UNITED STATES SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

     (Mark One)

     OR

     For the transition period from                                          to                                         

     Commission file number 0-16276

Registrant’s Telephone number, including area code: (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 þ No o

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

     Yes þ No o

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

     Common Stock, $5.00 Par Value – 23,028,405 shares outstanding as of April 29, 2005.

Sterling Financial Corporation and Subsidiaries
Index

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Part I – Financial Information

STERLING FINANCIAL CORPORATION AND SUBSIDIARIES
Consolidated Balance Sheets (Unaudited)

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

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STERLING FINANCIAL CORPORATION AND SUBSIDIARIES
Consolidated Statements of Income (Unaudited)

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

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STERLING FINANCIAL CORPORATION AND SUBSIDIARIES
Consolidated Statements of Changes in Stockholders’ Equity

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

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STERLING FINANCIAL CORPORATION AND SUBSIDIARIES
Consolidated Statements of Cash Flows (Unaudited)

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

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Notes to Consolidated Financial Statements
(All dollar amounts presented in the footnotes are in thousands, except per share data)

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 U. S. generally accepted accounting principles 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 U.S. generally accepted accounting principles 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, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005.

     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, 2004.

     The consolidated financial statements and footnotes thereto of Sterling Financial Corporation (Sterling) include the accounts of its wholly-owned subsidiaries, Bank of Lancaster County, N.A. (Bank of Lancaster County), First National Bank of North East (Bank of North East), Bank of Hanover and Trust Company (Bank of Hanover), Pennsylvania State Bank, Delaware Sterling Bank & Trust Company (Delaware Sterling), HOVB Investment Co., T&C Leasing, Inc. (T&C), Pennbanks Insurance Company, SPC, Church Capital Management, LLC, Bainbridge Securities Inc., Corporate Healthcare Strategies, LLC (d/b/a StoudtAdvisors), Lancaster Insurance Group, LLC 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 (EFI), 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 potentially dilutive stock options had been exercised. Potential common shares that may be issued by Sterling used in the dilutive per share calculation consist solely of outstanding stock options and are determined using the treasury stock method.

     Earnings per common share for the three months ended March 31, 2005 and 2004 have been computed based on the following:

     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 April 26, 2005 and payable on June 1, 2005.

     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

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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.

     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:

     Recent Accounting Pronouncements – In December 2003, the American Institute of Certified Public Accountants (AICPA) issued Statement of Position 03-3 “Accounting for Certain Loans or Debt Securities Acquired in a Transfer.” This statement addresses accounting for differences between contractual cash flows expected to be collected from an investor’s initial investment in non-homogeneous loans acquired in a transfer if those differences are attributable, at least in part, to credit quality. This statement limits the yield that may be accreted (accretable yield) to the excess of the investor’s estimate of undiscounted expected principal, interest, and other cash flows (cash flows expected at acquisition to be collected) over the investor’s initial investment in the loan. This statement requires that the excess of contractual cash flows over cash flows expected to be collected (nonaccretable difference) not be recognized as an adjustment of yield, loss accrual, or valuation allowance. This statement prohibits investors from displaying accretable yield and nonaccretable difference in the balance sheet. Subsequent increases in cash flows expected to be collected should be recognized prospectively through adjustment of the loan’s yield over its remaining life. Decreases in cash flows expected to be collected should be recognized as impairment. This statement is effective for loans acquired in fiscal years beginning after December 15, 2004.

Note 2 – Business Combinations

     Corporate Healthcare Strategies, LLC – On May 28, 2004, Sterling acquired 100 percent of the outstanding common shares of Corporate Healthcare Strategies, Inc. d/b/a StoudtAdvisors. StoudtAdvisors is headquartered in Lancaster, Pennsylvania. 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 StoudtAdvisors, Sterling issued 282,657 shares of its common stock and paid $7.398 million. In addition, 121,139 shares of Sterling’s common stock and $2.640 million are to be paid out over the next four years as contingent consideration based upon StoudtAdvisors reaching specified performance criteria. Based on the closing price of Sterling’s common stock on May 25, 2004, the 282,657 shares of common stock were valued at $7.162 million.

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     The transaction was accounted for under the provisions of FASB Statement No. 141, Business Combinations. The purchase price allocation included $6.624 million to finite-lived intangible assets, including $6.234 million to customer lists, $140 thousand to vendor contracts and $250 thousand to covenants not to compete. The intangible assets have lives ranging from 2 to 12 years, and a weighted average life of 4 years. The remaining portion of the purchase price, or $9.330 million, was assigned to goodwill within the Insurance Services segment. The goodwill is being amortized for tax purposes.

     Lancaster Insurance Group, LLC – As a result of the purchase of the remaining fifty percent of Lancaster Insurance Group’s membership interest effective July 1, 2004, this affiliate became a consolidated subsidiary of Sterling. Sterling paid $225 thousand to obtain the remaining fifty percent of the outstanding membership interest of this entity. To the extent that the purchase price exceeded tangible and intangible assets, the amount was allocated to goodwill.

     Pennsylvania State Bank – On December 3, 2004, Sterling completed the acquisition of The Pennsylvania State Banking Company, parent company of Pennsylvania State Bank. At the date of acquisition, The Pennsylvania State Banking Company was merged into Sterling, and Pennsylvania State Bank became a wholly owned subsidiary of Sterling. Sterling acquired Pennsylvania State Bank in order to enhance its banking franchise by entering Cumberland and Dauphin Counties of Pennsylvania.

     In connection with this transaction, Sterling acquired all of the outstanding shares of The Pennsylvania State Banking Company’s common stock for cash consideration of $11.436 million, 1,209,728 shares of Sterling’s common stock valued at $34.296 million, and the exchange of stock options into Sterling options valued at $2.440 million. In addition, shares of The Pennsylvania State Banking Company, valued at $421 thousand, owned by Sterling were not exchanged into Sterling shares, but are included in the acquisition cost.

     The transaction was accounted for under the provisions of FASB Statement No. 141, Business Combinations. The purchase price allocation included $13.400 million to net tangible assets, including a $2.851 million valuation adjustment, $3.804 million to core deposit intangibles and $237 thousand to a trademark. Additional costs of acquisition of $2.425 million were capitalized. The remaining goodwill of $33.379 million was assigned to the Community Banking segment and will not be amortized for tax purposes.

Note 3 – Goodwill and Intangible Assets

     The changes in the carrying amount of goodwill for the three months ended March 31, 2005 are as follows:

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A summary of intangible assets is as follows:

Note 4 – Stock Compensation

     Sterling has an omnibus stock incentive plan under which incentive and nonqualified stock options, stock appreciation rights, and 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 market value of the shares at the date of grant, and may have a term of up to ten years. As of March 31, 2005 Sterling had approximately 879,000 shares of common stock reserved for issuance under the stock incentive plan. 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 the plan 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.

     In December 2004, the FASB issued FASB Statement No. 123R, Share-Based Payment, (SFAS 123R), which was subsequently revised in April 2005 by delaying the implementation date. SFAS 123R addresses the accounting for share-based payments to employees and non-employees, including grants of employee stock options. Under the new standard, companies will no longer be able to account for share-based compensation transactions using the intrinsic method in accordance with APB Opinion No. 25, Accounting for Stock Issued to Employees. Instead, companies will be required to

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account for such transactions using a fair-value method and recognize the expense in the consolidated statement of income. SFAS 123R will be effective for years beginning after June 15, 2005. Sterling has not yet determined which fair-value method and transitional provision it will follow. However, Sterling expects that the adoption of SFAS 123R will have an impact on its results of operations, as shown in the proforma disclosure. Sterling does not expect that the adoption of SFAS 123R will have a material impact to its overall financial position. The calculation of compensation cost for share-based payment transactions after the effective date of SFAS 123R may be different from the calculation of compensation cost presented in the proforma information, but such differences have not yet been quantified by Sterling’s management.

Note 5 – Retirement Benefit Plan

     The components of Sterling’s post-retirement benefits cost for the three months ended March 31, 2005 and 2004 are as follows:

     In May 2004, the FASB issued Staff Position 106-2, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003, or FSP 106-2. FSP 106-2 supersedes FSP 106-1, and provides guidance on the accounting disclosure, effective date, and transition requirements related to the Medicare Prescription Drug Act. The Medicare Prescription Drug Act expands on existing Medicare benefits, primarily adding a prescription drug benefit for Medicare-eligible retirees beginning in 2006. The law also provides a federal subsidy to companies that sponsor post-retirement benefit plans that provide prescription drug coverage as long as the coverage is actuarially equivalent to Medicare Part D. FSP 106-2 was effective in the third quarter of 2004. At this time, Sterling is awaiting guidance from the Department of Health and Human Services to determine if its coverage meets the actuarially equivalence guidance. The accumulated plan obligation and related benefit costs does not presently include the federal subsidy, if any, for which Sterling may be eligible. Sterling does not feel that the adoption of this standard will have a significant impact on its results of operations, financial position, or liquidity.

Note 6 – Segment Information

     Sterling operates five major lines of business: Community Banking and Related Services; Leasing; Commercial Finance; Trust and Investment Services; and Insurance Related Services.

     The Community Banking and Related Services segment provides financial services to consumers, businesses, financial institutions and governmental units in southern Pennsylvania, northern Maryland and northern Delaware. These services include providing various types of loans to customers, accepting deposits, mortgage banking and other 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 Community Banking and Related Services segment lends money to the Leasing and Commercial Finance segments, and represents the intersegment elimination.

     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.

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     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 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. 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.

     The Insurance Related Services segment includes employee benefit products, consulting services, personal insurance coverage, including property and casualty, credit life insurance and disability insurance. Major revenue sources include commission on insurance products, as well as consulting fees. Expenses include personnel and support charges as well as amortization of intangible assets.

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

     The accounting policies of the segments are the same as those described in the summary of significant accounting policies disclosed in Sterling’s Annual Report on Form 10-K for the year ended December 31, 2004. Transactions between segments, principally loans, were on terms consistent with those that 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-interest income, non-interest expense, and the provision for income taxes in making decisions and determining resources to be allocated to the segments.

     Sterling does not have a single external customer from whom it derives 10% or more of its revenue.

Note 7 – Junior Subordinated Debentures Owed to Unconsolidated Subsidiary Trusts and Corporation-Obligated Mandatorily Redeemable Capital Securities of Subsidiary Trusts Holding Solely Debentures of the Corporation

     Sterling has four non-consolidated subsidiary trusts, Sterling Financial Statutory Trust I, Sterling Financial Statutory Trust II, Sterling Financial Statutory Trust III, and Sterling Financial Statutory Trust IV of which 100% of the common equity is owned by Sterling. The trusts were formed for the purpose of issuing corporation-obligated mandatorily redeemable capital securities (the capital securities) to third-party investors and investing the proceeds from the sale of such capital securities solely in junior subordinated debt securities of Sterling (the debentures). The debentures held by each trust are the sole assets of that trust. Distributions on the capital securities issued by each trust are payable quarterly

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at a rate per annum equal to the interest rate being earned by the trust on the debentures held by that trust. The capital securities are subject to mandatory redemption, in whole or in part, upon repayment of the debentures. Sterling has entered into agreements which, taken collectively, fully and unconditionally guarantee the capital securities subject to the terms of each of the guarantees.

     A summary of the junior subordinated debentures from Sterling to the subsidiary trusts is as follows:

Note 8 – Subsequent Events

     On April 26, 2005, Sterling’s Board of Directors declared a 5-for-4 stock split, effected in the form of a 25% stock dividend, payable June 1, 2005 to shareholders of record May 13, 2005. The balance sheet and statement of stockholders’ equity have been adjusted to reflect this stock split as if it happened March 31, 2005. All share and per share amounts have been properly restated to reflect the stock split effected in the form of a 25% stock dividend.

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Item 2 – Management’s Discussion 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.

     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 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;
	•	Integration of our newly acquired affiliates may not occur as quickly or smoothly as anticipated and projected synergies may not occur in the projected time frame or at all; 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 Reports 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, Pennsylvania State Bank, Delaware Sterling Bank & Trust Company, HOVB Investment Co., T&C Leasing, Inc., 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.

Critical Accounting Policies

     Sterling’s consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles and follow general practices within the industries in which it operates. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; 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

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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 as included in Sterling’s Annual Report on Form 10-K for the year ended December 31, 2004. 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. See the Allowance for Loan Losses section for additional discussion on this matter.

     Goodwill is 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.

     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 discussion and analysis refers to the efficiency ratio and non-interest income as a percent of net interest income and non-interest income that are non-GAAP financial measures that we believe provides readers with important information regarding Sterling’s results of operations. Comparison of Sterling’s efficiency ratio and non-interest income as a percent of net interest income and non-interest income with that of other companies may not be appropriate, as they may calculate their ratios 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 finance leases, which nets interest expense against interest income. The efficiency ratio excludes unusual items, such as gains/losses on securities activities and interest collected on charged-off loans.

     To be consistent with the efficiency ratio presentation, depreciation on operating leases has been netted against non-interest income in the discussion of non-interest income as a percent of net interest income and non-interest income ratio.

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

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RESULTS OF OPERATIONS

Three months ended March 31, 2005 compared to three months ended March 31, 2004

(Dollars in tables are in thousands)

Executive Overview

     Sterling’s net income was $9.279 million for the quarter ended March 31, 2005, an increase of $1.650 million, or 21.6% from the first quarter of 2004. Diluted earnings per share totaled $0.316 for the first quarter of 2005 versus $0.280 for the same period in 2004, an increase of 12.9%. Return on average realized equity for the first quarter of 2005 was 13.82%, compared to 14.78% in 2004.

     Sterling has continued its trend of improving net interest income, from $22.567 million for the first quarter of 2004 to $27.576 million in 2005, a 22.2% increase. Pennsylvania State Bank, acquired by Sterling on December 3, 2004, contributed $1.934 million of the increase in net interest income. The remainder of the improvement was the result of continued growth in interest earning assets particularly higher yielding loans, including commercial loans and finance receivables. Favorable influences in the funding mix have also contributed to higher levels of net interest income, including greater non-interest bearing demand deposits and money market accounts, as compared to the higher yielding certificates of deposits. The favorable mix in interest earning assets and interest bearing liabilities and increases in interest rates resulted in improvement in net interest margin, from 4.65% for the first quarter of 2004 to 4.82% in 2005.

     The provision for loan losses was $357 thousand for the quarter ended March 31, 2005, compared to $714 thousand for the same period in 2004. Overall, the decrease in the provision for loan losses reflects improvements in asset quality and in local and national economic conditions.

     Non-interest income, excluding securities gains, was $15.591 million for the quarter ended March 31, 2005, a 22.9% increase over $12.686 million earned in 2004. This is attributable to three factors: (1) StoudtAdvisors, an employee benefits agency and consulting firm, acquired at the end of May 2004 produced significant growth in insurance commissions and fees which were $1.832 million for the quarter ended March 31, 2005, compared to $67 thousand in 2004; (2) Sterling has been able to increase service charges primarily through new product offerings and increased volumes associated with greater number of accounts; and (3) Rental income on operating leases was $6.764 million for the quarter ended March 31, 2005, an 8.5% increase over 2004, as the company has noted customers migrating back to operating leases as a funding source due to the elimination of the federal income tax bonus depreciation incentive on finance leases that ended on December 31, 2004.

     Non-interest expenses were $30.107 million for the quarter ended March 31, 2005, compared to $24.972 million in 2004, a 20.6% increase. A primary reason for the increase in non-interest expenses is the result of new and enhanced financial services products being offered to Sterling’s customers, including employee benefits brokerage and consulting. In addition, non-interest expense growth can be attributed to the growth in Sterling’s banking franchises. This includes both the acquisition of Pennsylvania State Bank, covering Cumberland and Dauphin counties in Pennsylvania, and the expansion into other growth regions including Berks County, Pennsylvania.; Carroll County, Maryland.; and New Castle County, Delaware. As a result of new markets served and new products offered, increases were noted in virtually every non-interest expense category. Finally, consistent with the increase noted in rental income on operating leases, a similar increase in depreciation on operating leases was noted in 2005 compared to 2004.

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. Interest-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 of those assets and liabilities. The “interest rate spread” and “net interest margin” are two common statistics

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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 fully taxable equivalent basis, totaled $29.189 million for the first quarter of 2005 compared to $24.251 million for the first quarter of 2004, an increase of $4.938 million or 20.4%. This increase reflects a $345 million, or 16.7% increase in the quarterly average balance of interest-earning assets. Net interest margin increased 17 basis points (b.p.) from 4.65% to 4.82%.

     Pennsylvania State Bank, acquired by Sterling on December 3, 2004, contributed $1.977 million of the increase in net interest income and $190 million of the increase in the quarterly average balance of interest-earning assets.

     The overall increase in interest-earning assets came in the form of loans. Over the past year, the growth in loans has 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. Strong growth in the commercial loan and finance receivables portfolios as well as consumer loans contributed to the increase in total loans. Year-over-year, quarterly average loans increased $403 million (including $156 million from Pennsylvania State Bank), increasing the percentage of loans to interest-earning assets from 74% in 2004 to 80% in 2005. Generally, loans carry a higher yield than alternative interest-earning assets, namely securities and other investments.

     The remainder of the growth in loans was funded by growth in deposits, borrowings and stockholders’ equity. Strong growth has been experienced in demand and money market deposits while the average balance of time deposits increased but at a lower rate.

     Year-over-year, average short-term borrowings and borrowed funds increased $43 million and $36 million, respectively. 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, which has established federal funds lines for a number of community bank clients. The increase in borrowed funds reflects borrowings of $78 million in 2004 to provide funding for net loan growth and to replace maturities and payments. These borrowings included $29 million of borrowings acquired with Pennsylvania State Bank.

     Net interest margin increased to 4.82% from 4.65% resulting from a number of factors:

	•	After over three years of declining short-term interest rates, the Federal Reserve Bank began to raise the federal funds target rate in 2004. Since June of 2004, the Federal Reserve has increased the federal funds target by 25 b.p. on seven separate occasions. This increase in short-term rates is generally favorable due to Sterling’s modestly asset sensitive interest rate risk position. However, the “flattening” of the yield curve, explained further below, did have a dampening effect on the favorable impact of the increase in short-term rates.
	•	As noted previously, growth in loans has 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. Generally, loans carry a higher yield than alternative interest-earning assets, namely securities and other investments. This improved mix of earning assets has helped to increase the overall yield on earning assets by 34 b.p. from the first quarter of 2004 to 2005.
	•	While the cost of funds for Sterling has begun to increase, it has lagged behind the increase in the yield on earning assets. The rate paid on interest-bearing liabilities increased 19 b.p. from the first quarter of 2004 to 2005.
	•	Favorable influences in the funding mix have also contributed positively to the margin with greater growth in non-interest bearing demand deposits and money market accounts as compared to higher yielding certificates of deposits.

     Going forward, Sterling’s ability to continue to enhance the earning asset mix in the manner done over the past few years will be significantly reduced due to the need to maintain the securities portfolio volume to meet pledging requirements and liquidity needs. In addition, since the beginning of 2004, while short-term interest rates increased by 175 b.p, long-term rates increased only modestly. This “flattening” of the yield curve may have a negative impact on net

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interest margin. Finally, as short-term interest rates continue to increase, the ability to lag the rates paid on deposits will diminish, putting additional pressure on the net interest margin.

     The following table summarizes, on a fully taxable equivalent basis, net interest income, and net interest margin for the three months ended March 31, 2005 and 2004 (dollars in thousands):

Provision for Loan Losses

     The provision for loan losses was $357 thousand for the quarter ended March 31, 2005, a 50% decrease from the prior year’s provision of $714 thousand. As a result of an improving national and local economy, combined with

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improvements in 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.

Non-interest Income

     Total non-interest income totaled $15.725 million for the three months ended March 31, 2005 compared to $13.203 million in 2004, an increase of 19.1%. The impact of Sterling’s recent acquisition of companies that are fee oriented was the primary reason for the increase in non-interest income.

     Trust and investment management income was $2.292 million for the first quarter of 2005, an increase of $138 thousand, or 6.4% over 2004 results. Slight improvement in market conditions in 2005 compared to 2004, combined with new business development contributed to the increase in revenues.

     Service charges on deposit accounts increased from $1.474 million for the three months ended March 31, 2004 to $1.906 million for the same period in 2005. Sterling has been able to increase service charges primarily through new product offerings and increased volumes associated with great number of accounts.

     Insurance commissions and fees were $1.832 million for the first quarter of 2005, an increase of $1.765 million over the same period in 2004. The acquisition of StoudtAdvisors, an employee benefits consulting and brokerage firm, on May 28, 2004 was the primary reason for the increase.

     Mortgage banking income totaled $287 thousand for the quarter ended March 31, 2005, resulting in a decline of $122 thousand, or 29.8% over 2004 results. Mortgage loan origination volumes have declined since 2004 due to generally higher interest rates that have resulted in less mortgage refinancing business.

     Rental income on operating leases was $6.764 million for the quarter ended March 31, 2005, an 8.5% or $529 thousand increase over 2004 results. The increase is the result of an increase in interest rates, which allows for an increase in rental income charged to customers, as well as some customers migrating back to operating leases due to the expiration of the favorable tax treatment on assets purchased.

     Sterling recognized securities gains in the first quarter of 2005 of $134 thousand, compared to $517 thousand in 2004. The gains recognized in 2005 were principally related to asset/liability management, whereas the gains recognized in 2004 were the result of a strategic decision to liquidate certain large cap equity positions given our belief that they were fully valued. The proceeds of sales during 2004 were accumulated with the intent of capitalizing Delaware Sterling Bank & Trust Company.

