UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-Q

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 November 7, 2003: Common Stock, $1.00 Par Value – 3,532,275 shares.

CONTENTS

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 Nine Months Ended September 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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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

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 nine months ended September 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 nine months ended September 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 NINE MONTHS ENDED SEPTEMBER 30, 2003

Net income was $1,839,000, or $0.51 per diluted share, for the third quarter of 2003 compared with $1,763,000, or $0.51 per diluted share, for the same period in 2002. Net income increased $76,000, or 4.3%, while diluted earnings per share were comparable with that reported for the 2002 third quarter. The return on average assets and return on average shareholder’s equity were 0.93% and 11.24%, respectively, for the three months ended September 30, 2003, compared with 0.93% and 11.80%, respectively, for the third quarter of 2002.

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For the nine months ended September 30, 2003, net income was $6,310,000, or $1.78 per diluted share, compared to $5,078,000, or $1.46 per diluted share, for the same period in 2002. The $1,232,000 increase in net income in the first nine months of 2003 is up 24.3% over the same period in the previous year, while the earnings per share increase of $0.32 represents a 21.9% increase over the comparable period. The return on average assets increased to 1.07% from 0.92%, while the return on average shareholders’ equity rose to 13.01% from 11.98%, when comparing the nine months ended September 30, 2003 to the comparable period in 2002. Earnings for the first nine months of 2003 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 branch sale, net income for the first nine months of 2003 rose 5.6% and diluted earnings per share were up 3.4% over the same period in the prior year, while the return on average assets for the first nine months of 2003 was 0.91% and the return on average equity was 11.05%.

Analysis of Net Interest Income and the Net Interest Margin

For the three months ended September 30, 2003 compared to the three months ended September 30, 2002, net interest income increased $32,000, or 0.5%, to $6,725,000. The increase resulted as a $40,793,000, or 5.8%, increase in average earning assets generated additional income that more than offset the negative impact of a net interest margin that declined 18 basis points, from 4.00% for the quarter ended September 30, 2002 to 3.82% for the quarter ended September 30, 2003. The increase in average earning assets was the result of loan portfolio growth that exceeded 10% over the past twelve months. The decline in the net interest margin for the comparable periods resulted as lower market interest rates pushed asset yields 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 September 30, 2003 declined 9.6% compared with that reported for the quarter ended September 30, 2002, primarily as a result of lower yields on and reduced levels of mortgage-backed investment securities. Loan and lease income declined $102,000, or 1.4% for the comparable periods, as growth in the loan and lease portfolio nearly offset the decline in loan and lease yields. Average net loans and leases for the comparable periods increased $41,590,000, or 10.1%, with the growth most significant in indirect auto and single family residential mortgage loans. The change in the overall mix of average loans over the past twelve months reflected an increase of 3.6% in the percentage of indirect auto loans to total loans and a 2.6% decline in the percentage of commercial loans and leases to total loans. Average loan and lease yields declined 73 basis points with lower yields on indirect auto, residential mortgage, and home equity-dominated consumer loan categories most responsible for the overall yield decline. Investment income, which declined $923,000, or 25.4%, for the comparable periods, fell as a result of a 121-basis point decline in the average tax-equivalent yield on the portfolio. The decline in the yield reflects an increase in the 2003 third quarter amortization expense, associated with premiums previously paid on mortgaged-backed securities, along with lower yields on portfolio reinvestments. There was little change in the level of average investments for the comparable periods.

Interest expense declined $1,063,000, or 25.9%, to $3,042,000 for the quarter ended September 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 76 basis points. The decline in the average rate paid on interest-bearing liabilities, by far offset increased costs associated with a $31,021,000, or 4.9%, increase in average interest-bearing liabilities. Deposit expense declined $851,000, or 30.4%, primarily due to a decline of 69 basis points in the average rate paid on interest-bearing deposits. For the comparable periods, average interest-bearing deposits declined $1,087,000, or 0.2%. The lower average rate paid reflected lower rates paid on all categories of deposits, with the greatest impact resulting from an 81-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 5%, to 38% of total average deposits. All other categories increased. Average non interest-bearing demand deposits increased $4,003,000, or 7.3%, for the comparable periods, and as a percentage of total deposits, increased from 10% for the quarter ended September 30, 2002 to 10.7% for the quarter ended September 30, 2003. Interest expense on borrowings for the comparable periods declined $212,000, or 16.3%, as the average rate paid on borrowings was lower by 120 basis points, while average borrowings increased $32,108,000, or 23.1%.

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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 nine months ended September 30, 2003 compared to the nine months ended September 30, 2002, net interest income increased $359,000, or 1.8%, to $20,309,000. The increase resulted from a $42,161,000, or 6.1%, increase in average earning assets, that more than offset a 15-basis point decline in the net interest margin. Average earning assets for the comparable nine-month periods primarily increased as a result of an increase of $36,317,000, or 9.2%, 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 68 basis points while at the same time the average cost of interest bearing liabilities declined 58 basis points.

Total interest income declined $1,817,000, or 5.7%, for the nine months ended September 30, 2003 compared to the same period a year ago. A decline in investment income of $1,663,000, or 15.2%, was the primary reason for the decline in interest income, as loan and lease income declined less than 1% compared to that reported for the nine months ended September 30, 2002. The decline in investment income was attributable to a decline of 79 basis points in the average yield on the portfolio for the comparable periods, impacted by lower yields on reinvestments and increased amortization expense resulting from accelerated prepayments on mortgage-backed securities. Average investments increased $4,936,000, or 1.7%, for the comparable nine-month periods. Income from loans and leases declined $154,000, or 0.7%, for the nine-month period ending September 30, 2003 compared to the same period last year, as the negative impact from a 64-basis point decline in the average yield was nearly offset by the positive impact resulting from the increase in average loans and leases.

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Interest expense declined $2,176,000, or 18%, for the nine months ended September 30, 2003 compared with the nine months ended September 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 $1,725,000, or 20.8%, primarily the result of a decline of 57 basis points in the average rate paid on interest- bearing deposits. Average interest-bearing deposits increased $21,635,000, or 4.6%, for the comparable nine-month periods. Interest expense on borrowings declined $451,000, or 11.9%, primarily due to a 68-basis point reduction in the average rate paid for borrowings. Average borrowings increased $12,728,000, or 9%, for the comparable periods.

Analysis of the Provision and Allowance for Loan and Lease Losses

The Bank reported that its ratio of annualized net loan and lease charge-offs to average portfolio loans and leases for the third quarter of 2003 was 0.35% compared with a ratio of 0.24% for the 2002 third quarter. The increase reflects a rise in commercial loans charged off during the current quarter. Commercial loan charge-offs during the quarter were 56% of total loans charged off for the period and represented an annualized loss rate of 63 basis points of the commercial loan and lease portfolio. The majority of the commercial loan losses during the current quarter resulted from a loss on one account. Improvement for the comparable periods was reflected in the annualized rate of net indirect auto loans charged off to average indirect auto loans, that declined from 1.18% for the third quarter of 2002 to 0.54% for the third quarter of 2003. The reduction in the loss rate on indirect loans reflects the change in underwriting guidelines that has been in effect for the past two years. Improvement in this portfolio was further supported by a reduction in the delinquency rate (defined as loans over 30 days past due as a percentage of period-end indirect auto loans) that has declined from 1.42% at September 30, 2002 to 0.80% at September 30, 2003. Losses in other loan portfolio categories were minimal for the quarter ended September 30, 2003.

The ratio of non-performing loans to total loans at September 30, 2003 was 1.07% compared to 0.39% at September 30, 2002 with the increase continuing to reflect the inclusion of one large commercial relationship that was placed on non-accrual status in the first quarter of 2003. However, since the end of the 2003 first quarter, the ratio of non-performing loans to total loans has declined by nearly 20% from 1.33%, and the total amount of non-performing loans has declined $593,000, more than 10%, with a significant amount of the improvement relating to payments received on the large problem commercial credit.

Although the ratio of the provision for loan and lease loss expense to average loans and leases for the quarter ended September 30, 2003 declined compared with that reported for the quarter ended September 30, 2002, the allowance for loan and lease losses as a percentage of total loans and leases increased to 1.28%, up from 1.24% for the same period a year earlier, reflecting increased reserves built in the first half of 2003 associated with increased risk in the commercial loan portfolio. Based on management’s 2003 third quarter evaluation of the allowance, the Company believes that both specific reserves for problem credits, and the overall level of the allowance at September 30, 2003 are adequate. The Bank’s loan and lease delinquency rate, on all loans and leases over 30 days past due including non-accrual loans, was 1.61% at September 30, 2003 compared with 1.16% a year earlier. When excluding non-accrual loans from the ratio, the Bank’s loan and lease delinquency rate was 0.69% as of September 30, 2003, compared with 0.88% at September 30, 2002, and 0.93% at December 31, 2002.

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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.