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ARROW FINANCIAL CORPORATION

FORM 10-Q

September 30, 2003

INDEX

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ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Dollars in Thousands)(Unaudited)

See Notes to Unaudited Consolidated Interim Financial Statements.

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ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(In Thousands, Except Per Share Amounts)(Unaudited)

Share and Per Share amounts have been restated for the September 2003 five for four stock split.

See Notes to Unaudited Consolidated Interim Financial Statements.

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ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(In Thousands, Except Share and Per Share Amounts) (Unaudited)

Share and Per Share amounts have been restated for the September 2003 five for four stock split.

See Notes to Unaudited Consolidated Interim Financial Statements.

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ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY, Continued

(In Thousands, Except Share and Per Share Amounts) (Unaudited)

Share and Per Share amounts have been restated for the September 2003 five for four stock split.

See Notes to Unaudited Consolidated Interim Financial Statements.

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ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in Thousands)(Unaudited)

See Notes to Unaudited Consolidated Interim Financial Statements.

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ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED INTERIM FINANCIAL STATEMENTS

FORM 10-Q

September 30, 2003

1.   Financial Statement Presentation   

In the opinion of the management of Arrow Financial Corporation (the "Company"), the accompanying unaudited consolidated interim financial statements contain all of the adjustments necessary to present fairly the financial position as of September 30, 2003 and December 31, 2002; the results of operations for the three and nine month periods ended September 30, 2003 and 2002; the changes in shareholders’ equity for the nine month periods ended September 30, 2003 and 2002; and the cash flows for the nine month periods ended September 30, 2003 and 2002.  All such adjustments are of a normal recurring nature.  The unaudited consolidated interim financial statements should be read in conjunction with the annual consolidated financial statements of the Company for the year ended December 31, 2002, included in the Company’s 2002 Form 10-K.

2.   Accumulated Other Comprehensive Income (In Thousands)

The following table presents the components, net of tax, of accumulated other comprehensive income as of September 30, 2003 and December 31, 2002:

3.   Earnings Per Common Share (In Thousands, Except Per Share Amounts)

The following table presents a reconciliation of the numerator and denominator used in the calculation of basic and diluted earnings per common share (EPS) for the three and nine-month periods ended September 30, 2003 and 2002:

Share and Per Share amounts have been restated for the September 2003 five for four stock split.

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3.   Earnings Per Common Share (In Thousands, Except Per Share Amounts), Continued

Share and Per Share amounts have been restated for the September 2003 five for four stock split.

4.   Goodwill and Other Intangible Assets (In Thousands)

The Company adopted SFAS No. 147, "Acquisitions of Certain Financial Institutions," during the quarter ended September 30, 2002.  SFAS No. 147 affects the accounting for an unidentifiable intangible asset acquired in the acquisition of a bank or thrift (including acquisitions of branches), where the fair value of the liabilities assumed and other consideration paid to the seller exceeded the fair value of the assets acquired.  Under SFAS No. 147, if such a transaction met the criteria for a business combination, the carrying amount of the unidentifiable intangible asset is reclassified to goodwill (reclassified goodwill) as of the date SFAS No. 142 was applied in its entirety, which for the Company was January 1, 2002.  The carrying amounts of any recognized intangible assets that meet the recognition criteria of SFAS No. 141 that have been included in the amount reported as an unidentifiable intangible asset, and for which separ ate accounting records have been maintained, should be accounted for apart from the unidentifiable intangible asset and should not be reclassified to goodwill as of such date.  The reclassified goodwill should be accounted for and reported prospectively as goodwill under SFAS No. 142, for which amortization is not required, but which must be evaluated annually for impairment.  Prior to the adoption of SFAS No. 147, effective retroactive to January 1, 2002, the Company's unidentifiable intangible asset was being amortized over 15 years on a straight-line basis.  

Management concluded that the acquisition of branches that gave rise to the unidentifiable intangible asset was a business combination under SFAS No. 147, and therefore ceased amortizing the reclassified goodwill retroactive to January 1, 2002.  The carrying amount of the unidentifiable intangible asset related to the branch acquisitions and reclassified as goodwill was $9,297 as of January 1, 2002.

The carrying amounts of recognized intangible assets that meet the recognition criteria of SFAS No. 141 and for which separate accounting records have been maintained, primarily core deposit intangibles, have been included in the consolidated balance sheet as Other Intangible Assets, Net.  Core deposit intangibles are being amortized on a straight-line basis over a period of 15 years.  Mortgage servicing assets are being amortized on a straight-line basis over a period of 7 years as a reduction of loan servicing income.

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4.   Goodwill and Other Intangible Assets (In Thousands), Continued

The following table presents information on the Company’s intangible assets (other than goodwill) as of September 30, 2003 and December 31, 2002:

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5.   Stock-Based Compensation Plans

The Company accounts for its stock-based compensation plans under the recognition and measurement principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations.  No stock-based employee compensation cost has been reflected in net income for stock awards granted under these plans (other than for certain stock appreciation rights attached to options granted in 1992 and earlier, all of which have been exercised as of September 30, 2003), as all awards granted under these plans have been options having an exercise price equal to the market value of the underlying common stock on the date of grant.  However, options granted do generally impact diluted earnings per share by increasing the weighted average diluted shares outstanding and thereby decreasing diluted earnings per share as compared to basic earnings per share.

There were no options granted in the first nine months of 2003.  The weighted-average fair value of options granted during 2002 was $6.09 per option.  The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 2002: dividend yield of 3.24%; expected volatility of 27.5%; risk free interest rate of 3.13%; and expected lives of 7.0 years.  The Company also sponsors an Employee Stock Purchase Plan (ESPP) under which employees purchase the Company’s common stock at a 15% discount below market price at the time of purchase.  Under SFAS No. 123, the ESPP is considered a compensatory plan and the entire discount is considered to be a compensation expense in the pro forma disclosures set forth below.  Under APB 25, a plan with a discount of 15% or less is not considered compensatory and expense is not recognized.  The effects of applying SFAS No. 123 on the pro forma net income may not be representative of the effects on pro forma net income for future periods.  

The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” to stock-based employee compensation plans, restated for the September 2003 five for four stock split.

6.   Guarantees

The Company does not issue any guarantees that would require liability-recognition or disclosure, other than its standby letters of credit.  Standby and other letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party.  Those guarantees are primarily issued to support public and private borrowing arrangements, including bond financing and similar transactions.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.  Typically, these instruments have terms of twelve months or less.  Some expire unused, and therefore, the total amounts do not necessarily represent future cash requirements.  Some have automatic renewal provisions.

For letters of credit, the amount of the collateral obtained, if any, is based on management’s credit evaluation of the counter-party.   The Company had approximately $2.9 million of standby letters of credit on September 30, 2003, most of which will expire within one year and many of which were not collateralized.  At that date, all the letters of credit were for private borrowing arrangements.  The fair value of the Company’s standby letters of credit at September 30, 2003 was insignificant.

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7.   Recently Issued Accounting Pronouncements

In January 2003, the FASB issued Interpretation No. 46 (“FIN No. 46”), Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51, which establishes accounting guidance for consolidation of variable interest entities (VIE) that function to support the activities of the primary beneficiary.  The primary beneficiary of a VIE is the entity that absorbs a majority of the VIE’s expected losses, receives a majority of the VIE’s expected residual returns, or both, as a result of ownership, controlling interest, contractual relationship or other business relationship with a VIE.  Prior to the implementation of FIN No. 46, VIE were generally consolidated by an enterprise when the enterprise had a controlling financial interest through ownership of a majority of voting interest in the entity.  The provisions of FIN No. 46 were effective immediately for all arrangements entered int o after January 31, 2003, and are otherwise effective at the beginning of the first interim period ending after December 15, 2003, based on FASB Staff Position 46-6 dated October 8, 2003.

In its current form, FIN No. 46 may require the Company to recharacterize its investment in its wholly owned subsidiary business trusts (Arrow Capital Trust I and Arrow Capital Statutory Trust II) in future financial statements.  In July 2003, the Board of Governors of the Federal Reserve System issued a supervisory letter instructing bank holding companies to continue to include the trust preferred securities in their Tier I capital for regulatory capital purposes until notice is given to the contrary.  The Federal Reserve intends to review the regulatory implications of any accounting treatment changes and, if necessary or warranted, provide further appropriate guidance.  There can be no assurance that the Federal Reserve will continue to allow institutions to include trust preferred securities in Tier I capital for regulatory capital purposes.  As of September 30, 2003, if the Company was not allowed to include $15.0 million in tru st preferred securities issued by its wholly-owned business trusts within Tier I capital, then the Company would still exceed the regulatory required minimums for capital adequacy purposes.

In April 2003, the FASB issued Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities.  SFAS No. 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133.  In particular, the Statement clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative, and when a derivative contains a financing component that warrants special reporting in the statement of cash flows.  The Statement has been generally effective for contracts entered into or modified after June 30, 2003 and has not had a material impact on the Company’s financial statements.

In May 2003, the FASB issued Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity, which establishes standards for an issuer to classify and measure such instruments.  The Statement requires an issuer to classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) whereas many instruments were previously classified as equity.  The disclosure requirements of Statement No. 150 are effective for interim periods beginning after June 15, 2003.  Management has adopted the provisions of this Statement with no material impact on the Company’s consolidated financial position, results of operations, or liquidity.

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Independent Auditors’ Review Report

The Board of Directors and Shareholders

Arrow Financial Corporation

We have reviewed the accompanying consolidated balance sheet of Arrow Financial Corporation and subsidiaries (the “Company”) as of September 30, 2003, and the related consolidated statements of income for the three-month and nine-month periods ended September 30, 2003 and 2002, and consolidated statements of changes in shareholders’ equity and cash flows for the nine-month periods ended September 30, 2003 and 2002.  These consolidated financial statements are the responsibility of the Company’s management.

We conducted our review in accordance with standards established by the American Institute of Certified Public Accountants.  A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters.  It is substantially less in scope than an audit conducted in accordance with auditing standards generally accepted in the United States of America, the objective of which is the expression of an opinion regarding the financial statements taken as a whole.  Accordingly, we do not express such an opinion.

Based on our review, we are not aware of any material modifications that should be made to the consolidated financial statements referred to above for them to be in conformity with accounting principles generally accepted in the United States of America.

We have previously audited, in accordance with auditing standards generally accepted in the United States of America, the consolidated balance sheet of Arrow Financial Corporation and subsidiaries as of December 31, 2002, and the related consolidated statements of income, changes in shareholders’ equity and cash flows for the year then ended (not presented herein); and in our report dated January 21, 2003, we expressed an unqualified opinion on those consolidated financial statements.  In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2002, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

/s/ KPMG LLP

Albany, New York

October 17, 2003

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Item 2.

ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

SEPTEMBER 30, 2003

Cautionary Statement under Federal Securities Laws: The information contained in this Quarterly Report on Form 10-Q includes statements that are not historical in nature but rather are based on management’s beliefs, assumptions, expectations, estimates and projections about the future.  These statements are “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and involve a degree of uncertainty and attendant risk.  Words such as “expects,” “believes,” “anticipates,” “should,” “plans,” “estimates” and variations of such words and similar expressions are intended to identify such forward-looking statements.  Some of these statements are merely presentations of what future performance or changes in future performance would look like based on hypothetical assumptions and on simulation models.  Oth ers are based on management’s general perceptions of market conditions and trends in activity, both locally and nationally, as well as current management strategies for future operations and development.  

Examples of forward-looking statements in this Report are (i) statements in the first paragraph under the caption "Quarterly Taxable Equivalent Yield on Loans" on page 26 regarding loan yields in upcoming periods and (ii) statements in the fifth paragraph under the caption “Quantitative and Qualitative Disclosures About Market Risk” on page 38 regarding net interest margin and net interest income.  Forward-looking statements in this Report are not guarantees of future performance and involve certain risks and uncertainties that are difficult to quantify or, in some cases, to identify.  In the case of all forward-looking statements, actual outcomes and results may differ materially from what the statements predict or forecast.  Factors that could cause or contribute to such differences include, but are not limited to, unexpected changes in economic and market conditions, including unanticipated fluctuations in interest r ates, new developments in state and federal regulation, enhanced competition from unforeseen sources, new emerging technologies, sharp fluctuations in capital markets and similar risks inherent in banking operations.  Significant geopolitical developments, whether or not anticipated, also may cause differences between expected future outcomes as expressed in forward-looking statements and actual outcomes.  Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof.  Except as expressly required under applicable laws and regulations, the Company undertakes no obligation to revise or update forward-looking statements contained in this Report to reflect the occurrence of unanticipated events.  This Quarterly Report should be read in conjunction with the Company's Annual Report on Form 10-K for December 31, 2002.

Arrow Financial Corporation (the "Company") is a two-bank holding company headquartered in Glens Falls, New York.  Its banking subsidiaries are Glens Falls National Bank and Trust Company (“GFNB”) whose main office is located in Glens Falls, New York, and Saratoga National Bank and Trust Company (“SNB”) whose main office is located in Saratoga Springs, New York.

Peer Group Comparisons: At certain points in the ensuing discussion and analysis, the Company's performance is compared with that of its peer group of financial institutions. Unless otherwise specifically stated, this peer group is the group of 183 domestic bank holding companies with $1 to $3 billion in total consolidated assets identified in the Federal Reserve Board's "Bank Holding Company Performance Report" dated June 30, 2003.  Peer group data presented in this report was obtained from the Federal Reserve's Bank Holding Company Performance Report.

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Use of Non-GAAP Financial Measures: The Securities and Exchange Commission (SEC) recently adopted Regulation G, which applies to all public disclosures, including earnings releases, made by registered companies after March 28, 2003, that contain “non-GAAP financial measures.”  GAAP is generally accepted accounting principles in the United States of America.  Under Regulation G, companies making such disclosures must also disclose, along with the non-GAAP financial measures, certain additional information, including a reconciliation of the non-GAAP financial measures to the closest comparable GAAP financial measures and a statement of management's reasons for utilizing the non-GAAP financial measures as part of the Company's financial disclosures.  At the same time that the SEC issued Regulation G, it also made amendments to Item 10 of Regulation S-K, requiring companies to make the same sorts of supplemental disclosures wh enever they include non-GAAP financial measures in filings with the SEC.  The SEC has exempted from the definition of “non-GAAP financial measures” certain specific types of commonly used financial measures that are not based on GAAP.  When these exempted measures are included in public disclosures or SEC filings, supplemental information is not required.  The following measures may be affected by these new rules, however, management is unable to predict whether the SEC will regard these or certain other financial measures used by the Company in its normal presentation of financial information as "non-GAAP financial measures" within the meaning of the SEC's new rules.

Tax-Equivalent Net Interest Income and Net Interest Margin: Net interest income, as a component of the tabular presentation by financial institutions of Selected Financial Information regarding their recently completed operations, is commonly presented by financial institutions on a tax-equivalent basis.  That is, to the extent that some component of the institution's net interest income will be exempt from taxation (e.g., was received by the institution as a result of its holdings of state or municipal obligations), an amount equal to the tax benefit derived from that component is added back to the net interest income total.  This adjustment is considered helpful in the comparison of one financial institution's net interest income to that of another institution, as each will have a different proportion of tax-exempt items in their portfolios.  Moreover, net interest income is a component of a second financial mea sure commonly used by financial institutions, net interest margin, which is the ratio of net interest income to average earning assets.  For purposes of this measure as well, tax-equivalent net interest income is generally used by institutions, again to provide a better basis of comparison from institution to institution.  The Company follows these practices.

The Efficiency Ratio: Financial institutions often use an "efficiency ratio" as a measure of expense control.  The efficiency ratio typically is defined as the ratio of noninterest expense to net interest income and other income.  As in the case of net interest income generally, net interest income as utilized in calculating the efficiency ratio is typically expressed on a tax-equivalent basis.  Moreover, most issuers also adjust both noninterest expense and other income to exclude certain component elements, such as intangible asset amortization (deducted from noninterest expense) and securities gains or losses (excluded from other income), in calculating the efficiency ratio.  The Company follows these practices.

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OVERVIEW

Selected Quarterly Information:

(Dollars In Thousands, Except Per Share Amounts)

Per share amounts have been restated for the September 2003 five for four stock split.

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Selected Quarterly Information, Continued:

¹ See “Use of Non-GAAP Financial Measures” on page 14.

Selected Nine-Month Period Information:

(Dollars In Thousands, Except Per Share Amounts)

Per share amounts have been restated for the September 2003 five for four stock split.

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Selected Nine-Month Period Information, Continued:

¹ See “Use of Non-GAAP Financial Measures” on page 14.

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Average Consolidated Balance Sheets and Net Interest Income Analysis – Third Quarter

(see “Use of Non-GAAP Financial Measures” on page 15)

(Fully Taxable Basis using a marginal tax rate of 35%)

(Dollars In Thousands)

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Average Consolidated Balance Sheets and Net Interest Income Analysis - First Nine Months

(see “Use of Non-GAAP Financial Measures” on page 15)

(Fully Taxable Basis using a marginal tax rate of 35%)

(Dollars In Thousands)

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OVERVIEW

The Company reported earnings of $4.569 million for the third quarter of 2003, a decrease of $305 thousand, or 6.3%, as compared to $4.874 million for the third quarter of 2002.  Diluted earnings per share were $.45 for the 2003 quarter and $.48 for the 2002 quarter for a period-to-period decrease of $.03, or 6.3%.  Average shares outstanding decreased slightly between the two periods due to stock repurchases.  On a year-to-date basis, net income was $14.130 million for the first nine months of 2003, an increase of $12 thousand, or 0.1%, as compared to earnings of $14.118 million for the 2002 period.  Diluted earnings per share for the nine-month periods were $1.40 and $1.38, respectively, a period-to-period increase of $.02, or 1.4%.  The small increase in year-to-date earnings per share, versus no material increase in net income, was attributable to a lower number of outstanding average shares in the 2003 period, again due to s tock repurchases.

The returns on average assets were 1.35% and 1.58% for the third quarters of 2003 and 2002, respectively, a decrease of 23 basis points, or 14.6%.  The returns on average equity were 17.61% and 19.53% for the third quarters of 2003 and 2002, respectively, a decrease of 192 basis points, or 9.8%.   On a year-to-date basis, the returns on average assets were 1.44% and 1.58% for the first nine months of 2003 and 2002, respectively, a decrease of 15 basis points, or 9.4%.  The returns on average equity were 18.36% and 19.72% for the first nine months of 2003 and 2002, respectively, a decrease of 136 basis points, or 6.9%.

The net interest margin for the quarter was 3.90%, down 56 basis points, or 12.6%, from the third quarter 2002 margin and down 19 basis points from the margin for the June 30, 2003 quarter.

Total assets were $1.4 billion at September 30, 2003, which represented an increase of $112.8 million, or 8.9%, from December 31, 2002, and an increase of $121.2 million, or 9.6%, above the level at September 30, 2002.

During the first nine months of 2003, shareholders' equity increased $2.7 million to $104.1 million.  The Company's risk-based capital ratios and Tier 1 leverage ratio continued to exceed regulatory minimum requirements at period-end.  At September 30, 2003. both Company banks qualified as "well-capitalized" under federal bank guidelines.  Efficient utilization of capital remains a high priority of the Company.

CHANGE IN FINANCIAL CONDITION

Summary of Selected Consolidated Balance Sheet Data

(Dollars in Thousands)

(1) Includes Nonaccrual Loans

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Increases in Sources of Funds:  Increases in internally generated deposit balances (a net increase of $91.6 million, or 9.6%, from December 31, 2002 to September 30, 2003) accounted for most of the increase in the Company's sources of funds, supplemented by a $5.0 million increase in Federal Home Loan Bank advances, a $10.0 million issuance of guaranteed preferred beneficial interests in a junior subordinated debentures (trust preferred securities) in July 2003 and a $2.7 million increase in shareholders’ equity.  Municipal deposits, which represented 16.2% of all deposits at September 30, 2003, increased by $39.4 million, or 30.2%, from December 31, 2002 to September 30, 2003.  The Company experienced growth in all other non-maturity deposit product categories from December 31, 2002 to September 30, 2003, a combined increase of $71.4 million, or 12.4%.  Consumer time deposits decreased by $19.1 million, or 7.6%, during the same period.

Deployment of Funds into Earning Assets:  Total loans at September 30, 2003 amounted to $867.3 million, an increase of $56.0 million, or 6.9%, from December 31, 2002, and an increase of $81.4 million, or 10.4%, from September 30, 2002.  The segment of the loan portfolio experiencing the greatest increase over the twelve-month period was residential real estate loans, followed by commercial and commercial real estate loans.  Indirect consumer loan balances increased by 5.8% over the period, and continued to represent the largest single category of loans within the portfolio.  From September 30, 2001, to September 30, 2002, indirect loan balances remained essentially unchanged in absolute terms, and declined slightly as a percentage of the overall portfolio, in the face of manufacturers' heavily subsidized vehicle financing programs.  During the next three quarters (October 2002 – June 2003) the Company became mo re aggressive in pricing these loans and indirect loan balances began to grow again.  The period-end balance of indirect loans at September 30, 2003, however, was essentially unchanged from the prior quarter-end.

It is the intention of the Company that the greatest portion of its earning assets will consist of high quality loans.  However much of the earning asset growth occurring in the past twelve months took place in the investment securities portfolio.  As reported in the Consolidated Statement of Cash Flows, the cash flow received from the maturities and calls of securities in the available-for-sale portfolio amounted to $127.5 million for the first nine months of 2003.  Most of these cash flows resulted from the monthly amortization and prepayments of mortgage-backed securities.  Among other needs, this cash flow is available to fund loan growth or for redeployment in the available-for-sale portfolio.

In the first three quarters of 2003 the Company significantly reconfigured its securities available-for-sale portfolio with the sale of $121.6 million of securities and the purchase of $240.6 million of securities.  The reconfiguration is further detailed in the quarter-to-date and year-to-date sections on “Other Income” within the “Results of Operations” discussion in this Report.

Deposit Trends

The following two tables provide information on trends in the balance and mix of the Company’s deposit portfolio by presenting, for each of the last five quarters, the quarterly average balances by deposit type and the percentage of total deposits represented by each deposit type.

Quarterly Average Deposit Balances

(Dollars in Thousands)

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Percentage of Average Quarterly Deposits

For a variety of reasons, including the seasonality of municipal deposits, the Company typically experiences little net deposit growth in the first quarter of the year, but more significant growth in the second quarter.  In the first quarter of 2003, however, average deposits increased by 1.5%, or $14 million, over average deposits in the fourth quarter of 2002.  This increase was artificially enhanced by an atypical increase in municipal deposits at period-end, resulting from an automatic deposit of New York State funds into certain municipal accounts (approximately $20 million) on March 31, rather than on April 1, as usual. Average deposits also increased in the second quarter 2003, by $10 million, and in the third quarter of 2003, by $19 million.  Over the last twelve months, the Company experienced significant growth in all three categories of non-maturity deposits, based on average quarterly levels.  However, time deposits of $10 0,000 or more remained essentially flat and other time deposits decreased by 7.7%.  Early in 2002, the Company opened a new branch in Saratoga Springs, New York and in June 2003, the Company opened another branch in Queensbury, New York.  Otherwise, the increase in deposits was achieved through the Company's existing base of branches.

Quarterly Average Rate Paid on Deposits

Key Interest Rate Changes 1999 - 2003

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The Company’s net interest income has traditionally been sensitive to and impacted by changes in prevailing market interest rates.  Generally, there has been a negative correlation between changes in interest rates and net interest income in ensuing periods; as prevailing rates have declined, net interest income has increased, and vice versa.  As indicated in the preceding table, prevailing interest rates economy-wide increased in the second half of 1999 and throughout 2000, following a long period of flat or slowly-declining prevailing interest rates.  The 1999 rate hikes had a moderately negative impact on financial results for 1999, as the Company experienced decreases in net interest spread and net interest margin.  However, the full negative impact of rising rates was felt more sharply in 2000, when the decrease in net interest margin due to rising rates was significant.

In the first quarter of 2001, the Federal Reserve Board reversed direction and began decreasing short-term interest rates rapidly and significantly in response to perceived weakening in the economy.  By December 2001, the total decrease in prevailing short-term interest rates for the year was 475 basis points.  In the first ten months of 2002, there were no further rate changes, but the Federal Reserve Board resumed its rate cutting in November 2002 by decreasing rates another 50 basis points and again more recently by another 25 basis points on June 25, 2003.  Throughout all of 2001 and most of 2002, in reaction to these rate increases the Company experienced significant increases in net interest margin and net interest spread, and as a consequence in net interest income.  These positive developments were at least in part a reflection of differing repricing sensitivities of asset and liability portfolios, as interest-bearing liabilit ies (chiefly, deposits) repriced downward more rapidly than earning assets (primarily loans).  While the cost of deposits decreased in all quarters of 2001 and 2002, the Company did not experience a decrease in the average yield in the loan portfolio until the second quarter of 2001, and the decreases the Company experienced in successive quarters of 2001 and into 2002 were initially not as significant as the decreases it continued to experience in the average cost of deposits.  See the discussion under "Loan Trends" later in this report for a more complete analysis of yield trends in the loan portfolio.

The Federal Reserve Board's decrease in short-term interest rates in November 2002 and June 2003 had a more limited impact on the cost of deposits, because the Company’s rates on several deposit products, such as savings and NOW accounts, were already priced at such low levels that a matching 75 basis point decrease in rates was not practical or sustainable.  In the second half of 2002, the Company did effect minor rate decreases on all major categories of non-maturity deposit products, resulting in a small increase (3 basis points) in the net interest margin from the last quarter of 2002 to the first quarter of 2003, but for the second and third quarters of 2003 net interest margin continued a downward trend, declining 20 basis points from the first quarter to the second quarter of 2003 and another 19 basis points from the second quarter to the third quarter of 2003 (to 3.90%), as the decrease in yields on earning assets continued at a faster rate than the decrease in rates paid on interest-bearing liabilities.  See the discussion of net interest income and net interest margin in the section of this report entitled "Use of Non-GAAP Financial Measures," at the beginning of Management’s Discussion and Analysis.

During periods of falling interest rates, the Company typically experiences a pattern where customers reinvest maturing time deposits in non-maturity deposit products, pending a turn around in rates.  At December 31, 2000, before interest rates began their two-year decline, the Company’s time deposits represented approximately 42% of all deposits.  At September 30, 2003, after the steep decline in interest rates, time deposits constituted only 25% of total deposits.  If prevailing rates begin to rise, this trend may reverse itself enhancing margin pressures.

In both rising and falling rate environments, the Company faces significant competitive pricing pressures in its marketplace for both deposits and loans, and thus ultimately both assets and liabilities may be expected to reprice proportionately in response to changes in market rates.

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Non-Deposit Sources of Funds

The Company has borrowed funds from the Federal Home Loan Bank ("FHLB") under a variety of programs, including fixed and variable rate short-term borrowings and borrowings in the form of "convertible advances."  These convertible advances have maturities of 2 - 10 years and are callable by the FHLB at certain dates beginning no earlier than one year from the issuance date.  If the advances are called, the Company may elect to have the funds replaced by the FHLB at the then prevailing FHLB rates of interest.

Management continues to explore and evaluate new non-deposit sources of funds.  In 1999, the Company established a financing vehicle, Arrow Capital Trust I ("ACT I").  ACT I issued so-called trust preferred securities, that is, 30 year guaranteed preferred beneficial interests in ACT I’s assets ("capital securities") in the aggregate amount of $5.0 million at a fixed rate of 9.5%, ACT I then used the proceeds from the sale of the capital securities to acquire its sole asset, junior subordinated debentures issued by the Company, bearing the same interest rate (9.5%) and similar in amount ($5.0 million).  The debentures and capital securities are redeemable (subject to any required regulatory approval) at the option of the Company beginning December 31, 2004.  The ACT I capital securities, with associated expense that is tax deductible, qualify as Tier I capital of the Company under regulatory definitions.   ;In July 2003, the Company established a second financing vehicle, Arrow Capital Statutory Trust II ("ACST II") also to issue trust preferred securities.  ACST II issued 30 year guaranteed preferred beneficial interests in junior subordinated debentures of the Company ("capital securities") in the aggregate amount of $10.0 million at a fixed rate of 6.53% until September 30, 2008 (afterwards the rate is variable, set at the three month LIBOR rate plus 3.15%). ACST II then used the proceeds from the sale of the capital securities to acquire as its sole asset, junior subordinated debentures issued by the Company, bearing the same interest rate terms and similar in amount.  The ACST II capital securities, with associated expense that is tax deductible, also qualify as Tier I capital of the Company under regulatory definitions.  These securities are redeemable (subject to any required regulatory approval) at the option of the Company beginning September 30, 2008.

Both the ACT I and ACST II capital securities are subject to early redemption by the Company if the proceeds cease to qualify as Tier 1 capital of the Company, which would only happen if bank regulatory authorities were to reverse their current position that trust preferred securities issued by bank holding companies to certain threshold levels qualify for such treatment.  The Company does not anticipate any such change in regulatory interpretation, or that any such change would materially affect its ability to obtain funds.

Loan Trends

The following two tables present, for each of the last five quarters, the quarterly average balances by loan type and the percentage of total loans represented by each loan type.

Quarterly Average Loan Balances

(Dollars in Thousands)

Percentage of Quarterly Average Loans

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Indirect Consumer Loans: In the several years preceding the third quarter of 2001, the indirect consumer loan portfolio (consisting principally of auto loans financed through local dealerships where the Company acquires the dealer paper) was the fastest growing segment of the Company's loan portfolio, both in terms of absolute dollar amount and as a percentage of the overall portfolio.  Over the subsequent five quarters, this segment of the portfolio ceased to grow in absolute terms and decreased as a percentage of the overall portfolio.  This flattening out of indirect loans was largely the result of an aggressive campaign of zero rate and other subsidized financing commenced by the auto manufacturers in the Fall of 2001.  During the fourth quarter of 2002, and for the first two quarters of 2003, the indirect portfolio experienced a small amount of growth as the Company became more rate-competitive.  While the balance o f indirect loans remained essentially unchanged from June 30, 2003 to September 30, 2003, indirect loans still represent the largest category of loans (38.3%) in the Company’s loan portfolio, and any developments threatening the indirect loan business generally may be expected to have a negative impact on the Company due its to reliance on such loans.  If auto manufacturers continue to offer heavily subsidized financing programs, the indirect loan portfolio is likely to continue to experience rate pressure and limited, if any, overall growth.

Residential Real Estate Loans: Residential real estate loans represented the second largest segment of the Company’s loan portfolio at September 30, 2003, at 31.5% of average loans for the quarter.  This was the fastest growing segment in the Company's loan portfolio for the first and third quarters of 2003 and the second fastest for the second quarter of 2003.  Period-end residential real estate loan balances increased only $490 thousand during the second quarter as originations of $28.7 million were offset by normal amortization, refinanced loans, prepayments and the sale of $12.5 million of real estate loans to the secondary market (with the Company retaining servicing rights).  Even though the Federal Reserve Bank has not changed short-term interest rates since June 2003, rates on longer-term investments began to rise in the third quarter of 2003.  Consequently, the Company began to experience a slow-down in residential real estate loan applications in the last month of the third quarter of 2003 and into the fourth quarter of 2003, as refinancing activity, driven by the level or increasing interest rate environment, began to slow down.

Commercial and Commercial Real Estate Loans: Average commercial and commercial real estate loan balances increased by $17.6 million during the first three quarters of 2003.  These loans represented the second fastest growing segment of the Company's loan portfolio for the first quarter of 2003 and the fastest growing segment for the second quarter of 2003.  This growth rate fell-off in the third quarter of 2003, as average balances on these loans decreased $1.1 million during the third quarter of 2003.  Although the Company typically experiences most of its growth in commercial and commercial real estate loans in the spring and summer months, there were still a moderate number of commercial loan applications in the process of approval at the end of the third quarter.

Quarterly Taxable Equivalent Yield on Loans

In general, the yield on the Company's loan portfolio and other earning assets has been impacted by changes in prevailing interest rates, as discussed above under the heading "Key Interest Rate Changes 1999 - 2003."  Management expects that such will continue to be the case; that is, that loan yields will continue to rise and fall with changes in prevailing market rates, although the timing and degree of responsiveness will continue to be influenced by a variety of other factors, including the makeup of the loan portfolio, consumer expectations and preferences and the rate at which the portfolio expands.  Many of the loans in the commercial portfolio have variable rates tied to prime, FHLB or U.S. Treasury indices.   Additionally, there is a significant amount of cash flow from normal amortization and prepayments in all loan categories, and this cash flow reprices at current rates as new loans are generated at the lower curr ent yields.  As noted in the earlier discussion, during the recent period of declining rates (mid-2001 through 2003), the Company experienced a time lag between the impact of declining rates on the deposit portfolio (which occurred relatively quickly) and the impact on the loan portfolio, which positively affected the net interest margin during this period.

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Net interest margin expanded during 2001 and into the first quarter of 2002.  As prevailing rates and the Company's deposit rates began to flatten out in mid-2002, however, loan yields continued to decline and further declines in loan yields are expected in forthcoming periods, reinforced by the Federal Reserve's actions in November 2002 to decrease prevailing rates by 50 basis points and an additional 25 basis points in June 2003.  As a result, the net interest margin began to contract in the second quarter of 2002 and continued to do so for the following five quarters.  Although net interest margin increased by 3 basis points in the first quarter of 2003 (due primarily to a lagging decrease in the Company’s non-maturity deposit rates) it fell 20 basis points in the second quarter of 2003 and another 19 basis points in the third quarter of 2003.  

Asset Quality

The following table presents information related to the Company's allowance and provision for loan losses for the past five quarters.  

Summary of the Allowance and Provision for Loan Losses

(Dollars in Thousands)(Loans Stated Net of Unearned Income)

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The Company’s nonperforming assets at September 30, 2003 amounted to $2.4 million, a decrease of $385 thousand, or 14.0%, from December 31, 2002, and a decrease of $1.4 million, or 36.4%, from September 30, 2002.  The decrease from September 30, 2002 was primarily attributable to the repayment in full of one large nonperforming commercial loan, with no charge-off, in the fourth quarter of 2002.

At period-end, nonperforming assets represented .17% of total assets, a 5 basis point decrease from .22% at year-end 2002 and a 13 basis point decrease from .30% at September 30, 2002.  At June 30, 2003 this ratio for the Company’s peer group was .63%.

At September 30, 2003, the Company had identified only one commercial credit relationship that, although still performing and accruing interest, nevertheless exhibited sufficient weakness to warrant classification as a potential problem loan. The amount of the potential problem loan on that date was $2.3 million.  As of the same date, a related commercial credit to the same borrower was on nonaccrual status.  The amount of the nonaccruing credit was $319 thousand, reduced from $850 thousand on September 30, 2002, reflecting cash payments received from the borrower during the period.

In the first quarter of 2003, a commercial borrower announced plans to discontinue some or all aspects of its business operations.  The borrower was then indebted to the Company in the aggregate amount of $2.3 million through three separate loans.  During the third quarter of 2003, two loans totaling $1.8 million were repaid in full through liquidation of the underlying collateral.  The third loan with a balance of $466 thousand as of September 30, 2003, is secured by commercial real estate having an estimated market value significantly in excess of the loan balance.  There are no commitments to extend additional credit to the borrower.  Management believes that the risk of credit loss to this borrower, at this time, is very limited and the outstanding loan remains on accrual status.

The balance of other non-current loans as to which interest income was being accrued (i.e. loans 30-89 days past due as defined in bank regulatory agency guidance) totaled $5.1 million at September 30, 2003 and represented 0.59% of loans outstanding at that date, as compared to approximately $5.7 million of non-current loans representing 0.71% of loans outstanding at December 31, 2002.  These non-current loans were composed of approximately $4.3 million of consumer loans, principally indirect automobile loans, $671 thousand of residential real estate loans and commercial loans of $197 thousand.

The percentage of the Company's performing loans that demonstrate characteristics of potential weakness from time to time, typically a very small percentage, is for the most part dependent on economic conditions in the Company's geographic market area of northeastern New York State.  In general, the economy in this area was relatively strong in the 1997-2000 period.  As the country slid into a mild recession in 2001 and continued throughout 2002, the economic downturn was not as severe in this geographic area.  In the "Capital District" in and around Albany and in the area north of the Capital District, including the Company's principal service areas, unemployment remained below the national average.  The unemployment rate has been at or above the national average in the Company's other service areas including Clinton and Essex Counties, near the Canadian border, during 2002 and through the second quarter of 2003.

On an annualized basis, the ratio of the 2003 third quarter net charge-offs to average loans was .07%, 3 basis points lower than the annualized ratio of net charge-offs to average loans of .10% in the comparable 2002 period.  The provision for loan losses was $405 thousand for the third quarter of 2003, compared to a provision of $615 thousand for the third quarter of 2002 and a provision of $405 thousand for the June 30, 2003 quarter.  The provision as a percentage of average loans (annualized) was .19% for the third quarter of 2003, a decrease of 12 basis points from the .31% ratio for the comparable 2002 period.  The decrease in the provision is due primarily to the fact that nonperforming loans, net charge-offs and non-current loans had decreased from the levels at September 30, 2002, even as the Company experienced sustained growth in the loan portfolio.

The allowance for loan losses at September 30, 2003 amounted to $11.8 million. The ratio of the allowance to outstanding loans at September 30, 2003, was 1.36%, 2 basis points lower than the ratio at December 31, 2002 and 4 basis points lower than this ratio at September 30, 2002.   The allowance as a percent of nonperforming loans was 544.24% at September 30, 2003.

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CAPITAL RESOURCES

Shareholders' equity increased $2.7 million during the first nine months of 2003.  During this period, net income was $14.1 million, which was reduced by net unrealized losses on securities available-for-sale (net of tax) of approximately $2.2 million, stock repurchases (net of new stock issuances) of $3.1 million, and cash dividends of $6.1 million ($.62 per share).  From December 31, 2002 to September 30, 2003, shareholders' equity increased by 2.7%.  Current and prior period changes in shareholders' equity are presented in the Consolidated Statements of Changes in Shareholders' Equity, part of our financial statements set forth elsewhere in this report.

The following discussion of capital focuses on regulatory capital ratios, as defined and mandated for financial institutions by federal bank regulatory authorities.  Regulatory capital, although a financial measure that is not provided for or governed by GAAP, nevertheless has been exempted by the SEC from the definition of "non-GAAP financial measures" in the SEC's newly adopted rules governing disclosure of such non-GAAP financial measures.  Thus, certain information, which is required to be presented in connection with disclosure of non-GAAP financial measures need not be provided, and has not been provided, for the regulatory capital measures discussed below.  

The Company and its subsidiaries are currently subject to two sets of regulatory capital measures, a leverage ratio test and risk-based capital guidelines.  The risk-based guidelines assign risk weightings to all assets and certain off-balance sheet items of financial institutions and establish an 8% minimum ratio of qualified total capital to risk-weighted assets.  At least half of total capital must consist of "Tier 1" capital, which comprises common equity and common equity equivalents, retained earnings and a limited amount of permanent preferred stock and trust preferred securities, less intangible assets.  Up to half of total capital may consist of so-called "Tier 2" capital, comprising a limited amount of subordinated debt, other preferred stock, certain other instruments and a limited amount of the allowance for loan losses.  The second regulatory capital measure, the leverage ratio test, establishes minimu m limits on the ratio of Tier 1 capital to total tangible assets, without risk weighting.  For top-rated companies, the minimum leverage ratio is 3%, but lower-rated or rapidly expanding companies may be required to meet substantially higher minimum leverage ratios.  Federal banking law mandates certain actions to be taken by banking regulators for financial institutions that are deemed undercapitalized as measured by these ratios.  The law establishes five levels of capitalization for financial institutions ranging from "critically undercapitalized" to "well-capitalized."  The Gramm-Leach-Bliley Financial Modernization Act also ties the ability of banking organizations to engage in certain types of non-banking financial activities to such organizations' continuing to qualify as "well-capitalized" under these standards.  

As of September 30, 2003, the Tier 1 leverage and risk-based capital ratios for the Company and its subsidiary banks were as follows:  

Summary of Capital Ratios

All capital ratios for the Company and its subsidiary banks at September 30, 2003 were above minimum capital standards for financial institutions.  Additionally, at such date the Company and its subsidiary banks qualified as “well-capitalized” under FDICIA, based on their capital ratios on that date.

During July 2003, the Company issued $10 million of trust preferred securities in a private placement.  Such amount qualified as Tier 1 capital under regulatory guidelines.  See the discussion under “Non-Deposit Sources of Funds” on page 24.

The Company’s common stock is traded on The Nasdaq Stock Market^SM under the symbol AROW.  The high and low prices listed below represent actual sales transactions, as reported by Nasdaq.   

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On October 22, 2003, the Company announced the 2003 fourth quarter dividend of $.22 payable on December 15, 2003.

Quarterly Per Share Stock Prices and Dividends

(Restated for the September 2003 five for four stock split)

LIQUIDITY

Liquidity is measured by the ability of the Company to raise cash when it needs it at a reasonable cost.  The Company must be capable of meeting expected and unexpected obligations to its customers at any time.   Given the uncertain nature of customer demands as well as the desire to maximize earnings, the Company must have available sources of funds, on- and off-balance sheet, that can be acquired in time of need.  The Company measures and monitors its basic liquidity as a ratio of liquid assets to short-term liabilities, both with and without the availability of borrowing arrangements.

In addition to regular loan repayments, securities available-for-sale represent a primary source of on-balance sheet cash flow.  Certain securities are designated by the Company, at the time of purchase, as available-for-sale.  Selection of such securities is based on their ready marketability, ability to collateralize borrowed funds, as well as their yield and maturity.

In addition to liquidity arising from balance sheet cash flows, the Company has supplemented liquidity with additional off-balance sheet sources such as credit lines with the Federal Home Loan Bank ("FHLB").  The Company has established overnight and 30 day term lines of credit with the FHLB each in the amount of $57.6 million at September 30, 2003.  If advanced, such lines of credit are collateralized by mortgage-backed securities, loans and FHLB stock.  In addition, the Company has in place borrowing facilities from correspondent banks and the Federal Reserve Bank of New York and also has identified repurchase agreements and brokered certificates of deposit as appropriate potential sources of funding.

The Company is not aware of any known trends, events or uncertainties that will have or are reasonably likely to have a material effect or make material demands on the Company's liquidity in upcoming periods.  

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RESULTS OF OPERATIONS:

Three Months Ended Sep 30, 2003 Compared With

Three Months Ended Sep 30, 2002

Summary of Earnings Performance

(Dollars in Thousands, Except Per Share Amounts)