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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 year ended December 31, 2003

Commission File Number: 001-15089

Fidelity BancShares (N.C.), Inc.

(Exact name of Registrant as specified in its charter)

(919) 552-2242

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

8.50% Capital Securities issued by FIDBANK Capital Trust I

8.50% Junior Subordinated Debentures, issued by Registrant

Securities registered pursuant to Section 12(g) of the Act:

NONE

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 filing requirements for the past ninety 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 definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

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

        The aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold as of the last business day of the Registrant’s most recently completed second fiscal quarter was $24,842,500. (There is no established market, published quotes or reported prices for the Registrant’s common equity. The market value of shares held by non-affiliates has been calculated based on prices known to management of the Registrant in privately negotiated transactions.)

Common Stock - $25 Par Value, - 28,011 shares

(Number of shares outstanding, by class, as of March 22, 2004)

PART I

ITEM 1 – BUSINESS

General. Fidelity BancShares (N.C.), Inc. (BancShares), headquartered in Fuquay-Varina, North Carolina, was organized under the laws of Delaware on November 13, 1987 as a registered bank holding company for The Fidelity Bank (the Bank). BancShares operates through the Bank, which provides a variety of retail and commercial banking products and services to individuals and small to medium-sized businesses in the communities it serves. Certain statistical information with respect to BancShares’ business required by Guide 3 is contained in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Item 8. Financial Statements and Supplementary Data” which appears elsewhere in this filing.

Members of the Holding family, including Lewis R. Holding, have been actively involved in the management of BancShares. As a result, BancShares has been managed from a long-term perspective with primary emphasis being placed on balance sheet liquidity, loan quality, and earnings stability. Consistent with its management philosophy, BancShares has emphasized a low-risk loan portfolio derived from its local markets. (See Item 12. Security Ownership of Certain Beneficial Owners and Management.)

All significant activities of BancShares and its subsidiary are banking-related so that BancShares operates within one industry. Neither BancShares nor its subsidiary has any foreign operations.

The Bank is a state-chartered commercial bank. Its predecessor bank, Bank of Fuquay, was organized during 1909 and merged with Bank of Biscoe during 1970, at which time the continuing bank’s name was changed to The Fidelity Bank. The Bank currently operates 66 banking offices in 51 separate central North Carolina and Virginia communities, 24 of which have been opened or acquired from other institutions within the past five fiscal years. Most recently, during 2003 the Bank purchased an aggregate of $33.4 million in assets and assumed an aggregate of $113.5 million in deposit liabilities, associated with four branch offices of a related financial institution, First-Citizens Bank & Trust Company, Raleigh, North Carolina (FCB), and during 2001 the bank purchased an aggregate of $5.8 million in assets and assumed an aggregate of $49.5 million in deposit liabilities associated with three branch offices of First Union National Bank. Additionally, during 2001, the Bank opened 3 de novo branch offices. There were no de novo branches opened in 2002 or 2003.

The Bank has two wholly-owned subsidiaries, Fidelity Properties, Inc. and TFB Financial Services. TFB Financial Services, Inc. (TFB Financial Services), formerly Servco Service Corporation, was acquired on September 1, 1996 in the acquisition of Perpetual State Bank and provides non-deposit investment products, including mutual funds, annuities, stocks, and bonds. Fidelity Properties currently is inactive.

During 1999, BancShares formed FIDBANK Capital Trust I as a Delaware business trust (the trust) as a wholly-owned finance subsidiary. The trust sold $23,000,000 in preferred trust securities to the public and used the proceeds from that sale, together with the proceeds from the trust’s sale of all its common securities to BancShares, to purchase an aggregate of $23,711,350 in junior subordinated debentures issued by BancShares. The debentures call for interest payable quarterly at a rate of 8.50% per annum, with principal payable in full during 2029, and may be redeemed by BancShares in whole or in part on or after June 30, 2004. BancShares owns all of the trust’s common securities. Subject to certain limitations, BancShares has fully and unconditionally guaranteed the trust’s obligations under its preferred trust securities. Since its organization, BancShares has treated the trust as a consolidated subsidiary for financial statement purposes, and the trust’s assets and liabilities have been included in BancShares’ consolidated financial statements. However, as a result of the application of Financial Accounting Standards Board Interpretation No. 46, as revised (FIN 46R), as of December 31, 2003, BancShares has deconsolidated the trust. Additional information regarding FIN 46R and the effect of the deconsolidation of the trust is contained in Note 1(o) to BancShares’ consolidated financial statements, which are contained in Item 8 of this report.

