SECURITIES AND EXCHANGE COMMISSION

FORM 10-K

Annual Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the Fiscal Year Ended December 31, 2003

Commission File No. 0-24133

FRANKLIN FINANCIAL CORPORATION

A Tennessee Corporation
(IRS Employer Identification No. 62-1376024)
230 Public Square
Franklin, Tennessee 37064
(615) 790-2265

Securities Registered Pursuant to Section 12(b)
of the Securities Exchange Act of 1934:

NONE

Securities Registered Pursuant to Section 12(g)
of the Securities Exchange Act of 1934:

Common Stock, no par value per share

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    

Check if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained in this form, and disclosure 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.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).
Yes X            No    

The aggregate market value of the common stock of the registrant held by nonaffiliates of the registrant (3,817,375 shares) on June 30, 2003, the last business day of the registrant’s most recently completed second fiscal quarter, was approximately $114,712,119 based on the closing price of the registrant’s common stock as reported on the NASDAQ National Market on June 30, 2003. For the purposes of this response, officers, directors and holders of 5% or more of the registrant’s common stock are considered the affiliates of the registrant at that date.

The number of shares outstanding of the registrant’s common stock, as of March 1, 2004: 8,394,806 shares of no par value common stock.

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PART I

Safe Harbor Statement Under the Private Securities Litigation
Reform Act of 1995

     Certain statements in this Annual Report on Form 10-K contain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, which statements generally can be identified by the use of forward-looking terminology, such as “may,” “will,” “expect,” “estimate,” “anticipate,” “believe,” “target,” “plan,” “project,” or “continue” or the negatives thereof or other variations thereon or similar terminology, and are made on the basis of management’s plans and current analyses of the Company, its business and the industry as a whole. These forward looking statements are subject to risks and uncertainties, including, but not limited to, our ability to complete our acquisition with Fifth Third Bancorp, economic conditions, competition, interest rate sensitivity and exposure to regulatory and legislative changes. The above factors, in some cases, have affected, and in the future could affect, the Company’s financial performance and could cause actual results for fiscal 2004 and beyond to differ materially from those expressed or implied in such forward-looking statements. The Company does not undertake to publicly update or revise its forward-looking statements even if experience or future changes make it clear that any projected results expressed or implied therein will not be realized.

Item 1. Business.

General

     Franklin Financial Corporation (the “Company”) is a registered financial holding company under the Gramm-Leach-Bliley Financial Services Modernization Act, and owns 100% of the outstanding capital stock of Franklin National Bank, a national banking association headquartered in Franklin, Tennessee (the “Bank”). The Company was incorporated under the laws of the State of Tennessee on December 27, 1988, as a mechanism to enhance the Bank’s ability to serve its future customers’ requirements for financial services. The holding company structure provides flexibility for expansion of the Company’s banking business through the acquisition of other financial institutions and the provision of additional banking-related services which the traditional commercial bank may not provide under present laws.

Recent Developments

     On July 23, 2002, the Company entered into a definitive Affiliation Agreement (the “Agreement”) which provides for the acquisition of the Company by Fifth Third Bancorp, an Ohio corporation (“Fifth Third”) through the merger of the Company with and into a wholly owned subsidiary of Fifth Third. The original Agreement provided that each shareholder of the Company would receive, on a tax-free basis, between 0.3832 and 0.4039 shares of common stock of Fifth Third for each share of Company common stock owned, with the exact ratio to be determined based on the average closing price of the common stock of Fifth Third for the ten consecutive trading days ending on the fifth trading day preceding the closing of the merger.

     On September 9, 2002 and December 10, 2002, the parties amended the Agreement to extend the deadlines for certain regulatory and other filings by Fifth Third and to extend the termination date for the Agreement to April 1, 2003. The reasons for the delay related to an investigation by various banking regulators and a moratorium imposed by the banking regulators prohibiting acquisitions by Fifth Third, including the pending acquisition of the Company. On March 27, 2003, Fifth Third announced that it

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entered into a written agreement with the Federal Reserve Bank of Cleveland and the Ohio Department of Commerce, Division of Financial Institutions arising out of the previously discussed regulatory review of Fifth Third. The written agreement outlines a series of steps to address and strengthen Fifth Third’s risk management processes and internal controls. These steps include independent third party reviews and the submission of written plans in a number of areas. These areas include Fifth Third’s management, corporate governance, internal audit, account reconciliation procedures and policies, information technology, and strategic planning.

     On March 27, 2003, the Company entered into Amendment No. 3 to the Agreement to extend the termination date of the Agreement to June 30, 2004. In this amendment, Fifth Third agreed to amend the exchange ratio in the merger to provide that each outstanding share of Franklin Financial common stock will be exchanged for that number of shares or Fifth Third common stock equal to (1) the sum of (a) $31.00 and (b) any increase in the book value per share of Franklin Financial common stock, excluding certain items, from March 31, 2003 through the end of the fiscal quarter preceding the effective time of the merger divided by (2) the average closing price of Fifth Third common stock for the 10 consecutive trading days ending on the fifth day before the effective date of merger. In the event that the Board of Governors of the Federal Reserve System has not granted regulatory approval for the merger on or before May 31, 2004, the Company has the right to terminate the Agreement and to receive a termination fee of $27 million from Fifth Third.

     The closing of the transaction is subject to the approval of the Company’s shareholders and normal regulatory approvals. The terms of the Agreement and the amendments thereto are more fully described in the Company’s Current Reports on Form 8-K as filed with the Securities and Exchange Commission on July 25, 2002 (which report also contains a copy of the Affiliation Agreement), September 10, 2002, December 18, 2002 and March 27, 2003. The above description of the Agreement and the amendments thereto is qualified in its entirety by reference to the Agreement and the amendments, which are attached as exhibits to the Company’s Current Reports on Form 8-K and incorporated by reference into this Annual Report on Form 10-K.

Subsidiaries

     Franklin National Bank. The Bank commenced business operations on December 1, 1989 in a permanent facility located at 230 Public Square, Franklin, Tennessee 37064. The approximately 12,000 square foot facility is being leased from Gordon E. Inman, the Chairman, President and Chief Executive Officer of the Company. The Bank has an additional eight full service branches: one located in the Williamson Square Shopping Center, which opened in April 1994; one located in Spring Hill, Tennessee, which opened in January 1995; one located in Brentwood, Tennessee, which opened in April 1995; one located in Fairview, Tennessee, which opened in May 1997; one located in the Cool Springs area of Franklin, which opened in May 2000; one located in the Fieldstone Farms area of Franklin, which opened in June 2000; one in Green Hills, Tennessee, which opened in January 2001; and one in downtown Nashville, Tennessee, which opened in February 2001. The Bank also leases 9,000, 4,000 and 3,000 square foot facilities from Mr. Inman, which house its mortgage banking subsidiary, financial services subsidiary and insurance subsidiary sales functions.

     The Bank is a full service commercial bank, without trust powers. The Bank offers a full range of interest bearing and non-interest bearing accounts; including commercial and retail checking accounts, negotiable orders of withdrawal (“NOW”) accounts, money market accounts, individual retirement accounts, regular interest bearing statement savings accounts, certificates of deposit, commercial loans, real estate loans, commercial and consumer lines of credit, letters of credit, mortgage loans, home equity loans and consumer/installment loans. In addition, the Bank provides such consumer services as travelers checks, cashiers checks, Mastercard and Visa accounts, safe deposit boxes, direct deposit services, wire

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transfer services, cash management services, debit cards, automatic teller machines, an internet banking product and a 24-hour telephone inquiry system.

     Insurance Agency. In August 1996, the Bank opened an insurance subsidiary, Franklin Financial Insurance. The insurance subsidiary sold property, business and life insurance and provided products and services to both bank and nonbank customers. Effective November 1, 2003, the Company ceased operations of the insurance agency and sold all rights, title and interest of the insurance policies to an independent agency.

     Securities Company. Franklin Financial Securities commenced operations in October 1997. The securities subsidiary offers financial planning and securities brokerage services through Fifth Third Securities. The securities subsidiary receives referrals from Franklin National Bank employees. The securities subsidiary currently has one licensed brokers. The securities subsidiary was formed to respond to competition from other financial service companies that offer similar services. By offering these securities products and services, Franklin Financial believes it can gain a greater share of the customer’s business and have better opportunities for revenue generation.

     Mortgage Company. Franklin Financial Mortgage opened in December 1997 to originate and service mortgage loans. Since the Bank’s inception, it has focused on real estate lending. The mortgage subsidiary intends to capitalize on this lending expertise. The mortgage subsidiary primarily originates conforming residential mortgages that are then sold to certain other mortgage companies and government entities such as Freddie Mac on a service-retained basis. There are approximately 31 employees of the mortgage subsidiary.

Market Area and Competition

     The primary service area for the Bank encompasses Williamson, Maury and Davidson Counties in Tennessee. There are 62 banking offices within the primary service area of the Bank. Most of these offices are affiliated with major bank holding companies.

     The Bank competes with existing area financial institutions other than commercial banks and savings and loan associations, including insurance companies, consumer finance companies, brokerage houses, credit unions and other business entities, which have recently been invading the traditional banking markets. Due to the rapid growth of the Bank’s market area, it is anticipated that additional competition will continue from new entrants to the market.

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Distribution of Assets, Liabilities and Stockholders’ Equity

     The following is a presentation of the average consolidated balance sheet of the Company for the years ended December 31, 2003, 2002 and 2001. This presentation includes all major categories of interest-earning assets and interest-bearing liabilities.

AVERAGE CONSOLIDATED ASSETS

AVERAGE CONSOLIDATED LIABILITIES AND STOCKHOLDERS’ EQUITY

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Interest Rates and Interest Differential

     The following is a presentation of an analysis of the net interest earnings of the Company for the periods indicated with respect to each major category of interest-earning asset and each major category of interest-bearing liability:

	(1)		Includes non-accrual loans of $3,539.
	(2)		Interest earned on net loans includes $2,159 in loan fees and loan service fees.
	(3)		Includes interest earned on tax-exempt securities of $1,795.

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	(1)		Includes non-accrual loans of $2,127.
	(2)		Interest earned on net loans includes $2,602 in loan fees and loan service fees.
	(3)		Includes interest earned on tax-exempt securities of $1,004.

	(1)		Includes non-accrual loans of $682.
	(2)		Interest earned on net loans includes $2,471 in loan fees and loan service fees.
	(3)		Includes interest earned on tax-exempt securities of $713.

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Rate/Volume Analysis of Net Interest Income

     The effect on interest income, interest expense and net interest income in the periods indicated, of changes in average balance and rate from the corresponding prior period is shown below. The effect of a change in average balance has been determined by applying the average rate in the earlier period to the change in average balance in the later period, as compared with the earlier period. The effect of a change in rate has been determined by applying the average balance in the earlier period to the change in average rate in the later period, as compared with the earlier period. Changes resulting from average balance/rate variances have been determined by applying the change in average balance to the change in average rate in the later period, as compared with the earlier period. The changes attributable to the combined impact of balance and rate have all been allocated to the changes due to volume.

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Deposits

     The Bank offers a full range of interest bearing and non-interest bearing accounts, including commercial and retail checking accounts, negotiable order of withdrawal (“NOW’) accounts, money market accounts, individual retirement accounts, regular interest bearing statement savings accounts and certificates of deposit with fixed and variable rates and a range of maturity date options. The sources of deposits are residents, businesses and employees of businesses within the Bank’s market area, obtained through the personal solicitation of the Bank’s officers and directors, direct mail solicitation and advertisements published in the local media. The Bank pays competitive interest rates on time and savings deposits up to the maximum permitted by law or regulation. In addition, the Bank has implemented a service charge fee schedule competitive with other financial institutions in the Bank’s market area, covering such matters as maintenance fees on checking accounts, per item processing fees on checking accounts, returned check charges and the like.

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     The following tables present, for the periods indicated, the average amount of and average rate paid on each of the following deposit categories:

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     The following table indicates amounts outstanding of time certificates of deposit of $100,000 or more and respective maturities at December 31, 2003:

Loan Portfolio

     The Bank engages in a full complement of lending activities, including commercial, consumer/installment and real estate loans.

     Commercial lending is directed principally towards businesses whose demands or funds fall within the Bank’s legal lending limits and which are potential deposit customers of the Bank. This category of loans includes loans made to individual, partnership or corporate borrowers, and obtained for a variety of business purposes. Particular emphasis is placed on loans to small and medium-sized businesses. The Bank’s real estate loans consist of residential and commercial first and second mortgage loans, as well as real estate construction loans and real estate acquisition and development loans.

     The Bank’s consumer loans consist primarily of installment loans to individuals for personal, family and household purposes, including education and automobile loans to individuals and pre-approved lines of credit.

     At December 31, 2003, loans within four broad categories exceeded 10% of total loans: single family residential real estate loans ($130,404,000 or 23% of total loans), commercial real estate loans ($177,706,000 or 31% of total loans), commercial and industrial loans ($59,689,000 or 10% of total loans) and residential construction loans ($89,046,000 or 16% of total loans). Management believes that there is material borrower diversification within the single family residential real estate, commercial and commercial real estate loan categories. The vast majority of these loans are secured by properties located in the primary services area of the Bank (Williamson County and surrounding counties).

     The following table presents various categories of loans, including loans held for sale, contained in the Bank’s loan portfolio for the periods indicated and the total amount of all loans for such period:

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     The following is a presentation of an analysis of maturities of loans as of December 31, 2003:

     The following is a presentation of an analysis of sensitivities of loans to changes in interest rates as of December 31, 2003 (dollars in thousands):

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     The following table presents information regarding non-accrual, past due and restructured loans at the dates indicated (dollars in thousands):

     As of December 31, 2003, there were no loans classified by the regulators as doubtful, substandard or special mention that have not been disclosed in the above table, which (i) represent or result from trends or uncertainties which management reasonably expects will materially impact future operating results, liquidity, or capital resources, or (ii) represent material credits about which management is aware of any information which causes management to have serious doubts as to the ability of such borrowers to comply with the loan repayment terms.

     Accrual of interest is discontinued on a loan when management of the Bank determines upon consideration of economic and business factors affecting collection efforts that collection of interest is doubtful.

     Additional interest income of approximately $272,000 and $175,000 would have been recorded in the years ended December 31, 2003 and 2002, respectively, if all loans accounted for on a non-accrual basis had been current in accordance with their original terms.

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     As of December 31, 2003, management has identified other possible credit problems as follows (in thousands):

     These loans are performing loans but are classified due to payment history, decline in the borrower’s financial position or decline in collateral value. Loans categorized as “special mention” are currently protected but are potentially weak. These loans constitute an undue and unwarranted credit risk but not to the point of justifying a classification of substandard. Loans classified as “substandard” are inadequately protected by the current net worth and paying capacity of the obligor or the value of the collateral pledged, if any. Loans so classified must have a well-defined weakness or weakness that jeopardizes the liquidation of the debt. Loans classified as “doubtful” have all the weaknesses inherent in one classified substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. Loans classified as “loss” are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. Management has provided specific allocations of the allowance for possible loan losses of $387,647 relating to such loans. There are no other loans which are not disclosed above, but where known information about possible credit problems of borrowers causes management to have doubts as to the ability of such borrowers to comply with the present loan repayment terms.

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Summary of Loan Loss Experience

     An analysis of the Bank’s loss experience is furnished in the following table for the year indicated, as well as a breakdown of the allowance for possible loan losses:

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     The allocation of the allowance for loan losses by loan category at December 31 for each of the years indicated is presented below, along with percentage of loans in each category to total loans:

Loan Loss Reserve

     In considering the adequacy of the Bank’s allowance for possible loan losses, management has focused on the fact that as of December 31, 2003, 20% of outstanding loans are in the category of commercial loans. Commercial loans are generally considered by management as having greater risk than other categories of loans in the Bank’s loan portfolio. However, approximately 88% of these commercial loans at December 31, 2003 were made on a secured basis. Management believes that the secured condition of the preponderant portion of its commercial loan portfolio greatly reduces the risk of loss inherently present in commercial loans.

     The Bank’s consumer loan portfolio is also well secured. The majority of the Bank’s consumer loans were secured by collateral primarily consisting of automobiles, boats and other personal property. Management believes that these loans involve less risk than other categories of loans.

     As of December 31, 2003, real estate mortgage loans constituted 62% of outstanding loans. Approximately $130,404,000, or 37%, of this category represents first mortgage residential real estate mortgages where the amount of the original loan generally does not exceed 80% of the appraised value of the collateral. While the national real estate market has declined due to current economic factors, the Bank’s market area has seen a softening in real estate, but not as significant a decline as on the national level. The Bank does not anticipate losses in relation to the decline in the real estate market. The remaining portion of this category consists primarily of commercial real estate loans. Risk of loss for these loans is generally higher than residential loans. Therefore, management has allocated a significant portion of the allowance for loan losses to this category.

     The Bank’s Board of Directors monitors the loan portfolio quarterly to enable it to evaluate the adequacy of the allowance for loan losses. The loans are rated and the allowance established based on the assigned rating. The provision for loan losses charged to operating expenses is based on this established allowance. Factors considered by the Board in rating the loans include delinquent loans, underlying collateral value, payment history and local and general economic conditions affecting collectibility.

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     As part of the continual rating process, individual loans are assigned a credit risk rating based on their credit quality, which is subject to change as conditions warrant. Any changes in those risk assessments as determined by regulatory examiners or the Company’s internal credit review function are also considered. Management considers certain loans with weaker credit risk grades to be individually impaired and measures such impairment based upon available cash flows or the value of the collateral. Allowance or reserve levels are estimated for all other credit risk rated loans in the portfolio based on their assigned credit risk grade, type of loan and other matters related to credit risk. In estimating reserve levels, the Company aggregates certain credit risk rated loans into pools of similar credits and reviews the historical loss experience associated with these pools as additional criteria to allocate the allowance to each category.

     Management uses the information developed from the procedures described above in evaluating and rating the loan portfolio. This continual rating process is used to monitor the credit quality of the loan portfolio and to assist management in determining the appropriate levels of the allowance for loan losses.

     Management considers the allowance for loan losses adequate to cover the estimated losses inherent in the Company’s loan portfolio as of the date of the financial statements. Management believes it has established the allowance in accordance with accounting principles generally accepted in the United States of America and in consideration of the current economic environment. While management uses the best information available to make evaluations, future additions to the allowance may be necessary based on changes in economic and other conditions. Additionally, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowances for loan losses. Such agencies may require the recognition of adjustments to the allowances based on their judgments of information available to them at the time of their examinations.

     Impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, as a practical matter, at the loan’s observable market value or fair value of the collateral if the loan is collateral dependent. Most of the loans measured by fair value of the underlying collateral are commercial loans, while others consists of small balance homogenous loans and are measured collectively. The Company classifies a loan as impaired when, based on current information and events, management believes it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected. At December 31, 2003 and 2002, the recorded investment in loans that were considered to be impaired was approximately $16.7 million and $19.2 million, respectively. The average recorded balance of impaired loans during 2003 and 2002 was $17.0 million and $12.8 million, respectively. The related specific allocation of the allowance for loan losses for these loans was approximately $388,000 and $698,000 at December 31, 2003 and 2002, respectively. For the years ended December 31, 2003, 2002 and 2001, the Company recognized interest income on those impaired loans of approximately $890,000, $800,000 and $804,000, respectively.

     General economic trends greatly affect loan losses, and no assurances can be made that further charges to the loan loss allowance may not be significant in relation to the amount provided during a particular period or that further evaluation of the loan portfolio based on conditions then prevailing may not require sizable additions to the allowance, thus necessitating similarly sizable charges to operations. The allowance for loan losses was 1.02%, 1.03% and 0.96% of loans outstanding at December 31, 2003, 2002 and 2001, respectively, which was consistent with management’s assessment of the credit quality of the loan portfolio. The ratios of net charge-offs during the year to average loans outstanding during the period were 0.56%, 0.24% and 0.09% at December 31, 2003, 2002 and 2001, respectively. Management believes these ratios reflect management’s conservative lending and effective efforts to recover credit losses.

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     During 2003 the Company experienced a significantly higher amount of loan net charge offs than in 2002. Total net charge offs for 2003 was $3,056,000 compared to $1,173,000 for 2002 and $331,000 for 2001. Of the total charge offs during 2003, $2,852,000 or 93.3% were in the commercial loan portfolio which typically has greater risk than other loan categories. Of these commercial loans charged off $1.1 million were due to specific customer bankruptcies. The increase in commercial loan net charge-offs in 2003 is reflective of the overall challenging economic landscape and stress existing in several industry segments of the economy.

Investments

     As of December 31, 2003, investment securities, including mortgage-backed securities, comprised approximately 32% of the Bank’s assets. The Bank invests primarily in obligations of the United States or obligations guaranteed as to principal and interest by the United States, other taxable securities and in certain obligations of states and municipalities. The majority of the mortgage-backed securities are instruments of U.S. Government agencies. In addition, the Bank enters into Federal Funds transactions with its principal correspondent banks, and acts as a net seller of such funds. The sale of Federal Funds amounts to a short-term loan from the Bank to another bank. Since the Bank has been in a taxable position for the past several years and expects to be in a taxable position in the future, more tax exempt securities have been purchased.

     The following tables present, for the periods indicated, the carrying amount of the Bank’s investment securities, including mortgage-backed securities, separated by those available-for-sale and those held-to-maturity. The Bank does not currently maintain a trading portfolio.

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(1)

Yields are presented based on adjusted cost basis of securities available-for-sale. Yields based on carrying value would be higher since fair value is less than adjusted cost at December 31, 2003. The Company has invested in tax exempt obligations. Yields on tax exempt obligations have been computed on a tax equivalent basis. Income from tax exempt obligations is exempt from federal income tax only, therefore only the federal statutory rate of 34% has been used to compute the tax equivalent yield.

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(1)

The Company has invested in tax exempt obligations. Yields on tax exempt obligations have been computed on a tax equivalent basis. Income from tax exempt obligations is exempt from federal income tax only, therefore only the federal statutory rate of 34% has been used to compute the tax equivalent yield.

Selected Financial Ratios

     Selected financial ratios for the periods indicated are as follows:

Asset/Liability Management

     It is the objective of the Bank to manage assets and liabilities to provide a satisfactory, consistent level of profitability within the framework of established cash, loan, investment, borrowing and capital policies. Certain of the officers of the Bank are responsible for monitoring policies and procedures that are designed to ensure acceptable composition of the asset/liability mix, stability and leverage of all sources of funds while adhering to prudent banking practices. It is the overall philosophy of management to support asset growth primarily through growth of core deposits, which include deposits of all categories made by individuals, partnerships and corporations. Management of the Bank seeks to invest the largest portion of the Bank’s assets in commercial, consumer and real estate loans.

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     The Bank’s asset/liability mix is monitored on a daily basis with a quarterly report reflecting interest-sensitive assets and interest-sensitive liabilities being prepared and presented to the Bank’s Board of Directors. The objective of this policy is to control interest-sensitive assets and liabilities so as to minimize the impact of substantial movements in interest rates on the Bank’s earnings.

Correspondent Banking

     Correspondent banking involves the providing of services by one bank to another bank which cannot provide that service for itself from an economic or practical standpoint. The Bank purchases correspondent services offered by larger banks, including check collections, purchase of Federal Funds, security safekeeping, investment services, coin and currency supplies, overline and liquidity loan participations and sales of loans to or participations with correspondent banks.

Data Processing

     The Bank has in-house data processing, which provides a full range of data processing services including an automated general ledger, deposit accounting, commercial, real estate and installment lending data processing and central information file. The Bank has an ATM (automated teller machine) processing agreement with Intercept Systems, Inc.

Employees

     The Company presently employs 188 persons on a full-time basis, including 67 officers. The Company will hire additional persons as needed, including additional tellers and financial service representatives.

Monetary Policies

     The results of operations of the Bank are affected by credit policies of monetary authorities, particularly the Federal Reserve Board. The instruments of monetary policy employed by the Federal Reserve Board include open market operations in U.S. Government securities, changes in the discount rate on member bank borrowings, changes in reserve requirements against member bank deposits and limitations on interest rates which member banks may pay on time and savings deposits. In view of changing conditions in the national economy and in the money markets, as well as the effect of action by monetary and fiscal authorities, including the Federal Reserve Board, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand or the business and earnings of the Bank.

Supervision and Regulation

     The following discussion is only intended to provide brief summaries of significant statutes and regulations that affect the banking industry and therefore is not complete. Changes in applicable laws or regulations, and in the policies of regulators, may have a material effect on the Company’s business and prospects. Management cannot accurately predict the nature or extent of the effects on the Company’s business and earnings that fiscal or monetary policies, or new federal or state laws, may have in the future.

The Company

General. As a bank holding company, the Company is subject to the Bank Holding Company Act of 1956, which places the Company under the supervision of the Board of Governors of the Federal

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Reserve. The Company must file annual reports with the Federal Reserve and must provide it with such additional information as it may require. In addition, the Federal Reserve periodically examines the Company and the Bank.

Bank Holding Company Regulation. In general, the Bank Holding Company Act limits bank holding company business to owning or controlling banks and engaging in other banking-related activities. Bank holding companies must obtain the Federal Reserve Board’s approval before they:

•		acquire direct or indirect ownership or control of any voting shares of any bank that results in total ownership or control, directly or indirectly, of more than 5% of the voting shares of such bank;
•		merge or consolidate with another bank holding company; or
•		acquire substantially all of the assets of any additional banks.

Subject to certain state laws, a bank holding company that is adequately capitalized and adequately managed may acquire the assets of both in-state and out-of-state banks. Under the Gramm-Leach-Bliley Act of 1999, a bank holding company meeting certain qualifications may apply to the Federal Reserve Board to become a financial holding company, and thereby engage (directly or through a subsidiary) in certain activities deemed financial in nature, such as securities brokerage and insurance underwriting.

With certain exceptions, the Bank Holding Company Act prohibits bank holding companies from acquiring direct or indirect ownership or control of voting shares in any company that is not a bank or a bank holding company unless the Federal Reserve Board determines such activities are incidental or closely related to the business of banking.

The Change in Bank Control Act of 1978 requires a person (or group of persons acting in concert) acquiring “control” of a bank holding company to provide the Federal Reserve Board with 60 days’ prior written notice of the proposed acquisition. Following receipt of this notice, the Federal Reserve Board has 60 days (or up to 90 days if extended) within which to issue a notice disapproving the proposed acquisition. In addition, any “company” must obtain the Federal Reserve Board’s approval before acquiring 25% (5% if the “company” is a bank holding company) or more of the outstanding shares or otherwise obtaining control over the Company.

Financial Services Modernization. The laws and regulations that affect banks and bank holding companies underwent significant changes as a result of the Financial Services Modernization Act of 1999, also known as the Gramm-Leach-Bliley Act. Generally, the act (i) repealed the historical restrictions on preventing banks from affiliating with securities firms, (ii) provided a uniform framework for the activities of banks, savings institutions and their holding companies, (iii) broadened the activities that may be conducted by national banks and banking subsidiaries of bank holding companies, (iv) provided an enhanced framework for protecting the privacy of consumers’ information and (v) addressed a variety of other legal and regulatory issues affecting both day-to-day operations and long-term activities of financial institutions.

Bank holding companies may now engage in a wider variety of financial activities than permitted under previous law, particularly insurance and securities activities. In addition, in a change from previous law, a bank holding company may be owned, controlled or acquired by any company engaged in financially related activities, so long as such company meets certain regulatory requirements. The act also permits national banks (and certain state banks), either directly or through operating subsidiaries, to engage in

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certain non-banking financial activities.

Transactions with Affiliates. The Company and the Bank are deemed affiliates within the meaning of the Federal Reserve Act, and transactions between affiliates are subject to certain restrictions. Generally, the Federal Reserve Act limits the extent to which a financial institution or its subsidiaries may engage in “covered transactions” with an affiliate. It also requires all transactions with an affiliate, whether or not “covered transactions,” to be on terms substantially the same, or at least as favorable to the institution or subsidiary, as those provided to a non-affiliate. The term “covered transaction” includes the making of loans, purchase of assets, issuance of a guarantee and other similar types of transactions.

Tie-In Arrangements. The Company and the Bank cannot engage in certain tie-in arrangements in connection with any extension of credit, sale or lease of property or furnishing of services. For example, with certain exceptions, neither the Company nor the Bank may condition an extension of credit on either a requirement that the customer obtain additional services provided by either of the Company or the Bank, or an agreement by the customer to refrain from obtaining other services from a competitor. The Federal Reserve Board has adopted exceptions to its anti-tying rules that allow banks greater flexibility to package products with their affiliates. These exceptions were designed to enhance competition in banking and non-banking products and to allow banks and their affiliates to provide more efficient, lower cost service to their customers.

State Law Restrictions. As a Tennessee business corporation, the Company may be subject to certain limitations and restrictions under applicable Tennessee corporate law. In addition, although the Bank is a national bank and therefore primarily regulated by the Office of the Comptroller of the Currency (OCC), Tennessee banking law may restrict certain activities of the Bank.

The Bank

General. The Bank, as a national banking association, is subject to regulation and examination by the OCC. The federal laws that apply to the Bank regulate, among other things, the scope of its business, its investments, its reserves against deposits, the timing of the availability of deposited funds and the nature and amount of and collateral for loans. The laws and regulations governing the Bank generally have been promulgated to protect depositors and not to protect shareholders of the Company or the Bank.

Community Reinvestment Act. The Community Reinvestment Act requires that, in connection with examinations of financial institutions within their jurisdiction, the OCC evaluate the record of the financial institutions in meeting the credit needs of their local communities, including low and moderate income neighborhoods, consistent with the safe and sound operation of those banks. These factors are also considered in evaluating mergers, acquisitions, and applications to open a branch or facility.

Insider Credit Transactions. Banks are also subject to certain restrictions imposed by the Federal Reserve Act on extensions of credit to executive officers, directors, principal shareholders, or any related interests of such persons. Extensions of credit must be made on substantially the same terms, including interest rates and collateral, and follow credit underwriting procedures that are not less stringent than those prevailing at the time for comparable transactions with persons not covered above and who are not employees. Also, such extensions of credit must not involve more than the normal risk of repayment or present other unfavorable features.

Federal Deposit Insurance Corporation Improvement Act. Under the Federal Deposit Insurance Corporation Improvement Act of 1991 each federal banking agency has prescribed, by regulation,

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noncapital safety and soundness standards for institutions under its authority. These standards cover internal controls, information systems, and internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, fees and benefits, such other operational and managerial standards as the agency determines to be appropriate, and standards for asset quality, earnings and stock valuation. Management believes that the Bank meets all such standards.

Interstate Banking and Branching. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 permits nationwide interstate banking and branching under certain circumstances. This legislation generally authorizes interstate branching and relaxes federal law restrictions on interstate banking. Currently, bank holding companies may purchase banks in any state, and states may not prohibit such purchases. Additionally, banks are permitted to merge with banks in other states as long as the home state of neither merging bank has “opted out.” The act requires regulators to consult with community organizations before permitting an interstate institution to close a branch in a low-income area. The federal banking agencies prohibit banks from using their interstate branches primarily for deposit production and have accordingly implemented a loan-to-deposit ratio screen to ensure compliance with this prohibition.

Tennessee has “opted in” to the Interstate Act and allows in-state banks to merge with out-of-state banks subject to certain requirements. Tennessee law generally authorizes the acquisition of an in-state bank by an out-of-state bank by merger with a Tennessee financial institution that has been in existence for at least 3 years prior to the acquisition. With regard to interstate bank branching, an out-of-state bank that does not already operate a branch in Tennessee may establish de novo branches in Tennessee, if the laws of the home state of the out-of-state bank permit Tennessee banks to establish de novo branches in that state.

Deposit Insurance. The deposits of the Bank are currently insured to a maximum of $100,000 per depositor through a fund administered by the Federal Deposit Insurance Corporation. All insured banks are required to pay semi-annual deposit insurance premium assessments to the Federal Deposit Insurance Corporation.

Capital Adequacy

Federal bank regulatory agencies use capital adequacy guidelines in the examination and regulation of bank holding companies and banks. If capital falls below minimum guideline levels, the holding company or bank may be denied approval to acquire or establish additional banks or nonbank businesses or to open new facilities.

The Federal Deposit Insurance Corporation, the OCC and the Federal Reserve use risk-based capital guidelines for banks and bank holding companies. These are designed to make such capital requirements more sensitive to differences in risk profiles among banks and bank holding companies, to account for off-balance sheet exposure and to minimize disincentives for holding liquid assets. Assets and off-balance sheet items are assigned to broad risk categories, each with appropriate weights. The resulting capital ratios represent capital as a percentage of total risk-weighted assets and off-balance sheet items. The guidelines are minimums, and the Federal Reserve has noted that bank holding companies contemplating significant expansion programs should not allow expansion to diminish their capital ratios and should maintain ratios well in excess of the minimum. The current guidelines require all bank holding companies and federally-regulated banks to maintain a minimum risk-based total capital ratio equal to 8%, of which at least 4% must be Tier 1 capital. Tier 1 capital for bank holding companies includes common shareholders’ equity, certain qualifying perpetual preferred stock and minority interests in equity accounts of consolidated subsidiaries, less intangibles except as described above.

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The FDIC, the OCC and the Federal Reserve also employ a leverage ratio, which is Tier 1 capital as a percentage of total assets less intangibles, to be used as a supplement to risk-based guidelines. The principal objective of the leverage ratio is to constrain the maximum degree to which a bank holding company or bank may leverage its equity capital base. A minimum leverage ratio of 3% is required for the most highly rated bank holding companies and banks. Other bank holding companies and banks and bank holding companies seeking to expand, however, are required to maintain leverage ratios of at least 4% to 5%.

The Federal Deposit Insurance Corporation Improvement Act created a statutory framework of supervisory actions indexed to the capital level of the individual institution. Under regulations adopted by the FDIC, the OCC and the Federal Reserve, an institution is assigned to one of five capital categories depending on its total risk-based capital ratio, Tier 1 risk-based capital ratio, and leverage ratio, together with certain subjective factors. Institutions which are deemed to be “undercapitalized” depending on the category to which they are assigned are subject to certain mandatory supervisory corrective actions.

Recent Significant Changes in Banking Laws and Regulations

International Money Laundering Abatement and Anti-Terrorist Financing Act of 2001. On October 26, 2001, the USA PATRIOT Act was enacted. It includes the International Money Laundering Abatement and Anti-Terrorist Financing Act of 2001 and strong measures to prevent, detect and prosecute terrorism and international money laundering. As required by the IMLAFA, the federal banking agencies, in cooperation with the U.S. Treasury Department, established rules that generally apply to insured depository institutions and U.S. branches and agencies of foreign banks.

Among other things, the new rules require that financial institutions implement reasonable procedures to (1) verify the identity of any person opening an account; (2) maintain records of the information used to verify the person’s identity; and (3) determine whether the person appears on any list of known or suspected terrorists or terrorist organizations. The rules also prohibit banks from establishing correspondent accounts with foreign shell banks with no physical presence and encourage cooperation among financial institutions, their regulators and law enforcement to share information regarding individuals, entities and organizations engaged in terrorist acts or money laundering activities. The rules also limit a financial institution’s liability for submitting a report of suspicious activity and for voluntarily disclosing a possible violation of law to law enforcement.

Sarbanes-Oxley Act of 2002. On July 30, 2002, the Sarbanes-Oxley Act of 2002 was enacted to address corporate and accounting fraud. It established a new accounting oversight board that enforces auditing standards and restricts the scope of services that accounting firms may provide to their public company audit clients. Among other things, it also (i) requires chief executive officers and chief financial officers to certify to the accuracy of periodic reports filed with the Securities and Exchange Commission (the “SEC”); (ii) imposes new disclosure requirements regarding internal controls, off-balance-sheet transactions, and pro forma (non-GAAP) disclosures; (iii) accelerates the time frame for reporting of insider transactions and periodic disclosures by certain public companies; and (iv) requires companies to disclose whether or not they have adopted a code of ethics for senior financial officers and whether the audit committee includes at least one “audit committee financial expert.”

The Sarbanes-Oxley Act requires the SEC, based on certain enumerated factors, to regularly and systematically review corporate filings. To deter wrongdoing, it (i) subjects bonuses issued to top executives to disgorgement if a restatement of a company’s financial statements was due to corporate

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misconduct; (ii) prohibits an officer or director from misleading or coercing an auditor; (iii) prohibits insider trades during pension fund “blackout periods”; (iv) imposes new criminal penalties for fraud and other wrongful acts; and (v) extends the period during which certain securities fraud lawsuits can be brought against a company or its officers.

Available Information

     The Company maintains a website at www.franklinnetbranch.com. The Company will make available free of charge its annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K on its website as soon as practicable after such reports are filed with the SEC. The Company’s common stock is traded on the Nasdaq National Market under the symbol “FNFN.”

Item 2. Properties.

Main Office

     On January 5, 1989, the organizers of the Company entered into an agreement with Gordon E. Inman, the Chairman, President and Chief Executive Officer of the Company, to lease a two-story commercial building to house the Bank’s main office. Additional space in this building was leased by the Company from Mr. Inman in May 1991 and in June 1993. The two floors contain an aggregate of approximately 12,000 square feet. The building is situated on approximately one-tenth acre located at 230 Public Square, Franklin, Tennessee 37064. On May 1, 1997 the Company amended the original lease to include a 9,300 square foot building adjacent to the current facility. The building, Franklin Financial Center, is located at 216 East Main Street, Franklin, Tennessee 37064. On April 6, 1998, the Company again amended the original lease to include a 4,000 square foot building, which backs up to the original property. This building, which houses the Bank’s mortgage operations and facilities department, is located at 110 3rd Avenue, Franklin, TN 37064. On January 5, 1989, the organizers of the Company also entered into a ground lease with Mr. Inman for the lease of approximately .05 acres located adjacent to the proposed bank office. The Company is using this parcel to accommodate the Bank’s drive-in teller and bank window facility. Both leases provide for a term of 20 years, with three five-year renewal options, with the lease terms commencing on May 15, 1989. The current monthly rental under these leases total $41,465. The Company is subleasing the permanent facility and the adjacent parcel to the Bank at a rate, which includes reimbursement to the Company for payment of rent, taxes, insurance, repairs and maintenance of the properties.

Spring Hill Branch

     In May 1991, the Bank acquired a 3,000 square foot office building in Spring Hill, Tennessee from Mr. Inman at a purchase price of $305,000. This facility houses the Bank’s Spring Hill branch.

Williamson Square Branch

     In November 1993, the Bank entered into a 15 year lease with an unrelated third party for a commercial building in the Williamson Square Shopping Center on Highway 96E in Franklin, Tennessee. This facility houses the Bank’s Williamson Square branch. In January 1997, the Company purchased this property for $980,000.

Brentwood Branch

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     In July 1994, the Bank entered into a long-term lease with an unrelated third party for a commercial building in Brentwood, Tennessee. This facility housed the Bank’s Brentwood branch from April 1995 until February 2000. A new 4,900 square foot branch office was constructed and opened in February 2000. It is leased from an unrelated third party with monthly lease payments of $10,294.

Fairview Branch

     In January 1997, the Bank purchased a parcel of land in Fairview, Tennessee at a purchase price of $140,000. The Bank opened a branch office in a mobile unit at this site in the second quarter of 1997. The Bank constructed a 5,000 sq. foot permanent facility at this location which opened in the second quarter of 1998.

Cool Springs Branch

     In October 1998, the Company purchased a parcel of land in the Cool Springs area of Franklin for $650,000. In May 2000, the Company completed construction and opened a 4,900 square foot branch facility.

Fieldstone Farms Branch

     In July 1999, the Company purchased a parcel of land in the Fieldstone Farms area of Franklin for $740,000. In June 2000, the Company completed construction and opened a 4,900 square foot branch facility.

Green Hills Branch

     In July 2000, the Bank assumed a lease with an unrelated third party on a 5,000 square foot facility in the Green Hills area of Davidson County. The branch facility opened in January 2001. The monthly lease payments are $10,042.

Fourth and Union Branch

     In January 2001, the Bank leased from an unrelated third party a 6,900 square foot facility at the corner of Fourth Street and Union Street in downtown Nashville. The branch facility opened in February 2001 with monthly lease payments of $15,821.

Administrative Offices

     In December 1993, the Bank entered into a six and one-half year lease with Mr. Inman for office/warehouse space on Main Street in Franklin, Tennessee. This lease was amended in January 1996 to include an additional 3,000 square feet. The lease was amended in September 1998 to extend the term of the lease to fifteen and one-half years. In August 1999, the lease was further amended to include an additional 2,600 square feet. The lease, as amended, covers approximately 9,600 square feet and, provides for monthly payments to Mr. Inman of $10,407. The office space houses “back office” functions for the Bank, including data processing, check and document imaging, bookkeeping, and accounting.

     The Bank also leases a building from Mr. Inman, the Home Loan Center, which houses its mortgage origination functions. The lease provides for monthly payments to Mr. Inman of approximately $4,540.

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     The Bank is leasing an office building from an unrelated third party in downtown Franklin which houses the Human Resources department and a training facility. The monthly lease payments are approximately $3,091.

Item 3. Legal Proceedings.

     On August 24, 2000, Jerrold S. Pressman filed a complaint in the U.S. District Court for the Middle District of Tennessee, against Franklin National Bank and Gordon E. Inman, Chairman of the Board of the Company and the Bank, alleging breach of contract, tortuous interference with contract, fraud, and civil conspiracy in connection with the denial of a loan to a potential borrower involved in a real estate transaction. The Bank and Mr. Inman filed their answers in this matter on September 18, 2000, and a motion for Summary Judgment on October 10, 2000. The Court denied the Bank’s motion for Summary Judgment on February 15, 2001. On July 27, 2001, the Bank and Mr. Inman filed a second motion for Summary Judgment. The Court granted in part and denied in part the Bank and Mr. Inman’s motion for Summary Judgment on October 5, 2001. The case was set for trial to begin on March 5, 2002; however, on February 22, 2002, the Court, on it’s own Motion, continued the trial until September 10, 2002. Mr. Pressman’s amended complaint seeks compensatory damages in an amount not to exceed $20 million and punitive damages in an amount not to exceed $40 million from each defendant. On September 3, 2002, the Court granted Mr. Pressman’s motion to continue trial and set February 25, 2003, to begin the trial. A bench trial on the merits of the case was held between February 25 and March 7, 2003. On April 3, 2003, the United States District Judge issued an Order in which a judgment was entered for the Defendants Franklin National Bank and Mr. Inman on all of Mr. Pressman’s claims. On May 2, 2003, Mr. Pressman filed a Notice of Appeal to the United States Court of Appeals for the Sixth Circuit. A Proof Brief of Appellee Franklin National Bank was filed with the Court on November 20, 2003.

     Except as set forth above, there are no material pending legal proceedings to which the Company or the Bank is a party or of which any of their properties are subject; nor are there material proceedings known to the Company to be contemplated by any governmental authority; nor are there material proceedings known to the Company, pending or contemplated, in which any director, officer, or affiliate or any principle security holder of the Company, or any associate of any of the foregoing is a party or has an interest adverse to the Company or the Bank.

Item 4. Submission of Matters to a Vote of Security Holders.

          No matter was submitted during the fourth quarter ended December 31, 2003 to a vote of security holders of the Company.

PART II

Item 5. Market for Common Equity and Related Stockholder Matters.

     Market Information and Dividends. The Company’s common stock began trading on the NASDAQ National Market under the symbol “FNFN” in May 2001. From November 2000 until May 2001 the Company’s common stock was traded on the Over-the-Counter Bulletin Board. Prior to this

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time, the Company’s common stock was quoted in the “Pink Sheets,” an inter-broker quotation medium and no organized trading market existed. The market for the Company’s common stock must be characterized as a limited market due to its relatively low trading volume and analyst coverage. These quotations also reflect inter-dealer prices without retail mark-ups, mark-downs, or commissions and may not necessarily represent actual transactions. The Company has paid a quarterly cash dividend to its shareholders over the past two fiscal years as set forth in the table below.

     Holders of Common Stock. As of March 1, 2004, the approximate number of holders of record of the Company’s common stock was 841.

     The Bank is restricted in its ability to pay dividends under the national banking laws and by regulations of the OCC. Pursuant to 12 U.S.C. § 56, a national bank may not pay dividends from its capital. All dividends must be paid out, of undivided profits, subject to other applicable provisions of law. Payments of dividends out of undivided profits is further limited by 12 U.S.C. § 60(a), which prohibits a bank from declaring a dividend on its shares of common stock until its surplus equals its shared capital, unless there has been transferred to surplus not less than 1/10 of the Bank’s net income of the preceding two consecutive half year periods (in the case of an annual dividend). Pursuant to 12 U.S.C. § 60(b), the approval of the OCC is required if the total of all dividends declared by the Bank in any calendar year exceeds the total of its net income for that year combined with its retained net income for the preceding two years, less any required transfers to surplus.

     Recent Sales of Unregistered Securities.

     There were no sales of unregistered securities during the fourth quarter of 2003.

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Item 6. Selected Financial Data.

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Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operation

     Details regarding the Company’s financial performance are presented in the following discussion, which should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere herein.

General

     Franklin National Bank represents virtually all of the assets of Franklin Financial Corporation. The Bank, headquartered in Franklin, Tennessee, was opened in December of 1989 and continues to experience strong growth. The Bank has nine full service branches located throughout Williamson, Davidson and Maury Counties. In August 1996, the Bank opened an insurance subsidiary, Franklin Financial Insurance. Effective November 1, 2003, the Company ceased operations of the insurance agency. In October 1997, the Bank opened a securities subsidiary, Franklin Financial Securities. The securities subsidiary offers financial planning and securities brokerage services through Fifth Third Securities. In December 1997, the Bank began operating its mortgage division as a separate subsidiary, Franklin Financial Mortgage. Also in January 1998, the mortgage subsidiary began a wholesale mortgage operation. In September 2003, the mortgage subsidiary closed its retail mortgage origination office in Chattanooga, Tennessee. Franklin Financial Mortgage originates, sells and services mortgage loans. In June 2000, the Company formed Franklin Capital Trust I, a Delaware business trust and wholly owned subsidiary of the Company, for the purpose of issuing Trust Preferred Securities to the public. In December 2000, the Company received approval from the Federal Reserve Bank to convert from a bank holding company to a financial holding company to allow the Company additional avenues for growth opportunities.

Critical Accounting Policies

     Various elements of our accounting policies, by their nature, are inherently subject to estimation techniques, valuation assumptions and other subjective assessments. In particular, we have identified three policies that, due to the judgments, estimates and assumptions inherent in those policies, are critical to an understanding of our consolidated financial statements. These policies relate to the methodology for the determination of our allowance for loan and lease losses, the valuation of our repossessed and foreclosed assets and to the valuation of our mortgage servicing rights.

     The allowance for loan losses is maintained at a level which, in management’s judgment, is adequate to absorb credit losses inherent in the loan portfolio. The amount of the allowance is based on management’s evaluation of the collectibility of the loan portfolio, including the nature of the portfolio, credit concentrations, trends in historical loss experience, specific impaired loans, and economic conditions. Allowances for impaired loans are generally determined based on collateral values or the present value of estimated cash flows. A loan is considered impaired when management has determined it is possible that all amounts due according to the contractual terms of the loan agreement will not be collected. The allowance is increased by a provision for loan losses, which is charged to expense and reduced by charge-offs, net of recoveries.

     Repossessed and foreclosed assets are acquired through, or in lieu of, loan foreclosure and are held for sale and initially recorded at fair value at the date of foreclosure, thereby establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by independent appraisers and/ or management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Gains and losses from the sale of these assets are included

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in other income or other expense as appropriate. Any expenses to maintain such assets and changes in the valuation allowance, if any, are included in other expenses.

     Servicing assets on loans sold are measured by allocating the previous carrying amount between the assets sold and the retained interests based on their relative fair values at the date of transfer. Our mortgage servicing rights are related to in-house originations serviced for others. The initial amount recorded as mortgage servicing rights is essentially the difference between the amount that can be realized when loans are sold, with servicing released, as compared to loans sold, with servicing retained. Mortgage servicing rights are amortized in proportion to, and over the period of, estimated net servicing revenues. Impairment of mortgage servicing rights is assessed based on the fair value of those rights.

     These policies and the judgments, estimates and assumptions are described in greater detail in Note 1 to the consolidated financial statements included herein. We believe that the judgments, estimates and assumptions used in the preparation of our consolidated financial statements are appropriate given the factual circumstances at the time. However, given the sensitivity of our consolidated financial statements to these critical accounting policies, the use of other judgments, estimates and assumptions could result in actual results differing from those estimates.

Liquidity and Capital Resources

     General. The Company maintains its liquidity through the management of its assets and liabilities. The Company strives to maintain an asset/liability mix that provides the highest possible net interest margin without taking undue risk with regard to asset quality or liquidity. Liquidity management involves meeting the funds flow requirements of customers who may withdraw funds on deposit or have need to obtain funds to meet their credit needs. Banks in general must maintain adequate cash balances to meet daily cash flow requirements as well as satisfy reserves required by applicable regulations. The cash balances held are one source of liquidity. Other sources are provided by the investment portfolio, federal funds purchased, Federal Home Loan Bank advances, sale of loan participations, loan payments, brokered and public funds deposits and the Company’s ability to borrow funds as well as issue new capital.

     Management believes liquidity is at an adequate level with cash and due from banks of $51.0 million at December 31, 2003. Loans and securities scheduled to mature within one year exceeded $288.8 million at December 31, 2003, which should provide further liquidity. In addition, approximately $303.6 million of securities are classified as available for sale to help meet liquidity needs should they arise. Based on the current interest rate environment, the Bank anticipates $47.5 million in cash flow from its investment portfolio over the next year as a source of liquidity to help fund loan demand. The Company has a line of credit of $5.0 million with a lending institution and the Bank is approved to borrow up to $15.0 million in funds from the Federal Home Loan Bank and $72.5 million in federal funds lines to assist with capital and liquidity needs. At December 31, 2003, the Company had $1.1 million in borrowings against its line of credit and the Bank had $1.7 million federal funds purchased outstanding and $15.0 million from the Federal Home Loan Bank outstanding. The line of credit with the lending institution includes financial covenants requiring a (i) minimum loan loss reserve to non-performing assets ratio, (ii) minimum loan loss reserve to total loans, (iii) maximum ratio of non-performing loans to total loans, (iv) minimum return on average assets and (v) minimum tangible shareholder’s equity. The Company met all financial covenants at December 31, 2003.

     In February and August 1998, the Bank entered into long-term convertible Federal Home Loan Bank advances with a ten-year maturity and one-year call option totaling $6.0 million. During the fourth

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quarter of 1999 these advances converted to variable rate advances, which reprice quarterly based on LIBOR.

     On July 17, 2000 and August 11, 2000 the Company completed the sale of $11.0 million and $5.0 million, respectively, of trust preferred securities (the “Trust Preferred Securities”). The Company received net proceeds of $15.2 million from the offering, which it used to repay approximately $5.0 million of indebtedness under its line of credit, purchase investments as part of a leverage program to offset the interest expense associated with the Trust Preferred Securities and for general corporate purposes, including capital investments in the Bank. The Trust Preferred Securities pay cumulative cash distributions accumulating from the date of issuance at an annual rate of three-month LIBOR plus 3.50% of the liquidation amount of $1,000 per preferred security on January 15, April 15, July 15 and October 15 of each year. The Trust Preferred Securities have a thirty-year maturity and may be redeemed by the Company beginning in July 2005 or upon the occurrence of certain other conditions. Subject to certain limitations, the Trust Preferred Securities qualify as Tier 1 capital and are carried in Other Borrowings on the Company’s Balance Sheet. The Company purchased approximately $81.3 million of investment securities in a leverage program to gain immediate income benefits and offset interest expense of the Trust Preferred Securities. This leverage program was funded through proceeds from the offering of the Trust Preferred Securities, $52.0 million of Federal Home Loan Bank advances and brokered certificates of deposit. As part of the leverage program to offset interest expense associated with the Trust Preferred Securities offering, during the third quarter of 2000, the Bank entered into three long-term convertible Federal Home Loan Bank advances. One advance of $25.0 million has a ten-year maturity with a three-year call option. The other two advances totaling $27.0 million have a five-year maturity with a one-year call option. After the three and one-year call options, these advances may be converted by the FHLB from a fixed rate to a variable rate. The Bank has $200,000 outstanding in repurchase agreements to further develop its relationship with a customer. The Bank had approximately $73.5 million in brokered deposits at December 31, 2003 to help fund loan demand. The majority of these deposits are $100,000 or less, but they are generally considered to be more volatile than the Bank’s core deposit base.

     Approximately $48.3 million in loan commitments are expected to be funded within the next six months. Furthermore, the Bank has approximately $96.1 million of other loan commitments, primarily unused lines and letters of credit, which may or may not be funded.

     Capital Expenditures. Other than expenditures relating to the normal course of business, the Company does not have any significant capital expenditures planned for 2004.

     Management monitors the Company’s asset and liability positions in order to maintain a balance between rate sensitive assets and rate sensitive liabilities and at the same time maintain sufficient liquid assets to meet expected liquidity needs. Management believes that the Company’s liquidity is adequate at December 31, 2003. Other than as set forth above, there are no trends, demands, commitments, events or uncertainties that will result in or are reasonably likely to result in the Company’s liquidity increasing or decreasing in any material way. The Company is not aware of any current recommendations by the regulatory authorities which if they were to be implemented would have a material effect on the Company’s liquidity, capital resources, or results of operations.

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     Interest Rate Sensitivity. The following is an analysis of rate sensitive assets and liabilities as of December 31, 2003:

     As indicated in the preceding table, the Company has a negative gap in the 0-3 month and 3-12 month categories between rate sensitive assets and rate sensitive liabilities and has a positive gap in the greater than 12 months categories. A negative gap would allow the Company to reprice its liabilities faster than its assets in a falling rate environment which should have a positive effect on earnings. However, if rates are expected to increase within 12 months the Company would experience a short term decrease in earnings. In a positive gap situation, the Company’s assets would reprice faster in an increasing interest rate environment which should also have a positive effect on earnings.

     The above table has been prepared based on principal payment due dates, contractual maturity dates or repricing intervals on variable rate instruments. With regard to mortgage-backed securities, the estimated prepayment date is used. Actual payments on mortgage-backed securities are received monthly and therefore should occur earlier than the contractual maturity date. For non-maturing deposits the expected repricing dates have been used based on historical analysis of the Company’s deposit portfolio.

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     Cash Flows. Net cash flow provided by operating activities was $24.6 million in 2003. The most substantial impact being proceeds from the sale of loans exceeding loans originated for sale by $18.8 million in 2003. The majority of this loan origination volume is due to the increase in loans originated in the mortgage banking segment. Depreciation, amortization and accretion totaled $4.7 million for 2003. This is composed of $1.1 million of depreciation, $4.4 million of amortization offset by $723,000 of accretion. Amortization of premiums in the investment portfolio and of mortgage servicing rights increased substantially over 2002. Primary uses of cash flows included the increase in other assets of $8.9 million and the decrease in other liabilities of $3.0 million.

     Net cash used in investing activities was $61.0 million in 2003, which was largely due to the banking segment. The net change in the investment portfolio increased $46.1 million in 2003. Growth in the investment portfolio has increased due to cashflow from the investment portfolio being reinvested versus being redeployed to loan portfolio fundings as a result of slower loan growth. The increase in net loans was $34.5 million in 2003 compared to $120.2 million in 2002. The use of cashflow from investing activities is offset by the $18.9 million decrease in federal funds sold for 2003. At December 31, 2003, the Company had no federal funds sold outstanding.

     Net cash provided by financing activities was $59.3 million in 2003. The increase in cash flow is primarily due to an increase in deposits of $43.1 million and an increase in other borrowings by $15.4 million for 2003. The increase in other borrowings is due to a $15 million draw of the Company’s Federal Home Loan Bank line of credit as of December 31, 2003 for short term funding requirements. In addition, cashflow provided by financing activities increased due to $2.8 million of proceeds from common stock issuance which is primarily from exercise of employee stock options. Cash provided by financing activities is offset partially by $1.9 million of dividends paid.

     Contractual Obligations and Commitments. Refer to note 8 of the consolidated financial statements included herein for additional information regarding the Company’s off-balance sheet arrangements which includes other financial instruments, commitments, guarantees and contingencies. Note 8 provides detail information regarding the Company’s commitments to extend credit, credit card commitments and standby letters of credit. The following table provides information regarding the Company’s contractual obligations, aggregated by category of contractual obligation, for specified time periods, as of December 31, 2003:

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