STATE FINANCIAL SERVICES CORP - 10-Q Quarterly Report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10 - Q

(X)	Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended June 30, 2004
	or
( )	Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
	For the transition period from ______________________ to ______________________

Commission File Number 1-018166

STATE FINANCIAL SERVICES CORPORATION

(Exact name of registrant as specified in its charter)

WISCONSIN (State or other jurisdiction of incorporation or organization)	39-1489983 (I.R.S. Employer identification No.)

815 NORTH WATER STREET, MILWAUKEE, WISCONSIN 53202-3526

(Address and Zip Code of principal executive offices)

(414) 223-8400

(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [X]

Indicate by check mark whether the registrant is an accelerated filer (as defined by Rule 12b-2 of the Exchange Act).

Yes [X] No [ ]

As of August 6, 2004, there were 6,889,253 shares of Registrant's $0.10 Par Value Common Stock outstanding.


	1

	FORM 10-Q
	STATE FINANCIAL SERVICES CORPORATION
	INDEX
	PART I - FINANCIAL INFORMATION
		Page No.
Item 1.	Financial Statements. (Unaudited)
	Consolidated Statements of Financial Condition as of June 30, 2004 (unaudited) and December 31, 2003 (audited)	3
	Consolidated Statements of Income for the Three Months ended June 30, 2004 and June 30, 2003	4
	Consolidated Statements of Income for the Six Months ended June 30, 2004 and June 30, 2003	5
	Consolidated Statements of Cash Flows for the Six Months ended June 30, 2004 and June 30, 2003	6
	Notes to Consolidated Financial Statements	7
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations.	10
Item 3.	Quantitative and Qualitative Disclosures About Market Risk.	19
Item 4.	Controls and Procedures.	19
	PART II - OTHER INFORMATION
Item 1.	Legal Proceedings.	20
Item 2.	Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities.	20
Item 3.	Default Upon Senior Securities.	20
Item 4.	Submission of Matters to a Vote of Security Holders.	20
Item 5.	Other Information.	20
Item 6.	Exhibits and Reports on Form 8-K.	20
Signatures		22
Exhibit Index		23


	2

Part I. Financial Information

Item 1. Financial Statements.

State Financial Services Corporation And Subsidiaries

Consolidated Statements of Financial Condition

	June 30, 2004 (unaudited)			December 31, 2003 (audited)

Assets
Cash and due from banks	$	60,675,756		$	55,824,050
Interest-bearing bank balances		4,605,989			4,399,723
Federal funds sold		9,451,521			18,144,353
Cash and cash equivalents		74,733,266			78,368,126
Investment securities
Available-for-sale (at fair value)		538,139,392			397,061,108
Held-to-maturity (fair value of $697,395 - 2004 and $988,006 - 2003)		684,639			964,662
Loans (net of allowance for loan losses of $11,803,467-2004 and $10,706,350-2003)		880,892,266			863,323,685
Loans held for sale		3,393,403			1,900,438
Premises and equipment		33,180,006			32,918,853
Accrued interest receivable		5,708,824			5,246,660
Goodwill		37,646,354			37,626,045
Core deposit intangible		4,900,637			5,158,565
Bank owned life insurance		21,468,078			21,029,985
Other assets		5,132,114			9,331,295

Total Assets	$	1,605,878,979		$	1,452,929,422


Liabilities And Shareholders' Equity
Deposits:
Demand		179,505,191			180,872,397
Savings		264,726,008			253,202,071
Money market		251,869,875			233,003,329
Time deposits in excess of $100,000		150,585,564			126,127,203
Other time deposits		220,073,818			235,908,124

Total deposits		1,066,760,456			1,029,113,124

Federal Home Loan Bank advances		67,800,000			67,800,000
Notes payable		31,500,000			30,200,000
Trust preferred securities		30,000,000			15,000,000
Securities sold under agreements to repurchase		294,407,908			175,592,887
Federal funds purchased		-			-
Accrued expenses and other liabilities		3,611,315			21,071,418
Accrued interest payable		2,326,372			1,957,473

Total Liabilities		1,496,406,051			1,340,734,902

Shareholders' Equity:
Preferred stock, $1 par value; authorized-100,000 shares; issued and outstanding-none		-			-
Common stock, $0.10 par value; authorized-25,000,000 shares; issued 9,569,378 shares in 2004 and 9,527,489 shares in 2003, outstanding 6,941,538 shares in 2004 and 7,043,149 shares in 2003		956,938			952,749
Additional paid in capital		85,302,983			84,739,420
Retained earnings		67,834,747			63,152,966
Accumulated other comprehensive income		(48,940	)		3,763,835
Unearned shares held by ESOP		(3,981,360	)		(3,981,360	)
Treasury Stock - 2,627,840 shares in 2004 and 2,484,340 in 2003		(40,591,440	)		(36,433,090	)

Total Shareholders' Equity		109,472,928			112,194,520

Total Liabilities And Shareholders' Equity	$	1,605,878,979		$	1,452,929,422

See notes to unaudited consolidated financial statements.


	3

State Financial Services Corporation And Subsidiaries

Consolidated Statements of Income (Unaudited)

	Three Months Ended June 30,

	2004		2003

Interest income:
Loans	$	12,917,564	$	11,901,126
Investment securities:
Taxable		3,867,596		3,269,171
Tax-exempt		548,895		572,049
Federal funds sold and other short-term investments		28,729		41,847

Total interest income		17,362,784		15,784,193

Interest expense:
Deposits		3,787,688		3,394,689
Notes payable and other borrowings		1,523,524		1,563,119

Total interest expense		5,311,212		4,957,808

Net interest income		12,051,572		10,826,385

Provision for loan losses		600,000		825,000

Net interest income after provision for loan losses		11,451,572		10,001,385

Other income:
Service charges on deposit accounts		766,586		680,540
ATM and merchant service fees		259,070		759,238
Security commissions and management fees		192,659		101,923
Investment securities gains, net		198,899		80,274
Gain on sale of loans		516,824		1,323,429
Gain on sale of merchant processing		-		1,300,000
Other		1,041,218		1,056,222

Total other income		2,975,256		5,301,626

Other expenses:
Salaries and employee benefits		4,520,763		5,023,928
Net occupancy expense		762,237		702,127
Equipment rentals, depreciation and maintenance		1,070,919		1,004,452
Data processing		598,693		540,012
Legal and professional		198,517		411,188
ATM and merchant services		68,370		504,430
Advertising		329,424		267,567
Provision for merchant chargebacks		-		300,000
Merchant processing exit fee		-		150,000
Efficiency consulting expense		-		570,000
Severance charges		-		180,114
Other		1,813,638		1,450,540

Total other expenses		9,362,561		11,104,358

Income before income taxes		5,064,267		4,198,653
Income tax expense		1,626,895		1,162,008

Net income	$	3,437,372	$	3,036,645


Basic earnings per common share	$	0.52	$	0.46
Diluted earnings per common share		0.50		0.44
Dividends per common share		0.15		0.13

See notes to unaudited consolidated financial statements.


	4

State Financial Services Corporation And Subsidiaries

Consolidated Statements of Income (Unaudited)

	Six Months Ended June 30,

	2004		2003

Interest income:
Loans	$	25,781,330	$	23,664,366
Investment securities:
Taxable		7,328,775		7,033,438
Tax-exempt		1,093,232		1,185,826
Federal funds sold and other short-term investments		76,874		62,066

Total interest income		34,280,211		31,945,696

Interest expense:
Deposits		6,507,236		6,589,250
Notes payable and other borrowings		4,093,020		3,491,290

Total interest expense		10,600,256		10,080,540

Net interest income		23,679,955		21,865,156

Provision for loan losses		1,200,000		1,425,000

Net interest income after provision for loan losses		22,479,955		20,440,156

Other income:
Service charges on deposit accounts		1,629,106		1,379,880
ATM and merchant service fees		474,133		1,450,846
Security commissions and management fees		365,798		195,311
Investment securities gains, net		418,279		135,470
Gain on sale of loans		929,410		2,647,200
Gain on sale of merchant processing		-		1,300,000
Other		1,902,177		1,745,753

Total other income		5,718,903		8,854,460

Other expenses:
Salaries and employee benefits		8,887,374		10,139,997
Net occupancy expense		1,534,023		1,389,171
Equipment rentals, depreciation and maintenance		2,066,128		1,956,781
Data processing		1,192,852		1,069,733
Legal and professional		603,376		814,186
ATM and merchant services		143,893		965,436
Advertising		650,001		617,917
Provision for merchant chargebacks		-		300,000
Merchant processing exit fee		-		150,000
Efficiency consulting expense		-		570,000
Severance charges		-		180,114
Other		3,280,139		2,982,836

Total other expenses		18,357,786		21,136,171

Income before income taxes		9,841,072		8,158,445
Income tax expense		3,161,946		2,269,646

Net income	$	6,679,126	$	5,888,799


Basic earnings per common share	$	1.00	$	0.89
Diluted earnings per common share		0.97		0.87
Dividends per common share		0.30		0.26

See notes to unaudited consolidated financial statements.


	5

State Financial Services Corporation And Subsidiaries

Consolidated Statements of Cash Flows (Unaudited)

	Six Months Ended June 30,

		2004			2003
Operating Activities
Net income	$	6,679,126		$	5,888,799
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Provision for loan losses		1,200,000			1,425,000
Depreciation		1,503,488			1,398,325
Amortization of premiums and accretion of discounts on investment securities		337,675			742,192
Income from bank owned life insurance		(438,093	)		(309,756	)
Decrease (increase) in accrued interest receivable		(462,164	)		2,190,551
Increase (decrease) in accrued interest payable		368,899			(301,814	)
Realized investment securities gains		(418,279	)		(135,470	)
Payment to Lakes Region Bancorp’s shareholders for acquisition		(13,416,729	)		0
Other		2,357,580			(285,397	)

Net cash provided by (used in) operating activities		(2,288,497	)		10,612,430

Investing Activities
Proceeds from maturities or principal payments of investment securities held-to-maturity		280,000			190,000
Purchases of securities available-for-sale		(390,394,283	)		(366,371,246	)
Proceeds from maturities and sales of investment securities available-for-sale		243,619,695			415,763,291
Net increase in loans		(20,261,546	)		(55,548,829	)
Net purchases of premises and equipment		(1,764,641	)		(1,024,755	)
Net cash provided by (used in) investing activities		(168,520,775	)		(6,991,539	)

Financing Activities
Net (decrease) increase in deposits		37,647,332			(15,430,654	)
Repayment of notes payable		(19,000,000	)		(6,750,000	)
Proceeds of notes payable		20,300,000			5,230,000
Proceeds from trust preferred securities offering		15,000,000			0
Increase in securities sold under agreements to repurchase		118,815,021			27,100,876
Repayment of Federal Home Loan Bank advances		0			(15,000,000	)
Cash dividends		(1,997,345	)		(1,729,211	)
Repayment of federal funds purchased		0			500,000
Purchase of treasury stock		(4,158,350	)		(92,000	)
Proceeds from exercise of stock options		567,754			661,410

Net cash provided by (used in) financing activities		167,174,412			(5,509,579	)

Decrease in cash and cash equivalents		(3,634,860	)		(1,888,688	)
Cash and cash equivalents at beginning of period		78,368,126			67,516,805

Cash and cash equivalents at end of period	$	74,733,266		$	65,628,117

Supplemental information:
Interest paid	$	10,231,357		$	10,403,267
Income taxes paid		4,161,843			2,618,092

See notes to unaudited consolidated financial statements.


	6

State Financial Services Corporation And Subsidiaries

Notes to Unaudited Consolidated Financial Statements

June 30, 2004

NOTE A - BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements include the accounts of State Financial Services Corporation (the "Company" or “State”) and its subsidiaries. The Company owns State Financial Bank, National Association (the “Bank”). All significant intercompany balances and transactions have been eliminated. The unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and with the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP for complete financial statements have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation have been included. Interim operating results are not necessarily indicative of the results that may be expected for the year. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2003.

NOTE B - ACCOUNTING CHANGES

On March 9, 2004, the SEC issued Staff Accounting Bulletin (“SAB”) 105, "Application of Accounting Principles to Loan Commitments" to advise registrants of the staff's view that fair value of the recorded loan commitments, that are required to follow derivative accounting under Statement of Financial Accounting Standards (“SFAS”) 133, Accounting for Derivative Instruments and Hedging Activities, should not take into consideration the expected future cash flows related to the associated servicing of the future loan. The staff indicated its belief that incorporating expected future cash flows related to the associated servicing of the loan essentially results in the immediate recognition of a servicing asset, which is only appropriate once the servicing asset has been contract ually separated from the underlying loan by sale or by securitization of the loan with servicing retained. Furthermore, no other internally-developed intangible assets, such as customer relationship intangibles, should be recorded as part of the loan commitment derivative. The staff noted that recognition of such assets is only appropriate in the event of a third-party transaction, such as the purchase of a loan commitment either individually, in a portfolio, or in a business combination.

In addition, SAB 105 requires registrants to disclose their accounting policy for loan commitments pursuant to Accounting Principles Board (“APB”) Opinion No. 22, including methods and assumptions used to estimate fair value and any associated hedging strategies, as required by SFAS 107, SFAS 133 and Item 305 of Regulation S-K (Quantitative and Qualitative Disclosures About Market Risk).

SAB 105 does not explicitly require banks that apply derivative accounting to their loan commitments to treat the loan commitments only as liabilities. Rather, the staff appears to be deferring to the Financial Accounting Standards Board (“FASB”) to address this aspect of the fair value issue in its loan commitment project.

The provisions of SAB 105 must be applied to loan commitments accounted for as derivatives that are entered into after March 31, 2004. The staff will not object to the application of existing accounting practices to loan commitments accounted for as derivatives that are entered into on or before March 31, 2004, with appropriate disclosures.

The issuance of SAB 105 has not had a material impact on the Company as the loan commitments are generally not accounted for as derivatives.

In January 2003, the FASB issued FASB Interpretation No 46 (“FIN 46”), which provides guidance on how to identify a variable interest entity (VIE) and determine when the assets, liabilities, noncontrolling interests, and results of operations of a VIE are to be included in an entity's consolidated financial statements. A VIE exists when either the total equity investment at risk is not sufficient to permit the entity to finance its activities by itself, or the equity investors lack one of three characteristics associated with owning a controlling financial interest. Those characteristics include the direct or indirect ability to make decisions about an entity's activities through voting rights or similar rights, the obligation to absorb the expected losses of an entity if they occur, or the right to receive the expected residual returns of the entity if they occur.


	7

In December 2003, the FASB reissued FIN 46 with certain modifications and clarifications. Application of this guidance was effective for interests in certain VIEs commonly referred to as special-purpose entities (SPEs) as of December 31, 2003. Application for all other types of entities is required for periods ending after March 15, 2004, unless previously applied. The application of FIN 46 to any of the Company’s investments or interests has not had a material impact on the Company’s financial condition, results of operations, or liquidity.

NOTE C - EARNINGS PER SHARE

Basic earnings per share is computed by dividing net income by the weighted-average number of common shares outstanding during the period less unearned ESOP shares. Diluted earnings per share is computed by dividing net income by the weighted-average number of common shares outstanding during the period less unallocated ESOP shares plus the assumed conversion of all potentially dilutive securities. The denominators for the earnings per share amounts are as follows:

	Three months ended June 30,						Six months ended June 30,

	2004			2003			2004			2003

Basic:
Weighted-average number of shares outstanding		6,939,809			6,970,527			6,983,792			6,960,303
Less: weighted-average number of unearned ESOP shares		(281,288	)		(322,599	)		(287,881	)		(322,599	)

Denominator for basic earnings per share		6,658,521			6,647,928			6,695,911			6,637,704

Fully diluted:
Denominator for basic earnings per share		6,658,521			6,647,928			6,695,911			6,637,704
Add: assumed conversion of stock options using treasury stock method		196,396			196,709			200,825			160,764

Denominator for fully diluted earnings per share		6,854,917			6,844,637			6,896,736			6,798,468

NOTE D - COMPREHENSIVE INCOME

Comprehensive income is the total of reported net income and all other revenues, expenses, gains and losses that under accounting principles generally accepted in the United States are not included in reported net income but are instead reflected directly in shareholders’ equity.

	Three months ended June 30,						Six months ended June 30,

		2004			2003			2004			2003

Net Income	$	3,437,372		$	3,036,645		$	6,679,126		$	5,888,799
Other comprehensive income:
Change in unrealized securities gains (losses), net of tax		(4,383,320	)		907,277			(3,558,503	)		(528,115	)
Reclassification adjustment for realized gains included in net income, net of tax		(120,911	)		(48,799	)		(254,272	)		(82,352	)

Total comprehensive income (loss)	$	(1,066,859	)	$	3,895,123		$	2,866,351		$	5,278,332

NOTE E - STOCK REPURCHASE PROGRAM

On April 28, 2003, the Company’s Board of Directors authorized the repurchase of up to 5%, or approximately 348,000 shares, of the Company’s Common Stock. As of June 30, 2004, 163,500 shares have been repurchased at an average price of $28.67 per share.

NOTE F - STOCK-BASED COMPENSATION

The Company follows APB Opinion No. 25 under which no compensation expense is recorded when the exercise price of the Company’s employee stock options equals the market price of the underlying stock on the date of grant. The Company’s pro forma information regarding net income and net income per share has been determined as if these options had been accounted for since January 1, 1995, in accordance with the fair value method SFAS No. 123, “Accounting for Stock-Based Compensation”.


	8

The Black-Scholes option valuation model is commonly used in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Since the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimates, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.

In determining compensation expense in accordance with SFAS No. 123, the fair value for these options was estimated at the date of grant using the Black-Schole’s option pricing model with the following weighted average assumptions for the six months ended June 30, 2004 and June 30, 2003.

	Three months ended June 30,						Six months ended June 30,

	2004			2003			2004			2003

Expected life of options		2.706 years			6.75 years			2.706 years			6.75 years
Risk-free interest rate		2.90	%		3.80	%		2.90	%		3.60	%
Expected dividend yield		2.07	%		2.2	%		2.07	%		2.2	%
Expected volatility factor		38.79	%		26.40	%		38.79	%		26.40	%

For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting period, which is generally six months. The Company’s pro forma information is as follows:

	Three months ended June 30,						Six months ended June 30,

(Thousands, except per share data)	2004			2003			2004			2003

Net income, as reported	$	3,437		$	3,037		$	6,679		$	5,889
Compensation expense, net of taxes, as reported		3,068			3,634			6,032			7,319
Pro forma compensation expense in accordance with SFAS No. 123, net of tax		(3,157	)		(3,686	)		(6,211	)		(7,403	)
Pro forma net income	$	3,348		$	2,985		$	6,500		$	5,805


Net income per common share, as reported:
Basic	$	0.52		$	0.46		$	1.00		$	0.89
Diluted	$	0.50		$	0.44		$	0.97		$	0.87

Pro forma net income per common share:
Basic	$	0.50		$	0.45		$	0.97		$	0.87
Diluted	$	0.49		$	0.44		$	0.94		$	0.85

NOTE G – ACQUISITIONS

On December 6, 2003, the Company acquired Hawthorn Corporation (“Hawthorn”) and its wholly owned subsidiary Hawthorn Bank, Mundelein, Illinois. The Company purchased all of the outstanding common stock of Hawthorn for $6.4 million in cash. This “in-market” acquisition increased the Company’s share of the Illinois banking market. Hawthorn Bank has been merged into State Financial Bank, N.A.

On December 6, 2003, the Company also acquired Lakes Region Bancorp, Inc. (“Lakes Region”) and its wholly owned subsidiary Anchor Bank, Grayslake, Illinois. The Company purchased all of the outstanding common stock of Lakes Region for $13.4 million in cash. This “in-market” acquisition increased the Company’s share of the Illinois banking market. Anchor Bank has been merged into State Financial Bank, N.A.

Application of purchase accounting requires the inclusion of Hawthorn’s and Lake Region’s operating results in the consolidated statements of income from the date of acquisition. Accordingly, Hawthorn’s and Lakes Region’s operating results for the period January 1, 2004 through June 30, 2004 are included in the Company’s consolidated statements of income for three and six months ended June 30, 2004. Hawthorn’s and Lakes Region’s financial condition is included in the Company’s consolidated statements of financial condition as of June 30, 2004 and December 31, 2003.


	9

On a pro forma basis, the Company’s total income, net income, basic and fully diluted earnings per share for the three and six months ended June 30, 2004 and June 30, 2003, after giving effect to the acquisition of Hawthorn and Lakes Region as if they had occurred on January 1, 2003 are as follows (dollars in thousands):

	Three months ended June 30,				Six months ended June 30,

	2004		2003		2004		2003

Interest income	$	17,363	$	17,733	$	34,280	$	35,788
Interest expense		5,311		5,665		10,600		11,502

Net interest income		12,052		12,068		23,680		24,286
Provision for loan losses		600		861		1,200		1,497
Other income		2,975		5,420		5,719		9,086
Other expense		9,363		12,240		18,358		23,428

Net income before tax		5,064		4,387		9,841		8,447
Income taxes		1,627		1,485		3,162		2,710

Net income	$	3,437		2,902	$	6,679	$	5,737

Basic earnings per share	$	0.52	$	0.44	$	1.00	$	0.86
Diluted earnings per share	$	0.50	$	0.42	$	0.97	$	0.84

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

Application of Critical Accounting Policies

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States and follow general practices within the banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements. Future changes in information may affect these estimates, assumptions, and judgments, which, in turn, may affect amounts reported in the consolidated financial statements.

All significant accounting policies are presented in Note 1 to the consolidated financial statements in the Company’s 2003 Annual Report on Form 10-K. These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets and liabilities are valued in the consolidated financial statements and how those values are determined.

Management has determined that its accounting policies with respect to the allowance for loan losses is the accounting area requiring subjective or complex judgments to the Company’s financial position and results of operations, and therefore, is its most important critical accounting policy. The allowance for loan losses represents management’s estimate of probable credit losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio a lso represents the largest asset type on the consolidated statements of financial condition. Note 1 to the consolidated financial statements in the Company’s 2003 Annual Report on Form 10-K describes the methodology used to determine the allowance for loan losses. In addition, a discussion of the factors driving changes in the amount of the allowance for loan losses is included in the Provision for Loan Losses section of management’s discussion.

Effective January 1, 2002, the Company adopted SFAS No. 142, “Goodwill and Other Intangible Assets.” Under SFAS 142, the Company is required to perform annual impairment tests of its goodwill and intangible assets and more frequently in certain circumstances. The Company has elected to test for goodwill impairment in the fourth quarter of each year. The goodwill impairment test is a two-step process, which requires management to make judgments in determining what assumptions to use in the calculation. The first step of the process consists of estimating the fair value of each reporting unit based on a discounted cash flow model using revenue and profit forecasts and comparing those estimated fair values with the carrying values, which includes the allocated goodwill. If the estimated fair value is less than the carrying value, a second step is performed to compute the amo unt of the impairment by determining an “implied fair value” of goodwill. The determination of a reporting unit’s “implied fair value” of goodwill requires the Company to allocate the estimated fair value of the reporting unit to the assets and liabilities of the reporting unit. Any unallocated fair value represents the “implied fair value” of goodwill, which is compared to its corresponding carrying value.


	10

The Company cannot predict the occurrence of certain future events that might adversely affect the reported value of goodwill that totaled $37.6 million at June 30, 2004. Such events include, but are not limited to, strategic decisions made in response to economic and competitive conditions, the impact of the economic environment on the Company’s customer base, or a material negative change in its relationships with significant customers.

Changes in Financial Condition

The Company’s total assets were $1.6 billion at June 30, 2004 and $1.5 billion at December 31, 2003. During the first half of 2004, significant uses of funds by the Company consisted of a $20.3 million increase in loans, $146.5 million net increase in investment securities, $2.3 million decrease in net cash provided by operating activities, $4.2 million purchase of treasury stock, $2.0 million in payment of cash dividends, and $1.8 million in net purchases of premises and equipment. Funding sources for the first half of 2004 came from a $37.6 million increase in deposits, $118.8 million increase in securities sold under agreement to repurchase, $15.0 million in proceeds from trust preferred securities offering, $1.3 million net increase in notes payable, and $568 thousand in proceeds from the exercise of stock options.

Asset Quality

At June 30, 2004, the Company’s non-performing assets were $9.4 million, a decrease of $6.4 million from December 31, 2003 primarily due to a decrease of $4.5 million in other real estate owned and $1.9 million in non-accrual loans. The decrease in other real estate owned was mainly due to the sale of one large parcel of real property with a carrying value of $5.2 million which closed during the second quarter of 2004 at a price resulting in a gain to State of approximately $300 thousand. Total non-performing assets as a percentage of total assets were 0.59% at June 30, 2004 and 1.09% at December 31, 2003. As a percentage of total loans outstanding, the level of non-performing loans was 0.94% at June 30, 2004 compared to 1.18% at December 31, 2003. This percentage decrease was due to the decrease in non-performing loans and the increase in average loans outstanding.

When, in the opinion of management, serious doubt exists as to the collectibility of a loan, the loan is placed on non-accrual status. In all cases, however, when a loan reaches 90 days delinquent on the payment of principal or interest the loan is placed on non-accrual status. At the time a loan is classified as non-accrual, interest credited to income in the current year is reversed and interest income accrued in the prior year is charged to the allowance for loan losses. The following table summarizes non-performing assets on the dates indicated (dollars in thousands).

	Jun. 30 2004			Mar. 31 2004			Dec. 31 2003			Sep. 30 2003			Jun. 30 2003

Non-accrual loans	$	8,729		$	9,429		$	10,332		$	10,993		$	10,731
Accruing loans past due 90 days or more		-			-			-			-			-
Restructured loans		-			-			-			-			-

Total non-performing and restructured loans		8,729			9,429			10,332			10,993			10,731
Other real estate owned		988			5,742			5,483			5,381			371

Total non-performing assets	$	9,416		$	15,171		$	15,815		$	16,374		$	11,102

Ratios:
Non-performing loans to total loans		0.97	%		1.05	%		1.18	%		1.40	%		1.34	%
Allowance to total loans		1.32			1.24			1.22			1.32			1.23
Allowance to non-performing loans		135.22			118.53			103.62			94.29			91.50
Non-performing assets to total assets		0.61			1.01			1.09			1.24			0.84

Allowance for Loan Losses and Net Charge-offs

Management maintains the allowance for loan losses (the "Allowance") at a level considered adequate to provide for probable loan losses. The Allowance is increased by provisions charged to earnings and is reduced by charge-offs, net of recoveries. At June 30, 2004, the Allowance was $11.8 million, an increase of $1.1 million from the balance at December 31, 2003. The Allowance was increased primarily due to the increased number of commercial loans, which are generally higher risk, particularly during a weak economic period. As of June 30, 2004 and December 31, 2003 commercial and commercial real estate loans made up 77% of the total loan portfolio. As the commercial loan portfolio has grown in size, the complexity of the commercial relationship has also increased.


	11

As a percentage of total loans outstanding, the Allowance was 1.32% at June 30, 2004 compared to 1.22% at December 31, 2003. The determination of Allowance adequacy is based upon on-going evaluations of the Company’s loan portfolio conducted by the Internal Loan Review function of its banking subsidiary, State Financial Bank, N.A. (the “Bank”), and reviewed by management. These evaluations consider a variety of factors, including, but not limited to, general economic conditions, loan portfolio size, type, and composition, previous loss experience, the borrowers’ financial condition, collateral adequacy, and the level of non-performing loans. Based upon its analyses, management considered the Allowance adequate to recognize the risk inherent in the loan portfolio at June 30, 2004.

The following table sets forth an analysis of the Allowance for loan losses for the periods indicated (dollars in thousands):

	Six months ended June. 30, 2004			Year ended Dec. 31, 2003

Balance at beginning of period	$	10,706		$	8,805
Charge-offs:
Commercial		58			727
Real estate mortgage		205			712
Installment		153			390
Other		9			31

Total charge-offs		424			1,860
Recoveries:
Commercial		151			121
Real estate mortgage		145			18
Installment		24			75
Other		1			3

Total recoveries		321			217

Net charge-offs		103			1,643
Balance of acquired allowance at date of acquisitions		0			919

Additions charged to operations		1,200			2,625

Balance at end of period	$	11,803		$	10,706

Ratios:
Net charge-offs to average loans outstanding¹		0.02	%		0.21	%
Net charge-offs to total allowance¹		1.75			15.35
Allowance to period end loans outstanding		1.32			1.22

1.Annualized.

Results of Operations-Comparison of the Three-Month Periods Ended June 30, 2004 and June 30, 2003.

General

For the quarter ended June 30, 2004, the Company reported net income of $3.4 million and net income per share on a fully diluted basis of $0.50, compared to net income of $3.0 million and net income per share on a fully diluted basis of $0.44 reported for the quarter ended June 30, 2003.

Net Interest Income

The following table sets forth average balances, related interest income and expenses, and effective interest yields and rates for the three-month periods ended June 30, 2004 and June 30, 2003 (dollars in thousands):


	12

	Three months ended June 30, 2004								Three months ended June 30, 2003

	Average Balance			Interest		Yield/ Rate4			Average Balance			Interest		Yield/ Rate4

Assets
Interest-earning assets:
Loans123	$	894,760		$	12,926		5.81	%	$	777,927		$	11,911		6.14	%
Taxable investment securities		402,267			3,852		3.85	%		365,900			3,260		3.57	%
Tax-exempt investment securities3		57,647			844		5.89	%		61,084			880		5.78	%
Interest-earnings deposits		5,694			16		1.09	%		3,060			10		1.31	%
Federal funds sold		14,136			29		0.82	%		15,677			42		1.07	%

Total interest-earning assets		1,374,504			17,667		5.17	%		1,223,648			16,103		5.28	%
Non-interest-earnings assets:
Cash and due from banks		56,998								24,117
Premises and equipment, net		33,249								27,486
Other assets		78,932								60,331
Less: Allowance for loan losses		(11,385	)							(9,495	)

Total	$	1,532,298							$	1,326,087

Liabilities And Stockholders’ Equity
Interest-bearing liabilities:
Now accounts	$	123,732		$	85		0.28	%	$	126,191		$	125		0.40	%
Money market accounts		249,421			713		1.15	%		212,339			593		1.12	%
Savings deposits		135,692			134		0.40	%		129,455			155		0.48	%
Time deposits		378,538			2,390		2.54	%		319,998			2,334		2.93	%
Notes payable		62,247			579		3.74	%		27,480			275		4.01	%
FHLB borrowings		67,800			788		4.67	%		77,400			784		4.06	%
Federal funds purchased		2,452			8		1.31	%		923			4		1.74	%
Securities sold under agreement to repurchase		216,807			614		1.14	%		156,006			688		1.77	%

Total interest-bearing liabilities		1,236,689			5,311		1.73	%		1,049,792			4,958		1.89	%
Non-interest-bearings liabilities:
Demand deposits		178,119								158,704
Other		6,096								8,475

Total liabilities		1,420,904								1,216,971

Stockholders’ equity		111,394								109,116

Total	$	1,532,298							$	1,326,087

Net interest earning and interest rate spread				$	12,356		3.44	%				$	11,145		3.39	%

Net yield on interest-earning assets							3.62	%							3.65	%

1. For the purposes of these computations, non-accrual loans are included in the daily average loan amounts outstanding.

2. Interest earned on loans includes loan fees, which are not material in amount.

3. Tax equivalent adjusted

4. Annualized.

In accordance with new SEC rules required by the Sarbanes-Oxley Act of 2002 regarding the use of financial measures and ratios not calculated in accordance with GAAP, a reconciliation must be provided that shows these measures and ratios calculated according to GAAP and a statement why management believes these measures and ratios provide a more accurate view of performance.

Certain non-GAAP performance measures and ratios are used by management to evaluate and measure the Company's performance. These include taxable-equivalent net interest income (including its individual components) and net interest margin (including its individual components). Management believes that these measures and ratios provide users of the Company's financial information with a more accurate view of the performance of the interest-earning assets and interest-bearing liabilities for comparative purposes. Other financial holding companies may define or calculate these measures and ratios differently. See the table below for supplemental data and the corresponding reconciliation to GAAP financial measures for the three months ended June 30, 2004 and June 30, 2003.

Management reviews yields on certain asset categories and the net interest margin of the Company, and its banking subsidiaries, on a fully taxable-equivalent basis ("FTE"). In this non-GAAP presentation, net interest income is adjusted to reflect tax-exempt interest income on an equivalent before-tax basis. This measures comparability of net interest income arising from both taxable and tax-exempt sources (dollars in thousands).


	13

	Three months ended June 30,

	2004			2003

(A) Interest income (GAAP)	$	17,363		$	15,784
Taxable equivalent adjustment-loans		9			10
Taxable equivalent adjustment-Tax-exempt securities		295			309

Interest income-FTE		17,667			16,103
(B) Interest expense (GAAP)		5,311			4,958
(C) Net interest income (GAAP) (A minus B)		12,052			10,826

Net interest income-FTE		12,356			11,145
(D) Net interest margin (GAAP)(annualized)		3.52	%		3.55	%
Net interest margin-FTE (annualized)		3.62	%		3.65	%

Taxable-equivalent adjustments to interest income involve the conversion of tax-exempt sources of interest income to the equivalent amounts of interest income that would be necessary to derive the same net return if the investments had been subject to income taxes. A 35% incremental income tax rate is used in the conversion of tax-exempt interest income to a taxable-equivalent basis.

For the quarter ended June 30, 2004, the Company reported taxable-equivalent net interest income of $12.4 million, an increase of $1.2 million, or 10.9%, from the $11.1 million reported for the quarter ended June 30, 2003. This increase reflects the Company’s interest rate risk management policy, which is designed to minimize the impact of interest rate changes on net interest income. The taxable-equivalent yield on interest-earning assets (net interest margin) decreased to 3.62% in the second quarter of 2004 from 3.65% in the second quarter of 2003.

The Company’s taxable-equivalent total interest income increased $1.6 million for the quarter ended June 30, 2004 compared to the same period of 2003 due to the increase in average loans outstanding, partially offset by a lower rate environment. Average loans outstanding increased by $116.8 million, or 15.0%, in the second quarter of 2004 over the second quarter of 2003. For the quarter ended June 30, 2004, the taxable-equivalent yield on interest-earning assets was 5.17% compared to 5.28% for the quarter ended June 30, 2003. The second quarter 2004 loan yield was 5.81% compared to 6.14% in the second quarter of 2003. The Company experienced increased yields earned on its investment securities as cash flows from maturities and repayments were reinvested at higher rates. For the quarter ended June 30, 2004, the yield earned on taxable investment securities increased to 3.85% fr om 3.57% for the quarter ended June 30, 2003. The taxable equivalent yields earned on tax-exempt investment securities increased to 5.89% for the quarter ended June 30, 2004 from 5.78% for the quarter ended June 30, 2003. The increase in these yields for the second quarter of 2004 compared to the second quarter of 2003 is the result of matured or repaid securities replaced by higher yielding securities in a higher interest rate environment.

The Company’s funding costs were also impacted by the lower interest rate environment prevalent over the preceding twelve months. The cost of interest-bearing liabilities decreased to 1.73% for the second quarter of 2004 from 1.89% for the second quarter of 2003. The Company uses wholesale funding sources, such as the Federal Home Loan Bank (“FHLB”), to balance the timing differences between its various business funding sources and to support loan origination. In the second quarter of 2004, notes payable, FHLB borrowings, federal funds purchased, and securities sold under agreements to repurchase comprised 28.2% of the Company’s interest-bearing liabilities compared to 24.9% in the second quarter 2003 due to loan growth exceeding deposit growth in the period.

Provision for Loan Losses

The provision for loan losses was $600 thousand in the second quarter of 2004 and $825 in the second quarter of 2003. The provision is adjusted to reflect loan growth and management’s assessment of asset quality and risk inherent in the loan portfolio. This loan growth has been primarily concentrated in the commercial and commercial real estate loan categories. These loans inherently involve more risk than exists in residential mortgage and consumer loans.

Other Income

Total other income decreased $2.3 million in the second quarter of 2004 over the second quarter of 2003. The decrease was the result of a $1.3 million gain in the second quarter 2003 on the sale of the merchant credit card processing business, a decrease of $807 thousand in gains on the sale of mortgage loans due to decreased refinancing activity, and a decrease of $500 thousand in automated teller machine (“ATM”) and merchant services due to the sale of the merchant processing business. The decreases were offset by increases in service charges on deposit accounts, security commissions and management fees, and investment securities gains.


	14

Other Expenses

Other expenses decreased $1.7 million in the second quarter of 2004 over the second quarter of 2003. The decrease was due to non-recurring expenses in the second quarter 2003 of $450 thousand related to the sale of the merchant credit card processing business, efficiency consulting expense of $570 thousand, and severance charges of $180 thousand. The decrease was also the result of decreases in personnel costs, legal and professional fees, and ATM and merchant services. These decreases were offset by increases in net occupancy and equipment expense, data processing, advertising and other expense. Personnel costs decreased $503 thousand partially due to decreased sales commissions as a result of the decreased volume of refinancing activity on residential mortgages and lower staffing levels offset by the acquisition of Anchor Bank and Hawthorn Bank. Net occupancy and equipment expens e increased $127 thousand and data processing increased $59 thousand. Both increases are mainly due to the three additional locations as a result of the acquisitions in December 2003. Legal and professional expense decreased $213 thousand. ATM and merchant services decreased $436 thousand mainly due to the sale of the merchant credit card processing business. Other expense increased $363 thousand mainly due to increased amortization of core deposit intangible as a result of the acquisition of Anchor Bank and Hawthorn Bank.

Income Taxes

The Company's consolidated income tax rate varies from statutory rates principally due to nondeductible goodwill, tax-exempt interest income on investment securities, loans, and nondeductible merger related expenses. The effective tax rate for the three months ended June 30, 2004 was 32.1% compared to 27.7% for the three months ended June 30, 2003. Provisions for income tax were $1.6 million for the second quarter of 2004 compared to $1.2 million for the second quarter of 2003.

Results of Operations-Comparison of the Six-Month Periods Ended June 30, 2004 and June 30, 2003.

General

For the six months ended June 30, 2004, the Company reported net income of $6.7 million and net income per share on a fully diluted basis of $0.97, compared to net income of $5.9 million and net income per share on a fully diluted basis of $0.87 reported for the six months ended June 30, 2003.

Net Interest Income

The following table sets forth average balances, related interest income and expenses, and effective interest yields and rates for the six-month periods ended June 30, 2004 and June 30, 2003 (dollars in thousands):


	15

	Six months ended June 30, 2004								Six months ended June 30, 2003

	Average Balance			Interest		Yield/ Rate4			Average Balance			Interest		Yield/ Rate4

Assets
Interest-earning assets:
Loans123	$	890,249		$	25,799		5.83	%	$	762,089		$	23,693		6.27	%
Taxable investment securities		371,776			7,284		3.94	%		350,378			7,014		4.04	%
Tax-exempt investment securities3		57,558			1,682		5.88	%		62,799			1,824		5.86	%
Interest-earnings deposits		7,835			45		1.15	%		2,874			19		1.36	%
Federal funds sold		16,845			77		0.92	%		11,573			62		1.08	%

Total interest-earning assets		1,344,263			34,887		5.22	%		1,189,713			32,612		5.53	%
Non-interest-earnings assets:
Cash and due from banks		53,149								33,801
Premises and equipment, net		33,089								27,666
Other assets		79,197								61,015
Less: Allowance for loan losses		(11,151	)							(9,263	)

Total	$	1,498,547							$	1,302,932

Liabilities And Stockholders’ Equity
Interest-bearing liabilities:
Now accounts	$	121,962		$	163		0.27	%	$	115,414		$	224		0.39	%
Money market accounts		242,243			1,315		1.09	%		213,303			1,239		1.17	%
Savings deposits		135,680			268		0.40	%		127,765			361		0.57	%
Time deposits		372,506			4,761		2.57	%		321,340			4,765		2.99	%
Notes payable		60,287			1,109		3.70	%		28,785			547		3.83	%
FHLB borrowings		67,800			1,577		4.68	%		77,676			1,569		4.07	%
Federal funds purchased		2,466			20		1.63	%		1,536			13		1.71	%
Securities sold under agreement to repurchase		201,581			1,387		1.38	%		143,048			1,363		1.92	%

Total interest-bearing liabilities		1,204,525			10,600		1.77	%		1,028,867			10,081		1.98	%
Non-interest-bearings liabilities:
Demand deposits		173,291								156,674
Other		8,130								9,702

Total liabilities		1,385,946								1,195,243

Stockholders’ equity		112,601								107,689

Total	$	1,498,547							$	1,302,932

Net interest earning and interest rate spread				$	24,287		3.45	%				$	22,531		3.55	%

Net yield on interest-earning assets							3.63	%							3.82	%

1. For the purposes of these computations, non-accrual loans are included in the daily average loan amounts outstanding.

2. Interest earned on loans includes loan fees, which are not material in amount.

3. Tax equivalent adjusted

4. Annualized.


	16

	Six months ended June 30,

	2004			2003

(A) Interest income (GAAP)	$	34,280		$	31,946
Taxable equivalent adjustment-loans		18			29
Taxable equivalent adjustment-Tax-exempt securities		589			637

Interest income-FTE		34,887			32,612
(B) Interest expense (GAAP)		10,600			10,081
(C) Net interest income (GAAP) (A minus B)		23,680			21,865

Net interest income-FTE		24,287			22,531
(D) Net interest margin (GAAP)(annualized)		3.53	%		3.71	%
Net interest margin-FTE (annualized)		3.63	%		3.82	%

For the six months ended June 30, 2004, the Company reported taxable-equivalent net interest income of $24.3 million, an increase of $1.8 million, or 7.8%, from the $22.5 million reported for the six months ended June 30, 2003. This increase reflects the Company’s interest rate risk management policy, which is designed to minimize the impact of interest rate changes on net interest income. The taxable-equivalent yield on interest-earning assets (net interest margin) decreased to 3.63% in the first half of 2004 from 3.82% in the first half of 2003, reflecting repricing of assets in a low rate environment.

The Company’s taxable-equivalent total interest income increased $2.3 million for the six months ended June 30, 2004 compared to the same period of 2003 due to the increase in average loans outstanding, partially offset by a lower rate environment. Average loans outstanding increased by $128.2 million, or 16.8%, in the first half of 2004 over the first half of 2003. For the six months ended June 30, 2004, the taxable-equivalent yield on interest-earning assets was 5.22% compared to 5.53% for the six months ended June 30, 2003. The first half of 2004 loan yield was 5.83% compared to 6.27% in the first half of 2003. The Company also experienced decreased yields earned on its investment securities as cash flows from maturities and repayments were reinvested at lower rates. For the six months ended June 30, 2004, the yield earned on taxable investment securities decreased to 3.94% from 4.04% for the six months ended June 30, 2003. The taxable equivalent yields earned on tax-exempt investment securities increased to 5.88% for the six months ended June 30, 2004 from 5.86% for the six month ended June 30, 2003.

The Company’s funding costs were also impacted by the lower interest rate environment prevalent over the preceding twelve months. The cost of interest-bearing liabilities decreased to 1.77% for the first half of 2004 from 1.98% for the first half of 2003. The Company uses wholesale funding sources, such as the Federal Home Loan Bank (“FHLB”), to balance the timing differences between its various business funding sources and to support loan origination. In the first half of 2004, notes payable, FHLB borrowings, federal funds purchased, and securities sold under agreements to repurchase comprised 27.6% of the Company’s interest-bearing liabilities compared to 24.4% in the first half of 2003 due to loan growth exceeding deposit growth in the period.

Provision for Loan Losses

The provision for loan losses was $1.2 million in the first half of 2004 and $1.4 million in the first half of 2003. The provision is adjusted to reflect loan growth and management’s assessment of asset quality and risk inherent in the loan portfolio. This loan growth has been primarily concentrated in the commercial and commercial real estate loan categories. These loans inherently involve more risk than exists in residential mortgage and consumer loans.

Other Income

Total other income decreased $3.1 million for the first half of 2004 over the first half of 2003. The decrease was the result of a $1.3 million gain in the second quarter 2003 on the sale of the merchant credit card processing business, a decrease of $1.7 million in gains on sale of mortgage loans due to decreased refinancing activity, and a decrease of $977 thousand in automated teller machine (“ATM”) and merchant services due to the sale of the merchant processing business. The decreases were offset by increases in service charges on deposit accounts of $249 thousand, security commissions and management fees of $170 thousand, investment securities gains of $283 thousand, and other income of $156 thousand.


	17

Other Expenses

Other expenses decreased $2.8 million in the first half of 2004 over the first half of 2003. The decrease was due to expenses in the second quarter 2003 of $450 thousand related to the sale of the merchant credit card processing business, efficiency consulting expense of $570 thousand, and severance charges of $180 thousand. The decrease was also the result of decreases in personnel costs, legal and professional fees, and ATM and merchant services. These decreases were offset by increases in net occupancy and equipment expense, data processing, advertising and other expense. Personnel costs decreased $1.3 million partially due to decreased sales commissions as a result of the decreased volume of refinancing activity on residential mortgages and lower staffing levels offset by the acquisition of Anchor Bank and Hawthorn Bank. Net occupancy and equipment expense increased $254 thousa nd and data processing increased $123 thousand. Both increases are mainly due to the three additional locations as a result of the acquisitions in December 2003. Legal and professional expense decreased $211 thousand. ATM and merchant services decreased $822 thousand mainly due to the sale of the merchant credit card processing business. Other expense increased $297 thousand mainly due to increased amortization of core deposit intangible as a result of the acquisition of Anchor Bank and Hawthorn Bank.

Income Taxes

The Company's consolidated income tax rate varies from statutory rates principally due to nondeductible goodwill, tax-exempt interest income on investment securities, loans, and nondeductible merger related expenses. The effective tax rate for the six months ended June 30, 2004 was 32.1% compared to 27.8% for the six months ended June 30, 2003. Provisions for income tax were $3.2 million for the first half of 2004 compared to $2.3 million for the first half of 2003.

Liquidity

The primary functions of asset/liability management are to assure adequate liquidity and to maintain an appropriate balance between interest-earning assets and interest-bearing liabilities. Liquidity management involves the ability to meet the cash flow requirements of depositors and borrowers. Liquid assets (including cash deposits with banks, short-term investments, interest-earning deposits, and federal funds sold) are maintained primarily to meet customers’ current needs. The Company had liquid assets of $74.7 million and $78.4 million at June 30, 2004 and December 31, 2003, respectively.

Capital Resources

There are certain regulatory requirements that affect the Company's level of capital. The following table sets forth these requirements and the Company's capital levels and ratios at June 30, 2004 (dollars in thousands):

	Actual					Regulatory Minimum Requirement					Regulatory Well-capitalized Requirement

	Amount		Percent			Amount		Percent			Amount		Percent

Tier 1 leverage	$	96,970		6.5	%	$	59,559		4.0	%	$	74,449		5.0	%
Tier 1 risk-based capital	$	96,970		8.9	%	$	43,727		4.0	%	$	65,591		6.0	%
Risk-based capital	$	122,774		11.2	%	$	87,454		8.0	%	$	109,318		10.0	%

The Company is pursuing a policy of continued asset growth, which requires the maintenance of appropriate ratios of capital to assets. The existing capital levels allow for additional asset growth without further capital infusion. It is the Company's plan to maintain its capital position at or in excess of the "well-capitalized" definition. The Company seeks to obtain additional capital growth through earnings retention and a consistent dividend policy.


	18

Derivative Financial Instruments and Hedging Activities

Interest rate risk, the exposure of the Company’s net interest income and net fair value of its assets and liabilities, to adverse movements in interest rates, is a significant market risk exposure that can have a material effect on the Company’s financial position, results of operations and cash flows. The Company has policies to ensure that neither earnings nor fair value at risk exceed established guidelines and assesses these risks by continually identifying and monitoring changes in interest rates that may adversely impact expected future earnings and fair values.

The Company has designed strategies to confine these risks within the established limits and identify appropriate risk/reward trade-offs in the financial structure of its balance sheet. These strategies include the use of interest rate swap agreements to manage fluctuations in cash flows or fair values resulting from interest rate risk.

The Company designated the current interest swap outstanding as a fair value hedge of an existing loan that qualifies for “short-cut” treatment. Accordingly, the Company does not anticipate ineffectiveness arising from differences between the fair value of the loan and the fair value of the swap.

The following table summarizes the Company’s fair value hedges at June 30, 2004 (dollars in thousands):

Hedged Item	Hedging Instrument	Notional Amount	Fair Value	Remaining Term (Years)

Fixed Rate Loan	Receive Variable Swap	$3,905	$3,806	8.50

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

Refer to the Company’s annual report on Form 10-K for the year ended December 31, 2003 for a complete discussion of the Company’s market risk. There have been no material changes to the market risk information included in the Company’s 2003 Annual Report on Form 10-K.

Item 4. Controls and Procedures.

Disclosure Controls and Procedures

The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based on such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act.

Internal Controls Over Financial Reporting

There have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

Forward Looking Statements

Certain matters discussed in this Report are “forward-looking statements” that are intended to qualify for the safe harbor from liability established by the Private Securities Litigation Reform Act of 1995. These forward-looking statements can be identified as such because the statements generally will include words such as “believes,” “anticipates,” “expects,” or words of similar meaning. Similarly, statements that describe future plans, objectives, outlooks, targets or goals are also forward-looking statements. Such forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated as of the date of this Report. Factors that could cause such a variance include, but are not limited to, changes in interest rates, local market competition, customer loan and depo sit preferences, governmental regulations, and other general economic conditions. Shareholders, potential investors, and other readers are urged to consider these factors in evaluating the forward-looking statements and cautioned not to place undue reliance on such forward-looking statements. The forward-looking statements included in this Report are only made as of the date of this Report, and the Company undertakes no obligation to publicly update such forward-looking statements to reflect subsequent events or circumstances.


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Assumptions regarding interest rate sensitivity of some deposits also require significant judgment based on historical patterns relative to the industry and the Company’s own experience. Actual sensitivity may vary from the assumptions made, and have an impact on the Company’s net interest margin.

Part II. Other Information

Item 1. Legal Proceedings.

From time to time, the Company and the Bank, are party to legal proceedings arising out of their general lending activities and other operations. Currently there are no material proceedings.

Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities.

None.

Item 3. Default Upon Senior Securities.

None.

Item 4. Submission of Matters to Vote of Security Holders.

Annual Meeting of Shareholders. On May 5, 2004, at the Annual Meeting of the shareholders of the Company, the Company's shareholders reelected Michael J. Falbo and Ulice Payne Jr. and elected Richard A. Meeusen, and Kristine A. Rappe as directors for three-year terms expiring on the date of the annual shareholders' meeting to be held in 2007. The other directors of the Company whose terms of office continued after the 2004 annual meeting of shareholders are as follows: terms expiring at the 2005 annual meeting Jerome J. Holz, Thomas S. Rakow, and David M. Stamm; and terms expiring at the 2006 annual meeting Robert J. Cera, Richard A. Horn, and Barbara E. Weis. The Company’s shareholders also approved the proposed amendment to the State Financial Services Corporation 1998 Stock Incentive Plan.

Shareholder Vote with Respect to Matters Acted Upon at the Annual Meeting Election of Directors. Under Wisconsin law, the number of persons corresponding to the number of director positions to be filled at the Annual Meeting who received the highest number of votes are elected as directors. Michael J. Falbo, Ulice Payne Jr., Richard A. Meeusen, and Kristine A. Rappe stood for reelection and election as directors of the Company at the Annual Meeting. The votes with respect to the reelection and election of each were as follows:

Michael J. Falbo

5,933,073	votes were cast "FOR" the reelection of Mr. Falbo.
0	votes were withheld for the reelection of Mr. Falbo.
344,638	votes abstained or were broker non-votes.

Ulice Payne Jr.

5,814,229	votes were cast "FOR" the reelection of Mr. Payne.
0	votes were withheld for the reelection of Mr. Payne.
463,482	votes abstained or were broker non-votes.

Richard A. Meeusen

5,820,829	votes were cast "FOR" the election of Mr. Meeusen.
0	votes were withheld for the election of Mr. Meeusen.
456,882	votes abstained or were broker non-votes.

Kristine A. Rappe

5,819,003	votes were cast "FOR" the election of Ms. Rappe.
0	votes were withheld for the election of Ms. Rappe.
458,708	votes abstained or were broker non-votes.


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Amendment of State Financial Services Corporation 1998 Stock Incentive Plan. Under Wisconsin law, the amendment of the State Financial Services Corporation 1998 Stock Incentive Plan would be approved if, at the Annual Meeting, a greater number of votes were cast “FOR” the proposal than were cast “AGAINST” the proposal. Abstentions and brokers non-votes were not counted except for purposes of establishing a quorum. The vote on the amendment of the State Financial Services Corporation 1998 Stock Incentive Plan was as follows:

2,992,442	votes were cast “FOR” the amendment of the State Financial Services Corporation 1998 Stock Incentive Plan.
2,117,021	votes were cast “AGAINST” the amendment of the State Financial Services Corporation 1998 Stock Incentive Plan.
1,168,248	votes abstained or were broker non-votes.

Item 5. Other Information.

None.

Item 6. Exhibits and Reports on Form 8-K.

(a) Exhibits

31.1 Certification by the Chief Executive Officer pursuant to Rule 13a-14(a) or 15d-14(a) under the Securities Exchange Act of 1934.

31.2 Certification by the Chief Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a) under the Securities Exchange Act of 1934.

32 Certification Statement of the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350.

(b) Reports on Form 8-K

The Company filed a Current Report on Form 8-K, dated April 23, 2004, furnishing under Item 12 the Company’s press release dated April 20, 2004, with respect to financial results for the quarter ended March 31, 2004.


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SIGNATURES

Pursuant to the requirement of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

STATE FINANCIAL SERVICES CORPORATION

(Registrant)

Date: August 9, 2004 By /s/ Michael J. Falbo

Michael J. Falbo

President and Chief Executive Officer

Date: August 9, 2004 By /s/ Daniel L. Westrope

Daniel L. Westrope

Senior Vice President and

Chief Financial Officer


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STATE FINANCIAL SERVICES CORPORATION

EXHIBIT INDEX TO FORM 10-Q

For The Quarter Ended June 30, 2004

Exhibit Number

31.1 Certification by the Chief Executive Officer pursuant to Rule 13a-14(a) or 15d-14(a) under the Securities Exchange Act of 1934.

31.2 Certification by the Chief Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a) under the Securities Exchange Act of 1934.

32 Certification Statement of the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350.