BancShares’ principal executive offices are located at 100 South Main Street, Fuquay-Varina, North Carolina 27526 and its telephone number is (919) 552-2242. BancShares’ internet website is www.fidelitybankwelcome.com. BancShares’ Annual Reports on Form 10-K and other filings under the Securities Exchange Act of 1934 are available on the U.S. Securities and Exchange Commission’s website at www.sec.gov.

Description of Business. The Bank is a community-oriented bank which is engaged in a general commercial and consumer banking business. Its operations are primarily retail oriented and directed towards individuals and small- to medium-sized

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businesses in its market area. While the Bank provides most traditional commercial and consumer banking services, its principal activities are the taking of demand and time deposits and the making of secured and unsecured loans. The Bank’s deposits are insured by the Federal Deposit Insurance Corporation (FDIC) to the maximum amount permitted by law.

The Bank is focused on community-oriented banking via (i) localized lending, (ii) core deposit funding, (iii) conservative balance sheet management, and (iv) stable growth. The Bank’s franchise is well diversified, serving both large cities and small rural towns in North Carolina and Virginia. By outsourcing its core data processing requirements to FCB (see Item 13. Certain Relationships and Related Transactions), the Bank can offer a complete array of financial services while maintaining its community banking orientation. The Bank’s focus on diverse markets and its emphasis on customer service provide it with a stable source of core funding.

The Bank’s primary source of revenue is interest income from its lending activities. Since it commenced business, the Bank has pursued a strategy of growth through internal expansion by establishing branch offices in communities in its geographic market and by acquiring smaller institutions or offices of other institutions in its existing markets or in new markets.

Competition. Commercial banking in North Carolina and Virginia is highly competitive. In its market areas, the Bank competes directly with a number of local, regional and superregional banking organizations. Competition among financial institutions for loans and deposits is based, to a large extent, on interest rates charged or paid. Fees and charges for other services, office location, the quality of customer services, community reputation and continuity of personnel, and, in the case of loans to large commercial borrowers, relative lending limits, also are important competitive factors. Many of the Bank’s competitors have greater resources, broader geographic markets and higher lending limits and offer more services than the Bank, and they can better afford and make more effective use of media advertising, support services and electronic technology than can the Bank. The Bank depends on its reputation in its local community, direct customer contact, its ability to make credit and other business decisions locally, and personalized service to counter these competitive disadvantages.

In recent years, federal and state legislation has heightened the competitive environment in which all financial institutions must conduct their business, and the potential for competition among financial institutions of all types has increased significantly. Additionally, with the elimination of restrictions on interstate banking, a North Carolina commercial bank may be required to compete not only with other North Carolina financial institutions, but also with out-of-state financial institutions which may acquire North Carolina institutions and are able to provide certain financial services across state lines, thereby adding to the competitive atmosphere of the industry in general.

Employees. At December 31, 2003, the Bank employed 392 full-time employees and 31 part-time employees. The Bank is not a party to any collective bargaining agreements and considers relations with its employees to be good. BancShares does not have any separate employees.

Supervision and Regulation. The business and operations of BancShares and the Bank are subject to extensive federal and state governmental regulation and supervision.

BancShares is a bank holding company registered with the Federal Reserve Board (the FRB) under the Bank Holding Company Act of 1956, as amended (the BHCA). It is subject to supervision and examination by, and the regulations and reporting requirements of, the FRB. Under the BHCA, a bank holding company’s activities are limited to banking, managing or controlling banks, or engaging in any other activities which the FRB determines to be closely related and a proper incident to banking or managing or controlling banks. The internal affairs of BancShares, including the rights of its shareholders, are governed by Delaware law and by its Articles of Incorporation and Bylaws. BancShares files periodic reports under the Securities Exchange Act of 1934 and is subject to the jurisdiction of the Securities and Exchange Commission.

The BHCA prohibits a bank holding company from acquiring direct or indirect control of more than 5.0% of the outstanding voting stock, or substantially all of the assets, of any financial institution, or merging or consolidating with another bank holding company or savings bank holding company, without prior approval of the FRB. Additionally, the BHCA generally prohibits bank holding companies from engaging in, or acquiring ownership or control of more than 5.0% of the outstanding voting stock of any company that engages in a non-banking activity unless that activity is determined by the FRB to be closely related and a proper incident to managing or controlling banks.

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There are a number of obligations and restrictions imposed by law on a bank holding company and its insured bank subsidiaries that are designed to minimize potential loss to depositors and the FDIC insurance funds. For example, if a bank holding company’s insured bank subsidiary becomes “undercapitalized,” the bank holding company is required to guarantee (subject to certain limits) the subsidiary’s compliance with the terms of any capital restoration plan filed with its federal banking agency. A bank holding company is required to serve as a source of financial strength to its bank subsidiaries and to commit resources to support those banks in circumstances where it otherwise might not do so, absent such policy. Under the BHCA, the FRB may require a bank holding company to terminate any activity or to relinquish control of a non-bank subsidiary if the FRB determines that the activity or control constitutes a serious risk to the financial soundness and stability of a bank subsidiary of the bank holding company.

Regulation of the Bank. The Bank is an insured, state-chartered bank. Its deposits are insured by the FDIC’s Bank Insurance Fund, and it is subject to supervision and examination by, and the regulations and reporting requirements of, the Federal Deposit Insurance Corporation (the FDIC) and the North Carolina Commissioner of Banks (the Commissioner). The Bank is not a member of the Federal Reserve System.

As an insured bank, the Bank is prohibited from engaging as a principal in an activity that is not permitted for national banks unless (1) the FDIC determines that the activity would pose no significant risk to the deposit insurance fund and (2) the Bank is, and continues to be, in compliance with all applicable capital standards. Insured banks also are prohibited from directly acquiring or retaining any equity investment of a type or in an amount not permitted for national banks.

The Commissioner and the FDIC regulate all areas of the Bank’s business, including its payment of dividends and other aspects of its operations. They conduct regular examinations of the Bank, and the Bank must furnish periodic reports to the Commissioner and the FDIC containing detailed financial and other information regarding its affairs. The Commissioner and FDIC have broad powers to enforce laws and regulations that apply to the Bank and to require corrective action of conditions that affect its safety and soundness. Among others, these powers include issuing cease and desist orders, imposing civil penalties, removing officers and directors, and the ability otherwise to intervene in the operation and management of the Bank if examinations of and reports filed by the Bank reflect the need to do so.

Even though it is not a member of the Federal Reserve System, the business of the Bank is influenced by the monetary and fiscal policies of the FRB. The actions and policy directives of the FRB determine to a significant degree the cost and the availability of funds obtained from money market sources for lending and investing and also influence, directly and indirectly, the rates of interest paid by commercial banks on their time and savings deposits. Additionally, the Bank’s earnings are affected by general economic conditions, management policies, changes in state and Federal legislation and actions of various regulatory authorities, including those referred to above.

The following paragraphs summarize some of the other significant statutes and regulations that affect BancShares and the Bank, but they are not a complete discussion of all the laws that affect their business. Each paragraph is qualified in its entirety by reference to the particular statutory or regulatory provision or proposal being described.

Gramm-Leach-Bliley Act. The federal Gramm-Leach-Bliley Act (the GLB Act) adopted by Congress during 1999 dramatically changed various federal laws governing the banking, securities and insurance industries. The GLB Act expanded opportunities for banks and bank holding companies to provide services and engage in other revenue-generating activities that previously were prohibited to them.

The GLB Act permits bank holding companies to become “financial holding companies” and, in general (1) expands opportunities to affiliate with securities firms and insurance companies; (2) overrides certain state laws that would prohibit certain banking and insurance affiliations; (3) expands the activities in which banks and bank holding companies may participate; (4) requires that banks and bank holding companies engage in some activities only through affiliates owned or managed in accordance with certain requirements; and (5) reorganizes responsibility among various federal regulators for oversight of certain securities activities conducted by banks and bank holding companies.

Among its other provisions, the GLB Act also contains extensive customer privacy protection provisions which require banks to adopt and implement policies and procedures for the protection of the financial privacy of their customers, including procedures that allow customers to elect that certain financial information not be disclosed to certain persons.

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Under these provisions, a bank must provide to its customers, at the inception of the customer relationship and annually thereafter, the bank’s policies and procedures regarding the handling of customers’ nonpublic personal financial information. The GLB Act provides that, except for certain limited exceptions, a bank may not provide such personal information to unaffiliated third parties unless the bank discloses to the customer that such information may be so provided and the customer is given the opportunity to opt out of such disclosure. A bank may not disclose to a non-affiliated third party, other than to a consumer reporting agency, customer account numbers or other similar account identifiers for marketing purposes. The GLB Act permits states to adopt customer privacy protections that are stricter than those contained in the Act, and it makes it a criminal offense, except in limited circumstances, to obtain or attempt to obtain customer information of a financial nature by fraudulent or deceptive means.

The GLB Act has expanded opportunities for BancShares and the Bank to provide other services and obtain other revenues in the future. However, this expanded authority also may present BancShares and the Bank with new challenges as their larger competitors are able to expand their services and products into areas that are not feasible for smaller, community oriented financial institutions. To date BancShares has not elected to become a “financial holding company” and the GLB Act has not had a significant effect on its operations as presently conducted.

Payment of Dividends. Under current law, BancShares is authorized to pay dividends such as are declared by its Board of Directors, provided that no such distribution results in its insolvency on a going concern or balance sheet basis. However, BancShares is a legal entity separate and distinct from the Bank, and its principal source of funds with which it can pay dividends to its shareholders is dividends it receives from the Bank. Therefore, BancShares’ ability to pay dividends effectively is subject to the same limitations that apply to the Bank.

In general, the Bank may pay dividends only from its undivided profits. However, if its surplus is less than 50% of its paid-in capital stock, then the Bank’s directors may not declare any cash dividend until it has transferred from undivided profits to surplus 25% of its undivided profits or any lesser percentage necessary to raise its surplus to an amount equal to 50% of its paid-in capital stock.

Under federal law, and as an insured bank, the Bank is prohibited from making any capital distributions, including paying a cash dividend, if it is, or after making the distribution it would become, “undercapitalized” as that term is defined in the Federal Deposit Insurance Act (the FDIA). Additionally, if in the opinion of the FDIC an insured bank under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the bank, could include the payment of dividends), the FDIC may require, after notice and hearing, that the bank cease and desist from that practice. The federal banking agencies have indicated that paying dividends that deplete a bank’s capital base to an inadequate level would be an unsafe and unsound banking practice. The federal agencies have issued policy statements which provide that insured banks generally should only pay dividends out of current operating earnings, and under the FDIA no dividend may be paid by an FDIC-insured bank while it is in default on any assessment due the FDIC. The payment of dividends by the Bank also may be affected or limited by other factors, such as requirements that its regulators have authority to impose on it to maintain its capital above regulatory guidelines.

Capital Adequacy. BancShares and the Bank are required to comply with the capital adequacy standards established by the FRB in the case of BancShares, and by the FDIC in the case of the Bank. The FRB and FDIC have issued risk-based capital and leverage capital guidelines for determining the adequacy of a bank holding company’s or banks capital, and all applicable capital standards must be satisfied for a bank holding company or a bank to be considered in compliance with the FRB’s or FDIC’s requirements.

Under the risk-based capital measure, the minimum ratio (Total Capital Ratio) of an entity’s total capital (Total Capital) to its risk-weighted assets (including certain off-balance-sheet items, such as standby letters of credit) is 8.0%. At least half of Total Capital must be composed of common equity, undivided profits, minority interests in the equity accounts of consolidated subsidiaries, qualifying non-cumulative perpetual preferred stock, and a limited amount of cumulative perpetual preferred stock, less goodwill and certain other intangible assets (Tier 1 Capital). The remainder (Tier 2 Capital) may consist of certain subordinated debt, certain hybrid capital instruments and other qualifying preferred stock, and a limited amount of loan loss reserves. A bank or bank holding company that does not satisfy minimum capital requirements may be required to adopt and implement a plan acceptable to its federal banking regulator to achieve an adequate level of capital.

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Under the leverage capital measure, the minimum ratio (the Leverage Capital Ratio) of Tier 1 Capital to average assets, less goodwill and certain other intangible assets, is 3.0% for entities that meet certain specified criteria, including having the highest regulatory rating. All others generally are required to maintain an additional cushion of 100 to 200 basis points above the stated minimum. The guidelines also provide that banks experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum levels without significant reliance on intangible assets, and a bank’s “Tangible Leverage Ratio” (deducting all intangibles) and other indicators of capital strength also will be taken into consideration by banking regulators in evaluating proposals for expansion or new activities.

The FRB and the FDIC also consider interest rate risk (when the interest rate sensitivity of an institution’s assets does not match the sensitivity of its liabilities or its off-balance-sheet position) in the evaluation of an entity’s capital adequacy. The bank regulatory agencies’ methodology for evaluating interest rate risk requires banks with excessive interest rate risk exposure to hold additional amounts of capital against their exposure to losses resulting from that risk. The regulators also require banks to incorporate market risk components into their risk-based capital. Under these market risk requirements, capital is allocated to support the amount of market risk related to a bank’s trading activities.

The following table lists BancShares’ and the Bank’s regulatory capital ratios at December 31, 2003.

Capital categories are determined solely for the purpose of applying “prompt corrective action” rules described below which have been adopted by the various federal banking regulators, and they do not necessarily constitute an accurate representation of a bank’s overall financial condition or prospects for other purposes. A failure to meet capital guidelines could subject a bank holding company or bank to a variety of enforcement remedies under those rules, including the issuance of a capital directive, the termination of deposit insurance by the FDIC, a prohibition on the taking of brokered deposits, and certain other restrictions on its business. As described below, substantial additional restrictions can be imposed on banks that fail to meet applicable capital requirements.

Prompt Corrective Action. Current federal law establishes a system of prompt corrective action to resolve the problems of undercapitalized banks. Under this system, the FDIC has established five capital categories (“well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized”), and it is required to take certain mandatory supervisory actions, and is authorized to take other discretionary actions, with respect to banks in the three undercapitalized categories. The severity of any actions taken will depend upon the capital category in which a bank is placed. Generally, subject to a narrow exception, current federal law requires the FDIC to appoint a receiver or conservator for a bank that is critically undercapitalized.

Under the FDIC’s rules implementing the prompt corrective action provisions, an insured, state-chartered bank that (1) has a Total Capital Ratio of 10.0% or greater, a Tier 1 Capital Ratio of 6.0% or greater, and a Leverage Ratio of 5.0% or greater, and (2) is not subject to any written agreement, order, capital directive, or prompt corrective action directive issued by the FDIC, is considered to be “well capitalized.” A bank with a Total Capital Ratio of 8.0% or greater, a Tier 1 Capital Ratio of 4.0% or greater, and a Leverage Ratio of 4.0% or greater, is considered to be “adequately capitalized.” A bank that has a Total Capital Ratio of less than 8.0%, a Tier 1 Capital Ratio of less than 4.0%, or a Leverage Ratio of less than 4.0%, is considered to be “undercapitalized.” A bank that has a Total Capital Ratio of less than 6.0%, a Tier 1 Capital Ratio of less than 3.0%, or a Leverage Ratio of less than 3.0%, is considered to be “significantly undercapitalized,” and a bank that has a tangible equity capital to assets ratio equal to or less than 2.0% is deemed to be “critically undercapitalized.” For purposes of these rules, the term “tangible equity” includes core capital elements counted as Tier 1 Capital for purposes of the risk-based capital standards, plus the amount of outstanding cumulative perpetual preferred stock (including related surplus), minus all intangible assets (with various exceptions). A bank may be deemed to be in a capitalization category lower than indicated by its actual capital position if it receives an unsatisfactory examination rating.

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A bank that is categorized as “undercapitalized,” “significantly undercapitalized,” or “critically undercapitalized” is required to submit an acceptable capital restoration plan to the FDIC. An “undercapitalized” bank also is generally prohibited from increasing its average total assets, making acquisitions, establishing any branches, or engaging in any new line of business, except in accordance with an accepted capital restoration plan or with the approval of the FDIC. In addition, the FDIC has authority with respect to any “undercapitalized” bank to take any of the actions it is required to or may take with respect to a “significantly undercapitalized” bank if it determines that those actions are necessary to carry out the purpose of the law.

Reserve Requirements. Under regulations of the FRB, all FDIC-insured banks must maintain average daily reserves against their transaction accounts. No reserves are required to be maintained on the first $6.6 million of transaction accounts, but reserves equal to 3.0% must be maintained on the aggregate balances of those accounts between $6.6 million and $45.4 million, and reserves equal to 10.0% must be maintained on aggregate balances in excess of $45.4 million. Those percentages are subject to adjustment by the FRB. Because required reserves must be maintained in the form of vault cash or in a non-interest-bearing account at a Federal Reserve Bank, the effect of the reserve requirement is to reduce the amount of the Bank’s interest-earning assets.

FDIC Insurance Assessments. The FDIC currently uses a risk-based assessment system that takes into account the risks attributable to different categories and concentrations of assets and liabilities for purposes of calculating deposit insurance assessments to be paid by insured banks. The risk-based assessment system categorizes banks as “well capitalized,” “adequately capitalized” or “undercapitalized.” These three categories are substantially similar to the prompt corrective action categories described above, with the “undercapitalized” category including banks that are “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized” for prompt corrective action purposes. Banks also are assigned by the FDIC to one of three supervisory subgroups within each capital group, with the particular supervisory subgroup to which a bank is assigned being based on a supervisory evaluation provided to the FDIC by the bank’s primary federal banking regulator and information which the FDIC determines to be relevant to the bank’s financial condition and the risk posed to the deposit insurance funds (which may include, if applicable, information provided by the bank’s state supervisor). A different insurance assessment rate (ranging from zero to 27 basis points) applies to each of the nine assessment risk classifications (i.e., combinations of capital groups and supervisory subgroups). A bank’s assessment rate is determined based on the capital category and supervisory subgroup to which it is assigned. If the Bank’s capital classification were to drop, its assessment rate would increase in the future until it restored and maintained it capital at a higher level. A higher assessment rate would result in an increase in the assessments the Bank pays the FDIC for deposit insurance.

Under the Federal Deposit Insurance Act, the FDIC may terminate the Bank’s deposit insurance if it finds that it has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated applicable laws, regulations, rules or orders.

The FDIC is charged with the responsibility of maintaining the adequacy of the BIF, and the amount the Bank pays for deposit insurance is influenced not only by its capital category and supervisory subgroup but also by the adequacy of the insurance funds at any time. FDIC insurance assessments could be increased substantially in the future if the FDIC finds such an increase to be necessary in order to adequately maintain the insurance funds.

Restrictions on Transactions with Affiliates. The Bank is subject to the provisions of Section 23A of the Federal Reserve Act. Section 23A places limits on the amount of:

For purposes of Section 23A, BancShares and any other company or entity that it controls or that is under common control with it is treated as an affiliate of the Bank.

The total amount of the above transactions by the Bank is limited in amount, as to any one affiliate, to 10% of the Bank’s capital and surplus and, as to all affiliates combined, to 20% of the Bank’s capital and surplus. In addition to the

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limitation on the amount of these transactions, each of the above transactions must also meet specified collateral requirements. The Bank also must comply with other provisions of Section 23A designed to avoid the taking of low-quality assets from an affiliate.

The Bank also is subject to the provisions of Section 23B of the Federal Reserve Act which, among other things, prohibits it from engaging in the above transactions with its affiliates unless the transactions are on terms substantially the same, or at least as favorable to the Bank or its subsidiaries, as those prevailing at the time for comparable transactions with nonaffiliated companies.

Federal law also places restrictions on the Bank’s ability to extend credit to its or its executive officers, directors, principal shareholders and their related interests. These extensions of credit (1) must be made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated third parties, and (2) must not involve more than the normal risk of repayment or present other unfavorable features.

USA Patriot Act of 2001. The USA Patriot Act of 2001 was enacted in response to the terrorist attacks that occurred in New York, Pennsylvania and Washington, D.C. on September 11, 2001. The Act is intended to strengthen the ability of U.S. law enforcement and the intelligence community to work cohesively to combat terrorism on a variety of fronts. The potential impact of the Act on financial institutions of all kinds is significant and wide ranging. The Act contains sweeping anti-money laundering and financial transparency laws which require various new regulations, including standards for verifying customer identification at account opening, and rules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering. The Act has required financial institutions to adopt new policies and procedures to combat money laundering, and it grants the Secretary of the Treasury broad authority to establish regulations and impose requirements and restrictions on financial institutions’ operations.

