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

FORM 10-Q

For the quarterly period ending September 30, 2002

OR

For the transition period from _________ to __________

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

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, (or for shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.

YES:   XXX        NO:            

4,328,155 shares of common stock were outstanding
as of September 30, 2002

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NORTHERN STATES FINANCIAL CORPORATION AND SUBSIDIARY
FORM 10-Q
SEPTEMBER 30, 2002
INDEX

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INDEPENDENT ACCOUNTANTS’ REPORT

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

     We have reviewed the condensed consolidated balance sheet of NORTHERN STATES FINANCIAL CORPORATION as of September 30, 2002 and the condensed consolidated statements of income for the three and nine month periods ended September 30, 2002 and 2001 and the condensed consolidated statements of cash flows for the nine month periods ended September 30, 2002 and 2001. These financial statements are the responsibility of the Company’s management.

     We conducted our review in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with auditing standards generally accepted in the United States of America, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

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

/s/ Crowe, Chizek and Company LLP

Oak Brook, Illinois
November 1, 2002

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NORTHERN STATES FINANCIAL CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
September 30, 2002 and December 31, 2001
(In thousands of dollars) (Unaudited)

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

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NORTHERN STATES FINANCIAL CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
Three months and nine months ended September 30, 2002 and 2001
(In thousands of dollars, except per share data) (Unaudited)

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

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NORTHERN STATES FINANCIAL CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine months ended September 30, 2002 and 2001
(In thousands of dollars)(Unaudited)

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

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NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2002

(Dollar amounts in thousands, except per share data)

(Unaudited)

Note 1 — Basis of Presentation

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

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

     The interim condensed financial statements should be read in conjunction with the audited financial statements and accompanying notes (or “notes thereto”) of the Company for the years ended December 31, 2001, 2000 and 1999. The results of operations for the three and nine month periods ended September 30, 2002, are not necessarily indicative of the results to be expected for the full year.

     Net income was utilized to calculate both basic and diluted earnings per share for all periods presented. Information regarding weighted average shares utilized in computing basic and diluted earnings per share is as follows:

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NORTHERN STATES FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2002

(Dollar amounts in thousands, except per share data)

(Unaudited)

     On April 17, 2002 it was announced that the Northern States Financial Corporation’s Board of Directors had approved a stock repurchase program that allows the Company to purchase up to 200,000 shares of Northern States Financial Corporation stock either in open market or private transactions. At September 30, 2002, 144,100 shares of treasury stock had been purchased that the Company carries at cost.

     Information related to stockholders’ equity was as follows:

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

     At September 30, 2002 and December 31, 2001, the contract amount of the Company’s off-balance sheet commitments were as follows:

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

     The Company also has Community Reinvestment Act (CRA) investment commitments outstanding of $954. The commitment is to be funded over seven years.

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NORTHERN STATES FINANCIAL CORPORATION

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

     The following discussion focuses on the consolidated financial condition of the Northern States Financial Corporation (the “Company”) at September 30, 2002 and the consolidated results of operations for the three and nine month periods ended September 30, 2002, compared to the same periods of 2001. The purpose of this discussion is to provide a better understanding of the condensed consolidated financial statements and the operations of its subsidiary, the Bank of Waukegan (the “Bank”). This discussion should be read in conjunction with the interim condensed consolidated financial statements and notes thereto included herein.

     The statements contained in management’s discussion and analysis that are not historical facts are forward-looking statements subject to the safe harbor created by the Private Securities Litigation Reform Act of 1995. The Company cautions readers of this report that a number of important factors could cause the Company’s actual results subsequent to September 30, 2002 to differ materially from those expressed in any such forward-looking statements.

FINANCIAL CONDITION

     The consolidated total assets for the Company were $622.9 million at September 30, 2002, increasing $35.6 million from the Company’s year-end, December 31, 2001.

     The Company had $18.5 million in federal fund sold at September 30, 2002, as compared to $16.0 million at December 31, 2001. The Company on a daily basis invests excess cash into federal funds sold. Federal funds sold is a source of liquidity to the Company and fluctuates from day to day.

     The fair value of securities at September 30, 2002 was $216.5 million increasing by $2.5 million from the previous year-end. The increase to the fair value of the securities portfolio is the result of increases to the gross unrealized gains caused by market rate changes. At September 30, 2002, the Company’s securities showed net unrealized gains of $1.9 million as compared to net unrealized losses of $200,000 at December 31, 2001, a shift of $2.1 million. The amortized cost of the Company’s investment portfolio remained relatively unchanged from year-end increasing slightly to $214.6 million at September 30, 2001 compared to $214.2 million at December 31, 2001. The mix of securities remains substantially unchanged from year-end with the carrying value of securities issued by U.S. Government agencies and corporations accounting for 95% of the Company’s securities portfolio at September 30, 2002 as compared to 92% at the previous year-end. Although the prime lending interest rate did not change during the nine months ended September 30, 2002, Treasury note rates showed much volatility during the time period with interest rates generally decreasing. The decreased interest rates had the effect of increasing the fair value of the portfolio. As interest rates declined issuers of callable securities had the opportunity to call the security by issuing a new security at the lower rates. During the first nine months of 2002, securities totaling $191.4 million were called. At September 30, 2002 U.S. Government agency securities with the carrying value of $175.9 million either have call provisions or mature within 90 days. If rates continue to decline it is expected that more securities will be called.

     The Company’s loan portfolio at September 30, 2002 was $360.4 million, an increase of $33.7 million from December 31, 2001. Real estate-mortgage loans increased $30.0 million. Real estate-constuction

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NORTHERN STATES FINANCIAL CORPORATION

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

loans and home equity loans were $6.2 million and $4.5 million more than at the previous year-end. During the first nine months of 2002 two large real estate loans were made, one for $7.0 million for an apartment building complex and another for $6.4 million for a motel. Home equity loans remain popular with consumers as the interest paid on the loan may be used as a tax deduction.

     At September 30, 2002, deposits at the Company increased $51.1 million from December 31, 2001. The major increase was in time deposits, $100,000 and over, which increased $49.4 million from year-end. Public time deposits, $100,000 and over increased $34.2 million while large CDs from commercial and retail depositors increased $11.8 million and $3.4 million. The Company is located in the county seat and accepts deposits from local municipalities. Property taxes were collected in June and September 2002 and resulted in public entities investing their funds into time deposits. Many of the public time deposits, $100,000 and over require pledging of the Company’s investment portfolio as security for the deposit.

     Securities sold under repurchase agreements (repurchase agreements) and other short-term borrowings at the Company decreased $10.2 million from December 31, 2001 to $75.9 million at September 30, 2002 as commercial repurchase agreement customers drew down balances for business purposes. These funds mainly consist of repurchase agreements that are offered through an overnight repurchase agreement product and a term product with maturities from 7 days to one year. Commercial customers have increasingly placed their funds into repurchase agreements as repurchase agreements provide the commercial customer with added security for their funds in the form of an investment that is pledged by the Company. As of September 30, 2002 securities carried at $196.5 million were pledged to secure repurchase agreements and public deposits. Repurchase agreements also provide a source of funds to the Company that do not increase reserve requirements with the Federal Reserve Bank or create an expense relating to FDIC insurance and, therefore, are less costly to the Company.

     On September 30, 2002 the Company had a term advance from the Federal Home Loan Bank in the amount of $6.5 million. This borrowing has decreased $3.5 million from December 31, 2001 as deposits have increased.

     Total stockholders’ equity increased $977,000 during the nine months ended September 30, 2002. The increase is the result of net income of $5.8 million, plus the adjustment in the valuation allowance for the market value of securities available for sale, net of tax, of $1.3 million, plus $21,000 due to the exercise of 2,500 stock options pursuant to the Omnibus Incentive Plan on January 1, 2002 and $13,000 in tax benefits derived from the exercise of the options. At September 30, 2002 no stock options remained outstanding. These increases were partially offset by the repurchase of 144,100 shares of the Company’s common stock as treasury stock for $3.8 million and payment of cash dividends of $2.4 million on June 1, 2002.

     The tier 1 capital to average asset ratio at September 30, 2002 was 12.98% and the total capital to asset ratio, on a risk adjusted basis, amounted to 18.10%, exceeding the minimum required to be capitalized under prompt corrective action regulations, which minimums are 5.00% and 10.00%. Book value per share, was $17.86 at September 30, 2002 as compared to $17.08 at December 31, 2001. On September 30, 2002, the Company and its subsidiary were in compliance with all applicable regulatory capital requirements.

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NORTHERN STATES FINANCIAL CORPORATION

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

RESULTS OF OPERATIONS

NET INCOME

     The consolidated net income for the quarter ended September 30, 2002 was $1,685,000, a decrease of $346,000 compared to net income of $2,031,000 for the same period the previous year. The annualized return on average assets was 1.10% for the quarter, a decrease from a return on average assets for the same quarter the previous year of 1.44%. The consolidated net income for the nine months ended September 30, 2002 was $5,779,000, an increase of $111,000 over the first nine months of 2001. The annualized return on average assets for the first nine months of 2002 was 1.32%, down from the return on average assets for the same period the previous year of 1.38%.

NET INTEREST INCOME

     Net interest income, the difference between interest income earned on average interest earning assets and interest expense on average interest bearing liabilities, declined by $22,000 during the three months ended September 30, 2002 compared to the same three months in 2001. One of the largest factors attributing to this decline was the placement of lease pools totaling $11.3 million on nonaccrual status at June 30, 2002. Prior to being placed on nonaccrual status the Company had been recognizing interest income of $290,000 per quarter on these leases.

     Change in interest rates is an important factor affecting net interest income. During the third quarter of 2002 the prime lending rate remained unchanged at 4.75%, while the one and two-year Treasury note rates showed volatility. The one-year Treasury note rate declined from 2.01% at June 30, 2002 to 1.45% at September 30, 2002 and the two-year note rate decreased 117 basis points from June 30, 2002 ending the quarter at 1.73%. These declines in market interest rates impacted the rates earned on the Company’s taxable investments during the third quarter of 2002. As indicated in Table 1, “Analysis of Average Balance and Tax Equivalent Rates for the Three Months ended September 30, 2002 and 2001”, the average rate earned on taxable securities for the third quarter of 2002 was 3.86%. During the second quarter of 2002 the average rate earned on taxable securities was 4.63%. The reason this average rate decreased during the third quarter is that many of the taxable securities had been called or matured as interest rates declined. During the third quarter of 2002 securities totaling $237.1 million were called or matured and were replaced by the Company with lower yielding securities.

     Table 1, “Analysis of Average Balance and Tax Equivalent Rates for the Three Months ended September 30, 2002 and 2001”, shows that net yield on interest earning assets was 3.15% during the third quarter of 2002 compared to 3.47% for the same period last year. The contributing factors to this decline to the net yield during the third quarter of 2002 as compared to 2001, were the lost lease interest income and the lower income earned on securities as they were called and were discussed above. Table 2, “Analysis of Average Balance and Tax Equivalent Rates for the Nine Months ended September 30, 2002 and 2001”, shows that the net interest yield on earning assets during the first nine months of 2002 was 3.54% compared to 3.47% for the same period last year. This indicates that prior to the third quarter of 2002 the Company’s net interest margin had improved compared to the previous year. The reason for this

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NORTHERN STATES FINANCIAL CORPORATION

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

TABLE 1

NORTHERN STATES FINANCIAL CORPORATION
ANALYSIS OF AVERAGE BALANCE AND TAX EQUIVALENT RATES
For the Three Months Ended September 30, 2002 and 2001 — Rates are Annualized
($ 000s)

(1) -		Interest income on loans includes loan origination fees of $104 and $98 for the three months ended September 30, 2002 and 2001.
(2) -		Tax-exempt income is reflected on a fully tax equivalent basis utilizing a 34% rate.
(3) -		Non-accrual loans are included in average loans.

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NORTHERN STATES FINANCIAL CORPORATION

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

TABLE 2

NORTHERN STATES FINANCIAL CORPORATION
ANALYSIS OF AVERAGE BALANCE AND TAX EQUIVALENT RATES
For the Nine Months Ended September 30, 2002 and 2001- Rates are Annualized
($ 000s)