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ARROW FINANCIAL CORPORATION

FORM 10-K – INDEX

*These items are incorporated by reference to the Corporation’s Proxy Statement for the Annual Meeting of Shareholders to be held April 27, 2005.

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NOTE ON TERMINOLOGY

In this Annual Report on Form 10-K, the terms “Arrow,” “the registrant,” “we,” “us,” and “our” generally refer to Arrow Financial Corporation and its subsidiaries, as a group, except where the context indicates otherwise.

At certain points in this Report, our performance is compared with that of our “peer group” of financial institutions.  Peer data has been obtained from the September 2004 Federal Reserve Board’s “Bank Holding Company Performance Report.”  Unless otherwise specifically stated, our peer group is comprised of the group of 207 domestic bank holding companies with $1 to $3 billion in total consolidated assets.

FORWARD-LOOKING STATEMENTS

The information contained in this Annual Report on Form 10-K contains statements that are not historical in nature but rather are based on our 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 performance or changes in future performance would look like based on hypoth etical assumptions and on simulation models.  Other forward-looking statements are based on our 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.  We undertake no obligation to revise or update these forward-looking statements to reflect the occurrence of unanticipated events.

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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 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 our reasons for utilizing the non-GAAP financial measures as part of Arrow'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 whenever they include non-GAAP financial measures in filings with the SEC.  The SE C 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 we are 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 on a tax-equivalent basis.  That is, to the extent that some component of the institution's net interest income will be exempt from taxation (e.g., was received by the institution as a result of its holdings of state or municipal obligations), an amount equal to the tax benefit derived from that component is added back to the net interest income total.  This adjustment is considered helpful in comparing one financial institution's net interest income (pre-tax) to that of another institution, as each will have a different proportion of tax-exempt items in their portfolios.  Moreover, net interest income is itself a component of a second financial measure commonly use d 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 financial institutions, again to provide a better basis of comparison from institution to institution.  We follow 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 noninterest 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 financial institutions, in calculating the efficiency ratio, also adjust both noninterest expense and noninterest income to exclude from these items (as calculated under GAAP) certain component elements, such as intangible asset amortization (deducted from noninterest expense) and securities gains or losses (excluded from noninterest income).  We follow these practices.

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PART I

Item 1.  Business

A. GENERAL

Our holding company, Arrow Financial Corporation, 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.  Arrow owns two nationally chartered banks in New York, Glens Falls National Bank and Trust Company, Glens Falls, New York (Glens Falls National), and Saratoga National Bank and Trust Company, Saratoga Springs, New York (Saratoga National), as well as seven non-bank subsidiaries, the operations of which are not significant.  We own directly or indirectly all voting stock of all our subsidiaries.

Arrow’s business consists primarily of the ownership, supervision and control of our banks.  The holding company provides various advisory and administrative services and coordinates the general policies and operation of the banks.  There were 414 full-time equivalent employees at December 31, 2004.

We offer a full range of commercial and consumer banking and financial products.  Our deposit base consists of deposits derived principally from the communities we serve.  We target our lending activities to consumers and small and mid-sized companies in our immediate geographic areas.  Through our banks' trust operations, we provide retirement planning, trust and estate administration services for individuals, and pension, profit-sharing and employee benefit plan administration for corporations.

In 2000, Arrow 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 our Banks.

In 2001, we 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 our full-service branches.

Recent Acquisitions:  In November 2004, our lead bank, Glens Falls National, acquired all of the outstanding shares of common stock of Capital Financial Group, Inc. (CFG), an insurance agency headquartered in South Glens Falls, New York, which specializes in group health and life insurance products.  The acquisition was structured as a tax-free exchange of Arrow’s common stock for CFG’s common stock.  CFG’s president and staff continued with CFG after the acquisition.  We recorded the following intangible assets as a result of the acquisition (none of which are deductible for income tax purposes): goodwill ($1.422 million), covenant ($117 thousand) and expirations ($686 thousand).  The value of the covenant is being amortized over five years and the value of the expirations is being amortized over twenty years.  Under the acquisition agreement, we issued 60,976 shares of Arrow
46;s common stock at closing.  The agreement also provides for annual contingent future payments of Arrow common stock, based upon earnings, over a five-year period.  We have concluded that, under criteria established by SFAS No. 141, these payments will be recorded as additional goodwill at the time of payment.  The minimum contingent payment is zero and the maximum contingent payment is $3.0 million.

