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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 September 30, 2004

or

[__] Transition Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934

_________________

Commission File #000-30521

Pavilion Bancorp, Inc.
(Exact name of registrant as specified in its charter)

135 East Maumee Street, Adrian, Michigan 49221
(Address of principal executive offices, including Zip Code)

Registrant’s telephone number, including area code: (517) 265-5144, Fax (517) 265-3926

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 periods 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]

As of October 25, 2004, there were 851,447 outstanding shares of the registrant’s common stock, no par value.

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CROSS REFERENCE TABLE

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PART I
FINANCIAL INFORMATION

ITEM 1- FINANCIAL STATEMENTS
(a) CONDENSED CONSOLIDATED BALANCE SHEETS
In thousands of dollars

See accompanying notes to condensed consolidated financial statements.

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PART I
FINANCIAL INFORMATION

(b) CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
(unaudited)
In thousands of dollars, except per share data

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Discontinued operations
Income (loss) from operation of discontinued component				177			(31	)		291			(106	)
Provision (benefit) for income taxes				61			(11	)		101			(36	)
Income from discontinued operation				116			(20	)		190			(70	)
Net income			$	692		$	882		$	2,310		$	2,590
Earnings per share from continuing operations
Basic			$	.68		$	1.11		$	2.51		$	3.25
Diluted			$	.67		$	1.10		$	2.48		$	3.23
Earnings per share from discontinued operations
Basic			$	.14		$	(.02	)	$	.22		$	(.09	)
Diluted			$	.14		$	(.02	)	$	.22		$	(.08	)
Net earnings per share
Basic			$	.82		$	1.09		$	2.73		$	3.16
Diluted			$	.81		$	1.08		$	2.70		$	3.15

See accompanying notes to condensed consolidated financial statements.

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(c) CONDENSED CONSOLIDATED STATEMENTS OFCASH FLOWS
(unaudited)
In thousands of dollars

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(d) NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENT
(unaudited)

NOTE 1 – PRINCIPLES OF CONSOLIDATION AND NATURE OF OPERATIONS

The unaudited condensed consolidated financial statements include the accounts of Pavilion Bancorp, Inc. (the “Company”) and its wholly-owned subsidiaries, Bank of Lenawee (the “Bank”) and Bank of Washtenaw (together with Bank of Lenawee, the “Banks”). The Company consummated sale of the Bank of Washtenaw effective October 29, 2004. Please refer to Note 5 – Discontinued Operations for information regarding activity related to the Bank of Washtenaw. The Bank of Lenawee includes its wholly-owned subsidiaries, Pavilion Financial Services and Pavilion Mortgage Company (the “Mortgage Company”). All significant inter-company balances and transactions have been eliminated in consolidation.

The Bank provides a range of banking services to individuals, commercial businesses, light industries and municipal entities located in its service area. The Bank maintains a diversified loan portfolio with loans to business enterprises for current operations and expansion and loans to individuals for home mortgages, automobiles and personal expenditures. The Bank offers traditional bank deposit products, including checking, savings, money market savings, individual retirement accounts, certificates of deposit as well as a mobile banking courier service.

NOTE 2 — BASIS OF PRESENTATION

The unaudited condensed consolidated financial statements of Pavilion Bancorp, Inc. (the “Company”) have been prepared in accordance with generally accepted accounting principles for interim financial information and the instructions to Form 10-Q and Rule 10-01 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 of normal recurring adjustments) considered necessary for a fair presentation of financial position, results of operations and cash flows, have been included. Operating results for the nine month period ended September 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10 for the year ended December 31, 2003.

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NOTE 3 – ACCOUNTING FOR STOCK-BASED COMPENSATION

Compensation expense under stock options is reported using the intrinsic value method. The exercise price of stock options is generally equivalent to the market price of the underlying common stock as of the date of grant. No stock-based compensation cost is reflected in net income for stock options granted with an exercise price equal to or greater than the market price of the underlying common stock at date of grant. For stock options granted below market price, compensation expense is based upon the difference between the market price and the exercise price at the date of grant and is recorded over the vesting period of the options. Compensation expense actually recognized for the three and nine months ended September 30, 2004 and 2003 was not significant. The following table illustrates the effect on net income and earnings per share had the company applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation as indicated in the pro forma amounts below.

The weighted average fair value of stock options granted during the nine months ended September 30, 2004 and 2003 were $10.15 and $16.69. The fair value of options granted during the nine months ended September 30, 2004 and 2003 were estimated using an option pricing model with the following weighted average information as of the grant dates:

In future years, as additional options are granted, the pro-forma effect on net income and earnings per share may decrease. Stock options are used to reward directors and certain executive officers and provide them with an additional equity interest. Options are issued for ten year periods and have varying vesting schedules.

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NOTE 4 — EARNINGS PER SHARE

Basic earnings per share is calculated by dividing net income by the weighted – average number of common shares outstanding during the period. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued. Potential common shares that may be issued relate to outstanding stock options.

A reconciliation of the numerators and denominators of the basic earnings and diluted earnings per share computations for the three and nine months ended September 30, 2004 and 2003 is presented below in thousands, except for per share information:

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NOTE 5 – DISCONTINUED OPERATIONS

On July 16, 2004 Pavilion Bancorp, Inc. announced that it had signed a definitive agreement to sell the Bank of Washtenaw for $15,000,000. Sale of Bank of Washtenaw was initiated to concentrate the Company’s resources in the Lenawee County market, where the Board of Directors concluded more profit and growth potential exists. In accordance with Financial Accounting Standard 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which became effective for the company on January 1, 2002, the financial position and results of operations of Bank of Washtenaw are removed from the detail line items in the company’s financial statements and presented separately as “discontinued operations.” The sale was completed on October 29, 2004.

A condensed balance sheet and Statement of Operations for Bank of Washtenaw follows (in thousands):

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ITEM 2 — MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This discussion provides information about the consolidated financial condition and results of operations of the Company as of September 30, 2004 and for the three and nine month periods ended September 30, 2004 and 2003.

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, determining the fair value of securities and other financial instruments, the valuation of mortgage servicing rights 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 filings with the Securities and Exchange Commission.

Critical Accounting Policies

Certain of the Company’s accounting policies are important to the portrayal of the Company’s financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Estimates associated with these policies are susceptible to material changes as a result of changes in facts and circumstances. Facts and circumstances which could affect these judgments include, but without limitation, changes in interest rates, in the performance of the economy or in the financial condition of borrowers. Management believes that its critical accounting policies include determining the allowance for loan losses, determining the fair value of securities and other financial instruments and the valuation of mortgage servicing rights.

Allowance for Loan and Lease Losses

The allowance for loan and lease losses is management’s estimate of losses inherent in the Bank’s loan and lease portfolio. Management relies on a number of factors and sources of information in preparing this estimate. These include, but are not limited to, internal credit analyses and loan risk ratings, local economic conditions and trends, regulatory requirements, collateral values, loan types and loan documentation. Accordingly, the allowance for loan and lease losses includes a reserve calculation based on an evaluation of loans determined to be impaired, risk ratings, historical losses, loan types and other subjective factors management may believe to be relevant and/or material.

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Loan Classifications

The Company has established a risk rating system for loans that evaluates a variety of credit quality-related characteristics of each loan being rated. Initial risk ratings for loans are established by the originating (or assigned) lending official. The lending official is responsible for the continuing accuracy of the risk rating and is authorized to downgrade a loan to a lower risk rating if warranted by any information received. Loan risk ratings are also evaluated for accuracy through several processes that are independent of the loan origination process. The Bank retains independent consultants to review the accuracy of loan risk ratings on an annual basis. These results are reported to senior management of the Bank, as well as the Audit Committee and the Board of Directors. Additionally, the Bank’s Chief Credit Officer monitors individual loan risk ratings and overall credit quality through several monitoring systems and reports. The Chief Credit Officer reports directly to the CEO of the Bank and is independent of the loan origination process. Criticized loans have been risk-rated 5 and are individually included on a monthly Loan Watch Report submitted to senior management and the Board of Directors of the Bank. Classified loans have been risk-rated 6, 7 or 8 and are individually included on a monthly Problem Loan Report submitted to senior management and the Board of Directors of the Bank. The Bank’s Loan Policy specifically defines the characteristics of each risk rating as follows:

1 Rating: “Essentially risk free credit. Credit to premier customers having the bank’s highest credit rating based on an extremely strong financial condition, which compares favorably with industry standards (upper quartile of RMA ratios). Secured by readily marketable liquid collateral (traded stocks, bonds, certificates of deposit, savings account, etc.) with comfortable margins. Highly profitable firms that have a track record of always servicing their debts. Possible characteristic of such accounts:

2 Rating: “Low risk. Multiple ‘strong’ sources of repayment. Debt of borrower is modest relative to the borrower’s financial strength and ability to pay. Borrower must be profitable, have a demonstrated track record, very strong cash flow and margins above projected needs. Loan supported by unaudited financial statements containing strong balance sheets and five consecutive years of profits combined with a satisfactory relationship with the Bank. Customer demonstrates the ability to manage the working capital position and term financing requirements. Possessing a sound repayment source (and a secondary source) which definitely will allow repayment in a reasonable period of time. Individual loans backed by liquid personal assets, established history and unquestionable character. Other characteristics:

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3 Rating: “Moderate risk. ‘Good’ primary and secondary sources of repayment. Debt of the borrower is reasonable relative to borrower’s financial strength and ability to pay. Borrower must be profitable, have a demonstrated track record, exhibits sufficient cash flow and margins above projected needs. Borrowers have satisfactory asset quality and liquidity, adequate debt capacity and coverage, and good management in critical positions. Earning statements may reflect a one year loss, but borrowers have sufficient strength and financial flexibility to offset this event. Occasionally has a need for working capital and or term financing. Other characteristics:

4 Rating: “ Acceptable risk. Sufficient primary source of repayment and acceptable secondary source of repayment has either:

5 Rating: “Borderline risk, potential weaknesses. Borrowers who exhibit potential credit weaknesses or downward trends deserving bank management’s attention. If not checked or corrected, these trends will weaken the bank’s asset position. Acceptable primary source of repayment, but less than preferable secondary source of repayment. Credit will have minimal excess cash flow, and financially will be moderately or highly leveraged. A “satisfactory” credit exhibits manageable credit risk with two measurable sources of repayment. Loans may lack technical or legal support, including deficiencies in loan documentation.

6 Rating: “Substandard. A loan with well-defined credit weakness or weaknesses that jeopardize liquidation of the debt. A substandard loan is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. These may be loans that have been restructured so that payment terms and collateral represent major concessions to the borrower when compared to normal loan terms. Also, this category should include those loans with contemplated or pending foreclosure or legal action due to the apparent deterioration in the credit. Loans are characterized by the distinct possibility that a bank will sustain loss if the deficiencies are not corrected. Loss potential, while existing in aggregate amount of substandard assets, does not have to exist in individual assets classified substandard.”

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7 Rating: “Doubtful. A loan with weaknesses inherent to a substandard loan. The loan also has the added provision that the weaknesses make collection of debt in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. The possibility of loss is extremely high, but because of certain known factors which may work to the advantage and strengthening of the asset, (i.e., capital injection, perfecting liens on additional collateral, refinancing plans, etc.) its classification as an estimated loss is deferred until its more exact status may be determined.”

8 Rating: “Loss. Loans classified as Loss are considered uncollectible and of such nominal value that their continuance as bankable assets is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value, but rather it is unpractical or desirable to defer writing-off this basically worthless asset, even though partial recovery may be affected in the future. Losses should be taken in the period in which they surface as uncollectible. Known losses should be in process of charge off.”

Mortgage Servicing Rights (“MSR”)

The Bank records the original MSR based on market data. A periodic independent third party valuation is completed to determine potential impairment of MSR 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 on the carrying value of the MSR asset. Beginning with the third party independent valuation completed as of September 30, 2004, periodic valuations will be completed quarterly. Previously, independent third party valuations were completed twice per year.

Income Taxes

Deferred income tax assets and liabilities are determined using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined based upon the tax effects of the various temporary differences between book and tax bases of the various balance sheet asset and liabilities and gives current recognition to changes in tax rates and laws. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amounts expected to be realized.

Financial Overview

Total assets increased by $17.3 million or 5.45% from December 31, 2003 to September 30, 2004. This increase was primarily the result of an increase in loans outstanding. Total loans, net of the allowance for loan and lease losses, increased by $8.8 million or 4.2% from December 31, 2003 to September 30, 2004. Investment securities available for sale increased $1.7 million or 8% from December 31, 2003 to September 30, 2004. Total deposits increased $13.9 million or 6.9% from December 31, 2003 to September 30. 2004. Borrowed funds decreased $931,000 or 8.9%. Net income from continuing operations for the three months ended September 30, 2004 was $576,000 compared to $902,000 for the same period in 2003. For the nine months ended September 30, 2004, net income from continuing operations was $2.1 million compared to $2.7 million for the same period in 2003. Consolidated net income for the three months ended September 30, 2004 was $692,000 compared to $882,000 for the same period in 2003. Consolidated net income for the nine months ended September 30, 2004 was $2.3 million, compared to $2.6 million for the same period in 2003. Basic earnings per share (“EPS”) from continuing operations and diluted EPS from continuing operations for the three months ended September 30, 2004 were $.68 per share and $.67 per share, respectively. For the same period in 2003 basic and diluted EPS from continuing operations were $1.11 and $1.10, respectively. For the nine months ended September 30, 2004, basic and diluted EPS from continuing operations were $2.51 and $2.48, respectively. For the same period in 2003 basic and diluted EPS from continuing operations were $3.25 and $3.23, respectively.

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FINANCIAL CONDITION

Investments and Fed Funds Sold

Total investments comprising securities available for sale were $22.2 million at September 30, 2004, compared to $20.5 million at December 31, 2003. The increase is attributable to growth in deposits beyond funds required to meet existing loan demand. Investments in the Federal Reserve Bank of Chicago and the Federal Home Loan Bank of Indianapolis remained unchanged at $266,000 and $2.6 million, respectively. The Bank did not have any Fed Funds Sold at September 30, 2004 or December 31, 2003.

Loans and Allowance for Loan and Lease Losses

The following table summarizes the Company’s loan portfolio and loan mix at September 30, 2004 and December 31, 2003:

The Company’s loan portfolio increased 4.7% to $219.7 million at September 30, 2004 from $209.9 million at December 31, 2003. Increases in the consumer loan, agricultural loan and real estate mortgages accounted for the overall increase. The consumer loan portfolio grew by $2.2 million or 7.2% between December 31, 2003 and September 30, 2004 primarily from heightened demand for home equity loans and home equity lines of credit. The agricultural loan portfolio increased $2.5 million or 7.4% between December 31, 2003 and September 30, 2004. Increased demand in response to business development initiatives was the primary source of the increases. Loans held for sale increased moderately, from $433,000 at December 31, 2003 to $1.5 million at September 30, 2004. The outstanding amount of loans held for sale fluctuates based on demand for residential mortgage loans and the timing of receipt of funds from secondary market sources for residential mortgage loans. Overall, demand for residential mortgage loans declined significantly compared to earlier periods as interest rates have increased moderately thus far in 2004. Management anticipates that residential mortgage demand will remain at reduced levels pending any favorable change in interest rates.

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Off-Balance Sheet Items

The following is a summary of outstanding commitments by the Company to grant loans, unfunded commitments under lines of credit and letters of credit at September 30, 2004 and December 31, 2003:

Outstanding commitments to grant loans, lines of credit and letters of credit increased $9.4 million or 16.7% at September 30, 2004 from $56.5 million at December 31, 2003. The increase in such off-balance sheet items is due primarily to increased loan demand coupled with continued business development activities. Included in these totals are commitments to lend on 1-4 family residences. Such loans are generally sold to the secondary market. Management does not expect that all commitments will result in funded loans.

Classified Loans

The following tables present criticized and classified loans of the Company as of September 30, 2004 and December 31, 2003:

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Total criticized and classified assets of the Company decreased 23% from $28.7 million at December 31, 2003 to $22.2 million at September 30, 2004. The largest decrease was noted in loans risk-rated 5, which decreased $10.0 million or 45% from $22.4 million at December 31, 2003 to $12.4 million at September 30, 2004. Other categories of risk ratings, however, registered increases. Specifically, loans risk-rated 6 increased $3.4 million or 54% from $6.3 million at December 31, 2003 to $9.7 million at September 30, 2004. Loans risk-rated 7 increased by $105,000 or 350% over the same period. The majority of the decrease in loans risk-rated 5 was due to continued efforts to closely monitor such loans and work with the respective borrowers to affect corrective action. The Bank’s credit administration function is designed to provide increased information on adversely rated loans to ensure that any increase is identified in as timely a manner as possible. Accordingly, these internal controls were responsible for identifying loans where credit related weaknesses were identified and risk-rated 6. Some of these loans have migrated from a 5 risk rating, thus accounting for an increase in one category of risk rating while total classified assets decreased.

Management continues to closely monitor each loan adversely classified and institute appropriate measures to eliminate the basis of criticism. Please refer to the section entitled “Critical Accounting policies” located with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for the definition of each loan risk rating.

Nonperforming Assets

Nonperforming loans are comprised of loans accounted for on a nonaccrual basis, loans contractually past due 90 days or more as to interest or principal payments but still accruing interest and other nonperforming loans, such as the Bank’s program to purchase commercial accounts receivable from business customers. Our classifications of nonperforming loans are generally consistent with loans identified as impaired.

The following table sets forth information with respect to the Company’s impaired loans at September 30, 2004 and December 31, 2003:

At September 30, 2004 total nonperforming assets decreased $508,000 or 22% from December 31, 2003. The decline is primarily attributable to the Bank’s effort at maintaining overall loan quality and closely monitoring and managing nonperforming loans to determine and implement corrective action to improve the quality of nonperforming assets. The dollar amount in Other Real Estate is the result of several mortgage foreclosure proceedings, however, management does not expect significant losses with respect to the sale of this real estate awaiting disposition.

The consolidated activity in the allowance for loan and lease losses for the three months and nine months ended September 30, 2004 and 2003 is presented in the following table:

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			Three Months Ended September 30,						Nine Months Ended September 30,
			2004			2003			2004			2003
Beginning balance			$	2,358		$	2,236		$	2,302		$	2,100
Loan charge-offs				(27	)		(142	)		(147	)		(396	)
Loan recoveries				2			70			26			113
Net loan charge-offs				25			72			121			256
Provision for loan losses				63			135			215			455
Ending balance			$	2,396		$	2,299		$	2,396		$	2,299

For the three months ended September 30, 2004, net loan charge-offs declined $47,000 or 65% compared to the same period in 2003, falling to $25,000 from $72,000 in 2003. The decrease in net charge-offs was a primary reason for a decline in the provision for loan losses. For the three months ended September 30, 2004 provision for loan losses declined $72,000 or 53% to $63,000 from $135,000 for the same period in 2003. Improved credit quality, together with problem loan workout activities and an improved economy were the primary reasons for the reduced charge-off activity. Activity for the nine months ended September 30, 2004 registered a similar trend. Net loan charge-offs declined $135,000 or 53% to $121,000 for the nine months ended September 30, 2004 from $256,000 for the same period in 2003. Consequently, for the nine months ended September 30, 2004, provision for loan losses declined $240,000 or 53% to $215,000 from $455,000 for the same period in 2003. The reasons for the reduction in net loan charge-offs and provision for loan losses for the nine months ended September 30, 2004 are substantially the same as noted above.

The allowance for loan and lease losses (“allowance”) as a percentage of total loans was 1.09% at September 30, 2004, compared to 1.10% at December 31, 2003.

Management maintains an allowance for loan and lease losses believed to be sufficient to absorb estimated probable credit losses inherent in the loan portfolio, recognizing the imprecision inherent in the process of estimating credit losses. The allowance represents management’s estimate of probable net loan charge-offs in the portfolio at each balance sheet date. The allowance contains provisions for probable losses that have been identified relating to specific borrowing relationships as well as probable losses believed to be inherent in the loan portfolio and loan relationships not specifically identified.

The amount of provisions for loan losses recognized by the Company is based on management’s evaluation as to the amounts required to maintain an allowance adequate to provide for potential losses inherent in the loan portfolio. The level of the allowance is dependent upon the total amount of classified loans, past due and non-performing loans, historical charge-off experience, general economic conditions and management’s assessment of potential losses based upon internal credit evaluation of the loan portfolio and particular loans. In determining the provision for loan losses, management first determines the estimated allowance required for any specifically identified classified loans. Management then estimates potential charge-offs based on historical experience. Management also evaluates the general loan portfolio for credit risk based upon, but not limited to, the criteria noted above, and allocates an amount believed to be sufficient to cover estimated loan charge-offs inherent in the general loan portfolio. Management may then add, at its discretion, an allocation amount to adjust for current economic conditions, any additional perceived credit risk in the portfolio and any other information that management considers relevant. Please refer to Item 4 – Controls and Procedures, subparagraph (b) – Changes in Internal Controls for additional information regarding charges against the Allowance for Loan and Lease Losses related to accounting for unpaid accrued interest receivable.

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Deposits and Borrowed Funds

Total deposits increased $13.9 million, or 6.9%, from $202.4 million at December 31, 2003 to $216.3 million at September 30, 2004. Non-interest-bearing accounts increased $2.8 million or 6.6%, from $42.7 million at December 31, 2003 to $45.5 million at September 30, 2004. Interest-bearing accounts also registered an increase from $159.7 million at December 31, 2003 to $170.8 million at September 30, 2004, for an $11.1 million or a 7% increase. Continued business development efforts represent the primary reason for the rise in overall deposit levels. Though periodic fluctuations occur on a regular basis, management expects to retain and/or increase deposits in the future.

Borrowed funds remained stable, though decreasing moderately, from $10.5 million at December 31, 2003 to $9.5 million at September 30, 2004.

Capital Resources

Actual and certain regulatory minimum capital ratios as of September 30, 2004 and December 31, 2003, are shown in the following table:

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The Company and the Bank continue to maintain sufficient risk-based capital levels to remain categorized as “well-capitalized” under federal regulatory requirements. On a consolidated basis the Company improved its overall risk-based ratios in each measurement. Total risk-based capital (RBC) to risk-weighted assets (RWA) increased from 13.3% at December 31, 2003 to 16.5% at September 30, 2004. Similarly, Tier 1 capital to RWA declined from 12.3% at December 31, 2003 to 15.0% at September 30, 2004. Tier 1 capital to average assets declined from 11.6% to 9.5% for the same respective dates. No significant risk is associated with the decline in the Tier 1 capital to average assets ratio, as it remains well above regulatory requirements. The Company expects all risk-based capital ratios to remain above the “well-capitalized” thresholds.

The Company’s overall capitalization will register a significant increase as a result of the sale of the Bank of Washtenaw. As the Company’s Board of Directors determines the most appropriate form of permanent deployment of this additional capital, overall capitalization may change.

Liquidity

The Company must maintain an adequate liquidity position in order to respond to extensions of credit, the short-term demand for funds caused by withdrawals from deposit accounts, and for payment of operating expenses. Maintaining adequate liquidity is accomplished through management of a combination of liquid assets — those which can be converted into cash — and access to additional sources of funds. Primary liquid assets of the Company are cash and amounts due from banks, federal funds sold, investments held as “available for sale,” and maturing loans. The Company views Federal funds purchased and advances from the Federal Home Loan Bank system as a primary source of immediate liquidity, should the need arise. The Company anticipates renewing selected advances to fund liquidity requirements, as necessary. Maturities in the Company’s loan and investment portfolios are monitored regularly to avoid matching short-term deposits with long-term investments and loans. Other assets and liabilities are also monitored to provide the proper balance between liquidity, safety, and profitability. This monitoring process must be continuous due to the constant flow of cash that is inherent in a financial institution.

At September 30, 2004, the Company held cash and cash equivalents of $3.9 million and $22.2 million of the Company’s investment securities were classified as available for sale. However, available-for-sale securities with a market value of $5.99 million were pledged as collateral for Treasury Tax & Loan accounts and repurchase agreements and therefore were not available for liquidity needs. The amortized cost of the available for sale securities was more than the fair value at quarter-end, primarily as the result of increasing interest rates, which resulted in an unrealized loss within the investment portfolio. This unrealized loss, however, is normal given interest rate changes and does not represent a material risk to capital, in management’s opinion. Management does not believe the sale of any of the Company’s securities would materially affect the overall financial condition of the Company. Management believes it has sufficient liquidity and sources of liquidity to meet its obligations.

On October 29, 2004 with the consummation of the sale of the Bank of Washtenaw, the Company received approximately $15 million in cash. These proceeds will have a significant positive impact on the liquidity of the Company. Proceeds from the sale of Bank of Washtenaw will be invested in marketable investment securities in the short term. The Company’s Board of Directors is considering various options for long-term deployment of these funds.

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Results of Operations

Net Income

Net income from continuing operations decreased $326,000 or 36% for the three months ended September 30, 2004 to $576,000 from $902,000 for the same period in 2003. Similarly, consolidated net income decreased $190,000 or 22% for the three months ended September 30, 2004 to $692,000 from $882,000 for the same period in 2003. The decrease in earnings is primarily attributable to a lower level of residential mortgage-related fee income. Residential mortgage volume has declined as market interest rates have increased. Please refer to section entitled “Loans and Allowance for Loan and Lease Losses” for additional discussion regarding residential mortgage activity.

Net income from continuing operations of $2.1 million for the nine months ended September 30, 2004 was $540,000 or 20% below net income from continuing operations of $2.7 million for the same period in 2003. Consolidated net income of $2.3 million for the nine months ended September 30, 2004 was $280,000 or 11% below consolidated net income of $2.6 million for the same period in 2003. The primary reasons for this decline are the same as noted above.

Net Interest Margin

Following are the net interest margin calculations for the three and nine months ended September 30, 2004 and 2003: