PACIFIC CAPITAL BANCORP /CA/ - 10-Q Quarterly Report

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

Form 10-Q

(Mark One)
x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2004

o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ______________ to ____________

Commission File No.: 0-11113

PACIFIC CAPITAL BANCORP
(Exact Name of Registrant as Specified in its Charter)

California		95-3673456
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

1021 Anacapa St., 3rd Floor Santa Barbara, California		93101
(Address of principal executive offices)		(Zip Code)

(805) 564-6405
(Registrant’s telephone number, including area code)

Not Applicable
Former name, former address and former fiscal year, if changed since last report.

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 o

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

Common Stock - As of July 30, 2004 there were 45,603,534 shares of the issuer’s common stock outstanding.

TABLE OF CONTENTS

PART I.		FINANCIAL INFORMATION

	Item 1.	Financial Statements:

		Consolidated Balance Sheets (unaudited) June 30, 2004 and December 31, 2003

		Consolidated Statements of Income (unaudited) Three and Six-Month Periods Ended June 30, 2004 and 2003

		Consolidated Statements of Cash Flows (unaudited) Six-Month Periods Ended June 30, 2004 and 2003

		Consolidated Statements of Comprehensive Income (unaudited) Three and Six-Month Periods Ended June 30, 2004 and 2003

		Notes to Consolidated Financial Statements

The financial statements included in this Form 10-Q should be read with reference to Pacific Capital Bancorp’s Annual Report on Form 10-K for the fiscal year ended December 31, 2003.

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

	Item 3.	Quantitative and Qualitative Disclosures about Market Risk

	Item 4.	Controls and Procedures

PART II.		OTHER INFORMATION

	Item 1	Legal proceedings

	Item 2	Changes in Securities and Use of Proceeds

	Item 3	Defaults Upon Senior Securities

	Item 4	Submission of Matters to a vote of security holders

	Item 5	Other information

	Item 6	Exhibits and Reports on Form 8-K

SIGNATURES

PART 1 FINANCIAL INFORMATION

Item 1.	FINANCIAL STATEMENTS
PACIFIC CAPITAL BANCORP & SUBSIDIARIES
Consolidated Balance Sheets (Unaudited)
(dollars and share amounts in thousands except per share amounts)

	June 30, 2004			December 31, 2003

Assets:
Cash and due from banks	$	140,885		$	150,010
Federal funds sold and securities purchased under agreements to resell		12,000			33,010

Cash and cash equivalents		152,885			183,020

Securities available-for-sale, at fair value (Note 4)		1,491,853			1,317,962
Loans, net of allowance of $48,376 at June 30, 2004 and $49,550 at December 31, 2003 (Note 5)		3,692,502			3,131,329
Premises, equipment and other long-term assets		80,270			73,959
Accrued interest receivable		21,923			19,608
Goodwill (Note 7)		108,638			30,048
Other intangible assets (Notes 7 and 8)		7,234			2,962
Other assets (Note 6)		129,024			100,742

Total assets	$	5,684,329		$	4,859,630


Liabilities:
Deposits:
Noninterest bearing demand deposits	$	981,491		$	924,106
Interest bearing deposits		3,371,174			2,930,611

Total Deposits		4,352,665			3,854,717
Federal funds purchased and securities sold under agreements to repurchase		121,338			58,339
Long-term debt and other borrowings (Note 9)		730,907			499,548
Accrued interest payable and other liabilities		45,790			47,978

Total liabilities		5,250,700			4,460,582


Commitments and contingencies (Note 11)
Shareholders’ equity
Common stock (no par value; $0.25 per share stated value; 80,000 authorized; 45,546 outstanding at June 30, 2004 and 45,284 at December 31, 2003)		11,391			8,494
Surplus		75,044			72,916
Accumulated other comprehensive income		(1,793	)		12,807
Retained earnings		348,987			304,831

Total shareholders’ equity		433,629			399,048

Total liabilities and shareholders’ equity	$	5,684,329		$	4,859,630

The accompanying notes are an integral part of these consolidated financial statements.

PACIFIC CAPITAL BANCORP & SUBSIDIARIES
Consolidated Statements of Income (Unaudited)
(dollars and share amounts in thousands except per share amounts)

	For the Three-Month Periods Ended June 30,					For the Six-Month Periods Ended June 30,

	2004			2003		2004			2003

Interest income:
Loans	$	56,841		$	50,295	$	143,465		$	129,617
Securities		14,485			9,735		28,145			19,211
Federal funds sold and securities purchased under agreements to resell		103			402		584			852

Total interest income		71,429			60,432		172,194			149,680

Interest expense:
Deposits		9,898			9,382		18,886			19,286
Securities sold under agreements to repurchase and Federal funds purchased		223			71		757			542
Other borrowed funds		5,875			4,029		11,250			7,884

Total interest expense		15,996			13,482		30,893			27,712

Net interest income		55,433			46,950		141,301			121,968
Provision for credit losses (Note 5)		737			2,635		8,321			14,252

Net interest income after provision for credit losses		54,696			44,315		132,980			107,716

Non interest revenue:
Service charges on deposits		4,099			3,847		8,135			7,570
Trust fees		3,733			3,509		7,787			7,023
Refund transfer fees		3,097			3,075		20,812			19,535
Other service charges, commissions and fees, net		3,847			3,487		9,671			8,927
Net gain on sale of tax refund loans		-			-		2,945			8,031
Net (loss) gain on securities transactions		(449	)		604		(516	)		664
Other income		1,053			615		3,167			2,239

Total noninterest revenue		15,380			15,137		52,001			53,989

Operating expense:
Salaries and benefits		24,119			19,395		49,249			42,937
Net occupancy expense		3,853			3,593		7,405			7,097
Equipment expense		2,241			2,601		4,310			4,767
Other expense		13,830			12,910		30,195			28,145

Total operating expense		44,043			38,499		91,159			82,946

Income before income taxes		26,033			20,953		93,822			78,759
Provision for income taxes		9,486			7,554		34,684			28,942

Net income	$	16,547		$	13,399	$	59,138		$	49,817


Earnings per share - basic (Note 3)	$	0.36		$	0.29	$	1.30		$	1.08
Earnings per share - diluted (Note 3)	$	0.36		$	0.29	$	1.29		$	1.08
Average number of shares - basic		45,465			45,821		45,419			45,917
Average number of shares - diluted		45,774			46,289		45,747			46,338
Dividends declared per share	$	0.17		$	0.15	$	0.33		$	0.29
Dividends paid per share	$	0.17		$	0.15	$	0.33		$	0.29

The accompanying notes are an integral part of these consolidated financial statements.

PACIFIC CAPITAL BANCORP & SUBSIDIARIES
Consolidated Statements of Cash Flows (Unaudited)
(dollars in thousands)

	For the Six-Month
	Periods Ended June 30,
	2004			2003

Cash flows from operating activities:
Net Income	$	59,138		$	49,817
Adjustments to reconcile net income to net cash provided by operations:
Depreciation and amortization		4,869			4,940
Provision for credit losses		8,321			14,252
Net amortization of discounts and premiums for securities and commercial paper		1,603			1,526
Net change in deferred loan origination fees and costs		905			(411	)
Net loss (gain) on sales and calls of securities		516			(664	)
Change in accrued interest receivable and other assets		(3,610	)		(3,669	)
Change in accrued interest payable and other liabilities		(3,967	)		24,250

Net cash provided by operating activities		67,775			90,041

Cash flows from investing activities:
Purchase of bank or branches		(123,282	)		—
Proceeds from sales of AFS securities		47,079			48,102
Proceeds from calls, maturities, and partial paydowns of AFS securities		153,112			141,664
Proceeds from calls and maturities of HTM securities		—			2,680
Purchase of AFS securities		(282,793	)		(492,952	)
Net (increase) decrease in loans made to customers		(157,902	)		4,313
Purchase or investment in premises and equipment		(9,623	)		(7,911	)

Net cash used in investing activities		(373,409	)		(304,104	)

Cash flows from financing activities:
Net increase in deposits		207,460			112,354
Net increase (decrease) in borrowings with maturities of 90 days or less		36,094			(7,260	)
Proceeds from long-term debt and other borrowing		92,000			174,700
Payments on long-term debt and other borrowing		(50,098	)		(21,658	)
Cash paid for retirement of stock		—			(9,574	)
Proceeds from issuance of common stock		5,025			3,222
Dividends paid		(14,982	)		(13,063	)

Net cash provided by financing activities		275,499			238,721

Net (decrease) increase in cash and cash equivalents		(30,135	)		24,658
Cash and cash equivalents at beginning of period		183,020			151,540

Cash and cash equivalents at end of period	$	152,885		$	176,198

Supplemental disclosure:
Interest paid during period	$	30,395		$	27,947
Income taxes paid during period	$	14,000		$	17,200
Non-cash additions to other real estate owned (Note 1)	$	2,910		$	—

The accompanying notes are an integral part of these consolidated financial statements.

PACIFIC CAPITAL BANCORP & SUBSIDIARIES
Consolidated Statements of Comprehensive Income (Unaudited)
(dollars in thousands)

	For the Three-Month Period Ended June 30, 2004									For the Three-Month Period Ended June 30, 2003

	Before-Tax Amount			Tax (Benefit)/ Expense			Net-of-Tax Amount			Before-Tax Amount		Tax (Benefit)/ Expense		Net-of-Tax Amount


Net Income	$	26,033		$	9,486		$	16,547		$	20,953	$	7,554	$	13,399
Other comprehensive income:
Net unrealized (loss) gain on securities:
Net unrealized holding (losses) gains arising during period		(35,981	)		(15,130	)		(20,851	)		4,914		2,066		2,848
Less: reclassification adjustment for (losses) gains included in net income		(449	)		(189	)		(260	)		604		254		350

Other comprehensive (loss) income		(35,532	)		(14,941	)		(20,591	)		4,310		1,812		2,498

Comprehensive (loss) income	$	(9,499	)	$	(5,455	)	$	(4,044	)	$	25,263	$	9,366	$	15,897


	For the Six-Month Period Ended June 30, 2004									For the Six-Month Period Ended June 30, 2003

	Before-Tax Amount			Tax (Benefit)/ Expense			Net-of-Tax Amount			Before-Tax Amount		Tax (Benefit)/ Expense		Net-of-Tax Amount


Net Income	$	93,822		$	34,684		$	59,138		$	78,759	$	28,942	$	49,817
Other comprehensive income:
Net unrealized (loss) gain on securities:
Net unrealized holding (losses) gains arising during period		(25,710	)		(10,811	)		(14,899	)		11,815		4,968		6,847
Less: reclassification adjustment for (losses) gains included in net income		(516	)		(217	)		(299	)		664		279		385

Other comprehensive (loss) income		(25,194	)		(10,594	)		(14,600	)		11,151		4,689		6,462

Comprehensive income	$	68,628		$	24,090		$	44,538		$	89,910	$	33,631	$	56,279

The accompanying notes are an integral part of these consolidated financial statements.

PACIFIC CAPITAL BANCORP AND SUBSIDIARIES
Notes to Consolidated Condensed Financial Statements
June 30, 2004
(Unaudited)

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Consolidation and Basis of Presentation

The consolidated financial statements include the parent holding company, Pacific Capital Bancorp (“Bancorp”), and its wholly owned subsidiaries, Pacific Capital Bank, N.A. (the “Bank” or “PCBNA”), two service corporations, and two securitization subsidiaries. The activities of one of the service corporations are minimal; the other is inactive. The securitization subsidiaries are used for the transactions described in Note 8, “Transfers and Servicing of Financial Assets.” All references to the “Company” apply to Pacific Capital Bancorp and its subsidiaries. “Bancorp” will be used to refer to the parent company only. Material intercompany balances and transactions have been eliminated.

On March 5, 2004, the Company acquired Pacific Crest Capital, Inc. (“PCCI”) and its wholly owned subsidiaries, Pacific Crest Bank, Pacific Crest Capital Trust I (“PCC Trust I”), Pacific Crest Capital Trust II (“PCC Trust II”), and Pacific Crest Capital Trust III (“PCC Trust III”). PCCI was merged into Bancorp, while Pacific Crest Bank was merged into PCBNA. PCC Trust I, PCC Trust II, and PCC Trust III had been created by PCCI for the exclusive purpose of issuing trust preferred securities. These last three entities remain stand-alone subsidiaries of Bancorp but will not be consolidated in the Company’s financial statements (see New Accounting Pronouncements regarding the nonconsolidation of these subsidiaries and Note 2, “Business Combinations” for more information on the PCCI acquisition).

Prior to March 29, 2002, Bancorp had two wholly owned bank subsidiaries, Santa Barbara Bank & Trust (“SBB&T”) and First National Bank of Central California (“FNB”). SBB&T and FNB were merged on that date to form PCBNA. The “Bank” is intended to mean SBB&T and/or FNB, as appropriate, when referring to events or situations prior to March 29, 2002. PCBNA continues to use the brand names of “Santa Barbara Bank & Trust,” “First National Bank of Central California,” “South Valley National Bank,” and “San Benito Bank” in its various market areas. “Bank” also includes the operations of Pacific Crest Bank, which was merged into PCBNA as part of the March 5, 2004 acquisition of PCCI.

The accompanying unaudited consolidated financial statements have been prepared in a condensed format, and therefore do not include all of the information and footnotes required by accounting principles generally accepted in the United States (“GAAP”) for complete financial statements. In the opinion of Management, all adjustments (consisting only of normal recurring accruals) considered necessary for a fair statement have been reflected in the financial statements. However, the results of operations for the three-month and six-month periods ended June 30, 2004 are not necessarily indicative of the results to be expected for the full year.

Cash and Cash Equivalents

For the purposes of reporting cash flows, cash and cash equivalents include cash and due from banks, money market funds, Federal funds sold, and securities purchased under agreements to resell.

Securities

Securities may be classified as either “held-to-maturity” or “available-for-sale.” Securities for which the Company has positive intent and ability to hold until maturity are classified as held-to-maturity. Securities that might be sold prior to maturity because of interest rate changes, to meet liquidity needs, or to better match the repricing characteristics of funding sources are classified as available-for-sale. If the Company were to purchase securities principally for the purpose of selling them in the near term, they would be classified as trading securities. The Company holds no securities that should be classified as trading securities and has decided that all securities could be sold for any of the reasons noted above. Consequently, all securities are classified as available-for-sale. On determining gain or loss on securities, cost is determined by specific identification.

The Company has not purchased any securities arising out of highly leveraged transactions, and its investment policy prohibits the purchase of any securities of less than investment grade.

Loans

Nonaccrual Loans—When a borrower is not making payments as contractually required by the note, the Company must decide whether it is appropriate to continue to accrue interest income. Generally, the Company stops accruing interest when the loan has become delinquent by more than 90 days, or in the case of individually analyzed large loans, when an event of default has occurred and further analysis suggests that it is unlikely that the obligor will continue to pay according to the agreed terms of the credit.

Impairment—Specific kinds of loans are identified as impaired when it is probable that interest and principal will not be collected according to the contractual terms of the loan agreements. Because this definition is very similar to that used by Management to determine on which loans interest should not be accrued, the Company expects that most impaired loans will be on nonaccrual status. Therefore, in general, the accrual of interest on impaired loans is discontinued, and any uncollected interest is written off against interest income in the current period. No further income is recognized until all recorded amounts of principal are recovered in full or until circumstances have changed such that the loan is no longer regarded as impaired.

Impaired loans are reviewed each quarter or upon receipt of material information, to determine whether a valuation allowance for loan loss is required. The amount of the valuation allowance for impaired loans is determined by comparing the recorded investment in each loan with its value measured by one of three methods. The first method is to estimate the expected future cash flows and then discount them at the effective interest rate. The second method is to use the loan’s observable market price if the loan is of a kind for which there is a secondary market. The third method is to use the value of the underlying collateral. A valuation allowance is established for any amount by which the recorded investment exceeds the value of the impaired loan. If the value of the loan as determined by the selected method exceeds the recorded investment in the loan, and certain other factors suggest that the excess is or would be reasonably achievable in a reasonable period of time using methods available to the bank, then no valuation allowance for that loan is established.

GAAP recognizes that some impaired loans may have risk characteristics that are unique to the individual borrower and other impaired loans may have risk characteristics in common with other impaired loans. In the former case, the creditor is expected to apply the measurement methods mentioned in the preceding paragraph on a loan-by-loan basis. In the latter case, the creditor is allowed to aggregate those loans and use historical statistics in measuring the amount of the valuation allowance needed. Because the loans currently identified as impaired by the Company have unique risk characteristics, the valuation allowance disclosed in Note 5, “Loans and the Allowance for Credit Losses,” for impaired loans is determined on a loan-by-loan basis.

Allowance for Other Loans—The Company also provides an allowance for credit losses for other loans. These include: (1) groups of loans for which the allowance is determined by historical loss experience ratios for similar loans; (2) specific loans that are not included in one of the types of loans covered by the concept of “impairment” but for which repayment is nonetheless uncertain; and (3) probable losses incurred in the various loan portfolios, but which have not been specifically identified as of the period end. The amounts of the various components of the allowance for credit losses are based on review of individual loans, historical trends, current economic conditions, and other factors. This process is explained in detail in the notes to the Company’s Consolidated Financial Statements in its Annual Report on Form 10-K for the year ended December 31, 2003 (“2003 10-K”).

Loans that are deemed to be uncollectible are charged-off against the allowance for credit losses. Uncollectibility is determined based on the individual circumstances of the loan and historical trends.

Origination Fees—The Company defers and amortizes loan fees collected and origination costs incurred over the lives of the related loans. For each category of loans, the net amount of the unamortized fees and costs are reported as a reduction or addition, respectively, to the balance reported. Because the fees collected are generally less than the origination costs incurred for commercial and consumer loans, the total net deferred or unamortized amounts for these categories are additions to the loan balances.

Other Assets

Property acquired as a result of defaulted loans is included within other assets on the balance sheets. Property from defaulted loans is carried at the lower of the outstanding balance of the related loan at the time of foreclosure or the estimate of the market value of the assets less disposal costs. During the second quarter of 2004, the Company received a real estate property in satisfaction of a delinquent loan. The property was recorded at an estimate of its fair value less cost of disposal, $2.9 million. As of December 31, 2003, the Company held no properties which it had obtained from foreclosure.

Goodwill and Other Intangible Assets

Goodwill is recorded on the balance sheets in connection with acquisitions of other financial institutions. The Company recognized the excess of the purchase price over the estimated fair value of the assets received and liabilities assumed as goodwill. The goodwill recognized in connection with the March 5, 2004 PCCI acquisition is recorded in the “Pacific Capital” segment on the tables included in Note 14, “Segment Disclosure, “ while the remainder of the Company’s goodwill is recorded within the “Community Banking” segment. Prior to the effective date of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (“SFAS 142”), the purchased goodwill was being amortized over 10 and 15 year periods.

The deposits of financial institutions—especially the deposits other than certificates—are generally the result of long-term customer relationships. These deposits are therefore more valuable to a purchaser than simply their outstanding amount would indicate because financial institutions have to spend marketing and other acquisition costs to generate these customer relationships. Therefore, when deposits are purchased, the seller demands an acquisition cost representing the value of the relationship. In the sale of deposits, because the buyer is actually assuming a liability from the seller, this acquisition cost is represented by the amount that the liability assumed exceeds the cash paid to the buyer to assume the liability. This acquisition cost is termed a Core Deposit Intangible (“CDI”). The Company records this CDI as an asset and amortizes it against other expense over the expected average life of the deposit relationships acquired. The amount of the CDI and the expected average life of the relationship will differ depending on the nature of the deposits and the customers.

Intangible assets, including goodwill, have been and will be reviewed each year to determine if circumstances related to their valuation have been materially affected. In the event that the current market values are determined to be less than the current book values (impairment), a charge against current earnings will be recorded. No such impairment existed at June 30, 2004 or December 31, 2003.

See Note 2, “Business Combinations,” for information regarding the March 5, 2004 acquisition of PCCI.

Loan Sales and Mortgage Servicing Rights

Some of the residential loans sold are sold “servicing released” and the purchaser takes over the collection of the payments. However, most are sold with “servicing retained” and the Company continues to receive the payments from the borrower and forwards the funds to the purchaser. The Company earns a fee for this service. The sales are made without recourse, that is, the purchaser cannot look to the Company in the event the borrower does not perform according to the terms of the note. GAAP requires companies engaged in mortgage banking activities to recognize the rights to service mortgage loans for others as separate assets. For loans sold, a portion of the investment in the loan is ascribed to the right to receive this fee for servicing and this value is recorded as a separate asset.

Some of the SBA loans are originated with the intention of selling the guaranteed portion. As with the residential loans that are sold, these loans are sold promptly after origination. Consequently, the amount at any particular time and any adjustment to the market value from changes in interest rates are immaterial.

Comprehensive Income

Components of comprehensive income are changes in the equity accounts other than those changes resulting from investments by owners and distributions to owners. Net income is the primary component of comprehensive income. For the Company, the only component of comprehensive income other than net income is the unrealized gain or loss on securities classified as available-for-sale. The aggregate amount of such changes to equity that have not yet been recognized in net income are reported in the equity portion of the Consolidated Balance Sheets net of income tax effect as “Accumulated other comprehensive income.”

When an available-for-sale security is sold, a realized gain or loss will be included in net income and, therefore, in comprehensive income. Consequently, the recognition of any unrealized gain or loss for that security that had been included in comprehensive income in an earlier period must be reversed in the current period to avoid including it twice. These adjustments are reported in the Consolidated Statements of Comprehensive Income as a reclassification adjustment for gains or losses included in net income.

Segment Disclosure

While the Company’s products and services are all of the nature of commercial banking, the Company has six reportable segments. There are five specific segments: “Community Banking,” “Commercial Banking,” “Refund Programs,” “Fiduciary,” and “Pacific Capital.” The remaining activities of the Company are reported in a segment titled “All Other.”

Information regarding how the Company determines its segments is provided in Note 26, “Segment Reporting,” to the Consolidated Financial Statements included in the Company’s 2003 10-K. This information includes descriptions of the factors used in identifying these segments, the types and services from which revenues for each segment are derived, charges and credits for funds obtained from or provided to other segments, and how the specific measure of profit or loss was selected. Readers of these interim statements are referred to that information to better understand the disclosures for each of the segments in Note 14, “Segment Disclosure.” There have been no changes in the basis of segmentation or in the measurement of segment profit or loss from the description given in the 2003 10-K, other than the inclusion of the activities of Pacific Crest Bank, which was acquired in connection with the March 5, 2004 PCCI acquisition. As discussed in Note 14, some of the activities of the former Pacific Crest Bank are included in the Community Banking segment and some in the Pacific Capital segment.

Stock-Based Compensation

GAAP permits the Company to use either of two methods for accounting for compensation cost in connection with employee stock options. The first method—termed the “fair value” method—requires issuers to record compensation expense over the period the options are expected to be outstanding prior to exercise, expiration, or cancellation. The amount of compensation expense to be recognized over this term is the “fair value” of the options at the time of the grant as determined by an option pricing model. The option pricing model computes fair value for the options based on the length of their term, the volatility of the stock price in past periods, and other factors. Under this method, the issuer recognizes compensation expense regardless of whether the officer or director eventually exercises the options.

The second method is termed the “intrinsic value” method. Under this accounting method, if options are granted at an exercise price equal to the market value of the stock at the time of the grant, no compensation expense is recognized. GAAP requires that issuers that elect the second method must present pro forma disclosures of net income and earnings per share as if the first method had been elected. The Company uses this second method.

Had the Company recognized compensation expense over the expected life of the options based on the fair value method as discussed above, the Company’s pro forma salary expense, net income, and earnings per share for the three and six-month periods ended June 30, 2004 and 2003 would have been as follows:

	For the Three-Month Periods Ended June 30,						For the Six-Month Periods Ended June 30,

*(dollars in thousands)*	2004			2003			2004			2003


Net Income, as reported	$	16,547		$	13,399		$	59,138		$	49,817
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(446	)		(167	)		(568	)		(300	)

Pro forma net income	$	16,101		$	13,232		$	58,570		$	49,517


Earnings Per Share:
Basic - as reported	$	0.36		$	0.29		$	1.30		$	1.08
Basic - pro forma	$	0.35		$	0.29		$	1.29		$	1.08
Diluted - as reported	$	0.36		$	0.29		$	1.29		$	1.08
Diluted - pro forma	$	0.35		$	0.29		$	1.28		$	1.07

For purposes of this computation, the significant assumptions used, computed on a weighted average basis, were:

	Risk free interest rate:	3.52%
	Expected life:	4 years for 5-year options, 5 years for 10-year options
	Expected volatility 2 years:	0.2857
	Expected volatility 5 years:	0.2692
	Expected dividend:	$0.72 per year

Derivative Instruments

The Company has established policies and procedures to permit limited types and amounts of derivative instruments to help manage its interest rate risk. At various times, the Company has entered into interest rate swaps to mitigate interest rate risk. Under the terms of these swaps, the Company paid a fixed rate of interest to the counterparty and received a floating rate of interest. Such swaps have the effect of converting fixed rate financial instruments into variable or floating rate instruments. Such swaps may be related to specific instruments or specifically identified pools of instruments—loans, securities, or deposits with similar interest rate characteristics or terms.

The Company has also established policies and procedures to sell derivatives, specifically interest rate swaps, to customers to assist them in managing their interest rate risk. Generally these customers have wanted to protect themselves from rising rates. Depending on the notional amount of the swap, the Company may cover its position with an interest rate swap purchased from another counterparty with equal but opposite terms, thereby “covering” its position, so as not to incur any additional interest rate risk. With smaller transactions that mitigate the Company’s current interest rate risk position, the Company may not cover its position. The Company’s policy limits both the individual notional amount and the aggregate notional amount of these covered and uncovered derivatives.

The Company engages in a very small number of foreign exchange contracts with customers. These may be either spot or future contracts. Future contracts are always covered by an offsetting contract with another counterparty so that there is no risk of loss from changes in the relative price of currencies over the term of the contract.

Other types of derivatives are permitted by the Company’s policies, but have not been utilized.

All derivatives are required to be recorded at their current fair value on the balance sheet. Certain derivatives may be designated as either fair value or cash flow accounting hedges and qualify for the deferral of all or a part of changes in their fair value in the basis of the item being hedged or in accumulated other comprehensive income. Changes in the fair value of derivatives that are not related to specific instruments and do not meet the criteria for hedge accounting are included in net income, within other income or other expense as appropriate.

Because the swaps sold to customers are not intended to act as a hedge for the Company’s interest rate risk position with respect to the loan, only for the customer’s position, they do not meet the requirement for hedge accounting. Consequently, changes in the fair value of these hedges are included in net income in the period in which the changes occur. Because a derivative may not be used to hedge another derivative, any changes in the fair value of swaps entered into to cover the Company’s position on the customer swaps are also included in net income in the period in which they occur.

In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities (“FIN 46”). Certain disclosure requirements of this interpretation were effective for December 31, 2002 financial statements. The accounting requirements were effective for existing entities beginning December 31, 2003 and for newly formed entities beginning February 1, 2003. Previously issued accounting pronouncements required the consolidation of one entity in the financial statements of another if the second entity had a controlling interest in the first. Generally, controlling interest was defined in terms of a proportion of voting rights. In effect, FIN 46 applies broader criteria than just voting rights in determining whether a controlling financial interest in one entity by another exists. Specifically, if by design the owners of the entity have not made an equity investment sufficient to absorb its expected losses and the owners lack any one of three essential characteristics of controlling financial interest, the entity is to be consolidated in the financial statements of its primary beneficiary. The three characteristics are the ability to make decisions about the entity’s activities, the obligation to absorb the expected losses of the entity, and the right to receive the expected residual returns of the entity.

The Company has two special-purpose entities used for the securitizations described in Note 8, “Transfers and Servicing of Financial Assets.” The special-purpose entity used for the indirect auto loan securitization is exempt from this pronouncement because it is a qualifying special-purpose entity (“QSPE”) as described in Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (“SFAS 140”) . Instead of disclosing its rights and obligations related to this QSPE under the provisions of FIN 46, the Company discloses them under the provisions of SFAS 140.

The special-purpose entity used for the tax refund loan securitization is a variable interest entity within the scope of FIN 46, and is consolidated with the Company. In the structure of this securitization, the loans are sold by the special-purpose entity to securitization conduits established by two financial institutions to hold a variety of assets purchased from a number of other financial institutions. These conduits are variable interest entities within the scope of FIN 46. However, they hold refund anticipation loans (“RALs”) originated by the Company only during one month of each year. They continue to function during the eleven months of the year holding other types of loans purchased from other financial institutions. Therefore, because it is not the primary beneficiary of them and because it exercises no control over the other assets purchased or held, the Company concludes that consolidation of these conduits with the Company would not be required by FIN 46. While used only during the first quarter of each year, the special purpose entity for RALs remains in place from year to year.

In connection with the March 5, 2004 PCCI acquisition, Bancorp added three business trust subsidiaries which had been originally created by PCCI for the exclusive purpose of issuing trust preferred securities. The three subsidiaries are PCC Trust I, PCC Trust II, and PCC Trust III. The purchasers of the securities are the primary beneficiaries of these entities. Because Bancorp is not the primary beneficiary of these entities, they have not been consolidated by the Company in accordance with FIN 46. However, the Company has included the investments in these subsidiaries in “Other assets” and the subordinated debt owed to these subsidiaries in “Long-term debt and other borrowings” on its Consolidated Balance Sheets. In its Consolidated Statements of Income, the Company has reported dividend income from the subsidiaries in “Other income” and interest expense on the subordinated debt in “Other borrowed funds.”

The Company has invested in several partnerships that promote the development of low cost housing by providing incentives in the form of tax credits. The partnerships also help the Company to meet its obligations under the Community Reinvestment Act. These partnerships are variable interest entities within the scope of FIN 46 because, as a group, the holders of the equity interests in these entities do not have the direct or indirect ability to make decisions about the entities’ activities through voting rights or similar rights. In certain partnerships, the Company holds more than 50% of the limited partners’ interests and would be regarded as the primary beneficiary. However, if the other partners’ shares of the total assets and liabilities were to be consolidated with the assets and liabilities of the Company, the effect on the balance sheet of the Company would be immaterial. In addition, the liabilities of these partnerships are nonrecourse to the Company.

Management does not believe that the Company is the primary beneficiary of any other such entities.

New Accounting Pronouncements

In December 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure, an amendment of FASB Statement No. 123 (“SFAS 148”). Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), permitted two methods of accounting for stock options granted to employees. Because information for prior years was not readily available when SFAS 123 was adopted, only prospective application was permitted. That is, companies adopting the “fair value” method recommended by SFAS 123 were not permitted to restate prior year results as if the statement had been adopted as of the earliest year presented in the financial statements.

SFAS 148 permits companies voluntarily changing to the “fair value” method to choose between the current prospective transition method and two other transition approaches if the change occurred in 2003. After 2003, companies voluntarily changing to the “fair value” method will have to use one of the two new transition approaches. The Company is still considering whether to change to the “fair value” method, and, if so, the appropriate way in the valuation of the options to address the absence of the transferability of the options that is assumed in the standard valuation models. Because it did not adopt the “fair value” method in 2003, should it elect to later adopt that method, the Company will be required to use one of the two new transition approaches specified in SFAS 148.

In April 2003, the FASB issued Statement of Financial Accounting Standards No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities (“SFAS 149”). The provisions of SFAS 149 amend and clarify financial accounting and reporting for derivative instruments. The changes in SFAS 149 improve financial reporting by requiring that contracts with comparable characteristics be accounted for similarly. In particular, SFAS 149 (1) clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative discussed in paragraph 6(b) of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities; (2) clarifies when a derivative contains a financing component; (3) amends the definition of an underlying financial instrument to conform it to language used in FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others; and (4) amends certain other existing pronouncements. Those changes are intended to result in more consistent reporting of contracts as either derivatives or hybrid instruments. Included within the scope of these pronouncements are mortgage loans originated for sale. The Company does sell some of the mortgage loans that it originates, but there are no commitments to sell and the Company only makes the decision after the loans are originated. Consequently, it has not recorded these as loans originated for sale.

SFAS 149 was effective for contracts entered into or modified after June 30, 2003, except as stated above and for hedging relationships designated after June 30, 2003. In addition, except as stated above, all provisions of SFAS 149 are applied prospectively. The adoption of this statement did not have a material impact on the Company’s results of operations, financial position, or cash flows.

In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150 Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (“SFAS 150”). This statement requires that an issuer classify financial instruments that are within its scope as a liability. Many of these instruments would have been classified as equity under previous guidance. Most of the guidance in SFAS 150 is effective for all financial instruments entered into or modified after May 31, 2003, and otherwise effective at the beginning of the first interim period beginning after June 15, 2003. For the Company, (with the exception of its application to certain mandatorily redeemable financial instruments), the effective date was July 1, 2003. The Company holds no such financial instruments and the implementation of SFAS 150 had no impact on its consolidated financial statements.

With respect to certain mandatorily redeemable financial instruments, the effective date was the first fiscal period beginning after December 15, 2003. The Company has not issued any mandatorily redeemable instruments, and as a result, implementation has not impacted the Company.

In December 2003, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position 03-3 (“SOP 03-3”). SOP 03-3 requires loans that are acquired in a transfer or business combination to be accounted for at fair value. No allowance for loan losses or other valuation allowance is permitted at the time of acquisition. Valuation allowances should reflect only losses incurred after the acquisition. Provisions of the SOP are required to be adopted for fiscal years beginning after December 15, 2004. Early adoption is permitted. The Company does not expect to adopt SOP 03-3 prior to January 1, 2005, and accordingly, recognized and added $6.1 million to the allowance for loan losses in connection with the March 5, 2004 acquisition of PCCI.

In December 2003, the FASB issued a revision to Statement of Financial Accounting Standards No. 132, Employers’ Disclosures about Pensions and Other Postretirement Benefits (“SFAS 132-R”). SFAS 132R requires additional disclosures about defined benefit plans. The Company’s pension plans are defined contribution plans and are not included in the scope of this statement. Only the Company’s postretirement health plan is a defined benefit plan. The implementation of SFAS 132R did not have an impact on the Company’s results of operations, financial position, or cash flows. The quarterly disclosure required by SFAS 132 R is presented in Note 10.

2. BUSINESS COMBINATIONS

On March 5, 2004, the Company acquired Pacific Crest Capital, Inc. (“PCCI”) in an all cash transaction valued at $136 million, or $26 per each diluted share of Pacific Crest Capital common stock. Pacific Crest Capital, Inc. was an Agoura Hills, California-based bank holding company that conducted business through its wholly-owned subsidiary, Pacific Crest Bank, which had three full-service California branches located in Beverly Hills, Encino and San Diego. Since its establishment in 1974, Pacific Crest Bank had operated as a specialized business bank serving small businesses, entrepreneurs and investors. Products include customized loans on income producing real estate, business loans under the U.S. Small Business Administration (“SBA”) 7(a) and 504 programs, lines of credit and term loans to businesses and professionals, and specialized FDIC-insured savings and checking account programs. Pacific Crest Bank was an SBA-designated “Preferred Lender” in California, Arizona and Oregon. In addition to three branches, it operated six loan production offices in California and Oregon. The Company acquired PCCI primarily for its commercial real estate and SBA commercial business lending operations. The Company’s Consolidated Statements of Income include the operations of PCCI from March 6, 2004 through June 30, 2004. The Company acquired $131 million in investment securities, $412 million in loans, and $282 million in deposits in this transaction. The excess of the purchase price over the net fair value of the assets and liabilities, $78.6 million was recognized as goodwill as discussed in Note 7, Goodwill and Other Intangible Assets.

The following table presents pro forma combined information about results of operation as though the acquisition had occurred on January 1, 2003.

	Six Months Ended June 30, 2004			January 1, 2004 Through March 5, 2004			Six Months Ended June 30, 2004			Six Months Ended June 30, 2003

(dollars in thousands except per share amounts)	Pacific Capital Bancorp			Pacific Crest			ProForma Combined			Pacific Capital Bancorp			Pacific Crest		ProForma Combined


Revenues		$	224,195		$	7,996		$	232,191		$	203,669	$	10,762	$	214,431
Income before extraordinary items and the cumulative effect of accounting changes		$	59,138		$	1,694		$	60,832		$	49,817	$	2,115	$	51,932
Net income		$	59,138		$	1,694		$	60,832		$	49,817	$	2,115	$	51,932
Earnings per share		$	1.29					$	1.33		$	1.08			$	1.12

There were no extraordinary items or cumulative effects of accounting changes in the periods reported above for either company. The following nonrecurring items (pre-tax) are included in the Pacific Crest column in the above table for the period of January 1 through March 5, 2004 (in thousands):

Compensation cost to buy out stock options including payroll tax expense	$	3,680
Investment banking fees		1,018
Legal expenses		172
Other costs related to the acquisition.		193

Total	$	5,063

There were no material nonrecurring items included in the Company figures for the first six months of 2004 related to the acquisition.

The Company also acquired the deposits and certain loans of two branches of another financial institution in 2002. This acquisition and the core deposit intangible resulting from it are also discussed in Note 7.

3. EARNINGS PER SHARE

Earnings per share for all periods presented in the Consolidated Statements of Income are computed based on the weighted average number of shares outstanding during each period. Diluted earnings per share include the effect of the potential issuance of common shares. For the Company, these include only shares issuable on the exercise of outstanding stock options. Stock options with an exercise price greater than the average market price during the period have been excluded from the computations below because they are anti-dilutive.

The computation of basic and diluted earnings per share for the three and six-month periods ended June 30, 2004 and 2003, was as follows (share, option, and net income amounts in thousands):

	Three-month Periods						Six-month Periods
*(share and net income amounts* *in thousands)*	Basic Earnings Per Share			Diluted Earnings Per Share			Basic Earnings Per Share			Diluted Earnings Per Share
Period ended June 30, 2004
Numerator -- Net Income		$	16,547		$	16,547		$	59,138		$	59,138


Denominator -- weighted average shares outstanding			45,465			45,465			45,419			45,419

Plus: net shares issued in assumed stock option exercises						309						328

Diluted denominator						45,774						45,747


Earnings per share		$	0.36		$	0.36		$	1.30		$	1.29
Anti-dilutive options excluded						653						26

Period ended June 30, 2003
Numerator -- Net Income		$	13,399		$	13,399		$	49,817		$	49,817


Denominator -- weighted average shares outstanding			45,821			45,821			45,917			45,917

Plus: net shares issued in assumed stock option exercises						468						421

Diluted denominator						46,289						46,338


Earnings per share		$	0.29		$	0.29		$	1.08		$	1.08
Anti-dilutive options excluded						7						84

4. SECURITIES AVAILABLE-FOR-SALE

The amortized historical cost, market values and gross unrealized gains and losses of securities are as follows:

*(dollars in thousands)*	Amortized Cost			Gross Unrealized Gains			Gross Unrealized Losses				Estimated Fair Value

June 30, 2004
Available-for-sale:
U.S. Treasury obligations		$	113,471		$	914		$	(561	)		$	113,824
U.S. agency obligations			196,483			3,019			(406	)			199,096
Collateralized mortgage obligations			19,014			42			(143	)			18,913
Mortgage-backed securities			954,377			2,074			(18,732	)			937,719
Asset-backed securities			25,635			177			(57	)			25,755
State and municipal securities			185,968			13,379			(2,801	)			196,546

		$	1,494,948		$	19,605		$	(22,700	)		$	1,491,853

	Amortized Cost			Gross Unrealized Gains			Gross Unrealized Losses				Estimated Fair Value

December 31, 2003
Available-for-sale:
U.S. Treasury obligations		$	119,938		$	2,114		$	(33	)		$	122,019
U.S. agency obligations			207,020			5,918			(19	)			212,919
Collateralized mortgage obligations			12,327			83			(183	)			12,227
Mortgage-backed securities			737,929			2,787			(7,211	)			733,505
Asset-backed securities			26,804			227			—				27,031
State and municipal securities			191,845			19,528			(1,112	)			210,261

		$	1,295,863		$	30,657		$	(8,558	)		$	1,317,962

Gains or losses may be realized on securities in the available-for-sale portfolio if the Company sells any of these securities in response to changes in interest rates or for other reasons related to the management of the components of the balance sheet.

The fair value of securities can change due to credit concerns, i.e. whether the issuer will in fact be able to pay the obligation when due, and due to changes in interest rates. All of the securities held by the Company are classified as available for sale, and all are therefore carried at their fair value. However, as also explained in that note, adjustments to the carrying amount for changes in fair value for securities classified as available-for-sale are not recorded in the Company’s income statement. Instead, the after-tax effect of the change is shown in a special component of capital. Consequently, as shown in the first table in this note, there are unrealized gains and losses related to the securities held by the Company. The amount of unrealized losses at June 30, 2004 has increased $14.1 million from December 31, 2003. All of this increase is due to changes in interest rates and to the growth in the portfolio.

The amortized historical cost and estimated market value of debt securities by contractual maturity are shown below. The issuers of certain of the securities have the right to call or prepay obligations before the contractual maturity date. Depending on the contractual terms of the security, the Company may receive a call or prepayment penalty in such instances. As of December 31, 2003, the Company classified all of its investment securities as available-for-sale.

*(dollars in thousands)*	*June 30, 2004*			*December 31, 2003*

	Available- for-Sale			Available- for-Sale

Amortized cost:
In one year or less		$	115,165		$	98,316
After one year through five years			871,277			549,220
After five years through ten years			252,221			341,054
After ten years			256,285			307,273

Total Securities		$	1,494,948		$	1,295,863


Estimated fair value:
In one year or less		$	116,151		$	99,542
After one year through five years			860,961			556,563
After five years through ten years			251,284			342,757
After ten years			263,457			319,100

Total Securities		$	1,491,853		$	1,317,962

The following table discloses securities balances by category that are at an unrealized loss at June 30, 2004 and the range of duration of the loss. Included in the table are 261 securities that have been in an unrealized loss position for less than a year and three securities that has been in an unrealized loss position for more than one year. There are no credit concerns regarding any of these securities and consequently the Company has no reason to believe that the full par value of the securities will not be received. The Company has concluded that none of these securities is other than temporarily impaired. At June 30, 2004, the Company had the ability and intent to hold these securities until recovery. However, changes in interest rates or other circumstances could change that intent.

	*Less than 12 months*					*12 months or more*					*Total*

As of June 30, 2004 (dollars in thousands)	Fair Value		Unrealized Loss			Fair Value		Unrealized Loss			Fair Value		Unrealized Loss


US Treasury/US Agencies	$	97,728	$	(966	)	$	—	$	—		$	97,728	$	(966	)
Federal Agency Mortgage Backed Securities		752,004		(18,348	)		13,831		(384	)		765,835		(18,732	)
Municipal Bonds		50,947		(2,749	)		800		(53	)		51,747		(2,802	)
Asset backed Securities		10,179		(57	)		—		—			10,179		(57	)
Private CMO		17,271		(143	)		—		—			17,271		(143	)

Subtotal, Debt Securities		928,129		(22,263	)		14,631		(437	)		942,760		(22,700	)
Common Stock		—		—			—		—			—		—

Total temporarily impaired securities	$	928,129	$	(22,263	)	$	14,631	$	(437	)	$	942,760	$	(22,700	)

	*Less than 12 months*					*12 months or more*				*Total*

As of December 31, 2003 (dollars in thousands)	Fair Value		Unrealized Loss			Fair Value		Unrealized Loss		Fair Value		Unrealized Loss


US Treasury/US Agencies	$	21,032	$	(52	)	$	—	$	—	$	21,032	$	(52	)
Federal Agency Mortgage Backed Securities		514,653		(7,212	)		—		—		514,653		(7,212	)
Municipal Bonds		30,933		(1,112	)		—		—		30,933		(1,112	)
Asset backed Securities		9,011		(182	)		—		—		9,011		(182	)

Subtotal, Debt Securities		575,629		(8,558	)		—		—		575,629		(8,558	)
Common Stock		—		—			—		—		—		—

Total temporarily impaired securities	$	575,629	$	(8,558	)	$	—	$	—	$	575,629	$	(8,558	)

5. LOANS AND THE ALLOWANCE FOR CREDIT LOSSES

The balances in the various loan categories are as follows:

*(dollars in thousands)*	June 30, 2004		December 31, 2003			June 30, 2003

Real estate:
Residential - 1 to 4 family	$	835,417		$	799,793	$	695,564
Non-residential and multi-family residential		1,239,297			853,981		927,657
Construction		261,271			249,976		168,442
Commercial loans		735,718			680,679		645,208
Home equity loans		172,662			138,422		124,732
Consumer loans		283,677			296,286		273,673
Tax refund loans		2,989			—		—
Leases		187,042			148,504		137,037
Municipal tax-exempt obligations		14,187			11,419		23,055
Other loans		8,618			1,819		2,508

Total loans		3,740,878			3,180,879		2,997,876
Allowance for credit losses		48,376			49,550		50,031

Net loans	$	3,692,502		$	3,131,329	$	2,947,845

The loan balances at June 30, 2004, December 31, 2003 and June 30, 2003 are net of approximately $6.3 million, $5.4 million, and $4.9 million respectively, in deferred net loan fees and origination costs. The leases reported in the table above are fully-financed capital leases of commercial equipment. The Company is not in the business of automobile leasing.

Municipal tax-exempt obligations are loans to cities and special districts. These obligations are not bonded as are the municipal obligations in the securities portfolio.

Included in the total for loans is the market value adjustment related to the loans acquired from PCCI in the March 2004 acquisition. The amount of this adjustment was $6.3 million at the time of the acquisition. Because the amount that will be collected on these loans is not impacted by this adjustment, it must be amortized against interest income over the estimated lives of the loans so that the amount of the loans reported as outstanding at the time of payment equals the amount to be paid. Amortization expense on this adjustment for the second quarter of 2004 was $1.2 million. Estimated amortization expense for the remainder of 2004, for the next three years, and thereafter is as follows:

(dollars in thousands)		Year		Amortization Expense
		2004		$1,088
		2005		$1,138
		2006		$ 826
		2007		$ 664
		Thereafter		$1,423

The following table discloses balance information about the impaired loans and the related allowance as of June 30, 2004, December 31, 2003 and June 30, 2003:

*(dollars in thousands)*	June 30, 2004			December 31, 2003			June 30, 2003

Loans identified as impaired		$	38,459		$	57,355		$	49,486
Impaired loans for which a valuation allowance has been established		$	8,362		$	25,789		$	40,862
Amount of valuation allowance for impaired loans		$	1,376		$	9,047		$	12,745
Impaired loans for which no valuation allowance has been established		$	30,097		$	31,566		$	8,624

The following table discloses additional information about impaired loans for the three and six-month periods ended June 30, 2004 and 2003:

*(dollars in thousands)*	Three-month Periods Ended June 30,				Six-month Periods Ended June 30,
	2004		2003		2004		2003

Average amount of recorded investment in impaired loans for the year	$	42,080	$	51,789	$	47,041	$	50,196
Interest recognized during the period for impaired loans	$	151	$	10	$	265	$	11

The valuation allowance for impaired loans of $1.4 million as of June 30, 2004 is included within the allowance for credit losses of $48.1 million in the “All Other Loans” column in the statement of changes in the allowance account as of June 30, 2004 shown below. The amounts related to tax refund anticipation loans and to all other loans are shown separately.

*(dollars in thousands)*	All Other Loans				Tax Refund Loans				Total

For the six months ended June 30, 2004:
Balance, December 31, 2003		$	49,550			$	—			$	49,550
Addition from PCCI acquisition			6,146				—				6,146
Provision for credit losses			(633	)			8,954				8,321
Credit losses charged against allowance			(10,671	)			(12,251	)			(23,182	)
Recoveries added to allowance			3,696				3,845				7,541

Balance, June 30, 2004		$	48,088			$	288			$	48,376


For the quarter ended June 30, 2004:
Balance March 31, 2004		$	51,608			$	1,638			$	53,246
Addition from PCCI acquisition			—				—				—
Provision for credit losses			737				—				737
Credit losses charged against allowance			(5,618	)			(2,241	)			(7,859	)
Recoveries added to allowance			1,361				891				2,252

Balance, June 30, 2004		$	48,088			$	288			$	48,376


For the six months ended June 30, 2003:
Balance, December 31, 2002		$	53,821			$	—			$	53,821
Provision for credit losses			3,109				11,143				14,252
Credit losses charged against allowance			(10,476	)			(13,712	)			(24,188	)
Recoveries added to allowance			3,577				2,569				6,146

Balance, June 30, 2003		$	50,031			$	—			$	50,031


For the quarter ended June 30, 2003:
Balance March 31, 2003		$	53,903			$	89			$	53,992
Provision for credit losses			(1,299	)			3,934				2,635
Credit losses charged against allowance			(4,551	)			(4,570	)			(9,121	)
Recoveries added to allowance			1,978				547				2,525

Balance, June 30, 2003		$	50,031			$	—			$	50,031

6. OTHER ASSETS

Included in “Other assets” on the Consolidated Balance Sheets at June 30, 2004 and December 31, 2003, are deferred tax assets of $27.7 million and $19.4 million, respectively. Deferred tax assets represent the tax impact of expenses recognized as tax deductible for the financial statements that have not been deducted in the Company’s tax returns or taxable income reported on a return that has not been recognized in the financial statements as income. Changes in the amount are primarily related to provision for credit losses expense. The Company cannot necessarily deduct its provision for credit losses expense in its tax return in the same year in which it is recognized for financial statements. Provision for credit losses expense is deductible for income tax purposes only as loans are actually charged-off.

7. GOODWILL AND OTHER INTANGIBLE ASSETS

The balance of goodwill is $108.6 million at June 30, 2004, of which $78.6 million is related to the PCCI March 5, 2004 acquisition, and $30.0 million at December 31, 2003 which is related to previous acquisitions as explained in Note 1. Goodwill is allocated to the unit(s) of the acquired company that are deemed by Management to have provided the value in the acquisition. In the PCCI transaction, it was primarily for the lending units that the company was purchased. In the case of the prior purchases, the perceived value was in the deposit relationships and the consumer and small business lending. The goodwill arising from the PCCI acquisition is recorded in the “Pacific Capital” segment, while the remaining goodwill is recorded on the “Community Banking” segment which includes the Company’s deposit activities and consumer and small business lending. Goodwill is not amortized but periodically reviewed for impairment as discussed in Note 1.

Also recorded on the Consolidated Balance Sheets at June 30, 2004 is $1.7 million in loan servicing rights, some of which is related to the PCCI acquisition, as discussed in Note 8, “Transfers and Servicing of Financial Assets,” and an intangible asset of $5.6 million related to the purchase of certain of the assets and liabilities of two branches from another financial institution and to the value of core deposits acquired with PCCI. The Company has recorded this asset in the “Community Banking” segment. It is being amortized over 12 years.

Amortization expense for the remainder of 2004, over the next three years, and thereafter on this core deposit intangible and current other intangibles is expected to be:

*(dollars in thousands)*	Year	Amortization Expense
	2004		$	651
	2005		$	1,266
	2006		$	1,074
	2007		$	352
	Thereafter		$	1,491

8. TRANSFERS AND SERVICING OF FINANCIAL ASSETS

Indirect Auto Securitization

During the first quarter of 2001, the Bank securitized $58.2 million in automobile loans resulting in a gain on sale of approximately $566,000. Retained interest held by the Bank upon completion of this securitization was $3.5 million. The transaction was conducted through the SBB&T Automobile Loan Securitization Corporation, a wholly owned subsidiary of the Bank.

The terms of the securitization permitted the Company to repurchase the remaining loans once the outstanding balance was less than 10% of the original amount sold. In April, 2004, the Company exercised this option to repurchase the remaining loans, and they are now reported along with other consumer loans in the first Table in Note 5. SBBT Automobile Loan Securitization Corporation is currently inactive.

Refund Anticipation Loan Securitization

The Company established a special purpose subsidiary corporation in November 2000 named SBB&T RAL Funding Corporation and during the first quarters of 2003 and 2004 sold RALs into a multi-seller conduit, backed by commercial paper. The Company acted as the servicer for all such RALs during the securitization periods. By March 31, 2003 and 2004, all loans sold into the securitization earlier in the respective quarters were either repaid or charged-off, and no securitization-related balances remained during the second quarter of these years.

Mortgage Servicing Rights

The Company sells some of the residential mortgages it originates and for most of these sold loans servicing is retained. As of June 30, 2004, the Company serviced $ 88.9 million in residential loans for investors. The Company receives a fee for this service. The right to receive this fee for performing servicing (mortgage servicing rights or “MSR”) is of value to the Company and could be sold should the Company choose to do so. The rights are recorded at the net present value of the fees that will be collected, less estimated servicing cost, which approximates fair value. The longer the period of time over which the fees will be collected, the more valuable they are. Prepayment by the borrowers of these loans reduces the value of the MSR because the Company will not receive servicing fees for as long as it would if the loans were paid back over the original terms. The capitalized fees are amortized against noninterest revenue over the expected lives of the loans.

As of December 31, 2002, the value of the Company’s MSR was $995,000. During the first quarter of 2003, the rate of prepayments on these loans increased. This resulted in a shorter period of time over which the Company expected to receive the servicing fees. To reflect this shorter period, the Company increased the valuation allowance of the servicing rights by $444,000. This was in addition to the normal amortization expense for the quarter. Assuming that the higher prepayments would continue, the Company also reduced the value attributed to the MSR resulting from loans sold in the second quarter of 2003. No further adjustment was deemed necessary at the end of that quarter. The Company reduced the valuation allowance of the servicing rights by approximately $326,000 during the first quarter due to a decline in prepayments. During the second quarter, the valuation allowance was increased by approximately $176,000. The value of the MSR at June 30, 2004 was $1.7 million.

In connection with the March 5, 2004 PCCI acquisition, the Company obtained a non-mortgage servicing asset of $866,000. This asset was created by PCCI’s sales of SBA 7(a) commercial business loans, whereby PCCI sold the guaranteed portion of such loans and retained the servicing, for which it received servicing fees. The servicing asset was recorded at the present value of the excess of the contractual fees that will be collected over the estimated cost of servicing the loans. As with MSR, prepayments by the borrowers on the underlying loans reduce the value of the servicing asset. The servicing asset is amortized against noninterest revenue over the expected lives of the underlying loans. The amount of the SBA 7(a) loans sold and serviced by the Company at June 30, 2004 was $29.7 million, and the amount of the unamortized servicing rights was $831,000.

Servicing rights may be purchased from another institution that originates loans or from another entity that services loans. Aside from the rights acquired as part of the acquisition of another financial institution, the Company has never purchased such rights.

9. LONG-TERM DEBT AND OTHER BORROWINGS

Long-term debt and other borrowings included the following items:

*(dollars in thousands)*	June 30, 2004		December 31, 2003


Federal Home Loan Bank advances	$	588,796		$	380,100
Treasury Tax & Loan amounts due to Federal Reserve Bank		3,861			8,448
Subordinated debt issued by the Bank		71,000			71,000
Senior debt issued by the Bancorp		37,000			40,000
Subordinated debt issued by the Bancorp		30,250			—

Total	$	730,907		$	499,548

The “Subordinated debt issued by Bancorp” was assumed in connection with the March 5, 2004 PCCI acquisition. This debt is owed to the three business trust subsidiaries of Bancorp that were added in the PCCI acquisition and is comprised of the following: $13,750,000 owed to PCC Trust I, $6,190,000 owed to PCC Trust II, and $10,310,000 owed to PCC Trust III. Each of the three pieces of this subordinated debt will mature in 2033, but is callable by the Company in part or in total in 2008. The PCC Trust I debt has a fixed interest rate of 6.335% until 2008, after which the interest rate will float and reset quarterly at the three-month LIBOR rate plus 3.25%. The PCC Trust II debt has a fixed interest rate of 6.58% until 2008, after which the interest rate will float and reset quarterly at the three-month LIBOR rate plus 3.15%. The PCC Trust III debt

has a fixed interest rate of 6.80% until 2008, after which the interest rate will float and reset quarterly at the three-month LIBOR rate plus 3.10%.

As of June 30, 2004, the Federal Home Loan Bank (“FHLB”) advances had the following maturities: $146.3 million in 1 year or less; $349.5 million in 1 to 3 years, and $93.0 million in more than 3 years. The senior debt is due in July 2006 and the subordinated debt issued by the Bank is due in July 2011. The Treasury Tax and Loan notes are due on demand.

10. OTHER POSTRETIREMENT HEALTH BENEFITS

All eligible retirees may obtain health insurance coverage through the Company’s Retiree Health Plan (“the Plan”). The coverage is provided through the basic coverage plan provided for current employees. Based on a formula involving date of retirement, age at retirement, and years of service prior to retirement, the Plan provides that the Company will pay a portion of the health insurance premium for the retiree. Though the premiums for a retiree’s health coverage are not paid until after the employee retires, the Company is required to recognize the cost of those benefits as they are earned rather than when paid. The Plan is described in detail in Note 14 to the Company’s Consolidated Financial Statements in the 2003 10-K.

The commitment the Company has made to provide these benefits results in an obligation that must be recognized in the financial statements. This obligation, termed the accumulated postretirement benefit obligation (“APBO”), is the actuarial net present value of the obligation for: (1) already retired employees’ expected postretirement benefits; and (2) the portion of the expected postretirement benefit obligation earned to date by current employees. The net present value is that amount which if compounded at an assumed interest rate would equal the amount expected to be paid in the future.

The increase in the APBO for the benefits being earned each year, is recognized through a charge to income called the Net Periodic Postretirement Benefit Cost (the “NPPBC”). The various components of the NPPBC are explained in the 2003 10-K.

The amount of NPPBC recognized in the first quarters of 2003 and 2004 are disclosed in the following table.

	For the Three Month Periods Ended June 30,						For the Six Month Periods Ended June 30,
*(dollars in thousands)*	2004			2003			2004			2003


Service cost	$	366		$	248		$	731		$	496
Interest cost		199			167			398			333
Return on assets		(97	)		(73	)		(195	)		(146	)

Amortization of unrecognized transition obligation or transition asset		—			—			—			—
Recognized gains or (losses)		83			67			165			134
Prior service cost recognized		—			—			—			—
Gain or (loss) recognized due to a settlement or curtailment		—			—			—			—

Total	$	551		$	409		$	1,099		$	817

During the first half of 2004, Company contributed $1.1 million to the Voluntary Employee Benefit Association (“VEBA”) that the Company established to hold the funds for the Plan. The Company expects to contribute another $1 million during the remainder of 2004.

11. COMMITMENTS AND CONTINGENCIES

Legal Matters

The Company is a defendant in a class action lawsuit brought on behalf of persons who entered into a refund anticipation loan application and agreement (the “RAL Agreement”) with the Company from whose tax refund the Company deducted a debt owed by the applicant to another RAL lender. The lawsuit was filed on March 18, 2003 in the Superior Court in San Francisco, California as Canieva Hood and Congress of California Seniors v. Santa Barbara Bank & Trust, Pacific Capital Bank, N.A., and Jackson-Hewitt, Inc. The Company is a party to a separate cross-collection agreement with each of the other RAL lenders by which it agrees to collect sums due to those other lenders on delinquent RALs by deducting those sums from tax refunds due to its RAL customers and remitting those funds to the RAL lender to whom the debt is owed. This cross-collection procedure is disclosed in the RAL Agreement with the RAL customer and is specifically authorized and agreed to by the customer. The plaintiff does not contest the validity of the debt, but contends that the cross-collection is illegal and requests damages on behalf of the class, injunctive relief against the Company, restitution of sums collected, punitive damages and attorneys’ fees. Venue for this suit has been changed to Santa Barbara. The Company believes that there is no merit to the claims made in this action and intends to vigorously defend itself.

The Company is a defendant in a class action lawsuit brought on behalf of persons who entered into a refund transfer application and agreement (the “RT Agreement”) with the Company from whose tax refund the Company deducted a debt owed by the applicant to another RAL lender. The lawsuit was filed on May 13, 2003 in the Superior Court in San Francisco, California as Alana Clark, Judith Silverstine, and David Shelton v. Santa Barbara Bank & Trust. The cross-collection procedures mentioned in the description above of the Hood case is also disclosed in the RT Agreement with the RT customer and is specifically authorized and agreed to by the customer. The plaintiffs do not contest the validity of the debt, but contend that the cross-collection is illegal and request damages on behalf of the class, injunctive relief against the Company, restitution of sums collected, punitive damages and attorneys’ fees. The Company filed a motion for a change in venue from San Francisco to Santa Barbara. The plaintiffs’ legal counsel stipulated to the change in venue. Thereafter, the plaintiffs have dismissed the complaint without prejudice. The plaintiffs have filed a new complaint in San Francisco limited to a single cause of action alleging a violation of the California Consumer Legal Remedies Act. The Company believes that there is no merit to the claims made in this action and intends to vigorously defend itself.

The Company is a defendant in a class action law suit brought on behalf of residents of the State of New York who engaged Jackson Hewitt, Inc (“JHI”) to provide tax preparation services and who through JHI entered into an agreement with the Company to receive a RAL. JHI is also a defendant. The lawsuit was filed on June 18, 2004, in the Supreme Court of the State of New York, County of New York as Myron Benton v. Jackson Hewitt, Inc. and Santa Barbara Bank & Trust Co. As part of the RAL documentation, the customer receives and signs a disclosure form which discloses that the Company may share a portion of the federal refund processing fee and finance charge with JHI. The plaintiffs allege that the failure of JHI and the Company to disclose the specific amount of the fee which JHI receives is unlawful and request damages on behalf of the class, injunctive relief, punitive damages and attorneys’ fees. The Company believes that there is no merit to the claims made in this action and intends to vigorously defend itself.

The Company is involved in various litigation of a routine nature which is being handled and defended in the ordinary course of the Company’s business. Expenses are being incurred in connection with defending the Company, but in the opinion of Management, based in part on consultation with legal counsel, the resolution of this litigation will not have a material impact on the Company’s financial position, results of operations, or cash flows.

Securities and Loans Pledged as Collateral

Securities totaling approximately $1.15 billion and $1.12 billion at June 30, 2004 and December 31, 2003, respectively, were pledged to secure public funds, trust deposits, bankruptcy deposits, treasury tax and loan deposits, FHLB advances, customer repurchase agreements, and other borrowings as required or permitted by law.

Loans secured by first trust deeds on residential and commercial property of $729 million and $585 million at June 30, 2004 and December 31,2003, respectively, were pledged to the FHLB as security for borrowings.

Letters of Credit and Other Contractual Commitments

In order to meet the financing needs of its customers in the normal course of business, the Company is a party to financial instruments with “off-balance sheet” risk. These financial instruments consist of commitments to extend credit and standby letters of credit.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of material covenants indicating economic deterioration inconsistent with further lending. The Company sometimes charges fees in connection with loan commitments. Standby letters of credit are irrevocable commitments issued by the Company to guarantee the performance or support the debt of a customer to a third party. The Company charges a fee for these letters of credit.

The standby letters of credit involve, to varying degrees, exposure to credit risk in excess of the amounts recognized in the consolidated balance sheets. This risk arises from the possibility of the failure of the customer to perform according to the terms of a contract. In such a situation the third party might draw on the standby letter of credit to pay for completion of the contract and the Company would have to look to its customer to repay these funds to the Company with interest. To minimize the risk, the Company uses the same credit policies in making commitments and conditional obligations as it would for a loan to that customer. The decision as to whether collateral should be required is based on the circumstances of each specific commitment or conditional obligation. Because of these practices, Management does not anticipate that any unplanned for and unprovided for losses will arise from such draws, unless there are significant changes in the financial condition of the customers since the evaluation of the condition was performed by the Bank.

Changes in market rates of interest for those few commitments and undisbursed loans which have fixed rates of interest represent a possible cause of loss because of the contractual requirement to lend money at a rate that is no longer as great as the market rate at the time the loan is funded. To minimize this risk, if rates are quoted in a commitment, they are generally stated in relation to the Company’s prime or base lending rate, or to another external index. These rates vary with prevailing market interest rates. Fixed-rate loan commitments are not usually made for more than three months.

The maximum non-discounted exposure to credit risk is represented by the contractual notional amount of those instruments. The majority of the commitments are for one year or less. The majority of the credit lines and commitments may be withdrawn by the Company subject to applicable legal requirements. As of June 30, 2004 and December 31, 2003, the contractual notional amounts and the maturity of these instruments are as follows:

	As of June 30, 2004
											As of December 31, 2003
*(dollars in thousands)*	Less than one year		One to three years		Three to five years		More than five years		Total		As of December 31, 2003


Commercial lines of credit	$	248,126	$	94,860	$	37,499	$	59,951	$	440,436	$	455,991
Consumer lines of credit		3,167		5,542		8,824		195,064		212,597		173,888
Standby letters of credit		59,424		22,128		14,342		5,925		101,819		89,535

Total	$	310,717	$	122,530	$	60,665	$	260,940	$	754,852	$	719,414

The Company anticipates that a majority of the above commitments will not be fully drawn on by customers. Consumers do not tend to borrow the maximum amounts available under their home equity lines (the Company does not make credit card loans) and businesses typically arrange for credit lines in excess of their expected needs to handle contingencies.

The Company has established a liability for estimated credit losses on letters of credit. In accordance with GAAP, this liability is not included as part of the allowance for credit loss reported on the consolidated balance sheets for outstanding loans. Instead, the liability is included in other liabilities. In the second quarter of 2003, the Company added $2.1 million to the liability. The addition related to two letters of credit extended to a customer whose financial condition changed significantly enough that it would be unable to meet the financial obligations for which the letters of credit provide credit enhancement. In the third quarter of 2003, another $440,000 was added to this liability. During the fourth quarter of 2003, $3.0 million was written off as one of the letters of credit was drawn. The balance of the liability at March 31, 2004 was $4.1 million, $3.0 million of which related to the above-mentioned customer. The balance of the liability at June 30, 2004 was $3.0 million, $1.9 million of which related to the above-mentioned customer.

The following table shows the activity in this reserve account for the three and six -month periods ended June 30, 2003 and 2004:

	Three months ended June 30,		Six months ended June 30,
	2004	2003	2004	2003
Beginning reserve	$4,051	$3,251	$3,942	$2,446

Additions	21	2,066	130	2,871
Funded and written-off	1,061	—	1,061	—

Ending reserve	$3,011	$5,317	$3,011	$5,317

The following table discloses cash amounts contractually due from the Company under specific categories of obligations as of June 30, 2004 and December 31, 2003:

	As of June 30, 2004
											As of December 31, 2003
*(dollars in thousands)*	Less than one year		One to three years		Three to five years		More than five years		Total		As of December 31, 2003


Deposits *	$	4,004,823	$	250,065	$	96,443	$	1,334	$	4,352,665	$	3,854,717
Borrowings		315,367		377,720		104,158		55,000		852,245		557,887
Purchase obligations		1,448		—		—		—		1,448		1,682
Non-cancelable leases		10,230		17,692		13,712		46,086		87,720		89,535

Total	$	4,331,868	$	645,477	$	214,313	$	102,420	$	5,294,078	$	4,503,821

*	Only certificates of deposit have a specified maturity. The balances of other deposit accounts are assigned to the Less Than One Year time range.

Non-cancelable leases: The Company leases most of its office locations and substantially all of these office leases contain multiple five-year renewal options and provisions for increased rentals, principally for property taxes and maintenance. As of June 30, 2004, the minimum rentals under non-cancelable leases for the next five years and thereafter are shown in the above table. The amounts in the table for minimum rentals are not reported net of the contractual obligations of sub-tenants. Sub-tenants leasing space from the Company are contractually obligated to the Company for approximately $5.9 million. Approximately 60% of these payments are due to the Company over the next three years.

12. DERIVATIVE INSTRUMENTS

The Company had no swaps in place at the end of the second quarter of 2004 for managing its own interest rate risk.

The Company has entered into interest rate swaps and foreign exchange transactions with some of its customers to assist them in managing their interest rate and foreign currency risks. As of June 30, 2004, these swaps had a notional amount of $74.0 million and a fair value of $146,000. To avoid increasing its own interest rate or foreign exchange risk from entering into these swap agreements, the Company has entered into offsetting swap agreements with other larger financial institutions that cover these customer swaps. The effect of the offsetting swaps to the Company is to neutralize its interest rate and currency risk positions. The Company generally earns a spread to compensate it for its services. Credit risk is also associated with these swaps in that a counterparty, either the Company’s customer or the other financial institution, may default on its obligation.

13. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS

GAAP requires companies to disclose the fair value of those financial instruments for which it is practicable to estimate that value and the methods and significant assumptions used to estimate those fair values. This must be done irrespective of whether or not the instruments are recognized on the balance sheets of the Company.

There are several factors which users of these financial statements should keep in mind regarding the fair values disclosed in this note. First, there are uncertainties inherent in the process of estimating the fair value of certain financial instruments. Second, the Company must exclude from its estimate of the fair value of deposit liabilities any consideration of its on-going customer relationships which provide stable sources of investable funds.

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Cash and Cash Equivalents

The face value of cash, Federal funds sold, and securities purchased under agreements to resell are their fair value.

Securities

For securities, fair value equals quoted market price, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. As explained in Note 1, “Summary of Significant Accounting Policies,” all of the Company’s securities are classified as available-for-sale and are therefore carried at fair value. Consequently, the carrying amount is equal to the fair value in the table below.

Loans

The fair value of loans is estimated by discounting the future contractual cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. These contractual cash flows are adjusted to reflect estimates of uncollectible amounts.

Deposit Liabilities

The fair value of demand deposits, money market accounts, and savings accounts is the amount payable on demand as of the period end. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities.

Repurchase Agreements, Federal Funds Purchased, and Other Borrowings

For short-term instruments, the carrying amount is a reasonable estimate of their fair value. For FHLB advances, the fair value is estimated using rates currently quoted by the FHLB for advances of similar remaining maturities. When issued, the senior and subordinated notes had a coupon rate at a spread above U.S. Treasury securities of comparable maturity. The fair value of these notes is estimated by applying approximately the same spread to the rates current in the market for U.S. Treasury securities of comparable maturity.

Derivatives

Fair values for derivative financial instruments are based on quotes received from other financial institutions for the cost of or the benefit from settling the contract.

Financial Guarantees and Commitments

The fair value of guarantees and letters of credit is based on fees currently charged for similar agreements. The Company does not believe that its loan commitments have a fair value within the context of this note because generally fees have not been charged, the use of the commitment is at the option of the potential borrower, and the commitments are being written at rates comparable to current market rates.

Fair values for off-balance-sheet, credit related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing.

The fair value of the financial guarantees, commitments and other off-balance-sheet instruments are immaterial.

The carrying amount and estimated fair values of the Company’s financial instruments as of June 30, 2004 and December 31, 2003, are as follows:

	As of June 30, 2004				As of December 31, 2003
*(dollars in thousands)*	Carrying Amount		Fair Value		Carrying Amount		Fair Value


Financial assets:
Cash and due from banks	$	140,885	$	140,885	$	150,010	$	150,010
Federal funds sold		12,000		12,000		33,010		33,010
Securities available-for-sale		1,491,853		1,491,853		1,317,962		1,317,962
Net loans		3,692,502		3,736,362		3,131,329		3,185,813
Mortgage servicing rights		1,653		1,653		537		537
Derivatives		146		146		1,436		1,436

Total financial assets		5,339,039		5,382,899		4,634,284		4,688,768

Financial liabilities:
Deposits		4,352,665		4,350,780		3,854,717		3,861,008
Long-term debt, FHLB Advances		727,046		731,959		491,100		502,822
Repurchase agreements,
Federal funds purchased, and Treasury Tax & Loan		125,199		125,208		66,787		66,784
Derivatives		298		298		2,334		2,334

Total financial liabilities		5,205,208		5,208,245		4,414,938		4,432,948

Net financial Assets	$	133,831	$	174,654	$	219,346	$	255,820

14. SEGMENT DISCLOSURE

The following table presents information for each segment regarding assets, profit or loss, and specific items of revenue and expense that are included in that measure of segment profit or loss as reviewed by the chief operating decision maker. Except for the business activities acquired with PCCI, information regarding how the Company determines its segments is provided in Note 26, “Segment Reporting,” to the Consolidated Financial Statements included in the Company’s 2003 10-K.

In connection with the March 5, 2004 PCCI acquisition, the operations of the three branches acquired have been included in the “Community Banking” segment along with the other branch activities of the Company. The operations of PCCI’s commercial real estate and SBA lending areas report to the former CEO of PCCI, who reports to the CEO of the Company and, consequently, they have been identified as a reportable segment.

*(dollars in thousands)*	Community Banking		Commercial Banking		Refund Programs			*Fiduciary*		Pacific* Capital		All Other			*Total*

Three months ended June 30, 2004
Revenues from external customers	$	32,160	$	24,863	$	5,151		$	3,792	$	6,761	$	15,672		$	88,399
Intersegment revenues		25,239		—		562			434		—		880			27,115

Total revenues	$	57,399	$	24,863	$	5,713		$	4,226	$	6,761	$	16,552		$	115,514


Profit (Loss)	$	29,288	$	16,530	$	2,303		$	2,558	$	2,020	$	(25,076	)	$	27,623
Interest income		25,031		22,668		1,478			—		6,328		17,514			73,019
Interest expense		8,219		—		233			78		—		7,466			15,996
Internal charge for funds		7,265		4,584		—			1		2,979		12,287			27,115
Depreciation		1,054		39		179			20		17		3,560			4,869
Total assets		1,668,329		1,584,361		70,304			1,418		272,738		2,087,179			5,684,329
Capital expenditures		—		—		—			—		—		5,256			5,256

	Community Banking		Commercial Banking		Refund Programs			*Fiduciary*		Pacific* Capital		All Other			*Total*

Three months ended June 30, 2003
Revenues from external customers	$	31,113	$	24,411	$	5,293		$	3,595	$	—	$	13,219		$	77,631
Intersegment revenues		15,219		—		215			295		—		12,322			28,051

Total revenues	$	46,332	$	24,411	$	5,508		$	3,890	$	—	$	25,541		$	105,682


Profit (Loss)	$	18,745	$	15,094	$	(237	)	$	1,988	$	—	$	(13,015	)	$	22,575
Interest income		23,992		24,023		1,572			—		—		12,467			62,054
Interest expense		8,514		—		21			—		—		4,947			13,482
Internal charge for funds		7,748		7,236		288			5		—		12,774			28,051
Depreciation		949		41		132			27		—		1,338			2,487
Total assets		1,667,488		1,567,338		77,856			1,494		—		1,224,287			4,538,463
Capital expenditures		—		—		—			—		—		2,967			2,967

* As explained in the text, this segment represents the lending areas for the former PCCI, not Pacific Capital Bancorp, the holding company.


*(dollars in thousands)*	Community Banking		Commercial Banking		Refund Programs		*Fiduciary*		Pacific* Capital		All Other			*Total*

Six months ended June 30, 2004
Revenues from external customers	$	63,334	$	49,460	$	63,821	$	7,913	$	8,971		33,893		$	227,392
Intersegment revenues		44,294		—		4,385		784		—		2,279			51,742

Total revenues	$	107,628	$	49,460	$	68,206	$	8,697	$	8,971	$	36,172		$	279,134


Profit (Loss)		52,543		33,761		43,729		5,353	$	2,808		(41,174	)		97,019
Interest income		49,286		45,661		36,572		—		8,515		35,357			175,391
Interest expense		15,498		—		968		150		25		14,252			30,893
Internal charge for funds		14,242		9,801		—		1		3,761		23,936			51,742
Depreciation		1,869		77		314		40		22		4,823			7,145
Total assets		1,668,329		1,584,361		70,304		1,418		272,738		2,087,179			5,684,329
Capital expenditures		—		—		—		—		—		9,623			9,623

	Community Banking		Commercial Banking		Refund Programs		*Fiduciary*		Pacific* Capital		All Other			*Total*

Six months ended June 30, 2003
Revenues from external customers	$	62,905	$	49,008	$	62,076	$	7,172	$	—	$	26,227		$	207,388
Intersegment revenues		31,822		—		1,670		654		—		21,768			55,914

Total revenues	$	94,727	$	49,008	$	63,746	$	7,826	$	—	$	47,995		$	263,302


Profit (Loss)	$	39,267	$	29,875	$	40,630	$	4,310	$	—	$	(32,043	)	$	82,038
Interest income		48,111		48,157		31,647		—		—		25,044			152,959
Interest expense		17,265		—		772		—		—		9,675			27,712
Internal charge for funds		16,195		14,975		2,665		6		—		22,073			55,914
Depreciation		1,870		82		267		56		—		2,665			4,940
Total assets		1,667,488		1,567,338		77,856		1,494		—		1,224,287			4,538,463
Capital expenditures		—		—		—		—		—		7,911			7,911

* As explained in the text, this segment represents the lending areas for the former PCCI, not Pacific Capital Bancorp, the holding company.

The following table reconciles total revenues and profit for the segments to total revenues and pre-tax income, respectively, in the consolidated statements of income for the three and six-month periods ended June 30, 2004 and 2003.

*(dollars in thousands)*	Three months ended June 30,						Six months ended June 30,
	2004			2003			2004			2003

Total revenues for reportable segments	$	116,897		$	105,682		$	280,517		$	263,302
Elimination of intersegment revenues		(28,498	)		(28,051	)		(53,125	)		(55,914	)
Elimination of taxable equivalent adjustment		(1,590	)		(1,622	)		(3,197	)		(3,279	)

Total consolidated revenues	$	86,809		$	76,009		$	224,195		$	204,109


Total profit or loss for reportable segments	$	27,623		$	22,575		$	97,019		$	82,038
Elimination of taxable equivalent adjustment		(1,590	)		(1,622	)		(3,197	)		(3,279	)

Income before income taxes	$	26,033		$	20,953		$	93,822		$	78,759

Intersegment revenues consist of transfer pricing for the funds provided by the “Community Banking,” “Refund Programs,” and “Fiduciary” segments, and through the borrowings incurred by the Company’s Treasury department included in “All Other.” Internal charges for funds consist of the transfer pricing for the funds used for lending activities by “Community Banking” and “Commercial Banking” and for the purchases of investments by the Treasury department. The totals for intersegment revenues and charges for funds will equal each other because the Company’s Treasury unit acts as the net seller or buyer of funds and hence receives the difference between intersegment revenues earned by the other units and charges for funds assessed against the other units. Charges for funds are reduced because a portion of each segment’s assets are assumed to be funded by capital rather than borrowed funds. A charge for capital is not included in the pre-tax profitability for each segment.

Intersegment revenues and internal charges for funds will generally be higher when interest rates are higher and lower when rates are low. Short-term interest rates were generally lower in the three-month period ended June 30, 2004 than in the corresponding period of 2003, while intermediate-term rates were generally higher. The commercial loans in the Commercial Banking segment usually have short maturities or reprice frequently and are therefore this segment is charged for funds by reference to the short-term rates. The consumer and small business loans in the Community Banking segment are usually fixed or have infrequent repricings and therefore this segment is charged for funds by reference to intermediate-term rates. This results in the charge for funds in the Commercial Banking segment being lower in the second quarter of 2004 than in the corresponding period of 2003 while the charge for funds in the Community Banking segment is higher. The charge for funds in the Refund Programs segment is lower than would be expected especially in the tables for the six month periods ended June 30 given the amount of the loans. The reason for this is that a substantial portion of the funding for the RAL program is provided within the segment by the RT program. As indicated above, the Company’s Treasury unit functions as a “money center” balancing the funding uses and sources. The changes in its intersegment revenues and charges for funds from one year to the next are primarily the result of changes in the amounts for the other segments.

The Company records provision expense for all loans other than RALs in its Credit Administration Department which is included in the “All Other” segment. The $2.0 million increase in the provision for non-RAL loans for the second quarter of 2003 (a negative provision for non-RAL loans of $1.3 million) and the second quarter of 2004 (a provision of $0.7 million) is one of the reasons for the increase in the pre-tax loss in this segment in the first quarter of 2004 compared to the same quarter of 2003.

15. SUBSEQUENT EVENT

Included among the impaired loans reported as of June 30, 2004 in Note 5 were three loans that had been made to one borrower. The loans were secured by certain contractual rights used by the borrower in its business. They had been partially charged-off because of uncertainty of collection. The recorded amount was $1.18 million after the partial charge-off. Based on the information available to it as of June 30, 2004, the Company had concluded that while discussions with a potential purchaser had taken place, the likelihood of a sale was too uncertain to record a reduction in the allowance for credit losses for any recovery that would result from such a sale.

Subsequent to June 30, 2004, the Company was able to conclude a sale of these notes. Proceeds from the sale were $2.85 million. The excess of the proceeds over the recorded amount was recorded as a recovery and credited to the allowance for credit losses in the the third quarter of 2004.

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS

GAAP AND NON-GAAP MEASURES

In various sections of this discussion and analysis, attention is called to the significant impacts on the Company’s balance sheet and year to date income statement caused by its tax refund anticipation loans (“RAL”) and refund transfer (“RT”) programs. Because they relate to the filing of individual tax returns, these activities of these programs occur primarily during the first and second quarters of each year. The results of operations and actions taken by the Company to manage these programs are discussed in the section below titled “Refund Anticipation Loan and Refund Transfer Programs.” Included in the discussion is a summary statement of the results of operations for the programs. These programs comprise one of the Company’s operating segments for purposes of segment reporting in Note 14, “Segment Disclosure,” to the Consolidated Financial Statements. As such, Management believes that separately reporting operating results for the programs is consistent with accounting principles generally accepted in the United States (“GAAP”).

Because there are only two other financial institutions with nationwide refund programs of similar size to those of the Company, Management computes a number of amounts and ratios exclusive of the balances and operating results of these programs. Management does this so that it may compare the results of the Company’s traditional banking operations with the results of other financial institutions. For the last several years, the Company’s Management has conducted conference calls with analysts and investors in connection with its quarterly earnings releases. During these calls, investors and analysts have expressed through their questions an interest in knowing certain balances and the usual performance ratios for the Company exclusive of the RAL and RT programs. The Company’s Management believes analysts and investors request this information for the same reason that Management uses it internally, namely, to provide more comparability with virtually all of the rest of the Company’s peers that do not operate such programs. Consequently, the Company has provided these amounts and ratios both with and without the balances and results of the RAL and RT programs in its press releases and in its periodic quarterly and annual reports on Forms 10-Q and 10-K, respectively.

Note E to this discussion includes several tables that provide reconciliations for all numbers and ratios reported in this discussion exclusive of the RAL/RT balances or results to the same numbers and ratios for the Company as a whole reported in the Consolidated Financial Statements. The tables provide the consolidated numbers or ratios, the RAL/RT adjustment, and the numbers or ratios exclusive of the RAL/RT adjustment. Notes designated by a letter are found at the end of this analysis and discussion. Notes designated by a number are notes to the financial statements which they follow.

In addition to the non-GAAP measures computed related to the Company’s balances and results exclusive of its RAL and RT programs, this filing contains other financial information determined by methods other than in accordance with GAAP. Management uses these non-GAAP measures in their analysis of the business and its performance. In particular, net interest income, net interest margin and operating efficiency are calculated on a fully tax-equivalent basis (“FTE”).

Management believes that the measures calculated on an FTE basis provide a useful picture of net interest income, net interest margin and operating efficiency for comparative purposes. Net interest income and net interest margin on an FTE basis is determined by adjusting net interest income to reflect tax-exempt interest income on an equivalent before-tax basis. The efficiency ratio also uses net interest income on an FTE basis. The FTE calculation is explained in Note B. Many other banks also report these amounts and ratios on an FTE basis.

SUMMARY RESULTS

Pacific Capital Bancorp and its wholly owned subsidiaries (together referred to as “the Company”) earned $16.5 million for the quarter ended June 30, 2004, compared to $13.4 million in the second quarter last year, an increase of $3.1 million, or 23.5%. Diluted earnings per share for the second quarter of 2004 were $0.36 compared to $0.29 earned in the second quarter of 2003. The Company earned $59.1 million or $1.29 per diluted share in the first half of 2004, compared with $49.8 million or $1.08 per diluted share for the first half of 2003.

Compared to the second quarter of 2003, net interest income (the difference between interest income and interest expense) for the second quarter of 2004 increased by $8.4 million, or 18.1%. Total interest income increased by $11.0 million, or 18.2%, partially offset by an increase in interest expense of $2.5 million, or 18.7%. In general, balances of both earning assets and interest-bearing liabilities increased while rates earned and paid were lower compared to the second quarter of 2003.

The increase in interest income was due to an increase in interest on loans of $6.5 million, or 13.0%, as well as an increase in interest on securities of $4.8 million, or 48.8%. Exclusive of fees on RALs, interest and fees on loans increased by $6.5 million in the second quarter of 2004 compared to the same quarter of 2003. Despite the Federal Open Market Committee’s (“FOMC”) 25 basis point decrease, to 1.00%, in the target Federal funds rate in late June 2003, the growth in earning assets was sufficient to offset the lower rates earned.

Exclusive of RALs, average interest earning assets for the second quarter of 2004 increased by $1.05 billion, or 25.7%, over the same period in 2003. This was comprised of an increase in average non-RAL loans of $694 million, or 23.2%, as well as an increase in average securities of $458.6 million, or 46.4%.

The increase in interest expense was due to an increase in interest on borrowed funds of $1.8 million, or 45.8%, plus a slight increase in interest on deposits of $0.5 million, or 5.5%. Average interest-bearing liabilities increased by $903.6 million, or 28.8%, during the second quarter of 2004 compared to the same period in 2003. This was comprised of an increase in average deposits of $540.9 million, or 19.5%, as well as an increase in average borrowed funds of $362.7 million, or 101.2%. Despite the growth in deposits, interest on deposits decreased due to the lower rate environment in the second quarter of 2004 compared to 2003.

The addition of loans, securities and deposits from the acquisition of PCCI accounts for some of the growth in the average balances cited above.

Provision for credit losses expense decreased from $2.6 million in the second quarter of 2003 to $0.7 million in the second quarter of 2004. Provision expense for loans other than RALs increased from a negative $1.3 million to $0.7 million for the same respective periods. The provision expense for both quarters was impacted by some factors as explained in the discussion of credit quality below.

Noninterest revenue increased $243,000, or 1.6%, in the second quarter of 2004 over the same quarter of 2003. The increase would have been greater but for the change in gain or loss on securities sales. The Company recognized $604,000 in gains in the second quarter of 2003 and losses of $449,000 in the second quarter of 2004. Exclusive of the impact of fees from the refund transfer program, noninterest revenues increased by $221,000, or 1.8%. Operating expense increased by $5.5 million, or 14.4%, during the second quarter of 2004 compared to the same quarter of 2003, most of this increase is due to the additional expenses of PCCI. An explanation of these changes is presented later in this discussion in the sections below titled “Noninterest Revenue” and “Operating Expense,” respectively.

TABLE 1—PERFORMANCE RATIOS (Note A)

	Three Months Ended June 30, 2004				Three Months Ended June 30, 2003

	Consolidated		Excluding RALs/RTs		Consolidated		Excluding RALs/RTs

Return on average assets	1.18	%	1.13	%	1.21	%	1.25	%
Return on average consolidated equity	15.08	%	13.87	%	13.52	%	13.65	%
Operating efficiency	60.46	%	60.98	%	61.01	%	63.85	%
Net interest margin	4.42	%	4.35	%	4.71	%	4.59	%

	Six Months Ended June 30, 2004				Six Months Ended June 30, 2003

	Consolidated		Excluding RALs/RTs		Consolidated		Excluding RALs/RTs

Return on average assets	2.13	%	1.38	%	2.19	%	1.22	%
Return on average consolidated equity	28.06	%	16.04	%	25.96	%	13.69	%
Operating efficiency	46.27	%	60.37	%	46.45	%	62.60	%
Net interest margin	5.59	%	4.52	%	5.91	%	4.72	%

In 2004, the Company’s return on average assets (“ROA”) for the second quarter was 1.18%, compared to 1.21% for the same quarter of 2003, and the return on average equity (“ROE”) was 15.08%, compared to 13.52%. These annualized ratios are significantly impacted by the highly seasonal tax refund programs. Exclusive of the impact of RAL/RT programs in both periods, the ROA was 1.13% for the second quarter of 2004, compared to 1.25% for the same period in 2003.

The operating efficiency ratio measures what proportion of a dollar of operating income it takes to earn that dollar. The decrease in the operating efficiency ratio to 60.46% for the second quarter of 2004 from 61.01% for the same quarter in 2003 can be attributed to a faster rate of growth in net revenues than in operating expenses.

The decrease in the net interest margin, exclusive of the impact of RAL/RT programs, from the second quarter of 2003 to the second quarter of 2004, is the result of the leveraging strategy, discussed in the section titled, “Securities” below, and the 25 basis point decrease in the FOMC’s target funds rate in June 2003, and other reasons explained in the section titled “Interest Rate Sensitivity” below. The low interest rate environment tends to cause a lower net interest margin because the rates paid on deposits cannot be decreased at the same rate that interest rates the Company charges on loans are decreased to be competitive.

BUSINESS

The Company is a bank holding company. All references to “the Company” apply to Pacific Capital Bancorp and its subsidiaries on a consolidated basis. “Bancorp” will be used to refer to the parent company only. “The Bank” refers to the Company’s primary subsidiary, Pacific Capital Bank, N.A. The Bank uses five brand names in different geographic areas. “The Bank” is intended also to mean the prior individual subsidiary banks, as appropriate, when referring to events or situations prior to March 29, 2002 when they were merged into one charter. The Bank is a member of the Federal Reserve System. The Bank offers a full range of retail and commercial banking services. These include commercial, real estate, and consumer loans, a wide variety of deposit products, and full trust services.

Bancorp has seven other subsidiaries. PCB Services Corporation has only insignificant activities. Pacific Capital Services Corporation is an inactive corporation. SBB&T Automobile Loan Securitization Corporation was used for an automobile loan securitization that ended in the second quarter of 2004. SBB&T RAL Funding Corporation is used in the RAL securitization, that is described in Note 8, “Transfers and Servicing of Financial Assets,” to the Consolidated Financial Statements.

On March 5, 2004, the Company acquired Pacific Crest Capital, Inc. (“PCCI”) and its wholly owned subsidiaries, Pacific Crest Bank, Pacific Crest Capital Trust I (“PCC Trust I”), Pacific Crest Capital Trust II (“PCC Trust II”), and Pacific Crest Capital Trust III (“PCC Trust III”). PCCI was merged into Bancorp, while Pacific Crest Bank was merged into the Bank. PCC Trust I, PCC Trust II, and PCC Trust III had been created by PCCI for the exclusive purpose of issuing trust preferred securities. These last three entities will remain subsidiaries of Bancorp but are not consolidated in the financial statements of the Company (see the discussion on Financial Interpretation Number 46 in Note 1).

FORWARD-LOOKING INFORMATION

This quarterly report on Form 10-Q, including this discussion and analysis, contains forward-looking statements with respect to the financial condition, results of operation and business of the Company that are based on Management’s beliefs as well as assumptions made by and information currently available to the Company’s management. These include statements that relate to or are dependent on estimates or assumptions relating to the prospects of continued loan and deposit growth, improved credit quality, the trend and intensity of changes in interest rates, and the operating characteristics of the Company’s income tax refund programs. The subjects of these forward-looking statements involve certain risks and uncertainties, many of which are beyond the Company’s control. Such statements are intended to be covered by the safe-harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995 and this statement is being included for the purpose of invoking these safe-harbor provisions. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements include, among others, the following possibilities: (1) increased competitive pressure among financial services companies; (2) changes in the interest rate environment reducing interest margins or increasing interest rate risk; (3) deterioration in general economic conditions, internationally, nationally or in the State of California; (4) reduced demand for or earnings derived from the Company’s income tax refund loan and refund transfer programs; (5) judicial, legislative or regulatory changes adversely affecting the business in which the Company engages; (6) the occurrence of future events such as the terrorist acts of September 11, 2001

or consequences of U.S. military involvement in the Middle East; (7) difficulties integrating acquired operations; (8) implementation risk relating to a new computer system mentioned in the section titled “Operating Expense”; and (9) other risks detailed in the 2003 10-K. Forward-looking statements speak only as of the date they are made, and the Company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made.

CRITICAL ACCOUNTING POLICIES

A number of critical accounting policies are used in the preparation of the Consolidated Financial Statements which this discussion accompanies.

The Use of Estimates

The preparation of Consolidated Financial Statements in accordance with GAAP requires Management to make certain estimates and assumptions which affect the amounts of reported assets and liabilities as well as contingent assets and liabilities as of the date of these financial statements. These estimates and assumptions also affect the reported amounts of revenues and expenses during the reporting period(s). Although Management believes these estimates and assumptions to be reasonably accurate, actual results may differ.

The principal areas in which estimates are used are as follows:

Allowance for credit losses: An estimate of the amount of the probable losses incurred in the Company’s loan portfolio is used in determining the amount of the allowance for credit losses and therefore the periodic charge to income for the provision for credit losses expense. A description of the method of developing the estimate is described in the section below titled “Credit Quality and the Allowance for Credit Losses” and in Note 1, “Summary of Significant Accounting Policies,” to the Consolidated Financial Statements presented in the Company’s 2003 10-K. If the actual losses incurred in fact materially exceed the estimate of probable losses developed by Management, then the allowance for credit losses will have been understated and the Company will have to record additional provision expense in future periods as the actual amount of losses are recognized. If the losses currently in the portfolio are subsequently determined to be materially less than the estimate, then the Company will reverse the excess allowance through provision expense in future periods.

Events or circumstances that can cause this estimate of losses to be substantially different than eventually occur are primarily a lack of sufficient information about borrowers’ current financial condition or as such financial condition may change over time. This occurs because the borrower does not provide the information on a timely basis or because it is incomplete or inaccurate.

Realizability of deferred tax assets: The Company’s deferred tax assets are explained in the section below titled “Income Tax” and in Note 15, “Income Taxes,” to the Consolidated Financial Statements presented in the Company’s 2003 10-K. The Company uses an estimate of future earnings to support its position that the benefit of its deferred tax assets will be realized. If future pre-tax income should prove non-existent or less than the amount of the temporary differences giving rise to the deferred tax assets within the tax years to which they may be applied, the assets will not be realized and the Company’s net income will be reduced.

Actuarial estimates used in retiree health plan: The Company uses certain estimates regarding its employees to determine its liability for post retirement health benefits. These estimates include life expectancy, length of time before retirement, and future rates of growth of medical costs. Should these estimates prove materially wrong such that the liability is understated, the Company will either incur more expense to provide the benefits or it will need to amend the plan to limit benefits.

Prepayment assumptions used in determining the amortization of premium and discount for securities: Approximately two thirds of the Company’s investment securities are mortgage-backed or asset-backed securities which are subject to the prepayment of principal of the underlying loans. The rate at which prepayments are expected to occur in future periods impacts the amount of premium to be amortized in the current period. If prepayments in a future period are higher than estimated, then the Company will need to amortize a larger amount of premium in that future period, such that the total premium amortized to date as of the end of that future period will equal the amount that would have been amortized had the higher prepayment rate been experienced during all past periods over which the security was held. If future prepayments are

less than estimated, then less premium will be amortized in the future period to similarly result in an amount of premium amortization life-to-date as if the lower rate of prepayments had been experienced from the purchase of the security.

Estimates of the fair value of assets: Certain assets of the Company are recorded at fair value, or the lower of cost or fair value. In some cases, the fair value used is an estimate. Included among these assets are securities that are classified as available for sale, goodwill and other intangible assets, and other real estate owned and impaired loans. These estimates may change from period to period as they are impacted by changes in interest rates and other market conditions. Losses not anticipated or greater than anticipated could result if the Company were forced to sell one of these assets and discovered that its estimate of fair value had been too high. Gains not anticipated or greater than anticipated could result if the Company were to sell one of these assets and discovered that its estimate of fair value had been too low. Estimates of fair value are arrived at as follows:

Assumptions regarding mortgage and other servicing rights: For the Company, mortgage servicing rights (“MSRs) arise from the sale of loans as described below under “Loan Portfolio—Other Loan Portfolio Information—Loan Sales and Mortgage Servicing Rights.” There is a secondary market for MSRs wherein a financial institution may purchase the right to service loans for and receive a fee from the holder of mortgage loans. The market value for such servicing is based on the coupon rates, maturity, and prepayment rates experienced for the mortgages being serviced. The value of the servicing rights recorded by the Company at the time of the sale is based on Management’s best estimate of the market value of mortgage servicing rights for similar pools of loans. If the Company overestimates the value of the MSRs, it will recognize too large a gain at the time of sale and will hold an asset against which a charge to earnings will later have to be taken. If the Company underestimates the value of the MSRs, it will have recognized too small a gain and will later recognize income from the servicing that should have been recognized in the period in which the loans were sold. The Company also acquired servicing rights for loans other than mortgages with the PCCI acquisition. All of the comments made above with respect to MSRs apply to these other servicing rights as well.

Available-for-sale securities: The fair values of most securities classified as available-for-sale are based on quoted market prices. These quoted market prices are derived from two independent sources and compared for consistency. If the two sources differ significantly, or if quoted market prices are not available, alternative methods are used, which include seeking bids from brokers on a representative security or extrapolating the value from the quoted prices of similar instruments. The Company also uses estimates of the future rate of prepayments on the loans underlying the various mortgage-backed securities to determine the expected life of that security. That estimated life then determines the rate of amortization or accretion to recognize against the premium or discount of those instruments.

Goodwill and other intangible assets: As discussed in Note 7, “Goodwill and Other Intangible Assets,” to the Consolidated Financial Statements, the Company must assess goodwill and other intangible assets each year for impairment. This assessment involves estimating cash flows for future periods, preparing analyses of market multiples for similar operations, and estimating the fair values of the reporting unit to which the goodwill is allocated. If the future cash flows were materially less than the estimates, the Company would be required to take a charge against earnings to write down the asset to the lower fair value.

Other real estate owned and impaired loans: The fair value of other real estate owned or collateral supporting impaired loans is generally determined from appraisals obtained from independent appraisers. The Company also must estimate the costs to dispose of the property. This is generally done based on experience with similar properties. When determining the valuation allowance for impaired loans, the Company may use the discounted cash flow method which may include estimates of borrower revenue, expenses, capital expenditures and disposals of capital assets, along with estimates of future economic conditions including forecasts of interest rates and other economic factors which Management believes would impact estimated future customer cash flows.

Estimates relating to self-insurance from workers’ compensation: The Company self-insures for a portion of its workers’ compensation exposure. Because not all injuries are immediately reported to the Company, it must accrue an estimate of the claims loss for injuries that have occurred but not been reported. The estimate is based on actuarial data provided by the insurance company that covers the Company for large claims above the Company’s self-insured amount. If the Company underestimates the cost of unreported claims, it will need to recognize an expense for these claims in subsequent periods. If the estimate is too large, the Company will report a reduction in expense in subsequent years for the excess.

Income tax estimates: With each period end, it is necessary for Management to make certain estimates and assumptions to compute the provision for income tax. Management uses the best information available to develop these estimates and assumptions, but generally some of these estimates and assumptions are revised when the Company files its tax return in the

middle of the following year. In accordance with generally accepted accounting principles, revisions to estimates are recorded as income tax expense or benefit in the period in which they become known. Among the estimates used is the annual effective tax rate used to record income tax expense for the interim periods. The estimated effective tax rate is calculated by annualizing income, expenses, and permanent differences. As of June 30, 2004, Management estimates that the effective tax rate for the year will be 36.98%. To the extent that these estimates differ from the estimate at June 30, 2004, the effect of the change will be included in tax expense for that quarter. The effective tax rate is lower than the statutory rate of 42.05% due to the benefits relating to permanent differences such as tax-exempt income on municipal securities, tax exempt loans, bank owned life insurance, and employee and director stock option plans.

Alternative Methods of Accounting

The accounting and reporting policies of the Company are in accordance with GAAP and conform to practices within the banking industry. As such there are few alternatives available to the Company in its accounting for items of income or expense or for assets and liabilities. The few areas where choices are available are as follows:

Depreciation of fixed assets: The Company selects lives of assets over which to depreciate or amortize the cost based on the expected period it will benefit the Company. The Company’s methods of depreciation and the lives of fixed assets are described in Note 1, “Summary of Significant Accounting Policies,” to the Consolidated Financial Statements presented in the Company’s 2003 10-K. If a method is used or a life is chosen that results in a material amount of the cost not having been amortized when the asset provides no further benefit to the Company, then a loss will be incurred for the unamortized cost of the asset when it is disposed of or replaced.

Amortization of the cost of other assets:The Company’s methods of amortizing assets other than fixed assets are described in notes to these Consolidated Financial Statements or in the 2003 10-K. As with fixed assets, if the method of amortization or the amortization term results in unamortized cost when the asset has no further value, a loss will be recognized.

Stock options: When the Company adopted Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS 123”) in 1996, it elected to continue to use the method of accounting for stock options that did not recognize compensation expense at the time options were granted. As required by SFAS 123, pro forma amounts of compensation expense and the pro forma impact on net income and earnings per share were disclosed each year in the Company’s Annual Reports on Form 10-K and Quarterly Reports on Form 10-Q as if the Company had elected to instead use the accounting method that recognizes compensation expense.

For the second quarter and first six months of 2004, had the Company elected the second method of accounting for its stock options, the impact would be to lower its net income by 2.7% and 1.0%, respectively, and fully diluted earnings per share by 2.8% and 0.8%, respectively. These percentages of dilution compare to 1.2% and 0.6% for net income and 0.0% and 0.9% for earnings per share for the corresponding periods of 2003. Options are granted to directors and certain officers of the Company by authorization of the Compensation Committee of the Board. Stock options are issued to new directors and new and promoted employees depending on their job classification throughout the year. The Committee authorizes a broader issuance of options to current employees approximately every two years. This broader issuance occurred in the second quarter of 2004 and is the reason for the higher amount of dilution in that quarter compared to the second quarter of 2003.

NEW ACCOUNTING PRONOUNCEMENTS

The Company’s financial results have been or will be impacted by several accounting pronouncements, issued over the last two years. These pronouncements and the nature of their impact are discussed in Note 1, “Summary of Significant Accounting Policies.” to the Consolidated Financial Statements.

RISKS FROM CURRENT EVENTS

As of this writing, there seems to be no clear consensus as to how long U.S. military forces will be engaged in Iraq and Afghanistan. Commentators have expressed opinions that prolonged presence of US military forces in the region would be both expensive and could provoke further terrorist actions. Either of these consequences could have an impact on the economy and therefore on the results of operations for the Company.

During 2003, the California legislature adopted a budget that was signed by the governor one month after the required date. The budget included the reduction of expenditures, but still required the issuance of a large amount of new debt to balance revenues and the lower level of expenditures. The general obligation debt of the state was downgraded by the national rating agencies. The budget for the 2004-2005 fiscal year was also passed after the required date. A number of commentators expressed disappointment that there were no significant expenditure reductions and/or tax increases that would structurally change the budget picture. Instead, there was a reliance on additional borrowing to balance the budget.

While these events clearly impact the California economy, the Company does not believe that they will have any material impact on its operating results. The Company does not own any State of California debt obligations and has no concentration of customers that will specifically be impacted by the lower levels of governmental expenditures.

GROWTH TRENDS IN ASSETS AND DEPOSITS

The chart below shows the growth in average total assets and deposits since 1998. Annual averages are shown for 1998, 1999, 2000, and 2001; quarterly averages are shown for 2002, 2003, and 2004. Because significant but unusual cash flows sometimes occur at the end of a quarter and at year-end, the overall trend in the Company’s growth is better shown by the use of average balances for the periods.

CHART 1—GROWTH IN AVERAGE ASSETS AND DEPOSITS
(dollars in millions)

CHART

Deposit balances also have been included in the chart because an important factor in the profitability of the Company is the portion of assets that are funded by deposits. The interest rate paid on deposit accounts is generally less than the rate paid on nondeposit sources of funding.

There are three primary reasons for the overall growth trend shown above for the Company. The first is the acquisition of other financial institutions. The acquisition in 2000 of Los Robles Bank added $172 million to the Company’s assets and $155 million to deposits. The acquisition of PCCI in March 2004 added $284 million in assets and $282 million deposits.

The Company’s other mergers in 1998 and 2000 were accounted for by the pooling of interest method, asset and deposit totals for periods prior to the mergers have been restated to include their balances and so do not impact the totals shown in the above chart. However, growth at these institutions subsequent to the mergers is reflected in the chart above.

Secondly, the Company’s experience with acquisitions and mergers has been contrary to the general pattern in which banks lose customers of the acquired institution. Depositors of banks acquired by or merged with the Company have kept their deposits with the Company. The Company attributes this to its efforts to maintain the acquired institution’s culture and management in place. The impact of this reason has been less in the last several years as the frequency of acquisitions in the financial industry has slowed.

Third, the Bank has opened three new offices in Ventura County and one new office in northern Santa Barbara County during the period covered by the table. The company also acquired some of the assets and deposits of two of the branches of another financial institution on March 29, 2002.

Average assets and deposits increase during the first quarters of each year and then generally decrease in the second quarter. The major reason for this is the Company’s tax refund loan program. The growth in assets is from the loans held by the Company. The growth in deposits is due both to certificates of deposit used as one of the sources of funding for the refund loans and to the outstanding checks issued for loans and transfers (See Note D).

INTEREST RATE SENSITIVITY

Banks act as financial intermediaries. As such, they take in funds from depositors and then either lend the funds to borrowers or invest the funds in securities and other instruments. The Company earns interest income on loans and securities and pays interest expense on deposits and other borrowings. Net interest income is the difference in dollars between the interest income earned and the interest expense paid. On an annual basis, net interest income represents approximately 70%-75% of the Company’s net revenues.

Period-to-period Comparison of the Components of Net Interest Income and Net Interest Margin

Tables 2A and 2B show the average balances of the major categories of earning assets and liabilities for the three and six-month periods ended June 30, 2004 and 2003 together with the related interest income and expense. Table 3, an analysis of volume and rate variances, explains how much of the difference in interest income or expense compared to the corresponding period of 2003 is due to changes in the balances (volume) and how much is due to changes in rates. For example, Table 2A shows that for the second quarter of 2004, real estate loans—multi-family and nonresidential averaged $1.3 billion, interest income for them was $22.0 million, and the average rate received was 5.91%. In the same quarter of 2003, real estate loans—multi-family and nonresidential averaged $1.1 billion, interest income for them was $17.7 million, and the average rate received was 6.47%. Table 3 shows that the $4.3 million increase in interest income for these loans from the second quarter of 2003 compared to the second quarter of 2004 is the net result of a $1.6 million increase in interest income due to lower rates in 2004, and an increase of $5.9 million due to higher balances during 2004.

Tables 2A and 2B also disclose the net interest margin for the reported periods. Net interest margin is the ratio of net interest income to average earning assets. This ratio is useful in allowing the Company to monitor the spread between interest income and interest expense from month to month and year to year irrespective of the growth of the Company’s assets. The net interest margin and net interest income are reported on a “taxable equivalent” basis (Note B). If the Company is able to maintain the net interest margin as the Company grows, the amount of net interest income will increase. If the net interest margin decreases, net interest income can still increase, but earning assets must increase at a higher rate. The increased volume of earning assets serves to replace the net interest income that is lost by the decreasing rate.

As shown in Table 2A, the net interest margin, 4.42%, for the second quarter of 2004 was lower than the comparable figure, 4.71%, for the second quarter of 2003, while the net interest income for the second quarter of 2004, $57.0 million, was higher than the $48.6 million for 2003. As noted at the start of this discussion, the RAL and RT programs have a significant impact on the Company’s operating results. This is most pronounced during the first quarter, but also impacts the second quarter of each year in a more limited way. However, interest income from RALs is not affected by the interest rate environment. Therefore, to analyze the impact of changes in interest rates on the Company’s net interest income and net interest margin, it is informative to compare the net interest margin excluding the effect of the RAL balances and interest income and excluding any direct liabilities used to fund the RALs and the related interest expense. Exclusive of the RAL program (the RT program does not directly impact balances or interest income) the net interest margin for the second quarter of 2004 was 4.35% compared to 4.59% for the second quarter of 2003 (See Note E).

The Federal Reserve Bank’s (“FRB”) target Federal funds rate averaged 1.00% in the second quarter of 2003 and averaged 1.00% in the second quarter of 2004 but the other interest rates were almost all higher than in 2003. This caused the interest rate yield curve to have generally the same slope during the second quarter of 2004 as during the second quarter of 2003 except in the short-term where it is now steeper. (See Note G). The target rate was raised by 0.25% on June 30, 2004.

As discussed in the section below titled “Securities,” during 2003 the Company initiated a leveraging strategy of purchasing some securities funded by FHLB advances. During 2003 and the first half of 2004, this strategy added to net interest income because the interest income earned on the securities exceeded the interest expense incurred on the liabilities. However, it will tends to reduce the net interest margin because the difference between the rates earned on the securities and the rate paid on the debt incurred is less than the average spread between the rates earned on other earning assets and the rates paid on other liabilities.

The net interest margin exclusive of the impact of the RAL/RT programs decreased by 28 basis points from the first quarter of 2004 to the second quarter of 2004.

The sequential quarter decrease in net interest margin is attributable to a number of factors including the following: (1) the full quarter impact of adding the former PCCI, which had a lower net interest margin than PCB’s (Note M); (2) an increase in

prepayments in the securities portfolio, which resulted in premium amortization of 2 million dollars, up from 1 million dollars in the prior quarter (Note N); (3) fixed rate loans that are continuing to renew in a lower rate environment; (4) and a slightly higher cost of funds, due to an increase in the CD rates we are paying in order to remain competitive. In addition, one of the five products in the suite of no-fee checking accounts introduced last year is a higher yielding checking account. There have been some account conversions to this product among previously existing customers, which has had a slight impact on our cost of funds.

TABLE 2A—AVERAGE BALANCES, INCOME AND EXPENSE, YIELDS AND RATES (1)
(dollars in thousands)

	Three months ended June 30, 2004						Three months ended June 30, 2003

	Balance		Income		Rate (4)		Balance			Income	Rate (4)

Assets:
Money market instruments:
Commercial paper	$	-	$	-	0.00	%	$	-	$	-	0.00	%
Federal funds sold		37,312		103	1.11	%		129,482		402	1.25	%

Total money market instruments		37,312		103	1.11	%		129,482		402	1.25	%

Securities: (2)
Taxable		1,262,649		11,908	3.79	%		820,239		7,264	3.55	%
Non-taxable		183,620		4,055	8.83	%		167,413		3,893	9.30	%

Total securities		1,446,269		15,963	4.44	%		987,652		11,157	4.53	%

Loans: (3)
Commercial (including leasing)		909,323		14,530	6.43	%		796,283		12,836	6.47	%
Real estate-multi family & nonres		1,492,719		22,056	5.91	%		1,095,856		17,733	6.47	%
Real estate-residential 1-4 family		831,658		11,594	5.58	%		700,333		10,936	6.25	%
Consumer		463,943		8,749	7.58	%		420,284		8,971	8.56	%
Other		11,335		24	0.85	%		2,207		19	3.45	%

Total loans		3,708,978		56,953	6.18	%		3,014,963		50,495	6.72	%

Total earning assets		5,192,559		73,019	5.66	%		4,132,097		62,054	6.02	%

FAS 115 Market Value Adjustment		32,045						25,951
Non-earning assets		399,239						284,589

Total assets	$	5,623,843					$	4,442,637


Liabilities and shareholders’ equity:
Interest bearing deposits:
Savings and interest bearing transaction accounts	$	1,900,341		2,902	0.61	%	$	1,558,179		2,793	0.72	%
Time certificates of deposit		1,420,863		6,996	1.98	%		1,222,126		6,589	2.16	%

Total interest bearing deposits		3,321,204		9,898	1.20	%		2,780,305		9,382	1.35	%

Borrowed funds:
Repos and Federal funds purchased		94,635		223	0.95	%		32,821		71	0.87	%
Other borrowings		710,382		5,875	3.33	%		325,573		4,029	4.96	%

Total borrowed funds		805,017		6,098	3.05	%		358,394		4,100	4.59	%

Total interest bearing liabilities		4,126,221		15,996	1.56	%		3,138,699		13,482	1.72	%

Noninterest-bearing demand deposits		979,903						832,896
Other liabilities		76,440						73,423
Shareholders’ equity		441,279						397,619

Total liabilities and shareholders’ equity	$	5,623,843					$	4,442,637


Interest income/earning assets					5.66	%					6.02	%
Interest expense/earning assets					1.24	%					1.31	%

Tax equivalent net interest income/margin				57,023	4.42	%				48,572	4.71	%
Provision for credit losses charged to operations/earning assets				737	0.06	%				2,635	0.25	%

Net interest margin after provision for credit losses on tax equivalent basis				56,286	4.36	%				45,937	4.46	%


Less: tax equivalent income included in interest income from non-taxable securities and loans				1,590						1,622

Net interest income			$	54,696					$	44,315


Loans other than RALs	$	3,683,666	$	55,475	6.06	%	$	2,989,682	$	48,923	6.56	%
Consumer loans other than RALs	$	438,631	$	7,271	6.67	%	$	395,003	$	7,399	7.49	%


(1)	Income amounts are presented on a fully taxable equivalent (FTE) basis. (See Note B)
(2)	Average securities balances are based on amortized historical cost, excluding SFAS 115 adjustments to fair value which are included in other assets.
(3)	Nonaccrual loans are included in loan balances. Interest income includes related fee income.
(4)	Annualized.

TABLE 2B—AVERAGE BALANCES, INCOME AND EXPENSE, YIELDS AND RATES (1)
(dollars in thousands)

	Six months ended June 30, 2004						Six months ended June 30, 2003

	Balance		Income		Rate (4)		Balance		Income		Rate (4)

Assets:
Money market instruments:
Commercial paper	$	-	$	-	0.00	%	$	-	$	-	0.00	%
Federal funds sold		107,080		584	1.10	%		132,246		852	1.30	%

Total money market instruments		107,080		584	1.10	%		132,246		852	1.30	%

Securities: (2)
Taxable		1,193,911		22,937	3.86	%		750,307		14,282	3.84	%
Non-taxable		184,721		8,189	8.87	%		166,783		7,759	9.30	%

Total securities		1,378,632		31,126	4.54	%		917,090		22,041	4.85	%

Loans: (3)
Commercial (including leasing)		881,284		27,898	6.37	%		785,412		24,017	6.17	%
Real estate-multi family & nonres		1,357,527		40,969	6.04	%		1,096,467		36,977	6.74	%
Real estate-residential 1-4 family		824,299		23,176	5.62	%		702,257		22,490	6.41	%
Consumer		638,481		51,600	16.25	%		639,688		46,533	14.67	%
Other		7,895		39	0.99	%		2,678		49	3.69	%

Total loans		3,709,486		143,682	7.79	%		3,226,502		130,066	8.13	%

Total earning assets		5,195,198		175,392	6.79	%		4,275,838		152,959	7.21	%

FAS 115 Market Value Adjustment		27,129						22,564
Non-earning assets		355,782						287,738

Total assets	$	5,578,109					$	4,586,140


Liabilities and shareholders’ equity:
Interest bearing deposits:
Savings and interest bearing transaction accounts	$	1,815,602		5,332	0.59	%	$	1,530,729		5,540	0.73	%
Time certificates of deposit		1,407,412		13,554	1.94	%		1,241,431		13,746	2.23	%

Total interest bearing deposits		3,223,014		18,886	1.18	%		2,772,160		19,286	1.40	%

Borrowed funds:
Repos and Federal funds purchased		147,606		757	1.03	%		85,398		542	1.28	%
Other borrowings		659,077		11,250	3.43	%		292,763		7,884	5.43	%

Total borrowed funds		806,683		12,007	2.99	%		378,161		8,426	4.49	%

Total interest bearing liabilities		4,029,697		30,893	1.54	%		3,150,321		27,712	1.77	%

Noninterest-bearing demand deposits		1,093,275						943,539
Other liabilities		31,314						105,279
Shareholders’ equity		423,823						387,001

Total liabilities and shareholders’ equity	$	5,578,109					$	4,586,140


Interest income/earning assets					6.79	%					7.21	%
Interest expense/earning assets					1.20	%					1.30	%

Tax equivalent net interest income/margin		19,252		144,499	5.59	%				125,247	5.91	%
Provision for credit losses charged to operations/earning assets				8,321	0.32	%				14,252	0.68	%

Net interest margin after provision for credit losses on tax equivalent basis				136,178	5.27	%				110,995	5.23	%


Less: tax equivalent income included in interest income from non-taxable securities and loans				3,198						3,279

Net interest income			$	132,980					$	107,716


Loans other than RALs	$	3,504,347	$	107,110	6.15	%	$	2,981,165	$	98,419	6.66	%
Consumer loans other than RALs	$	433,342	$	15,028	6.97	%	$	394,351	$	14,886	7.55	%


(1)	Income amounts are presented on a fully taxable equivalent (FTE) basis. (See Note B)
(2)	Average securities balances are based on amortized historical cost, excluding SFAS 115 adjustments to fair value which are included in other assets.
(3)	Nonaccrual loans are included in loan balances. Interest income includes related fee income.
(4)	Annualized.

TABLE 3—RATE/VOLUME ANALYSIS (1) (2)
(dollars in thousands)

	Three months ended June 30, 2004 vs. June 30, 2003												Six months ended June 30, 2004 vs. June 30, 2003

	Change in Average Balance			Change in Income/ Expense			Rate			Volume			Change in Average Balance			Change in Income/ Expense			Rate			Volume

Increase (decrease) in:
Assets:
Money market instruments:
Federal funds sold	$	(92,170	)	$	(299	)	$	(41	)	$	(258	)	$	(25,166	)	$	(268	)	$	(120	)	$	(148	)

Total money market investment		(92,170	)		(299	)		(41	)		(258	)		(25,166	)		(268	)		(120	)		(148	)

Securities:
Taxable		442,410			4,644			517			4,127			443,604			8,655			75			8,580
Non-taxable		16,207			162			(202	)		364			17,938			430			(120	)		550

Total securities		458,617			4,806			315			4,491			461,542			9,085			(45	)		9,130

Loans:
Commercial (including leasing)		113,040			1,694			(81	)		1,775			95,872			3,881			815			3,066
Real estate-multi family & nonres		396,863			4,323			(1,629	)		5,952			261,060			3,992			(1,445	)		5,437
Real estate-residential 1-4 family		131,325			658			(1,246	)		1,904			122,042			686			(1,329	)		2,015
Consumer loans		43,659			(222	)		(1,091	)		869			(1,207	)		5,067			5,066			1
Other loans		9,128			5			(23	)		28			5,217			(10	)		(29	)		19

Total loans		694,015			6,458			(4,070	)		10,528			482,984			13,616			3,078			10,538

Total earning assets		1,060,462			10,965			(3,796	)		14,761			919,360			22,433			2,913			19,520


Liabilities:
Interest bearing deposits:
Savings and interest bearing transaction accounts		342,162			109			(458	)		567			284,873			(208	)		(630	)		422
Time certificates of deposit		198,737			407			(585	)		992			165,981			(192	)		(1,002	)		810

Total interest bearing deposits		540,899			516			(1,043	)		1,559			450,854			(400	)		(1,632	)		1,232

Borrowed funds:
Repos and Federal funds purchased		61,814			152			8			144			62,208			215			(38	)		253
Other borrowings		384,809			1,846			(1,663	)		3,509			366,314			3,366			(1,484	)		4,850

Total borrowed funds		446,623			1,998			(1,655	)		3,653			428,522			3,581			(1,522	)		5,103

Total interest bearing liabilities	$	987,522			2,514			(2,698	)		5,212		$	879,376			3,181			(3,154	)		6,335

Tax Equivalent Net Interest Income				$	8,451		$	(1,098	)	$	9,549					$	19,252		$	6,067		$	13,185


Loans other than RALs	$	693,984		$	6,552		$	(3,977	)	$	10,529		$	523,182		$	8,691		$	(2,623	)	$	11,314
Consumer loans other than RALs	$	43,628		$	(128	)	$	(872	)	$	744		$	38,991		$	142		$	(578	)	$	720

(1)	Income amounts are presented on a fully taxable equivalent basis.
(2)	The change not solely due to volume or rate has been prorated into rate and volume components. The proration is done based on the relative amounts of the rate and volume variances prior to the proration.

Measuring Interest Rate Sensitivity

Because such large proportions of the Company’s balance sheet are made up of interest-earning assets and interest-bearing liabilities, and because such a large proportion of its earnings is dependent on the spread between interest earned and interest paid, it is critical that the Company measure and manage the sensitivity of the value of its financial instruments and its earnings to changes in interest rates. Measurement may be done by estimating the impact of hypothetical changes in interest

rates on net economic value and on net interest income over the next twelve months. Net economic value is the net present value of the cash flows arising from assets and liabilities discounted at their acquired rate plus or minus the specified assumed changes in rates.

Estimating changes in net interest income or net economic value from increases or decreases in balances is relatively straightforward. Estimating changes that would result from increases or decreases in interest rates is substantially more difficult. Estimation is complicated by a number of factors: (1) some financial instruments have interest rates that are fixed for their term, others that vary with rates, and still others that are fixed for a period and then reprice using then current rates; (2) the rates paid on some deposit accounts are set by contract—certificates of deposit—while others are priced at the option of the Company according to then current market conditions—checking and savings; (3) the rates for some loans vary with the market, but only within a limited range because of periodic or lifetime caps or floors (Note L); (4) consumers may prepay loans or withdraw deposits if interest rates move to their disadvantage, effectively forcing a repricing sooner than would be called for by the contractual terms of the instrument; and (5) external interest rates which are used as indices for various products offered by the Company do not change at the same time or to the same extent as the Federal Reserve Board’s target Federal funds rate, the usual reference rate.

To address the complexity resulting from these and other factors, a standard practice developed in the industry is to compute the impacts of hypothetical interest rate “shocks” on the Company’s asset and liability balances. A shock is an immediate change in all interest rates. The resulting impacts indicate how much of the Company’s net interest income and net economic value are “at risk” (would deviate from the base level—Note I) if rates were to change in this manner.

Although interest rates normally would not change suddenly in this manner, this exercise is valuable in identifying exposures to risk and in providing comparability both with other institutions and between periods. The results reported below for the Company’s June 30, 2003, December 31, 2003 and June 30, 2004 balances indicate that the Company’s net interest income at risk over a one year period and net economic value at risk from 2% shocks are within normal expectations for such sudden changes, and that changes from these shock are relatively minimal, i.e., as explained below, the Company’s risk position is slightly “asset-sensitive.”

TABLE 4—RATE SENSITIVITY (Note K)

	Shocked by -2%			Shocked by +2%
As of June 30, 2004
Net interest income		(5.80	)%		+0.80	%
Net economic value		+15.68	%		(7.78	)%

As of December 31, 2003
Net interest income		(6.25	)%		+3.22	%
Net economic value		+18.87	%		(8.01	)%

As of June 30, 2003
Net interest income		(18.08	)%		+12.37	%
Net economic value		+18.66	%		(18.66	)%

In general, differences in the results from one period to the next are due to changes in (1) the maturities and/or repricing opportunities of the financial instruments held and (2) the assumptions used regarding how responsive the rates for specific instruments are to the hypothetical 2% change in market rates.

Because the measurement period for changes in net interest income is one year, the impact on net interest income from these hypothetical changes in interest rates will depend on whether more assets or liabilities will reprice within the twelve-month period. An asset or liability reprices because either (a) it matures or is sold and is replaced with a new asset or liability priced at current market rates or (b) its contractual terms call for a periodic resetting or repricing of the interest rate. If the Company has more assets repricing within one year than it has liabilities, then net interest income will increase with increases in rates and decrease as rates decline. The opposite effects will be observed if more liabilities than assets reprice in the next twelve months.

The Company has a slightly asset-sensitive interest rate risk position. The change in its interest rate position from December 31, 2003 to June 30, 2004 is minimal. The addition of the assets and liabilities from the PCCI transaction did not change the

position to any significant degree because PCCI’s interest rate risk position was similar to the Company’s interest rate risk position.

The changes to net interest income that would have occurred from 2% shocks at June 30, 2003 compared to the changes at June 30, 2004 is larger. This indicates a significant change in the Company’s interest rate position between those two dates. As shown in Table 4 above, at June 30, 2003, the Company was more “asset sensitive,” i.e. its assets were more sensitive to interest rate changes compared to its liabilities than they are at June 30, 2004. The major reasons for the change in the interest rate risk profile in the last year were (1) the leveraging strategy implemented during 2003—the liabilities incurred to fund the purchases had shorter maturities than the securities that were purchased; (2) loan floors were established on some commercial loans during 2003 prior to the most recent FOMC action and the interest rate charged on these loans will not increase until interest rates rise more than 25 basis points; and (3) many of the loans originated in 2003 were fixed-rate loans or variable-rate loans with long initial fixed terms.

Repricing Opportunities

While the Company does not manage its interest rate risk by means of a gap analysis—a table in which the difference between assets and liabilities maturing or repricing in each period is shown as a “gap analysis”—the following table is provided for the reader to help understand the comments above about the effect of changes in the relative balance of certain assets and liabilities on interest rate sensitivity. It summarizes the time periods in which maturities and or repricing opportunities occur for the major categories of assets and liabilities for June 30, 2004, and provides summary lines for December 31, 2003 and June 30, 2003. The cumulative gap and the cumulative gap as a percentage of total assets are also reported. A positive number indicates that assets maturing or repricing in that specific period exceed maturing or repricing liabilities. A negative number indicates the opposite. As of June 30, 2004, the Company had a slight excess of assets repricing or maturing overnight. There is a large excess of liabilities over assets repricing in the next maturity period. Ordinarily, this would suggest that the Company is liability sensitive rather than asset sensitive as was stated in the preceding paragraph. However, this excess of liabilities over assets is an artifact of the assumption that all non-term deposit accounts could be repriced at any time. In fact these deposit accounts are not immediately repriced with each change in market interest rates, nor do they change to the same degree as market rates when they are repriced. Rather than drawing the conclusion of “asset sensitive” or “liability sensitive” from the table, a better use for it is to note that the Company has a wide distribution of maturities or repricing opportunities in both its assets and liabilities. There were no appreciable changes in this condition from June 30, 2003 to June 30, 2004.

TABLE 5— GAP TABLE

*(dollars in thousands)*	Immediate or one day			2 day to 6 months			6 months to 12 months			1 year to 3 years			3 years to 5 years			More than 5 years			Total rate sensitive			Total non-rate sensitive			Total


As of June 30, 2004
Assets:
Cash and due from banks	$	—		$	—		$	—		$	—		$	—		$	—		$	—		$	140,885		$	140,885
Federal funds sold		—			12,000			—			—			—			—			12,000			—			12,000
Securities		32,436			105,591			147,040			457,040			214,513			730,846			1,687,466			(195,613	)		1,491,853
Loans		—			1,951,293			380,344			864,550			384,191			160,106			3,740,484			394			3,740,878
Allowance for loan and lease losses		—			—			—			—			—			—			—			(48,376	)		(48,376	)
Other assets		—			—			—			—			—			—			—			347,089			347,089

Total assets	$	32,436		$	2,068,884		$	527,384		$	1,321,590		$	598,704		$	890,952		$	5,439,950		$	244,379		$	5,684,329


Liabilities and Equity:
Deposits	$	—		$	3,665,003		$	339,820		$	250,065		$	96,443		$	1,334		$	4,352,665		$	—		$	4,352,665
Borrowings		—			245,367			70,000			377,720			104,158			55,000			852,245			—			852,245
Other liabilities		—			—			—			—			—			—			—			45,790			45,790
Shareholders’ equity		—			—			—			—			—			—			—			433,629			433,629

Total liabilities and equity	$	—		$	3,910,370		$	409,820		$	627,785		$	200,601		$	56,334		$	5,204,910		$	479,419		$	5,684,329


Gap	$	32,436		$	(1,841,486	)	$	117,564		$	693,805		$	398,103		$	834,618		$	235,040			(235,040	)		—
Cumulative gap	$	32,436		$	(1,809,050	)	$	(1,691,486	)	$	(997,681	)	$	(599,578	)	$	235,040		$	235,040			—			—
Cumulative gap/ total assets		0.57	%		-31.83	%		-29.76	%		-17.55	%		-10.55	%		4.13	%		4.13	%		0.00	%		0.00	%

As of December 31, 2003
Gap	$	22,447		$	(1,592,109	)	$	192,214		$	695,877		$	272,092		$	725,493		$	316,014		$	(316,014	)		—
Cumulative gap	$	22,477		$	(1,569,662	)	$	(1,377,448	)	$	(681,571	)	$	(409,479	)	$	316,014		$	316,014			—			—
Cumulative gap/ total assets		0.46	%		-32.30	%		-28.34	%		-14.03	%		-8.43	%		6.50	%		6.50	%		0.00	%		0.00	%

As of June 30, 2003
Gap	$	23,296		$	(1,444,745	)	$	222,278		$	766,661		$	288,452		$	477,249		$	333,191		$	(333,191	)	$	—
Cumulative gap	$	23,296		$	(1,421,449	)	$	(1,199,171	)	$	(432,510	)	$	(144,058	)	$	333,191		$	333,191		$	—		$	—
Cumulative gap/ total assets		0.51	%		-31.32	%		-26.42	%		-9.53	%		-3.17	%		7.34	%		7.34	%		0.00	%		0.00	%

Note: The model places all non-time deposits in the immediate category. Securities are listed by their maturity or any repricing prior to maturity. The $32.4 million placed in the immediate category for securities is the market value adjustment for available-for-sale securities. As the market value of securities are determined by the current interest rate environment any changes in interest rates would have an immediate change in their market values and the corresponding adjustment. The negative $195 million in the non-rate sensitive category is the unaccreted discount net of unamortized premium on the securities. These amounts do not change with interest rates, but instead are accreted or amortized by the level yield method over the term of the security.

The market value of fixed rate securities or loans increase as rates decline because the fixed rate is then higher than the current market level. Conversely the market value declines when rates rise because the instrument is earning at a lower rate than the current level. In other words, the price of the security or loan changes in response to changes in market rates to bring the effective yield on the instrument equal to the rate on new instruments. The longer the maturity of the asset, the more sensitive is its market value to changes in interest rates, because the mismatch of the instrument’s coupon rate will differ from the market rate for a longer time. The market value of fixed rate liabilities changes in exactly the opposite manner. For example, they are less valuable (more costly) to the Company when rates decline because the Company must continue to pay the higher rate until they mature.

As indicated above, net economic value in the context of interest rate risk measurement, is the sum of the net present value of the cash flows associated with the Company’s financial assets and liabilities. The net economic value of truly variable rate instruments does not change with increases or decreases in rates because their rates change with the market. Therefore the Company’s net economic value increases or decreases as interest rates change depending on the relative proportion and maturities of fixed rate assets and liabilities and the relative terms of these instruments. The Company has more fixed rate assets than liabilities and they generally have longer maturities. Therefore, it is expected that the net economic value of the Company’s portfolio will decrease when rates rise and increase when rates decline.

It is also expected that the percentage change in the net economic value resulting from a given change in interest rates would be greater than the percentage change in the net interest income. This occurs because the expected change in net interest income is measured only over the next twelve months while the change in net economic value is the present value of the cash flows over the entire maturity terms of the assets and liabilities.

Financial instruments do not respond in parallel fashion to rising or falling interest rates. This can cause an asymmetry in the magnitude of changes in net interest income and net economic value resulting from the hypothetical increases and decreases in rates. In other words, as can be seen in Table 4, the same percentage of increase and decrease in the hypothetical interest rate will not necessarily cause the same percentage change in net interest income or net economic value. An asymmetrical or nonparallel response occurs because various contractual limits and non-contractual factors come into play. An example of a contractual limit is the “interest rate cap” on some residential real estate loans, which may limit the amount that the loan rate may increase, but not limit the amount it may decrease. Examples of a non-contractual factor are the assumption of the extent to which rates paid on administered accounts would be changed by the Company were market rates to go up or down by 200 basis points, and the fact that interest rates on assets currently earning less than 2% cannot be reduced by 2%.

In addition, the degree of asymmetry can change as the base rate changes from period to period and as there are changes in the Company’s product mix. For example, if savings accounts are paying 4% when one measures the impact of a 2% decrease in market rates, the measured responsiveness of the rate paid on these accounts to that decrease will be greater than the responsiveness if the current rate is 3% when the measurement is done. This is because the Company cannot assume that it will be able to lower the rates paid on these deposits as much from a 3% base as from a 4% base while it can assume a full 2% increase from either base. Another example of non-contractual factors coming into play relates to consumer variable rate loans that have interest rate caps. To the extent those loans are a larger proportion of the portfolio than in a previous period, the caps on loan rates would have more of an adverse impact on the overall result if rates were to rise. Similarly, if interest rates have increased substantially from the initial rate on these loans, the current rate may be close to their life-time cap and further rises in market rates will have limited effect.

For these measurements, the Company makes certain assumptions that significantly impact the results. The most significant assumption is the use of a “forecasted” balance sheet—the Company applies the interest rate shocks to what it forecasts its balance sheet to look like over the horizon covered by the calculation. This forecast projects changes in the size or mix of the various assets and liabilities based on information supplied by the Company’s business unit managers. However, due to changes in interest rates or other business conditions, the Company will not always follow the forecast in making business decisions and the size and mix of the various asset and liability balances may be different than the forecast. Additional assumptions include the duration of the Company’s non-maturity deposits because they have no contractual maturity, and the extent to which the Company would adjust the rates paid on its administered rate deposits as external yields change. As mentioned above, changes in assumptions regarding the extent to which deposit rates would be raised or lowered in the event of a 200 basis point increase or decrease and to changes in the assumptions with respect to prepayment speeds on residential mortgages are part of the reason for the difference in the amount of changes to net income and economic value in response to 200 basis point shocks shown in Table 4 between December 31, 2003 and June 30, 2004.

As interest rates change, the assumptions regarding responsiveness to further change must be reviewed, and any changes will affect the computed results. These assumptions are reviewed each quarter and are changed as deemed appropriate to reflect the best information available to Management.

The Company’s exposure to interest rate risk and how it addresses this risk is discussed in more detail in Management’s Discussion and Analysis in the 2003 10-K.

DEPOSITS AND RELATED INTEREST EXPENSE

While occasionally there may be slight decreases in average deposits from one quarter to the next, the overall trend is one of growth as shown in Chart 1. As noted in the discussion accompanying that chart, there is a significant increase in deposits during the first quarter of each year related to the tax refund programs. These deposits include brokered certificates of deposit used to fund the tax refund loans. Generally these have a term of only one month, and consequently the amounts at each of the quarter-ends shown in Table 6 are minimal. The Company also uses brokered certificates of deposit to help manage its interest rate risk. At June 30, 2004, December 31, 2003, and June 30, 2003, deposits used for this purpose totaled $47.2 million, $28.6 million, and $20.6 million, respectively. An additional $128.5 million was used for funding of the leverage strategy mentioned above. These deposits bear a higher interest rate than other deposits and the rate paid on time deposits, as shown in Tables 2A and 2B, reflect this higher rate.

The table below shows the major categories of deposits as of June 30, 2004 and 2003 and as of December 31, 2003.

TABLE 6—CATEGORIES OF DEPOSITS

*(dollars in thousands)*	June 30, 2004		December 31, 2003			June 30, 2003

Noninterest bearing deposits	$	981,491		$	924,106	$	847,596
Interest bearing deposits:
NOW accounts		731,717			556,740		452,796
Money market deposit accounts		763,542			803,554		860,738
Other savings deposits		421,873			272,883		264,746
Time certificates of $100,000 or more		924,153			834,819		735,457
Other time deposits		529,889			462,615		467,098

Total deposits	$	4,352,665		$	3,854,717	$	3,628,431

The table below shows the interest expense for the major categories of deposits for the three and six-month periods ended June 30, 2004 and 2003.

TABLE 7—INTEREST EXPENSE FOR CATEGORIES OF DEPOSITS

	Interest Expense for the
	Three-Month Periods Ended June 30,						Six-Month Periods Ended June 30,
*(dollars in thousands)*	2004			2003			2004		2003

NOW accounts		$	682		$	127	$	1,145	$	233
Money market deposit accounts			1,576			2,391		3,186		4,763
Other savings deposits			644			275		1,001		544
Time certificates of $100,000 or more			4,115			3,611		8,136		7,434
Other time deposits			2,881			2,978		5,418		6,312

Total interest on deposits		$	9,898		$	9,382	$	18,886	$	19,286

LOANS AND RELATED INTEREST INCOME

The table in Note 5, “Loans and the Allowance for Credit Losses,” to the Consolidated Financial Statements shows the balances by loan type for June 30, 2004, December 31, 2003, and June 30, 2003. The end-of-period loan balances as of June 30, 2004 have increased by $560.0 million compared to December 31, 2003 and increased by $743.0 million compared to June 30, 2003. The major dollar increases from the totals at June 30, 2003 to June 30, 2004 occurred in the non-residential and multifamily loan type, as well as the residential 1-4 family loan type. The major percentage in increase occurred in construction, home equity, commercial equipment leasing, and non-residential and multi-family. The major increases from the totals at December 31, 2003 to June 30, 2004 occurred in the non-residential and multi-family residential loan type, as well as the commercial loan type. The major percentage of increases occurred in non-residential and multi-family residential, leasing, and home equity loans. The increase in the non-residential and multi-family loan type for both periods and in the commercial category from December 31, 2003 to June 30, 2004 was primarily due to the March 5, 2004 PCCI acquisition.

Within the average balance of consumer loans in Tables 2A and 2B are some of the tax refund loans. About 85% or more of tax refund loans are made in the first quarter of each year with the remainder in the second quarter. Tax refund loans that were sold into the securitization and the fees charged on those loans were excluded from Tables 2A and 2B.

Average yield for loans for the three-month period ended June 30, 2004 was 6.18%, and for the three-month period ended June 30, 2003 was 6.72%. These average yields are impacted by the RAL loans included in Table 2A among the consumer loans. Excluding RALs, the average yield for the first quarter of 2004 for loans was 6.06% and the average for the first quarter of 2003 was 6.56%. This decrease in average rates earned in 2004 compared to 2003 is reflective of the FOMC’s 25 basis point decrease in the target Federal funds rate in June 2003. Along with most other financial institutions, the Company decreased its prime rate to reflect the change in market rates. It also reflects that in general more of the loan growth that occurred in the last 12 months was in the lower yielding types of loans.

The decrease in yield was also due to the growth in the residential loan portfolio. These loans earn a lower interest rate because of their very low credit risk. Approximately half of the residential real estate loans held are fixed rate loans. In addition to the fixed rate loans, the Company also holds adjustable rate mortgages (“ARMs”). Some of these ARMs have initial “teaser” rates. The yield increases for these loans as the teaser rates expire. Applicants for these loans are qualified based on the fully-indexed rate.

During 2001, the Bank had securitized $58.2 million in automobile loans. In addition to servicing the loans after the sale, the Company must perform certain special reporting for the security holders and must revalue the retained interest each quarter. To avoid such tasks when the remaining loan amounts are lower, the terms of the securitization permitted the Company to repurchase the remaining loans once the outstanding balance was less than 10% of the original amount sold. In April, 2004, the Company exercised this option to repurchase the remaining loans, and they are now reported along with other consumer loans.

CREDIT QUALITY AND THE ALLOWANCE FOR CREDIT LOSSES

The Allowance for Credit Losses is provided in recognition that the principal of all loans will not be fully paid according to their contractual terms. The Company is required by regulation, generally accepted accounting principles, and safe and sound banking practices to maintain an allowance that is adequate to absorb losses that are inherent in the portfolio of loans and leases, including those not yet identified. The methodology used to determine the adequacy of the allowance for credit loss is discussed in detail in Note 1, “Summary of Significant Accounting Policies,” to the 2003 10-K. This methodology involves

estimating the amount of credit loss inherent in each of the loan and lease portfolios by taking into account such factors as historical charge-off rates, economic conditions, and concentrations by industry, geography, and collateral type. In addition, generally accepted accounting principles require the establishment of a valuation allowance for impaired loans as described in Note 5, “Loans and the Allowance for Credit Losses,” to the Consolidated Financial Statements.

Loan Grading

Part of the methodology used by the Company to determine the adequacy of the allowance for credit losses involves grading loans. The Company uses a 10-point scale. Grades 1 through 5 are considered “Pass” grades and there are no specific credit concerns regarding the loans to which these grades have been assigned. Grade 6 is also considered a “Pass” grade, but there is some factor which causes the Company to monitor loans graded 6 more closely. This factor may reflect above average risk through erratic debt coverage, strained liquidity, or inconsistent earnings. Alternatively, this factor may not pertain to the specific loan, but instead may relate to the industry or geography in which the customer does business.

Grades 7 and 8 correspond to the regulatory designations of “Special Mention” and “Substandard,” respectively. Loans graded 7 or 8 are generally still performing according to contractual terms, i.e. the customer is making principal and interest payments on time, or at most they are one or two months delinquent in their payments. However, even if currently performing, the Company is aware of factors specific to the loans which cause heightened concern regarding eventual payment. Examples of such factors would be declining sales for a business customer or loss of a job for a consumer customer. In the case of a Grade 7 loan, the factor or situation is potential but if it occurs, it is probable that the customer will not be able to continue to perform according to the contract terms. In the case of a Grade 8 loan, generally the factor or situation which has been identified as a potential weakness has occurred, is well defined, and continuation of the situation will reasonably be expected to cause default by the customer. In some cases, Grade 8 loans will be classified as nonaccrual, i.e., the Company will have stopped recognizing interest on the loans and all payments will be applied to principal. This generally occurs when factors relating to a probable default as well as shortfalls in cash flows or collateral suggest the loan may not be repaid in full.

Grade 9 corresponds to the regulatory designation of “Doubtful,” and loans graded 9 are usually three months or more delinquent. Generally the Company has stopped accruing interest on them unless they are well secured and the Company is actively pursuing collection efforts. Doubtful loans have sufficient weaknesses that collection or liquidation is not expected to satisfy the debt. Grade 10 corresponds to the regulatory designation of “Loss.” The only loans graded 10 would be those in the process of being charged-off.

Impaired Loans

Special considerations apply when loans are determined to be impaired. These considerations, described in Note 5, “Loans and the Allowance for Credit Losses,” to the Consolidated Financial Statements, which this discussion accompanies, affect the amount of allowance that the Company allocates to these loans.

The Migration of Problem Loans

At any point in time there will be some loans in each of the grades 7 through 9. The amount of loan balances in each grade will increase in periods of economic slowdown or recession, but the totals for each grade will not generally increase at the same time. Instead, depending on the pace or intensity of the slowdown and how quickly it impacts customers, there will generally be an increase in grades 7 and 8, later an increase in 9, and later still an increase in charge-offs. Individual loans can also migrate from grade to grade irrespective of the condition of the general economy based on factors specific to the borrower.

However, not all problem or potential problem loans continue to decline in credit quality. As business customers adjust their business plans or consumers adjust their spending levels, some loans may migrate to better grades even if recovery does not occur until later. Other loans will remain in one grade throughout the economic cycle, improving only with the eventual general recovery. In addition, different categories of loans migrate through the grades differently when the economy slows or goes into recession. Unsecured loans tend to migrate faster than secured loans and consumer loans tend to migrate to poorer credit quality faster than commercial loans (Note H). Because of these factors—that totals in each grade do not increase at the same time, that loans migrate at different rates, and that some do not migrate and may even improve—it is to be expected that credit quality measurements may lag standard indicators that show a decline in economic strength or growth. For example, a loan graded 7 because lower sales were anticipated could be downgraded to 8 when the anticipated event occurred even though from a broad perspective, the economy may not appear to be worsening or may even be improving overall, but not in the borrower’s industry. It has been the experience of the Company that not only does the increase in nonperforming loans lag indicators that show a slowdown in economic activity, but nonperforming loans to commercial customers are likely to be classified as such for a longer period of time than special mention or substandard loans. This occurs because the triggering event must be removed or overcome and a new pattern of performance must emerge before the grading will be improved. This may only occur some months after the economy demonstrably improves. Similarly, charge-offs, the last step in the migration sequence, may be higher as the economy has stabilized or is even improving. These charge-offs are the result of the ability of some customers to pay their debt being so damaged by the economic slowdown that they do not recover even when the economy does.

It is also the Company’s experience that overall credit quality can be improving as measured by declining balances in grades 7 and 8 and yet some loans still migrate into grade 9.

The Relationship of Allowance and Provisions Expense to Problem Loan Migration

Generally, more allowance will be allocated to loans as they decline in credit quality. Consequently, as loan balances increase in grades 7 through 9, it would be expected that the allowance would increase through additional charges to provision expense. However, there are two factors which can cause provision expense to vary from this expectation, at least in the short run.

The first factor is that banks seldom provide an allowance of 100% of the loan. If the prospects are poor for repayment, a loan is charged-off. Therefore, charge-offs generally entail extra provision expense to cover the portion of the loan balance for which allowance had not been provided. Otherwise, the remaining allowance would be insufficient to cover the risk of loss in the other loans. Consequently, even after the general economy has improved and overall balances in grades 7 through 9 are decreasing, additional provision expense may be higher as charge-offs are occurring.

The second factor may cause provision expense to be lower when the balances of loans graded 7 through 9 are increasing, and it is due to the fact that some of these loans secured by collateral to the extent that no loss is anticipated or that all anticipated loss was provided prior to migrating to the lower grade. Therefore, should these loans migrate lower in their grading, no additional provision expense would be necessary. For example, better information about the cash flows of the borrower may be obtained such that it becomes more certain that the borrower will default. However, the value of the collateral remains the same and therefore the estimate of the amount of the allowance necessary to cover any loss also does not change.

The Company defines “potential problem loans” as loans graded 7 and loans graded 8 on which the Company is still accruing interest. “Nonperforming loans” are those loans graded 8 that are not accruing interest or are loans 90 days or more delinquent but still accruing interest and loans graded 9.

The table below shows total potential problem loans and nonperforming loans as of each of the last six quarters. Also included in the table are the net charge-offs, allowance, and provision expense. The top half of the table discloses the figures for all loans. All RALs outstanding at June 30, 2004 are included in the balances of potential problem loans as of that date. The bottom half discloses the figures for loans other than RALs. This disclosure is provided because in relating the credit quality statistics disclosed in Table 10 to the economy, the impact of RALs tends to obscure the trends of other loans, as the seasonal patterns of this program are unrelated to the economic cycle. The discussion of the trends that follows Table 8 addresses the second half of the table, the portion that excludes RALs. Because the factors impacting the credit quality issues for the RAL program are unique to that program, they are discussed separately in the section below titled “Refund Anticipation Loan and Refund Transfer Programs.”

TABLE 8—POTENTIAL PROBLEM AND NONPERFORMING LOANS, NET CHARGE-OFFS, ALLOWANCE, AND PROVISION

*(dollars in thousands)*	June 30, 2004		March 31, 2004				December 31, 2003			September 30, 2003				June 30, 2003			March 31, 2003

Including RAL:
Potential problem loans	$	98,979		$	78,026			$	92,435		$	96,266		$	117,536			$	126,297
Nonperforming loans	$	23,609		$	35,267			$	43,175		$	45,316		$	54,369			$	61,338
Net charge-offs	$	5,606		$	10,034			$	4,822		$	(307	)	$	6,596			$	11,446
Allowance for credit losses	$	48,376		$	53,246			$	49,550		$	52,991		$	50,031			$	53,992
Provision expense for loans	$	737		$	7,584			$	1,381		$	2,653		$	2,635			$	11,617

Exclusive of RAL:
Potential problem loans	$	95,990		$	78,026			$	92,435		$	96,266		$	117,536			$	126,297
Nonperforming loans	$	23,609		$	35,267			$	43,175		$	45,316		$	54,369			$	61,338
Net charge-offs	$	4,256		$	2,718			$	5,800		$	1,328		$	2,573			$	4,326
Allowance for credit losses	$	48,088		$	51,608			$	49,550		$	52,991		$	50,031			$	53,903
Provision expense for loans	$	737		$	(1,370	)		$	2,359		$	4,288		$	(1,299	)		$	4,408

In the first quarter of 2003, there was not much change in the economic outlook as most companies seemed unwilling to commit to expansion while the military situation in the Middle East remained unclear. For the Company, potential problem loans, nonperforming loans, and charge-offs remained at the approximately the same levels as the previous quarter.

Prior to the second quarter of 2003, the Company had actively instituted ongoing remedial actions aimed at addressing credit issues, and saw improvement in both potential problem loans and nonperforming loans. The former decreased by $8.8 million and the latter by $3.7 million from the prior quarter. Net charge-offs declined by $4.8 million. The decrease in net charge-offs reduced the amount of allowance that had to be provided and the decreases in potential problem loans and nonperforming loans reduced the Company’s estimate of losses in the portfolio and hence the allowance needed. Together these factors resulted in a negative provision expense (exclusive of RALs) for the quarter.

In the third quarter of 2003, the Company saw a $21.3 million decrease in potential problem loans and a $9.1 million decrease in nonperforming loans. The decrease in nonperforming loans was partially due to the sale of a $15.8 million problem credit to a third party. The note, secured by a prominent hotel property in the Santa Barbara area, had been classified in the fourth quarter of 2002 as a nonperforming loan.

In the fourth quarter of 2003, the Company was able to satisfactorily resolve another one of its large problem relationships. The business was recapitalized and the Company restructured the loans to this borrower. As expected, a portion of the loans were charged-off, but no additional provision was needed. The restructure could also result in the remaining balances being returned to performing status once a regular pattern of performance has been established. These charge-offs caused net charge-offs in the fourth quarter of 2003 to be higher than the Company’s normal levels.

In the first quarter of 2004, the Company continued to benefit from matured credit quality initiatives and saw a continued decrease in both potential problem loans and nonperforming loans. Net charge-offs were lower than the prior quarter. Only several days before the end of the quarter, the Company also received some real estate in payment of one of its problem loans. This was not received in time for the Company to be recorded as the owner, and consequently, the loan balance remained in the Company’s loan totals at March 31, 2004, but the allowance that had been allocated to the loan was no longer needed. This permitted a reduction in allowance recorded through a negative provision expense. As shown in the last table of Note 5, the allowance for credit losses increased due to the $6.1 million in allowance acquired in the PCCI transaction.

The trend of generally improving credit quality continued in the second quarter of 2004, as nonperforming loans decreased $11.7 million. Nonaccrual loans decreased $13.5 million, but loans delinquent more than 90 days increased $1.8 million. Of the decrease in nonaccrual loans, $2.9 million was reclassified to other real estate owned.

The following table sets forth the allocation of the allowance for all adversely graded loans by classification as of June 30, 2004 and December 31, 2003. There is no allocation of allowance in this table to RAL loans at December 31, 2003 because the Company held no RALs at that date. The RAL loans outstanding at June 30, 2004 are all classified as substandard. Consequently the whole amount of the RAL allowance of $288,000 at June 30, 2004 is included in the allocation for substandard loans.

TABLE 9—ALLOCATION OF ALLOWANCE
(dollars in thousands)

	June 30, 2004		December 31, 2003

Doubtful	$	1,752		$	4,108
Substandard		8,968			13,967
Special Mention		5,893			4,521

Total	$	16,613		$	22,596

Table 10 shows the amounts of nonperforming loans and nonperforming assets for the Company at the end of the second quarter of 2004 and at the end of the previous four quarters. A set of standard credit quality ratios for the Company and its peers is also provided. Nonperforming assets include nonperforming loans and foreclosed collateral (generally real estate). There is no standard industry definition for “potential problem loans” so while the Company’s totals for the last six quarters are shown in Table 8, peer comparisons are not available.

As with Table 8, the Company’s ratios are computed both with and without RALs, the allowance related specifically to RALs, and charged-off RALs. Again, with only two other banks having nationwide RAL programs, Management believes that better comparability of credit quality performance may be obtained by reviewing credit quality exclusive of the impact of the RAL program.

TABLE 10—ASSET QUALITY *

*(dollars in thousands)*	June 30, 2004				March 31, 2004				December 31, 2003				September 30, 2003				June 30, 2003

COMPANY AMOUNTS:
Loans delinquent 90 days or more		$	2,310			$	506			$	763			$	1,117			$	3,931
Nonaccrual loans			21,299				34,761				42,412				44,199				50,438

Total nonperforming loans			23,609				35,267				43,175				45,316				54,369
Foreclosed collateral			2,910				—				—				—				—

Total nonperforming assets		$	26,519			$	35,267			$	43,175			$	45,316			$	54,369

Allowance for credit losses other than RALs		$	48,088			$	51,608			$	49,550			$	52,991			$	50,032
Allowance for RALs			288				1,638				—				—				—

Total allowance		$	48,376			$	53,246			$	49,550			$	52,991			$	50,032


COMPANY RATIOS (Including RALs):
Coverage ratio of allowance for credit losses to total loans			1.29	%			1.44	%			1.56	%			1.73	%			1.67	%
Coverage ratio of allowance for credit losses to nonperforming loans			205	%			151	%			115	%			117	%			92	%
Ratio of nonperforming loans to total loans			0.63	%			0.95	%			1.36	%			1.48	%			1.81	%
Ratio of nonperforming assets to total assets			0.47	%			0.63	%			0.89	%			0.96	%			1.20	%
Ratio of allowance for credit losses to potential problem loans and nonperforming loans			39.46	%			47.00	%			36.54	%			37.43	%			29.10	%

COMPANY RATIOS (Exclusive of RALs):
Coverage ratio of allowance for credit losses to total loans			1.29	%			1.42	%			1.56	%			1.73	%			1.67	%
Coverage ratio of allowance for credit losses to nonperforming loans			204	%			146	%			115	%			117	%			92	%
Ratio of nonperforming loans to total loans			0.63	%			0.97	%			1.36	%			1.48	%			1.81	%
Ratio of nonperforming assets to total assets			0.47	%			0.67	%			0.89	%			0.96	%			1.20	%
Ratio of allowance for credit losses to potential problem loans and nonperforming loans			40.21	%			45.55	%			36.54	%			37.43	%			29.10	%

FDIC PEER GROUP RATIOS: (Note B)
Coverage ratio of allowance for credit losses to total loans			n/a				1.58	%			1.65	%			1.63	%			1.67	%
Coverage ratio of allowance for credit losses to nonperforming loans			n/a				179	%			173	%			164	%			161	%
Ratio of nonperforming loans to total loans			n/a				0.88	%			0.95	%			0.99	%			1.03	%
Ratio of nonperforming assets to total assets			n/a				0.63	%			0.65	%			0.68	%			0.70	%

* The amounts for total loans and total assets with and without RAL for June 30, 2004 and March 31, 2004 are reconciled in Table 23. There are no differences for the other quarters in this table.

Shown for both the Company and its peers are the coverage ratio of the allowance to total loans and the ratio of nonperforming loans to total loans. While the Company does not determine its allowance for credit loss by attempting to achieve particular target ratios, the Company nonetheless computes its ratios and compares them with peer ratios as a check on its methodology. Also shown for comparative purposes are the Company and peer ratios of nonperforming loans to total loans and nonperforming assets to total assets.

When the economy is changing, comparing the Company’s ratios at the end of the current quarter with peers’ ratios at the end of the prior quarter must be done cautiously. The Company’s allowance as of the end of the current quarter may reflect impacts from the economy on the Company’s borrowers that will only become apparent in the peer statistics when they are published near the end of the next quarter.

The ratio of allowance for credit losses to nonperforming loans is a common ratio reported for banks. Excluding RALs, the Company’s ratio of allowance for credit losses compared to nonperforming loans at June 30, 2004 (204%) was higher than the ratio for its peers (179%) at March 31, 2004. While this is a common statistic used in comparing bank’s asset quality profile, it is important to keep in mind that the allowance is not provided just for nonperforming loans and that some nonperforming loans do not require an allowance. Approximately $8.8 million of the $23.6 million in nonperforming loans are comprised of two specific loans. While they are not performing according to their contractual terms, because of collateral coverage, the Company does not expect to incur any loss of principal from these loans and consequently it has concluded that providing an allowance for them is not necessary.

The following table shows the types of loans included among nonperforming and potential problem loans as of June 30, 2004 and December 31, 2003.

TABLE 11—NONPERFORMING AND OTHER POTENTIAL PROBLEM LOANS

	June 30, 2004						December 31, 2003

*(dollars in thousands)*	Nonperforming Loans			Potential Problem Loans other than Nonperforming			Nonperforming Loans			Potential Problem Loans other than Nonperforming

Loans secured by real estate:
Construction and land development		$	1,159		$	1,825		$	6,190		$	8,204
Agricultural			2,893			9,613			2,899			9,699
Home equity lines			140			785			282			751
1-4 family mortgage			3,651			1,256			6,132			4,946
Multifamily			110			6,212			117			626
Non-residential, nonfarm			883			29,708			5,003			25,585
Commercial and industrial			11,813			37,173			19,723			32,450
Leases			1,427			3,218			966			4,025
Other Consumer Loans			1,492			8,388			1,770			5,237
Other			41			801			93			912

Total		$	23,609		$	98,979		$	43,175		$	92,435

Charge-offs

Table 12 shows the ratio of net charge-offs to average loans both with and without RALs.

TABLE 12—RATIO OF NET CHARGE-OFFS TO AVERAGE LOANS

	2004 YTD Annualized			2003			2002			2001			2000			1999


Pacific Capital Bancorp (including tax refund loans)		0.85	%		0.72	%		0.50	%		0.48	%		0.46	%		0.37	%
Pacific Capital Bancorp (excluding tax refund loans)		0.40	%		0.46	%		0.44	%		0.33	%		0.33	%		0.23	%
FDIC Peers (Note C)		0.48	%		0.59	%		0.88	%		1.03	%		0.70	%		0.68	%

Conclusion

The amount of allowance for credit losses allocated to nonperforming loans, potential problem loans, impaired loans and to all other loans are determined based on the factors and methodology discussed in Note 1, “Summary of Significant Accounting Policies,” to the Company’s 2003 10-K. Based on these considerations, Management believes that the allowance for credit losses at June 30, 2004 represents its best estimate of the allowance necessary to cover the probable losses incurred in the loan and lease portfolios as of that date.

As discussed in Notes 1 and 11 and in the section below titled “Operating Expense,” the Company has established a reserve for loan commitments and letters of credit. This reserve is separate from the allowance for credit losses. The activity in this reserve for the three and six month periods ended June 30, 2003 and 2004 is shown in a table in Note 11.

FEDERAL FUNDS SOLD AND SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL

Uninvested cash is a nonearning asset, so the Bank strives to maintain the minimum balances necessary for efficient operations. Cash in excess of the amount needed each day to fund loans, invest in securities, or cover deposit withdrawals is sold to other institutions as Federal funds or invested with other institutions on a collateralized basis as securities purchased under agreements to resell (“reverse repurchase agreements”). Federal funds sold are unsecured borrowings between financial institutions. The reverse repurchase agreements are investments which are collateralized by securities or loans of the borrower and mature on a daily basis. The Company requires the investments to be over-collateralized by 102% for securities and 105% for loans. The sales of Federal funds are done on an overnight basis as well. The amount of Federal funds sold and reverse repurchase agreements purchased during the quarter is an indication of Management’s estimation during the quarter of immediate cash needs, the difference between funds supplied by depositors compared to funds lent to borrowers, and relative yields of alternative investment vehicles. At the relatively low rates available on these instruments—approximately 1.00%—the Company has kept minimal balances.

SECURITIES

Securities increased from $1.3 billion at the end of 2003 to $1.5 billion as of June 30, 2004. The increase was primarily due to the mortgage-backed securities obtained in the March 5, 2004 PCCI acquisition.

Between March 31, 2003 and December 31, 2003, the Company implemented a leveraging strategy involving the purchase of securities funded by additional borrowings. It is termed leveraging because the purchaser is increasing its assets without a corresponding increase in capital, hence leveraging its capital. The ideal manner for a financial institution to grow or to increase its net interest income is through adding deposits and investing the received funds in loans, because the spread between the interest earned and paid is then maximized. However, with interest rates low, loan demand relatively weak, and customers unwilling to place their funds in longer-term CDs, the opportunities to grow in this manner are limited. The Company decided that the purchase of securities funded by the borrowings would provide some additional net interest income, even though the relatively thin spread between the earnings rate on the securities and the cost of the borrowings would negatively impact the net interest margin.

CMOs and MBSs were purchased and funded by term borrowings from the Federal Home Loan Bank (“FHLB”). The use of term debt to fund the purchases reduces the interest rate risk incurred by the purchase of the securities, because the spread between the assets and liabilities would be “locked in” for at least the term of the debt. The Company did not try to exactly “match fund” the purchases—exactly match the term of the securities purchased and the debt incurred—because the spreads would then be too narrow. Because the Company had been asset sensitive as explained in the section titled “Interest Rate Sensitivity,” it could afford some mismatching of the maturities to obtain a wider spread in the interest income and expense.

During the second quarter of 2003, the Company purchased $300 million of mortgage-backed securities with funding obtained from the FHLB. The securities were purchased at yields of 3.25% to 3.50% with the funding costs at 1.25% to 1.75%. In the third quarter, $200 million in additional securities were purchased with yields of 3.40% to 4.80% with funding costs of 2.25% to 2.80%. The underlying loans supporting these mortgage-backed securities are hybrid ARMS–mortgages that have a fixed rate for several years and then reprice in response to changes in market rates. Along with the fixed rate on the funding used to purchase the securities, the repricing characteristics of these securities provide the Company with some protection when interest rates rise.

Both CMOs and MBSs represent the right to receive interest and principal payments from underlying mortgages. Some of these securities were purchased at a premium. As with any purchased premium on securities, the premium is amortized against interest income over the life of the security. The amortization of premium lowers the carrying amount of the security to the par value that will be received at maturity and reduces the interest income earned. In the case of single maturity debt instruments like US Treasury securities, it is relatively simple to compute the amount of premium to be amortized each month to obtain a level effective yield. In the case of CMOs and MBSs the calculation is more complicated. The amortization is based on the actual and estimated paydown of the principal. Prepayments by the mortgage customers accelerate the amortization of the premium in two ways. First, the premium associated with the balance paid off prematurely must immediately be amortized against income. Second, prepayment shortens the average life of the remaining outstanding amount of the security over which the remaining premium is to be amortized.

Prepayment speeds increased substantially during 2002 and the first half of 2003 as interest rates remained at relatively low levels. In the third quarter of 2003, the Company amortized approximately $2 million of premium. Some of this amortization was simply due to the normal payment by the borrowers of their principal payments, but the majority was due to prepayments. Most of the prepayments relate to securities purchased in 2002 and early 2003, as prepayments are not typically received in the first months after their issue. While the FOMC lowered short-term rates in late June 2003, intermediate rates actually increased 1% higher than before short-term rates were dropped. Intermediate rates have fluctuated since then, but generally have remained higher. Premium amortization was $825,000 in the fourth quarter of 2003 and $997,000 in the first quarter of 2004, but increased to $2 million in the second quarter of 2004. The increase in prepayments in the second quarter of 2004 was due to a temporary decrease in intermediate-term rates in the latter part of the first quarter of 2004 (Note N). The Company did not see a corresponding increase in prepayment of residential loans in its portfolio. Assuming that the economy continues to improve, it would be expected that the rate of prepayments and therefore the amortization of premiums will remain lower, stabilizing or increasing the effective yield of the securities.

As explained above, leveraging increases assets without a corresponding increase in capital. As explained below in the section titled “Capital Resources and Company Stock,” the Company has capital ratios substantially in excess of the standard for classification as well capitalized, and this position has not been eroded by the implementation of the strategy, as the amount of leverage added in this strategy is approximately 10% of the total assets. As prepayments occur, the Company intends to maintain the balance of securities through additional purchases with the proceeds.

FEDERAL FUNDS PURCHASED AND SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE

Federal funds purchased are exactly the converse of Federal funds sold in that they are overnight borrowings from other financial institutions used by the Company’s subsidiaries as needed to manage their daily liquidity positions. At various times during each quarter, the Company may experience loans growing or other cash outflows occurring at a higher rate than cash inflows from deposit growth. In these situations, the Company first uses its short-term investments to provide the needed funds—see the above section of this discussion—and then borrows funds overnight in the form of Federal funds purchased until cash flows are again balanced.

Small amounts of Federal funds are purchased from other local financial institutions as an accommodation to them, i.e. the Company provides the smaller institution with an opportunity to place funds at a better rate, for the relatively small amounts they sell, than they could obtain in the general market. The Company either earns a spread on what it can sell the funds for or reduces the expense on what it would otherwise have to borrow for its own liquidity needs.

As described in the previous section discussing securities purchased under agreements to sell, the Company uses reverse repurchase agreements as a means of investing short-term excess cash. While the Company could borrow money overnight in the same repurchase agreement market that it lends funds, it instead generally uses repurchase agreements as a “retail” product. Funds in amounts that exceed FDIC deposit insurance coverage are borrowed from customers for periods of one week to two months. An exception to this general pattern occurs in the first quarter of each year as the Company uses repurchase agreements to borrow funds from other financial institutions to support the funding needs of the RAL program. Whether the repurchase agreements are with retail customers or other financial institutions, the borrowings are collateralized by securities held by the Company in its investment portfolios.

Table 13 indicates the average balances (dollars in millions), the rates for these borrowings and the proportions of total assets funded by them over the last seven quarters. The increased amounts in the first quarters of 2003 and 2004 are obvious in this table.

TABLE 13—FEDERAL FUNDS PURCHASED AND SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE (dollars in millions)

Quarter Ended		Average Outstanding			Average Rate			Percentage of Average Total Assets


December	2002		$	36.0		1.10	%		0.9	%
March	2003			138.6		1.38	%		2.9	%
June	2003			32.8		0.87	%		0.7	%
September	2003			41.0		0.73	%		0.9	%
December	2003			56.8		0.88	%		1.2	%
March	2004			200.6		1.07	%		3.6	%
June	2004			94.6		0.95	%		1.7	%

LONG-TERM DEBT, OTHER BORROWINGS, AND RELATED INTEREST EXPENSE

Treasury Tax and Loan demand notes, borrowings from the FRB, advances from the FHLB, and the senior and subordinated notes are reported on the Consolidated Balance Sheets as long-term debt and other borrowings.

Other Borrowings:

Treasury Tax and Loan demand notes are amounts received from customers that are due to the Internal Revenue Service for payroll and other taxes. Banks may immediately forward these funds to the IRS, or may retain the funds and pay interest on them. The Company elects to retain these funds.

As a backup source of short-term liquidity, banks may borrow funds from the FRB. The Company did not borrow funds from this source during the quarter.

Long-Term Debt:

Long-term debt at June 30, 2004 included $588.8 million in advances from the FHLB, $71.0 million in subordinated debt at the Bank, $37.0 million in senior debt at Bancorp, and $30.3 million in subordinated debt at Bancorp assumed in connection with the March 5, 2004 PCCI acquisition. The scheduled maturities of the advances are $146.3 million in 1 year or less,

$349.5 million in 1 to 3 years, and $93.0 million in more than 3 years. The maturity of the Bancorp senior debt is July 2006 and the maturity of the Bank subordinated debt is July 2011. The subordinated debt at Bancorp matures in 2033, but the notes are callable in part or in total by the Company in 2008.

Table 14 indicates the average balances that are outstanding (dollars in millions) and the rates and the proportion of total assets funded by long-term debt over the last seven quarters.

TABLE 14—LONG-TERM DEBT
(dollars in millions)

Quarter Ended		Average Outstanding			Average Rate			Percentage of Average Total Assets


December	2002		$	253.2		6.27	%		6.1	%
March	2003			256.9		6.08	%		5.4	%
June	2003			322.3		5.13	%		7.3	%
September	2003			419.0		4.23	%		9.0	%
December	2003			461.1		4.03	%		9.6	%
March	2004			603.2		3.60	%		10.9	%
June	2004			706.1		3.37	%		12.6	%

The Company uses long-term debt both to supplement other sources of funding for loan growth and as a means of mitigating the market risk incurred through the growth in fixed rate loans. One of the methods of managing interest rate risk is to match repricing characteristics of assets and liabilities. When fixed-rate assets are matched by similar term fixed-rate liabilities, the deterioration in the value of the asset when interest rates rise is offset by the benefit to the Company from holding the matching debt at lower than market rates. Most customers do not want CDs with maturities longer than a few years, but the Company can borrow funds from the FHLB at longer terms to match the loan maturities.

As discussed in “Securities” above, the Company used advances from the FHLB to fund the purchases of securities for its leveraging strategy. Advances were added in the second, third, and fourth quarters of 2003.

The senior note issued by Bancorp and $36 million of the subordinated notes issued by the Bank were issued in July 2001 by the Bank and by Bancorp, respectively. The subordinated debt was structured to qualify as Tier 2 regulatory capital both for the Bank and for the Company. It was issued to permit continued loan growth and expansion of the RAL program at the Bank. The proceeds from the senior debt provided cash to retire some of the Company’s outstanding shares, to pay the note mentioned in the succeeding paragraph, and to fund some of the cash dividends during the last few quarters. This avoided the need to fund these dividends through dividends from the bank which would lower its capital.

The Bank issued another $35 million of subordinated debt both to partially fund the acquisition of PCCI and to supplement the Bank’s regulatory capital—like the other subordinated debt mentioned above, it qualifies as Tier 2 capital—for the addition of the PCCI assets.

The subordinated debt issued by Bancorp was assumed in connection with the March 5, 2004 PCCI acquisition. This debt is owed to the three business trust subsidiaries of Bancorp that were added in the PCCI acquisition and is comprised of the following: $13,750,000 owed to PCC Trust I, $6,190,000 owed to PCC Trust II, and $10,310,000 owed to PCC Trust III. Each of the three pieces of this subordinated debt will mature in 2033, but is callable by the Company in part or in total in 2008. The PCC Trust I debt has a fixed interest rate of 6.335% until 2008, after which the interest rate will float and reset quarterly at the three-month LIBOR rate plus 3.25%. The PCC Trust II debt has a fixed interest rate of 6.58% until 2008, after which the interest rate will float and reset quarterly at the three-month LIBOR rate plus 3.15%. The PCC Trust III debt has a fixed interest rate of 6.80% until 2008, after which the interest rate will float and reset quarterly at the three-month LIBOR rate plus 3.10%.

NONINTEREST REVENUE

Noninterest revenue consists of income earned other than interest. On a year-to-date basis, the largest individual component of noninterest revenue is the fees earned on tax refund transfers. About 90% of these occur in the first quarter as purchasers of this product tend to file their returns very early in the tax season. The amount recognized in the second quarter is substantially less. These fees and other operating income and expense of the tax refund programs are explained below in the section titled “Refund Anticipation Loan and Refund Transfer Programs.” The $8.0 million gain on sale of RALs that occurred in the first quarter of 2003 and the $2.9 million gain on sale that occurred in the first quarter of 2004, are also discussed in detail in “Refund Anticipation Loan and Refund Transfer Programs.” They do not recur in the second quarter of the year because the securitization is completed prior to the end of the first quarter. There is no significance to the lower amount of gain in 2004 compared to 2003 other than that fewer loans were sold into the securitization in 2004 than in 2003.

Service charges on deposit accounts and trust and investment services fees are the next largest components of noninterest revenue. The fees from service charges on deposits are primarily due to overdraft fees, and have increased along with the growth in deposit balances.

Management fees on trust accounts are generally based on the market value of assets under administration, most of which are equity securities. Fees increased $252,000 or 6% from the same quarter a year ago. Fees in the first quarter of 2004 were 15% higher than fees in the first quarter of 2003 as equity markets were higher in early 2004 relative to 2003 than they were in the second quarter. However, new accounts have been obtained and continue result in increases in fees earned.

Other service charges, commissions, and fees are higher due to increases in collection fees related to the RAL program, fees on standby letters of credit, and debit card fees, offset by a decrease in real estate loan broker fees due to few loans being sold. The net total for these amounts was $360,000 higher in the second quarter of 2004 than in the second quarter of 2003.

The other income category consists of gain or loss on sale of loans, dividends on FHLB and FRB stock, and earnings on Bank-owned life insurance. The major change from the same quarter a year ago was the additional gains on the sale of SBA loans by the former PCCI SBA lending unit.

Also included in non-interest revenue are gains or losses on securities. The Company recognized $440,000 in losses in the second quarter of 2004 compared to $604,000 in gains in the same quarter of 2003. The Company had initiated an effort in 2003 to reduce the number of individual securities held (over 700) to make portfolio management more efficient. With most securities at the time having a fair value greater than their amortized carrying cost, gains were the result. In 2004, the proportion of securities having fair values less than their amortized cost has been greater and the result of the sales were losses. The reinvestment of the proceeds from these sales into higher yielding securities will generate more interest income than the Company would earn from holding the securities that were earning less than current market votes.

OPERATING EXPENSE

The largest component of noninterest expense is salaries and benefits, or staff expense. Within this category are (1) actual salaries and bonuses, (2) commissions paid to sales staff, (3) statutory benefits like payroll taxes and workers’ compensation insurance, and (4) discretionary benefits like health insurance.

Actual salaries and bonuses (including commissions) grew approximately $4.7 million in the second quarter of 2004, compared to the same quarter of 2003.

Several factors cause some variation in staff expense from quarter to quarter. $1.6 million of the increase was due to the additional staff added in the PCCI transaction.

Employee bonuses are paid from a bonus pool, the amount of which is set by the Board of Directors based on the Company meeting or exceeding its goals for net income and specific business unit goals. For most employees, the Company accrues compensation expense for the pool for employee bonuses throughout the year based on projected progress in meeting the goals. The amount accrued each quarter is adjusted as the year progresses and as it becomes clearer whether these goals will be achieved. Almost all of the bonuses for employees responsible for the RAL/RT business are accrued in the first quarter when the income is earned. With pre-tax income from these programs essentially even with 2003, the bonus accrual for this area was also even with the accrual in 2003.

Also, included within benefits is the Company’s workers’ compensation insurance expense. Most companies in California have seen substantial increases over the last year or so in the cost of this coverage. The Company’s change to a partially self-insured plan is described in the 2003 10-K. The Company’s expense for the second quarter of 2004 increased $255,000, over the second quarter of 2003.

Staff size is closely monitored in relation to the growth in the Company’s revenues and assets. Table 15 compares salary and benefit costs as a percentage of revenues and assets for the three and six-month periods ended June 30, 2004 and 2003, and shows that salaries and benefits grew at a slightly faster rate than revenues and at a slightly slower rate than assets.

TABLE 15—SALARIES AND BENEFITS AS A PERCENTAGE OF REVENUES AND ASSETS

	Three Months Ended June 30,						Six Months Ended June 30,
	2004			2003			2004			2003

Salary and benefits as a percentage of net revenues		33.85	%		31.55	%		25.41	%		24.49	%
Salary and benefits as a percentage of average assets		0.43	%		0.44	%		0.88	%		0.94	%

Equipment expense fluctuates over time as needs change, maintenance is performed, and equipment is purchased.

The Company leases rather than owns most of its premises. Many of the leases provide for annual rent adjustments.

The following table shows the major items of operating expense for the three-months ended June 30, 2004 and 2003 that are not specifically listed in the consolidated statements of income.

TABLE 16— OPERATING EXPENSE

	Three Months Ended June 30,						Six Months Ended June 30,
*(dollars in thousands)*	2004			2003			2004			2003


Marketing		$	1,279		$	810		$	2,135		$	1,711
Consultants			2,066			1,345			3,759			2,818
Amortization of core deposit intangibles			463			213			675			425
Provision expense for letters of credit			21			2,066			130			2,871

Consultant expense in the three-month and six-month periods ended June 30, 2004 is higher than in corresponding periods of 2003. The Company has engaged consultants to assist it in meeting the new regulatory requirements of the Sarbanes-Oxley Act discussed in the section below titled “Regulation.” Companies frequently find it more cost-effective to outsource these short-term projects than to hire staff to handle these large but relatively short-term projects.

The core deposit intangible was recognized in connection with the purchase of the deposits from another financial institution in 2002 and from the deposits acquired with PCCI.

As described in Note 11, “Commitments and Contingencies,” to the Consolidated Financial Statements, the Company has issued commitments to or on behalf of customers. Most of these are conditional on the financial condition of the customer,

that is, the Company can cancel the commitment if the customer’s condition would indicate that it will not be able to repay any amount extended under the commitment. There are some commitments, like standby letters of credit, that the Company extends specifically to protect a third party in the event of the customer’s inability to meet its financial or contractual commitments.

There is an element of credit risk that pertains to such commitments. Should a customer fail to perform on its financial or contractual agreements with a third party, the Company is required to pay a specified amount of damages to a third party. The Company must then seek reimbursement from its customer. If the customer is not able to reimburse the Company, the Company has suffered a credit loss.

The allowance for credit loss is intended as a valuation allowance for loans. That is, the total of loans less the allowance is intended to represent the Company’s best estimate of the amount that will be collected from the outstanding loans. Any allowance for unfunded commitments is therefore not included in the allowance for credit loss, but is instead recognized as another liability in the same manner as a “contingency reserve” would be established for a legal settlement or other operational loss. Similarly, this allowance is not established by a charge to provision expense for credit loss, but instead through an “other expense.” The expense for the first quarter of 2004 simply recognizes growth in the balances outstanding, whereas the amounts for the first and second quarters of 2003 included provision for some deterioration of credit quality for these commitments.

The Company is in the process of replacing its mainframe computer system with a smaller, more flexible “client-server” system. At the same time, the Company will be installing a new customer relationship management system. Under the provisions of GAAP, most of the expected $20 million cost of the new systems is being capitalized. The capitalized costs include those for hardware and for the development of software. The Company will amortize the hardware costs over the estimated useful life of the equipment. The capitalized software costs are expected to be amortized over a five year period beginning when the Company starts to use the new system. This is anticipated to be in the second quarter of 2005. The Company expects operating savings as a result of implementing the new system.

A common means of measuring the operating efficiency for banks is a ratio that divides the noninterest or operating expense of the bank by its net revenues. Net revenues are stated on a tax equivalent basis and represent interest income and noninterest income less interest expense. As was mentioned in the section titled “Summary Results” above, the Company’s operating efficiency ratio for the second quarter of 2004 was 60.46% compared to 61.01% for the same quarter of 2003. Stated differently, this means that the Company required about one half cent less in operating expenses to earn each dollar of net revenues in the second quarter of 2004 than in the same period of 2003. Operating expenses (the numerator of the operating efficiency ratio) increased 14.4%, while net revenues (the denominator) increased 15.4%. The reason for the slightly higher rate of growth in net revenues is the improved economy, which helped to increase loan growth and trust fee income, and the additional net revenues from the leveraging strategy.

The Company will continue to work on reducing costs, but the consulting expense will remain higher than normal for the next several quarters to respond to the Sarbanes-Oxley Act of 2002. The Company is expecting to spend approximately $2 million in 2004 for assistance in implementing the documentation and testing requirements of this legislation.

SEGMENT PERFORMANCE

Each of the comments below regarding changes in segment performance apply to both the three and six month periods ended June 30, 2004 compared to the same periods of 2003 unless otherwise stated.

Community Banking

The Community Banking segment includes both revenues from customers in the form of interest earned on consumer and small business loans and intersegment revenues representing the credit for funds earned on the deposits at the Company’s branches. Interest income for the same periods of 2004 is up slightly as the balance of consumer loans increased but the average rate earned decreased. Intersegment revenue is up more substantially than interest income as deposit balances increased. Interest expense remained relatively unchanged as deposit rates decreased during most of the last twelve months as NOW and savings account rates remained low and CDs repriced at lower rates than those at which they had been originated. The net result of the above changes is greater profitability in 2004 than 2003.

Commercial Banking

The Commercial Banking segments earns interest income from customers for commercial and commercial real estate loans. While the commercial real estate category in Tables 2A and 2B show a substantial increase from 2003 to 2004, most of that increase relates to income producing property loans that are included in the Pacific Capital segment. Consequently, loan balances in this segment are somewhat higher, but these higher balances are partially offset by lower rates earned on the loans. The net result is an increase in profitability of 9% for the three month period and 13% for the six month period.

Refund Programs

The changes in the RAL/RT programs from 2003 to 2004 are explained in the section below titled “Refund Anticipation Loan and Refund Transfer Programs.”

Fiduciary

Income for the Fiduciary segment consists of fees earned from trust services and from the sale of retail investment products to customers. The fees are based on asset values and are up as equity market valuations are higher in 2004 than in 2003.

Pacific Capital

Income for the Pacific Capital segment is interest income on loans to customers. This is a new segment created at a result of the acquisition of Pacific Crest Capital Inc. in March 2004.

All Other

Income from external customers for the All Other segment consists of interest earned on investments in the Company’s treasury activities and in interest earned on loans from the Company’s private banking department. With the additional investments added in the Company’s leveraging program described in the section above titled “Securities,” income from external customers is higher in 2004 than in 2003. The changes in intersegment revenues and charges for funds are described in Note 14 to the Consolidated Financial Statements. The increase in interest expense is due to the additional borrowings incurred to fund the leverage strategy.

INCOME TAX

Income tax expense is comprised of a current tax provision and a deferred tax provision for both Federal income tax and state franchise tax. The current tax provision recognizes an expense for what must be paid to taxing authorities for taxable income earned this year. The deferred tax provision recognizes an expense or benefit related to items of income or expense that are included in or deducted from taxable income in a period different than when the items are recognized in the financial statements under generally accepted accounting principles. Examples of such timing differences and the impact of the major items are shown in Note 15, “Income Taxes,” to the Consolidated Financial Statements in the Company’s 2003 10-K.

With each period end, it is necessary for Management to make certain estimates and assumptions to compute the provision for income tax. Management uses the best information available to develop these estimates and assumptions, but generally some of these estimates and assumptions are revised when the Company files its tax return in the middle of the following year. In accordance with generally accepted accounting principles, revisions to estimates are recorded as income tax expense or benefit in the period in which they become known.

LIQUIDITY

Liquidity is the ability to raise funds on a timely basis at acceptable cost in order to meet cash needs, such as might be caused by fluctuations in deposit levels, customers’ credit needs, and attractive investment opportunities. The Company’s objective is to maintain adequate liquidity at all times. The Company has defined and manages three types of liquidity: (1) “immediate liquidity,” which is the ability to raise funds today to meet today’s cash obligations, (2) “intermediate liquidity,” which is the ability to raise funds during the next few weeks to meet cash obligations over that time period, and (3) “long term liquidity,” which is the ability to raise funds over the entire planning horizon to meet anticipated cash needs due to strategic balance sheet changes. Adequate liquidity is achieved by (a) holding liquid assets, (b) maintaining the ability to raise deposits or borrow funds, and (c) keeping access open to capital markets.

Immediate liquidity is provided by the prior day’s balance of Federal funds sold and repurchase agreements, any cash in excess of the Federal Reserve balance requirement, unused Federal funds lines from other banks, and unused repurchase agreement facilities with other banks or brokers. The Company maintains total sources of immediate liquidity of not less than 5% of total assets, increasing to higher targets during the RAL/RT season. At June 30, 2004, the Company’s immediate liquidity was substantially in excess of the 5% target.

Sources of intermediate liquidity include maturities or sales of commercial paper and securities classified as available-for-sale, securities classified as held-to-maturity maturing within three months, term repurchase agreements, advances from the FHLB, and deposit increases from special programs. The Company projects intermediate liquidity needs and sources over the next several weeks based on historical trends, seasonal factors, and special transactions. Appropriate action is then taken to cover any anticipated unmet needs. At June 30, 2004, the Company’s intermediate liquidity was adequate to meet all projected needs.

Long term liquidity is provided by special programs to increase core deposits, reducing the size of the investment portfolios, selling or securitizing loans, and accessing capital markets. The Company’s policy is to address cash needs over the entire planning horizon from actions and events such as market expansions, acquisitions, increased competition for deposits, anticipated loan demand, economic conditions and the regulatory outlook. At June 30, 2004, the Company’s long term liquidity was adequate to meet cash needs anticipated over its planning horizon.

As discussed below in the section titled “Refund Anticipation Loan and Refund Transfer Programs,” the Company uses a securitization vehicle to sell a portion of the RALs during the first quarter. This securitization represents a significant source of liquidity for the Company for this program.

CAPITAL RESOURCES AND COMPANY STOCK

Capital Ratios

The following table presents a comparison of several important amounts and ratios as of June 30, 2004 and December 31, 2003.

TABLE 17—CAPITAL RATIOS
(dollars in thousands)

	Pacific Capital Bancorp Actual					Minimums for Capital Adequacy Purposes					Minimums to be Well-Capitalized

	Amount		Ratio			Amount		Ratio			Amount		Ratio

As of June 30, 2004
Total Tier I & Tier II Capital (to Risk Weighted Assets)	$	478,051		11.5	%	$	332,048		8.0	%	$	415,060		10.0	%
Tier I Capital (to Risk Weighted Assets)	$	355,664		8.6	%	$	166,024		4.0	%	$	249,036		6.0	%
Tier I Capital (to Average Tangible Assets)	$	355,664		6.5	%	$	219,811		4.0	%	$	274,763		5.0	%

Risk Weighted Assets	$	4,150,602
Average Tangible Assets for the Quarter	$	5,495,264

As of December 31, 2003
Total Tier I & Tier II Capital (to Risk Weighted Assets)	$	468,851		13.3	%	$	281,730		8.0	%	$	352,162		10.0	%
Tier I Capital (to Risk Weighted Assets)	$	353,714		10.0	%	$	140,865		4.0	%	$	211,297		6.0	%
Tier I Capital (to Average Tangible Assets)	$	353,714		7.4	%	$	190,000		4.0	%	$	237,500		5.0	%

Risk Weighted Assets	$	3,521,619
Average Tangible Assets for the Quarter	$	4,749,992

As of June 30, 2004 and December 31, 2003, the Company’s ratios of tangible common equity to tangible assets were 5.8% and 7.4% respectively.

The operating earnings of the bank are the largest source of capital for the Company. For reasons mentioned in various sections of this discussion, Management expects that there will be variations from quarter to quarter in operating earnings. Areas of uncertainty or seasonal variations include changes in market interest rates, asset quality, loan demand, and the tax refund loan and transfer programs. A substantial change in overall credit quality or an increase in charge-offs might require the Company to record a larger provision for loan loss to restore the allowance to an adequate level, and this would negatively impact earnings. Income from the tax refund loan and transfer programs, occurring almost entirely in the first quarter, introduces significant seasonality and causes variation in the Tier 1 leverage ratio which is based on average quarterly assets.

Capital must be managed at both the Company and at the Bank level. The FRB sets minimum capital guidelines for U.S. banks and bank holding companies based on the relative risk of the various types of assets. The guidelines require banks to

have risk-based capital equivalent to at least 8% of risk adjusted assets. To be classified as “well capitalized,” the Bank is required to have risk-based capital equivalent to at least 10% of risk adjusted assets.

As of June 30, 2004, the Bank’s total risk-based capital ratio was 11.9%, Tier 1 capital was 9.0% of risk-adjusted assets and 6.8% of average tangible assets, and its tangible common equity to tangible assets was 6.7%.

Debt Qualifying as Capital

The total risk-based capital ratio for the Company of 11.5% includes the effect of the $36 million in subordinated debt at the Bank which qualifies as Tier 2 capital for the Bank and for the Company. As indicated in the discussion of the subordinated note in the section above titled “Other Borrowings, Long-term Debt and Related Interest Expense,” some of this debt was issued in 2001 and some in 2003 to assist the Company in maintaining the required capital ratios at the Bank as its general loan portfolios and the refund loan program continued to grow and in anticipation of the additional assets that would be added with the PCCI acquisition.

The total risk-based capital ratio also includes the effect of $30.3 million in subordinated debt issued by Bancorp which qualifies as Tier 1 capital for the Company. This debt resulted from the March 5, 2004 acquisition of PCCI and relates to the debt owed by Bancorp to the three business trusts established by PCCI.

Dividends

While the earnings of its wholly-owned subsidiaries are recognized as earnings of the Company, generally dividends must be declared and paid by the subsidiary Bank to provide Bancorp with the funds for it to pay dividends to its shareholders. As a nationally-chartered bank, the Bank’s ability to pay dividends is governed by Federal law and regulations. Generally banks may dividend their earnings from the last three years to their parent company. In its second year of operations since the merger of the subsidiary banks—Santa Barbara Bank & Trust and First National Bank of Central California into Pacific Capital Bank, N.A.— the Bank is limited to its earnings since the merger at the end of March 2002. Earnings to date in 2002, 2003, and 2004 have been more than adequate to meet the cash required to maintain the current declared quarterly dividend rate of $0.18 per share.

Dividends are paid each quarter in February, May, August and November. The dividend rate is reviewed each quarter and increases are periodically authorized to stay within the Company’s target range of a payout ratio of 35%-40% of net income The quarterly dividend rate, adjusted for the 2^nd quarter 2004 stock split, was $0.14 per share until the first quarter of 2003. It was increased to $0.15 per share in the second quarter of 2003, increased to $0.16 per share in the third quarter of 2003, increased to $0.17 per share in the first quarter of 2004, and increased to $0.18 per share in the third quarter of 2004.

Share Repurchases

During 2002, adjusted for the 2^nd quarter 2004 stock split , approximately 992,000 shares were repurchased at an average price of $18.30 per share for a total of $18.2 million. During the first nine months of 2003, approximately 1.18 million shares were repurchased at an average price of $23.93 per share for a total of $28.1 million. Under the most recent authorization, as of June 30, 2004, the Company had repurchased approximately 43,000 shares at an average price of $25.08 per share for a total price of $1.1 million. Due to the anticipated capital requirements of the Company’s acquisition of Pacific Crest Capital, the Company stopped repurchasing shares in August 2003. Management anticipates that its share repurchase activity will be modest in the foreseeable future as it appears that the economy is improving and loan demand is expected to increase.

Other Capital Disclosures

Aside from the $18.9 million amount authorized for share repurchases and those commitments reported in Note 11 to the consolidated financial statements, there are no material commitments for capital expenditures or “off-balance sheet” financing arrangements planned at this time. There is no specified time within which the share repurchases must be accomplished.

As the Company pursues its stated plan to expand beyond its current market areas, Management will consider opportunities to form strategic partnerships with other financial institutions that have compatible management philosophies and corporate cultures and that share the Company’s commitment to superior customer service and community support. Such transactions will be accounted for as a purchase of the other institution by the Company. To the extent that consideration is paid in cash rather than Company stock, the assets of the Company would increase by more than its equity and therefore the ratio of capital to assets would decrease. In addition, depending on the size of the institution acquired, Bancorp might be required to borrow funds for the cash consideration.

REGULATORY ENVIRONMENT

The Company is closely regulated by Federal and State agencies. The Company and its subsidiaries may only engage in lines of business that have been approved by their respective regulators and cannot open or close branch offices without their approval. Disclosure of the terms and conditions of loans made to customers and deposits accepted from customers are both heavily regulated as to content. The Bank is required by the provisions of the Community Reinvestment Act (“CRA”) to make significant efforts to ensure that access to banking services is available to all members of the communities served.

As a bank holding company, Bancorp is primarily regulated by the FRB. As a nationally-chartered member bank of the Federal Reserve System, the Bank’s primary Federal regulator is the Office of the Comptroller of the Currency (“OCC”). Both of these regulatory agencies conduct periodic examinations of the Company and/or its subsidiaries to ascertain their compliance with laws, regulations, and safe and sound banking practices. The primary reason for the merger of the banking charters of SBB&T and FNB into one nationally-chartered bank was to simplify the regulatory environment for the Company. Prior to the merger, SBB&T had the FRB as its primary Federal regulator and was also regulated by the California Department of Financial Institutions while FNB was regulated by the OCC.

The regulatory agencies may take action against bank holding companies and banks should they fail to maintain adequate capital or to comply with specific laws and regulations. Such action could take the form of restrictions on the payment of dividends to shareholders, requirements to obtain more capital from investors, or restrictions on operations. The Company and the Bank have the highest capital classification, “well capitalized,” given by the regulatory agencies and therefore are not subject to any of these restrictions. Management expects the Company and the Bank to continue to be classified as well capitalized in the future.

While financial institutions have long been required by regulation to report large cash transactions to assist in preventing money laundering activities, the USA Patriot Act of 2001 and subsequent implementing regulations have imposed significant additional reporting requirements to limit the access to funds by terrorists. The Company, along with all other financial institutions must not only report cash transactions above a certain threshold, it must now report activities deemed by the banking regulators to be “suspicious.” To comply with this new level of reporting requirement, the Company has installed new “rule-based” software to detect suspicious activity. The Company has also implemented enhanced customer identification procedures as well as processes for detecting and reporting suspicious activity. It has provided new training for its employees in how to confirm whether the suspicious activity detected is in fact questionable or whether it represents the normal business activity for the specific customer.

Provisions in the Sarbanes-Oxley Act of 2002 require all public companies to include certifications signed by its chief executive officer and chief financial officer in their periodic reportings to the Securities and Exchange Commission. Companies’ independent auditors will be required to evaluate management’s assertion in 2004 annual reports relating to the effectiveness of the companies’ disclosure controls in ensuring financial reporting that appropriately reflect companies’ financial condition and results of operations. This requirement is expected to significantly increase consulting and audit fees as companies seek assistance from their accountants in documenting their disclosure controls and as the auditors spend more time testing the effectiveness of those controls.

Concerns about consumer financial privacy have grown in recent years. In response to these concerns Congress and the Federal banking agencies have adopted new laws and regulations and reemphasized existing laws and regulations. On June 1, 2000, the Federal banking agencies jointly released final regulations implementing the consumer privacy protection rules mandated by Section 504 of the Gramm-Leach-Bliley Act (GLB Act). The GLB Act imposes certain notice requirements and restrictions on a financial institution’s ability to disclose nonpublic personal information about consumers to affiliates

and nonaffiliated third parties. While the Company has always made the privacy and protection of customer information a priority, it has responded to the new laws, and any customer concerns, by enhancing both its systems and manual processes. There has been a significant investment in electronic data security measures along with manual processes to safeguard customer information.

REFUND ANTICIPATION LOAN AND REFUND TRANSFER PROGRAMS

Since 1992, the Company has extended tax refund anticipation loans to taxpayers who have filed their returns electronically with the IRS and do not want to wait for the IRS to send them their refund check. The Company earns a fixed fee per loan for advancing the funds rather than by applying an interest rate to the balance for the time the loan is outstanding. Nonetheless, the fees are required by GAAP to be classified as interest income. The Company also provides refund transfers to customers who do not want or do not qualify for loans. The transfer product facilitates the receipt of the refund by the customer by authorizing the customer’s tax preparer to print a check for the customer after the refund has been received by the Company from the IRS. Fees for this service are included in non-interest income among other service charges, commissions, and fees. Because of the mid-April tax filing deadline, almost all of the loans and transfers are made and repaid during the first quarter of the year.

If a taxpayer meets the Company’s credit criteria for the refund loan product, and wishes to receive a loan with the refund as security, the taxpayer applies for and receives an advance less the transaction fees, which are considered finance charges. The Company is repaid directly by the IRS and then remits any refund amount over the amount of the loan to the taxpayer.

Congress has given the IRS a mandate to increase the number of returns that are filed electronically in order to reduce IRS processing and storage costs. Greater use of the refund loan and transfer programs helps the IRS to meet this mandate because these programs facilitate electronic filing.

The Company’s volume of RAL and RT transactions has increased significantly over the last several years. As recently as 1998, the Company processed approximately 650,000 transactions. In 2002, it processed approximately 3.8 million transactions and processed approximately 4.6 million transactions in 2003. The product mix for the program in 2003 was 65% RALs, 35% RTs. The total transaction volume increased in 2004 to approximately 5.1 million, but the growth was primarily in RTs, resulting in a product mix of 69% RTs, 31% RALs

While the Company is one of very few financial institutions in the country which operate these electronic loan and transfer programs, the electronic processing of payments involved in these programs is similar to other payment processing regularly done by the Company and other commercial banks for their customers such as direct deposits and electronic bill paying. The refund loan and transfer programs have significant impacts on the Company’s activities and results of operations during the first quarters of each year. While not quite as pronounced, these impacts are still significant to the second quarter and year-to-date results of operations. These impacts and other details of the programs are discussed in the following five sections.

Seasonality Impact on Earnings:

Because the programs relate to the filing of income tax returns, activity is concentrated in each year, specifically in the period half from late January through February. This causes first quarter net income to average about 35% to 40% of each year’s net income. For 2002, the first quarter’s net income was 37% of the net income for the year. In 2003, the first quarter’s net income was 46% of the net income for the year. Because the pretax profitability of the RAL/RT programs has increased less in 2004 over 2003 while pretax income for the remainder of the Company’s activities increased 46%, the proportion of 2004 net income that will be represented by the first quarter is expected to decrease from the 2003 proportion. This seasonality significantly impacts a number of performance ratios, including ROA, ROE and the operating efficiency ratio. These impacts are apparent in both the first quarter of each year and the year-to-date ratios in subsequent quarters. As indicated above, the Company provides computations of these ratios without the impact of RAL and RT income and the related direct expenses for better comparability of the “traditional” banking activities with peer ratios. The reconciling computations are found in Note E to this discussion.

Funding Sources:

The Company borrows substantial funds during the first quarter to lend to RAL customers. With the exception of the use of uncommitted overnight funds, the shorter-term funding sources are more expensive because the lender needs to recover its costs over the shorter period of time. Consequently fees must usually be paid in addition to daily interest, and the cost to the Company is greater than the typical deposit sources used to fund other loans.

As the RAL program has increased in loan volume, the Company has had to use more sophisticated funding arrangements.

The various funding arrangements that have been used over the last five years as the programs grew significantly are discussed in the “Tax Refund Anticipation Loan and Refund Transfer Programs” section of Management’s Discussion and Analysis in the 2003 10-K.

For 2004, the Company used the same sources as in 2003, but used a smaller securitization—$500 million compared to $900 million in 2003. This reduction was done to minimize this most expensive of funding sources. The reduced size of the securitization also accounts for the smaller gain on sale of loans into the securitization.

Fees for Services:

The Company does not market these products directly to consumers. Instead, the Company markets to electronic filers. These are companies that have developed software for use by tax preparers or individuals for the preparation of tax returns. The fees for RALs and RTs vary depending on the contracts with the electronic filers and tax preparers. Taxpayers are provided with a statement of the fees for the two products and, in the case of the RALs, with an Annual Percentage Rate (“APR”) computation for the loan based on an estimate of the time that the loan will be outstanding. If payment by the IRS is delayed past the estimated term, the customer’s fee does not change.

The fees for the RAL product are higher than the fees for the RT product because of the credit risk addressed in the section below titled, “Credit Losses” and to cover the funding costs mentioned above.

Risks Associated with the Program:

There are risks related to the programs related to credit, the availability of sufficient funding at reasonable rates, risks associated with the IRS, litigation, and regulatory or legislative risk.

The Company’s liquidity risk is increased during the first quarter due to the RAL program. The Company has committed to the electronic filers and tax preparers that it will make RALs available to their customers under the terms of its contracts with them. This requires the Company to develop sufficient sources of liquidity to fund these loans. As mentioned above, the sources of this funding are described in detail in the 2003 10-K. Some of the sources are committed lines and some are uncommitted. In the case of uncommitted sources, the Company arranges for approximately twice the amount expected to be needed to ensure an adequate amount is available.

As discussed in Note 11, “Commitments and Contingencies,” of the Consolidated Financial Statements, the Company is currently involved in three lawsuits related to the RAL program. The Company does not expect that these suits will have any material impact on its financial condition or operating results.

Concern has been expressed by consumer advocates regarding the high APR for the loans and they have exerted pressure on state legislatures and regulators to prohibit RALs or limit the amount of the fee that may be charged. The APR is relatively high compared to other consumer loans because they are outstanding for a short time. These loans are not “rolled over” or renewed. When the fee is annualized in the APR computation, the result is a relatively high APR. It is Management’s position that the amount of the fee is reasonable given the credit risk, the funding costs, and processing expense. From the Company’s point of view, the high APR is the result of the fact that the Company cannot recover the costs of the loan over a longer period of time through periodic interest charges as is done with other lending products (Note J).

Accounting for the RAL Securitization:

The securitization arrangements used for funding involve a “true sale” of the loans into the securitization vehicle. Under the terms of the securitization, the loans are sold for their face amount less a discount representing the Company’s retained interest in the loans. There are fees associated with the securitization that the Company is charged based on the size of the commitment to purchase and how much of the commitment is utilized. Any of the loans sold into the securitization that are not paid by the IRS are charged against the Company’s retained portion until that amount was exhausted. Losses on defaulted loans in excess of the discount would be recognized by the securitization purchasers. The loans sold into the securitization and the fees associated with them are not included in Tables 2 or 3.

Normally, the securitization of loans impacts the timing of the recognition of income. That is, income from the loans may be recognized by the seller in different periods than it would be if the loans were not sold. Typically, a gain on sale is recognized at the time of sale that accelerates income recognition. However, in the case of the RAL securitization, because it is initiated and closed within the same quarter, and because the RALs sold would have been made and paid-off within the same quarter, there is no acceleration of income, and the amounts of income and expense are the same as they would be if the loans were not sold. With the exception of the commitment and utilization fees charged to the Company, the only accounting impact from securitizing a portion of the RALs is to change the category on the income statement where the operating results are reported. All of the cash flows associated with the RALs sold to the Company’s securitization partners were reported net as a gain on sale of loans. This gain account is reported as a separate line on the statements of income as noninterest revenue. The cash flows associated with these RALs are the fee income received from the customer, the interest expense paid to fund the loans, and the provision expense for defaulted loans.

The default rate of the loans is unaffected by whether they are sold, and in both years, defaulted loans were less than the Company’s retained interest, so the only impact of the securitization on defaulted loans is to reclassify the loss from provision expense to an offset against the gain on sale.

The following table summarizes the components of the gain on sale of RAL loans for the six-month periods ended June 30, 2004 and 2003.

TABLE 18—RAL GAIN ON SALE SUMMARY

	Six Months Ended June 30,
*(dollars in thousands)*	2004			2003


RAL fees	$	5,920		$	12,472
Fees paid to investor		(162	)		(612	)
Commitment fees paid		(678	)		(800	)
Provision expense		(2,135	)		(3,029	)

Net gain on sale of RAL loans	$	2,945		$	8,031

Summary of Operating Results

The following table summarizes operating results for the RAL and RT programs for the three-month periods ended June 30, 2004 and 2003.

TABLE 19—OPERATING RESULTS FOR THE RAL AND RT PROGRAMS

*(dollars in thousands)*	For the Three-Month Periods Ended June 30,								For the Six-Month Periods Ended June 30,
	2004				2003				2004				2003


Interest income from RALs		$	1,478			$	1,572			$	36,572			$	31,647
Interest expense on funding			(233	)			(21	)			(967	)			(772	)
Intersegment revenues			562				215				4,385				1,670
Internal charge for funds			–				(288	)			–				(2,665	)

Net interest income			1,807				1,478				39,990				29,880
Provision for credit losses--RALs			–				(3,934	)			(8,954	)			(11,143	)
Refund transfer fees			3,097				3,075				20,812				19,535
Collection Fees			576				647				3,492				2,863
Gain on sale of loans			–				–				2,945				8,031
Operating expense			(3,177	)			(1,503	)			(14,555	)			(8,536	)

Income before taxes		$	2,303			$	(237	)		$	43,730			$	40,630


Charge-offs		$	2,241			$	4,570			$	12,511			$	13,712
Recoveries			(891	)			(547	)			(3,845	)			(2,569	)

Net charge-offs		$	1,350			$	4,023			$	8,666			$	11,143

Credit Losses

The allowance table in Note 5, “Loans and the Allowance for Credit Losses,” to the Consolidated Financial Statements shows the activity in the allowance for RAL losses separate from the activity for other loans. Based on experience from prior years, a number of the loans charged off may yet be paid during the remainder of this year or during the 2005 filing season. It is difficult, however, to estimate the rate of recovery for future periods since 2004 collections are dependent on whether the IRS actually issues the requested refund and 2005 collections are primarily dependent on whether the customer applies for a RAL or RT during the 2005 season. While the charge-offs above do not include the $2.1 million charged-off for RALs sold into the securitization, any recoveries received on those loans accrue to the Company.

There is a higher credit risk associated with refund loans than with other types of loans because (1) the Company does not have personal contact with the customers of this product; (2) the customers conduct no business with the Company other than this once-a-year transaction; and (3) contact subsequent to the payment of the advance, if there is a problem with the tax return, may be difficult because many of these taxpayers have no permanent address.

Credit risk is lowered because of the debt indicator provided by the IRS. This electronic signal indicates whether the IRS or other Federal agencies have placed liens against the taxpayer’s refund because of amounts owed for past taxes, delinquent student loans, etc. Nonetheless, the charge-off rate for RALs still remains approximately two or three times as high as for the rest of the Company’s loan portfolios.

Credit risk arises from denial by the IRS of some or all of the amount claimed as a refund by the taxpayer. Credit risk is discussed below in the section titled “Credit Losses.” Credit risk is managed by the acceptance criteria set by the Company, the use of the debt indicator supplied by the IRS, and supplemented by the use of credit reports. A proportion of loans

charged-off each year are collected in subsequent years. When the customer applies for loan or transfer the following year, any charged-off amount from the prior year(s) is deducted from the amount of the current loan proceeds or transfer amount as permitted by the terms of the original loan agreement.

For many of the taxpayers wishing to use this product, a major portion of the refund is due to eligibility for the Earned Income Tax Credit (“EIC”). Such returns are subject to more scrutiny by the IRS than refunds that are primarily based on excess withholding. Each year the IRS reviews many of these EIC returns as part of its “revenue protection” program. Such review can cause a delay in payment of a loan made on the return. Such delays reduce the profitability of the program because there is no interest charged for the time the loan is outstanding, yet the Company must continue to pay interest on the funds it has lent to the taxpayer.

The usefulness of the debt indicator is dependent on the IRS having received data from other Federal agencies on liens to which the refunds are subject.

Approximately 105 basis points of the RALs were charged-off in 2003. This was higher than in 2002, but not as high as in earlier years. The Company anticipates charge-offs for 2004 will be approximately 110 to 120 basis points.

The 2003 collection experience confirmed two trends in the collections of delinquent RALs. Over the last three years both a higher proportion of loans outstanding at June 30th were being collected in the second half of each year and a higher proportion of total annual collections were being received in the second half of the year. In other words, during the last three years, both more delinquent loans were being collected and they were more likely to be collected in the second half of the year than was the case in prior years. Specifically, in the second half of each year, the Company collected $2.4 million, $1.3 million, and $2.6 million in loans that had been charged-off at June 30, of 2001, 2002, and 2003, respectively.

These changes in collection experience have led Management to revise its estimate of the collections on loans outstanding at June 30th that are likely to be received during the second half of 2004. Using the experience of the last three years, applied to a higher balance of unpaid loans at June 30, 2004, it has been estimated that a net amount of approximately $2.6 million in RALs will be collected during the second half of 2004. The gross RALs remaining on the books at June 30, 2004 are $2.9 million with an allowance of $288,000. Based on this analysis, no additional provision was required for the second quarter of 2004, compared to a provision expense of $3.9 million for the second quarter of 2003.

There is no credit risk associated with the refund transfers because checks are issued only after receipt of the refund payment from the IRS.

Expectations for the Remainder of 2004

The Company has estimated the amount of loans outstanding at June 30, 2004 on which it expects to receive payments during the second half of 2004. Also during the remainder of 2004, the tax refund programs will continue to incur expenses for salaries, occupancy, legal, marketing, data processing, etc.

Expectations for 2005 and Subsequent Years

The Company and Jackson-Hewitt Inc. (“JHI”) have renegotiated their contract under which the Company provides RALs and RTs to the customers of JHI. The contract now extends for another four years. The major change in the contract is that the Company will now assume the credit risk for the loans made by JHI offices. Under the terms of the prior contract, JHI assumed the credit risk for the first 2½ % of all credit losses on loans made through its offices. Losses above that amount would be shared by the Company and JHI in a ratio of 35% and 65% respectively. The loss rate has never been above 2½%. The Company will now retain a larger proportion of the fee charged for the loans to cover the additional credit risk. In 2005 and subsequent years, the Company expects that credit losses and therefore provision expense will be substantially higher than in 2004 also expects that revenues will more than offset the additional expense.

NOTES TO MANAGEMENT’S DISCUSSION AND ANALYSIS

Note A—The Company does not allocate equity to different product lines. In other words, when ROE figures for non-RAL/RT activities are computed, the denominator of the ratio is the total or consolidated equity for the whole Company. The change in ROE for the first quarter of 2004 compared to the first quarter of 2003 for non-RAL/RT activities is lower than the change in total ROE because the numerator of the non-RAL/RT ratio changed 12.38% compared to 23.49% for the whole Company.

	2nd Qtr 2004			2nd Qtr 2003			% change

Total net income		$	16,547		$	13,399		23.49	%
Net income excluding RAL/RT activities		$	15,212		$	13,536		12.38	%

Note B—For Tables 2A, 2B, and 3, the yield on tax-exempt state and municipal securities and loans has been computed on a tax equivalent basis. To compute the tax equivalent yield for these securities and loans one must first add to the actual interest earned an amount such that if the resulting total were fully taxed (at the Company’s incremental tax rate of 42.05%), the after-tax income would be equivalent to the actual tax-exempt income. This tax equivalent income is then divided by the average balance to obtain the tax equivalent yield. The dollar amount of the adjustment is shown at the bottom of Tables 2A and 2B as “Tax equivalent income included in interest income from non-taxable securities and loans.”

Note C—To obtain information on the performance ratios for peer banks, the Company primarily uses The FDIC Quarterly Banking Profile, published by the FDIC Division of Research and Statistics. This publication provides information about all FDIC insured banks and certain subsets based on size and geographical location. Geographically, the Company is included in a subset that includes 12 Western States plus the Pacific Islands. By asset size, the Company is included in the group of financial institutions with total assets from $1-10 billion. The information in this publication is based on year-to-date information provided by banks each quarter. It takes about 2-3 months to process the information. Therefore, the published data is always one quarter behind the Company’s information. For this quarter, the peer information is for the first quarter of 2004. All peer information in this discussion and analysis is reported in or has been derived from information reported in this publication.

Note D—Most of the loans or transfers are paid to the taxpayer by means of a cashier’s check issued by the tax preparer. The Company records the check as a deposit liability when it is issued and then removes the check from the deposit totals when it is paid by the Company.

Note E—The four tables below, Tables 20-23, show the balances and amounts of interest income and expense line items that are excluded or included in computing the without RAL, without RAL/RT, or the FTE adjusted amounts and ratios disclosed in various sections of Management’s Discussion and Analysis:

TABLE 20—RAL AMOUNTS USED IN COMPUTATION OF NET INTEREST MARGIN EXCLUSIVE OF RALs

	Three Months Ended June 30, 2004							Three Months Ended June 30, 2003

*(dollars in thousands)*	Consolidated			RAL/RT		Excluding RAL/RT		Consolidated			RAL/RT		Excluding RAL/RT


Average consumer loans		$	463,943	$	25,312	$	438,631		$	420,284	$	25,280	$	395,004
Average loans			3,708,978		25,312		3,683,666			3,014,963		25,281		2,989,682
Average total assets			5,623,843		204,694		5,419,149			4,442,637		113,612		4,329,025
Average earning assets			5,192,559		31,681		5,160,878			4,132,097		25,281		4,106,816
Average certificates of deposit			3,321,204		2,000		3,319,204			2,780,305		2,000		2,778,305
Average interest bearing liabilities			4,126,221		85,970		4,040,251			3,138,699		2,000		3,136,699
Consumer loans interest income			8,749		1,494		7,255			8,971		1,572		7,399
Loan interest income			56,841		1,494		55,347			50,295		1,572		48,723
Interest income			71,429		1,478		69,951			60,432		1,572		58,860
Interest expense			15,996		233		15,763			13,482		21		13,461
Net interest income			55,433		1,245		54,188			46,950		1,551		45,399
Tax equivalent adjustment			1,590		—		1,590			1,622		—		1,622

	Six Months Ended June 30, 2004							Six Months Ended June 30, 2003

*(dollars in thousands)*	Consolidated			RAL/RT		Excluding RAL/RT		Consolidated			RAL/RT		Excluding RAL/RT


Average consumer loans		$	638,481	$	205,139	$	433,342		$	639,688	$	245,337	$	394,351
Average loans			3,709,486		205,139		3,504,347			3,226,502		245,337		2,981,165
Average total assets			5,578,109		659,877		4,918,232			4,586,140		229,145		4,356,995
Average earning assets			5,195,198		352,297		4,842,901			4,275,838		245,337		4,030,501
Average certificates of deposit			3,223,014		22,093		3,200,921			2,772,160		21,366		2,750,794
Average interest bearing liabilities			4,029,697		449,699		3,579,998			3,150,321		21,366		3,128,955
Consumer loans interest income			51,600		36,439		15,161			46,533		31,647		14,886
Loan interest income			143,465		36,439		107,026			129,617		31,647		97,970
Interest income			172,194		36,572		135,622			149,680		31,647		118,033
Interest expense			30,893		967		29,926			27,712		772		26,940
Net interest income			141,301		35,605		105,696			121,968		30,875		91,093
Tax equivalent adjustment			3,198		—		3,198			3,279		—		3,279

	Three Months Ended March 31, 2004							Three Months Ended March 31, 2003

*(dollars in thousands)*	Consolidated			RAL/RT		Excluding RAL/RT		Consolidated			RAL/RT		Excluding RAL/RT


Average consumer loans		$	813,018	$	384,967	$	428,051		$	861,529	$	467,839	$	393,690
Average loans			3,709,995		384,967		3,325,028			3,440,391		467,839		2,972,552
Average total assets			5,537,781		695,449		4,842,332			4,722,973		345,977		4,376,996
Average earning assets			5,197,838		583,639		4,614,199			4,421,175		467,839		3,953,336
Average certificates of deposit			3,124,826		42,187		3,082,639			2,763,927		40,947		2,722,980
Average interest bearing liabilities			3,933,178		393,820		3,539,358			3,162,077		40,947		3,121,130
Consumer loans interest income			42,851		34,945		7,906			37,562		30,075		7,487
Loan interest income			86,624		34,945		51,679			79,322		30,075		49,247
Interest income			100,765		35,094		65,671			89,248		30,075		59,173
Interest expense			14,897		735		14,162			14,230		752		13,478
Net interest income			85,868		34,359		51,509			75,018		29,323		45,695
Tax equivalent adjustment			1,607		—		1,607			1,657		—		1,657

Note E (Cont.)

TABLE 21—CALCULATION OF RATIOS OF NET CHARGE-OFFS INCLUDING AND EXCLUDING RALs

*(dollars in thousands)*	2004 YTD Annualized			2003			2002			2001			2000


Total Including RALs
Net charge-offs	$	15,640		$	22,557		$	14,778		$	12,924		$	10,908
Average loans	$	3,709,486		$	3,151,328		$	2,942,082		$	2,678,225		$	2,388,740
Ratio		0.85	%		0.72	%		0.50	%		0.48	%		0.46	%

Total Excluding RALs
Net charge-offs	$	6,974		$	14,027		$	12,673		$	8,730		$	7,741
Average loans	$	3,504,347		$	3,029,669		$	2,874,091		$	2,619,325		$	2,328,576
Ratio		0.40	%		0.46	%		0.44	%		0.33	%		0.33	%

TABLE 22—RECONCILIATION OF OTHER AMOUNTS WITH AND WITHOUT RAL/RT AMOUNTS

	Three Months Ended June 30, 2004									Three Months Ended June 30, 2003

*(dollars in thousands)*	Consolidated			RAL/RT			Excluding RAL/RT			Consolidated			RAL/RT				Excluding RAL/RT


Other service charges, commissions and fees		$	3,847		$	576		$	3,271		$	3,487		$	647			$	2,840
Noninterest revenue			15,380			3,673			11,707			15,137			3,721				11,416
Operating expense			44,043			2,615			41,428			38,499			1,575				36,924
Provision for credit losses			737			—			737			2,635			3,934				(1,299	)
Income before income taxes			26,033			2,303			23,730			20,953			(237	)			21,190
Provision for income taxes			9,486			968			8,518			7,554			(100	)			7,654
Net Income			16,547			1,335			15,212			13,399			(137	)			13,536

	Six Months Ended June 30, 2004										Six Months Ended June 30, 2003

*(dollars in thousands)*	Consolidated			RAL/RT			Excluding RAL/RT				Consolidated			RAL/RT			Excluding RAL/RT


Other service charges, commissions and fees		$	9,671		$	3,492		$	6,179			$	8,927		$	2,863		$	6,064
Noninterest revenue			52,001			27,249			24,752				53,989			30,429			23,560
Operating expense			91,159			10,170			80,989				82,946			9,531			73,415
Provision for credit losses			8,321			8,954			(633	)			14,252			11,143			3,109
Income before income taxes			93,822			43,730			50,092				78,759			40,630			38,129
Provision for income taxes			34,684			18,388			16,296				28,942			17,085			11,857
Net Income			59,138			25,342			33,796				49,817			23,545			26,272

	Three Months Ended March 31, 2004										Three Months Ended March 31, 2003

*(dollars in thousands)*	Consolidated			RAL/RT			Excluding RAL/RT				Consolidated			RAL/RT			Excluding RAL/RT


Other service charges, commissions and fees		$	5,824		$	2,916		$	2,908			$	5,467		$	2,218		$	3,249
Noninterest revenue			36,621			23,576			13,045				38,852			26,709			12,143
Operating expense			47,116			7,555			39,561				44,447			7,956			36,491
Provision for credit losses			7,584			8,954			(1,370	)			11,617			7,209			4,408
Income before income taxes			67,789			41,426			26,363				57,806			40,867			16,939
Provision for income taxes			25,198			17,420			7,778				21,388			17,185			4,203
Net Income			42,591			24,006			18,585				36,418			23,682			12,736

TABLE 23—FTE AMOUNTS USED IN COMPUTATION OF NET INTERST MARGIN AND OPERATING EFFICIENCY RATIO

	Three Months Ended June 30, 2004									Three Months Ended June 30, 2003

*(dollars in thousands)*	Consolidated			FTE Adjustment			Including FTE Adjustment			Consolidated			FTE Adjustment			Including FTE Adjustment


Loan income		$	56,841		$	112		$	56,953		$	50,295		$	200		$	50,495
Loan income excluding RAL/RT activities			55,347			112			55,459			48,723			200			48,923

Securities income		$	14,485		$	1,478		$	15,963		$	9,735		$	1,422		$	11,157
Securities income excluding RAL/RT activities			14,485			1,478			15,963			9,735			1,422			11,157

Net interest income		$	55,433		$	1,590		$	57,023		$	46,950		$	1,622		$	48,572
Net interest income excluding RAL/RT activities			54,188			1,590			55,778			45,399			1,622			47,021

	Six Months Ended June 30, 2004									Six Months Ended June 30, 2003

*(dollars in thousands)*	Consolidated			FTE Adjustment			Including FTE Adjustment			Consolidated			FTE Adjustment			Including FTE Adjustment


Loan income		$	143,465		$	217		$	143,682		$	129,617		$	449		$	130,066
Loan income excluding RAL/RT activities			107,026			217			107,243			97,970			449			98,419

Securities income		$	28,145		$	2,981		$	31,126		$	19,211		$	2,830		$	22,041
Securities income excluding RAL/RT activities			28,145			2,981			31,126			19,211			2,830			22,041

Net interest income		$	141,301		$	3,198		$	144,499		$	121,968		$	3,279		$	125,247
Net interest income excluding RAL/RT activities			105,696			3,198			108,894			91,093			3,279			94,372

Note F—Generally, interest income earned on loans is a function of the outstanding balance multiplied by the rate specified in the loan agreement. For RALs, however, the interest income is unrelated to the length of time the loan is outstanding and there is no explicit interest rate. The flat fee charged is instead simply recognized as income when the loan is collected from the IRS. Because relatively few RALs are made during the second quarter each year, the average balance of RALs in these quarters is primarily related to the speed of payment by the IRS of loans made in the first quarter and also related to when during the quarter delinquent loans are charged-off.

Note G—Market interest rates available for financial instruments may be plotted on a graph by their maturities, with the rates on the Y-axis (vertical) and maturities on the X-axis (horizontal). The line that connects the points will normally be a curve sloping up to the right because generally short term instruments have lower rates and long term instruments have higher rates. Based on expectations in the markets with respect to interest rate changes, the shape and slope of the curve will change. When there is a wider divergence between short term and long term rates, the slope will become steeper. When there is a

narrower difference between short term and long term rates, the slope will become flatter. Occasionally, the slope (or a portion of the slope) inverts and short-term rates are actually higher than long term rates.

Note H—In fact, because consumer and small business loans including leasing loans are generally charged-off as soon as they become 120 days delinquent, they will frequently migrate directly from a pass or grade 7 classification to loss without appearing as nonaccrual from a reporting standpoint, simply because there is only a one in three chance that a quarter-end will occur while they are in nonaccrual status.

Note I—The base case amount for net interest income is not the same as the Company’s forecast of the net interest income for the next twelve months. As indicated in the text, the computation assumes a static balance sheet. That is, the product mix remains as it currently is, with financial instruments that mature within the next twelve months being replaced by similar instruments at current market rates. That is not necessarily what the Company expects to happen.

Note J—To understand what appears to be a high APR for RALs, it may help to see the credit cost of the average RAL expressed as an APR. The average RAL is approximately $2,600. For 2003, the Company charged-off an average of about 105 basis points. 105 basis points for an average loan would be $27.30. Expressed as an APR, the $27.30 would be 38.3%. Funding and processing costs are incurred in addition to the credit costs.

Note K—In the current interest rate environment, some assets are earning less than 2% and could not have their interest rates decreased by 200 basis points. For purposes of the shock analysis reported in Table 4, their rates have been reduced to 0%.

Note L—Caps are limits as to how much the interest rate can rise and floors are limits as to how much rates may fall. These limits may apply to each time the rate is due for re-setting, to how much they may move over a period of time, e.g. a year, or to how much they may change over the whole term of the loan.

Note M—During the second quarter of 2004, the average rate earned on loans in the two Pacific Capital lending units was 5.94% compared to 6.17% at the other lending units. The average rate on deposits during the same period at the former PCCI branches was 1.91% compared to 1.12% at the Company’s other branches.

Note N—Changes in intermediate-term rates do not immediately impact prepayment rates on residential loans and MBS investments. There was a decrease in intermediate rates in the latter part of the first quarter of 2004. This caused an increase in refinancing activity, but it took about two months before the applications could be processed and the old loans paid off.

Item 3.	Quantitative and Qualitative Disclosures about Market Risk

		Quantitative and qualitative disclosures about market risk are located in Management’s Discussion and Analysis of Financial Condition and Results of Operations in the section on interest rate sensitivity.

Item 4.	Controls and Procedures

		As of the end of the period covering the report, Pacific Capital Bancorp carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in our periodic SEC filings. There have been no significant changes in internal controls or in other factors that could significantly affect internal controls during the last fiscal quarter.

PART II

OTHER INFORMATION

Item 1. Legal Proceedings

The Company has been named in three class action lawsuits related to the cross-collection agreement it has with other providers of refund anticipation loans. These suits are described in Note 11, “Commitments and Contingencies,” to the Consolidated Financial Statements. The Company does not expect that the suits will have any material impact on its financial condition or operating results.

The Company is involved in various litigation of a routine nature which is being handled and defended in the ordinary course of the Company’s business. In the opinion of Management, based in part on consultation with legal counsel, the resolution of these litigation matters will not have a material impact on the Company’s financial position.

Item 2. Changes in Securities and Use of Proceeds

(dollars in thousands)
Period		(a) Total Number of Shares Purchased		(b) Average Price Paid per Share		(c) Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs		(d) Approximate Dollar Value of Shares that May Yet Be Purchased Under the Plans or Programs
Begin Date	End Date
04/01/2004	04/30/2004		—		n/a		—		$	18,933
05/01/2004	05/31/2004		—		n/a		—		$	18,933
06/01/2004	06/30/2004		—		n/a		—		$	18,933

Total			—		n/a		—

On July 17, 2003, the Company announced its Board of Directors had authorized the repurchase of up to $20 million of its common stock. Due to the anticipated capital requirements of the Company’s acquisition of Pacific Crest Capital, the Company stopped repurchasing shares in August 2003 after purchasing only $1.1 million from the authorized amount. Management anticipates that its share repurchase activity will be modest in the foreseeable future as it appears that the economy is improving and loan demand is expected to increase. This authorization has no expiration date and the Company had no prior plans which expired during the second quarter of 2004.

Item 3. Defaults Upon Senior Securities

	None.

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

The Company’s Annual Meeting of stockholders was held on April 27, 2004. A total of 34,029,557 shares of common stock were outstanding and entitled to vote as of the record date for the meeting. The following matters were submitted to a vote of the security holders:

Election of Directors:

The following 12 directors were elected:

	Votes For				Votes Withheld

Edward E. Birch		29,072,088	85.43	%		182,290
Richard M. Davis		28,869,264	84.84	%		385,114
Richard S. Hambleton, Jr.		29,179,212	85.75	%		75,166
D. Vernon Horton		29,163,926	85.70	%		90,452
Roger C. Knopf		28,909,252	84.95	%		345,126
Robert W. Kummer		29,162,487	85.70	%		91,891
Clayton C. Larson		29,099,981	85.51	%		154,397
John R. Mackall		28,886,235	84.89	%		368,143
Gerald T. McCullough		29,026,304	85.30	%		228,074
Richard A. Nightingale		28,984,973	85.18	%		269,405
Kathy J. Odell		29,189,828	85.78	%		64,550
William S. Thomas, Jr.		29,111,692	85.55	%		142,686

Ratification of appointment of PricewaterhouseCoopers as the Company’s independent accountants:

The shareholder vote was:

	Votes		% of Shares Voting

For		28,884,020		98.73	%
Against		256,772		0.88	%
Abstain		113,586		0.39	%

	Number		% of Shares Outstanding

Nonvotes		4,775,179		14.03	%

Item 5. Other information

	None.

Item 6. Exhibits and reports on Form 8-K

(a)	Exhibit Index:

	Exhibit Number	Item Description

	3.0	Articles of Incorporation and Bylaws:

		3.1 Certificate of Restatement of Articles of Incorporation of Pacific Capital Bancorp dated July 22, 2004

	31.1	Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

	31.2	Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

	32		Certifications of Chief Executive Officer and Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002


(b)	Reports on Form 8-K

	The following current reports on Form 8-K were filed with the Securities and Exchange Commission during the second quarter of 2004.

	Subject			Filing Date

	Item 7.	Financial Statements and Exhibits		April 23, 2004
		Press release announcing earnings for first quarter of 2004.

	The following current reports on Form 8-K have been filed with the Securities and Exchange Commission to date during the third quarter of 2004.

	Subject			Filing Date

	Item 7.	Financial Statements and Exhibits		July 22, 2004
		Press release announcing earnings for second quarter of 2004.

Shareholders may obtain a copy of any exhibit by writing to:

	Carol Kelleher
	Corporate Secretary
	Pacific Capital Bancorp
	P.O. Box 60839
	Santa Barbara, CA 93160-0839

SIGNATURES

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

PACIFIC CAPITAL BANCORP


	/s/ William S. Thomas, Jr.
	William S. Thomas, Jr.	August 9, 2004
	President
	Chief Executive Officer


	/s/ Donald Lafler
	Donald Lafler	August 9, 2004
	Executive Vice President
	Chief Financial Officer