CITIZENS SOUTH BANKING CORP - 10-K Annual Report

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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

Annual Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934

For the Fiscal Year Ended December 31, 2003

Commission File Number: 0-23971

Citizens South Banking Corporation
(Exact name of Registrant as specified in its Charter)

Delaware 54-2069979
(State of Incorporation) (I.R.S. Employer Identification No.)

245 West Main Avenue, Gastonia, North Carolina 28052-4140
(Address of principal executive office)

(704) 868-5200
(Registrant's telephone number, including area code)

Securities Registered Pursuant to Section 12(b) of the Act: None

Securities Registered Pursuant to Section 12(g) of the Act:

Common Stock, $0.01 par value
(Title of Class)

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding twelve months (or for such shorter period that the
registrant was required to file such reports) and (2) has been subject to such
requirements for the past 90 days. YES |X| NO |_|

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in the definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendments to this Form 10-K. |X|

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2) YES |X| NO |_|

As of March 4, 2004, 8,503,313 shares of common stock, $0.01 par value,
were outstanding. As of March 8, 2004, the aggregate market value of the voting
stock held by non-affiliates was $95.4 million.

Documents Incorporated by Reference

PART III: Portions of the Definitive Proxy Statement dated April 2, 2004,
as filed pursuant to Section 14 of the Securities Exchange Act of 1934 in
connection with the 2003 Annual Meeting of Shareholders.

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CITIZENS SOUTH BANKING CORPORATION
AND SUBSIDIARIES

FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003

TABLE OF CONTENTS

Page
----
Part I

Item 1. Business................................................................. 1
Item 2. Properties............................................................... 8
Item 3. Legal Proceedings........................................................ 9
Item 4. Submission of Matters to a Vote of Security Holders...................... 9

Part II

Item 5. Market for Registrant's Common Stock and Related Shareholder Matters..... 10
Item 6. Selected Financial Data.................................................. 11
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations.......................................................... 12
Item 7A. Quantitative and Qualitative Disclosures About Market Risk............... 32
Item 8. Financial Statements and Supplementary Data.............................. 33
Independent Auditors' Report............................................. 33
Consolidated Statements of Financial Condition........................... 34
Consolidated Statements of Operations.................................... 35
Consolidated Statements of Comprehensive Income.......................... 36
Consolidated Statements of Changes in Stockholders Equity................ 37
Consolidated Statements of Cash Flows.................................... 38
Notes to Consolidated Financial Statements............................... 39
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure................................................... 65
Item 9A. Controls and Procedures.................................................. 65

Part III

Item 10. Directors and Executive Officers of the Registrant....................... 65
Item 11. Executive Compensation................................................... 65
Item 12. Security Ownership of Certain Beneficial Owners and Management........... 65
Item 13. Certain Relationships and Related Transactions........................... 65
Item 14. Principal Accountant Fees and Services................................... 65
Item 15. Exhibits, Financial Statement Schedules, and Reports on Forms 8-K........ 66

Signatures

PART I

ITEM 1. Business

Citizens South Banking Corporation

Citizens South Banking Corporation (also referred to as the "Company", the
"Registrant", "We", "Us", or "Our") is a Delaware corporation that owns all of
the outstanding shares of common stock of Citizens South Bank (the "Bank"). The
common stock of the Company trades on the Nasdaq National Market under the
ticker symbol "CSBC".

On December 31, 2001, the Company acquired Innes Street Financial
Corporation ("Innes Street"), of Salisbury, North Carolina, which merged into
the Company in a cash transaction valued at $37.9 million. Innes Street was the
holding company of Citizens Bank, Inc., a North Carolina chartered savings bank
which operated three full service branch offices in Salisbury, North Carolina.
At the time of the acquisition, the Company assumed the assets and liabilities
of Innes Street at the estimated fair market value including total assets of
$221.8 million, net outstanding loans of $170.5 million, total deposits of
$175.4 million, and total liabilities of $183.9 million. The transaction was
accounted for using the purchase method of accounting and resulted in $9.5
million in intangible assets. The Company filed a Current Report on Form 8-K
with the Securities and Exchange Commission on December 31, 2001, which provides
additional information about the acquisition and is incorporated herein by
reference. As a result of the Company's expansion outside of Gaston County,
Gaston Federal Bank changed its name to Citizens South Bank on March 11, 2002.

The Company became the holding company for the Bank on September 30, 2002
in connection with the mutual-to-stock conversion of Citizens South Holdings,
MHC, the mutual holding company (the "Mutual Holding Company") of Citizens South
Banking Corporation, a federal corporation ("Citizens Federal"), formerly named
Gaston Federal Bancorp, Inc. As a result of the mutual-to-stock conversion, the
Company succeeded to all of the rights of Citizens Federal. As part of the
mutual-to-stock conversion, the Company sold 5,259,945 shares of common stock at
$10.00 per share in a stock offering. The shares sold represented the Mutual
Holding Company's ownership interest in Citizens Federal. Shares owned by
stockholders of Citizens federal other than the Mutual Holding Company received
new shares of the Company. The net proceeds of the stock offering were $45.5
million.

Management has been utilizing a number of strategies to leverage the
Company's excess capital and enhance shareholder value. These strategies are
discussed throughout this report and include; 1) constructing new full-service
offices in growth markets; 2) expanding into other financial-related business
fields; 3) pursuing the acquisition of existing branch offices; 4) growing the
retail and banking segments of our business; and 5) patiently pursuing the
acquisition of other financial institutions or related businesses. Also, as a
part of the Company's capital management strategy, the Board has authorized a
stock repurchase program that is currently being executed by management, and has
approved the payment of cash dividends to the Company's shareholders. These
strategies are constantly being evaluated and modified as necessary.

The Company's principal business activities are overseeing and directing
the business of the Bank and investing the net stock offering proceeds retained
by the Company. The Company's assets consist primarily of the outstanding
capital stock of the Bank, deposits held at the Bank, and investment securities.
The Company's executive office is located at 245 West Main Avenue, P.O. Box
2249, Gastonia, North Carolina 28053-2249. Its telephone number at this address
is (704) 868-5200. The Company also maintains a website at www.citizenssouth.com
that includes important information on our Company, including a list of our
products and services, branch locations, current financial information, and
links to the Company's 1934 Securities Exchange Act filings with the SEC.

Citizens South Bank

Citizens South Bank is a federally chartered savings bank headquartered in
Gastonia, North Carolina. The Bank's principal business activity is offering
FDIC-insured deposit accounts to local customers through its ten branch offices
and investing those deposits, together with funds generated from operations and
borrowings, in nonresidential real estate loans,

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construction loans, commercial business loans, consumer loans, investment
securities, and mortgage-backed securities. The Bank also acts as a broker in
both the origination of loans secured by one-to-four family dwellings and in the
sale of uninsured financial products. The Bank's results of operations are
heavily dependent on net interest income, which is the difference between the
interest earned on loans and securities and the interest paid on deposits and
borrowings. Results of operations are also materially affected by the Bank's
provision for loan losses, gains or losses from the sales of assets, fee income
generated from deposit and loan accounts, commissions earned from the sale of
uninsured investment products, and noninterest expenses. The Bank's noninterest
expense primarily consists of compensation and employee benefits, occupancy
expense, professional services, advertising, and other noninterest expenses.
Results of operations are also significantly affected by general economic and
competitive conditions, changes in interest rates, and actions of regulatory and
governmental authorities.

Citizens South Bank is the successor entity to Gaston Federal Bank, which
was established on December 31, 1904, as Gastonia Mutual Building and Loan
Association ("Gastonia Mutual") under a charter from the State of North
Carolina. Gastonia Mutual converted to a Federal charter and became Gaston
Federal Savings and Loan Association ("Gaston Federal") on June 10, 1981. On
April 30, 1982, Mount Holly Federal Savings and Loan Association merged into
Gaston Federal and on April 9, 1998, Gaston Federal reorganized and sold stock
and became Gaston Federal Bank, a wholly-owned subsidiary of Gaston Federal
Bancorp, Inc.

Citizens South Bank has ten full-service branch offices in the North
Carolina Counties of Gaston, Rowan, and Iredell. The Bank's executive office is
located at 245 West Main Avenue, P.O. Box 2249, Gastonia, North Carolina
28053-2249. Its telephone number at this address is (704) 868-5200.

Market Area and Competition

We consider our primary market area to be the North Carolina Counties of
Gaston, Rowan, Iredell, Mecklenburg, Cabarrus, Lincoln, and Cleveland, and the
South Carolina County of York. Our market area predominately centers in the
suburbs surrounding the Metro region of Charlotte, North Carolina. The Metro
Charlotte region has a diverse economic base that includes business sectors in
banking and finance, insurance, manufacturing, textiles, apparel, fabricated
metals, construction, health care, transportation, retail trade,
telecommunications, government services, and education. The Bank's corporate
headquarters is located in Gastonia, North Carolina, which is located in the
I-85 corridor, approximately 20 miles west of Charlotte.

The Bank's corporate headquarters and five branch offices are located in
Gaston County, North Carolina. These offices are located in the cities of
Gastonia (three offices), Dallas, Mount Holly, and Stanley. According to data
provided by the FDIC as of June 30, 2003, there were 12 banks and thrifts
operating in Gaston County with $1.7 billion in deposits. As of June 30, 2003,
the Bank had $206.9 million in deposits in Gaston County, or 11.9% of the total
County deposits. This represents the third highest market share in Gaston
County.

We also operate two branch offices in Rowan County, North Carolina, which
is approximately 60 miles northeast of the corporate headquarters. These offices
are located in the cities of Salisbury and Rockwell. According to data provided
by the FDIC as of June 30, 2003, there were 11 banks and thrifts operating in
Rowan County with $1.1 billion in deposits. As of June 30, 2003, the Bank had
$110.5 million in deposits in Rowan County, or 9.6% of the total County
deposits. This represents the fourth highest market share in the County.

We also have two branch offices in Iredell County, North Carolina, in the
cities of Statesville and Mooresville. These offices are approximately 60 miles
north of the corporate office. According to data provided by the FDIC as of June
30, 2003, there were 12 banks and thrifts operating in Iredell County with $1.5
billion in deposits. As of June 30, 2003, the Bank had $51.8 million in deposits
in Iredell County, or 3.4% of the total County deposits. This represents the
tenth highest market share in the County. The new Mooresville office was opened
in July 2003, and accordingly, did not have any deposit balances as of June 30,
2003.

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Employees

As of December 31, 2003, the Company had 101 full-time and 11 part-time
employees, none of whom is represented by a collective bargaining unit. The
Company provides employee benefit programs, including an Employee Stock
Ownership Plan, matching contributions to a 401(k) retirement/savings plan,
group life, heath, and dental insurance, and paid vacation and sick leave.
Management believes its relationship with its employees is good.

Supervision and Regulation

Citizens South Banking Corporation is a unitary savings and loan holding
company, subject to regulation and supervision by the Office of Thrift
Supervision ("OTS"). The OTS has enforcement authority over Citizens South
Banking Corporation and its non-savings institution subsidiaries. This authority
permits the OTS to restrict or prohibit activities that are determined to be a
risk to Citizens South Bank. Federal law prohibits a savings and loan holding
company from acquiring control of another savings institution or holding company
thereof, without prior written approval of the OTS. It also prohibits the
acquisition or retention of, with specified exceptions, more than 5% of the
equity securities of a company engaged in activities that are not closely
related to banking or financial in nature or acquiring or retaining control of
an institution that is not federally insured. In evaluating applications by
holding companies to acquire savings institutions, the OTS must consider the
financial and managerial resources, future prospects of the savings institution
involved, the effect of the acquisition on the risk to the insurance fund, the
convenience and needs of the community and competitive factors.

Citizens South Bank is a federal savings bank and derives its lending and
investment powers from the Home Owners' Loan Act, as amended, and the
regulations of the OTS. Under these laws and regulations, Citizens South Bank
may invest in mortgage loans secured by residential and commercial real estate,
commercial business and consumer loans, certain types of debt securities and
certain other assets. Citizens South Bank also may establish subsidiaries that
may engage in activities not otherwise permissible for Citizens South Bank,
including real estate investment and securities and insurance brokerage.
Citizens South Bank is a federally chartered SAIF-insured stock savings bank,
subject to examination, supervision, and regulation by the OTS, as its primary
federal regulator, and the Federal Deposit Insurance Corporation ("FDIC"), as
the deposit insurer. Citizens South Bank is also a member of and owns stock in
the Federal Home Loan Bank of Atlanta, which is a part of the Federal Home Loan
Bank System. The Bank must file reports with the OTS and the FDIC concerning its
activities and financial condition in addition to obtaining regulatory approvals
prior to entering into certain transactions such as mergers or acquisitions.
This regulation and supervision establishes a comprehensive framework of
activities in which an institution may engage and is intended primarily for the
protection of the insurance fund and depositors. Under this system of federal
regulation, financial institutions are periodically examined to ensure that they
satisfy applicable standards with respect to their capital adequacy, assets,
management, earnings, liquidity and sensitivity to market interest rates.
Citizens South Bank also is regulated to a lesser extent by the Board of
Governors of the Federal Reserve System, governing reserves to be maintained
against deposits and other matters. Citizens South Bank's relationship with its
depositors and borrowers also is regulated to a great extent by both federal and
state laws, especially in matters concerning the ownership of deposit accounts
and the form and content of Citizens South Bank's loan documents.

The following discussion summarizes certain material elements of the
regulatory framework applicable to Citizens South Banking Corporation and its
subsidiaries. These summaries of statutes and regulations are not intended to be
complete and such summaries are qualified in their entirety by reference to such
statutes and regulations. A change in the statutes, regulations, or regulatory
policies applicable to Citizens South, or its subsidiaries, could have a
material effect on the business of the Company.

Standards for Safety and Soundness. Federal law requires each federal
banking agency to prescribe certain standards for all insured depository
institutions. These standards relate to, among other things, internal controls,
information systems and audit systems, loan documentation, credit underwriting,
interest rate risk exposure, asset growth, compensation, and other operational
and managerial standards as the agency deems appropriate. If the appropriate
federal banking agency determines that an institution fails to meet any standard
prescribed by the guidelines, the agency may require the institution to submit
to the agency

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an acceptable plan to achieve compliance with the standard. If an institution
fails to meet these standards, the appropriate federal banking agency may
require the institution to submit a compliance plan. The OTS has primary
enforcement responsibility over federal savings institutions and has the
authority to bring enforcement action against all "institution-affiliated
parties," including stockholders, and attorneys, appraisers and accountants who
knowingly or recklessly participate in wrongful action likely to have an adverse
effect on an insured institution. Formal enforcement action may range from the
issuance of a capital directive, a cease and desist order, removal of officers
and/or directors of the institution, receivership, conservatorship, civil
penalties, or the termination of deposit insurance. The FDIC also has the
authority to recommend to the Director of the OTS that enforcement action be
taken with respect to a particular savings institution. If action is not taken
by the Director, the FDIC has authority to take action under specified
circumstances.

OTS regulations require savings banks to meet three minimum capital
standards: a 1.5% tangible capital ratio, a 4% leverage ratio and an 8%
risk-based capital ratio. At December 31, 2003, Citizens South Bank's capital
exceeded all applicable requirements. Under prompt corrective action
regulations, the OTS is required and authorized to take supervisory actions
against undercapitalized savings banks. For this purpose, a savings bank is
placed in one of the following five categories based on the bank's capital: 1)
well-capitalized (at least 5% leverage capital, 6% tier 1 risk-based capital and
10% total risk-based capital); 2) adequately capitalized (at least 4% leverage
capital, 4% tier 1 risk-based capital and 8% total risk-based capital); 3)
undercapitalized (less than 8% total risk-based capital, 4% tier 1 risk-based
capital or 3% leverage capital); 4) significantly undercapitalized (less than 6%
total risk-based capital, 3% tier 1 risk-based capital or 3% leverage capital);
and 5) critically undercapitalized (less than 2% tangible capital). At December
31, 2003, Citizens South Bank met the criteria for being considered
"well-capitalized."

OTS regulations govern capital distributions by a federal savings bank,
which include cash dividends, stock repurchases and other transactions charged
to the capital account. A savings bank must file an application for approval of
a capital distribution if; (1) the total capital distributions for the
applicable calendar year exceed the sum of the savings bank's net income for
that year to date plus the savings bank's retained net income for the preceding
two years; (2) the bank would not be at least adequately capitalized following
the distribution; (3) the distribution would violate any applicable statute,
regulation, agreement or OTS-imposed condition; or (4) the savings bank is not
eligible for expedited treatment of its filings. Even if an application is not
otherwise required, every savings bank that is a subsidiary of a holding company
must still file a notice with the OTS at least 30 days before the board of
directors declares a dividend or approves a capital distribution. The OTS may
disapprove a notice or application if; (1) the savings bank would be
undercapitalized following the distribution; (2) the proposed capital
distribution raises safety and soundness concerns; or (3) the capital
distribution would violate a prohibition contained in any statute, regulation or
agreement.

Community Reinvestment Act and Fair Lending Laws. All savings banks have a
responsibility under the Community Reinvestment Act and related regulations of
the OTS to help meet the credit needs of their communities, including low- and
moderate-income neighborhoods. In connection with its examination of a federal
savings bank, the OTS is required to assess the savings bank's record of
compliance with the Community Reinvestment Act. In addition, the Equal Credit
Opportunity Act and the Fair Housing Act prohibit lenders from discriminating in
their lending practices on the basis of characteristics specified in those
statutes. A bank's failure to comply with the provisions of the Community
Reinvestment Act could, at a minimum, result in regulatory restrictions on its
activities. The failure to comply with the Equal Credit Opportunity Act and the
Fair Housing Act could result in enforcement actions by the OTS, as well as
other federal regulatory agencies and the Department of Justice. Citizens South
Bank received a "Satisfactory" Community Reinvestment Act rating in its most
recent federal examination.

Transactions with Affiliates. A federal savings bank's authority to engage
in transactions with its "affiliates" is limited by OTS regulations and by
Sections 23A and 23B of the Federal Reserve Act (the "FRA"). The term
"affiliates" for these purposes generally means any company that controls or is
under common control with an institution. Citizens South Banking Corporation and
its non-savings institution subsidiaries are affiliates of Citizens South Bank.
In general, transactions with affiliates must be on terms that are as favorable
to the savings bank as comparable transactions with non-affiliates. In addition,
certain types of these transactions are restricted to an aggregate percentage of
the savings bank's capital. Collateral in specified amounts must usually be
provided by affiliates in order to receive loans from the savings bank. In
addition, OTS regulations

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prohibit a savings bank from lending to any of its affiliates that are engaged
in activities that are not permissible for bank holding companies and from
purchasing the securities of any affiliate, other than a subsidiary.

Citizens South Bank's authority to extend credit to its directors,
executive officers and 10% shareholders, as well as to entities controlled by
such persons, is currently governed by the requirements of Sections 22(g) and
22(h) of the FRA and Regulation O of the Federal Reserve Board. Among other
things, these provisions require that extensions of credit to insiders (i) be
made on terms that are substantially the same as, and follow credit underwriting
procedures that are not less stringent than, those prevailing for comparable
transactions with unaffiliated persons and that do not involve more than the
normal risk of repayment or present other unfavorable features, and (ii) not
exceed certain limitations on the amount of credit extended to such persons,
individually and in the aggregate, which limits are based, in part, on the
amount of Citizens South Bank's capital. In addition, extensions of credit in
excess of certain limits must be approved by Citizens South Bank's Board of
Directors.

Qualified Thrift Lender Test. As a federal savings bank, Citizens South
Bank is subject to a qualified thrift lender, or "QTL," test. Under the QTL
test, Citizens South Bank must maintain at least 65% of its portfolio assets in
qualified thrift investments in at least nine months of the most recent 12-month
period. Portfolio assets generally means total assets of a savings institution,
less the sum of specified liquid assets up to 20% of total assets, goodwill and
other intangible assets, and the value of property used in the conduct of the
savings bank's business. Qualified thrift investments includes various types of
loans made for residential and housing purposes, investments related to such
purposes, including certain mortgage-backed and related securities, and loans
for personal, family, household and certain other purposes up to a limit of 20%
of portfolio assets. Qualified thrift investments also include 100% of an
institution's credit card loans, education loans and small business loans.
Citizens South Bank also may satisfy the QTL test by qualifying as a "domestic
building and loan association" as defined in the Internal Revenue Code of 1986.
A savings bank that fails the qualified thrift lender test must either convert
to a bank charter or operate under specified restrictions. At December 31, 2003,
Citizens South Bank maintained approximately 69% of its portfolio assets in
qualified thrift investments.

Insurance of Deposit Accounts. Deposit accounts in Citizens South Bank are
insured by the Savings Association Insurance Fund of the Federal Deposit
Insurance Corporation, generally up to a maximum of $100,000 per separately
insured depositor. Citizens South Bank's deposits therefore are subject to FDIC
deposit insurance assessments. The FDIC has adopted a risk-based system for
determining deposit insurance assessments. The FDIC is authorized to raise the
assessment rates as necessary to maintain the required ratio of reserves to
insured deposits of 1.25%. In addition, all FDIC-insured institutions must pay
assessments to the FDIC at an annual rate of approximately .0212% of insured
deposits to fund interest payments on bonds maturing in 2017 issued by a federal
agency to recapitalize the predecessor to the Savings Association Insurance
Fund.

Federal Home Loan Bank System. Citizens South Bank is a member of the
Federal Home Loan Bank System ("FHLB"), which provides a central credit facility
primarily for member institutions. As a member of the FHLB of Atlanta, Citizens
South Bank is required to acquire and hold shares of capital stock in the FHLB
in an amount at least equal to 1% of the aggregate principal amount of its
unpaid residential mortgage loans and similar obligations at the beginning of
each year, or 1/20 of its borrowings from the FHLB, whichever is greater. As of
December 31, 2003, Citizens South Bank was in compliance with this requirement.

Federal Reserve System. The Federal Reserve Board regulations require savings
banks to maintain non-interest-earning reserves against their transaction
accounts, such as negotiable order of withdrawal and regular checking accounts.
At December 31, 2002, Citizens South Bank was in compliance with these reserve
requirements. The balances maintained to meet the reserve requirements imposed
by the Federal Reserve Board may be used to satisfy liquidity requirements
imposed by the Office of Thrift Supervision.

The Gramm-Leach-Bliley Financial Modernization Act of 1999. The
Gramm-Leach-Bliley Act ("G-L-B Act") was enacted in November 1999. The G-L-B Act
restricted unitary savings and loan holding companies to those activities
permissible for financial holding companies or for multiple savings and loan
holding companies. A financial holding company may engage in activities that are
financial in nature, including underwriting equity securities and insurance,
incidental to

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financial activities or complementary to a financial activity. A multiple
savings and loan holding company is generally limited to activities permissible
for bank holding companies under Section 4(c)(8) of the Bank Holding Company
Act, subject to the prior approval of the OTS, and certain additional activities
authorized by OTS regulations.

Sarbanes-Oxley Act of 2002. In July 2002, the President signed into law
the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley"), which implemented legislative
reforms intended to address corporate and accounting fraud. In addition to the
establishment of a new accounting oversight board that will enforce auditing,
quality control and independence standards and will be funded by fees from all
publicly traded companies, Sarbanes-Oxley places certain restrictions on the
scope of services that may be provided by accounting firms to their public
company audit clients. Any non-audit services being provided to a public company
audit client will require preapproval by the company's audit committee. In
addition, Sarbanes-Oxley makes certain changes to the requirements for audit
partner rotation after a period of time. Sarbanes-Oxley requires chief executive
officers and chief financial officers, or their equivalent, to certify to the
accuracy of periodic reports filed with the Securities and Exchange Commission,
subject to civil and criminal penalties if they knowingly or willingly violate
this certification requirement. The Company's Chief Executive Officer and Chief
Financial Officer have signed certifications to this Form 10-K as required by
Sarbanes-Oxley. In addition, under Sarbanes-Oxley, counsel will be required to
report evidence of a material violation of the securities laws or a breach of
fiduciary duty by a company to its chief executive officer or its chief legal
officer, and, if such officer does not appropriately respond, to report such
evidence to the audit committee or other similar committee of the board of
directors or the board itself.

Under Sarbanes-Oxley, longer prison terms will apply to corporate
executives who violate federal securities laws; the period during which certain
types of suits can be brought against a company or its officers is extended; and
bonuses issued to top executives prior to restatement of a company's financial
statements are now subject to disgorgement if such restatement was due to
corporate misconduct. Executives are also prohibited from trading the company's
securities during retirement plan "blackout" periods, and loans to company
executives (other than loans by financial institutions permitted by federal
rules and regulations) are restricted. In addition, a provision directs that
civil penalties levied by the Securities and Exchange Commission as a result of
any judicial or administrative action under Sarbanes-Oxley be deposited to a
fund for the benefit of harmed investors. The Federal Accounts for Investor
Restitution provision also requires the Securities and Exchange Commission to
develop methods of improving collection rates. The legislation accelerates the
time frame for disclosures by public companies, as they must immediately
disclose any material changes in their financial condition or operations.
Directors and executive officers must also provide information for most changes
in ownership in a company's securities within two business days of the change.

Sarbanes-Oxley also increases the oversight of, and codifies certain
requirements relating to audit committees of public companies and how they
interact with the company's "registered public accounting firm." Audit committee
members must be independent and are absolutely barred from accepting consulting,
advisory or other compensatory fees from the company. In addition, companies
must disclose whether at least one member of the committee is a "financial
expert" (as such term is defined by the Securities and Exchange Commission) and
if not, why not. Under Sarbanes-Oxley, a company's registered public accounting
firm is prohibited from performing statutorily mandated audit services for a
company if such company's chief executive officer, chief financial officer,
comptroller, chief accounting officer or any person serving in equivalent
positions had been employed by such firm and participated in the audit of such
company during the one-year period preceding the audit initiation date.
Sarbanes-Oxley also prohibits any officer or director of a company or any other
person acting under their direction from taking any action to fraudulently
influence, coerce, manipulate or mislead any independent accountant engaged in
the audit of the company's financial statements for the purpose of rendering the
financial statements materially misleading.

The USA PATRIOT Act. In response to the events of September 11, 2001, the
Uniting and Strengthening America by Providing Appropriate Tools Required to
Intercept and Obstruct Terrorism Act of 2001, or the USA PATRIOT Act, was signed
into law in October 2001. The USA PATRIOT Act gives the federal government new
powers to address terrorist threats through enhanced domestic security measures,
expanded surveillance powers, increased information sharing and broadened
anti-money laundering requirements. By way of amendments to the Bank Secrecy
Act, Title III of the USA PATRIOT Act takes measures intended to encourage
information sharing among bank regulatory agencies and law enforcement bodies.
Further, certain provisions of Title III impose affirmative obligations on a
broad range of financial institutions, including banks, thrifts, brokers,

6

dealers, credit unions, money transfer agents and parties registered under the
Commodity Exchange Act. Among other requirements, Title III of the USA PATRIOT
Act imposes the following requirements with respect to financial institutions:
1) all financial institutions must establish anti-money laundering programs that
include, at minimum: (i) internal policies, procedures, and controls; (ii)
specific designation of an anti-money laundering compliance officer; (iii)
ongoing employee training programs; and (iv) an independent audit function to
test the anti-money laundering program; 2) minimum standards must be established
with respect to customer identification at the time new accounts are opened; 3)
financial institutions that establish, maintain, administer, or manage private
banking accounts or correspondence accounts in the United States for non-United
States persons or their representatives (including foreign individuals visiting
the United States) to establish appropriate, specific, and, where necessary,
enhanced due diligence policies, procedures, and controls designed to detect and
report money laundering; 4) financial institutions are prohibited from
establishing, maintaining, administering or managing correspondent accounts for
foreign shell banks (foreign banks that do not have a physical presence in any
country), and will be subject to certain record keeping obligations with respect
to correspondent accounts of foreign banks and 5) bank regulators are directed
to consider a holding company's effectiveness in combating money laundering when
ruling on Federal Reserve Act and Bank Merger Act applications.

Federal Securities Laws. Citizens South Banking Corporation filed with the
Securities and Exchange Commission a registration statement under the Securities
Act of 1933 for the registration of the common stock issued pursuant to the 2002
conversion. Citizens South Banking Corporation common stock continues to be
registered with the Securities and Exchange Commission under the Securities
Exchange Act of 1934. Citizens South Banking Corporation continues to be subject
to the information, proxy solicitation, insider trading restrictions and other
requirements under the Securities Exchange Act of 1934. The registration under
the Securities Act of 1933 of shares of common stock does not cover the resale
of those shares. Shares of common stock purchased by persons who are not
affiliates of Citizens South Banking Corporation may be resold without
registration. Shares purchased by an affiliate of Citizens South Banking
Corporation will be subject to the resale restrictions of Rule 144 under the
Securities Act of 1933. If Citizens South Banking Corporation meets the current
public information requirements of Rule 144 under the Securities Act of 1933,
each affiliate of Citizens South Banking Corporation that complies with the
other conditions of Rule 144, including those that require the affiliate's sale
to be aggregated with those of other persons, would be able to sell in the
public market, without registration, a number of shares not to exceed, in any
three-month period, the greater of 1% of the outstanding shares of Citizens
South Banking Corporation, or the average weekly volume of trading in the shares
during the preceding four calendar weeks. In the future, Citizens South Banking
Corporation may permit affiliates to have their shares registered for sale under
the Securities Act of 1933.

Taxation

Federal. The Company and the Bank are subject to the provisions of the
Internal Revenue Code of 1986, as amended (the "Code") in the same general
manner as other corporations. For federal income tax purposes, the Bank reports
its income and expenses on the accrual method of accounting and uses a tax year
ending December 31 for filing its federal income tax returns.

The Small Business Protection Act of 1996 (the "1996 Act") eliminated the
use of the reserve method of accounting for bad debt reserves by savings
institutions, effective for taxable years beginning after 1995. Prior to the
1996 Act, the Bank was permitted to establish a reserve for bad debts and to
make annual additions to the reserve. As a result of the 1996 Act, the Bank was
required to use the specific charge off method in computing its bad debt
deduction beginning with its 1996 federal tax return. In addition, the 1996 Act
required the recapture of the excess of tax bad debt reserves at September 30,
1996 over those established as of September 30, 1988. The reserve was recaptured
over a six-year period and was completely amortized as of December 31, 2003.

State of North Carolina. Under North Carolina law, the corporate income
tax is 7.0% of federal taxable income as computed under the Code, subject to
certain prescribed adjustments. In addition, an annual state franchise tax is
imposed at a rate of 0.15% applied to the greatest of the company's capital
stock, surplus and undivided profits, investment in tangible property in North
Carolina or 55% of the appraised valuation of property in North Carolina.

7

State of Delaware. Delaware franchise taxes are imposed on the Company.
Two methods are provided for calculating the tax and the lesser tax is payable.
The first method is based on the authorized number of shares. The tax under this
method is $90.00 for the first 10,000 authorized number of shares plus $50.00
for each additional 10,000 shares or part thereof. The second method is based on
an assumed par value capital. The tax rate under this method is $200 per
$1,000,000 or portion thereof of assumed par value capital. Assumed par is
computed by dividing total assets by total issued shares (including treasury
shares). Assumed par value capital is calculated by multiplying the lesser of
assumed par or stated par value by total authorized shares.

ITEM 2. Properties

The following table sets forth certain information regarding offices
currently in operation at December 31, 2003. Management considers the facilities
to be well maintained and sufficiently suitable for present operations.

Approximate Owned
Location Principal Use Facility Size or Leased
- -------- ------------- ------------- ---------
(square feet)

245 West Main Avenue Headquarters and 12,400 Owned
Gastonia, North Carolina 28052-4140 Banking Office

251 West Main Avenue, Suite 201 Office Support 2,380 Leased
Gastonia, North Carolina 28052-4140

1535 Burtonwood Drive Banking Office 4,740 Owned
Gastonia, North Carolina 28054-4011

233 South Main Street Banking Office 2,370 Owned
Mount Holly, North Carolina 28120-1620

1670 Neal Hawkins Road Banking Office and 5,320 Owned
Gastonia, North Carolina 28056-6429 Mortgage Center

3135 Dallas High Shoals Highway Banking Office 3,225 Owned
Dallas, North Carolina 28034-1307

412 South Highway 27 Banking Office 3,225 Owned
Stanley, North Carolina 28164-2055

401 West Innes Street Banking Office 5,560 Owned
Salisbury, North Carolina 28144-4232

106 West Main Street Banking Office 1,500 Owned
Rockwell, North Carolina 28138-8859

307 North Center Street Banking Office and 8,260 Owned
Statesville, North Carolina 28677-4063 Leased Space

649 Brawley School Road Banking Office 3,800 Owned
Mooresville, North Carolina 28177-9121

8

ITEM 3. Legal Proceedings

Periodically, there have been various claims and lawsuits involving the
Company or the Bank, such as claims to enforce liens, condemnation proceedings
on properties in which we hold security interests, claims involving the making
and servicing of real property loans and other issues incident to our business.
We are not a party to any pending legal proceedings that we believe would have a
material adverse effect on the financial condition or operations of the Company
or the Bank.

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

On October 23, 2003, the Company held a Special Meeting of Shareholders
for the purpose of approving the Citizens South Banking Corporation 2003 Stock
Option Plan and the Citizens South Banking Corporation 2003 Recognition and
Retention Plan. The Citizens South Banking Corporation 2003 Stock Option Plan
provided for the issuance of up to 525,995 options for certain directors and
officers to purchase the Company's common stock. The results of the vote of
shareholders was:

For 4,477,421
Against 809,800
Abstain 27,113
----------
Total 5,314,334

The Citizens South Banking Corporation 2003 Recognition and Retention Plan
provided for the granting of up to 210,398 shares of Company stock to certain
directors and officers. The results of the vote of shareholders was:

For 4,425,229
Against 859,550
Abstain 29,555
----------
Total 5,314,334

No other business was transacted at the Special Meeting of Shareholders.

9

PART II

ITEM 5. Market for Registrant's Common Stock and Related Shareholder Matters

The Company's common stock, $0.01 par value, trades on the Nasdaq National
Market under the symbol CSBC. Price and volume information is contained in The
Wall Street Journal and other daily newspapers in the Nasdaq section under the
National Market System listings. As of February 1, 2004, the Company had 1,255
stockholders of record (excluding the number of persons or entities holding
stock in street name through various brokerage firms), and 9,062,727 shares
outstanding. The following brokers made a market in the Company's stock during
2003:

Fig Partners, LLC 1-866-344-2657
FTN Midwest Research Secs. 1-800-880-7264
Friedman, Billings, Ramsey & Co. 1-800-688-3272
Goldman, Sachs & Co. 1-212-902-1000
Keefe, Bruyette & Woods, Inc. 1-800-342-5529
Knight Equity Markets, L.P. 1-800-222-4910
McDonald Investments (Trident) 1-800-340-6355
Merrill Lynch, Pierce, Fenner 1-800-937-0501
Moors & Cabot, Inc. 1-800-426-0501
Morgan Stanley & Co., Inc. 1-800-223-6559
Ryan Beck & Co., Inc. 1-800-395-7926
Sandler O'Neill & Partners 1-800-898-6547
Schwab Capital Markets 1-212-514-5140

The following table sets forth quarterly closing market price ranges for the
Common Stock over the past two years. The closing prices for all quarters prior
to September 30, 2002, have been adjusted to reflect the exchange ratio of
2.1408-to-1 in conjunction with the Company's stock offering.

Fiscal Year 2003 High Low

First quarter $11.89 $10.04
Second quarter $13.71 $11.99
Third quarter $15.24 $12.90
Fourth quarter $15.15 $13.70

Fiscal Year 2002 High Low

First quarter $ 7.73 $ 6.65
Second quarter $10.70 $ 7.52
Third quarter $10.42 $ 8.64
Fourth quarter $10.24 $ 9.30

10

ITEM 6. Selected Financial Data

The following table sets forth certain information concerning the
financial position of Citizens South Banking Corporation and its subsidiaries as
of and for the dates indicated. The consolidated data is derived from, and
should be read in conjunction with the Consolidated Financial Statements of the
Company and its subsidiaries and related notes presented in Item 8.

At and for the twelve months ended December 31,
-----------------------------------------------------------------
2003 2002 2001 2000 1999
-------- -------- -------- -------- --------
(Dollars in thousands, except per share data) (unaudited) (unaudited)

Income Statement Data:
Interest income .............................................. $ 21,969 $ 24,716 $ 16,382 $ 16,833 $ 15,481
Interest expense ............................................. 8,732 10,195 9,770 9,684 8,132
-------- -------- -------- -------- --------
Net interest income .......................................... 13,237 14,521 6,612 7,149 7,349
Provision for loan losses .................................... 60 225 120 53 97
-------- -------- -------- -------- --------
Net interest income after provision for loan losses .......... 13,177 14,296 6,492 7,096 7,252
Noninterest income ........................................... 5,561 4,121 3,006 2,473 2,470
Noninterest expense .......................................... 13,891 11,381 7,092 6,975 6,440
-------- -------- -------- -------- --------
Income before income taxes ................................... 4,847 7,036 2,406 2,594 3,282
Income tax expense ........................................... 1,456 2,528 702 846 1,146
-------- -------- -------- -------- --------
Net income ................................................... $ 3,391 $ 4,508 $ 1,704 $ 1,748 $ 2,136
======== ======== ======== ======== ========

Per Share Data (1):
Basic net income ............................................. $ 0.39 $ 0.51 $ 0.20 $ 0.20 $ 0.23
Diluted net income ........................................... 0.39 0.51 0.20 0.20 0.23
Cash dividends declared ...................................... 0.24 0.16 0.14 0.11 0.10
Period-end book value ........................................ 10.11 10.64 4.62 4.40 4.23

Balance Sheet Data:
Total assets ................................................. $495,751 $492,873 $447,581 $252,750 $235,742
Loans receivable, net ........................................ 295,026 299,906 334,321 158,820 169,931
Mortgage-backed and related securities ....................... 89,168 70,409 25,405 22,955 18,865
Investment securities ........................................ 56,233 39,594 25,946 32,822 31,334
Deposits ..................................................... 342,446 340,862 353,692 167,931 158,603
Borrowings ................................................... 58,981 47,575 42,057 42,737 35,500
Stockholders' equity ......................................... 87,669 96,383 41,630 39,763 38,901

Performance Ratios:
Return on average assets ..................................... 0.68% 0.98% 0.65% 0.71% 0.93%
Return on average equity ..................................... 3.61 7.61 4.17 4.46 5.36
Avg. interest-earning assets to avg. interest-bearing
liabilities ................................................ 118.65 109.19 116.08 117.85 121.23
Noninterest expense to average total assets .................. 2.81 2.48 2.70 2.85 2.80
Interest rate spread ......................................... 2.57 3.26 2.05 2.34 2.57
Net interest margin (2) ...................................... 2.67 3.17 2.52 2.92 3.20

Asset Quality Ratios:
Allowance for loan losses to total loans at the end of period 0.97% 0.97% 0.91% 0.95% 0.88%
Nonperforming loans to total loans ........................... 0.18 0.17 0.35 0.30 0.07
Nonperforming assets to total assets ......................... 0.14 0.37 0.59 0.19 0.16

Capital Ratios:
Average equity to average total assets ....................... 18.96% 12.93% 15.55% 16.02% 17.36%
Equity to assets at period end ............................... 17.68 19.56 9.30 15.73 16.50
Dividend payout ratio (1) (3) ............................... 61.54 31.37 70.00 55.00 43.48

(1) All per share data for periods prior to September 30, 2002, has been
adjusted to reflect the exchange ratio of 2.1408-to-1 in conjunction with
the Company's stock offering.

(2) Net interest margin is calculated by dividing net interest income by
average assets for the period.

(3) Dividend payout ratio is calculated by dividing cash dividends per share
declared for the period by net income per share for the period. Citizens
South Holdings, MHC, the mutual holding company for Citizens South Banking
Corporation, began waiving dividends in August 2000 and as of September
30, 2002, had waived dividends totaling approximately $1.8 million. The
MHC owned between 53% and 58% of the outstanding common stock of the
Company during the period in which the dividends were waived.

11

ITEM 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations

Overview. Management's Discussion and Analysis is provided to assist in
understanding and evaluating the results of operations and financial condition
of the Company and its subsidiaries. The following discussion should be read in
conjunction with the consolidated financial statements and related notes
included in Item 8. of this report.

Forward-Looking Statements. This report may contain certain
"forward-looking statements" that represent the Company's expectations or
beliefs concerning future events. Such forward-looking statements are about
matters that are inherently subject to certain risks and uncertainties that
could cause actual results to differ materially from those projected in the
forward-looking statements. Factors that could cause such a difference include,
but are not limited to, the timing and amount of revenues that may be recognized
by the Company, continuation of current revenue and expense trends (including
trends affecting chargeoffs and provisions for loan losses), unforeseen changes
in the Company's markets, legal and regulatory changes, and general changes in
the economy. Because of the risks and uncertainties inherent in forward-looking
statements, readers are cautioned not to place undue reliance on these
statements. The Company assumes no obligation to update or revise these
forward-looking statements to reflect events or circumstances that occur after
the date of this report. Readers should carefully review the risk factors
described in other documents the Company files from time to time with the SEC,
including annual reports on Form 10-K, quarterly reports on Form 10-Q, and
current reports on Form 8-K.

Critical Accounting Policies. The accounting and financial policies of the
Company and its subsidiaries are in accordance with accounting principles
generally accepted in the United States and conform to general practices in the
banking industry. The more critical accounting and reporting policies include
the Company's accounting for the allowance for loan losses. The Company's
accounting policies relating to the allowance for loan losses involve the use of
estimates and require significant judgments to be made by management. These
estimates are based on management's opinion of an amount that is adequate to
absorb losses in the Company's existing loan portfolio. The allowance for loan
losses is established through a provision for loan losses based on available
information including the composition of the loan portfolio, historical loan
losses, specific impaired loans, availability and quality of collateral, age of
the various portfolios, changes in local economic conditions, and loan
performance and quality of the portfolio. Different assumptions used in
evaluating the adequacy of the Company's allowance for loan losses could result
in material changes in the Company's consolidated financial condition or
consolidated financial results of operations. The Company's policies with
respect to the methodology for determining the allowance for loan losses involve
a higher degree of complexity and require management to make subjective
judgments that often require assumptions or estimates about uncertain matters.
These critical policies and their assumptions are periodically reviewed with the
Board of Directors.

Comparison of Financial Condition for the Years Ended December 31, 2003,
and December 31, 2002

Total assets increased by $2.9 million, or 0.6%, from $492.9 million at
December 31, 2002 to $495.8 million at December 31, 2003. Cash and cash
equivalents was abnormally high at December 31, 2002, due to the receipt of
$45.5 million in net stock proceeds from the stock offering that was completed
on September 30, 2002, which is described in the "Business" section of Item 1.
of this report. The proceeds were primarily used to purchase investment and
mortgage-backed securities during 2003, resulting in a decrease in cash and cash
equivalents and increases in investment and mortgage-backed securities. Cash and
cash equivalents decreased by $38.8 million, or 82.5%, while investment
securities increased by $16.6 million, or 42.0%, and mortgage-backed securities
increased by $18.8 million, or 26.6%. Management plans to reinvest the proceeds
into higher-yielding commercial and consumer loans as cash flows are generated
from investments and mortgage-backed securities through maturities and principal
and interest payments.

Management continues to emphasize the origination of shorter-term
commercial and consumer loans in order to reduce the Company's vulnerability to
rising interest rates. During 2003, these loans, which include construction
loans, multifamily residential loans, nonresidential real estate loans, consumer
loans, and commercial business loans, increased by $30.9 million, or 19.4%, to
$190.5 million at December 31, 2003. Also during 2003, the Company's portfolio
of one-to-four family residential loans decreased from $148.8 million to $114.1
million. This decrease of $34.7 million, or 23.3%, was primarily due to the high
level of mortgage loan refinancings during 2003 resulting from historically low
interest rates. The Company originates and closes

12

substantially all new fixed-rate one-to-four family residential loans as a
broker for an independent third party on a servicing-released basis. This
generates additional fee income and reduces the potential adverse effects of
rising interest rates on the Company's future earnings that normally result from
holding long-term fixed-rate loans. As a result, total net outstanding loans
decreased $4.9 million, or 1.6%, to $295.0 million at December 31, 2003.

Also during 2003, the Company completed the construction of its tenth
full-service banking office in Mooresville, North Carolina, completed extensive
renovations to upgrade its existing facilities in Salisbury and Rockwell, North
Carolina, and began construction of a new office in Gastonia, North Carolina
that will replace an existing facility. As a result, premises and equipment
increased by $6.1 million, or 69.6%, to $14.9 million. The Company currently
plans to expand into Belmont, North Carolina and York County, South Carolina
within the next two years. The Company also purchased $6.0 million in bank-owned
life insurance during 2003. This type of investment provides tax-advantaged
income with superior yields to other investment securities.

Total liabilities increased by $11.6 million, or 2.9%, from $396.5 million
at December 31, 2002, to $408.1 million at December 31, 2003. This increase was
primarily due to an $11.4 million increase in borrowed money and a $1.5 million
increase in deposits. The increase in borrowed money was used to provide funds
to purchase mortgage-backed securities and to fund loans. Core deposits, which
include demand deposits, money market demand accounts, and savings accounts,
increased by $12.1 million, or 10.5%, to $128.6 million. This increase was
offset by a $10.6 million, or 4.7%, decrease in higher-costing certificates of
deposit. This change in the deposit portfolio composition reflects management's
commitment to building new and enhancing existing customer relationships by
focusing on a customer's primary financial needs such as checking accounts,
savings accounts, and money market deposit accounts. Management plans to
continue to aggressively market its retail and commercial deposit products to
the local community and to increase the Bank's core deposit market share through
an expanding branch network.

Total equity at December 31, 2003, decreased by $8.7 million, or 9.0%,
from $96.4 million at December 31, 2002 to $87.7 million. This decrease was
primarily due to the repurchase of 695,435 shares of common stock for $9.8
million. These shares were repurchased as a part of stock repurchase plans
announced in March 2003 and October 2003. The plan announced in March 2003
provided for the repurchase of 343,027 shares of stock. All of the shares
authorized under this plan were repurchased by September 2003. The October 2003
repurchase plan provides for the repurchase of up to 879,900 shares of stock, or
approximately 10% of the outstanding shares. As of December 31, 2003, the
Company had repurchased 353,235 shares under the plan and had 526,665 shares
remaining to be repurchased. Management plans to continue to repurchase shares
of common stock in the Company at prices that are considered to be attractive
and in the best interests of both the Company and its shareholders.

Total equity also decreased in 2003 as a result of the payment of $2.1
million in cash dividends, or $0.24 per share, and a $1.6 million decrease in
accumulated net unrealized gains on investments available for sale. These
decreases were partly offset by $3.4 million in net income and $975,000 in
vesting of stock issued under the Citizens South Banking Corporation 2003
Recognition and Retention Plan which is described in more detail in "Note 13 -
Employee Benefit Plans" under Item 8. of this report.

Results of Operations

The following discussion relates to operations for the year ended December
31, 2003, compared to the year ended December 31, 2002, as well as the year
ended December 31, 2002, compared to the year ended December 31, 2001. The net
income of the Company is heavily dependent upon net interest income. Net
interest income is the difference between the interest earned on loans,
investment and mortgage-backed securities, and interest-bearing deposits in
other banks, offset by the interest paid on deposits and borrowings.

13

Comparison of Results of Operations for the Years Ended December 31, 2003
and 2002

Net income was $3.4 million, or $0.39 per share, for the year ended
December 31, 2003, compared to $4.5 million, or $0.51 per share, for the year
ended December 31, 2002. The earnings provided returns on average equity of
3.61% in 2003, compared to 7.61% in 2002, and returns on average assets of 0.68%
in 2003, compared to 0.98% in 2002.

Net interest income, the Company's largest source of income, decreased by
$1.3 million, or 8.8%, due in part to the decreasing spread between the yield on
interest-earning assets and the cost of interest-bearing liabilities caused by
the historically low interest rate environment. The interest rate spread between
interest-earning assets and interest-bearing liabilities decreased from 3.26% in
2002 to 2.57% in 2003, resulting in a decrease in the net interest margin from
3.17% to 2.67% during the same period. The compression in the Company's net
interest margin reached its low point of 2.43% during the third quarter of 2003,
and showed signs of considerable improvement in the fourth quarter of 2003,
reaching 2.68%, an increase of 25 basis points from the previous quarter.
Management believes that continued improvement in the Company's net interest
margin and resulting net interest income will take place in 2004, as interest
rates have stabilized, prepayments on loans and mortgage-backed securities have
slowed and loan demand has improved. However, if interest rates continue to
decline and/or loan prepayments accelerate, management's expectations for 2004
may not be realized.

Interest income for the year ended December 31, 2003, decreased by $2.7
million, or 11.1%, to $22.0 million. This decrease was primarily due to a $4.4
million, or 20.9%, reduction in interest income on loans. During the year,
average outstanding loans decreased by $23.0 million, or 7.2%, from $320.5
million to $297.5 million, while the average yield on loans decreased from 6.6%
to 5.7%. These changes were primarily the result of a 25 basis point decrease in
the prime lending rate in June 2003, and an abnormally high level of loan
prepayments and refinancings that reduced both yields and outstanding balances.
The reduction in average outstanding loans was primarily due to the fact that
the Bank originates and closes substantially all new fixed-rate residential
loans as a broker for an independent third party. This reduces the Bank's
vulnerability to increases in interest rates. The level of prepayments and
refinancings slowed during the fourth quarter of 2003 as interest rates began to
stabilize. Interest income on interest-bearing bank deposits also decreased,
with a reduction of $351,000, or 58.5%. Average balances of interest-bearing
bank deposits decreased by $15.1 million, or 39.8%, to $22.8 million. This
reduction was primarily due to the investment of the proceeds received in the
2002 stock offering (see the "Business" section of Item 1. for further
discussion) into higher-yielding investment and mortgage-backed securities.
Also, the average yield on interest-bearing bank deposits decreased to from 1.6%
to 1.1%, as short-term interest rates continued to decrease in 2003.

Interest earned on investment securities increased slightly to $1.5
million. The average balance of investment securities increased by $9.0 million,
or 30.5%, to $38.5 million; however, this increase was offset by a decrease in
the yield from 5.0% to 3.9%. Interest earned on mortgage-backed securities
increased by $2.0 million, or 144.4%. This increase was due to a $63.1 million,
or 219.6% increase in average outstanding balances to $91.9 million for the 12
months ending December 31, 2003. These balances increased due to the investment
in net proceeds received in the September 2002 stock offering (see the
"Business" section of Item 1. for further discussion), the reinvestment of funds
received from loan prepayments, and the investment of funds received from
borrowed money. The increase in average balances was partly offset in a decrease
in the average yield from 4.9% to 3.7%. Management plans to reinvest the cash
flows generated from these mortgage-backed securities into new consumer and
commercial loan originations.

Interest expense for the year ended December 31, 2003, decreased $1.5
million, or 14.3%, to $8.7 million. This decrease was due to a $1.5 million, or
18.3%, decrease in interest paid on deposits. Average interest-bearing deposits
decreased $8.7 million, or 2.6%, to $328.7 million. Most of this decrease was
attributable to a $19.0 million decrease in higher-costing certificates of
deposit. All other deposits, including demand deposits, money market demand
accounts, and savings accounts, increased by $10.3 million. This change in the
deposit mix reflects management's commitment to building new and enhancing
existing customer relationships by focusing on a customer's primary financial
needs such as checking accounts, savings accounts, and money market demand
accounts. Average deposit balances decreased from 2002 to 2003 primarily as a
result of the maturity of higher-costing certificates of deposit acquired in the
acquisition of Innes Street in December 2001, which is detailed in the
"Business" section in Item 1. of this report. Actual year-end deposit balances
increased by $1.5 million from 2002 to 2003. The

14

average interest rate paid on deposits decreased from 2.3% to 1.9% due to lower
market rates. Average borrowings increased by $7.0 million, or 15.8%, to $51.2
million, while the rate paid on borrowings decreased from 5.1% to 4.4% due to
lower market interest rates and the restructuring of $15.0 million in Federal
Home Loan Bank advances. This restructuring reduced the average interest rate on
these advances from 5.8% to 1.8%. These changes resulted in minor reduction of
interest paid on borrowings to $2.2 million.

The Company provided $60,000 and $225,000 in loan loss provisions for the
years ended December 31, 2003 and 2002, respectively. The allowance for loan
losses as a percentage of loans was 0.97% at both December 31, 2003, and
December 31, 2002. The ratio of allowances to total loans has remained flat due
to the stable ratio of nonperforming loans to total loans of 0.17% at December
31, 2002, and 0.18% at December 31, 2003. Refer to the "Allowance for Loan
Losses" section of Item 7. of this report for further discussion.

For the year ended December 31, 2003, noninterest income increased by $1.4
million, or 35.0%, from $4.1 million to $5.6 million. The primary reasons for
the change were a $161,000 increase in fees on deposit accounts, a $62,000
increase in mortgage banking loan fee income, a $779,000 increase in gains on
sale of assets, and a $311,000 increase in the fair value adjustment on deferred
compensation assets. The increase in fees on deposit accounts resulted from our
continued emphasis on building our portfolio of fee-generating demand deposit
accounts and a competitive fee structure on deposit products. Mortgage banking
loan fee income increased due to a higher number of loan originations resulting,
in part, from lower interest rates. We originated and closed many of these
residential loans as a broker for a third party, resulting in immediate fee
income for the Bank. The demand for residential loans, and subsequent fee income
derived from originating such loans, may decrease if interest rates begin to
rise. The increase in the fair value adjustment on investments associated with
deferred compensation assets totaled $311,000, which was offset by a
corresponding $311,000 adjustment to compensation expense, resulting in no net
impact on net income. During the year ended December 31, 2003, the Company sold
$8.1 million in investment securities and $12.1 million in mortgage-backed
securities at a net gain of $1.0 million. These gains were used to offset the
impact of vesting a portion of the common stock granted in the Citizens South
Banking Corporation 2003 Recognition and Retention Plan, which is described in
"Note - 13 Employee Benefit Plans" under Item 8. of this report. During the
fiscal year ended December 31, 2002, the Company sold $4.0 million in investment
securities, $5.0 million in mortgage-backed securities, and $1.4 million of
residential loans at a gain of $243,000.

Noninterest expense increased by $2.5 million, or 22.1%, from $11.4
million in 2002 to $13.9 million in 2003. The primary reasons for the increase
were a $1.7 million increase in compensation, a $1.3 million prepayment penalty
on FHLB advances, a $255,000 increase in professional services, a $101,000
increase in telephone expense, and a $238,000 increase in other noninterest
expenses. Compensation increased due in part to the vesting of a portion of the
common stock granted in the Citizens South Banking Corporation 2003 Recognition
and Retention Plan, the opening of the Company's tenth full service office, and
fair value adjustments made on deferred compensation plans. These fair value
adjustments totaled $311,000 in 2003 and are offset by a corresponding $311,000
adjustment to other noninterest income, resulting in no net impact on net
income. During 2003, we recognized a $1.3 million pre-tax prepayment penalty
associated with the restructuring of $15.0 million in borrowed funds. This
action was taken by the Company in an effort to capitalize on historically low
interest rates, lower the Company's cost of funds, and improve the Company's net
interest margin. This restructuring reduced the average interest rate paid on
these borrowed funds from 5.8% to 1.8%, resulting in an immediate reduction in
interest expense of $150,000 per quarter for the first year. The reduction in
interest expense is expected to amount to approximately $1.7 million over the
next five years. Professional services increased by $255,000, or 78.0%, during
2003 due, in part, to additional outside services being needed to ensure proper
corporate governance in light of new regulatory requirements. Telephone expense
increased by $101,000, or 48.5%, due partly to the opening of a new branch
office and enhanced data communications service at the existing Bank offices.
Other noninterest expense increased by $238,000, or 16.7% due, in part, to
franchise tax payments to the state of Delaware and other miscellaneous
operating expenses.

These increases in noninterest expenses were partially offset by a
$559,000, or 58.0%, reduction in the amortization of the core deposit
intangible. The core deposit intangible was created as a result of the
acquisition of Innes Street in 2001, which is described in the "Business"
section of Item 1. of this report. It is being amortized over a seven-year
period on an accelerated

15

basis. The unamortized balance of the core deposit intangible as of December 31,
2003, was $1.1 million. The Company also experienced decreased expenses
associated with data processing expenses, office supplies and advertising
totaling $260,000, or 27.1%. These decreases were primarily attributable to
higher than normal expenses experienced in 2002 relating to the changing of the
Bank's name and the consolidation of the Bank's computer systems following the
acquisition of Innes Street in December 2001, which is described in the
"Business" section of Item 1. of this report.

The Company's provision for income taxes was $1.5 million and $2.5 million
for the years ended December 31, 2003 and 2002, respectively. The change was
primarily due to a $2.2 million decrease in pretax income. The effective tax
rate decreased from 35.9% to 30.0% due to a larger percentage of income being
derived from tax-advantaged assets such as municipal securities, U.S. Government
Agency securities, and bank-owned life insurance that generate tax-exempt
income.

Comparison of Results of Operations for the Years Ended December 31, 2002
and 2001

Net income was $4.5 million, or $0.51 per share, for the year ended
December 31, 2002, compared to $1.7 million, or $0.20 per share, for the year
ended December 31, 2001. The earnings provided returns on average assets of
0.98% in 2002, compared to 0.65% in 2001, and returns on average equity of 7.61%
in 2002, compared to 4.17% in 2001.

Net interest income, the Company's largest source of income, increased by
$7.9 million, or 119.6%, due primarily to the acquisition of Innes Street on
December 31, 2001, which is described in the "Business" section of Item 1. of
this report. Due to this acquisition, average interest-earning assets increased
$171.1 million to $416.7 million, while average interest-bearing liabilities
increased $170.0 million to $381.7 million. In addition, the spread between
interest-earning assets and interest-bearing liabilities increased from 2.05% in
2001 to 3.26% in 2002. The increase in interest-earning assets, net of
interest-bearing liabilities, coupled with the increase in the interest rate
spread resulted in the $7.9 million increase in net interest income.

Interest income for the year ended December 31, 2002 increased by $8.3
million, or 50.9%, to $24.7 million. This increase was primarily due to the
$171.1 million, or 69.6%, increase in average interest-earning assets to $416.7
million due to the acquisition. Interest earned on loans increased by $9.0
million, or 73.3%, to $21.2 million. During the year, average outstanding loans
increased by $153.9 million, or 92.4%, from $166.6 million to $320.5 million,
while the average yield on loans decreased from 7.4% to 6.6%. Interest earned on
investment securities decreased by $222,000, or 13.0%. The average balance of
investment securities increased by $365,000, to $29.5 million; however, the
yield on investment securities decreased from 5.9% to 5.0%. Average
interest-earning bank deposits increased by $13.3 million, or 53.7%, from $24.7
million to $38.0 million, while the average yield decreased from 4.0% to 1.6%.
These changes resulted in a reduction in interest earned on interest-bearing
balances of $393,000, or 39.6%, to $600,000. Interest earned on mortgage-backed
securities decreased $32,000, or 2.2%. Average outstanding mortgage-backed
securities increased by $3.5 million, or 14.1%, to $28.8 million, while the
yield decreased from 5.7% to 4.9%.

Interest expense for the year ended December 31, 2002, increased $425,000,
or 4.3%, to $10.2 million. This increase was due to a $589,000, or 8.0%,
increase in interest paid on deposits. Average interest-bearing deposits
increased $168.6 million, or 99.9%, to $337.4 million. The average interest rate
paid on deposits decreased from 4.2% to 2.3% due to lower market rates. Average
borrowings increased by $1.4 million, or 3.4%, to $44.2 million, while the rate
paid on borrowings decreased from 5.6% to 5.1% due to lower market interest
rates. These changes resulted in a $165,000, or 6.9%, reduction of interest paid
on borrowings to $2.2 million.

The Company provided $225,000 and $120,000 in loan loss provisions for the
years ended December 31, 2002 and 2001, respectively. The allowance for loan
losses as a percentage of loans was 0.97% at December 31, 2002, compared to
0.91% at December 31, 2001. The increase in the ratio of allowances to total
loans was primarily due to the continued slowdown in the local economy resulting
from layoffs and business closings. Due in part to the slowdown in the local
economy, the amount of loans charged-off increased from $104,000 in 2001 to
$384,000 in 2002. Refer to the "Allowance for Loan Losses" section in Item 7. of
this report for further discussion.

16

For the year ended December 31, 2002, noninterest income increased by $1.1
million, or 37.1%, from $3.0 million to $4.1 million. The primary reasons for
the change were a $475,000 increase in fees on deposit accounts and a $310,000
increase in mortgage banking loan fee income. The increase in fees on deposit
accounts resulted from a continued emphasis on building our portfolio of
fee-generating demand deposit accounts, the additional deposit accounts acquired
from Innes Street, and a competitive fee structure on deposit products. Mortgage
banking loan fee income increased due to a higher number of loan originations
resulting, in part, from lower interest rates. Commissions on sales of financial
products decreased by $51,000 due to reduced sales resulting from a declining
stock market. Dividends on FHLB stock increased due to additional shares held as
a result of the acquisition. Other income increased by $107,000 due, in part, to
income generated by additional purchases of bank-owned life insurance during
2001. During the year ended December 31, 2002, the Company sold $4.0 million in
investment securities, $5.0 million in mortgage-backed securities, and $1.4
million of residential loans at a gain of $243,000. During the fiscal year ended
December 31, 2001, the Company did not recognize any gains on the sale of
assets.

Noninterest expense increased by $4.3 million, or 60.5%, from $7.1 million
in 2001 to $11.4 million in 2002. The primary reason for the increase was the
acquisition and the resulting staffing and operating expenses related to the
addition of three full-service branch offices. Compensation and benefits
increased $1.7 million, or 44.3%, to $5.6 million due to the increased personnel
needed to operate three additional offices and the additional personnel needed
to complete the acquisition. All of the back office functions of the two
organizations were consolidated during the first quarter of 2002. The additional
offices also caused office occupancy to increase by $697,000, or 95.0%, to $1.4
million. Advertising expense increased by $203,000, or 111.2%, to $385,000 as a
result of the Company and Bank changing their names in 2002 to reflect the
Company's expansion outside of Gaston County. Professional services increased by
$104,000, or 46.9%, to $327,000 due to increased expenses associated with
operating a larger fully-public organization. During 2002, the Company amortized
$963,000 of the $2.4 million core deposit premium booked in conjunction with the
acquisition. The core deposit premium is being amortized over a seven-year
period on an accelerated basis. Other expenses increased by $531,000, or 45.6%,
to $1.7 million as a result of the name change, the increased number of offices,
and the valuation allowance recognized on real estate owned. During 2002,
management accepted a written contract to sell a parcel of commercial real
estate acquired by foreclosure for $1.1 million. This resulted in the
recognition of a $169,000 valuation allowance during 2002 to adjust the book
value of the property to reflect the fair value of the property. The sale was
consummated in February 2003.

The Company's provision for income taxes was $2.5 million and $702,000 for
the years ended December 31, 2002 and 2001, respectively. The change was
primarily due to a $4.6 million increase in pretax income. The effective tax
rate increased from 29.2% to 35.9% due to a smaller percentage of income being
derived from tax-advantaged assets such as municipal securities, U.S. Government
Agency securities, and bank-owned life insurance that generate tax-exempt
income.

17

Net Interest Income

The net income of the Company is heavily dependent upon net interest
income. Net interest income represents the difference between income on
interest-earning assets and expense on interest-bearing liabilities. Net
interest income also depends on the relative amounts of interest-earning assets
and interest-bearing liabilities and the interest rate earned or paid on them,
respectively. The following table sets forth certain information relating to the
Company for the years ended December 31, 2003, 2002 and 2001. For the periods
indicated, the total dollar amount of interest income from average
interest-earning assets and the resultant yields, as well as the interest
expense on average interest-bearing liabilities, is expressed both in dollars
and rates. No tax equivalent adjustments were made.

Table 1
Average Balances and Net Interest Income Analysis

December 31, 2003 December 31, 2002
----------------------------------- -----------------------------------
Interest Average Interest Average
Average Income/ Yield/ Average Income/ Yield/
(Dollars in Thousands) Balance Expense Cost Balance Expense Cost
- ----------------------------------------------------------------------------- -----------------------------------

Assets:
Interest-earning assets:
Loans receivable (1) ................ $ 297,517 $ 16,798 5.65% $320,505 $ 21,232 6.62%
Interest-bearing bank deposits ...... 22,847 249 1.09 37,963 600 1.58
Investment securities ............... 38,523 1,496 3.88 29,515 1,482 5.02
Mortgage-backed securities .......... 91,939 3,426 3.73 28,765 1,402 4.87
--------- --------- --------- -------- --------- ---------
Total interest-earning assets ......... 450,826 21,969 4.87 416,748 24,716 5.93
Noninterest-earning assets ............ 44,372 41,568
--------- --------

Total assets .......................... $ 495,198 $458,316
========= ========

Liabilities and Stockholders' Equity:
Interest-bearing liabilities:
Demand deposit accounts ............. $ 28,525 $ 91 0.32% $ 23,485 $ 93 0.40%
Money market deposit accounts ....... 43,097 550 1.28 32,285 498 1.54
Savings accounts .................... 39,705 305 0.77 45,292 638 1.41
Certificates of deposit ............. 217,395 5,555 2.56 236,360 6,733 2.85
Borrowed funds ...................... 51,238 2,231 4.35 44,242 2,233 5.05
--------- --------- --------- -------- --------- ---------
Total interest-bearing liabilities .... 379,960 8,732 2.30 381,664 10,195 2.67
--------- ---------
Noninterest-bearing liabilities ....... 21,365 17,409
--------- ---------
Total liabilities ..................... 401,325 399,073

Stockholders' equity .................. 93,873 59,243
--------- ---------

Total liabilities and equity .......... $ 495,198 $ 458,316
========= =========

Net interest income ................... $ 13,237 $ 14,521
========= =========

Interest rate spread (2) .............. 2.57% 3.26%
========= =========

Net interest margin (3) ............... 2.67% 3.17%
========= =========

Net yield on interest-earning
assets (4) .......................... 2.94% 3.48%
========= =========

Ratio of average interest-earning
assets to avg. interest-bearing
liabilities ......................... 118.65% 109.19%
========= =========

December 31, 2001
--------------------------------
Interest Average
Average Income/ Yield/
(Dollars in Thousands) Balance Expense Cost
- --------------------------------------------------------------------------

Assets:
Interest-earning assets:
Loans receivable (1) ................ $166,574 $ 12,252 7.36%
Interest-bearing bank deposits ...... 24,707 993 4.02
Investment securities ............... 29,150 1,704 5.85
Mortgage-backed securities .......... 25,221 1,434 5.69
-------- --------- -------
Total interest-earning assets ......... 245,652 16,383 6.67
Noninterest-earning assets ............ 17,148
--------

Total assets .......................... $262,800
========

Liabilities and Stockholders' Equity:
Interest-bearing liabilities:
Demand deposit accounts ............. 15,285 186 1.22%
Money market deposit accounts ....... 16,862 460 2.73
Savings accounts .................... 18,677 398 2.13
Certificates of deposit ............. 117,993 6,329 5.36
Borrowed funds ...................... 42,803 2,398 5.60
-------- --------- -------
Total interest-bearing liabilities .... 211,620 9,771 4.62
---------
Noninterest-bearing liabilities ....... 10,304
--------
Total liabilities ..................... 221,924

Stockholders' equity .................. 40,876
--------

Total liabilities and equity .......... $262,800
========
Net interest income ................... $ 6,612
=========

Interest rate spread (2) .............. 2.05%
=======

Net interest margin (3) ............... 2.52%
=======

Net yield on interest-earning
assets (4) .......................... 2.69%
=======

Ratio of average interest-earning
assets to avg. interest-bearing
liabilities ......................... 116.08%
=======

- -------------
(1) Average loan balances include nonaccrual loans.

(2) Interest rate spread represents the difference between the average yield
on interest-earning assets and the average cost of interest-earning
liabilities.

(3) Net interest margin is calculated by dividing net interest income by
average assets for the period.

(4) Net yield on interest-earning assets represents net interest income as a
percentage of average interest-earning assets.

18

Changes in interest income and expense can result from changes in both
volume and rates. The following table sets forth information regarding changes
in our interest income and interest expense for the periods indicated. For each
category of our interest-earning assets and interest-bearing liabilities,
information is provided on changes attributable to (i) changes in volume
(changes in volume multiplied by old rate); (ii) changes in rate (changes in
rate multiplied by old volume); (iii) the net change. The changes attributable
to the combined impact of volume and rate have been allocated proportionately to
the changes due to volume and the changes due to rate.

Table 2
Volume and Rate Variance Analysis

For The Year Ended For the Year Ended
December 31, 2003 vs December 31, 2002 December 31, 2002 vs December 31, 2001
Increase (Decrease) Increase (Decrease)
Due to Due to
--------------------------------------- --------------------------------------
(In Thousands) Volume Rate Net Volume Rate Net
- -------------- ------- ------- ------- ------- ------- -------

Interest income:
Loans receivable ............. $(1,449) $(2,985) $(4,434) $10,062 $(1,082) $ 8,980
Interest-bearing bank deposits (197) (154) (351) 2,992 (3,385) (393)
Investment securities ........ 55 (41) 14 21 (243) (222)
Mortgage-backed securities ... 2,267 (243) 2,024 2,155 (2,187) (32)
------- ------- ------- ------- ------- -------

Total interest income ......... 676 (3,423) (2,747) 15,230 (6,897) 8,333
------- ------- ------- ------- ------- -------

Interest expense:
Deposits ..................... (415) (1,046) (1,461) 1,093 (504) 589
Borrowed funds ............... (15) 13 (2) 85 (250) (165)
------- ------- ------- ------- ------- -------

Total interest expense ........ (430) (1,033) (1,463) 1,178 (754) 424
------- ------- ------- ------- ------- -------

Net interest income ........... $ 1,106 $(2,390) $(1,284) $14,052 $(6,143) $ 7,909
======= ======= ======= ======= ======= =======

Loans

The Company generally makes consumer loans, commercial loans and
residential mortgage loans within its market area. In the past, we concentrated
our lending activities on conventional first mortgage loans secured by
one-to-four family properties. However, since converting to a stock-owned
company in 1998, the Company has focused more of its lending activities on
construction loans, nonresidential real estate loans, commercial business loans
and consumer loans. A substantial portion of our loan portfolio is secured by
real estate, either as primary or secondary collateral, located in our primary
market area. The Company has a diversified loan portfolio with no material
concentrations to any one borrower or industry.

Our lending activities are subject to the written, non-discriminatory,
underwriting standards and loan origination procedures established by management
and approved by our Board of Directors. Loan originations come from a number of
sources including real estate agents, home builders, walk-in customers,
referrals and existing customers. Loan officers also call on local businesses
soliciting commercial products. We advertise our loan products in various print
media including the local newspaper. In our marketing, we emphasize our
community ties, personalized customer service, and an efficient underwriting and
approval process. All real estate collateral is appraised or evaluated in
accordance with regulatory requirements. On new loan originations, we require
hazard, title and, to the extent applicable, flood insurance on all security
property. The amounts and types of loans outstanding over the past five years
are shown on the following table.

19

Table 3
Loan Portfolio

December 31, 2003 December 31, 2002 December 31, 2001
----------------- ----------------- -----------------
Amount Percent Amount Percent Amount Percent
-------- ------- -------- ------- -------- -------
(Dollars in Thousands)

Real estate loans:
One- to four family residential $114,121 37.47% $148,844 48.26% $196,572 57.33%
Multifamily residential ....... 11,517 3.78 8,962 2.90 8,696 2.54
Construction .................. 15,636 5.13 15,321 4.97 16,525 4.82
Nonresidential ................ 90,871 29.83 61,984 20.10 49,235 14.36
-------- ------- -------- ------- -------- -------
Total real estate loans ......... 232,145 76.21 235,111 76.23 271,028 79.05
Commercial business loans ....... 13,935 4.57 12,084 3.92 6,930 2.03
Consumer loans .................. 58,535 19.22 61,213 19.85 64,883 18.92
-------- ------- -------- ------- -------- -------
Total gross loans ............... 304,615 100.00% 308,408 100.00% 342,841 100.00%
======= ======= ======== =======
Less:
Loans in process .............. 6,586 5,418 5,306
Deferred loan fees, net ....... 34 89 78
Allowance for loan losses ..... 2,969 2,995 3,136
-------- -------- --------
Total loans, net ............ $295,026 $299,906 $334,321
======== ======== ========

[Additional columns below]

[Continued from above table, first columns repeated]

December 31, 2000 September 30, 2000 September 30, 1999
----------------- ------------------ ------------------
Amount Percent Amount Percent Amount Percent
-------- ------- -------- ------- -------- -------
(Dollars in Thousands)

Real estate loans:
One- to four family residential ..... $109,907 66.43% $129,031 70.37% $129,332 73.42%
Multifamily residential ............. 2,003 1.21 2,046 1.12 2,414 1.37
Construction ........................ 9,597 5.80 6,939 3.78 8,513 4.83
Nonresidential ...................... 12,925 7.81 12,633 6.89 7,266 4.13
-------- ------- -------- ------- -------- -------
Total real estate loans ............... 134,432 81.25 150,649 82.16 147,525 83.75
Commercial business loans ............. 12,834 7.76 15,552 8.48 17,019 9.67
Consumer loans ........................ 18,183 10.99 17,168 9.36 11,599 6.58
-------- ------- -------- ------- -------- -------
Total gross loans ..................... 165,449 100.00% 183,369 100.00% 176,143 100.00%
======= ======= =======
Less:
Loans in process .................... 4,758 4,544 6,205
Deferred loan fees, net ............. 305 325 385
Allowance for loan losses ........... 1,566 1,537 1,509
-------- -------- --------
Total loans, net .................. $158,820 $176,963 $168,044
======== ======== ========

All loans of $2.0 million or more, or in any amount to borrowers with
existing exposure to us of $2.0 million or more, or in any amount that when
added to the borrower's existing exposure to us causes such total exposure to be
$2.0 million or more, must be approved by our Board of Directors. All single
loans in excess of $1.5 million, regardless of the borrower's exposure to the
Bank, must be approved by our Board of Directors. In addition, all unsecured
loans of $400,000 or more, or in any amount when added to a borrower's existing
unsecured exposure to us causes such unsecured exposure to be $400,000 or more,
must be approved by our Board of Directors. Loans of less than $2.0 million, or
customers with exposure (including the proposed loan) of less than $2.0 million,
or unsecured loans of less than $400,000, or customers with unsecured exposure
(including the proposed loan) of less than $400,000, as applicable, may be
approved individually or jointly by our lending officers within loan approval
limits delegated by our Board of Directors. In addition, the Board of Directors
has delegated "incremental" loan approval limits to certain lending officers
which allows them to approve a new loan to an existing customer in an amount
equal to, or less than, their incremental loan limit that would otherwise
require approval by the Board of Directors or the additional approval of another

20

lending officer. Any loan approved by a lending officer using their incremental
loan limit must be ratified by the Board of Directors or approved by another
lending officer, as applicable, after the loan has been made.

The following table represents the maturity distribution of the Company's
loans by type, including fixed rate loans as of December 31, 2003. Demand loans,
loans having no stated schedule of repayments and no stated maturity, and
overdrafts are reported as becoming due within one year. Loan balances do not
include undisbursed loan proceeds, unearned discounts, unearned income and
allowance for loan losses.

Table 4
Maturity Distribution of Loan Portfolio

One year One to Over Five
or Less Five Years Years Total
-------- ---------- --------- ---------
(In thousands)

Real Estate:
One-to-four family residential ................... $ 4,568 $ 10,741 $ 98,812 $ 114,121
Multifamily residential .......................... 404 7,970 3,143 11,517
Construction ..................................... 14,367 0 1,269 15,636
Nonresidential ................................... 13,024 55,833 22,014 90,871
Commercial business ................................ 5,319 5,103 3,513 13,935
Consumer ........................................... 1,724 2,744 54,067 58,535
-------- ---------- --------- ---------
Total loans ........................................ $ 39,406 $ 82,391 $ 182,818 $ 304,615
======== ========== ========= =========

The following table sets forth the dollar amount of all loans as of
December 31, 2003, for which final payment is not due until after December 31,
2004. The table also shows the amount of each type of loan that has a fixed rate
of interest and those that have an adjustable rate of interest.

Table 5
Interest Rate Distribution of Loan Portfolio

Fixed Rates Adjustable Rates Total
----------- ---------------- ---------
(In thousands)

Real Estate Loans:
One-to-four family residential . $ 45,357 $ 64,196 $ 109,553
Multifamily residential ........ 2,001 9,112 11,113
Construction ................... 1,087 182 1,269
Nonresidential ................. 17,958 59,889 77,847
----------- ---------- ---------
Total real estate loans ........... 66,403 133,379 199,782
Commercial business ............... 2,691 5,925 8,616
Consumer loans .................... 5,226 51,585 56,811
----------- ---------- ---------
Total loans .................... $ 74,320 $ 190,889 $ 265,209
=========== ========== =========

Scheduled contractual principal repayments of loans do not reflect the
actual life of such assets. The average life of a loan is substantially less
than its contractual terms because of prepayments. In addition, due-on-sale
clauses on loans generally give us the right to declare loans immediately due
and payable in the event, among other things, that the borrower sells the real
property subject to the mortgage and the loan is not repaid. The average life of
mortgage loans tends to increase, however, when current mortgage loan market
rates are substantially higher than rates on existing mortgage loans and,
conversely, decrease when rates on existing mortgage loans are substantially
higher than current mortgage loan market rates.

21

Nonperforming Assets and Delinquencies. When a borrower fails to make a
required payment on a loan, we attempt to cure the deficiency by contacting the
borrower and collecting the payment. Computer generated late notices are mailed
15 days after a payment is due. In most cases, deficiencies are cured promptly.
If a delinquency continues, additional contact is made either through a notice
or other means and we will attempt to work out a payment schedule and actively
encourage delinquent residential mortgage borrowers to seek home ownership
counseling. While we generally prefer to work with borrowers to resolve such
problems, we will institute foreclosure or other proceedings, as necessary, to
minimize any potential loss. Loans are placed on nonaccrual status generally if,
in the opinion of management, principal or interest payments are not likely in
accordance with the terms of the loan agreement, or when principal or interest
is past due 90 days or more. Interest accrued but not collected at the date the
loan is placed on nonaccrual status is reversed against income in the current
period. Loans may be reinstated to accrual status when payments are under 90
days past due and, in the opinion of management, collection of the remaining
past due balances can be reasonably expected. Our Board of Directors is informed
monthly of the total amount of loans which are more than 30 days delinquent.
Loans that are more than 90 days delinquent or in foreclosure are reviewed by
the Board on an individual basis each month.

The following table sets forth information with respect to our
nonperforming assets at the dates indicated. As of such dates, we had no
restructured loans within the meaning of SFAS No. 15.

Table 6
Schedule of Nonperforming Assets

December 31, September 30,
------------------------------------------------ --------------------
2003 2002 2001 2000 2000 1999
------ ------ ------ ------ ------ ------
(Dollars in Thousands)

Loans accounted for on a nonaccrual basis:
Real estate loans:
One-to-four family residential ....... $ 193 $ 329 $ 756 $ 236 $ 211 $ 94
Multifamily residential .............. 0 0 70 71 0 0
Construction ......................... 0 90 0 0 0 0
Nonresidential real estate ........... 20 0 0 0 0 0
Commercial business ...................... 203 21 150 75 0 0
Consumer ................................. 113 76 196 97 46 0
------ ------ ------ ------ ------ ------
Total nonaccrual loans ................... 529 516 1,172 479 257 94
Accruing loans which were contractually
past due 90 days or more ............. 0 0 0 0 0 0
------ ------ ------ ------ ------ ------

Total nonperforming loans ................ 529 516 1,172 479 257 94
Real estate owned ........................ 145 1,307 1,470 0 0 259
------ ------ ------ ------ ------ ------

Total nonperforming assets ............... $ 674 $1,823 $2,642 $ 479 $ 257 $ 353
====== ====== ====== ====== ====== ======

Nonperforming loans to total loans ....... 0.18% 0.17% 0.35% 0.30% 0.15% 0.06%

Nonperforming assets to total assets ..... 0.14% 0.37% 0.59% 0.19% 0.11% 0.15%

Real Estate Acquired in Settlement of Loans. Real estate acquired by us as
a result of foreclosure or by deed-in-lieu of foreclosure is classified as real
estate acquired in settlement of loans until sold. Generally, foreclosed assets
are held for sale and such assets are carried at the lower of cost or market
value minus estimated cost to sell the property. After the date of acquisition,
all costs incurred in maintaining the property are expensed and costs incurred
for the improvement or development of such property are capitalized up to the
extent of their net realizable value. At December 31, 2003, we had $145,000 in
real estate acquired in settlement of loans. This balance is comprised of one
single-family residence located in the Bank's normal lending area. This property
was acquired in 2003 and is listed for sale with a local real estate broker.

22

Restructured Loans. Under generally accepted accounting principles in the
United States of America ("GAAP"), we are required to account for certain loan
modifications or restructuring as a "troubled debt restructuring." In general,
the modification or restructuring of a debt constitutes a troubled debt
restructuring if we, for economic or legal reasons related to the borrower's
financial difficulties, grant a concession to the borrowers that we would not
otherwise consider. Debt restructurings or loan modifications for a borrower do
not necessarily always constitute troubled debt restructurings, however, and
troubled debt restructurings do not necessarily result in nonaccrual loans. We
had no restructured loans as of December 31, 2003.

Asset Classification. The OTS has adopted various regulations regarding
problem assets of financial institutions. The regulations require that each
insured institution review and classify its assets on a regular basis. In
addition, in connection with examinations of insured institutions, OTS examiners
have the authority to identify problem assets and, if appropriate, require them
to be classified. There are three classifications for problem assets:
substandard, doubtful and loss. Substandard assets have one or more defined
weaknesses and are characterized by the distinct possibility that the insured
institution will sustain some loss if the deficiencies are not corrected.
Doubtful assets have the weaknesses of substandard assets with the additional
characteristic that the weaknesses make collection or liquidation in full on the
basis of currently existing facts, conditions and values questionable, and there
is a high possibility of loss. An asset classified as loss is considered
uncollectible and of such little value that continuance as an asset of the
institution is not warranted. If an asset or portion thereof is classified as
loss, we establish specific allowances for loan losses for the full amount of
the portion of the asset classified as loss. All or a portion of general loan
loss allowances established to cover possible losses related to assets
classified substandard or doubtful can be included in determining an
institution's regulatory capital, while specific valuation allowances for loan
losses generally do not qualify as regulatory capital. Assets that do not
currently expose the insured institution to sufficient risk to warrant
classification in one of the aforementioned categories but possess weaknesses
are designated "special mention" and monitored by us.

As of December 31, 2003, we had $2.6 million in assets classified
substandard, $203,000 classified doubtful, and no assets classified as loss. The
aggregate amount designated special mention as of December 31, 2003, was $3.1
million. Pursuant to Statement of Financial Accounting Atandards ("SFAS") No.
114, management determined that impaired loans were not material as of December
31, 2003.

As of December 31, 2002, we had $5.5 million classified as substandard,
$47,000 classified as doubtful and no assets classified as loss. The aggregate
amount designated special mention was $2.6 million. Pursuant to SFAS 114,
management determined that impaired loans were not material as of December 31,
2002.

Allowance for Loan Losses

Management has established a systematic methodology for evaluating the
adequacy of the Company's allowance for loan losses. The methodology is set
forth in a formal policy and considers all loans in the portfolio. Specific
allowances are established for certain individual loans that management
considers impaired under SFAS 114. The remainder of the portfolio is segmented
into groups of loans with similar risk characteristics for evaluation and
analysis. In originating loans, we recognize that losses will be experienced and
that the risk of loss will vary with, among other things, the type of loan being
made, the creditworthiness of the borrower, the term of the loan, general
economic conditions, and in the case of a secured loan, the quality of the
collateral. We increase our allowance for loan losses by charging provisions for
loan losses against our current period income. Management's periodic evaluation
of the adequacy of the allowance is consistently applied and is based on our
past loan loss experience, particular risks inherent in the different kinds of
lending that we engage in, adverse situations that may affect the borrower's
ability to repay, the estimated value of any underlying collateral, current
economic conditions, and other relevant internal and external factors that
affect loan collectibility.

At December 31, 2003, we had an allowance for loan losses of $3.0 million.
Management believes that this amount meets the requirement for losses on loans
that management considers to be impaired, for known losses, and for risks
inherent in the remaining loan portfolios. Although management believes that it
uses the best information available to make such determinations, future
adjustments to the allowance for loan losses may be necessary and results of
operations could be

23

significantly adversely affected if circumstances differ substantially from the
assumptions used in making the determinations. The allowance for loan losses is
subject to periodic evaluation by various regulatory authorities and may be
subject to adjustment upon their examination. The following table sets forth an
analysis of our allowance for loan losses.

Table 7
Allowance of Loan Losses

At and For the Twelve Months Ended
----------------------------------------------------------------------------
December 31, September 30,
------------------------------------------------ --------------------
2003 2002 2001 2000 2000 1999
------ ------ ------ ------ ------ ------
(Dollars in Thousands)

Allowance at beginning of period ....... $2,995 $3,136 $1,566 $1,517 $1,509 $1,411

Charge-offs:
One-to-four family residential ..... 0 16 0 0 0 0
Nonresidential mortgage loans ...... 0 175 0 0 0 0
Commercial business loans .......... 0 150 0 0 0 0
Consumer loans ..................... 94 42 104 4 3 8
------ ------ ------ ------ ------ ------
Total charge-offs ...................... $ 94 $ 383 $ 104 $ 4 $ 3 $ 8

Recoveries:
One-to-four family residential ..... 0 0 0 0 0 0
Nonresidential mortgage loans ...... 0 0 0 0 0 0
Commercial business loans .......... 0 0 0 0 0 0
Consumer loans ..................... 8 17 1 1 1 1
------ ------ ------ ------ ------ ------
Total recoveries ....................... $ 8 $ 17 $ 1 $ 1 $ 1 $ 1
------ ------ ------ ------ ------ ------

Net charge-offs ........................ $ 86 $ 366 $ 103 $ 3 $ 2 $ 7

Provision for loan losses .............. 60 225 120 52 30 105
Allowance acquired in acquisition ...... 0 0 1,553 0 0 0
------ ------ ------ ------ ------ ------

Allowance at end of period ............. $2,969 $2,995 $3,136 $1,566 $1,537 $1,509
====== ====== ====== ====== ====== ======

Allowance for loan losses to total loans 0.97% 0.97% 0.91% 0.95% 0.84% 0.86%

Net charge-offs to average loans ....... 0.03% 0.12% 0.06% 0.00% 0.00% 0.00%

The following table sets forth the breakdown of the allowance for loan
losses by loan category at the dates indicated. Management believes that the
allowance can be allocated by category only on an approximate basis. The
allocation of the allowance to each category is not necessarily indicative of
future losses and does not restrict the use of the allowance to absorb losses in
any other category.

24

Table 8
Allocation of Allowance for Loan Losses

December 31, 2003 December 31, 2002 December 31, 2001
----------------- ----------------- -----------------
% of % of % of
Amount Total Loans Amount Total Loans Amount Total Loans
------ ----------- ------ ----------- ------ -----------
(dollars in thousands)

Real estate loans:
One-to-four family residential $ 399 37.47% $ 475 48.26% $ 800 57.33%
Multifamily residential ...... 100 3.78 100 2.90 100 2.54
Construction ................. 150 5.13 150 4.97 150 4.82
Nonresidential ............... 550 29.83 500 20.10 225 14.36
------ ------- ------ ------- ------ -------
Total real estate loans ......... 1,199 76.21 1,225 76.23 1,275 79.05
Commercial business ............. 600 4.57 600 3.92 744 2.03
Consumer loans .................. 1,170 19.22 1,170 19.85 1,117 18.92
------ ------- ------ ------- ------ -------
Total allowance for loan losses . $2,969 100.00% $2,995 100.00% $3,136 100.00%
====== ======= ====== ======= ====== =======

[Additional columns below]

[Continued from above table, first columns repeated]

December 31, 2000 September 30, 2000 September 30, 1999
------------------ ------------------ ------------------
% of % of % of
Amount Total Loans Amount Total Loans Amount Total Loans
------ ----------- ------ ----------- ------ -----------
(dollars in thousands)

Real estate loans:
One-to-four family residential $ 400 66.43% $ 400 70.36% $ 700 73.42%
Multifamily residential ...... 50 1.21 50 1.12 75 1.37
Construction ................. 55 5.80 50 3.78 100 4.83
Nonresidential ............... 70 7.81 50 6.90 225 4.13
------ ------- ------ ------- ------ -------
Total real estate loans ......... 575 81.25 550 82.16 1,110 83.75
Commercial business ............. 500 7.76 500 8.48 273 9.67
Consumer loans .................. 491 10.99 487 9.36 136 6.58
------ ------- ------ ------- ------ -------
Total allowance for loan losses . $1,566 100.00% $1,537 100.00% $1,506 100.00%
====== ======= ====== ======= ====== =======

Deposits

Our deposit products include a broad selection of deposit instruments,
including checking accounts, money market deposit accounts, savings accounts,
individual retirement accounts, and term certificate accounts. We offer these
products to both retail and commercial customers. Deposit account terms vary
with the principal difference being the minimum balance deposit, early
withdrawal penalties and the interest rate. We review our deposit mix and
pricing weekly. We do not utilize brokered deposits, nor have we aggressively
sought jumbo certificates of deposit. We believe that we are competitive in the
type of accounts and interest rates we offer on our deposit products. We do not
seek to pay the highest deposit rates, but a competitive rate. Management
determines the rates paid based on a number of conditions, including rates paid
by competitors, rates on U.S. Treasury securities, rates offered on alternative
lending programs, and the deposit growth rate we are seeking to achieve. The
following table sets forth information concerning our deposit accounts.

25

Table 9
Deposit Portfolio Composition

December 31, 2003 December 31, 2002 December 31, 2001
------------------------ ------------------------ ------------------------
Average Average Average
Actual Interest Actual Interest Actual Interest
Category ................. Balance Rate Balance Rate Balance Rate
-------- -------- -------- -------- ------- --------
(dollars in thousands)

Noninterest bearing demand $ 12,906 0.0% $ 11,203 0.0% $ 7,953 0.0%
Interest bearing demand .. 30,780 0.3 25,773 0.4 25,330 1.2
Money market deposit ..... 48,189 1.3 35,811 1.5 29,489 2.7
Savings accounts ......... 36,754 0.8 43,670 1.4 44,011 2.1
Certificates of deposit .. 213,817 2.6 224,405 2.9 246,909 5.4
-------- -------- -------- -------- ------- --------
Total Deposits ........... $342,446 1.9% $340,862 2.3% $353,69 24.2%
======== ======== ======== ======== ======= ========

The following table indicates the amount of our time deposits (also
referred to as certificates of deposits) with a principal balance greater than
$100,000 by time remaining until maturity as of December 31, 2003.

Table 10
Maturities of Time Deposits over $100,000

Maturity Period ..................................... Time Deposits
--------------
(In Thousands)

Within three months ................................. $18,061
Three to six months ................................. 15,246
Six through twelve months ........................... 11,119
Over twelve months .................................. 12,214
-------
Total time deposits over $100,000 ................ $56,640
=======

The following table sets forth the amount of time deposits in the Bank
categorized by rates as of December 31st at the dates indicated.

Table 11
Time Deposit Interest Rate Composition

2003 2002 2001
-------- -------------- --------
(In Thousands)

Interest Rate
Less than 2.00% .......................................................... $ 85,060 $ 38,066 $ 0
2.01-4.00% ............................................................... 108,170 159,892 96,028
4.01-6.00% ............................................................... 20,470 24,145 129,737
6.01-8.00% ............................................................... 117 2,301 21,144
-------- ---------- --------
$213,817 $ 224,405 $246,909
======== ========== ========

The following table sets forth the amount of time deposits in the Bank
categorized by rates and maturities at December 31, 2003, for the years ending
December 31.

26

Table 12
Time Deposit Maturity Schedule

After
Interest Rate 2004 2005 2006 2007 Total
- -------------- --------- -------- ------- ------- --------
(In Thousands)

Less than 2.0% $ 79,566 $ 5,493 $ 0 $ 0 $ 85,059
2.01-4.0% .... 91,335 11,179 3,888 1,768 108,170
4.01-6.0% .... 6,056 8,857 247 5,311 20,471
6.01-8.0% .... 0 117 0 0 117
--------- -------- ------- ------- --------
Total ........ $ 176,957 $ 25,646 $ 4,135 $ 7,079 $213,817
========= ======== ======= ======= ========

Capital Adequacy and Resources

OTS regulations require savings banks to meet three minimum capital
standards: a 1.5% tangible capital ratio, a 4% leverage ratio and an 8%
risk-based capital ratio. At December 31, 2003, Citizens South Bank's capital
exceeded all applicable requirements. Under prompt corrective action
regulations, the OTS is required and authorized to take supervisory actions
against undercapitalized savings banks. For this purpose, a savings bank is
placed in one of the following five categories based on the bank's capital: 1)
well-capitalized (at least 5% leverage capital, 6% tier 1 risk-based capital and
10% total risk-based capital); 2) adequately capitalized (at least 4% leverage
capital, 4% tier 1 risk-based capital and 8% total risk-based capital); 3)
undercapitalized (less than 8% total risk-based capital, 4% tier 1 risk-based
capital or 3% leverage capital); 4) significantly undercapitalized (less than 6%
total risk-based capital, 3% tier 1 risk-based capital or 3% leverage capital);
and 5) critically undercapitalized (less than 2% tangible capital). At December
31, 2003, Citizens South Bank met the criteria for being considered
"well-capitalized."

Funding for future growth is dependent upon the earnings of the Company
and its subsidiaries. At December 31, 2003, the Company had a capital to assets
ratio of 17.68%. As such, the Company fully expects to be able to meet future
capital needs caused by growth and expansion as well as regulatory requirements.
A primary reason for the Company's strong capital position was the successful
stock offering that was completed in September 2002 that raised net proceeds of
$45.5 million as discussed in the "Business" section of Item 1. of this report.
The Company plans to continue to repurchase its common stock in the open market
from time to time as market conditions warrant. During 2003, the Company
repurchased 695,435 shares of common stock for $9.8 million.

Liquidity

The objectives of the Company's liquidity management policy include
providing adequate funds to meet the cash needs of both borrowers and
depositors, to provide for the on-going operations of the Company, and to
capitalize on opportunities for expansion. Liquidity management addresses the
Company's ability to meet deposit withdrawals on demand or at contractual
maturity, to repay borrowings as they mature, and to fund new loans and
investments as opportunities arise. The primary sources of internally generated
funds are principal and interest payments on loans receivable, increases in
local deposits, cash flows generated from operations, and cash flows generated
by investments. If the Company requires funds beyond its internal funding
capabilities, it may rely upon external sources of funds such in brokered
deposits and Federal Home Loan Bank ("FHLB") advances. The Company has $64.9
million in additional advances available from its line of credit from the FHLB
and an additional $2.0 million line of credit with another financial
institution. The FHLB functions as a central reserve bank providing credit for
member financial institutions. As a member of the FHLB, we are required to own
capital stock in the FHLB and we are authorized to apply for advances on the
security of such stock and certain of our mortgage loans and other assets
(principally securities that are obligations of, or guaranteed by, the U.S.
Government) provided certain creditworthiness standards have been met. Advances
are made pursuant to several different credit programs. Each credit program has
its own interest rate and range of maturities. Depending on the program,
limitations on the amount of advances are based on the financial condition of
the member institution and the adequacy of collateral pledged to secure the
credit. The Company may also solicit brokered deposits

27

for providing funds for asset growth; however, to date, the Company has not used
such deposits to supplement its liquidity position.

In the normal course of business, various commitments are outstanding that
are not reflected in the consolidated financial statements. Commitments to
extend credit and undisbursed advances on customer lines of credit are
agreements to lend to a customer as long as there is no violation of any
condition established in the contract. The funding of these commitments and
previously approved undisbursed lines of credit could effect the Company's
liquidity position. At December 31, 2003, the Company had loan commitments
(excluding undisbursed portions of construction loans of $6.6 million) of $27.7
million and unused lines of credit of $70.6 million. The Company believes that
it has adequate resources to fund loan commitments and lines of credit as they
arise. The Company does not have any special purpose entities of other similar
forms of off-balance sheet financing.

Under existing contractual obligations, the Company will be required to
make payments in future periods. The following table presents aggregated
information about payments due under such contractual obligations at December
31, 2003. The Company expects that a portion of the deposits will not be renewed
upon maturity. If there is a higher than normal level of time deposits that are
not renewed at maturity, then the Company may experience a decrease in
liquidity. This may result in the Company offering higher than market interest
rates to maintain deposits, which would increase interest expense. Transaction
deposit accounts with indeterminate maturities have been classified as having
payments due in one year or less.

Table 13
Contractual Maturities

Payments Due by Period at December 31, 2003
-----------------------------------------------------------------
One Year One to Three to Over Five
Or Less Three Years Five Years Years Total
--------- ----------- ----------- --------- ---------
(in thousands)

Borrowed Funds .. $ 21,981 $ 14,000 $ 10,000 $ 13,000 $ 58,981
Deposits ........ 305,586 29,781 7,079 0 342,446
Lease Obligations 55 90 86 0 231
--------- ---------- ---------- --------- ---------
Total ........... $ 327,622 $ 43,871 $ 17,165 $ 13,000 $ 401,658
========= ========== ========== ========= =========

Market Risks

Market risk reflects the risk of economic loss resulting from adverse
changes in market price and interest risks. The risk of loss can be reflected in
diminished market values and/or reduced net interest income in future periods.

The Company's most significant form of market risk is interest rate risk,
as the majority of the Company's assets and liabilities are sensitive to changes
in interest rates. The structure of the Company's loan and deposit portfolios is
such that significant declines in interest rates could adversely impact net
market values and net interest income. The Company does not maintain a trading
account, nor is it subject to currency exchange risk or commodity price risk.
The Company's Asset/Liability Committee ("ALCO") is responsible for monitoring
and managing exposure to interest rate risk, as discussed below in "Interest
Rate Sensitivity".

28

Interest Rate Sensitivity

The Company's ALCO monitors the Company's level of interest rate
sensitivity and ensures that the level of sensitivity of the Company's net
portfolio value is maintained within limits established by the Board of
Directors. Through such management, the ALCO seeks to reduce the vulnerability
of the Company's operations to changes in interest rates. During the past year,
the ALCO utilized the following strategies to manage interest rate risk: (1)
emphasizing the origination and retention of short-term commercial business
loans and nonresidential mortgage loans; (2) emphasizing the origination of
adjustable-rate home equity lines of credit; (3) emphasizing the origination and
retention of one- to four- family residential adjustable-rate mortgage loans;
(4) originating all new fixed-rate mortgage loans as a broker for a third party;
and (5) investing in shorter-term investment securities.

The Office of Thrift Supervision requires the computation of amounts by
which the net present value of the Bank's cash flow from assets, liabilities,
and off balance sheet items (the Bank's net portfolio value or "NPV") and the
net interest income ("NII") of the Bank would change in the event of a range of
assumed changes in market interest rates. These computations estimate the effect
on a bank's NPV and NII from instantaneous and permanent one hundred- to three
hundred-basis point increases and decreases in market interest rates. The
following table presents the Bank's projected change in NPV and NII at December
31, 2003, as calculated by an independent third party, based upon information
provided by the Bank. The Bank's level of sensitivity, given a hypothetical,
immediate, and sustained change in interest rates from + 300 basis points to -
300 basis points, is within the range of acceptable sensitivity established by
the Board of Directors.

Table 14
Interest Rate Sensitivity

Estimated Theoretical Estimated Theoretical
Hypothetical, Immediate, Net Interest Income Net Portfolio Value
and Sustained ------------------------ ------------------------
Changes in Interest Rates Amount % Change Amount % Change
- ------------------------- -------- -------- -------- --------
(dollars in thousands)

300 basis point rise $ 13,284 10.1% $ 67,966 -8.6%
200 basis point rise 12,952 7.4% 70,027 -5.8%
100 basis point rise 12,555 4.1% 72,027 -3.1%
No change 12,062 0.0% 74,327 0.0%
100 basis point decline 11,146 -7.6% 74,003 -0.4%
200 basis point decline 10,109 -16.2% 72,363 -2.6%
300 basis point decline 8,252 -31.6% 72,107 -3.0%

Certain shortcomings are inherent in the methodology used in the above
interest rate risk measurement. Modeling changes in NPV require the making of
certain assumptions, which may or may not reflect the manner in which actual
yields and costs respond to changes in market interest rates. In this regard,
the NPV table presented assumes that the composition of the interest sensitive
assets and liabilities existing at the beginning of a period remains constant
over the period being measured and also assumes that a particular change in
interest rates is reflected uniformly across the yield curve regardless of the
duration to maturity or repricing of specific assets and liabilities.
Accordingly, although the NPV table provides an indication of the Bank's
interest rate risk exposure at a particular point in time, such measurements are
not intended to and do not provide a precise forecast of the effect of changes
in market interest rates on the Bank's net interest income and will differ from
actual results.

29

Impact of Inflation and Changing Prices

The consolidated financial statements and related notes have been prepared
in accordance with U.S. Generally Accepted Accounting Principles which require
the measurement of financial position and operating results in terms of
historical dollars, without considering the change in the relative purchasing
power of money over time due to inflation. Unlike most industrial companies,
nearly all the assets and liabilities of the Company are financial in nature. As
a result, interest rates have a more significant impact on the Company's
performance than the effect of inflation. Interest rates do not necessarily
change in the same magnitude as the price of goods and services.

30

Table 15
Quarterly Financial Data (unaudited)

First Second Third Fourth
------- ------- ------- -------
(in thousands, except per share data)

2003
Interest income ........................ $ 5,903 $ 5,645 $ 5,206 $ 5,215
Interest expense ....................... 2,328 2,286 2,202 1,916
------- ------- ------- -------

Net interest income .................... 3,575 3,359 3,004 3,299
Provision for loan losses .............. 15 15 15 15
------- ------- ------- -------

Net int. income after provision for loan
losses ............................... 3,560 3,344 2,989 3,284
Noninterest income ..................... 1,085 1,358 1,159 2,068
Noninterest expense .................... 2,763 3,131 4,148 3,958
------- ------- ------- -------

Income before income taxes ............. 1,882 1,571 0 1,394
Income taxes ........................... 675 447 (94) 428
------- ------- ------- -------

Net income ............................. $ 1,207 $ 1,124 $ 94 $ 966
======= ======= ======= =======

Per share data:
Net income:
Basic ......................... $ 0.14 $ 0.13 $ 0.01 $ 0.11
Diluted ....................... 0.14 0.13 0.01 0.11
Cash dividends declared ........... 0.06 0.06 0.06 0.06
Common stock price:
High .......................... 11.89 13.71 15.24 15.15
Low ........................... 10.04 11.99 12.90 13.70

2002
Interest income ........................ $ 6,300 $ 6,192 $ 6,154 $ 6,119
Interest expense ....................... 2,677 2,539 2,533 2,495
------- ------- ------- -------

Net interest income .................... 3,623 3,653 3,621 3,624
Provision for loan losses .............. 65 70 70 20
------- ------- ------- -------

Net int. income after provision for loan
losses ............................... 3,558 3,583 3,551 3,604
Noninterest income ..................... 1,018 904 1,066 1,332
Noninterest expense .................... 3,034 2,710 2,766 3,070
------- ------- ------- -------

Income before income taxes ............. 1,542 1,777 1,851 1,866
Income taxes ........................... 550 646 651 681
------- ------- ------- -------

Net income ............................. $ 992 $ 1,131 $ 1,200 $ 1,185
======= ======= ======= =======

Per share data:
Net income:
Basic ......................... $ 0.11 $ 0.13 $ 0.14 $ 0.14
Diluted ....................... 0.11 0.13 0.14 0.13
Cash dividends declared ........... 0.04 0.04 0.04 0.05
Common stock price:
High .......................... 7.73 10.70 10.42 10.24
Low ........................... 6.65 7.52 8.64 9.30

31

ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk

Information responsive to this item in contained in Item 7. above under
the captions "Management of Market Risk" and "Liquidity and Capital Resources".

32

ITEM 8. Financial Statements and Supplementary Data

[LOGO]
CHERRY
BEKAERT &
HOLLAND
CERTIFIED PUBLIC
ACCOUNTANTS &
CONSULTANTS

REPORT OF INDEPENDENT AUDITORS

The Board of Directors
Citizens South Banking Corporation

We have audited the accompanying consolidated statements of condition of
Citizens South Banking Corporation as of December 31, 2003 and 2002 and the
related consolidated statements of operations, comprehensive income, changes in
stockholders' equity and cash flows for each of the years in the three-year
period ended December 31, 2003. These financial statements are the
responsibility of management. Our responsibility is to express an opinion on
these financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Citizens South
Banking Corporation as of December 31, 2003 and 2002 and the results of their
operations and their cash flows for each of the years in the three-year period
ended December 31, 2003, in conformity with accounting principles generally
accepted in the United States of America.

/s/ Cherry, Bekaert & Holland, L.L.P.

Gastonia, North Carolina
February 13, 2004

33

CITIZENS SOUTH BANKING CORPORATION

Consolidated Statements of Condition

December 31,
2003 2002
------------- -------------

Assets
Cash and due from banks $ 5,374,150 $ 7,606,918
Interest-earning bank balances 2,840,035 39,391,870
------------- -------------
Cash and cash equivalents 8,214,185 46,998,788
Investment securities available-for-sale 56,233,140 39,593,947
Mortgage-backed and related securities available-for-sale 89,168,143 70,408,888
Loans, net 295,026,346 299,905,719
Premises and equipment, net 14,938,818 8,806,912
Accrued interest receivable 1,942,899 1,912,610
Federal Home Loan Bank stock 2,915,000 2,639,500
Intangible assets 7,984,320 8,658,504
Bank owned life insurance 12,317,201 6,833,628
Other assets 7,010,742 7,114,256
------------- -------------
Total assets $ 495,750,794 $ 492,872,752
============= =============

Liabilities and Equity
Deposits $ 342,445,676 $ 340,861,932
Advances from Federal Home Loan Bank 58,300,000 46,500,000
Repurchase agreements 681,394 1,075,182
Deferred compensation 6,164,432 6,097,029
Other liabilities 490,384 1,955,929
------------- -------------
Total liabilities 408,081,886 396,490,072
Commitments and contingencies
Stockholders' Equity
Preferred stock, 10,000,000 shares authorized, none issued -- --
Common stock, $0.01 par value, 20,000,000 shares authorized
in 2003 and 2002, issued and outstanding 9,062,727 in 2003 and 2002 90,628 90,628
Additional paid-in-capital 68,280,596 68,175,723
Unallocated common stock held by Employee Stock Ownership Plan (1,978,722) (2,161,566)
Unearned compensation related to Recognition and Retention Plan (1,979,449) --
Retained earnings, substantially restricted 28,823,864 28,739,476
Accumulated unrealized gain (loss) on securities available-for-sale, net of tax (39,963) 1,538,419
Treasury stock of 392,414 shares at cost (5,528,046) --
------------- -------------
Total stockholders' equity 87,668,908 96,382,680
------------- -------------

Total liabilities and stockholders' equity $ 495,750,794 $ 492,872,752
============= =============

See notes to consolidated financial statements.

34

CITIZENS SOUTH BANKING CORPORATION

Consolidated Statements of Operations

Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2003 2002 2001
------------ ------------ ------------

Interest income
Loans $ 16,797,651 $ 21,232,156 $ 12,251,432
Investment securities 1,745,240 2,082,359 2,696,812
Mortgage-backed and related securities 3,426,438 1,401,924 1,434,278
------------ ------------ ------------
Total interest income 21,969,329 24,716,439 16,382,522

Interest expense
Deposits 6,501,361 7,961,809 7,372,689
Borrowed funds 2,230,995 2,233,383 2,397,790
------------ ------------ ------------
Total interest expense 8,732,356 10,195,192 9,770,479
------------ ------------ ------------

Net interest income 13,236,973 14,521,247 6,612,043

Provision for loan losses 60,000 225,000 120,000
------------ ------------ ------------

Net interest income after provision for loan losses 13,176,973 14,296,247 6,492,043

Noninterest income
Fee income on deposit accounts 2,448,921 2,287,598 1,812,370
Fee income on mortgage banking activities 831,806 769,337 459,348
Gain on sale of securities 1,020,673 243,233 --
Gain on sale of other assets 1,213 -- --
Commissions on sales of financial products 161,296 161,951 213,261
Dividends on FHLB stock 102,057 177,119 146,908
Fair market adjustment on deferred compensation assets 312,230 2,356 --
Increase in value of bank owned life insurance 490,082 325,215 232,624
Other income 192,833 153,704 141,487
------------ ------------ ------------
Total noninterest income 5,561,111 4,120,513 3,005,998

Noninterest expense
Compensation and benefits 7,281,487 5,555,507 3,849,821
Occupancy 1,345,107 1,430,026 733,389
Office supplies expense 303,640 377,080 199,301
NOW account expense 261,490 251,300 367,008
Advertising 280,597 384,620 182,093
Professional services 581,321 326,596 222,374
Telephone 310,356 208,959 93,662
Data processing 115,192 197,764 331,197
Deposit insurance 59,666 61,475 32,972
Loss on sale of assets -- 137,647 9,537
Prepayment penalty on FHLB advances 1,289,000 65,059 --
Amortization of core deposit intangible 404,000 963,000 --
Other expense 1,659,255 1,421,741 1,070,832
------------ ------------ ------------
Total noninterest expense 13,891,111 11,380,774 7,092,186
------------ ------------ ------------

Income before income taxes 4,846,973 7,035,986 2,405,855
Provision for income taxes 1,456,407 2,528,052 701,730
------------ ------------ ------------

Net income $ 3,390,566 $ 4,507,934 1,704,125
============ ============ ============

Earnings per share
Basic earnings per share $ 0.39 $ 0.51 $ 0.20
Diluted earnings per share $ 0.39 $ 0.51 $ 0.20

See notes to consolidated financial statements.

35

CITIZENS SOUTH BANKING CORPORATION

Consolidated Statements of Comprehensive Income

Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2003 2002 2001
-------------- -------------- -------------

Net income $ 3,390,566 $ 4,507,934 $1,704,125

Other comprehensive income, net of tax:
Unrealized gains (losses) on securities
Unrealized holding gains (losses) arising
during period, net of tax effect of
$520,397, $(324,917), and
$(292,053), respectively (925,151) 577,630 519,206
Reclassification adjustment for losses (gains)
included in net income, net of tax effect of
$367,442, $87,564, and
$3,281, respectively (653,231) (155,669) 5,834
----------- ----------- ----------
Other comprehensive income (1,578,382) 421,961 525,040
----------- ----------- ----------

Comprehensive income $ 1,812,184 $ 4,929,895 $2,229,165
=========== =========== ==========

See notes to consolidated financial statements.

36

CITIZENS SOUTH BANKING CORPORATION

Consolidated Statements of Changes in Stockholders' Equity

Unearned
Additional Unallocated Compensaton
Preferred Common Paid-In Common Stock Related to
Stock Stock Capital Held by ESOP RRP
--------- ----------- ------------ ------------- -------------

Balance, December 31, 2000 $ -- $ 4,581,034 $ 16,673,486 $ (1,352,543) $ --

Comprehensive results:
Net income -- -- -- -- --
Other comprehensive results, net of tax -- -- -- -- --
Allocation from shares purchased with loan to ESOP -- -- 169,942 112,712 --
Cash dividends declared on common stock -- -- -- -- --
Repurchase of common stock -- -- -- -- --
--------- ----------- ------------ ------------- -------------

Balance, December 31, 2001 -- 4,581,034 16,843,428 (1,239,831) --

Comprehensive results:
Net income -- -- -- -- --
Other comprehensive results, net of tax -- -- -- -- --
Loan to ESOP for purchase of common stock -- -- -- (1,051,980) --
Allocation from shares purchased with loan to ESOP -- -- 143,733 130,245 --
Exercise of options -- 24,052 264,572 -- --
Issuance of common stock -- (4,514,458) 50,923,990 -- --
Cash dividends declared on common stock -- -- -- -- --
--------- ----------- ------------ ------------- -------------

Balance, December 31, 2002 -- 90,628 68,175,723 (2,161,566) --

Comprehensive results:
Net income -- -- -- -- --
Other comprehensive results, net of tax -- -- -- -- --
Allocation from shares purchased with loan to ESOP -- -- 104,873 182,844 --
Repurchase of common stock -- -- -- -- --
Issuance of Recognition and Retention Plan stock -- -- -- -- (2,954,297)
Vesting of Recognition and Retention Plan -- -- -- -- 974,848
Exercise of options -- -- -- -- --
Cash dividends declared on common stock -- -- -- -- --
--------- ----------- ------------ ------------- -------------

Balance, December 31, 2003 $ -- $ 90,628 $ 68,280,596 $ (1,978,722) $ (1,979,449)
========= =========== ============ ============= =============

Retained Accumulated
Earnings Unrealized Total
Substantially Gains(Losses), Treasury Stockholders'
Restricted net of tax Stock Equity
------------- -------------- ------------- -------------

Balance, December 31, 2000 $ 23,930,533 $ 591,418 $ (4,660,517) $ 39,763,411

Comprehensive results:
Net income 1,704,125 -- -- 1,704,125
Other comprehensive results, net of tax -- 525,040 -- 525,040
Allocation from shares purchased with loan to ESOP -- -- -- 282,654
Cash dividends declared on common stock (529,397) -- -- (529,397)
Repurchase of common stock -- -- (115,486) (115,486)
------------- -------------- ------------- -------------

Balance, December 31, 2001 25,105,261 1,116,458 (4,776,003) 41,630,347

Comprehensive results:
Net income 4,507,934 -- -- 4,507,934
Other comprehensive results, net of tax -- 421,961 -- 421,961
Loan to ESOP for purchase of common stock -- -- -- (1,051,980)
Allocation from shares purchased with loan to ESOP -- -- -- 273,978
Exercise of options -- -- -- 288,624
Issuance of common stock -- -- 4,776,003 51,185,535
Cash dividends declared on common stock (873,719) -- -- (873,719)
------------- -------------- ------------- -------------

Balance, December 31, 2002 28,739,476 1,538,419 -- 96,382,680

Comprehensive results:
Net income 3,390,566 -- -- 3,390,566
Other comprehensive results, net of tax -- (1,578,382) -- (1,578,382)
Allocation from shares purchased with loan to ESOP -- -- -- 287,717
Repurchase of common stock -- -- (9,801,707) (9,801,707)
Issuance of Recognition and Retention Plan stock -- -- 2,954,297 --
Vesting of Recognition and Retention Plan -- -- -- 974,848
Exercise of options (1,169,571) -- 1,319,364 149,793
Cash dividends declared on common stock (2,136,607) -- -- (2,136,607)
------------- -------------- ------------- -------------

Balance, December 31, 2003 $ 28,823,864 $ (39,963) $ (5,528,046) $ 87,668,908
============= ============== ============= =============

See notes to consolidated financial statements.

