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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549


FORM 10-Q


(Mark One)
[X]       Quarterly report pursuant to Section 13 or l5(d) of the Securities Exchange Act of 1934
For the quarterly period ended June 30, 2004

[   ]       Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the transition period from ________ to ________

Commission File Number 000-24503


WASHINGTON BANKING COMPANY
(Exact name of registrant as specified in its charter)

Washington 91-1725825
(State or other jurisdiction of
incorporation or organization) 		   (I.R.S. Employer
Identification Number)


450 SW Bayshore Drive
Oak Harbor, Washington         98277
(Address of principal executive offices) (Zip Code)

(360) 679-3121
(Issuer’s telephone number, including area code)

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the issuer: (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 the registrant is an accelerated filer within the meaning of Rule 12b-2 under the Securities Exchange Act of 1934, as amended.   Yes  [   ]    No  [X]

The number of shares of the issuer’s Common Stock outstanding at August 6, 2004 was 5,409,999.

Table of Contents

PART I		 Page
Item 1. Financial Statements  
 
                Condensed Consolidated Statements of Financial Condition -
                     June 30, 2004 and December 31, 2003 1 
 
                Condensed Consolidated Statements of Income -
                     Three and Six Months Ended June 30, 2004 and 2003 2 
 
                Condensed Consolidated Statements of Shareholders’ Equity and Comprehensive Income -
                     Six Months Ended June 30, 2004 and 2003 4 
 
                Condensed Consolidated Statements of Cash Flows -
                     Six Months Ended June 30, 2004 and 2003 5 
 
                Notes to Condensed Consolidated Financial Statements 7 
 
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 11 
 
Item 3. Quantitative and Qualitative Disclosures about Market Risk 23 
 
Item 4. Controls and Procedures 23 
 
Part II
 
Item 2. Changes in Securities and Use of Proceeds 24 
 
Item 4. Submission of Matters to a Vote of Security Holders 24 
 
Item 5. Other Information 24 
 
Item 6. Exhibits and Reports on Form 8-K 24 
 
                    Signatures 25 

Item 1. Financial Statements

WASHINGTON BANKING COMPANY
AND SUBSIDIARIES
Condensed Consolidated Statements of Financial Condition
June 30, 2004 and December 31, 2003 (unaudited)
(Dollars in thousands)

Assets June 30,
2004
December 31,
2003
Cash and due from banks     $ 19,832   $ 15,454  
      ($1,221 and $1,138, respectively, are restricted)    
Interest-earning deposits       210     356  
Federal funds sold       5,510     4,795  
              Total cash, restricted cash, and cash equivalents       25,552     20,605  
Investment securities available for sale       19,259     15,421  
Investment securities held to maturity       —     14,745  
              Total investment securities       19,259     30,166  
 
Subsidiary investment       320     —  
Federal Home Loan Bank stock       2,325     2,280  
 
Loans held for sale       15,859     8,251  
Loans receivable       540,336     499,919  
Allowance for loan losses       (6,926 )   (6,116 )
              Total loans, net       549,269     502,054  
 
Premises and equipment, net       20,496     19,814  
Bank owned life insurance       10,010     —  
Other assets       6,240     6,822  
              Total assets     $ 633,471   $ 581,741  
Liabilities and Shareholders’ Equity    
Liabilities:    
    Deposits    
       Noninterest-bearing     $ 75,560   $ 75,756  
       Interest-bearing       267,424     238,180  
       Time deposits       215,028     187,561  
              Total deposits       558,012     501,497  
 
    Other borrowed funds       11,500     17,500  
    Junior subordinated debentures       15,007     —  
    Trust preferred securities       —     15,000  
    Other liabilities       2,680     3,384  
              Total liabilities       587,199     537,381  
 
Commitments and contingencies       —     —  
 
Shareholders’ equity:    
    Preferred stock, no par value. Authorized 20,000 shares:    
       no shares issued or outstanding       —     —  
    Common stock, no par value. Authorized 10,000,000 shares:    
       issued and outstanding 5,409,999 and 5,357,880 shares    
       at June 30, 2004 and December 31, 2003, respectively       31,291     31,125  
    Retained earnings       14,878     13,273  
    Accumulated other comprehensive income (loss), net       103     (38 )
              Total shareholders’ equity       46,272     44,360  
              Total liabilities and shareholders’ equity     $ 633,471   $ 581,741  

See accompanying notes to consolidated financial statements.

1

WASHINGTON BANKING COMPANY
AND SUBSIDIARIES
Condensed Consolidated Statements of Income
Three and Six months ended June 30, 2004 and 2003 (unaudited)
(Dollars in thousands, except per share data)

Three Months Ended
June 30		 Six Months Ended
June 30
2004
2003
2004
2003
Interest income:                    
     Interest and fees on loans     $ 9,258   $ 8,824   $ 18,110   $ 17,326  
     Interest on taxable investment securities       79     65     187     141  
     Interest on tax-exempt investment securities       139     166     302     335  
     Other       52     99     93     218  
              Total interest income       9,528     9,154     18,692     18,020  
Interest expense:    
     Interest on deposits       1,894     1,905     3,667     3,900  
     Interest on other borrowings       101     154     247     310  
     Interest on junior subordinated debentures       184     —     364     —  
     Interest on trust preferred securities       —     189     —     378  
              Total interest expense       2,179     2,248     4,278     4,588  
                    Net interest income       7,349     6,906     14,414     13,432  
Provision for loan losses       (775 )   (837 )   (1,600 )   (1,600 )
              Net interest income after provision    
                 for loan losses       6,574     6,069     12,814     11,832  
Noninterest income:    
     Service charges and fees       771     517     1,517     994  
     Gain on sale of securities       144     —     144     —  
     Gain on sale of loans       372     504     624     962  
     Secondary market fees       28     64     54     133  
     ATM income       155     118     280     216  
     Other       96     99     250     267  
              Total noninterest income       1,566     1,302     2,869     2,572  
Noninterest expense:    
     Salaries and benefits       3,421     3,014     6,906     6,036  
     Occupancy       991     875     1,962     1,711  
     Office supplies and printing       163     158     316     328  
     Data processing       126     107     242     222  
     Consulting and professional fees       123     91     206     144  
     Other       1,082     901     1,979     1,767  
              Total noninterest expense       5,906     5,146     11,611     10,208  
              Income before income taxes       2,234     2,225     4,072     4,196  
Provision for income taxes       (742 )   (781 )   (1,362 )   (1,455 )
Income from continuing operations       1,492     1,444     2,710     2,741  
Loss from discontinued operations, net of tax benefit of $156, $47, $238 and $76 for the three and six months ended June 30, 2004 and 2003, respectively.       (247 )   (24 )   (370 )   (81 )
              Net income     $ 1,245   $ 1,420   $ 2,340   $ 2,660  
(Continued)

2

WASHINGTON BANKING COMPANY
AND SUBSIDIARIES
Condensed Consolidated Statements of Income
Three and Six months ended June 30, 2004 and 2003 (unaudited)
(Dollars in thousands, except per share data)

Three Months Ended
June 30		 Six Months Ended
June 30
2004
2003
2004
2003
   
Net income per share, basic    
     Continuing operations     $ 0.28   $ 0.27   $ 0.50   $ 0.51  
     Discontinued operations       (0.05 )   —     (0.07 )   (0.01 )
     Net Income     $ 0.23   $ 0.27   $ 0.43   $ 0.50  
Net income per share, diluted    
     Continuing operations     $ 0.27   $ 0.26   $ 0.48   $ 0.50  
     Discontinued operations       (0.05 )   —     (0.06 )   (0.02 )
     Net Income     $ 0.22   $ 0.26   $ 0.42   $ 0.48  
Average number of shares outstanding, basic       5,409,985     5,354,835     5,399,381     5,327,703  
Average number of shares outstanding, diluted       5,612,460     5,562,041     5,603,816     5,519,980  

See accompanying notes to condensed consolidated financial statements.