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In December 2004, Arrow’s subsidiary banks entered into agreements to acquire from HSBC Bank USA, N.A. (“HSBC”) three bank branches located within the Banks’ service areas.  Glens Falls National agreed to acquire two HSBC branches located in Argyle and Salem, New York, and Saratoga National agreed to acquire a branch located in Corinth, New York.  The banks will acquire substantially all deposit liabilities, the physical facilities and certain loans related to the branches.  The acquisitions are subject to receipt of all required regulatory approvals and satisfaction of certain other terms and conditions, and are expected to be completed in April 2005.  Total deposits of the three branches are approximately $66 million and the related loans are approximately $11 million.  We expect that the acquisition will result in total intangible assets of approximately $6 million.

B. LENDING ACTIVITIES

Arrow 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.  We also maintain an active indirect lending program through our sponsorship of dealer programs, under which we purchase dealer paper from automobile and other dealers meeting pre-established specifications.  We have periodically sold a portion of 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.  Recent sales were of longer-term residential mortgage loans, with interest rates that were both fixed and historically low.

In addition to sales of loans into the secondary market, we have periodically securitized some of the mortgage loans in our portfolio.  We securitized $11.5 million and $30.2 million of residential real estate loans in 2003 and 2001, respectively, with a combined remaining balance of $17.2 million at December 31, 2004.  In the transactions, we sold mortgage loans and concurrently purchased an equivalent amount of guaranteed mortgage-backed securities issued by Freddie, with the sold loans representing the underlying collateral for the pooled securities.  In addition to interest earned on loans, we receive 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, we continue 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 our 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”).  Future cash payments may be applied all to principal, however, income in some cases may be recognized on a cash basis.

We lend primarily to borrowers within our 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.  We do 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.

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C. SUPERVISION AND REGULATION

The following generally describes the laws and regulations to which we are subject.  Bank holding companies, banks and their affiliates 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 our business and prospects.

Arrow 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, Arrow is subject to regulation by the New York State Banking Department.  Our 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 Arrow from engaging, directly or indirectly, in activities other than banking, activities closely related to banking, and certain other financial activities.  Under the BH C 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.D., “Recent 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.  Under final rules, issued February 28, 2005 by the FRB, trust preferred securities may also qualify as Tier 1 capital, in an amou nt not to exceed 25% of Tier 1 capital.  The final rule limits restricted core capital elements to a percentage of the sum of core capital elements, net of goodwill less any associated deferred tax liability.  We have issued trust preferred securities in each of the last two years.  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.  Our subsidiary banks ar e 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.  Arrow and each of our subsidiary banks currently qualify as “well capitalized.”  The year-end 2004 capital ratios of Arrow and our subsidiary banks are set forth in Part II, Item 7.E. "Capital Resources and Dividends."  

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, our ability to pay dividends to our shareholders, and our subsidiary banks’ ability to pay dividends to our holding company, are 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 Arrow and the banks to pay dividends in the future is, and is expected to continue to be, influenced b y regulatory policies, capital guidelines and applicable law.

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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 Arrow nor any of our subsidiaries is now, or has been within the past year, subject to any formal or informal regulatory enforcement action or order.

D. 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 Arrow.  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 Arrow'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 corporate 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 our 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 C., “Supervision and Regul ation,” above).  We have not as yet elected to become a “financial holding company” but continue 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, such as our banks.  Since 1996, the premium paid by the best-rated banks (including our 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 our 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 our banks) was 1.440 cents per $100 of insured deposits at December 31, 2004.

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

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E. CRITICAL ACCOUNTING POLICIES

In order to prepare our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America, we were 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.  We consider 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 us to increase the allowance for loan losses resulting in a negative impact on our results of operations and financial condition.  

Liabilities for retirement plans:  We have 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, our own operations or applicable law may result in material changes to our liability for postretirement expense, with consequent impact on our 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.  Our 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 our portfolio.

F. 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.

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G. COMPETITION

Arrow faces intense competition in all markets we serve.  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 Arrow and our subsidiary banks.  As a result of the Gramm-Leach-Bliley Act, such non-banking financial organizations now may be in a position not only to offer comparable products to those offered by us, but actually to establish or acquire their own commercial banks.

