UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, DC 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, 2002 ------------------ 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 No. 0-25766 Community Bank Shares of Indiana, Inc. (Exact name of registrant as specified in its charter) Indiana 35-1938254 ------- ---------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 101 W. Spring Street, New Albany, Indiana 47150 ----------------------------------------- ----- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code 812-944-2224 ------------ Not applicable - -------------------------------------------------------------------------------- Former name, former address and former fiscal year, if changed since last report 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. [X] Yes [ ] No Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). [ ] Yes [X] No APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: 2,402,206 shares of common stock were outstanding as of November 12, 2002. COMMUNITY BANK SHARES OF INDIANA, INC. INDEX Part I Financial Information Page Item 1. Financial Statements Consolidated Balance Sheets 3 Consolidated Statements of Income 4 Consolidated Statements of Changes in Stockholders' Equity 5-6 Consolidated Statements of Cash Flows 7 Notes to Consolidated Financial Statements 8-12 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 13-24 Item 3. Quantitative and Qualitative Disclosures About Market Risk 25-27 Item 4. Controls and Procedures 28 Part II Other Information Item 6. Exhibits and Reports on Form 8-K 29 Signatures 30 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31-32 2 PART I - FINANCIAL INFORMATION COMMUNITY BANK SHARES OF INDIANA, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Unaudited) September 30, December 31, 2002 2001 ---- ---- ASSETS (In thousands, except share data) Cash and due from banks $ 7,338 $ 8,442 Interest bearing deposits in other financial institutions 2,055 2,657 Securities available for sale, at fair value 107,481 99,101 Loans held for sale 1,636 1,401 Loans, net 306,163 294,030 Federal Home Loan Bank stock, at cost 7,689 7,658 Cash surrender value of life insurance 10,370 - Foreclosed real estate 560 560 Premises and equipment, net 11,442 11,216 Accrued interest receivable and other assets 4,345 4,551 --------------------------------------------------- Total Assets $ 459,079 $ 429,616 =================================================== LIABILITIES Deposits $ 298,179 $ 255,892 Short-term borrowings 26,345 39,075 Federal Home Loan Bank advances 88,000 89,000 Accrued interest payable and other liabilities 3,523 3,284 --------------------------------------------------- Total Liabilities 416,047 387,251 --------------------------------------------------- STOCKHOLDERS' EQUITY Preferred stock, without par value; 5,000,000 shares authorized; none issued - - Common stock, $.10 par value per share; 10,000,000 shares authorized; 2,728,298 shares issued; 2,407,306 and 2,475,894 shares outstanding 273 273 Additional paid-in capital 19,533 19,513 Retained earnings 27,068 26,653 Accumulated other comprehensive income (loss) 1,162 (259) Unearned ESOP and performance share awards - 9,096 Shares (13,413 shares at December 31, 2001) (96) (143) Treasury stock, at cost - 311,896 shares (238,691 shares at December 31, 2001) (4,908) (3,672) --------------------------------------------------- Total Stockholders' Equity 43,032 42,365 --------------------------------------------------- Total Liabilities and Stockholders' Equity $ 459,079 $ 429,616 =================================================== See accompanying notes to consolidated financial statements. 3 PART I - FINANCIAL INFORMATION COMMUNITY BANK SHARES OF INDIANA, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Unaudited) Three Months Ended Nine Months Ended September 30, September 30, ------------- ------------- 2002 2001 2002 2001 ---- ---- ---- ---- INTEREST INCOME (In thousands, except per share data) Loans, including fees $4,981 $5,635 $15,210 $17,572 Securities: Taxable 961 1,329 2,904 3,847 Tax exempt 113 113 362 302 Federal Home Loan Bank cash and stock dividends 118 139 344 433 Interest bearing deposits in other financial institutions 72 116 115 395 ------------------------- ------------------------- Total interest income 6,245 7,332 18,935 22,549 ------------------------- ------------------------- INTEREST EXPENSE Deposits 2,005 2,734 5,880 8,680 Federal Home Loan Bank advances 1,319 1,335 4,143 4,000 Short-term borrowings 63 145 237 615 ------------------------- ------------------------- Total interest expense 3,387 4,214 10,260 13,295 Net interest income 2,858 3,118 8,675 9,254 Provision for loan losses 171 89 1,001 440 ------------------------- ------------------------- Net interest income after provision for loan losses 2,687 3,029 7,674 8,814 ------------------------- ------------------------- NON-INTEREST INCOME Service charges on deposit accounts 288 223 720 719 Commission income 65 128 280 502 Gain (loss) on sale of available for sale securities 237 - 357 (18) Net gain on sale of mortgage loans 52 86 377 265 Loan servicing income, net of amortization 26 24 66 78 Increase in cash surrender value of life insurance 142 - 370 - Other 31 27 124 118 ------------------------- ------------------------- Total non-interest income 841 488 2,294 1,664 ------------------------- ------------------------- NON-INTEREST EXPENSE Salaries and employee benefits 1,606 1,379 4,482 3,814 Occupancy and equipment 456 390 1,240 1,071 Data processing 261 225 834 650 Other 564 412 1,511 1,260 ------------------------- ------------------------- Total non-interest expense 2,887 2,406 8,067 6,795 ------------------------- ------------------------- Income before income taxes 641 1,111 1,901 3,683 Income tax expense 139 406 425 1,295 ------------------------- ------------------------- Net Income $ 502 $ 705 $ 1,476 $ 2,388 ========================= ========================= Earnings per share: Basic $ 0.21 $ 0.28 $ 0.60 $ 0.95 ========================= ========================= Diluted $ 0.21 $ 0.28 $ 0.60 $ 0.95 ========================= ========================= See accompanying notes to consolidated financial statements. 4 PART I - FINANCIAL INFORMATION COMMUNITY BANK SHARES OF INDIANA, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (Dollar amounts in thousands, except per share data) (Unaudited) - -------------------------------------------------------------------------------------------------------------------------------------- Unearned Accumulated ESOP Common Additional Other And Total Shares Common Paid-In Retained Comprehensive Performance Treasury Stockholders' Outstanding Stock Capital Earnings Income Shares Stock Equity - -------------------------------------------------------------------------------------------------------------------------------------- Balance, January 1, 2002 2,475,894 $ 273 $ 19,513 $ 26,653 $ (259) $ (143)$ (3,672) $ 42,365 Cash dividends declared on common stock ($0.145 per share) - - - (355) - - - (355) Repurchase common stock (35,037) - - - - - (567) (567) Commitment of shares to be released under the ESOP 1,439 - 8 - - 15 - 23 Stock options exercised 2,000 - (5) - - - 31 26 Comprehensive income: Net income - - - 718 - - - 718 Change in unrealized gain (loss) on securities available for sale, net of tax effects - - - - (106) - - (106) Minimum pension liability, net of tax effects - - - - (2) - - (2) - -------------------------------------------------------------------------------------------------------------------------------------- Total comprehensive income 610 - -------------------------------------------------------------------------------------------------------------------------------------- Balance, March 31, 2002 2,444,296 $ 273 $ 19,516 $ 27,016 $ (367) $ (128)$ (4,208) $ 42,102 ====================================================================================================================================== Cash dividends declared on common stock ($0.145 per share) - - - (358) - - - (358) Repurchase common stock (1,870) - - - - - (32) (32) Commitment of shares to be released under the ESOP 1,439 - 10 - - 15 - 25 Stock options exercised 3,602 - (2) - - - 56 54 Vesting of performance share awards 300 - - - - 2 - 2 Comprehensive income: Net income - - - 256 - - - 256 Change in unrealized gain (loss) on securities available for sale, net of tax effects - - - - 1,151 - - 1,151 Minimum pension liability, net of tax effects - - - - 43 - - 43 - -------------------------------------------------------------------------------------------------------------------------------------- Total comprehensive income 1,450 - -------------------------------------------------------------------------------------------------------------------------------------- Balance, June 30, 2002 2,447,767 $ 273 $ 19,524 $ 26,914 $ 827 $ (111)$ (4,184) $ 43,243 ====================================================================================================================================== 5 PART I - FINANCIAL INFORMATION COMMUNITY BANK SHARES OF INDIANA, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (Dollar amounts in thousands, except per share data) (Unaudited) - -------------------------------------------------------------------------------------------------------------------------------------- Unearned Accumulated ESOP Common Additional Other And Total Shares Common Paid-In Retained Comprehensive Performance Treasury Stockholders' Outstanding Stock Capital Earnings Income Shares Stock Equity - -------------------------------------------------------------------------------------------------------------------------------------- Balance, June 30, 2002 2,447,767 $ 273 $ 19,524 $ 26,914 $ 827 $ (111)$ (4,184) $ 43,243 Cash dividends declared on common stock ($0.145 per share) - - - (348) - - - (348) Repurchase common stock (41,900) - - - - - (724) (724) Commitment of shares to be released under the ESOP 1,439 - 9 - - 15 - 24 Comprehensive income: Net income - - - 502 - - - 502 Change in unrealized gain (loss) on securities available for sale, net of tax effects - - - - 341 - - 341 Change in unrealized gain (loss) on interest rate swap, net of tax effects - - - - 106 - - 106 Minimum pension liability, net of tax effects - - - - (112) - - (112) - -------------------------------------------------------------------------------------------------------------------------------------- Total comprehensive income 837 - -------------------------------------------------------------------------------------------------------------------------------------- Balance, September 30, 2002 2,407,306 $ 273 $ 19,533 $ 27,068 $ 1,162 $ (96)$ (4,908) $ 43,032 ====================================================================================================================================== See accompanying notes to consolidated financial statements. 6 PART I - FINANCIAL INFORMATION COMMUNITY BANK SHARES OF INDIANA, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) Nine Months Ended September 30, 2002 2001 ---- ---- CASH FLOWS FROM OPERATING ACTIVITIES (In thousands) Net income $ 1,476 $ 2,388 Adjustments to reconcile net income to net cash from operating activities: Provision for loan losses 1,001 440 Depreciation expense 735 569 Net amortization of securities 539 161 Loss (gain) on sale of available for sale securities (357) 18 Mortgage loans originated for sale (14,563) (30,255) Proceeds from mortgage loan sales 30,739 29,587 Net gain on sales of mortgage loans (377) (265) Increase in cash surrender value of life insurance (370) - Federal Home Loan Bank stock dividends (31) (45) ESOP and performance share award expense 72 75 Changes in assets and liabilities: Accrued interest receivable and other assets 424 1,468 Accrued interest payable and other liabilities (856) (692) ---------------------------- Net cash from operating activities 18,432 3,449 ---------------------------- CASH FLOWS FROM INVESTING ACTIVITIES Net change in interest bearing deposits with banks 602 (7,149) Activity in available for sale securities: Sales 28,094 2,982 Purchases (48,689) (58,417) Maturities, prepayments and calls 14,149 46,342 Loan originations and payments, net (28,991) 7,625 Purchase of premises and equipment, net (961) (1,041) Investment in cash surrender value of life insurance (10,000) - ---------------------------- Net cash from investing activities (45,796) (9,658) ---------------------------- CASH FLOWS FROM FINANCING ACTIVITIES Net change in deposits 42,287 5,160 Net change in short-term borrowings (12,730) 577 Proceeds from Federal Home Loan Bank advances 11,000 7,000 Repayment of advances from Federal Home Loan Bank (12,000) (9,800) Purchase of treasury stock (1,323) (552) Stock options exercised 87 - Dividends paid (1,061) (1,089) ---------------------------- Net cash from financing activities 26,260 1,296 ---------------------------- Net change in cash and due from banks (1,104) (4,913) Cash and due from banks at beginning of period 8,442 12,805 ---------------------------- Cash and due from banks at end of period $ 7,338 $ 7,892 ============================ Non cash transfers: Transfer from loans to loans held for sale $ 16,034 $ - Transfer from loans to foreclosed real estate $ 145 $ - Transfer from loans to repossessed assets $ 32 $ - See accompanying notes to consolidated financial statements. 7 COMMUNITY BANK SHARES OF INDIANA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. Presentation of Interim Information Community Bank Shares of Indiana, Inc. (the "Company") was incorporated on April 7, 1995. The Company is a multi-bank holding company headquartered in New Albany, Indiana. The Company's wholly owned banking subsidiaries (the "Banks") are Community Bank of Southern Indiana ("Community") and Community Bank of Kentucky ("Community of Kentucky"). During the quarter ended March 31, 2002, a former subsidiary of the Company, Heritage Bank of Southern Indiana, was merged with and into Community. Community and Community of Kentucky are state-chartered stock commercial banks headquartered in New Albany, Indiana and Bardstown, Kentucky, respectively. In the opinion of management, the unaudited consolidated financial statements include all normal adjustments considered necessary to present fairly the financial position as of September 30, 2002, the results of operations for the three and nine months ended September 30, 2002 and 2001, and cash flows for the nine months ended September 30, 2002 and 2001. All of these adjustments are of a normal, recurring nature. Interim results are not necessarily indicative of results for a full year. The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions for Form 10-Q. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. For further information, refer to the consolidated financial statements and footnotes included in the Company's annual report for the year ended December 31, 2001. The consolidated financial statements include the accounts of the Company and the Banks. All material intercompany balances and transactions have been eliminated in consolidation. 8 COMMUNITY BANK SHARES OF INDIANA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 2. Securities The amortized cost and fair value of available for sale securities and the related unrealized holding gains and losses were as follows: Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value ------------------------------------------------------ (in thousands) September 30, 2002: Securities available for sale: U. S. Government and federal agency $14,332 $ 285 $ - $ 14,617 State and municipal 11,827 512 - 12,339 Mortgage-backed 69,483 1,041 - 70,524 Corporate bonds 9,900 104 (3) 10,001 ------------------------------------------------------ Total securities available for sale $ 105,542 $1,942 $ (3) $ 107,481 ====================================================== December 31, 2001: Securities available for sale: U. S. Government and federal agency $27,023 $ 232 $ (166) $ 27,089 State and municipal 10,838 94 (225) 10,707 Mortgage-backed 54,467 327 (440) 54,354 Corporate bonds 6,950 32 (31) 6,951 ------------------------------------------------------ Total securities available for sale $99,278 $ 685 $ (862) $ 99,101 ====================================================== 3. Loans Loans at September 30, 2002 and December 31, 2001 consisted of the following: September 30, 2002 December 31, 2001 --------------------------------------------------- (in thousands) Commercial $ 101,368 $ 94,159 Mortgage loans on real estate: Residential 73,753 81,249 Commercial 67,797 76,754 Construction 27,823 14,506 Home equity 28,622 19,818 Consumer and other 10,327 10,574 --------------------------------------------------- Subtotal 309,690 297,060 Less: Allowance for loan losses (3,527) (3,030) --------------------------------------------------- Loans, net $ 306,163 $ 294,030 =================================================== 9 COMMUNITY BANK SHARES OF INDIANA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 4. Deposits Deposits at September 30, 2002 and December 31, 2001 consisted of the following: September 30, 2002 December 31, 2001 ------------------------------------------------ (in thousands) Demand (NOW) $ 35,920 $ 43,378 Money market accounts 76,893 10,782 Savings 32,801 45,897 Individual retirement accounts 17,193 15,412 Certificates of deposit, $100,000 and over 31,577 39,030 Other certificates of deposit 78,909 81,277 ------------------------------------------------ Total interest bearing deposits 273,293 235,776 Total non-interest bearing deposits 24,886 20,116 ------------------------------------------------ Total deposits $ 298,179 $ 255,892 ================================================ 10 COMMUNITY BANK SHARES OF INDIANA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 5. Supplemental Disclosure for Earnings Per Share Earnings per share were computed as follows: Three months ended Nine months ended In thousands, except for share September 30, September 30, ------------------------------- -------------------------------- and per share amounts 2002 2001 2002 2001 --------------------- -------------- --------------- --------------- --------------- Basic: Earnings: Net income $ 502 $ 705 $ 1,476 $ 2,388 ============== =============== =============== =============== Shares: Weighted average common shares outstanding 2,421,323 2,496,238 2,446,096 2,504,260 ============== =============== =============== =============== Net income per share, basic $ 0.21 $ 0.28 $ 0.60 $ 0.95 ============== =============== =============== =============== Diluted: Earnings: Net income $ 502 $ 705 $ 1,476 $ 2,388 ============== =============== =============== =============== Shares: ------ Weighted average Common shares outstanding 2,421,323 2,496,238 2,446,096 2,504,260 Add: Dilutive effect of outstanding options 16,187 8,376 17,337 495 -------------- --------------- --------------- --------------- Weighted average common shares outstanding, as adjusted 2,437,510 2,504,614 2,463,433 2,504,755 ============== =============== =============== =============== Net income per share, diluted $ 0.21 $ 0.28 $ 0.60 $ 0.95 ============== =============== =============== =============== Stock options for 70,700 and 103,400 shares of common stock were excluded from the three months ended September 30, 2002 and September 30, 2001 diluted net income per share, respectively, because their impact was antidilutive. Stock options for 70,700 and 135,817 shares of common stock were excluded from the nine months ended September 30, 2002 and September 30, 2001 diluted net income per share, respectively, because their impact was antidilutive. 11 COMMUNITY BANK SHARES OF INDIANA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 6. Derivative Financial Instruments and Hedging Activities The Company uses derivative financial instruments for the purpose of hedging the risks of future cash flows caused by movements in interest rates. The Company uses derivatives only for the purpose of hedging such risks, not for speculation. The Company entered into a hedging relationship such that the change in cash flows of items and transactions being hedged are expected to be offset by corresponding changes in the values of the derivatives. At September 30, 2002, a hedging relationship existed for $25.0 million in floating rate commercial loans. During 2002, the hedge was highly effective, thus changes in the fair value of the swap are reported in other comprehensive income and will be reclassified to earnings over the life of the hedge. Following is an analysis of the changes in the net gain on cash flow hedges included in accumulated other comprehensive income, net of tax: September 30, December 31, 2002 2001 ------------------------------------------------ (in thousands) Beginning balance $ - $ - - - Net gain for the year 128 - Transferred to earnings (22) - ------------------------------------------------ Ending balance $ 106 $ - ================================================ 12 PART I - ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS COMMUNITY BANK SHARES OF INDIANA, INC. AND SUBSIDIARIES Safe Harbor Statement for Forward-Looking Statements This report may contain forward-looking statements within the meaning of the federal securities laws. These statements are not historical facts but rather statements based on the Company's current expectations regarding its business strategies and their intended results and its future performance. Forward-looking statements are preceded by terms such as "expects," "believes," "anticipates," "intends" and similar expressions. Forward-looking statements are not guarantees of future performance. Numerous risks and uncertainties could cause or contribute to the Company's actual results, performance and achievements to be materially different from those expressed or implied by the forward-looking statements. Factors that may cause or contribute to these differences include, without limitation, general economic conditions, including changes in market interest rates and changes in monetary and fiscal policies of the federal government; legislative and regulatory changes; competitive conditions in the banking markets served by the Banks; the adequacy of the allowance for losses on loans and the level of future provisions for losses on loans; and other factors disclosed periodically in the Company's filings with the Securities and Exchange Commission. Because of the risks and uncertainties inherent in forward-looking statements, readers are cautioned not to place undue reliance on them, whether included in this report or made elsewhere from time to time by the Company or on its behalf. The Company assumes no obligation to update any forward-looking statements. Financial Condition Total assets increased 6.9% to $459.1 million at September 30, 2002 from $429.6 million at December 31, 2001, primarily a result of increases in net loans receivable of $12.1 million, securities available for sale of $8.4 million and other assets of $10.2 million. Funding was provided by total liabilities, which increased by $28.8 million from December 31, 2001, primarily a result of increases in deposits of $42.3 million offset by reductions in short term borrowings of $12.7 million. Total equity increased $667,000 from December 31, 2001, primarily as a result of increases in unrealized gains on securities and retained earnings, offset by treasury stock purchases and dividends to shareholders. Loans receivable, net, were $306.2 million at September 30, 2002 as compared to $294.0 million at December 31, 2001, an increase of 4.1%. This increase was primarily the result of increases in commercial business loans of $7.2 million, construction real estate loans of $13.3 million, and home equity lines of credit of $8.8 million as the Company continued to emphasize lending in these areas. Commercial mortgage loans decreased $9.0 million to $67.8 at September 30, 2002 from $76.8 million at December 31, 2001 because of principal payments on loans in this category that exceeded the dollar volume of new loans. In addition, the balance of residential mortgage loans declined by $7.5 million because of increases in mortgage loans sold and increased refinancing activity. The Company currently retains fifteen-year mortgage loans that it originates and sells substantially all thirty-year conforming mortgage loans into the secondary market to reduce the interest rate risk of holding such assets should interest rates rise. 13 PART I - ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS COMMUNITY BANK SHARES OF INDIANA, INC. AND SUBSIDIARIES Securities available for sale increased 8.5% from $99.1 million at December 31, 2001 to $107.5 million at September 30, 2002 as management worked to reduce liquidity on hand by investing cash inflows from loan repayments and net increases in total deposits. Additionally, $27.8 million in securities have been sold during 2002 to take advantage of $357,000 in market gains. During the first quarter of 2002 the Company invested $10.0 million in cash surrender value of life insurance on key employees to offset existing employee benefits. The increase in cash surrender value of life insurance is not taxable for state or federal income tax purposes, resulting in a higher yield than alternative investment opportunities. Total deposits increased from $255.9 million at December 31, 2001 to $298.2 million at September 30, 2002, an increase of 16.5%. Growth in deposits over the last nine months occurred primarily in money market accounts, which management attributes primarily to its competitive pricing. The Company priced its money market accounts near the top of the range of rates within its market area over the first six months of 2002. The Company lowered its money market rate closer to the market average at the end of the third quarter of 2002; consequently, the rate of growth in these accounts slowed at the end of the third quarter. The Company expects that it will not experience significant growth in money market accounts over the next year as it plans on maintaining its interest rate on these accounts closer to the market average. The Company continues to focus on non-interest demand deposits as a way to reduce its borrowing costs. Non-interest bearing deposits increased $4.8 million to $24.9 million at September 30, 2002 from $20.1 million at December 31, 2001, an increase of 23.9%. The Company is opening non-interest deposit accounts at a faster rate than in past years, but these accounts generally have low average balances and a large number of such accounts is required to substantially affect the total outstanding balance of such accounts. Total certificates of deposit declined $9.8 million for the nine months ended September 30, 2002 as the Company focused on the opening of lower-cost transaction accounts. Results of Operations Net Income. Net income was $502,000 ($0.21 per share diluted) for the three months ended September 30, 2002 compared to $705,000 ($0.28 per share diluted) for the three months ended September 30, 2001. Return on average assets was 0.44% for the three months ended September 30, 2002 as compared to 0.66% for the same period in 2001. Return on average equity was 4.74% for the third quarter of 2002 as compared to 6.46% for the same quarter in 2001. Net income, earnings per share, return on average assets, and return on average equity all decreased for the three months ended September 30, 2002 as compared to the same period in 2001 primarily because of (i) increases in non-interest expense and the provision for loan losses and (ii) a decrease in net interest income. Partially offsetting these items were increased non-interest income and a reduced effective income tax rate. Return on average equity was favorably affected by the repurchase of the Company's common stock; average treasury stock was $4.6 million for the three months ended September 30, 2002 as compared to $3.3 million for the same period in 2001. 14 PART I - ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS COMMUNITY BANK SHARES OF INDIANA, INC. AND SUBSIDIARIES Net income was $1,476,000 ($0.60 per share diluted) for the nine months ended September 30, 2002 compared to $2,388,000 ($0.95 per share diluted) for the nine months ended September 30, 2001. Return on average assets was 0.44% for the nine months ended September 30, 2002 as compared to 0.77% for the same period in 2001. Return on average equity was 4.59% for the nine months ended September 30, 2002 as compared to 7.50% for the same period in 2001. Net income, earnings per share, return on average assets, and return on average equity all declined due to the same factors that affected results for the third quarter of 2002. Return on average equity was favorably affected by the repurchase of the Company's common stock; average treasury stock was $4.2 million for the nine months ended September 30, 2002 as compared to $3.1 million for the same period in 2001. The Company does not expect net income for the fourth quarter of 2002 to vary significantly from net income of $567,000 for the same period in 2001. In response to the decline in the prime interest rate of 0.5% in early November 2002, the Company anticipates that its net interest margin will continue to decline over the period due to the asset sensitivity of the Company's balance sheet (See Part I - Item 3, Quantitative and Qualitative Disclosures about Market Risk, for a more detailed discussion of the Company's exposure to fluctuations in interest rates). The Company's net interest margin is depressed due to the rapid decline in interest rates during 2001; the Company does not expect that its net interest margin will improve dramatically over the next year. 15 PART I - ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS COMMUNITY BANK SHARES OF INDIANA, INC. AND SUBSIDIARIES Net interest income. Net interest income decreased $260,000 from $3.1 million for the third quarter of 2001 to $2.9 million for the third quarter of 2002, primarily because of the rapid decline in market interest rates during 2001 and the high cost associated with the Company's long-term Federal Home Loan Bank advances. The yield on interest-earning assets decreased to 5.81% for the third quarter of 2002 from 7.25% for the same quarter in 2001. The cost of interest-bearing liabilities decreased to 3.45% from 4.68% over the same period. As a result, net interest margin declined to 2.66% for the third quarter of 2002 from 3.08% for the same period in 2001. Partially offsetting the decline in net interest margin was an increase in average interest-earning assets to $426.7 million for the third quarter of 2002 from $401.5 million for the same quarter in 2001. Net interest income decreased $579,000 from $9.3 million for the nine months ended September 30, 2001 to $8.7 million for the same period in 2002 because of the same factors outlined above with respect to the third quarter of 2002. As a result, net interest margin declined to 2.79% for the first nine months of 2002 compared with 3.13% for the same period in 2001. Partially offsetting the decline in net interest margin was an increase in average interest-earning assets to $416.3 million for the first nine months of 2002 from $395.2 million for the same period in 2001. The yield on interest-earning assets decreased to 6.08% for the first nine months of 2002 from 7.63% for the same period in 2001. The cost of interest-bearing liabilities decreased to 3.62% from 5.08% over the same period. The reasons for the decline in net interest margin for both the three and nine-month periods ended September 30, 2002 were substantially the same. The yield on interest-earning assets declined faster than the cost of interest-bearing liabilities because the volume of assets repricing over the last year exceeded the volume of liabilities repricing over the same period. Additionally, various asset and liability concentrations have contributed to the decline in net interest margin. At December 31, 2000, the Company owned approximately $53.6 million in callable agency securities, which is a type of security that can be called by the issuer as of a specific date(s) when it is in the issuer's interest to do so. Generally, issuers of these securities will exercise the call as market interest rates for securities with similar characteristics fall below the coupon on a given issue. Consequently, most of the callable agency securities owned by the Company as of December 31, 2000 were called during 2001 as market interest rates declined. The Company reinvested the proceeds from such called securities at substantially lower interest rates, resulting in a decline in the Company's net interest margin over 2001 that has persisted into 2002. 16 PART I - ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS COMMUNITY BANK SHARES OF INDIANA, INC. AND SUBSIDIARIES The cost of interest-bearing liabilities has been significantly affected by the $88.0 million in funding provided by Federal Home Loan Bank (FHLB) advances, which principally consist of putable (or convertible) instruments that give the FHLB the option at the conversion date (and quarterly thereafter) to put an advance back to the Banks. If an advance is put back to the Banks by the FHLB, the Banks can choose to prepay the advance without penalty or allow the interest rate on the advance to adjust to three-month LIBOR (London Interbank Offer Rate) at the conversion date (and adjusted quarterly thereafter). The Company estimates that three-month LIBOR would have to rise in excess of 300 basis points before the FHLB would exercise its option on any of the individual advances. The cost of FHLB advances for the third quarter of 2002 was 5.93%, only 2 basis points less than the same period in 2001. The cost of FHLB advances for the nine months ended September 30, 2002 was 5.88%, only 11 basis points less than the same period in 2001. In contrast, the cost of federal funds purchased and repurchase agreements, which are both highly interest sensitive, fell to 1.04% and 1.15% for the three and nine months ended September 30, 2002, respectively, from 2.74% and 2.92% for the same periods in 2001. The Company will continue to explore strategies to improve its net interest margin and reduce the exposure to changing interest rates. To this end, the Company is employing a financial derivative called an interest rate swap to hedge the cash flows on floating-rate commercial loans against possible future declines in interest rates. An interest rate swap is a financial instrument that derives its cash flows, and therefore its value, by reference to underlying interest rate indexes. The Company entered into a five year interest rate swap agreement on August 30, 2002 in an effort to mitigate the risks associated with an asset-sensitive balance sheet and to manage interest margins in periods of decreasing interest rates. Derivative contracts are written in amounts referred to as notional amounts, which only provide the basis for calculating payments between counterparties and do no represent amounts to be exchanged between parties or a measure of financial risk. On September 30, 2002, the Company had financial derivative instruments outstanding with notional amounts totaling $25 million and an estimated fair value of $185,000 reported in other assets and as a component of other comprehensive income, net of tax. In connection with the interest rate swap, the Company recorded additional interest income on loans of $39,000 during the third quarter of 2002. 17 PART I - ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS COMMUNITY BANK SHARES OF INDIANA, INC. AND SUBSIDIARIES Average Balance Sheets. The following tables set forth certain information relating to the Company's average balance sheets and reflects the average yields earned and rates paid. Such yields and costs are derived by dividing income or expense by the average balance of assets or liabilities, respectively, for the periods presented. Average balances are computed on daily average balances, when available. Management does not believe that the use of month-end balances instead of daily average balances has caused any material difference in the information presented. Three Months Ended September 30, ------------------------------------------------------------------------ 2002 2001 ----------------------------------- ----------------------------------- Average Average Average Average ASSETS Balance Interest Yield/Cost Balance Interest Yield/Cost ------------- --------- ----------- ------------ --------- ----------- Earning assets: (in thousands) (in thousands) Interest-bearing deposits with banks $ 14,744 $ 72 1.94% $ 13,806 $ 116 3.33% Taxable securities 89,081 961 4.28% 90,349 1,329 5.84% Non-taxable securities 9,798 113 4.58% 9,057 113 4.95% Total loans and fees 305,353 4,981 6.47% 280,639 5,635 7.97% FHLB stock 7,679 118 6.10% 7,631 139 7.23% ------------- --------- ----------- ------------ --------- ----------- Total earning assets 426,655 6,245 5.81% 401,482 7,332 7.25% Less: Allowance for loan losses 3,506 2,954 Non-earning assets: Cash and due from banks 9,106 7,193 Bank premises and equipment, net 11,500 10,798 Accrued interest receivable and other assets 13,380 4,633 ------------- ------------ Total assets $ 457,135 $ 421,152 ============= ============ LIABILITIES AND STOCKHOLDERS' EQUITY Interest-bearing liabilities: Deposits $ 277,332 2,005 2.87% $ 242,639 2,705 4.42% Federal funds purchased and repurchase agreements 24,145 63 1.04% 25,220 174 2.74% FHLB advances 88,228 1,319 5.93% 89,000 1,335 5.95% ------------- --------- ----------- ------------ --------- ----------- Total interest-bearing liabilities 389,705 3,387 3.45% 356,859 4,214 4.68% Non-interest bearing liabilities: Non-interest demand deposits 23,936 18,749 Accrued interest payable and other liabilities 1,495 2,268 Stockholders' equity 41,999 43,276 ------------- ------------ Total liabilities and stockholders' equity $ 457,135 $ 421,152 ============= ============ Net interest income $ 2,858 $ 3,118 ========= ========= Net interest spread 2.36% 2.57% Net interest margin 2.66% 3.08% 18 PART I - ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS COMMUNITY BANK SHARES OF INDIANA, INC. AND SUBSIDIARIES Nine Months Ended September 30, ------------------------------------------------------------------------ 2002 2001 ------------------------------------ ----------------------------------- Average Average Average Average ASSETS Balance Interest Yield/Cost Balance Interest Yield/Cost ------------ --------- ----------- ------------ --------- ----------- Earning assets: (in thousands) (in thousands) Interest-bearing deposits with banks $ 7,376 $ 115 2.08% $ 11,928 $ 396 4.44% Taxable securities 84,813 2,904 4.58% 83,703 3,847 6.14% Non-taxable securities 10,262 362 4.72% 7,928 302 5.09% Total loans and fees 306,220 15,210 6.64% 284,073 17,571 8.27% FHLB stock 7,668 344 6.00% 7,611 433 7.61% ------------ --------- ----------- ------------ --------- ----------- Total earning assets 416,339 18,935 6.08% 395,243 22,549 7.63% Less: Allowance for loan losses 3,239 2,891 Non-earning assets: Cash and due from banks 9,075 7,366 Bank premises and equipment, net 11,349 10,620 Accrued interest receivable and other assets 12,077 4,679 ------------ ------------ Total assets $ 445,601 $ 415,017 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY Interest-bearing liabilities: Deposits $ 256,819 $ 5,880 3.06% $ 232,607 $ 8,680 4.99% Federal funds purchased and repurchase agreements 27,665 237 1.15% 28,194 615 2.92% FHLB advances 94,278 4,143 5.88% 89,337 4,000 5.99% ------------ --------- ----------- ------------ --------- ----------- Total interest-bearing liabilities 378,762 10,260 3.62% 350,138 13,295 5.08% Non-interest bearing liabilities: Non-interest demand deposits 22,505 19,346 Accrued interest payable and other liabilities 1,322 2,948 Stockholders' equity 43,012 42,585 ------------ ------------ Total liabilities and stockholders' equity $ 445,601 $ 415,017 ============ ============ Net interest income $ 8,675 9,254 ========= ========= Net interest spread 2.46% 2.55% Net interest margin 2.79% 3.13% 19 PART I - ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS COMMUNITY BANK SHARES OF INDIANA, INC. AND SUBSIDIARIES Rate/Volume Analysis. The table below illustrates the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities affected the Company's interest income and interest expense during the periods indicated. Information is provided in each category with respect to (i) changes attributable to changes in volume (changes in volume multiplied by prior rate), (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume), and (iii) the net change. The changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate. Three Months Ended September 30, 2002 Nine Months Ended September 30, 2002 compared to compared to Three Months Ended September 30, 2001 Nine Months Ended September 30, 2001 Increase/(Decrease) Due to Increase/(Decrease) Due to ------------------------------------- -------------------------------------- Total Net Total Net Change Volume Rate Change Volume Rate ------------------------------------- -------------------------------------- (in thousands) (in thousands) Interest income: Interest-bearing deposits with banks $ (44) $ 7 $ (51) $ (281) $ (118) $ (163) Taxable securities (368) (18) (350) (943) 50 (993) Tax-exempt securities - 9 (9) 60 84 (24) Total loans and fees (654) 466 (1,120) (2,361) 1,293 (3,654) FHLB stock (21) 1 (22) (89) 3 (92) ------------------------------------- --------------------------------------- Total increase (decrease) in interest income (1,087) 465 (1,552) (3,614) 1,312 (4,926) ------------------------------------- --------------------------------------- Interest Expense: Deposits (700) 347 (1,047) (2,800) 829 (3,629) Federal funds purchased and repurchase agreements (111) (7) (104) (378) (11) (367) FHLB advances (16) (12) (4) 143 218 (75) ------------------------------------- --------------------------------------- Total increase (decrease) in interest expense (827) 328 (1,155) (3,035) 1,036 (4,071) ------------------------------------- --------------------------------------- Increase (decrease) in net interest income $ (260) $ 137 $ (397) $ (579) $ 276 $ (855) ===================================== ======================================= 20 PART I - ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS COMMUNITY BANK SHARES OF INDIANA, INC. AND SUBSIDIARIES Allowance and Provision for Loan Losses. The provision for loan losses was $171,000 and $1,001,000 for the three and nine months ended September 30, 2002, respectively, as compared to $89,000 and $440,000 for the same periods in 2001. The provision for loan losses increased for both periods because of increases in non-performing loans and the level of probable losses incurred on impaired loans. Loans (including impaired loans under the Financial Accounting Standard Board's Statement of Financial Accounting Standards 114 and 118) are placed on non-accrual status when they become past due ninety days or more as to principal or interest (180 days for residential real estate). When loans are placed on non-accrual status, all unpaid accrued interest is reversed. These loans remain on non-accrual status until the loan becomes current or the loan is deemed uncollectible and is charged off. The Company defines impaired loans to be those commercial loans that management has classified as doubtful (collection of total amount due is highly questionable or improbable) or loss (all or a portion of the loan has been written off or a specific allowance for loss has been provided). Impaired loans increased from $1.9 million at December 31, 2001, to $3.9 million at September 30, 2002. The increase in impaired loans is related to a determination by the Company through its normal credit risk monitoring procedures that certain specific loans, most of which had been classified as of December 31, 2001 as substandard (collection of total amount due is unlikely), exhibited an increased risk of loss during the third quarter. The Company does not believe that this indicates a trend in the overall loan portfolio. The allowance for loan losses increased $497,000 to $3.5 million at September 30, 2002 from $3.0 million at December 31, 2001 primarily as a result of the increase in impaired loans. Management believes, based on information presently available, that it has adequately provided for loan losses at September 30, 2002. Summary of Loan Loss Experience: Three Months Ended Nine Months Ended September 30, September 30, ---------------------------------- --------------------------------- Activity for the period ended: 2002 2001 2002 2001 ---------------------------------- --------------------------------- (in thousands) (in thousands) Beginning balance $ 3,714 $ 2,931 $ 3,030 $ 2,869 Charge-offs: Real Estate - (9) (24) (9) Commercial (360) (32) (462) (275) Consumer (3) (26) (29) (72) ---------------------------------- --------------------------------- Total (363) (67) (515) (365) Recoveries: Real Estate - 2 - 2 Commercial 4 - 7 - Consumer 1 1 4 1 ---------------------------------- --------------------------------- Total 5 3 11 3 Provision 171 89 1,001 440 ---------------------------------- --------------------------------- Ending balance $ 3,527 $ 2,956 $ 3,527 $ 2,956 ================================== ================================= 21 PART I - ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS COMMUNITY BANK SHARES OF INDIANA, INC. AND SUBSIDIARIES Non-performing loans: September 30, 2002 December 31, 2001 ------------------------------------------------ (in thousands) Loans on non-accrual status $ 3,430 $ 1,588 Loans past due 90 days or more and still accruing - 39 ------------------------------------------------ Total non-performing loans 3,430 1,627 Other real estate owned 560 560 ------------------------------------------------ Total non-performing assets $ 3,990 $ 2,187 ================================================ Non-performing loans to total loans 1.11% 0.55% Non-performing assets to total loans 1.29% 0.74% Allowance as a percent of non-performing loans 102.83% 186.23% Allowance as a percent of total loans 1.14% 1.02% Non-interest income. Non-interest income increased 72.3% to $841,000 for the three months ended September 30, 2002 from $488,000 for the three months ended September 30, 2001. The increase is attributable primarily to increases in net gain on the sale of available for sale securities of $237,000 and other income of $146,000. Other income increased primarily due to increased earnings on the cash surrender value of life insurance purchased on key employees of the Banks during the first quarter of 2002. The Banks purchased life insurance on key employees to offset existing employee benefits expenses and because the tax-equivalent yields were better than alternative investments. The Company reduced its risk in relation to the life insurance purchase by spreading the total investment among three life insurance carriers rated AA or better by Standard & Poor's. Also contributing to the increase in total non-interest income was an increase of $65,000 in service charges on deposit accounts. Commission income on the sale of investment products declined by $63,000 for the third quarter of 2002 as compared to the same period in 2001, the result of reduced customer transactions due to substantial declines and increased volatility in major stock markets over the past year. Net gain on sale of residential mortgage loans decreased to $52,000 for the third quarter of 2002 compared to $86,000 for the same period in 2001. This decrease is attributable to management's decision to retain primarily all new mortgage loans originated during the third quarter of 2002 instead of selling them in the secondary market. By retaining these loans, management feels it can moderate the risks associated with an asset sensitive balance sheet. The changes in non-interest income categories between the nine-month periods ended September 30, 2001 and 2002 were caused by the same factors that affected the three-month periods ended 22 PART I - ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS COMMUNITY BANK SHARES OF INDIANA, INC. AND SUBSIDIARIES September 30, 2001 and 2002. However, net gain on sale of mortgage loans increased $112,000 because of the transfer from loans to loans held for sale and subsequent sale of $16.0 million of residential mortgage loans at the end of the second quarter of 2002. The Company's decision to sell these loans was based on its assessment that interest rates would start rising in the near future. Based on this view, the Company sold these loans, which are generally longer-term assets, to increase the sensitivity of its interest income to rising interest rates. The Company has since revised its assessment of the interest rate environment and believes that interest rates will stay flat or decline for the foreseeable future. See Part I - Item 3, Quantitative and Qualitative Disclosures about Market Risk, in the Company's 10-Q for the period ended June 30, 2002 for a more detailed discussion of this transaction. Non-interest expense. Non-interest expense increased by $481,000 for the three months ended September 30, 2002 as compared to the same period in 2001. Compensation and benefits expense increased by $227,000 from 2001 to 2002 due to the hiring of key personnel within the commercial and retail management areas of the Company, the implementation of a customer call center, and the opening of two new branches located within Wal-Mart Supercenters. Occupancy and equipment costs increased $66,000 in the third quarter of 2002 compared to the same quarter in 2001 due to initiatives to improve the Company's technological and retail infrastructures and the aforementioned new branches. Data processing service expense increased $36,000 due primarily to an increase in third party data processing costs related to additional services offered to customers of the Banks. Other non-interest expense increased $152,000, primarily a result of increased marketing and advertising expenses. Non-interest expense increased by $1,272,000 for the nine months ended September 30, 2002 as compared to the same period in 2001. The factors affecting each category of non-interest expense in the third quarter of 2002 were predominantly the same reasons for the increases in these categories from the first nine months of 2001 to the same period in 2002. Income tax expense. Income tax expense for the three-month period ended September 30, 2002 was $139,000 as compared to $406,000 for the same period in 2001. The effective tax rate for the three months ended September 30, 2002 was 21.7% compared to 36.5% for the same period in 2001. The effective tax rate declined substantially for the three months ended September 30, 2002 as compared to the same period in 2001 due to various tax strategies implemented in the first quarter of 2002 coupled with the decline in net income before taxes between the two periods. 23 PART I - ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS COMMUNITY BANK SHARES OF INDIANA, INC. AND SUBSIDIARIES Liquidity and Capital Resources The Company must maintain an adequate level of liquidity to ensure the availability of sufficient funds to support loan growth and deposit withdrawals, to satisfy financial commitments and to take advantage of investment opportunities. Historically, the Company has been able to retain a significant amount of its deposits as they mature. The Company's primary sources of funds are customer deposits, customer repurchase agreements, proceeds from loan repayments, maturing securities and FHLB advances. While loan repayments and maturities are a predictable source of funds, deposit flows and mortgage prepayments are greatly influenced by market interest rates, general economic conditions and competition. At September 30, 2002, the Company had cash and interest-bearing deposits with banks of $9.4 million and securities available-for-sale with a fair value of $107.5 million. If the Company requires funds beyond the funds it is able to generate internally, it has $6.8 million in additional aggregate borrowing capacity with the Federal Home Loan Banks of Indianapolis and Cincinnati, and unused federal funds lines of credit with various nonaffiliated financial institutions of $29.0 million. The Banks are required to maintain specific amounts of capital pursuant to regulatory requirements. As of September 30, 2002, the Banks were in compliance with all regulatory capital requirements that were effective as of such date with capital ratios as follows: Total Tier 1 Tier 1 Capital To Capital To Capital To Risk-weighted Risk-weighted Average Assets Assets Assets ---------------------- ------------------- ---------------- Consolidated 14.3% 13.2% 9.1% Community Bank 13.6% 12.5% 8.6% Community Bank of Kentucky 18.4% 17.4% 12.3% Minimum to be well capitalized under regulatory capital requirements: 10.0% 6.0% 5.0% The Company has actively been repurchasing shares of its common stock since May 21, 1999. A total of 343,007 shares (at a cost of $5.5 million) have been repurchased under these plans, with 78,807 shares costing $1,323,000 purchased since December 31, 2001. The Company's Board of Directors authorized the current share repurchase plan in March 2001 of up to $3.0 million of the Company's common stock. Through September 30, 2002, a total of $1,888,447 had been expended to purchase shares under this repurchase plan. 24 PART I - ITEM 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Asset/liability management is the process of balance sheet control designed to ensure safety and soundness and to maintain liquidity and regulatory capital standards while sustaining acceptable net interest income. Interest rate risk is the exposure to adverse changes in net interest income as a result of market fluctuations in interest rates. Management continually monitors interest rate and liquidity risk so that it can implement appropriate funding, investment, and other balance sheet strategies. Management considers market interest rate risk to be the Company's most significant ongoing business risk consideration. The Company currently contracts with an independent third party consulting firm to measure its interest rate risk position. The consulting firm utilizes an earnings simulation model to analyze net interest income sensitivity. Current balance sheet amounts, current yields and costs, corresponding maturity and repricing amounts and rates, other relevant information, and certain assumptions made by management are combined with gradual movements in interest rates of 100 basis points down and 200 basis points up within the model to estimate their combined effects on net interest income over a one-year horizon. Interest rate movements are spread equally over the forecast horizon of one year. Previously, the Company applied instantaneous interest rate movements within its internal model. The Company feels that using gradual interest rate movements within the model is more representative of future interest rate changes than instantaneous interest rate shocks. The Company does not project growth in amounts for any balance sheet category when constructing the model because of the belief that projected growth can mask current interest rate risk imbalances over the projection horizon. The Company believes that the changes made to its interest rate risk measurement process have improved the accuracy of results of the process. Consequently, the Company believes that it has better information on which to base asset and liability allocation decisions going forward. Assumptions based on the historical behavior of the Company's deposit rates and balances in relation to changes in interest rates are incorporated into the model. These assumptions are inherently uncertain and, as a result, the model cannot precisely measure future net interest income or precisely predict the impact of fluctuations in market interest rates on net interest income. The Company continually monitors and updates the assumptions as new information becomes available. Actual results will differ from the model's simulated results due to timing, magnitude and frequency of interest rate changes and actual variations from the managerial assumptions utilized under the model, as well as changes in market conditions and the application and timing of various management strategies. Given a gradual 200 basis point increase in the projected yield curve used in the simulation model, it is estimated that as of September 30, 2002 net interest income for the Company would decrease by 3.4 percent over one year ending September 30, 2003. However, the simulation analysis indicates that over two years net interest income would increase approximately 8.9% in response to a 200 basis points gradual increase in the yield curve over the first year. As of December 31, 2001, the Company estimated that net interest income would decrease 6.0 percent over one year ending December 31, 2002 using an instantaneous 200 basis point upward shock to the yield curve. A gradual decline of 200 basis points in the yield curve would cause a decrease in net interest income of an estimated 2.8 percent over one year ending September 30, 2003. This compares to an estimated decrease of 8.1 percent for one year ending December 31, 2002. The Company is asset sensitive in that its interest-earning assets are likely to reprice faster in response to changing interest rates than its interest-bearing liabilities. The estimated changes in net interest income for all interest rate change scenarios are within the policy guidelines established by the Company's board of directors. However, the Company will continue to take action to limit its exposure to stable or falling interest rate environments. 25 PART I - ITEM 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The interest sensitivity profile of the Company at any point in time will be affected by a number of factors. These factors include, among other things, the mix of interest sensitive assets and liabilities as well as their relative repricing schedules. It is also influenced by market interest rates, deposit growth, loan growth, and other factors. The table below is representative only and is not a precise measurement of the effect of changing interest rates on the Company's net interest income in the future. 26 PART I - ITEM 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The following table illustrates the Company's estimated one-year net interest income sensitivity profile based on the asset/liability model as of September 30, 2002: Interest Rate Sensitivity for the Year Ended September 30, 2003 ------------------------------------------------------------------ Gradual Decrease in Gradual Increase in Rates of 100 Rates of 200 Basis Points Base Basis Points ------------------------------------------------------------------ (in thousands) Projected interest income: Loans $19,255 $19,879 $20,623 Investments 4,632 4,778 5,020 FHLB stock 480 480 480 Interest-bearing bank deposits 144 222 371 ----------------------- ------------------- ---------------------- Total interest Income 24,511 25,359 26,494 Projected interest expense: Deposits 6,853 7,189 8,420 Other borrowings 5,385 5,547 5,877 ----------------------- ------------------- ---------------------- Total interest expense 12,238 12,736 14,297 ----------------------- ------------------- ---------------------- Net interest income $12,273 $12,623 $12,197 ======================= =================== ====================== Change from base $(350) $(426) Percent change from base (2.8)% (3.4)% The following table illustrates the Company's estimated one-year net interest income sensitivity profile based on the asset/liability model as of December 31, 2001: Interest Rate Sensitivity for the Year Ended December 31, 2002 ----------------------------------------------------------------------------- Decrease in Rates Increase in Rates ----------------- ----------------- 200 100 100 200 Basis Points Basis Points Base Basis Points Basis Points ----------------------------------------------------------------------------- (in thousands) Projected interest income: Loans $18,438 $19,736 $20,951 $22,071 $23,164 Investments 4,673 5,052 5,368 5,612 5,824 Short-term investments 4 14 24 43 61 --------------- -------------- --------------- -------------- --------------- Total interest income 23,115 24,802 26,343 27,726 29,049 Projected interest expense: Deposits 4,762 5,373 6,559 8,060 9,406 Other borrowings 5,487 5,635 5,783 6,107 6,488 --------------- -------------- --------------- -------------- --------------- Total interest expense 10,249 11,008 12,342 14,167 15,894 --------------- -------------- --------------- -------------- --------------- Net interest income $12,866 $13,794 $14,001 $13,559 $13,155 =============== ============== =============== ============== =============== Change from base $(1,135) $(207) $(442) $(846) Percent change from base (8.1)% (1.5)% (3.2)% (6.0)% 27 PART I - ITEM 4 CONTROLS AND PROCEDURES Company management, including the Chief Executive Officer (serving as the principal executive officer) and Chief Financial Officer, have conducted an evaluation of the effectiveness of disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the disclosure controls and procedures are effective in ensuring that all material information required to be filed in this quarterly report has been made known to them in a timely fashion. There have been no significant changes in internal controls, or in other factors that could significantly affect internal controls, subsequent to the date the Chief Executive Officer and the Chief Financial Officer completed their evaluation. 28 PART II OTHER INFORMATION COMMUNITY BANK SHARES OF INDIANA, INC. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits The exhibits required by Item 601 of Regulation S-K are listed in the Exhibit Index of this Form 10-Q and are filed as a part of this report. (b) Reports on Form 8-K The Company filed a report on Form 8-K on July 24, 2002 reporting, under Item 5, earnings for the three months ended June 30, 2002. 29 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed by the undersigned thereunto duly authorized. COMMUNITY BANK SHARES OF INDIANA, INC. (Registrant) Dated: November 12, 2002 BY: /s/ James D. Rickard ---------------------------------- ----------------------------- James D. Rickard President and Chief Executive Officer (Principal Executive Officer) Dated: November 12, 2002 BY: /s/ Paul A. Chrisco ----------------------------------- ------------------------ Paul A. Chrisco Senior Vice President and Chief Financial Officer (Principal Financial Officer) 30 CERTIFICATIONS PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 CERTIFICATION I, James D. Rickard, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Community Bank Shares of Indiana, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: November 12, 2002 /s/ James D. Rickard - ---------------------------------------------- James D. Rickard President and Chief Executive Officer 31 CERTIFICATIONS PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 CERTIFICATION I, Paul A. Chrisco, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Community Bank Shares of Indiana, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: November 12, 2002 /s/ Paul A. Chrisco - ------------------------------------------- Paul A. Chrisco Senior Vice President and Chief Financial Officer 32 EXHIBIT INDEX COMMUNITY BANK SHARES OF INDIANA, INC. EXHIBIT INDEX Exhibit No. Description - --------------------- -------------------------------------------------------------------------- 11 Statement Regarding Computation of Per Share Earnings 99.1 Certification of Principal Executive Officer Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 99.2 Certification of Principal Financial Officer Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 33 COMMUNITY BANK SHARES OF INDIANA, INC. Exhibit 11. Statement Regarding Computation of Per Share Earnings See Part 1, Note 5 "Supplemental Disclosure for Earnings Per Share" for calculations. 34 Exhibit 99.1 CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the accompanying Form 10-Q of Community Bank Shares of Indiana, Inc. for the quarter ended September 30, 2002, I, James D. Rickard, Chief Executive Officer of Community Bank Shares of Indiana, Inc., hereby certify pursuant to 18 U.S.C.ss.1350, as adopted pursuant toss.906 of the Sarbanes-Oxley Act of 2002, that: (1) Such Form 10-Q for the quarter ended September 30, 2002 fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in such Form 10-Q for the quarter ended September 30, 2002 fairly presents, in all material respects, the financial condition and results of operation of Community Bank Shares of Indiana, Inc. By: /s/ James D. Rickard ---------------------------------- James D. Rickard President and Chief Executive Officer Date: November 12, 2002. 35 Exhibit 99.2 CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the accompanying Form 10-Q of Community Bank Shares of Indiana, Inc. for the quarter ended September 30, 2002, I, Paul A. Chrisco, Chief Financial Officer of Community Bank Shares of Indiana, Inc., hereby certify pursuant to 18 U.S.C.ss.1350, as adopted pursuant toss.906 of the Sarbanes-Oxley Act of 2002, that: (1) Such Form 10-Q for the quarter ended September 30, 2002 fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in such Form 10-Q for the quarter ended September 30, 2002 fairly presents, in all material respects, the financial condition and results of operation of Community Bank Shares of Indiana, Inc. By: /s/ Paul A. Chrisco ---------------------------------- Paul A. Chrisco Senior Vice President and Chief Financial Officer Date: November 12, 2002. 36