3

WASHINGTON BANKING COMPANY
AND SUBSIDIARIES
Condensed Consolidated Statements of Shareholders’ Equity
and Comprehensive Income
Six months ended June 30, 2004 and 2003 (unaudited)
(Dollars and shares in thousands, except per share data)

Common stock
Retained Accumulated
other
comprehensive
income		 Total
shareholders’
Shares
Amount
earnings
(loss), net
equity
Balances at December 31, 2002     4,541     $ 21,025   $ 18,363   $ 44   $ 39,432  
Comprehensive income:    
    Net income     —       —     2,660     —     2,660  
    Net change in unrealized gain (loss) on    
     securities available for sale, net of tax of $1     —       —     —     (2 )   (2 )
      Total comprehensive income (1)               2,658  
Cash dividend, $0.12 per share     —       —     (651 )   —     (651 )
Stock option compensation     —       11     —     —     11  
Stock options exercised     115       311     —     —     311  
Balances at June 30, 2003     4,656     $ 21,347   $ 20,372   $ 42   $ 41,761  
 
Balances at December 31, 2003     5,358     $ 31,125   $ 13,273   $ (38 ) $ 44,360  
Comprehensive income:    
    Net income     —       —     2,340     —     2,340  
    Net change in unrealized gain (loss) on    
     securities available for sale, net of tax of $(84)     —       —     —     141     141  
      Total comprehensive income (1)               2,481
Cash dividend, $0.145 per share     —       —     (735 )   —     (735 )
Stock option compensation     —       11     —     —     11  
Stock options exercised     52       155     —     —     155  
Balances at June 30, 2004     5,410     $ 31,291   $ 14,878   $ 103   $ 46,272  

(1)     Comprehensive income for the three months ended June 30, 2004 and 2003 was $1,289 and $1,415, respectively.

See accompanying notes to condensed consolidated financial statements.

4

WASHINGTON BANKING COMPANY
AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows
Six months ended June 30, 2004 and 2003 (unaudited)
(Dollars in thousands)

Six Months Ended June 30
2004
2003
Cash flows from operating activities:            
     Net income from continuing operations     $ 2,710   $ 2,741  
     Adjustments to reconcile net income to net cash    
       provided by operating activities:    
         Federal Home Loan Bank stock dividends       (45 )   (64 )
         Deferred income tax benefit       (3 )   (3 )
         Amortization of investment premiums, net       17     40  
         Net increase in subsidiary investment       (313 )   —  
         Earnings on bank owned life insurance       (10 )   —  
         Provision for loan losses       1,600     1,600  
         Net increase in loans held for sale       (7,608 )   (29,581 )
         Depreciation of premises and equipment       892     758  
         Net gain on sale of securities       (144 )   —  
         Net loss on sale of other real estate and premises and equipment       192     17  
         Net (increase) decrease in other assets       423     (1,095 )
         Stock option compensation       11     11  
         Net decrease in other liabilities       (704 )   (388 )
             Net cash used in continuing operating activities       (2,982 )   (25,964 )
     Net loss from discontinued operations       (370 )   (81 )
             Net cash used in operating activities       (3,352 )   (26,045 )
Cash flows from investing activities:    
     Purchases of investment securities available for sale       —     (4,000 )
     Maturities/calls of investment securities available for sale       4,855     3,500  
     Principal payments on mortgage-backed securities       130     1,674  
     Sale of investment securities, available for sale       5,799     —  
     Maturities/calls of investment securities held to maturity       475     875  
     Purchase of bank-owned life insurance       (10,000 )   —  
     Net increase in loans       (41,225 )   (35,957 )
     Purchases of premises and equipment       (1,811 )   (1,680 )
     Proceeds from the sale of other real estate owned and premises and    
         equipment       141     274  
             Net cash used in investing activities       (41,636 )   (35,314 )
Cash flows from financing activities:    
     Net increase in deposits       56,515     36,099  
     Net decrease in other borrowed funds       (1,000 )   —  
     Net decrease in federal funds purchased       (5,000 )   —  
     Dividends paid on common stock       (735 )   (651 )
     Proceeds from stock options exercised       155     311  
             Net cash provided by financing activities       49,935     35,759  
             Net increase (decrease) in cash and cash equivalents       4,947     (25,600 )
Cash and cash equivalents at beginning of period       20,605     55,887  
Cash and cash equivalents at end of period     $ 25,552   $ 30,287  
(Continued)    

5

WASHINGTON BANKING COMPANY
AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows
Six months ended June 30, 2004 and 2003 (unaudited)
(Dollars in thousands)

Six Months Ended June 30
2004
2003
Supplemental information:    
     Loans foreclosed and transferred to other real estate owned     $ 18   $ 557  
     Loans made on bank-owned property sold       —     94  
     Cash paid for interest       4,204     4,740  
     Cash paid for taxes       1,499     1,440  
     Transfer of investments from HTM to AFS       14,260     —  

See accompanying notes to condensed consolidated financial statements.

6

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six months ended June 30, 2004 and 2003 (unaudited)
(Dollars in thousands, except per share data)

(1) Description of Business and Summary of Significant Accounting Policies

(a)         Description of Business

Washington Banking Company (“WBCO”) is a registered bank holding company formed on April 30, 1996. At June 30, 2004, WBCO had two wholly-owned subsidiaries – Whidbey Island Bank (“WIB” or the “Bank”), the Company’s principal subsidiary and Washington Banking Capital Trust I (the “Trust”). On May 26, 2004, WBCO announced plans to close its wholesale lending subsidiary, Washington Funding Group, Inc. (“WFG”) effective June 30, 2004. WFG was formed in January 2003 for the purpose of expanding the Bank’s wholesale mortgage real estate lending platform. During the second quarter of 2004, the Company decided to concentrate corporate resources toward the Bank’s retail operations and close WFG’s operations. Although the wholesale business enhanced the Company’s noninterest income during 2003, the operation of those offices did not provide a satisfactory financial return.

The business of the Bank, WBCO’s principal subsidiary, which is focused in the northern area of Western Washington, consists primarily of attracting deposits from the general public and originating loans. Although the Bank has a diversified loan portfolio, a substantial portion of its borrowers’ ability to repay their loans is dependent upon the economic conditions affecting this area.

The Trust, the second subsidiary of WBCO, was formed in June 2002 for the exclusive purpose of issuing trust preferred securities and common securities and using the $15,000 in proceeds from the issuance to acquire junior subordinated debentures issued by WBCO.

The Company’s website address is www.wibank.com. Exchange Act reports are available free of charge from the Company’s website. The reports can also be obtained through the Securities and Exchange Commission’s (the “SEC”) EDGAR database at http://www.sec.gov. The contents of the Company’s Internet website are not incorporated into this report or into any other communication delivered to security holders or furnished to the SEC.

(b)         Basis of Presentation

The accompanying interim condensed consolidated financial statements include the accounts of WBCO and two of its subsidiaries, WIB and WFG, (together, the “Company”). The accompanying interim condensed consolidated financial statements have been prepared, without audit, pursuant to the rules and regulations of the SEC. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. These condensed consolidated financial statements should be read in conjunction with the December 31, 2003 audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K filed with the SEC on March 24, 2004. In management’s opinion, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the six months ended June 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. In preparing the consolidated financial statements, estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses are required. Actual results could differ from those estimates.

(c)         Segments

Pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 131, Disclosure about Segments of an Enterprise and Related Information, the Company has evaluated the requirements of this standard and had identified two reportable segments: Whidbey Island Bank and the discontinued operations of Washington Funding Group, Inc., both wholly-owned subsidiaries of Washington Banking Company. Due to the discontinuation of WFG in the second quarter of 2004, the Company currently has only one segment, Whidbey Island Bank and is not required to disclose segment reporting by this standard.

7

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six months ended June 30, 2004 and 2003 (unaudited)
(Dollars in thousands, except per share data)

(d)         Reclassifications

Certain amounts in prior year’s financial statements may have been reclassified to conform to the 2004 presentation.

(e)         Recent Financial Accounting Pronouncements

In January 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46, Consolidation of Variable Interest Entities, which was replaced by FASB Interpretation No. 46R (“FIN 46R”) in December 2003. FIN 46R became effective in the first quarter of 2004 and defined a variable interest entity (“VIE”) as a corporation, partnership, trust, or any other legal structure used for the business purpose that either does not have equity investors with voting rights or has equity investors that do not provide sufficient financial resources for the entity to support its activities. This interpretation requires a VIE to be consolidated or deconsolidated by a company generally based on the risk of loss or return. Most of the original provisions of Interpretation No. 46 were delayed until March 31, 2004 through the issuance of FIN 46R. The Company has a VIE in the form of a trust set up to issue trust preferred securities and accordingly, the implementation of FIN 46R required the deconsolidation of the Trust. The Company’s adoption of FIN 46R did not have a material impact on the Company’s financial position and results of operations. The restatement of prior years financial statements was not required by FIN 46R and the Company did not restate the prior year’s financial statements.

(2) Earnings Per Share

The following table reconciles the denominator of the basic and diluted earnings per share computation.

Three Months Ended
June 30		 Six Months Ended
June 30
2004
2003
2004
2003
Weighted average shares-basic       5,409,985     5,354,835     5,399,381     5,327,703  
Effect of dilutive securities: stock options       202,475     207,206     204,435     192,277  
Weighted average shares-diluted       5,612,460     5,562,041     5,603,816     5,519,980  

On February 26, 2004, the Company issued a 15% stock dividend to shareholders of record as of February 10, 2004. On October 24, 2002, the Company issued a 10% stock dividend to shareholders of record as of October 8, 2002. All periods presented have been restated to reflect the stock dividends. At June 30, 2004 and 2003, there were options to purchase 364,124 and 419,507 shares of common stock outstanding, respectively. For the three and six months ended June 30, 2004 and 2003 no shares were antidilutive and therefore all were included in the computation of diluted net income per share.

(3) Trust Preferred Securities

Washington Capital Trust I (the “Trust”), a wholly-owned subsidiary of WBCO, is a statutory business trust created for the exclusive purposes of issuing and selling capital securities and utilizing sale proceeds to acquire junior subordinated debt issued to WBCO. On June 27, 2002, the Trust issued $15,000 of trust preferred securities with a 30-year maturity, callable after the fifth year by Washington Banking Company. The rate adjusts quarterly based on LIBOR plus 3.65%. These securities, within certain limitations, are considered Tier I capital for the purposes of regulatory capital requirements. Accordingly, the junior subordinated debentures are the sole assets of the Trust, and payments under the junior subordinated debentures will be the sole revenues of the Trust. All of the common securities of the Trust are owned by WBCO. Washington Banking Company has fully and unconditionally guaranteed the capital securities along with all obligations of the Trust under the trust agreements. Prior to FIN 46R, the Trust was a consolidated subsidiary of the Company. As a result of the adoption of FIN 46R, the Company deconsolidated the special purpose trust, as the Company is not considered to be the primary beneficiary under this accounting standard. Accordingly, on the Company’s Consolidated Statements of Financial Condition, the trust preferred securities that were issued by the Trust have been replaced by the junior subordinated debentures issued to the Trust by WBCO.

8

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six months ended June 30, 2004 and 2003 (unaudited)
(Dollars in thousands, except per share data)

The following table sets forth the financial data pertaining to the previously consolidated special purpose trust:

Name of trust
Aggregate
liquidation
amount of trust
preferred securities
Aggregate
liquidation
amount of
common securities
Aggregate
principal
amount of notes
Stated
maturity of notes
Per annum
interest rate
of notes
Redemption
option
Washington Banking                       On or after  
Capital Trust I     $ 15,000   $ 464   $ 15,464     2032     4.78 %   June 27, 2007  

(4) Stock-Based Compensation

The Company recognizes the financial effects of stock-based employee compensation based on the intrinsic value method of accounting prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”) and FASB Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation (“FIN 44”). Generally, stock options are issued at a price equal to the fair value of the Company’s stock as of the grant date. Under APB 25, options issued in this manner do not result in the recognition of employee compensation in the Company’s financial statements. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value provisions of FASB SFAS 123, Accounting for Stock-Based Compensation.

The following table sets forth the reconciliation of pro forma net income and pro forma earnings per share:

Three Months Ended
June 30		 Six Months Ended
June 30
2004
2003
2004
2003
Net income, as reported     $ 1,245   $  1,420    $ 2,340   $ 2,660  
Stock compensation recognized       6    5     11     11  
Additional compensation for    
     fair value of stock options       (22 )  (22 )    (44 )   (44 )
Pro forma net income     $ 1,229   $  1,403    $ 2,307   $ 2,627  
Basic earnings per share:    
     As reported    
Income from continuing operations     $ 0.28 $  0.27   $ 0.50 $ 0.51
Income (loss) from discontinued operations       (0.05 )    —     (0.07 )   (0.01 )
Net Income     $ 0.23 $  0.27   $ 0.43 $ 0.50
     Pro forma    
Income from continuing operations     $ 0.28 $  0.26   $ 0.50 $ 0.50
Income (loss) from discontinued operations       (0.05 )    —     (0.07 )   (0.01 )
Net Income     $ 0.23 $  0.26   $ 0.43 $ 0.49
Diluted earnings per share:    
     As reported    
Income from continuing operations     $ 0.27 $  0.26   $ 0.48 $ 0.50
Income (loss) from discontinued operations       (0.05 )    —     (0.06 )   (0.02 )
Net Income     $ 0.22 $  0.26   $ 0.42 $ 0.48
     Pro forma    
Income from continuing operations     $ 0.27 $  0.25   $ 0.47 $ 0.50
Income (loss) from discontinued operations       (0.05 )    —     (0.06 )   (0.02 )
Net Income     $ 0.22 $  0.25   $ 0.41 $ 0.48

9

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six months ended June 30, 2004 and 2003 (unaudited)
(Dollars in thousands, except per share data)

(5) Subsequent Event

On July 15, 2004, the Board of Directors declared a cash dividend of $0.0725 per share to shareholders of record as of August 10, 2004, which is payable on August 25, 2004.

(6) Commitments

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing and similar transactions. Except for certain long-term guarantees, most guarantees expire in one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral supporting those commitments, for which collateral is deemed necessary, generally amounts to one hundred percent of the commitment amount at June 30, 2004. The Company routinely charges a fee for these credit facilities. Such fees are amortized into income over the life of the agreement, and unamortized amounts are not significant as of June 30, 2004.

As of June 30, 2004 the commitments under these agreements were as follows:

  Standby letters of credit and financial guarantees $245

At June 30, 2004, the Company is the guarantor of trust preferred securities. The Company has issued subordinated debentures to a wholly-owned special purpose trust, which has issued trust preferred securities. The sole assets of the special purpose trust are the subordinated debentures issued by the Company. Washington Banking Company has fully and unconditionally guaranteed the capital securities along with all obligations of the Trust under the trust agreements. The maximum amount of future payments the Company will be required to make under these agreements is the principal and interest of the trust preferred securities, the principal of which totaled $15,000 at June 30, 2004.

(7) Closing of Subsidiary

The Company closed its Washington Funding Group, Inc. (“WFG”) subsidiary effective June 30, 2004. The subsidiary provided a loan funding source for mortgage loan brokers, primarily in Washington, Oregon and Idaho. Business in process was transferred to the Bank’s Burlington, WA office.

WFG was formed in January 2003 and began operations in April 2003 as a way to expand services and grow revenues. It provided a loan funding source for mortgage brokers. While gain on sale of loans increased, WFG continued to have a negative impact on WBCO’s earnings in spite of efforts to improve WFG’s performance. Whidbey Island Bank will continue to offer retail mortgages and wholesale mortgage funding to brokers as it did before the funding group was established.

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

Note Regarding Forward-Looking Statements: This Form 10-Q includes forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). These forward-looking statements describe Washington Banking Company’s (the “Company”) management’s expectations regarding future events and developments such as future operating results, growth in loans and deposits, continued success of the Company’s business plan and the strength of the local economy. The words “will,” “believe,” “expect,” “should,” “anticipate” and words of similar construction are intended in part to help identify forward-looking statements. Future events are difficult to predict, and the expectations described below are necessarily subject to risk and uncertainty that may cause actual results to differ materially and adversely. In addition to discussions about risks and uncertainties set forth from time to time in the Company’s filings with the Securities and Exchange Commission (the “SEC”), factors that may cause actual results to differ materially from those contemplated in such forward-looking statements include, among others, the following possibilities: (1) local and national general and economic conditions, including the possible impact of international conflict or further terrorist events, are less favorable than expected or have a more direct and pronounced effect than expected on the Company and adversely affect the Company’s ability to continue its internal growth at historical rates and maintain the quality of its earning assets; (2) changes in interest rates reduce interest margins more than expected or negatively affect liquidity; (3) projected business increases following strategic expansion or the opening or acquisition of new branches are lower than expected; (4) there are greater than expected costs or difficulties related to the integration of acquisitions; (5) there is increased competitive pressure among financial institutions; (6) legislation or regulatory requirements or changes that adversely affect the banking and financial services sector; and (7) the Company is unable to realize the efficiencies it expects to derive from its investment in personnel and infrastructure. However, you should be aware that these factors are not an exhaustive list, and you should not assume that these are the only factors that may cause actual results to differ from expectations. In addition, you should note that we do not intend to update any of the forward-looking statements or the uncertainties that may adversely impact those statements.

The following discussion and analysis should be read in conjunction with the financial statements and notes thereto presented elsewhere in this report.

Overview

Washington Banking Company (“WBCO” or the “Company”) is a registered bank holding company with two wholly-owned subsidiaries: Whidbey Island Bank (the “Bank” or “WIB”) and Washington Banking Capital Trust I (the “Trust”); and one discontinued subsidiary, Washington Funding Group, Inc. (“WFG”). The Company’s principal subsidiary, the Bank, is a Washington state-chartered bank that conducts a full-service community commercial banking business. Its business includes commercial, real estate and construction loan portfolios, and it is active in the consumer banking field, providing personal and consumer-oriented loan programs. The Bank also provides a wide range of deposit services, insured by the Federal Deposit Insurance Corporation (the “FDIC”), for individuals and businesses including checking and savings accounts as well as money market accounts, certificates of deposit, individual retirement accounts, safe deposit boxes and other consumer and business related financial services. The Bank also offers nondeposit managed investment portfolios, which are not FDIC insured, through the investment advisory company Elliott Cove Capital Management LLC. Several Whidbey Island Bank employees have been registered in Washington State as investment advisor representatives. These employees work with individuals, companies and institutions to help them determine their risk preferences and select a portfolio. Prior to the Bank’s affiliation with Elliott Cove, non-FDIC insured investment products were offered through the Bank’s wholly-owned subsidiary, WIB Financial Services, Inc. Another nondeposit product offered through WIB, which is not FDIC insured, is a sweep investment option available through a brokerage account.

The Bank’s primary market area is located in northwestern Washington State between Seattle and the Canadian border. Its geographical expansion to date has been concentrated along the I-5 corridor from Snohomish to Whatcom counties, however, additional areas will be considered if they meet the Company’s criteria.

The Trust was formed in June 2002 for the exclusive purpose of issuing trust preferred securities to acquire junior subordinated debentures issued by the Company. Those debentures are the sole assets of the Trust and payments on the debt will be the sole revenues of the Trust. The Company has fully and unconditionally guaranteed all obligations of the Trust.

11

WFG, a wholesale mortgage real estate lending company, was a Washington State corporation formed in January 2003. The primary purpose of this subsidiary was to provide a loan funding source for brokers of mortgage loans. The loans were originated and sold in the name of the Bank. During the second quarter of 2004, the Company decided to concentrate corporate resources toward the Bank’s retail operations and close WFG’s wholesale lending operations. Although the wholesale business enhanced the Company’s noninterest income during 2003, the operation of those offices did not provide a satisfactory financial return.

Headquartered in Oak Harbor, the Company’s market area is primarily northwestern Washington. The market area encompasses distinct economies, and none are particularly dependent upon a single industrial or occupational source. The economies within the market areas have evolved from being heavily dependent upon forestry, fishing and farming to a more diverse blend of industries including retail trade, services, manufacturing, tourism and a large military presence. Unemployment levels in the Pacific Northwest over the past few years have been higher than national averages, but the region appears to be showing signs of a slow, but steady economic recovery.

The Company’s strategy is one of value-added growth. Management believes that qualitative and sustainable growth of the Company, coupled with maintaining profitability, is currently the most appropriate path to providing good value for its shareholders. To date, the Company’s growth has been achieved organically and it attributes its reputation for focusing on customer service and satisfaction as one of the cornerstones to the Company’s success. Acquisition of banks or branches may also be used as a means of expansion if appropriate opportunities are presented. Management recognizes that growth requires expenditures of substantial sums to purchase or lease real property and equipment and to hire experienced personnel, and that earnings may be negatively affected. The Company’s primary long-term objectives are to improve profitability and operating efficiencies, to increase market penetration in areas currently served and to continue an expansion strategy in appropriate market areas.

Financial Condition

Total Assets. Total assets grew to $633.5 million at June 30, 2004 from $581.7 million at December 31, 2003, an increase of 8.9%. This increase resulted mainly from growth in the loan portfolio and the investment in bank owned life insurance, which was funded by deposit growth and the sale of investment securities.

Total Loans. Total loans were $556.2 million at June 30, 2004, an increase of 9.5% from $508.2 million at December 31, 2003. The Company increased its allowance for loan losses to $6.9 million at June 30, 2004 representing 1.28% of loans (excluding loans held for sale), from $6.1 million or 1.22% of loans (excluding loans held for sale) at December 31, 2003. The allowance was increased to keep pace with loan growth and prospective losses inherent in the loan portfolio, while remaining conservative and maintaining adequate coverage.

Total Investment Securities. Total investment securities were $19.3 million and $30.2 million at June 30, 2004 and December 31, 2003, respectively. The decrease of 36.2% was a result of the sale and maturity of available-for-sale investment securities that were not replaced due to the low rate environment coupled with an anticipated increase in loan demand and purchase of bank owned life insurance (“BOLI”).

Premises and Equipment. Premises and equipment, net of depreciation, were $20.5 million at June 30, 2004 and $19.8 million on December 31, 2003. The Company purchased a building located in Oak Harbor, WA for the purpose of consolidating its back room operating functions. The Company is in the process of selling the Oak Harbor property that was previously used as an operations center. The Company has continued its expansion strategy by opening a new grocery store branch in Arlington, WA; and by leasing space for a future branch site in Friday Harbor, WA; and additional office space in Bellingham, WA.

Deposits.     Deposits grew 11.3% to $558.0 million at June 30, 2004 from $501.5 million at December 31, 2003. Management’s philosophy is to develop long-term customer relationships. Management believes that the best way to establish customer loyalty is by placing an emphasis on meeting customers’ financial needs and providing exceptional service. Management attributes the Company’s successful deposit growth to its continuing deposit promotions, cross-sales efforts, strategic planning and other means. In addition, many customers continue to seek the security of FDIC-insured deposit vehicles in contrast to the potential volatility of the investment market.

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At June 30, 2004, average noninterest-bearing deposits increased 23.2% from June 30, 2003, while average interest-bearing deposits increased 12.3% for the same period. Average interest demand and money market deposits represented 45.00% of total average interest-bearing deposits at June 30, 2004 compared to 45.09% a year ago.

Average savings deposits and average CDs represented 9.63% and 45.37%, respectively, of total average interest-bearing deposits at June 30, 2004 compared to 8.28% and 46.63%, respectively, a year ago. All deposit product averages increased during the second quarter of 2004 as management focused on establishing customer relationships and attracting deposits.

Shareholders’ Equity. The Company’s shareholders’ equity increased 4.3% to $46.3 million at June 30, 2004 from $44.4 million at December 31, 2003. The increase reflects earnings, proceeds from stock options exercised, stock option compensation and an increase in unrealized gain on available-for-sale securities, net of tax, offset by the payment of cash dividends during the first six months of 2004.

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Consolidated Average Balance Sheet and Analysis of Net Interest Income and Expense

The following table sets forth the Company’s consolidated average balance sheet and analysis of net interest income and expense:

Three Months Ended June 30, 2004 Three Months Ended June 30, 2003
(Dollars in thousands) Average
balance
Interest
earned/paid
Average
yield (1)
Average
balance
Interest
earned/paid
Average
yield (1)
           Assets                            
Loans (2)     $ 545,394   $ 9,258     6.79 % $ 469,568 $  8,824     7.52 %
Federal funds sold       9,029     22     0.97 %   15,324     43     1.12 %
Interest-earning cash       667     1     0.60 %   11,037     27     0.98 %
Investments:    
     Taxable       13,799     108     3.13 %   10,508     94     3.58 %
     Non-taxable (3)       12,501     186     5.95 %   14,211     222     6.25 %
Interest-earning assets       581,390     9,575     6.59 %   520,648     9,210     7.08 %
Noninterest-earning assets       42,225             36,115          
    
   
     Total assets     $ 623,615           $ 556,763          
    
   
       Liabilities and    
    Shareholders’ equity    
Deposits:    
     Interest demand and    
      money market     $ 210,606   $ 393     0.75 %  $ 187,958 $  420     0.89 %
     Savings       45,075     88     0.78 %   34,519     72     0.83 %
     CDs       212,380     1,413     2.66 %   194,359     1,413     2.91 %
Interest-bearing deposits       468,061     1,894     1.62 %   416,836     1,905     1.83 %
Federal funds purchased       1,571     4     1.02 %   —     —      —
Junior subordinated debentures       15,007     184     4.90 %   —     —      —  
Trust preferred securities       —     —     —     15,000     189     5.04 %
Other interest-bearing liabilites       8,958     97     4.33 %   15,114     154     4.08 %
Interest-bearing liabilities       493,597     2,179     1.77 %   446,950     2,248     2.01 %
Noninterest-bearing deposits       81,561             66,196          
Other noninterest-bearing liabilities       2,976             2,676          
Total liabilities       578,134             515,822          
Shareholders’ equity       45,481             40,941          
     Total liabilities and    
       shareholders’ equity     $ 623,615           $ 556,763          
Net interest income (3)         $ 7,396           $ 6,962      
Net interest spread (1)               4.82 %           5.07 %
Net interest margin (1)               5.09 %           5.35 %

(1) Annualized

(2) Includes loan fees of $338 and $387 for the three months ended June 30, 2004 and 2003, respectively.

(3) Interest income on non-taxable investments is presented on a fully taxable-equivalent basis using the federal statutory rate of 34%. These adjustments were $47 and $56 for the three months ended June 30, 2004 and 2003, respectively.

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Results of Operations

The Company’s results of operations are dependent to a large degree on net interest income. Interest income and cost of funds are affected significantly by general economic conditions, particularly changes in market interest rates, and by government policies and the actions of regulatory authorities. The Company generates noninterest income generally through service charges and fees, gain on sale of loans and other sources. The Company’s noninterest expenses consist primarily of compensation and employee benefit expense, and occupancy expense.

Net Income. Net income for the second quarter of 2004 decreased 12.3% to $1.2 million or $0.22 per diluted share as compared to the second quarter of 2003. Net income for the six months ended June 30, 2004 decreased 12.0% to $2.3 million, or $0.42 per diluted share, from $2.7 million, or $0.48 per diluted share, for the six months ended June 30, 2003. The decrease was due largely to the increase in noninterest expense, the reduction in gain on sale of loans, and the operating losses and costs associated with closing the Washington Funding Group, Inc. subsidiary.

Income from continuing operations for the second quarter of 2004 increased 3.3% to $1.5 million from $1.4 million for the second quarter of 2003. The Company’s loss from discontinued operations for the second quarter of 2004 increased to a loss of $247,000 from a loss of $24,000 for the second quarter of 2003. The major portion of this loss was attributable to the costs of closing the operations of WFG.

Income from continuing operations for the six months ended June 30, 2004 and 2003 remained level at $2.7 million for both periods. The Company’s loss from discontinued operations for the six month period in 2004 increased to a loss of $370,000 from a loss of $81,000 for the like period one year ago.

Net Interest Income. Net interest income for the second quarter of 2004 increased 6.4% to $7.3 million from $6.9 million for the second quarter of 2003. For the first six months of 2004, net interest income increased 7.3% to $14.4 million from $13.4 million for the like period in 2003. The increase is largely due to interest income from increased average loan volume, combined with a decrease in the cost of funds.

Average interest-earning assets for the second quarter increased to $581.4 million at June 30, 2004, compared to $520.6 million at June 30, 2003, a growth of 11.7%, while the average yield on interest-earning assets decreased to 6.59% compared to 7.08% in second quarter of the prior year. The average yield on loans decreased to 6.79% for the quarter ended June 30, 2004 from 7.52% for the second quarter of 2003.

The average cost of interest-bearing liabilities decreased in the second quarter of 2004 to 1.77% from 2.01% for the quarter ended June 30, 2003. Average interest-bearing liabilities for the quarter increased to $493.6 million at June 30, 2004 compared to $447.0 million a year ago, a growth of 10.4%.

The overall result of these changes was a decrease in the net interest spread to 4.82% for the quarter ended June 30, 2004 from 5.07% for the quarter ended June 30, 2003. Net interest margin (net interest income divided by average interest-earning assets) decreased to 5.09% in the second quarter of 2004 from 5.35% in the second quarter of 2003.

Noninterest Income. Noninterest income increased $264,000, or 20.3%, in the second quarter of 2004 compared to the like period in 2003. For the first six months of 2004, noninterest income increased $297,000, or 11.5% compared to the like period a year ago. This increase was primarily due to an increase in service charges and fees on deposits in association with the Bank’s new overdraft product, Whidbey Overdraft Coverage and a gain on sale of securities offset by a decrease in gain on sale of loans.

In the past, selling single-family residential loans to the secondary market contributed significantly to the noninterest income, but slowing of mortgage activity caused a decrease in income from the gain on sale of loans.

Noninterest Expense. Noninterest expense increased $760,000 in the second quarter of 2004, or 14.8% from a year ago. Three major components of noninterest expense — employee compensation, occupancy and other noninterest expense — increased 13.5%, 13.3% and 20.1%, respectively, for the quarter compared with the like period in 2003.

For the first six months of 2004, noninterest expense rose to $11.6 million from $10.2 million one year ago, a 13.7% increase. Employee compensation, occupancy and other noninterest expense increased 14.4%, 14.7% and 12.0%, respectively, compared with the like period in 2003.

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The Company experienced a cost increase in employee benefits. Additionally, increased costs associated with insurance, operating fees and advertising have contributed to other noninterest expense, primarily as a result of the expansion of the Company. With the purchase of an office building on Oak Harbor, WA to consolidate back office operations into one building, the Company expects to improve operating efficiencies.

The efficiency ratio (noninterest expense divided by the sum of net interest income plus noninterest income less non-recurring gains) was 66.25% for the second quarter 2004 compared to 62.69% for the like period in 2003. For the first six months of 2004 and 2003, the efficiency ratio was 67.18% and 63.78%, respectively.

Income Taxes. For the second quarters of 2004 and 2003, the Company recorded an income tax provision of $742,000 and $781,000, respectively. For the first six months of 2004 and 2003, the Company recorded income tax provisions of $1.4 million and $1.5 million, respectively. The overall effective tax rate was approximately 33% and 35% for the three months ended June 30, 2004 and 2003, respectively. For the six months ended June 30, 2004 and 2003, the overall effective tax rate was approximately 33% and 35%, respectively.

The results from discontinued operations disclosed on the consolidated statement of income are net of tax.

Lending Activities

Loan Portfolio Composition. The Company originates a wide variety of loans including commercial, real estate and consumer loans. The following table sets forth the Company’s loan portfolio composition by type of loan:

June 30, 2004
December 31, 2003
(Dollars in thousands) Balance
% of total
Balance
% of total
Commercial     $ 84,098     15.1 % $ 87,371     17.2 %
Real estate mortgages:    
  1 – 4 Family residential       42,994     7.7 %   43,460     8.5 %
  Commercial       159,344     28.7 %   133,539     26.3 %
     Total real estate mortgages       202,338     36.4 %   176,999     34.8 %
Real estate construction       87,611     15.8 %   70,974     14.0 %
Consumer       181,717     32.7 %   172,406     34.0 %
  Subtotal       555,764     100.0 %   507,750     100.0 %
Less: allowance for loan losses       (6,926 )       (6,116 )    
Deferred loan fees, net       431         420      
Loans, net     $ 549,269       $ 502,054      
 
 

Total loans, net, were $549.3 million at June 30, 2004, representing a 9.4% increase from year-end 2003. The majority of the increase was in real estate mortgage and real estate construction loans, which increased 14.3% and 23.4%, respectively, at June 30, 2004 from year-end 2003. Included in real estate mortgages are loans originated and held for sale on the secondary market. At June 30, 2004, loans held for sale were $15.9 million as compared to $8.3 million at December 31, 2003, an increase of 92.2%. The Company has $10.0 million of indirect consumer loans in loans held for sale as of June 30, 2004. Due to the liability sensitivity of our balance sheet, the Company opted to sell these fixed rate loans without recourse to increase liquidity for core lending activity. WBCO plans on selling the loans by the end of the third quarter. Of the remaining loans held for sale, $2.8 million were originated by WFG and $3.1 million were originated by the Bank’s retail real estate division, compared to $3.8 million originated by WFG and $4.5 million originated from the Bank’s retail real estate division at December 31, 2003. The majority of the increase in real estate construction loans was due to residential construction, residential land development projects and a few large commercial construction loans.

16

The Company makes automobile and recreational vehicle loans for new and used vehicles originated indirectly by selected automobile dealers located in the Company’s market areas. Indirect loans were $109.0 million, or 60.00% of the consumer loan portfolio and 19.60% of the total loan portfolio at June 30, 2004. At December 31, 2003, indirect loans were $105.6 million, or 61.27% of the consumer loan portfolio and 20.79% of the total loan portfolio.

Nonperforming Assets. The following table sets forth an analysis of the composition of the Company's nonperforming assets:

(Dollars in thousands) June 30, 2004
December 31, 2003
Nonaccrual loans     $ 4,829   $ 4,158      
Restructured loans    

—

  

—
    Total nonperforming loans       4,829     4,158  
Other real estate owned       426     504  
    Total nonperforming assets     $ 5,255   $ 4,662  
Impaired loans     $ —   $ 2,563  
Accruing loans past due > 90 days    

—

  

—

Potential problem loans       120     314  
Allowance for loan losses       6,926     6,116  
Nonperforming loans to loans (1)       0.89 %   0.83 %
Allowance for loan losses to loans (1)       1.28 %   1.22 %
Allowance for loan losses to nonperforming loans       143.43 %   147.09 %
Nonperforming assets to total assets       0.83 %   0.80 %

(1)     Excludes loans held for sale

Nonperforming loans increased to $4.8 million, or 0.89% of loans (excluding loans held for sale), at June 30, 2004 from $4.2 million, or 0.83% of loans (excluding loans held for sale), at December 31, 2003. The current allowance for loan losses of $6.9 million represents 143.43% of nonperforming loans as compared to 147.09% of nonperforming loans at December 31, 2003. The allowance for loan losses is 1.28% of loans (excluding loans held for sale) at June 30, 2004 as compared to 1.22% at December 31, 2003. A loan in the amount of $2.6 million listed as impaired since December 2003 has been removed from impaired status. The balance has been significantly reduced and the credit is performing. Due to subsequent events since quarter end, nonaccraul loans have been reduced by $1.2 million from $4.8million to $3.6 million as of the date of this report.

Provision and Allowance for Loan Losses. The Company recorded a $775,000 provision for loan losses for the second quarter of 2004, compared with $837,000 for the like period a year ago. Net loan charge-offs were $329,000, representing 0.06% of average loans (excluding loans held for sale), for the second quarter of 2004, compared with $765,000, or 0.17% of average loans (excluding loans held for sale), for the like period last year.

For the six months ended June 30, 2004 and 2003, the Company recorded a $1.6 million provision for loan losses in both periods. The Company recorded $790,000 in net loan charge-offs, representing 0.15% of average loans (excluding loans held for sale) during the first six months of 2004, compared with $1.2 million or 0.26% for the like period in 2003.

Indirect loans may involve greater risk than other consumer loans, including direct automobile loans, due to the nature of third-party transactions. To mitigate these risks, the Company limits its indirect automobile loan purchases primarily to dealerships that are established and well known in their market areas and to applicants that are not classified as sub-prime. In addition, the Company has increased its oversight of the approval process and uses a loan grading system, which limits the risks inherent in dealer originated loans.

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The following table sets forth an analysis of the Company’s indirect and other net charge-offs to average loans:

Three Months Ended
June 30		 Six Months Ended
June 30
(Dollars in thousands) 2004
2003
2004
2003
Indirect net charge-offs     $ (244 ) $ (252 ) $ (534 ) $ (448 )
Other net charge-offs       (85 )   (513 )   (256 )   (719 )
     Total net charge-offs     $ (329 ) $ (765 ) $ (790 ) $ (1,167 )
Average indirect loans     $ 107,454   $ 101,531   $ 106,846   $ 99,074  
Average other loans (1)       426,962     350,497     414,207     345,115  
     Total average loans (1)     $ 534,416   $ 452,028   $ 521,053   $ 444,189  
Indirect net charge-offs to average indirect loans       0.23 %   0.25 %   0.50 %   0.45 %
Other net charge-offs to average other loans (1)       0.02 %   0.15 %   0.06 %   0.21 %
Net charge-offs to average loans (1)       0.06 %   0.17 %   0.15 %   0.26 %

(1)     Excludes loans held for sale

Net loan charge-offs attributed to indirect loans were $244,000, representing 69.32% of net consumer charge-offs during the second quarter of 2004, compared to $252,000 or 92.65% of net consumer charge-offs for the like period in 2003. For the six months ended June 30, 2004, net charge-offs attributed to indirect dealer loans were $534,000, or 73.35% of net consumer charge-offs, as compared with $448,000, or 77.64%, for the like period in 2003.

The allowance for loan losses is maintained at a level considered adequate by management to provide for anticipated loan losses based on management’s assessment of various factors affecting the loan portfolio. This includes a review of problem loans, general business and economic conditions, seasoning of the loan portfolio, bank regulatory examination results and findings of internal credit examiners, loss experience and an overall evaluation of the quality of the underlying collateral. Management reviews the allowance quarterly. The allowance is increased by provisions charged to operations and reduced by loans charged off, net of recoveries.

The following table sets forth the changes in the Company’s allowance for loan losses. The provision is based on an evaluation of defined loan problems, historical ratios of loan losses and other factors that may affect future loan losses in the categories of loans shown:

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Three Months Ended
June 30		 Six Months Ended
June 30
(Dollars in thousands) 2004
2003
2004
2003
Balance at beginning of period     $ 6,480   $ 5,875   $ 6,116   $ 5,514  
Charge-offs:    
      Commercial       (67 )   (451 )   (198 )   (522 )
      Real estate       (23 )   (65 )   (23 )   (95 )
      Consumer       (411 )   (345 )   (943 )   (722 )
      Total charge-offs     $ (501 ) $ (861 ) $ (1,164 ) $ (1,339 )
Recoveries:    
      Commercial       97     23     141     27  
      Real estate       16     —     18     —  
      Consumer       59     73     215     145  
      Total recoveries     $ 172   $ 96   $ 374   $ 172  
Net charge-offs       (329 )   (765 )   (790 )   (1,167 )
Provision for loan losses       775     837     1,600     1,600  
Balance at end of period     $ 6,926   $ 5,947   $ 6,926   $ 5,947  

While management believes that it uses the best information available to determine the allowance for loan losses, unforeseen market conditions could result in adjustments to the allowance for loan losses, and net income could be significantly affected if circumstances differ substantially from the assumptions used in making the final determination. Management anticipates that normal growth of the loan portfolio may require continued increases in the allowance for loan losses.

Deposits

The Company provides an array of deposit services, including noninterest-bearing checking accounts, interest-bearing checking and savings accounts, money market accounts and certificates of deposit (“CDs”). These accounts generally earn interest at rates established by management based on competitive market factors and management’s desire to increase or decrease certain types or maturities of deposits. The Company does not pay brokerage commissions to attract deposits. It strives to establish customer relationships to attract core deposits in noninterest-bearing transactional accounts and thus reduce its costs of funds.

The following table sets forth the average balances outstanding and average interest rates for each major category of deposits:

Three Months Ended June 30
2004
2003
(Dollars in thousands) Average
balance
Average
rate
Average
balance
Average
rate
Interest-bearing demand and                    
   money market deposits     $ 210,606     0.75 % $  187,958     0.89 %
Savings deposits       45,075     0.78 %   34,519     0.83 %
CDs       212,380     2.66 %   194,359     2.91 %
     Total interest-bearing deposits       468,061     1.62 %   416,836     1.83 %
Demand and other    
   noninterest-bearing deposits       81,561           66,196        
     Total average deposits     $ 549,622         $ 483,032        

19

Average balances in noninterest-bearing deposits increased 23.2% in the second quarter of 2004 compared to the second quarter of 2003. For the same period, average balances in total interest-bearing deposits increased 12.3%, while the smallest portion of the increase was in the higher cost CDs.

Liquidity and Sources of Funds

Sources of Funds. The Company’s sources of funds are customer deposits, loan repayments, current earnings, cash and demand balances due from other banks, federal funds, short-term investments, investment securities available for sale and trust preferred securities. These funds are used for loan originations and deposit withdrawals, to satisfy other financial commitments and to support continuing operations. The Company relies primarily upon customer deposits and investments to provide liquidity. The Company will mainly use such funds to make loans and to purchase securities, the majority of which are issued by federal, state and local governments. Additional funds are available through established Federal Home Loan Bank (“FHLB”) and correspondent bank lines of credit, which the Company may use to supplement funding sources.

The Company’s strategy includes maintaining a “well-capitalized” status for regulatory purposes, while maintaining a favorable liquidity position and proper asset/liability mix. With this strategy in mind, management evaluated potential capital-raising alternatives such as trust preferred securities, issuance of common stock and other sources. Management determined that issuing trust preferred securities would be in the best interest of the Company and on June 27, 2002, the Trust issued $15.0 million of trust preferred securities. Trust preferred securities are held as debt for tax purposes, while the proceeds of the offering count as Tier I capital without increasing the shareholder base, and therefore not diluting earnings per share. Due to FIN 46R, the Trust was deconsolidated in current period financial statements.

Deposits.     Total deposits increased 11.3% to $558.0 million at June 30, 2004 from $501.5 million at December 31, 2003. Certificates of deposit are the only deposit group that has stated maturity dates. At June 30, 2004, the Company had $215.0 million in CDs, of which approximately $125.0 million, or 58.11%, are scheduled to mature within one year. Management anticipates that a sizable portion of outstanding CDs will renew upon maturity.

The Company has not accepted brokered deposits. It has made a concerted effort to attract deposits in the market area it serves through competitive pricing and delivery of quality service. Historically, the Company has been able to retain a considerable amount of its deposits as they mature.

Borrowings.     At June 30, 2004 the Company had a line of credit with the FHLB of $94.8 million, of which $7.5 million was advanced in short-term borrowings and $4.0 million in federal funds. The Company also had unused lines of credit with correspondent banks in the amount of $27.0 million at June 30, 2004.

Investments.     The Company’s total portfolio of investment securities decreased 36.2% to $19.3 million at June 30, 2004 from $30.2 million at December 31, 2003. The Company transferred its held-to-maturity municipal security portfolio of $14.3 million to available-for-sale investments. Available-for-sale investments are recorded at market value and this transfer caused an increase in accumulated other comprehensive income of $272,000. During the second quarter of 2004, $5.8 million were sold to help reposition the Company’s liability sensitive balance sheet against the anticipation of a rising rate environment. The investment portfolio consists of government agency securities, pass-through securities, corporate securities, municipal securities and preferred stock. No investment exceeds 10% of the shareholders’ equity.

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The following table summarizes the amortized cost, market value and recorded value of securities in the Company’s portfolio by contractual maturity groups:

June 30, 2004
(Dollars in thousands) Amortized cost
Market value
Recorded value
Amounts maturing:                
Within one year     $ 1,756   $ 1,785   $ 1,785  
One to five years       15,153     15,286     15,286  
Six to ten years       1,679     1,684     1,684  
Over ten years       504     504     504  
       Total     $ 19,092   $ 19,259   $ 19,259  

At June 30, 2004, the Company’s investment portfolio consisted of no held-to-maturity investments, as compared with $14.7 million, or 48.88% at December 31, 2003. Available-for-sale securities, which are carried at market value, were $19.3 million, or 100.0% of the investment portfolio as compared with $15.4 million, or 51.12% at December 31, 2003. In the second quarter of 2004, the Company changed the designation of the municipal securities from held-to-maturity to available-for-sale. For liquidity purposes, the Company’s future security purchases will primarily be designated as available-for-sale and will increase as a percent of total investment securities at market value.

During the second quarter of 2004, the Bank made a $10.0 million investment in bank owned life insurance (“BOLI”). These policies insure the lives of officers of the Bank, and names the Bank as beneficiary. Noninterest income is generated tax-free from the increase in the policies’ underlying investments made by the insurance company. WIB is capitalizing on the ability to partially offset costs associated with employee compensation and benefit programs with the BOLI.

Capital and Capital Ratios

The Company’s shareholders’ equity increased to $46.3 million at June 30, 2004 from $44.4 million at December 31, 2003. This increase is due to net income of $2.3 million, proceeds from stock options exercised in the amount of $155,000, stock option compensation of $11,000 and an increase in unrealized gain on available-for-sale securities (net of tax) of $141,000, offset by the payment of cash dividends of $735,000 during the first six months of 2004. Total assets increased to $633.5 million at June 30, 2004 from $581.7 million at December 31, 2003, an increase of 8.9%. Shareholders’ equity to total assets was 7.3% at June 30, 2004 compared to 7.6% at December 31, 2003.

Banking regulations require bank holding companies and banks to maintain a minimum leverage ratio of core capital to adjusted average total assets of at least 4%. In addition, banking regulators have adopted risk-based capital guidelines, under which risk percentages are assigned to various categories of assets and off-balance sheet items to calculate a risk-adjusted capital ratio. Tier I capital generally consists of common shareholders’ equity (which does not include unrealized gains and losses on securities), less goodwill and certain identifiable intangible assets, while Tier II capital includes the allowance for loan losses and subordinated debt, both subject to certain limitations.

The FDIC established the qualifications necessary to be classified as a “well-capitalized” bank, primarily for assignment of FDIC insurance premium rates. As the following table indicates, the Company (on a consolidated basis) and the Bank qualified as “well-capitalized” at June 30, 2004 and December 31, 2003:

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FDIC Requirements
Actual Ratios
Adequately-
capitalized
Well-
capitalized
June 30,
2004
December 31,
2003
Total risk-based capital ratio        
    Consolidated

8%

10%

 11.14% 12.01%
    Whidbey Island Bank

8%

10%

 10.83% 11.69%
Tier 1 risk-based capital ratio
    Consolidated

4%

6%

 10.01% 10.85%
    Whidbey Island Bank

4%

6%

 9.69% 10.56%
Leverage ratio
    Consolidated

4%

5%

 9.81% 10.17%
    Whidbey Island Bank

4%

5%

 9.50% 9.89%

There can be no assurance that additional capital will not be required in the near future due to greater-than-expected growth, unforeseen expenses or revenue shortfalls, or otherwise.

Capital Expenditures and Commitments

The Company purchased a building commonly known as the Bayshore building located in Oak Harbor, WA. The building was purchased as a new operations center to consolidate back office functions and improve efficiencies.

Significant Accounting Policies

See “Notes to Condensed Consolidated Financial Statements.”

Anticipated Future Performance

Future events are difficult to predict, and the expectations of management are necessarily subject to uncertainty and risk that may cause actual results to differ materially from those stated here. In making the following statements, management has made a number of assumptions including that: (1) the interest rate environment will gradually increase throughout the remainder of 2004, (2) the local economy will continue on a steady course of improvement, and (3) residential real estate loan volumes will decline from 2003.

WBCO expects to continue its growth strategy and expand its presence in the Pacific Northwest. The Company’s commitment to maintaining asset quality, improving operating efficiency, being attentive to customer satisfaction and maximizing shareholder value remains strong. WBCO has identified long-term performance measurement targets. Those targets include a return on equity in excess of 18%, an efficiency ratio in the mid-50% range, earnings per share growth of at least 10% per year, and dividend growth of at least 8% annually. Management does not expect to attain these targets in the short-term, but rather measures its business plan progression against these long-term goals.

Management anticipates that 2004 performance will be affected by a number of factors. A primary consideration, and one that is subject to uncertainty, is the stability of the economy. In management’s opinion, the Company is in a transition from that of heavy residential mortgage loan volumes into a period of increasing commercial lending activity. In light of this transition and an expected increase in competition for loans, management believes that the Company will achieve loan growth in the range of 10% — 15% for the year 2004.

The Company is projecting a modest increase in deposits for 2004. If deposit rate repricing is required to maintain deposits or should rates increase more than expected, the net interest margin could be negatively impacted due to the Company’s current position of being slightly liability sensitive. Other unexpected changes, such as significant changes in the economy, substantial credit deterioration, or depositors moving sizeable amounts of their funds back into the stock market, could also affect the anticipated performance of the Company.

Residential real estate loan volumes have declined from the high volumes experienced in recent years, and therefore have generated less fee income. WFG, the Company’s wholesale lending subsidiary, continued to negatively impact earnings. In response, the Company closed WFG during the second quarter of 2004.

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Management had expected WFG to contribute to 2004 earnings when earnings growth projections were identified earlier in the year. Considering the impact caused by the closure and losses of the mortgage subsidiary, and given the preceding assumptions, management expects that it will be difficult to substantially increase profits over 2003. The Bank has a large portion of market share in Island County, which is where the Company was founded and has an established identity and reputation within the community. Management believes there are significant opportunities to gain a larger share of the market in the other three counties where the branches are still relatively young and not as well known. Opportunities will be pursued while applying credit discipline and deliberate analysis to ensure quality growth.

Readers should not construe these statements as assurances of future performance, and should note that management does not plan to update these projections as the year progresses.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

A number of measures are used to monitor and manage interest rate risk, including income simulations and interest sensitivity (gap) analyses. An income simulation model is the primary tool used to assess the direction and magnitude of changes in net interest income resulting from changes in interest rates. Key assumptions in the model include prepayment speeds on mortgage-related assets, cash flows and maturities of other investment securities, loan and deposit volumes, and pricing. These assumptions are inherently uncertain and, as a result, the model cannot precisely estimate net interest income or precisely predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes, changes in market conditions and management strategies, among other factors. At June 30, 2004, based on the measures used to monitor and manage interest rate risk, there had not been a material change in the Company’s interest rate risk since December 31, 2003. Should rates increase, the Company could be negatively impacted due to its current slightly liability sensitive position. For additional information, refer to the Company’s Form 10-K for year ended December 31, 2003 filed with the SEC on March 24, 2004.

Item 4. Controls and Procedures

As of the end of the period covered by this report, management evaluated the effectiveness of the design and operation of its disclosure controls and procedures. The principal executive and financial officers supervised and participated in this evaluation. Based on this evaluation, the chief executive and financial officer each concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information required to be included in the periodic reports to the SEC. The design of any system of controls is based in part upon various assumptions about the likelihood of future events, and there can be no assurance that any of the Company’s plans, products, services or procedures will succeed in achieving their intended goals under future conditions. In addition, there have been no significant changes in the internal controls or in other factors known to management that could significantly affect the internal controls subsequent to the most recent evaluation. Management found no facts that would require WBCO to take any corrective actions with regard to significant deficiencies or material weaknesses.

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PART II

Item 2. Changes in Securities and Use of Proceeds

(a)  –  (e) Not applicable

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

The annual meeting of shareholders was held at Oak Harbor, Washington at 3:00 p.m. on April 29, 2004. The total number of shares of common stock were 4,746,637 and were represented in person or by proxy at the meeting. This represented 88% of the 5,401,274 shares held by shareholders as of March 10, 2004 and entitled to vote at the meeting. The following issue came before the shareholders for vote:

  Election of directors to serve on the Board of Directors until the annual meeting of shareholders in the year 2007, or until their successors are duly elected and qualified - three of the nine director position terms had expired and were open for election. The nominees for these positions were Michal D. Cann; Jerry C. Chambers; and Marlen L. Knutson, who were each elected with the following vote totals:

  For
Against
Withheld
Michal D. Cann 4,721,050  0  25,587 
Jerry C. Chambers 4,720,321  0  26,316 
Marlen L. Knutson 4,716,372  0  30,265 

The other six directors who continue in office are: Karl C. Krieg, III; Jay T. Lien; Robert B. Olson; Anthony B. Pickering; Alvin J. Sherman; and Edward J. Wallgren.

Item 5. Other Information

(a)     Not applicable

(b)     There have been no material changes in the procedures for shareholders to nominate directors to the Company’s board.

Item 6. Exhibits and Reports on Form 8-K

(a)     Exhibits

         31.1     Certification of Chief Executive Officer required by Rule 13a-14(b) or Rule 15d-14(a) and Section 302 of the
                     Sarbanes Oxley Act of 2002

         31.2     Certification of Chief Financial Officer required by Rule 13a-14(b) or Rule 15d-14(a) and Section 302 of the
                     Sarbanes Oxley Act of 2002

         32.1     Certification of Chief Executive Officer required by Rule 13a-14(b) or Rule 15d-14(b) and Section 906 of the
                     Sarbanes Oxley Act of 2002, 18 U.S.C. Section 1350

         32.2     Certification of Chief Financial Officer required by Rule 13a-14(b) or Rule 15d-14(b) and Section 906 of the
                     Sarbanes Oxley Act of 2002, 18 U.S.C. Section 1350

(b)     Reports on Form 8-K

During the quarter ended June 30, 2004, the Company filed two reports on Form 8-K. The first 8-K filed during the quarter announced the release of the Company’s first quarter 2004 earnings and the second quarter cash dividend and was filed on May 3, 2004. The second Form 8-K contained the Company’s press release announcing the Company’s intent to close WFG, and was filed on June 16, 2004.

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SIGNATURES

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

WASHINGTON BANKING COMPANY

Date: August 13, 2004 By /s/ Michal D. Cann
     Michal D. Cann
      President and
  Chief Executive Officer




 		    
Date: August 13, 2004 By /s/ Phyllis A. Hawkins
   Phyllis A. Hawkins
Senior Vice President and
Chief Financial Officer

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