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UNITED STATES

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FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE

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COMMERCE BANCSHARES, INC.

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

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

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

Yes  X  No

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of 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 checkmark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act.) þ

As of February 9, 2004, the aggregate market value of the voting stock held by non-affiliates of the Registrant was approximately $2,673,000,000.

As of February 9, 2004, there were 67,899,501 shares of Registrant’s $5 Par Value Common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

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Portions of the definitive proxy statement with respect to the annual meeting of shareholders to be held on April 21, 2004, are incorporated in Part III.

Table of Contents

Commerce Bancshares, Inc.

Form 10-K

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General

      Commerce Bancshares, Inc. (the “Company”), a bank holding company as defined in the Bank Holding Company Act of 1956, as amended, was incorporated under the laws of Missouri on August 4, 1966. The Company presently owns all of the outstanding capital stock of four national banking associations, which are headquartered in Missouri, Illinois, Kansas, and Nebraska. The Nebraska bank is limited in its activities to the issuance of credit cards. The remaining three banking subsidiaries engage in general banking business, providing a broad range of retail, corporate, investment and private banking products and services to individuals and businesses. The Company also owns, directly or through its banking subsidiaries, various non-banking subsidiaries. Their activities include owning real estate leased to the Company’s banking subsidiaries, underwriting credit life and credit accident and health insurance, selling property and casualty insurance (relating to consumer loans made by the banking subsidiaries), venture capital investment, securities brokerage, mortgage banking, and leasing activities. The Company owns two second tier holding companies that are the direct owners of several of the above-mentioned banks. A list of the Company’s subsidiaries is included as Exhibit 21.

      The Company is the largest bank holding company headquartered in Missouri. At December 31, 2003, the Company had consolidated assets of $14.3 billion, loans of $8.1 billion, deposits of $10.2 billion, and stockholders’ equity of $1.5 billion.

      The Company’s Missouri bank charter is its largest, with total assets of $12.1 billion and offices in both Missouri and Kansas. The Missouri bank charter comprises approximately 85% of the banking assets of the Company. The Company’s bank charters in Kansas and Illinois operate within each of the states and have total assets of $1.2 billion and $903 million, respectively. The Kansas banking charter has significant operations and banking facilities mainly in the areas of Wichita, Hays, and Garden City, Kansas, along with facilities in the southeast Kansas area. The Illinois banking charter operates mainly in the Peoria and Bloomington, Illinois areas.

      The markets these three banking charters serve, being centrally located in the Midwest, provide natural sites for production and distribution facilities and also serve as transportation hubs. The economy has been well-diversified with many major industries represented, including telecommunications, automobile manufacturing, aircraft manufacturing, numerous service industries, food production and agricultural production and related industries. The markets served by the Illinois bank are located in an area with some of the best land in the world for crop production. The three banking charters operate in areas with stable real estate markets, which in the past have avoided the volatile prices that other parts of the country have experienced.

      The Company regularly evaluates the potential acquisition of, and holds discussions with, various financial institutions eligible for bank holding company ownership or control. In addition, the Company regularly considers the potential disposition of certain of its assets and branches. On January 1, 2003, the Company acquired The Vaughn Group, Inc., a direct equipment lessor based in Cincinnati, Ohio with a portfolio of direct financing, sales type and operating leases. The Company’s most recent bank acquisition was in March 2001, when Breckenridge Bancshares Company and its subsidiary, Centennial Bank, were acquired. For additional information on these acquisitions and other branch disposition activity, refer to pages 11 and 52.

Operating Segments

      The Company is managed in three operating segments. The Consumer segment includes the retail branch network, consumer installment lending, bank card, student lending, and discount brokerage services. It provides services through a network of 185 full-service branches, an extensive ATM network, and the use of alternative delivery channels such as online banking and telephone banking. In 2003, this segment contributed 42% of total segment pre-tax income. The Commercial segment provides a full array

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Supervision and Regulation

      The Company, as a bank holding company, is primarily regulated by the Board of Governors of the Federal Reserve System under the Bank Holding Company Act of 1956 (BHC Act). Under the BHC Act the Federal Reserve Board’s prior approval is required in any case the Company proposes to acquire all or substantially all of the assets of any bank, acquire direct or indirect ownership or control of more than 5% of the voting shares of any bank, or merge or consolidate with any other bank holding company. The BHC Act also prohibits, with certain exceptions, the Company from acquiring direct or indirect ownership or control of more than 5% of any class of voting shares of any nonbanking company. Under the BHC Act, the Company may not engage in any business other than managing and controlling banks or furnishing certain specified services to subsidiaries and may not acquire voting control of nonbanking companies unless the Federal Reserve Board determines such businesses and services to be closely related to banking. When reviewing bank acquisition applications for approval, the Federal Reserve Board considers, among other things, each subsidiary bank’s record in meeting the credit needs of the communities it serves in accordance with the Community Reinvestment Act of 1977, as amended (CRA). The Missouri, Kansas and Nebraska bank charters have current CRA ratings of “outstanding”, and the Illinois charter has a “satisfactory” rating.

      The Company is required to file with the Federal Reserve Board various reports and such additional information as the Federal Reserve Board may require. The Federal Reserve Board also makes regular examinations of the Company and its subsidiaries. The Company’s four banking subsidiaries are organized as national banking associations and are subject to regulation, supervision and examination by the Office of the Comptroller of the Currency (OCC). All banks are also subject to regulation by the Federal Deposit Insurance Corporation. In addition, there are numerous other federal and state laws and regulations which control the activities of the Company and its banking subsidiaries, including requirements and limitations relating to capital and reserve requirements, permissible investments and lines of business, transactions with affiliates, loan limits, mergers and acquisitions, issuance of securities, dividend payments, and extensions of credit. This regulatory framework is intended primarily for the protection of depositors and the preservation of the federal deposit insurance funds, and not for the protection of security holders. Statutory and regulatory controls increase a bank holding company’s cost of doing business and limit the options of its management to employ assets and maximize income.

      In addition to its regulatory powers, the Federal Reserve impacts the conditions under which the Company operates by its influence over the national supply of bank credit. The Federal Reserve Board employs open market operations in U.S. government securities, changes in the discount rate on bank borrowings, changes in the federal funds rate on overnight inter-bank borrowings, and changes in reserve requirements on bank deposits in implementing its monetary policy objectives. These instruments are used in varying combinations to influence the overall level of the interest rates charged on loans and paid for deposits, the price of the dollar in foreign exchange markets and the level of inflation. The monetary policies of the Federal Reserve have had a significant effect on the operating results of financial institutions in the past, most notably the low rate environment in recent years. In view of changing conditions in the national economy and in the money markets, as well as the effect of credit policies of monetary and

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      Under Federal Reserve policy, the Company is expected to act as a source of financial strength to each of its bank subsidiaries and to commit resources to support each bank subsidiary in circumstances when it might not otherwise do so. In addition, any capital loans by a bank holding company to any of its subsidiary banks are subordinate in right of payment to deposits and to certain other indebtedness of such subsidiary banks. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to a priority of payment.

      The principal source of the Company’s cash revenues is dividends from the subsidiary banks. The Federal Reserve Board may prohibit the payment of dividends by bank holding companies if their actions constitute unsafe or unsound practices. The OCC limits the payment of dividends by bank subsidiaries in any calendar year to the net profit of the current year combined with the retained net profits of the preceding two years. The payment of dividends by the bank subsidiaries may also be affected by factors such as the maintenance of adequate capital.

      The Company is required to comply with the capital adequacy standards established by the Federal Reserve. These capital adequacy guidelines generally require bank holding companies to maintain total capital equal to 8% of total risk-adjusted assets and off-balance sheet items (the “Total Risk-Based Capital Ratio”), with at least one-half of that amount consisting of Tier I or core capital and the remaining amount consisting of Tier II or supplementary capital. Tier I capital for bank holding companies generally consists of the sum of common shareholders’ equity, qualifying non-cumulative perpetual preferred stock, a limited amount of qualifying cumulative perpetual preferred stock and minority interests in the equity accounts of consolidated subsidiaries, less goodwill and other non-qualifying intangible assets. Tier II capital generally consists of hybrid capital instruments, term subordinated debt and, subject to limitations, general allowances for loan losses. Assets are adjusted under the risk-based guidelines to take into account different risk characteristics.

      In addition, the Federal Reserve also requires bank holding companies to comply with minimum leverage ratio requirements. The leverage ratio is the ratio of a banking organization’s Tier I capital to its total consolidated quarterly average assets (as defined for regulatory purposes), net of the allowance for loan losses, goodwill and certain other intangible assets. The minimum leverage ratio for bank holding companies is 4%. At December 31, 2003, all of the subsidiary banks were “well-capitalized” under regulatory capital adequacy standards, as further discussed on page 70.

      These laws and regulations are under constant review by various agencies and legislatures, and are subject to sweeping change. The Gramm-Leach-Bliley Financial Modernization Act of 1999 (GLB Act) contained major changes in laws that previously kept the banking industry largely separate from the securities and insurance industries. The GLB Act authorized the creation of a new kind of financial institution, known as a “financial holding company” and a new kind of bank subsidiary called a “financial subsidiary”, which may engage in a broader range of investment banking, insurance agency, brokerage, and underwriting activities. The GLB Act also included privacy provisions that limit banks’ abilities to disclose non-public information about customers to non-affiliated entities. Banking organizations are not required to become financial holding companies, but instead may continue to operate as bank holding

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      In 2001, President Bush signed into law comprehensive anti-terrorism legislation known as the USA Patriot Act. Title III of the USA Patriot Act substantially broadened the scope of U.S. anti-money laundering laws and regulations by imposing significant new compliance and due diligence obligations, creating new crimes and penalties and expanding the extra-territorial jurisdiction of the United States. The U.S. Treasury Department issued a number of regulations implementing the USA Patriot Act that apply certain of its requirements to financial institutions such as the Company’s broker-dealer subsidiary. The regulations impose new obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing.

Competition

      The Company’s locations in regional markets throughout Missouri, Kansas and central Illinois face intense competition from hundreds of financial service providers. The Company competes with national and state banks for deposits, loans and trust accounts, and with savings and loan associations and credit unions for deposits. In addition, the Company competes with other financial intermediaries such as securities brokers and dealers, personal loan companies, insurance companies, finance companies, and certain governmental agencies. The methods of competition center around various factors, such as customer services, interest rates on loans and deposits, lending limits and customer convenience, such as location of offices. The passage of the GLB Act, which removed barriers between banking and the securities and insurance industries, has resulted in greater competition among these industries.

Employees

      The Company and its subsidiaries employed 4,399 persons on a full-time basis and 701 persons on a part-time basis at December 31, 2003. The Company provides a variety of benefit programs including retirement and 401K plans as well as group life, health, accident, and other insurance. The Company also maintains training and educational programs designed to prepare employees for positions of increasing responsibility.

Available Information

      The Company’s principal offices are located at 1000 Walnut, Kansas City, Missouri (telephone number 816-234-2000). The Company makes available free of charge, through its web site at www.commercebank.com, reports filed with the Securities and Exchange Commission as soon as reasonably practicable after the electronic filing. These filings include the annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports.

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Statistical Disclosure

      The information required by Securities Act Guide 3 – “Statistical Disclosure by Bank Holding Companies” is located on the pages noted below.

      The Missouri, Illinois, and Kansas bank subsidiaries maintain their main offices in various multi-story office buildings. These are owned by the bank or a subsidiary of the bank. The banks lease unoccupied premises to the public. The buildings, located in the downtown areas of the major market they serve, include:

      The Nebraska credit card bank leases its offices in Omaha, Nebraska. Additionally, certain other installment loan and credit card functions operate out of leased offices in downtown Kansas City. The Company also has 178 branch locations in Missouri, Illinois and Kansas which are owned or leased, and an additional 143 off-site ATM locations.

      The information required by this item is set forth in Item 8 under Note 18, Commitments, Contingencies and Guarantees on page 75.

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      No matters were submitted during the fourth quarter of 2003 to a vote of security holders through the solicitation of proxies or otherwise.

Commerce Bancshares, Inc.

      The following table sets forth the high and low prices of actual transactions for the Company’s common stock (CBSH) and cash dividends paid for the periods indicated (restated for the 5% stock dividend distributed in December 2003).

      Commerce Bancshares, Inc. common shares are publicly traded on The Nasdaq Stock Market (NASDAQ). NASDAQ is a highly-regulated electronic securities market comprised of competing Market Makers whose trading is supported by a communications network linking them to quotation dissemination, trade reporting, and order execution systems. The Company had 4,920 shareholders of record as of December 31, 2003.

      The required information is set forth below in Item 7.

Overview

      Commerce Bancshares, Inc. (the Company) operates as a super-community bank offering an array of sophisticated financial products delivered with high-quality, personal customer service. It is the largest bank holding company headquartered in Missouri, with its principal offices in Kansas City and St. Louis, Missouri. Customers are served from over 300 locations in Missouri, Kansas, and Illinois, using delivery platforms which include an expansive ATM network, full-featured online banking, and a central contact center.

      The core of the Company’s competitive advantage is its concentration on relationship banking with high service levels and competitive products. In order to enhance shareholder value, the Company focuses

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      Various indicators are used by management in evaluating the Company’s financial condition and operating performance. Among these indicators are the following:

	•	Growth in earning per share – Diluted earnings per share rose 8.9% over 2002 and has risen 9.8%, compounded annually, over the last 5 years
	•	Growth in total revenue – Total revenue is comprised of net interest income and non-interest income, and grew 3.0% over 2002. Net interest income increased slightly over 2002, in spite of historically low short-term interest rates. Non-interest income rose 7.5%.
	•	Expense control – Total non-interest expense grew by only 3% this year due to prudent management and expanded use of technology.
	•	Asset quality – Net charge-offs during 2003 averaged .46% of loans compared to .43% in 2002.
	•	Shareholder return – Total shareholder return, including the stock price and dividends, was 9.9% over the past 5 years.

      The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes. The historical trends reflected in the financial information presented below are not necessarily reflective of anticipated future results.

Key Ratios

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Selected Financial Data

Results of Operations

      Commerce Bancshares, Inc. announced an 8.9% increase in fully diluted earnings per share, which rose to $2.95 in 2003 compared to $2.71 in 2002. Net income for 2003 was $206.5 million, which rose 5.2% over 2002, making 2003 the 19th consecutive year of record earnings. Return on assets amounted to 1.52% compared with 1.58% last year and the return on equity totaled 14.27% compared to 14.42% last year. The efficiency ratio was 58.83% in 2003 compared with 58.62% in 2002.

      Net income rose in 2003 principally due to growth in non-interest income of $21.1 million, or 7.5%, combined with effective expense management and lower income tax expense. Non-interest expense increased by 3.0% over last year and income tax expense declined 7.8%. Net interest income rose slightly, reflecting the effects of low short-term interest rates and a lack of growth in commercial loans. The provision for loan losses increased $6.6 million to $40.7 million, largely due to increases in consumer credit losses. The increase in non-interest income was largely due to increases in deposit account fees of 12.4% and bank card fees of 7.6%, partly offset by small declines in bond, brokerage, and mortgage banking revenues. Non-interest expense increased a modest 3.0%, mainly due to increases in salaries and benefits costs (up 3.4%), but pressured by higher costs for occupancy (up 11.8%) and equipment (up 5.4%). These increases were partly offset by a 9.8% decline in data processing and software expense. Income tax expense declined in 2003 primarily due to the recognition of additional tax benefits from various corporate reorganization initiatives.

      Net income in 2002 was $196.3 million, which was a $17.6 million, or 9.8%, increase over 2001. Diluted earnings per share increased 11.5% to $2.71 compared to $2.43 in 2001. The increase in net income resulted from strong growth in net interest income of $31.2 million, or 6.7%, coupled with lower credit costs and good expense management. Non-interest income increased 2.0% while non-interest expense grew by

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      Effective January 2003, the Company acquired The Vaughn Group, Inc. (Vaughn), a direct equipment lessor based in Cincinnati, Ohio. At acquisition, Vaughn had a lease portfolio that was mainly comprised of $38.7 million of direct financing leases. These leases are secured mainly by computer hardware and office equipment. In addition, at the date of acquisition Vaughn serviced approximately $350 million of lease agreements for other institutions involving capital equipment, ranging from production machinery to transportation equipment. The Company issued a combination of cash and stock to complete this purchase. Goodwill of $5.3 million was recognized in the transaction and recorded in the 2003 consolidated balance sheet.

      In March 2001, the Company acquired Breckenridge Bancshares Company and its subsidiary, Centennial Bank. The bank had three locations in the St. Louis area, with assets of $254 million, loans of $189 million, and deposits of $216 million. Common stock valued at $34.4 million was issued by the Company as consideration in the transaction. The acquisition was accounted for as a pooling of interests transaction; however, the Company’s prior year financial statements were not restated because restated amounts did not differ materially from historical results.

      The Company continually evaluates its network of bank branches throughout Missouri, Kansas and Illinois. As a result of this evaluation process, the Company sold two branch facilities in 2003, at their approximate cost. During 2002, the Company sold two bank branches and a branch facility, realizing pre-tax gains of $2.4 million on these sales. The branches sold in 2002 had loans of $15.0 million, deposits of $38.4 million, and premises of $2.9 million. In 2001, the Company sold one bank branch and two branch facilities. Pre-tax gains of $2.2 million were realized on the 2001 sales, which included loans of $662 thousand, deposits of $5.3 million, and premises of $714 thousand.

      Effective January 1, 2003, the Company voluntarily adopted the provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation”, pursuant to which the cost of stock options are expensed. The Company restated all prior periods to reflect the compensation expense that would have been recognized had the recognition provisions of Statement No. 123 been applied to all options granted to employees after January 1, 1995. The effect of the restatement on 2002 and 2001 was to lower earnings per share by $.04 in each year.

      During 2002, the Company’s investment in a venture capital limited partnership, previously accounted for on the equity method, was reclassified as a consolidated subsidiary. Financial statements for prior periods were also reclassified. At December 31, 2002, the partnership had assets of $9.8 million and no outstanding debt. Limited partnership interests of 47% are held by outside investors. While there was no change to net income, the effect of the reclassification on the 2001 consolidated statement of income was to increase net interest income $865 thousand, decrease non-interest income $2.513 million, and decrease other non-interest expense $1.648 million.

      The Company distributed a 5% stock dividend for the tenth consecutive year on December 12, 2003. All per share and average share data in this report has been restated to reflect the 2003 stock dividend.

Critical Accounting Policies

      The Company’s consolidated financial statements are prepared based on the application of certain accounting policies, the most significant of which are described in Note 1 to the consolidated financial statements. Certain of these policies require numerous estimates and strategic or economic assumptions that may prove inaccurate or be subject to variations which may significantly affect the Company’s

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      The Company has identified several policies as being critical because they require management to make particularly difficult, subjective and/or complex judgments about matters that are inherently uncertain and because of the likelihood that materially different amounts would be reported under different conditions or using different assumptions. These policies relate to the allowance for loan losses, the valuation of certain non-marketable investments, pension accounting, and accounting for income taxes.

      The Company performs periodic and systematic detailed reviews of its loan portfolio to assess overall collectability. The level of the allowance for loan losses reflects the Company’s estimate of the losses inherent in the loan portfolio at any point in time. While these estimates are based on substantive methods for determining allowance requirements, nevertheless, actual outcomes may differ significantly from estimated results, especially in the areas of determining allowances for business, lease, construction and business real estate loans. These loan types are normally larger and more complex, and their collection rates are harder to predict. Consumer loans, including personal mortgage, credit card and personal loans, are individually smaller and perform in a more homogenous manner, making loss estimates more predictable. Extensive explanation of the methodologies used in establishing the allowance is provided in the Allowance for Loan Losses section of this discussion.

      The Company, through its Small Business Investment subsidiaries, has numerous private equity and venture capital investments, which totaled $24.9 million at December 31, 2003. These private equity and venture capital securities are reported at estimated fair values in the absence of readily ascertainable fair values. The values assigned to these securities where no market quotations exist are based upon available information and management’s judgment. Although management believes its estimates of fair value reasonably and conservatively reflect the fair value of these securities, key assumptions regarding the projected financial performance of these companies, the evaluation of the investee company’s management team, and other economic and market factors may affect the amounts that will ultimately be realized from these investments. However, since the portfolio is not significant relative to the Company as a whole, it is not expected that differences between key assumptions and actual outcomes on realization of these assets will materially impact overall Company net income performance.

      Management is required to make various assumptions in valuing its pension assets and liabilities. These assumptions include the expected rate of return on plan assets, the discount rate, and the rate of increase in future compensation levels. Changes to these assumptions could impact earnings in future periods. The Company takes into account the plan asset mix, funding obligations, and expert opinions in determining the various rates used to estimate pension expense. The Company also considers the Moody’s AA corporate bond yields and other market interest rates in setting the appropriate discount rate. In addition, the Company reviews expected inflationary and merit increases to compensation in determining the rate of increase in future compensation levels. While differences in these rate assumptions could alter pension expense, given not only past history and controls in place including use of expert opinions, it is not expected that such estimates could alter expense by more than $1 to $3 million.

      The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Judgment is required in assessing the future tax consequences of events that have been recognized in the Company’s financial statements or tax returns. Fluctuations in the actual outcome of these future tax consequences, including

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Net Interest Income

      Net interest income, the largest source of revenue, results from the Company’s lending, investing, borrowing, and deposit gathering activities. It is affected by both changes in the level of interest rates and changes in the amounts and mix of interest earning assets and interest bearing liabilities. The following table summarizes the changes in net interest income on a fully taxable equivalent basis, by major category of interest earning assets and interest bearing liabilities, identifying changes related to volumes and rates. Changes not solely due to volume or rate changes are allocated to rate.

      Net interest income was $502.4 million in 2003, $500.0 million in 2002 and $468.8 million in 2001. Compared to the prior year, net interest income increased $2.4 million, or .5%, in 2003 compared to an increase of $31.2 million, or 6.7%, in 2002. During 2003, net interest income increased only slightly over

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      During 2002, interest rates were stable through October. Most of the re-pricing came from the Company’s certificate of deposit products, although certain money market deposits also began to re-price downward in late summer. In November 2002, the Federal Reserve lowered short-term rates by 50 basis points, which reduced interest income on large portions of the Company’s loan portfolio that were variably priced. Rates on deposits were also lowered, but some interest checking and savings products had only limited rate reductions due to the already low rate environment. The large fixed rate investment portfolio helped temper the effects of these rate reductions; however, the net interest margin did compress somewhat in the fourth quarter.

      The net yield on earning assets was 4.04% in 2003, 4.39% in 2002 and 4.35% in 2001. Average interest earning assets rose 9.4% in 2003 over 2002, compared to a 5.7% increase in 2002 over 2001. Average interest bearing liabilities increased 9.3% in 2003 compared to a 7.4% increase in 2002.

      Total interest income was $617.4 million in 2003, $652.6 million in 2002 and $751.8 million in 2001. Tax equivalent interest income did not materially differ. Interest income declined $35.1 million, or 5.4%, in 2003 compared to the previous year. As mentioned above, this decline was primarily due to decreases in yields on all loan categories and the Company’s investment securities portfolio, as a result of the reduction in market rates occurring mainly late in 2002 and in 2003. Average loan balances, which earn higher rates, increased $247.7 million during 2003 and generated approximately $22 million of interest income; however, this increase was offset by the effect of lower rates which reduced interest income by over $60 million. Since large sections of the loan portfolio are tied to indices which fluctuate with the prime rate, the rate reductions by the Federal Reserve mentioned above caused much of the loan portfolio to re-price downward. Yields on investment securities were also lower, as maturing securities and an acceleration of early principal payments on mortgage-backed securities were reinvested in lower earning securities and bond premiums were amortized at a faster pace. However, through additional purchases, average balances of investment securities grew $845.6 million, contributing approximately $42 million in additional interest income. At December 31, 2003, average balances of investment securities comprised 35% of average earning assets compared to 31% in 2002. Average loans comprised 64% of average earning assets, down from 68% in 2002.

      Total interest income declined $99.2 million, or 13.2% in 2002 compared to 2001. Average loan balances decreased $48.2 million or .6% in 2002 compared to 2001, while loan yields declined 149 basis points. Increased liquidity provided by deposit growth and increased borrowings allowed the Company to purchase investment securities, which increased an average of $1.1 billion. However, average rates earned on investment securities and overnight investments fell 66 and 237 basis points, respectively, during 2002. The effect of interest rate declines on earning assets, especially loan rates, more than offset the income provided by higher average investment balances.

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      Total interest expense was $115.0 million in 2003, $152.6 million in 2002 and $283.0 million in 2001. Interest expense declined $37.6 million, or 24.6%, in 2003 compared to 2002. The average rate paid on interest bearing liabilities was 1.06% in 2003 compared to 1.54% in 2002. The lower interest rate environment described above resulted in an interest rate decline of 50 basis points on deposits and 29 basis points on overnight borrowings. The decline in deposit rates affected all deposit products, with the largest effect on the Company’s money market deposit accounts, where rates declined 52 basis points. A decline of $207.9 million in average retail certificates of deposit decreased interest expense by $6.5 million. In addition, new certificates of deposit issued in 2003 were at lower rates which further lowered interest expense compared to 2002. This continued re-pricing of deposits was offset by an increase in interest expense of $4.8 million on other borrowings which resulted mainly from growth of $776.2 million in average federal funds purchased and repurchase agreements.

      In 2002, interest expense decreased $130.4 million, or 46.1%, from 2001. The decrease was due to rate declines of 148 basis points on deposits, 191 basis points on overnight borrowings, and 212 basis points on longer-term borrowings. The decline in deposit interest resulted mainly from rate reductions of 195 basis points paid on the Company’s certificates of deposit of less than $100,000 and 242 basis points paid on the Company’s certificates of deposit of $100,000 and over. Average interest bearing deposits grew $447.1 million, or 5.3%, during 2002.

Provision for Loan Losses

      The provision for loan losses was $40.7 million in 2003, compared with $34.1 million in 2002 and $36.4 million in 2001. The provision for loan losses is recorded to bring the allowance for loan losses to a level deemed adequate by management based on the factors mentioned in the following “Allowance for Loan Losses” section of this discussion.

Non-Interest Income

     Non-interest income increased $21.1 million, or 7.5%, during 2003 to $301.7 million. The largest increase occurred in deposit account fees, which rose 12.4%, or $11.3 million, as a result of growth in fee income on overdraft and return items, coupled with higher commercial cash management fees. The increase in overdraft fees was due to both pricing increases in the Company’s Missouri markets coupled with improved collection efficiencies. Compared to the previous year, bank card fee income rose $4.4 million, or 7.6%, mainly due to 11.1% growth in cardholder transaction fees and 10.9% growth in merchant interchange revenue. Growth in debit card fees (which is a component of bank card fees) slowed to 1.9% as a result of lower transaction pricing which went into effect in August as a result of the WalMart lawsuit settlement with VISA U.S.A., Inc. Trust fee revenue increased slightly in 2003 over 2002 as the value of

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      As was mentioned in previous reports on Form 10-Q, in April 2003, VISA U.S.A., Inc. reach an agreement to settle litigation concerning debit card interchange fees with a large group of retailers. As a result of this litigation, the Company previously estimated that annual debit card revenue, based on current volumes, could potentially decline by approximately $6.2 million, or 10% of estimated annual total bank card transaction fees. Since then, as noted above, new pricing on debit card transactions has gone into effect. However, other transaction and pricing initiatives have been identified which should help offset this lost revenue. As a result, the Company believes this lost annual revenue estimate could be reduced by as much as 10% to 20%. Over time, growth in overall transactions will help compensate for these pricing changes. The Company is continuing its evaluation of various initiatives which could further reduce the impact of this lost revenue.

      In 2002, non-interest income totaled $280.6 million, which was a $5.6 million, or 2.0%, increase over 2001. Trust fees decreased $2.1 million, or 3.3%, because of declining values in trust account assets. Most of the decline in trust fees occurred in the personal trust product line, while institutional trust fees increased somewhat. Deposit account fees increased 8.1%, or $6.8 million, in 2002 due to higher fee income in commercial cash management accounts and fees earned on deposit account overdrafts. Bank card fees increased $3.3 million, or 6.0%, mainly due to growth in debit card fee income, which rose 15.0% over the previous year. Also, fees on credit cardholder transactions increased 7.2%. Trading account fees rose 4.1%, and were strong in 2002 as a result of sustained customer demand. Consumer brokerage service fees increased 5.8% on sales of annuities. Mortgage banking revenues declined $1.9 million as a result of lower sales of mortgages to upstream correspondent banks. During 2002, the Company retained more 15 year fixed rate loan originations on its balance sheet than in previous years. This reduced sales to upstream banks and reduced mortgage banking profit. Net gains on securities transactions amounted to $2.8 million in 2002, a decrease of $305 thousand from the previous year. The 2002 activity included gains of $6.0 million resulting from sales from the banks’ securities portfolios and losses of $3.2 million recognized on venture capital investments. Other non-interest income included a $1.5 million gain on the sale of the Company’s minority interest in an Illinois community bank. Also included were gains on sales of student loans, which declined $1.5 million due to lower loan volume sold in 2002. Sales of bank branches and facilities were comparable in 2002 and 2001, with gains of $2.4 million recorded in 2002 and $2.2 million in 2001.

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Non-Interest Expense

      Non-interest expense rose 3.0% in 2003 to total of $472.1 million, compared to $458.2 million in 2002. Salary expense increased $7.2 million, or 3.3%, resulting from normal merit increases, but partly offset by lower costs for overtime and contract labor. Benefit costs increased 4.0% due to higher pension plan expense, offset by declines in medical plan and 401K contribution expense. Full-time equivalent employees declined from 5,012 during 2002 to 4,976 during 2003. Occupancy expense rose $4.1 million, or 11.8%, mainly due to higher depreciation and operating costs resulting from a renovated office building, which was re-opened in October 2002, and termination fees paid on vacated rental space. Equipment expense increased $1.2 million, or 5.4%, due to higher depreciation expense on computer hardware and higher maintenance contract expense. Data processing and software expense fell $4.4 million, or 9.8%, from 2002 largely because of cost savings realized from consolidating the Company’s mainframe computer operations in-house during the second quarter of 2002. These operations had previously been out-sourced to an external vendor. Other non-interest expense included operating lease depreciation and associated costs totaling $3.3 million related to the new leasing subsidiary mentioned earlier, which were not present in 2002. Also, minority interest expense, which resulted from venture capital gains reported by a 53%-owned affiliate, increased $1.7 million compared to the previous year when venture capital losses were recorded by this affiliate.

      Non-interest expense was $458.2 million in 2002, an increase of $15.1 million, or 3.4%, over 2001. Salary expense grew $7.3 million, or 3.5%, due to higher full-time employee costs and growth in incentive payments. Employee benefit costs increased $7.3 million, or 23.6%, due to higher health care costs, higher 401K contribution expense, and an increase in pension expense. Net occupancy expense rose $2.6 million over the prior year, partly due to costs associated with the renovated office building mentioned above. Marketing expense increased $2.1 million, or 16.2%, compared to the previous year as a result of added advertising costs for several consumer loan products. Data processing costs declined $2.2 million, mainly due to the in-house consolidation of the Company’s mainframe computer operations as mentioned above. Goodwill amortization was subject to new accounting rules, which discontinued the amortization of goodwill in 2002. This had the effect of lowering non-interest expense by $4.7 million in 2002 compared to 2001. Other non-interest expense included a $2.1 million charitable contribution of securities in 2002. In addition, losses related to check processing increased in 2002 compared to 2001 because of certain recoveries which were recorded in 2001.

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Income Taxes

      Income tax expense was $84.7 million in 2003, compared to $91.9 million in 2002, and $85.5 million in 2001. Income tax expense in 2003 decreased 7.8% compared to 2002, compared to a 1.0% increase in pre-tax income. The effective tax rate on income from operations was 29.1%, 31.9% and 32.4% in 2003, 2002 and 2001, respectively. The Company’s effective tax rates were lower than the federal statutory rate of 35% mainly due to tax exempt interest on state and municipal obligations, state and federal tax credits realized, and the recognition of additional tax benefits from various corporate reorganization initiatives.

      The decline in the effective tax rate between 2003 and 2002 resulted mainly from (i) the recognition of $11.2 million of additional net tax benefits in 2003 associated with various corporate reorganization initiatives, offset by (ii) a $5.3 million reduction in net federal and state rehabilitation credits related to the renovation of an office building.

      In 2003, total net tax benefits relating to the above discussed corporate reorganization initiatives amounted to $15.2 million. Additional tax benefits related to these initiatives will not be recognized in income until certain conditions are satisfied. It is projected that such conditions may be resolved as early as the third quarter of 2004 relating to approximately $18.9 million of the remaining benefits. However, because of the timing of such recognition, it is expected that the effective tax rate will be higher in the first two quarters of 2004.

      The effective rate in 2002 declined slightly from 2001 because of the elimination of non-deductible goodwill amortization and the additional accrual of state and federal rehabilitation credits associated with the renovation of an office building. All of the above factors, tending to lower the effective tax rate, were partly offset by state and local income taxes.

Financial Condition

      A schedule of average balances invested in each category of loans appears on page 38. Classifications of consolidated loans by major category at December 31 for each of the past five years are as follows:

      At December 31, 2002, the Company elected to reclassify certain segments of its business, construction, business real estate and personal portfolios. The reclassifications were made to better realign the loan reporting with its related collateral and purpose. The adjustments also reclassified certain construction loans that had moved into amortizing term loans following project completion. The table below shows the

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      The contractual maturities of loan categories at December 31, 2003, and a breakdown of those loans between fixed rate and floating rate loans are as follows: