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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

(Mark One)

For the fiscal year ended December 31, 2001

or

Commission file number 0-12638

F&M BANCORP
(Exact name of registrant as specified in its charter)

(888) 694-4170
(Registrant's telephone number, including area code)

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

Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK ($5 PAR VALUE)
(Title of class)

        Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes /X/    No / /

        Indicate by check mark 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 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. / /

        At February 8, 2002, the aggregate market value of 10,853,300 shares of Common Stock outstanding and held by non-affiliates of Registrant was $297,706,019.

        DOCUMENTS INCORPORATED BY REFERENCE: Portions of F&M Bancorp's 2001 Annual Report to Shareholders are incorporated herein by reference into Part II. Portions of the Proxy Statement dated March 15, 2002 relating to the 2002 Annual Meeting of Stockholders of the Registrant are incorporated herein by reference into Part III.

TABLE OF CONTENTS

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PART I

ITEM 1.    BUSINESS

The Companies:

        GENERAL:    F&M Bancorp ("Bancorp") is a bank holding company headquartered in Frederick, Maryland that is organized under the laws of the State of Maryland and registered under the Bank Holding Company Act of 1956. Bancorp derives substantially all of its income from operation of its wholly-owned subsidiary, Farmers & Mechanics Bank ("the Bank").

        On December 31, 2001, Bancorp had consolidated assets of $1.881 billion, total loans of $1.162 billion, total deposits of $1.516 billion, and total shareholders' equity of $167 million. The principal executive offices of Bancorp are located at 110 Thomas Johnson Drive, Frederick, Maryland 21702 and its telephone number is (888) 694-4170.

        On November 20, 2001, Bancorp through Farmers & Mechanics Bank, sold assets and liabilities associated with the Fairfield and Gettysburg, Pennsylvania branch offices to Adams County National Bank. Under the terms of the agreement, Adams County National Bank assumed responsibility for services related to checking, savings, and certificates of deposit products totaling $24.3 million, purchased the branch office and real estate located at 20 East Main Street, Fairfield, PA, and assumed the lease for the Middle St. office in Gettysburg.

        On July 16, 2001, Bancorp dissolved Home Appraisals, Inc. and Founders Mortgage Co. Both businesses were acquired in previous acquisitions. Farmers & Mechanics Bank has assumed the services rendered by these companies.

        On June 1, 2001, Bancorp completed the consolidation of its two banking subsidiaries into one state banking charter. Home Federal Savings Bank began operating as a division of Farmers & Mechanics Bank. The consolidation of F&M Bancorp's two banking subsidiaries into a single state-chartered institution will provide enhanced operating efficiencies for the company.

        On May 10, 2001, Bancorp consolidated two insurance affiliates into Keller Stonebraker Insurance, Inc. ("KS"), Hagerstown, MD, Charles S. Gardner Insurance Agency, Inc. and JRH Insurance, Inc. KS operates as an independent, wholly-owned subsidiary of the Bank and provides a full line of consumer and commercial business insurance products through offices in Hagerstown, Cumberland, MD and Keyser, WV. Consumer insurance products include annuities, homeowners, automobile, life and personal umbrellas. Commercial business products include property and casualty packages, workers' compensation, bonds, professional liability, umbrella, and 401(k) and other benefit plans.

        On May 10, 2001, Bancorp consolidated C&F Insurance Agency into Potomac Basin Group Associates, Inc. ("PB"), Beltsville, MD, PB operates as an independent, wholly-owned subsidiary of the Bank and is an independent insurance agency specializing in corporate employee benefit plans and property and casualty packages through its offices in Beltsville and Ellicott City, MD.

        On April 26, 2001, Bancorp dissolved TBT Title VIII, Inc., Central Maryland Service Corp., CLC Associates, Inc., Family Home Insurance Agency, Inc. and Keystone General Partnership. These businesses were inactive companies that were acquired in previous acquisitions. Farmers & Mechanics Bank and its affiliates have assumed any services rendered by these companies.

        On December 30, 1999, Bancorp completed the acquisition of Patapsco Valley Bancshares, Inc. ("PVB") and its commercial banking subsidiary, Commercial & Farmers Bank ("C&F"), Ellicott City, MD, in a tax-free exchange of shares accounted for as a pooling-of-interests. Under the terms of the merger agreement, C&F was merged with and into the Bank at closing, increasing the Bank's assets by

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approximately $173 million, loans by approximately $118 million, and deposits by approximately $150 million.

        On July 15, 1999, Bancorp consummated a merger with Potomac Basin Group Associates, Inc. ("PB"), in a tax-free exchange of shares accounted for as a pooling-of-interests. PB is a Beltsville, MD-based, full-line independent insurance agency specializing in corporate employee benefit plans.

        Farmers & Mechanics Bank:    Farmers & Mechanics Bank was incorporated in 1865 as a national banking association under the laws of the United States, and is the successor to Maryland State chartered banking institution dating from 1817. In 1915, the Bank acquired trust powers. Effective April 1, 2001, Farmers & Mechanics Bank commenced operations as a Maryland state-chartered bank. Effective June 1, 2001, Home Federal Savings Bank began operating as a division of Farmers & Mechanics Bank. The Bank, the deposits of which are insured by the Federal Deposit Insurance Corporation, conducts general banking and trust company business through 50 full-service offices and 81 automated teller machines located in Frederick, Carroll, Montgomery, Baltimore, Howard, Washington and Allegany Counties, in Maryland. The Bank also operates the East Coast's first full-service mobile unit, Express Bank, and delivers electronic services throughout its market with personal and business PC internet banking access and with its 24-hour telephone banking service, ExpressLine.

        Bank Deposit and Lending Activities:    As of December 31, 2001, the Bank had deposits of $1.516 billion. No material portion of the bank's deposits has been obtained from any single depositor or group of related depositors, including federal, state and local governments and agencies. As of December 31, 2001, the Bank had $1.162 billion in loans representing approximately 62% of its total assets of $1.881 billion. No material portion of the Bank's loans are concentrated within a single industry or group of related industries. The Bank is not dependent upon any single borrower or a few principal borrowers. The loss of any individual or of a few principal borrowers would not have a material adverse effect on the operations or earnings of the Bank.

        Banking Products and Services:    Bancorp, through its wholly-owned subsidiaries, provides banking and bank-related financial services to middle market and small business organizations, local governmental units, and retail customers in central Maryland and surrounding areas. Bancorp, through its subsidiaries, also provides broad-based commercial and retail banking services, brokerage, personal trust, investment management, and financial planning services; and a wide variety of related financial products and services to individuals, businesses and governmental units. In addition, Bancorp provides a full line of consumer and commercial business insurance products through offices in Beltsville, Ellicott City, Hagerstown, and Cumberland, Maryland and Keyser, West Virginia.

        Environmental Liabilities:    Management of Bancorp is not aware of any environmental liabilities that would have a material adverse effect on the operations or earnings of Bancorp.

        Seasonal Aspects:    Management does not believe that the deposits or the business of the Bank or its subsidiaries in general are seasonal in nature. The deposits may, however, vary with local and national economic conditions but should not have a material effect on planning and policy making.

        Employees:    As of December 31, 2001, Bancorp had no full-time equivalent employees. As of that date, the Bank and its subsidiaries had 740 full-time equivalent employees.

        Competition:    The market for banking and bank-related services is highly competitive and is growing more competitive every year. Traditional banks are developing capabilities in nontraditional lines of business such as insurance, brokerage, mutual funds, investment banking, securities underwriting and asset management. Commercial enterprises such as insurance companies, investment banking firms and retailers are gaining regulatory approvals to offer traditional banking products and services either alone or through affiliations.

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        Bancorp operates in a highly competitive marketplace that has intensified in the past several years largely as a result of interstate banking and the acquisition of in-state financial institutions by larger, out-of-state banks. The full range of competition includes other bank holding companies, other commercial banks, other savings and loan associations, credit unions, money market funds, brokerage houses, investment managers, mortgage companies, consumer finance companies, leasing companies, insurance carriers, other insurance agencies, automobile manufacturers and their financing units and commercial loan syndicates.

        Bancorp competes successfully in its marketplace by effectively focusing its business energy and resources on meeting the specific needs of its customers with a level of sales, service and support intended to foster long-term relationships. Additionally, Bancorp has been able to expand its presence throughout the Maryland market to better serve clients who demand a statewide presence. Bancorp's growth strategy may include the use of strategic acquisitions and it regularly evaluates opportunities and conducts due diligence activities in connection with possible transactions. As a result, discussions and, in some cases, negotiations may take place and future acquisitions involving cash, debt or equity securities may occur.

Supervision and Regulation

        Bancorp and its bank subsidiary are subject to an extensive system of banking laws and regulations that are intended primarily for the protection of customers and depositors. These laws and regulations govern such areas as permissible activities, reserves, loans and investments, and rates of interest that can be charged on loans. In addition, Bancorp and its subsidiaries are subject to general U.S. federal laws and regulations and to the laws and regulations of the states in which they conduct their businesses. Described below are material elements of selected laws and regulations applicable to the Corporation and its subsidiaries. The descriptions are not intended to be complete and are qualified in their entirety by reference to the full text of the statutes and regulations described.

        Bank Holding Company Regulation:    F&M Bancorp is registered with the Federal Reserve Board (the "FRB") as a bank holding company and is subject to reporting requirements, supervision and examination by the FRB under the Bank Holding Company Act of 1956 (the "Act"), as amended. The Act restricts the business activities and acquisitions that may be engaged in or made by Bancorp. Bancorp is generally prohibited from acquiring direct or indirect ownership or control of more than 5% of any class of the voting shares of any company which is not a bank or bank holding company and from engaging in any business other than that of banking or of managing or controlling banks, or of furnishing services to, or performing services for, its affiliated banks. The Act and regulations thereunder require prior approval of the FRB of the acquisition by Bancorp of more than 5% of any class of the voting shares of any additional bank. After prior approval or notice, Bancorp may acquire other banks and bank holding companies and engage directly or indirectly in certain activities closely related to banking. Bancorp must give prior notice of certain purchases or redemptions of its outstanding equity securities. Bancorp and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, lease, sale of property, or furnishing of services.

        The FRB may issue cease and desist orders against bank holding companies and nonbank subsidiaries to stop actions believed to present a serious threat to the Bank. The FRB also regulates certain debt obligations of bank holding companies.

        Bank Regulations:    The Bank is subject to supervision and regulation by the State of Maryland, the FRB, and the Federal Deposit Insurance Corporation ("FDIC") as of December 31, 2001. On December 14, 2000 the Bank made application with the Maryland State Commissioner of Financial Regulation to become a state-chartered Bank. Approval from the Commissioner occurred and was effective April 1, 2001. This made the Bank subject to supervision by the State of Maryland with the

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FRB serving as the primary regulator. Deposits, reserves, investments, loans, consumer law compliance, issuance of securities, payment of dividends, establishment of branches, mergers and consolidations, changes in control, electronic funds transfers, responsiveness to community needs, management practices, compensation policies and other aspects of operations are subject to regulation by the appropriate Federal supervisory authorities and the applicable banking laws of the State of Maryland. The Bank may establish branch banking offices and engage in certain corporate activities without geographic limitation in the state of Maryland without prior approval. Mergers of the Bank with any other bank would require approval of, and involve review by, various governmental agencies.

        Some of the aspects of the lending and deposit business of the Bank which are subject to regulation by the FRB or the FDIC include disclosure requirements in connection with personal or mortgage loans, interest on deposits and reserve requirements. In addition, the Bank is subject to numerous federal, state and local laws and regulations which set forth specific restrictions and procedural requirements with respect to extensions of credit (including to insiders), credit practices, disclosure of credit terms and discrimination in credit transactions.

        The Bank is subject to restrictions under federal law which limit the transfer of funds by the Bank to Bancorp and its nonbanking subsidiaries, whether in the form of loans, extensions of credit, investments, asset purchases, or otherwise. Such transfers by the Bank to Bancorp or any of Bancorp's nonbanking subsidiaries are limited in amount to 10% of the Bank's capital and surplus and, with respect to Bancorp and all such nonbanking subsidiaries, to an aggregate of 20% of the Bank's capital and surplus. Furthermore, such loans and extensions of credit are required to be secured in specified amounts.

        Support of Subsidiary Banks:    Under FRB policy, Bancorp is expected to act as a source of financial strength and to commit resources to support its banking subsidiary. This support may be required at times when, absent of such FRB policy, Bancorp may not be inclined to provide it. In the event of a bank holding company's bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to a priority in payment.

        A depository institution insured by the FDIC can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC in connection with the default of a commonly controlled FDIC insured depository institution or any assistance provided by the FDIC to any commonly controlled FDIC insured depository institution "in danger of default." Default is defined generally as the appointment of a conservator or receiver and "in danger of default" is defined generally as the existence of certain conditions indicating that a default is likely to occur in the absence of regulatory assistance. Liability for the losses of commonly controlled depository institutions can lead to the failure of some or all depository institutions in a holding company structure, if the remaining institutions are unable to pay the liability assessed by the FDIC. Any obligation or liability owed by a subsidiary bank to its parent company is subordinate to the subsidiary bank's cross-guarantee liability for losses of commonly controlled depository institutions.

        Payment of Dividends and Other Restrictions:    Bancorp is a legal entity separate and distinct from its subsidiaries. There are various legal and regulatory limitations on the extent to which Bancorp's subsidiaries, including its bank subsidiary, can finance or otherwise supply funds to the Bancorp. See Note 14, Regulatory Restrictions, Notes to Consolidated Financial Statements, for additional information regarding certain regulatory restrictions on inter-company transfers of funds and on the payment of dividends by the Bank to Bancorp.

        Capital Requirements:    Under regulatory capital adequacy guidelines discussed below, Bancorp and the Bank were "well capitalized" at December 31, 2001 and 2000.

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        The Federal Reserve Bank maintains capital adequacy guidelines applicable to Bancorp and the Bank, respectively, which set forth minimum levels of capital relative to assets and risk-adjusted assets. The guidelines require Bancorp and the Bank to maintain a minimum tangible (leverage) capital ratio of 3% Tier 1 capital (primarily shareholders' equity) to total regulatory assets, plus, for all but the most highly rated institutions, an additional cushion of 100 to 200 basis points. Tier 1 capital for bank holding companies includes common equity, minority interest in equity accounts of consolidated subsidiaries, and qualifying perpetual preferred stock. Tier 1 capital excludes goodwill and other disallowed intangibles, certain deferred tax assets and any net unrealized loss on marketable equity securities. At December 31, 2001, Bancorp's tangible capital ratio was 8.71%.

        Bancorp and the Bank must also meet a minimum core "Tier 1" capital to risk-weighted assets ratio of 4%. Each must also meet a minimum core and supplemental "Total" capital to risk-weighted assets ratio of 8%, measuring the amount of defined capital as a percentage of the amount and nature of assets, as well as commitments currently at risk. The risk-weighted capital rules specify four categories of asset or commitment risk with each category being assigned a weight ranging from 0% to 100% depending upon the defined risk of each category. At least 50% of Bancorp's total capital must be made up of Tier 1 capital elements including common equity, retained earnings, guaranteed preferred beneficial interest in junior subordinated debentures, and a limited amount of perpetual preferred stock after subtracting goodwill and certain other adjustments. The remainder may consist of perpetual debt, mandatory convertible debt securities, a limited amount of subordinated debt, other preferred stock, and a limited amount of loan loss reserves. At December 31, 2001, Bancorp's Tier 1 and Total risk-weighted capital ratios were 12.24% and 13.30%, respectively.

        The FDIC requires "prompt corrective action" when an insured institution's capital falls to certain levels. This rule restricts or prohibits certain activities and requires an insured institution to submit a capital restoration plan when it becomes undercapitalized. The restrictions and prohibitions become more severe as an institution's capital level declines.

        Capital adequacy guidelines also provide for consideration of interest rate risk in the overall determination of a bank's minimum capital requirement. The guidelines explicitly provide that a bank's exposure to declines in the economic value of its capital due to changes in interest rates is a factor to be considered in evaluating capital adequacy.

        For additional information pertaining to capital adequacy and interest rate risk management, see Management's Discussion and Analysis of Financial Condition and Results of Operations,

        Monetary Policy:    The earnings and growth of Bancorp and the Bank are affected by general economic conditions as well as by monetary policies of regulatory authorities including the FRB, which regulates the national money supply in order to mitigate recessionary and inflationary pressures. Among the techniques available to the FRB are engaging in open market transactions in U.S. Government securities, changing the discount rate on bank borrowings and changing reserve requirements against bank deposits. These techniques are used in varying combinations to influence the overall growth and distribution of bank loans, investments and deposits. Their use may also affect interest rates charged on loans or paid on deposits. The effect of governmental monetary policies on the earnings of Bancorp cannot be predicted.

        Legislation:    The enactment of the Gramm-Leach-Bliley Act in 1999 significantly changed the business of banking. Also known as the "Financial Services Modernization Act" the Act became effective March 12, 2000. This act, among other things, repealed the sections of the Glass-Steagall Act, which have prohibited the affiliation of banks with securities firms. This allows a bank holding company to affiliate with any financial company, for example insurance or securities, and to cross sell an affiliate's products thus allowing any financial company to offer to its customers any financial product or service.

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        The act further expands the number of permissible bank holding company activities to include a long list of financial activities. It includes any activity which in the future is deemed by the FRB and the Treasury Department to be "financial in nature or incidental to financial activities" and any activity that the FRB determines is complimentary to a financial activity, which does not pose a substantial safety and soundness risk.

        The new standard is much broader than the previous permissible activities standard. The broader standard allows bank holding companies to expand their product mix and to adapt to changing market conditions. State laws prohibiting such affiliations are expressly pre-empted. Significantly, the act removes the ability of commercial businesses to acquire or establish a thrift holding company or receive a thrift charter and requires existing unitary thrift holding companies to be sold only to financial companies in the future.

        The act also confirms state regulation of insurance, subject, however, to a standard that no state may discriminate against affiliates of a bank, thus attempting to provide for equal treatment of both bank affiliated insurance agencies and non-bank affiliated insurance agencies. The act also allows banks to engage in new and existing financial activities through subsidiaries without regard to geographic limitation and streamlines bank holding company supervision and clarifies the roles of various regulators. Regulations are currently being promulgated to implement the provisions of the act.

        The act also contains rules requiring Bancorp and its subsidiaries to safeguard the confidentiality of any "nonpublic personal information" that it has about a customer. These provisions generally restrict the ability of Bancorp to transfer information about consumers to nonaffiliated third parties and require Bancorp to provide certain privacy-related notices to consumers.

        Proposals to change the laws and regulations governing the banking industry are frequently introduced in Congress, in the states' legislatures, and before the various bank regulatory agencies. Some of these proposals could have significant effects on the way in which Bancorp and its subsidiaries, and financial institutions in general, conduct their business, and could have significant effects on Bancorp's operating results. Bancorp cannot, however, accurately predict what those effects would be.

ITEM 2.    PROPERTIES

        The following describes the location and general character of the principal offices and other materially important physical properties of Bancorp and its subsidiaries.

        The Bank owns a fee simple interest in its principal executive offices and main banking facility, totaling approximately 115,000 square feet, located at 110 Thomas Johnson Drive, Frederick, MD. The Bank also owns a fee simple interest in the principal executive office and main banking facility of its division Home Federal, with approximately 39,000 square feet, located at 122-128 West Washington Street, Hagerstown, MD. Keller Stonebraker leases approximately 8,000 square feet for its headquarters office located at 1120 Professional Court, Hagerstown, MD, from a partnership in which Keller Stonebraker's executive officers hold a 30% limited partnership interest. Bancorp acquired in its merger with Monocacy Bancshares, Inc., a fee simple interest in the 43,500 square foot headquarters building of Taneytown Bank & Trust Company located at 222 East Baltimore Street, Taneytown, MD. Out of a total of 50 full-service branch offices of the Bank at December 31, 2001, 28 were owned and 22 were leased. Information concerning Bancorp's lease commitments is included in Note 12, Commitments and Contingencies, Notes to Consolidated Financial Statements.

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ITEM 3.    LEGAL PROCEEDINGS

        Bancorp and its subsidiaries become involved, from time to time, in various legal proceedings incidental to their respective businesses. As disclosed in Note 12, Commitments and Contingencies, Notes to Consolidated Financial Statements, in the opinion of the management, there were no legal matters pending as of December 31, 2001, which would have a material effect on the consolidated financial statements.

ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

        There were no matters submitted to a vote of security holders since the 2001 Annual Shareholder meeting.

PART II

ITEM 5.    MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

        The principal market on which F&M Bancorp Common Stock is traded is The NASDAQ Stock Market. Stock price and dividend information is provided below.

        Shareholders received quarterly cash dividends totaling $11,977,000 in 2001 and $12,332,000 in 2000. Since 1996, dividends per share have risen at a compound annual growth rate of 19.4%.

        The ratio of dividends per share to basic earnings per share was 56.6% in 2001 compared to 61.7% for 2000. The Board of Directors establishes the dividend amount each quarter. In making its decision on dividends, the Board considers operating results, financial condition, capital adequacy, regulatory requirements, shareholder returns, and other factors.

        Bancorp has a stock repurchase program that permits the purchase of up to 500,000 shares of its outstanding common stock. Repurchases are made in connection with shares expected to be issued under Bancorp's dividend reinvestment, stock option, and benefit plans, as well as for other corporate purposes. Shares repurchased under this program totaled 178,400 in 2001.

Stock Price and Dividends

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ITEM 6.    SELECTED FINANCIAL DATA

(1)

Reflects the percentage relationship of cash dividends paid to basic earnings per share.

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ITEM 7.    MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

        The following discussion provides an overview of the financial condition and results of operations of F&M Bancorp and Subsidiaries ("Bancorp") for the three years in the period ended December 31, 2001, and is intended to assist readers in their analysis and understanding of the accompanying consolidated financial statements and notes thereto.

        Bancorp's acquisition of Potomac Basin Group Associates, Inc. ("PB"), completed in July 1999, and Patapsco Valley Bancshares, Inc. ("PVB") and its wholly-owned subsidiary, Commercial & Farmers Bank ("C&F"), completed in December 1999, are accounted for as pooling-of-interests transactions. Accordingly, the consolidated financial statements, notes, and historical financial data contained herein were restated for all prior periods presented to include the financial condition and results of operations for PB and PVB. Refer to Note 2, Notes to Consolidated Financial Statements, for further information regarding acquisition activity within the periods reported.

        All per share amounts in this report have been restated to give effect to subsequent stock dividends and shares issued in pooling-of-interests transactions.

Forward-Looking Statements

        Certain information included in the following section of this report, other than historical information, may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are identified by terminology such as "may", "will", "believe", "expect", "estimate", "anticipate", "likely", "unlikely", "continue", or similar terms. Although Bancorp believes that the expectations reflected in such forward-looking statements are reasonable, actual results may differ materially from those projected in the forward-looking statements.

OVERVIEW

        Bancorp achieved favorable growth in deposits and noninterest income in the year 2001 while continuing to maintain strong net income growth and asset quality. During the year there was a growing concern over the recessionary environment that prompted the Federal Reserve Bank to cut rates, pushing the federal funds rate to a four-decade low of 1.75%. As a result of the declining rate environment, the Federal Reserve hoped to increase consumer confidence and spending to reduce the effects of the recession that began in March. Against this background, economic conditions within the Bancorp's operating area in Maryland remained generally strong and credit quality has remained at traditionally strong levels.

        Bancorp's net income for 2001 totaled $21.1 million or $1.92 per diluted share compared with $19.3 million or $1.75 per diluted share in 2000, a 9% increase. Return on average equity declined slightly to 12.65% in 2001 from 12.98% due to an increase in equity attributable to the improved market performance of the investment portfolio. Return on average assets increased to 1.18% in 2001 from the 1.11% achieved in 2000.

        In 2001 average deposits increased $123.3 million or 9.3%. This increase was driven from growth in demand deposits, money market accounts, and certificates of deposit. In November 2001, the Bancorp sold two Pennsylvania branches that totaled $24.3 million in deposits that were acquired, through a previous acquisition.

        Our principal revenue category, net interest income, grew by 5% in 2001 compared to 2000. This increase was due to a 4% increase in average earning assets and the net interest margin increasing to 4.22% from 4.20% in the prior year. The stability of the net interest margin during a year when

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interest rates declined by 4.75% attests to the effectiveness of Bancorp's interest rate risk management practices.

        Noninterest income grew $2.1 million to $30.9 million in 2001 versus $28.8 million in 2000, a 7% increase. This increase resulted primarily from a significant increase in the mortgage banking business, strong insurance sales and increases in deposit services utilized. Bancorp has made it a strategic priority to grow and diversify its sources of noninterest income. In the past five years, Bancorp has diversified its revenue so that noninterest revenues now comprise over 30% of total revenue, up from 27% in 1997.

        In 2001 Bancorp's efficiency ratio at 63.88%, which is a measure of operating cost management, was improved from 64.73% achieved in 2000. Total noninterest expense increased 4% over 2000 and has been contained to a 3% five-year compound growth rate.

        Asset quality remained at Bancorp's traditionally strong levels. The ratio of net charge-offs to average loans outstanding was .25%. At year end the allowance for credit losses represented 10.9 times the level of year-end nonperforming loans. The additional provision for credit losses of $445 thousand over 2000 reflects Bancorp's conservative approach in factoring in the effects of a recessionary environment and the potential impact on its customers.

TABLE 1. CHANGES IN DILUTED NET INCOME PER COMMON SHARE

Table 1. Changes in Diluted Net Income per Share

RESULTS OF OPERATIONS

        Bancorp's operating results for the year reflected strong revenue growth, with total revenues rising $5.2 million or 6% to $99 million. Increases occurred in both net interest income and fee-generating business as Bancorp's strategies and growth initiatives continued to generate strong revenue momentum. Credit losses continued to be modest while loan quality remained strong. Bancorp continues to initiate technology enhancements and capitalize on acquisition and consolidation synergies to moderate expense growth.

Net Interest Income

        Net interest income for 2001 was $68.1 million, representing an increase of $3 million or 5% from 2000. A 5% increase was achieved in 2000 compared to 1999, resulting in net interest income of $65.0 million. Bancorp's principal source of revenue is net interest income, the difference between interest income on earning assets and interest expense on deposits and borrowings. Interest income for purposes of analysis is presented on a tax-equivalent basis to recognize associated tax benefits. The presentation provides a basis for comparison of yields with taxable earning assets.

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TABLE 2. CONSOLIDATED AVERAGE BALANCES AND RATES

(1)

Interest and yields on obligations of states and political subdivisions and tax-exempt loans are computed on a taxable equivalent basis using the U.S. statutory tax rate of 35%. In addition, loan fee income is included in the interest income calculations and nonaccrual loans are included in the average loan base upon which the interest rate earned on loans is calculated.

        Consolidated Average Balances and Rates reveals a relatively stable net interest margin accomplished by significant increases in average earning assets over the three year period ended December 31, 2001. As a result, Bancorp was able to achieve tax-equivalent net interest income of $71.2 million in 2001, representing a 5% increase, preceded by $68.2 million in 2000.

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TABLE 3. ANALYSIS OF CHANGES IN NET INTEREST INCOME

(1)

The change in interest due to both rate and volume has been allocated to rate and volume changes in proportion to the relationship of the absolute dollar amounts of the change in each.

        Analysis of Changes in Net Interest Income reveals that the percentage increase in tax-equivalent net interest income for 2001 has declined slightly compared to 2000. This was attributable to the impact of slower earning asset growth in 2001 offset by an improvement in the impact of changing rates. Competitive pricing pressures on loans and deposits have increased in the recessionary environment and present a significant management challenge. This has heightened the emphasis to diversify revenue streams and requires greater sophistication in net interest margin management.

Interest Income

        Bancorp's tax-equivalent interest income decreased $3.8 million or 3% in 2001 compared to 2000. This decline was primarily the result of a 54 basis point decrease in the average yield on earning assets offset by a $65.7 million increase in those assets.

        During 2001, average loans yielding 8.06% declined $5.9 million. This decrease was attributable to prepayments in residential mortgage loans, consumer automobile loans and commercial loans. As a percentage of average earning assets, average loans were 71%, 74% and 68% in 2001, 2000 and 1999, respectively.

        Average total securities yielding 5.98% increased 15% to $473 million in 2001. They represented 28% of average earning assets in 2001 as compared to 25% in 2000. The growth in the securities portfolio in 2001 resulted from the significant deposit growth achieved during the year.

        Tax-equivalent interest income increased 10% or $12.2 million in 2000 compared to 1999, due to significantly higher average earning assets and by a 27 basis point improvement in the average yield earned on these funds.

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Interest Expense

        Interest expense declined 11% or $6.8 million in 2001 compared to 2000. The change was attributable to a 54 basis point decline in the average total rate paid on interest-bearing liabilities, offset by a 1% or $18.1 million increase in those liabilities.

        Interest bearing deposits increased 9% or $101.8 million in 2001 compared to 2000 primarily in money market accounts and certificates of deposit. Average total borrowings, typically the most expensive funding source, declined 33% or $83.7 million. The average rate paid on interest-bearing deposits decreased by 24 basis points in 2001 compared to 2000, representing a 6% decrease, while the average rate for borrowings decreased 179 basis points representing a 30% decrease.

        Interest expense increased 17% or $9.1 million in 2000 as compared to 1999, due to a 7% increase or $88.3 million higher average interest-bearing liabilities, accompanied by a 40 basis point increase in the average rate paid for those funds.

Interest Rate Performance

        Net interest margin, the profit margin achieved on Bancorp's earning assets, increased 2 basis points in 2001 compared to 2000. The net interest spread improved by 1 basis point. On an average basis, interest rates were lower in 2001 than in 2000, and the decline in rates had an equivalent impact on both interest-bearing assets and liabilities which was consistent with the Bancorp's interest rate risk profile. The decline in net interest margin was 8 basis points in 2000 compared to 1999 and the net interest spread declined 12 basis points.

        During 2001 interest rates declined significantly from the beginning of the first quarter and until year-end. The decrease in the average interest rates earned on assets outpaced the decrease in the average rate paid on deposit accounts largely due to competitive pressure on loan prices and a higher mix of investment securities that earn lower yields than loans. Reducing expensive borrowings and lowering the cost of those borrowings offset the compression on the net interest margin by traditional bank products and services, by 179 basis points.

Provision for Credit Losses

        Provisions for credit losses are charges to earnings to bring the total allowance for credit losses to a level considered by management as adequate to provide for estimated losses based on management's evaluation of the collectibility of the loan portfolio. Management considers the nature of the loan portfolio, credit-concentration trends, historical loan loss experience, specific impaired loans and economic conditions. Management also considers the level of problem assets that the Bancorp classifies in accordance with regulatory requirements. The provision for credit losses was $3.7 million in 2001 which was $.4 million higher than in 2000. This increase in provision resulted primarily from Bancorp's conservative approach in factoring in the impact of the recessionary environment on its borrowers.

Noninterest Income

        Total noninterest income rose $2.1 million or 7% to $30.9 million for the year. Growth occurred mainly in gains on sales of loans, insurance income and service charges on deposit accounts. Noninterest income grew 15% or $3.8 million in 2000 versus 1999.

        Gains on sales of loans from mortgage banking activities increased $1.7 million or 82% to $3.8 million in 2001 compared to 2000, after a decline of 6% or $136 thousand in 2000 compared to 1999. Declining interest rates resulted in a shift in consumer demand toward fixed-rate mortgages which are generally not held in the loan portfolio but are sold in the market. Lower interest rates also increased refinancing activity, resulting in higher origination fees, which are also included in this

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category. These gains reflect a reclassification of miscellaneous loan fees that had no impact on net income.

        Insurance commission income grew $767 thousand or 10% to $8.8 million. Revenues of $8.0 million for 2000 represented an increase of $1.1 million or 16% over 1999. Team-based selling efforts between the insurance subsidiaries and the bank affiliates have brought a vast array of consumer and commercial insurance products to the community bank customer.

        Bank card income increased $382 thousand or 15% to $3.0 million. Revenues from debit card usage increased 26% or $535 thousand in 2000 versus 1999. This income is derived primarily from debit card transactions. The continuing growth in this product resulted from increased consumer acceptance of the service, greater marketing focus to raise awareness and increased customer usage of this product.

        Revenues from service charges on deposit accounts rose $465 thousand or 6% in 2001 and $822 thousand or 12% in 2000. This increase resulted from the overall level of new deposit account customers and the conversion of acquired accounts in 2000 to Bancorp's fee schedule.

        Commissions and fees from alternative investments and brokerage services declined $336 thousand or 9% partly due to current market conditions. Revenues increased 8% or $303 thousand in 2000 compared to 1999. It is the goal of our Wealth Management Group to provide innovative financial solutions individually designed for the affluent, emerging affluent and small business customer.

TABLE 4. ANALYSIS OF CHANGES IN NONINTEREST INCOME

Noninterest Expense

        Total noninterest expense rose $2.4 million or 4%, to $65.2 million in 2001 over 2000 and declined 7% or $4.4 million in 2000 over 1999. Bancorp incurs additional costs in order to provide new services, expand its market, and support the growth of the company. Management controls operating costs with the goal of maximizing profitability over time.

        Management views the efficiency ratio as an important measure of overall operating expense performance and cost management. Lower ratios indicate improved productivity. Bancorp's efficiency ratio (the ratio of noninterest expense to the sum of net interest income on a tax equivalent basis and noninterest income) decreased to 63.88% for 2001 compared to 64.73% and 74.60% for 2000 and 1999, respectively.

        Total personnel expense grew $2.0 million or 6% for 2001. Salary expense rose $1.6 million or 6%, primarily due to higher commission costs related to insurance activities, normal employee merit

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increases and successful recruitment of open positions. Employee benefits increased by $449 thousand or 8% to $6.0 million primarily due to higher employee medical costs.

        Efficient staffing is a strategic priority of management. Staffing additions are tied directly to achieving gains in financial performance. Average full-time equivalent employees declined to 740 in 2001 representing a decrease of 4% from 770 in 2000 which was 4% below the 803 recorded in 1999. The ratios of net income per full-time equivalent employee increased to $29,000 in 2001, from $25,000 and $16,000 in 2000 and 1999, respectively. Total personnel expense grew $70 thousand or .2% in 2000 compared to 1999.

        Merger-related expense decreased to zero in 2001 from $318 thousand in 2000 and $5.0 million in 1999. These expenses are largely associated with legal and accounting fees, severance payments, contract terminations, and similar expenses related to the acquisition and merger of Patapsco Valley Bancshares, Inc. which closed on December 30, 1999.

        Professional services decreased $542 thousand or 19.3% primarily due to fewer recruiting expenses associated with the efforts to fill open positions for 2001. Telephone expense decreased $306 thousand or 16.6%. Computer software and maintenance costs decreased $193 thousand or 10.4%. These decreases are attributed to managing the cost associated with technology investments to improve customer service and provide productivity enhancements to the organization.

TABLE 5. ANALYSIS OF CHANGES IN NONINTEREST EXPENSE

Income Taxes

        Income tax expense increased by 6% to $9.0 million for 2001 from $8.5 million for 2000 and $5.2 million in 1999. Tax expense varies with changes in the level of income before taxes, the amount of tax-exempt income realized, and the relationship of these changes to each other. Also, the amount of income tax expense differs from the amount computed at statutory rates primarily because the interest realized on state and municipal obligations and certain loans is tax-exempt.

        The effective tax rates, which is the provision for income taxes divided by income before taxes, were 29.8% for 2001, 30.5% for 2000, and 28.4% for 1999.

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FINANCIAL CONDITION

        Bancorp's total assets reached $1.881 billion at December 31, 2001, an increase of 5% or $86.2 million from $1.795 billion at December 31, 2000. Earning assets increased $83.7 million or 5% in 2001, to $1.751 billion at December 31, 2001 from $1.667 billion at the prior year-end.

        Investment Securities:    The investment portfolio increased 28% or $120.3 million to $546.5 million at December 31, 2001 from $426.2 million at December 31,2000. The investment securities portfolio is structured and managed to meet several important financial objectives:

•

To maintain sufficient balance sheet liquidity to meet any reasonable decline in deposits and any anticipated increase in loans.



•

To insure safety of principal and interest by investing only in securities permitted by regulation.



•

To maximize income consistent with liquidity and safety requirements.



•

To maintain a source of assets which can be pledged as collateral for federal, state and municipal deposits.

        For accounting and reporting purposes, investments owned by Bancorp are held as available-for-sale ("AFS") securities, which are intended to be held for an indefinite period of time, but not necessarily to maturity. This determination is made when the securities are purchased and is integral to Bancorp's asset/liability management ("ALM") policies.

        Table 6, Investment Portfolio Distribution, displays the year-end amortized cost of the investment securities portfolio which increased to $542 million at December 31, 2001 from $428 million at December 31, 2000.

TABLE 6. INVESTMENT PORTFOLIO DISTRIBUTION—AMORTIZED COST(1)

(1)

Reflects the cost of securities purchased, adjusted for amortization of premiums and accretion of discounts, which differs from the amounts reflected in the consolidated balance sheets due to fair value adjustments made in accordance with Financial Accounting Standards Board Statement No. 115.

        As shown in Table 7, Investment Portfolio Analysis, the amortized cost of AFS securities totaled $542 million and represented 100% of the total securities portfolio and 29% of consolidated total assets at December 31, 2001. AFS securities provide substantial liquidity, chiefly for unexpected loan growth or deposit withdrawal requirements.

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TABLE 7. INVESTMENT PORTFOLIO ANALYSIS—DECEMBER 31, 2001