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U. S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

For the fiscal year ended December 31, 2002

For the transition period from            to            

Commission file number 0-26016

PALMETTO BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

Securities registered pursuant to Section 12(b) of the Act:  None

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

Common Stock, par value $5.00 per share

(Title of class)

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    Yes  x    No  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 126-2).    Yes  x    No  ¨

The aggregate market value of the voting stock held by non-affiliates of the registrant (computed by reference to the price at which the stock was most recently sold) was $154,314,104 as of February 28, 2003. There is no established public trading market for the shares. See Part II, Item 5.

6,329,909 shares of the registrant’s common stock were outstanding as of February 28, 2003.

DOCUMENTS INCORPORATED BY REFERENCE

The Company’s Proxy Statement dated March 18, 2003 with respect to an Annual Meeting of Shareholders to be held April 22, 2003: Incorporated by reference in Part III of this Form 10-K.

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PALMETTO BANCSHARES, INC. AND SUBSIDIARY

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Part I

Item 1.    Business

General

Palmetto Bancshares (“Bancshares”) is a bank holding company headquartered in Laurens, South Carolina and organized in 1982 under the laws of South Carolina. Through its wholly owned subsidiary, The Palmetto Bank (the “Bank”), and the Bank’s wholly owned subsidiary, Palmetto Capital, Inc. (“Palmetto Capital”), (collectively Palmetto Bancshares, Inc., or the “Company”), the Company engages in the general banking business through 30 retail branch offices in the upstate South Carolina markets of Laurens, Greenville, Spartanburg, Greenwood, Anderson, Cherokee, Abbeville, and Oconee counties (the “Upstate”). The Bank was organized and chartered under South Carolina law in 1906. At December 31, 2002 the Company had total assets of $825.0 million, total deposits of $750.0 million, and stockholders’ equity of $67.5 million.

The industry in which the Bank operates exists primarily to provide an intermediary service to the general public with funds to deposit and, by using these funds, to originate loans in the markets in which they serve. The Bank provides a full range of banking activities, including such services as checking, savings, money market, and other time deposits for a wide range of consumer and commercial depositors; loans for business, real estate, and personal uses; safe deposit box rental; various electronic funds transfer services; telephone banking; and bank card services. The Bank’s sales finance department establishes relationships with Upstate automobile dealers to provide customer financing on qualifying automobile purchases, and the Bank’s mortgage banking operation meets a range of its customers’ financial service needs by originating, selling, and servicing mortgage loans. The Bank also offers both individual and commercial trust services through an active trust department. Palmetto Capital, the brokerage subsidiary of the Bank, offers customers stocks, treasury and municipal bonds, mutual funds and insurance annuities, as well as college and retirement planning.

Impact of Inflation

The consolidated financial statements and related financial data presented herein have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and operating results in terms of historical dollars, without considering changes in relative purchasing power over time due to inflation. Virtually all of the assets and liabilities of the Company are monetary in nature and, as a result, its operations can be significantly affected by interest rate fluctuations.

Competition

The Upstate is a highly competitive banking market in which most of the largest financial institutions in the state are represented. As a result, the Bank faces strong competition when attracting deposits and originating loans. The competition among the various financial institutions is based upon interest rates offered on deposit accounts, interest rates charged on loans, credit and service charges, the quality of service rendered and the convenience of banking facilities. The Company feels that it sets itself apart from its competitors by providing a level of consistently superior personal service. This is accomplished through a variety of delivery channels marketing a full range of high quality financial products and services. The Company believes it competes effectively in its market.

South Carolina legislation permits banks and bank holding companies in certain states to acquire banks in South Carolina to the extent that such other states have reciprocal legislation applicable to South Carolina banks and bank holding companies. As a result, a number of the Company’s competitor banks have been and continue to be purchased by large, out-of-state bank holding companies. Size gives the larger banks certain advantages in competing for business from larger corporations. These advantages include higher lending limits and the ability to offer services in other areas of South Carolina and the region. As a result, the Company does not generally attempt to compete for the banking relationships of larger corporations, but concentrates its efforts on small and medium-size businesses and individuals.

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Market Expansion

In late 2000, the South Carolina State Board of Financial Institutions approved the Bank’s application to open a branch in Travelers Rest, South Carolina, located in Greenville County. The Travelers Rest office was opened in January 2002.

During 2001, the Company began making plans to enter into the Oconee County market and opened a branch in Seneca, South Carolina in March 2002.

Management continually reviews opportunities for Upstate expansion that it believes to be in the best interest of the Bank, its customers and its shareholders.

Employees

At December 31, 2002, the Company had 368 full-time equivalent employees, none of whom are subject to a collective bargaining agreement. Employees, depending on their level of employment, are offered a comprehensive program that includes medical and dental benefits, life insurance, long-term disability coverage, a noncontributory defined benefit pension plan, and a 401k plan. Management believes its relationship with its employees is excellent.

Supervision and Regulation

General

Bancshares and its subsidiary is extensively regulated under federal and state law. To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular statutory and regulatory provisions. Any change in applicable laws may have a material effect on the business and prospects of the Company. The operations of the Company may be affected by possible legislative and regulatory changes and by the monetary policies of the United States.

Bancshares.    As a bank holding company registered under the Bank Holding Company Act of 1956, as amended (the “BHCA”), Bancshares is subject to regulation and supervision by the Federal Reserve. Under the BHCA, Bancshares’ activities and those of its subsidiary are limited to banking, managing or controlling banks, furnishing services to or performing services for its subsidiary or engaging in any other activity that the Federal Reserve determines to be so closely related to banking, managing or controlling banks as to be a proper incident thereto. The BHCA prohibits Bancshares from acquiring direct or indirect control of more than 5% of any class of outstanding voting stock, or substantially all of the assets of any bank, or merging or consolidating with another bank holding company without prior approval of the Federal Reserve. The BHCA also prohibits Bancshares from engaging in or from acquiring ownership or control of more than 5% of the outstanding voting stock of any company engaged in a nonbanking business unless such business is determined by the Federal Reserve to be closely related to banking or managing or controlling banks.

Until September 29, 1995, the BHCA prohibited Bancshares from acquiring control of any bank operating outside the State of South Carolina, unless the statutes of the state where the bank to be acquired was located specifically authorized such action. Additionally, as of June 1, 1997, a bank headquartered in one state was authorized to merge with a bank headquartered in another state, as long as neither of the states had opted out of such interstate merger authority prior to such date. After a bank has established branches in a state through an interstate merger transaction, the bank may establish and acquire additional branches at any location in the state where a bank headquartered in that state could have established or acquired branches under applicable federal or state law.

There are a number of obligations and restrictions imposed on bank holding companies and their depository institution subsidiaries by law and regulatory policy that are designed to minimize potential loss exposure to the

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depositors of such depository institutions and to the Federal Deposit Insurance Corporation (“FDIC”) insurance funds in the event the depository institution becomes in danger of defaulting or in default under its obligations to repay deposits. For example, under current federal law, to reduce the likelihood of receivership of an insured depository institution subsidiary, a bank holding company is required to guarantee the compliance of any insured depository institution subsidiary that may become “undercapitalized” with the terms of any capital restoration plan filed by such subsidiary with its appropriate federal banking agency up to the lesser of (i) an amount equal to 5% of the institution’s total assets at the time the institution became undercapitalized, or (ii) the amount that is necessary (or would have been necessary) to bring the institution into compliance with all applicable capital standards as of the time the institution fails to comply with such capital restoration plan. Under a policy of the Federal Reserve with respect to bank holding company operations, a bank holding company is required to serve as a source of financial strength to its subsidiary depository institutions and to commit resources to support such institutions in circumstances where it might not do so absent such policy. The Federal Reserve also has the authority under the BHCA to require a bank holding company to terminate any activity or relinquish control of a nonbank subsidiary (other than a nonbank subsidiary of a bank) upon the Federal Reserve’s determination that such activity or control constitutes a serious risk to the financial soundness or stability of any subsidiary depository institution of the bank holding company. Further, federal law grants federal bank regulatory authorities additional discretion to require a bank holding company to divest itself of any bank or nonbank subsidiary if the agency determines that divestiture may aid the depository institution’s financial condition.

On November 12, 1999, the Gramm-Leach-Bliley Financial Services Modernization Act of 1999 (“GLBA”) was signed into law. The purpose of this legislation is to modernize the financial services industry by establishing a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms and other financial service providers. Generally, the GLBA:

The GLBA adopts a system of functional regulation under which the Federal Reserve Board is confirmed as the umbrella regulator for bank holding companies, but bank holding company affiliates are to be principally regulated by functional regulators such as the FDIC for state nonmember bank affiliates. The GLBA also imposes certain obligations on financial institutions to develop privacy policies, restrict the sharing of nonpublic customer data with nonaffiliated parties at the customer’s request, and establish procedures and practices to protect and secure customer data. These privacy provisions were implemented by regulations that were effective on November 12, 2000. Compliance with the privacy provisions was required by July 1, 2001.

As a bank holding company registered under the South Carolina Bank Holding Company Act, Bancshares also is subject to regulation by the South Carolina State Board of Financial Institutions (“State Board”). Bancshares must file with the State Board periodic reports with respect to its financial condition and operations, management and intercompany relationships between Bancshares and its subsidiary. Additionally, if applicable, Bancshares must obtain approval from the State Board prior to engaging in acquisitions of banking or nonbanking institutions or assets.

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The Bank.    The Bank is a FDIC-insured, state-chartered banking corporation and is subject to various statutory requirements and rules and regulations promulgated and enforced primarily by the FDIC and the State Board. These statutes, rules and regulations relate to insurance of deposits, required reserves, allowable investments, loans, mergers, consolidations, issuance of securities, payment of dividends, establishment of branches and other aspects of the business of the Bank. The FDIC is an independent federal agency established originally to insure the deposits, up to prescribed statutory limits, of federally insured banks and to preserve the safety and soundness of the banking industry. In addition, federal law imposes a number of restrictions on state-chartered, FDIC-insured banks and their subsidiaries. These restrictions range from prohibitions against engaging as a principal in certain activities to the requirement of prior notification of branch closings. The Bank is not a member of the Federal Reserve System.

The Bank is subject to the requirements of the CRA. The CRA requires that financial institutions have an affirmative and ongoing obligation to meet the credit needs of their local communities, including low-income and moderate-income neighborhoods, consistent with the safe and sound operation of those institutions. Each financial institution’s efforts in meeting community credit needs are evaluated as part of the examination process pursuant to twelve assessment factors. These factors are also considered in evaluating mergers, acquisitions and applications to open a branch or facility.

Dividends

The holders of the Company’s common stock are entitled to receive dividends when and if declared by the Board of Directors out of funds legally available for such dividends. Bancshares is a legal entity separate and distinct from the Bank and Palmetto Capital and depends for its revenues on the payment of dividends from the Bank. Current federal law would prohibit, except under certain circumstances and with prior regulatory approval, an insured depository institution, such as the Bank, from paying dividends or making any other capital distribution if, after making the payment or distribution, the institution would be considered “undercapitalized,” as that term is defined in applicable regulations. In addition, as a South Carolina-chartered bank, the Bank is subject to legal limitations on the amount of dividends it is permitted to pay.

For discussion of the amount currently available for the payment of dividends, see Item 5, “Market for Registrant’s Common Stock and Related Shareholder Matters.”

Capital Adequacy

Bancshares.    The Federal Reserve has adopted risk-based capital guidelines for bank holding companies. Under these guidelines, the minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) is 8%. At least half of the total capital is required to be “Tier 1 capital,” principally consisting of common shareholders’ equity, noncumulative preferred stock, a limited amount of cumulative perpetual preferred stock and minority interest in the equity accounts of consolidated subsidiaries, less certain goodwill items. The remainder (Tier 2 capital) may consist of a limited amount of subordinated debt and intermediate-term preferred stock, certain hybrid capital instruments and other debt securities, perpetual preferred stock and a limited amount of the general loan loss allowance. In addition to the risk-based capital guidelines, the Federal Reserve has adopted a minimum Tier 1 (leverage) capital ratio under which a bank holding company must maintain a minimum level of Tier 1 capital (as determined under applicable rules) to average total consolidated assets of at least 3% in the case of bank holding companies which have the highest regulatory examination ratios and are not contemplating significant growth or expansion. All other bank holding companies are required to maintain a ratio of at least 4%. At December 31, 2002, Bancshares exceeded both the risk-based capital guidelines and the minimum leverage capital ratio.

The Bank.    The Bank is subject to capital requirements imposed by the FDIC. The FDIC requires state-chartered nonmember banks to comply with risk-based capital standards substantially similar to those required by the Federal Reserve, as described above. The FDIC also requires state-chartered nonmember banks to maintain a minimum leverage ratio similar to that adopted by the Federal Reserve. Under the FDIC’s leverage capital

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requirement, state nonmember banks that (i) receive the highest rating during the examination process and (ii) are not anticipating or experiencing any significant growth are required to maintain a minimum leverage ratio of 3% of tier 1 capital to total assets; all other banks, including the Bank, are required to maintain an absolute minimum leverage ratio of not less than 4%. As of December 31, 2002, the Bank exceeded each of the applicable regulatory capital requirements.

See Note 18 of Notes to Consolidated Financial Statements contained in Item 8 herein for a summary of all applicable capital requirements.

Deposit Insurance Assessments

The Bank is subject to insurance assessments imposed by the FDIC. The FDIC maintains two separate insurance funds: the Bank Insurance Fund (“BIF”) and the Savings Association Insurance Fund (“SAIF”). As insurer of the Company’s deposits, the FDIC has examination, supervisory and enforcement authority over the Company. As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of and to require reporting by FDIC insured institutions. It also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious risk to the SAIF or the BIF. Additionally, the FDIC has the authority to initiate enforcement actions against savings institutions and may terminate the deposit insurance if it determines that the institution has engaged in unsafe or unsound practices or is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. Management of the Company does not know of any practice, condition or violation that might lead to termination of deposit insurance.

Effective January 1, 1993, the FDIC implemented a risk-based assessment schedule where the actual assessment to be paid by each FDIC-insured institution is based on the institution’s assessment risk classification. This classification is determined based on whether the institution is considered “well capitalized,” “adequately capitalized” or “undercapitalized,” as such terms have been defined in applicable federal regulations adopted to implement the prompt corrective action provisions of the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), and whether such institution is considered by its supervisory agency to be financially sound or to have supervisory concerns. The assessment rate for the first quarter 2003 was 0.0168% (annualized) for insured deposits. This rate is set quarterly and may change during the year. For the years ended December 31, 2002, 2001 and 2000, premiums paid for FDIC insurance amounted to $112,000, $110,000 and $111,000, respectively.

Other Safety and Soundness Regulations

Prompt Corrective Action.    Current law provides the federal banking agencies with broad powers to take prompt corrective action to resolve problems of insured depository institutions. The extent of these powers depends upon whether the institutions in question are “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized.” Under uniform regulations defining such capital levels issued by each of the federal banking agencies, a bank is considered “well capitalized” if it has (i) a total risk-based capital ratio of 10% or greater, (ii) a Tier 1 risk-based capital ratio of 6% or greater, (iii) a leverage ratio of 5% or greater, and (iv) is not subject to any order or written directive to meet and maintain a specific capital level for any capital measure. An “adequately capitalized” bank is defined as one that has (i) a total risk-based capital ratio of 8% or greater, (ii) a Tier 1 risk-based capital ratio of 4% or greater, and (iii) a leverage ratio of 4% or greater (or 3% or greater in the case of a bank with a composite CAMELS rating of 1). A CAMELS rating is a score given to a financial institution by its primary regulator which represents a composite rating of the various areas examined: Capital adequacy, Asset Quality, Management, Earnings, Liquidity and Sensitivity to market risk. A bank is considered (A) “undercapitalized” if it has (i) a total risk-based capital ratio of less than 8%, (ii) a Tier 1 risk-based capital ratio of less than 4% or (iii) a leverage ratio of less than 4% (or 3% in the case of a bank with a composite CAMELS rating of 1); (B) “significantly undercapitalized” if the bank has (i) a total risk-based capital ratio of less than 6%, or (ii) a Tier 1

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risk-based capital ratio of less than 3%, or (iii) a leverage ratio of less than 3%; and (C) “critically undercapitalized” if the bank has a ratio of tangible equity to total assets equal to or less than 2%. At December 31, 2002, Bancshares and the Bank each currently meet the definition of “well capitalized.”

Brokered Deposits.    Current federal law also regulates the acceptance of brokered deposits by insured depository institutions to permit only a “well capitalized” depository institution to accept brokered deposits without prior regulatory approval. Under FDIC regulations, “well capitalized” insured depository institutions may accept brokered deposits without restriction, “adequately capitalized” insured depository institutions may accept brokered deposits with a waiver from the FDIC (subject to certain restrictions on payments of interest rates), while “undercapitalized” insured depository institutions may not accept brokered deposits. The regulations provide that the definitions of “well capitalized,” “adequately capitalized” and “undercapitalized” are the same as the definitions adopted by the agencies to implement the prompt corrective action provisions of FDICIA (as described in the applicable preceding paragraph). The Company does not believe that these regulations will have a material adverse effect on its current operations.

Transactions between Bancshares Its Subsidiary and Affiliates

Bancshares’ subsidiary is subject to certain restrictions on extensions of credit to executive officers, directors, principal shareholders or any related interest of such persons. Extensions of credit (i) must be made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unaffiliated persons; and (ii) must not involve more than the normal risk of repayment or present other unfavorable features. Aggregate limitations on extensions of credit also may apply. Bancshares’ subsidiary also is subject to certain lending limits and restrictions on overdrafts to such persons.

Subsidiary banks of a bank holding company are subject to certain restrictions imposed by the Federal Reserve Act on extensions of credit to the bank holding company or its nonbank subsidiary, on investments in their securities and on the use of their securities as collateral for loans to any borrower. Such restrictions may limit Bancshares’ ability to obtain funds from its bank subsidiary for its cash needs, including funds for acquisitions, interest and operating expenses.

In addition, under the BHCA and certain regulations of the Federal Reserve, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services. For example, a subsidiary may not generally require a customer to obtain other services from any other subsidiary or Bancshares, and may not require the customer to promise not to obtain other services from a competitor, as a condition to an extension of credit to the customer.

Additional Regulation

FDICIA Regulations

To facilitate the early identification of problems, FDICIA required the federal banking agencies to prescribe more stringent reporting requirements. The FDIC final regulations implementing those provisions, among other things, require that management report on the institution’s responsibility for preparing financial statements and establishing and maintaining an internal control structure and procedures for financial reporting and compliance with designated laws and regulations concerning safety and soundness, and that independent auditors attest to and report separately on assertions in management’s reports concerning compliance with such laws and regulations, using FDIC approved audit procedures. These regulations apply to financial institutions with greater than $500 million in assets at the beginning of their fiscal year. Accordingly, the Bank is subject to these regulations.

The USA Patriot Act

In response to the terrorist events of September 11, 2001, the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, or the USA PATRIOT Act, was signed into law on October 26, 2001. The USA PATRIOT Act gave the federal government additional

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powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing, and broadened anti-money laundering requirements. By way of amendments to the Bank Secrecy Act, Title III of the USA PATRIOT Act takes measures intended to encourage information sharing among bank regulatory agencies and law enforcement bodies. Further, certain provisions of Title III impose affirmative obligations on a broad range of financial institutions, including banks, thrifts, brokers, dealers, credit unions, money transfer agents and parties registered under the Commodity Exchange Act.

Among other requirements, Title III of the USA PATRIOT Act imposes the following requirements with respect to financial institutions:

To date, it has not been possible to predict the impact the USA PATRIOT Act and its implementing regulations may have on the Bank.

Monetary Policy

The results of operations of the Company are affected by credit policies of monetary authorities, particularly the Federal Reserve. An important function of the Federal Reserve is regulation of the money supply. The instruments of monetary policy employed by the Federal Reserve include open market operations in U.S. Government securities, changes in the discount rate on member bank borrowings, changes in reserve requirements against member bank deposits and limitations on interest rates which member banks may pay on time and savings deposits. The Federal Reserve uses these methods in varying combinations to influence overall growth and distribution of bank loans, investments, and deposits. The use of these methods may also affect interest rates charged on loans or paid on deposits.

The monetary policies of the Federal Reserve have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. In light of changing conditions in the national economy and in the money markets, as well as the effect of action by monetary and fiscal authorities, including the Federal Reserve, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand or the business and earnings of the Company.

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Item 2.     Properties

The Company’s principal executive offices are located at 301 Hillcrest Drive, Laurens, South Carolina (“Corporate Center”). The Company owns these premises. The main office of the Bank is located at 101 West Main Street, Laurens, South Carolina, which also contains a three lane drive-in facility.

At December 31, 2002, the Bank had thirty full-service branches in the Upstate region of South Carolina in the following counties: Laurens County (4), Greenville County (10), Spartanburg County (5), Greenwood County (5), Anderson County (3), Cherokee County (2), and Oconee County (1) in addition to one Palmetto Capital office, 29 ATM locations (including three at non-branch locations) and five limited service branches located in various retirement centers located in the Upstate.

Offices range in size from branch locations of approximately 800 to 10,000 square feet, to the Corporate Center location of approximately 55,000 square feet. Facilities are protected by alarm and security systems that meet or exceed regulatory standards.

Nine of the Bank’s full service branch offices are leased. Additionally, the Bank has entered into seven grounds and / or parking lot leases. Two of the three ATMs located at non-branch locations are leased from third parties. Reference is made to Note 14 of Notes to Consolidated Financial Statements contained in Item 8 herein for information relating to minimum lease commitments under the Company’s leases for office facilities.

At December 31, 2002 and 2001, the total net book value of the premises and equipment owned by the Company was $19.7 million and $19.2 million, respectively. Reference is made to Note 5 of Notes to Consolidated Financial Statements contained in Item 8 herein for further details on the Company’s properties.

The Company evaluates on a continuing basis the suitability and adequacy of all of its facilities, including branch offices and service facilities, and has active programs of relocating, remodeling or closing any as necessary to maintain efficient and attractive facilities. The Company believes its present facilities are in good condition and capable of handling increased volume. Additionally, all of the locations are considered suitable and adequate for their intended purposes.

Item 3.     Legal Proceedings

The Company is currently subject to various legal proceedings and claims that have arisen in the ordinary course of its business. In the opinion of management based on consultation with external legal counsel, any reasonably foreseeable outcome of such current litigation would not materially affect the Company’s consolidated financial position or results of operations.

In its Annual Report on Form 10-K for the fiscal year ended December 31, 2001, the Company disclosed a legal proceeding between the Bank and M. Snyder’s, Inc., an automobile dealership, relating to sales finance contracts that M. Snyder’s sold to the Bank. The Bank, in turn, filed a counterclaim against M. Snyder and a third party complaint against a M. Snyder’s Inc. employee. In December 2002, the Bank and M. Snyder’s Inc. entered into a final settlement agreement, in connection with which Progressive Casualty Insurance Company paid $150,000 to M. Snyder’s Inc. in full and final settlement of all claims made against the Bank.

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

No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended December 31, 2002.

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Part II

Item 5.     Market for Registrant’s Common Stock and Related Shareholder Matters

There is no public market for the common stock of the Company, and it is not traded on any established public trading market. The last known trading price of the Company common stock, based on information available to its management, was $28.00 per share on December 31, 2002. Management is aware of a number of transactions in which the Company’s stock traded at this price. However, management has not ascertained that these transactions are a result of arms length negotiations between the parties and, because of the limited number of shares involved, these prices may not be indicative of the market value of the common stock. As of December 31, 2002, the Company had 1,107 shareholders representing 6,324,659 shares outstanding.

The Company or its predecessor, the Bank, has paid regular dividends on common stock since 1909. For the years ended December 31, 2002, 2001 and 2000, cash dividends were paid of $2.8 million or $.45 per share, $2.6 million or $0.41 per share, and $2.3 million or $0.37 per share, respectively. These dollars equate to dividend payout ratios (dividends declared divided by net income) of 29.46%, 30.58% and 33.12% in 2002, 2001 and 2000, respectively.

Set forth below is information concerning high and low sales prices by quarter for each of the last two fiscal years and dividend information for the same periods. The Company acts as its own transfer agent, and the information concerning sales prices set forth below is derived from the Company’s stock transfer records.

Sales Prices and Dividends by Quarter

The Bank’s total risk-based capital ratio at December 31, 2002 was 10.57%. Reference is made to Note 18 of Notes to Consolidated Financial Statements contained in Item 8 herein for information relating to regulatory capital requirements. At December 31, 2002, the Bank had $3.6 million of excess capital available for payment of dividends and still be considered “well-capitalized” related to the total risk based capital ratio.

Please refer to “Item 1. Business—Supervision and Regulation—Dividends” for information with respect to current restrictions on the Bank’s ability to pay dividends to Bancshares.

Set forth below is information required under Regulation S-K regarding compensation plans under which equity securities of the Company are authorized for issuance as of December 31, 2002. All equity compensation plans of the Company in existence at December 31, 2002 were previously approved by security holders.

Equity Compensation Plan Information

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Item 6.     Selected Financial Data

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

The following discussion and analysis is presented to assist in understanding the financial condition and results of operations of the Company. This discussion should be read in conjunction with the audited consolidated financial statements and related notes and other financial data presented in Item 8 of this report and the supplemental financial data appearing throughout this report. Percentage calculations contained herein have been calculated based upon actual, not rounded, results.

Forward Looking Statements

Management’s Discussion and Analysis of Financial Condition and Results of Operations as well as other portions of this Annual Report contain certain forward-looking statements (as defined in the Private Securities Litigation Reform Act of 1995) to assist in the understanding of anticipated future operating and financial performance, growth opportunities, growth rates, and other similar forecasts and statements of expectations. These forward-looking statements reflect current views, but are based on assumptions and are subject to risks, uncertainties, and other factors, which may cause actual results to differ materially from those in such statements. These factors include, but are not limited to, the following:

Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those expected or projected. Such forward-looking statements speak only as of the date on which such statements are made. We undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made to reflect the occurrence of unanticipated events. In addition, certain statements in future filings by the Company with the Securities Exchange Commission, in press releases and in oral and written statements made by or with the approval of the Company, which are not statements of historical fact, constitute forward-looking statements.

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Significant Accounting Policies

The Company’s accounting policies are discussed in Item 8, Note 1 to the Consolidated Financial Statements. Of these significant accounting policies, the Company considers its policies regarding the Allowance to be its most critical accounting policy due to the significant degree of management judgment exercised in relation to this estimate. The Company has developed policies and procedures for assessing the adequacy of the Allowance recognizing that this process requires a number of assumptions and estimates with respect to its loan portfolio. These assessments may be impacted in future periods by changes in economic conditions, the impact of regulatory examinations, and the discovery of information with respect to borrowers, which is not known to management at the time of the issuance of the consolidated financial statements. For discussion relating to the Allowance, see “Balance Sheet Review—Allowance for Loan Losses” and Note 4 of Notes to Consolidated Financial Statements contained in Item 8 herein.

Current National and Economic Environment

The 2002 calendar year was a year of considerable economic uncertainty, both nationally and in Upstate South Carolina, due in large part to the continued uncertainty following the terrorist attacks of September 11, 2001 and the possibility of United States military action. Across our market unemployment numbers rose as businesses reacted to a weakened manufacturing sector. During the fourth quarter of 2001, the Federal Reserve Open Market Committee (“FOMC”) cut interest rates (the eleventh cut in a twelve-month period) reducing the Federal Funds rate to 1.75% by December 31, 2001. In November 2002 the FOMC further reduced the Fed Funds rate another 50 basis points to 1.25%, the lowest in approximately 40 years. In 2002 there continued to be lower returns and expectations of the equity markets.

Balance Sheet Review

Overview

At December 31, 2002, the Company’s assets totaled $825.0 million, an increase of $89.7 million or 12.2% from December 31, 2001. Contributing significantly to the increase in assets in 2002 over 2001 was an increase in total loans, including mortgage loans held for sale, of $73.5 million. Also contributing to the increase in assets was an increase in investments available for sale of $20.0 million, or 21.0%, at December 31, 2002 over December 31, 2001. Average assets increased 11.0% during the year and average interest-earning assets increased by 10.8%. Total liabilities increased $81.3 million, or 12.0%, at December 31, 2002 over December 31, 2001, to a balance of $757.5 million. This increase is the direct result of an increase in total deposits, including retail repurchase agreements and commercial paper, of $78.0 million, or 11.6%, to a balance of $749.7 million at December 31, 2002. Total shareholders’ equity at December 31, 2002 totaled $67.5 million, an increase of $8.5 million, or 14.3%, over December 31, 2001.

Total assets at December 31, 2001 increased $71.9 million, or 10.8%, over December 31, 2000 to a balance of $735.3 million. Net asset growth during this time period was also due to growth within the loan portfolio of $65.0 million, which includes growth within the mortgage loans held for sale portfolio. Also contributing to this growth was an increase in liquid assets, which includes cash and due from banks, federal funds sold, and investments, of $4.0 million at December 31, 2001 compared with December 31, 2000. Average assets increased 9.8% during the year and average interest-earning assets increased by 10.6%. Liabilities totaled $676.2 million at December 31, 2001, an increase of $65.4 million, or 10.7%, over December 31, 2000. Deposit growth over this time period totaled $63.7 million, or 10.5%. Total shareholders’ equity at December 31, 2001 totaled $59.1 million, an increase of $6.5 million, or 12.3%, over December 31, 2000.

Investment Portfolio

Investment securities available for sale totaled $115.1 million at December 31, 2002, an increase of $20.0 million, or 21.0%, over December 31, 2001. The primary objective of the Company, in its management of the investment portfolio, is to maintain a portfolio of high quality, highly liquid investments yielding competitive returns.

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The Company is required under federal regulations to maintain adequate liquidity to ensure safe-and-sound operations. Investment decisions are made by authorized officers of the Company within policies established by the Company’s Boards of Directors.

Securities may differ in terms of default risk, interest risk, liquidity risk and expected rate of return. Default risk is the risk that an issuer will be unable to make interest payments, or to repay the principal amount on schedule. The Company primarily invests in U.S. Government and federal agency obligations. U.S. Government obligations are regarded as free of default risk. The issues of most government agencies are backed by the strength of the agency itself plus a strong implication that in the event of financial difficulty the federal government would assist the agency.

The following tables set forth the carrying value of the Company’s investment and mortgage-backed securities portfolio (excluding stock in the FHLB), maturities and average yields at December 31, 2002. The fair value of the Company’s investment and mortgage-backed securities portfolio (excluding stock in the FHLB) was $115.1 million on December 31, 2002.

Investment and Mortgage-backed Securities Portfolios

Maturity and Yield Schedule at December 31, 2002

(dollars in thousands)

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See Note 1 of Notes to Consolidated Financial Statements contained in Item 8 herein for a discussion of the Company’s accounting policy for investment securities. Also see Note 3 of Notes to Consolidated Financial Statements contained in Item 8 herein for additional information regarding investment securities.

Loan Portfolio

Loans represent the most significant component of interest-earning assets accounting for 81.9% and 83.9% of average interest-earning assets in 2002 and 2001, respectively. The Bank strives toward maintaining a diversified loan portfolio in an effort to spread risk and reduce exposure to economic downturns that may occur within different segments of the economy, geographic locations or in particular industries. Commercial loans are made to businesses within most industry sectors with no particular industry concentrations.

The loan portfolio, including those mortgage loans held for sale, increased during both 2001 and 2002. Mortgage loans held for sale increased $1.8 million at December 31, 2002 over December 31, 2001 and $9.4 million at December 31, 2001 over December 31, 2000. The remaining loans within the portfolio (those originated for retention by the Bank) increased $71.7 million at December 31, 2002 over December 31, 2001 and $55.6 million at December 31, 2001 over December 31, 2000.

The loan portfolio consists of real estate mortgage loans, installment loans, commercial loans, home equity loans, other consumer loans (including sales finance loans), bankcard loans, and commercial business loans. Increases within the total portfolio are associated, for the most part, with increases in mortgage real estate and commercial lending. See Note 4 of Notes to Consolidated Financial Statements contained in Item 8 herein for a discussion of composition of the loan portfolio.

Certain risks are inherent with loan portfolios containing commercial real estate, commercial business and consumer loans. While these types of loans provide benefits to the Company’s asset/liability management programs and reduce exposure to interest rate changes, such loans may entail significant additional credit risks compared with residential mortgage lending.

Commercial mortgage lending generally involves greater risk than single family lending since such lending typically involves larger loan balances. Furthermore, the repayment of loans secured by income producing properties is typically dependent on the successful operation of the related commercial real estate project. If assumptions for the income production of the property are not indicative of future results, the cash flow from the property may affect the borrower’s ability to make the required loan payments.

Commercial business lending also generally involves greater risk than residential mortgage lending and involves risks that are different from those associated with real estate lending. Real estate lending is generally considered to be collateral based lending with loan amounts based on predetermined loan to collateral values and liquidation of the underlying real estate collateral is viewed as the primary source of repayment in the event of borrower default. Although commercial business loans are often collateralized by equipment, inventory, accounts receivable or other business assets, the liquidation of collateral in the event of a borrower default is often not a sufficient source of repayment because accounts receivable may be uncollectible, and inventories and equipment may be obsolete or of limited use, among other things. Accordingly, the repayment of a commercial business loan depends primarily on the creditworthiness of the borrower (and any guarantors), while liquidation of collateral is a secondary and often insufficient source of repayment.

Construction loans also involve additional risks because loan funds are advanced upon the security of the project under construction.

Consumer loans entail greater risk than do residential mortgage loans, particularly in the case of loans that are unsecured or secured by rapidly depreciating assets such as automobiles and other vehicles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the

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outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount that can be recovered on such loans.

All of the above risk factors are inherent in the loan portfolio at December 31, 2002. Since lending activities comprise such a significant source of revenue, our main objective is to adhere to sound lending practices.

The Bank makes both fixed rate and adjustable rate loans and generally retains servicing on loans originated. A large percentage of single family loans are made pursuant to certain guidelines that will permit the sale of these loans in the secondary market to government agencies or private agencies. This practice enables the Bank to satisfy the demand for such loans in its market area while developing a source of fee income through the servicing of such loans. The Bank typically sells fixed rate and balloon term loans. Sales of such loans totaled $101.0 million, $93.2 million, and $9.9 million during 2002, 2001, and 2000, respectively. At December 31, 2002 the Bank serviced mortgage loans for others with principal balances totaling $241.3 million. Generally on mortgage loans exceeding an 80% loan to value ratio, the Bank requires private mortgage insurance which protects the Bank against losses of at least 20% of the mortgage loan amount. It is the Bank’s policy to have property securing real estate loans appraised.

Allowance for Loan Losses

The Allowance is maintained at a level that management believes is sufficient to cover inherent losses in the loan portfolio at a specific point in time. Assessing the adequacy of the Allowance requires considerable judgment. The adequacy of the Allowance is analyzed on a monthly basis using its internal analysis model. For purposes of this analysis, adequacy is defined as a level sufficient to absorb probable losses in the portfolio. An allowance model is used that takes into account factors including the composition of the loan portfolio including risk grade classifications (based on an internally developed grading system), historical asset quality trends including, but not limited to, previous loss experience ratios, and reviews of specific high risk sectors of the portfolio. Loans are graded at inception and are reviewed on a periodic basis to ensure that assigned risk grades are proper based on the definition of such classification. The value of underlying collateral is also considered during such analysis. The resulting monthly model and the related conclusions are reviewed and approved by senior management. Our analysis of Allowance adequacy includes consideration for loan impairment.

As noted above, a loan grade classification system is used for loans held for investment. Under this classification system, loans graded “1” represent loans of superior quality. Loans graded “2” represent loans of high quality. Loans graded “3” represent loans that are satisfactory. Loans graded “4” represent loans that are considered marginal. Problem assets are typically classified as “special mention,” “substandard,” “doubtful” or “loss,” depending on the presence of certain characteristics.

“Special mention” assets are defined as those that do not currently expose an institution to a sufficient degree of risk to warrant classification as either “substandard,” “doubtful” or “loss” but do possess credit deficiencies or potential weaknesses deserving management’s close attention which, if not corrected, could weaken the asset and increase such risk in the future. An asset is considered “substandard” if inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. “Substandard” assets include those assets characterized by the “distinct possibility” that the institution will sustain “some loss” if the deficiencies are not corrected. Assets classified as “doubtful” have all of the weaknesses inherent in those classified “substandard” with the added characteristic that the weaknesses present make “collection or liquidation in full,” on the basis of currently existing facts, conditions, and values, “highly questionable and improbable.” Assets classified “loss” are those considered “uncollectible” and of such little value that continuance as assets without the establishment of a specific loss reserve is not warranted. Assets determined to be problem assets are reserved at a higher percentage in accordance with the Allowance model

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than assets graded superior quality, high quality, satisfactory, or marginal (for which general reserves are provided). General allowances represent loss allowances, which have been established to recognize the inherent risks associated with lending activities, but which, unlike specific allowances, have not been allocated to particular problem assets.

At December 31, 2002, there were $7.0 million of assets designated “special mention,” $8.1 million of assets designated as “substandard,” $1.3 million of assets designated as “doubtful,” and $115 thousand of assets designated as “loss.” At December 31, 2001, there were $6.9 million of assets designated “special mention,” $6.5 million of assets designated as “substandard,” $657 thousand of assets designated as “doubtful,” and no assets designated as “loss.”

Management periodically reviews its loan portfolio, and has, in the opinion of management, appropriately classified and established allowances against all assets requiring classification under the regulation.

For further discussion of the Company’s problem assets, see “Credit Quality,” and Note 4 of Notes to Consolidated Financial Statements contained in Item 8 herein.

The methodology for assessing the adequacy of the Allowance establishes both an allocated and unallocated component of the contra asset balance. The allocated component is based principally on current loan grades and historical loss rates. The unallocated component is the result of the portion of the assessment that estimates probable losses in the portfolio that are not fully captured in the allocated Allowance. These analyses include, but are not necessarily limited to, industry concentrations, model imprecision and the estimated impact of current economic conditions on historical loss rates. On a continual basis, management monitors trends within the portfolio, both quantitative and qualitative.

Management’s judgments as they relate to the Allowance and the related adequacy model are based on numerous assumptions about current events, which we believe to be reasonable, but which may or may not prove valid in the future. Thus, there can be no assurance that loan losses in future periods will not exceed the current Allowance allocation or that future increases in the Allowance will not be required thus adversely affecting the operating results of the Company.

The Allowance is subject to examination and adequacy testing by regulatory agencies. In addition, such regulatory agencies could require Allowance adjustments based on information available to them at the time of their examination.

The Allowance totaled $6.4 million, and $5.7 million, at December 31, 2002 and 2001, respectively representing 1.02% of loans, less mortgage loans held for sale, at both December 31, 2002 and 2001.

The fair value of mortgage loans held for sale is based on prices for outstanding commitments to sell these loans. Typically, the carrying amount approximates fair value due to the short-term nature of these instruments. Likewise, such instruments are not included in the assumptions related to the Allowance model.

During mid-1999 management noted deterioration in the performance of the sales finance portfolio resulting in increased charge-offs during 2000 and 2001. As noted above in “Balance Sheet Review—Loan Portfolio,” the sales finance portfolio includes loans with more inherent risk than the loans in the Bank’s direct lending portfolio. Net charge-offs as a percentage of average loans excluding mortgage loans held for sale have declined from 72 basis points at December 31, 2001 to 61 basis points at December 31, 2002. Additionally, it was noted that the sales finance portfolio has decreased to $14.7 million at December 31, 2002 from $15.9 at December 31, 2001.

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The Allowance to nonperforming loans ratio was 2.56 times and 1.66 times at December 31, 2002 and December 31, 2001, respectively. Nonperforming loans decreased to $2.5 million at December 31, 2002 from $3.4 million at December 31, 2001. For further discussion of the Company’s problem assets, see “Credit Quality,” and Note 4 of Notes to Consolidated Financial Statements contained in Item 8 herein.

Based on the current economic environment and other factors, management believes that the Allowance at December 31, 2002 was maintained at a level adequate to provide for estimated probable losses in the loan portfolio.

The following tables set forth the allocation of the Allowance by loan category and the activity in the Allowance at the dates indicated. Please note in regards to the second table, losses and recoveries are charged or credited to the Allowance at the time realized. Management believes that the Allowance can be allocated by category only on an approximate basis. The allocation of the Allowance to each category is not necessarily indicative of future losses and does not restrict the use of the Allowance to absorb losses in any category.

Allowance for Loan Losses Allocation by Loan Category

(dollars in thousands)

Allowance for Loan Losses Activity

(dollars in thousands)

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Total net loan charge-offs decreased to $3.5 million in 2002 from $3.8 million in 2001. Commercial business loan net charge-offs were $969 thousand in 2002 compared with $801 thousand in 2001. Net real estate loan charge-offs totaled $389 thousand in 2002 compared with net charge-offs of $69 thousand in 2001. Consumer loan net charge-offs were $2.2 million in 2002 compared with $3.0 million in 2001. Consumer loan charge-offs decreased mainly related to the sales finance portfolio. Underwriting standards were tightened in fiscal 2000 on certain auto lending programs contributing to this decline. The Company expects the charge-off rate to be lower in the future related to this area of the loan portfolio. For further discussion of the Company’s sales finance portfolio, see “Earnings Review—Provision for Loan Losses.”

Deposits

Retail deposits have traditionally been the primary source of funds for the Company and also provide a customer base for the sale of additional financial products and services. The Company sets strategic targets for net growth in deposit accounts annually.

The Company offers a number of deposit accounts including noninterest-bearing checking accounts, interest-bearing checking accounts, savings accounts, money market accounts, Individual Retirement Accounts (“IRAs”) and certificate accounts. The Bank’s deposits are obtained primarily from residents of South Carolina. The principal methods used by the Company to attract deposit accounts include the offering of a wide variety of services and accounts, competitive interest rates, and convenient office locations and service hours. Deposit account terms vary, with the principal differences being the minimum balance required, the time period the funds must remain on deposit and the interest rate.

The Company is subject to fluctuations in deposit flows because of the influence of general interest rates, money market conditions and competitive factors. The Asset-Liability Committee of the Company meets weekly and makes changes relative to the mix, maturity and pricing of assets and liabilities in order to minimize the impact on earnings from such external conditions. Deposits are attractive sources of liquidity because of their stability, generally lower cost than other funding and the ability to provide fee income through service charges and cross-sales of other services.

The Company provides customers with access to the convenience of automated teller machines (“ATMs”) through an ATM network, as well as access to regional and national ATM networks. The Bank had 29 ATM locations (including three at non-branch locations) and five limited service branches located in various retirement centers located in the Upstate at December 31, 2002. The Company also provides access through Internet Banking. Management believes the Company enjoys an excellent reputation for providing products and services to meet the needs of the Company’s market segments, such as seniors. For example, Seniority Club members benefit from a number of advantageous programs.

The Company’s deposit accounts increased $78.0 million during the year ended December 31, 2002. The table set forth below reflects the Company’s deposit composition at December 31, 2002 and 2001 (dollars in thousands).

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Management believes that conditions in fiscal 2002 and fiscal 2001 were favorable for deposit growth as a result of factors such as the low returns on investments and mutual funds that may have increased traditional deposit inflows. Core deposits grew by $32.3 million in fiscal 2002 over fiscal 2001, or 9.1%, while higher costing time balances increased by $44.4 million, or 15.4%. At December 31, 2002, deposits as a percentage of liabilities were 95.3% compared with 95.4% at December 31, 2001. The Company’s average cost of deposits for the year ended December 31, 2002 was 2.15% compared with 5.29% for the same period ended December 31, 2001.

Jumbo Certificates of Deposit

The following table indicates the amount of the Company’s jumbo certificates of deposit by time remaining until maturity at December 31, 2002, 2001, and 2000 (in thousands). Jumbo certificates of deposit require minimum deposits of $100,000.

The increase of jumbo certificates of deposit maturing after December 31, 2003 is due to the offering of a 36-month certificate of deposit promotion in 2002. These deposits will mature in 2005.

Borrowings

The Company employs additional sources, other than retail deposits, to supplement its supply of lendable funds and assist in meeting deposit withdrawal requirements. Retail repurchase agreements and commercial paper serve as the Company’s primary sources of such funds.

At December 31, 2002, the Company had retail repurchase agreements totaling $12.8 million at an average annual rate of .93% and commercial paper totaling $14.8 million at an average annual rate of .98%. The maturities of these borrowings are taken into account in the Interest Risk Sensitivity Analysis included within Item 7 of this report. For additional information related to borrowings, see Note 10 of Notes to Consolidated Financial Statements contained in Item 8 herein.

Capital Resources

Average shareholder’s equity was $64.1 million during 2002, or 8.26% of average assets, increasing from 8.12% during 2001. The principal reason for the increase in average equity to average assets during the current period is due to the retention of net income. The Consolidated Statements of Changes in Shareholders’ Equity and Comprehensive Income contained in Item 8 herein provide details of the changes in stockholders’ equity during the year. At December 31, 2002 and 2001 the Company and the Bank were each categorized as “well capitalized” under the regulatory framework for prompt corrective action. For further discussion of the Bank’s and the Company’s capital regulatory requirements, see Note 18 of Notes to Consolidated Financial Statements contained in Item 8 herein. There are no current conditions or events that management believes would change the Company’s or the Bank’s category.

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Total equity capital increased from $59.1 million at December 31, 2001 to $67.5 million at December 31, 2002. The Company’s capital ratio of total capital to total assets was 8.18% at December 31, 2002 compared with 8.03% at December 31, 2001.

During fiscal 2002, the Company’s cash dividend payout ratio was 29.46% compared with a payout ratio of 30.58% in 2001. Cash dividends per share in 2002 totaled $.45, an increase of 9.8% over dividends per share in 2001 of $.41.

In conjunction with the 2003 budgeting process $1.9 million of 2003 capital expenditures were approved for purposes including, but not limited to, technological advances, and upgrades and routine maintenance of premises. Funds to fulfill such commitments will come from retained earnings of the Company.

Asset-Liability Management and Market Risk Sensitivity

Asset/liability management is the process by which the Company changes the mix, maturity and pricing of assets and liabilities in an attempt to reduce a materially adverse impact on earnings resulting from the direction, frequency and magnitude of change in market interest rates.

Market risk is the risk of loss from adverse changes in market prices and rates. The Company’s market risk arises principally from interest rate risk inherent in its lending, deposit, borrowing and investing activities which could potentially reduce net interest income in future periods. This risk can also be reflected in diminished current market values. Management actively monitors and manages its inherent rate risk exposure. Although the Company manages other risks, such as credit quality and liquidity risk, in the normal course of business, management considers interest rate risk to be its most significant market risk. This risk could potentially have the largest material effect on the Company’s financial condition and results of operations. Other types of market risks, such as foreign currency exchange rate risk and commodity price risk, do not arise in the normal course of the Company’s business activities.

Although the net interest income of any financial institution is perceived as being vulnerable to fluctuations in interest rates, the Company’s management has attempted to minimize such vulnerability. Management’s goal is to maintain a reasonable balance between exposure to interest rate fluctuations and earnings. A sudden and substantial increase or decrease in interest rates may adversely impact the Company’s earnings to the extent that the interest rates on interest-earning assets and interest-bearing liabilities do not change at the same speed, to the same extent or on the same basis. The future regulatory capital requirements of all financial institutions will become subject to the inclusion of additional components measured by exposure to interest rate sensitivity.

The Company’s goal is to minimize interest rate risk between interest-bearing assets and liabilities at various maturities through its Asset-Liability Management. Asset-Liability Management involves managing the mix and pricing of assets and liabilities in the face of uncertain interest rates and an uncertain economic outlook. It seeks to achieve steady growth of net interest income with an acceptable amount of interest rate risk and sufficient liquidity.

The Company uses several tools to monitor and manage interest rate risk. A primary tool the Company uses is a simulation model which is used to analyze earnings at risk and the interest sensitivity gap (the difference between the amount of rate sensitive assets maturing or repricing within a specific time period and the amount of rate sensitive liabilities maturing or repricing within the same time period). The model takes into account interest rate changes as well as changes in the mix and volume of assets and liabilities. The model’s inputs (such as interest rates and levels of loans and deposits) are updated on a regular basis.

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The following table shows the Company’s financial instruments that are sensitive to changes in interest rates and the related interest sensitivity gap at December 31, 2002. The Company uses certain assumptions to estimate fair values and expected maturities. For assets, expected maturities are based upon contractual maturities, projected repayments, prepayment of principal and potential calls. Loans include nonperforming loans and unamortized deferred loan costs and are reduced by unamortized discounts. It does not include mortgage loans held for sale, as those are not considered to be interest sensitive given that the Bank has commitments to sell these loans at agreed upon rates. Investment securities include the unrealized gain or loss on securities.  Interest-bearing liabilities are included in the period in which the balances are expected to be withdrawn as a result of contractual maturities. For core deposits without contractual maturities (i.e., interest checking, savings, money market and noninterest-bearing deposit accounts), the table presents principal cash flows based on management’s judgment concerning their most likely runoff. The actual maturities and runoff could vary substantially if future prepayments, runoff, and calls differ from historical experience and management’s judgment.

Interest Risk Sensitivity Analysis at December 31, 2002

(dollars in thousands)