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FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

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

For the quarterly period ended September 30, 2003

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

For the transition period from _______ to ________

Commission file number 0-22461

O.A.K. FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)

2445 84th Street, S.W., Byron Center, Michigan 49315
(Address of principal executive offices) (Zip Code)

Registrant's telephone number, including area code: (616) 878-1591

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes      No  X .

The number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 2,040,780 shares of the Corporation’s Common Stock ($1 par value) were outstanding as of November 14, 2003.

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INDEX

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O.A.K. FINANCIAL CORPORATION AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except per share data)

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

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O.A.K. FINANCIAL CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

(Dollars in thousands except per share data)		Three Months and Nine Months ended September 30, 2003 and 2002 (Unaudited)
		Three Months				Nine Months
Interest Income		2003		2002		2003		2002
Interest and fees on loans		$  5,426		$  7,093		$17,625		$21,635
Available-for-sale securities		820		837		2,493		2,513
Restricted investments		37		45		119		133
Federal funds sold		51		31		210		44
Total interest income		6,334		8,006		20,447		24,325
Interest expense
Deposits		1,703		2,558		5,858		7,686
Borrowed funds		443		494		1,329		1,569
Securities sold under agreements to repurchase		101		207		392		527
Total interest expense		2,247		3,259		7,579		9,782
Net interest income		4,087		4,747		12,868		14,543
Provision for loan losses		100		600		625		3,245
Net interest income after provision for loan losses		3,987		4,147		12,243		11,298
Non-interest income
Service charges on deposit accounts		555		475		1,591		1,363
Mortgage production revenue		532		1,021		1,315		1,931
Net gain on sales of available-for-sale securities		3		-		4		81
Insurance premiums and brokerage fees		384		319		1,204		1,041
Other		426		50		640		159
Total non-interest income		1,900		1,865		4,754		4,575
Non-interest expenses
Salaries		2,144		1,725		5,975		5,282
Employee benefits		450		430		1,459		1,361
Occupancy (net)		313		318		950		911
Furniture and fixtures		258		278		815		782
Other		1,078		1,231		3,701		3,625
Total non-interest expenses		4,243		3,982		12,900		11,961
Income before federal income taxes		1,644		2,030		4,097		3,912
Federal income taxes		466		605		1,133		1,056
Net income		$  1,178		$  1,425		$  2,964		$  2,856
Income per common share:
Basic		$  0.58		$  0.70		$  1.46		$  1.40
Diluted		$  0.58		$  0.70		$  1.46		$  1.40
The accompanying notes are an integral part of these consolidated financial statements

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O.A.K. FINANCIAL CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY

(Dollars in thousands)	Nine Months Ended September 30, (Unaudited)
		2003		2002
Shares of common stock issued and outstanding
Balance, beginning of period		2,041		2,041
Common stock issued		-		-
Balance, end of period		2,041		2,041
Common stock
Balance, beginning of period		$   2,041		$   2,041
Common stock issued		-		-
Balance, end of period		2,041		2,041
Additional paid-in-capital
Balance, beginning of period		6,307		6,302
Allocation of ESOP shares		(10	)	(5	)
Balance, end of period		6,297		6,297
Retained earnings
Balance, beginning of period		42,716		40,396
Unallocated ESOP shares		-		6
Cash dividends		(490	)	(976	)
Net income		2,964		2,856
Balance, end of period		45,190		42,283
Accumulated other comprehensive (loss) income
Balance, beginning of period		1,868		916
Other comprehensive income (loss)		(494	)	759
Balance, end of period		1,374		1,675
Unallocated common stock held by ESOP
Balance, beginning of period		(326	)	(373	)
Allocation of ESOP shares		47		47
Balance, end of period		(279	)	(326	)
Total stockholders' equity		$ 54,623		$ 51,970

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

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O.A.K. FINANCIAL CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)	Nine Months Ended September 30, (Unaudited)
		2003		2002
Cash flows from operating activities
Net income		$     2,964		$     2,856
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation and amortization		826		756
Provision for loan losses		625		3,245
Proceeds from sales of loans held for sale		152,425		108,317
Originations of loans held for sale		(153,615	)	(98,318	)
Net gain on sales of available-for-sale securities		(4	)	(81	)
Net gain on sales of loans held for sale		(1,238	)	(959	)
Net amortization of investment premiums		629		300
Loss on sales of property and equipment		6		15
Deferred federal income taxes (benefit)		(191	)	(539	)
Changes in operating assets and liabilities which (used) provided cash:
Accrued interest receivable		317		306
Other assets		(977	)	(1,388	)
Other liabilities		(114	)	(114	)
Net cash (used in) provided by operating activities		1,653		14,396
Cash flows from investing activities
Available-for-sale securities
Proceeds from maturities		14,452		16,779
Proceeds from sales		72		3,599
Purchases		(34,158	)	(21,489	)
Purchases of restricted investments		(52	)	-
Net decrease (increase) in loans held for investment		25,407		(19,288	)
Purchases of premises and equipment		(371	)	(3,661	)
Proceeds from the sale of premises and equipment		2		38
Net cash provided by (used) in investing activities		5,352		(24,022	)
Cash flows from financing activities
Net (decrease) increase in deposits		(33,488	)	31,626
Net (decrease) increase in TT&L note		(370	)	587
Proceeds from FHLB borrowings		-		4,000
Repayments of FHLB borrowings		(1,000	)	(4,000	)
Net other borrowed funds (repayments)		-		(123	)
Net increase (decrease) in securities sold under
agreements to repurchase and fed funds purchased		2,277		(580	)
Dividends paid		(491	)	(976	)
Net cash (used in) provided by financing activities		(33,072	)	30,534
Net (decrease) increase in cash and cash equivalents		(26,067	)	20,908
Cash and cash equivalents, beginning of period		57,004		12,052
Cash and cash equivalents, end of period		$   30,937		$  32,960
Supplementary cash flows information
Interest paid		$     8,007		$   10,010
Income taxes paid		$        843		$     1,232
The accompanying notes are an integral part of these consolidated financial statements.

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O.A.K. FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

Note 1 – Financial Statements

        The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the nine-month period ended September 30, 2003 are not necessarily indicative of the results that may be expected for the year ending December 31, 2003. For further information, refer to the consolidated financial statements and footnotes thereto included in the Corporation’s annual report on Form 10-K for the year ended December 31, 2002.

Note 2 – Earnings per Share (in thousands)

        All earnings per share amounts have been presented to conform to the requirements of Statement of Financial Accounting Standard No. 128, Earnings Per Share (SFAS 128). Basic earnings per share exclude any dilutive effect of stock options. The basic earnings per share for the Corporation is computed by dividing net income by the weighted average number of common shares outstanding. Diluted earnings per share for the Corporation is computed by dividing net income by the sum of the weighted average number of common shares outstanding plus the dilutive effect of outstanding stock options. The following table summarizes the number of shares used in the denominator of the basic and diluted earnings per share computations:

Note 3 – Comprehensive Income (in thousands)

Note 4 – Segment Reporting

        The Corporation provides a broad range of financial products and services through its branch network in West Michigan. While the Corporation’s chief decision makers monitor the revenue streams of various products and services, operations are managed and financial performance is evaluated on a corporate wide basis. Accordingly, all of the Corporation’s operations are considered by Management to be aggregated in one reportable operating segment.

Note 5 – Special Purpose Entities

    O.A.K. ELC is an employee leasing company that leases employees to Byron Center State Bank, O.A.K. Financial Services and Dornbush Insurance Agency. The purpose of O.A.K. ELC is to reduce the administrative burden of multiple payrolls, reduce the payroll tax reporting burden, and facilitate the ability to allocate shared employment cost between business units. The financial results of O.A.K. ELC and elimination of inter-company

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transactions are included in the consolidated results of the corporation.

        Byron Acquisition, LLC, a Michigan limited liability company, was established to hold certain bank property. The purpose of Byron Acquisition, LLC, is to protect the corporation from the potential liability that could arise as a result of the property’s use by a non-consolidated operating entity. The financial results of Byron Acquisition, LLC and elimination of inter-company transactions are included in the consolidated results of the corporation. At September 30, 2003 substantially all of the assets of Byron Acquisition, LLC, had been sold.

Note 6 – Allowance for Loan Losses

        The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings.  Loan losses are charged against the allowance when management believes the uncollectibility of the loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

        The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

        A loan is considered impaired when, based on current information and events, it is probable that the Corporation will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

Note 7 – Interest Rate Risk

        The primary components of the balance sheet are interest-earning assets, which are funded by interest-bearing liabilities. The differences in cash flows of these rate sensitive assets and liabilities, combined with shifts, or changes in the overall market yield curve result in interest rate risk. Interest rate risk is the change in net interest income due to interest rate changes. Interest rate risk is inherent to banking and cannot be eliminated.

        The Asset and Liability Management Committee (ALCO) is responsible for overseeing the financial management of net interest income, liquidity, investment activities, and other related activities. In regard to interest rate risk, management utilizes re-pricing GAP analysis, which is a traditional method of assessing interest rate risk. Recognizing that there is no single measure that absolutely measures current or future risk, management also relies on a simulation analysis to assess risk in dynamic interest rate environments.

Note 8 – Stock Compensation and Stock Option Plans (dollars in thousands, except per share data)

        The Corporation maintains stock option plans for non-employee directors (the Director’s Plan) and employees and officers of the Corporation and its subsidiary (the Employees’ Plan). The stock compensation plans were established in 1999, and authorize the issue of up to 165,000 options under the Employees’ Plan and up to 35,000 options under the Directors’ Plan.

        Options under both plans become exercisable after the first anniversary of the award date. The option exercise price is at least 100% of the market value of the common stock at the grant date. No options have been awarded in 2003. During 2002, 14,747 options were awarded with an exercise price of $44.50 per share.

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The following tables summarize information about stock option transactions:

        All options expire 10 years after the date of the grant; 138,113 shares are reserved for future issuance under the Employee Stock Compensation Plan and 24,000 shares are reserved for future issuance under the Stock Option Plan for non-employee directors.

        Statement of Financial Accounting Standards (SFAS) No. 123, as amended by (SFAS) No. 148, Accounting for Stock-Based Compensation, encourages all entities to adopt a fair value based method of accounting for stock compensation plans, whereby compensation cost is measured at the grant date based on the value of the award and is recognized over the service period, which is usually the vesting period.

        Had compensation costs for the Corporation’s stock option plans been determined based on fair value at the grant dates for awards under the plans consistent with the method prescribed by FASB 123, the Corporation’s net income and earnings per share would have been adjusted to the pro forma amounts indicated below:

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Note 9 – New Accounting Pronouncements

        The Financial Accounting Standards Board (FASB) recently issued two new accounting standards, Statement 149, Amendment on Statement 133 on Derivative Instruments and Hedging Activities, and Statement 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity, both of which generally became effective in the quarter beginning July 1, 2003. Because the Corporation does not currently have any of these instruments, the new accounting standards do not effect the Corporation’s operating results or financial condition.

FORWARD LOOKING STATEMENTS

        This report includes “forward-looking statements” as that term is used in the securities laws. All statements regarding our expected financial position, business and strategies are forward-looking statements. In addition, the words “anticipates,” “believes,” “estimates,” “seeks,” “expects,” “plans,” “intends,” and similar expressions, as they relate to us or our management, are intended to identify forward-looking statements. The presentation and discussion of the provision and allowance for loan losses and statements concerning future profitability or future growth or increases, are examples of inherently forward looking statements in that they involve judgments and statements of belief as to the outcome of future events. Our ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse affect on our operations and our future prospects include, but are not limited to, 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 loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in our market area and accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Further information concerning us and our business, including additional factors that could materially affect our financial results, is included in our other filings with the Securities and Exchange Commission.

Bank Regulatory Matters

        On October 16, 2003, O.A.K. Financial Corporation (the “Corporation”) and Byron Center State Bank (the “Bank”) were released from the Written Agreement, dated October 4, 2002, with the Federal Reserve Bank of Chicago and the Michigan Office of Financial and Insurance Services. The Written Agreement addressed issues including management and asset quality. While the Written Agreement was in effect, the Corporation and the Bank needed prior regulatory approval to pay dividends, add new directors, employ new senior executive officers, and to pay certain severance or related compensation. The Corporation also agreed that, without prior regulatory approval, it would not incur debt or redeem any stock. With the release from the written agreement, the Corporation will no longer have those restrictions.

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS.

        O.A.K. Financial Corporation (the “Corporation”) is a single bank holding company, which owns O.A.K. ELC, which is discussed below under Special Purpose Entities, and Byron Center State Bank (the “Bank”). The Bank has eleven banking offices serving eleven communities in Kent, Ottawa and Allegan Counties. The Bank owns a subsidiary, O.A.K. Financial Services and Byron Acquisition, LLC, which is discussed below under Special Purpose Entities. O.A.K. Financial Services offers mutual fund products, securities brokerage services, retirement planning services, investment management and advisory services. O.A.K. Financial Services in turn owns Dornbush Insurance Agency, which sells property and casualty, life, disability and long-term care insurance products.

        During the third quarter of 2003, the Bank launched Mobile Banking, a courier service in West Michigan that provides convenient, safe, and reliable pick-up and delivery for a variety of items including cash, checks and important bank documents. The Mobile Banking vans are staffed by an experienced Bank employee and a professional armed guard. Deposits are kept secure within a vault inside the van.

        The Bank plans to open a banking office in Jenison during the fourth quarter of 2003. The office was previously a banking office of a competitor that was purchased and significantly remodeled.

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        The following is management’s discussion and analysis of the factors that influenced O.A.K. Financial Corporation’s financial performance. The discussion should be read in conjunction with the Corporation’s 2002 annual report on Form 10-K and the audited financial statements and notes contained therein.

Critical Accounting Policies

        The financial services industry is highly regulated. Furthermore, the nature of the financial services industry is such that, other than described below, the use of estimates and management judgment are not likely to present a material risk to the financial statements. In cases where estimates or management judgment are required, internal controls and processes are established to provide assurance that such estimates and management judgments are materially correct to the best of management’s knowledge.

        Allowance for loan losses — Accounting for loan classifications, accrual status, and determination of the allowance for loan losses is based on regulatory guidance. This guidance includes, but is not limited to, generally accepted accounting principles, the uniform retail credit classification and account management policy issued by the Federal Financial Institutions Examination Council, and the joint policy statement on the allowance for loan losses methodologies, issued by the Federal Financial Institutions Examination Council, Federal Deposit Insurance Corporation, and various other regulatory agencies. Accordingly, the allowance for loan losses includes a reserve calculation based on an evaluation of loans determined to be impaired, risk ratings, historical losses, loans past due, and other subjective factors.

        Commercial loan rating system and identification of impaired loans – The Corporation has a defined risk rating system that is designed to assess the risk of individual loans and overall risk of the commercial loan portfolio. The system assigns a risk weighting to factors such as cash flow, collateral, financial condition, operating performance, repayment history, management, and strength of the industry. An assessment of risk is performed as a part of the loan approval process as well as periodic updates based on the circumstances of the individual loan. The Corporation employs both internal and external loan review services to assess risk ratings.

        Originated mortgage-servicing rights (“OMSR”) — The Corporation records the original “OMSR” based on market data. The “OMSR” is amortized over the shorter of seven years or actual loan repayment of the underlying mortgages. Additionally, an independent third party valuation is performed to determine potential impairment of the “OMSR” as a result of changes in interest rates and expected future loan repayment speeds. Significant changes in interest rates or repayment speeds could have a significant impact of the carrying value of the mortgage servicing assets.

        Accounting for deferred income taxes – The Corporation’s accounting for income taxes involves the valuation of deferred tax assets and liabilities primarily associated with differences in the timing of the recognition of revenues and expenses for financial reporting and tax purposes. Changes in tax laws, changes in tax rates and the Corporation’s future level of earnings can adversely impact the ultimate realization of the Corporation’s net deferred tax asset or liability.

FINANCIAL CONDITION

Summary

        Total assets decreased $31 million, or 5.8% to $507 million from December 31, 2002 to September 30, 2003. The significant changes include a decline in cash and cash equivalents, an increase in available-for-sale securities, a decrease in net loans receivable, and a decrease in total deposits. Cash and cash equivalents declined $26 million, or 46%, of which cash and due from banks declined $6 million and federal funds sold declined $20 million. The decline in federal funds sold was mainly the result of funds being invested into available-for-sale securities to manage interest rate risks. As a result available-for-sale securities increased $18 million, or 23%. Net loans receivable declined $26 million, or 7.1%, of which the commercial loan portfolio decreased $27 million, the consumer loan portfolio decreased $14 million, and the residential real estate portfolio increased $15 million. The decrease in loans is the result of increased competition and steps that management has taken to improve credit quality of the loan portfolio (see “Portfolio Loans”). Deposits decreased $33 million, 8.4% to $364 million from December 31, 2002 to September 30, 2003. Interest-bearing deposits decreased $35 million and non-interest bearing deposits increased $2 million. The significant change in the interest bearing deposits came from a decrease

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in time deposits of $38 million. Time deposits $100,000 or greater decreased $14 million, time deposits under $100,000 decreased $15 million and brokered time deposits decreased $9 million from December 31, 2002 to September 30, 2003. The decrease in deposits is mainly the result of the Bank not having to compete as aggressively for deposits during the past nine months. It is expected that as loan growth resumes, the Bank will compete more aggressively for deposits and deposit growth will resume.

Securities (dollars in thousands)

        The Corporation maintains a diversified securities portfolio, which includes obligations of government sponsored entities, securities issued by states and political subdivisions, corporate securities, and mortgage-backed securities. The Corporation’s investment securities portfolio serves as a source of earnings and contributes to the management of interest rate risk and liquidity risk.

        All of the Corporation’s securities are classified as available-for-sale. The Corporation’s total holdings increased $18 million from December 31, 2002 to September 30, 2003. The increase in the investment portfolio is intended to manage the Bank’s interest rate risk associated with further declines in interest rates. The majority of the securities purchased over the past nine months have been obligations of government sponsored entities and securities issued by state and political subdivisions with maturities or call features of less than 5 years. The modified duration of the portfolio at September 30, 2003 was 3.042, compared to 3.522 at December 31, 2002. See Asset/Liability Gap Position.

        The majority of the securities are pledged to secure borrowed funds from the Federal Home Loan Bank, securities sold under agreements to repurchase and other purposes as required or permitted by law. The Bank generally pledges more securities than required to assure that adequate collateral is available to meet the Bank’s pledging requirement, which changes on a daily basis as a result of customer balances in the repurchase product. Additional liquidity of $25 million at September 30, 2003 and $13 million at December 31, 2002 were available to meet pledging requirements from securities already pledged and from securities, which are not currently pledged.

Portfolio Loans

        The Bank’s largest concentration of loans is to businesses in the form of commercial loans and real estate mortgages. The Bank’s consumer lending activity includes direct consumer loans, indirect consumer loans, home equity loans, unsecured lines of credit and residential real estate loans. In an effort to mitigate the exposure to changes in interest rates, most of the residential real estate loans are sold to the Federal Home Loan Mortgage Corporation (“FHLMC”). However, the Bank retains servicing rights on the majority of such loans sold. At September 30, 2003 and December 31, 2002, the Bank was servicing loans for FHLMC totaling $257 million and $259 million, respectively. Subject to established underwriting criteria, the Bank also participates in commercial lending transactions with certain non-affiliated banks.

        The Bank has taken steps to improve consumer credit quality that will result in a decline in indirect consumer lending. Indirect consumer loans declined $11 million, or 36%, from $31 million at December 31, 2002 to $20 million at September 30, 2003. It is expected that the indirect consumer loan portfolio will continue to shrink throughout the year. Total commercial loans declined $27 million, or 10%, from $259 million at December 31, 2002 to $232 million at September 30, 2003, which includes a $14 million, or 54%, reduction in loans considered to be impaired. The commercial real estate loan portfolio declined $23 million, or 11%, and commercial loans declined $4 million, or 9%, from December 31, 2002 to September 30, 2003. This was the result of increased competition in the local market and steps taken to improve commercial credit quality. The decline in total loans and change in the loan mix will result in a lower yield on total earnings assets. Residential real estate loans increased $15 million, or 24%, from $65 million at December 31, 2002 to $81 million at September 30, 2003. Management expects residential real estate loans to stay at this level for the remainder of the year.

        The improvement in asset quality has resulted in a 7% decline in total loans from December 31, 2002. The decline in total loans was expected as a result of aggressive management of non-performing loans and the exit of the indirect consumer loan business. Loan growth is expected to resume during the fourth quarter of 2003.

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Loan Portfolio Composition (dollars in thousands)

        The lending policy of the Bank was written to reduce credit risk, enhance earnings and guide the lending officers in making credit decisions. The Board of Directors of the Bank approves the loan authority for each lender and has appointed a Chief Lending Officer who is responsible for the supervision of the lending activities of the Bank. The Board has also appointed a loan review officer who monitors the credit quality of the loan portfolio independent of the loan approval process. The loan review officer submits periodic reviews to the Chief Lending Officer and these reviews are submitted to the Audit/Compliance Committee on a quarterly basis. The Bank has no foreign loans and there were no concentrations of loans that reflect any unusual risk concentration, that are not disclosed as a separate category.

        The historically high levels of re-financing activity that occurred during the first half of 2003 has slowed. Future volume will be a function of the economy and the direction of interest rates. For discussion regarding interest rate risk exposure and management of this risk see the “Interest Rate Risk” and “Asset/Liability Gap Position” sections.

Non-performing Assets (dollars in thousands)

        Non-performing assets are comprised of loans for which the accrual of interest has been discontinued, accruing loans 90 days or more past due in payments, collateral for loans and other real estate, which has been acquired primarily through foreclosure and is awaiting disposition. Loans, including loans considered impaired under SFAS 118, are generally placed on a non-accrual basis when principal or interest is past due 90 days or more and when, in the opinion of management, full collection of principal and interest is unlikely.

        Total non-performing assets declined 81% to $1.8 million at September 30, 2003 from $9.3 million at December 31, 2002. The allowance for loan loss is 480% of the total non-performing assets as of September 30, 2003, compared to 90% as of December 31, 2002.

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Allowance for Loan Losses (dollars in thousands)

        The allowance for loan losses represents the Corporation’s estimate of probable credit losses related to specifically identified loans as well as probable credit losses inherent in the remainder of the loan portfolio that have been incurred as of the balance sheet date. The allowance for loan losses is maintained at an adequate level through additions to the provision for loan losses. An appropriate level of the risk allocated allowance is determined based on the application of risk percentages to graded loans by categories. Specific reserves are established for individual loans when deemed necessary by management. In addition, management considers other factors when determining the unallocated allowance, including loan quality, changes in the size and character of the loan portfolio, consultation with regulatory authorities, amount of non-performing loans, delinquency trends and economic conditions and industry trends.

        Inherent risks and uncertainties related to the operation of a financial institution require management to rely on estimates, appraisals and evaluations of loans to prepare the Corporation’s financial statements. Changes in economic conditions and the financial prospects of borrowers may result in abrupt changes to the estimates, appraisals or evaluations used. In addition, if actual circumstances and losses differ substantially from management’s assumptions and estimates, the allowance for loan losses may not be sufficient to absorb all future losses, and net income could be significantly impacted.

        Impaired loans as of September 30, 2003 and December 31, 2002 were $12.0 million and $26.2 million, respectively. The allowance for impaired loans was $2.1 million and $3.1 million as of September 30, 2003 and December 31, 2002, respectively. Non-performing loans totaled $0.2 million at September 30, 2003 compared to $9.3 million at December 31, 2002.

        For the three-month period ended September 30, 2003 versus the same period in 2002, net loans charged off declined 74%. The provision for loan losses charged to operations declined to $0.1 million for the three-month period ended September 30, 2003 versus $0.6 million for the same period in 2002. Net charge offs declined 63% for the nine-month period ended September 30, 2003 versus the same period in 2002. The provision for loan losses charged to operations declined to $0.6 million for the nine-month period ended September 30, 2003 versus $3.2 million for the same period in 2002. The decreased provision for loan losses charged to operations, reflects the decline in the loan portfolio and the probable losses inherent in the portfolio, as well as the significant reductions that have been made to the Bank’s non-performing assets. The majority of loan charge offs, during the first nine months of 2003, are from the commercial loan portfolio and the consumer loan portfolio. Management believes that the allowance for loan losses is adequate for the current level of non-performing assets and the remainder of the loan portfolio.

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Allocation of the Allowance for Loan Losses (dollars in thousands)

        The allowance for loan losses is analyzed quarterly by management. In so doing, management assigns a portion of the allowance to specific credits that have been identified as impaired loans, reviews past loss experience, the local economy and a number of other factors.

        In determining the adequacy of the allowance for loan losses, management determines (i) a specific allocation for loans when a loss is probable, (ii) allocation based on credit risk rating for individual commercial loans, (iii) allocation based principally on historical losses for various categories of loans, and (iv) subjective factors including local and general economic factors and trends. The allowance for loan losses as a percent of total loans reflects managements assessment of a weak, but improving economy; weak labor market, especially in manufacturing, which is an important component of the economy in the Corporation’s market area; and although significantly improved, a continued high level of credits requiring close monitoring by management.

        Asset quality continued to improve in the third quarter. The allowance for loan losses was maintained at approximately $8.4 million. The specific allocation for loans when a loss is probable was reduced and the subjective allocation was increased. Although management expects continued improvement in asset quality the subjective allocation reflects the overall level of asset quality, economic conditions and level of loans requiring close monitoring by management.

        Actual losses experienced in the future, could significantly vary from the estimated allocation of the loan loss reserve. Changes in local and national economic factors could significantly affect the adequacy of the allowance for loan losses. While amounts are allocated to various portfolios as directed by Statement of Financial Accounting Standards No. 114, the entire allowance for loan losses is available to absorb losses from any portfolio segment.

Deposits and borrowed funds (dollars in thousands)

The following table sets forth the deposit balances and the portfolio mix:

        Total deposits decreased $33 million from $397 million at December 31, 2002 to $364 million at September 30, 2003. Non-interest bearing deposits increased $2 million, NOW, MMDA and savings deposits increased $3 million and time deposits decreased $38 million. The decrease in time deposits includes brokered CD’s, which decreased $9 million, time deposits under $100,000, which decreased $15 million and time deposits greater than $100,000, which decreased $14 million. The decline in time deposits reflects the maturity of previously issued certificates of deposit at promotional rates that management opted not to compete for upon maturity. Due to

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an increase in local deposits, that has occurred over the past 12 months and commercial borrowers shifting from fixed rate to floating rate loans, the Bank was able to reduce its use of brokered time deposits. The average cost of funds for brokered deposits is approximately 30 basis points higher than local deposits. Decreasing dependence on brokered deposits should lower the average cost of funds.

        The use of alternative funding sources such as fed funds, brokered certificates and FHLB advances supplement the Bank’s core deposits and also is an integral component of the Bank’s asset/liability management effort. Borrowed funds, from the Federal Home Loan Bank, were $33 million at September 30, 2003, compared to $34 million at December 31, 2002.

Contractual Obligations (dollars in thousands)

        The Corporation’s debt obligations consist entirely of fixed rate advances from the Federal Home Loan Bank that were purchased to fund growth in the loan portfolio.

Capitalization (dollars in thousands)

        The capital of the Corporation consists of common stock, additional paid-in capital, retained earnings and accumulated other comprehensive income. Total stockholders’ equity increased $2 million, or 4 % from December 31, 2002 to September 30, 2003, as the retention of earnings was slightly offset by a change in accumulated other comprehensive income and the distribution of cash dividends.

RESULTS OF OPERATIONS

Summary

        Net income totaled $1.2 million for the three months ended September 30, 2003, compared to $1.4 million for the same period in 2002. This is a 17% decrease from the same period in 2002. The decrease from the comparable period in 2002 is mainly the result of lower net interest income and higher non-interest expense, which were somewhat offset by a reduction in the provision for loan losses charged to operations.

        Net income increased $.1 million or 4% for the nine-month period ended September 30, 2003 to $3.0 million, compared to $2.9 million for the same period in 2002. The increase from the comparable period in 2002 is mainly the result of a reduction in the provision for loan losses charged to operations, interest on non-accrual loans and prepayment penalties on commercial loans, which were offset by lower net interest income and higher non-interest expense.

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Earnings Performance (dollars in thousands, except per share data)

Net Interest Income (dollars in thousands)

        The following schedule presents the average daily balances, interest income on a fully taxable equivalent basis (“FTE”) and interest expense and average rates earned and paid for the Corporation’s major categories of assets, liabilities, and stockholders’ equity for the periods indicated:

        Net interest income is the principal source of income for the Corporation. Net interest income is the difference between the interest earned on loans and investments and the interest paid on deposits and borrowed funds. Tax equivalent net interest income decreased $640,000 to $4,217,000 for the three-month period ended September 30, 2003, a 13% decrease from the same period in 2002, of which $646,000 was due to a decline in interest rate, which was slightly offset by an increase of $6,000 that was due to a change in volume. The yield on total earning assets decreased 131 basis points for the three-month period ended September 30, 2003, compared to the same period in 2002. This compares to an 88 basis point decline in the total interest bearing liabilities cost of funds. Both the net interest spread and net interest margin decreased for the three-month period ended September 30, 2003 compared to the same period in 2002.

        Tax equivalent net interest income decreased $1,673,000 to $13,226,000 for the nine-month period ended September 30, 2003, an 11% decrease from the same period in 2002, of which $438,000 was due to a decline in volume and $1,235,000 was due to a decline in interest rates. The yield on earning assets decreased 112 basis points for the nine-month period ended September 30, 2003, compared to the same period in 2002. This compares to a 72 basis point decline in the total interest bearing liabilities cost of funds. Both the net interest spread and net interest margin decreased for the nine-month period ended September 30, 2003 compared to the same period in 2002.

        The compression of the net interest margin is a result of significant commercial loan refinancing from long-term fixed rates to short-term variable rates, combined with the lowest interest rates in 40 years, which compressed the Corporation’s net interest margin. The non-accrual loan balance as of September 30, 2003 is significantly lower than the balance as of December 31, 2002.

        Management expects continued pressure on the fully taxable-equivalent (FTE) net interest margin, because

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of fierce competition for deposits in its local markets, increased sophistication of funds management by the Corporation’s customers and the low interest rate environment.

Provision for loan losses

        The provision for loan losses charged to earnings declined 83%, to $100,000 for the three-month period ended September 30, 2003, compared to $600,000 for the same period in 2002. The provision for loan losses charged to earnings declined 81% to $625,000 for the nine-month period ended September 30, 2003, compared to $3,245,000 for the same period in 2002. The decrease in the provision primarily reflects improved credit quality, as well as the lower level of outstanding loans.

        Management has taken significant steps to improve underwriting standards and loan administration and has decided to exit the indirect consumer loan business. These changes have improved asset quality despite general economic conditions, which remain weak. Management does not expect any additional loan loss provision during the fourth quarter of 2003.

Non-interest Income (in thousands)

        Non-interest income consists of service charges on deposit accounts, insurance fees, brokerage fees, gains on the sales of investment securities, gains from the sales of mortgage loans and servicing fees on the loans sold with the servicing rights retained. The majority of the mortgage loans, that the Bank originates, are sold to the Federal Home Loan Mortgage Corporation (FHLMC). The Bank retains the servicing rights on the loans sold to FHLMC.

        Non-interest income increased $35,000, or 2%, for the three-month period ended September 30, 2003 versus the same period for 2002. Service charges on deposit accounts increased $80,000, or 17%. The increase was a result of continued growth in the number of new accounts and changes in the service charge structure. The net gain on sales of loans held for sale decreased $141,000, or 13%. The decrease reflects the sale of some mortgages at a loss. It is the Bank’s practice to obtain rate locks on nearly all of the mortgage production that is sold, however, the overwhelming volume of mortgages in the third quarter prevented the Bank from closing all mortgage production within the rate lock time period. At the end of the third quarter the Bank had very few mortgages with expired rate locks. The amortization of mortgage servicing rights increased $380,000, or 187%. The increase is a direct result of the low interest rate environment, which resulted in the significant increase in the mortgage refinance business. Loan servicing fees increased $32,000, or 26%. The increase was the result of the increase in the number of loans that the Bank was servicing for FHLMC. Insurance premiums increased $26,000, or 10%. The increase was a result of continued growth in insurance policies. Brokerage fees increased $39,000, or 67%. The increase in brokerage fees is a result of the brokerage activity being very low during the third quarter of 2002. Other non-interest income increased $376,000, or 852%. The increase in other non-interest income includes a $146,000 gain, net of income taxes, on the sale of other real estate, which was previously a non-performing asset.

        Non-interest income increased $179,000 or 4% for the nine-month period ended September 30, 2003 versus the same period for 2002. Service charges on deposit accounts increased $228,000, or 17%. The increase in service

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charges on deposit accounts was a result of continued growth in the number of new accounts and a change in the service charge structure. The net gain on sale of loans held for sale increased $415,000, or 19%. This was partially offset by a $1,064,000, or 191%, increase in the amortization of mortgage servicing rights and a $75,000 increase on the impairment of mortgage servicing rights. The increase in the net gain on sale of loans held for sale, the amortization of mortgage servicing rights and impairment of mortgage servicing rights is a direct result of a low interest rate environment, which resulted in a significant increase in the mortgage refinance business. Loan servicing fees increased $108,000, or 31%, for the nine-month period ended September 30, 2003, versus the same period in 2002. This increase is the result of the increase in the number of loans that the Bank was servicing for FHLMC. Insurance revenue increased $114,000, or 13%. This increase was a result of profit-sharing revenue and continued growth in insurance policies. Brokerage fees increased $49,000, or 3%. This is a result of the brokerage activity being very low during the first three quarters of 2002. Other non-interest income increased $481,000, or 303%. The increase includes a gain on the sale of other real estate, which was previously a non-performing asset.

Mortgage Loan Activity (dollars in thousands)

        The volume of loans sold is dependant upon the Bank’s ability to originate real estate mortgage loans. Net gains on real estate loans are also dependent upon economic and competitive factors as well as the Bank’s ability to effectively manage exposure to changing interest rates and thus can be a volatile part of the Bank’s overall revenues. Based upon the current economic conditions and interest rate environment, the mortgage refinancing volume is expected to be lower in the fourth quarter.

        Net gains as a percent of real estate mortgage loans sold declined to 1.40% for the three months ended September 30, 2003, compared to 3.47% for the same period in 2002. Net gains as a percent of real estate mortgage loans sold declined to 1.66% for the nine months ended September 30, 2003, compared to 1.99% for the same period in 2002. The decline reflects the sale of some mortgages at a loss, due to the overwhelming volume of mortgages in the third quarter as well as increased competition.

Non-interest Expense (in thousands)

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        Non-interest expense increased $261,000 or 7% for the three-month period ended September 30, 2003, versus the same period in 2002. Salaries and employee benefits increased $439,000 or 20% for the three-month period ended September 30, 2003, versus the same period in 2002. This increase is the result of the addition of several key management positions as well as higher mortgage commissions that were paid in the third quarter due to the high volume of mortgages. Occupancy and equipment expense decreased $25,000 or 4% for the three-month period ended September 30, 2003, compared to the same period in 2002. This decrease is due to a company wide effort to lower total operating expenses. Data processing & software expense increased $40,000, or 16% for the three-month period ended September 30, 2003, versus 2002. The increase is a result of the introduction of internet banking, upgrades to the Bank’s lending software and increasing costs for software support. Printing and supplies expense decreased $19,000 or 16% for the three-month period ended September 30, 2003, compared to 2002. This is the result of a company wide supply ordering and tracking program that was implemented early in 2003. Marketing and other expenses decreased $176,000 or 24% for the three-month period ended September 30, 2003 versus 2002. The decrease is largely due to an organizational emphasis on expense control.

        Non-interest expense increased $939,000 or 8% for the nine-month period ended September 30, 2003, versus the same period in 2002. Salaries increased $693,000 or 13% for the nine-month period ended September 30, 2003, versus the same period in 2002. This increase is the result of the addition of several key management positions as well as higher mortgage commissions due to the high volume of mortgages during the year. The Corporation’s employee benefits expense increased $98,000, or 7% for the nine-month period ended September 30, 2003 versus 2002. The increase reflects rising costs in medical insurance plans, a higher number of medical claims and more employees enrolled in the plan. Occupancy expense increased $39,000 or 4% for the nine-month period ended September 30, 2003, compared to the same period in 2002. The increase is due to higher building repairs and maintenance costs, and higher utilities expense. Equipment expense increased $33,000 or 4% for the nine-month period ended September 30, 2003, compared to 2002. This is the result of higher depreciation expense on equipment that was purchased. Data processing & software expense increased $150,000, or 22% for the nine-month period ended September 30, 2003, versus 2002. The increase is a result of upgrades to the Bank’s lending software and increasing costs for software support. Legal & Professional fees increased $39,000, or 10% for the nine-month period ended September 30, 2003. The increase is a result of professional fees and other consulting expense. Printing and supplies expense decreased $86,000 or 22% for the nine-month period ended September 30, 2003, compared to 2002. This is the result of a company wide supply ordering and tracking program that was implemented early in 2003. Marketing and other expenses declined $27,000 or 1% for the nine-month period ended September 30, 2003 versus 2002. The decrease is largely due to an organizational emphasis on expense control, which was somewhat offset by higher FDIC fees during the first half of the year due to issues discussed under Bank Regulatory Matters. The FDIC fees declined ,from the second quarter of 2003 to the third quarter of 2003, and will continue to be lower for the remainder of the year as a result of an improved regulatory rating.

Provision for Federal Income Tax

        The provision for income taxes was $466,000, which equates to an effective tax rate of 28% for the three-month period ended September 30, 2003, compared to $605,000, which equates to an effective tax rate of 30%, for the same period in 2002. The provision for income taxes was $1,133,000, which equates to an effective tax rate of 28% for the nine-month period ended September 30, 2003 compared to $1,056,000, which equates to an effective tax rate of 27% for the same period in 2002. The difference between the Corporation’s effective tax rate and statutory tax rate is largely due to investment interest income that is exempt from federal taxation. Tax-exempt income, net of nondeductible interest expense totaled $247,000 and $232,000 for the three-month periods ended September 30, 2003 and 2002, respectively. Tax-exempt income, net of non-deductible interest expense totaled $719,000 and $760,000 for the nine-month periods ended September 30, 2003 and 2002, respectively.

Impact of Inflation

        The majority of assets and liabilities of financial institutions are monetary in nature. Generally, changes in interest rates have a more significant impact on earnings of the Corporation than inflation. Although influenced by inflation, changes in rates do not necessarily move in either the same magnitude or direction as changes in the price of goods and services. Inflation does impact the growth of total assets, creating a need to increase equity capital at a higher rate to maintain an adequate equity to assets ratio, which in turn reduces the amount of earnings available for cash dividends.

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LIQUIDITY AND CAPITAL RESOURCES

Capital

        The capital of the Corporation consists of common stock, additional paid-in capital, retained earnings and accumulated other comprehensive income. Total stockholders’ equity increased $2,017,000, from December 31, 2002 to September 30, 2003, which includes a $494,000 decrease of accumulated other comprehensive income.

        There are minimum risk based capital regulatory guidelines placed on the Corporation’s capital by the Federal Reserve Board. The following table sets forth the percentages required under the Risk Based Capital guidelines and the Corporation’s ratios at September 30, 2003:

Capital Resources (dollars in thousands)

Liquidity

        Liquidity management is a significant responsibility of the Asset and Liability Management Committee (ALCO). The objective of liquidity management is to ensure the availability of funds to meet the demands of depositors and borrowers. The primary sources of liquidity include the repayment of customer loans, maturity of and repayment of Corporation investments, deposits, and borrowings. The Bank also has at its disposal the ability to borrow funds from other banks, borrow funds from the Federal Home Loan Bank, and purchase brokered certificates of deposits from outside the Bank’s market area. The use of brokered certificates of deposit decreased by $8.9 million from December 31, 2002 to September 30, 2003.

        Cash and cash equivalents equaled 6% of total assets as of September 30, 2003, and as of September 30, 2002. Net cash provided by operations was $1.6 million for the nine-month period ended September 30, 2003, compared to $14.4 million that was provided by operations for the same period in 2002. The high level of cash provided by operations in 2002 was the result of loan sales. Investing activities provided $5.4 million during the nine-month period ended September 30, 2002, versus $24 million that was used in investing activities during the same period in 2002. The cash flow provided by investing activities in 2003 was the result of a decline in loans held for investment, compared to an increase in loans held for investment in 2002. Financing activities used $33.1 million during the nine-month period ended September 30, 2003, compared to $30.5 million that was provided by financing activities during the same period in 2002. The cash flow used in financing activities in 2003 was the result of a decrease in deposits, compared to an increase in deposits in 2002. The cumulative effect of the Corporation’s operating, investing and financing activities was a $26.1 million decrease in cash and cash equivalents during the nine-month period ended September 30, 2003, compared to a $20.9 million increase in cash and cash equivalents during the same period in 2002. The Corporation’s liquidity is considered adequate by management.

        The Corporation’s primary source of liquidity includes deposit growth, asset sales and ability to borrow funds. At September 30, 2003 the Corporation had unused federal funds borrowing capacity of $27 million as well as access to the brokered deposit market.

        Management expects to utilize, in part, the current liquidity by investing in other interest-earning assets such as loans and securities. Management also expects to utilize some of the current liquidity to reduce brokered deposits and borrowings at the Federal Home Loan Bank. Overall liquidity is significantly determined by deposit and loan growth in addition to borrowing and security investment activity.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

        Derivative financial instruments include futures, forwards, interest rate swaps, option contracts, and other financial instruments with similar characteristics. The Corporation currently does not enter into futures, forwards, swaps, or options. However, the Corporation is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates and may require collateral from the borrower if deemed necessary by the Corporation. Standby letters of credit are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party up to a stipulated amount and with specified terms and conditions.

        Commitments to extend credit and standby letters of credit are not recorded as an asset or liability by the Corporation until the instrument is exercised. The Corporations total outstanding other commercial commitments are listed in the table below:

Other Commercial Commitments

        All of the commercial commitments are underwritten using the Bank’s commercial loan underwriting guidelines.

        The Corporation’s exposure to market risk is reviewed on a regular basis by the Asset and Liability Management Committee (See “Market Risk”). Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to manage the inherent risk while at the same time maximize income. Management realizes certain risks are inherent and that the goal is to identify and minimize the risks. Tools used by management include the standard GAP report and a simulation model. The Corporation has no market risk sensitive instruments held for trading purposes.

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Asset/Liability Gap Position (dollars in thousands)