UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

For the transition period from                     to                    

Commission File Number 0-20750

STERLING BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (713) 466-8300

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

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $1.00 par value

(Title of Class)

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

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (17 CFR 229.405) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

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

     The aggregate market value of the registrant’s common stock held by non-affiliates as of June 30, 2004, the last business day of the most recently completed second fiscal quarter, was $579,269,629 based on the closing sales price of $14.19 on such date. For purposes of this calculation, affiliates are defined as all directors and executive officers.

     As of March 3, 2005, registrant had outstanding 45,135,715 shares of Common Stock, $1.00 par value.

     Documents incorporated by reference: Portions of Sterling Bancshares, Inc.’s definitive proxy statement relating to the registrant’s 2005 Annual Meeting of Shareholders, which proxy statement will be filed under the Securities Exchange Act of 1934 within 120 days of the end of the registrant’s fiscal year ended December 31, 2004, are incorporated by reference into Part III of this Form 10-K.

STERLING BANCSHARES, INC.

2004 ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS

PART I

      The disclosures in this item are qualified by the section entitled “Forward-Looking Statements” in Management’s Discussion and Analysis of Financial Condition and Results of Operations included in Item 7 of this report.

OVERVIEW

      For over 30 years, Sterling Bancshares, Inc. and Sterling Bank have been committed to serving small to mid-sized businesses. We provide a broad array of financial services to Texas businesses and consumers through 36 banking offices in the greater metropolitan areas of Houston, San Antonio and Dallas, Texas. These cities are the 4th, 8th and 9th largest, respectively, in the United States based on population according to the U.S. Census Bureau.

      Sterling Bancshares was incorporated under the laws of the State of Texas in 1980 and became the parent bank holding company of Sterling Bank in 1981. Sterling Bank was chartered in 1974 under the laws of the State of Texas. Our principal executive offices are located at 2550 North Loop West, Suite 600, Houston, Texas, 77092 and our telephone number is (713) 466-8300.

      In this filing, we may refer to Sterling Bancshares, Inc., on a parent-only basis, as “Sterling Bancshares” and to Sterling Bank as the “Bank”. Sterling Bancshares, the Bank and other subsidiaries of both may be collectively referred to as the “Company.”

      At December 31, 2004, we had consolidated total assets of $3.3 billion, deposits of $2.4 billion, and shareholders’ equity of $313.2 million.

      During the fourth quarter of 2003, we completed the acquisition of South Texas Capital Group, Inc., a privately held bank holding company that operated three banking offices in San Antonio, Texas under the name of Plaza Bank. Because systems consolidation efforts were still underway at the end of 2003, we had two state-banking charters (Sterling Bank and Plaza Bank). The operational integration of Plaza Bank was completed in January 2004 and we now operate these acquired offices under the name of Sterling Bank.

      On September 30, 2003, we sold our 80% interest in Sterling Capital Mortgage Company (“SCMC”). SCMC provided mortgage-banking services to consumers through 110 production offices in Texas and 15 other states. After we acquired our initial interest in 1996, SCMC grew substantially. We sold SCMC because its operations were not a part of our fundamental business strategy and its size placed us at significant risk to adverse changes in the mortgage industry caused by interest rate fluctuations. This sale has allowed us to focus on our core business strategy of providing commercial banking services to small and mid-sized owner operated businesses.

      SCMC’s operations were reported previously as the Company’s mortgage banking segment. Following the sale of SCMC, the Company operates a single segment engaged in the commercial banking business. The results of SCMC have been segregated from continuing operations and are reported as discontinued operations in the Company’s Consolidated Financial Statements.

Commercial Banking

      We provide a wide range of commercial and consumer banking services, including demand, savings and time deposits; commercial, real estate and consumer loans; merchant credit card services; letters of credit; and cash and asset management services. In addition, we facilitate sales of brokerage, mutual fund, alternative financing and insurance products through third party vendors. Bank deposits are insured up to applicable limits by the Bank Insurance Fund (“BIF”) of the Federal Deposit Insurance Corporation (“FDIC”).

      Our primary lending focus is providing commercial loans and owner-occupied real estate loans to local businesses with annual sales ranging from $300 thousand to $30 million. Typically, these customers have financing requirements between $50 thousand and $4 million. The Bank’s credit range allows for greater diversity in the loan portfolio, less competition from large banks, and better pricing opportunities. At December 31, 2004, we had more than 19 thousand loans and our average loan size was approximately $123 thousand.

      Business Banking Strategy. Under our business banking strategy, we focus on offering a broad line of financial products and services for small to mid-sized businesses through full service banking offices. Each banking office is managed by senior management with extensive lending experience. These managers exercise substantial authority over credit and pricing decisions, subject to a concurrence process and loan committee approval for larger credits. This approach, coupled with continuity of service by the same staff members, enables us to develop long-term customer relationships, maintain high quality service and respond quickly to customer needs. We believe that our emphasis on local relationship banking, together with a conservative approach to lending, are important factors in our success and growth.

      The Bank offers services which extend beyond traditional banking needs through our Treasury Management, specialized lending (including energy, leasing and wholesale real estate lending) and Trust Services groups. Additionally, the Bank’s Capital Markets group is involved in secondary purchases of government guaranteed loans from originating lenders and secondary market dealers. These additional services have enabled the Bank to be a more comprehensive financial resource dedicated to helping owner operated businesses meet their financial services needs.

      We maintain a strong community orientation by, among other things, supporting the active participation of our officers and employees in local charitable, civic, school, religious and community development activities. Each banking office may also appoint selected customers to a business development board that assists in introducing prospective customers to us and in developing or improving products and services to meet customer needs. Our lending and investing activities are funded primarily by core deposits. This stable source of funding comes to us by developing broad banking relationships with customers and because our 36 banking offices offer customers a high level of convenience and service. Over one-third of our total deposits are noninterest-bearing demand deposits.

      We further facilitate customer service by centralizing certain operational and support functions that are transparent to customers. This has allowed us to improve consistency and cost efficiencies in the delivery of products and services by each banking office. Centralized functions include services such as data processing, bookkeeping, accounting and finance, loan administration, loan review, compliance, risk management and internal auditing. Credit policy and administration, strategic planning, marketing and other administrative services also are provided centrally. Our banking offices work closely with our operational and support functions to develop new products and services and to introduce enhancements to existing products and services.

Company Growth Strategy

      Our growth strategy has been concentrated on increasing our banking presence in the greater Houston, San Antonio and Dallas market areas. We have grown through a combination of internal growth, mergers and acquisitions and the opening of new banking offices. We regularly evaluate opportunities to acquire banks and other financial services companies that complement our existing business, expand our market coverage and enhance our product offerings. In late 2003, we formed a wholesale real estate funding department to diversify our loan portfolio geographically, while supplementing our growth in our niche market segment, small to medium-size businesses. This department focuses on the origination, co-origination and purchase of commercial real estate loans referred by smaller financial institutions nationwide. More than 80% of these loans have variable interest rates and amortize over twenty- or twenty-five years.

      De Novo Offices. De novo offices are new banking offices that we build or lease. Since 2000, we have opened five new banking offices, three of which are located in Houston. During 2004, we opened a loan production office in Dallas, where in December 2000 we had first expanded outside the Houston market.

      In most cases where we open a new office, we issue a separate series of convertible preferred stock to local business owners and others who are able to contribute substantially to the business development efforts of the new banking office. These preferred shares typically are convertible into common shares after three years at ratios based on deposit growth objectives of the new banking office. Refer to Note 14 to the Consolidated Financial Statements for more discussion of these preferred stock issuances. Strategically, this practice is not designed to raise capital, but rather to attract and retain the foundational relationships that allow a new office to achieve profitability in a shorter period of time.

      Mergers and Acquisitions. Acquisitions have been important to our growth. Our acquisitions since 2000 are listed in the following table:

      Refer to Note 2 to the Consolidated Financial Statements for more information regarding recent mergers and acquisitions. We continue to seek acquisitions and new office opportunities as they become available and prove to be aligned with our business banking philosophy.

      Strategic Divestitures of Banking Offices. During 2004, we closed one banking office and merged its operations into another location. We retained substantially all of the loans and deposits associated with this location. The bank building and related fixtures for this location were sold for a pre-tax loss of $27 thousand.

      During 2003, we sold five rural banking offices that were not consistent with our focus on large urban centers with greater concentrations of owner operated businesses. These banking offices were acquired as parts of previous acquisitions and included the banking offices in Eagle Pass, Pearsall, Crystal City, Carrizo Springs, and Highlands, Texas. In the aggregate, assets of $37.8 million, loans of $34.0 million and deposits of $150.9 million were sold in three transactions for an aggregate pre-tax net gain of $3.5 million.

Competition

      The financial services industry is highly competitive. Also, there are a number of new banking competitors who have entered, or greatly expanded their presence in Texas — particularly in the Houston, San Antonio and Dallas markets in which we operate. We experience significant competition in attracting and retaining deposits and making loans, as well as in providing other financial services in each of our market areas. Product pricing, customer convenience and service capabilities, and breadth of product lines are significant competitive factors. We also experience significant competition in attracting, developing and retaining qualified banking professionals.

      Our most direct competition for loans comes from other banks. Our most direct competition for deposits comes from other banks, savings institutions and credit unions doing business in our market areas. As with all banking organizations, we have also experienced competition from nonbanking sources, including mutual funds, corporate and governmental debt securities and other investment alternatives offered within and outside of our primary market areas. Many of our competitors are much larger in total assets and capitalization, have greater access to capital markets and offer a broader range of financial products and services, in particular on the retail side of our business.

SUPERVISION AND REGULATION

      Bank holding companies and banks are extensively regulated under federal and state laws. This regulation is intended primarily for the protection of depositors and the deposit insurance fund and not for the benefit of shareholders. Set forth below is a summary description of the material laws and regulations that relate to our operations. The following descriptions do not purport to be complete and are qualified in their entirety by reference to such statutes and regulations.

Sterling Bancshares

      Sterling Bancshares and its second tier holding company, Sterling Bancorporation, Inc., are bank holding companies registered under the Bank Holding Company Act of 1956, as amended (“BHCA”), and are subject to supervision and regulation by the Federal Reserve Board. Federal laws subject bank holding companies to particular restrictions on the types of activities in which they may engage, and to a range of supervisory requirements and activities, including regulatory enforcement actions for violations of laws and policies. In addition, Texas law authorizes the Texas Department of Banking to supervise and regulate a holding company controlling a state bank. Further, our securities are registered with the Securities and Exchange Commission (“SEC”) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). As such, we are subject to the information, proxy solicitation, insider trading and other requirements and restrictions of the Exchange Act.

      Permissible Activities. As a bank holding company, Sterling Bancshares’ activities, as well as the activities of entities which it controls or in which it owns 5% or more of the voting securities, are limited by the BHCA to banking, management and control of banks, furnishing or performing services for its subsidiaries, or any other activity which the Federal Reserve Board determines to be incidental or closely related to banking or managing or controlling banks. The Gramm-Leach-Bliley Act enacted in 2000 amended the BHCA and granted certain expanded powers to bank holding companies as discussed below. In approving acquisitions of entities engaged in banking-related activities, the Federal Reserve Board considers a number of factors, including the expected benefits to the public, such as greater convenience and increased competition or gains in efficiency, which are weighted against the risks of possible adverse effects, such as an attempt to monopolize the business of banking, undue concentration of resources, decreased or unfair competition, conflicts of interest, or unsound banking practices.

      Non-Banking Activities. The BHCA sets forth exceptions to its general prohibition against bank holding company ownership of voting shares in any company engaged in non-banking activities. The exceptions include certain activities exempt based upon the type of activity and those determined by the Federal Reserve Board to be closely related to banking or managing or controlling banks.

      Gramm-Leach-Bliley. The Gramm-Leach-Bliley (“G-L-B”) Act, which became effective in 2000, authorizes affiliations between banking, securities and insurance firms and authorizes bank holding companies and state banks, if permitted by state law, to engage in a variety of new financial activities. Bank holding companies may also elect to become financial holding companies if they meet certain requirements relating to capitalization and management and have filed a declaration with the Federal Reserve Board electing to be a financial holding company. Among the new activities that are permitted by bank holding companies are securities and insurance brokerage, securities underwriting, insurance underwriting and merchant banking. The Federal Reserve Board, in consultation with the Department of Treasury, may approve additional financial activities.

      We have not filed an election to be a financial holding company. The G-L-B Act is intended to grant to community banks certain powers as a matter of right that larger institutions have accumulated on an ad hoc basis. Nevertheless, this act has resulted in significant consolidation in the financial industry which has increased competition from larger institutions and other types of companies offering financial products, many of which may have substantially more financial resources than we do.

      USA PATRIOT Act. The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “USA PATRIOT Act”) is intended to

strengthen U.S. law enforcement’s and the intelligence communities’ ability to work cohesively to combat terrorism on a variety of fronts. Its impact is significant and wide-ranging. The regulations adopted by the U.S. Department of Treasury require financial institutions to maintain policies, procedures and controls designed to address, any or all of the following matters: money laundering; suspicious activities and currency transaction reporting; and currency crimes. We maintain policies and procedures designed to comply with the USA PATRIOT Act requirements.

      Safety and Soundness Standards. The Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”) expanded the Federal Reserve Board’s authority to prohibit activities of bank holding companies and their non-banking subsidiaries which represent unsafe and unsound banking practices or which constitute violations of laws or regulations. Notably, FIRREA increased the amount of civil monetary penalties that the Federal Reserve Board can assess for certain activities conducted on a knowing and reckless basis, if those activities cause a substantial loss to a depository institution. The penalties can be as high as $1 million per day. FIRREA also expanded the scope of individuals and entities against which such penalties may be assessed.

      The federal agencies that regulate banks and savings associations jointly issued guidelines for safe and sound banking operations as required by Section 132 of the Federal Deposit Insurance Corporation Improvement Act (“FDICIA”). The guidelines identify the fundamental standards that the four agencies follow when evaluating the operational and managerial controls at insured institutions. An institution’s performance will be evaluated against these standards during the regulators’ periodic on-site examinations.

      Dividend Restrictions. It is the policy of the Federal Reserve Board that bank holding companies should pay cash dividends on common stock only out of income available over the past year and only if prospective earnings retention is consistent with the organization’s expected future needs and financial condition. This policy provides that bank holding companies should not maintain a level of cash dividends that undermines the bank holding company’s ability to serve as a source of strength to its banking subsidiaries.

      Under Federal Reserve Board policy, a bank holding company is expected to act as a source of financial strength to each of its banking subsidiaries and commit resources to their support. Such support may be required at times when, absent this Federal Reserve Board policy, a bank holding company may not be inclined to provide it.

      Capital Adequacy Requirements. The Federal Reserve Board monitors the capital adequacy of bank holding companies and has adopted a system using risk-based capital adequacy guidelines to evaluate their capital adequacy. Under the risk-based capital guidelines, different categories of assets are assigned different risk weights, based generally on the perceived credit risk of the asset. These risk weights are multiplied by corresponding asset balances to determine a “risk-weighted” asset base. Certain off-balance sheet items are added to the risk-weighted asset base by converting them to a balance sheet equivalent and assigning to them the appropriate risk weight. In addition, the guidelines define each of the capital components. Total capital is defined as the sum of “core capital elements” (“Tier 1”) and “supplemental capital elements” (“Tier 2”), with “Tier 2” being limited to 100% of “Tier 1.” For bank holding companies, “Tier 1” capital includes, with certain restrictions, common shareholders’ equity, noncumulative perpetual preferred stock, a limited amount of cumulative perpetual preferred stock and related surplus, and a limited amount of cumulative perpetual stock and minority interest in equity accounts of consolidated subsidiaries, less goodwill and other intangible assets. “Tier 2” capital includes, with certain limitations, perpetual preferred stock not meeting the Tier 1 definition, mandatory convertible securities, subordinated debt, and allowances for credit losses, less certain required deductions. The guidelines require Sterling Bancshares to maintain a minimum ratio of total capital-to-risk-weighted assets of 8.0% (of which at least 4.0% is required to be comprised of “Tier 1” capital elements).

      In addition to the risk-based capital guidelines, the Federal Reserve Board and the FDIC have adopted the use of a minimum “Tier 1” leverage ratio as an additional tool to evaluate the capital adequacy of banks and bank holding companies. The banking organization’s “Tier 1” leverage ratio is defined to be its “Tier 1” capital divided by its average total consolidated assets. Certain highly rated bank

holding companies may maintain a minimum leverage ratio of 3.0% “Tier 1” capital to total average assets but other bank holding companies are required to maintain a leverage ratio of 4.0% to 5.0%.

      For information regarding the capital ratios of Sterling Bancshares see the discussion under the section captioned “Capital Resources” included in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 18 — Regulatory Matters in the Notes to the Consolidated Financial Statements included in this report.

      Imposition of Liability for Undercapitalized Subsidiaries. A bank holding company that fails to meet the applicable risk-based capital standards will be at a disadvantage. For example, Federal Reserve Board policy discourages the payment of dividends by a bank holding company from borrowed funds as well as payments that would adversely affect capital adequacy. Failure to meet the capital guidelines may result in the issuance of supervisory or enforcement actions by the Federal Reserve Board. FDICIA requires bank regulators to take “prompt corrective action” to resolve problems associated with insured depository institutions whose capital declines below certain levels.

      Acquisitions by Bank Holding Companies. The BHCA requires a bank holding company to obtain the prior approval of the Federal Reserve Board before it acquires all or substantially all of the assets of any bank, or ownership or control of any voting shares of any bank, if after such acquisition it would own or control, directly or indirectly, more than 5% of the voting shares of such bank. In approving bank acquisitions, the Federal Reserve Board considers the financial and managerial resources and future prospects of the bank holding company and the banks concerned the convenience and needs of the communities to be served, and various competitive factors. The Attorney General of the United States may, within 30 days after approval of an acquisition by the Federal Reserve Board, bring an action challenging such acquisition under the federal antitrust laws, in which case the effectiveness of such approval is stayed pending a final ruling by the courts.

      Community Reinvestment Act. The Community Reinvestment Act of 1977 (“CRA”) and the regulations promulgated by the FDIC to implement CRA are intended to ensure that banks meet the credit needs of their service area, including low and moderate income communities and individuals, consistent with safe and sound banking practices. The CRA regulations also require the banking regulatory authorities to evaluate a bank’s record in meeting the needs of its service area when considering applications to establish new offices or consummate any merger or acquisition transaction. Under FIRREA, the federal banking agencies are required to rate each insured institution’s performance under CRA and to make such information publicly available. In the case of an acquisition by a bank holding company, the CRA performance records of the banks involved in the transaction are reviewed as part of the processing of the acquisition application. A CRA rating other than ‘outstanding’ or ‘satisfactory’ can substantially delay or block a transaction. Based upon our most recent CRA examination the Bank has a satisfactory CRA rating.

      Interstate Banking. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the “Interstate Branching Act”) increased the ease and likelihood of interstate branching throughout much of the United States. The Interstate Branching Act removes state law barriers to acquisitions in all states and allows multi-state banking operations to merge into a single bank with interstate branches. Interstate banking and branching authority is subject to certain conditions and restrictions, such as capital adequacy, management and CRA compliance. The Interstate Branching Act preempts existing barriers that restrict entry into all states, such as regional compacts and reciprocal agreements, thus creating opportunities for expansion into markets that were previously closed. Under the Interstate Branching Act, bank holding companies are now able to acquire banks in any state, subject to certain conditions. Banks acquired pursuant to this authority may subsequently be converted to branches. Interstate branching is permitted by allowing banks to merge across state lines to form a single institution. Interstate merger transactions can be used to consolidate existing multi-state operations or to acquire new branches. A bank may establish a new branch as its initial entry into a state only if the state has authorized de novo branching. In addition, out-of-state banks may merge with a single branch of a bank if the state has authorized such a transaction. The Federal Reserve Board, however, will only allow the acquisition by a bank holding company of an

interest in any bank located in another state if the statutory laws of the state in which the target bank is located expressly authorize such acquisitions. Texas elected to “opt out” of the Interstate Branching Act. Despite having opted out of the Interstate Branching Act, the Texas Banking Act permits, in certain circumstances, out-of-state bank holding companies to acquire certain existing banks and bank holding companies in Texas.

      Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act is intended to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to securities laws.

      The Sarbanes-Oxley Act is the most far-reaching U.S. securities legislation enacted in some time. It generally applies to all companies, both U.S. and non-U.S., that file or are required to file periodic reports with the SEC under the Exchange Act.

      The Sarbanes-Oxley Act includes additional disclosure requirements and new corporate governance rules, requires the SEC and securities exchanges to adopt extensive additional disclosure, corporate governance and other related rules and mandates further studies of certain issues by the SEC. The Sarbanes-Oxley Act represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and between a board of directors and its committees.

      The Sarbanes-Oxley Act addresses, among other matters:

Sterling Bank

      Sterling Bank is a Texas-chartered banking association and its deposits are insured, up to applicable limits, by the Bank Insurance Fund of the FDIC. The Bank is subject to supervision and regulation by both the Texas Department of Banking and the FDIC and may be subject to special restrictions, supervisory requirements and potential enforcement actions. The Bank is not a member of the Federal Reserve System; however, the Federal Reserve Board also has supervisory authority that indirectly affects

the Bank. The Bank is a member of the Federal Home Loan Bank and, therefore, is subject also to compliance with its requirements.

      Permissible Activities for State-Chartered Institutions. The Texas Constitution provides that a Texas-chartered bank has the same rights and privileges that are granted to national banks domiciled in Texas. However, FDICIA provides that no state bank or subsidiary thereof may engage as principal in any activity not permitted for national banks, unless the institution complies with applicable capital requirements and the FDIC determines that the activity poses no significant risk to the Bank Insurance Fund (“BIF”).

      Branching. Texas law provides that a Texas-chartered bank can establish a branch anywhere in Texas provided that the branch is approved in advance by the Commissioner of the Texas Department of Banking (the “Commissioner”). The branch must also be approved by the FDIC, which considers a number of factors, including financial history, capital adequacy, earnings prospects, character of management, needs of the community, and consistency with corporate powers. There are no federal limitations on the ability of insured non-member state banks to branch across state lines; however, such branching would be subject to applicable state law restrictions.

      Restrictions on Transactions with Affiliates and Insiders. Transactions between the Bank and its nonbanking affiliates, including Sterling Bancshares, are subject to Section 23A of the Federal Reserve Act and Regulation W promulgated thereunder. Section 23A defines “covered transactions,” which include extensions of credit, and limits a bank’s covered transactions with any affiliate to ten percent (10%) of such bank’s capital and surplus. All covered and exempt transactions between a bank and its affiliates must be on terms and conditions consistent with safe and sound banking practices, and banks and their subsidiaries are prohibited from purchasing low-quality assets from the bank’s affiliates. Finally, Section 23A requires that all of a bank’s extensions of credit to its affiliates be appropriately secured by acceptable collateral.

      Affiliate transactions are also subject to Section 23B of the Federal Reserve Act which generally requires that covered and other transactions between the Bank and its affiliates be on terms substantially the same, or at least as favorable to the Bank, as those prevailing at that time for comparable transactions with or involving other non-affiliated persons.

      The restrictions on loans to directors, executive officers, principal shareholders and their related interests (collectively, the “insiders”) contained in the Federal Reserve Act and Regulation O apply to all insured institutions and their subsidiaries and holding companies. These restrictions include limits on loans to one borrower and conditions that must be met before such a loan can be made. There is also an aggregate limitation on all loans to insiders and their related interests. These loans cannot exceed the institution’s total unimpaired capital and surplus, and the FDIC may determine that a lesser amount is appropriate. Insiders are subject to enforcement actions for knowingly accepting loans in violation of applicable restrictions.

      Capital Adequacy Requirements. The Bank is subject to capital adequacy requirements promulgated by the FDIC and the Texas Department of Banking. The FDIC may establish higher minimum requirements if, for example, a bank has previously received special attention or has a high susceptibility to interest rate risk.

      The FDIC’s risk-based capital guidelines generally require state banks to have a minimum ratio of Tier 1 capital to total risk-weighted assets of 4.0% and a ratio of total capital to total risk-weighted assets of 8.0%.

      The FDIC’s leverage guidelines require state banks to maintain Tier 1 capital of not less than 4.0% of average total assets, except in the case of certain highly rated banks for which the requirement is 3.0% of average total assets. The Texas Banking Department has issued a policy which generally requires state chartered banks to maintain a leverage ratio (defined in accordance with federal capital guidelines) of 6.0%.

      Corrective Measures for Capital Deficiencies. The federal banking regulators are required to take “prompt corrective action” with respect to capital-deficient institutions. Agency regulations define, for each capital category, the levels at which institutions are “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” A “well capitalized” bank has a total risk-based capital ratio of 10.0% or higher; a Tier 1 risk-based capital ratio of 6.0% or higher; a leverage ratio of 5.0% or higher; and is not subject to any written agreement, order or directive requiring it to maintain a specific capital ratio for any capital measure. An “adequately capitalized” bank has a total risk-based capital ratio of 8.0% or higher; a Tier 1 risk-based capital ratio of 4.0% or higher; a leverage ratio of 4.0% or higher (3.0% or higher if the bank was rated a composite 1 in its most recent examination report and is not experiencing significant growth). A bank is “undercapitalized” if it fails to meet any one of the ratios required to be adequately capitalized. The Company believes that as of December 31, 2004, the Bank was “well capitalized” based on the guidelines and ratios for purposes of the FDIC’s prompt corrective action regulations.

      In addition to requiring undercapitalized institutions to submit a capital restoration plan, agency regulations contain broad restrictions on certain activities of undercapitalized institutions including asset growth, acquisition, branch establishment and expansion into new lines of business. With certain exceptions, an insured depository institution is prohibited from making capital distributions, including dividends, and is prohibited from paying management fees to control persons if the institution would be undercapitalized after any such distribution or payment.

      As an institution’s capital decreases, the FDIC’s enforcement powers become more severe. A significantly undercapitalized institution is subject to mandated capital raising activities, restrictions on interest rates paid and transactions with affiliates, removal of management and other restrictions. The FDIC has only very limited discretion in dealing with a critically undercapitalized institution and is virtually required to appoint a receiver or conservator.

      Banks with risk-based capital and leverage ratios below the required minimums may also be subject to certain administrative actions, including the termination of deposit insurance upon notice and hearing, or a temporary suspension of insurance without a hearing in the event the institution has no tangible capital.

      For information regarding the capital ratios of the Bank see the discussion under the section captioned “Capital Resources” included in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 18 — Regulatory Matters in the Notes to the Consolidated Financial Statements included in this report.

      Brokered Deposit Restrictions. FIRREA and FDICIA generally limit institutions that are not well capitalized from accepting brokered deposits. In general, undercapitalized institutions may not solicit, accept or renew brokered deposits. Adequately capitalized institutions may not solicit, accept or renew brokered deposits unless they obtain a waiver from the FDIC. Even in that event, the institution must comply with rate limitations imposed by the Federal Deposit Insurance Act.

      Restrictions on Subsidiary Banks. Dividends paid by the Bank provided substantially all of Sterling Bancshares’ cash flow during 2004 and will continue to do so in the foreseeable future. Under federal law, a bank may not pay a dividend that results in an “undercapitalized” situation. At December 31, 2004, there was an aggregate of approximately $44.2 million available for the payment of dividends by the Bank to Sterling Bancshares.

      Other requirements in Texas law affecting the operation of subsidiary banks include requirements relating to maintenance of reserves against deposits, restrictions on the nature and amount of loans that may be made and the interest that may be charged thereon and limitations relating to investments and other activities.

      Examinations. The FDIC periodically examines and evaluates insured banks. FDIC examinations are conducted every 12 months. The FDIC may, however, accept the result of a Texas Department of Banking examination in lieu of conducting an independent examination. FDICIA authorizes the FDIC to assess the institution for its costs of conducting the examinations.

      The Texas Banking Commissioner also conducts examinations annually, unless additional examinations are deemed necessary to safeguard the interests of shareholders, depositors and creditors. The Commissioner may accept the results of a federal examination in lieu of conducting an independent examination. However, since the Bank’s total assets exceed $1 billion, the FDIC and the Texas Department of Banking conduct a joint examination on an annual basis.

      Audit Reports. Insured institutions with total assets of $500 million or more must submit annual audit reports prepared by an independent registered public accounting firm to federal and state regulators. In some instances, the audit report of the institution’s holding company can be used to satisfy this requirement. In addition, financial statements prepared in accordance with generally accepted accounting principles, management’s certifications concerning responsibility for the financial statements, internal controls and compliance with legal requirements designated by the FDIC, and an attestation by the independent registered public accounting firm regarding the statements of management relating to the internal controls must be submitted. For certain institutions with total assets of more than $3 billion, an independent registered public accounting firm may be required to review quarterly financial statements. FDICIA requires that independent audit committees be formed, consisting solely of outside directors. Committees must include members with experience in banking or financial management, must have access to outside counsel, and must not include representatives of large customers. Our audit committee is comprised solely of outside directors with at least one certified public accountant designated as a financial expert.

      Deposit Insurance Assessments. The FDIC assesses deposit insurance premiums on all banks in order to adequately fund the BIF so as to resolve any insured institution that is declared insolvent by its primary regulator. The FDIC has established a risk-based deposit insurance premium system to calculate a depository institution’s semi-annual deposit insurance assessment. The FDIC’s semi-annual assessment is based upon the designated reserve ratio for the BIF and the probability and extent to which the BIF will incur a loss with respect to the institution. In addition, the FDIC can impose special assessments to cover the cost of borrowings from the U.S. Treasury, the Federal Financing Bank, and BIF member banks.

      The FDIC may adjust the assessment rate schedule twice a year without seeking prior public comment, but only within a range of five cents per $100 above or below the premium schedule adopted. The FDIC can make changes in the rate schedule outside the five-cent range above or below the current schedule only after a full rulemaking with opportunity for public comment.

      Expanding Enforcement Authority. One of the major additional impacts imposed by FDICIA is the increased ability of banking regulators to monitor the activities of banks and their holding companies. The Federal Reserve Board and FDIC have extensive authority to police unsafe or unsound practices and violations of applicable laws and regulations by depository institutions and their holding companies. For example, the FDIC may terminate the deposit insurance of any institution that it determines has engaged in an unsafe or unsound practice. The agencies can also assess civil money penalties, issue cease and desist or removal orders, seek injunctions, and publicly disclose such actions. FDICIA, FIRREA and other laws have expanded the agencies’ authority in recent years, and the agencies have not yet fully tested the limits of their powers.

      Effect on Economic Environment. The policies of regulatory authorities, including the monetary policy of the Federal Reserve Board, have a significant effect on the operating results of bank holding companies and their subsidiaries. Among the means available to the Federal Reserve Board to affect the money supply are open market operations in U.S. government securities, changes in the discount rate on member bank borrowings and changes in reserve requirements against member bank deposits. These means are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use may affect interest rates charged on loans or paid for deposits.

      Federal Reserve Board monetary policies have materially affected the operating results of commercial banks in the past and are expected to continue to do so in the future. The nature of future monetary policies and the effect of such policies on our business and earnings cannot be predicted.

      Consumer Laws and Regulations. Banks are also subject to certain consumer laws and regulations that are designed to protect consumers in transactions with banks. Among the more prominent of such laws and regulations are the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, the Fair Credit Reporting Act, the Fair Housing Act and consumer privacy protection provisions of the Gramm-Leach-Bliley. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must deal with customers when taking deposits or making loans to such customers. We must comply with the applicable provisions of these consumer protection laws and regulations as part of our ongoing customer relations.

Employees

      The Company had 961 full time equivalent employees as of December 31, 2004. None of our employees are represented by collective bargaining agreements and the Company considers its employee relations to be good. In January 2005, Sterling Bancshares was named for the third consecutive year as one of the top 100 companies to work for in America by Fortune magazine.

Available Information

      Under the Exchange Act, Sterling Bancshares is required to file annual, quarterly and current reports, proxy statements and other information with the SEC. You may read a copy of any document we file with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information about the Public Reference Room. The SEC maintains a web site at http://www.sec.gov that contains reports, proxy and information statements, and other information we file electronically with the SEC.

      We make available, free of charge through our web site, our reports on Forms 10-K, 10-Q and 8-K, and amendments to those reports, as soon as reasonably practicable after such reports are filed with the SEC. Additionally, we have adopted and posted on our web site a Code of Ethics for Senior Financial Officers that applies to our principal executive officer, principal financial officer and principal accounting officer. Our web site also includes the charters for our Audit Committee and Corporate Governance and Nominating Committee. The address for our web site is http://www.banksterling.com. We will also provide a printed copy of any of these aforementioned documents upon request.

      Our principal executive offices are located at 2550 North Loop West, Suite 600, Houston, Texas, 77092, in space leased by the Company. In addition to our principal office, we operate the following locations:

      The Company has options to renew leases at most locations.

      From time to time, the Company is a party to various legal proceedings incident to its business. Currently, neither Sterling Bancshares nor any of its subsidiaries is involved in any material legal proceedings.

      No matters were submitted to a vote of security holders during the fourth quarter of 2004.

PART II

COMMON STOCK MARKET PRICES AND DIVIDENDS

      Our stock trades through The Nasdaq National Market under the symbol “SBIB.” The following table sets forth the high and low closing stock prices of Sterling Bancshares’ common stock and the dividends paid thereon for each quarter of the last two years.

      On January 31, 2005, the Board of Directors declared a quarterly cash dividend of $0.06 per share payable on February 26, 2005, to shareholders of record on February 12, 2005. We intend to continue to pay a dividend at a minimum rate of $0.06 per share quarterly throughout 2005. We are not able to predict whether we will continue to pay cash dividends on our common stock in the future or the amount or frequency of any such dividend. The payment of future dividends is dependent on our future earnings, capital requirements and financial condition.

      For information on the ability of the Bank to pay dividends and make loans to Sterling Bancshares, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Financial Condition — Interest Rate Sensitivity and Liquidity” and Note 18 to the Consolidated Financial Statements.

      As of March 7, 2005, the Company estimates that there were 1,044 shareholders of record of common stock. The number of beneficial shareholders is unknown to the Company at this time.

RECENT SALES OF UNREGISTERED SECURITIES

      As of November 7, 2004, the Company issued an aggregate of 20,000 shares of our common stock upon the conversion of 20,000 shares of Series I Convertible Preferred Stock. The holders of the Series I Convertible Preferred Stock previously acquired such shares from the Company in a private transaction in

2002. No additional consideration was due from or paid by the holders of the Series I Convertible Preferred Stock. The common shares issued upon such conversion were not registered under the Securities Act of 1933 because the exchange of the Series I Convertible Preferred Stock for the shares of common stock was exempt from registration under the Securities Act of 1933 pursuant to Section 3(a)(9) thereunder.

      The following selected consolidated financial data is derived from the Company’s audited Consolidated Financial Statements. The selected consolidated financial data does not purport to be complete and should be read in conjunction with, and is qualified by, the more detailed information, including the Consolidated Financial Statements and related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere in this report.

      During the periods indicated, we completed five acquisitions of bank holding companies and/or banks. With respect to one acquisition completed during the reported periods which was accounted for using the “pooling of interest” method, all financial data has been restated to include the acquired entity’s balance sheet data and historical results of operation. On September 30, 2003, we sold our 80% interest in SCMC. Accordingly, the operating results of SCMC are now reported together with the net gain realized on the sale as discontinued operations. Please read “Risk Factors” beginning on page 39 for a discussion of material uncertainties which might cause the selected consolidated financial data not to be indicative of our future financial conditions or results of operations.

FORWARD-LOOKING STATEMENTS

      This Annual Report on Form 10-K, other periodic reports filed by us under the Exchange Act, and other written or oral statements made by or on behalf of the Company contain certain statements relating to future events and our future results which constitute forward-looking statements under the Private Securities Litigation Reform Act of 1995. These “forward-looking statements” are typically identified by words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” or words of similar meaning, or future or conditional verbs such as “will,” “would,” “should,” “could,” or “may.”

      Forward-looking statements reflect our expectation or predictions of future conditions, events or results based upon information currently available and involve risks and uncertainties that may cause actual results to differ materially from those in such statements. These risks and uncertainties include, but are not limited to, the following:

      Forward-looking statements speak only as of the date they are made. We do not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events, such as market deterioration that adversely affects credit quality and asset values.

OVERVIEW

      “Management’s Discussion and Analysis of Financial Condition and Results of Operations” analyzes major elements of our Consolidated Financial Statements and provides insight into important areas of management’s focus. This introduction highlights selected information in this report and may not contain all of the information that is important to you. For a more complete understanding of trends, events, commitments, liquidity, capital resources and critical accounting estimates, you should carefully read this entire report. This section should also be read in conjunction with our Consolidated Financial Statements and related Notes included elsewhere in this report.

      Our success is highly dependent on economic conditions and market interest rates. Because we operate primarily in Houston, and to a lesser extent, in the Dallas and San Antonio metropolitan areas, the local economic conditions of these areas are particularly important. The Houston and Texas economies continued to improve during 2004 and we remain fairly optimistic that our internal growth and related credit quality should steadily improve going forward. We are seeing improved results in our customer’s financial condition, including increases in their backlogs and improved liquidity and profitability in their financial statements. In addition, local economists are predicting that job growth in key sectors such as energy and manufacturing should increase in Houston during 2005.

      During the first half of 2004, we undertook a significant effort related to improving asset quality. With subsequent overall asset quality improvements, we were able to further focus our efforts toward loan growth, the further development of our new and existing customer base, as well as the redeployment of our capital in the second half of 2004.

      During 2004, we implemented an expense management initiative whereby numerous expense reduction and alignment projects were identified including the consolidation of smaller offices, disposition of unprofitable initiatives, modification of certain perquisite benefit programs and continued reductions of staffing levels through attrition. These projects are expected to reduce our non-interest expense base and

allow for greater control of expense growth in 2005. As part of this initiative, we terminated two consulting contracts and closed one unprofitable banking facility. These combined two initiatives are expected to save approximately $1.4 million annually beginning in 2005.

      We realize income primarily from the difference between interest earned on loans and investments and the interest paid on deposits and borrowings. Each of these financial instruments reacts differently to interest rates. During 2004, the Federal Reserve Bank increased overnight interest rates a total of 125 basis points beginning in June 2004. Prior to these increases, interest rates were near 40-year lows. While we are impacted significantly by the size and timing of short-term rate increases, as well as the shape of the yield curve and other competitive factors, our balance sheet is generally positioned to benefit from a rising interest rate environment.

      There are several factors impacting comparisons of our financial statements for 2004 to earlier years. These factors should be kept in mind when considering our future prospects as well:

      During 2003 and 2004, we made several decisions designed to more clearly align our operations with our long term vision and strategy. In 2003 we made the strategic decision to divest of SCMC in order to better position us to focus our efforts on the commercial banking needs of small to mid-sized businesses. We have used the net proceeds of the sale to support our ongoing internal growth. SCMC’s operations were reported previously as the Company’s mortgage-banking segment; which is reported together with the net gain on sale as discontinued operations. Other areas of our financial statements affected by the sale of SCMC are not as easily highlighted. As a banking operation, the Bank benefited by providing SCMC with a warehouse line of credit which financed mortgage loans held for sale. Additionally, SCMC maintained operating and escrow deposits with the Bank reducing the Bank’s other borrowing needs. Due to decisions made by the buyer of SCMC, the Bank lost the benefit of these loans and deposit balances shortly after completing the sale of SCMC in September 2003.

      In 2004, we closed one of our banking offices and merged its operations into another location. We retained substantially all of the loans and deposits associated with this location. In 2003, we sold five banking offices acquired as part of previous acquisitions. These five banking offices were located in Eagle Pass, Pearsall, Crystal City, Carrizo Springs and Highlands, Texas and were sold because their operations and growth potential did not align with our business banking strategy of serving small and mid-sized businesses in the major metropolitan areas.

      Finally, acquisitions we made will not only affect comparisons with previous periods, but also our future prospects. During the fourth quarter of 2003, we completed the acquisition of South Texas Capital Group, Inc. of San Antonio and its subsidiary bank, Plaza Bank.

CRITICAL ACCOUNTING POLICIES

      An understanding of our accounting policies is important to an understanding of our reported results. Accounting policies are described in detail in Note 1 to the Consolidated Financial Statements in this annual report.

      Allowance for credit losses — The allowance for credit losses is a valuation allowance for probable losses incurred on loans. Loans are charged to the allowance when the loss actually occurs or when a determination is made that a probable loss has occurred. Recoveries are credited to the allowance at the time of recovery. Throughout the year, management estimates the probable level of losses to determine whether the allowance for credit losses is adequate to absorb losses in the existing portfolio. Based on these estimates, an amount is charged to the provision for credit losses and credited to the allowance for credit losses in order to adjust the allowance to a level determined to be adequate to absorb losses. Management’s judgment as to the level of probable losses on existing loans involves the consideration of

current economic conditions and their estimated effects on specific borrowers; an evaluation of the existing relationships among loans, potential credit losses and the present level of the allowance; results of examinations of the loan portfolio by regulatory agencies; and management’s internal review of the loan portfolio. In determining the collectibility of certain loans, management also considers the fair value of any underlying collateral. The amount ultimately realized may differ from the carrying value of these assets because of economic, operating or other conditions beyond our control. Please refer to the subsequent discussion of “Allowance for Credit Losses” below as well as in Note 1 to the Consolidated Financial Statements for additional insight into management’s approach and methodology in estimating the allowance for credit losses.

      Stock-based Compensation — We account for stock-based employee compensation plans using the intrinsic value-based method. Because the exercise price of the Company’s employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized on options granted. Compensation expense for restricted stock awards is based on the market price of the stock on the date of grant and is recognized ratably over the vesting period of the award. We make pro-forma disclosures of net income and earnings per share assuming the fair value-based accounting method in Note 1 to the Consolidated Financial Statements.

      We expect to adopt the provisions of SFAS No. 123R “Share-Based Payment (Revised 2004),” on July 1, 2005. Among other things, SFAS 123R eliminates the ability to account for stock-based compensation using the intrinsic value-based method of accounting and requires that such transactions be recognized as compensation expense in the income statement based on their fair values on the date of the grant. SFAS 123R is effective on July 1, 2005. SFAS 123R will require that management make assumptions related to our stock price volatility and employee turnover that are utilized to measure compensation expense.

RESULTS OF OPERATIONS

Performance Summary

      Net income for the year ended December 31, 2004 was $25.0 million, or $0.55 per diluted share, compared with $49.1 million, or $1.10 per diluted share earned for 2003 and $36.6 million, or $0.82 per diluted share earned for 2002. Income from continuing operations was equal to reported net income in 2004, while income from continuing operations totaled $28.4 million, or $0.64 per diluted share for 2003 and $33.2 million, or $0.74 per diluted share for 2002.

      Net income for 2003 and 2002 included discontinued operations related to the sale of SCMC which was sold in 2003. Income from continuing operations for 2004 decreased $3.4 million compared to 2003. This decrease was primarily due to decreases during 2004 in both net interest income and other income of $2.8 million and $2.3 million, respectively, and an increase in total noninterest expense of $8.2 million. These changes were offset by a decrease in the provision for credit losses of $5.4 million and lower provision for income taxes of $4.6 million. Net income for 2004 included total after-tax net gains on the sales of securities of $3.2 million, or $0.07 per diluted share, impairment charges on certain bank assets totaling $2.3 million, or $0.05 per diluted share, net of taxes and contract termination charges of $764 thousand, or $0.02 per diluted share, net of taxes. We also reduced income tax expense during 2004 by $1.2 million, or $0.03 per diluted share as a result of the expiration of previous tax contingencies and refunds received.

      Income from continuing operations for the 2003 period included after-tax net gains on the sales of rural banking offices of $2.3 million, or $0.05 per diluted share. Income from continuing operations for 2003 decreased $4.8 million compared to 2002. This decrease was primarily due to decreases in net interest income of $2.8 million, an increase in the provision for credit losses of $6.0 million, offset by an increase in noninterest income of $3.5 million due primarily to the gain on sales of rural banking offices discussed above.

      Two commonly used industry measures of a banking institution’s performance are return on average assets and return on average common equity. Return on average assets (“ROA”) measures net income in relation to average total assets and is an indicator of a company’s ability to employ its resources profitably. For 2004, our ROA (from continuing operations) was 0.78%, as compared to 0.86% and 1.10% for 2003 and 2002, respectively.

      Return on average common equity (“ROE”) measures net income in relation to average common equity and is an indicator of a company’s return to its owners. For 2004, our ROE (from continuing operations) was 8.23% compared to 10.50% and 14.06% for 2003 and 2002, respectively.

Net Interest Income

      Net interest income represents the amount by which interest income on interest-earning assets, including loans and securities, exceeds interest paid on interest-bearing liabilities, including deposits and borrowings. Net interest income is our principal source of earnings. Interest rate fluctuations, as well as changes in the amount and type of earning assets and liabilities, combine to affect net interest income.

      The Federal Reserve Board significantly influences market interest rates, including rates offered for loans and deposits by many financial institutions. Generally, when the Federal Reserve Board changes the target overnight interest rate charged by banks, the market responds with a similar change in the prime lending rate. Our loan portfolio is impacted significantly by changes in short-term interest rates. During the fourth quarter of 2002, the Federal Reserve Board decreased overnight interest rates by 50 basis points from 1.75% to 1.25%. During the second quarter of 2003, overnight interest rates decreased an additional 25 basis points to 1.00%. During this period, market interest rates were near 40-year lows. This extended period of declining and then low interest rates negatively impacted our net interest margin and net interest income during these periods.

      Beginning in June 2004 the Federal Reserve Board began increasing overnight interest rates for a combined increase of 125 basis points to a Fed Funds target rate of 2.25% at December 31, 2004. Since our balance sheet is asset sensitive, our interest-earning assets generally reprice more quickly than the interest-bearing liabilities. Our net interest margin began to improve during the second half of 2004 following these increases in interest rates.

      Net interest income for 2004 was $135.4 million, down $2.9 million or 2.1% from $138.2 million for 2003. Interest income decreased $5.3 million due to a decrease in average interest-earning assets and a nine basis point decrease in the average yield earned on interest-earning assets. This was partially offset by a decrease in interest expense of $2.4 million compared to 2003, resulting from a decrease in average interest-bearing liabilities and a decrease in average yield paid on interest-bearing liabilities of six basis points. Net interest income and margin were primarily impacted by the sale of SCMC and the changes in interest rates as discussed above. During 2003, net interest income decreased $2.8 million or 2.0% from $141.0 million earned for 2002. This decrease was primarily attributable to the decrease in yields on loans, securities and deposits due to decreases in interest rates discussed above offset by increases in volumes.

      Average interest-earning assets decreased $44.4 million or 1.5% in 2004 compared to 2003. The average yield earned on interest-earning assets decreased nine basis points in 2004 compared to 2003. These decreases resulted in part from a decrease in average loans held for sale of $431.0 million compared to 2003. Average loans held for sale for 2003 included $432.7 million related to the mortgage warehouse we financed for our mortgage-banking operation. On September 30, 2003, we completed the sale of our mortgage-banking operations and we lost the benefit of the mortgage warehouse shortly after completing the sale when the buyer decided to pay off this credit facility. The decrease in interest income resulting from lower loan volumes was offset somewhat by additional investments in investment securities with lower yields than that of the mortgage warehouse.

      Average interest-earning assets increased $307.0 million or 11.6% during 2003 compared to 2002. These increases were primarily due to growth in loans held for investment which increased on average $233.6 million and an increase in average investments on securities of $36.2 million. The average yield on

interest-earning assets decreased 95 basis points from 6.75% in 2002 to 5.80% in 2003 due to combined overnight interest rate reductions of 75 basis points during 2002 and 2003 as discussed above.

      Beginning in the fourth quarter of 2003 and continuing throughout 2004, we increased the size of the investment portfolio for balance sheet liquidity purposes and to replace a portion of the earning assets related to our mortgage-banking operation. On average, the securities portfolio was higher by $240.8 million or 69.9% for 2004 compared to 2003 and $36.2 million or 11.7% for 2003 as compared with 2002. As mentioned above, the average yields on these securities were less than the yield previously earned on the mortgage warehouse credit facility. During the second quarter of 2004, we sold our lower yielding U.S. Treasury securities. These funds were redeployed into higher yielding mortgage-backed securities with a profile similar to those in the existing investment portfolio during the third quarter of 2004.

      Average interest-bearing liabilities for 2004 were $2.0 billion, a decrease of $70.9 million or 3.4% compared to 2003. The average balance of short-term borrowings and notes payable decreased $136.2 million or 33.1% compared to 2003. We repaid certain borrowings and notes payable immediately after the sale of our mortgage-banking operations in 2003. Average interest-bearing liabilities for 2003 were $2.1 billion, an increase of $190.0 million or 10.0% compared to 2002. The cost of interest-bearing liabilities decreased six basis points from 1.58% for 2003 to 1.52% for 2004 and 41 basis points during 2003 compared to 1.99% for 2002. The decrease in the average cost of interest-bearing deposits for both periods was due primarily to decreases in market interest rates mentioned above. The decrease in the average cost of interest-bearing liabilities helped offset the impact of declining yields on interest-earning assets. Competitive pressures often limit our ability to reduce rates on deposits by the same amount as that of loans during periods of declining rates.

      Our net interest margin was 4.65% for 2004 compared to 4.68% for 2003 and 5.32% for 2002. The decrease of three basis points from 2004 to 2003 was primarily attributable to the payoff of the higher yielding mortgage warehouse credit facility and declines in market interest rates that occurred prior to 2004. These declines were partially offset by increases in overnight interest rates during the last half of 2004. Overall, the net interest margin decreased 64 basis points from 2003 to 2002.

      Certain average balances, together with the total dollar amounts of interest income and expense and the average interest yield/rates are included below. No tax equivalent or day count adjustments were made (dollars in thousands):

     The following rate/volume analysis shows the portions of the net change in interest income and expense due to changes in volume or rate. The changes in interest income due to both rate and volume in the analysis have been allocated proportionately to the volume or rate changes (in thousands):

Noninterest Income

      Noninterest income consisted of the following (in thousands):

      Customer service fees for 2004 decreased $1.7 million or 10.3% compared to 2003 while customer service fees for 2003 decreased $679 thousand or 4.0% compared to 2002. Customer service fees decreased due in large part to the sale of banking offices in 2003. These rural offices had a more retail customer base

and their location and growth potential did not align with our metropolitan business banking strategy. Additionally, insufficient fund fees decreased during 2004 due in part to improvements in asset quality wherein certain marginal relationships exited the Bank.

      During 2003, our net gain on the sale of four banking offices was $3.5 million. During 2004, we closed one banking offices and merged its operations into another location. The bank building and related fixtures were sold for a pre-tax loss of $27 thousand. We retained substantially all of the loans and deposits associated with this location.

      Losses on trading assets in 2004 were attributable to declines in the fair market value of these assets and a decrease in trading activity resulting from current market conditions and a change in governmental regulations. Trading assets are carried at fair market value in our consolidated balance sheets. Gains on trading assets did not significantly fluctuate in 2003 compared to 2002.

      Net gain on the sale of securities increased $4.0 million for 2004 compared to 2003. These gains were primarily the result of two separate securitization transactions during 2004 in which we sold $75.6 million of certain interest-only securities held in our available-for-sale portfolio. We received proceeds of $83.9 million which resulted in net gains totaling $5.2 million during 2004. The Company did not retain any interests in these securities and neither the investors in the securitization trusts nor the trusts have any recourse other than for a breach of customary representations as to ownership and origination, but not for credit loss or default. These gains were offset by a realized loss of $853 thousand for the sale of lower yielding U.S. Treasury Securities during the second quarter of 2004. Net gains on securities transactions in 2003 and 2002 were not significant and were the result of routine portfolio management activities in the securities portfolio.

Noninterest Expense

      The following table shows the detail of noninterest expense (in thousands):

      During 2004, we took various steps to reduce our overall expense base and control the growth of future expenses. After a review by management and employees, numerous expense reduction and alignment projects were identified, including the consolidation of smaller offices, disposition of unprofitable initiatives, modification of certain perquisite benefit programs and continued reductions in staffing levels through attrition. These projects are expected to help reduce our current noninterest expense base and allow for greater control of expense growth in 2005.

      Salaries and employee benefits for 2004 increased of $2.7 million or 4.2% compared to 2003, and $2.1 million or 3.3% for 2003 compared to 2002. These increases were primarily related to increased staffing levels, merit-based and market-driven salary increases and increases in incentive pay and profit sharing. Staffing levels increased in large part due to the three new offices we obtained in the Plaza Bank acquisition which occurred on October 31, 2003. We had 961 full-time equivalent employees at

December 31, 2004 compared with 1,036 at December 31, 2003 and 1,065 at December 31, 2002. The full-time equivalent employee count decreased during the latter part of 2004 due in large part to the expense management initiative previously mentioned.

      Technology expense increased $957 thousand or 18.5% for 2004 compared to 2003 while technology expense for 2003 remained consistent compared to 2002 with a slight increase of $124 thousand or 2.5%. The increase in 2004 was due primarily to the costs of upgrading our computer systems.

      Professional fees increased $2.4 million or 51.4% for 2004 compared to 2003 and $419 thousand or 10.0% for 2003 compared to 2002. The increase during 2004 was due in large part to charges of $1.2 million related to the termination of certain consulting agreements coupled with various legal, audit and consulting fees totaling approximately $720 thousand in connection with Sarbanes-Oxley compliance. The increase in 2003 was primarily attributable to consulting fees of $759 thousand related to various analysis and operations overviews of SCMC prior to the announced sale.

      Marketing expense decreased slightly for 2004 compared to 2003. Marketing expense increased $932 thousand or 164.7% in 2003 compared to 2002. We increased our marketing and branding efforts through increased television, print and radio advertising in 2003.

      Other noninterest expenses totaled $17.8 million for 2004, an increase of $2.0 million or 12.4% over 2003. Other noninterest expense decreased $1.3 million or 7.7% for 2003 compared to 2002. The increase during 2004 was primarily due to impairment charges of $1.4 million related to one bank office building and two tracts of unused land and losses incurred on the write-off of certain purchased lease interests totaling $1.1 million. In 2002, we recorded $1.4 million of non-cash expenses related to the early redemption of trust preferred securities in November 2002.

Income Taxes

      We provided $9.5 million for federal income taxes for 2004, $39.1 million for 2003 and $18.1 million for 2002. The effective tax rates for 2004, 2003, and 2002 were 27.5%, 44.3%, and 33.1%, respectively. During the fourth quarter of 2004, we reduced income tax expense by $1.2 million which resulted in a significantly lower effective tax rate for 2004 compared with 2003. This reduction was the result of the expiration of previous tax contingencies and refunds received, including the filing of various state and federal tax returns related to our mortgage-banking segment. Our provision for taxes and our effective tax rate increased during 2003 primarily because of a tax election we made pursuant to Section 338(h)(10) of the Internal Revenue Code as part of the sale of SCMC.

      On a continuing operations basis, our effective tax rates for 2004, 2003, and 2002 were 27.5%, 33.1%, and 32.1%, respectively.

FINANCIAL CONDITION

Loans Held for Investment

      The following table summarizes our loan portfolio by type as of December 31 of the year indicated, excluding loans held for sale (dollars in thousands):

      At December 31, 2004, loans held for investment were $2.3 billion, an increase of $207.4 million or 9.7% over loans held for investment at December 31, 2003. This increase was primarily related to growth in the commercial real estate loan category. Our primary lending focus is commercial and industrial loans and owner-occupied real estate loans to businesses with annual sales ranging from $300 thousand to $30 million. Typically, our customers have financing requirements between $50 thousand and $4 million. The Bank’s legal lending limit was $20 million at December 31, 2004 and was not exceeded by any single loan relationship.

      We make commercial loans primarily to small and mid-sized businesses and to professionals. Our commercial loan products include revolving lines of credit, letters of credit, working capital loans, loans to finance accounts receivable and inventory and equipment finance leases. Commercial loans typically have floating rates of interest and are for varying terms (generally not exceeding three years). In most instances, these loans are personally guaranteed by the business owner and are secured by accounts receivable, inventory and/or other business assets. In addition to the commercial loans secured solely by non-real estate business assets, we make commercial loans that are secured by owner-occupied real estate, as well as other business assets.

      Commercial mortgage loans are often secured by first liens on real estate, typically have floating interest rates, and are most often amortized over a 15-year period with balloon payments due at the end of three years. In underwriting commercial mortgage loans, we give consideration to the property’s operating history, future operating projections, current and projected occupancy, location and physical condition. The underwriting analysis also includes credit checks, appraisals and a review of the financial condition of the borrower.

      Our wholesale real estate funding department, formed in late 2003, enhances our strategic goals by originating co-originating, or purchasing first-lien, commercial real estate mortgage loans referred by other financial institutions nationwide. The nationwide credit exposure permits us to diversify our loan portfolio geographically, while supplementing growth in our niche market segment, small to medium-sized businesses. These loans generally have low loan-to-value ratios below 60%, and over 58% of the portfolio has a U.S. Small Business Administration second lien loan behind our first lien. We utilize real estate appraisers familiar with the geographic region in which the property is located in evaluating potential loans. Additionally, these appraisals are reviewed by a third-party appraisal review vendor for accuracy and compliance with bank standards and regulations. More than 80% of these loans have variable interest rates and amortize over twenty, or twenty-five years.

      At December 31, 2004, commercial and industrial loans and commercial real estate loans were 29.2% and 43.4%, respectively, of loans held for investment.

      We also make loans to finance the construction of residential and, to a lesser extent, nonresidential properties, such as churches. Generally, construction loans are secured by first liens on real estate and have floating interest rates. The Bank conducts periodic inspections, either directly or through an architect or other agent, prior to approval of periodic draws on these loans. Underwriting guidelines similar to those described above are also used in our construction lending activities.

      The Bank makes automobile, boat, home improvement and other loans to consumers. These loans are primarily made to customers who have other business relationships with us.

      Loan maturities and rate sensitivity of the total loan portfolio excluding residential real estate-mortgage and consumer loans at December 31, 2004 were as follows (in thousands):

      As of December 31, 2004, there was no concentration of loans to any one industry exceeding 10% of total loans nor were there any loans classified as highly leveraged transactions. The Bank had no material foreign loans outstanding for the years ended December 31, 2000 through 2004.

      Loans held for investment were 95.7% of deposits and 70.1% of total assets at December 31, 2004. At December 31, 2003, loans held for investment were 88.1% of deposits and 66.5% of total assets.

Loans Held for Sale

      Loans held for sale totaled $6.9 million at December 31, 2004, as compared with $26.3 million at December 31, 2003. Loans held for sale at December 31, 2003 included certain purchased commercial real estate loans and the guaranteed portion of SBA loans originated by the Bank. Beginning in 2004, we no longer considered purchased commercial real estate loans as held for sale. Due to the timing of the sales of SBA loans to investors, the balance of loans in the held for sale category at any given time may be somewhat volatile.

Securities

      The carrying amount of available-for-sale and held-to-maturity securities we held at December 31 is shown below (dollars in thousands).