NORTHERN STATES FINANCIAL CORP /DE/ - 10-Q Quarterly Report

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United States
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_________________________________________________________

FORM 10-Q

[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2004

OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________ to __________

_________________________________________________________

NORTHERN STATES FINANCIAL CORPORATION
(Exact name of Registrant as specified in its charter)

Delaware 0-19300 36-3449727
(State of Incorporation) (Commission (I.R.S. Employer
File Number) Identification No.)

1601 North Lewis Avenue
Waukegan, Illinois 60085
(847) 244-6000
(Address, including zip code, and telephone number, including
area code, of principal executive office)
_________________________________________________________

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 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: XXX NO:
--- ----

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). YES: XXX NO:
--- ----

4,305,105 shares of common stock were outstanding
as of July 29, 2004

NORTHERN STATES FINANCIAL CORPORATION AND SUBSIDIARY
----------------------------------------------------
FORM 10-Q
---------
FOR THE QUARTER ENDED JUNE 30, 2004
-----------------------------------
INDEX
-----

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements Page Number

Report of Independent Accountants.................................2

Condensed Consolidated Financial Statements and Notes..............3

Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations............................9

Item 3. Quantitative and Qualitative Disclosures
About Market Risk............................................22

Item 4. Controls and Procedures........................................24

PART II. OTHER INFORMATION

Item 1. Legal Proceedings.............................................24

Item 2. Changes in Securities, Use of Proceeds
and Issuer Purchases of Equity Securities...................24

Item 3. Defaults upon Senior Securities...............................24

Item 4. Submission of Matters to a Vote of Security Holders...........25

Item 5. Other Information.............................................25

Item 6. Exhibits and Reports on Form 8-K..............................25

Signatures.............................................................26

EXHIBIT INDEX.............................................................27

1

PART 1. FINANCIAL INFORMATION
- -----------------------------

ITEM 1. FINANCIAL STATEMENTS
- ----------------------------

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Stockholders
Northern States Financial Corporation
Waukegan, Illinois

We have reviewed the accompanying interim condensed consolidated
balance sheet of NORTHERN STATES FINANCIAL CORPORATION as of June 30, 2004 and
the condensed consolidated statements of income for the three month and six
month periods ended June 30, 2004 and 2003 and the condensed consolidated
statements of cash flows for the six months ended June 30, 2004 and 2003. These
interim financial statements are the responsibility of the Company's management.

We conducted our review in accordance with standards of the Public
Company Accounting Oversight Board (United States). A review of interim
financial information consists principally of applying analytical procedures and
making inquiries of persons responsible for financial and accounting matters. It
is substantially less in scope than an audit conducted in accordance with the
standards of the Public Company Accounting Oversight Board, the objective of
which is the expression of an opinion regarding the financial statements taken
as a whole. Accordingly, we do not express such an opinion.

Based on our review, we are not aware of any material modifications
that should be made to the accompanying interim condensed financial statements
for them to be in conformity with U.S. generally accepted accounting principles.

/s/ Crowe Chizek and Company LLC

Oak Brook, Illinois
August 5, 2004

2

NORTHERN STATES FINANCIAL CORPORATION
- -------------------------------------
CONDENSED CONSOLIDATED BALANCE SHEETS
- -------------------------------------
June 30, 2004 and December 31, 2003
(In thousands of dollars)(Unaudited)

June 30, December 31,
Assets 2004 2003
------------- ------------

Cash and due from banks......................................................... $ 28,479 $ 18,403
Interest bearing deposits in financial institutions -
maturities less than 90 days.................................................. 203 181
Federal funds sold.............................................................. 12,850 20,000
-------- --------
Total cash and cash equivalents............................................... 41,532 38,584
Securities available for sale................................................... 281,541 280,445
Loans and leases................................................................ 440,241 358,226
Less: Allowance for loan and lease losses....................................... (5,818) (4,383)
-------- --------
Loans and leases, net......................................................... 434,423 353,843
Federal Home Loan Bank and Federal Reserve Bank stock........................... 2,080 1,871
Office buildings and equipment, net............................................. 9,247 5,370
Other real estate owned......................................................... 4,916 3,766
Goodwill........................................................................ 9,717 85
Other intangible assets......................................................... 3,014 0
Accrued interest receivable and other assets.................................... 8,003 5,655
-------- --------
Total assets.................................................................. $794,473 $689,619
======== ========
Liabilities and Stockholders' Equity
Liabilities
Deposits
Demand - noninterest bearing.................................................. $61,564 $52,398
Interest bearing.............................................................. 581,973 440,734
-------- --------
Total deposits.............................................................. 643,537 493,132
Securities sold under repurchase agreements..................................... 46,487 83,367
Federal funds purchased......................................................... 18,000 26,500
Federal Home Loan Bank advance.................................................. 6,500 6,500
Advances from borrowers for taxes and insurance................................. 874 535
Accrued interest payable and other liabilities.................................. 6,921 4,256
-------- --------
Total liabilities........................................................... 722,319 614,290

Stockholders' Equity
Common stock.................................................................... 1,789 1,789
Additional paid-in capital...................................................... 11,584 11,584
Retained earnings............................................................... 66,368 66,833
Accumulated other comprehensive income (loss)................................... (3,199) (489)
Treasury stock, at cost......................................................... (4,388) (4,388)
-------- --------
Total stockholders' equity.................................................... 72,154 75,329
-------- --------
Total liabilities and stockholders' equity.................................. $794,473 $689,619
======== ========

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

3

NORTHERN STATES FINANCIAL CORPORATION
- -------------------------------------
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
- -------------------------------------------
Three and six months ended June 30, 2004 and 2003
(In thousands of dollars, except per share data)(Unaudited)

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

Interest income
Loans (including fee income)........................................... $5,728 $5,114 $11,379 $10,346
Securities
Taxable.............................................................. 1,912 1,699 3,830 3,401
Exempt from federal income tax....................................... 96 85 193 167
Federal funds sold and other........................................... 73 17 168 36
------ ------ ------- -------
Total interest income.............................................. 7,809 6,915 15,570 13,950
------ ------ ------- -------
Interest expense
Time deposits.......................................................... 1,747 1,626 3,378 3,409
Other deposits......................................................... 387 354 764 730
Repurchase agreements, federal funds purchased
and Federal Home Loan Bank advances.................................. 256 542 561 1,088
------ ------ ------- -------
Total interest expense............................................. 2,390 2,522 4,703 5,227
------ ------ ------- -------
Net interest income...................................................... 5,419 4,393 10,867 8,723
Provision for loan and lease losses...................................... 2,300 150 2,550 280
------ ------ ------- -------
Net interest income after provision for
loan and lease losses.................................................. 3,119 4,243 8,317 8,443
------ ------ ------- -------
Noninterest income
Service fees on deposits............................................... 631 570 1,250 1,084
Trust income........................................................... 175 174 390 331
Mortgage banking income................................................ 46 117 64 237
Other operating income................................................. 261 225 475 360
------ ------ ------- -------
Total noninterest income............................................. 1,113 1,086 2,179 2,012
------ ------ ------- -------
Noninterest expense
Salaries and employee benefits......................................... 2,141 1,705 4,257 3,405
Occupancy and equipment, net........................................... 490 339 955 709
Data processing........................................................ 379 174 696 307
Legal.................................................................. 181 200 349 583
Amortization of intangible assets...................................... 116 0 232 0
Other operating expenses............................................... 768 632 1,363 998
------ ------ ------- -------
Total noninterest expense............................................ 4,075 3,050 7,852 6,002
------ ------ ------- -------
Income before income taxes............................................... 157 2,279 2,644 4,453
Income tax expense (benefit)............................................. (85) 777 741 1,569
------ ------ ------- -------
Net income............................................................... $242 $1,502 $1,903 $2,884
====== ====== ======= =======

Basic and diluted earnings per share..................................... $0.06 $0.35 $0.44 $0.67

Comprehensive income (loss).............................................. ($3,866) $1,798 ($807) $2,917

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

4

NORTHERN STATES FINANCIAL CORPORATION
- -------------------------------------
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
- -----------------------------------------------
Six months ended June 30, 2004 and 2003
(In thousands of dollars)(Unaudited)

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

Cash flows from operating activities
Net income............................................................... $ 1,903 $ 2,884
Adjustments to reconcile net income to net cash from
operating activities:
Depreciation........................................................... 273 189
Amortization of other intangible assets................................ 232 0
Net gains on sales of other real estate owned.......................... 0 (29)
Federal Home Loan Bank stock dividends................................. (59) (76)
Provision for loan and lease losses.................................... 2,550 280
Deferred loan fees..................................................... 46 74
Proceeds from sale of loans............................................ 1,164 0
Loans originated for sale.............................................. (837) 0
Net change in accrued interest receivable and other assets............. 552 371
Net change in accrued interest payable and other liabilities........... 575 (818)
-------- --------
Net cash from operating activities................................... 6,399 2,875
-------- --------
Cash flows from investing activities
Acquisition of subsidiary, net of cash equivalents received.............. (366) 0
Proceeds from maturities and calls of securities available for sale...... 375,261 670,839
Purchases of securities available for sale............................... (366,992) (686,861)
Proceeds from sales of other real estate owned........................... 0 535
Change in loans made to customers........................................ (14,064) (704)
Property and equipment expenditures...................................... (240) (245)
-------- --------
Net cash from investing activities..................................... (6,401) (16,436)
-------- --------
Cash flows from financing activities
Net increase (decrease) in:
Deposits............................................................... 50,599 2,123
Securities sold under repurchase agreements
and federal funds purchased............................................ (45,380) (3,591)
Advances from borrowers for taxes and insurance........................ 99 40
Purchases of treasury stock............................................ 0 (285)
Dividends paid......................................................... (2,368) (2,325)
-------- --------
Net cash from financing activities................................... 2,950 (4,038)
-------- --------
Net change in cash and cash equivalents.................................... 2,948 (17,599)
Cash and cash equivalents at beginning of period........................... 38,584 37,578
-------- --------
Cash and cash equivalents at end of period................................. $41,532 $19,979
======== ========

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

5

NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
----------------------------------------------------

June 30, 2004

(Dollar amounts in thousands, except share and per share data)

(Unaudited)

Note 1 - Basis of Presentation
- ------------------------------

The accompanying interim condensed consolidated financial statements
are prepared without audit and reflect all adjustments which are of a normal and
recurring nature and, in the opinion of management, are necessary to present
interim financial statements of Northern States Financial Corporation (the
"Company") in accordance with accounting principles generally accepted in the
United States of America. The interim financial statements do not purport to
contain all the necessary financial disclosures covered by accounting principles
generally accepted in the United States of America that might otherwise be
necessary for complete financial statements.

To prepare financial statements in conformity with accounting
principles generally accepted in the United States of America, management makes
estimates and assumptions based on available information. These estimates and
assumptions affect the amounts reported in the financial statements and the
disclosures provided, and future results could differ. The allowance for loan
and lease losses and status of contingencies are particularly subject to change.

The interim condensed financial statements should be read in
conjunction with the audited financial statements and accompanying notes (or
"notes thereto") of the Company for the years ended December 31, 2003 and 2002.
The results of operations for the three and six month periods ended June 30,
2004, are not necessarily indicative of the results to be expected for the full
year.

Net income was utilized to calculate both basic and diluted earnings
per share for all periods presented. Information regarding weighted average
shares utilized in computing basic and diluted earnings per share follows. It
should be noted that all stock options were exercised in early 2002 and there
have since been none outstanding.

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

Average outstanding common shares..... 4,305,105 4,305,105 4,305,105 4,306,652
Effect of stock options............... 0 0 0 0
--------- --------- --------- ---------
Average outstanding shares for
diluted earning per share........... 4,305,105 4,305,105 4,305,105 4,306,652
--------- --------- --------- ---------

On April 17, 2002, the Company announced that its Board of Directors
had approved a stock repurchase program that allows the Company to purchase up
to 200,000 shares of Northern States Financial Corporation stock either in open
market or private transactions. On February 19, 2003, the Company announced that
its Board of Directors had approved an additional repurchase program to purchase
an additional 200,000 shares of its stock. At June 30, 2004, the Company had a
total of 167,150 shares of treasury stock that it purchased under these
programs. Treasury stock is carried at cost.

6

NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
----------------------------------------------------

June 30, 2004

(Dollar amounts in thousands, except share and per share data)

(Unaudited)

Information related to common stock was as follows:

June 30, December 31,
2004 2003
--------- ------------
Par value per share........................ $0.40 $0.40
Authorized shares.......................... 6,500,000 6,500,000
Issued shares.............................. 4,472,255 4,472,255
Treasury shares............................ 167,150 167,150
Outstanding shares......................... 4,305,105 4,305,105

Note 2 - Commitments, Off-Balance Sheet Risk and Contingencies
- --------------------------------------------------------------

At June 30, 2004 and December 31, 2003, the contract amount of the
Company's off-balance sheet commitments were as follows:

June 30, December 31,
2004 2003
--------- -----------
Unused lines of credit and commitments to make loans:
Fixed Rate........................................... $10,402 $14,101
Variable rate........................................ 89,222 72,809
------- -------
Total.............................................. $99,624 $86,910
======= =======

Standby Letters of credit.............................. $5,181 $5,605

Since many commitments to make loans expire without being used, the
amounts above do not necessarily represent future cash commitments. Collateral
obtained upon exercise of the commitments is determined using management's
credit evaluation of the borrower, and may include commercial and residential
real estate and other business and consumer assets.

Commitments to make loans to related parties totaled $639 and $642 at
June 30, 2004 and December 31, 2003. These commitments were made at the same
terms and conditions available to nonrelated parties.

The Company also has Community Reinvestment Act (CRA) investment
commitments outstanding of $774 as of June 30, 2004. The commitments are to be
funded over the next five years.

7

NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
----------------------------------------------------

June 30, 2004

(Dollar amounts in thousands, except share and per share data)

(Unaudited)

Note 3 - Acquisition
- --------------------

On January 5, 2004, the Company acquired the outstanding stock of Round
Lake Bankcorp, Inc., the holding Company for First State Bank of Round Lake
("First State Bank"), for cash in the amount of $21,408 including transaction
costs. Round Lake Bankcorp, Inc. was dissolved through the transaction with
First State Bank remaining as a separate subsidiary of the Company. The results
of First State Bank have been included in the consolidated financial statements
since that date. As a result of the acquisition, the Company has expanded into
the Round Lake area of Lake County, Illinois. The Company expects to merge the
First State Bank into its Bank of Waukegan subsidiary at some point in the
future.

The following table summarizes estimated fair values of the assets acquired
and liabilities assumed at January 5, 2004. The allocation of the purchase price
is subject to refinement.

January 5, 2004
---------------

Cash and cash equivalents $21,042
Securities available for sale 13,810
Loans 70,589
Federal Reserve Bank stock 150
Office buildings and equipment 3,910
Other assets 1,165
Intangible assets 3,246
Goodwill 9,632
------------------
Total assets acquired 123,544

Deposits 99,806
Other liabilities 2,330
------------------
Total liabilities acquired 102,136
------------------
Net assets acquired $21,408
==================

The acquired intangible asset was assigned to core deposits and will be
amortized over 10 years.

Unaudited proforma, consolidated results of operation for the three and
six months ended June 30, 2003 as though First State Bank had been acquired as
of January 1, 2003 are presented below.

Three months Six months
ended ended
June 30, June 30,
2003 2003
------------------------------

Net interest income $5,350 $10,873
Net income 1,638 3,362
Basic and diluted earnings per share 0.38 0.78

8

NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
- -------------------------------------------------------------------
AND RESULTS OF OPERATIONS
- -------------------------

The following discussion focuses on the consolidated financial
condition of Northern States Financial Corporation (the "Company") at June 30,
2004 and the consolidated results of operations for the three and six month
periods ended June 30, 2004, compared with the same period of 2003. The purpose
of this discussion is to provide a better understanding of the condensed
consolidated financial statements of Northern States Financial Corporation and
the operations of its wholly owned subsidiaries, Bank of Waukegan (the "Bank")
and First State Bank of Round Lake ("First State Bank") and the Bank's wholly
owned subsidiary, Northern States Community Development Corporation ("NSCDC").
This discussion should be read in conjunction with the interim condensed
consolidated unaudited financial statements and notes thereto included herein.

Statements contained in this management's discussion and analysis that
are not historical facts may constitute forward-looking statements (within the
meaning of Section 21E of the Securities Exchange Act of 1934, as amended),
which involve significant risks and uncertainties. The Company intends such
forward-looking statements to be covered by the safe harbor provisions for
forward-looking statements contained in the Private Securities Litigation Reform
Act of 1995, and is including this statement for purposes of invoking these safe
harbor provisions. Forward-looking statements, which are based on certain
assumptions and describe future plans, strategies and expectations of the
Company, are generally identifiable by the use of the words "believe," "expect,"
"intend," "anticipate," "estimate," "project," "plan," or similar expressions.
The Company's ability to predict results or the actual effect of future plans or
strategies is inherently uncertain and actual results may differ from those
predicted. The Company undertakes no obligation to update these forward-looking
statements in the future. The Company cautions readers of this report that a
number of important factors could cause the Company's actual results subsequent
to June 30, 2004 to differ materially from those expressed in forward-looking
statements. Factors that could cause actual results to differ from those
predicted and could affect the future prospects of the Company and its
subsidiaries include, but are not limited to, difficulties in integrating the
acquired operations of First State Bank, changes from the estimated purchase
accounting adjustments relating to the acquisition of Round Lake Bankcorp, Inc.,
difficulties in achieving anticipated cost savings related to the operation of
the acquired banking offices or higher than expected costs related to the
transaction, the potential for further deterioration in the credit quality of
the Company's loan and lease portfolio, uncertainty regarding the Company's
ability to ultimately recover on the surety bonds and cash held by the
bankruptcy trustee relating to the equipment lease pools currently on nonaccrual
status, unanticipated changes in interest rates, general economic conditions,
legislative/regulatory changes, monetary and fiscal policies of the U.S.
Government, including policies of the U.S. Treasury and the Federal Reserve
Board, the quality or composition of the Company's loan or securities
portfolios, deposit flows, competition, demand for loan products and financial
services in the Company's market area, and changes in accounting principles,
policies and guidelines. These risks and uncertainties should be considered in
evaluating forward-looking statements.

9

NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------

OVERVIEW
- --------

Records were set at June 30, 2004 for assets, loans and leases and
deposits. Assets reached $794.5 million at June 30, 2004 compared with $689.6
million at December 31, 2003. Loans and leases totaled $440.2 million at June
30, 2004. Deposits, at June 30, 2004, totaled a record $643.5 million. The
growth is primarily attributable to the acquisition of First State Bank that
added $129.8 million in assets, $69.2 million in loans and $105.8 million in
deposits to the Company at June 30, 2004. Book value declined to $16.76 per
share from $17.50 per share at December 31, 2003 as $2.4 million was paid out as
cash dividends during the first half of 2004 and decreases in the market value
of the Company's securities caused the unrealized loss on securities available
for sale to increase $2.7 million during the same period. The decrease in the
market value of securities is from increased market interest rates and not from
credit risk in the portfolio. The Company recorded $12.9 million of goodwill and
other intangible assets resulting from the acquisition of First State Bank in
the first quarter of 2004.

Earnings declined during the second quarter of 2004 and were $.06 per
share (diluted), or $242,000 as compared with $.35 per share (diluted), or
$1,502,000 for the second quarter of 2003, a decline of 83% in earnings per
share. Net income for the six months ended June 30, 2004 was $1,903,000, or $.44
per share (diluted), compared with $2,884,000, or $.67 per share (diluted), for
the same period last year. The decrease in earnings during the quarter ended
June 30, 2004 is primarily attributable to an increase in the provision for loan
and lease losses. The provision for loan and lease losses for the second quarter
of 2004 was $2,300,000 compared to $150,000 for the same quarter last year. Much
of this additional provision was allocated to $11.3 million in nonaccrual lease
pools. (See "Asset Quality and the Provision for Loan Losses" and "Legal
Proceedings.") It is expected that the provision for loan losses will continue
to be greater in 2004 if levels of nonperforming loans and leases remain at
current levels or increase. At June 30, 2004, nonperforming loans and leases
totaled $19,882,000 as compared to $19,650,000 at December 31, 2003.

Noninterest income increased $27,000 during the second quarter of 2004
as compared with the same quarter of 2003. These increases were in part from the
acquisition of First State Bank as the number of accounts increased and service
fee income on deposits grew $61,000 as a result. Mortgage banking income
decreased $71,000 during the three months ended June 30, 2004 as compared with
the same time period last year as home mortgage rate increases in 2004 caused
the volume of mortgage refinancing to slow.

Noninterest expense increased $1,025,000 during the three months ended
June 30, 2004 as compared to the same quarter of 2003, mostly attributable to
the acquisition of First State Bank. The acquisition added 38 additional
employees and two branch offices that increased salary and occupancy and
equipment expenses compared to the same quarter last year. Data processing
expense also increased during the quarter as First State Bank uses a separate
data processing service bureau from the Bank.

CRITICAL ACCOUNTING POLICIES
- ----------------------------

Certain critical accounting policies involve estimates and assumptions
by management. To prepare financial statements in conformity with accounting
principles generally accepted in the United States of America, management makes
estimates and assumptions based on available information. These estimates and
assumptions affect the amounts reported in the financial statements and the
disclosures provided, and future results could differ. The allowance for loan
and lease losses is a critical accounting policy for the Company because
management must make estimates of losses and these estimates are subject to
change.

10

NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------

The allowance for loan and lease losses is a valuation allowance for
probable incurred credit losses, increased by the provision for loan and lease
losses and decreased by charge-offs less recoveries. Management estimates the
allowance balance required using past loan and lease loss experience, the nature
and volume of the portfolio, information about specific borrower situations,
estimated collateral values, economic conditions and other factors. Allocations
of the allowance may be made for specific loans and leases, but the entire
allowance is available for any loan or lease that, based on management's
judgement, should be charged-off.

Management analyzes the adequacy of the allowance for loan and lease
losses at least quarterly. Loans and leases judged to be impaired, with probable
incurred loss exposure, that are no longer accruing interest, and historical net
loss percentages are reviewed in the analysis of the allowance for loan and
lease losses. Factors considered in assessing the adequacy of the allowance
include: changes in the type and volume of the loan and lease portfolio; review
of the larger credits within the subsidiary banks; historical loss experience;
current economic trends and conditions; review of the present value of expected
cash flows or fair value of collateral on impaired loans and leases; growth; and
other factors management deems appropriate. Based on management's analysis, the
allowance for loan and lease losses at June 30, 2004 is adequate to cover
probable incurred credit losses.

One of the components of the allowance for loan losses is historical
loss experience. Different loan classifications within the portfolio have
different loss experience ratios. For example, loans secured by real estate
generally have a better loss experience than loans secured by other assets.
Changes in the classification between periods can impact the allocation for
historical losses. Although loans increased due to the acquisition of First
State Bank during the first quarter of 2004, there was no significant change in
the composition of the loan portfolio.

Management specifically analyzes its nonperforming loans for probable
losses. The change in the volume of nonperforming loans may significantly impact
the amount of estimated losses specifically allocated to these loans depending
on the adequacy of the loan collateral and the borrowers' ability to repay the
loan. As specific allocations are done on a loan-by-loan basis, the amount of
the specific allocation is more likely subject to fluctuation than an allocation
for a pool of loans based on historical loss trends. The specific allocation on
the $11.3 million of nonaccrual lease pools was increased during the second
quarter of 2004. At June 30, 2004, $3.0 million was specifically allocated to
these lease pools. The amount of the allocations on nonperforming loans may
fluctuate in future periods due to changes in conditions of underlying
collateral and changes in the borrowers' ability to repay.

A loan or lease is impaired when full payment under the loan or lease
terms is not expected. Impairment is evaluated on an aggregate basis for
smaller-balance loans of similar nature such as residential mortgage and
consumer loans and on an individual loan or lease basis for other loans and
leases. If a specific loan or lease is determined to be impaired, a portion of
the allowance is allocated so that the loan or lease, net of the allocated
estimated loss, is carried at the present value of estimated cash flows using
the loan's or lease's existing rate or at the fair value of collateral if
repayment is expected solely from the collateral. Loan and lease losses are
charged against the allowance when management believes the uncollectibility of a
loan or lease balance is confirmed.

11

NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------

FINANCIAL CONDITION
- -------------------

The Company's consolidated total assets were $794.5 million at June 30,
2004, increasing $104.9 million from $689.6 million at December 31, 2003. Loans
and leases, at June 30, 2004, increased $82.0 million and totaled $440.2 million
as compared with $358.2 million at December 31, 2003. Deposits also increased
$150.4 million to $643.5 million at June 30, 2004 as compared to $493.1 million
at December 31, 2003. These increases were primarily the result of the First
State Bank acquisition on January 5, 2004. First State Bank added $129.8 million
in assets, $69.2 million in loans and $105.8 million in deposits at June 30,
2004. The Company recorded $12.9 million of goodwill and other intangible assets
as a result of the acquisition.

The Company's federal funds sold at June 30, 2004 decreased $7.2
million to $12.8 million from $20.0 million at December 31, 2003. The Company's
federal funds sold position decreased as the loan portfolio grew during the
first half of 2004. The fair value of securities at June 30, 2004 was $281.5
million, of which $237.0 million were pledged to secure repurchase agreements
and public deposits. At June 30, 2004, the Company has $212.0 million in U.S.
Government agency securities with call options.

Loans and leases increased to $440.2 million at June 30, 2004 from
$358.2 million at December 31, 2003 with the growth primarily due to the
acquisition of First State Bank. The cash flow statement shows that the net cash
outflows for loans and leases made to customers came to $14.1 million during the
first half of 2004. Loan commitments have increased $12.7 million to $99.6
million at June 30, 2004 compared with $86.9 million at December 31, 2003, with
only $7.0 million of the increase attributable to the First State Bank
acquisition. Borrowers have not been drawing on their credit lines due to
uncertainties as to future interest rates and fuel prices.

At June 30, 2004, loans to related parties totaled $4.8 million,
increasing $203,000 from December 31, 2003. Loan commitments to related parties
were $639,000 at June 30, 2004.

During the first six months of 2004, deposits increased by $150.4
million to $643.5 million at June 30, 2004 from $493.1 million at December 31,
2003. A majority of the growth in deposits is attributable to the acquired First
State Bank that had $105.8 million in deposits at June 30, 2004 of which $70.1
million were in core deposits consisting of checking, NOW, money market and
savings accounts. Additional growth in deposits came from brokered time deposits
that increased $39.8 million to $88.7 million at June 30, 2004 compared with
$48.9 million at December 31, 2003. Brokered time deposits of $21.9 million at
June 30, 2004 have remaining maturities of greater than one year. Brokered time
deposits in denominations of $100,000 or more totaled $63.1 million at June 30,
2004. At June 30, 2004, deposits from related parties totaled $14.2 million.

Securities sold under repurchase agreements decreased by $36.9 million
to $46.5 million at June 30, 2004 from $83.4 million at December 31, 2003.
Securities sold under repurchase agreements are offered through either an
overnight repurchase agreement product or a term product with maturities from 7
days to one year. The decrease in repurchase agreements was mainly from the term
product as purchasers of the term product retained their funds for other
business purposes or found higher yielding financial instruments. At June 30,
2004, securities sold under repurchase agreements to related parties totaled
$6.6 million. Borrowings from the Federal Home Loan Bank through term advances
remained at $6.5 million during the first six months of 2004.

12

NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------

Included in other liabilities at June 30, 2004 is $400,000 related to
estimated environmental clean-up expenses, an obligation that was assumed by the
Company in the First State Bank acquisition. If the actual expenses are greater
than $400,000, there may be an adjustment to goodwill. The Company intends to
seek reimbursement of these expenses from the State of Illinois that has a fund
for this type of cleanup. However, there can be no assurance that the Company
will be successful in obtaining any such reimbursement.

CAPITAL
- -------

Total stockholders' equity decreased $3.2 million to $72.2 million
during the six months ended June 30, 2004. The decrease is the result of net
income of $1.9 million, less the adjustment to the market value of securities
available for sale, net of deferred tax, of $2.7 million, less the cash
dividends paid to stockholders of $.55 per share that amounted to $2.4 million.
Book value per share was $16.76 at June 30, 2004 as compared to $17.50 at
December 31, 2003.

The Company's tier 1 capital to total assets ratio at June 30, 2004 was
7.89% and the total capital to assets ratio, on a risk adjusted basis, amounted
to 13.20%. These ratios exceed the minimum required to be considered "well
capitalized" under Federal Reserve regulations, which minimums are 5.00% and
10.00%, respectively. The impact of $12.7 million in goodwill and other
intangible assets associated from the First State Bank transaction caused the
tier 1 capital to assets and total capital to risk adjusted assets ratios to
decline from December 31, 2003, when they had been 11.92% and 17.67%,
respectively. Goodwill and other intangible assets must be deducted from capital
when determining capital for regulatory purposes.

LIQUIDITY
- ---------

Liquidity management involves the ability to meet the cash flow
requirements of customers. The Company needs to have proper cash flow to meet
the requirements of depositors wanting to withdraw funds. Federal funds sold,
interest bearing deposits in banks and available for sale securities,
particularly those of shorter maturities, are principal sources of liquidity.
Federal funds sold at June 30, 2004 were $12.9 million. The Company sells excess
funds overnight to money center banks. The Company classifies all of its
securities as available for sale, which increases the Company's flexibility in
that the Company can sell any of its unpledged securities to meet liquidity
requirements. Securities available for sale had a carrying value of $281.5
million at June 30, 2004, of which $237.0 million were pledged to secure public
deposits and repurchase agreements.

Other sources of liquidity available to the Company for funds are
deposits and borrowings. The Company has used brokered deposits for liquidity
and at June 30, 2004 had $88.7 million in brokered time deposits. To help ensure
the ability to meet its funding needs, including any unexpected strain on
liquidity, the Company has arrangements to purchase $35.0 million in federal
funds from two independent banks. At June 30, 2004 the Company had purchased
$18.0 million of federal funds under these arrangements.

13

NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------

RESULTS OF OPERATIONS
- ---------------------

NET INCOME

Consolidated net income for the quarter ended June 30, 2004 was
$242,000 decreasing $1,260,000 compared with net income of $1,502,000 for the
same quarter the previous year. The annualized return on average assets was .12%
for the quarter, a decrease from a return on average assets for the same quarter
the previous year of .95%. The decrease in earnings is primarily attributable to
increases to the provision for loan and lease losses of $2,150,000 during the
quarter compared with the same period last year. For the six months ended June
30, 2004 consolidated net income was $1,903,000 compared to $2,884,000 for the
same period last year. The annualized return on average assets for the first six
months of 2004 was .48%, decreasing from the return on average assets for the
same period of 2003 of .91%.

NET INTEREST INCOME

Net interest income, the difference between interest income earned on
interest earning assets and interest expense on interest bearing liabilities,
increased $1,026,000 or 23.4% to $5,419,000 during the three months ended June
30, 2004, compared with $4,393,000 for the same period of 2003.

A positive factor that helped to increase net interest income for the
three months ended June 30, 2004 was that rates paid on deposits and borrowings
declined to a greater extent than the yields earned on interest earning assets.
Table 1 shows that the yield on interest earning assets decreased 35 basis
points to 4.22% during the second quarter of 2004 from 4.57% during the same
quarter last year. The rate on interest bearing liabilities decreased to a
greater extent and was 53 basis points lower during the second quarter of 2004
at 1.47% as compared to 2.00% during the second quarter of 2003. The decline in
average rates paid on interest bearing liabilities during the second quarter of
2004 was aided by the influx of lower cost core deposits acquired with First
State Bank. The core deposits of First State Bank averaged $67.8 million during
the quarter.

Another factor that increased net interest income during the first
quarter of 2004 was the growth in interest earning assets resulting from the
acquisition of First State Bank. Average interest earning assets increased
$132.6 million during the second quarter of 2004 as compared with the same
quarter last year, with most of the increase attributable to the acquisition.

For similar reasons, net interest income for the six months ended June
30, 2004 increased $2,144,000 compared to the same period of 2003. Table 2 shows
that yield on interest earning assets declined 39 basis points during the first
half of 2004 compared to the first half of 2003. Table 2 shows that rates paid
on interest bearing liabilities decreased to a greater extent, declining 62
basis points in 2004 compared to the same six months of 2003. The influx of
lower cost core deposits acquired with First State Bank assisted in decreasing
the average rates paid on interest bearing liabilities during the first half of
2004.

14

NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------

TABLE 1

NORTHERN STATES FINANCIAL CORPORATION
ANALYSIS OF AVERAGE BALANCE AND TAX EQUIVALENT RATES
For the Three Months Ended June 30, 2004 and 2003 - Rates are Annualized
($ 000s)

2004 2003
---------------------------- ----------------------------
Average Average
Balance Interest Rate Balance Interest Rate
---------------------------- ----------------------------

Assets
Loans (1)(2)(3) $435,331 $5,754 5.29% $354,382 $5,124 5.78%
Taxable securities(4) 267,360 1,912 2.83% 243,757 1,699 2.81%
Tax advantaged securities(2)(4) 11,485 145 5.08% 8,494 128 6.24%
Federal funds sold 30,625 73 0.95% 5,610 17 1.21%
---------------------------- ----------------------------
Interest earning
assets (4) 744,801 7,884 4.22% 612,243 6,968 4.57%
Noninterest earning assets 49,940 23,097
---------- ----------
Average assets $794,741 $635,340
========== ==========

Liabilities and stockholders' equity
NOW deposits $65,831 $92 0.56% $50,873 $83 0.65%
Money market deposits 65,553 140 0.85% 50,158 144 1.15%
Savings deposits 84,879 155 0.73% 51,650 127 0.98%
Time deposits 367,105 1,747 1.90% 246,027 1,626 2.64%
Other borrowings 67,228 256 1.52% 105,047 542 2.06%
---------------------------- ----------------------------
Total interest bearing
liabilities 650,596 2,390 1.47% 503,755 2,522 2.00%
--------------- ---------------
Demand deposits 61,771 48,368
Other noninterest bearing
liabilities 7,459 6,570
Stockholders' equity 74,915 76,647
---------- ----------
Average liabilities and
Stockholders' equity $794,741 $635,340
========== ==========
Net interest income $5,494 $4,446
========== ==========
Net yield on interest
Earning assets (4) 2.94% 2.91%
======== =======
Interest-bearing
liabilities
to earning assets ratio 87.35% 82.28%
======== =======

(1) Interest income on loans includes loan origination fees of $160 and
$129 for the three months ended June 30, 2004 and 2003.
(2) Tax-exempt income is reflected on a fully tax equivalent basis
utilizing a 34% rate.
(3) Non-accrual loans are included in average loans.
(4) Rate information was calculated on the average amortized cost for
securities. The three months ended June 30, 2004 and 2003 average
balance information includes an average unrealized gain (loss) for
taxable securities of ($3,057) and $1,799 and for tax-advantaged
securities of $66 and $295.

15

NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------

TABLE 2
NORTHERN STATES FINANCIAL CORPORATION
ANALYSIS OF AVERAGE BALANCE AND TAX EQUIVALENT RATES
For the Six Months Ended June 30, 2004 and 2003 - Rates are Annualized
($ 000s)

2004 2003
---------------------------- --------------------------
Average Average
Balance Interest Rate Balance Interest Rate
---------------------------- --------------------------

Assets
Loans (1)(2)(3) $431,686 $11,429 5.30% $356,265 $10,367 5.82%
Taxable securities (4) 261,875 3,830 2.91% 239,058 3,401 2.87%
Tax advantaged securities(2)(4) 11,243 292 5.28% 8,226 253 6.37%
Federal funds sold 35,155 168 0.96% 6,089 36 1.18%
---------------------------- ---------------------------
Interest earning assets (4) 739,959 15,719 4.24% 609,638 14,057 4.63%
Noninterest earning assets 47,368 22,114
---------- ----------
Average assets $787,327 $631,752
========== ==========

Liabilities and
stockholders' equity
NOW deposits $63,495 $ 174 0.55% $50,182 $ 165 0.66%
Money market deposits 66,984 285 0.85% 49,438 318 1.29%
Savings deposits 83,331 305 0.73% 50,280 247 0.98%
Time deposits 355,613 3,378 1.90% 249,387 3,409 2.73%
Other borrowings 72,849 561 1.54% 102,625 1,088 2.12%
---------------------------- ---------------------------
Total interest bearing
liabilities 642,272 4,703 1.46% 501,912 5,227 2.08%
------------------ -----------------
Demand deposits 62,137 47,002
Other noninterest bearing
liabilities 6,813 5,987
Stockholders' equity 76,105 76,851
---------- ----------
Average liabilities and
stockholders' equity $787,327 $631,752
========== ==========
Net interest income $11,016 $ 8,830
========== =========
Net yield on interest
earning assets (4)
2.97% 2.91%
======== ========
Interest-bearing
liabilities
to earning assets ratio
86.80% 82.33
======== ========

(1) Interest income on loans includes loan origination and other fees of
$266 and $215 for the six months ended June 30, 2004 and 2003.
(2) Tax-exempt income is reflected on a fully tax equivalent basis
utilizing a 34% rate.
(3) Non-accrual loans are included in average loans.
(4) Rate information was calculated on the average amortized cost for
securities. The six months ended June 30, 2004 and 2003 average balance
information includes an average unrealized gain (loss) for taxable
securities of ($1,571) and $1,828 and for tax-advantaged securities of
$172 and $285.

16

NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------

ASSET QUALITY AND THE PROVISION FOR LOAN AND LEASE LOSSES

Management, with the concurrence of the Board of Directors, after
carefully reviewing the adequacy of the allowance for loan and lease losses and
the levels of nonperforming and impaired loans and leases, found that a
$2,300,000 provision for loan and lease losses was necessary for the three
months ended June 30, 2004 compared to $150,000 for the same period of 2003. For
the six months ended June 30, 2004 the provision for loan and lease losses was
$2,550,000 compared to $280,000 for the six months ended June 30, 2003. The
increased provision for loan and lease losses during the second quarter of 2004
resulted from the need to allocate a greater amount of the allowance to
nonperforming lease pools totaling $11.3 million that were placed on nonaccrual
status at June 30, 2002. At June 30, 2004, the Company had $3.0 million of its
allowance for loan and lease losses allocated to these lease pools. The lease
pools were purchased in late 2000 and 2001 from Commercial Money Center, a now
bankrupt equipment leasing company, and are secured by equipment and carry
surety bonds that were designed to provide protection against losses from
defaults on these lease pools. The sureties are Illinois Union Insurance
Company, a wholly owned subsidiary of Ace Limited Insurance Company, and RLI
Insurance Company.

During the quarter ended June 30, 2004, the bankruptcy trustee for the
former servicer of the lease pools brought suit against financial institutions
owning the various lease pools, including the Company, in an attempt to make the
financial institutions unsecured creditors. At June 30, 2004, the bankruptcy
trustee was holding $1.3 million of payments on the Company's lease pools that
the Company had previously expected would be paid to the Company by the
bankruptcy trustee. The Company believes that it will prevail against the
bankruptcy trustee and be found to be a secured creditor. Meanwhile, the Company
is continuing its efforts to collect on these leases from the sureties through
litigation. The sureties have asserted certain defenses against having to pay
under the surety bonds. No assurance can be given as to the exact amounts that
will be ultimately collected from the bankruptcy trustee and the sureties.

At June 30, 2004, the allowance for loan and lease losses was
$5,818,000 or 1.32% of loans and leases as compared with $4,383,000 or 1.22% of
total loans and leases at December 31, 2003. The acquisition of First State Bank
on January 5, 2004 included an allowance for loan and lease losses of $805,000.
During the first six months of 2004, $1,933,000 in loans were charged off
through the allowance compared with $352,000 during the same period last year.
Of the $1,933,000 charged off during the first six months of 2004, the Company
had specific loss allocations of $1,765,000 at December 31, 2003. There were
$13,000 in recoveries of loans previously charged off during the first six
months of 2004 compared with $162,000 in recoveries during the same period in
2003.

Nonperforming loans and leases, which includes loans and leases on
nonaccrual status in addition to loans and leases 90 days or more past due and
in the process of collection, were $19.9 million at June 30, 2004 or 4.52% of
total loans and leases. Included as part of the $19.9 million of nonperforming
loans at June 30, 2004 were $19.0 million in loans and leases classified as
nonaccrual and $849,000 in loans and leases 90 days past due and in the process
of collection. Nonperforming loan and leases at December 31, 2003 totaled $19.7
million and were 5.49% of total loans and leases.

In addition to the $11.3 million in lease pools that are nonperforming,
the Company is carrying a $4.3 million loan on nonaccrual status that is for a
90-unit condominium construction project. This loan was classified as nonaccrual
at December 31, 2003. The Company has participated on this construction project
with other financial institutions and only has a portion of the total loan. The
construction project has experienced substantial cost overruns and the principal
borrowers have declared bankruptcy. The participating financial institutions as
a group have begun foreclosure procedures in an attempt to remedy the situation.
At June 30, 2004, the Company has $243,000 of the allowance for loan and lease
losses allocated to this loan.

17

NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------

The Company also has a nonperforming loan totaling $1.5 million that is
secured by a motel. This loan has been classified as nonaccrual since June 30,
2003. The lodging industry has been especially hurt by the aftermath of 9/11 due
to the decline in travel. The Company has $500,000 of the allowance for loan and
lease losses allocated at June 30, 2004 to this loan. At June 30, 2004, the
Company had loans for motels totaling $38.8 million in its loan portfolio that,
other than the $1.5 million discussed above, are not considered as nonperforming
loans.

Impaired loans and leases at June 30, 2004 were $19.8 million,
increasing from $18.2 million at December 31, 2003. The Company considers a loan
or lease impaired if full principal and interest will not be collected under the
contractual terms of the note. Nonaccrual loans and leases are considered
impaired. Impaired loans and leases are carried at the present value of expected
cash flows discounted at the loan's effective interest rate or at the fair value
of the collateral, if the loan or lease is collateral dependent. The amount of
the allowance for loan and lease losses specifically allocated for impaired
loans and leases was $3.9 million at June 30, 2004, increasing from $1.2 million
at December 31, 2003.

Another component of nonperforming assets is other real estate owned,
consisting of assets acquired through loan foreclosure and repossession. The
fair value of other real estate owned is reviewed by management at least
quarterly to help ensure the reasonableness of its carrying value, which is
lower of cost or the fair value less estimated selling costs. At June 30, 2004,
other real estate owned was $4.9 million, increasing $1.2 million from December
31, 2003 as the Company took title to a local office building used to secure
loans to a business that went bankrupt. One major piece of property reported as
other real estate owned is carried at the amount of $1,783,000 and was acquired
by the Bank of Waukegan through the receipt of a deed in lieu of foreclosure in
1987. The parcel consists of approximately 525,000 square feet of land situated
on Lake Michigan in Waukegan, Illinois. During the fourth quarter of 2002, the
Bank formed Northern States Community Development Corporation ("NSCDC") as a
subsidiary of the Bank. NSCDC assets consist of cash and this parcel of other
real estate owned. For purposes of financial reporting NSCDC is consolidated
into the Bank's financial statements and this property is carried by the Company
as other real estate owned. This subsidiary was formed for the purpose of
developing and selling this parcel as part of the City of Waukegan's lakefront
development plans. Proposals under discussion for use of this property include
the building of a minor league baseball park and condominiums. The Company also
has title to two motels, valued together at $1.5 million, that the Company is
actively attempting to sell.

NONINTEREST INCOME

Noninterest income for the three months ended June 30, 2004 was
$1,113,000 as compared to $1,086,000 for the three months ended June 30, 2003,
an increase of $27,000. Service fees on deposits increased $61,000 during the
second quarter of 2004 as a result of a higher number of accounts resulting from
the acquisition of First State Bank. Mortgage banking income declined in the
second quarter of 2004 by $71,000 compared to the same quarter last year as the
level of mortgage banking activity slowed due to an increase in mortgage rates.
Other operating income increased during the quarter by $36,000 with much of the
increase resulting from the First State Bank acquisition.

For the six months ended June 30, 2004, noninterest income was
$2,179,000 as compared to $2,012,000 for the first half of 2003, an increase of
$167,000. The acquisition of First State Bank increased the number of accounts,
and service fees on deposits consequently increased $166,000 during the first
half of 2004 compared to the same period last year. Trust income increased
$59,000 during the six months ended June 30, 2004 compared to the same period of
2003 as the trust area has brought in new customers. The improvement in equity
markets also had a positive impact on trust fee income. Increased home mortgage
rates caused mortgage banking activity to decrease and mortgage banking income
consequently declined $173,000 in the first half of 2004. The First State Bank
acquisition helped to increase other

18

NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------

operating income that was $115,000 greater during the six months ended June 30,
2004 compared to the same period last year.

NONINTEREST EXPENSE

Noninterest expense for the quarter ended June 30, 2004 was $4,075,000,
increasing $1,025,000 from the same quarter last year. The Company's efficiency
ratio, noninterest expense divided by the sum of net interest income and
noninterest income, was 62.39% for the second quarter of 2004 as compared with
55.67% for the same quarter of 2003. Increased noninterest expense due to the
purchase of First State Bank primarily affected this ratio. The Company expects
that its efficiency ratio will continue to be impacted until the two bank
subsidiaries are merged at some point in the future.

Salary and employee benefits were $436,000 greater during the second
quarter of 2004 compared to the same period last year. The acquisition of First
State Bank added 38 employees to the staff of the Company adding to salary
expense. In January 2004, yearly merit increases occurred, also increasing
salary expense compared to 2003.

Occupancy and equipment expense for the second quarter of 2004 was
$151,000 greater than the same quarter of 2003. Two offices were added to the
Company from the First State Bank acquisition and the depreciation and utility
expenses of these branches account for this increase.

Data processing expense increased $205,000 during the three months
ended June 30, 2004 to $379,000 compared to $174,000 last year. First State Bank
uses a separate data processing service bureau than the one used by the Bank of
Waukegan. The Company plans to convert First State Bank to the same data
processing service bureau during the fourth quarter of 2004. This conversion
should reduce some data processing expenses after the conversion takes place. In
April 2004, the Bank of Waukegan outsourced its item processing function to
accommodate new check clearing technologies required to meet new regulations.
Data processing expense increased $49,000 in the second quarter as a result of
the implementation of the new item processing technology. The outsourcing of the
item processing function is expected to continue to contribute to data
processing expense in the future.

Legal expenses decreased $19,000 during the first quarter of 2004
compared to the same time period last year. Most of the legal fees pertain to
litigation involving the nonperforming lease pools. It is expected that similar
levels of legal fees will continue in future periods as litigation in this
matter, including the costs of responding to the complaint filed by the
bankruptcy trustee.

Purchase accounting for financial institutions requires that an
intangible asset be recorded for the acquisition of lower-cost core deposits
such as checking, savings and money market accounts. The core deposit valuation
for the acquisition of First State Bank was $3.2 million and is being amortized
over an estimated life of approximately ten years. During the second quarter of
2004, the related amortization of intangibles was $116,000.

The Company's other operating expenses during the three months ended
June 30, 2004 were $136,000 greater than the same period of 2003. Once again,
the acquisition of First State Bank increased these expenses as compared to the
prior year.

For the six months ended June 30, 2004, noninterest expense was
$7,852,000, increasing $1,850,000 from the same period last year. Noninterest
expense increased during the first half of 2004 primarily due to the acquisition
of First State Bank on January 5, 2004 and the addition of two offices and 38
additional employees.

19

NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------

Salary and employee benefits were $852,000 greater during the first
half of 2004 compared to the same period last year for the same reasons
discussed earlier. The additional employees from the acquisition of First State
Bank added to salary expense as well as annual merit increases.

The two offices gained by the Company through the First State Bank
acquisition caused occupancy and equipment expense to increase $246,000 to
$955,000 during the first half of 2004 compared to $709,000 for the first half
of 2003.

Data processing expense increased $389,000 during the six months ended
June 30, 2004 compared to the same period last year for the same reasons
discussed earlier.

Legal expenses decreased $234,000 to $349,000 for the first six months
of 2004 compared to $583,000 for the same time period last year. Most of the
legal fees pertain to litigation involving the nonperforming lease pools as
discussed earlier. Legal fees during the first half of 2003 were greater than in
2004 as there were higher initial legal fees in early 2003 related to this
litigation.

The Company's other operating expenses during the six months ended June
30, 2004 were $365,000 greater than during the same period of 2003. The
acquisition of First State Bank substantially contributed to the increase in
other operating expenses for the first half of 2004 as compared to last year.

FEDERAL AND STATE INCOME TAXES

For the three months ended June 30, 2004, the Company had an income tax
benefit of $85,000 compared to an income tax expense of $777,000 for the same
three months last year. The tax benefit for the second quarter of 2004 resulted
from lower pre-tax income and interest earned on the Company's U.S. agency
securities portfolio, that had a carrying value of $253.4 million at June 30,
2004, that was not subject to state income taxes.

For the six months ended June 30, 2004 and 2003, the Company's federal
and state income tax expense was $741,000 and $1,569,000, which as a percentage
of pre-tax income was 28.0% and 35.2%. The tax rate for the first half of 2004
was lower as pre-tax income declined substantially and a larger percentage of
pre-tax income was not taxable for state purposes due to the amount of U.S.
agency securities that are carried by the Company.

CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS
- ----------------------------------------------------------

The Company has contractual obligations that may not appear on the
balance sheet. The largest of these obligations are commitments to make loans or
extend credit through stand-by letters of credit. Many of the commitments expire
without being used. The following Table 3 presents the Company's significant
fixed and determinable contractual obligations as of June 30, 2004, by payment
date. The payment amount represents those amounts contractually due to the
recipient and do not include any unamortized premiums or discounts or similar
carrying amount adjustments. The Company does not have any material off-balance
sheet arrangements that have, or are reasonably likely to have, a current or
future effect on its financial condition.

20

NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
-----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------

TABLE 3

NORTHERN STATES FINANCIAL CORPORATION
CONTRACTUAL OBLIGATIONS, COMMITMENTS, CONTINGENT
LIABILITIES AND OFF-BALANCE SHEET ARRANGEMENTS
As of June 30, 2004
($000s)

Greater than
1 year and
less than or
One year or equal to 3 Greater than
less years 3 years Total
----------- ------------- ------------- -------

Long-term debt
Federal Home Loan Bank advance............... $0 $0 $6,500 $6,500
Other contractual obligations
Unused commitments to make loans............. 61,477 11,073 27,074 99,624
Standby letters of credit.................... 5,181 0 0 5,181
Community Reinvestment Act
investment commitment...................... 0 0 774 774
Data processing contracts.................... 1,220 912 480 2,612

21

NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
- ------------------------------------------------------------------

The Company's primary market risk exposure is interest rate risk and,
to a lesser extent, liquidity risk. Interest-rate risk ("IRR") is the exposure
of a banking organization's financial condition to adverse movements in interest
rates. Accepting this risk can be an important source of profitability and
stockholder value, however excessive levels of IRR can pose a significant threat
to the Company's earnings and capital base.

Evaluating a financial institution's exposure to changes in interest
rates includes assessing both the adequacy of the management process used to
control IRR and the organization's quantitative level of exposure. When
assessing the IRR management process, the Company seeks to ensure that
appropriate policies, procedures, management information systems and internal
controls are in place to maintain IRR at prudent levels with consistency and
continuity. Evaluating the quantitative level of IRR exposure requires the
Company to assess the existing and potential future effects of changes in
interest rates on its consolidated financial condition, including capital
adequacy, earnings, liquidity, and, where appropriate, asset quality.

One approach used by management to analyze IRR is to periodically
evaluate the "shock" to the balance sheet of an assumed instantaneous decrease
and increase in rates of 2% using computer simulation to show the effect of rate
changes on the fair value of the Company's financial instruments. This approach
falls under the broad definition of asset/liability management. The Company's
primary asset/liability management technique is the interest rate shock.

Several ways the Company can manage IRR include: selling existing
assets or repaying certain liabilities and matching repricing periods for new
assets and liabilities, for example, by shortening terms of new loans or
securities. Financial institutions are also subject to prepayment risk in
falling rate environments. For example, a debtor may prepay financial assets so
that the debtor may refinance obligations at new, lower rates. Prepayments of
assets carrying higher rates reduce the Company's interest income and overall
asset yields. A large portion of an institution's liabilities may be short term
or due on demand, while most of its assets may be invested in longer-term loans
or securities. Accordingly, the Company seeks to have in place sources of cash
to meet short-term demands. Increasing deposits, borrowing, or selling assets
can obtain these funds.

Table 4 shows how interest rate shocks of decreasing rates 2% and
increasing rates 2% affect the fair value of the Company's financial instruments
at June 30, 2004 and December 31, 2003. The computer simulation model used to do
the interest rate shocks and calculate the effect on the fair value of the
Company's financial instruments takes into consideration maturity and repricing
schedules of the various assets and liabilities as well as call provisions on
the Company's securities. At June 30, 2004 the fair value of securities
available for sale increases $3.3 million when rates are shocked downward 2%
while the fair value decreases $13.6 million for a 2% upwards rate shock. The
change in fair value of securities is smaller when rates are shocked down
because there were call provisions on $188.5 million of the U.S. Government
agency securities at June 30, 2004. At June 30, 2004 the fair value of the
Company's financial asset instruments was $756.1 million compared to the fair
value on the Company's financial asset instruments at December 31, 2003 of
$680.1 million. This increase reflects the financial instruments added to the
Company through the acquisition of First State Bank on January 5, 2004.

22

NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
----------------------------------------------------------

TABLE 4
NORTHERN STATES FINANCIAL CORPORATION
EFFECT OF INTEREST SHOCKS ON FINANCIAL INSTRUMENTS
as of June 30, 2004 and December 31, 2003
($000s)

Fair Value at June 30, 2004
----------------------------------------------
Down 2% Current Up 2%
----------------------------------------------

Assets
Cash and cash equivalents $41,534 $41,532 $41,530
Securities available for sale 284,847 281,541 267,904
Loans and leases 446,530 427,514 409,915
Federal Home Loan Bank and Federal
Reserve Bank stock 2,080 2,080 2,080
Accrued interest receivable 3,409 3,409 3,409

Financial liabilities:
Deposits $645,779 $641,386 $637,466
Securities sold under repurchase agreements
and other short-term borrowings 46,482 46,389 46,296
Federal funds purchased 18,000 18,000 18,000
Federal Home Loan Bank term advance 6,622 6,244 5,888
Advances from borrowers for taxes and
insurance 874 874 874
Accrued interest payable 2,238 2,238 2,238

Fair Value at December 31, 2003
----------------------------------------------
Down 2% Current Up 2%
----------------------------------------------
Assets
Cash and cash equivalents $38,586 $38,584 $38,582
Securities available for sale $284,264 $280,445 $267,427
Loans and leases $370,694 $355,769 $342,007
Federal Home Loan Bank stock $1,871 $1,871 $1,871
Accrued interest receivable $3,429 $3,429 $3,429

Financial liabilities:
Deposits $497,245 $493,555 $490,134
Securities sold under repurchase agreements
and other short-term borrowings $83,573 $83,352 $83,132
Federal funds purchased $26,500 $26,500 $26,500
Federal Home Loan Bank term advance $7,001 $6,542 $6,115
Advances from borrowers for taxes and
insurance $535 $535 $535
Accrued interest payable $2,180 $2,180 $2,180

23

NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------

ITEM 4. CONTROLS AND PROCEDURES
- -------------------------------

As of the end of the period covered by this report, an evaluation was
carried out under the supervision and with the participation of Northern States
Financial Corporation's management, including our Chairman of the Board and
President and Vice President and Treasurer, of the effectiveness of our
disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e)
under the Securities Exchange Act of 1934). Based on and as of the date of their
evaluation, our Chairman of the Board and President and Vice President and
Treasurer have concluded that the Company's disclosure controls and procedures
are, to the best of their knowledge, effective in all material respects, to
ensure that information required to be disclosed by Northern States Financial
Corporation in reports that it files or submits under the Exchange Act is
recorded, processed, summarized and reported within the time periods specified
in Securities and Exchange Commission rules and forms.

PART II. OTHER INFORMATION
- --------------------------

ITEM 1. LEGAL PROCEEDINGS
- --------------------------

On May 5, 2004, the bankruptcy trustee for Commercial Money Center and
its affiliate brought suit in the United States Bankruptcy Court Southern
District of California (San Diego) against financial institutions owning the
various lease pools, including the Company, in an attempt to make the financial
institutions unsecured creditors (Adversary Proceeding 04-90139-JH), alleging,
among other things, that the Bank of Waukegan failed to timely file Form UCC-1
Financing Statements relating to the acquisition of certain rights associated
with individual lease pools and property. The Company believes that it will
prevail against the bankruptcy trustee and be found to be a secured creditor.

At June 30, 2004, the bankruptcy trustee is holding $1.3 million of
payments on the Company's lease pools that the Company had previously expected
would be paid to the Company by the bankruptcy trustee. The Company is
continuing its efforts to collect on these leases from the sureties through
litigation. The sureties have asserted certain defenses against having to pay
under the surety bonds. No assurance can be given as to the exact amounts that
will be ultimately collected from the bankruptcy trustee and the sureties.

ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND
- --------------------------------------------------
ISSUER PURCHASES OF EQUITY SECURITIES
-------------------------------------

None

ITEM 3. DEFAULTS UPON SENIOR SECURITIES
- ----------------------------------------

None

24

NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------

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

The annual meeting of stockholders of Northern States Financial
Corporation was held on May 20, 2004 with the stockholders of record at March
18, 2004 voting in person or by proxy, with one vote for each share owned, to
elect directors for a one year term each and to ratify Crowe Chizek and Company
LLC as independent auditors of the Company for the year ending December 31,
2004. There were 4,305,105 shares of stock as of March 18, 2004 that could be
voted. Crowe Chizek and Company LLC was ratified as the Company's independent
auditors for the year ending December 31, 2003 by a vote of 3,802,822 for
ratification, 5,573 against, and 1,322 abstaining. The following directors were
duly elected.

VOTE FOR VOTES WITHHELD
-------- --------------
Fred Abdula ..................... 3,791,441 18,276
Kenneth W. Balza ................ 3,807,879 1,838
Jack H. Blumberg ................ 3,792,359 17,358
Frank Furlan .................... 3,807,679 2,038
Harry S. Gaples ................. 3,802,494 7,223
James A. Hollensteiner .......... 3,802,499 7,218
Raymond M. Mota ................. 3,762,129 47,588
Helen Rumsa ..................... 3,807,241 2,476
Frank Ryskiewicz ................ 3,807,241 2,476
Henry G. Tewes .................. 3,807,879 1,838

ITEM 5. OTHER INFORMATION
- --------------------------

None

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
- -----------------------------------------

(a) Exhibits.

Exhibit 3.1 Articles of Incorporation of the Company, as amended to
date. (Filed with Company's annual report on Form 10-K for the year
ended December 31, 1994 (Commission File 0-19300) and incorporated
herein by reference.)

Exhibit 3.2 By-Laws of the Company, as amended and restated to date.
(Filed with Company's quarterly report on Form 10-Q for the quarter
ended March 31, 2004 (Commission File 0-19300) and incorporated herein
by reference.)

Exhibit 31.1 Section 302 Certification of Chairman of the Board and
President.

Exhibit 31.2 Section 302 Certification of Vice President and Treasurer.

Exhibit 32.1 Section 906 Certification.

(b) The following current reports on Form 8-K were filed by the Company
with the Securities and Exchange Commission during the quarter ended
June 30, 2004:

(1) Form 8-K (Item 12) filed with the SEC on April 21, 2004.

25

NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
FORM 10-Q
---------
JUNE 30, 2004
-------------

SIGNATURES
----------

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report on Form 10-Q to be signed on its behalf
by the undersigned hereunto duly authorized, on this 16th day of August 2004.

NORTHERN STATES FINANCIAL CORPORATION
(Registrant)

Date: August 16, 2004 By: /s/ Fred Abdula
--------------------------- ----------------------------------
Fred Abdula
Chairman of the Board of
Directors and President

Date: August 16, 2004 By: /s/ Thomas M. Nemeth
--------------------------- ----------------------------------
Thomas M. Nemeth
Vice President and Treasurer

26

NORTHERN STATES FINANCIAL CORPORATION
-------------------------------------
FORM 10-Q
---------
JUNE 30, 2004
-------------

EXHIBIT INDEX
-------------

Exhibits
- --------

Exhibit 3.1 Articles of Incorporation of the Company, as amended to
date. (Filed with Company's annual report on Form 10-K for the year
ended December 31, 1994 Commission File 0-19300 and incorporated here
by reference.)

Exhibit 31.1 Section 302 Certification of Chairman of the Board and
President.

Exhibit 31.2 Section 302 Certification of Vice President and Treasurer.

Exhibit 32.1 Section 906 Certification.

27