H. EXECUTIVE OFFICERS OF THE REGISTRANT

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

I. 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.  We also make 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, and our Code of Ethics.  We have adopted a financial code of ethics that applies to Arrow’s chief executive officer, chief financial officer and principal accounting officer.  We have also adopted a business code of ethics that applies to all directors, officers and employees. & nbsp;Both are available on our website: www.arrowfinancial.com.

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Item 2.  Properties

Our main offices are at 250 Glen Street, Glens Falls, New York.  The building is owned by us and serves as the main office for Glens Falls National Bank.  We own 22 branch offices, 19 of them belonging to Glens Falls National, and  lease four others at market rates.

In the opinion of management, the physical properties of Arrow and our subsidiary banks are suitable and adequate.  For more information on our 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

We are not the subject of any material pending legal proceedings, other than ordinary routine litigation occurring in the normal course of our business.

On an ongoing basis, we are the subject of or a party to various legal claims, which arise in the normal course of our 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 2004.

PART II

Item 5.  Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

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 our September 2004 three percent stock dividend.

The payment of dividends by Arrow is at the discretion of its Board of Directors and is dependent upon, among other things, our 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 5,294 holders of record of Arrow’s common stock at December 31, 2004. Arrow has no other class of stock outstanding.

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Unregistered Sales of Equity Securities

On November 29, 2004, Arrow issued 60,976 shares of its common stock to the sole shareholder of Capital Financial Group, Inc. (CFG), an insurance agency engaged in the sale of group health and life insurance products, in connection with the acquisition of CFG by our subsidiary bank, Glens Falls National.  See “Recent Acquisitions” on page 5 of this Report for more information regarding the transaction.  The shares were issued without registration under the Securities Act of 1933, as amended, in reliance upon the exemption for such registration set forth in Section 3(a)(II) of the Act and Rule 147 promulgated by the Securities and Exchange Commission thereunder.  In the transaction, structured as a merger of a newly formed subsidiary of Glens Falls National with and into CFG, Glens Falls National acquired 100 percent of the outstanding shares of CFG.

Issuer Purchases of Equity Securities

The following table presents information about purchases by Arrow during the three months ended December 31, 2004 of our own equity securities registered pursuant to section 12 of the Securities Exchange Act of 1934 (i.e., Arrow Financial Corporation’s Common Stock):

¹The total number of shares purchased and the average price paid per share include shares purchased in open market transactions under the Arrow Financial Corporation Automatic Dividend Reinvestment Plan (the DRIP) by the administrator of the DRIP and shares surrendered to Arrow by holders of options to acquire Arrow common stock in connection with the exercise of such options.  In the months indicated, the listed number of shares purchased included the following numbers of shares purchased through such methods:  November 2004 – option exercises (9,230 shares); December 2004 – DRIP purchases (14,701 shares), option exercises (517 shares)

²Includes only shares subject to publicly-announced stock repurchase programs.  Does not include shares purchased or subject to purchase under the DRIP or any compensatory stock plan.

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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 included 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 and 2000.

³ Share and per share amounts have been adjusted for subsequent stock splits and dividends, including the most recent September 2004 3% stock

     dividend

⁴ Tangible book value excludes intangible assets from total equity.

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

The following discussion and analysis focuses on and reviews our results of operations for each of the years in the three-year period ended December 31, 2004 and our financial condition as of December 31, 2004 and 2003.  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)

Share and per share amounts have been adjusted for subsequent stock splits and dividends, including the most recent September 2004 3% stock dividend.

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Selected Quarterly Information, Continued:

¹ See “Use of Non-GAAP Financial Measures” on page 4.

Selected Twelve-Month Information:

(Dollars In Thousands, Except Per Share Amounts)

Share and per share amounts have been adjusted for subsequent stock splits and dividends, including the most recent September 2004 3% stock dividend.

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Selected Twelve-Month Information, Continued:

¹ See “Use of Non-GAAP Financial Measures” on page 4.

Summary of 2004 Financial Results

We reported net income of $19.5 million for 2004, an increase of $561 thousand, or 3.0%, compared to 2003.  Diluted earnings per share increased $.06, or 3.3%, from 2003.  During 2004, the challenge of maintaining high quality earning assets in the face of falling net interest margins placed great pressure on our earnings.  For the second consecutive year, our net interest margin decreased, reflecting the industry-wide trend that could effectively be offset only by growth and/or new lines of business.  We continued to grow in 2004, albeit at a diminished rate compared to prior years.  At year-end, we announced two acquisition transactions, which are expected to add three branches and approximately $66 million in deposits.  See “Recent Acquisitions” on page 5.

At December 31, 2004, our tangible book value per share (calculated based on shareholders’ equity reduced by intangible assets including goodwill and other intangible assets) amounted to $10.43, an increase of $.85, or 8.9%, from year-end 2003.  The increase was primarily attributable to retained earnings, offset in part, by periodic repurchases of our common stock and an increase in intangible assets resulting from an acquisition of an insurance agency in November 2004.  As of the last trading day of 2004, the average of our bid and asked stock price was $31.23, resulting in a trading multiple of 2.99 to tangible book value.

The Board of Directors increased the quarterly cash dividend twice in 2004, to $.23 per share by the fourth quarter.  Total cash dividends (as adjusted for stock dividends and stock splits) were $.89 for 2004, compared to $.81 for 2003, an increase of $.08, or 9.9%.

Nonperforming loans amounted to $2.1 million at December 31, 2004, a decrease of $398 thousand, or 15.9%, from the prior year-end.  Loans charged-off (net of recoveries) against the allowance for loan losses were $816 thousand for 2004, as compared to a similar amount of $811 thousand for the prior year.   At year-end 2004, the allowance for loan losses, at $12.0 million, represented a coverage ratio to total loans of 1.38%, unchanged from the prior year-end.

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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 had the greatest impact on our results of operations for 2004 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 $51.8 million in 2004, an increase of $271 thousand, or 0.5%, from $51.5 million in 2003.  This compared to a $659 thousand, or 1.3%, decrease between 2002 and 2003.  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.

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CHANGE IN NET INTEREST INCOME

(In thousands) (Tax-equivalent basis)

The following table reflects the components of our net interest income, setting forth, for years ended December 31, 2004, 2003 and 2002 (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.  

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Average Consolidated Balance Sheets and Net Interest Income Analysis

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

(Dollars in Thousands)

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CHANGES IN NET INTEREST INCOME DUE TO RATE

We experienced a slight increase in net interest income of $271 thousand from 2003 to 2004.  This reflected on the one hand the positive effect of an increase in average earning assets, which had a $2.3 million positive impact on net interest income, offset, in part, by the negative effect of a decrease in the net interest spread and net interest margin (i.e. changes in rates), which had a negative impact of $2.1 million on net interest income.  For the change in net interest income from 2002 to 2003, we experienced a decrease in net interest income of $659 thousand, as the positive impact of an increase in average earning assets (a $5.8 million positive impact on net interest income) was more than offset by the negative impact of changes in the interest rate environment (a $6.4 million negative impact).  

The following items have a major impact on changes in net interest income due to rate:  general interest rate changes, the ratio of our 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 – 2005

The Federal Reserve Board attempts to influence prevailing federal funds and prime interest rates, in part by determining where to set the Federal Reserve Bank discount rate.  The following chart presents rate changes in recent years:

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

In the first quarter of 2001, after an extended period of stable interest rates and six months of moderate rate increases, the Federal Reserve Board 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 425 basis points.  For the following eleven months there were no rate changes, but the Federal Reserve Board then decreased rates another 50 basis points in November 2002 and followed with an additional 25 basis point decrease in September 2003.  As a result of this multi-year decrease in prevailing rates, we experienced a decrease in the cost of deposits in all quarters of 2001, which continued throughout 2002, 2003 and into 2004.  We also experienced a decrease in the average yield in our loan portfolio during these years, although the decrease in our loan yield generally tra iled, or lagged behind, our cost of deposits by three to six months resulting in higher margins and higher net interest income during the earlier portions of this declining rate period.

During 2003 and 2004, the effect of the Federal Reserve’s rate decreases on our deposit rates began to diminish, because rates on several of our deposit products, such as savings and NOW accounts, were already priced at such low levels that further significant decreases in the rates for such products was not practical or sustainable.  Yields on our loan portfolio, however, continued to fall significantly in 2003 and 2004, putting serious pressure on the net interest margin.  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 for 2003 and 2004 the low rate environment had a negative impact on net interest margin.

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

First Quarter 2004: The net interest margin for the first quarter of 2004 was 3.97%, an increase of 2 basis points from the net interest margin for the fourth quarter of 2003.  However, in the first quarter of 2004, both the yields on average earning assets and the cost of paying liabilities decreased slightly from the fourth quarter of 2003.

Second Quarter 2004: The net interest margin for the second quarter of 2004 was 3.86%, a decrease of 11 basis points from the net interest margin for the first quarter of 2004.  Yields on average earning assets decreased 14 basis points from the first quarter, while the cost of paying liabilities only decreased 4 basis points.

Third Quarter 2004: As the above table indicates, the Federal Reserve reversed direction in the second quarter of 2004 and began to increase prevailing rates with five successive 25 basis point increases in the federal funds rate in 2004, and one more, so far, in 2005.  This change in direction did not immediately impact either our cost of paying liabilities or our yield on earning assets, both because of normal time-lag in the responsiveness of such rates to Federal Reserve actions and for reasons unique to our portfolios.  The change in the mix of our total deposits in the third quarter of 2004, reflecting our decision to de-emphasize certain high cost municipal deposits, had a positive impact on net interest margin for the third quarter, which increased by 10 basis points to 3.96% from the second quarter.  The cost of all NOW accounts fell from 1.21% for the second quarter to .80% for the third quarter.  The yield on earning assets, meanwhile, only decreased 3 basis points from the prior quarter.

Fourth Quarter 2004: Generally, by the end of the third quarter of 2004, the increases in the target federal funds rate started to have the expected impact on our net interest margin.  Rates paid on new time deposits by the end of the quarter were higher than the rates on maturing time deposits.  Our net interest margin for the fourth quarter of 2004 was 3.91%, a decrease of 5 basis points from the third quarter.  There was very little change in rates paid on average earning assets from the third quarter to the fourth quarter.  The decrease in net interest margin was primarily due to the fact that, in the aggregate, the cost of deposits and other borrowed funds was increasing faster than rates on earning assets.

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We are not able to predict how long it will be before the recent increase in prevailing rates or any possible future increases may result in an increase in our yield on earning assets, or whether or for how long our net interest margin may continue to decrease, adversely affecting earnings.  However, the yield on our average loan balances for the fourth quarter of 2004 was only one basis point below the yield for the third quarter of 2004.  

In both rising and falling rate environments, we face significant competitive pricing pressures in the marketplace for our 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 our 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)

2004 vs. 2003:

In general, an increase in average earning assets has a positive impact on net interest income, assuming a positive spread between the cost paid on interest-bearing liabilities and the yield earned on interest-bearing assets.  For 2004, average earning assets increased $48.4 million over 2003, while average paying liabilities only increased $28.9 million.  This combination led to a $2.3 million increase in net interest income (offset by the $2.1 million decrease due to changing rates discussed above).

The $48.4 million increase in average earning assets from 2003 to 2004 reflected an increase in average loans of $18.0 million, or 2.12%, and an increase in average investment securities of $28.3 million, or 6.9%.  Within the loan portfolio, the average balance of indirect loans (which represented the second largest segment of the loan portfolio) actually decreased by $18.4 million, or 5.7%.  Indirect loans are primarily auto loans financed through local dealerships from whom we acquire the dealer paper.  This decrease was more than offset by increases in the average balances of commercial and commercial real estate loans ($15.4 million, or 8.7%), residential real estate loans ($20.1 million, or 4.2%) and other consumer loans ($1.0 million, or 11.8%).

The $28.9 million increase in average paying liabilities resulted from a $41.1 increase in interest-bearing nonmaturity deposits and an $11.0 million increase in other borrowed funds, offset in part by a decrease of $23.2 million in time deposits.

The fact that average earning assets grew at a faster pace than average paying liabilities was primarily due to an $18.4 million, or 12.7%, increase in the average balance on non-interest bearing demand deposits.

2003 vs. 2002:

During 2003 average earning assets increased $112.2 million, an increase of 9.7%.  Average paying liabilities increased 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 between the two years resulting from the change in interest rates discussed above.

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During 2003, we experienced growth in our 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 in 2003.  The average balance of residential mortgage loans increased by over $41 million, or 15.8%.  Commercial and commercial real estate lending represented the second largest growth area in the portfolio, expanding by over $20 million, or 14.8%.  The average balance of indirect consumer lending increased by over $13 million in 2003, or 4.3%.  Changes in the loan portfolio are discussed in more detail in the following section C.II. “Loan Portfolio.”

The $97.9 million increase in average paying liabilities in 2003 was experienced primarily in traditional banking deposit products, which increased by $79.9 million, or 11.2%, from the prior year, and secondarily in Federal Home Loan Bank (FHLB) borrowings, which increased by $17.3 million, or 13.3%.  The increase in deposit balances during 2003 was generated by our pre-existing branch network, although Glens Falls National Bank 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.”

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

We consider our 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 may have on our results of operations.  In addition to the following discussion, see Note 1 to the consolidated financial statements, included in Item 8 of this Report, for a description of our 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, we consider 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.

2004 vs. 2003:

At December 31, 2004, the quality of our loan portfolio remained strong and, to date, had not been negatively affected by the loan growth experienced in recent periods.  At period-end, our ratio of nonperforming loans (loans 90 days or more past due and accruing interest plus nonaccrual loans) as a percentage of total loans was .24%.  The September 30, 2004 ratio for our peer group was .63%.  At December 31, 2004, nonperforming loans amounted to $2.1 million, a decrease of $398 thousand, or 15.9%, from the balance at year-end 2003.

While we believe that the 2004 year-end allowance of $12.0 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, will not require increased provisions to the allowance or result in a higher incidence of loan charge-offs.

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The provision for loan losses was $1.0 million for 2004, a decrease of $440 thousand, or 30.1%, from 2003.  The provision was reduced, despite the growth in the loan portfolio, because asset quality indicators improved.  During 2004, loan losses charged against the allowance, net of recoveries, were $816 thousand, virtually unchanged from the 2003 amount.  The result was a $204 thousand, or 1.7%, increase in the allowance.  Because loans increased by a similar percentage during the year, our coverage ratio, (allowance to period-end loans) was the same at year-end 2004 as at year-end 2003 (1.38%).  Net charge-offs as a percentage of average loans outstanding was .09% for 2004, down slightly from .10% for 2003.  Net charge-offs, on an annualized basis, for our peer group at September 30, 2004 was .16% of average loans. If the current economic conditions should worsen, we anticipate that net charge-offs may exceed the levels ex perienced in recent years.

2003 vs. 2002:

At period-end 2003, the ratio of our nonperforming loans (loans 90 days or more past due and accruing interest plus nonaccrual loans) to total loans was .29%.  The September 30, 2003 ratio for our 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.

The provision for loan losses was $1.5 million for 2003, a decrease of $828 thousand, or 36.2%, from 2002.  This reduction in the provision, like the subsequent reduction in 2004, reflected general improvement in the portfolio quality indicators.  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, our coverage ratio, 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 our peer group at September 30, 2003 was .22% of average loans.

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, we 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 our peer group at December 31, 2002 was .30% of average loans, or 172.7% higher than our 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 growth in the loan portfolio between the two years resulted in the 2002 provision for loan losses remaining consistent with 2001.

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.

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SUMMARY OF THE ALLOWANCE AND PROVISION FOR LOAN LOSSES

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

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III. OTHER INCOME

The majority of our 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)

2004 vs. 2003: Total other income increased $845 thousand, or 6.8%, from 2003 to 2004.  Without regard to net securities transactions, total other income increased by $1.2 million, or 10.7%, from 2003 to 2004.

For 2004, income from fiduciary activities increased $579 thousand, or 15.9%, from 2003.  At year-end 2004, the market value of assets under trust administration and investment management amounted to $801.7 million, an increase of $53.3 million, or 7.1%, from year-end 2003.  This increase reflected the general improvement in the equity markets during 2004 and substantial new accounts attributable to business development efforts.

Income from fiduciary activities includes income from funds under investment management in our proprietary 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 had a market value of $145.5 million and $112.9 million at December 31, 2004 and 2003, respectively.  The funds were introduced in March 2001, and are advised by our subsidiary investment advisers, North Country Investment Advisers, Inc.  Currently, the funds are owned almost entirely by qualified employee benefit plan accounts.  We also offer these funds on a retail basis through our bank branches.  Included as an investor in the funds is our pension plan, which owns shares in the funds with a market value of approximately $17.6 million at both December 31, 2004 and 2003.

Fees for other services to customers include deposit account service charges, insurance agency commissions, credit card and debit card merchant processing fees, safe deposit box fees and loan servicing fees.  These fees amounted to $7.5 million in 2004, an increase of $736 thousand, or 10.9%, from 2003.  The increase was primarily attributable to credit card and debit card merchant processing fees, deposit account service charges and insurance commission income.  In November 2004, we acquired a local insurance agency engaged in the sale of group health and life insurance.  See “Recent Acquisitions” on page 5 of this Report.

In 2004, total other income included securities gains of $362 thousand on the sale of $73.9 million of securities available-for-sale.  The primary purpose of the sales was to extend and restructure the maturities of certain investments with shorter remaining lives.  The following table presents sales and purchases within the available-for-sale portfolio during 2004.

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2004 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 2004, other operating income decreased $77 thousand, or 6.6%, from 2003, primarily because we sold fewer loans into the secondary market in 2004.  During 2004, we sold $15.4 million of newly originated loans (primarily residential real estate loans) to the secondary market.  The net gains of $336 thousand were primarily due to the fact that we were able to write loans with yields slightly higher than those required by the secondary market.  By comparison, for 2003, we sold $18.5 million of loans for net gains of $489 thousand.

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 market value occurred toward the end of 2003; the average market value of assets under trust administration and investment management did not increase between the two years.  Fiduciary account fees, in general, are tied to the value of assets under administration.  The increase in the market value of assets under administration 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 20 03 was above the respective quarters in 2002.

Income from fiduciary activities includes income from funds under investment management in our proprietary mutual funds, the North Country Funds, described in the preceding section.  On a combined basis, these funds had a market value of $112.9 million and $84.8 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.

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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, we experienced above-average amounts of prepayments of mortgage-backed securities and CMO’s in the available-for-sale portfolio, many of which we had purchased in the markets at premiums at times when they had above-market 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 he ld-to-maturity portfolios during 2003.  Total purchases in the table below include $11.5 million of asset-backed securities purchased by us and secured by assets (loans) originated by our Banks.  Such securities are not, however, included in the total amount listed under “Purchase of Securities Available-for-Sale” in the Consolidated Statement of Cash Flows included in our Consolidated Financial Statements in Part III, Item 8 of this Report, as our securitization of these loans and purchase of the asset-backed securities was a non-cash transaction.

2003 Investment Sales and Purchases

(In Thousands)

For 2003, other operating income increased $8 thousand, or 0.7%, from 2002.  During 2003, we 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 also because we were able to write loans with yields slightly higher than those required by the secondary market.  In 2002, we 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 our group employee insurance trust and a $173 thousand recovery related to the former Vermont operations.  Credit card processing income decreased by $55 thousand from 2002 to 2003 as we completed our exit from this business in 2003.

IV. OTHER EXPENSE

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

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ANALYSIS OF OTHER EXPENSE

(Dollars In Thousands)

2004 vs. 2003:  Other expense for 2004 amounted to $33.0 million, an increase of $487 thousand, or 1.5%, from 2003.  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 2004, the efficiency ratio for Arrow was 51.0%, a slight decrease from the 2003 ratio of 51.4%.  Our 2004 ratio, however, compared favorably to the year-to-date ratio for our peer group of 61.1% as of September 30, 2004.  For information on the calculation of our efficiency ratios on a quarterly and annual basis, see pages 14 and 16 of this Report.  Also see the discussion on page 4 regarding “Use of Non-GAAP Financial Measures.&# 148;

Salaries and employee benefits expense increased $857 thousand, or 4.5%, from 2003 to 2004.  The increase in salary expense for 2004 was 2.9% over 2003 due primarily to merit increases.  The increase in employee benefits from 2003 to 2004 was 8.6%, and was primarily attributable to increases in nonpension postretirement benefit costs, as well as increases in health insurance benefit costs.  On an annualized basis, the ratio of total personnel expense (salaries and employee benefits) to average assets was 1.43% for 2004, 19 basis points less than the ratio for our peer group of 1.62% at September 30, 2004.

Occupancy expense increased $171 thousand, or 6.8%, from 2003 to 2004. Most of the increase was attributable to increased costs of lease expense, depreciation and real estate taxes.  Furniture and equipment expense actually decreased by $126 thousand, or 4.5%, from 2003 to 2004.  The decrease was primarily attributable to a decrease in equipment maintenance costs.

Other operating expense also decreased from 2003 to 2004, by $415 thousand, or 5.0%.  The net decrease was distributed among a variety of categories of other operating expense.

2003 vs. 2002:  Other expense for 2003 amounted to $32.5 million, an increase of $1.1 million, or 3.5%, from 2002.  For 2003, our efficiency ratio was 51.4%, an increase from the 2002 ratio of 49.5%.  Our 2003 ratio, however, compared favorably to the ratio for our peer group of 60.4%, annualized as of September 30, 2003.  

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.  This was offset, in part, by decreases in pension expense (due primarily to our 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 our peer group of 1.67%, annualized 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.

V. INCOME TAXES

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

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INCOME TAXES AND EFFECTIVE RATES

(Dollars in Thousands)

The provisions for federal and state income taxes amounted to $9.0 million, $8.6 million and $8.8 million for 2004, 2003 and 2002, respectively.   The effective income tax rates for 2004, 2003 and 2002 were 31.5%, 31.3% and 31.7%, respectively.

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 reporting 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, 2004, we held no trading securities.  Set fo rth below is certain information about our securities available-for-sale portfolio and securities held-to-maturity portofolio.

Securities Available-for-Sale:

The following table sets forth the carrying value of our securities available-for-sale portfolio at year-end 2004, 2003 and 2002.

SECURITIES AVAILABLE-FOR-SALE

(In Thousands)

In all periods, 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.  Our practice has been 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 2004, approximately $8.4 million, or 88.7%, of the listed amount of mutual funds and equity securities consisted of required holdings of stock of the Federal Reserve Bank of New York and the Fed eral Home Loan Bank of New York.

The following table sets forth the maturities of our securities available-for-sale portfolio as of December 31, 2004.  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.

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MATURITIES OF SECURITIES AVAILABLE-FOR-SALE

(In Thousands)

The following table sets forth the tax-equivalent yields of our securities available-for-sale portfolio at December 31, 2004.

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, 2004.  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, 2004 and 2003, the weighted average maturity was 2.4 and 4.3 years, respectively, for debt securities in the available-for-sale portfolio.  At December 31, 2004, the net unrealized gain on securities available-for-sale amounted to $1.3 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, 2004 represents a $1.0 million decrease since December 31, 2003 and is primarily attributable to the decreased fair value of the debt securities portfolios resulting from an increase in long-term rates during 2004.

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

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Securities Held-to-Maturity:

The following table sets forth the carrying value of our portfolio of securities held-to-maturity at December 31 of each of the last three years.

SECURITIES HELD-TO-MATURITY

(In Thousands)

For information regarding the fair value at December 31, 2004, of our 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 our portfolio of securities held-to-maturity as of December 31, 2004.

MATURITIES OF SECURITIES HELD-TO-MATURITY

(In Thousands)

The following table sets forth the tax-equivalent yields of our portfolio of securities held-to-maturity at December 31, 2004.

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, 2004.  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 2004, 2003 and 2002, we sold no securities from the held-to-maturity portfolio.  The weighted-average maturity of the held-to-maturity portfolio was 3.9 years and 4.7 years at December 31, 2004 and 2003, respectively.

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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: For several years preceding the third quarter of 2001, the indirect consumer loan portfolio (consisting principally of auto loans financed through local dealerships where we acquire the dealer paper) was the fastest growing segment of our 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 we became more rate-competitive, but the level of indirect loans was flat for the third quarter of 2 003 and decreased by $11.9 million during the fourth quarter of 2003.  During 2004, (excluding the third quarter) indirect loan balances continued to decline.  However, indirect loans still represent the second largest category of loans (34%) in our portfolio, and it continues to be the case that any developments threatening the indirect loan business generally may be expected to have a negative impact on our financial performance due to our reliance on such loans.  If auto manufacturers continue to offer heavily subsidized financing programs, our 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 our loan portfolio at December 31, 2004, at 39% of loans at year-end.  This segment of our portfolio increased $14.3 million from 2003 to 2004, despite the fact that we sold (with servicing retained) $15.4 million of low-rate fixed rate mortgages during the year.  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, no longer driven by falling rates, began to slow down.  Residential mortgage demand remained moderate during 2004, as rates stayed near, if not at, their record low levels of prior years.

During 2003 we 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 discussed earlier in this Report.  In effect, the securitized loans were merely transferred to our securities available-for-sale portfolio.  We also securitized $30.0 million of mortgage loans in 2001.

Commercial and Commercial Real Estate Loans: We continued to experience strong to moderate demand for commercial loans in 2004, 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.