UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

For the quarterly period ended March 31, 2005

OR

For the transition period from                     to                    

Commission file number 000-11448

LSB BANCSHARES, INC.

LSB BANCSHARES, INC.
ONE LSB PLAZA
LEXINGTON, NORTH CAROLINA 27292

(336) 248-6500

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

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

LSB Bancshares, Inc. had 8,568,965 shares of common stock outstanding as of April 29, 2005.

LSB BANCSHARES, INC.
AND SUBSIDIARIES

FORM 10-Q
TABLE OF CONTENTS

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PART I
FINANCIAL INFORMATION

Item 1. Financial Statements.

Consolidated Balance Sheets

Notes to consolidated financial statements are an integral part hereof.

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Consolidated Statements of Income
(Unaudited)

Notes to consolidated financial statements are an integral part hereof.

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Consolidated Statements
Of Changes in Shareholders’ Equity
(Unaudited)

Notes to consolidated financial statements are an integral part hereof.

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Consolidated Statements of Cash Flows
(Unaudited)

Notes to consolidated financial statements are an integral part hereof.

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Consolidated Statements of Cash Flows continued
(Unaudited)

Notes to consolidated financial statements are an integral part hereof.

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Notes To Consolidated Financial Statements
As of or for the Periods Ended March 31, 2005 and 2004

Note 1 – Basis of Presentation

The accompanying interim unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States for interim financial information and in accordance with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. They do not include all of the information and footnotes required by generally accepted accounting principles in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three-month period ended March 31, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005.

LSB Bancshares, Inc. (“Bancshares”) is a bank holding company headquartered in Lexington, North Carolina. Bancshares’ principal business is providing banking and other financial services through its banking subsidiary, Lexington State Bank (the “Bank”). The Bank has two wholly owned subsidiaries, Peoples Finance Company of Lexington, Inc. (“Peoples Finance”) and LSB Investment Services, Inc. (“LSBIS”). The Bank offers a complete array of services in commercial banking including accepting deposits, corporate cash management, discount brokerage, IRA plans, mortgage production, secured and unsecured loans and trust functions through twenty-six offices in seventeen communities located in Davidson, Forsyth, Stokes, Guilford, Randolph and Wake counties. Peoples Finance offers secured and unsecured loans to individuals up to a maximum of $10,000 as well as dealer originated loans. LSBIS offers products through UVEST Investment Services, an independent broker-dealer. Investments are neither deposits nor obligations of the Bank, nor are they guaranteed or insured by any depository institution, the Federal Deposit Insurance Corporation, or any other government agency.

The organization and business of Bancshares, accounting policies followed by Bancshares and other relevant information are contained in the notes to the consolidated financial statements in Bancshares Annual Report on Form 10-K for the fiscal year ended December 31, 2004, filed with the Securities and Exchange Commission (the “SEC”) on March 11, 2005 (SEC File No. 000-11448)(the “Form 10-K”). This quarterly report should be read in conjunction with such Form 10-K.

Note 2 — Net Income Per Share

Basic and diluted net income per share is computed based on the weighted average number of shares outstanding during each period. Diluted net income per share reflects the potential dilution that could occur if stock options were exercised, resulting in the issuance of common stock that then shared in the net income of Bancshares.

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A reconciliation of the basic average common shares outstanding to the diluted average common shares outstanding is as follows (In thousands):

Note 3 — Investment Securities (In thousands)

The following is a schedule of securities in a loss position as of March 31, 2005 (In thousands):

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Investment securities with amortized cost of $90,543,000 and $84,470,000, as of March 31, 2005, and December 31, 2004, respectively, were pledged to secure public deposits and for other purposes. The Bank has also obtained a $10,000,000 and a $20,000,000 irrevocable letter of credit, which will expire on August 11, 2010, and September 3, 2014, respectively. These letters of credit were issued by the Federal Home Loan Bank of Atlanta (“FHLB”) in favor of the State of North Carolina and are used in lieu of securities to pledge against public deposits.

No investment securities were sold during the period ending March 31, 2005.