37

CITIZENS SOUTH BANKING CORPORATION

Consolidated Statements of Cash Flows

Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2003 2002 2001
------------- ------------- -------------

Operating Activities
Net Income $ 3,390,566 $ 4,507,934 $ 1,704,125
Adjustments to reconcile net income to net cash
provided by operating activities
Provision for loan losses 60,000 225,000 120,000
Depreciation 697,578 744,650 359,971
Deferred income tax (benefit) (238,800) 198,052 (46,000)
(Gain) loss on sale of investments available-for-sale (1,020,673) (243,233) 9,115
(Gain) loss on sale of other assets (1,213) (31,756) 422
Deferred loan origination fees 176,411 12,191 (228,188)
Amortization of intangible assets 404,000 963,000 --
Allocation of shares to the ESOP 287,717 273,978 282,654
Vesting of shares issued for the RRP Plan 974,848 -- --
(Increase) decrease in interest receivable (30,289) (185,996) 394,864
Purchase of bank-owned life insurance (6,000,000) -- (2,600,000)
Net (increase) decrease in other operating assets (89,342) 72,988 1,558,787
------------- ------------- -------------
Net cash (used in) provided by operating activities (1,389,197) 6,536,808 1,555,750

Investing Activities
Net decrease(increase) in loans made to customers 4,642,964 33,094,308 (4,865,741)
Proceeds from the sale of loans -- 1,418,648 --
Proceeds from the sale of premises
and equipment 25,000 26,281 196,131
Proceeds from the sale of investment securities 8,051,817 4,000,000 --
Proceeds from the sale of mortgage-backed
and related securities 12,153,771 5,043,176 1,256,834
Proceeds from sale of REO 1,014,791 300,357 --
Maturities and prepayments of investment
securities 16,109,679 6,856,814 12,821,204
Maturities and prepayments of mortgage-backed
and related securities 33,630,059 11,257,899 7,899,220
Purchases of investment securities (41,263,571) (24,200,000) (5,420,000)
Purchases of mortgage-backed and related
securities (65,652,143) (60,754,560) (9,041,182)
Purchases of FHLB stock (275,500) -- --
Proceeds from sale of FHLB stock -- 1,253,200 --
Acquisition of Innes Street Financial, net of cash acquired -- -- (19,174,273)
Purchases of premises and equipment (6,852,372) (934,824) (1,244,290)
------------- ------------- -------------
Net cash used in investing activities (38,415,505) (22,638,701) (17,572,097)

Financing Activities
Net increase (decrease) in deposits 1,583,744 (8,143,224) 10,411,725
Issuance of common stock -- 45,446,376 --
Dividends to stockholders (2,136,607) (873,719) (529,397)
Exercise of options 149,793 288,624 --
Repurchase of common stock (9,801,707) -- (115,486)
Advances from FHLB 17,800,000 7,500,000 5,000,000
Repayments of advances from FHLB (6,000,000) (1,500,000) (5,679,941)
Increase (decrease) in repurchase agreements (393,788) (481,510) 1,320,063
Decrease in advances from
borrowers for insurance and taxes (181,336) (75,180) (160,165)
------------- ------------- -------------
Net cash provided by financing activities 1,020,099 42,161,367 10,246,799

Net increase (decrease) in cash and cash equivalents (38,784,603) 26,059,474 (5,769,548)
Cash and cash equivalents at the beginning of the year 46,998,788 20,939,314 26,708,862
------------- ------------- -------------
Cash and cash equivalents at the end of the year $ 8,214,185 $ 46,998,788 $ 20,939,314
============= ============= =============

See notes to consolidated financial statements.

38

CITIZENS SOUTH BANKING CORPORATION

Notes to Consolidated Financial Statements

Note 1 - Organization and Summary of Significant Accounting Policies

Citizens South Banking Corporation (the "Company"), formerly Gaston Federal
Bancorp, Inc., is a stock holding company whose activities are primarily limited
to holding the stock of Citizens South Bank, formerly Gaston Federal Bank (the
"Bank"). The Bank is a community-oriented federal stock savings bank engaged
primarily in the business of offering deposits to customers through its branch
offices and investing those deposits, together with funds generated from
operations and borrowings, in residential, commercial and consumer loans and in
mortgage-backed and investment securities. The Bank's wholly-owned subsidiary,
Citizens South Financial Services, Inc. (doing business as Citizens South
Investment Services) acts as an independent agent selling various uninsured
financial products.

The Board of Directors of the Citizens South Holdings, MHC (the "MHC") a federal
mutual holding company which owned a majority of the Company's outstanding
shares of common stock, the Company and the Bank approved the Plan of Conversion
and Reorganization (the "Plan") on May 23, 2002. Pursuant to the Plan, the MHC
converted from the mutual holding company form of organization to the fully
public form and merged into the Bank. Pursuant to the plan, the Company, which
owns 100% of the Bank, was succeeded by a new Delaware corporation with the same
name, Citizens South Banking Corporation. As part of the conversion, shares of
common stock of Citizens South Banking Corporation representing the ownership
interest of the MHC were offered for sale in the offering. The existing publicly
held shares of the Company, which represented the remaining ownership interest
in the Company, were exchanged for new shares of common stock of Citizens South
Banking Corporation, the new Delaware corporation. The exchange ratio of 2.1408
shares of $0.01 par value common stock for each share of $1.00 par value common
stock ensured that immediately after the reorganization and the share exchange,
the public stockholders of the Company owned the same aggregate percentage of
Citizens South Banking Corporation common stock that they owned immediately
prior to the reorganization. At the time of the Conversion, the Bank established
a memo liquidation account in an amount equal to its equity for the benefit of
eligible account holders and supplemental eligible account holders who continue
to maintain their accounts at the Bank after the Conversion.

On September 30, 2002, the mutual-to-stock conversion of Citizens South
Holdings, MHC, and the related stock offering of the Mutual Holding Company's
ownership in Citizens South Banking Corporation were completed. In conjunction
with the stock offering, the Company sold 5,259,945 shares of common stock at
$10.00 per share, which represented the "super maximum" range of the stock
offering. Gross proceeds from the stock offering amounted to $52.6 million. Net
proceeds amounted to $45.5 million and reflect the following reductions from
gross proceeds: 1) $1.4 million in costs incurred related to the stock offering;
2) $1.0 million used to purchase stock for the ESOP; and 3) $4.7 million in
withdrawals from Citizens South Bank deposit accounts (the stock purchased by
the ESOP via loan and the application of deposits for shares are non-cash
financing activities).

39

CITIZENS SOUTH BANKING CORPORATION

Notes to Consolidated Financial Statements (Continued)

Note 1 - Organization and Summary of Significant Accounting Policies (continued)

As a result of the conversion, all historical financial information that is
based on or derived from the actual or average number of outstanding shares of
common stock during any period prior to September 30, 2002, has been
appropriately adjusted to reflect the exchange ratio of 2.1408-to-1. The
conversion was accounted for as a change in corporate form with no subsequent
change in historical basis for the Company's assets, liabilities and equity.

On December 31, 2001, Citizens South Banking Corporation completed its
acquisition of Innes Street Financial Corporation and its wholly-owned
subsidiary, Citizens Bank, Inc. As part of the acquisition, Innes Street's
stockholders received $18.50 per share for each of Innes Street's common stock
issued and outstanding. The aggregate purchase price for the transaction was
approximately $38 million. The transaction was accounted for using the purchase
method. See Note 2 for additional information.

The accounting and reporting policies of Citizens South Banking Corporation
follow accounting principles generally accepted in the United States of America
and policies within the financial services industry. The following is a summary
of the more significant policies.

Principles of Consolidation - The consolidated financial statements include the
accounts of Citizens South Banking Corporation, its wholly-owned subsidiary,
Citizens South Bank, and the Bank's wholly-owned subsidiary, Citizens South
Financial Services, Inc. All significant intercompany accounts and transactions
have been eliminated.

Use of Estimates - The financial statements are prepared in accordance with
accounting principles generally accepted in the United States of America which
require management to make estimates and assumptions that affect the amounts
reported in the financial statements and accompanying notes. Actual results
could differ from those estimates.

Cash and Cash Equivalents - The Company considers cash on hand, cash due from
banks, which are maintained in financial institutions, and interest-earning
deposits, which are maintained with the Federal Home Loan Bank (FHLB), as cash
and cash equivalents.

Securities - Management determines the appropriate classification of securities
at the time of purchase.

Securities classified as available-for-sale are carried at fair value. Such
securities are used to execute asset/liability management strategies and to
manage liquidity. Adjustments for unrealized gains or losses, net of related
income tax effect, are recorded as an addition or deduction from equity in the
form of other comprehensive results.

The Company has no securities classified as held-to-maturity.

Amortization of premiums and accretion of discounts are included in interest
income over the life of the related security, or in the case of mortgage-backed
and related securities, the estimated life of the security. Gains or losses on
the sale of securities are recognized on a specific identification, trade date
basis.

Loans and Allowance for Loan Losses - Loans are carried at their principal
amount outstanding. Income on loans is accrued based upon the outstanding
principal balance. Generally, loans are classified as nonaccrual, and the
accrual of interest is discontinued, when the contractual payment of principal
and interest has become 90 days past due or when, in management's judgment,
principal or interest is not collectible in accordance with the terms of the
obligation. Cash receipts on nonaccrual loans are applied to principal. The
accrual of interest resumes when the loan returns to performing status.

40

CITIZENS SOUTH BANKING CORPORATION

Notes to Consolidated Financial Statements (Continued)

Note 1 - Organization and Summary of Significant Accounting Policies (continued)

Loans and Allowance for Loan Losses (continued) - The Company evaluates
impairment of its residential mortgage and consumer loans on a collective basis.
For commercial loans, a loan is considered to be impaired when based on current
information, it is probable that the Company will not collect all amounts due in
accordance with contractual terms. Management monitors several internally
generated reports, including past due reports, payment histories, criticized
asset reports, which include loans with historical payment problems or borrowers
in troubled industries as well as other sources of information such as borrower
financial statements, the value collateral, etc. to identify impaired loans.
Discounted cash flow analyses or the estimated fair value of collateral are used
in determining the fair value of impaired loans. When the ultimate
collectibility of the principal balance of an impaired loan is in doubt, cash
receipts are applied to principal.

The allowance for loan losses is determined by management and maintained at a
level based on losses inherent in the portfolio that are probable and reasonably
estimated at the balance sheet date. Management's determination of the adequacy
of the allowance is based on an evaluation of the portfolio, historical loan
loss experience, availability and quality of collateral, changes in economic
conditions, and the quality of the loan portfolio. Loans are charged to the
allowance at the time they are determined to be losses. Subsequent recoveries
are credited to the allowance.

Mortgage Servicing Rights - Statement of Financial Accounting Standards ("SFAS")
No. 140 requires the recognition of mortgage servicing rights ("mortgage
servicing rights" or "MSRs") as assets by allocating total costs incurred
between the originated loan sold and the servicing rights retained based on
their relative fair values. MSRs are amortized in proportion to the servicing
income over the estimated life of the related mortgage loan using the interest
method.

Concentrations of Credit Risk - The Company makes loans to individuals and small
businesses primarily in Gaston, Rowan, and Iredell Counties, North Carolina and
surrounding counties. The Company has a diversified loan portfolio, and the
borrowers' ability to repay their loans is not dependent upon any specific
economic segment.

Premises and Equipment - Premises and equipment are stated at cost less
accumulated depreciation and amortization. Depreciation and amortization are
computed over the estimated useful lives of the assets (from 3 to 30 years)
primarily by the straight-line method. Leasehold improvements are amortized on a
straight-line basis over the shorter of the estimated useful life of the
improvement or the lease term.

Intangible Assets - Intangible assets with finite lives, primarily core deposit
intangibles, are amortized over their estimated useful life. Goodwill is not
amortized, but is evaluated for impairment on an annual basis.

Other Real Estate Owned - Other real estate owned is comprised of real estate
properties acquired in partial or total satisfaction of problem loans. The
properties are recorded at the lower of cost or fair value less estimated costs
to sell at the date acquired. Losses arising at the time of acquisition of such
properties are charged against the allowance for loan losses. Subsequent
write-downs that may be required to the carrying value of these properties are
charged to noninterest expenses. Gains and losses realized from the sale of
other real estate owned are included in noninterest income.

Loan Origination Fees - Origination fees received and direct costs incurred are
deferred and amortized to interest income over the contractual lives of the
loans, using the level yield method.

41

CITIZENS SOUTH BANKING CORPORATION

Notes to Consolidated Financial Statements (Continued)

Note 1 - Organization and Summary of Significant Accounting Policies (continued)

Income Taxes - Deferred income taxes reflect the net tax effects of temporary
differences between the carrying amounts of assets and liabilities for financial
reporting purposes and the amounts used for income tax purposes. Amounts
provided for deferred income taxes relate primarily to differences between tax
and financial reporting for unrealized gains and losses on securities
available-for-sale, allowances for loan losses, depreciation, and deferred
compensation.

Advertising - Advertising costs are expensed as incurred.

Reclassifications - Certain of the prior year amounts have been reclassified to
conform to current year presentation; such reclassifications are immaterial to
the financial statements.

Comprehensive Income - SFAS No. 130, Reporting Comprehensive Income, establishes
standards for the reporting and display of comprehensive income and its
components in financial statements. SFAS No. 130 defines comprehensive income as
net income, as currently reported, as well as unrealized gains and losses on
assets available for sale and certain other items not currently included in the
income statement. The disclosure requirements of SFAS No. 130 have been included
in the Consolidated Statements of Comprehensive Income.

Operating Segments - SFAS No. 131, Disclosures about Segments of an Enterprise
and Related Information, establishes standards for the way public business
enterprises report information about operating segments. This statement also
establishes standards for related disclosures about products, services,
geographic areas and major customers. In adopting SFAS No. 131, the Company has
determined that, using the definitions contained in the statement, all of its
activities constitute only one reportable operating segment.

Business Combinations - SFAS No. 141, Business Combinations, establishes
standards for the financial accounting and reporting for business combinations
and supersedes APB Opinion No. 16, Business Combinations, and FASB Statement No.
38, Accounting for Preacquisition Contingencies of Purchased Enterprises. The
provisions of this statement apply to business combinations initiated after June
30, 2001. All business combinations are to be accounted for using the purchase
method. The reporting and disclosure requirements of SFAS No. 141 have been
included in the financial statements.

Goodwill and Other Intangible Assets - SFAS No. 142, Goodwill and Other
Intangible Assets, requires that goodwill and intangible assets with indefinite
useful lives no longer be amortized, but instead tested for impairment at least
annually in accordance with its provisions. SFAS No. 142 also requires that
intangible assets with definite useful lives be amortized over their respective
estimated useful lives to their estimated residual values. In connection with
adoption of SFAS No. 142, the Company is required to perform an initial
assessment of whether there is an indication that goodwill is impaired. During
the second quarter of 2002, the Company completed its initial analysis of
potential impairment under the provisions of SFAS No. 142, and determined based
on that analysis that goodwill was not impaired. The Company also completed its
annual impairment tests at December 31, 2003 and 2002 and determined based on
that analysis that goodwill was not impaired. Goodwill will be tested for
impairment annually, or between annual tests if an event occurs or circumstances
change that would more likely than not reduce the fair value of a reporting unit
below its carrying amount. The Company had no goodwill related to acquisitions
initiated prior to July 1, 2001, or other intangible assets recorded prior to
the adoption of the provisions of SFAS No. 142 whose carrying amounts or
amortization were changed by the adoptions of the provisions of SFAS No. 142.

42

CITIZENS SOUTH BANKING CORPORATION

Notes to Consolidated Financial Statements (Continued)

Note 1 - Organization and Summary of Significant Accounting Policies (continued)

SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB
Statement No. 13, and Technical Corrections, was issued in April 2002. The
adoption of the provisions of this statement did not have a significant effect
on the consolidated financial statements of the Company.

SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities,
was issued in June 2002 and addresses financial accounting and reporting for
costs associated with exit or disposal activities. This statement is effective
for exit or disposal activities initiated after December 31, 2002 and did not
have a material impact on the consolidated financial statements of the Company.

SFAS No. 148, Accounting for Stock-Based Compensation - Transition and
Disclosure - An Amendment of FASB Statement No. 123, was issued in December 2002
and provides alternative methods of transition for a voluntary change to the
fair value based method of accounting for stock-based employee compensation. In
addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to
require prominent disclosures in both annual and interim financial statements
about the method of accounting for stock-based employee compensation and the
effect of the method used on reported results.

The Company applies the provisions of Accounting Principles Board Opinion No. 25
in accounting for the plans and accordingly, no compensation expense has been
recognized in connection with the granting of the stock options. In accordance
with SFAS No. 123, Accounting for Stock-Based Compensation, the Company adopted
the disclosure-only option and elected to apply the provisions of APB No. 25 for
financial statement purposes. The Company recognizes compensation expense for
fixed awards with pro rata vesting on a straight-line basis.

Had the compensation cost for the Company's stock option plan been determined in
accordance with the fair-value accounting provisions of SFAS No. 123, net
income, basic earnings per share, and diluted earnings per share would have been
as follows (note that all earnings per share numbers in 2001 have been adjusted
to the reflect the exchange ratio of 2.1408-to-1):

Year Ended Year Ended Year Ended
December 31 December 31 December 31
2003 2002 2001
------------- ------------- -------------
Net income:
As reported $ 3,390,566 $ 4,507,934 $ 1,704,125
Pro forma $ 3,278,341 $ 4,398,801 $ 1,600,118
Basic earnings per share:
As reported $ 0.39 $ 0.51 $ 0.20
Pro forma $ 0.38 $ 0.50 $ 0.18
Diluted earnings per share:
As reported $ 0.39 $ 0.51 $ 0.20
Pro forma $ 0.37 $ 0.50 $ 0.18

The fair value of each option grant is estimated on the date of grant using the
Black-Scholes option-pricing model with the following weighted average
assumptions used for the year ended December 31, 2003: dividend yield of 1.848%,
expected volatility of 30%, a risk-free interest rate of 3.500%, and expected
lives of 5 years. The following weighted average assumptions were used for the
year ended December 31, 2002: dividend yield of 3.27%, expected volatility of
34%, a risk-free interest rate of 5.00%, and expected lives of 7 years. The
following weighted average assumptions were used for the years ended December
31, 2001; dividend yield of 2.08%, expected volatility of 22%, a risk-free
interest rate of 6.00%, and expected lives of 7 years for the options.

43

CITIZENS SOUTH BANKING CORPORATION

Notes to Consolidated Financial Statements (Continued)

Note 1 - Organization and Summary of Significant Accounting Policies (continued)

FASB Statement No. 149, Amendment of Statement 133 on Derivative Instruments and
Hedging Activities, was issued in April 2003 and amends SFAS No. 133 for certain
decisions made by the Financial Accounting Standards Board as part of the
Derivatives Implementation Group process and to clarify the definition of a
derivative. This statement is effective for contracts entered into or modified
after June 30, 2003, except for certain specific issues already addressed by the
Derivatives Implementation Group and declared effective that are included in the
statement. The adoption of the provisions of this statement did not have a
material impact on the consolidated financial statements of the Company.

FASB Statement No. 150, Accounting for Certain Financial Instruments with
Characteristics of Both Liabilities and Equity, was issued in May 2003 and
establishes standards for how to classify and measure certain financial
instruments with characteristics of both liabilities and equity. This statement
is effective for financial instruments entered into or modified after May 31,
2003, and otherwise is effective at the beginning of the first interim period
beginning after June 15, 2003. The adoption of the provisions of this statement
did not have a material impact on the consolidated financial statements of the
Company.

FASB Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements
for Guarantees, Including Guarantees of Indebtedness of Others an interpretation
of FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No.
34 was issued in November 2002 and elaborates on the disclosures to be made by a
guarantor in its interim and annual financial statements about its obligations
under certain guarantees that it has issued. It also clarifies that a guarantor
is required to recognize, at the inception of a guarantee, a liability for the
fair value of the obligation undertaken in issuing the guarantee. The adoption
of the provisions of this FASB Interpretation did not have a material impact on
the consolidated financial statements of the Company.

FASB Interpretation No. 46, Consolidation of Variable Interest Entities an
interpretation of ARB No. 51 as amended by FASB Interpretation No. 46R, was
issued in January 2003 and addresses consolidation by business enterprises of
variable interest entities. The Company does not have interests in variable
interest entities as defined by this Interpretation and therefore, the adoption
of the provisions of this FASB Interpretation did not have a material impact on
the consolidated financial statements of the Company.

Note 2 - Business Combination

On December 31, 2001, the Company acquired 100% of the outstanding shares of
common stock of Innes Street Financial Corporation and its wholly-owned
subsidiary, Citizens Bank. Accordingly, the results of operations of Innes
Street Financial Corporation have been included in the consolidated financial
statements of the Company since the acquisition effective at the close of
business, December 31, 2001.

As part of the acquisition, Innes Street's stockholders received $18.50 per
share for each share of Innes Street's common stock issued and outstanding. The
aggregate purchase price for the transaction was approximately $38 million.

Innes Street Financial Corporation and its subsidiary have served the Salisbury,
North Carolina area for over ninety years by providing this community and
surrounding counties with general banking services. As a result of the
acquisition, the Company will expand its market reach and provide its banking
products in new markets in North Carolina that it had previously not been
servicing.

44

CITIZENS SOUTH BANKING CORPORATION

Notes to Consolidated Financial Statements (Continued)

Note 2 - Business Combination (continued)

At the time of the acquisition, the Company recorded an intangible asset of
$2,872,000 due to the assets acquired from Innes Street. Of the $2,872,000 of
intangible assets, $2,447,000 was assigned to core deposit premium, which is
being amortized over a 7-year life on an accelerated basis. The remaining
intangibles relate to mortgage servicing rights. Goodwill of $6,581,000
represents the excess of the purchase price over the fair value of assets
acquired and liabilities assumed, none of which is deductible for income tax
purposes.

Note 3 - Investment Securities

The aggregate book and fair values, as well as gross unrealized gains and
losses, of investment securities as of December 31 were as follows:

December 31, 2003
----------------------------------------------------
Book Unrealized Unrealized Fair
Value Gains Losses Value
----------------------------------------------------
Investment securities Available for Sale
- ----------------------------------------

U.S. Treasury and other agencies $ 35,476,026 387,200 (17,909) 35,845,317

Municipals 11,048,565 324,965 (9,493) 11,364,037

FHLMC stock 2,200 126,104 -- 128,304

Corporate bonds 2,000,000 -- -- 2,000,000

Trust preferred securities 2,000,000 -- -- 2,000,000

FNMA preferred stock 2,000,000 -- (361,770) 1,638,230

FHLMC preferred stock 2,051,806 -- (139,791) 1,912,015

Other equity securities 1,252,617 92,620 -- 1,345,237
------------ ---------- ---------- ----------

Total available-for-sale $ 55,831,214 930,889 (528,963) 56,233,140
============ ========== ========== ==========

December 31, 2003
---------------------------------------------------
Book Unrealized Unrealized Fair
Value Gains Losses Value
---------------------------------------------------
Mortgage-backed and related securities Available-for-Sale
- ---------------------------------------------------------

FNMA $56,528,234 125,231 (429,795) 56,223,670

GNMA 4,746,663 4,877 (21,919) 4,729,621

CMO 2,972,800 -- (17,270) 2,995,530

SBA's 1,551,636 -- (6,276) 1,545,361

FHLMC 23,836,379 105,262 (227,679) 23,713,961
----------- ---------- ---------- ----------
Total mortgage-backed and
Related securities $89,635,712 235,370 (702,939) 89,168,143
=========== ========== ========== ==========

45

CITIZENS SOUTH BANKING CORPORATION

Notes to Consolidated Financial Statements (Continued)

Note 3 - Investment Securities (continued)

December 31, 2002
--------------------------------------------------------
Book Unrealized Unrealized Fair
Value Gains Losses Value
--------------------------------------------------------
Investment securities Available for Sale
- ----------------------------------------

U.S. Treasury and other agencies $ 25,052,753 $ 567,878 $ -- $ 25,620,631

Municipals 7,413,046 283,925 (8,013) 7,688,958

FHLMC stock 19,200 1,114,560 -- 1,133,760

Trust preferred securities 2,000,000 -- -- 2,000,000

Other equity securities 3,244,208 13,637 (107,247) 3,150,598
------------ ----------- ----------- ------------

Total available-for-sale $ 37,729,207 $ 1,980,000 $ (115,260) $ 39,593,947
============ =========== =========== ============

December 31, 2002
--------------------------------------------------------
Book Unrealized Unrealized Fair
Value Gains Losses Value
--------------------------------------------------------
Mortgage-backed and related securities Available-for-Sale
- ---------------------------------------------------------

FNMA $ 33,951,075 $ 289,856 $ (13,752) $ 34,227,179

GNMA 9,408,318 126,846 (1,506) 9,533,658

SBA's 1,719,851 -- (18,704) 1,701,147

FHLMC 24,667,415 281,796 (2,307) 24,946,904
------------ ----------- ----------- ------------
Total mortgage-backed and
Related securities $ 69,746,659 $ 698,498 $ (36,269) $ 70,408,888
============ =========== =========== ============

46

CITIZENS SOUTH BANKING CORPORATION

Notes to Consolidated Financial Statements (Continued)

Note 3 - Investment Securities (continued)

The book value and estimated fair value of debt securities at December 31, 2003,
by contractual maturity, are shown below. Expected maturities will differ from
contractual maturities because borrowers may have the right to call or prepay
obligations with or without call or prepayment penalties.

December 31, 2003
-------------------------

Book Fair
Value Value
-------------------------
Available-for-Sale
- ------------------

Due in one year or less $ 4,205,732 4,247,243

Due after one year through five years 30,964,091 31,206,947

Due after five years through ten years 5,945,175 6,237,103

Due after ten years 9,409,593 9,518,061

Equities 5,306,623 5,023,786
------------ ----------

$ 55,831,214 56,233,140
============ ==========

Mortgage-backed and related securities $ 89,635,712 89,168,143
============ ==========

Gross realized gains on the sale of securities available for sale were
$1,105,627, $256,661 and $0 for the years ended December 31, 2003, December 31,
2002, and December 31, 2001, respectively. Gross realized losses on the sale of
securities available for sale were $84,954, $13,428 and $9,115 for the years
ended December 31, 2003, December 31, 2002, and December 31, 2001, respectively.
After-tax net gains (losses) on the sale of securities were $653,231, $155,669
and $(5,834) for the years ended December 31, 2003, December 31, 2002, and
December 31, 2001, respectively.

Investment securities having a carrying amount of approximately $11,205,000 have
been pledged as collateral to secure public deposits at December 31, 2003.
Investment securities having a carrying amount of $2,000,000 have been pledged
as collateral for repurchase agreements at December 31, 2003.

47

CITIZENS SOUTH BANKING CORPORATION

Notes to Consolidated Financial Statements (Continued)

Note 3 - Investment Securities (continued)

The unrealized losses and fair value of the investments by investment type
segregated between those that have been in a continuous unrealized loss position
for less than twelve months and more than twelve months are as follows:

December 31, 2003
---------------------------------------------------------------------------------------
Less than 12 months 12 months or more Total
-------------------------- ------------------------- ----------------------------
Fair Unrealized Fair Unrealized Fair Unrealized
Description of Securities Value Loss Value Loss Value Loss
- ------------------------- ------------ ----------- ----------- ----------- ------------ -------------

US Treasury obligations
and direct obligations
of US government
agencies $ 7,981,023 $ (17,909) $ -- $ -- $ 7,981,023 $ (17,909)

Municipals 1,778,144 (9,493) -- -- 1,778,144 (9,493)

Federal agency mortgage
backed securities 62,299,543 (696,663) 1,541,026 (6,276) 63,840,569 (702,939)

Corporate bonds -- -- -- -- -- --
Subtotal, debt securities 72,058,710 (724,065) 1,541,026 (6,276) 73,599,736 (730,341)

Preferred stock 1,912,015 (139,791) 1,638,230 (361,770) 3,550,245 (501,561)
------------ ----------- ----------- ----------- ------------ -------------
Total temporarily
impaired securities $ 73,970,725 $ (863,856) $ 3,179,256 $ (368,046) $ 77,149,981 $ (1,231,902)
============ =========== =========== =========== ============ =============

The Company holds a variable-rate FNMA preferred stock issue, which is in an
unrealized loss position of $361,770 at December 31, 2003, and has been in a
continuous unrealized loss position for greater than twelve months. The Company
does not consider the FNMA preferred stock to be other-than-temporarily impaired
due to the nature of the stock. This stock is issued by a government sponsored
enterprise with high credit ratings. In addition, a significant portion of the
value of the stock is derived from the variable dividend rate and the income tax
exclusion of seventy percent of the preferred stock dividends received. The
Company expects that as interest rates rise, the price of the preferred stock
will also increase as the dividend rate and the corresponding tax advantage
increase.

48

CITIZENS SOUTH BANKING CORPORATION

Notes to Consolidated Financial Statements (Continued)

Note 4 - Loans and Allowance for Loan Losses

The following is a summary of loans outstanding by category at December 31:

2003 2002
------------ ------------

Real estate:

One-to-four family residential $114,121,093 $148,843,298

Multi-family residential 11,516,945 8,961,744

Commercial mortgage 70,479,361 52,053,943

Construction 15,635,508 15,321,560

Land 20,391,707 9,930,316

Commercial 13,935,517 12,084,201

Consumer 58,534,853 61,213,368
------------ ------------
Gross loans 304,614,984 308,408,430

Less:

Loans in process 6,585,877 5,418,729

Deferred loan fees, net 34,251 89,406

Allowance for loan losses 2,968,510 2,994,576
------------ ------------
Net loans $295,026,346 $299,905,719
============ ============

The Company evaluates impairment of its residential mortgage and consumer loans
on a collective basis. Commercial loans individually evaluated and considered
impaired under SFAS No. 114 at December 31, 2003 and 2002 were immaterial.

Changes in the allowance for loan losses for the years ended December 31, 2003,
December 31, 2002 and December 31, 2001 were as follows:

Year Ended Year Ended Year Ended
December December December
2003 2002 2001
----------- ----------- -----------

Balance at beginning of year $ 2,994,576 $ 3,136,058 $ 1,566,298

Reserve acquired in acquisition -- -- 1,553,099
Provision for loan losses 60,000 225,000 120,000
Loans charged off (94,008) (383,515) (104,282)
Recoveries on loans previously charged off 7,942 17,033 943
----------- ----------- -----------
Balance at end of year $ 2,968,510 $ 2,994,576 $ 3,136,058
=========== =========== ===========

49

CITIZENS SOUTH BANKING CORPORATION

Notes to Consolidated Financial Statements (Continued)

Note 4 - Loans and Allowance for Loan Losses (continued)

Directors, executive officers, and associates of such persons were customers of
and had transactions with the Bank in the ordinary course of business. Included
in such transactions are outstanding loans and commitments, all of which were
made under normal credit terms and did not involve more than normal risk of
collection. The aggregate amounts of these loans were $7,630,171 and $3,604,217
at December 31, 2003 and 2002, respectively. During the year ended December 31,
2003, new loans of $1,984,678 were made, payments totaled $1,387,759 and seven
previously existing loans in the aggregate amount of $3,429,035 to newly
appointed directors of the Company's subsidiary Bank were included at December
31, 2003. During the year ended December 31, 2002, new loans of $1,694,356 were
made and payments totaled $631,876.

The Bank held no loans for sale at December 31, 2003 and 2002.

Note 5 - Premises and Equipment

Premises and equipment at December 31 are summarized as follows:

2003 2002
----------- -----------

Land $ 4,542,235 $ 2,846,805
Buildings 10,559,124 6,186,770
Land Improvements 289,599 110,715
Furniture and equipment 3,173,267 2,754,801
----------- -----------
18,564,225 11,899,091

Less: accumulated depreciation 3,625,407 3,092,179
----------- -----------
$14,938,818 $ 8,806,912
=========== ===========

Note 6 - Bank Owned Life Insurance

The Company owns bank-owned life insurance to fund certain employee benefit
plans. The Company purchased $6,000,000 of bank-owned life insurance during the
year ended December 31, 2003, $2,600,000 in bank-owned life insurance during the
year ended December 31, 2001 and acquired approximately $800,000 in bank-owned
life insurance in the acquisition of Innes Street Financial Corporation
effective December 31, 2001. The bank-owned life insurance policies are recorded
in other assets at their cash surrender values of $12,317,201 and $6,833,628 at
December 31, 2003 and 2002, respectively.

50

CITIZENS SOUTH BANKING CORPORATION

Notes to Consolidated Financial Statements (Continued)

Note 7 - Intangible Assets

Amortized intangible assets at December 31, 2003 and 2002 are summarized as
follows:

December 31, 2003 December 31, 2002
----------------- -----------------

Core deposit intangible $2,447,000 $2,447,000
Mortgage servicing rights 673,896 673,896
---------- ----------
3,120,896 3,120,896

Less: accumulated amortization 1,807,098 1,132,914
---------- ----------
$1,313,798 $1,987,982
========== ==========

Amortization expense for intangible assets subject to amortization was $485,337
during the year ended December 31, 2003 and $1,102,873 during the year ended
December 31, 2002 since the majority of these intangibles were recognized on
December 31, 2001 in connection with the acquisition of Innes Street Financial
Corporation as described in Note 2. The fair value of MSRs at December 31, 2003
and 2002 approximated carrying value. The total amount of loans serviced for
others at December 31, 2003 and December 31, 2002 were $17,550,135 and
$33,503,785, respectively.

Estimated amortization expense for the next five succeeding fiscal years ending
December 31 are as follows:

2004 $ 393,000
2005 $ 327,000
2006 $ 264,000
2007 $ 197,798
2008 $ 132,000

The balance of goodwill was $6,670,522 at December 31, 2003 and 2002.

Note 8 - Deposits

Deposit balances and interest expense and average rates paid for the years ended
December 31, 2003, December 31, 2002, and December 31, 2001 are summarized as
follows:

December 31, December 31,
2003 2002
---------------------------------------- ------------------------------------------
Actual Interest Average Actual Interest Average
Balance Expense Rate Balance Expense Rate
------------- --------- ------- ------------- ----------- -------

Noninterest bearing $ 12,906,002 -- -- $ 11,203,428 $ -- --
Interest bearing checking 30,779,656 91,383 0.3% 25,772,621 93,452 0.4%
Money market deposit 48,188,873 549,917 1.3% 35,810,998 497,398 1.5%
Savings 36,754,570 305,298 0.8% 43,670,086 637,769 1.4%
Certificates of deposit 213,816,575 5,554,763 2.6% 224,404,799 6,733,190 2.9%
------------- --------- ------- ------------- ----------- -------
$ 342,445,676 6,501,361 1.9% $ 340,861,932 $ 7,961,809 2.3%
============= ========= ======= ============= =========== =======

51

CITIZENS SOUTH BANKING CORPORATION

Notes to Consolidated Financial Statements (Continued)

Note 8 - Deposits (continued)

December 31,
2001
-------------------------------------------
Actual Interest Average
Balance Expense Rate
------- ------- ----
Noninterest bearing $ 7,952,755 $ -- --
Interest bearing checking 25,329,824 186,098 1.2%
Money market deposit 29,489,123 459,947 2.7%
Savings 44,011,250 398,268 2.1%
Certificates of deposit 246,909,362 6,328,376 5.4%
------------- ----------- -------
$ 353,692,314 $ 7,372,689 4.2%
============= =========== =======

Contractual maturities of certificates of deposit as of December 31, 2003 and
2002 are as follows:

2003 2002
---- ----
Under 1 year $176,956,932 $169,266,978
1 to 2 years 25,646,184 36,368,520
2 to 3 years 4,134,446 12,739,157
3 to 4 years 5,869,583 6,030,144
4 years or greater 1,209,430 --
------------ ------------
$213,816,575 $224,404,799
============ ============

Certificates of deposit in excess of $100,000 totaled $56,639,500 and
$49,140,313 at December 31, 2003 and 2002, respectively, and may not be fully
insured by the FDIC. Interest paid on deposits and other borrowings was
$10,400,401 and $10,382,999 for the years ended December 31, 2003 and 2002,
respectively.

Directors, executive officers, and associates of such persons were customers of
and had transactions with the Bank in the ordinary course of business. Included
in such transactions are deposit accounts, all of which were made under normal
terms. The aggregate amount of these deposit accounts was $1,668,391 and
$3,333,855 at December 31, 2003 and 2002, respectively.

The deposits of the Bank are insured by the Savings Association Insurance Fund
(SAIF), one of two funds administered by the FDIC. The Bank's annual SAIF
premium rates were $0.016, $0.0204, and $0.0204 per $100 of deposits for the
years ended December 31, 2003, December 31, 2002 and December 31, 2001,
respectively.

Note 9 - Advances from the Federal Home Loan Bank

Advances from the Federal Home Loan Bank of Atlanta are pursuant to lines of
credit and are collateralized by a lien on qualifying first mortgage loans in an
amount necessary to satisfy outstanding indebtedness plus accrued interest.
Advances had interest rates ranging from 1.18% to 6.25% at December 31, 2003 and
1.95% to 6.60% at December 31, 2002. The total amount available on the line of
credit is 25% of total assets of the Bank. The unused portion of the line of
credit available to the Company at December 31, 2003 was approximately
$65,000,000.

52

CITIZENS SOUTH BANKING CORPORATION

Notes to Consolidated Financial Statements (Continued)

Note 9 - Advances from the Federal Home Loan Bank (continued)

Maturities of advances at December 31 are as follows:

2003 2002
----------- -----------
Advances from FHLB due:

Less than 1 year $21,300,000 $ 6,000,000

1 to 2 years 10,000,000 6,500,000

2 to 3 years 4,000,000 7,000,000

3 to 4 years 2,000,000 --

4 to 5 years 8,000,000 --

5 to 10 years 13,000,000 27,000,000

After 10 years -- --
----------- -----------
$58,300,000 $46,500,000
=========== ===========

Interest rates on certain convertible advances may be reset on certain dates at
the option of the Federal Home Loan Bank in accordance with the terms of the
note. The Bank has the option of repaying the outstanding advance or converting
the interest rate from a fixed rate to a floating rate at the time the advance
is called by the Federal Home Loan Bank. The Bank has one $5.0 million advance
that will be callable quarterly beginning November 2005 until it matures in
November 2012. The Bank also has three other advances that have a one-time call
option. Two advances totaling $8.0 million may be called in 2004 and one $5.0
million advance may be called in 2005.

During the year ended December 31, 2003, the Company refinanced $15.0 million of
advances with the Federal Home Loan Bank to take advantage of significantly
lower finance rates. As a result of the early extinguishment of the advances,
the Company paid a prepayment penalty of approximately $1.2 million.

The Company also has a $2,000,000 line of credit with First Charter Bank with no
outstanding balance at December 31, 2003.

Note 10 - Income Taxes

The provision for income taxes is summarized below:

Year Ended Year Ended Year Ended
December December December
2003 2002 2001
----------- ----------- ----------

Currently payable

Federal $ 1,457,207 $ 1,978,000 $ 734,730

State 238,000 352,000 13,000
----------- ----------- ----------
1,695,207 2,330,000 747,730

53

CITIZENS SOUTH BANKING CORPORATION

Notes to Consolidated Financial Statements (Continued)

Note 10 - Income Taxes (continued)

Year Ended Year Ended Year Ended
December December December
2003 2002 2001
----------- ----------- ----------
Deferred

Federal (229,800) 207,052 (37,000)

State (9,000) (9,000) (9,000)
----------- ----------- ----------

(238,800) 198,052 (46,000)
----------- ----------- ----------

Total income taxes $ 1,456,407 $ 2,528,052 $ 701,730
=========== =========== ==========

The reasons for the difference between consolidated income tax expense and the
amount computed by applying the statutory federal income tax rate of 34% to
income before income taxes were as follows:

Year Ended Year Ended Year Ended
December December December
2003 2002 2001
----------- ----------- ----------

Federal income taxes at statutory rate $ 1,648,000 $ 2,392,000 $ 818,000

State income taxes, net of federal benefit 151,000 226,000 (2,000)

Effect of federal tax exempt interest (112,000) (92,000) (91,000)

Effect of earnings on life insurance (161,000) (109,000) (116,000)

Other (69,593) 111,052 92,730
----------- ----------- ----------
$ 1,456,407 $ 2,528,052 $ 701,730
=========== =========== ==========
Effective tax rate 30.2% 35.9% 29.2%
=========== =========== ==========

Income taxes receivable are included in other assets and were $200,170 and
$253,786 at December 31, 2003 and 2002, respectively. Income taxes paid for the
years ended December 31, 2003 and 2002 were $1,680,000 and $2,530,000,
respectively.

54

CITIZENS SOUTH BANKING CORPORATION

Notes to Consolidated Financial Statements (Continued)

Note 10 - Income Taxes (continued)

The tax effects of temporary differences that give rise to significant portions
of deferred tax assets and liabilities at December 31 are as follows:

2003 2002
---------------------------
Deferred tax assets

Deferred compensation $ 1,132,374 $ 1,036,156

Allowance for loan losses 1,196,047 1,171,478

Excess carrying value of liabilities
assumed for financial reporting
purposes over tax basis -- 49,663

Other 117,552 175,114
----------- -----------
Gross deferred tax assets 2,445,973 2,432,411

Deferred tax liabilities

Excess carrying value of assets acquired
for financial reporting purposes over
tax basis 1,112,913 1,477,478

Deferred loan fees 181,650 160,074

Unrealized gain on securities

Available-for-sale -- 988,550

Other 13,698 --
----------- -----------

Gross deferred tax liabilities 1,307,661 2,626,102
----------- -----------

Net deferred tax asset (liability) $ 1,138,312 $ (193,691)
=========== ===========

The Company, in accordance with SFAS No. 109, did not record a deferred tax
liability of approximately $3,140,000 as of December 31, 2003 related to the
cumulative special bad debt deduction for savings and loan associations
recognized for income tax reporting prior to September 30, 1988, Citizen South
Bank's base year.

Management believes that the Company will fully realize deferred tax assets
based on future taxable temporary differences, refundable income taxes from
carryback years, and current levels of operating income.

55

CITIZENS SOUTH BANKING CORPORATION

Notes to Consolidated Financial Statements (Continued)

Note 11 - Commitments

Commitments to extend credit are agreements to lend as long as there is no
violation of any condition established in the contract. Commitments generally
have fixed expiration dates or other termination clauses and may require payment
of a fee. Since commitments may expire without being drawn upon, the total
commitment amounts do not necessarily represent future cash requirements. These
commitments represent no more than normal lending risk that the Bank commits to
its borrowers and management believes that these commitments can be funded
through normal operations. Commitments to extend credit as of December 31 are as
follows:

2003 2002
------------ ------------

Residential mortgage loan commitments $ 2,215,000 $ 3,674,100

Non-residential mortgage loan commitments 23,668,000 2,450,000

Commercial loan commitments 1,125,000 1,780,000

Consumer loan commitments 577,400 920,686

Unused lines of credit

Commercial 23,631,000 12,492,446

Consumer 47,013,000 44,332,632

The Bank began construction on a new building to be utilized as its headquarters
during the year. At December 31, 2003, the Bank had outstanding commitments of
approximately $3.8 million for the completion of the project.

Note 12 - Regulatory Capital Requirements

The Bank is subject to various regulatory capital requirements administered by
the federal banking agencies. Under the capital adequacy guidelines and the
regulatory framework for prompt corrective action, the Bank must meet specific
capital guidelines that involve quantitative measures of assets, liabilities,
and certain commitments as calculated under regulatory accounting practices. The
capital amounts and classification are also subject to qualitative judgments by
the regulators about components, risk weightings and other factors. Failure to
meet minimum capital requirements can initiate certain mandatory, and possibly
discretionary, actions by regulators that, if undertaken, could have a direct
material effect on the Bank's financial statements.

The Bank is required to maintain: tangible capital of at least 1.5% of adjusted
total assets; core capital of at least 4.0% of adjusted total assets; and total
capital of at least 8.0% of risk weighted assets. At December 31, 2003, the
Bank's tangible capital and core capital were both $61,389,000 or 12.65% of
tangible assets, and total capital was $64,415,000 or 18.38% of risk-weighted
assets. The Company's primary regulator, the Office of Thrift Supervision,
informed the Bank that it was in the well-capitalized category as of the most
recent regulatory examination, and management is not aware of any events that
have occurred since that would have changed its classification.

56

CITIZENS SOUTH BANKING CORPORATION

Notes to Consolidated Financial Statements (Continued)

Note 12 - Regulatory Capital Requirements (continued)

To Be Well
Capitalized Under
For Capital Prompt Corrective
Actual Adequacy Purposes Action Provisions
------------------- ---------------- -----------------
Amount Ratio Amount Ratio Amount Ratio
-------- ----- ------ ----- ------ ------
(dollars in thousands) (dollars in thousands) (dollars in thousands)

As of December 31, 2003

Total Risk-Based Capital
(to Risk-Weighted Assets) $ 64,415 18.38% 28,037 8.00% 35,046 10.00%

Tier 1 Capital
(to Risk-Weighted Assets) 61,389 17.52% 14,019 4.00% 21,028 6.00%

Tier 1 Capital
(to Adjusted Total Assets) 61,389 12.65% 19,409 4.00% 24,261 5.00%

Tangible Capital
(to Adjusted Total Assets) 61,389 12.65% 7,278 1.50% 14,556 3.00%

As of December 31, 2002

Total Risk-Based Capital
(to Risk-Weighted Assets) $ 60,801 19.69% 24,702 8.00% 30,877 10.00%

Tier 1 Capital
(to Risk-Weighted Assets) 57,304 18.56% 12,351 4.00% 18,526 6.00%

Tier 1 Capital
(to Adjusted Total Assets) 57,304 11.92% 19,232 4.00% 24,040 5.00%

Tangible Capital
(to Adjusted Total Assets) 57,304 11.92% 7,212 1.50% 14,424 3.00%

On May 23, 2002, the MHC approved a Plan of Conversion and Reorganization. As a
result of the Conversion, the Bank established a memo liquidation account in an
amount equal to its equity at the time of the Conversion of approximately $44
million for the benefit of eligible account holders and supplemental eligible
account holders who continue to maintain their accounts at the Bank after the
Conversion. In the event of a complete liquidation of the Bank, each eligible
account holder and supplemental eligible account holder will be entitled to
receive a distribution from the liquidation account in an amount proportionate
to the current adjusted qualifying balances for accounts then held. As a result,
stockholders' equity is substantially restricted at December 31, 2003 and 2002.

57

CITIZENS SOUTH BANKING CORPORATION

Notes to Consolidated Financial Statements (Continued)

Note 13 - Employee Benefit Plans

The Bank provides supplemental benefits to substantially all employees through a
401(k) savings plan. Effective January 1, 2002, eligible participants may
contribute up to 75% of eligible compensation, with the Bank providing matching
contributions of 50% of employee contributions up to 6% of eligible
compensation. Prior to January 1, 2002, eligible participants were allowed
contribute up to 15% of eligible compensation, with the Bank providing matching
contributions of 50% of employee contributions up to 6% of compensation. The
plan also provides for discretionary employer contributions. During 2003, 2002
and 2001, no discretionary employer contributions were made to the 401(k) plan.
Total expense relating to this plan was $106,973 for the year ended December 31,
2003, $93,032 for the year ended December 31, 2002 and $62,314 for the year
ended December 31, 2001.

The Bank also maintains nonqualified deferred compensation and/or supplemental
retirement plans for certain of its directors. During 2001, the Bank added a
similar plan for certain executive officers. Total expense for the plans was
$737,483 for the year ended December 31, 2003, $312,182 for the year ended
December 31, 2002 and $300,199 for the year ended December 31, 2001.

Prior to the acquisition at December 31, 2001, Citizens Bank maintained
non-qualified deferred compensation plans for key employees and directors: a
diversified and a non-diversified plan. These plans have been adopted by
Citizens South Bank. The eligible employees may defer a portion of their
compensation and the directors may defer a portion of their directors' fees. The
deferred assets are maintained in rabbi trusts, which are included in Other
Assets of the Company. The assets are accounted for at market value in
accordance with SFAS Statement No. 115, Accounting for Certain Investments in
Debt and Equity Securities, with the resulting gains or losses in value recorded
in income. The corresponding change in fair value of the deferred compensation
obligation is recorded as compensation expense.

2003 Recognition and Retention Plan ("RRP") - Pursuant to resolutions of the
Board of Directors of Citizens South Banking Corporation adopted on August 18,
2003, and the subsequent approval by the stockholders of the Company on October
23, 2003, the Company has adopted and implemented the Citizens South Banking
2003 Recognition and Retention Plan (the "Recognition and Retention Plan") with
a total of 210,398 shares. On November 3, 2003, the following awards of
restricted stock were made under the 2003 Recognition and Retention Plan:
Restricted Stock as to 196,560 shares as follows: 63,060 restricted shares to
six holding company non-employee directors; 127,500 restricted shares to seven
senior executives of the Bank; and 6,000 restricted shares to three
non-executive vice presidents of the Bank, all shares vesting over a seven-year
period commencing on the date of the award, at the rate of 30% immediately, 10%
on January 2, 2004, 10% on November 3, 2005, and 10% per year on November 3 of
each year thereafter. The fair market value of the restricted stock on November
3, 2003, was $15.04 per share. During 2003, there were a total of 196,560
restricted shares granted, of which 58,968 vested on November 3, 2003, and no
shares forfeited. At December 31, 2003, there remain 13,838 restricted shares
unissued and available for grants under the 2003 Recognition and Retention Plan.

1999 Stock Option Plan - On April 12, 1999, the Company's shareholders approved
the Citizens South Bank 1999 Stock Option Plan that provided the issuance of
211,335 options for directors and officers to purchase the Company's common
stock. Pursuant to the mutual holding company conversion and reorganization
completed on September 30, 2002, each share of the $1.00 par value common stock
of Citizens South Banking Corporation (the former Federal corporation) was
exchanged for 2.1408 shares of $0.01 par value common stock of the Citizens
South Banking Corporation (the new Delaware Corporation), which preserved the
previous shareholders' interest in Citizens South Banking Corporation. Thus, the
options for 211,335 shares of common stock in the 1999 Stock Option Plan were
exchanged for options for 452,425 shares, with the exercise prices of previously
granted options adjusted according to the same ratio.

58

CITIZENS SOUTH BANKING CORPORATION

Notes to Consolidated Financial Statements (Continued)

Note 13 - Employee Benefit Plans (continued)

During 2003, there were a total of 19,993 incentive options granted under the
1999 Stock Option Plan. At December 31, 2003, there remain 541 options unissued
and available for grants under the 1999 Stock Option Plan.

2003 Stock Option Plan - Pursuant to resolutions of the Board of Directors of
Citizens South Banking Corporation adopted on August 18, 2003, and the
subsequent approval by the stockholders of the Company on October 23, 2003, the
Company has adopted and implemented the Citizens South Banking Corporation 2003
Stock Option Plan (the "2003 Stock Option Plan"), with a total of 525,995 shares
available for grant. On November 3, 2003, the following awards of stock options
were made under the 2003 Stock Option Plan: Non-statutory options as to 157,020
shares as follows: 136,020 non-statutory options at $15.04 to six holding
company non-employee directors, with the five-year vesting requirement
satisfied; 12,000 non-statutory options at $15.04 to six subsidiary bank
non-employee directors, with the five-year vesting period beginning September
15, 2003 (fully vested September 15, 2008); and 9,000 non-statutory options at
$15.04 to nine county advisory board members, vesting over a five-year period at
20% per year, commencing on the initial date of the optionee's service on the
county advisory board of the Bank (as early as December 31, 2001). Incentive
options as to 360,000 shares as follows: 280,000 incentive options at $15.04 to
seven senior executives of the Bank, vesting over a five-year period at 20% per
year, commencing on the initial date of the optionee's employment with the Bank
or its predecessor, Gaston Federal Bank (excluding service to the former
Citizens Bank, Inc.); and 80,000 incentive options at $5.04 to 18 non-executive
officer vice presidents of the Bank, vesting over a five-year period at 20% per
year, commencing on the initial date of the optionee's employment by the Bank or
its predecessor, Gaston Federal Bank (excluding service to the former Citizens
Bank, Inc.). During 2003, there were a total of 517,020 options granted, all at
the market price of the stock on the date of grant, no reload options issued, no
options forfeited, and no options exercised under the 2003 Stock Option Plan. At
December 31, 2003, there remain 8,975 options unissued and available for grants
under the 2003 Stock Option Plan.

The following is a summary of stock option activity and related information for
the years ended December 31, 2003, 2002 and 2001.

Year Ended December 31, 2003 Year Ended December 31, 2002 Year Ended December 31, 2001
---------------------------- ---------------------------- ----------------------------
Weighted Avg. Weighted Avg. Weighted Avg.
Options Exercise Price Options Exercise Price Options Exercise Price
--------- ------------- ------- ------------- ------- -------------

Outstanding-
Beginning of period 380,401 $ 5.73 410,494 $ 5.63 410,949 $ 5.63
Granted 598,803 14.81 21,407 7.26 -- --
Exercised (168,251) 5.605 (51,500) 5.605 -- --
Forfeited -- -- -- -- --
--------- ---------- ------- ---------- ------- ----------
Outstanding-end of
period 810,953 $ 7.00 380,401 $ 5.73 410,494 $ 5.63
========= ========== ======= ========== ======= ==========
Exercisable-end of
period 690,795 $ 12.27 294,451 $ 5.63 287,826 $ 5.62
========= ========== ======= ========== ======= ==========
Weighted average
fair value of
options granted
during the period $ 3.69 $ 1.60 $ --
========== ========== ==========

59

CITIZENS SOUTH BANKING CORPORATION

Notes to Consolidated Financial Statements (Continued)

Note 13 - Employee Benefit Plans (continued)

Exercise prices for options outstanding as of December 31, 2003 ranged from
$5.605 to $15.04. Exercise prices for options outstanding as of December 31,
2002 ranged from $5.61 to $7.27. The weighted average remaining contractual life
of those options is approximately four years at December 31, 2003 and three
years at 2002.

Employee Stock Ownership Plan - The Bank established an Employee Stock Ownership
Plan (ESOP). The ESOP is a tax-qualified retirement plan designed to invest
primarily in the Company's common stock. All full-time employees of the Bank who
have completed one year of service with the Bank will be eligible to participate
in the ESOP. The ESOP utilized funds borrowed from the Company totaling
$1,690,680, to purchase approximately 8%, or 169,068 shares of the Company's
common stock issued in the 1998 Conversion. The ESOP utilized funds borrowed
from the Company totaling $1,051,980 to purchase 105,198 additional shares of
the Company's common stock issued in the 2002 Conversion. The loans to the ESOP
will be primarily repaid with contributions from the Bank to the ESOP over a
period not to exceed 15 years for each loan. Under the terms of the ESOP, the
Bank makes contributions to the ESOP sufficient to cover all payments of
principal and interest as they become due. The 1998 loan had an outstanding
balance of $1,014,907 with an interest rate of 4.00% and $1,127,119 with an
interest rate of 4.25% at December 31, 2003 and 2002, respectively. The interest
rate on the loan is based on the Bank's prime rate. The 2002 loan had an
outstanding balance of $911,716 with an interest rate of 4.00% and $981,848 with
an interest rate of 4.25% at December 31, 2003 and 2002, respectively.

Shares purchased with the loan proceeds are held in a suspense account by the
trustee of the plan for future allocation among participants as the loan is
repaid. Contributions to the ESOP and shares released from the suspense account
are allocated among participants on the basis of compensation as described in
the plan. The number of shares released to participants will be determined based
upon the percentage of principal and interest payments made during the year
divided by the total remaining principal and interest payments including the
current year's payment. Participants will vest in the shares allocated to their
respective accounts over a period not to exceed 5 years. Any forfeited shares
are allocated to the then remaining participants in the same proportion as
contributions. As of December 31, 2003, 122,636 shares have been allocated to
participants and 279,702 shares remain unallocated. The fair value of the
unallocated shares was $3,901,843 at December 31, 2003. The Company recognizes
compensation expense attributable to the ESOP ratably over the fiscal year based
upon the estimated number of ESOP shares to be allocated each December 31st. The
Company recognized $219,333, $145,305, and $315,000 as compensation expense in
the years ended December 31, 2003, December 31, 2002 and December 31, 2001,
respectively.

The trustee for the ESOP must vote all allocated shares held in the ESOP trust
in accordance with the instructions of the participants. Unallocated shares held
by the ESOP trust are voted by the trustee in a manner calculated to most
accurately reflect the results of the allocated ESOP shares voted, subject to
the requirements of the Employee Retirement Income Security Act of 1974, as
amended (ERISA).

Note 14 - Fair Value of Financial Instruments

The following methods and assumptions were used by the Company in estimating its
fair value disclosures for financial instruments. In cases where quoted market
prices are not available, fair values are based on estimates using present value
or other valuation techniques. The estimates are significantly affected by the
assumptions used, including discount rates and estimates of future cash flows.
These estimates may differ substantially from amounts that could be realized in
an immediate sale or settlement of the instrument.

60

CITIZENS SOUTH BANKING CORPORATION

Notes to Consolidated Financial Statements (Continued)

Note 14 - Fair Value of Financial Instruments (continued)

Fair value approximates book value for the following financial instruments due
to their short-term nature: cash and due from banks, interest-earning bank
balances, and advances from customers for taxes and insurance.

Fair value for investment securities and mortgage-backed and related securities
are based on quoted market prices. If a quoted market price is not available,
fair value is estimated using market prices for similar securities.

Fair value for variable rate loans that reprice frequently is based on the
carrying value reduced by an estimate of credit losses inherent in the
portfolio. Fair value for all other loans is estimated by discounting their
future cash flows using interest rates currently being offered for loans of
comparable terms and credit quality.

Fair value for demand deposit accounts and interest-bearing accounts with no
fixed maturity is equal to the carrying value. Certificate of deposit fair
values are estimated by discounting cash flows from expected maturities using
interest rates currently being offered for similar instruments.

The carrying amount of repurchase agreements approximates fair value due to the
short-term nature of the agreements.

Fair value for the advances from the Federal Home Loan Bank Board is based on
discounted cash flows using current interest rates.

At December 31, 2003 and 2002, the Company had outstanding unfunded commitments
to extend credit offered in the normal course of business. Fair values of these
commitments are based on fees currently charged for similar instruments. At
December 31, 2003 and 2002, the carrying amounts and fair values of these
off-balance sheet financial instruments were immaterial.

The Company has used management's best estimates of fair values of financial
instruments based on the above assumptions. This presentation does not include
certain financial instruments, nonfinancial instruments or certain intangible
assets such as customer relationships, deposit base intangibles, or goodwill.
Accordingly, the aggregate fair value amounts presented do not represent the
underlying value of the Company. The estimated fair values of financial
instruments as of December 31 were as follows:

2003 2002
--------------------------- ---------------------------
Carrying Estimated Carrying Estimated
Amount Fair Value Amount Fair Value
----------- ----------- ----------- -----------

Financial assets
Cash and due from banks $ 5,374,150 $ 5,374,150 $ 7,606,918 $ 7,606,918
Interest-earning bank balances 2,840,035 2,840,035 39,391,870 39,391,870
Investments and mortgage-
backed securities 145,401,283 145,401,283 110,002,835 110,002,835
Loans 295,026,346 297,407,462 299,905,719 308,059,946

Financial liabilities
Deposits 342,445,676 349,743,577 340,861,932 362,762,003
Repurchase agreements 681,394 681,394 1,075,182 1,075,182
Advances from FHLB 58,300,000 59,928,212 46,500,000 50,182,876

61

CITIZENS SOUTH BANKING CORPORATION

Notes to Consolidated Financial Statements (Continued)

Note 15 - Earnings per share

Earnings per share has been determined under the provisions of SFAS No. 128,
Earnings Per Share. Basic earnings per share is computed by dividing net income
applicable to common stock by the weighted average number of common shares
outstanding during the period, without considering any dilutive items. Diluted
earnings per share is computed by dividing net income applicable to common stock
by the weighted average number of common shares and common stock equivalents for
items that are dilutive, net of shares assumed to be repurchased using the
treasury stock method. Common stock equivalents arise from the assumed
conversion of outstanding stock options.

The only potential stock of the Company as defined in SFAS No. 128, are stock
options granted to various directors and officers of the Bank and unvested RRP
shares. The following is a summary of the computation of basic and diluted
earnings per share (note all earnings per share amounts for 2001 have been
adjusted to reflect the 2.1408-to-1 conversion which occurred in 2002):

Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2003 2002 2001
------------ ------------ ------------

Net income $ 3,390,566 $ 4,507,934 $ 1,704,125

Weighted average outstanding shares 8,623,838 8,767,982 8,745,626

Basic earnings per share $ 0.39 $ 0.51 $ 0.20

Weighted average outstanding shares 8,623,838 8,767,982 8,745,626

Dilutive effect of stock options 138,707 102,072 40,637
------------ ------------ ------------

Weighted average diluted shares 8,762,545 8,870,054 8,786,263

Diluted earnings per share $ 0.39 $ 0.51 $ 0.20

Options to purchase 426,620 shares of common stock at $15.04 per share were
outstanding since November 2003 but were not included in the computation of
diluted earnings per share because the options' exercise price was greater than
the average market price of the common shares. These options will expire in
November 2013.

On October 9, 1998, the Company's Board of Directors announced the authorization
to repurchase up to 105,668 shares of outstanding common stock under the 1998
Stock Repurchase Plan. On April 19, 1999, the Company's Board of Directors
announced the authorization to repurchase 295,869 shares of outstanding common
stock for the 1999 Stock Option Plan and the 1999 Recognition and Retention
Plan. On May 23, 2000, the Company's Board of Directors announced the
authorization to repurchase up to 92,539 shares of outstanding common stock. On
March 28, 2003, the Company's Board of Directors announced the authorization to
repurchase of up to 343,027 shares of outstanding common stock under the 2003
Stock Option Repurchase Plan. During October 2003, the Company's Board of
Directors announced the authorization to repurchase up to 879,900 shares of
outstanding common stock under the October 2003 Repurchase Plan.

As of December 31, 2003, 1,067,035 shares have been repurchased under these
plans at an average price of $13.58 per share.

62

CITIZENS SOUTH BANKING CORPORATION

Notes to Consolidated Financial Statements (Continued)

Note 16 - Parent-Only Financial Information

The earnings of the Bank are recognized by Citizens South Banking Corporation
using the equity method of accounting. Accordingly, undistributed earnings of
the Bank are recorded as increases in the Company's investment in the Bank. The
following are the condensed financial statements of the Company as of December
31, 2003 and 2002 and for the years ended December 31, 2003, 2002 and 2001.

Condensed Statements of Financial Condition

December 31, December 31,
2003 2002
------------ ------------

Assets
Cash and cash equivalents $ 15,190,646 $ 28,332,114
Investment in securities available-for-sale 3,095,237 961,644
Investment in subsidiary 69,140,517 67,034,481
Other assets 362,655 185,735
------------ ------------
Total assets $ 87,789,055 $ 96,513,974
============ ============

Liabilities and Stockholders' Equity
Liabilities $ 120,147 $ 131,294
Stockholders' Equity 87,668,908 96,382,680
------------ ------------
Total liabilities and stockholders' equity $ 87,789,055 $ 96,513,974
============ ============

Condensed Statements of Operations

Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2003 2002 2001
------------ ------------ ------------

Interest income $ 474,295 $ 255,815 $ 75,772
Interest expense -- (26,865) --
Other operating income 10,177 81,592 --
Other operating expenses (980,671) (94,346) (74,481)
------------ ------------ ------------

Income before income taxes and undistributed
earnings from subsidiaries (496,199) 216,196 1,291
Income taxes (204,995) (83,162) (200)
------------ ------------ ------------

Income before undistributed earnings from
subsidiaries (291,204) 133,034 1,091
Equity in undistributed earnings of subsidiaries 3,681,770 4,374,900 1,703,034
------------ ------------ ------------

Net income $ 3,390,566 $ 4,507,934 $ 1,704,125
============ ============ ============

63

CITIZENS SOUTH BANKING CORPORATION

Notes to Consolidated Financial Statements (Continued)

Note 16 - Parent-Only Financial Information (continued)

Condensed Statements of Cash Flows

Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2003 2002 2001
------------ ------------ ------------

Operating activities
Net income $ 3,390,566 $ 4,507,934 $ 1,704,125
Adjustments to reconcile net income to net
Cash provided by operating activities
(Gain) on sale of investments -- (81,592) --
Equity in undistributed (earnings) loss of subsidiaries (3,681,770) (4,374,900) (1,703,034)
Allocation of shares to ESOP 287,717 273,998 282,654
Vesting of shares issued for the RRP 974,848 -- --
Decrease (increase) in other operating
subsidiaries (14,772) (48,551) (62,391)
(Decrease) increase in other operating
liabilities (309,536) 84,972 9,336
------------ ------------ ------------

Net cash provided by operating activities 647,053 361,861 230,690

Investing activities
Purchase of investments available-for-sale (2,000,000) (94,117) --
Acquisition of Innes Street Financial Corp., net of
cash acquired -- -- (22,607,382)
------------ ------------ ------------

Net cash used in investing activities (2,000,000) (94,117) (22,607,382)

Financing activities
Issuance of additional common stock -- 50,133,534 --
Repurchase of common stock (9,801,707) -- (115,486)
Contributed capital to bank subsidiary -- (23,124,612) --
Dividends received from bank subsidiary -- -- 22,555,137
Exercise of options 149,793 -- --
Dividends to stockholders (2,136,607) (873,719) (529,397)
------------ ------------ ------------

Net cash (used in) provided by financing
activities (11,788,521) 26,135,203 21,910,254

Net increase (decrease) in cash and cash equivalents (13,141,468) 26,402,947 (466,438)
Cash and cash equivalents, beginning of period 28,332,114 1,929,167 2,395,605
------------ ------------ ------------
Cash and cash equivalents, end of period $ 15,190,646 $ 28,332,114 $ 1,929,167
============ ============ ============

64

ITEM 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure

None.

ITEM 9A. Controls and Procedures

Under the supervision and with the participation of the Company's
management, including the Company's Chief Executive Officer and Chief Financial
Officer, the Company has evaluated the effectiveness of the design and operation
of its disclosure controls and procedures (as defined in Rule 13a-15(e) and
15d-15(e) under the Exchange Act) as of the end of the period covered by this
report. Based upon that evaluation, the Chief Executive Officer and Chief
Financial Officer concluded that, as of the end of the period covered by this
report, the Company's disclosure controls and procedures were effective to
ensure that information required to be disclosed in the reports that the Company
files or submits under the Exchange Act is recorded, processed, summarized and
reported, within the time periods specified in the SEC's rules and forms.

There has been no change in the Company's internal control over financial
reporting identified in connection with the quarterly evaluation that occurred
during the Company's last fiscal quarter that has materially affected, or is
reasonably likely to materially affect, the Company's internal control over
financial reporting.

PART III

ITEM 10. Directors and Executive Officers of the Registrant

The "Proposal I - Election of Directors" section of the Registrant's
Definitive Proxy Statement dated April 2, 2004, (the "Proxy Statement") as filed
pursuant to Section 14 of the Securities Exchange Act of 1034 in connection with
the 2003 Annual Meeting of Shareholders is incorporated herein by reference. In
addition, the Item 1. "Executive Officers of the Registrant" section of the
Proxy Statement is incorporated herein by reference.

ITEM 11. Executive Compensation

The "Proposal I - Election of Directors" section of the Registrant's Proxy
Statement is incorporated herein by reference.

ITEM 12. Security Ownership of Certain Beneficial Owners and Management

The "Proposal I - Election of Directors" section of the Registrant's Proxy
Statement is incorporated herein by reference.

ITEM 13. Certain Relationships and Related Transactions

The "Proposal I - Election of Directors" section of the Registrant's Proxy
Statement is incorporated herein by reference.

ITEM 14. Principal Accountant Fees and Services

The "Principal Accountant's Fees and Services" section of this
Registrant's Proxy Statement is incorporated herein by reference.

65

ITEM 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K

A. Index of Exhibits

3.1 Certificate of Incorporation of Citizens South Banking Corporation
(incorporated herein by reference to the Registration Statement on Form S-1
(File No. 333-91498), originally filed with the Commission on June 28, 2002

3.2 Bylaws of Citizens South Banking Corporation (incorporated herein by
reference to the Registration Statement on Form S-1 (File No. 333-91498),
originally filed with the Commission on June 28, 2002

4 Form of Common Stock Certificate of Citizens South Banking Corporation
(incorporated herein by reference to the Registration Statement on Form S-1
(File No. 333-91498), originally filed with the Commission on June 28, 2002

10.1 Employment Agreement with Kim S. Price (incorporated by reference to
the Registration Statement on Form SB-2 (File No. 333-42951), originally filed
with the Commission on December 22, 1997

10.2 Deferred Compensation and Income Continuation Agreement (incorporated
by reference to the Registration Statement on Form SB-2 (File No. 333-42951),
originally filed with the Commission on December 22, 1997

10.3 Employee Stock Option Plan (incorporated by reference to the
Registration Statement on Form SB-2 (File No. 333-42951), originally filed with
the Commission on December 22, 1997

10.4 Supplemental Executive Retirement Plan (incorporated by reference to
the Registration Statement on Form SB-2 (File No. 333-42951), originally filed
with the Commission on December 22, 1997

10.5 Form of Merger/Protection Agreement with Gary F. Hoskins
(incorporated herein by reference to the Registration Statement on Form S-1
(File No. 333-91498), originally filed with the Commission on June 28, 2002

10.6 Form of Merger/Protection Agreement with Paul L. Teem, Jr.
(incorporated herein by reference to the Registration Statement on Form S-1
(File No. 333-91498), originally filed with the Commission on June 28, 2002

10.7 Form of Merger/Protection Agreement with Michael R. Maguire
(incorporated herein by reference to the Registration Statement on Form S-1
(File No. 333-91498), originally filed with the Commission on June 28, 2002

14 Code of Ethics Policy (incorporated herein by reference to the
"Proposal I - Election of Directors" section of the Registrant's Proxy Statement
dated April 2, 2004

21 Subsidiaries of Registrant (incorporated herein by reference to the
Registration Statement on Form S-1 (File No. 333-91498), originally filed with
the Commission on June 28, 2002

23 Consent of Cherry, Bekaert & Holland, L.L.P.

24 Power of Attorney (set forth on signature page)

31 Certification of Chief Executive Officer and Chief Financial Officer
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32 Statement of Chief Executive Officer and Chief Financial Officer
furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

66

Signatures

Pursuant to the requirements of Section 13 of 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.

Citizens South Banking Corporation

Date: March 15, 2004 By: /s/ Kim S. Price
-------------------------------------
Kim S. Price
President and Chief Executive Officer

Pursuant to the requirements of the Securities Exchange of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.

By: /s/ Kim S. Price By: /s/ Gary F. Hoskins
--------------------------------- ---------------------------------
Kim S. Price Gary F. Hoskins
President, Chief Executive Executive Vice President,
Officer and Director (Principal Treasurer and Chief Financial
Executive Officer) Officer (Principal Financial
and Accounting Officer)

Date: March 15, 2004 Date: March 15, 2004

By: /s/ David W. Hoyle By: /s/ Ben R. Rudisill, II
----------------------------- ---------------------------------
David W. Hoyle Ben R. Rudisill, II
Chairman Vice Chairman

Date: March 15, 2004 Date: March 15, 2004

By: /s/ Martha B. Beal By: /s/ Charles D. Massey
----------------------------- ---------------------------------
Martha B. Beal Charles D. Massey
Director Director

Date: March 15, 2004 Date: March 15, 2004

By: /s/ James J. Fuller By: /s/ Eugene R. Matthews, II
----------------------------- ---------------------------------
James J. Fuller Eugene R. Matthews, II
Director Director

Date: March 15, 2004 Date: March 15, 2004

67