UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-Q

ALLIANCE FINANCIAL CORPORATION
(Exact name of Registrant as specified in its charter)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes |X|           No |_|

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes |X|           No |_|

The number of shares outstanding of the Registrant’s common stock on August 11, 2003: Common Stock, $1.00 Par Value – 3,525,442 shares.

CONTENTS

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

ALLIANCE FINANCIAL CORPORATION
Consolidated Statements of Condition
(Dollars in Thousands)

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

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ALLIANCE FINANCIAL CORPORATION
Condensed Consolidated Statements of Income
(Unaudited)
(Dollars in Thousands, except per share data)

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

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ALLIANCE FINANCIAL CORPORATION
Consolidated Statements of Changes in Shareholders’ Equity
For the Six Months Ended June 30, 2003
(Unaudited)
(Dollars in Thousands)

The accompanying notes are an integral part of the financial statements.

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ALLIANCE FINANCIAL CORPORATION
Consolidated Statements of Cash Flows
(Unaudited)
(Dollars in Thousands)

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

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ALLIANCE FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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General

Throughout this analysis, the term “the Company” refers to the consolidated entity of Alliance Financial Corporation, its wholly-owned banking subsidiary, Alliance Bank, N.A. (the “Bank”), and the Bank’s subsidiaries, Alliance Preferred Funding Corp. and Alliance Leasing, Inc. The Company is a New York corporation, which was formed in November 1998 as a result of the merger of Cortland First Financial Corporation and Oneida Valley Bancshares, Inc.

The following discussion presents material changes in the Company’s results of operations and financial condition during the three and six months ended June 30, 2003, which are not otherwise apparent from the consolidated financial statements included in this report.

This discussion and analysis contains certain forward-looking statements (within the meaning of the Private Securities Litigation Reform Act of 1995) with respect to the financial condition, results of operations and business of the Company. These forward-looking statements involve certain risks and uncertainties. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements include, among others, the following possibilities: (1) an increase in competitive pressures in the banking industry; (2) changes in the interest rate environment that reduce margins; (3) changes in the regulatory environment; (4) general economic conditions, either nationally or regionally, that are less favorable than expected, resulting in, among other things, a deterioration in credit quality; (5) changes in business conditions and inflation; (6) changes in the securities markets; (7) changes occur in technology used in the banking business; (8) possible inability to maintain and increase market share and control expenses; and (9) other factors detailed from time to time in the Company’s SEC filings.

Operating results for the three and six months ended June 30, 2003 are not necessarily indicative of the results that may be expected for the year ending December 31, 2003.

RESULTS OF OPERATIONS FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2003

Net income was $2,781,000, or $0.77 per diluted share, for the second quarter of 2003 compared with $1,693,000, or $0.49 per diluted share, for the same period in 2002. Net income increased $1,088,000, or 64.3%, while diluted earnings per share were up $0.28, or 57.1%, over the comparable period. The return on average assets and return on average shareholder’s equity were 1.43% and 17.06%, respectively, for the three months ended June 30, 2003, compared with 0.91% and 12.31%, respectively, for the second quarter of 2002.

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Earnings for the 2003 second quarter were positively impacted by a $950,000 after tax gain on the sale of the Bank’s Whitney Point, N.Y. branch and the premium received on the deposits, which were included as a part of the sale. Excluding the gain associated with the sale of this branch, net income for the second quarter of 2003 rose 8.2% and diluted earnings per share were up 4.1% over the same period in the prior year, while the return on average assets for the second quarter 2003 was 0.94% and the return on average equity was 11.23%.

For the six months ended June 30, 2003, net income was $4,471,000, or $1.26 per diluted share, compared to $3,315,000, or $0.95 per diluted share, for the same period in 2002. The $1,156,000 increase in net income in the first half of 2003 is up 34.9% over the same period in the previous year, while the earnings per share increase of $0.31 represents a 32.6% increase over the comparable period. The return on average assets increased to 1.15% from 0.91%, while the return on average shareholders’ equity rose to 13.91% from 12.08%, when comparing the six months ended June 30, 2003 to the comparable period in 2002. Excluding the gain associated with the branch sale, net income for the first half of 2003 rose 6.2% and diluted earnings per share were up 4.2% over the same period in the prior year, while the return on average assets for the first six months of 2003 was 0.91% and the return on average equity was 10.96%.

Analysis of Net Interest Income and the Net Interest Margin

For the three months ended June 30, 2003 compared to the three months ended June 30, 2002, net interest income declined $25,000, or 0.4%, to $6,653,000. The minimal decline resulted as a $24,776,000, or 3.6%, increase in average earning assets generated additional income nearly sufficient to offset the negative impact of a net interest margin that declined from 4.02% for the quarter ended June 30, 2002 to 3.89% for the quarter ended June 30, 2003. The increase in average earning assets was due to strong growth across all loan business lines. The decline in the net interest margin for the comparable periods resulted as lower market interest rates pushed asset yields (particularly mortgage loan and mortgage-backed securities) lower, and to a greater degree than the Bank’s ability to reduce the costs of interest bearing liabilities.

Total interest income for the quarter ended June 30, 2003 declined 7.2% compared with that reported for the quarter ended June 30, 2002, primarily as a result of lower yields on and reduced levels of mortgage-backed investment securities. Loan and lease income declined only $17,000, less than ¼ of 1% for the comparable periods, as growth in all loan categories offset the decline in loan and lease yields. Average net loans and leases for the comparable periods increased $33,664,000, or 8.5%, with the growth most significant in home equity lines of credit and indirect auto loans. The overall mix of average loans reflected little change over the past twelve months, with a 2.5% increase in the percentages of indirect auto loans to total loans offsetting slight declines in the percentage of residential mortgage and commercial loans to total loans. Average loan and lease yields declined 56 basis points with lower yields on indirect auto and home equity-dominated consumer loan categories chiefly responsible for the overall yield decline. Investment income, which declined $766,000, or 20.2%, for the comparable periods, fell as a result of a decline of $10,887,000, or 3.6% in average investments and a 80-basis point decline in the average portfolio yield. The reduction in the level of average investments funded approximately one-third of the Bank’s loan growth over the past twelve months.

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Interest expense declined $752,000, or 18.3%, to $3,356,000 for the quarter ended June 30, 2003 when compared with the same period in 2002, as lower market interest rates positively impacted the average rate paid on interest bearing liabilities, reducing it by 54 basis points. The decline in the average rate paid on interest bearing liabilities, by far offset increased costs associated with a $16,379,000, or 2.6%, increase in average interest bearing liabilities. Although average interest bearing deposits for the comparable periods increased $15,787,000, or 3.3%, deposit expense declined $593,000, or 20.9%, as the average rate paid on interest bearing deposits fell by 55 basis points. The lower average rate paid reflected lower rates paid on all categories of deposits, with the greatest impact resulting from a 74-basis point reduction in the time deposit category. For the comparable periods, there was a slight change in the average deposit mix, as average time deposits as a percentage of total average deposits declined nearly 2%, to 39.7% of total average deposits. All other categories increased. Average non-interest bearing demand deposits increased $3,371,000, or 6.3%, for the comparable periods, and as a percentage of total deposits, increased from 10.1% for the quarter ended June 30, 2002 to 10.3% for the quarter ended June 30, 2003. Interest expense on borrowings for the comparable periods declined $159,000, or 12.5%, as the average rate paid on borrowings was lower by 44 basis points, while average borrowings increased a modest $592,000, or 0.4%.

The following table sets forth information concerning average interest-earning assets and interest-bearing liabilities and the average yields and rates thereon for the periods indicated. Interest income and yield information is adjusted for items exempt from federal income taxes and assumes a 34% tax rate. Nonaccrual loans have been included in the average balances. Securities are shown at average amortized cost.

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The following table sets forth the dollar volume of increase (decrease) in interest income and interest expense resulting from changes in the volume of earning assets and interest-bearing liabilities, and from changes in rates for the periods indicated. Volume changes are computed by multiplying the volume difference by the prior period’s rate. Rate changes are computed by multiplying the rate difference by the prior period’s balance. The change in interest income and expense due to both rate and volume has been allocated equally between the volume and rate variances.

The following table sets forth information concerning average interest-earning assets and interest-bearing liabilities and the average yields and rates thereon for the periods indicated. Interest income and yield information is adjusted for items exempt from federal income taxes and assumes a 34% tax rate. Nonaccrual loans have been included in the average balances. Securities are shown at average amortized cost.

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For the six months ended June 30, 2003 compared to the six months ended June 30, 2002, net interest income increased $327,000, or 2.5%, to $13,584,000. The increase resulted from a $42,845,000, or 6.3%, increase in average earning assets, that more than offset a 13-basis point decline in the net interest margin. Average earning assets for the comparable six-month periods primarily increased as a result of an increase of $33,680,000, or 8.6%, in average loans. The decline in the margin is primarily due to lower market interest rates in 2003 impacting loan and investment yields more rapidly than the cost of interest bearing liabilities. Average earning asset yields for the comparable periods declined 57 basis points while at the same time the average cost of interest bearing liabilities declined 49 basis points.

Total interest income declined $786,000, or 3.7%, for the six months ended June 30, 2003 compared to the same period a year ago. A decline in investment income of $740,000, or 10.2%, was the primary reason for the decline in interest income, as loan interest income was comparable with that reported during the six months ended June 30, 2002. The decline in investment income was attributable to a decline of 59 basis points in the average yield on the portfolio for the comparable periods, impacted most significantly by lower yields on mortgage-backed securities. Average investments increased $7,400,000, or 2.6%, for the comparable six- month periods. Loan interest income declined $52,000, or 0.4%, for the six-month period ending June 30, 2003 compared to the same period last year, as the negative impact from a 59-basis point decline in the average yield on loans was nearly offset by the positive impact resulting from the increase in average loans.

Interest expense declined $1,113,000, or 13.9%, for the six months ended June 30, 2003 compared with the six months ended June 30, 2002. The lower interest expense was most significantly the result of lower rates paid on both deposits and borrowings. Deposit expense for the comparable periods declined $874,000, or 15.9%, primarily the result of a decline of 50 basis points in the average rate paid on interest bearing deposits. Average interest bearing deposits increased $32,995,000, or 7.1%, for the comparable six-month periods. Interest expense on borrowings declined $239,000, or 9.6%, primarily due to a 39-basis point reduction in the average rate paid for borrowings. Average borrowings increased $3,038,000, or 2.1%, for the comparable periods.

Analysis of the Provision and Allowance for Loan and Lease Losses

The Bank continued to report a trend of lower net loans and leases charged off during the second quarter of 2003, as the ratio of annualized net charge-offs to average portfolio loans and leases at 0.29% were comparable with a rate of 0.28% reported for the 2003 first quarter, and below the 0.34% rate reported for the entire year of 2002. The trend reflects continued improvement in the quality of the indirect auto loan portfolio. When comparing the three months ended June 30, 2003 with the comparable period in 2002, the annualized rate of net indirect auto loans charged off to average indirect auto loans declined from 0.84% to 0.65%. The annualized loss rate on the Bank’s commercial loan and lease portfolio was 0.35%, and losses on residential mortgage loans were minimal for the quarter ended June 30, 2003. The increase in the ratio of non-performing loans to total loans, when comparing the 2003 second quarter to the 2002 second quarter, reflects the downgrade during the first quarter of 2003 in the risk rating of a $4,100,000 commercial loan relationship, and continuation of the credit on nonaccrual status. The commercial relationship is with a long-term customer of the Bank, which has been recently impacted by the weak economy. During the 2003 second quarter, the ratio of nonperforming loans to total loans improved from 1.33% at March 31, 2003.

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Although the ratio of the provision for loan and lease loss expense to average loans and leases for the quarter ended June 30, 2003 was comparable with that reported for the quarter ended June 30, 2002, the allowance for loan and lease losses as a percentage of total loans and leases increased to 1.35%, up from 1.19% a year earlier, reflecting the 2003 first quarter increase in the reserve associated with the problem commercial credit. Within the balance of the allowance for loan and lease losses, the Bank has established a specific reserve for the commercial credit, and the Company believes that both the specific reserve for the credit and the overall level of the allowance at June 30, 2003 are adequate. The change in the Bank’s loan and lease portfolio credit quality indicators, particularly those relating to non-performing loans and leases, the provision for loan and lease loss expense, and the coverage ratios, is related to the change in the risk rating of the specific commercial credit. Loan and lease quality indicators, when reviewed excluding the commercial credit, are comparable with those reported at year-end 2002. The Bank’s loan and lease delinquency rate, on loans and leases over 30 days past due (but excluding nonaccrual loans and leases) as a percentage of total loans and leases, continues to be at a very low level, reported at 0.98% as of June 30, 2003, compared with 0.72% at June 30, 2002, and 0.93% at December 31, 2002.

The following tables present loan quality ratios for the periods indicated and a summary of the changes in the allowance for loan and lease losses arising from loans charged off and recoveries on loans previously charged off and additions to the allowance, which have been charged to expense for the periods indicated.

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When comparing the six months ended June 30, 2003 with the same period in 2002, net loans charged off declined $86,000, or 12.5%. The improvement in the ratio of net charge-offs to average loans for the comparable periods reflected a lower loss rate on consumer loans. For the comparable periods, the provision for loan losses increased $466,000 and was primarily attributable to the increased risk associated with the commercial credit placed on nonaccrual status in the 2003 first quarter. The change in the Bank’s loan and lease portfolio credit quality indicators for the comparable periods, particularly those relating to non-performing loans and leases, the provision for loan and lease loss expense, and the coverage ratios, is primarily related to the change in the risk rating of the specific commercial credit that occurred during the first quarter of 2003.

Non-interest Income

The following table sets forth certain information on non-interest income for the periods indicated: