Washington, D. C. 20549

(Mark One)

OR

For the transition period from   to                               

Commission file number 0-16276

STERLING FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

Registrant’s Telephone number, including area code: (717) 581-6030

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12 (g) of the Act:

Common Stock, Par Value $5.00 Per Share

(Title of class)

      Indicated by a check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

      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 o

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

      The aggregate market value of the voting stock held by non-affiliates of the Registrant at June 30, 2004, was approximately $548,988,000.

      The number of shares of Registrant’s Common Stock outstanding on March 11, 2005 was 23,311,426.

Documents Incorporated by Reference

      Portions of the Registrant’s 2005 Proxy Statement are incorporated by reference into Part III of this report.

Sterling Financial Corporation

Table of Contents

Part I

       The management of Sterling Financial Corporation has made forward-looking statements in this Annual Report on Form 10-K. 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, Bank of Lancaster County, N.A., First National Bank of North East, Bank of Hanover and Trust Company, Pennsylvania State Bank, Delaware Sterling Bank & Trust Company, Church Capital Management LLC, Bainbridge Securities, Inc., T & C Leasing, Inc., HOVB Investment Co., StoudtAdvisors, Lancaster Insurance Group, LLC and Sterling Mortgage Services, Inc. (inactive). The consolidated financial statements also include Town & Country Leasing, LLC, Sterling Financial Trust Company, Equipment Finance LLC and Sterling Community Development Corporation, L.L.C., all wholly-owned subsidiaries of Bank of Lancaster County, N.A. When words such as “believes,” “expects,” “anticipates,” “may,” “could,” “should,” “estimates” or similar expressions occur in this annual report, management is making forward-looking statements.

      Shareholders 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 expressed in this report. These risk factors include the following:

      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 and any Current Reports on Form 8-K.

Item 1 — Business

      Sterling Financial Corporation is a $2.743 billion financial holding company headquartered in Lancaster, Pennsylvania. Through its banking and nonbanking subsidiaries, Sterling provides a full range of banking and financial services to individuals and businesses, through its five business segments: Community Banking and Related Services; Leasing; Commercial Finance; Trust and Investment Services; and Insurance and Related Services.

      Community Banking and Related Services

      The Community Banking and Related Services segment provides financial services to consumers, businesses, financial institutions and governmental units in south central Pennsylvania, northern Maryland and northern Delaware. These services include providing various types of loans to customers, accepting deposits, mortgage banking and other traditional 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 and branch network support charges.

      Our Community Banking and Related Services segment is comprised of our banking affiliates, summarized below (dollars in millions).

      In addition to its network of 63 office locations, the Community Banking and Related Services segment delivers its services through alternative delivery channels, including the ATM network, internet and telephone banking.

      The Community Banking and Related Services segment’s geographic market is among the strongest and most stable economies in Pennsylvania, Maryland and Delaware with agriculture, industry and tourism all contributing to the overall strength of the economy. No single sector dominates the region’s economy.

      The affiliate banks are subject to regulation and periodic examination by their regulators, including the Office of the Comptroller of the Currency for the national banks, the Federal Deposit Insurance Corporation and Pennsylvania Department of Banking for the state chartered non-member bank, Bank of Hanover and the Federal Reserve for the state chartered, member bank, Pennsylvania State Bank. The Federal Deposit Insurance Corporation, as provided by law, insures the bank’s deposits.

      At December 31, 2004, the Community Banking and Related Services segment represented approximately 82% of Sterling’s consolidated assets, and contributed approximately 56% of Sterling’s net income for the year ended December 31, 2004.

      Leasing

      The Leasing Segment provides fleet and equipment financing services to commercial businesses. Sterling has two affiliates that comprise the leasing segment, including Town & Country Leasing, LLC, a wholly-owned subsidiary of Bank of Lancaster County, and T & C Leasing, Inc., a direct subsidiary of Sterling.

      The Leasing segment provides fleet management and equipment financing and leasing alternatives to customers headquartered primarily in Pennsylvania and surrounding states. Through its customers’ branch offices, the Leasing segment conducts business in all 50 states.

      At December 31, 2004, the Leasing segment represented approximately 9% of Sterling’s consolidated assets, and contributed approximately 4% of Sterling’s net income for the year ended December 31, 2004. Major revenue sources include net interest income and rental income on operating leases. Expenses include personnel, support and depreciation charges on operating leases.

      Commercial Finance

      Equipment Finance LLC, which was acquired by Sterling in February 2002, represents the sole affiliate within the commercial finance segment. Equipment Finance specializes in financing forestry and land-clearing equipment through more than 150 equipment dealer locations ranging from Maine to Florida.

      At December 31, 2004, the Commercial Finance segment represented approximately 8% of Sterling’s consolidated assets, and contributed approximately 36% of Sterling’s net income for the year ended December 31, 2004. Major revenue sources include net interest income. Expenses include personnel and support charges. Since the acquisition of Equipment Finance in 2002, finance receivables have grown from $81 million to $194 million, and represent one of Sterling’s fastest growing segments.

      Trust and Investment Services

      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 to medium size businesses 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.

      Prior to October 2003, Sterling Financial Trust Company, a wholly-owned subsidiary of Bank of Lancaster County, and its predecessor wealth management and investment services divisions at Bank of Lancaster County and Bank of Hanover were the only units within this segment. In 2002, the wealth management and investment services divisions of the two banks were combined into the newly created Trust Company to increase revenue generation opportunities, while increasing operating efficiencies.

      In the fourth quarter of 2003, Sterling acquired Church Capital Management LLC and Bainbridge Securities, Inc. These acquisitions result in our ability to offer a wider array of financial services within the Trust and Investment Services segment. Church Capital is a SEC Registered Investment Advisor and Bainbridge Securities is a National Association of Securities Dealers (NASD) broker/ dealer that offers complementary products to the more traditional wealth management services. Sterling expects that these acquisitions will enhance earnings and provide financial product diversification.

      At December 31, 2004, the Trust and Investment Services segment represented approximately 1% of consolidated assets, and contributed approximately 3% of Sterling’s net income for the year ended December 31, 2004. In addition, the Trust and Investment Services segment had assets under management of approximately $1.7 billion. 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.

      Insurance and Related Services

      Sterling’s affiliates offer insurance and related services to its customers including benefit products and consulting services to medium and large business through Corporate Healthcare Strategies, credit life and disability reinsurance, through Pennbanks Insurance Company, comprehensive personal insurance and coverages through Lancaster Insurance Group, LLC, and Sterling Financial Settlement Services, a settlement and title insurance agency joint venture that it has established with a local realtor agency.

      In May 2004, Sterling strengthened this segment of its business through the acquisition of Corporate Healthcare Strategies, doing business as StoudtAdvisors, located in Lancaster, Pennsylvania. The acquisition of StoudtAdvisors is consistent with Sterling’s philosophy of becoming a diversified financial company. It is anticipated that StoudtAdvisors will be able to bring another product offering to our customer base, allowing us to continue to build on our relationship management model. In addition, effective July 1, 2004, Sterling purchased the remaining fifty percent of Lancaster Insurance Group’s membership interest, and became a wholly-owned subsidiary of Sterling.

      At December 31, 2004, the Insurance and Related Services segment represented less than 1% of consolidated assets, and contributed less than 1% of net income for the year ended December 31, 2004. Although not significant in 2004, it is anticipated that revenues and profits will grow in future periods. Major revenue sources of this segment include commissions on sales of insurance products and consulting fees. Expenses primarily consist of personnel and support charges, as well as amortization of intangible assets.

      For more detailed financial information pertaining to our operating segments, please refer to Note 23 of the Consolidated Financial Statements.

      Sterling’s major sources of operating funds, as a parent company, are dividends received from its subsidiaries and reimbursement of operating expenses from the affiliates. Sterling’s expenses are primarily operating expenses. Dividends that Sterling pays to shareholders are funded, in part, by dividends paid to Sterling by its subsidiaries.

      Sterling and its subsidiaries do not have any portion of their businesses dependent on a single or limited number of customers, the loss of which would have a material adverse effect on their businesses. No substantial portion of their loans or investments are concentrated within a single industry or group of related industries, although a significant amount of loans are secured by real estate located in south central Pennsylvania, and northern Maryland. Loan exposure to the forestry industry is approximately 10% of total loans outstanding. The businesses of Sterling and its subsidiaries are not seasonal in nature.

      The common stock of Sterling is listed on The NASDAQ Stock Market National Market System under the symbol SLFI.

Competition

      The financial services industry in Sterling’s market area is highly competitive, including competition from commercial banks, savings banks, credit unions, finance companies and nonbank providers of financial services. Several of Sterling’s competitors have legal lending limits that exceed Sterling’s subsidiaries, as well as funding sources in the capital markets that exceeds Sterling’s availability. The increased competition has resulted from a changing legal and regulatory climate, as well as from the economic climate.

Environmental Compliance

      Sterling’s and its subsidiaries’ compliance with federal, state and local environmental protection laws had no material effect on capital expenditures, earnings or their competitive position in 2004, and is not expected to have a material effect on such expenditures, earnings or competitive position in 2005.

Supervision and Regulation

      Bank holding companies and banks operate in a highly regulated environment and are regularly examined by Federal and State regulatory authorities.

      The following discussion highlights various Federal and State laws and regulations and the potential impact of such laws and regulations on Sterling and its subsidiaries.

      To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular statutory or regulatory provisions themselves. Proposals to change laws and regulations are frequently introduced in Congress, the state legislatures, and before the various regulatory agencies. Sterling cannot determine the likelihood or timing of any such proposals or legislation or the impact they may have on Sterling and its subsidiaries. A change in law, regulations or regulatory policy may have a material effect on the business of Sterling and its subsidiaries.

      Sterling is a financial holding company and, as such, is subject to the regulations of the Board of Governors of the Federal Reserve System under the Bank Holding Company Act of 1956, as amended (BHC Act). Bank holding companies are required to file periodic reports with and are subject to examination by the

Federal Reserve. The BHC Act requires a financial holding company to serve as a source of financial and managerial strength to its banking subsidiaries, which may result in providing adequate capital funds to the banks during periods of financial stress or adversity.

      The BHC Act prohibits Sterling from acquiring direct or indirect control of more than 5% of the outstanding voting stock of any bank, or substantially all of the assets of any bank, or merger with another bank holding company, without the prior approval of the Federal Reserve. The BHC Act allows interstate bank acquisitions and interstate branching by acquisition and consolidation in those states that had not elected out by the required deadline. The Pennsylvania Department of Banking also must approve any similar consolidation. Pennsylvania law permits Pennsylvania financial holding companies to control an unlimited number of banks.

      In addition, the BHC Act restricts our nonbanking activities to those that are determined by the Federal Reserve Board to be financial in nature, incidental to such financial activity, or complementary to a financial activity. The BHC Act does not place territorial restrictions on the activities of nonbank subsidiaries of financial holding companies.

      The Federal Deposit Insurance Corporation Improvement Act requires a bank holding company to guarantee the compliance of any insured depository institution subsidiary that may become “undercapitalized”, as defined by regulations, with the terms of any capital restoration plan filed by such subsidiary with its appropriate federal banking agency, up to specified limits.

      In November 1999, the Gramm-Leach-Bliley Act of 1999, or the GLB, was enacted. As a result of GLB, new opportunities became available to financial institution holding companies as it removed the restrictions that resulted from a regulatory framework that had its origin in the Great Depression of the 1930s. In addition, the GLB also contains provisions that expressly preempt any state law restricting the establishment of financial affiliations, primarily related to insurance.

      The general effect of GLB is to permit banks, other depository institutions, insurance companies and securities firms to enter into combinations that result in a single financial services organization to offer customers a wider array of financial services and products, through a new entity known as a “financial holding company.” “Financial activities” is broadly defined to include not only banking, insurance and securities activities, but other activities incidental to such financial activities or complementary activities that do not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally. The GLB also permits national banks to engage in expanded activities through the formation of financial subsidiaries.

      Sterling elected “financial holding company” status in April, 2001 and has utilized the opportunities available under the GLB to expand into a diversified holding company. Sterling acquired First National Bank of North East in June 1999, Bank of Hanover and Trust Company in July 2000, Equipment Finance LLC in February 2002, Church Capital Management LLC and Bainbridge Securities, Inc. in October 2003, Corporate Healthcare Strategies, LLC in May 2004, Lancaster Insurance Group, LLC in June 2004, and Pennsylvania State Bank in December 2004.

      To the extent that the GLB permits banks, securities firms and insurance companies to affiliate, the financial services industry may experience further consolidation. The GLB is intended to grant to community banks certain powers as a matter of right that larger institutions have accumulated on an ad hoc basis and which unitary savings and loan holding companies already possess. Nevertheless, the GLB may have the result of increasing the amount of competition that Sterling faces from larger institutions and other types of companies offering financial products, many of which may have substantially more financial resources than does Sterling.

      On October 26, 2001, the USA Patriot Act of 2001 was enacted. This act contains the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001, which sets forth anti-money laundering measures affecting insured depository institutions, broker-dealers and other financial institutions. The Act requires U.S. financial institutions to adopt new policies and procedures to combat money laundering and grants the Secretary of the Treasury broad authority to establish regulations and to impose requirements and restrictions on the operations of financial institutions.

      On July 30, 2002, the Sarbanes-Oxley Act of 2002 was enacted. The Sarbanes-Oxley Act represents a comprehensive revision of laws affecting corporate governance, accounting obligations and corporate reporting. The Sarbanes-Oxley Act is applicable to all companies with equity securities registered or that file reports under the Securities Exchange Act of 1934. In particular, the Sarbanes-Oxley Act established: (i) new requirements for audit committees, including independence, expertise and responsibilities; (ii) additional responsibilities regarding financial statements for the Chief Executive Officer and Chief Financial Officer of the reporting company; (iii) new standards for auditors and regulation of audits; (iv) increased disclosure and reporting obligations for the reporting company and its directors and executive officers; and (v) new and increased civil and criminal penalties for violations of the securities laws. Many of the provisions were effective immediately while other provisions became effective over a period of time and are subject to rulemaking by the SEC and the Public Company Accounting Oversight Board (PCAOB). Because Sterling’s common stock is registered with the SEC, it is subject to this Act.

      Throughout 2002 and 2003, the SEC and the NASDAQ Stock Market issued new regulations affecting our corporate governance and heightening our disclosure requirements. Among the many new changes this year are enhanced proxy statement disclosures on corporate governance, stricter independence requirements for the Board of Directors and its committees, posting of various SEC reports on our website, and documentation, testing and analysis of our internal controls and procedures. The full impact of the Sarbanes-Oxley Act and the increased costs related to Sterling’s compliance are still uncertain and evolving.

          Regulation W

      Sterling and its banking affiliates are subject to Regulation W, which provides guidance on permissible activities and transactions between affiliated companies. In general, subject to certain specified exemptions, a bank or its subsidiaries are limited in their ability to engage in “covered transactions” with affiliates:

      In addition, a bank and its subsidiaries may engage in covered transactions and other specified transactions only on terms and under circumstances that are substantially the same, or at least as favorable to the bank or its subsidiary, as those prevailing at the time for comparable transactions with nonaffiliated companies. A “covered transaction” includes:

      In addition, under Regulation W:

          Check 21

      The Check Clearing for the 21^st Century Act, or “Check 21” as it is commonly known, became effective on October 28, 2004. Check 21 facilitates check collection by creating a new negotiable instrument called a “substitute check” that permits, but does not require, banks to replace original checks with substitute checks or information from the original check and process the check information electronically. Banks that do not use substitute checks must comply with certain notice and recredit rights. Check 21 is expected to cut the time and cost involved in physically transporting paper items and reduce float (i.e., the time between the deposit of a check in a bank and payment), especially in cases in which items were not already being delivered same-day or overnight.

      We cannot predict what legislation might be enacted or what regulations might be adopted, or if enacted or adopted, the effect thereof on our operations.

          Dividends

      Sterling is a legal entity separate and distinct from its subsidiary banks and nonbank subsidiaries. Our revenues, on a parent company only basis, result almost entirely from dividends paid to the corporation by its subsidiaries. Federal and state laws regulate the payment of dividends by our subsidiaries, as outlined in the “Supervision and Regulation — Regulation of the Banks” section below.

      Further, Federal Reserve policy dictates that bank holding companies should pay dividends only out of current earnings. Federal banking regulators also have the authority to prohibit banks and bank holding companies from paying a dividend if they deem such payment to be an unsafe or unsound practice.

          FDIC Insurance

      The subsidiary banks are subject to Federal Deposit Insurance Corporation assessments. The FDIC has adopted a risk-related premium assessment system for both the Bank Insurance Fund for banks and the Savings Association Insurance Fund for savings associations. Under this system, FDIC insurance premiums are assessed based on capital and supervisory measures.

      Under the risk-related premium assessment system, the FDIC, on a semiannual basis, assigns each institution to one of three capital groups, “well capitalized,” “adequately capitalized,” or “undercapitalized,” and further assigns such institution to one of three subgroups within a capital group corresponding to the FDIC’s judgment of its strength based on supervisory evaluations, including examination reports, statistical analysis, and other information relevant to gauging the risk posed by the institution. Only institutions with a total risk-based capital to risk-adjusted assets ratio of 10% or greater, a Tier 1 capital to risk-adjusted assets ratio of 6% or greater, and a Tier 1 leverage ratio of 5% or greater, are assigned to the well-capitalized group. Sterling and each of its subsidiary banks, at December 31, 2004, qualify as “well capitalized” under these regulatory standards.

          Regulation of Banks

      The operations of our banking subsidiaries are subject to federal and state statutes, and are subject to the regulations of the Office of the Comptroller of the Currency, the Federal Reserve, the FDIC, and the Pennsylvania Department of Banking.

      The Office of the Comptroller of the Currency, the primary supervisory authority over national banks, and the FDIC and Federal Reserve, the primary regulators of the state chartered banks, regularly examines the subsidiary banks in such areas as reserves, loans, investments, management practices, electronic banking and other aspects of operations. These examinations are designed for the protection of the banks’ depositors rather than our shareholders. The subsidiary banks must file quarterly and annual reports with the FDIC and Federal Reserve.

      The National Bank Act requires the subsidiary national banks to obtain the prior approval of the Office of the Comptroller of the Currency for the payment of dividends if the total of all dividends declared by the banks in one year would exceed the banks’ net profits, as defined and interpreted by regulation, for the two preceding years, less any required transfers to surplus. In addition, the banks may only pay dividends to the extent that their retained net profits, including the portion transferred to surplus, exceed statutory bad debts, as defined by regulation. Under Pennsylvania statutes, state chartered banks are restricted, unless prior regulatory approval is obtained, in the amount of dividends, which it may declare in relation to its accumulated profits, less any required transfer to surplus. These restrictions have not had, nor are they expected to have any impact on our dividend policy.

      Sterling and our subsidiary banks are affected by the monetary and fiscal policies of government agencies, including the Federal Reserve and FDIC. Through open market securities transactions and changes in its discount rate and reserve requirements, the Board of Governors of the Federal Reserve exerts considerable influence over the cost and availability of funds for lending and investment. The nature of monetary and fiscal policies on future business and earnings of Sterling cannot be predicted at this time.

          Other

      From time to time, various federal and state legislation is proposed that could result in additional regulation of, and restrictions on, the business of Sterling and its subsidiaries, or otherwise change the business environment. Management cannot predict whether any future legislation will have a material effect on the business of Sterling.

Products and Services with Reputation Risk

      Sterling and its subsidiaries offer a diverse range of financial and banking products and services. In the event one or more customers and/or governmental agencies become dissatisfied or object to any product or service offered by Sterling or any of its subsidiaries, negative publicity with respect to any such product or service, whether legally justified or not, could have a negative impact on Sterling’s reputation. The discontinuance of any product or service, whether or not any customer or governmental agency has challenged any such product or service, could have a negative impact on Sterling’s reputation.

Employees

      As of December 31, 2004, Sterling had approximately 1,000 full-time equivalent employees. None of these employees are represented by a collective bargaining agreement, and Sterling believes it enjoys good relations with its personnel. For more detailed information on Sterling Financial Corporation, please visit our website at www.sterlingfi.com. Except as expressly provided to the contrary [in Part III, Item 14 of this Form 10-K], information contained on Sterling’s Internet site is not incorporated by reference into this document. Documents required to be filed with the SEC and posted on Sterling’s website are available on our website as soon as reasonably practical after such material is electronically filed with or furnished to the SEC. They can also be obtained without charge by writing to: Investor Relations, Sterling Financial Corporation, 101 North Pointe Blvd., Lancaster, PA 17601.

Item 2 — Properties

      As of December 31, 2004, Sterling and its affiliates occupy 63 office locations in Lancaster, York, Adams, Lebanon, Berks, Chester, Bucks, Cumberland and Dauphin Counties, Pennsylvania, Cecil and Carroll Counties, Maryland and New Castle County, Delaware. The majority of these offices are utilized by the

banking affiliates to service the needs of their retail and business customers. Offices at 34 locations are occupied under leases, and at four locations the affiliate owns the building, but leases the land. The remainder of the locations are owned by one of the bank affiliates.

      In addition to the banking locations, the corporate headquarters, located in Lancaster, Pennsylvania, and operations centers located in East Petersburg, and Hanover, Pennsylvania, are owned by the bank affiliates. A certain amount of space in the Lancaster and East Petersburg buildings are leased to third parties.

      All real estate owned by the subsidiary banks is free and clear of encumbrances. The leases of the subsidiary banks expire intermittently over the years through 2024 and most are subject to one or more renewal options. During 2004, aggregate annual rentals for real estate did not exceed 2% of our operating expenses.

Item 3 — Legal Proceedings

      As of December 31, 2004, there were no material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which Sterling or its subsidiaries are a party or by which any of their property is the subject.

      We are party to various legal proceedings that arise in the normal course of our business. Although the outcomes of these proceedings cannot be predicted with certainty, management believes that the final outcome of any single proceeding or all proceedings in the aggregate will not have a material adverse effect on Sterling’s consolidated financial position or results of operations.

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

      There were no matters submitted to a vote of security holders during the fourth quarter of 2004.

Part II

Item 5 — Market for the Registrant’s Common Equity and Related Stockholder Matters

      Sterling Financial Corporation’s common stock trades on the NASDAQ Stock Market National Market System under the symbol SLFI. There were 70,000,000 shares of common stock authorized at December 31, 2004, and 23,106,586 shares outstanding. As of December 31, 2004, Sterling had approximately 4,950 shareholders of record. In addition, there were 10,000,000 shares of preferred stock authorized at December 31, 2004, with no shares issued.

      Sterling is restricted as to the amount of dividends that it can pay to shareholders by virtue of the restrictions on the subsidiaries’ ability to pay dividends to Sterling.

      The following table reflects the quarterly high and low prices of Sterling’s common stock for the periods indicated and the cash dividends declared on the common stock for the periods indicated.

      All per share information has been restated for the 5-for-4 stock split, effected in the form of a 25% stock dividend, declared in January 2004 and paid in February 2004.

      In May 2003, Sterling’s Board of Directors authorized the repurchase of up to 1,042,692 shares of its common stock. Shares repurchased are held for reissuance in connection with Sterling’s stock compensation plans and for general corporate purposes. Through December 31, 2004, 873,942 shares remained authorized for repurchase under the plan.

      During the fourth quarter of 2004, Sterling did not repurchase any of its shares under the repurchase plan.

Item 6 — Selected Financial Data

Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations

      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, Pennsylvania State Bank, HOVB Investment Co., T & C Leasing, Inc. (T & C), Pennbanks Insurance Company, SPC, Church Capital Management LLC, Bainbridge Securities, Inc., StoudtAdvisors, Lancaster Insurance Group, LLC and Sterling Mortgage Services, Inc. (inactive). The consolidated financial statements also include Town & Country Leasing, LLC, Sterling Financial Trust Company and Equipment Finance LLC, all wholly-owned subsidiaries of Bank of Lancaster County.

      Management’s discussion and analysis should be read in conjunction with the audited financial statements and footnotes appearing elsewhere in this report and is intended to assist in understanding and evaluating the major changes in the financial condition and results of operations of the company with a primary focus on Sterling’s performance.

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 the 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 and determined that no impairment write-offs 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.

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 non-interest expense, less depreciation on operating leases, by the sum of tax equivalent net interest income and non-interest 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, such as 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).

Inflation and Interest Rates

      The majority of assets and liabilities of a financial institution are monetary in nature and, therefore, differ greatly from most commercial and industrial companies that have significant investments in fixed assets or inventories. However, inflation does have an important impact on the growth of total assets and on non-interest expenses, which tend to rise during periods of general inflation. Inflationary pressures over the last few years have been modest, although the potential for future inflationary pressure is always present given changing trends in the economy.

      During the past several years, the Federal Reserve has been very active in monitoring economic data, and has used interest rates to help stimulate economic growth and control inflation. Starting in 2001 short term interest rates decreased, with sharp reductions in 2001 and more modest reductions in 2002 and 2003. However, in 2004, the Federal Reserve began a measured effort to control inflationary pressures and raised the federal funds rate five times in 25 basis point increments.

      Management recognizes that asset/liability management, including the effect of rate changes on interest earning assets and interest-bearing liabilities, is of critical importance.

RESULTS OF OPERATIONS

      (All dollar amounts presented within tables are in thousands, except per share data.)

Executive Overview

      Sterling’s executive management team and board of directors have identified three performance measurements that they feel are key elements for enhancing shareholder value. These include: 1) increase in earnings per share; 2) return on realized equity; and 3) efficiency ratio.

      The primary source of Sterling’s revenues, are net interest income derived from investments, which would include loans and investments, less their deposit and borrowing funding costs, as well as fees from financial

services provided to customers, including rental income on operating leases. Revenues are influenced by general economic factors, including market interest rates, the economy of the markets served, stock market conditions, as well as competitive forces within the markets.

      Despite a low interest rate environment and overall decline in the financial services industry’s net interest margin, Sterling was able to improve its net interest margin, from 4.38% and 4.65% in 2002 and 2003, to 4.83% in 2004. The improvement was 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. Net interest income increased to $97,417,000 in 2004, compared to $85,918,000 in 2003 and $74,948,000 in 2002.

      The acquisition of Church Capital, Bainbridge Securities and StoudtAdvisors favorably impacted non-interest income. Total non-interest income, excluding securities gains was $57,225,000, $49,210,000 and $45,292,000 in 2004, 2003 and 2002. The revenue generated from the new services provided more than offset the declines in mortgage banking income and rental income on operating leases. In addition, securities gains (losses) were $2,071,000, $511,000 and $(460,000) in 2004, 2003 and 2002. This increase is the direct result of the investment strategies of exiting insurance industry positions due to their demutualization, and gains that were taken upon the liquidation of certain bank stocks given favorable market conditions. The proceeds of the sale of these securities were used to capitalize Delaware Sterling Bank & Trust Company, a Delaware chartered bank that commenced operations on January 3, 2005.

      As a result of the growth Sterling has experienced in its revenues over the past three years, non-interest expense has also increased to $107,086,000 in 2004, compared to $92,568,000 in 2003 and $85,922,000 in 2002. The increase in revenues that Sterling has experienced can be attributed to our relationship management model, which has resulted in new customer relationships, new financial services products being offered to meet their needs and expansion of our market into new geographic regions. These efforts have resulted in increases in salaries and employee benefits, higher occupancy and equipment charges and other non-interest expenses. Also, intangible asset amortization has increased as a direct result of the identifiable intangible assets that resulted from the acquisitions of Church Capital Management, StoudtAdvisors and Pennsylvania State Bank.

      Sterling’s overall strategy is to enhance growth in existing markets and affiliates, and complement this with new products and services, through the leveraging of existing resources. This has resulted in net income of $33,329,000, or $1.51 per diluted share in 2004, compared to $29,059,000, or $1.35 per diluted share in 2003, and $24,745,000, or $1.18 per diluted share in 2002. This represents an 11.9% increase in diluted earnings per diluted share in 2004, over 2003 results, and a 14.4% increase in 2003 over 2002 results. Returns on average realized equity decreased slightly, to 15.00% in 2004, compared to 15.10% and 14.47% in 2003 and 2002.

      Sterling’s efficiency ratio, which expresses non-interest expenses as a percentage of tax-equivalent net interest income and non-interest income, has slipped to 61.3% in 2004, compared to 59.2% in 2003 and 60.2% in 2002. This is the direct result of intangible asset amortization, expansion into new market territories and its impact on expenses and the acquisition of non-bank affiliates that generally carry higher expense to revenue ratios than bank affiliates.

      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, borrowed funds and subordinated debt. 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. 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 taxable equivalent net interest income to average earning assets. Due mainly to demand deposits and stockholders’ equity, the net interest margin exceeds the interest rate spread, as these funding sources are non-interest bearing.

      Table 1 presents net interest income on a fully taxable equivalent basis, interest rate spread and net interest margin for the years ending December 31, 2004, 2003, and 2002. Table 2 analyzes the changes in net interest income for the periods broken down by their rate and volume components.

      Net interest income, on a tax equivalent basis, totaled $104,123,000 in 2004 compared to $92,394,000 for 2003 and $80,492,000 in 2002 (excluding the interest recovery on a charged-off loan).

      The increase in net interest income of $11,729,000 from 2003 to 2004 reflects both an 8.5% increase in the average balance of interest-earning assets as well as a shift in the mix of interest-earning assets that led to an 18 b.p. increase in net interest margin.

      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 federal funds over the past year. Strong growth in the commercial loan and finance receivable portfolios as well as consumer loans and leases contributed to the increase in total loans. Year-over-year, average loans increased $236,489,000, increasing the percentage of loans to interest-earning assets from 71% in 2003 to 76% in 2004. Generally, loans carry a higher yield than alternative interest-earning assets, primarily securities and other investments.

      The remainder of the growth in loans was funded by growth in deposits, borrowings and shareholders’ equity. Strong growth was experienced in demand and savings deposits while the average balance of time deposits decreased. Over the past year, Sterling experienced a significant volume of maturing certificates of deposits at high interest rates. During that time, current certificates of deposit rates were consciously held at the now lower market levels.

      The increase in short-term borrowings reflects a shift in Sterling’s overnight federal funds position from selling federal funds to purchasing federal funds, in part due to the development of Sterling’s Correspondent Services Group. This Group has established a number of federal funds lines for community bank clients. The increase in borrowed funds reflects borrowings of $78,403,000 in 2004 to provide funding for net loan growth and to replace scheduled maturities and repayments of debt. These borrowings also included $28,909,000 of borrowings acquired with Pennsylvania State Bank. In addition, during 2003, Sterling leveraged the proceeds of trust preferred securities by borrowing $75,000,000 from the Federal Home Loan Bank and purchase securities with these funds. Because these funds were borrowed part way through the year, they partially increased the prior year’s average.

      Net interest margin increased to 4.83% from 4.65% resulting from a number of factors:

      The increase in net interest income of $11,902,000 from 2002 to 2003 reflects both an 8.2% increase in the average balance of interest-earning assets as well as a 27 b.p. increase in net interest margin.

      Several factors had an impact on 2003’s results:

      Sterling’s ability to continue to improve its net interest margin through enhancing its earning asset mix in a similar manner as that experienced in the past few years will diminish due to the need to maintain the securities portfolio to meet pledging requirements and liquidity needs of its banking affiliates. In addition, while the acquisition of Pennsylvania State Bank will increase the level of earning assets and net interest income, it is expected to have a slightly negative impact on margin. Finally, during 2004, although short-term interest rates increased by more than 100 b.p., long-term rates remained relatively unchanged during this period. The resulting “flattening” of the yield curve is anticipated to have a negative impact on net interest margin.

Table 1 — Distribution of Assets, Liabilities and Stockholders’ Equity Interest Rates and Interest Differential-Tax Equivalent Yields

Yields on tax-exempt assets have been computed on a fully taxable equivalent basis assuming a 35% tax rate.

For yield calculation purposes, nonaccruing loans are included in the average loan balance.

Table 2 — Analysis of Changes in Net Interest Income

      The rate-volume variance analysis set forth in the table below, which is computed on a taxable equivalent basis, compares changes in net interest income for the periods indicated by their rate and volume components. The change in interest income/expense due to both volume and rate has been allocated to change in rate.

Provision for Loan Losses

      The provision for loan losses was $4,438,000 in 2004, compared to $3,697,000 in 2003 and $2,095,000 in 2002. The increase in provision levels, despite improving asset quality metrics, is a direct result of the growth that Sterling has experienced in its loan portfolio. Further, as a result of the changing composition of the loan portfolio and geographic mix, Sterling reevaluated and made certain modifications to its methodology for establishing its reserve to account for these changing risks in its loan portfolio. Sterling’s methodology reflects

its entrance into emerging markets with little credit history to this point, as well as its ability to enter into larger credit facilities with customers. The provision for loan losses reflects the amount required to maintain an adequate allowance to meet the risk characteristics of the loan portfolio.

      See further discussion in “Asset Quality” below.

Non-interest Income

      Consistent with Sterling’s recent strategy of broadening its financial services offered to its customers through the acquisition of fee-based companies and the development of new products, non-interest income continues to show steady increases over the past several years. As a result, Sterling has been able to increase its non-interest income, excluding securities gains/losses, as a percent of total net interest income and non-interest income to 27.1%, 24.4% and 24.6% for the years ended December 31, 2004, 2003 and 2002. This percentage also includes netting depreciation on operating income with related income.

      Details of non-interest income for the years ended December 31, 2004, 2003 and 2002 are as follows:

Table 3 — Non-interest Income

      Trust and investment management income grew to $9,057,000 in 2004 compared to $5,578,000 and $4,227,000 in 2003 and 2002. The acquisition of Church Capital Management, a registered investment advisor, in the fourth quarter of 2003, positive effects of new business development and favorable market conditions as compared to 2003, all contributed to the revenue growth.

      Service charges on deposit accounts were $6,415,000 for the year ended December 31, 2004, compared to $5,842,000 in 2003, an increase of 9.8%. The 9.8% growth in 2004 exceeded the 4.3% growth in 2003. Sterling has been able to increase its service charges on deposit accounts primarily as a result of the increased number of deposit accounts. In the fourth quarter of 2004, a new overdraft protection program was introduced to customers electing to take advantage of this product. As a result, we anticipate service charges on deposit accounts will continue to grow, as a full year of the overdraft protection program is in place.

      Brokerage fees and commissions totaled $3,351,000 for the year ended December 31, 2004, up from $1,383,000, in 2003 and $984,000 in 2002. The acquisition of Bainbridge Securities, Inc., a broker/ dealer, in the fourth quarter of 2003 was the primary reason for the increase in revenues. In addition to the expansion of services available to Sterling’s customers, the acquisition of Bainbridge enables Sterling to now handle brokerage transactions without having to use outside, third party sources. Favorable market conditions have also resulted in increased brokerage volume, as certain consumers are shifting their investment funds back towards the equity and mutual fund markets.

      Insurance commissions and fees were $4,611,000, $323,000 and $514,000 in 2004, 2003 and 2002. The acquisition of Corporate Healthcare Strategies in the second quarter of 2004 and the acquisition of the remaining interest of Lancaster Insurance Group in the third quarter of 2004 were the primary factors

contributing to the increase. These acquisitions were consistent with Sterling’s philosophy of building a comprehensive financial services organization, and as a result, management believes it has enhanced its ability to deliver benefit solutions to its individual and business customers.

      Mortgage banking income was $1,854,000 in 2004, down 54.1% from $4,037,000 in 2003 and $3,103,000 in 2002. The decrease in mortgage banking revenue in 2004 compared to 2003 is the result of lower production and sales volume arising from a generally higher interest rate environment in 2004 and the resulting reduction in refinancing activities. Conversely, the higher revenues in 2003 compared to 2002, was the result of 40-year lows in interest rates, which generated an active housing market as well as increases in refinancings.

      Rental income on operating leases was $24,969,000 in 2004 compared to $25,799,000 in 2003, a decrease of $830,000 or 3.2%. This follows a slight increase of 0.2% in 2003. The lack of growth in rental income is primarily due to customers entering into more traditional financing arrangements such as commercial loans and finance leases, given the favorable tax treatment related to the depreciation of the assets leased/purchased.

      Securities gains and losses, all from the available-for-sale portfolio, are summarized as follows:

      Gains and losses on debt securities are realized as part of ongoing investment portfolio and balance sheet management strategies. In 2004, Sterling experienced net gains on the debt security portfolio of $62,000 versus net gains of $315,000 in 2003 and net losses of $60,000 in 2002.

      Equity security gains and losses are generated primarily through Sterling’s equity portfolio of financial institution sector stocks. Net securities gains on equities were $2,009,000 for the year ended December 31, 2004 versus securities gains of $196,000 in 2003 and net losses of $400,000 in 2002. Gains are taken as the result of ongoing asset liability management strategies and capitalizing on appreciated values on certain equity security portfolio positions. In 2004, the proceeds from the sales of certain equity securities were used to capitalize Delaware Sterling Bank & Trust Company, a wholly-owned subsidiary of Sterling that commenced operations on January 3, 2005.

      During 2004, Sterling took no other than temporary impairment charges on the financial institution portfolio versus $130,000 and $1,160,000 in 2003 and 2002.

Non-interest Expense

      Total non-interest expenses were $107,086,000 for the year ended December 31, 2004, an increase of $14,518,000, or 15.7%, over $92,568,000 in 2003. This followed a $6,646,000, or 7.7%, increase in 2003 over 2002’s non-interest expenses of $85,922,000.

      In general terms, the increases experienced by Sterling are largely attributable to the acquisitions completed during this time period. Consistent with the accounting rules surrounding purchase accounting, expenses are included in Sterling’s results of operations after the acquisition is completed. As such, expenses

related to Church Capital and Bainbridge are included from October 2003 forward, expenses of Corporate Healthcare Strategies are included from June 2004 and forward, and Sterling’s most recent acquisition, Pennsylvania State Bank, is included from December 3, 2004 and forward.

      A more thorough discussion of non-interest expense follows:

Table 4 — Non-interest Expense

      The largest component of non-interest expense is salaries and employee benefits, which totaled $48,201,000 for the year ended December 31, 2004, an $8,767,000 or 22.2% increase over 2003, after increasing $2,574,000 or 7.0% in 2003. The increase is attributable to the following factors:

      Net occupancy expense increased to $5,445,000 in 2004, up from $4,926,000 in 2003 and $4,209,000 in 2002. This increase is a direct result of the overall growth of the company, including expansion into the emerging markets of Berks County, Pennsylvania; Carroll County, Maryland; and New Castle County, Delaware. In addition, renovations were made to existing locations, which resulted in additional occupancy changes. Sterling’s new affiliates have office space that also contributed to an increase in occupancy charges.

      Furniture and equipment charges were $7,016,000, $6,419,000 and $5,785,000 in 2004, 2003 and 2002. The steady upward trend in furniture and equipment expense is the result of enhancements to the channels available to deliver products and services 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 office locations, as well as renovations made to existing offices also contributed to the increase.

      Professional services totaled $4,410,000 for the year ended December 31, 2004 compared to $3,154,000 in 2003, and $2,845,000 in 2002. The regulatory climate is becoming increasingly complex; most significantly, as the result of the Sarbanes-Oxley Act of 2002. Due to these complexities, professional service fees have

increased, resulting in higher compliance costs as well as contracted temporary resources necessary to meet the heightened demands and timelines of this piece of legislation. In addition, professional service expenses have increased as a result of long-term strategic planning efforts, including evaluating potential acquisition targets, the evaluation of new market territories for bank affiliates, and contracted labor to assist in integration of the new affiliates into Sterling’s systems and processes.

      Taxes other than income were $2,237,000 for the year ended December 31, 2004, an increase from $1,656,000, or 35.1%, in 2003 and $1,442,000 in 2002. Taxes other than income consist primarily of taxes based on shareholders’ equity. As a result of the growing equity base of Sterling’s affiliates, including the bank affiliates, combined with the acquisition of companies subject to similar taxes, the taxes other than income expense has increased over the past several years.

      In connection with Sterling’s recent acquisitions, several identifiable intangible assets were acquired, the most significant of which is customer lists and core deposit intangibles. The increase is the direct result of the timing of the acquisitions. Included in 2004 is a full year of intangible amortization for Church Capital, as opposed to two and one half months in the prior year. Also included in 2004 totals are seven months of amortization for Corporate Healthcare Strategies and one month of Pennsylvania State Bank’s intangible assets. Management anticipates amortization expense will increase, as a full year worth of amortization will be included in future results. See further discussion in Note 9 to the consolidated financial statements.

      Other non-interest expense totaled $17,043,000 in 2004, compared to $15,305,000 in 2003 and $13,712,000 in 2002. Expenses in this category consist of marketing, advertising, promotions, postage, lending related expenses, insurance and telephone expenses. The primary increase in other non-interest expenses is a function of Sterling’s overall growth, which results in higher expenses.

      Operating expense levels are often measured by the efficiency ratio, which expresses non-interest expense, excluding merger related and restructuring charges, as a percentage of tax-equivalent net interest income and other income. In calculating its efficiency ratio, Sterling nets depreciation on operating leases with the related rental income to more consistently present operating results with the banking industry.

      Sterling’s efficiency ratio slipped to 61.3% for the year ended December 31, 2004 from 59.2% in 2003 and 60.2% in 2002. This is the direct result of the intangible asset amortization and expansion into new market territories and its impact on expenses, combined with the acquisition of non-bank affiliates that generally carry higher expense to revenue ratios than bank affiliates.

      Sterling recognized income taxes of $11,860,000, $10,315,000 and $7,018,000 for the years ended December 31, 2004, 2003 and 2002. The increase in income tax expense is consistent with the higher levels of pre-tax income.

      A more meaningful comparison is the effective tax rate, a measurement of income tax expense as a percent of pre-tax income, which was 26.3%, 26.2% and 22.1% for the years ended December 31, 2004, 2003 and 2002. Sterling’s effective tax rate is less than the 35% federal statutory rate, primarily due to tax-exempt loan and security income and tax credits associated with low-income housing projects, offset by certain non-deductible expenses and state income taxes.

      The 2002 effective tax rate of 22.1% was favorably influenced by converting Town & Country Leasing, a C-Corporation at the time, to a single member limited liability company on July 1, 2002. Due to the conversion, Sterling reversed a $1,200,000 deferred state tax liability, which lowered its income tax expense. Excluding the $1,200,000 reversal, 2002’s effective tax rate would have been approximately 25.9%.

      Average assets were $2,405,932,000 in 2004, representing 8.9% growth compared to 2003’s average assets of $2,208,455,000. The growth experienced in 2004 was consistent with the 8.5% growth in average assets in 2003. Sterling’s loan growth was 16.8% in 2004 and 12.9% in 2003, which outpaced total asset growth.

      As part of an overall strategy to increase the return on equity of the corporation, the remaining growth in assets and more specifically loans, was funded by growth in average deposits, and supplemented with a reduction in the average level of federal funds sold and the cash flows from the investment securities portfolio.

      Average deposits were $1,809,215,000 for the year ended December 31, 2004, which represent 3.8% growth over 2003 average deposits of $1,716,591,000. In order to meet the funding needs of the strong loan growth, average borrowings increased from $246,101,000 for the year ended December 31, 2003 to $324,504,000 in 2004. A more thorough discussion of asset and liabilities follows.

      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 December 31, 2004, securities totaled $501,671,000, which represents a decrease of $74,334,000 or 12.9% from the December 31, 2003 balance of $576,005,000. In addition, $33,075,000 was acquired in connection with the purchase of Pennsylvania State Bank. During 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 $131,701,000. Purchases of $28,931,000 were completed primarily to meet pledging requirements.

      This activity most significantly decreased holdings of agency and corporate securities. This was a result of a number of factors, including the generally low interest rate environment, a continued effort to reduce the credit risk associated with corporate securities and a need to maintain a sufficient level of securities that are qualified to serve as collateral for public fund and other deposits requiring pledged securities.

      In addition to the cash flow activity noted above, the decrease in the portfolio reflects a change in the balance of unrealized gains on securities available-for-sale. At December 31, 2004, the securities balance included net unrealized gains on available-for-sale securities of $16,686,000 versus net unrealized gains of $22,747,000 at December 31, 2003. The decrease in unrealized gains resulted from higher interest rates at year-end 2004 versus year-end 2003. Higher interest rates generally decrease the value of debt securities.

      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 indicators in determining whether a debt security is other-than-temporary-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 December 31, 2004, there were no holdings below investment grade.

Table 5 — Investment Securities

      The following table shows the amortized cost of the held-to-maturity securities owned by Sterling as of the dates indicated. Securities are stated at cost adjusted for amortization of premiums and accretion of discounts.

      Included in held-to-maturity equity securities is Federal Reserve Bank stock, Federal Home Loan Bank of Pittsburgh stock, and Atlantic Central Bankers Bank stock.

      The following table shows the amortized cost and fair value of the available-for-sale securities owned as of the dates indicated.