Note 4 — Loans and Allowance for Loan Loss

A summary of consolidated loans follows (In thousands):

Nonperforming assets are summarized as follows (In thousands):

Impaired loans and related information are summarized in the following tables (In thousands):

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Bancshares’ policy for impaired loan accounting subjects all loans to impairment recognition except for large groups of smaller balance homogeneous loans such as credit card, residential mortgage and consumer loans. Bancshares generally considers loans 90 days or more past due and all nonaccrual loans to be impaired. Interest income on impaired loans is recognized consistent with Bancshares’ income recognition policy of daily accrual of income until the loan is determined to be uncollectible and placed in a nonaccrual status.

An analysis of the changes in the allowance for loan losses follows (In thousands):

At March 31, 2005, loans totaling $20,886,000 were held for sale stated at the lower of cost or market on an individual basis.

Note 5 — Recent Accounting Pronouncements

In March 2004, the FASB issued Emerging Issues Task Force Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“EITF Issue No. 03-1”), which provides new guidance for assessing impairment losses on debt and equity investments and includes new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB delayed the accounting provisions of EITF Issue No. 03-1; however, the disclosure requirements remain effective and have been adopted by Bancshares in these financial statements. Bancshares adopted the currently effective provisions of EITF Issue No. 03-1 with no resulting material effect on its financial position or operating results.

In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (“SFAS 123R”), which is a revision of SFAS 123 and supersedes APB Opinion No. 25. SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be valued at fair value on the date of grant, and to be expensed over the applicable vesting period. In addition, compensation cost for the unvested portion of previously granted awards that remain outstanding on the effective date of SFAS 123R shall be recognized on or after the effective date, as the related services are rendered, based on the awards’ grant-date fair value as previously calculated for the pro-forma disclosure under SFAS 123. SFAS 123R is effective for all stock-based awards granted on or after January 1, 2006. Bancshares is currently assessing the effect of adopting SFAS 123R on its financial position and operating results. See “Subsequent Event” in Managements Discussion and Analysis.

Note 6 — Stock Compensation Plans

Bancshares accounts for its stock-based compensation plans using the accounting prescribed by Accounting Principles Board Opinion Number 25, “Accounting for Stock Issued to Employees.” In October 1995, Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), was issued and encourages, but does not require, adoption of a fair value method of accounting for employee stock-based compensation plans. In December 2002, the FASB

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Issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure-an Amendment of FASB Statement No. 123” (“SFAS 148”). As permitted by SFAS 123 and SFAS 148, Bancshares has elected to disclose the pro forma net income and earnings per share as if the fair value method had been applied in measuring compensation cost.

Bancshares had stock based compensation plans at March 31, 2005 accounted for under Accounting Principles Board Opinion Number 25, under which no compensation cost has been recognized. Had compensation cost for these plans been determined consistent with SFAS 123 and SFAS 148, Bancshares’ net income and earnings per share would have been reduced to the following pro forma amounts (In thousands, except per share amounts):

Note 7 — Pension and Post Retirement Medical Benefit Expenses

The components of net periodic benefit cost for pension and retiree medical plans are as follows:

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The discussion presented herein is intended to provide an overview of the changes in financial condition and results of operation during the time periods required by Item 303 of Regulation S-K for Bancshares and its wholly-owned subsidiary the Bank. The consolidated financial statements also include the accounts and

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results of operation of the Bank’s wholly owned subsidiaries, Peoples Finance and LSBIS. This discussion and analysis is intended to complement the unaudited financial statements, footnotes and supplemental financial data in this Form 10-Q, and should be read in conjunction therewith.

This report contains certain forward-looking statements related to anticipated future operating and financial performance, and other similar statements of expectations. These forward-looking statements are often identified by words such as “believes”, “anticipates”, “expects” or other similar words or phrases. These forward-looking statements are based on estimates, beliefs and assumptions made by management and are not guarantees of future performance. Actual results may differ from those expressed or implied as the result of various factors, including: (1) the strength of the United States’ economy generally and the strength of the local economies in which Bancshares conducts operations may be different than expected resulting in, among other things, a deterioration in credit quality or a reduced demand for credit, including the resultant effect on Bancshares’ loan portfolio and allowance for loan losses; (2) the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System; (3) inflation, interest rate, market and monetary fluctuations; (4) adverse conditions in the stock market, the public debt market and other capital markets (including changes in interest rate conditions) and the impact of such conditions on Bancshares’ capital markets and capital management activities, including, without limitation, Bancshares’ private equity investment activities and brokerage activities; (5) the timely development (or lack thereof) of competitive new products and services by Bancshares and the acceptance of these products and services by new and existing customers; (6) the willingness of customers to accept third party products marketed by Bancshares; (7) the willingness of customers to substitute competitors’ products and services for Bancshares’ products and services and vice versa; (8) the impact of changes in financial services’ laws and regulations (including laws concerning taxes, banking and securities); (9) technological changes; (10) changes in consumer spending and saving habits; (11) the effect of corporate restructurings, acquisitions and/or dispositions, and the failure to achieve the expected revenue growth and/or expense savings from such corporate restructurings, acquisitions and/or dispositions; (12) the growth and profitability of Bancshares’ noninterest or fee income being less than expected; (13) unanticipated regulatory or judicial proceedings; (14) the impact of changes in accounting policies by the SEC or other regulatory agencies; (15) adverse changes in financial performance and/or condition of Bancshares’ borrowers which could impact repayment of such borrowers’ outstanding loans; and (16) Bancshares’ success at managing the risks involved in the foregoing. Bancshares cautions that the foregoing list of important factors is not exclusive. Bancshares does not undertake to update any forward-looking statement, whether written or oral, that may be made from time to time by or on behalf of Bancshares.

Introduction

Bancshares is a bank holding company headquartered in Lexington, North Carolina. Its principal assets are all of the outstanding shares of common stock of its commercial bank subsidiary, Lexington State Bank. Founded in 1949, the Bank operates as a North Carolina chartered commercial bank serving customers through twenty-six offices in seventeen communities located in Davidson, Forsyth, Stokes, Guilford, Randolph, and Wake counties in North Carolina. Bancshares expanded its operations during 2004 through the opening of a mortgage loan production office in the Raleigh-Durham area of North Carolina and with the opening of a full service bank branch located in Jamestown, North Carolina. In the third quarter of 2004, the Bank completed the modernization and consolidation of its branch network in Lexington in order to better serve its customers. This was accomplished through the closing of one office and the consolidation of two other offices into existing branches. Through the Bank and the Bank’s two non-bank subsidiaries, Peoples Finance and LSBIS, Bancshares provides a wide range of financial services to individuals and corporate customers.

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Bancshares’ results of operations are dependent primarily on the results of operations of the Bank and thus are dependent to a significant extent on net interest income, which is the difference between the income earned on its loan and investment portfolios and its cost of funds, consisting of interest paid on deposits and borrowings. The Bank’s noninterest income has become increasingly important to its performance through fees earned by its non-bank subsidiary LSBIS. Results of operations are also affected by Bancshares’ provision for loan losses, mortgage loan sales activities, service charges and other fee income, and noninterest expense. Bancshares’ noninterest expense principally consists of compensation and employee benefits, office occupancy and equipment expense, data processing, professional fees, and advertising and business promotion expenses. Bancshares’ results of operations are also significantly affected by general economic and competitive conditions, particularly changes in interest rates, government policies and actions of regulatory authorities.

The Bank (and Bancshares as its holding company) faces competition in both the attraction of deposit accounts and in the origination of mortgage, commercial, and consumer loans. Its most direct competition for deposits has historically derived from other commercial banks located in and around the counties in which it maintains banking offices. The Bank also competes for deposits with both regional and super-regional banks, and money market instruments and mutual funds. The Bank competes for loans principally through the interest rates and loan fees it charges and the efficiency and quality of services it provides borrowers. Its competition for loans also comes principally from other commercial banks, including offices of regional and super-regional banks, located in and around the counties in which it maintains banking offices. Competition for deposits and loans is likely to continue to increase as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry. Technological advances, for example, have lowered barriers to market entry, allowed banks to expand their geographic reach by providing services over the Internet and made it possible for non-depository institutions to offer products and services that traditionally have been provided by banks. Recent legislation permits affiliation among banks, securities firms and insurance companies, and further legislation will likely continue to change the competitive environment in which Bancshares does business.

The following discussion and analysis is presented on a consolidated basis and focuses on the major components of Bancshares’ operations and significant changes in its results of operations for the periods presented. For further information, refer to the Consolidated Financial Statements and footnotes thereto included in the Form 10-K.

Critical Accounting Policies

The accounting and reporting policies of the Bank and its subsidiaries comply with generally accepted accounting principles in the United States and conform to standards within the industry. Bancshares believes that its most significant accounting policies deal with:

	•	The allowance for loan loss, as it requires the most subjective and complex judgments from senior management. Management considers several factors in determining the allowance for loan loss. These include economic conditions, advice of regulators, historical experience and factors affecting particular borrowers. Changes in the assumptions of these policies could result in a significant impact on the Bank’s financial statements. For further information, see the Asset Quality and Allowance for Loan Losses section.
	•	Pension and post retirement benefit plans to employees. The calculation of obligations and related expenses under these plans requires the use of actuarial valuation methods and assumptions. Actuarial valuations and the determination of future market values of

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plan assets are subject to management judgment and may differ significantly if different assumptions are used. Please refer to Note 7, “Pension and Post Retirement Medical Benefit Expenses,” in the “Notes to Consolidated Financial Statements” for disclosures related to Bancshares’ benefits plans.

Three Months Ended March 31, 2005 Compared to Three Months Ended March 31, 2004

Net Interest Income

The primary source of earnings for Bancshares is net interest income, which represents the dollar amount by which interest generated from earning assets exceeds the cost of funds. Earning assets consist primarily of loans and investment securities and cost of funds is the interest paid on interest-bearing deposits and borrowed funds.

Net interest income for the first quarter of 2005 of $10.353 million was up $919,000 or 9.7% compared to $9.434 million for the first quarter of 2004. The increase was largely attributable to an improvement in the net interest margin from 4.73% at March 31, 2004 to 4.88% at March 31, 2005, and 7.2% growth in average earning assets. Loan growth in the first quarter of 2005 was $31.771 million or 4.5% compared to December 31, 2004, and $64.976 million or 9.6% compared to March 31, 2004. For the period ended March 31, 2005, total deposits were up $41.425 million or 5.7% compared to December 31, 2004, and $63.563 million or 9.1% compared to March 31, 2004.

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The following table provides an analysis of average volumes, yields and rates and net interest income on a tax-equivalent basis for the quarters ended March 31, 2005 and 2004.

Fully taxable equivalent basis¹ (In thousands):

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Noninterest Income and Expense

In the first quarter of 2005 noninterest income declined $94,000 or 2.8%. The decline in noninterest income for 2005 was the result of a decrease in service charges on deposit accounts from $1.671 million for the first quarter of 2004 to $1.553 million for the first quarter of 2005, a 7.1% decrease. Gain on sale of mortgage loans increased $22,000 or 20.0% for the first quarter of 2005 compared to the same period in 2004.

In the first quarter of 2005, noninterest expense increased $659,000 or 7.2% compared to the same period in 2004. Personnel expense in the first quarter of 2005, consisting of employee salaries and benefits, increased $187,000 or 3.6% from the same period in 2004. The increase in personnel expense is largely attributable to an increase in health insurance costs of $119,000, due to unusually low claims activity in the first quarter of 2004, and an increase in incentive compensation anticipated for 2005, due to the Bank and its subsidiaries increased loan and sales projections for 2005 over the 2004 activity. These increases were slightly offset by a modest reduction in staff, which decreased salary expense. The staff reductions resulted from consolidation of three offices in the Lexington community and improved efficiencies in bank operations. Full-time equivalent employees for Bancshares totaled 418 at March 31, 2005 compared to 430 at March 31, 2004. Equipment depreciation and maintenance expense increased $52,000 or 9.7% in the first quarter of 2005 compared to the same period in 2004. The increase in equipment depreciation and maintenance expense is largely due to the Bank insulting a new item processing system during 2004 along with the normal result of growth.

For the changes in other operating expenses, please see the table, Other Operating Income and Expenses, below.

Other Operating Income and Expenses (In thousands)

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Asset Quality and Allowance for Loan Losses

At March 31, 2005, the allowance for loan losses was $8.145 million or 1.09% of loans outstanding compared to $7.962 million or 1.12% of loans outstanding at December 31, 2004, and $8.224 million or 1.21% of loans outstanding at March 31, 2004. Net charge-offs for the quarter ended March 31, 2005 were $356,000 or 0.05% of average loans outstanding compared to net charge-offs of $133,000 or 0.02% of average loans outstanding as of March 31, 2004. The low level of net charge-offs for the first quarter 2004 are related, in large part, to some recoveries of two problem credits that were written off in the fourth quarter of 2003. Adequate provisions and allowances for loan loss reserves are based on numerous factors including growth of the loan portfolio, delinquencies, net charge-offs, non-performing loans and collateral values. Additional information regarding the allowance for loan losses is presented in the table, Asset Quality Analysis, below.

The provision for loan losses charged to operations for the first quarter of 2005 totaled $539,000 compared to $511,000 for the first quarter of 2004. At March 31, 2005, the allowance for loan losses was 2.61 times nonperforming loans compared to 1.94 at December 31, 2004 and 1.64 times at March 31, 2004. Based on analysis of the current loan portfolio and levels of current problem assets and potential problem loans, management believes the allowance for loan losses to be adequate. Management continues to monitor the asset quality of the loan portfolio. Loans charged-off are recorded based upon the financial condition of the borrower and the likelihood of repayment.

Loans classified for regulatory purposes as loss, doubtful, substandard or special mention that have not been disclosed herein as nonperforming do not represent or result from trends or uncertainties which management reasonably expects will materially impact future operating results, liquidity, or capital resources. For these loans, management is not 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. In the opinion of management, all loans where serious doubts exist as to the ability of borrowers to comply with the present repayment terms have been included in the schedule presented below.

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Asset Quality Analysis

Accrued income taxes applicable to income for the quarter ended March 31, 2005 were $1.081 million compared to $1.022 million for the quarter ended March 31, 2004. Pretax income for the first quarter of 2005 of $3.313 million increased $138,000 compared to $3.175 million for the first quarter of 2004. The increase in accrued taxes for the quarter ended March 31, 2005 is primarily due to the increased taxable income. During 2003, the Bank purchased an investment tax credit partnership interest for $540,000. The partnership is expected to yield $1.000 million in tax credits over the years 2003 to 2009. Actual credits applied to the quarter ended March 31, 2005 and 2004, were $39,000 and $47,000, respectively. Bancshares accounts for tax credits using the flow-through method, thereby reducing income tax expense in the year in which the credits were received.

Capital Resources and Shareholders’ Equity

In May 2004, the Board of Directors of Bancshares approved an extension of the stock repurchase program, first approved in November of 1998 and extended in August of 1999, for up to an additional 300,000 shares of Bancshares’ common stock. Currently, this repurchase program is scheduled to conclude on May 31, 2006. The Board authorized the repurchase of shares of common stock in the open market or privately negotiated transactions on a time-to-time and ongoing basis, depending upon market conditions and subject to compliance with all applicable securities laws and regulations. The repurchase program assists in the goal of building shareholder value and maintaining appropriate capital levels.

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The following table shows a breakdown of the shares that have been repurchased under the repurchase program during the quarter.

Regulatory guidelines require minimum levels of capital based on a risk weighting of each asset category and off-balance sheet contingencies. Regulatory agencies divide capital into Tier 1 or core capital and total capital. Tier 1 capital, as defined by regulatory agencies, consists primarily of common shareholders’ equity less goodwill and certain other intangible assets. Total capital consists of Tier 1 capital plus the allowable portion of the allowance for loan losses and certain long-term debt. Additional regulatory capital measures include the Tier 1 leverage ratio. Tier 1 leverage ratio is defined as Tier 1 capital divided by average total assets less goodwill and certain other intangibles and has a regulatory minimum of 3.0%, with most institutions required to maintain a ratio of at least 4.0% to 5.0%, depending primarily upon risk profiles. In addition to the aforementioned risk-based capital requirements, the Bank is subject to a leverage capital requirement, requiring a minimum ratio of Tier 1 Capital (as defined previously) to total adjusted average assets of 3.0% to 5.0%. The Bank’s capital requirements are summarized in the table below (Dollars in thousands):

Subsequent Event

Due to the pending adoption of SFAS No. 123(R), effective April 11, 2005, the Stock Option and Compensation Committee of the Board of Directors of Bancshares (the “Compensation Committee”) voted to immediately vest certain unvested and underwater options held by current employees and executive officers.

The decision to vest these options, which the Compensation Committee and the Executive Committee of the Board of Directors of Bancshares believe was in the best interests of Bancshares and its shareholders, was made to reduce compensation expense that otherwise would have been recorded in future periods once Bancshares became subject to SFAS 123(R), which is currently scheduled to become effective for Bancshares’ fiscal year beginning January 1, 2006. As a result of this accelerated vesting, Bancshares expects to reduce its future aggregate compensation expense related to the options subject to the vesting

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by a total of approximately $227,000, based on estimated value calculations using Black-Scholes valuation methodology.

Market Risk Management

Bancshares’ market risk arises primarily from the interest rate risk inherent in its lending and deposit-taking activities. The objectives of market risk management are to ensure long-range profitability performance and minimize risk, adhere to proper liquidity and maintain sound capital. To meet these goals, the Asset/liability Committee of Bancshares (“ALCO”) monitors the exposure to interest rate risk, balance sheet trends, pricing policies and liquidity position. The objectives are to achieve relatively stable net interest margins and assure liquidity through coordinating the volumes, maturities or repricing opportunities of earning assets, deposits and borrowed funds. This is accomplished through strategic pricing of asset and liability accounts. As a result of this management, appropriate maturities and/or repricing opportunities are developed to produce consistent earnings during changing interest rate environments.

Based upon its view of existing and expected market conditions, ALCO adopts balance sheet strategies intended to optimize net interest income to the extent possible while minimizing the risk associated with unanticipated changes in interest rates. Core deposits have historically been the primary funding sources for asset growth. Correspondent relationships have been maintained with several large banks in order to have access to federal funds purchases when needed. The Bank also has available lines of credit maintained with the FHLB, which can be used for funding and/or liquidity needs. This credit is collateralized by a blanket lien on qualifying loans secured by first mortgages on 1-4 family residences as well as qualified multi-family and home equity lines. The Bank has a $10 million and a $20 million irrevocable letter of credit with the FHLB that are used in lieu of securities to pledge against public deposits. The Bank also has retail CD brokerage agreements that provide additional sources of liquidity for funding needs.

To minimize risk of interest rate movements, the asset/liability management process seeks to match maturities and repricing opportunities of interest-sensitive assets and interest-sensitive liabilities. The Bank uses an asset/liability simulation model to produce a gap analysis. The simulation model computes projected runoff of deposits that do not have contractual maturity dates. On March 31, 2005, the one-year cumulative interest sensitivity gap was a positive $171 million for a ratio of interest-sensitive assets to interest-sensitive liabilities of 1.55. Management believes that is an acceptable ratio.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Market risk reflects the risk of economic loss resulting from adverse changes in market price and interest rates. This risk of loss can be reflected in diminished current market values and/or reduced potential net interest income in future periods.

Bancshares’ market risk arises primarily from the interest rate risk inherent in its lending and deposit-taking activities. The structure of Bancshares’ loan and deposit portfolios is such that a significant decline in interest rates may adversely impact net market values and net interest income. Bancshares does not maintain a trading account nor is it subject to currency exchange risk or commodity price risk. Responsibility for monitoring interest rate risk rests with ALCO, which is appointed by Bancshares’ Board of Directors. ALCO meets on a regular basis to review interest rate risk exposure and liquidity positions. Balance sheet management and funding strategies are reviewed to ensure that any potential impact on earnings and liquidity, resulting from a fluctuation in interest rates, is within acceptable standards.

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Item 4. Controls and Procedures

As of the end of the period covered by this report, Bancshares has evaluated, under the supervision and with the participation of Bancshares’ management, including Bancshares’ Chief Executive Officer and Chief Financial Officer, the effectiveness of Bancshares’ disclosure controls and procedures (as defined in Rule 13a-15(e) promulgated under the Exchange Act). Based upon that evaluation, Bancshares’s Chief Executive Officer and Chief Financial Officer have concluded that Bancshares’s disclosure controls and procedures are effective to ensure that information required to be disclosed by Bancshares in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within time periods specified in the rules and forms of the SEC.

During the quarterly period covered by this report, there has been no change in Bancshares’ internal control over financial reporting (as defined in Rule 13a-15(f) promulgated under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, Bancshares’ internal control over financial reporting.

PART II. OTHER INFORMATION

Item 6. Exhibits

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

EXHIBIT INDEX

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