Non-interest Expenses

     Non-interest expenses totaled $30.107 million for the quarter ended March 31, 2005 compared to $24.972 million for the same period in 2004, an increase of 20.6%.

     The largest component of non-interest expense is salaries and employee benefits, which totaled $13.878 million for the quarter ended March 31, 2005, a $2.838 million or 25.7% increase over the same period in 2004. The increase is attributable to the following factors:

	•	A full quarter’s worth of salaries and employee benefits associated with Sterling’s newest affiliates, Pennsylvania State Bank, StoudtAdvisors and Lancaster Insurance Group with no similar expense in the prior year.
	•	Increased number of employees, the result of expansion into emerging markets;
	•	Rising health care costs consistent with national trends and a growing employee base;
	•	Additions to staff required to continue to serve our customers in light of increased transaction volumes; and
	•	Normal merit increases to existing employees.

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     Net occupancy totaled $1.616 million for the first quarter of 2005, an increase of $187 thousand or 13.1% over the same period in 2004. This increase is a direct result of the overall growth of the corporation including the acquisition of Pennsylvania State Bank and their six branches, StoudtAdvisors’ two office locations and the expansion into the emerging markets of Berks County, Pennsylvania; Carroll County, Maryland; and New Castle County, Delaware.

     Furniture and equipment charges increased to $1.903 million for the quarter ended March 31, 2005, an increase of $181 thousand, or 10.5%, from the same period in 2004. The steady upward trend in furniture and equipment expense is the result of enhancements to the delivery channels available to deliver products to customers, and additional office locations from expansion opportunities. Additionally, certain equipment charges are based on number of accounts opened and their related transaction volumes. As Sterling’s customer base and geographic market area continues to grow, these types of charges will grow as well.

     Professional services totaled $952 thousand for the quarter ended March 31, 2005, compared to $765 thousand for the same period in 2004, an increase of $187 thousand, or 24.4%. The regulatory climate is becoming increasingly complex as a result of certain legislation and regulatory initiatives including the Sarbanes-Oxley Act, Check 21 and the USA Patriot Act. As a result of these complexities, professional service fees have increased, the result of higher compliance costs as well as contracted professional resources to meet the heightened demands of legislation.

     Intangible asset amortization was $691 thousand for the quarter ended March 31, 2005, an increase of $441 thousand over first quarter 2004 results. The increase in expense is the result of the amortization of customer lists at StoudtAdvisors and of the core deposit intangible at Pennsylvania State Bank. A full quarter’s worth of amortization was expensed on these intangible assets in 2005, versus no similar charge at these entities in 2004 as they were acquired in the second and fourth quarters, respectively.

     Other non-interest expense totaled $4.735 million for the quarter ended March 31, 2005, compared to $3.940 million for the same period in 2004. Expenses in this category consist of marketing, advertising, promotions, postage, lending related expenses, insurance and telephone expenses. The increase in other non-interest expenses is primarily a function of Sterling’s overall growth, which results in higher expenses.

     As a result of Sterling’s investment in 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 the bank affiliates, Sterling’s efficiency ratio exceeds its desired target of 60%. Intangible asset amortization is the primary reason the efficiency ratio has slipped from 62.3% for the quarter ended March 31, 2004, to 62.5% for the same quarter in 2005. Excluding the impact of this non-cash amortization of intangible assets, the efficiency ratio has improved from 61.5% for the quarter ended March 31, 2004 to 60.8% for the quarter ended March 31, 2005.

Income Taxes

     Income tax expense for the quarter ended March 31, 2005 was $3.558 million resulting in an effective tax rate of 27.7%, versus 24.4% for the quarter ended March 31, 2004. Higher levels of pretax income taxed at the incremental 35% statutory tax rate led to the increase in effective income tax rate.

FINANCIAL CONDITION

     Total assets at March 31, 2005 totaled $2.752 billion compared to $2.743 billion at December 31, 2004. This represents a slight increase of approximately $9 million.

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, 2005, securities totaled $493.638 million, which represents a 1.6% decrease from the December 31, 2004 balance of $501.671 million. The primary reason for the decrease is due to rising interest rates, which has caused unrealized losses in fair value on securities available for sale.

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     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, 2005, there were no holdings below investment grade.

     In addition to its debt securities, Sterling also maintains an available-for-sale equity portfolio, comprised of the following: