FORM 10-Q

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

For the quarterly period ended March 31, 2004

OR

For the transition period from _________ to _________

Commission file number 0-16276

STERLING FINANCIAL CORPORATION

(717) 581-6030

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 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. Yes [X] No [  ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 126-2). Yes [X] No [  ]

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practical data.

Common Stock, $5.00 Par Value – 21,484,340 shares outstanding as of April 30, 2004.

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Sterling Financial Corporation and Subsidiaries
Index

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Part I — Financial Information
STERLING FINANCIAL CORPORATION AND SUBSIDIARIES

The accompanying notes are an integral part of these consolidated financial statements.

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STERLING FINANCIAL CORPORATION AND SUBSIDIARIES

The accompanying notes are an integral part of these consolidated financial statements.

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STERLING FINANCIAL CORPORATION AND SUBSIDIARIES

The accompanying notes are an integral part of these consolidated financial statements.

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STERLING FINANCIAL CORPORATION AND SUBSIDIARIES

The accompanying notes are an integral part of these consolidated financial statements.

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Notes to Consolidated Financial Statements

Note 1 – Summary of Significant Accounting Policies

     Basis of Presentation – The accompanying unaudited consolidated financial statements of Sterling Financial Corporation and subsidiaries have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation have been included.

     Operating results for the three months ended March 31, 2004, are not necessarily indicative of the results that may be expected for the year ended December 31, 2004.

     For further information, refer to the audited consolidated financial statements and footnotes thereto, included in the Annual Report on Form 10-K, for the year ended December 31, 2003.

     The consolidated financial statements and footnotes thereto of Sterling Financial Corporation include the accounts of its wholly owned subsidiaries, Bank of Lancaster County, N.A. (Bank of Lancaster County), First National Bank of North East (First National), Bank of Hanover and Trust Company (Bank of Hanover), HOVB Investment Co., T&C Leasing, Inc. (T&C), Pennbanks Insurance Company, SPC, Church Capital Management, LLC, Bainbridge Securities Inc., and Sterling Mortgage Services, Inc. (inactive). The unaudited consolidated financial statements also include Town & Country Leasing, LLC (Town & Country), Sterling Financial Trust Company, and Equipment Finance, LLC, all wholly-owned subsidiaries of Bank of Lancaster County. All significant intercompany balances and transactions have been eliminated in consolidation.

     Earnings Per Share – Basic earnings per share represents income available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflect additional common shares that would have been outstanding if potential dilutive common shares had been issued. Potential common shares that may be issued by Sterling consist solely of outstanding stock options and are determined using the treasury stock method.

     Earnings per common share have been computed based on the following (dollars in thousands):

     All share and per share amounts have been properly restated to reflect the 5-for-4 stock split effected in the form of a 25% stock dividend declared in January 2004 and paid in February 2004.

     Comprehensive Income – Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities and interest rate derivatives are reported as separate components of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income.

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     The components of other comprehensive income and related tax effects are as follows:

     The ending accumulated balances for each item included in accumulated other comprehensive income, net of related income taxes, were as follows:

     Reclassifications – Certain items in the 2003 consolidated financial statements have been reclassified to conform to the 2004 presentation format. Such reclassifications had no impact on net income.

     Recent Accounting Pronouncements – Sterling accounts for interest rate lock commitments (“IRLCs”) for those mortgage loans that it intends to sell as derivatives in accordance with SFAS No. 133. On March 9, 2004, the SEC staff released Staff Accounting Bulletin (“SAB”) No. 105 that requires registrants to exclude the future expected cash flows related to expected servicing fees from the fair value of IRLCs. This statement delays the recognition of such servicing revenues until such time as the loan is sold, however, the pronouncement would have no effect on the ultimate amount of revenue or cash flows recognized over time. This pronouncement is effective April 1, 2004 and must be adopted prospectively for commitments entered into after March 31, 2004. Sterling does not anticipate a significant impact to its financial condition or results of operations as a result of SAB 105.

     In December 2003, the Financial Accounting Standards Board (FASB) revised Statement No. 132, Employers’ Disclosures about Pensions and Other Postretirement Benefits. This Statement retains the disclosures required by the original Statement No. 132 and requires additional disclosures about the assets, obligations, cash flows and net periodic benefit cost of defined benefit pension and postretirement plans. In addition, this Statement requires interim period disclosure of the components of net period benefit cost and contributions if significantly different from previously reported amounts. Sterling adopted the provisions of this Statement as of December 31, 2003. See Note 5 for the additional pension and other postretirement benefit disclosures.

     In January 2003, the FASB issued Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities, FIN 46 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.

     During the third quarter of 2003, Sterling applied the provisions of FIN 46 to two wholly-owned special purpose subsidiary trusts, Sterling Financial Statutory Trust I and II that have issued preferred capital securities to third-party investors. The application of FIN 46 resulted in the deconsolidation of the two wholly-owned subsidiary trusts. The assets, which consisted entirely of a subordinated debenture in Sterling, and liabilities, which consisted solely of

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preferred securities held by third parties and common securities held by Sterling, of the subsidiary trusts that were deconsolidated totaled $20.633 million and $36.111 million, respectively. As allowed by the transition provisions of FIN 46, Sterling restated all previous periods presented as if FIN 46 had been adopted as of the date of the establishment of the subsidiary trusts. There was no material impact to results of operations or liquidity as of and for the year ended December 31, 2003 and 2002 as a result of applying these provisions of FIN 46.

     In December 2003 the FASB made certain modifications to clarify FIN 46. 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 impact upon the adoption of this guidance did not have a material impact on Sterling’s financial condition or results of operations.

Note 2 – Business Combinations

     Church Capital Management, LLC and Bainbridge Securities Inc. — On October 15, 2003, Sterling acquired 100 percent of the outstanding common shares of Church Capital Management, LLC and its affiliate, Bainbridge Securities Inc. Church Capital Management is a SEC Registered Investment Advisor with assets under management of approximately $700 million. Bainbridge Securities is a National Association of Securities Dealers (NASD) securities broker/dealer offering a wide array of investment services. As a result of the acquisition, Sterling plans to enhance earnings and provide financial product diversification.

     In connection with the completion of the acquisition of Church and Bainbridge, Sterling issued 359,998 shares of its common stock and paid $7.920 million. In addition, 240,002 shares of Sterling’s common stock and $5.280 million were placed in escrow, which will be released over the next five years based upon Church and Bainbridge reaching specified performance criteria and the settlement, if any, of outstanding litigation at the date of acquisition. Based on the closing price of Sterling’s common stock at the time the agreement was entered into, the 600,000 shares of common shares are valued at $12.192 million.

     The transaction was accounted for under the provisions of Statement No. 141, Business Combinations. The purchase price allocation included $38 thousand to premises and equipment and $5.110 million to finite-lived intangible assets, including $3.700 million to customer list, $480 thousand to trademark, and $930 thousand to covenants not to compete. The intangible assets have a weighted average life of approximately 7 years. The remaining portion of the purchase price, or $12.218 million, was assigned to goodwill, within the Trust and Investment Services segment. This transaction will generate additional goodwill, as the cash and shares held in escrow are released upon the satisfying of the specified performance criteria. The goodwill is not expected to be written off for tax purposes.

Note 3 – Stock Compensation

     Sterling has an omnibus stock incentive plan under which incentive and nonqualified stock options, stock appreciation rights, or restricted stock may be issued. To date, only incentive and nonqualified stock options have been issued under the plan. The options are granted periodically to key employees at a price not less than the fair value of the shares at the date of grant, and have a term of ten years. As of March 31, 2004, Sterling had approximately 696,500 shares of common stock reserved for issuance under the stock incentive plans. All options issued were in connection with the omnibus stock incentive plan, which was approved by shareholders.

     Sterling accounts for its stock incentive plan under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost for option grants are reflected in net income, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if Sterling had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.

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Note 4 – Segment Information

     Sterling operates four major lines of business: Community Banking and Related Services; Leasing; Commercial Finance; and Trust and Investment Services. A fifth line of business, Insurance Related Services does not presently meet the thresholds for reportable segment reporting; therefore it is included in the all other category.

     The Community Banking and Related Services segment provides financial services to consumers, businesses, financial institutions and governmental units in southern Pennsylvania, northern Maryland and Delaware. These services include providing various types of loans to customers, accepting deposits, mortgage banking and other typical banking services. Parent company and treasury function income is included in the community-banking segment, as the majority of effort of these functions is related to this segment. Major revenue sources include net interest income and service fees on deposit accounts. Expenses include personnel, branch support and network support charges.

     The Leasing segment provides vehicle and equipment financing alternatives to businesses primarily located in south central Pennsylvania and northeastern Maryland, although assets are located throughout the United States. Major revenue sources include net interest income and rental income on operating leases. Expenses include personnel, support and depreciation charges on operating leases.

     The Commercial Finance segment specializes in financing forestry and land-clearing equipment through more than 150 equipment dealer locations ranging from Maine to Florida. Major revenue sources include net interest income. Expenses include personnel and support charges.

     The Trust and Investment Services segment includes both corporate asset and personal wealth management services. The corporate asset management business provides retirement planning services, investment management, custody and other corporate trust services to small and medium size business in Sterling’s market area. Personal wealth management services include investment management, brokerage, estate and tax planning, as well as trust management and administration for high net worth individuals and their families. Major revenue sources include management and estate fees and commissions on security transactions. Expenses primarily consist of personnel and support charges, as well as amortization of intangible assets. Prior year information for this segment has been segregated from the all other segment for consistent presentation with 2004.

     The accounting policies of the segments are the same as those described in the summary of significant accounting policies. Transactions between segments, principally loans, were at terms consistent with that which would be obtained from a third party.

     Sterling’s reportable segments are strategic business units that offer different products and services. They are managed separately because each segment appeals to different markets and, accordingly, requires different technology and marketing strategies. Sterling’s chief operating decision maker utilizes interest income, interest expense, non-

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interest income, non-interest expense, and the provision for income taxes in making decisions and determining resources to be allocated to the segments.

     Information about reportable segments, and reconciliation of such information to the consolidated financial statements follows (in thousands):

     Sterling does not have a single external customer from whom it derives 10% or more of its revenue. As of March 31, 2004, $17.220 million of goodwill has been allocated to the commercial finance segment, $12.218 million to the trust and investment services segment and $1.031 million has been allocated to the commercial banking segment.

Note 5 – Retirement Benefit Plan

     The components of Sterling’s post-retirement benefits cost for the quarter ended March 31, 2004 and 2003 is as follows:

     In December 2003, President Bush signed into law a bill that expands Medicare benefits, primarily adding a prescription drug benefit for Medicare-eligible retirees beginning in 2006. The law also provides a federal subsidy to companies which sponsor postretirement benefit plans that provide prescription drug coverage. FASB Staff Position 106-1, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003” permits deferring the recognition of the new Medicare provisions’ impact due to lack of specific authoritative guidance on accounting for the federal subsidy. Sterling has elected to defer accounting for the effects of this new legislation until the specific authoritative guidance is issued. Accordingly, the postretirement benefit obligations and net periodic costs reported in the accompanying financial statements and notes do not reflect the impact of this legislation. The accounting guidance, when issued, could require changes to previously reported

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financial information. Sterling anticipates its benefit costs after 2006 will be somewhat lower as a result of the new Medicare provisions, however, the adoption of this standard is not expected to have a material impact on results of operations, financial position, or liquidity.

Note 6 – Subsequent Events

     On January 12, 2004, Sterling entered into a definitive agreement to purchase Corporate Healthcare Strategies, Inc., doing business as The Stoudt Companies, a Lancaster, Pennsylvania, based firm that provides benefit products and benefit consulting services to medium and large-sized businesses in the Central Pennsylvania region. Stoudt consists of three divisions, StoudtAdvisors (employee benefits insurance consulting and brokerage services), CapRisk (provides financial protection nationally to employers who self-fund their medical, dental and prescription plans), and the Lancaster Chamber Health Plan (a joint partnership with the Lancaster Chamber of Commerce which includes over 1,200 employer groups in Lancaster County, Pennsylvania).

     Sterling has agreed to issue up to 338,461 shares of its common stock and pay $8.800 million in cash to acquire the Stoudt Companies. Up to 30% of the merger consideration is subject to performance criteria for payment over the next four years. Assuming that all conditions are satisfied without delay, it is anticipated that the effective date of the merger will occur in the second quarter of 2004.

Item 2 – Management’s Discussions and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

     In addition to providing historical information, the management of Sterling has made forward-looking statements in this Quarterly Report on Form 10-Q. These forward-looking statements may be subject to risks and uncertainties. Forward-looking statements include the information concerning possible or assumed future results of operations of Sterling Financial Corporation and its wholly owned subsidiaries, or the combined company. When words such as “believes,” “expects,” “anticipates,” “may,” “could,” “should,” “estimates” or similar expressions occur in this quarterly report, management is making forward-looking statements.

     Stockholders should note that many factors, some of which are discussed elsewhere in this report, could affect the future financial results of Sterling Financial Corporation and its subsidiaries, both individually and collectively, and could cause those results to differ materially from those expectations expressed in this report. These risk factors include the following:

	•		Operating, legal and regulatory risks;
	•		Economic, political and competitive forces impacting our various lines of business;
	•		The risk that our analysis of these risks and forces could be incorrect and/or that the strategies developed to address them could be unsuccessful;
	•		The possibility that increased demand or prices for Sterling’s financial services and products may not occur;
	•		Volatility in interest rates; and
	•		Other risks and uncertainties.

     Sterling undertakes no obligation to publicly revise or update these forward-looking statements to reflect events or circumstances that arise after the date of this report. Readers should carefully review the risk factors described in other documents Sterling files periodically with the Securities and Exchange Commission, including Quarterly Reports on Form 10-Q, the Annual Report on form 10-K and any Current Reports on Form 8-K.

General

     The following discussion provides management’s analysis of the consolidated financial condition and results of operations of Sterling Financial Corporation and its wholly-owned subsidiaries, Bank of Lancaster County, N.A. First National Bank of North East, Bank of Hanover and Trust Company, HOVB Investment Co., T&C Leasing, Inc., Pennbanks Insurance Company, SPC, Church Capital Management, LLC, Bainbridge Securities Inc. and Sterling Mortgage Services, Inc. (inactive). The consolidated financial statements also include Town & Country Leasing,

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LLC, Sterling financial Trust Company and Equipment Finance, LLC, all wholly-owned subsidiaries of Bank of Lancaster County.

Critical Accounting Policies

     Sterling’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States and follow general practices within the industries in which it operates. Application of these principles require 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; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available. When third-party information is not available, valuation adjustments are estimated in good faith by management primarily through the use of internal cash flow modeling techniques.

     The most significant accounting policies followed by Sterling are presented in Note 1 to the consolidated financial statements. These policies, along with the disclosures presented in the other financial statement notes and in this financial review, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified the determination of the allowance for loan losses and the evaluation of goodwill impairment to be the accounting areas that require the most subjective or complex judgments, and as such could be most subject to revision as new information becomes available.

     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 also represents the largest asset type on the consolidated balance sheet. Note 1 to the consolidated financial statements describes the methodology used to determine the allowance for loan losses.

     With the adoption of SFAS No. 142 on January 1, 2002, Sterling is no longer required to amortize goodwill resulting from business acquisitions. Goodwill is now subject to impairment testing at least annually to determine whether write-downs of the recorded balances are necessary. Sterling tests for impairment based on the goodwill maintained at each defined reporting unit. An independent party using various market valuation methodologies determines a fair value. If the fair values of the reporting units exceed their book values, no write-downs of recorded goodwill are necessary. If the fair value of the reporting unit is less than its book value, an impairment expense may be required to be recorded to write down the related goodwill to the proper carrying value. Sterling completed its annual impairment testing during the fourth quarter of 2003 and determined that no impairment charges were necessary. No assurance can be given that future impairment tests will not result in a charge to earnings.

     Any material effect on the financial statements related to these critical accounting areas is also discussed in this management discussion and analysis.

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Non-GAAP Presentations

     This management’s discussion and analysis refers to the efficiency ratio that is a non-GAAP financial measure that we believe provides readers with important information regarding Sterling’s operational efficiency. Comparison of Sterling’s efficiency ratio with other companies’ may not be appropriate, as they may calculate their efficiency ratio in a different manner.

     The efficiency ratio is computed by dividing noninterest expense, less depreciation on operating leases, by the sum of tax equivalent net interest income and noninterest income, less depreciation on operating leases. Sterling nets the depreciation on operating leases against related income, as it is consistent with utilizing net interest income presentation for comparable capital leases, which nets interest expense against interest income. The efficiency ratio excludes unusual items, including gains/losses on securities activities, interest collected on charged-off loans, etc.

     Sterling, in referring to its net income, is referring to income determined in conformity with accounting principles generally accepted in the United States (GAAP).

RESULTS OF OPERATIONS

(Dollars in tables are in thousands)

Executive Overview

     Sterling’s net income was $7.629 million for the quarter ended March 31, 2004, an increase of $1.004 million, or 15.2% from the first quarter 2003. Diluted earnings per share totaled $0.35 for the first quarter 2004 versus $0.31 for the same period 2003, an increase of 12.9%. Return on average realized equity for the first quarter of 2004 was 14.78%, compared to 14.52% in the first quarter of 2003.

     Despite a challenging interest rate environment for the financial services industry, Sterling has been able to improve net interest income, from $20.571 million for the first quarter of 2003 to $22.567 million in 2004, a 9.7% increase. The improvement is primarily the result of a shift in the composition of Sterling’s interest earning assets, away from lower yielding federal funds and securities, to higher yielding loans, particularly commercial loans and finance receivables. Sterling’s net interest margin was 4.65% for the first quarter of 2004, which matches 2003 levels.

     Despite growth in loans receivable, Sterling’s provision for loan losses was $714 thousand for the quarter ended March 31, 2004, compared to $1.035 million in 2003. The decrease in the provision was the direct result of improving asset quality ratios, combined with minimal net charge-offs during the period.

     Noninterest income, excluding securities gains, was $12.686 million for the quarter ended March 31, 2004, an 11.0% increase over $11.428 million earned in 2003. Mortgage banking income declined $386 thousand as mortgage loan origination volumes have declined as 2004 interest rates have increased over 2003 levels. Offsetting this decline was trust and investment management income and brokerage fees and commissions, which increased from $1.307 million for the first quarter of 2003 to $2.982 million in 2004. The acquisition of Church Capital Management LLC, a registered investment advisor, and Bainbridge Securities, Inc., a NASD registered broker dealer, in the fourth quarter of 2003 contributed to the 128% increase in trust and investment management income and brokerage fees and commissions.

     Noninterest expenses were $24.972 million for the quarter ended March 31, 2004 compared to $21.912 million in 2003, a 14.0% increase. The increase in noninterest expenses can be attributed to the growth that Sterling has experienced, both organic and through expansion into new geographic regions, including Berks County, Pennsylvania, Carroll County, Maryland, and New Castle County, Delaware. In addition, new and enhanced financial services products are being offered to Sterling’s customers, including brokerage services and registered investment advisor consultation. As a result of new markets served and product expansion, increases were noted in virtually every noninterest expense category, including a full quarter’s worth of expenses for Church Capital Management and Bainbridge Securities in 2004, compared to no similar expenses in 2003.

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     Sterling’s efficiency ratio for the quarter ended March 31, 2004 was 62.1%, which was higher than the first quarter 2003 ratio of 58.8%. As a result of Sterling being an acquisitive and growing financial services company, the efficiency ratio has slipped slightly in the short term, as we have incurred expenses in trying to assimilate new affiliates into the Sterling family with little disruption to our customer base. Additionally, as our banking segment expands in to new geographic markets, the additional office locations also negatively impacts Sterling’s efficiency ratio in the short-term.

     A more thorough discussion of Sterling’s results of operations is included in the following pages.

Net Interest Income

     The primary component of Sterling’s revenue is net interest income, which is the difference between interest income and fees on interest-earning assets and interest expense on interest-bearing funds. Earning assets include loans, securities and federal funds sold. Interest-bearing funds include deposits and borrowed funds. To compare the tax-exempt yields to taxable yields, amounts are adjusted to pretax equivalents based on a 35% federal corporate income tax rate.

     Net interest income is affected by changes in interest rates, volume of interest-bearing assets and liabilities and the composition of those assets and liabilities. The “interest rate spread” and “net interest margin” are two common statistics related to changes in net interest income. The interest rate spread represents the difference between the yields earned on interest-earning assets and the rates paid for interest-bearing liabilities. The net interest margin is defined as the percentage of net interest income to average earning assets. Due to demand deposits and stockholders equity, the net interest margin exceeds the interest rate spread, as these funding sources are non-interest bearing.

     Net interest income, on a tax equivalent basis, totaled $24.251 million for the first quarter of 2004 compared to $22.161 million for the first quarter of 2003, an increase of $2.090 million or 9.4%. This increase reflects a $171 million or 9.0% increase in the average balance of interest-earning assets. Net interest margin matched the prior year’s quarter at 4.65%.

     The increase in interest-earning assets came primarily in the form of loans. In fact, the growth in loans exceeded the growth in earning assets, reflecting the funding of a portion of the loan growth with securities portfolio cash flow and overnight fed funds over the past year. Strong growth in the commercial loan and finance receivables portfolios as well as consumer loans and leases contributed to the increase in total loans. Year over year, quarterly average loans increased $208 million, increasing the percentage of loans to interest-earning assets from 69% in 2003 to 74% in 2004. Generally, loans carry a higher yield than alternative interest-earning assets, namely securities and other investments.

     Funding for the growth in assets came from deposits, borrowings and shareholders’ equity. Strong growth was experienced in demand and savings deposits, which more than offset the decrease in time deposits. Over the past year, Sterling experienced a significant volume of maturing CDs at high interest rates. During that time, the banks were less aggressive in obtaining CDs, and the rates were consciously held at the now lower market levels.

     The following table summarizes, on a fully taxable equivalent basis, net interest income, and net interest margin for the three months ended March 31, 2004 and 2003:

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     During 2003, Sterling leveraged the proceeds of the trust preferred issued by borrowing $75 million from the Federal Home Loan Bank and initiated the purchase of securities with these funds. These additional borrowed funds were offset by maturities of other FHLB borrowings and the continued pay-downs of third-party borrowings that had been used to fund both finance receivables and operating leases.

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     Net interest margin remained at 4.65% resulting from a number of offsetting factors:

	•		During the two years from January 2001 to December 2002, the Federal Reserve Bank lowered the federal funds rate twelve times totaling 5.25%. This dramatic decrease in short-term interest rates has resulted in a significant decrease in the cost of funds for Sterling. The rate paid on interest bearing liabilities declined 41 b.p. from the first quarter of 2003 to 2004.
	•		During the second half of 2003 and continuing into the first quarter of 2004, the downward repricing of assets accelerated relative to the repricing of liabilities, resulting in a diminishing benefit from the prolonged low level of interest rates. This general downward repricing of assets has been offset in part by a continued improving mix of earning assets in the balance sheet to higher yielding assets, generally loans versus securities and specifically growth in high yielding finance receivables. The rate earned on interest earning assets declined 38 b.p. from the first quarter of 2003 to 2004.

Provision for Loan Losses

     The provision for loan losses was $714 thousand for the quarter ended March 31, 2004, a decrease of $321 thousand from $1.035 million for 2003. As a result of an improving national and local economy, Sterling’s net charge-offs for the quarter ended March 31, 2004 were $288 thousand, compared to $701 thousand in 2003. As a result of the decline in net charge-offs combined with improving asset quality ratios, it was determined that a lower provision for loan losses during the current year was appropriate. The provision for loan losses reflects the amount required to maintain an adequate allowance to meet the present risk characteristics of the loan portfolio.

     See further discussion in the allowance for loan losses section.

Noninterest Income

     Total noninterest income totaled $13.203 million for the three months ended March 31, 2004 compared to $11.432 million in 2003, an increase of 15.5%.

     Trust and investment management income was $2.154 million for the first quarter of 2004, and increase of $1.015 million, or 89.1%, over 2003 results. The positive effects of new business development, favorable market conditions as compared to 2003, and the acquisition of Church Capital Management, a registered investment advisor, in the fourth quarter of 2003 all contributed to the revenue growth.

     Brokerage fees and commissions totaled $828 thousand for the quarter ended March 31, 2004, compared to $168 thousand for the same period last year, resulting in a $660 thousand increase. The acquisition of Bainbridge Securities Inc., an NASD registered broker dealer, in the fourth quarter of 2003 was the primary reason for the increase in revenues. Favorable market conditions have also resulted increased brokerage volume, as consumers are shifting their investment funds back towards the equity and mutual fund markets.

     Mortgage banking income was $409 thousand for the quarter ended March 31, 2004, a $386 thousand decline as compared to 2003. Mortgage loan origination volumes have declined as 2004 interest rates have increased over 2003 levels, which has negatively impacted mortgage-banking income.

     During the first quarter of 2004, Sterling recognized securities gains of $517 thousand. These gains were primarily the result of two separate equity investment strategies, including sales of insurance industry positions acquired as a result of demutualization, and gains that were taken through liquidation of certain bank stocks given our belief that these stocks were fully valued. It is anticipated that the proceeds from the securities sold will be used to capitalize Sterling’s entrance into the New Castle County, Delaware market, with its separately chartered Delaware Sterling Bank.

Noninterest Expenses

     Noninterest expenses totaled $24.972 million for the quarter ended March 31, 2004 compared to $21.912 million for the same period in 2003, an increase of 14.0%.

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     The largest component of noninterest expense is salaries and employee benefits, which totaled $11.040 million for the quarter ended March 31, 2004, a $1.892 million or 20.7% increase over the same period in 2003. The increase is attributable to the following factors:

	•		A full quarter’s worth of salaries and wages associated with Sterling’s new affiliates, Church Capital Management and Bainbridge Securities, with no similar expense in the prior year;
	•		Increased number of employees, the result of branch expansion including the addition of PennSterling Bank and Delaware Sterling Bank;
	•		Additions to staff required to continue to serve our customers in light of increased transaction volumes; and
	•		Normal merit increases to existing employees.

     Net occupancy expense increased to $1.429 million for the quarter ended March 31, 2004, an increase of $118 thousand, or 9.0%, from the same period in 2003. This increase is a direct result of the overall growth of the corporation. Offsetting the increases in areas such as rent expense and utilities was a decrease of approximately $80 thousand in snow removal due to the extreme weather conditions experienced in the first quarter of 2003 in comparison to 2004.

     Furniture and equipment charges were $1.722 million and $1.533 million for the quarters ended March 31, 2004 and 2003. The steady upward trend in furniture and equipment expense is the result of enhancements to the delivery channels available to deliver products to customers. Additionally, certain equipment charges are based on the number of accounts opened and their transaction volumes. As Sterling’s customer base continues to grow, these types of charges grow as well. The increase in number of branch offices, and renovations made to existing branches also contributed to the increase.

     Taxes other than income was $590 thousand for the quarter ended March 31, 2004, compared to $365 thousand in 2003. The primary reason for the increase is the acquisition of Church Capital and Bainbridge Securities, which results in additional Pennsylvania capital stock tax. Also contributing to the increase were increases in Pennsylvania bank shares and capital stock tax that has resulted from the additional equity bases at the bank affiliates and Equipment Finance.

     Intangible asset amortization was $250 thousand for the quarter ended March 31, 2004, compared to $36 thousand in 2003. The significant increase is the result of the acquisition of Church Capital Management, in which several intangible assets were identified, including customer list, trademark and covenants not to compete. The first quarter of 2004 includes a full quarter of amortization on these assets, while the prior year amortization consists solely of core deposit amortization on two branches purchased in the mid-1990s.

     Other noninterest expense totaled $3.940 million for the quarter ended March 31, 2004, compared to $3.480 million in 2003. Expenses in this category consist of marketing, advertising, promotions, postage, lending related expenses, insurance and telephone expenses. Marketing and advertising expenditures have increased as Sterling enters new geographic markets and offers new products. The remaining increase in other noninterest expenses is a function of Sterling’s overall growth, which results in higher expenses.

     Sterling’s efficiency ratio for the quarter ended March 31, 2004 was 62.1%, which was higher than the first quarter 2003 ratio of 58.8%. As a result of Sterling being an acquisitive and growing financial services company, the efficiency ratio has slipped slightly in the short term, as we have incurred expenses in trying to assimilate new affiliates into the Sterling family with little disruption to our customer base. Additionally, as our banking segment expands in to new geographic markets, the additional office locations also negatively impacts Sterling’s efficiency ratio in the short-term.

Income Taxes

     Income tax expense for the quarter ended March 31, 2004 was $2.455 million resulting in an effective tax rate of 24.3%, versus 26.8% in 2003. Two factors have influenced the improvement in the effective tax rate. First, tax-free income comprises a greater percentage of pre-tax income, and a subsidiary converted to a single member limited liability corporation on April 1, 2003. As a result, the first quarter of 2003 includes state income taxes on this affiliate, whereas no comparable tax was incurred in 2004.

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FINANCIAL CONDITION

     Total assets at March 31, 2004, totaled $2.335 billion compared to $2.344 billion at December 31, 2003. This represents a slight decrease of $8.546 million or 0.4% over that period of time.

Securities

     Sterling utilizes investment securities as a primary tool for managing interest rate risk, to generate interest and dividend income and to provide liquidity to the parent company and affiliates. As of March 31, 2004, securities totaled $552.447 million, which represents a 4.1% decrease from the December 31, 2003 balance of $576.005 million. During the first three months of 2004, as with the prior year, the cash flows from investment securities were generally used to fund loan growth generated by the company. Proceeds from maturities, sales and calls totaled $38.897 million. Purchases of $9.072 million were completed primarily to meet pledging requirements.

     Sterling’s securities portfolio includes debt and equity instruments that are subject to varying degrees of credit and market risk. This risk arises from general market conditions, factors impacting specific industries, as well as corporate news that may impact specific issues. Management continuously monitors its debt securities, including routine updating of credit ratings, monitoring market, industry and corporate news, as well as volatility in market prices. Sterling uses various indictors in determining whether a debt security is other-than-temporarily impaired, including whether it is probable that the contractual interest and principal will not be collected in full. One such indicator is credit ratings. As of March 31, 2004, there were no holdings below investment grade.

     In addition to its debt securities, Sterling also maintains an equity security portfolio, comprised of the following:

     The government agency portfolio is maintained in part to meet certain regulatory requirements. Holdings of community bank and financial services industry stocks are maintained for long-term appreciation in these segments of the market.

     Adjusted cost reflects a reserve for other than temporary impairment charges totaling $749 thousand. These charges are recognized when the market value of a specific holding has not exceeded adjusted cost at any time in the prior six months.

     Sterling recognized no other than temporary impairment charges in the first quarter of 2004.

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Loans

     The following table sets forth the composition of Sterling’s loan portfolio, at March 31, 2004 and December 31, 2003:

     During the first quarter of 2004, loans outstanding have increased $52.663 million, or 3.5%, primarily in the areas of commercial loans, finance receivables and lease financing. Consistent with the trends noted in 2003, Sterling continues to experience strong loan growth, particularly in the specialty lending including finance receivables and leases. Commercial loan growth has also been strong, as Sterling benefits from their strong customer relationship model in new and existing markets.

Allowance for Loan Losses

     Sterling maintains the allowance for loan losses at a level that management believes adequate to absorb potential losses inherent in the loan portfolio and is established through a provision for loan losses charged to earnings. Additionally, when Sterling acquires a company in a purchase business combination, the acquired allowance is combined with Sterling’s existing allowance. Quarterly, Sterling utilizes a defined methodology in determining the adequacy of the allowance for loan losses. This methodology considers specific credit reviews, past loan loss experience, qualitative factors and other factors that management may deem appropriate. (For a more thorough discussion of the allowance for loan losses methodology, please refer to the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2003).

     Management believes this methodology accurately reflects losses inherent in the portfolio. Management charges actual loan losses to the allowance for loan losses. Management periodically updates this methodology, which reduces the difference between actual losses and estimated losses. Management bases the provision for loan losses on the overall analysis taking the methodology into account.

     Non-performing assets include nonaccrual and restructured loans, accruing loans past due 90 days or more and other foreclosed assets. Sterling’s general policy is to cease accruing interest on loans when management determines that a reasonable doubt exists as to the collectibility of additional interest. When management places a loan on nonaccrual status, it reverses unpaid interest credited to income in the current year, and charges unpaid interest accrued in prior years to the allowance for loan losses. Sterling typically returns nonaccrual loans to performing status when the borrower brings the loan current and performs in accordance with contractual terms for a reasonable period of time. Sterling categorizes a loan as restructured if it changes the terms of the loan such as interest rate, repayment schedule or both, to terms that it otherwise would not have granted originally.

     The following table presents information concerning the aggregate amount of nonaccrual, past due and restructured loans as of March 31, 2004 and December 31, 2003:

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     As of March 31, 2004, non-performing assets were $4.549 million, a decrease of $701 thousand or 13.4% from December 31, 2003, primarily in the area of loans past due 90 days or more and still accruing. Two loans previously included in this category were paid off during the first quarter of 2004.

     Potential problem loans are defined as performing loans, which have characteristics that cause management to have serious doubts as to the ability of the borrower to perform under present loan repayment terms and which may result in the reporting of these loans as nonperforming loans in the future. Total potential problem loans were approximately $5.801 million at March 31, 2004 as compared to $7.125 million at December 31, 2003. Additionally, outstanding letter of credit commitments totaling approximately $3.482 million could result in potential problem loans, if drawn upon. The majority of these loans are secured by a combination of business assets and/or real estate with acceptable loan-to-value ratios.

     The rollforward of the allowance for loan losses for the three months ended March 31, 2004 and 2003 were as follows: