Back to GetFilings.com

ARROW FINANCIAL CORPORATION

FORM 10-K

INDEX

PART    I

Item 1.

Business

A.

General

Cautionary Statement under Federal Securities Laws

Code of Ethics

Critical Accounting Policies

Use of Non-GAAP Financial Measures

Peer Group Comparisons

B. Lending Activities

C. Supervision and Regulation

D. Competition

E. Statistical Disclosure (Guide 3)

F. Recent Legislative Developments

G. Executive Officers of the Registrant

Item 2.

Properties

Item 3.

Legal Proceedings

Item 4.

Submission of Matters to a Vote of Security Holders

PART   II

Item 5.

Market for the Registrant's Common Equity and  Related Stockholder Matters

Item 6.

Selected Financial Data

Item 7.

Management's Discussion and Analysis of Financial Condition and Results of Operations

A. Overview

B. Results of Operations

  I.  Net Interest Income

 II.  Provision for Loan Losses and Allowance for Loan Losses

III.  Other Income

IV.  Other Expense

 V.  Income Taxes

C. Financial Condition

  I.  Investment Portfolio

 II.  Loan Portfolio

a. Distribution of Loans

b. Risk Elements

III.  Summary of Loan Loss Experience

IV.  Deposits

 V.  Time Deposits of $100,000 or More

D. Liquidity

E. Capital Resources and Dividends

F. Off-Balance Sheet Arrangements

G. Contractual Obligations

H. Fourth Quarter Results

Item 7A.

Quantitative and Qualitative Disclosures About Market Risk

Item 8.

Financial Statements and Supplementary Data

Item 9.

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

Item 9A

Controls and Procedures

PART  III

Item 10.

Directors and Executive Officers of the Registrant*

Item 11.

Executive Compensation*

Item 12.

Security Ownership of Certain Beneficial Owners and Management *

Item 13.

Certain Relationships and Related Transactions*

Item 14.

Principal Accountant Fees and Services*

PART   IV

Item 15.

Exhibits, Financial Statement Schedules and Reports on Form 8-K

Signatures

Exhibits Index

*These items are incorporated by reference to the Corporation’s Proxy Statement for the Annual Meeting of Shareholders to be held April 28, 2004.

#

PART I

Item 1:  Business

A. GENERAL

Cautionary Statement under Federal Securities Laws: The information contained in this Annual Report on Form 10-K contains 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,” “estimates” and variations of such words and similar expressions are intended to identify such forward-looking statements.  Some of these statements, such as those included in the interest rate sensitivity analysis in section 7A, below, entitled “Quantitative and Qualitative Disclosures About Market Risk,” are merely presentations of what future per formance or changes in future performance would look like based on hypothetical assumptions and on simulation models.  Others 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 referenced in the table below:

These statements 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 rates; new developments in state and federal regulation; enhanced competition from unforeseen sources; new emerging technologies; unexpected loss of key personnel; and similar risks inherent in banking operations or business generally.  Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof.  The Company undertakes no obligation to revise or update these forward-looking statements to reflect the occurrence of unanticipated events.

Organization:

Arrow Financial Corporation (the Company), a New York corporation, was incorporated on March 21, 1983 and is registered as a bank holding company within the meaning of the Bank Holding Company Act of 1956.  The Company owns two nationally chartered banks in New York, Glens Falls National Bank and Trust Company, Glens Falls, New York (GFNB), and Saratoga National Bank and Trust Company, Saratoga Springs, New York (SNB), as well as five non-bank subsidiaries, the operations of which are not significant.  The Company owns directly or indirectly all voting stock of all its subsidiaries.

Available Information:

Our Internet address is www.arrowfinancial.com.  We make available free of charge on or through our Internet website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to the Exchange Act, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission.  The Company also makes available on the internet website various other documents related to corporate operations, including Corporate Governance Guidelines (By-laws) and the charters of principal committees of the Board of Directors.

Code of Ethics: The Company has adopted a financial code of ethics that applies to its chief executive officer, chief financial officer and principal accounting officer.  The Company has also adopted a business code of ethics that applies to all directors, officers and employees.  Both are available on the Company’s website: www.arrowfinancial.com.

Critical Accounting Policies:  In order to prepare the Company’s consolidated financial statements in accordance with accounting principles generally accepted in the United States of America, management was required to make estimates and assumptions that affected the amounts reported in these statements.  There are uncertainties inherent in making these estimates and assumptions, which could materially affect the results of operations and financial position.  Management considers the following to be critical accounting policies:

The allowance for loan losses:  The adequacy of the allowance for loan losses is sensitive to changes in current economic conditions that may make it difficult for borrowers to meet their contractual obligations.  A significant downward trend in the economy, regional or national, may require the Company to increase the allowance for loan losses resulting in a negative impact on its results of operations and financial condition.  

Liabilities for retirement plans:  The Company has a variety of pension and retirement plans.  Liabilities under these plans rely on estimates of future salary increases, numbers of employees and employee retention, discount rates and long-term rates of investment return.  Changes in these assumptions due to changes in the financial markets, the economy, the Company’s own operations or applicable law may result in material changes to the Company’s liability for postretirement expense, with consequent impact on its results of operations and financial condition.

Valuation Allowance for deferred tax assets:  Statement of Financial Accounting Standards No. 109 requires a reduction in the carrying amount of deferred tax assets by a valuation allowance if, based on the weight of available evidence, it is more likely than not (a likelihood of more than 50 percent) that some portion or all of the deferred tax assets will not be realized.  The valuation allowance should be sufficient to reduce the deferred tax asset to the amount that is more likely than not to be realized.  The Company’s analysis of the need for a valuation allowance for deferred tax assets is, in part, based on an estimate of future taxable income.

#

Goodwill:  SFAS No. 142 requires that goodwill be tested for impairment at a level of reporting referred to as a reporting unit.  Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value.  The first step of the goodwill impairment test, used to identify potential impairment, compares the fair value of a reporting unit with its carrying amount, including goodwill.  The second step of the goodwill impairment test, used to measure the amount of impairment loss, compares the implied fair value of a reporting unit’s goodwill with the carrying amount of that goodwill.

Other than temporary decline in the value of debt and equity securities:  SFAS No. 115 requires that, for individual securities classified as either available-for-sale or held-to-maturity, an enterprise shall determine whether a decline in fair value below the amortized cost basis is other than temporary.  For example, if it is probable that the investor will be unable to collect all amounts due according to the contractual terms of a debt security not impaired at acquisition, an other-than-temporary impairment shall be considered to have occurred.  If the decline in fair value is judged to be other than temporary, the cost basis of the individual security shall be written down to fair value as a new cost basis and the amount of the write-down shall be included in earnings.  A significant economic downturn might result in an other-than-temporary impairment in securities held in the Company’s portfolio.

Use of Non-GAAP Financial Measures: The Securities and Exchange Commission (SEC) has 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 types of supplemental disclosures wheneve r 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 used in this Report may constitute "non-GAAP financial measures" within the meaning of the SEC's new rules, although management is unable to state with certainty that the SEC will so regard them.

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 any 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 meas ure 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 institutions 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, to provide a better basis of comparison with other institutions.

#

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.  Peer data has been obtained from the September 2003 Federal Reserve Board’s “Bank Holding Company Performance Report.”  Unless otherwise specifically stated, the Company’s peer group is comprised of the group of 181 domestic bank holding companies with $1 to $3 billion in total consolidated assets.

The business of the Company consists primarily of the ownership, supervision and control of its bank subsidiaries.  The Company provides its subsidiaries with various advisory and administrative services and coordinates the general policies and operation of the subsidiary banks.  There were 401 full-time equivalent employees of the Company and the subsidiary banks at December 31, 2003.

The Company offers a full range of commercial and consumer banking and financial products.  The Company’s deposit base consists of deposits derived principally from the communities served by the subsidiary banks.  The Company targets its lending activities to consumers and small and mid-sized companies in the banks' immediate geographic areas.  Through its banks' trust departments, the Company provides retirement planning, trust and estate administration services for individuals, and pension, profit-sharing and employee benefit plan administration for corporations.

B. LENDING ACTIVITIES

The Company through its subsidiary banks engages in a wide range of lending activities, including commercial and industrial lending primarily to small and mid-sized companies; mortgage lending for residential and commercial properties; and consumer installment and home equity financing.  The Company also maintains an active indirect lending program through its sponsorship of dealer programs, under which it purchases dealer paper from automobile and other dealers meeting pre-established specifications.  The Company has periodically sold a portion of its residential real estate loan originations into the secondary market, primarily to the Federal Home Loan Mortgage Corporation (Freddie Mac) and state housing agencies, while retaining the servicing rights.  The recent sales were of longer-term residential mortgage loans, with interest rates that were both fixed and historically low, that the Company did not want to keep in its own portfolio.

#

In addition to these transactions involving periodic loan sales into the secondary market, the Company has securitized $11.5 million, $0 and $30.2 million of residential real estate loans in 2003, 2002 and 2001, respectively (remaining balance of $25.6 million at December 31, 2003).  This represents the sale of mortgage loans and the concurrent purchase of the securities issued by Freddie Mac as guaranteed mortgage-backed securities, with the sold loans representing the underlying collateral for the pooled securities.  In addition to interest earned on loans, the Company receives facility fees for various types of commercial and industrial credits, and commitment fees for extension of letters of credit and certain types of loans.

Generally, the Company continues to implement conservative lending strategies and policies that are intended to protect the quality of the loan portfolio.  These include stringent underwriting and collateral control procedures and credit review systems through which intensive reviews are conducted.  It is the Company's policy to discontinue the accrual of interest on loans when the payment of interest and/or principal is due and unpaid for a designated period (generally 90 days) or when the likelihood of repayment is, in the opinion of management, uncertain (see Part II, Item 7.C.II.b., “Risk Elements”).  Income on such loans is thereafter recognized only upon receipt.

The Company lends primarily to borrowers within its geographic area.  The loan portfolio does not include any foreign loans or any significant risk concentrations except as described in Note 26 to the Consolidated Financial Statements in Part II, Item 8 of this report.  The Company does not participate in loan syndications, either as originator or as a participant.  The portfolio, in general, is fully collateralized, and many commercial loans are further secured by personal guarantees.

In 2000, the Company formed a subsidiary, North Country Investment Advisers, Inc. (NCIA), which is an investment adviser registered with the U. S. Securities and Exchange Commission. NCIA advises two SEC-registered mutual funds, the North Country Intermediate Bond Fund and the North Country Equity Growth Fund.  Currently, the investors in these funds consist primarily of individual, corporate and institutional trust customers of the Company.

In 2001, the Company established a subsidiary insurance agency, NC Financial Services, Inc., which is licensed by the State of New York to sell various insurance products, including life insurance, fixed annuities and long-term health care products.  The agency is headquartered in Warrensburg, New York and offers these products at most of its full-service branches.

C. SUPERVISION AND REGULATION

The following generally describes the regulation to which the Company and its affiliates are subject.  Bank holding companies and banks are extensively regulated under both federal and state law.  To the extent that the following information summarizes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular laws and regulations.  Any change in applicable law or regulation may have a material effect on the business and prospects of the Company.

The Company is a registered bank holding company within the meaning of the Bank Holding Company Act of 1956 (BHC Act) and is subject to regulation by the Board of Governors of the Federal Reserve System (FRB).  Additionally, as a “bank holding company” under New York state law, the Company is subject to regulation by the New York State Banking Department.  The two subsidiary banks are both nationally chartered banks and are subject to supervision and examination by the Office of the Comptroller of the Currency (OCC). The banks are members of the Federal Reserve System and the deposits of each bank are insured by the Bank Insurance Fund of the Federal Deposit Insurance Corporation (FDIC) up to $100,000 per depositor.  The BHC Act generally prohibits the Company from engaging, directly or indirectly, in activities other than banking, activities closely related to banking, and certain other financial activities.  Under the BHC Act, a bank holding company must obtain FRB approval before acquiring, directly or indirectly, 5% or more of the voting shares of another bank or bank holding company (unless it already owns a majority of such shares).  Bank holding companies are able to acquire banks or other bank holding companies located in all 50 states.  In addition, 48 of the 50 states permit banks headquartered in other states to establish branches in their states, although in some cases such branching may be achieved only by acquiring existing banks in such states.  As a result of the Gramm-Leach-Bliley Act, bank holding companies are now permitted to affiliate with a much broader array of other financial institutions than was previously permitted, including insurance companies, investment banks and merchant banks.  See Item 1.F., “Legislative Developments.”

#

An important area of banking regulation is the establishment by federal regulators of minimum capitalization standards for banks and bank holding companies.  The FRB has adopted various "capital adequacy guidelines" for its use in the examination and supervision of bank holding companies.  The FRB’s risk-based capital guidelines assign risk weightings to all assets and certain off-balance sheet items and establish an 8% minimum ratio of qualified total capital to the aggregate dollar amount of risk-weighted assets (which is almost always less than the dollar amount of such assets without risk weighting).  At least half of total capital must consist of "Tier 1" capital, which comprises common equity, retained earnings and a limited amount of permanent preferred stock, less goodwill.  Up to half of total capital may consist of so-called "Tier 2" capital, comprising a limited amount of subordinated debt , preferred stock not qualifying as Tier 1 capital, certain other instruments and a limited amount of the allowance for loan losses. The FRB’s other important guideline for measuring a bank holding company’s capital is the leverage ratio standard, which establishes minimum limits on the ratio of a bank holding company's "Tier 1" capital to total tangible assets (not risk-weighted).  For top-rated holding companies, the minimum leverage ratio is 3%, but lower-rated companies may be required to meet substantially greater minimum ratios.  Subsidiary banks are subject to similar capital requirements adopted by their primary federal regulator, the OCC.

Under applicable law, federal banking regulators are required to take prompt corrective action with respect to depository institutions that do not meet minimum capital requirements.  The regulators have established five capital classifications for banking institutions, the highest being "well capitalized."   Under regulations adopted by the federal bank regulators, a banking institution is considered "well capitalized" if it has a total risk-adjusted capital ratio of 10% or greater, a Tier 1 risk-adjusted capital ratio of 6% or greater and a leverage ratio of 5% or greater and is not subject to any regulatory order or written directive regarding capital maintenance.  The Company and each of its subsidiary banks currently qualify as “well capitalized.”  The year-end 2003 capital ratios of the Company and its subsidiary banks are set forth in Part II, Item 7.E. "Capital Resources and Dividends.&qu ot;  

A holding company's ability to pay dividends or repurchase its outstanding stock, as well as its ability to expand its business through acquisitions of additional banking organizations or permitted non-bank companies, may be restricted if capital falls below these minimum capitalization ratios or fails to meet other informal capital guidelines that the regulators may apply from time to time to specific banking organizations.  In addition to these potential regulatory limitations on payment of dividends, the ability to pay dividends is also subject to various restrictions under applicable corporate laws, including banking laws (affecting subsidiary banks) and the New York Business Corporation Law (affecting the holding company).  The ability of the Company and the banks to pay dividends in the future is, and is expected to continue to be, influenced by regulatory policies, capital guidelines and applicable law.

In cases where banking regulators have significant concerns regarding the financial condition, assets or operations of a bank or bank holding company, the regulators may take enforcement action or impose enforcement orders, formal or informal, against the organization.  Neither the Company nor any of its subsidiaries is now, or has been within the past year, subject to any formal or informal regulatory enforcement action or order.

D. COMPETITION

The Company faces intense competition in all markets it serves.  Traditional competitors are other local commercial banks, savings banks, savings and loan institutions and credit unions, as well as local offices of major regional and money center banks.  Also, non-banking financial organizations, such as consumer finance companies, insurance companies, securities firms, money market and mutual funds and credit card companies offer substantive equivalents of the transactional deposit accounts and various loan and financial products, even though these non-banking organizations are not subject to the same regulatory restrictions and capital requirements that apply to the Company and its subsidiary banks.  As a result of the Gramm-Leach-Bliley Act (discussed further in Part I.1.F., below), such non-banking financial organizations now may be in a position not only to offer comparable products to those offered by the Company, but actually to est ablish or acquire their own commercial banks.

#

E. STATISTICAL DISCLOSURE

Set forth below is an index identifying the location in this Report of various items of statistical information required to be included in this Report by the SEC’s industry guide for Bank Holding Companies.

F. RECENT LEGISLATIVE DEVELOPMENTS

The Sarbanes-Oxley Act (the "Act"), signed into law on July 30, 2002, adopted a number of measures having a significant impact on all publicly-traded companies, including the Company.  Generally, the Act seeks to improve the quality of financial reporting of these companies, strengthen the independence of their auditors and compel them to adopt good corporate governance practices.  The Act places substantial additional duties on directors, officers, auditors and attorneys of public companies.  Among other specific measures, the Act requires that chief executive officers and chief financial officers certify periodically to the SEC regarding the accuracy of the company's financial statements and the integrity of its internal controls.  The Act also accelerates insiders' reporting obligations for transactions in company securities, restricts certain executive officer and director transactions, imposes new obligations on corpora te audit committees, and provides for enhanced review of company filings by the SEC.  As part of the general effort to improve public company auditing, the Act placed limits on consulting services that may be performed by a company's independent auditors and creates a federal public company accounting oversight board to set auditing standards, inspect registered public accounting firms, and exercise enforcement powers, subject to oversight by the SEC.  In the wake of the Sarbanes-Oxley Act, the nation’s stock exchanges, including the Company’s exchange, the National Association of Securities Dealers, Inc. (NASD), promulgated a wide array of good governance standards that must be adopted by listed companies.  The NASD standards include having a Board of Directors the majority of whose members are independent of management, and having audit, compensation and nomination committees of the Board consisting exclusively of independent directors.

The USA Patriot Act of 2001, as amended (the "Patriot Act"), has imposed substantial new record-keeping and due diligence obligations on banks and other financial institutions, with a particular focus on detecting and reporting money-laundering transactions involving domestic or international customers.  The U.S. Treasury Department has issued and will continue to issue regulations clarifying the Patriot Act's requirements.  The Patriot Act requires all "financial institutions," as defined, to establish certain anti-money laundering compliance and due diligence programs.

In November 1999, Congress enacted the Gramm-Leach-Bliley Act ("GLBA"), which permitted bank holding companies to engage in a wider range of financial activities.  For example, under GLBA bank holding companies may underwrite all types of insurance and annuity products and all types of securities products and mutual funds, and may engage in merchant banking activities.  Bank holding companies that wish to engage in these or other newly-permitted financial activities generally must do so through separate “financial” subsidiaries and may themselves be required to register (and qualify to register) as so-called “financial holding companies.”  A bank holding company that does not register as a financial holding company will remain a bank holding company subject to substantially the same regulatory restrictions and permitted activities as applied to bank holding companies prior to GLBA (See Part I.1.C., “Super vision and Regulations,” above).  The Company has not yet elected to become a “financial holding company” but continues to evaluate the opportunities provided by GLBA.  Under GLBA, as well as the Fair Credit Reporting Act amendment of 2003, all financial institutions have become subject to more stringent customer privacy regulations.

#

The FDIC levies a deposit insurance premium on insured banks.  Since 1996, the premium paid by the best-rated banks (including the Company’s subsidiary banks) has been a flat charge of $2 thousand per year. Also in that year, Congress enacted the Deposit Insurance Funds Act, under which deposits insured by the Bank Insurance Fund (“BIF”), such as the deposits of the Company’s banks, are subject to assessment for payment on bond obligations financing the FDIC’s Savings Association Insurance Fund (“SAIF”) at a rate 1/5 the rate paid on deposits by SAIF-insured thrift institutions.  Beginning in 2000, the BIF and SAIF rates were equalized.  The BIF rate for institutions with the lowest risk classification (including the Company) was 1.540 cents per $100 of insured deposits at December 31, 2003.

Various federal bills that would significantly affect banks are introduced in Congress from time to time.  The Company cannot estimate the likelihood of any currently pending banking bills being enacted into law, or the ultimate effect that any such potential legislation, if enacted, would have upon its financial condition or operations.

G. EXECUTIVE OFFICERS OF THE REGISTRANT

The names and ages of the executive officers of the Company and positions held by each are presented in the following table.  Officers are elected annually by the Board of Directors.

Item 2:  Properties

The Company is headquartered at 250 Glen Street, Glens Falls, New York.  The building is owned by the Company’s subsidiary, Glens Falls National Bank, and serves as the bank’s main office.  Glens Falls National Bank owns nineteen additional offices and leases four others at market rates.  The Company’s other subsidiary bank, Saratoga National Bank, owns its three offices.

In the opinion of management of the Company, the physical properties of the Company and the subsidiary banks are suitable and adequate.  For more information on the Company’s properties, see Notes 1, 6 and 22 to the Consolidated Financial Statements contained in Part II, Item 8 of this Report.

#

Item 3:  Legal Proceedings

The Company is not the subject of any material pending legal proceedings, other than ordinary routine litigation occurring in the normal course of its business.

On an ongoing basis, the Company's subsidiary banks are the subjects of or parties to various legal claims which arise in the normal course of their business.  The various pending legal claims against the subsidiary banks will not, in the opinion of management based upon consultation with counsel, result in any material liability.

Item 4:  Submission of Matters to a Vote of Security Holders

None in the fourth quarter of 2003.

PART II

Item 5:  Market for the Registrant's Common Equity and Related Stockholder Matters

The common stock of Arrow Financial Corporation 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.  These prices and the cash dividends per share have been restated for the September 2003 five for four stock split.

The payment of dividends by the Company is at the discretion of the Board of Directors and is dependent upon, among other things, the Company's earnings, financial condition and other factors, including applicable legal and regulatory restrictions.  See "Capital Resources and Dividends" in Part II, Item 7.E. of this report.

There were approximately 3,194 holders of record of common stock at December 31, 2003. The Company has no other class of stock outstanding.

#

Item 6:  Selected Financial Data

FIVE YEAR SUMMARY OF SELECTED DATA

Arrow Financial Corporation and Subsidiaries

(Dollars In Thousands, Except Per Share Data)

¹ Other Income in 2000 includes the net gain on the sale of the credit card portfolio of $825.

² Amortization of goodwill was discontinued effective January 1, 2002, upon the adoption of SFAS No. 147.  Goodwill amortization amounted to $888

     in 2001, 2000 and 1999.

³ Share and per share amounts have been adjusted for subsequent stock splits and dividends, including the most recent September 2003 five-for-four

     stock split.

⁴ Tangible book value excludes from total equity intangible assets, primarily goodwill and intangible assets associated with prior branch purchases.

#

Item 7:  Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis focuses on and reviews the Company's results of operations for each of the years in the three-year period ended December 31, 2003 and the financial condition of the Company as of December 31, 2003 and 2002.  The discussion below should be read in conjunction with the consolidated financial statements and other financial data presented elsewhere herein.

A. OVERVIEW

Selected Quarterly Information:

(Dollars In Thousands, Except Per Share Amounts)

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

#

Selected Quarterly Information, Continued:

¹ See “Use of Non-GAAP Financial Measures” on page 5.

Selected Twelve-Month Information:

(Dollars In Thousands, Except Per Share Amounts)

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

#

Selected Twelve-Month Information, Continued:

¹ See “Use of Non-GAAP Financial Measures” on page 5.

Summary of 2003 Financial Results

The Company reported net income of $18.9 million for 2003, an increase of $23 thousand, or 0.1%, compared to 2002.  Diluted earnings per share increased $.03, or 1.6%, from 2002 to 2003 following an increase of $.30, or 19.4%, from 2001 to 2002.  The flat earnings growth between 2002 and 2003 was primarily attributable to pressures on net interest income arising from a prolonged low interest rate environment, as average yields of loans and other earning assets decreased more rapidly than the average cost of funds.  The increase in diluted earnings per share was attributable to a lower number of shares outstanding due to the Company’s repurchases of its own common stock.

At December 31, 2003, the Company’s tangible book value per share (calculated based on shareholders’ equity reduced by intangible assets including goodwill, mortgage servicing rights and intangible pension plan assets) amounted to $9.86, an increase of $.61, or 6.6%, from year-end 2002.  The increase was primarily attributable to retained earnings offset in part by a decrease in net unrealized gains, net of tax, on securities available-for-sale and periodic repurchases of the Company’s common stock.  As of the last trading day of 2003, the average of the Company’s bid and asked stock price was $27.765, resulting in a trading multiple of 2.82 to tangible book value.

The Board of Directors increased the quarterly cash dividend twice in 2003, to $.22 per share by the fourth quarter.  Total cash dividends (as adjusted) were $.84 for 2003, compared to $.76 for 2002, an increase of $.08, or 10.5%.  

Nonperforming loans amounted to $2.5 million at December 31, 2003, a decrease of $55 thousand, or 2.2%, from the prior year-end.  Loans charged-off (net of recoveries) against the allowance for loan losses were $811 thousand for 2003, as compared to a similar amount of $815 thousand for the prior year.   At year-end 2003, the allowance for loan losses, at $11.8 million, represented a coverage ratio to total loans of 1.38%, unchanged from the prior year-end.

#

B. RESULTS OF OPERATIONS

The following analysis of net interest income, the provision for loan losses, noninterest income, noninterest expense and income taxes, highlights the factors that are primarily responsible for the Company’s results of operations for 2003 and the prior two years.

I. NET INTEREST INCOME (Tax-equivalent Basis)

Net interest income represents the difference between interest and dividends earned on loans, securities and other earning assets and interest paid on deposits and other sources of funds.  Changes in net interest income result from changes in the level and mix of earning assets and sources of funds (volume) and changes in the yields earned and interest rates paid (rate).  Net interest margin is the ratio of net interest income to average earning assets.  Net interest income may also be described as the product of average earning assets and the net interest margin.

COMPARISON OF NET INTEREST INCOME

(Dollars In Thousands) (Tax-equivalent Basis)

On a tax-equivalent basis, net interest income was $51.5 million in 2003, a decrease of $659 thousand, or 1.3%, from $52.2 million in 2002.  This compared to a $5.2 million, or 11.0%, increase between 2001 and 2002.  Factors contributing to the increase in net interest income are discussed in the following portions of this section B.I.

ANALYSIS OF CHANGES IN NET INTEREST INCOME

The following table presents net interest income components on a tax-equivalent basis and reflects changes between periods attributable to movement in either the average daily balances or average rates for both earning assets and interest-bearing liabilities.  Changes attributable to both volume and rate have been allocated proportionately between the categories.

#

CHANGE IN NET INTEREST INCOME

(In thousands) (Tax-equivalent basis)

The following table reflects the components of the Company's net interest income, setting forth, for years ended December 31, 2003, 2002 and 2001 (I) average balances of assets, liabilities and shareholders' equity, (II) interest and dividend income earned on earning assets and interest expense incurred on interest-bearing liabilities, (III) average yields earned on earning assets and average rates paid on interest-bearing liabilities, (IV) the net interest spread (average yield less average cost) and (V) the net interest margin (yield) on earning assets.  Rates are computed on a tax-equivalent basis.  The yield on securities available-for-sale is based on the amortized cost of the securities.  Nonaccrual loans are included in average loans.  

#

Average Consolidated Balance Sheets and Net Interest Income Analysis

(Tax-equivalent basis using a marginal tax rate of 35%)

(Dollars in thousands)

#

CHANGES IN NET INTEREST INCOME DUE TO RATE

The Company experienced a decrease in net interest income from 2002 to 2003 of $659 thousand.  This reflected the fact that the positive impact of an increase in average earning assets (which had a $5.8 million positive impact on net interest income between the two years) was more than offset by the negative impact of changes in the interest rate environment (which had a $6.4 million negative impact).  By contrast, the $5.2 million increase in net interest income between 2001 and 2002 reflected the fact that the positive impact of an increase in average earning assets (which added $4.7 million to net interest income between the years) was reinforced by a positive impact from changing interest rates ($406 thousand).

The following items have a major impact on changes in net interest income due to rate:  general interest rate changes, the ratio of the Company's rate sensitive assets to rate sensitive liabilities (interest rate sensitivity gap) during periods of interest rate changes and the level of nonperforming loans.  

Key Interest Rate Changes 1999 – 2003

The Federal Reserve Board attempts to influence prevailing federal funds and prime interest rates and sets changes to the Federal Reserve Bank discount rate.  The following chart presents rate changes in recent years:

The Company’s net interest income, for the past several years, has been very sensitive to changes in interest rates.  As indicated in the table above, prevailing interest rates economy-wide began to increase in the second half of 1999 through the second half of 2000.  This marked a turnaround from a long period of flat or slowly declining prevailing interest rates.  The 1999 rate hikes had a moderate negative impact on the Company’s financial results for 1999, which continued to show decreases from prior periods in the average rate earned on earning assets and the average rate paid on interest-bearing liabilities, as well as decreases in the Company’s net interest spread and net interest margin.  However, the full and negative impact of rising rates was felt in 2000, when the decrease in net interest income due to rates was significant.

#

In the first quarter of 2001, after an extended period of stable interest rates and six months of moderate rate increases, 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.  After eleven months with no rate changes, the Federal Reserve Board decreased rates another 50 basis points in November 2002.  As a result, the Company experienced a decrease in the cost of deposits in all quarters of 2001, which continued throughout 2002 and 2003, although the Federal Reserve did not reduce short-term rates again until the end of 2003.  Although decreases in deposit rates began to be experienced in the first quarter of 2001, the Company did not experience a decrease in the average yield in its loan portfolio until the second quarter of 2001.  Yields on the loan portfolio continued to decrease through the remainder of 2001 and through all of 2002 and 2003.  See the “Loan Portfolio” section in the discussion of “Financial Condition” later on in this Report, for a more complete analysis of yield trends in the loan portfolio.

As the table above demonstrates, the Federal Reserve Board decreased short-term interest rates by 50 basis points in November 2002 and again by 25 basis points in June 2003.  By 2003, however, the cumulative Federal Reserve rate decreases began to have only a limited impact on the Company’s deposit rates, because rates on several of the Company’s deposit products, such as savings and NOW accounts, were already priced at such low levels that a such a further decrease in rates was not practical or sustainable, although the Company did lower rates to a much smaller extent on certain non-maturity deposit products.  Yields on the loan portfolio, however, did continue to fall in 2003, putting serious pressure on the net interest margin for the first time in years.  Thus the decreasing rate environment had a positive impact on net interest income during 2001 and 2002, as net interest margins increased both years, but by 2003 the low rat e environment eventually had a negative impact on both net interest income and net interest margin.

The net interest margin for 2003 was 4.05%, a decrease of 45 basis points, or 10.0%, from 2002.  During 2003 the yields on earning assets fell 91 basis points, while the cost of paying liabilities fell only 57 basis points.

The net interest margin for 2002 was 4.50%, an increase of 9 basis points from the 4.41% margin for 2001.  The net interest spread between the two years increased by 26 basis points.  As noted, these increases in margin and spread were attributable to the fact that during 2002 the Company’s paying liabilities repriced downward at a faster rate than its earning assets.  Another factor reinforcing this development was the relocation of a significant dollar amount of maturing time deposits into other lower cost deposit accounts, a relocation that often accompanies falling interest rates but also often proves temporary.

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.

A discussion of the impact on net interest income resulting from changes in interest rates vis a vis the repricing patterns of the Company’s earning assets and interest-bearing liabilities is included later in this report under Item 7A, “Quantitative and Qualitative Disclosures About Market Risk.”  

CHANGES IN NET INTEREST INCOME DUE TO VOLUME

AVERAGE BALANCES

(Dollars In Thousands)

#

2003 vs. 2002:

Other things being equal, changes in the volume of earning assets and interest-bearing liabilities generally will result in corresponding changes in net interest income.  That is, in the normal course of business, as assets and liabilities proportionately increase, so will net interest income.  The recently completed year, 2003, was not normal, as discussed above.  Moreover, changes due to volume can be enhanced or restricted by shifts within the relative mix of earning assets or interest-bearing liabilities between instruments of different rates.  The change in net interest income due to changes in volume was an increase of $5.8 million in 2003 and an increase of $4.7 million in 2002.

During 2003 average earning assets increased $112.2 million, an increase of 9.7%.  Average paying liabilities grew at a similar but lower amount, increasing by $97.9 million, or 10.1%.  The combined effect of these changes in volume was to increase net interest income by approximately 11.1%, before giving effect to the 12.3% negative impact on net interest income resulting from the change in interest rates discussed above.

During 2003, the Company experienced its growth in average earning assets primarily within the loan portfolio (which accounted for approximately 65% of the increase) and secondarily within the investment portfolio (approximately 35%).

In comparing year-to-date average balances, the fastest growing segment of the loan portfolio in 2003 was residential real estate loans.  While some of the segment growth represented extensions in connection with refinancing of existing loans, most of the growth was from new mortgage loans.  The average balance of residential mortgage loans increased by over $41 million in 2003, or 15.8%.  Commercial and commercial real estate lending represented the second largest growth area for the Company, expanding by over $20 million in 2003, or 14.8%.  The average balance of Indirect consumer lending increased by over $13 million in 2003, or 4.3%.  Indirect loans are primarily auto loans financed through local dealerships from whom the Company acquires the dealer paper.  Changes in the loan portfolio are discussed in more detail in the following section C.II. “Loan Portfolio.”

The Company’s $97.9 million growth in average paying liabilities in 2003 was experienced primarily in traditional banking deposit products, which increased by $79.9 million, or 11.2%, from 2002 to 2003, and secondarily in Federal Home Loan Bank (FHLB) borrowings, which increased by $17.3 million, or 13.3%, from 2002 to 2003.  The increase in deposit balances during 2003 was generated by the Company’s pre-existing branch network, although the Company’s Glens Falls National Bank and Trust Company franchise did open its twenty-fourth branch in 2003 (in Queensbury, NY).  No other branches were added or acquired in 2003.  Changes in the deposit balances are discussed in more detail in the following section C.IV. “Deposits.”

2002 vs. 2001:

During 2002, average earning assets increased $92.3 million, an increase of 8.7%.  Average paying liabilities grew at a somewhat slower pace, increasing by $72.4 million, or 8.1%.  The combined effect of these changes in volume was to increase net interest income by approximately 10.0%, before giving effect to the 1.0% positive impact on net interest income resulting from the change in interest rates discussed in the previous section.

During 2002, the Company experienced its growth in average earning assets primarily within the investment portfolio (which accounted for approximately 71% of the increase) and secondarily within the loan portfolio (approximately 29%). That is, most of the increase in the sources of funds during 2002 was redeployed, at least temporarily, into the investment securities portfolio, awaiting ultimate commitment of those funds into the loan portfolio.

As in 2003, the fastest growing segment of the loan portfolio in 2002 was residential real estate ($25.3 million), followed by commercial loans ($17.9 million).

The Company’s $72.4 million growth in average paying liabilities in 2002 was experienced primarily in traditional banking deposit products, which increased by $106.6 million, and secondarily in Federal Home Loan Bank (FHLB) borrowings, which increased by $15.2 million.  These increases were offset, in part, by a $54.2 million decrease in the average balance of time deposits of $100,000 or more.  The increase in deposit balances during 2002 was generated by the Company’s pre-existing branch network, although the Company’s Saratoga National Bank and Trust Company franchise did open its third branch (the second branch in Saratoga Springs) at the beginning of 2002.  No other branches were added or acquired in 2002.

#

Increases in the volume of loans and deposits, as well as yields and costs by type, are discussed later in this report under Item 7.C. “Financial Condition.”

II. PROVISION FOR LOAN LOSSES AND ALLOWANCE FOR LOAN LOSSES

Management considers its accounting policy relating to the allowance for loan losses to be a critical accounting policy given the uncertainty involved in evaluating the level of the allowance required to cover credit losses inherent in the loan portfolio, and the material effect that such judgments can have on the Company’s results of operations.  See Note 1 to the consolidated financial statements, included in Item 8 of this Report, as well as the discussion below, for a description of the Company’s policy with respect to estimating the level of the allowance for loan losses.

Through the provision for loan losses, an allowance (reserve) is maintained for the inherent risk of loss in the current portfolio.  Actual loan losses are charged against this allowance when loans are deemed uncollectible.  In evaluating the adequacy of the allowance for loan losses, management considers various risk factors influencing asset quality.  The analysis is performed on a loan by loan basis for impaired and large balance loans, and by portfolio type for smaller balance homogeneous loans. This analysis is based on judgments and estimates and may change in response to economic developments or other conditions that may influence borrowers' financial conditions or prospects.

The determination of actual provisions for loan losses on an ongoing basis is largely influenced by the prevailing level of nonperforming loans, the level of loans actually charged-off against the allowance for loan losses during the prior periods, recent changes in the mix and volume of loan categories within the loan portfolio and overall changes in the size of the portfolio.

2003 vs. 2002:

The quality of the Company’s loan portfolio remains strong and, to date, has not been negatively affected by the loan growth experienced in recent periods.  At period-end, the ratio of nonperforming loans (loans 90 days or more past due and accruing interest plus nonaccrual loans) as a percentage of total loans was .29% for the Company.  The September 30, 2003 ratio for the Company’s peer group was .80%.  At December 31, 2003, nonperforming loans amounted to $2.5 million, a decrease of $55 thousand, or 2.1%, from the balance at year-end 2002.

While management believes that the 2003 year-end allowance of $11.8 million was adequate under the circumstances, there can be no assurances that future economic or financial developments, including general interest rate increases or a slowdown in the economy, might not lead to a need for increased provisions to the allowance or a higher incidence of loan charge-offs.

The provision for loan losses was $1.5 million for 2003, a decrease of $828 thousand, or 36.2%, from 2002.  This reduction was primarily due to the improved asset quality indicators, offset somewhat by the growth in the loan portfolio, as well as consideration of the other noted factors.  During 2003, loan losses charged against the allowance, net of recoveries, were $811 thousand, virtually unchanged from the 2002 amount.  The result was a $700 thousand, or 6.0%, increase in the allowance.  Because loans increased by a similar percentage during the year, the Company’s coverage ratio, its allowance to period-end loans, was the same at year-end 2003 as at year-end 2002 (1.38%).  Net charge-offs as a percentage of average loans outstanding was .10% for 2003, down slightly from .11% for 2002.  Net charge-offs, on an annualized basis, for the Company’s peer group at September 30, 2003 was .22% of average loans, or 54.6 % higher than the Company’s full-year ratio. If the current economic conditions should worsen, management anticipates that net charge-offs may exceed the levels experienced in recent years.

2002 vs. 2001:

At December 31, 2002, the allowance for loan losses was $11.2 million, or 1.38%, of total loans, as compared to $9.7 million, or 1.29% of total loans at December 31, 2001.  The allowance for loan losses represented 437% of the amount of nonperforming loans at December 31, 2002, as compared to 283% of nonperforming loans at December 31, 2001.

#

During the second quarter of 2001, the Company charged-off $512 thousand on one commercial loan.  Disregarding this item, net charge-offs for 2002 increased by $31 thousand, or 4.0%, over 2001.   Net charge-offs as a percentage of average loans outstanding was .11% for 2002.  Net charge-offs, on an annualized basis,  for the Company’s peer group at December 31, 2002 was .30% of average loans, or 172.7% higher than the Company’s ratio.

At December 31, 2002, nonperforming loans amounted to $2.6 million, a decrease of $876 thousand, or 25.5%, from the balance at year-end 2001.  The decrease in 2002 was primarily attributable to one $749 thousand commercial loan that was designated as nonperforming at year-end 2001, but was paid-off in full during December 2002.  While nonperforming loans and net loans charged-off improved in 2002, as compared to 2001, the continued growth in the loan portfolio resulted in the 2002 provision for loan losses remaining consistent with 2001.

At December 31, 2002, the allowance for loan losses was $9.7 million, or 1.38%, of total loans, as compared to $8.7 million, or 1.29% of total loans at December 31, 2001.  At year-end 2002 the allowance for loan losses represented 437% of the amount of nonperforming loans, as compared to 283% of nonperforming loans at December 31, 2001.

Net charge-offs as a percentage of average loans outstanding was .17% for 2001.  The provision for loan losses, as a percentage of average loans outstanding was .31% for 2001.  Net charge-offs, on an annualized basis, for the Company’s peer group at December 31, 2001 was .30% of average loans, or 76.5% higher than the Company’s ratio.

2001 vs. 2000:

At December 31, 2001, nonperforming loans amounted to $3.4 million, an increase of $1.4 million, or 67.3%, from the balance at year-end 2000.  The increase was primarily attributable to two commercial loans, totaling $1.6 million, which were placed on nonaccrual status during the fourth quarter of 2001.

2000 vs. 1999:

The provision for loan losses was $1.5 million for 2000, an increase of $47 thousand, or 3.3%, from 1999.  At December 31, 2000, nonperforming loans amounted to $2.1 million, essentially unchanged from the balance at December 31, 1999.  At December 31, 2000, the allowance for loan losses was $8.7 million, or 1.19% of total loans.  The allowance for loan losses represented 425% of the amount of nonperforming loans at that date.  During 2000, loan losses charged against the allowance, net of recoveries, were $528 thousand, or .08%, of average loans for the period, an increase of $146 thousand, or 38%, from the prior year amount.  The principal reason for the increase in net loan losses in 2000 as compared with 1999 was a recovery of $315 thousand in the 1999 period related to the final repayment of a large commercial loan.  Excluding the large recovery, net loan losses for 1999 would have exceeded those for 2000, and would hav e represented .12% of average loans.  The provision for loan losses charged to expense for 2000 was $1.5 million, or .21%, of average loans for the period.

#

SUMMARY OF THE ALLOWANCE AND PROVISION FOR LOAN LOSSES

(Dollars In Thousands) (Loans, Net of Unearned Income)

#

III. OTHER INCOME

The majority of other (i.e., noninterest) income constitutes fee income from services, principally fees and commissions from fiduciary services, deposit account service charges, computer processing fees and other recurring fee income.  Net gains or losses on the sale of securities available-for-sale is another category of other income.

ANALYSIS OF OTHER INCOME

(Dollars In Thousands)

2003 vs. 2002: Total other income increased $1.0 million, or 9.1%, from 2002 to 2003.  Without regard to net securities transactions, total other income increased by $379 thousand, or 3.4%, from 2002 to 2003.

For 2003, income from fiduciary activities decreased $216 thousand, or 5.6%, from 2002, even though total assets under administration and management increased.  At year-end 2003, the market value of assets under trust administration and investment management amounted to $748.5 million, an increase of $128.1 million, or 20.6%, from year-end 2002.  However, most of this increase in volume occurred at the end of 2003.  Fiduciary account fees, in general, are tied to the value of assets under administration.  The increase in the market value of assets under trust administration and investment management in 2003 reflected the general improvement in the equity markets in the second half of 2003 and substantial new volume attributable to business development efforts.  Both the third and fourth quarter income from fiduciary activities for 2003 was above the respective quarters in 2002.

Income from fiduciary activities includes income from funds under investment management in the Company-advised North Country Funds, which include the North Country Equity Growth Fund (NCEGX) and the North Country Intermediate Bond Fund (NCBDX).  On a combined basis, these funds reached a market value of $112.9 million and $84.8 million at December 31, 2003 and 2002, respectively.  The funds were introduced in March 2001, and are advised by the Company’s subsidiary, North Country Investment Advisors, Inc.  Currently, the funds are owned almost entirely by qualified employee benefit plan accounts.  The Company also offers these funds on a retail basis through its branches.  Included as an investor in the funds is the Company’s pension plan, which owns shares in the funds with a market value of $17.6 million and $13.6 million at December 31, 2003 and 2002, respectively.

Fees for other services to customers include deposit account service charges, credit card and debit card merchant processing fees, safe deposit box fees and loan servicing fees.  These fees amounted to $6.8 million in 2003, an increase of $587 thousand, or 9.5%, from 2002.  The increase was primarily attributable to growth in the number of transaction deposit accounts and the related service charges on those accounts and an increase in merchant credit card processing income.

For 2003, total other income included securities gains of $755 thousand on the sale of $121.7 million of securities available-for-sale.  During the second and third quarters of 2003, the Company experienced above-average amounts of prepayments of mortgage-backed securities and CMO’s in the available-for-sale portfolio.  The Company had purchased many of these securities at premiums since the underlying mortgages were written during periods when mortgage rates were higher than the recent extended period of historically low rates.  The higher than anticipated prepayment levels had the effect of accelerating amortization of the premiums (an offset against interest income in the portfolio), ultimately reducing the yield on the portfolio below the projected yield.  The primary purpose of the 2003 sales in the available-for-sale portfolio was to extend and restructure the maturities of certain investments with shorter remaining lives.  The following table presents sales in the available-for-sale portfolio and purchases in the available-for-sale and the held-to-maturity portfolios during 2003.  Total purchases in the table below include $11.5 million of loan securitizations, which have not been included in the total listed in the Consolidated Statement of Cash Flows for “Purchases of Securities Available-for-Sale” of $294,011, as the securitization was a non-cash transaction.

#

2003 Investment Sales and Purchases

(In Thousands)

Other operating income includes net gains on the sale of loans and other real estate owned, if any, as well as other miscellaneous revenues.  For 2003, other operating income increased $8 thousand, or 0.7%, from 2002.  During 2003, the Company sold $18.5 million of newly originated loans (primarily residential real estate loans) to the secondary market.  The net gains of $489 thousand were due, in part, to the fact that market interest rates on residential real estate loans kept falling during the period, but primarily because the Company was able to write loans with yields slightly higher than those required by the secondary market.  In 2002, the Company recognized $101 thousand in gains on the sale of loans.  The 2002 period also included a one-time benefit of $92 thousand from the demutualization of an insurance company for the Company’s group employee insurance trust and a $173 thousand recovery related to the former Ver mont operations.  Credit card processing income decreased by $55 thousand from 2002 to 2003 as the Company completed its exit from that business in 2003.

2002 vs. 2001:  Total other income increased $794 thousand, or 7.5%, from 2001 to 2002.  Without regard to net securities transactions, total other income was $11.2 million for 2002 and $10.3 million for 2001, an increase of $889 thousand, or 8.6%.

For 2002, income from fiduciary activities decreased $196 thousand, or 4.8%, from 2001, primarily as a result of a decrease in assets under administration and management from declining equity markets between the two years.  At year-end 2002, the market value of assets under trust administration and investment management amounted to $620.4 million, a decrease of $78.5 million, or 11.2%, from year-end 2001.  Partially offsetting the negative effect on fiduciary income from the decline in the equity markets during 2002, was an increase in the number of accounts under administration during the year.  Fiduciary account fees, in general, are tied to the value of assets under administration.

Income from fiduciary activities includes advisory income from the Company’s subsidiary, North Country Investment Advisors, which advises the North Country Equity Growth Fund (NCEGX) and the North Country Intermediate Bond Fund (NCBDX).

Fees for other services to customers include deposit account service charges, credit card and debit card merchant processing fees, safe deposit box fees and loan servicing fees.  These fees amounted to $6.2 million in 2002, an increase of $887 thousand, or 16.7%, from 2001.  Over half of the increase was attributable to increases in deposit service charges.  An increase in credit card and debit card merchant processing fees also made a significant contribution to the total increase in fees for other services to customers.

#

During 2002, the Company realized net securities gains of $100 thousand on the sale of $40.8 million from its available-for-sale portfolio.  The primary purpose of the sales was to restructure the maturity profile of the investment portfolio.  This represented a decline of $95 thousand from net securities gains of $195 thousand in 2001.

Other operating income includes net gains on the sale of loans and other real estate owned, if any, as well as other miscellaneous revenues.  For 2002, other operating income increased $198 thousand, or 20.6%.   The increase was primarily attributable to an increase in data processing servicing fee income received from one upstate New York bank, a one-time benefit of $92 thousand from the demutualization of an insurance company for the Company’s group employee insurance trust and a $173 thousand recovery related to the former Vermont operations.

IV. OTHER EXPENSE

Other (i.e., noninterest) expense is a means of measuring the delivery cost of services, products and business activities of the Company.  The key components of other expense are presented in the following table.

ANALYSIS OF OTHER EXPENSE

(Dollars In Thousands)

2003 vs. 2002:  Other expense for 2003 amounted to $32.5 million, an increase of $1.1 million, or 3.5%, from 2002.  One comparative measure of operating expenses for financial institutions is the efficiency ratio.  The efficiency ratio (a ratio where lower is better) is calculated as the ratio of other expense to the sum of tax equivalent net interest income and other income.  Excluded from the calculation are goodwill amortization and any net securities gains or losses.  For 2003, the efficiency ratio for the Company was 51.4%, an increase from the 2002 ratio of 49.5%.  The Company’s 2003 ratio, however, compared favorably to the year-to-date ratio for the Company’s peer group of 60.4% as of September 30, 2003.  For information on the calculation of the Company’s efficiency ratios on a quarterly and annual basis, see pages 13 and 15 of this Report.  Also see the discussion on page 5 regarding “Use of Non-GAAP Financial Measures.”

Salaries and employee benefits expense increased $109 thousand, or 0.6%, from 2002 to 2003.  The increase in salary expense for 2003 was 7.9% over 2002 due to merit increases, as well as the hiring of additional employees in 2003 principally to staff the new Queensbury, New York office of Glens Falls National Bank.  This was offset, in part, by decreases in pension expense (due primarily to the 2002 conversion to a cash balance plan) and a decrease in the accrual for incentive compensation.  On an annualized basis, the ratio of total personnel expense (salaries and employee benefits) to average assets was 1.42% for 2003, 25 basis points less than the ratio for the Company’s peer group of 1.67% at September 30, 2003.

Occupancy expense increased $194 thousand, or 8.3%, from 2002 to 2003. Most of the increase was attributable to increased costs of insurance, maintenance and real estate taxes.  Furniture and equipment expense increased by $334 thousand, or 13.7%, from 2002 to 2003.  The increase was spread among all areas, including maintenance contracts, data processing and depreciation expenses.

Other operating expense increased $451 thousand, or 5.8%, from 2002 to 2003.  The increase was distributed among all categories of other operating expense.

2002 vs. 2001:  Other expense for 2002 amounted to $31.4 million, an increase of $853 thousand, or 2.8%, from 2001.  This comparison was significantly affected by a change in accounting principles between the two periods.  The significant change was the discontinuance in 2002 of goodwill amortization upon the adoption of SFAS No. 147, retroactive to January 1, 2002.  Goodwill amortization for 2001 was $907 thousand, but was $0 for 2002.  Disregarding goodwill amortization, the increase in other expense between 2001 and 2002 would have been substantially higher, specifically, $1.8 million, or a 5.8%, year-to-year increase.

#

The 2002 efficiency ratio of 49.5% was an improvement from the 2001 ratio of 51.6%.  The Company’s 2002 ratio also compared favorably to the ratio for the Company’s peer group of 59.4% for the year ending December 31, 2002.  For information on the calculation of the Company’s efficiency ratios on a quarterly and annual basis, see pages 13 and 15 of this Report.  Also see the discussion on page 5 regarding “Use of Non-GAAP Financial Measures.”

Salaries and employee benefits increased $1.6 million, or 9.4%, from 2001 to 2002.  Salaries increased  $785 thousand, or 6.6%.  The increase was attributable to normal merit pay increases, as well as to the hiring of additional employees late in 2001 principally to staff the new West Avenue office of Saratoga National Bank and Trust Company in Saratoga Springs, New York and the Company’s new insurance agency subsidiary.  Employee benefits increased $840 thousand, or 15.7% during the period. In 2002, all categories of employee benefits experienced increases from 2001, except incentive compensation, which decreased slightly.  The most significant increase to employee benefits was an increase in expenses for the Company’s defined benefit pension plan.  During 2002, the Company adopted a “cash balance” plan for all new employees.  Current employees were offered the opportunity to switch to the “cas h balance” plan or to remain with the prior plan, under which retirement benefits are calculated on a “final pay” formula. Over 90% of current employees elected to switch to the cash balance plan.

Occupancy expense increased $82 thousand, or 3.6%, from 2001 to 2002. Most of the increase was attributable to increased costs of insurance and real estate taxes.  Furniture and equipment expense decreased slightly by $22 thousand, or 0.9%, from 2001 to 2002.  

Other operating expense increased $75 thousand, or 1.0%, from 2001 to 2002, without considering goodwill amortization, which was included in other operating expense in 2001 but not in 2002 due to a change in accounting principles, as discussed above.

V. INCOME TAXES

The following table sets forth the Company's provision for income taxes and effective tax rates for the periods presented.

INCOME TAXES AND EFFECTIVE RATES

(Dollars in Thousands)

The provisions for federal and state income taxes amounted to $8.6 million, $8.8 million and $7.1 million for 2003, 2002 and 2001, respectively.   The effective income tax rates for 2003, 2002 and 2001 were 31.3%, 31.7% and 30.8%, respectively.  The change in the effective tax rates from 2001 to 2002 and from 2002 to 2003 was primarily attributable to proportionate changes in taxable income over the level of tax-exempt income.

#

C. FINANCIAL CONDITION

I. INVESTMENT PORTFOLIO

Investment securities are classified as held-to-maturity, trading, or available-for-sale, depending on the purposes for which such securities were acquired and are being held.  Securities held-to-maturity are debt securities that the Company has both the positive intent and ability to hold to maturity; such securities are stated at amortized cost.  Debt and equity securities that are bought and held principally for the purpose of sale in the near term are classified as trading securities and are reported at fair value with unrealized gains and losses included in earnings.  Debt and equity securities not classified as either held-to-maturity or trading securities are classified as available-for-sale and are reported at fair value with unrealized gains and losses excluded from earnings and reported net of taxes in accumulated other comprehensive income or loss.  At December 31, 2003, the Company held no trading securities.

Securities Available-for-Sale:

The following table sets forth the carrying value of the Company's securities available-for-sale portfolio, at year-end 2003, 2002 and 2001.

SECURITIES AVAILABLE-FOR-SALE

(In Thousands)

Other mortgage-backed securities principally consisted of agency mortgage pass-through securities.  Pass-through securities provide to the investor monthly portions of principal and interest pursuant to the contractual obligations of the underlying mortgages.  Collateralized mortgage obligations (“CMOs”) separate the repayments into two or more components (tranches), where each tranche has a separate estimated life and yield.  The Company’s practice is to purchase pass-through securities and collateralized mortgage obligations guaranteed by federal agencies and tranches of CMOs with shorter maturities.  Included in corporate and other debt securities are highly rated corporate bonds and commercial paper.  At year-end 2003, approximately $8.2 million, or 88.9%, of the listed amount of mutual funds and equity securities consist of required holdings of Federal Reserve Bank of New York and Federal Home Loan Bank of New York stock.

The following table sets forth the maturities of the Company's securities available-for-sale portfolio as of December 31, 2003.  CMO’s and other mortgage-backed securities are included in the table based on their expected average lives.  Mutual funds and equity securities, which have no stated maturity, are included in the after 10 year category.

#

MATURITIES OF SECURITIES AVAILABLE-FOR-SALE

(In Thousands)

The following table sets forth the tax-equivalent yields of the Company's securities available-for-sale portfolio at December 31, 2003.

YIELDS ON SECURITIES AVAILABLE-FOR-SALE

(Fully Tax-Equivalent Basis)

The yields on debt securities shown in the table above are calculated by dividing annual interest, including accretion of discounts and amortization of premiums, by the amortized cost of the securities at December 31, 2003.  Yields on obligations of states and municipalities exempt from federal taxation were computed on a fully tax-equivalent basis using a marginal tax rate of 35%.  Dividend earnings derived from equity securities were adjusted to reflect applicable federal income tax exclusions.

At December 31, 2003 and 2002, the weighted average maturity was 4.3 and 2.8 years, respectively, for debt securities in the available-for-sale portfolio.  At December 31, 2003, the net unrealized gain on securities available-for-sale amounted to $2.3 million.  The net unrealized gain or loss on such securities, net of tax, is reflected in accumulated other comprehensive income/loss.  The net unrealized gain at December 31, 2003 represents a $4.3 million decrease since December 31, 2002 and is primarily attributable to the decreased fair value of the debt securities portfolios resulting from an increase in long-term rates during 2003.

For further information regarding the Company's portfolio of securities available-for-sale, see Note 3 to the Consolidated Financial Statements contained in Part II, Item 8 of this report.

#

Securities Held-to-Maturity:

The following table sets forth the carrying value of the Company's portfolio of securities held-to-maturity at December of each of the last three years.

SECURITIES HELD-TO-MATURITY

(In Thousands)

For information regarding the fair value at December 31, 2003, of the Company's portfolio of securities held-to-maturity, see Note 3 to the Consolidated Financial Statements contained in Part II, Item 8 of this report.

The following table sets forth the maturities of the Company's portfolio of securities held-to-maturity, as of December 31, 2003.

MATURITIES OF SECURITIES HELD-TO-MATURITY

(In Thousands)

The following table sets forth the tax-equivalent yields of the Company's portfolio of securities held-to-maturity at December 31, 2003.

YIELDS ON SECURITIES HELD-TO-MATURITY

(Fully Tax-Equivalent Basis)

The yields shown in the table above are calculated by dividing annual interest, including accretion of discounts and amortization of premiums, by the carrying value of the securities at December 31, 2003.  Yields on obligations of states and municipalities exempt from federal taxation were computed on a fully tax-equivalent basis using a marginal tax rate of 35%.

During 2003, 2002 and 2001, the Company sold no securities from the held-to-maturity portfolio.  The weighted-average maturity of the held-to-maturity portfolio was 4.7 years and 5.3 years at December 31, 2003 and 2002, respectively.

#

II. LOAN PORTFOLIO

The amounts and respective percentages of loans outstanding represented by each principal category on the dates indicated were as follows:

a. DISTRIBUTION OF LOANS

(Dollars In Thousands)

Indirect 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 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 loan totals was largely the result of aggressive campaigns 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, but the level of indirect loans was flat for the third quarter of 2003 and decreased by $11.9 million during the fourth quarter of 2003.  However, indirect loans still represent the second largest category of loans (36%) 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 largest segment of the Company’s loan portfolio at December 31, 2003, at 38% of loans at year-end.  This was the fastest growing segment in the Company's loan portfolio for the first, third and fourth quarters of 2003 and the second fastest for the second quarter of 2003.  The period of strong demand for residential real estate loans, which began when rates started falling in 2001, began to weaken in the third and fourth quarters of 2003, as refinancing activity, driven by the level or increasing interest rate environment, began to slow down.

During 2003 the Company sold (with servicing retained) $15.8 million of low-rate residential real estate loans.  The level of the portfolio was also impacted by the securitization of $11.5 million of mortgage loans cited earlier in this report.  In effect, the securitized loans were not sold but merely transferred to the Company's securities available-for-sale portfolio.  The Company also securitized $30.0 million of mortgage loans in 2001.

Commercial and Commercial Real Estate Loans: The Company continued to experience strong to moderate demand for commercial loans in 2003, a continuing trend that has persisted for several years, as commercial and commercial real estate loans have grown each year for the past five years, both in dollar amount and as a percentage of the overall loan portfolio.

#

The following table indicates the changing mix in the Company’s loan portfolio by including the quarterly average balances for the Company’s significant loan products for the past five quarters.  The ensuing tables present the percentage of total loans represented by each category as well as the annualized tax-equivalent yield.

LOAN PORTFOLIO

Quarterly Average Loan Balances

(Dollars In Thousands)

Percentage of Total Quarterly Average Loans

Quarterly Tax-Equivalent Yield on Loans

In general, management expects the Company’s yield on its loan portfolio will be impacted by actions the Federal Reserve Board takes from time to time affecting prevailing interest rates.  There is a time lag, however, between the Federal Reserve’s changes in prevailing rates and the impact of those changes on the Company’s loan portfolio.  As discussed above in this Report in the section entitled “Changes in Net Interest Income Due to Rate,” prevailing interest rates, after increasing steadily throughout 2000, decreased in 2001, 2002 and 2003 in response to the Federal Reserve Board’s rate-cutting actions during all four quarters of 2001, in November 2002 and again in June 2003.  The yield on the Company’s loan portfolio was affected by these rate changes, although the decrease in average yields on loans and other earning assets lagged behind the decrease in average rates paid on deposits, leading to exp ansion in the net interest margin in 2001 and 2002 and ultimately a contraction in 2003 as loan yields continued to fall while deposit rates bottomed out.  Many of the loans in the commercial portfolio have variable rates tied to prime 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 ultimately reprices at current rates as new loans are generated at the lower current yields.

#

The following table indicates the respective maturities and repricing structure of the Company's commercial, financial and agricultural loans and its real estate - construction loans at December 31, 2003.  For purposes of determining relevant maturities, loans are assumed to mature at (but not before) their scheduled repayment dates as required by contractual terms.  Demand loans and overdrafts are included in the “Within 1 Year” maturity category.  All of the real estate - construction loans are for single family houses where the Company has made a commitment for permanent financing.

MATURITY AND REPRICING OF COMMERCIAL LOANS

(In Thousands)

COMMITMENTS AND LINES OF CREDIT

Stand-by letters of credit represent extensions of credit granted in the normal course of business, which are not reflected in the financial statements because the commitments were not funded at period-end.  As of December 31, 2003, the total contingent liability for standby letters of credit amounted to $2.9 million.  In addition to these instruments, the Company has issued lines of credit to customers, including home equity lines of credit, commitments for residential and commercial construction loans and other personal and commercial lines of credit, which also may be unfunded or only partially funded from time to time.  Commercial lines, generally issued for a period of one year, are usually extended to provide for the working capital requirements of the borrower.  At December 31, 2003, the Company had outstanding unfunded loan commitments in the aggregate amount of approximately $137.7 million.

b. RISK ELEMENTS

NONACCRUAL, PAST DUE AND RESTRUCTURED LOANS

The Company designates loans as nonaccrual when the payment of interest and/or principal is due and unpaid for a designated period (generally 90 days) or when the likelihood of the full repayment of principal and interest is, in the opinion of management, uncertain.  Under the Uniform Retail Credit Classification and Account Management Policy, established by banking regulators, fixed-maturity consumer loans must generally be charged-off no later than when 120 days past due.  Open-end credits and residential real estate loans should be charged-off no later than when 180 days past due.  Commercial loans are evaluated for charge-off on a loan-by-loan basis.  There were no material commitments to lend additional funds on outstanding nonaccrual loans at December 31, 2003.

Loans past due 90 days or more and still accruing interest, as identified in the table presented on page 24 under the heading “SUMMARY OF THE ALLOWANCE AND PROVISION FOR LOAN LOSSES,” are those loans which were contractually past due 90 days or more but because of expected repayments, were still accruing interest.

#

SFAS No. 114 requires that all impaired loans, except for large groups of smaller-balance homogeneous loans, be measured based on (I) the present value of expected future cash flows discounted at the loan's effective interest rate, (II) the loan's observable market price or (III) the fair value of the collateral if the loan is collateral dependent.  The Company applies the provisions of SFAS No. 114 to all impaired commercial and commercial real estate loans over $250 thousand, and to all restructured loans.  Allowances for losses for the remaining smaller-balance loans are evaluated under SFAS No. 5.  Under the provisions of SFAS No. 114, the Company determines impairment for collateralized loans based on fair value of the collateral less estimated cost to sell.  For other loans, impairment is determined by comparing the recorded value of the loan to the present value of the expected cash flows, discounted at the loan’s effectiv e interest rate.  The Company determines the interest income recognition method for impaired loans on a loan-by-loan basis.  Based upon the borrowers’ payment histories and cash flow projections, interest recognition methods include full accrual or cash basis.

During 2003 one commercial loan was considered impaired under SFAS No. 114 with an average recorded investment of $254 thousand.  The loan was returned to accrual status before year-end 2003.  There were no impaired loans at December 31, 2003.

At December 31, 2003, nonperforming loans amounted to $2.5 million, a decrease of $55 thousand, or 2.1%, from the balance at year-end 2002.  Total nonperforming loans at year-end 2003 represented .29% of period-end loans, a decrease from .32% at year-end 2002.  The ratio of nonperforming loans to average loans for the Company’s peer group at September 30, 2003 was .80%, or 175.9% higher than the Company’s ratio at December 31, 2003.

During 2003 income recognized on year-end balances of nonaccrual loans was $107 thousand.  Income that would have been recognized during that period on nonaccrual loans if all such loans had been current in accordance with their original terms and had been outstanding throughout the period (or since origination if held for part of the period) was $160 thousand.

At December 31, 2002 one commercial loan was considered impaired under SFAS No. 114 with a recorded investment of $319 thousand, an allowance for loan losses of $160 thousand and a net carrying amount of $159 thousand.  This loan was included in nonaccrual loans in the schedule of nonperforming loans.

At December 31, 2002, nonperforming loans amounted to $2.6 million, a decrease of $876 thousand, or 25.5%, from the balance at year-end 2001.  The decrease was primarily attributable to one $749 thousand commercial loan designated nonperforming at year-end 2001, which was paid-off by the borrower during December 2002.  Total nonperforming loans at year-end 2002 represented .32% of period-end loans, a decrease from .46% at year-end 2001.  The ratio of nonperforming loans to period-end loans for the Company’s peer group at December 31, 2002 was .78%, or 143.8% higher than the Company’s ratio at December 31, 2002.

During 2002 income recognized on year-end balances of nonaccrual loans was $110 thousand.  Income that would have been recognized during that period on nonaccrual loans if all such loans had been current in accordance with their original terms and had been outstanding throughout the period (or since origination if held for part of the period) was $215 thousand.

At December 31, 2001, two commercial loans were considered impaired loans under SFAS No. 114 with a recorded investment of $1.6 million, an allowance for loan losses of $800 thousand and a net carrying amount of $800 thousand.  These loans were included in nonaccrual loans in the schedule of nonperforming loans above.

At December 31, 2001, nonperforming loans amounted to $3.4 million, an increase of $1.4 million, or 67.3%, from the balance at year-end 2000.  The increase was attributable to the two impaired commercial loans described in the preceding paragraph, which were placed on nonaccrual status during the fourth quarter of 2001.  The allowance for loan losses, at December 31, 2001, included specific impairment allowances of $800 thousand for these two loans.  Total nonperforming loans at year-end 2001 represented .46% of period-end loans, an increase from .28% at year-end 2000.  The ratio of nonperforming loans to average loans for the Company’s peer group at December 31, 2001 was .75%, or 63.0% higher than the Company’s ratio at December 31, 2001.

#

During 2001 income recognized on year-end balances of nonaccrual loans was $189 thousand.  Income that would have been recognized during that period on nonaccrual loans if all such loans had been current in accordance with their original terms and had been outstanding throughout the period (or since origination if held for part of the period) was $258 thousand.

POTENTIAL PROBLEM LOANS

On at least a quarterly basis, the Company applies an internal credit quality rating system to commercial loans that are either past due or fully performing loans which may exhibit certain characteristics that could reflect a potential weakness.  Loans are placed on nonaccrual status when the likely amount of future principal and interest payments are expected to be less than the contractual amounts, even if such loans are not 90 days past due.  Because of this approach toward placing commercial loans on nonaccrual status, the Company normally does not identify any significant number of potential  problem loans in its portfolio that do not otherwise meet one of the classifications discussed above (e.g., nonaccrual, troubled debt restructurings).  At year-end 2003, the Company had no such additional potential problem loans.  At year-end 2002 the Company had identified only one credit that, although still accruing interest, exhibit ed such significant weakness as to warrant mention as a potential problem.  In 2003 the Company up-graded the status of that borrower and no longer considers the credit to be classified as a potential problem loan.

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 $456 thousand as of December 31, 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 to which interest income was being accrued (i.e. loans 30-89 days past due as defined in bank regulatory agency guidance) totaled $6.6 million at December 31, 2003 and represented 0.78% of loans outstanding at that date, as compared to approximately $5.7 million, or 0.71% of loans at December 31, 2002.  These non-current loans at December 31, 2003 were composed of approximately $5.3 million of consumer loans, principally indirect motor vehicle loans, $584 thousand of residential real estate loans, $200 thousand of commercial real estate loans and $515 thousand of commercial loans.

The overall level of the Company’s performing loans which demonstrate characteristics of potential weakness from time-to-time is for the most part dependent on economic conditions in northeastern New York State.  In general, the economy in the Company’s geographic market area was relatively strong in the 1997-2000 period.  Although the U.S. experienced a mild recession in 2001 which continued throughout 2002 and into 2003, the economic downturn was not as severe in northeastern New York State.  In the “Capital District” in and around Albany and in the area north of the Capital District, which are the Company’s principal service areas, unemployment remained below the national average.

FOREIGN OUTSTANDINGS - None

LOAN CONCENTRATIONS

The loan portfolio is well diversified.  There are no concentrations of credit that exceed 10% of the portfolio, other than the general categories reported in the preceding Section II.a. of this report.  For further discussion, see Note 26 to the Consolidated Financial Statements in Part II, Item 8 of this report.

#

OTHER REAL ESTATE OWNED AND REPOSSESSED ASSETS

Other real estate owned (OREO) consists of real property acquired in foreclosure.  OREO is carried at the lower of (i) fair value less estimated cost to sell or (ii) the recorded investment in the loan at the date of foreclosure, or cost.  The Company establishes allowances for OREO losses.  The allowances are established and monitored on a property by property basis and reflect management's ongoing estimate of the property's estimated fair value less costs to sell (when such amount is less than cost).  For all periods, all OREO was held for sale.  Repossessed assets consist almost entirely of automobiles.

DISTRIBUTION OF OTHER REAL ESTATE OWNED AND REPOSSESSED ASSETS

(Net of Allowance) (In Thousands)

The following table summarizes changes in the net carrying amount of other real estate owned for each of the periods presented.

SCHEDULE OF CHANGES IN OTHER REAL ESTATE OWNED

(Net of Allowance) (In Thousands)

The following is a summary of changes in the allowance for OREO losses:

ALLOWANCE FOR OTHER REAL ESTATE OWNED LOSSES

(In Thousands)

During 2003, the Company acquired one property for $10 thousand through foreclosure.  Also during the year, the Company sold two properties with a carrying amount of $61 thousand for a net gain of $12 thousand.

During 2002, the Company acquired two properties totaling $114 thousand through foreclosure.  Also during the year, the Company sold seven properties with a carrying amount of $317 thousand for a net gain of $40 thousand.  The Company received other payments on foreclosed properties of $41 thousand.

#

During 2001, the Company acquired five properties totaling $222 thousand through foreclosure.  Also during the year, the Company sold five properties with a carrying amount of $290 thousand for a net gain of $103 thousand.  The Company received other payments on foreclosed properties of $57 thousand.

During 2000, the Company acquired nine properties totaling $554 thousand through foreclosure.  Also during the year, the Company sold thirteen properties with a carrying amount of $715 thousand for a net gain of $29 thousand.

III. SUMMARY OF LOAN LOSS EXPERIENCE

The Company monitors credit quality through a continuous review of the entire loan portfolio.  All significant loans (primarily commercial and commercial real estate loans) are reviewed at least semi-annually, and those under special supervision are reviewed at least quarterly.  Additionally, regulatory examiners perform periodic examinations of the Company’s loan portfolios and report on these examinations to management. The boards of directors of the Company's subsidiary banks, upon recommendations from management, determine the extent of charge-offs and have the final decision-making responsibility in authorizing charge-offs.  

Through the provision for loan losses, an allowance (reserve) is maintained for probable loan losses.  Actual loan losses are charged against this allowance when they are identified.  In evaluating the adequacy of the allowance for loan losses, management considers various risk factors influencing asset quality.  The analysis is performed on a loan-by-loan basis for impaired and large balance loans, and by portfolio type for smaller balance homogeneous loans. This analysis is based on judgments and estimates and may change in response to economic developments or other conditions that may influence borrowers' economic outlook and financial condition and prospects.

In addition to conclusions regarding the adequacy of the allowance, the provision for loan losses is influenced by the total size of the loan portfolio, the level of nonperforming loans, by the level of loans actually charged-off against the allowance during prior periods and the change in the mix of loan categories within the loan portfolio.

The table in Part II, Item 7.B.II. “Provision for Loan Losses and Allowance for Loan Losses” presents a summary of the activity in the Company's allowance for loan losses.

ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES