Supervision and Regulation

     The Company is a financial services holding company subject to the Financial Holding Company Act (“FHCA”). The Company reports to, registers with, and may be examined by, the FRB. The FRB also has the authority to examine the Company’s subsidiaries. The costs of any examination by the FRB are payable by the Company.

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     The Company is a bank holding company within the meaning of Section 3700 of the California Financial Code. As such, the Company and the Bank are subject to examination by, and may be required to file reports with, the California Commissioner of Financial Institutions (the “Commissioner”). The FRB has significant supervisory and regulatory authority over the Company and its affiliates. The FRB requires the Company to maintain certain levels of capital. See “Capital Standards.” The FRB also has the authority to take enforcement action against any bank holding company that commits any unsafe or unsound practice, or violates certain laws, regulations or conditions imposed in writing by the FRB. See “Prompt Corrective Action and Other Enforcement Mechanisms.”

     Under the FHCA, a company generally must obtain the prior approval of the FRB before it exercises a controlling influence over a bank, or acquires directly or indirectly, more than 5% of the voting shares or substantially all of the assets of any bank or bank holding company. Thus, the Company is required to obtain the prior approval of the FRB before it acquires, merges or consolidates with any bank or financial services holding company. Any company seeking to acquire, merge or consolidate with the Company also would be required to obtain the prior approval of the FRB.

     A financial services holding company may acquire banks in states other than its home state without regard to the permissibility of such acquisitions under state law, but subject to any state requirement that the bank has been organized and operating for a minimum period of time, not to exceed five years, and the requirement that the bank holding company, prior to or following the proposed acquisition, controls no more than 10% of the total amount of deposits of insured depository institutions in the United States and no more than 30% of such deposits in that state (or such lesser or greater amount set by state law). Banks may also merge across state lines, therefore creating interstate branches. Furthermore, a bank is now able to open new branches in a state in which it does not already have banking operations if the laws of such state permit such de novo branching.

     Under California law, (a) out-of-state banks that wish to establish a California branch office to conduct core banking business must first acquire an existing five year old California bank or industrial loan company by merger or purchase; (b) California state-chartered banks are empowered to conduct various authorized branch-like activities on an agency basis through affiliated and unaffiliated insured depository institutions in California and other states and (c) the Commissioner is authorized to approve an interstate acquisition or merger which would result in a deposit concentration exceeding 30% if the Commissioner finds that the transaction is consistent with public convenience and advantage. However, a state bank chartered in a state other than California may not enter California by purchasing a California branch office of a California bank or industrial loan company without purchasing the entire entity or by establishing a de novo California bank.

     The FRB generally prohibits a financial services holding company from declaring or paying a cash dividend which would impose undue pressure on the capital of subsidiary banks or would be funded only through borrowing or other arrangements that might adversely affect a bank holding company’s financial position.

     The FRB’s policy is that a bank holding company should not continue its existing rate of cash dividends on its common stock unless its net income is sufficient to fully fund each dividend and its prospective rate of earnings retention appears consistent with its capital needs, asset quality and overall financial condition. See “-Restrictions on Dividends and Other Distributions” for additional restrictions on the ability on the Company and the Bank to pay dividends.

     Transactions between the Company and the Bank are subject to a number of other restrictions. FRB policies forbid the payment by bank subsidiaries of management fees, which are unreasonable in amount or exceed the fair market value of the services rendered (or, if no market exists, actual costs plus a reasonable profit).

     Subject to certain limitations, depository institution subsidiaries of financial services holding companies may extend credit to, invest in the securities of, purchase assets from, or issue a guarantee, acceptance, or letter of credit on behalf of, an affiliate, provided that the aggregate of such transactions with affiliates may not exceed 10% of the capital stock and surplus of the institution, and the aggregate of such transactions with all affiliates may not exceed 20% of the capital stock and surplus of such institution. The Company may only borrow from depository institution subsidiaries if the loan is secured by marketable obligations with a value of a designated amount more than the loan. Further, the Company may not sell a low-quality asset to a depository institution subsidiary.

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     Comprehensive amendments to Regulation Y became effective in 1997, and are intended to improve the competitiveness of financial services holding companies by, among other things: (i) expanding the list of permissible nonbanking activities in which well-run bank holding companies may engage without prior FRB approval, (ii) streamlining the procedures for well-run bank holding companies to obtain approval to engage in other nonbanking activities and (iii) eliminating most of the anti-tying restrictions imposed upon bank holding companies and their nonbank subsidiaries.

     Amended Regulation Y also provides for a streamlined and expedited review process for bank acquisition proposals submitted by well-run bank holding companies and eliminates certain duplicative reporting requirements when there has been a further change in bank control or in bank directors or officers after an earlier approved change. These changes to Regulation Y are subject to numerous qualifications, limitations and restrictions. In order for a financial services holding company to qualify as “well-run,” both it and the insured depository institutions that it controls must meet the “well-capitalized” and “well-managed” criteria set forth in Regulation Y.

     To qualify as “well-capitalized,” the bank must, on a consolidated basis: (i) maintain a total risk-based capital ratio of 10% or greater, (ii) maintain a Tier 1 risk-based capital ratio of 6% or greater and (iii) not be subject to any order by the FRB to meet a specified capital level. Its lead insured depository institution must be well-capitalized (as that term is defined in the capital adequacy regulations of the applicable bank regulator), 80% of the total risk-weighted assets held by its insured depository institutions must be held by institutions that are well-capitalized, and none of its insured depository institutions may be undercapitalized.

     To qualify as “well-managed”: (i) each of its lead depository institutions and its depository institutions holding 80% of the total risk-weighted assets of all its depository institutions at their most recent examination or review must have received a composite rating, rating for management and rating for compliance which were at least satisfactory, (ii) none of the bank holding company’s depository institutions may have received one of the two lowest composite ratings and (iii) neither the bank holding company nor any of its depository institutions during the previous 12 months may have been subject to a formal enforcement order or action.

     Bank Regulation and Supervision

     The Bank is a California chartered bank insured by the Federal Deposit Insurance Corporation (the “FDIC”), and as such is subject to regulation, supervision and regular examination by the California Department of Financial Institutions (“DFI”) and the FDIC. As a non-member of the Federal Reserve System, the primary federal regulator of the Bank is the FRB. The regulations of these agencies affect most aspects of the Bank’s business and prescribe permissible types of loans and investments, the amount of required reserves, requirements for branch offices, the permissible scope of the Bank’s activities and various other requirements.

     The Bank is also subject to applicable provisions of California law, insofar as such provisions are not in conflict with or preempted by federal banking law. In addition, the Bank is subject to certain regulations of the FRB dealing primarily with check-clearing activities, establishment of banking reserves, Truth-in-Lending (Regulation Z), Truth-in-Savings (Regulation DD), and Equal Credit Opportunity (Regulation B).

     Under California law, a state chartered bank is subject to various restrictions on, and requirements regarding, its operations and administration including the maintenance of branch offices and automated teller machines, capital and reserve requirements, deposits and borrowings, shareholder rights and duties, and investment and lending activities. Whenever it appears that the contributed capital of a California bank is impaired, the Commissioner is required to order the bank to correct such impairment. If a bank is unable to correct the impairment, the bank is required to levy and collect an assessment upon its common shares. If such assessment becomes delinquent, the common shares are to be sold by the bank.

     California law permits a state chartered bank to invest in the stock and securities of other corporations, subject to a state chartered bank receiving either general authorization or, depending on the amount of the proposed investment, specific authorization from the Commissioner. The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), however, imposes limitations on the activities and equity investments of state chartered, federally insured banks. FDICIA also prohibits a state bank from engaging as a principal in any activity that is not permissible for a national bank, unless the bank is adequately capitalized and the FDIC approves the activity after determining that such activity does not pose a significant risk to the bank deposit insurance fund.

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     The FDIC rules on activities generally permit subsidiaries of banks, without prior specific FDIC authorization, to engage in those that have been approved by the FRB for bank holding companies because such activities are so closely related to banking to be a proper incident thereto. Other activities generally require specific FDIC prior approval and the FDIC may impose additional restrictions on such activities on a case-by-case basis in approving applications to engage in otherwise impermissible activities.

     Capital Standards

     The federal banking agencies have risk-based capital adequacy guidelines intended to provide a measure of capital adequacy that reflects the degree of risk associated with a banking organization’s operations for both transactions reported on the balance sheet as assets and transactions, such as letters of credit and recourse arrangements, which are recorded as off balance sheet items. Under these guidelines, nominal dollar amounts of assets and credit equivalent amounts of off balance sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk, such as certain U.S. government securities, to 100% for assets with relatively higher credit risk, such as certain loans.

     In determining the capital level a bank is required to maintain, the federal banking agencies do not, in all respects, follow accounting principles generally accepted in the United States of America (“GAAP”) and have special rules which have the effect of reducing the amount of capital that will be recognized for purposes of determining the capital adequacy of a bank.

     A banking organization’s risk-based capital ratios are obtained by dividing its qualifying capital by its total risk-adjusted assets and off balance sheet items. The regulators measure risk-adjusted assets and off balance sheet items against both total qualifying capital (the sum of Tier 1 capital and limited amounts of Tier 2 capital) and Tier 1 capital. Tier 1 capital consists of common stock, retained earnings, non-cumulative perpetual preferred stock, other types of qualifying preferred stock including trust prefererred securities and minority interests in certain subsidiaries, less most other intangible assets and other adjustments. Net unrealized losses on available-for-sale equity securities with readily determinable fair value must be deducted in determining Tier 1 capital. For Tier 1 capital purposes, deferred tax assets that can only be realized if an institution earns sufficient taxable income in the future are limited to the amount that the institution is expected to realize within one year, or ten percent of Tier 1 capital, whichever is less. Tier 2 capital may consist of a limited amount of the allowance for possible loan and lease losses, term preferred stock and other types of preferred stock not qualifying as Tier 1 capital, term subordinated debt and certain other instruments with some characteristics of equity. The inclusion of elements of Tier 2 capital are subject to certain other requirements and limitations of the federal banking agencies. The federal banking agencies require a minimum ratio of qualifying total capital to risk-adjusted assets and off balance sheet items of 8%, and a minimum ratio of Tier 1 capital to adjusted average risk-adjusted assets and off balance sheet items of 4%. The Company exceeds the minimum requirements.

     On October 1, 1998, the FDIC adopted two rules governing minimum capital levels that FDIC-supervised banks must maintain against the risks to which they are exposed. The first rule makes risk-based capital standards consistent for two types of credit enhancements (i.e., recourse arrangements and direct credit substitutes) and requires different amounts of capital for different risk positions in asset securitization transactions. The second rule permits limited amounts of unrealized gains on debt and equity securities to be recognized for risk-based capital purposes as of September 1, 1998.

     The FDIC rules also provide that a qualifying institution that sells small business loans and leases with recourse must hold capital only against the amount of recourse retained.

     In general, a qualifying institution is one that is well capitalized under the FDIC’s prompt corrective action rules. The amount of recourse that can receive the preferential capital treatment cannot exceed 15% of the institution’s total risk-based capital.

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     In addition to the risked-based guidelines, federal banking regulators require banking organizations to maintain a minimum amount of Tier 1 capital to adjusted average total assets, referred to as the leverage capital ratio. For a banking organization rated in the highest of the five categories used by regulators to rate banking organizations, the minimum leverage ratio of Tier 1 capital to total assets must be 3%. It is improbable; however, that an institution with a 3% leverage ratio would receive the highest rating by the regulators since a strong capital position is a significant part of the regulators’ rating. For all banking organizations not rated in the highest category, the minimum leverage ratio must be at least 100 to 200 basis points above the 3% minimum. Thus, the effective minimum leverage ratio, for all practical purposes, must be at least 4% or 5%. In addition to the uniform risk-based capital guidelines and leverage ratios that apply across the industry, the regulators have the discretion to set individual minimum capital requirements for specific institutions at rates significantly above the minimum guidelines and ratios.

     As of December 31, 2002, the Company’s and the Bank’s capital ratios exceeded applicable regulatory requirements. The tables on page 38 present the capital ratios for the Company and the Bank, compared to the standards for well-capitalized depository institutions, as of December 31, 2002.

     Banking agencies must take into consideration concentrations of credit risk and risks from non-traditional activities, as well as an institution’s ability to manage those risks, when determining the adequacy of an institution’s capital. This evaluation is a part of the institution’s regular safety and soundness examination. Banking agencies must also consider interest rate risk (when the interest rate sensitivity of an institution’s assets does not match the sensitivity of its liabilities or its off-balance-sheet position) in evaluation of a banks capital adequacy.

     Dividends and Other Distributions

     The power of the board of directors of an insured depository institution to declare a cash dividend or other distribution with respect to capital is subject to statutory and regulatory restrictions which limit the amount available for such distribution depending upon the earnings, financial condition and cash needs of the institution, as well as general business conditions. FDICIA prohibits insured depository institutions from paying management fees to any controlling persons or, with certain limited exceptions, making capital distributions, including dividends, if, after such transaction, the institution would be undercapitalized.

     In addition to the restrictions imposed under federal law, banks chartered under California law generally may only pay cash dividends to the extent such payments do not exceed the lesser of retained earnings of the bank or the bank’s net income for its last three fiscal years (less any distributions to shareholders during such period).

     In the event a bank desires to pay cash dividends in excess of such amount, the bank may pay a cash dividend with the prior approval of the Commissioner in an amount not exceeding the greatest of the bank’s retained earnings, the bank’s net income for its last fiscal year, or the bank’s net income for its current fiscal year.

     Regulators also have authority to prohibit a depository institution from engaging in business practices which are considered to be unsafe or unsound, possibly including payment of dividends or other payments under certain circumstances even if such payments are not expressly prohibited by statute.

Prompt Corrective Action and Other Enforcement Mechanisms

     FDICIA requires each federal banking agency to take prompt corrective action to resolve the problems of insured depository institutions, including but not limited to those that fall below one or more prescribed minimum capital ratios. The law required each federal banking agency to promulgate regulations defining the following five categories in which an insured depository institution will be placed, based on the level of its capital ratios: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized.

     Under the prompt corrective action provisions of FDICIA, an insured depository institution generally will be classified in the following categories based on the capital measures indicated below:

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     An institution that, based upon its capital levels, is classified as “well capitalized,” “adequately capitalized” or “undercapitalized” may be treated as though it were in the next lower capital category if the appropriate federal banking agency, after notice and opportunity for hearing, determines that an unsafe or unsound condition or an unsafe or unsound practice warrants such treatment. At each successive lower capital category, an insured depository institution is subject to more restrictions. The federal banking agencies, however, may not treat an institution as “critically undercapitalized” unless its capital ratio actually warrants such treatment.

     If an insured depository institution is undercapitalized, it will be closely monitored by the appropriate federal banking agency. Undercapitalized institutions must submit an acceptable capital restoration plan with a guarantee of performance issued by the holding company. Further restrictions and sanctions are required to be imposed on insured depository institutions that are critically undercapitalized. The most important additional measure is that the appropriate federal banking agency is required to either appoint a receiver for the institution within 90 days, or obtain the concurrence of the FDIC in another form of action.

     In addition to measures taken under the prompt corrective action provisions, commercial banking organizations may be subject to potential enforcement actions by the federal regulators for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency. Enforcement actions may include the imposition of a conservator or receiver, the issuance of a cease-and-desist order that can be judicially enforced, the termination of insurance of deposits (in the case of a depository institution), the imposition of civil money penalties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the issuance of removal and prohibition orders against institution-affiliated parties and the enforcement of such actions through injunctions or restraining orders based upon a judicial determination that the agency would be harmed if such equitable relief was not granted.

     Additionally, a holding company’s inability to serve as a source of strength to its subsidiary banking organizations could serve as an additional basis for a regulatory action against the holding company.

     Safety and Soundness Standards

     FDICIA also implemented certain specific restrictions on transactions and required federal banking regulators to adopt overall safety and soundness standards for depository institutions related to internal control, loan underwriting, documentation, and asset growth. Among other things, FDICIA limits the interest rates paid on deposits by undercapitalized institutions, restricts the use of brokered deposits, limits the aggregate extensions of credit by a depository institution to an executive officer, director, principal shareholder or related interest, and reduces deposit insurance coverage for deposits offered by undercapitalized institutions for deposits by certain employee benefits accounts.

     The federal banking agencies may require an institution to submit to an acceptable compliance plan as well as have the flexibility to pursue other more appropriate or effective courses of action given the specific circumstances and severity of an institution’s noncompliance with one or more standards.

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     Premiums for Deposit Insurance and Assessments for Examinations

     The Bank has its deposits insured by the Bank Insurance Fund (“BIF”) administered by the FDIC. The FDIC is authorized to borrow up to $30 billion from the United States Treasury; up to 90% of the fair market value of assets of institutions acquired by the FDIC as receiver from the Federal Financing Bank; and from depository institutions that are members of the BIF. Any borrowings not repaid by asset sales are to be repaid through insurance premiums assessed to member institutions. Such premiums must be sufficient to repay any borrowed funds within 15 years and provide insurance fund reserves of $1.25 for each $100 of insured deposits. FDICIA also provides authority for special assessments against insured deposits. No assurance can be given at this time as to what the future level of premiums will be.

     Community Reinvestment Act and Fair Lending Developments

     The Bank is subject to certain fair lending requirements and reporting obligations involving home mortgage lending operations and Community Reinvestment Act (“CRA”) activities. The CRA generally requires the federal banking agencies to evaluate the record of a financial institution in meeting the credit needs of their local communities, including low and moderate-income neighborhoods. In addition to substantive penalties and corrective measures that may be required for a violation of certain fair lending laws, the federal banking agencies may take compliance with such laws and CRA into account when regulating and supervising other activities.

     Recently Enacted Legislation

     On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002 (the “Act”). This is the most comprehensive reform since the securities acts of the 1930’s. The Act reaffirms the authority of the Securities and Exchange Commission (“SEC”) with the goal of restoring investor confidence. The SEC has been assigned the task of implementing corporate governance through rulemaking under a short timeframe. The rules to date require:

•		both the Chief Executive Officer and Chief Financial Officer to certify that disclosure of all material information is included in both quarterly and annual reports;
•		that the Company adopt a code of ethics and that every senior officer of the company abide by the code;
•		requires that the Audit Committee have substantial financial expertise;
•		that MD&A disclosures of off-balance sheet arrangements and aggregate contractual obligations are fully disclosed in the filings;
•		that Insider trading is suspended during blackout periods;
•		establishing standards for attorney’s practicing before the SEC;
•		and fixes retention periods of records relevant to audits and reviews.

     Final rules have been issued relative to auditor independence and accelerated filing dates for the 10-Q and 10-K reports. Rules that are still open for comments include Audit committee responsibilities and Attorney conduct rules and all rules are expected to be in place during 2003.

     Key points addressed to the Audit Committee include:

•		Auditor relationship shifts from Company management to the Audit committee in relation to hiring, firing and compensation practices
•		Establishing effective communications among auditors, audit committees and management
•		Ensuring that the Company’s audit committee consist of financial experts with such attributes as education and experience as a principal financial officer, principal accounting officer, controller, public accountant or auditor; with experience actively supervising such accounting experts; or other relevant experience qualifying the members as financial experts.
•		Establishing procedures to allow whistle-blower access to the audit committee. For information concerning the role, independence and responsibilities of the Audit Committee please refer to the company’s Audit Committee Charter which is included in the annual proxy statement as appendix “A”.

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     The breadth and volume of the new requirements affect all significant participants in the financial reporting process and the Board of Directors and Senior Management acknowledge that continued improvement and changes will come as experience is gained with the new rules and reporting requirements, while all efforts are geared towards full compliance to the intent of the Act.

     On October 26, 2001, President Bush signed into law the Uniting and Strengthening America by Providing Appropriate Tools Required to Obstruct Terrorism Act (the “USA Patriot Act”), thereby amending the anti-money laundering provisions of the Bank Secrecy Act. The amendments are intended to make it easier to prevent, detect, and prosecute international money laundering and the financing of terrorism.

     The final rule implementing information sharing was issued on September 26, 2002 and added sections 103.100 and 103.110 to the Bank Secrecy Act regulations. The new section 103.100 establishes a mechanism for law enforcement to communicate the names of suspected terrorists and money launders to financial institutions in return for securing the ability to promptly locate accounts and transactions involving suspects. Financial Institutions receiving names of suspects must search their account and transaction records for potential matches and report positive results to the Treasury’s Financial Crimes Enforcement Network (“FinCen”) in the manner and time frame specified in the request. The new section 103.110 outlines how financial institutions can share information concerning suspected terrorist and money laundering activity with other financial institutions under the protection of the statutory safe harbor from liability.

The law also:

•		Provides for financial institutions to take reasonable steps to ensure they are not providing banking services directly or indirectly to foreign shell banks;
•		Provides an enhanced framework for identification of customers;
•		Proposes similar anti-money laundering programs for Insurance companies, unregistered investment companies, savings associations and credit unions, futures commission merchants, mutual funds, money service businesses and credit card systems;
•		Modifies the laws governing the Bank Secrecy Act; and
•		Addresses a variety of other legal and regulatory issues affecting both day-to-day operations and long-term activities of financial institutions in relation to money laundering and terrorism.

     The Company does not expect the USA Patriot Act to have a material effect on operations.

     The Company filed for and was approved as a Financial Services Holding Company in April 2000. Financial Services Holding Companies may affiliate with securities firms and insurance companies and engage in other activities that are financial in nature or are complementary to activities that are financial in nature. “Financial in nature” activities include: securities underwriting; dealing and market making; sponsoring mutual funds and investment companies; insurance underwriting and agencies; merchant banking; and activities that the Federal Reserve, in consultation with the Secretary of the Treasury, determines from time to time to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.

     Pending Legislation and Regulations

     Certain pending legislative proposals include bills to let banks pay interest on business checking accounts, to cap consumer liability for stolen debit cards, and to give judges the authority to force high-income borrowers to repay their debts rather than cancel them through bankruptcy.

     Competition

     In the past, an independent bank’s principal competitors for deposits and loans have been other banks (particularly major banks), savings and loan associations and credit unions. To a lesser extent, competition was also provided by thrift and loans, mortgage brokerage companies and insurance companies.

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     Other institutions, such as brokerage houses, mutual fund companies, credit card companies, and even retail establishments have offered new investment vehicles, which also compete with banks for deposit business. The direction of federal legislation in recent years seems to favor competition between different types of financial institutions and to foster new entrants into the financial services market, and it is anticipated that this trend will continue.

     Among the competitive advantages, that major banks have is their ability to finance wide ranging advertising campaigns and to allocate their investment assets into investments of higher yield and demand. Such institutions offer certain services such as trust services and international banking services that are not offered directly by the Bank (but are offered indirectly through correspondent relationships). Because of their greater total capitalization, major banks have substantially higher legal lending limits than the Bank.

     In order to compete with major banks and other competitors in its primary service areas, the Bank relies upon the experience of its executive and senior officers in serving business clients, and upon its specialized services, local promotional activities and the personal contacts made by its officers, directors and employees. For customers whose loan demand exceeds the Bank’s legal lending limit, the Bank may arrange for such loans on a participation basis with correspondent banks. Competitive pressures in the banking industry significantly increase changes in the interest rate environment, reducing net interest margins, and less than favorable economic conditions can result in a deterioration of credit quality and an increase in the provisions for loan losses.

     With respect to its credit card processing services, the Bank competes with other banks, independent sales organizations (“ISOs”) and other nonbank processors. Many of these competitors are substantially larger than the Bank. The bank competes on the basis of price, the availability of products and services, the quality of customer service, support, and transaction processing speed. The majority of the Bank’s contracts with merchants are cancelable at will or on short notice or provide for renewal at frequent periodic intervals and, accordingly, the Bank regularly rebids such contracts. This competition may influence the prices that can be charged by the Bank and require aggressive cost control or increase transaction volume in order to maintain acceptable profit margins. Further, because of tightening margins, there has been a trend toward consolidation in the merchant processing industry.

     Consolidation will enable certain of the Company’s competitors to have access to significant capital, management, marketing and technological resources that are equal to or greater than those of the Company.

     Employees

     As of December 31, 2002, the Company employed 112 persons. None of the Company’s employees are represented by a labor union and the Company considers its employee relations to be excellent.

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Risk Factors That May Affect Results

     This report includes forward-looking statements within the meaning of the Securities Exchange Act of 1934 (the “Exchange Act”). These statements are based on management’s beliefs and assumptions, and on information available to management as of the date of this document. Forward-looking statements include the information concerning possible or assumed future results of operations of the Company set forth under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Forward-looking statements also include statements in which words such as “expect,” “anticipate,” “intend,” “plan,” “believe,” “estimate,” “consider” or similar expressions are used. Forward-looking statements are not guarantees of future performance. They involve risks, uncertainties and assumptions, including the risks discussed under the heading “Risk Factors That May Affect Results” and elsewhere in this report. The Company’s actual future results and shareholder values may differ materially from those anticipated and expressed in these forward-looking statements. Many of the factors that will determine these results and values, including those discussed under the heading “Risk Factors That May Affect Results,” are beyond the Company’s ability to control or predict. Investors are cautioned not to put undue reliance on any forward-looking statements. In addition, the Company does not have any intention or and assumes no obligation to update forward-looking statements after the date of the filing of this report, even if new information, future events or other circumstances have made such statements incorrect or misleading. Except as specifically noted herein all referenced to the “Company” refer to Redding Bancorp, a California corporation, and its consolidated subsidiaries.

     Lending Risks Associated with Commercial Banking and Construction Activities

     The business strategy of the Bank is to focus on commercial, single family and multi-family real estate loans, construction loans and commercial business loans. Loans secured by commercial real estate are generally larger and involve a greater degree of credit and transaction risk than residential mortgage (one-to-four family) loans. Because payments on loans secured by commercial and multi-family real estate properties are often dependent on successful operation or management of the underlying properties, repayment of such loans may be subject to a greater extent to the then prevailing conditions in the real estate market or the economy. Moreover, real estate construction financing is generally considered to involve a higher degree of credit risk than long-term financing on improved, owner-occupied real estate. Risk of loss on a construction loan is dependent largely upon the accuracy of the initial estimate of the property’s value at completion of construction or development compared to the estimated cost (including interest) of construction. If the estimate of value proves to be inaccurate, the Bank may be confronted with a project which, when completed, has a value which is insufficient to assure full repayment of the construction loan.

     Although the Bank manages lending risks through its underwriting and credit administration policies, no assurance can be given that such risks would not materialize, in which event the Company’s financial condition, results of operations, cash flows and business prospects could be materially adversely affected.

     Dependence on Real Estate

     At December 31, 2002, approximately 65.7% of the loans of the Bank were secured by real estate. The value of the Bank’s real estate collateral has been, and could in the future be adversely affected by any economic recession and any resulting adverse impact on the real estate market in Upstate California such as that experienced during the early years of the 1990’s. See “-Economic Conditions and Geographic Concentration “- page 16.

     The Bank’s primary lending focus has historically been commercial real estate, construction and, to a lesser extent, commercial lending. At December 31, 2002, commercial real estate and construction loans comprised approximately 51% and 14%, respectively, of the total loans in the portfolio of the Bank. At December 31, 2002, all of the Bank’s real estate mortgage and real estate construction loans, commercial real estate loans, were secured fully or in part by deeds of trust on underlying real estate. The Bank’s dependence on real estate increases the risk of loss in the loan portfolio of the Bank and its holdings of other real estate owned if economic conditions in Upstate California deteriorate in the future. Deterioration of the real estate market in Upstate California could have a material adverse effect on the Company’s business, financial condition and results of operations. See “-Economic Conditions and Geographic Concentration “ - page 16.

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     Risks Specific to Operations in California

     The Company’s operations are located entirely in California, which has in recent years experienced economic disruptions that are unique to the state. At the time this report was being prepared, the state legislature was still debating how to respond to the forecast 2003 record multi-billion dollar state deficit. In the recent past the state also experienced an energy crisis that resulted in higher energy costs to consumers and businesses, with attendant negative economic effects. The Company can offer no assurances that such unique issues within the state will not have a material adverse affect on the Company’s customers or on the Company’s business, financial condition and results of operations.

     Interest Rate Risk

     The income of the Bank depends to a great extent on “interest rate differentials” and the resulting net interest margins (i.e., the difference between the interest rates earned on the Bank’s interest-earning assets such as loans and investment securities, and the interest rates paid on the Bank’s interest-bearing liabilities such as deposits and borrowings). These rates are highly sensitive to many factors, which are beyond the Company’s control, including general economic conditions, inflation, recession and the policies of various governmental and regulatory agencies, in particular, the FRB. Because of the Bank’s predisposition to variable rate pricing, and non-interest bearing demand deposit accounts the Bank is asset sensitive. As a result, the Company is generally adversely affected by declining interest rates. In addition, changes in monetary policy, including changes in interest rates, influence the origination of loans, the purchase of investments and the generation of deposits and affect the rates received on loans and investment securities and paid on deposits, which could have a material adverse effect on the Company’s business, financial condition and results of operations. See “Quantitative and Qualitative Disclosure about Market Risk.”

     Merchant Credit Card Processing Services

     The Bank’s fee income from merchant processing services represented approximately 2.1%, 4.1% and 8.2% of the Company’s consolidated revenues in 2002, 2001 and 2000, respectively. In addition, contract deposit relationships with the merchants in the portfolio of the Bank and CSI represented $7.7 million or approximately 2.4% of the Bank’s total deposits as of December 31, 2002.

     In April 1993, the Bank entered into an agreement (the “Merchant Services Agreement”) with Cardservice International, Inc. (“CSI”), an independent sales organization (“ISO”) and nonbank merchant credit card processor, pursuant to which the Bank has agreed to provide credit and debit card processing services for merchants solicited by CSI who accept credit and debit cards as payment for goods and services. Pursuant to the Merchant Services Agreement, the Bank acts as a clearing bank for CSI and processes credit or debit card transactions into the Visa® or MasterCard® system for presentment to the card issuer. As a result of the Merchant Services Agreement, the Bank has acquired electronic credit and debit card processing relationships with merchants in various industries on a nationwide basis. The Merchant Services Agreement with CSI was renewed on April 1, 2001. Effective April 1, 2001, pricing of the contract renewal is .002 percent of transaction processing and one-half of the earnings on the deposit relationship. The contract renewal represents a significant decline in revenues from merchant credit card processing.

     The Company has been successful in pursuing various strategies to offset the decline in revenues, including expansion of the Roseville Bank of Commerce, purchase of the Sunrise branch office, and projecting aggressive growth in the loan markets.

     See “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Noninterest Income-Merchant Processing Services Income.”

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     Chargebacks and Payment Risks Associated with Merchant Processing Services

     The Bank is subject to the Card Association Rules in processing credit and debit card transactions. In the event of certain types of billing disputes between a cardholder and a merchant, the processor of the transaction assists the merchant in investigating and resolving the dispute. If the dispute is not resolved in favor of the merchant, the transaction is “charged back” to the merchant and that amount is credited or otherwise refunded to the cardholder. If the processor is unable to collect such amounts from the merchant’s account, and if the merchant refuses or is unable due to bankruptcy or other reasons to reimburse the processor for the chargeback, the processor bears the loss for the amount of the refund paid to the cardholder. Pursuant to the Merchant Services Agreement, CSI has agreed to indemnify the Bank against losses incurred in connection with credit card transactions generated by merchants in CSI’s portfolio. In addition, pursuant to the Merchant Services Agreement, CSI is required to maintain a general account with the Bank and has granted the Bank a security interest in such account to secure CSI’s obligations under the Merchant Services Agreement.

     The balances required to be maintained by CSI in general account constitute a small percentage of the dollar volume of transactions processed by the Bank each month. In the event that the funds in accounts maintained by CSI are not sufficient to cover chargebacks and refund payments to cardholders and CSI is unable to reimburse the Bank for such deficiencies, the Bank would bear the loss which could have a material adverse effect on the Company’s financial condition, results of operations and cash flows. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Noninterest Income-Merchant Processing Services Income.”

     Chargeback exposure can also result from fraudulent credit card transactions initiated by merchant customers. Examples of merchant fraud include logging fictitious sales transactions and falsification of transaction amounts on actual sales. The Bank conducts a background review of its merchant customers at the time the relationship is established with the merchant. The Bank also can withhold or delay a merchant’s daily settlement if fraudulent activity is suspected, thereby mitigating exposure to loss. However, there can be no assurance that the Bank will not experience significant amounts of merchant fraud, which could have a material adverse effect on the Company’s business, financial condition and results of operations. The degree of exposure to chargebacks may also be adversely affected by the development of new transaction delivery channels, such as the Internet, which have yet to be fully evaluated.

     The Company is not exposed to card issuer credit losses unassociated with a dispute between the cardholder and the merchant.

     Potential Volatility of Deposits

     At December 31, 2002, time certificates of deposit in excess of $100,000 represented approximately 26% of the dollar value of the total deposits of the Bank. As such, these deposits are considered volatile and could be subject to withdrawal. Withdrawal of a material amount of such deposits could adversely affect the liquidity of the Bank, profitability, business prospects, results of operations and cash flows. The bank monitors activity of volatile liability deposits on a quarterly basis. Approximately $30.0 million of the $81.7 million in time certificates of deposit over $100,000 act as core deposits with over five years history of rollover with the bank.

     Dividends

     Because the Company conducts no other significant activity than the management of its investment in the Bank, the Company is dependent on the Bank for income. The ability of the Bank to pay cash dividends in the future depends on the profitability, growth and capital needs of the Bank. In addition, the California Financial Code restricts the ability of the Bank to pay dividends. No assurance can be given that the Company or the Bank will pay any dividends in the future or, if paid, such dividends will not be discontinued.

     See “-Supervision and Regulation-Supervision and Regulation of Bank Holding Companies” and “-Supervision and Regulation-Restrictions on Dividends and Other Distributions.”

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     Competition in Primary Market

     In California generally, and in the Company’s primary market area specifically, major banks and brokerage firms dominate the financial services industry. By virtue of their larger capital bases, such institutions have substantially greater lending limits than those of the Bank do. In obtaining deposits and making loans, the Bank competes with these larger commercial banks and other financial institutions, such as savings and loan associations and credit unions, which offer many services, which traditionally, were offered only by banks. In addition, the Bank competes with other institutions such as money market funds, brokerage firms, and even retail stores seeking to penetrate the financial services market. During periods of declining interest rates, competitors with lower costs of capital may solicit the Bank’s customers to refinance their loans. Furthermore, during periods of economic slowdown or recession, the borrowers of the Bank may face financial difficulties and be more receptive to offers from the Bank’s competitors to refinance their loans. No assurance can be given that the Bank will be able to compete with these lenders.

     Competition in the merchant processing industry is intense. The Bank competes with other banks, ISOs and other nonbank processors. Many of these competitors are substantially larger than the Bank. The Bank competes on the basis of price, the availability of products and services, the quality of customer service and support and transaction processing speed. The majority of the Bank’s contracts with merchants are cancelable at will or on short notice or provides for renewal at frequent periodic intervals and, therefore, the Bank regularly rebids such contracts.

     This competition may influence the prices that can be charged by the Bank and require aggressive cost control or increased transaction volume in order to maintain acceptable profit margins. If the Bank is not able to maintain acceptable profit margins, it could be forced to discontinue merchant processing services, which would have a material adverse effect on the Company’s results of operations and cash flows. Further, because of tightening margins, there has been a trend toward consolidation in the merchant processing industry. Consolidation will enable certain of the Bank’s competitors to have access to significant capital, management, marketing and technological resources that are equal to or greater than those of the Bank. No assurance can be given that the Bank or any ISO for which the Bank performs clearing bank services will be able to compete successfully for merchant processing business in the future.

     Government Regulation and Legislation

     The Company and the Bank are subject to extensive state and federal regulation, supervision and legislation, which govern almost all aspects of the operations of the Company and the Bank. The business of the Company is particularly susceptible to being affected by the enactment of federal and state legislation which may have the effect of increasing or decreasing the cost of doing business, modifying permissible activities or enhancing the competitive position of other financial institutions. Such laws are subject to change from time to time and are primarily intended for the protection of consumers, depositors and the deposit insurance funds and not for the protection of shareholders of the Company. The Company cannot predict what effect any presently contemplated or future changes in the laws or regulations or their interpretations would have on the business and prospects of the Company, but it could be material and adverse. See “-Supervision and Regulation.”

     Economic Conditions and Geographic Concentration

     The Company’s operations are located and concentrated primarily in Upstate California, particularly the counties of El Dorado, Placer, Shasta and Sacramento, and are likely to remain so for the foreseeable future. At December 31, 2002, approximately 65.7% of the Bank’s loan portfolio consisted of real estate related loans, all of which were related to collateral located in Upstate California. A change in California economic and business conditions may adversely affect the performance of these loans. Deterioration in economic conditions could have a material adverse effect on the quality of the loan portfolio of the Bank and the demand for its products and services. In addition, during periods of economic slowdown or recession, the Bank may experience a decline in collateral values and an increase in delinquencies and defaults. A decline in collateral values and an increase in delinquencies and defaults increase the possibility and severity of losses. California real estate is also subject to certain natural disasters, such as earthquakes, floods and mudslides, which are typically not covered by the standard hazard insurance policies maintained by borrowers.

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     Uninsured disasters may make it difficult or impossible for borrowers to repay loans made by the Bank.

     Reliance on Key Employees and Others

     As of December 31, 2002, the Company and its subsidiaries employed in the aggregate 112 employees. The Company considers employee relations to be excellent. A collective bargaining group represents none of the employees of the Company or its subsidiaries. Failure of the Company to attract and retain qualified personnel could have an adverse effect on the Company’s business, financial condition and results of operations. The Company does maintain life insurance with respect to two of its officers with regard to a salary continuation plan.

     Adequacy of Allowance for Loan and Other Real Estate Losses

     The Bank’s allowance for estimated losses on loans was approximately $3.8 million, or 1.3% of total loans at December 31, 2002. Material future additions to the allowance for estimated losses on loans might be necessary if material adverse changes in economic conditions occur and the performance of the loan portfolio of the Bank deteriorates.

     In addition, future additions to the Bank’s allowance for losses on other real estate owned may also be required in order to reflect changes in the markets for real estate in which the Bank’s other real estate owned is located and other factors which may result in adjustments which are necessary to ensure that the Bank’s foreclosed assets are carried at the lower of cost or fair value, less estimated costs to dispose of the properties. Moreover, the FDIC and the DFI, as an integral part of their examination process, periodically review the Bank’s allowance for estimated losses on loans and the carrying value of its assets. The Bank was most recently examined by the FDIC in this regard during the first quarter of 2002. Increases in the provisions for estimated losses on loans and foreclosed assets could adversely affect the Bank’s financial condition and results of operations. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Asset Quality” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Allowance for Loan Losses (ALL).”

     Certain Ownership Restrictions under California and Federal Law

     Federal law prohibits a person or group of persons “acting in concert” from acquiring “control” of a bank holding company unless the FRB has been given 60 days prior written notice of such proposed acquisition and within that time period the FRB has not issued a notice disapproving the proposed acquisition or extending for up to another 30 days, the period during which such a disapproval may be issued. An acquisition may be made before the expiration of the disapproval period if the FRB issues written notice of its intent not to disapprove the action. Under a rebuttable presumption established by the FRB, the acquisition of more than 10% of a class of voting stock of a bank with a class of securities registered under Section 12 of the Exchange Act (such as the Common Stock), would, under the circumstances set forth in the presumption, constitute the acquisition of control. In addition, any “company” would be required to obtain the approval of the FRB under the BHCA, before acquiring 25% (5% in the case of an acquiror that is, or is deemed to be, a bank holding company) or more of the outstanding shares of the Company’s Common Stock, or such lesser number of shares as constitute control. See “-Supervision and Regulation-Regulation and Supervision of Bank Holding Companies.”

     Under the California Financial Code, no person shall, directly or indirectly, acquire control of a California licensed bank or a bank holding company unless the Commissioner has approved such acquisition of control. A person would be deemed to have acquired control of the Company and the Bank under this state law if such person, directly or indirectly, has the power (i) to vote 25% or more of the voting power of the Company or (ii) to direct or cause the direction of the management and policies of the Company. For purposes of this law, a person who directly or indirectly owns or controls 10% or more of the Common Stock would be presumed to direct or cause the direction of the management and policies of the Company and thereby control the Company.

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     Shares Eligible for Future Sale

     As of December 31, 2002, the Company had 2,641,536 shares of Common Stock outstanding, of which 1,752,885 shares are eligible for sale in the public market without restriction. 888,651 shares are eligible for sale in the public market pursuant to Rule 144 under the Securities Act of 1933, as amended (the “Securities Act”). Future sales of substantial amounts of the Company’s Common Stock, or the perception that such sales could occur, could have a material adverse effect on the market price of the Common Stock. In addition, options to acquire approximately 412,444 shares of the issued and outstanding shares of Common Stock at exercise prices ranging from $8.25 to $20.00 have been issued to directors and certain employees of the Company under the Company’s 1998 Stock Option Plan. No prediction can be made as to the effect, if any, that future sales of shares, or the availability of shares for future sale, will have on the market price of the Company’s Common Stock.

     Technology and Computer Systems

     Advances and changes in technology can significantly impact the business and operations of the Company. The Bank faces many challenges including the increased demand for providing computer access to bank accounts and the systems to perform banking transactions electronically. The Company’s ability to compete depends on its ability to continue to adapt its technology on a timely and cost-effective basis to meet these requirements. In addition, the Bank’s business and operations are susceptible to negative impacts from computer system failures, communication and energy disruption and unethical individuals with the technological ability to cause disruptions or failures of the Bank’s data processing systems.

     During the first quarter 2003, the Company will be reviewing proposals to replace and enhance its core data processing systems. A decision is expected to occur early 2003, for conversion to the new systems in the first quarter of 2004. The Bank anticipates the change to be transparent to customer service. During the process, the bank will be enhancing workflow processes through out the Company to improve efficiencies using advanced technologies.

     Environmental Risks

     The Bank, in its ordinary course of business, acquires real property securing loans that are in default, and there is a risk that hazardous substance or waste, contaminants or pollutants could exist on such properties. The Bank may be required to remove or remediate such substances from the affected properties at its expense, and the cost of such removal or remediation may substantially exceed the value of the affected properties or the loans secured by such properties. Furthermore, the Bank may not have adequate remedies against the prior owners or other responsible parties to recover its costs. Finally, the Bank may find it difficult or impossible to sell the affected properties either before or following any such removal.

     In addition, the Bank may be considered liable for environmental liabilities concerning its borrowers’ properties, if, among other things, it participates in the management of its borrowers’ operations. The occurrence of such an event could have a material adverse effect on the Company’s business, financial condition, results of operations and cash flows.

     Dilution

     The Company has issued options to purchase shares of the Company’s Common Stock at prices equal to 85% of the fair market value of the Company’s Common Stock on the date of grant. As of December 31, 2002, the Company had outstanding options to purchase an aggregate of 412,444 shares of Common Stock at exercise prices ranging from $8.25 to $20.00 per share, or a weighted average exercise price per share of $10.58. To the extent such options are exercised, shareholders of the Company will experience dilution. The Company established a Stock Repurchase program to mitigate the effects of dilution. The program authorizes a systematic approach to repurchasing shares over a seven-year period.

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ITEM 2. PROPERTIES.

     The Company’s principal offices and the Bank’s main office are housed in a two-story building with approximately 21,000 square feet of space located at 1951 Churn Creek Road, Redding, California, 96002. The Bank owns the building and the 1.25 acres of land on which the building is situated. The Bank also owns the land and building located at 1177 Placer Street, Redding, California, 96002, in which the Bank uses approximately 11,650 square feet of space for its banking operations.

     The Company’s Roseville Bank of Commerce at Eureka office is located on the first floor of a three-story building with approximately 8,550 square feet of space located at 1504 Eureka Road, Roseville, California. The Company leases the space pursuant to a triple net lease expiring in August 1, 2011. The Company’s Roseville Bank of Commerce at Sunrise office is a free standing building with approximately 4,982 square feet of space located at 6950 Sunrise Boulevard, Citrus Heights. The Company subleases the space from Wells Fargo Bank expiring on March 5, 2009.

ITEM 3. LEGAL PROCEEDINGS.

     The Company and its subsidiaries are involved in various legal actions arising in the ordinary course of business. The Company believes that the ultimate disposition of all currently pending matters will not have a material adverse effect on the Company’s financial condition or results of operations.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

     No matters were submitted during the quarter ended December 31, 2002 to a vote of the Company’s security holders.

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PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS.

     Trades in the Company’s common stock are made through Hoefer & Arnett located at 555 Market Street, 18^th Floor, San Francisco, California 94105. The Company’s common stock is traded on the OTC Bulletin Board under the symbol, “RDDB”. The Company plans to apply to the BBX (Bulletin Board Exchange) during 2003.

     The following table, which summarizes trading activity during the Company’s last two fiscal years, is based on information obtained from the OTC Bulletin Board. The quotations reflect the price that would be received by the seller without retail mark-up, mark-down or commissions and may not have represented actual transactions.

     As of December 31, 2002 there were approximately 400 shareholders of record of the Company’s Common Stock and the market price on that date was $19.80 per share.

     The Company’s ability to pay dividends is subject to certain regulatory requirements. The Federal Reserve Board (“FRB”) generally prohibits a financial services holding company from declaring or paying a cash dividend which would impose undue pressure on the capital of subsidiary banks or would be funded only through borrowing or other arrangements that might adversely affect a financial services holding company’s financial position. The FRB’s policy is that a financial services holding company should not continue its existing rate of cash dividends on its common stock unless its net income is sufficient to fully fund each dividend and its prospective rate of earnings retention appears consistent with its capital needs, asset quality and overall financial condition. The power of the board of directors of an insured depository institution to declare a cash dividend or other distribution with respect to capital is subject to statutory and regulatory restrictions which limit the amount available for such distribution depending upon the earnings, financial condition and cash needs of the institution, as well as general business conditions.

     On October 22, 2002 and 2001, a cash dividend of $0.65 per share was paid to shareholders of record as of October 1, 2002 and 2001 respectively.

     The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) prohibits insured depository institutions from paying management fees to any controlling persons or, with certain limited exceptions, making capital distributions, including dividends, if, after such transaction, the institution would be undercapitalized.

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     In addition to the restrictions imposed under federal law, banks chartered under California law generally may only pay cash dividends to the extent such payments do not exceed the lesser of retained earnings of the bank or the bank’s net income for its last three fiscal years (less any distributions to shareholders during such period). In the event a bank desires to pay cash dividends in excess of such amount, the bank may pay a cash dividend with the prior approval of the Commissioner of Financial Institutions in an amount not exceeding the greatest of the bank’s retained earnings, the bank’s net income for its last fiscal year, or the bank’s net income for its current fiscal year.

     Regulators also have authority to prohibit a depository institution from engaging in business practices which are considered to be unsafe or unsound, possibly including payment of dividends or other payments under certain circumstances even if such payments are not expressly prohibited by statute.

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ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     The following discussion should be read in conjunction with the Consolidated Financial Statements of the Company and related notes thereto appearing elsewhere in this report. All statements other than statements of historical fact included in the following discussion are forward-looking statements within the meaning of the Exchange Act. These statements are based on management’s beliefs and assumptions, and on information currently available to management. Forward-looking statements include the information concerning possible or assumed future results of operations of the Company and also include statements in which words such as “expect,” “anticipate,” “intend,” “plan,” “believe,” “estimate,” “consider” or similar expressions are used. Forward-looking statements are not guarantees of future performance. They involve risks, uncertainties and assumptions, including the risks discussed under the heading “Risk Factors That May Affect Results” and elsewhere in this report. The Company’s future results and shareholder values may differ materially from those expressed in these forward-looking statements. Many of the factors that will determine these results and values, including those discussed under the heading “Risk Factors That May Affect Results,” are beyond the Company’s ability to control or predict. Investors are cautioned not to put undue reliance on any forward-looking statements. In addition, the Company does not have any intention or obligation to update forward-looking statements after the filing of this report, even if new information, future events or other circumstances have made them incorrect or misleading.

Critical Accounting Policies

General

     Redding Bancorp’s financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The financial information contained within our statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. We use historical loss factors as a component to determine the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical and other factors that we use. Other estimates that we use are expected useful lives of our depreciable assets. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would affect our transactions could change.

Allowance for Loan Losses

     The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting. (1) Statement of Financial Accounting Standards (SFAS) No. 5 “Accounting for Contingencies”, which requires that losses be accrued when they are probable of occurring and estimable and (2) SFAS No. 114, “Accounting by Creditors for Impairment of a Loan”, which requires that losses be accrued based on the differences between that value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.

     Our allowance for loan losses has three basic components: the formula allowance, the specific allowance and the allowance tied to economic trends and other factors. Each of these components is determined based upon estimates that can and do change when the actual events occur. The formula allowance uses an historical loss view applied to the pool of unimpaired loans as an indicator of future losses and, consequently, could differ from the loss incurred in the future. However, since this history is updated with the most recent loss information, the errors that might otherwise occur are mitigated. The specific allowance uses various techniques to arrive at an estimate of loss on impaired or likely impaired loans. Historical loss information and fair market value of collateral are used to estimate those losses. The use of these values is inherently subjective and our actual losses could be greater or less than the estimates. The unallocated allowance captures losses that are attributable to various economic events, industry or geographic sectors whose impact on the portfolio have occurred but have yet to be recognized in either the formula or specific allowances. For further information regarding our allowance for loan losses, see page 32.

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Accounting for Stock Options

     The Company uses the intrinsic value based method for measuring compensation cost related to stock options. Under the intrinsic value based method, compensation cost is the excess, if any, of the quoted market price of the stock at grant date over the amount an employee must pay to acquire the stock. This cost is amortized on a straight-line basis over the vesting period of the options granted.

     The Company applies Accounting Principles Board Opinion No. 25 “Accounting for Stock Issues to Employees” (APB 25) and related interpretations in accounting for stock options. The fair value of options granted is determined on the date of the grant using a binomial option-pricing model with the following assumptions: a current volatility rate of 27% , a risk-fee interest rate of 2.71% (based upon the five year treasury coupon rate at December 31, 2002), expected dividends of $0.65 per share per year, an annual dividend rate of 3.06% and an assumed forfeiture rate of zero and an expected life of seven years.

The Company

     Redding Bancorp (the “Company”) is a financial services holding company (“FHC”) registered under the Bank Holding Company Act of 1956, as amended, and was incorporated in California on January 21, 1982, for the purpose of organizing, as a wholly owned subsidiary, Redding Bank of Commerce (the “Bank”). The Company elected to change to a FHC in 2000. As a financial services holding company, the Company is subject to the Financial Holding Company Act and to supervision by the Board of Governors of the Federal Reserve System (“FRB”). The Company’s principal business is to serve as a holding company for the Bank and Redding Service Corporation, a California corporation formed in 1993 for the purpose of processing trust deeds, and for other banking or banking-related subsidiaries which the Company may establish or acquire. On January 2, 2003, Redding Service Corporation has changed its name to RBC Mortgage Services. The principal business of the subsidiary will be mortgage brokerage services. The Company’s principal source of income is dividends from its subsidiaries. The Company conducts its corporate business operations at the offices of the Bank located at 1951 Churn Creek Road, Redding, California 96002. The Company conducts its business operations in two geographic market areas, Redding and Roseville, California and within two industry segments, general banking and credit card processing. The Company considers Upstate California to be the major market area of the Bank.

     The Bank was incorporated as a California banking corporation on November 25, 1981, and received its certificate of authority to begin banking operations on October 22, 1982. The Bank operates three full service branches and one focused-service deposit facility. The Company established its first full service branch at 1177 Placer Street, Redding, California, and opened for business on October 22, 1982. On November 1, 1988, the Bank received a certificate of authority to establish and maintain a loan production office in Citrus Heights, California. On September 1, 1998, the Company relocated the loan production office to 2400 Professional Drive in Roseville, California.

     On March 1, 1994, the Bank received a certificate of authority to open a second full-service branch at 1951 Churn Creek Road in Redding, California. On June 30, 2000, the Bank received a certificate of authority to convert the loan production office in Roseville to a full service banking facility under the name Roseville Bank of Commerce, a division of Redding Banking of Commerce. On June 15, 2001 the Bank acquired the deposit liabilities of FirstPlus Bank at Citrus Heights, California and has renamed the facility Roseville Bank of Commerce at Sunrise, a division of Redding Bank of Commerce. On February 22, 2002, the Roseville Bank of Commerce at Eureka Road, a division of Redding Bank of Commerce office relocated to its permanent location at 1504 Eureka Road, Suite 100, Roseville, California.

     The Bank is principally supervised and regulated by the California Department of Financial Institutions (“DFI”) and the Federal Deposit Insurance Corporation (“FDIC”), and conducts a general commercial banking business in the counties of El Dorado, Placer, Shasta, and Sacramento, California.

     The services offered by the Bank include those traditionally offered by commercial banks of similar size and character in California, such as checking, interest-bearing checking (“NOW”) and savings accounts, money market deposit accounts, commercial, real estate, construction, and term loans; travelers checks, safe deposit boxes, collection services and electronic banking activities. The primary focus of the Bank is to provide services to the business and professional community of its major market area, including Small Business Administration loans, payroll and accounting packages, benefit administration and billing services.

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The Bank does not offer trust services or international banking services and does not plan to do so in the near future.

     Most of the Bank’s customers are small to medium sized businesses, professionals and other individuals with medium to high net worth, and most of the Bank’s deposits are obtained from such customers. The Bank emphasizes servicing the needs of local businesses and professionals and individuals requiring specialized services. The primary business strategy of the Bank is to focus on its lending activities. The Bank’s principal lines of lending are (i) commercial, (ii) real estate construction and (iii) commercial and residential real estate. The majority of the loans of the Bank are direct loans made to individuals and small businesses in the major market area of the Bank and are secured by real estate. See “-Risk Factors That May Affect Results-Dependence on Real Estate.” A relatively small portion of the loan portfolio of the Bank consists of loans to individuals for personal, family or household purposes. The Bank accepts real estate, listed and unlisted securities, savings and time deposits, automobiles, machinery and equipment and other general business assets such as accounts receivable and inventory as collateral for loans.

     The Company derives its income from two principal sources: (i) Net interest income, which is the difference between the interest income it receives on interest-earning assets and the interest expense it pays on interest-bearing liabilities, and (ii) fee income, which includes fees earned on deposit services, income from SBA lending, electronic-based cash management services and merchant credit card processing services.

     Management considers the business of the Company to be divided into two segments: (i) commercial banking and (ii) credit card services. Credit card services are limited to those revenues, net of related data processing costs, associated with the Merchant Services Agreement and the Bank’s agreement to provide credit and debit card processing services for merchants solicited by the Bank who accept credit and debit cards as payment for goods and services.

Results of Operations

Year Ended December 31, 2002 Compared to Year Ended December 31, 2001

     The Company reported net income of $3.7 million for the year ended December 31, 2002, representing a decrease of approximately $577,000 or 13.5%, over net income of $4.3 million for the year ended December 31, 2001. Primary factors contributing to the decrease in net income include a reduction in the Merchant Credit Card processing service income pursuant to new contract pricing, increases in salaries and benefits and occupancy expenses related to the growth of the Company and new facilities in the Roseville market, the lingering effects of loan portfolio repricing and the drop in investment security yields . The Company’s provision for loan losses increased to $620,000 in 2002 from $255,000 in 2001 resulting primarily from the growth in the loan portfolio.

     Return on average assets (ROA) was 1.09% and return on average common equity (ROE) was 13.92% in 2002 compared with 1.49% and 15.43% respectively in 2001. Diluted earnings per share for 2002 and 2001 were $1.29 and $1.44, respectively, a decrease of 10.4% in 2002 over 2001. The Company’s average total assets increased to $339.2 million in 2002 or 18.4% from $286.6 million in 2001. As a result of the continuing expansion of the Company’s Roseville Bank of Commerce at Eureka additional loan demand in the Redding market area, net loans, at December 31, 2002 increased to $280.1 million over $216.7 million in 2001, an increase of $63.4 million or 29.3%.

     Yields on portfolio loans dropped 189 basis points over the prior year due to the lingering effects of the dramatic rate reductions in 2001 and the timing of repricing opportunities, while federal funds sold dropped 198 basis points over the prior year. Interest-bearing liabilities recognized a drop of 175 basis points, resulting in a net interest margin (spread) of 4.06% compared with 4.24% in 2001 and 5.16% in 2000.

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Year Ended December 31, 2001 Compared to Year Ended December 31, 2000

     The Company reported net income of $4.3 million for the year ended December 31, 2001, representing a decrease of approximately $500,000, or 10.4%, over net income of $4.8 million for the year ended December 31, 2000. Factors contributing to the decrease in net income include a significant decrease in net interest income resulting from multiple interest rate reductions partially offset by increased loan volume and repricing of deposit liabilities. The provision for loan loss was increased by $113,000 during 2001 over 2000 reflecting the Company’s increased loan portfolio, ongoing efforts to increase the effectiveness of its collection efforts, offset by a reduction in classified assets.

     Return on average assets (ROA) was 1.49% and return on average common equity (ROE) was 15.43% in 2001 compared with 1.98% and 17.95% respectively in 2000. Diluted earnings per share for 2001 and 2000 were $1.44 and $1.59, respectively, a decrease of 9.4% in 2001 over 2000. The Company’s average total assets increased to $286.6 million in 2001 or 17.8% from $243.3 million in 2000. As a result of the expansion of the Company’s Roseville Bank of Commerce in Roseville, California and continued loan demand in the Redding market area, net loans, at December 31, 2001 increased to $216.7 million over $191.3 million in 2000, an increase of $25.4 million or 13.3%.

Net Interest Income

     The primary source of income for the Bank is derived from net interest income. Net interest income represents the excess of interest and fees earned on assets (loans, securities and federal funds sold) over the interest paid on deposits and borrowed funds. Net interest margin is net interest income expressed as a percentage of average earning assets.

     Net interest income increased to $12.5 million in 2002 versus $11.2 million in 2001 and $11.5 million in 2000, representing a 11.6% increase in 2002 over 2001, and a 2.6% decrease in 2001 over 2000. The average balance of total earning assets increased to $308.3 million or 16.7% over 2001. Average loan balances outstanding increased $48.6 million or 23.7% in 2002, while average balances of investments and federal funds sold decreased $4.4 million or 8.0% in 2002. The average yields on loans decreased by 189 basis points and investment income decreased by 58 basis points. The resulting yield on interest earning assets decreased to 6.02% in 2002 from 7.65% 2001. The increased volume of loan activity offset the continued declining interest rate environment, coupled with aggressive deposit liability repricing resulted in a gain in the net interest margin of $1.3 million, or 11.9%.

     Total interest expense decreased to $6.0 million in 2002, from $9.0 million in 2001 and $8.7 million in 2000, representing a 33.0% decrease for 2002 over 2001, and a 3.5% increase in 2001 over 2000. Average balances of interest-bearing liabilities increased to $259.1 million over $221.3 million for the year ended December 31, 2002, or 17.0%. Yields on deposits decreased 175 basis points, to 2.33% from 4.08% in 2001. The reduction in funding costs reflects the Company’s strategy to grow core deposits and use Federal Home Loan borrowings to support the loan growth while holding higher cost certificate of deposit accounts to a minimum. Demand checking accounts increased 23.9%, Interest-bearing demand instruments increased 26.3%, Savings deposits increased 22.1% while certificate of deposit accounts increased a modest 0.2% over the prior year.

     The most significant impact on net interest income between periods is derived from the interaction of changes in the volume of and rate earned or paid on interest-earning assets and interest-bearing liabilities. The volume of interest-earning assets in loans and investments, compared to the volume of interest-bearing liabilities represented by deposits and borrowings, combined with the spread, produces the changes in net interest income between periods. The Company’s net interest margin was 4.06% in 2002 and 4.24% in 2001. The combined effect of increasing the volume of earning assets and repricing deposit liabilities resulted in an increase of $1.3 million or 11.9% in net interest income for the year ended December 31, 2002 over 2001.

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     The following table sets forth the Company’s daily average balance sheet, related interest income or expense and yield or rate paid for the periods indicated. The yield on tax-exempt securities has not been adjusted to a tax-equivalent yield basis.

     Interest income on loans includes fee income of $272,000, $285,000 and $369,000 for the years ended December 31, 2002, 2001, and 2000 respectively.

     The Company’s average total assets increased to $339.2 million in 2002 to $286.6 in 2001 and $243.3 in 2000, representing a 18.3% increase 2002 over 2001, and 17.8% increase in 2001 over 2000. Average portfolio loans increased to $253.4 million in 2002 and $204.8 million in 2001, representing an increase of 23.7% and 14.7%, respectively.

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     The following tables set forth changes in interest income and expense for each major category of earning assets and interest-bearing liabilities, and the amount of change attributable to volume and rate changes for the periods indicated. Changes not solely attributable to rate or volume has been allocated to volume. The yield on tax-exempt securities has not been adjusted to a tax-equivalent yield basis.