       | **2002**                             |       | **2003** |   | **2002** |   |
|                                                                                                                     |   | **(In thousands)**          |       |
| Interest income:                                                                                                         |   |                        | ** ** |                                 | ** ** |   | ** ** |   | ** ** |
| Loans, including fees                                                                                                    |   | $                           | 11,498     |                                 | $          | 11,478 |   | $ | 22,839 |   | $ | 23,248 |   |
| Securities                                                                                                               |   | 2,742                       |       | 4,024                                |       | 5,744 |   | 8,570 |   |
| Deposits in other banks                                                                                                  |   | 38                          |       | 83                                   |       | 59 |   | 146 |   |
| Federal funds sold                                                                                                       |   | 58                          |       | 107                                  |       | 124 |   | 227 |   |
| Total interest income                                                                                                    |   | 14,336                      |       | 15,692                               |       | 28,766 |   | 32,191 |   |
| Interest expense:                                                                                                        |   |                        |       |                                 |       |   |   |   |   |
| Deposits                                                                                                                 |   | 2,160                       |       | 3,706                                |       | 4,665 |   | 8,015 |   |
| Securities sold under agreement to repurchase                                                                            |   | 45                          |       | 51                                   |       | 81 |   | 89 |   |
| Federal funds purchased                                                                                                  |   | —                      |       | —                               |       | — |   | 2 |   |
| Notes payable                                                                                                            |   | 11                          |       | 10                                   |       | 23 |   | 19 |   |
| Total interest expense                                                                                                   |   | 2,216                       |       | 3,767                                |       | 4,769 |   | 8,125 |   |
| Net interest income                                                                                                      |   | 12,120                      |       | 11,925                               |       | 23,997 |   | 24,066 |   |
| Provision for loan losses                                                                                                |   | —                      |       | 285                                  |       | 118 |   | 740 |   |
| Net interest income after provision for loan losses                                                                      |   | 12,120                      |       | 11,640                               |       | 23,879 |   | 23,326 |   |
| Noninterest income:                                                                                                      |   |                        |       |                                 |       |   |   |   |   |
| Service charges                                                                                                          |   | 2,295                       |       | 2,015                                |       | 4,319 |   | 3,837 |   |
| Trust fees                                                                                                               |   | 146                         |       | 123                                  |       | 290 |   | 252 |   |
| Gain on sale of loans                                                                                                    |   | 851                         |       | 497                                  |       | 1,625 |   | 873 |   |
| Gain on sale of securities                                                                                               |   | 1                           |       | —                               |       | 11 |   | 72 |   |
| Other income                                                                                                             |   | 859                         |       | 786                                  |       | 1,651 |   | 1,602 |   |
| Total noninterest income                                                                                                 |   | 4,152                       |       | 3,421                                |       | 7,896 |   | 6,636 |   |
| Noninterest expenses:                                                                                                    |   |                        |       |                                 |       |   |   |   |   |
| Salaries and employee benefits                                                                                           |   | 5,427                       |       | 4,998                                |       | 10,898 |   | 9,872 |   |
| Net occupancy and equipment expense                                                                                      |   | 1,783                       |       | 2,030                                |       | 3,770 |   | 3,921 |   |
| Amortization of intangible assets                                                                                        |   | 673                         |       | 761                                  |       | 1,346 |   | 1,522 |   |
| Professional fees                                                                                                        |   | 235                         |       | 303                                  |       | 465 |   | 620 |   |
| Communication expense                                                                                                    |   | 279                         |       | 392                                  |       | 652 |   | 805 |   |
| Data processing expense                                                                                                  |   | 171                         |       | 405                                  |       | 595 |   | 879 |   |
| Distributions on guaranteed preferred beneficial interests in the  company’s subordinated debentures                |   | 280                         |       | 280                                  |       | 561 |   | 560 |   |
| Net costs (revenues) applicable to other real estate and other  repossessed assets                                       |   | 2                           |       | (10                                  | )          | 131 |   | 9 |   |
| Merger-related expense                                                                                                   |   | 28                          |       | —                               |       | 780 |   | — |   |
| Other expenses                                                                                                           |   | 2,100                       |       | 1,792                                |       | 3,884 |   | 3,857 |   |
| Total noninterest expenses                                                                                               |   | 10,978                      |       | 10,951                               |       | 23,082 |   | 22,045 |   |
| Income from continuing operations before federal income taxes and  cumulative effect of a change in accounting principle |   | 5,294                       |       | 4,110                                |       | 8,693 |   | 7,917 |   |
| Federal income tax expense                                                                                               |   | 1,839                       |       | 1,260                                |       | 2,960 |   | 2,654 |   |
| Income from continuing operations before cumulative effect of a change  in accounting principle                          |   | 3,455                       |       | 2,850                                |       | 5,733 |   | 5,263 |   |
| Discontinued Operations                                                                                                  |   |                        |       |                                 |       |   |   |   |   |
| Gain (loss) from branches held-for-sale                                                                                  |   | —                      |       | 72                                   |       | (33 | ) | 130 |   |
| Federal income tax expense (benefit)                                                                                     |   | —                      |       | 24                                   |       | (11 | ) | 44 |   |
| Net gain (loss) from branches held-for-sale                                                                              |   | —                      |       | 48                                   |       | (22 | ) | 86 |   |
| Income before cumulative effect of a change in accounting principle                                                      |   | 3,455                       |       | 2,898                                |       | 5,711 |   | 5,349 |   |
| Cumulative effect of a change in accounting principle – goodwill  impairment                                        |   | —                      |       | —                               |       | — |   | 15,642 |   |
| Net income (loss)                                                                                                        |   | $                           | 3,455      |                                 | $          | 2,898 |   | $ | 5,711 |   | $ | (10,293 | ) |

 

See Accompanying Notes to Interim Consolidated Financial Statements.

 

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**INDEPENDENTBANKSHARES, INC.**

**A WHOLLY OWNED SUBSIDIARY OF STATE NATIONALBANCSHARES, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**SIX MONTHPERIODS ENDED JUNE 30, 2003 and 2002**

**(Unaudited)**

**(InThousands)**

 
|                                                                                      |   | **Six Month Period Ended June 30,** |   |
|-------------------------------------------------------------------------------------------|--------|-------------------------------------|--------|
|                                                                                      |   | **2003**                            |   | **2002** |   |
| Cash flows from operating activities:                                                     |   |                                |   |   |   |
| Net income (loss)                                                                         |   | $                                   | 5,711  |   | $ | (10,293 | ) |
| Adjustments to reconcile net income (loss) to net cash provided by  operating activities: |   |                                |   |   |   |
| Depreciation and amortization                                                             |   | 2,902                               |   | 3,218 |   |
| Net amortization of premium/discount                                                      |   | 732                                 |   | 568 |   |
| Provision for loan losses                                                                 |   | 118                                 |   | 740 |   |
| Cumulative effect of a change in accounting principle – goodwill  impairment         |   | —                              |   | 15,642 |   |
| Net loss on sales of premises and equipment                                               |   | 2                                   |   | 8 |   |
| Writedown of premises and equipment                                                       |   | 146                                 |   | 14 |   |
| Gain on sale of investments                                                               |   | (11                                 | )      | (72 | ) |
| Gain on branch sale                                                                       |   | (57                                 | )      | — |   |
| Net (gain) loss on sales of other real estate and other repossessed  assets               |   | (11                                 | )      | 26 |   |
| Loans originated for sale                                                                 |   | (72,574                             | )      | (40,339 | ) |
| Proceeds from sales of loans held for sale                                                |   | 80,976                              |   | 41,966 |   |
| Gain on sale of loans                                                                     |   | (1,625                              | )      | (873 | ) |
| Decrease in other assets                                                                  |   | 1,178                               |   | 1,048 |   |
| Increase (decrease) in other liabilities                                                  |   | 180                                 |   | (400 | ) |
| Net cash provided by operating activities                                                 |   | 17,667                              |   | 11,253 |   |
|                                                                                      |   |                                |   |   |   |
| Cash flows from investing activities:                                                     |   |                                |   |   |   |
| Proceeds from maturities of available-for-sale securities                                 |   | 88,598                              |   | 107,393 |   |
| Proceeds from sales of available-for-sale securities                                      |   | 536                                 |   | 6,868 |   |
| Purchases of available-for-sale securities                                                |   | (55,040                             | )      | (85,855 | ) |
| Purchase of bank owned life insurance                                                     |   | —                              |   | (9,494 | ) |
| Net (increase) decrease in loans                                                          |   | (29,793                             | )      | 5,336 |   |
| Net cash in branches held for sale                                                        |   | (2,434                              | )      | (395 | ) |
| Proceeds from sales of premises and equipment                                             |   | 17                                  |   | 29 |   |
| Additions to premises and equipment                                                       |   | (3,299                              | )      | (477 | ) |
| Proceeds from sales of other real estate and other repossessed assets                     |   | 951                                 |   | 425 |   |
| Net cash provided by (used in) investing activities                                       |   | (464                                | )      | 23,830 |   |
|                                                                                      |   |                                |   |   |   |
| Cash flows from financing activities:                                                     |   |                                |   |   |   |
| Decrease in deposits                                                                      |   | (12,115                             | )      | (46,340 | ) |
| Advances on notes payable                                                                 |   | 319                                 |   | — |   |
| Principle paydown on notes payable                                                        |   | (40                                 | )      | (20 | ) |
| Increase in federal funds purchased and securities sold under  agreements to repurchase   |   | 2,248                               |   | 6,259 |   |
| Capital reduction                                                                         |   | —                              |   | (5,000 | ) |
| Payment of cash dividends                                                                 |   | (10,000                             | )      | (2,000 | ) |
| Net cash used in financing activities                                                     |   | (19,588                             | )      | (47,101 | ) |
| Net decrease in cash and cash equivalents                                                 |   | (2,385                              | )      | (12,018 | ) |
| Cash and cash equivalents at beginning of period                                          |   | 84,224                              |   | 90,707 |   |
| Cash and cash equivalents at end of period                                                |   | $                                   | 81,839 |   | $ | 78,689 |   |
|                                                                                      |   |                                |   |   |   |
| Noncash investing activities:                                                             |   |                                |   |   |   |
| Additions to other real estate and other repossessed assets through  foreclosures         |   | $                                   | 1,336  |   | $ | 574 |   |

 

See Accompanying Notes to Interim Consolidated Financial Statements.

 

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**INDEPENDENTBANKSHARES, INC.**

**NOTES TOINTERIM CONSOLIDATED FINANCIAL STATEMENTS**

 

**(1)           Summaryof Significant Accounting Policies**

 

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

 

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 the Merger, the balance sheet andresults of operations of the SNB El Paso have been included in the Company’sconsolidated financial statements since August 11, 2000, the date of theacquisition of the Company by State National.

 

**(3)           AccumulatedOther Comprehensive Income**

 

An analysis of accumulated other comprehensiveincome for the quarters and six-month periods ended June 30, 2003 and 2002, isas follows:

 
|                         |   | **Unrealized  Gain (Loss) on Available-for-  sale Securities, net** |   |
|------------------------------|--------|---------------------------------------------------------------------|--------|
|                         |   | **Quarter  Ended  June 30,**                                        |   | **Six Month  Period  Ended June 30,** |   |
|                         |   | **2003**                                                            |   | **2002** |   | **2003** |   | **2002** |   |
|                         |   | **(In  thousands)**                                                 |   |
| Balance, beginning of period |   | $                                                                   | 4,680  |   | $ | 2,958 |   | $ | 5,316 |   | $ | 4,309 |   |
| Current period change        |   | (212                                                                | )      | 1,501 |   | (848 | ) | 240 |   |
| Balance, at June 30          |   | $                                                                   | 4,468  |   | $ | 4,459 |   | $ | 4,468 |   | $ | 4,549 |   |

 

**(4)****                                ****Adoption of AccountingStandards and Goodwill Impairment**

 

InJune 2001 the FASB issued SFAS No. 142, “Goodwill and Other Intangible Assets”*,*which addresses the accounting forgoodwill and other intangible assets. SFAS No. 142 prohibits the amortization of goodwill and intangibleassets with indefinite useful lives. SFAS No. 142 requires that these assets be reviewed for impairment atleast annually.  Intangible assets withfinite lives will continue to be amortized over their estimated usefullives.  Additionally, SFAS No. 142requires that goodwill included in the carrying value of equity methodinvestments no longer be amortized.

 

SFAS No. 142 was effective for the Company’s fiscalyear beginning January 1, 2002.  Theimplementation of SFAS No. 142 resulted in the Company recording a non-cashgoodwill impairment charge of $15,642,000 during the first quarter of2002.  This charge reflects thecumulative effect of adopting the accounting change in the statement ofoperations, but does not affect the Company’s operations and has no impact oncash flows.  The Company’s assets were

 

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reviewed again for impairmentas of October 1, 2002.  The results ofthis review determined that an impairment did not need to be recorded at thetime of the review.

 

In August 2001 the FASB issued SFAS No. 144,“Accounting for the Impairment or Disposal of Long-Lived Assets”.  SFAS No. 144 addresses financial accountingand reporting for the impairment of long-lived assets and for long-lived assetsto be disposed of.  More specifically,this statement broadens the presentation of discontinued operations to includea component of an entity whose operations and cash flows can be clearlydistinguished, operationally and for financial reporting purposes, from therest of the entity.  It supersedes, withexceptions, SFAS No. 121, “Accounting for the Impairment of Long-Lived Assetsand Long-Lived Assets to be Disposed of”, and was adopted January 1, 2002.

 

In 2002 the Company sold three branches located inBangs and Trent, Texas and Belen, New Mexico. In 2003 the Company sold one branch located in Socorro, New Mexico  Accordingly, the operating results of thedeposed properties have been reclassified and reported as discontinuedoperations in the consolidated statements of operations and the assets andliabilities of the branches held-for-sale have been reclassified and reportedas such on the consolidated balance sheets.

 

In November 2002, the FASB issued FinancialAccounting Standards Board Interpretation (“FIN”) No. 45, “Guarantor’sGuarantees of Indebtedness of Others, and Interpretation of FASB Statements No.5, 57, and 107 and Rescission of FASB Interpretation No. 34” (“FIN 45”).  FIN 45 elaborates on the disclosure to bemade by a guarantor in its interim and annual financial statements about itsobligations under certain guarantees that it has issued.  It also clarifies that a guarantor isrequired to recognize, at the inception of a guarantee, a liability for thefair value of the obligation undertaken in issuing the guarantee.  The initial recognition and measurementprovisions of FIN 45 are applicable on a prospective basis to guarantees issuedor modified after December 31, 2002. The disclosure requirements of FIN 45 are effective for financialstatements of interim or annual periods ending after December 15, 2002, andwere adopted in the Company’s financial statements for the year ended December31, 2002.  Adoption of FIN 45 did nothave a material impact on the Company’s financial position or results ofoperations.

 

In January 2003, the FASB issued FIN No. 46,“Consolidation of Variable Interest Entities, an interpretation of AccountingResearch Bulleting No. 51.”  FIN 46establishes guidance for consolidation of variable interest entities (“VIE”)that function to support the activities of the primary beneficiary.  The primary beneficiary of a VIE entity isthe entity that absorbs a majority of the VIE’s expected losses, receives amajority of the VIE’s expected residual returns, or both, as a result ofownership, controlling interest, contractual relationship or other businessrelationship with a VIE.  Prior to theimplementation of FIN 46, VIEs were generally consolidated by an enterprisewhen the enterprise had a controlling financial interest through ownership of amajority of voting interest in the entity. The provisions of FIN 46 were effective immediately for all arrangementsentered into after January 31, 2003, and are otherwise effective at thebeginning of the first interim period beginning after June 15, 2003.

 

The Company adopted FIN 46 on July 1, 2003.  In its current form, FIN 46 may require theCompany to de-consolidate its investments in Independent Capital Trust infuture financial statements.  Thepotential de-consolidation of subsidiary trusts of bank holding companiesformed in connection with the issuance of trust preferred securities, likeIndependent Capital Trust, appears to be an unintended consequence of FIN46.  It is currently unknown if, orwhen, the Financial Accounting Standards Board will address this issue.  In July 2003, the Board of Governors of theFederal Reserve System (“Federal Reserve”) issued a supervisory letterinstructing bank holding companies to continue to include the trust preferredsecurities in their Tier 1 capital for regulatory capital purposes until noticeis given to the contrary.  The FederalReserve intends to review the regulatory implications of any accountingtreatment changes and, if necessary or warranted, provide further appropriateguidance.  There can be no assurancethat the Federal Reserve will continue to allow institutions to include trustpreferred securities in Tier 1 capital for regulatory capital purposes.  As of June 30, 2003, assuming the Companywas not allowed to include the $11 million in trust preferred securities issuedby Independent Capital Trust in Tier 1 capital, the Company would still exceedthe regulatory required minimums for capital adequacy purposes.

 

In January 2003, the FASB issued SFAS No. 148,“Accounting for Stock-Based Compensation - Transition and Disclosure”, (SFAS148”).  SFAS 148 amends FASB SFAS No.123, “Accounting for Stock-Based Compensation”, (“SFAS 123”) to providealternative methods of transition for a voluntary change to the fair valuebased method of accounting for stock-based employee compensation.  In addition, SFAS 148 amends the disclosurerequirements of SFAS 123 to require prominent disclosures in both annual andinterim financial statements of the method of accounting

 

7

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for stock-based employeecompensation and the effect of the method used on reported results.  SFAS 148 is effective for fiscal yearsbeginning after December 15, 2002.  Theadoption of this statement did not have a material impact on the Company’s financialposition or results of operation.

 

In April 2003, the FASB issued SFAS No. 149,“Amendment of Statement 133 on Derivative Instruments and Hedging Activities”(“SFAS 149”).  SFAS 149 amends andclarifies financial accounting and reporting for derivative instruments,including certain derivative instruments embedded in other contracts and forhedging activities under SFAS 133, “Accounting for Derivative Instruments andHedging Activities.”  The new guidanceamends SFAS 133 for decisions made:  (i)as part of the Derivatives Implementation Group process that effectivelyrequired amendments to SFAS 133, (b) in connection with other Board projectsdealing with financial instruments, and (c) regarding implementation issuesraised in relation to the application of the definition of a derivative.  SFAS 149 also modifies various otherexisting pronouncements to conform with the changes made to SFAS 133. SFAS 149is effective for contracts entered into or modified after June 30, 2003, andfor hedging relationships designated after June 30, 2003, with all provisionapplied prospectively.  The adoption ofthis statement did not have a material impact on the Company’s financialposition or results of operation.

 

In May 2003, the FASB issued SFAS No. 150, “Accountingfor Certain Financial Instruments with Characteristics of Both Liabilities andEquity”, (“SFAS 150”).  SFAS 150establishes standards for how any issuer classifies, measures and discloses inits financial statements certain financial instruments with characteristics ofboth liabilities and equity.  SFAS 150requires certain financial instruments that embody obligations of the issuerand have characteristics of both liabilities and equity to be classified asliabilities.  SFAS 150 is effective forcontracts entered into or modified after May 31, 2003, and is otherwiseeffective at the beginning of the first interim period beginning after June 15,2003.  The adoption of this statementdid not have a material impact on the Company’s financial position or resultsof operation.

 

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

 

On February 10, 2003, the Bank sold its branch inSocorro, New Mexico to an unrelated financial institution.  A pre tax gain of $50,000 was recordedrelated to this transaction.  Net lossfor the period ended March 31, 2003 for this branch was $22,000.

 

8

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**Item 2.    Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

*This Quarterly Report on Form 10-Qcontains certain forward-looking statements and information relating toIndependent Bankshares, Inc. (the “Company”, and at or prior to the date of theAcquisition, “IBK”) and its subsidiaries that are based on the beliefs of theCompany’s management as well as assumptions made by and information currentlyavailable to the Company’s management. When used in this report, the words“anticipate,” “believe,” “estimate,” “expect” and “intend” and words or phrasesof similar import, as they relate to the Company or its subsidiaries or Companymanagement, are intended to identify forward-looking statements. Suchstatements are intended to be covered by the safe-harbor provisions forforward-looking statements contained in the Private Securities LitigationReform Act of 1995 and we are including this statement for purposes of invokingthose safe- harbor provisions.  Theseforward-looking statements reflect the current view of the Company with respectto future events and are subject to certain risks, uncertainties andassumptions, many of which are beyond the Company’s control, related to certainfactors including, without limitation, competitive factors, general economicconditions nationally and within the State of Texas, customer relations, theinterest rate environment, governmental regulation and supervision,nonperforming asset levels, loan concentrations, changes in industry practices,acts of terrorism and war, one time events and other factors described herein.Based upon changing conditions, should any one or more of these risks oruncertainties materialize, or should any underlying assumptions proveincorrect, actual results may vary materially from those described herein asanticipated, believed, estimated, expected or intended. The Company does notintend to update these forward-looking statements.*

 

**The Company**

 

The Company is a bank holding company headquarteredin Lubbock, Texas. The Company is an indirect wholly owned subsidiary of StateNational Bancshares, Inc., Lubbock, Texas (“State National”). At June 30, 2003,the Company owned all of the common securities of Independent Capital Trust(“Independent Capital”) and indirectly owned, through a Delaware subsidiary,Independent Financial Corp. (“Independent Financial”), 100% of the stock ofState National Bank, Lubbock, Texas (the “Bank”). At June 30, 2003, the Bankoperated full-service banking locations in the Texas cities of Abilene (fourlocations), 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.

 

**General**

 

The following discussion and analysis presents themore significant factors affecting the Company’s results of operations for eachof the quarters and six-month periods ended June 30, 2003 and 2002, and thefinancial condition at June 30, 2003, and December 31, 2002. This discussionand analysis should be read in conjunction with the Consolidated FinancialStatements, notes thereto and other financial information appearing elsewherein this quarterly report.

 

**Analysis of Results of Operations**

 

*Net Income (Loss)*

 

Net income for the quarter ended June 30, 2003amounted to $3,455,000 compared to net income of $2,898,000 for the quarterended June 30, 2002.  Net income beforecumulative effect of a change in accounting principle for the six month periodended June 30, 2003 was $5,711,000 compared to net income before cumulativeeffect of a change in accounting principle of $5,349,000 for the six monthperiod ended June 30, 2002. The increase in net income between the quarter ended June 30, 2003 compared to thequarter ended June 30, 2002 as well as the increase in net income beforecumulative effect of a change in accounting principle for the six month periodended June 30, 2003 compared to the six month period ended June 30, 2002 wasprimarily due to the reduction of the provision for loan loss recorded in thesix month period ended June 30, 2003 as compared to the loan loss provisionrecorded for the same periods in 2002 and increases in mortgage and servicecharge income.  Giving effect to thecumulative effect of a change in accounting principle, net income for the sixmonth period ended June 30, 2003, was $5,711,000 compared to net loss of$10,293,000 for the six month period ended June 30, 2002. The loss in the sixmonth period ended June 30, 2002 was due to a $15,642,000 impairment recordedin the first quarter of 2002 as a cumulative effect of a change in accountingprinciple, related to the adoption of Statement of Accounting Standards, No.142 “Goodwill and Other Intangible Assets” (“FAS 142”).

 

9

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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 interestincome is the principal source of the Company’s earnings.  Interest rate fluctuations, as well aschanges in the amount and type of interest-earning assets and interest-bearingliabilities, combine to affect net interest income.

 

Net interest income amounted to $12,120,000 for thesecond quarter of 2003, an increase of $195,000, or 1.64%, when compared to thesecond quarter of 2002.  Net interestincome for the second quarter of 2002 was $11,925,000.  Net interest income for the first six monthsof 2003 was $23,997,000, a decrease of $69,000, or 0.29%, when compared to netinterest income of $24,066,000 for the first six months of 2002.  Net interest margin on a fullytaxable-equivalent basis increased from 4.83% for the second quarter of 2002 to5.11% for the second quarter of 2003, as well as from 4.82% for the first sixmonths of 2002 to 5.04% for the first six months of 2003.  The increase in net interest margin fromJune 30, 2002 to June 30, 2003 was primarily caused by the realignment of thedeposit mix.

 

At June 30, 2003, approximately $393,119,000, or57.19%, of the Company’s total loans, net of unearned income, were loans withfloating interest rates.  During 2002,loans with floating interest rates were subjected to declining interest ratesas the prime interest rate was decreased from 4.75% to 4.25% on November 7,2002 which is the primary cause of the decrease in the yield on loans from7.44% at June 30, 2002 to 6.88% at June 30, 2003.  However, total loans, net of unearned income increased $56,459,000since June 30, 2002.  This increase intotal loans, net of unearned income allowed for the slight increase in loaninterest income from the second quarter of 2002 to the second quarter of 2003and helped offset the decrease from the first six months of 2002 to the firstsix months of 2003.

 

Security yields decreased from 5.23% at June 30,2002 to 4.54% at June 30, 2003.  Thisdecrease was primarily caused by declines in yields in the bond market on newpurchases between the periods ended June 30, 2002 and June 30, 2003.

 

These net changes caused the Company’s overall yieldon interest earning assets to decrease from 6.35% for the quarter ended June30, 2002 to 6.04% for the quarter ended June 30 2003, and to decrease from6.45% to 6.04% for the six month period ended June 30, 2002 and 2003,respectively.

 

Average overall rates paid for various types ofcertificates of deposit decreased when comparing the first six months of 2002to the first six months of 2003. For example, the average rate paid forcertificates of deposit less than $100,000 decreased from 3.22% for the firstsix months of 2002 to 2.13% for the first six months of 2003, while the averagerate paid by the Company for certificates of deposit of $100,000 or more alsodecreased from 3.35% during the first six months of 2002 to 2.26% during thefirst six months of 2003.

 

Rates on other types of deposits, such asinterest-bearing demand, savings and money market deposits, also decreased froman average of 0.80% during the six month period ended June 30, 2002 to anaverage of 0.48% during the first six months of 2003.  These decreases were primarily caused by the decline in interestrates during the time period from June 30, 2002 to June 30, 2003.  These changes caused the Company’s overallcost of interest-bearing deposits to decrease from 1.65% for the first sixmonths of 2002 to 0.99% for the first six months of 2003.

 

10

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The following table presentsthe average balance sheets of the Company for the quarters and six monthperiods ended June 30, 2003 and 2002, and indicates the interest earned or paidon the major categories of interest-earning assets and interest-bearingliabilities on a fully taxable-equivalent basis and the average rates earned orpaid on each major category.  This analysisdetails the contribution of interest-earning assets and the impact of the costof funds on overall net interest income.

 
|                                                                                     |   | **Quarter  Ended June 30,** |      |
|------------------------------------------------------------------------------------------|--------|-----------------------------|-----------|
|                                                                                     |   | **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)                                                        |   | $                           | 669,899   |   | $ | 11,498 |   | 6.87 | % | $ | 624,248 |   | $ | 11,478 |   | 7.35 | % |
| Securities (2)                                                                           |   | 245,036                     |      | 2,762 |   | 4.51 | % | 321,656 |   | 4,073 |   | 5.07 | % |
| Interest-earning time deposits in other banks                                            |   | 13,356                      |      | 38 |   | 1.14 | % | 20,522 |   | 83 |   | 1.62 | % |
| Federal funds sold                                                                       |   | 21,946                      |      | 58 |   | 1.06 | % | 25,878 |   | 107 |   | 1.65 | % |
| Total interest-earning assets                                                            |   | 950,237                     |      | 14,356 |   | 6.04 | % | 992,304 |   | 15,741 |   | 6.35 | % |
|                                                                                     |   |                        |      |   |   |   |   |   |   |   |   |   |   |
| Noninterest-earning assets:                                                              |   |                        |      |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks                                                                  |   | 45,697                      |      |   |   |   |   | 56,510 |   |   |   |   |   |
| Intangible assets                                                                        |   | 53,159                      |      |   |   |   |   | 57,819 |   |   |   |   |   |
| Premises and equipment                                                                   |   | 26,720                      |      |   |   |   |   | 26,151 |   |   |   |   |   |
| Accrued interest receivable and other assets                                             |   | 49,710                      |      |   |   |   |   | 40,531 |   |   |   |   |   |
| Allowance for possible loan losses                                                       |   | (11,033                     | )         |   |   |   |   | (11,931 | ) |   |   |   |   |
| Total noninterest-earning assets                                                         |   | 164,253                     |      |   |   |   |   | 169,080 |   |   |   |   |   |
|                                                                                     |   |                        |      |   |   |   |   |   |   |   |   |   |   |
| Total assets                                                                             |   | $                           | 1,114,490 |   |   |   |   |   | $ | 1,161,384 |   |   |   |   |   |
|                                                                                     |   |                        |      |   |   |   |   |   |   |   |   |   |   |
| LIABILITIES AND STOCKHOLDER’S EQUITY                                                |   |                        |      |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities:                                                            |   |                        |      |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing, savings and money market deposits                                      |   | $                           | 344,389   |   | $ | 416 |   | 0.48 | % | $ | 350,924 |   | $ | 674 |   | 0.77 | % |
| Time deposits                                                                            |   | 338,894                     |      | 1,744 |   | 2.06 | % | 395,410 |   | 3,032 |   | 3.07 | % |
| Notes Payable                                                                            |   | 1,078                       |      | 11 |   | 4.08 | % | 671 |   | 10 |   | 5.96 | % |
| Federal funds purchased and securities sold under agreements to  repurchase              |   | 24,499                      |      | 45 |   | 0.73 | % | 18,821 |   | 51 |   | 1.08 | % |
| Total interest-bearing liabilities                                                       |   | 708,860                     |      | 2,216 |   | 1.25 | % | 765,826 |   | 3,767 |   | 1.97 | % |
| Noninterest-bearing liabilities:                                                         |   |                        |      |   |   |   |   |   |   |   |   |   |   |
| Demand deposits                                                                          |   | 249,678                     |      |   |   |   |   | 215,194 |   |   |   |   |   |
| Accrued interest payable and other liabilities                                           |   | 11,880                      |      |   |   |   |   | 33,121 |   |   |   |   |   |
| Total noninterest-bearing liabilities                                                    |   | 261,558                     |      |   |   |   |   | 248,315 |   |   |   |   |   |
| Total liabilities                                                                        |   | 970,418                     |      |   |   |   |   | 1,014,141 |   |   |   |   |   |
| Guaranteed preferred beneficial interests in the Company’s  subordinated debentures |   | 10,943                      |      |   |   |   |   | 10,924 |   |   |   |   |   |
| Stockholder’s equity                                                                |   | 133,129                     |      |   |   |   |   | 136,319 |   |   |   |   |   |
|                                                                                     |   |                        |      |   |   |   |   |   |   |   |   |   |   |
| Total liabilities and stockholder’s equity                                          |   | $                           | 1,114,490 |   |   |   |   |   | $ | 1,161,384 |   |   |   |   |   |
| Tax-equivalent net interest income                                                       |   |                        |      | $ | 12,140 |   |   |   |   |   | $ | 11,974 |   |   |   |
| Interest rate spread (3)                                                                 |   |                        |      |   |   | 4.79 | % |   |   |   |   | 4.38 | % |
| Net interest margin (4)                                                                  |   |                        |      |   |   | 5.11 | % |   |   |   |   | 4.83 | % |

 

----

(1)          Nonaccrual loans are included in the Average Balance columns, andincome recognized on these loans, if any, is included in the InterestIncome/Expense columns.  Interest incomeon loans includes fees on loans, which are not material in amount.

(2)          Nontaxable interest income on securities was adjusted to a taxableyield assuming a tax rate of 34%.

(3)          The interest rate spread is the difference between the average yield oninterest-earning assets and the average cost of interest-bearing liabilities.

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

 

11

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|                                                                                     |   | **Six Month  Period Ended June 30,** |      |
|------------------------------------------------------------------------------------------|--------|--------------------------------------|-----------|
|                                                                                     |   | **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)                                                        |   | $                                    | 664,145   |   | $ | 22,839 |   | 6.88 | % | $ | 624,623 |   | $ | 23,248 |   | 7.44 | % |
| Securities (2)                                                                           |   | 255,258                              |      | 5,790 |   | 4.54 | % | 331,263 |   | 8,669 |   | 5.23 | % |
| Interest-earning time deposits in other banks                                            |   | 10,518                               |      | 59 |   | 1.12 | % | 17,669 |   | 146 |   | 1.65 | % |
| Federal funds sold                                                                       |   | 23,519                               |      | 124 |   | 1.05 | % | 28,371 |   | 227 |   | 1.60 | % |
| Total interest-earning assets                                                            |   | 953,440                              |      | 28,812 |   | 6.04 | % | 1,001,926 |   | 32,290 |   | 6.45 | % |
|                                                                                     |   |                                 |      |   |   |   |   |   |   |   |   |   |   |
| Noninterest-earning assets:                                                              |   |                                 |      |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks                                                                  |   | 45,888                               |      |   |   |   |   | 57,213 |   |   |   |   |   |
| Intangible assets                                                                        |   | 53,521                               |      |   |   |   |   | 65,173 |   |   |   |   |   |
| Premises and equipment                                                                   |   | 26,320                               |      |   |   |   |   | 26,455 |   |   |   |   |   |
| Accrued interest receivable and other assets                                             |   | 50,139                               |      |   |   |   |   | 43,591 |   |   |   |   |   |
| Allowance for possible loan losses                                                       |   | (11,057                              | )         |   |   |   |   | (11,699 | ) |   |   |   |   |
| Total noninterest-earning assets                                                         |   | 164,811                              |      |   |   |   |   | 180,733 |   |   |   |   |   |
|                                                                                     |   |                                 |      |   |   |   |   |   |   |   |   |   |   |
| Total assets                                                                             |   | $                                    | 1,118,251 |   |   |   |   |   | $ | 1,182,659 |   |   |   |   |   |
|                                                                                     |   |                                 |      |   |   |   |   |   |   |   |   |   |   |
| LIABILITIES AND STOCKHOLDER’S EQUITY                                                |   |                                 |      |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities:                                                            |   |                                 |      |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing, savings and money market deposits                                      |   | $                                    | 346,470   |   | $ | 834 |   | 0.48 | % | $ | 352,725 |   | $ | 1,409 |   | 0.80 | % |
| Time deposits                                                                            |   | 350,731                              |      | 3,831 |   | 2.18 | % | 404,103 |   | 6,606 |   | 3.27 | % |
| Notes Payable                                                                            |   | 999                                  |      | 23 |   | 4.60 | % | 676 |   | 19 |   | 5.62 | % |
| Federal funds purchased and securities sold under agreements to  repurchase              |   | 23,593                               |      | 81 |   | 0.69 | % | 17,541 |   | 91 |   | 1.04 | % |
| Total interest-bearing liabilities                                                       |   | 721,793                              |      | 4,769 |   | 1.32 | % | 775,045 |   | 8,125 |   | 2.10 | % |
| Noninterest-bearing liabilities:                                                         |   |                                 |      |   |   |   |   |   |   |   |   |   |   |
| Demand deposits                                                                          |   | 241,837                              |      |   |   |   |   | 216,992 |   |   |   |   |   |
| Accrued interest payable and other liabilities                                           |   | 11,560                               |      |   |   |   |   | 34,724 |   |   |   |   |   |
| Total noninterest-bearing liabilities                                                    |   | 253,397                              |      |   |   |   |   | 251,716 |   |   |   |   |   |
| Total liabilities                                                                        |   | 975,190                              |      |   |   |   |   | 1,026,761 |   |   |   |   |   |
| Guaranteed preferred beneficial interests in the Company’s  subordinated debentures |   | 10,940                               |      |   |   |   |   | 10,922 |   |   |   |   |   |
| Stockholder’s equity                                                                |   | 132,121                              |      |   |   |   |   | 144,976 |   |   |   |   |   |
|                                                                                     |   |                                 |      |   |   |   |   |   |   |   |   |   |   |
| Total liabilities and stockholder’s equity                                          |   | $                                    | 1,118,251 |   |   |   |   |   | $ | 1,182,659 |   |   |   |   |   |
| Tax-equivalent net interest income                                                       |   |                                 |      | $ | 24,043 |   |   |   |   |   | $ | 24,165 |   |   |   |
| Interest rate spread (3)                                                                 |   |                                 |      |   |   | 4.72 | % |   |   |   |   | 4.35 | % |
| Net interest margin (4)                                                                  |   |                                 |      |   |   | 5.04 | % |   |   |   |   | 4.82 | % |

 

----

(1)          Nonaccrual loans are included in the Average Balance columns, and incomerecognized on these loans, if any, is included in the Interest Income/Expensecolumns.  Interest income on loansincludes fees on loans, which are not material in amount.

(2)          Nontaxable interest income on securities was adjusted to a taxableyield assuming a tax rate of 34%.

(3)          The interest rate spread is the difference between the average yield oninterest-earning assets and the average cost of interest-bearing liabilities.

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

 

12

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The following table presentsthe changes in the components of net interest income and identifies the part ofeach change due to differences in the average volume of interest-earning assetsand interest-bearing liabilities and the part of each change due to the averagerate on those assets and liabilities. The changes in interest due to both rate and volume in the table havebeen allocated to volume or rate change in proportion to the absolute amountsof the change in each.

 
|                                                                        |   | **Quarter  Ended  June 30, 2003 vs. 2002**  |   | **Six Month  Period Ended  June 30, 2003 vs. 2002** |   |
|-----------------------------------------------------------------------------|--------|---------------------------------------------|--------|-----------------------------------------------------|--------|
|                                                                        |   | **Increase  (Decrease) Due to  Changes in** |   | **Increase  (Decrease) Due to  Changes in**         |   |
|                                                                        |   | **Volume**                                  |   | **Rate**                                            |   | **Total** |   | **Volume** |   | **Rate** |   | **Total** |   |
|                                                                        |   | **(Dollars  in thousands)**                 |   | **(Dollars  in thousands)**                         |   |
| Interest-earning assets:                                                    |   |                                        |   |                                                |   |   |   |   |   |   |   |   |   |
| Loans, net of unearned income (1)                                           |   | $                                           | 839    |                                                | $      | (819 | ) | $ | 20 |   | $ | 1,471 |   | $ | (1,880 | ) | $ | (409 | ) |
| Securities (2)                                                              |   | (970                                        | )      | (341                                                | )      | (1,311 | ) | (1,989 | ) | (890 | ) | (2,879 | ) |
| Interest-earning time deposits in other banks                               |   | (29                                         | )      | (16                                                 | )      | (45 | ) | (59 | ) | (28 | ) | (87 | ) |
| Federal funds sold                                                          |   | (16                                         | )      | (33                                                 | )      | (49 | ) | (39 | ) | (64 | ) | (103 | ) |
| Total interest income                                                       |   | (176                                        | )      | (1,209                                              | )      | (1,385 | ) | (616 | ) | (2,862 | ) | (3,478 | ) |
|                                                                        |   |                                        |   |                                                |   |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities:                                               |   |                                        |   |                                                |   |   |   |   |   |   |   |   |   |
| Deposits:                                                                   |   |                                        |   |                                                |   |   |   |   |   |   |   |   |   |
| Savings and money market deposits                                           |   | (13                                         | )      | (246                                                | )      | (259 | ) | (25 | ) | (550 | ) | (575 | ) |
| Time deposits                                                               |   | (433                                        | )      | (855                                                | )      | (1,288 | ) | (872 | ) | (1,903 | ) | (2,775 | ) |
| Notes Payable                                                               |   | 6                                           |   | (5                                                  | )      | 1 |   | 9 |   | (5 | ) | 4 |   |
| Federal funds purchased and securities sold under agreements to  repurchase |   | 16                                          |   | (21                                                 | )      | (5 | ) | 31 |   | (41 | ) | (10 | ) |
| Total interest expense                                                      |   | (424                                        | )      | (1,127                                              | )      | (1,551 | ) | (857 | ) | (2,499 | ) | (3,356 | ) |
|                                                                        |   |                                        |   |                                                |   |   |   |   |   |   |   |   |   |
| Increase (decrease) in net interest income                                  |   | $                                           | 248    |                                                | $      | (82 | ) | $ | 166 |   | $ | 241 |   | $ | (363 | ) | $ | (122 | ) |

 

----

(1)          Nonaccrual loans have been included in average assets for the purposesof the computations, thereby reducing yields.

(2)          Information with respect to tax-exempt securities is provided on afully taxable-equivalent basis 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 six month period ended June 30, 2003 was $118,000, comparedto $740,000 for the six month period ended June 30, 2002. The relatively lowprovision recorded in the first six months 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 $731,000, or21.4%, from $3,421,000 during the second quarter of 2002 to $4,152,000 duringthe second quarter of 2003.  Totalnoninterest income also increased $1,260,000, or 19.0%, from $6,636,000 for thefirst six months of 2002 to $7,896,000 for the first six months of 2003.

 

Service charges on deposit accounts and on othertypes of services are the major source of noninterest income to theCompany.  This source of incomeincreased $280,000, or 13.9%, from $2,015,000 during the second quarter of 2002to $2,295,000 during the second quarter of 2003, and increased $482,000, or12.6%, from $3,837,000 for the first

 

13

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six months of 2002 to$4,319,000 for the first six months of 2003. The increase in service charges ondeposit accounts was primarily due to stricter collection policies enforced bymanagement during 2003.

 

Trust fees from the operation of the trustdepartment of the Company increased $23,000, or 18.7%, from $123,000 during thesecond quarter of 2002 to $146,000 during the same period in 2003, andincreased $38,000, or 15.1%, from $252,000 for the first six months of 2002 to$290,000 for the first six months of 2003. The increase is primarily a result of the growth of the client base inthe trust department.

 

Gain on sale of loans increased $354,000, or 71.2%,from $497,000 during the second quarter of 2002 to $851,000 during the secondquarter of 2003 and increased $752,000, or 86.1%, from $873,000 for the firstsix months of 2002 to $1,625,000 for the first six months of 2003.  The increase is primarily due to an increasein loans originated and sold during the period ended June 30, 2003 as comparedto the period ended June 30, 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, Bank OwnedLife Insurance (“BOLI”) income and other sources of miscellaneous income. Otherincome increased $73,000, or 9.3%, from $786,000 during the second quarter of2002 to $859,000 during the second quarter of 2003, and increased $49,000, or3.1%, from $1,602,000 for the first six months of 2002 to $1,651,000 for thecorresponding period in 2003.  The increasein 2003 is primarily due to income generated from additional BOLI, which waspurchased late in the second quarter of 2002.

 

*Noninterest Expenses*

 

Total noninterest expenses increased $27,000, or0.3%, from $10,951,000 during the second quarter of 2002 to $10,978,000 duringthe second quarter of 2003, and increased $1,037,000, or 4.7%, from $22,045,000during the first six months of 2002 to $23,082,000 during the first six monthsof 2003.

 

Salaries and employee benefits, the largest singlecomponent of noninterest expense, increased $429,000, or 8.6%, from $4,998,000for the second quarter of 2002 to $5,427,000 for the corresponding period of2003, and increased $1,026,000, or 10.4%, from $9,872,000 for the six monthperiod ended June 30, 2002, to $10,898,000 for the corresponding period of 2003.The increase between the six month periods ended June 30, 2002 and June 30,2003 was primarily a result of annual raises, increases in commission basedwages generated from non-interest income and increased costs related to medicalbenefits.

 

Net occupancy expense decreased $247,000, or 12.2%,from $2,030,000 for the second quarter of 2002 to $1,783,000 for the sameperiod in 2003, and decreased $151,000, or 3.9%, from $3,921,000 for the firstsix months of 2002 to $3,770,000 for the first six months of 2003.  The decrease in net occupancy expense isprimarily due to costs recorded in the second quarter of 2002 associated withthe removal of old documents and data. Document retention policies were reviewed and it was determined thatolder documents and data which were no longer required to be retained, wereable to be destroyed and removed. Several storage facilities, which held some of these very old records,were cleaned out and many of the old documents were eliminated or moved todifferent storage facilities.  Thedecrease in expense is also related to clean up costs recorded in the secondquarter of 2002 associated with an event of flooding that occurred at one ofthe Abilene branches.

 

Amortization of intangible assets decreased $88,000,or 11.6%, from $761,000 during the second quarter of 2002 to $673,000 duringthe second quarter of 2003, and decreased $176,000, or 11.6%, from $1,522,000for the first six months of 2002 to $1,346,000 for the first six months of2003.  As core deposit intangibles areamortized using an accelerated method, the amortization expense will decreaseeach year over the first half of the life of the core deposit intangiblebalance.

 

Professional fees, which include legal, accountingand other professional fees, decreased $68,000, or 22.4%, from $303,000 duringthe second quarter of 2002 to $235,000 during the second quarter of 2003 anddecreased $155,000, or 25.0%, from $620,000 during the first six months of 2002to $465,000 for the corresponding period of 2003.  The decrease is due primarily to collection efforts occurringduring the second quarter of 2002 as well as legal expenses related to the saleof the branches.

 

Communication expense decreased $113,000, or 28.8%,from $392,000 in the second quarter of 2002 to $279,000 in the second quarterof 2003, and decreased $153,000, or 19.0%, from $805,000 in the first sixmonths of 2002 to

 

14

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$652,000 for the correspondingperiod of 2003.  The decrease isprimarily due to cost saving measures implemented by management in late 2002.

 

Data processing expense decreased $234,000, or57.8%, from $405,000 in the second quarter of 2002 to $171,000 in the secondquarter of 2003, and decreased $284,000, or 32.3%, from $879,000 in the firstsix months of 2002 to $595,000 for the corresponding period of 2003.  The decrease is primarily due to cost savingbenefits derived from the Merger.

 

Distributions on guaranteed preferred beneficialinterests in the Company’s subordinated debentures totaled $280,000 for thesecond quarter of 2002 and 2003, and totaled $560,000 for the first six monthof 2002 and $561,000 for the first six months of 2003.

 

Net costs applicable to other real estate and otherrepossessed assets consist of expenses associated with holding and maintainingrepossessed assets, the net gain or loss on the sales of such assets, thewrite-down of the carrying value of the assets and any rental income that iscredited as a reduction in expense. The Company recorded net costs of $2,000 inthe second quarter of 2003 as compared to net revenues of $10,000 in the secondquarter of 2002 and recorded net costs of $131,000 for the first six months of2003 as compared to net costs of $9,000 for the same period in 2002.  The increase is primarily related to largecommercial properties that were foreclosed on in the fourth quarter of 2002which incur significant month to month operating expenses.  The costs were offset by a gain recorded onthe sale of property in the second quarter which was obtained many years ago bya bank eventually acquired by the Company. These assets had been written off due to the length of time the assetshad been possessed, so the entire sale was recorded as a gain.

 

Merger-related expenses increased from none in thesecond quarter of 2002 to $28,000 the second quarter of 2003 and increased fromnone the first six months of 2002 to $780,000 in the same period in 2003.  The merger related expenses recorded duringthe first six months of 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.  These expenses increased $308,000, or 17.2%,from $1,792,000 during the second quarter of 2002 to $2,100,000 during thesecond quarter of 2003, and increased $27,000, or 0.7%, from $3,857,000 for thefirst six months of 2002 to $3,884,000 for the first six months of 2003.  The increase in other expenses is primarilyrelated to a large advertising campaign initiated in the second quarter of2003.

 

*Federal Income Taxes*

 

The Company recorded a federal income tax expense of$1,284,000 in the second quarter of 2002 compared to $1,839,000 in federalincome tax expense in the second quarter of 2003, and recorded a federal incometax expense of $2,698,000 in the first six months of 2002 as compared to$2,949,000 in federal income tax expense in the same period for 2003.  The increase in tax expense from the quarterand six month period ended June 30, 2002 to the quarter and six month periodended June 30, 2003 was due to higher income before federal income taxes.

 

*Impact of Inflation*

 

The effects of inflation on the local economy and onthe Company’s operating results have been relatively modest during the past severalyears. Because substantially all of the Company’s assets and liabilities aremonetary in nature, such as cash, securities, loans and deposits, their valuesare less sensitive to the effects of inflation than to changing interest rates,which do not necessarily change in accordance with inflation rates. The Companytries to control the impact of interest rate fluctuations by managing therelationship between its interest rate-sensitive assets and liabilities. See“Analysis of Financial Condition—Interest Rate Sensitivity” herein.

 

15

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**Analysis of Financial Condition**

 

*Assets*

 

Total assets decreased $17,772,000, or 1.6%, from$1,141,677,000 at December 31, 2002, to $1,123,905,000 at June 30, 2003.  This 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 total cash, due from banks andinterest-earning time deposits decreased $2,385,000, or 2.8%, from $84,224,000at December 31, 2002, to $81,839,000 at June 30, 2003. The decrease during theperiod is due primarily to the seasonality of the cash balances from December31, 2002 to June 30, 2003.

 

*Securities*

 

Securities decreased $36,100,000, or 13.2%, from$274,342,000 at December 31, 2002, to $238,242,000 at June 30, 2003, dueprimarily to shrinkage of the deposit balance.

 

The Board of Directors of the Company 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 an average life nogreater than 10 years. The Company’s policy is to maintain a securitiesportfolio with staggered maturities to meet its overall liquidity needs.Municipal securities must be rated A or better. Certain school district issues,however, are acceptable with a Baa rating. All securities totaling $238,242,000 are classified asavailable-for-sale and are carried at fair value at June 30, 2003. The decisionto sell securities classified as available-for-sale is based upon management’sassessment of changes in economic or financial market conditions.

 

Certain of the Company’s securities are pledged tosecure public and trust fund deposits and for other purposes required orpermitted by law. At June 30, 2003, the book value of U.S. Treasury and otherU.S. Government agency securities so pledged amounted to $90,215,000, or 37.9%of the total securities portfolio.

 

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

 
|                                                                                   |   | **June 30,  2003**          |    | **December  31, 2002** |   |
|----------------------------------------------------------------------------------------|--------|-----------------------------|---------|------------------------|--------|
|                                                                                   |   | **Amount**                  |    | **%**                  |   | **Amount** |   | **%** |   |
|                                                                                   |   | **(Dollars  in thousands)** |    |
| Carrying value:                                                                        |   |                        |    |                   |   |   |   |   |   |
| U.S. Treasury securities and obligations of U.S. Government agencies  and corporations |   | $                           | 143,029 |                   | 60.0   | % | $ | 172,016 |   | 62.7 | % |
| Mortgage-backed securities and collateralized mortgage obligations                     |   | 83,577                      |    | 35.1                   |   | 89,697 |   | 32.7 |   |
| Obligations of states and political subdivisions                                       |   | 3,292                       |    | 1.4                    |   | 4,610 |   | 1.7 |   |
| Other securities                                                                       |   | 8,344                       |    | 3.5                    |   | 8,019 |   | 2.9 |   |
|                                                                                   |   |                        |    |                   |   |   |   |   |   |
| Total carrying value of securities                                                     |   | $                           | 238,242 |                   | 100.0  | % | $ | 274,342 |   | 100.0 | % |
|                                                                                   |   |                        |    |                   |   |   |   |   |   |
| Total fair value of securities                                                         |   | $                           | 238,242 |                   |   |   | $ | 274,342 |   |   |   |

 

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The following table provides the maturity distributionand weighted average interest rates of the Company’s total securities portfolioat June 30, 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 book value of previous securities classified as held-to-maturity was theircost, adjusted for previous amortization or accretion. The restatement of theyields on tax-exempt securities to a fully taxable-equivalent basis has beencomputed assuming a tax rate of 34%.

 

 
| **Type and Maturity Grouping at June 30, 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                                                                              |   | $                           | 62,241  |                | $      | 63,303                    |   | $                            | 63,303  |   | 4.40 | % |
| After one but within five years                                                              |   | 75,071                      |    | 79,726              |   | 79,726                    |   | 4.90                         | %       |
| After five but within ten years                                                              |   | —                      |    | —              |   | —                    |   | 0.00                         | %       |
| Total U.S. Treasury securities and obligations of U.S. Government  agencies and corporations |   | 137,312                     |    | 143,029             |   | 143,029                   |   | 4.68                         | %       |
|                                                                                         |   |                        |    |                |   |                      |   |                         |    |
| Mortgage-backed securities and collateralized mortgage obligations                           |   | 82,694                      |    | 83,577              |   | 83,577                    |   | 4.00                         | %       |
|                                                                                         |   |                        |    |                |   |                      |   |                         |    |
| Obligations of states and political subdivisions:                                            |   |                        |    |                |   |                      |   |                         |    |
| Within one year                                                                              |   | 811                         |    | 808                 |   | 808                       |   | 5.75                         | %       |
| After one but within five years                                                              |   | 1,717                       |    | 1,799               |   | 1,799                     |   | 6.77                         | %       |
| After five but within ten years                                                              |   | 490                         |    | 551                 |   | 551                       |   | 7.12                         | %       |
| After ten years                                                                              |   | 120                         |    | 134                 |   | 134                       |   | 8.13                         | %       |
| Total obligations of states and political subdivisions                                       |   | 3,138                       |    | 3,292               |   | 3,292                     |   | 6.61                         | %       |
|                                                                                         |   |                        |    |                |   |                      |   |                         |    |
| Other securities:                                                                            |   |                        |    |                |   |                      |   |                         |    |
| Within one year                                                                              |   | 0                           |    | 0                   |   | 0                         |   | 0.00                         | %       |
| After one but within five years                                                              |   | 0                           |    | 0                   |   | 0                         |   | 0.00                         | %       |
| After five but within ten years                                                              |   | 0                           |    | 0                   |   | 0                         |   | 0.00                         | %       |
| After ten years                                                                              |   | 8,328                       |    | 8,344               |   | 8,344                     |   | 1.00                         | %       |
| Total other securities                                                                       |   | 8,328                       |    | 8,344               |   | 8,344                     |   | 1.00                         | %       |
|                                                                                         |   |                        |    |                |   |                      |   |                         |    |
| Total securities                                                                             |   | $                           | 231,472 |                | $      | 238,242                   |   | $                            | 238,242 |   | 4.34 | % |

 

*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 at settlement datesand are determined by the difference between the sales proceeds and thecarrying value of the loans.  All salesare made without recourse.  Loansheld-for-sale decreased $6,777,000 or 43.8% from $15,475,000 at December 31,2002 to $8,698,000 at June 30, 2003. The decrease 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$28,484,000, or 4.3%, from $658,867,000 at December 31, 2002 to $687,351,000 atJune 30, 2003.

 

The Bank primarily makes commercial loans to smallto medium sized businesses and professionals. The Bank offers a variety of commercial and real estate lending productsincluding revolving lines of credit, letters of credit, working capital loansand loans to finance accounts receivable, inventory and equipment, commercialreal estate purchase loans, construction loans, refinance loans and varioustypes of agriculture loans. Typically, the Bank’s

 

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commercial loans have floatingrates of interest, are for varying terms (generally not exceeding five years),are personally guaranteed by the principal owner and are collateralized by realestate, accounts receivable, inventory or other business assets.  Due to customer demand, the Bank also makesinstallment loans to individuals.

 

The following table presents the Company’s loanbalances at the dates indicated separated by loan types.

 
|                          |   | **June 30,  2003**  |    | **December  31,  2002** |   |
|-------------------------------|--------|---------------------|---------|-------------------------|--------|
|                          |   | **(In  thousands)** |    |
|                          |   |                |    |                    |   |
| Real estate loans             |   | $                   | 410,464 |                    | $      | 387,477 |   |
| Commercial loans              |   | 187,626             |    | 184,963                 |   |
| Loans to individuals          |   | 38,648              |    | 43,730                  |   |
| Agriculture and other loans   |   | 50,614              |    | 42,700                  |   |
| Total loans                   |   | 687,352             |    | 658,870                 |   |
| Less unearned income          |   | 1                   |    | 3                       |   |
|                          |   |                |    |                    |   |
| Loans, net of unearned income |   | $                   | 687,351 |                    | $      | 658,867 |   |

 

Loan concentrations are considered to exist whenthere are 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 June 30, 2003, exceptfor those described above and a geographic concentration of loans in West andNorth Texas. The Bank had loans outstanding to foreign countries or borrowersheadquartered in foreign countries totaling $11,592,000 at June 30, 2003.

 

Management of the Company may renew loans atmaturity when requested by a customer whose financial strength appears tosupport such renewal or when such renewal appears to be in the Company’s bestinterest. The Company requires payment of accrued interest in such instancesand may adjust the rate of interest, require a principal reduction or modifyother terms of the loan at the 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 June 30, 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            |   | $                      | 249,073 |                   | $      | 125,528              |   | $                          | 35,863 |   | $ | 410,464 |   |
| Commercial loans             |   | 152,098                |    | 24,350                 |   | 11,178               |   | 187,626                    |   |
| Agriculture and other loans  |   | 45,189                 |    | 3,563                  |   | 1,862                |   | 50,614                     |   |
|                         |   |                   |    |                   |   |                 |   |                       |   |
| Total loans                  |   | $                      | 446,360 |                   | $      | 153,441              |   | $                          | 48,903 |   | $ | 648,704 |   |
|                         |   |                   |    |                   |   |                 |   |                       |   |
| With fixed interest rates    |   | $                      | 80,832  |                   | $      | 137,713              |   | $                          | 37,040 |   | $ | 255,585 |   |
| With variable interest rates |   | 365,528                |    | 15,728                 |   | 11,863               |   | 393,119                    |   |
|                         |   |                   |    |                   |   |                 |   |                       |   |
| Total loans                  |   | $                      | 446,360 |                   | $      | 153,441              |   | $                          | 48,903 |   | $ | 648,704 |   |

 

*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 the

 

18

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Company’s allowance for loanlosses (the “allowance”). The allowance is created by direct charges againstincome (the “provision” for loan losses), and the allowance is available toabsorb probable loan losses. See “Analysis of Results of Operations - Provisionfor 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 $10,854,000, or 1.6% of loans, net ofunearned income, at June 30, 2003, compared to $10,914,000, or 1.7% of loans,net of unearned income, at December 31, 2002.

 

Credit and loan decisions are made by management andthe Board of Directors of the Company in conformity with loan policiesestablished by the Board of Directors of the Company. The Company’s practice isto charge off any loan or portion of a loan when it is determined by managementto be uncollectible 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 $485,000 and $669,000in loans during the second quarter and first six months of 2003, respectively.Recoveries during the second quarter and first six months of 2003 were $243,000and $491,000, respectively.

 

The following table presents the provisions for loanlosses, loans charged off and recoveries on loans previously charged off, theamount of the allowance, the average loans outstanding and certain pertinentratios for the quarters and six-month periods ended June 30, 2003 and 2002.

 
|                                                                                                          |   | **Quarter  Ended June 30,** |    | **Six Month  Period Ended  June 30,** |   |
|---------------------------------------------------------------------------------------------------------------|--------|-----------------------------|---------|---------------------------------------|--------|
|                                                                                                          |   | **2003**                    |    | **2002**                              |   | **2003** |   | **2002** |   |
|                                                                                                          |   | **(Dollars  in thousands)** |    |
| Analysis of allowance for loan losses:                                                                        |   |                        |    |                                  |   |   |   |   |   |
| Balance, beginning of period                                                                                  |   | $                           | 11,096  |                                  | $      | 11,877 |   | $ | 10,914 |   | $ | 10,756 |   |
| Provision for loan losses                                                                                     |   | —                      |    | 285                                   |   | 118 |   | 740 |   |
|                                                                                                          |   | 11,096                      |    | 12,162                                |   | 11,032 |   | 11,496 |   |
| Loans charged off:                                                                                            |   |                        |    |                                  |   |   |   |   |   |
| Real estate loans                                                                                             |   | 130                         |    | 15                                    |   | 165 |   | 39 |   |
| Commercial loans                                                                                              |   | 249                         |    | 718                                   |   | 253 |   | 818 |   |
| Loans to individuals                                                                                          |   | 106                         |    | 208                                   |   | 226 |   | 499 |   |
| Agriculture other loans                                                                                       |   | —                      |    | —                                |   | 25 |   | — |   |
| Total charge-offs                                                                                             |   | 485                         |    | 941                                   |   | 669 |   | 1,356 |   |
| Recoveries of loans previously charged off:                                                                   |   |                        |    |                                  |   |   |   |   |   |
| Real estate loans                                                                                             |   | 152                         |    | 5                                     |   | 152 |   | 19 |   |
| Commercial loans                                                                                              |   | 37                          |    | 169                                   |   | 234 |   | 1,089 |   |
| Loans to individuals                                                                                          |   | 54                          |    | 77                                    |   | 105 |   | 173 |   |
| Agriculture and other loans                                                                                   |   | —                      |    | 20                                    |   | — |   | 71 |   |
| Total recoveries                                                                                              |   | 243                         |    | 271                                   |   | 491 |   | 1,352 |   |
| Net loans charged off (recovered)                                                                             |   | 242                         |    | 670                                   |   | 178 |   | 4 |   |
|                                                                                                          |   |                        |    |                                  |   |   |   |   |   |
| Balance, at June 30                                                                                           |   | $                           | 10,854  |                                  | $      | 11,492 |   | $ | 10,854 |   | $ | 11,492 |   |
|                                                                                                          |   |                        |    |                                  |   |   |   |   |   |
| Average loans outstanding, net of unearned income                                                             |   | $                           | 669,899 |                                  | $      | 624,248 |   | $ | 664,145 |   | $ | 624,623 |   |
| Ratio of nonperforming loans to total loans, net of unearned income,  at end of period                        |   | 1.05                        | %       | 1.71                                  | %      | 1.05 | % | 1.71 | % |
| Ratio of net loan charge-offs (recoveries) to average loans  outstanding, net of unearned income (annualized) |   | 0.04                        | %       | 0.11                                  | %      | 0.03 | % | 0.00 | % |
| Ratio of allowance for loan losses to nonperforming loans, at end of  period                                  |   | 150.96                      | %       | 106.76                                | %      | 150.96 | % | 106.76 | % |
| Ratio of allowance for loan losses to total loans, net of unearned  income, at end of period                  |   | 1.58                        | %       | 1.82                                  | %      | 1.58 | % | 1.82 | % |

 

19

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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 June 30, 2003 and December 31, 2002, loansidentified as being impaired consisted of loans placed on non-accrual status.

 

At June 30, 2003 and December 31, 2002, the recordedinvestment in loans that are considered to be impaired under FAS 114 wasapproximately $7,190,000 and $8,529,000, respectively.  Included in this amount at June 30, 2003 andDecember 31, 2002, was approximately $7,036,000 and $8,389,000, respectively,of impaired loans for which the related specific reserve for loan losses wasapproximately $1,577,000 and $1,867,000, respectively.  Impaired loans of $154,000 and $140,000 atJune 30, 2003 and December 31, 2002, respectively, did not have a specificreserve for loan losses.

 

The following table shows the allocations in theallowance and the respective percentages of each loan category to total loansat June 30, 2003, and December 31, 2002.

 
|                                     |   | **June 30,  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                        |   | $                                                | 1,822  |                                                                   | 44.6   | % | $ | 1,937 |   | 58.8 | % |
| Commercial loans                         |   | 1,234                                            |   | 30.2                                                                   |   | 1,566 |   | 28.1 |   |
| Loans to individuals                     |   | 512                                              |   | 12.5                                                                   |   | 778 |   | 6.6 |   |
| Agriculture and other loans              |   | 520                                              |   | 12.7                                                                   |   | 263 |   | 6.5 |   |
| Total allocated                          |   | 4,088                                            |   | 100.0                                                                  | %      | 4,544 |   | 100.0 | % |
| Unallocated                              |   | 6,766                                            |   |                                                                   |   | 6,370 |   |   |   |
| Total allowance for possible loan losses |   | $                                                | 10,854 |                                                                   |   |   | $ | 10,914 |   |   |   |

 

*Loan Review Process*

 

The Company follows a loan review program toevaluate the credit risk in its loan portfolio. Through the loan reviewprocess, the Bank maintains an internally classified loan list that, along withthe list of nonperforming loans discussed below, helps management assess theoverall quality 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 include some loans that are past due atleast 90 days, are on nonaccrual status or have been restructured. Loansclassified as “loss” are those loans that are usually in the process of beingcharged off. There were no loans designated as loss at June 30, 2003.

 

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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 June 30, 2003 were current and paying in accordancewith loan terms. See “Nonperforming Assets” below.

 

*Nonperforming Assets*

 

Nonperformingloans consist of nonaccrual, past due and restructured loans. A past due loanis an accruing loan that is contractually past due 90 days or more as toprincipal or interest payments. Loans on which management does not expect tocollect interest in the normal course of business are placed on nonaccrual orare restructured. When a loan is placed on nonaccrual status, any interestpreviously accrued but not yet collected is reversed against current incomeunless, in the opinion of management, the outstanding interest remainscollectible. Thereafter, interest is included in income only to the extent ofcash received. A loan is restored to accrual status when all interest andprincipal payments are current and the borrower has demonstrated to managementthe ability to make payments of principal and interest as scheduled.

 

A “troubled debt restructuring” is a restructuredloan upon 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 theCompany acquiring other real estate and other repossessed assets. Accordingly,the Company incurs other expenses, specifically net costs applicable to otherreal estate and other repossessed assets, in maintaining, insuring and sellingsuch assets. 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 listsnonaccrual, past due and restructured loans and other real estate and otherrepossessed assets at June 30, 2003, and December 31, 2002.

 
|                                               |   | **June 30,  2003**  |   | **December  31,  2002** |   |
|----------------------------------------------------|--------|---------------------|--------|-------------------------|--------|
|                                               |   | **(In  thousands)** |   |
|                                               |   |                |   |                    |   |
| Nonaccrual loans                                   |   | $                   | 7,190  |                    | $      | 8,529 |   |
| Accruing loans contractually past due over 90 days |   | 363                 |   | 151                     |   |
| Restructured loans                                 |   | 1,099               |   | 848                     |   |
| Other real estate and other repossessed assets     |   | 4,096               |   | 3,703                   |   |
|                                               |   |                |   |                    |   |
| Total nonperforming assets                         |   | $                   | 12,748 |                    | $      | 13,231 |   |

 

The gross interest income that would have been recordedduring the second quarter and first six months 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 $139,000 and $301,000, respectively.  Interest income totaling $10,000 wasrecorded (received) on loans that were on nonaccrual during the six monthperiod ended June 30, 2003.

 

A potential problem loan is defined as a loan whereinformation about possible credit problems of the borrower is known, causingmanagement to have serious doubts as to the ability of the borrower to complywith the present loan

 

21

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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 potential problem loansother than those reported in the previous table or those included on the watchlist as discussed above.

 

*Intangible Assets*

 

Intangible assets decreased $1,389,000, or 2.6%,from $54,261,000 at December 31, 2002, to $52,872,000 at June 30, 2003. Thisdecrease was primarily due to core deposit intangible amortization expenserecorded during the first six months of 2003.

 

Amortizableintangibles assets at June 30, 2003 and December 31, 2002:

 
|                                  |   | **June 30,  2003**  |   | **December  31,  2002** |   |
|---------------------------------------|--------|---------------------|--------|-------------------------|--------|
|                                  |   | **(in  thousands)** |   |
| Core deposit intangible               |   | $                   | 28,246 |                    | $      | 28,342 |   |
| Less:  Accumulated  amortization |   | 13,308              |   | 12,015                  |   |
|                                  |   |                |   |                    |   |
| Amortizable intangible assets         |   | $                   | 14,938 |                    | $      | 16,327 |   |
|                                       |        |                     |        |                         |        |  |  |  |

 

Coredeposit intangible amortization expense was $1,346,000 for the six month periodended June 30, 2003.

 

Aggregateamortization expense is anticipated to be as follows for the years endedDecember 31 (in thousands):

 
| Remaining  in 2003    |   | $     | 1,332  |   |
|-----------------------|--------|-------|--------|--------|
| 2004                  |   | 2,514 |   |
| 2005                  |   | 2,469 |   |
| 2006                  |   | 2,421 |   |
| 2007 & Thereafter |   | 6,202 |   |
| Total                 |   | $     | 14,938 |   |

 

Thechange in the carrying amount of goodwill for the quarter ended June 30, 2003is as follows (in thousands):

 
| Balance as of January 1, 2003       |   | $      | 37,934 |   |
|-------------------------------------|--------|--------|--------|--------|
| Reductions or increases to Goodwill |   | — |   |
| Balance as of June 30, 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 $1,599,000, or6.4%, during the first six months of 2003, from $24,944,000 at December 31,2003, to $26,543,000 at June 30, 2003. The increase was primarily due to thepurchase of the building in Lubbock which houses the Bank’s operations as wellas the upgrade of the Company’s computer system.  These additions were partially offset by depreciation recordedduring the first quarter of 2003 of $1,547,000.

 

*Accrued Interest Receivable*

 

Accrued interest receivable consists of interestthat has accrued on securities and loans, but is not yet payable under theterms of the related agreements. The balance of accrued interest receivabledecreased $969,000, or 13.8%, from $7,044,000 at December 31, 2002, to$6,075,000 at June 30, 2003. The decrease was primarily a result of the

 

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seasonal paydown of interest onloans.  Of the total balance at June 30,2003, $3,437,000, or 56.6%, was interest accrued on loans and $2,638,000, or43.4%, was interest accrued on securities. The amounts of accrued interestreceivable and percentages attributable to loans and securities at December 31,2002, were $3,934,000, or 55.9%, and $3,110,000, or 44.1%, respectively.

 

*Other Real Estate and Other Repossessed Assets*

 

Other real estate and other repossessed assetsconsist of real property and other assets unrelated to banking premises orfacilities. Income derived from other real estate and other repossessed assets,if any, is generally less than that which would have been earned as interest atthe original contract rates on the related loans. At June 30, 2003, andDecember 31, 2002, other real estate and other repossessed assets had anaggregate book value of $4,096,000 and $3,703,000, respectively. Other realestate and other repossessed assets increased $393,000, or 10.6%, during thefirst six months of 2003.  Of the June30, 2003 balance, $3,422,000 represents thirteen commercial and agriculturalproperties, $656,000 represents five residential properties, and $18,000represents nine repossessed vehicles and other equipment.

 

*Other Assets*

 

The balance of other assets decreased $208,000, or0.7%, from $29,251,000 at December 31, 2002 to $29,043,000 at June 30, 2003.

 

*Deposits*

 

The Company’s lending and investing activities arefunded almost entirely by core deposits, 65.1% of which are demand, savings andmoney market deposits at June 30, 2003. Total deposits decreased $10,964,000,or 1.1%, from $964,714,000 at December 31, 2002, to $953,750,000 at June 30,2003. The reduction in the deposit balance was primarily due to decreases ininterest rates paid on time deposit accounts causing a lower demand for theseaccounts. The reduction was one which management planned, specifically in aneffort to realign the deposit mix.  TheCompany does not have any brokered deposits.

 

The following table presents the average amounts of,and the average rates paid on, deposits of the Company for the quarters and sixmonth periods ended June 30, 2003 and 2002.

 
|                                                       |   | **Quarter  Ended June 30,** |    | **Six Month  Period Ended June 30,** |   |
|------------------------------------------------------------|--------|-----------------------------|---------|--------------------------------------|--------|
|                                                       |   | **2003**                    |    | **2002**                             |   | **2003** |   | **2002** |   |
|                                                       |   | **Average  Amount**         |    | **Average  Rate**                    |   | **Average  Amount** |   | **Average  Rate** |   | **Average  Amount** |   | **Average  Rate** |   | **Average  Amount** |   | **Average  Rate** |   |
|                                                       |   | **(Dollars  in thousands)** |    | **(Dollars  in thousands)**          |   |
| Noninterest-bearing demand deposits                        |   | $                           | 249,678 |                                 | — | % | $ | 215,194 |   | — | % | $ | 241,837 |   | — | % | $ | 216,992 |   | — | % |
| Interest-bearing demand, savings and money market deposits |   | 344,389                     |    | 0.48                                 | %      | 350,924 |   | 0.77 | % | 346,470 |   | 0.48 | % | 352,725 |   | 0.80 | % |
| Time deposits of less than $100,000                        |   | 200,100                     |    | 2.00                                 | %      | 250,552 |   | 3.02 | % | 206,699 |   | 2.13 | % | 253,192 |   | 3.22 | % |
| Time deposits of $100,000 or more                          |   | 138,794                     |    | 2.15                                 | %      | 144,858 |   | 3.15 | % | 144,032 |   | 2.26 | % | 150,911 |   | 3.35 | % |
|                                                       |   |                        |    |                                 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total deposits                                             |   | $                           | 932,961 |                                 | 0.93   | % | $ | 961,528 |   | 1.54 | % | $ | 939,038 |   | 0.99 | % | $ | 973,820 |   | 1.65 | % |

 

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The maturity distribution oftime deposits of $100,000 or more at June 30, 2003 is presented below.

 
|                                    |   | **At June  30, 2003** |    |
|-----------------------------------------|--------|-----------------------|---------|
|                                    |   | **(In thousands)**    |    |
| 3 months or less                        |   | $                     | 45,424  |   |
| Over 3 through 6 months                 |   | 27,148                |    |
| Over 6 through 12 months                |   | 34,167                |    |
| Over 12 months                          |   | 30,210                |    |
|                                    |   |                  |    |
| Total time deposits of $100,000 or more |   | $                     | 136,949 |   |

 

Time deposits of $100,000 or more are a morevolatile and costly source of funds than other deposits and are most likely toaffect the Company’s future earnings because of interest rate sensitivity. AtJune 30, 2003, and December 31, 2002, deposits of $100,000 or more representedapproximately 14.4% and 16.1%, respectively, of the Company’s total assets.

 

*Fed Funds Purchased and Securities Sold Under Agreement to Repurchase*

 

The balance of fed funds purchased and securitiessold under agreement to repurchase increased $2,248,000, or 10.8%, from$20,762,000 at December 31, 2002 to $23,010,000 at June 30, 2003.

 

*Accrued Interest Payable*

 

Accrued interest payable consists of interest thathas accrued on deposits, but is not yet payable under the terms of the relatedagreements. The balance of accrued interest payable decreased $240,000, or23.8%, from $1,009,000 at December 31, 2002, to $769,000 at June 30, 2003, dueto a decrease in interest-bearing deposit balances as well as decreases ininterest rates being paid on interest-bearing time deposits during the first sixmonths of 2003.

 

*Notes Payable*

 

The note payable balance consists of advances ofapproximately $1,068,000 and $789,000, at June 30, 2003 and December 31, 2002,respectively, from the Federal Home Loan Bank of Dallas (the “FHLB”).  These advances represent seven separatenotes with interest rates ranging from 2.65% to 5.45%, maturities ranging fromJanuary 2008 to February 2018, and are collateralized by a blanket floatinglien on all securities held in safekeeping by the FHLB, the FHLB capital stockowned 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 decreased$13,000 or 0.1.%, from $9,525,000 at December 31, 2002, to $9,512,000 at June30, 2003.

 

*Guaranteed Preferred Beneficial Interests in theCompany’s Subordinated Debentures*

 

Independent Capital sold 1,300,000 shares of TrustPreferred Securities at $10.00 per preferred security in an underwrittenoffering in 1998.  The proceeds from thesale of the Trust Preferred Securities were used by Independent Capital topurchase an equivalent amount of Subordinated Debentures of the Company.  The Trust Preferred Securities carry adistribution rate of 8.5%, have a stated maturity of September 22, 2028, andare guaranteed by State National.  Thesecurities are redeemable at par on or after September 22, 2003.

 

State National recently issued $15,000,000 in TrustPreferred Securities with the intent of using a portion of the net proceeds toredeem Independent Capital’s Trust Preferred Securities on September 22, 2003(the “Redemption Date”).  IndependentCapital will redeem all of its 8.5% Cumulative Trust Preferred Securities andits 8.5% Common Securities at a redemption price equal to the $10.00liquidation amount of each security plus all accrued and unpaid interest persecurity up to the Redemption Date.  TheBank of New York, property trustee of the Trust Preferred Securities, willnotify the holders of the Trust Preferred Securities.

 

24

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*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-earning assets and interest-bearing liabilitiesto determine the difference between the two in specific time frames. Thisdifference is known as the rate-sensitivity gap. A company is considered to beasset sensitive, or having a positive gap, when the amount of interestearning-assets maturing or repricing within a given period exceeds the amountof its interest-bearing liabilities also maturing or repricing within that timeperiod.  Conversely, a company isconsidered to be liability sensitive, or having a negative gap, when the amountof its interest-bearing liabilities maturing or repricing within a given timeperiod exceeds the amount of its interest-earning assets also maturing orrepricing within that time period. During a period of rising interest rates, a negative gap would tend toaffect net income adversely, while a positive gap would tend to result in anincrease in net interest income.  Duringa period of falling interest rates, a negative gap would tend to result in anincrease in net interest income, while a positive gap would tend to affect netinterest income adversely.  Maintaininga balanced 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 table, are 87.4% atthe 90-day interval, 86.5% at the 180-day interval and 93.2% at the 365-dayinterval at June 30, 2003. Currently, the Company is in a liability-sensitiveposition at the three intervals. However, the Company had $342,050,000 ofinterest-bearing demand, savings and money market deposits at June 30, 2003, onwhich, from the Company’s experience, interest rates change more slowly.Therefore, excluding these types of deposits, the Company’s interest-sensitiveassets to interest-sensitive liabilities ratio at the 365-day interval wouldhave been 193.9% at June 30, 2003. The interest sensitivity position ispresented as of a point in time and can be modified to some extent bymanagement as changing conditions dictate.

 

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The following table showsthe interest rate sensitivity position of the Company at June 30, 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                            |   | $                                                    | 15,225  |                                      | $      | 15,225       |   | $ | 15,225 |   | $ | — |   | $ | 15,225 |   |
| Securities                                    |   | 39,528                                               |    | 60,333                                    |   | 104,554      |   | 133,688 |   | 238,242 |   |
| Loans, net of unearned income                 |   | 360,038                                              |    | 390,927                                   |   | 461,558      |   | 225,793 |   | 687,351 |   |
| Total interest-earning assets                 |   | 414,791                                              |    | 466,485                                   |   | 581,337      |   | 359,481 |   | 940,818 |   |
|                                          |   |                                                 |    |                                      |   |         |   |   |   |   |   |
| Interest-bearing liabilities:                 |   |                                                 |    |                                      |   |         |   |   |   |   |   |
| Demand, savings and money market deposits     |   | 342,050                                              |    | 342,050                                   |   | 342,050      |   | — |   | 342,050 |   |
| Securities Sold Under Agreement to Repurchase |   | 23,010                                               |    | 23,010                                    |   | 23,010       |   | — |   | 23,010 |   |
| Time deposits                                 |   | 109,381                                              |    | 174,108                                   |   | 258,474      |   | 74,559 |   | 333,033 |   |
| Total interest-bearing liabilities            |   | 474,441                                              |    | 539,168                                   |   | 623,534      |   | 74,559 |   | 698,093 |   |
|                                          |   |                                                 |    |                                      |   |         |   |   |   |   |   |
| Rate-sensitivity gap (1)                      |   | $                                                    | (59,650 | )                                         | $      | (72,683      | )      | $ | (42,197 | ) | $ | 284,922 |   | $ | 242,725 |   |
|                                          |   |                                                 |    |                                      |   |         |   |   |   |   |   |
| Rate-sensitivity ratio (2)                    |   | 87.4                                                 | %       | 86.5                                      | %      | 93.2         | %      |   |   |   |   |

 

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

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

 

26

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*Selected Financial Ratios*

 

The following table presents selected financialratios (annualized) for the quarters and six month periods ended June 30, 2003and 2002.

 
|                                                                                 |   | **Quarter  Ended  June 30,** |   | **Six Month  Period  Ended June 30,** |   |
|--------------------------------------------------------------------------------------|--------|------------------------------|--------|---------------------------------------|--------|
|                                                                                 |   | **2003**                     |   | **2002**                              |   | **2003** |   | **2002** |   |
| Income (loss) Before Cumulative Effect of a Change in Accounting  Principle to: |   |                         |   |                                  |   |   |   |   |   |
| Average assets                                                                       |   | 1.24                         | %      | 1.00                                  | %      | 1.02 | % | 0.91 | % |
| Average interest-earning assets                                                      |   | 1.45                         |   | 1.17                                  |   | 1.20 |   | 1.07 |   |
| Average stockholder’s equity                                                    |   | 10.38                        |   | 8.50                                  |   | 8.65 |   | 7.38 |   |
| Net income (loss) to:                                                                |   |                         |   |                                  |   |   |   |   |   |
| Average assets                                                                       |   | 1.24                         |   | 1.00                                  |   | 1.02 |   | (1.74 | ) |
| Average interest-earning assets                                                      |   | 1.45                         |   | 1.17                                  |   | 1.20 |   | (2.06 | ) |
| Average stockholder’s equity                                                    |   | 10.38                        |   | 8.50                                  |   | 8.65 |   | (14.20 | ) |
| Dividend payout (1) to:                                                              |   |                         |   |                                  |   |   |   |   |   |
| Net income                                                                           |   | 72.36                        |   | 8.63                                  |   | 87.55 |   | (9.72 | ) |
| Average stockholder’s equity                                                    |   | 7.51                         |   | 0.73                                  |   | 7.57 |   | 1.38 |   |
| Average stockholder’s equity to:                                                |   |                         |   |                                  |   |   |   |   |   |
| Average total assets                                                                 |   | 11.95                        |   | 11.74                                 |   | 11.82 |   | 12.26 |   |
| Average loans (2)                                                                    |   | 19.87                        |   | 21.84                                 |   | 19.89 |   | 23.21 |   |
| Average total deposits                                                               |   | 14.27                        |   | 14.18                                 |   | 14.07 |   | 14.89 |   |
| Average interest-earning assets to:                                                  |   |                         |   |                                  |   |   |   |   |   |
| Average total assets                                                                 |   | 85.26                        |   | 85.44                                 |   | 85.26 |   | 84.72 |   |
| Average total deposits                                                               |   | 101.85                       |   | 103.20                                |   | 101.53 |   | 102.89 |   |
| Average total liabilities                                                            |   | 97.92                        |   | 97.85                                 |   | 97.77 |   | 97.58 |   |
| Ratio to total average deposits of:                                                  |   |                         |   |                                  |   |   |   |   |   |
| Average loans (2)                                                                    |   | 71.80                        |   | 64.92                                 |   | 70.73 |   | 64.14 |   |
| Average noninterest bearing deposits                                                 |   | 26.76                        |   | 22.38                                 |   | 25.75 |   | 22.28 |   |
| Average interest-bearing deposits                                                    |   | 73.24                        |   | 77.62                                 |   | 74.25 |   | 77.72 |   |
| Total interest expense to total interest income                                      |   | 15.46                        |   | 24.01                                 |   | 16.58 |   | 25.24 |   |
| Efficiency Ratio (3)                                                                 |   | 61.60                        |   | 64.64                                 |   | 66.01 |   | 65.15 |   |

 

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(1)          Dividends on Common Stock only.

(2)          Before allowance for possible loan losses.

(3)          Calculated as noninterest expense less distributions on guaranteedpreferred beneficial interests in the Company’s subordinated debentures,amortization of intangibles and expenses related to other real estate and otherrepossessed assets 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 to maintain funds on hand arises principally frommaturities of short-term borrowings, deposit withdrawals, customers’ borrowingneeds and the maintenance of reserve requirements.  Liquidity with respect to a financial institution can be met fromeither assets or liabilities.  On theasset side, the primary sources of liquidity are cash and due from banks,federal funds sold, maturities of securities and scheduled repayments andmaturities of loans.  The Bank maintainsadequate levels of cash and near-cash investments to meet its day-to-dayneeds.  Cash and due from banks averaged$45,697,000 and $45,888,000 during the second quarter and first six months of2003, respectively, and $56,510,000 and $57,213,000 during the second quarterand first six months of 2002, respectively. These amounts comprised 4.1% of average total assets during the secondquarter and first six months of 2003, respectively, and 4.9% and 4.8% ofaverage total assets during the second quarter and first six months of 2002,respectively.

 

27

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The average level of securities, interest-earningtime deposits in other banks and federal funds sold was $280,338,000 and$289,295,000 during the second quarter and first six months of 2003,respectively, and $368,056,000 and $377,303,000 during the second quarter andfirst six months of 2002, respectively.

 

There were no securities sold during the quarter andthe six month period ended June 30, 2003. A total of $536,000 and $6,868,000 of securities classified asavailable-for-sale were sold during the six month period ended June 30, 2003and June 30, 2002, respectively.  AtJune 30, 2003, $64,111,000, or 41.5%, of the Company’s securities portfolio,excluding mortgage-backed securities, matured within one year, and $81,525,000,or 52.7%, excluding mortgage-backed securities, matured after one but withinfive years. The Bank’s commercial and real estate lending activities areconcentrated in loans with maturities of less than five years with both fixedand adjustable interest rates, while its installment lending activities areconcentrated in loans with maturities of three to five years and with primarilyfixed interest rates.  At June 30, 2003,approximately $461,558,000, or 67.2%, of the Company’s loans, net of unearnedincome, matured within one year and/or had adjustable interest rates.Approximately $446,360,000, or 68.8%, 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 second quarter and first six months of 2003, the Company’s averagedeposits were $932,961,000 and $939,038,000, or 83.7% and 84.0%, of averagetotal assets, respectively, compared to $961,528,000 and $973,820,000, or 82.8%and 82.3% of average total assets, respectively, during the second quarter andfirst six months of 2002. The Company attracts its deposits primarily fromindividuals and businesses located within its market areas. See “Analysis ofFinancial 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’s Trust Preferred Securities and to coverother operating expenses. The Company’s immediate liquidity needs have been andcan continue to be satisfied by advances from the Company’s parent company.

 

The payment of dividends to the Company is subjectto applicable law and the scrutiny of regulatory authorities.  Cash paid by the Bank to IndependentFinancial during the second quarter and first six months of 2003 was$10,000,000 by means of a capital reduction at the Bank.  As discussed below, there are dividendrestrictions placed on the Bank by regulatory authorities.  However, due to the fact that the impairmentof goodwill is excluded from regulatory capital calculations, the Bank hadadequate regulatory capital.  Managementand the Board of Directors determined that it was in the best interest of theBank, the Company and State National to have a capital reduction at the Bankand contribute those funds to the Company which in turn contributed most of thefunds to State National in the form of a dividend to be used to fund possiblefuture acquisitions and provide for general corporate liquidity needs.  As such, during the second quarter and firstsix months of 2003, Independent Financial and Independent Capital paiddividends to the Company totaling $10,009,000 and $10,017,000,respectively.  There were no dividendspaid by the Bank to Independent Financial during the second quarter and firstsix months of 2002, respectively.  SNBEl Paso paid dividend of $1,000,000 and $2,000,000 to State National prior tothe Merger in the second quarter and first six months of 2002,respectively.  Independent Financial andIndependent Capital paid dividends to the Company of $9,000 and $17,000,respectively, during the same time periods. At June 30, 2003, there were nodividends available for payment to Independent Financial by the Bank withoutfirst obtaining regulatory approval.

 

Current tax liabilities totaling $2,004,000 and$3,252,000 were paid by the Bank to the Company during the second quarter andthe six month period ended June 30, 2003, respectively and current taxliabilities totaling $1,654,000   and$2,902,000 were paid by the Bank to the Company during the corresponding timeperiod for 2002.

 

**Capital Resources**

 

At June 30, 2003, stockholders’ equity totaled$124,853,000, or 11.1% of total assets, compared to $129,990,000, or 11.4% oftotal assets, at December 31, 2002.

 

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Bank regulatory authorities in the United Stateshave risk-based capital standards by which all bank holding companies and banksare evaluated in terms of capital adequacy. These guidelines relate a bankingcompany’s capital to the risk profile of its assets. The risk-based capitalstandards require all banking companies to have Tier 1 capital of at least 4%and total capital (Tier 1 and Tier 2 capital) of at least 8% of risk-weightedassets, and to be designated as well-capitalized, the banking company must haveTier 1 and total capital ratios of at least 6% and 10%, respectively. For theCompany, Tier 1 capital includes common stockholders’ equity (net of availablefor sale fair value adjustment) and qualifying guaranteed preferred beneficial interestsin the Company’s subordinated debentures, reduced by intangible assets net ofthe deferred tax liability associated with the core deposit intangible, and anydeferred tax asset disallowed for regulatory capital purposes. For the Company,Tier 2 capital is comprised of the remainder of the guaranteed preferredbeneficial interests in the Company’s subordinated debentures not qualifyingfor Tier 1 capital and the qualifying amount of the allowance for loan losses.

 

Banking regulators also have leverage ratiorequirements. The leverage ratio requirement is measured as the ratio of Tier 1capital to adjusted quarterly average assets. The leverage ratio standardsrequire all banking companies to have a minimum leverage ratio of at least 4%and to be designated as well-capitalized, the banking company must have aleverage ratio of at least 5%. The following table provides a calculation ofthe Company’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 June 30, 2003.

 
|                              |   | **June 30,  2003**  |      |
|-----------------------------------|--------|---------------------|-----------|
|                              |   | **(In  thousands)** |      |
|                              |   |                |      |
| Tier 1 capital                    |   | $                   | 82,030    |   |
| Tier 2 capital                    |   | 9,114               |      |
|                              |   |                |      |
| Total capital                     |   | $                   | 91,144    |   |
|                              |   |                |      |
| Net risk-weighted assets          |   | $                   | 727,373   |   |
|                              |   |                |      |
| Adjusted quarterly average assets |   | $                   | 1,061,111 |   |

 
|                                             |   | **Regulatory  Minimum** |   | **“Well  Capitalized”  Minimum** |   | **Actual  Ratios at  June 30, 2003** |   |
|--------------------------------------------------|--------|-------------------------|--------|--------------------------------------------|--------|--------------------------------------|--------|
|                                             |   |                    |   |                                       |   |                                 |   |
| The Company                                      |   |                    |   |                                       |   |                                 |   |
|                                             |   |                    |   |                                       |   |                                 |   |
| Tier 1 capital to net risk-weighted assets ratio |   | 4.00                    | %      | 6.00                                       | %      | 11.28                                | %      |
| Total capital to net risk-weighted assets ratio  |   | 8.00                    |   | 10.00                                      |   | 12.53                                |   |
| Leverage ratio                                   |   | 4.00                    |   | 5.00                                       |   | 7.73                                 |   |
|                                             |   |                    |   |                                       |   |                                 |   |
| The Bank                                         |   |                    |   |                                       |   |                                 |   |
|                                             |   |                    |   |                                       |   |                                 |   |
| Tier 1 capital to net risk-weighted assets ratio |   | 4.00                    | %      | 6.00                                       | %      | 11.31                                | %      |
| Total capital to net risk-weighted assets ratio  |   | 8.00                    |   | 10.00                                      |   | 12.56                                |   |
| Leverage ratio                                   |   | 4.00                    |   | 5.00                                       |   | 7.79                                 |   |

 

The Federal Deposit Insurance CorporationImprovement Act of 1991 (“FDICIA”) requires each federal banking agency torevise its risk-based capital standards to ensure that those standards takeadequate account of interest rate risk, concentration of credit risk and therisks of non-traditional activities, as well as reflect the actual performanceand expected risk of loss on multi-family mortgages. This law also requireseach federal banking agency to specify the levels at which an insuredinstitution would be considered “well capitalized,” “adequately capitalized,”“undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.”Under the FDIC’s regulations, the Company and the Bank were both “wellcapitalized” at June 30, 2003.

 

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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.

 

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 has promulgated apolicy prohibiting bank holding companies from paying dividends on common stockunless such bank holding company can pay such dividends from current earnings.

 

**Item 3.    Quantitativeand Qualitative Disclosures About Market Risk**

 

Therehas been no material change in the Company’s market risk profile from theinformation disclosed in the Company’s Form 10-K for the year ended December31, 2002.

 

**Item 4. Controls and Procedures**

 

Basedon the evaluation of the Company’s disclosure controls and procedures as of adate within 90 days prior to the filing date of this report, each of Tom C.Nichols, the Company’s Chairman, President and Chief Executive Officer, and DonE. Cosby, the Company’s Executive Vice President, Chief Financial Officer andSecretary, have concluded that, in their judgment, the Company’s disclosurecontrols and procedures are effective to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to such officers by others within the Company or its subsidiaries.

 

There were no significant changes in the Company’sinternal controls or in other factors that could significantly affect thesecontrols subsequent to the date of their evaluation, including any correctiveactions with regard to significant deficiencies and material weaknesses.

 

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PART II

 

OTHER INFORMATION

 

Item1.    Legal Proceedings.

 

From time to time, the Company is a party inlitigation proceedings incidental to the normal course of its business. In theopinion of management, the ultimate liability, if any, resulting from known,current litigation, either singularly or in the aggregate, would not reasonablybe expected to have a material adverse effect on the Company’s financialposition, results of operations, or cash flows.

 

Item2.    Changes in Securities.

 

None

 

Item3.    Defaults upon Senior Securities.

 

None

 

Item4.    Submission of Matters to a Vote ofSecurity Holders

 

None

 

Item5.    Other Information.

 

None

 

Item6.    Exhibits and Reports on Form 8-K.

 

(a)                                  Exhibits

 

Exhibit 31.1 Certification of the Chief ExecutiveOfficer

 

Exhibit 31.2 Certification of the Chief FinancialOfficer

 

Exhibit 32.1 Chief Executive Officer and ChiefFinancial Officer Certification

 

(b)                                 Reports on Form 8-K

 

None

 

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SIGNATURE

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 

 
| Date:  August 8, 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) |

 

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