Community Reinvestment. Under the Community Reinvestment Act (CRA), as implemented by regulations of the federal bank regulatory agencies, an insured bank has a continuing and affirmative obligation, consistent with its safe and sound operation, to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for banks, nor does it limit a bank’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The CRA requires the federal bank regulatory agencies, in connection with their examination of insured banks, to assess the Bank’s records of meeting the credit needs of its communities, using the ratings of “outstanding,” “satisfactory,” “needs to improve,” or “substantial noncompliance,” and to take that record into account in its evaluation of certain applications by those banks. All insured banks are required to make public disclosure of their CRA performance ratings. The Bank received a satisfactory rating in its most recent CRA examination.

Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 (the SOX Act) represents a comprehensive revision of laws affecting corporate governance, accounting obligations and corporate reporting. Among other requirements, the SOX Act established: (1) new requirements for audit committees of listed companies, including independence, expertise, and responsibilities; (2) additional responsibilities regarding financial statements for the chief executive officers and chief financial officers of reporting companies; (3) new standards for auditors and regulation of audits; (4) increased disclosure and reporting obligations for reporting companies regarding various matters relating to corporate governance, and (5) new and increased civil and criminal penalties for violation of the securities laws.

ITEM 2 – PROPERTIES

At December 31, 2003 the Bank maintained 66 banking offices in 49 North Carolina and 2 Virginia communities. BancShares owns the majority of the buildings and leases other facilities from third parties. Statistical information with respect to BancShares’ property and equipment is contained in this filing under Item 8. Financial Statements and Supplementary Data.

ITEM 3 – LEGAL PROCEEDINGS

The Bank is a party to various legal proceedings in the ordinary course of its business. However, based on information presently available, and after consultation with legal counsel, BancShares’ management believes that the ultimate outcome in such proceedings, in the aggregate, will not have any material adverse effect on BancShares’ financial condition.

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ITEM 4 – SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

PART II

ITEM 5 – MARKET FOR BANCSHARES’ COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES

There is no established trading market, published quotes or reported prices for BancShares’ common stock. All sales of the stock are in privately negotiated transactions between individual holders. On December 31, 2003, there were 121 record holders of BancShares’ common stock. There were no common stock repurchases by BancShares during the fourth quarter of 2003.

The per share cash dividends paid by BancShares during each quarterly period during 2003 and 2002 are set forth in Table XI under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 of this report. A cash dividend of $8.00 per share was declared by the Board of Directors on February 23, 2004, payable March 29, 2004, to holders of record as of March 1, 2004. BancShares’ sole source of funds for the payment of dividends to its shareholders is dividends it receives from the Bank. Payments of dividends by BancShares and the Bank are made at the discretion of their Boards of Directors and are contingent upon satisfactory earnings as well as projected future capital needs. Subject to the foregoing, it is currently management’s expectation that comparable cash dividends will continue to be paid in the future. Information regarding restrictions on BancShares’ and the Bank’s abilities to pay dividends are described in Item 1 of the Report under the caption “Payment of Dividends.”

ITEM 6 – SELECTED FINANCIAL DATA

The following table sets forth certain selected consolidated financial information for BancShares as of and for the years ended December 31, 2003, 2002, 2001, 2000 and 1999. The data has been derived from BancShares’ audited consolidated financial statements. The consolidated balance sheets as of December 31, 2003 and 2002, the consolidated statements of income, changes in shareholders equity and comprehensive income and cash flows for each of the years in the three year period ended December 31, 2003, and the independent auditors’ report thereon, are included elsewhere in this filing. The following should also be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere herein.

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Table 1

SELECTED FINANCIAL DATA

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ITEM 7 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Introduction

Management’s discussion and analysis of earnings and related financial data are presented to assist in understanding the financial condition and results of operations of Fidelity BancShares (N.C.), Inc. and Subsidiaries (BancShares), for the years 2003, 2002, and 2001. This discussion and analysis should be read in conjunction with the audited Consolidated Financial Statements and related notes presented under “Item 8. Financial Statements and Supplementary Data.” BancShares is a bank holding company with one wholly owned subsidiary – The Fidelity Bank (the Bank), a North Carolina-chartered bank.

Executive Overview

Fidelity Bank was chartered in 1909 and over the years has remained a closely held bank. It has successfully met the challenges presented by depressions, demise of agriculture, and currently a global economy depressing textile and furniture manufacturing in North Carolina. As a result of decreased manufacturing, Fidelity Bank has extended its presence into the Research Triangle, Triad, and other areas of North Carolina that are supported by research Universities, biotech, pharmaceutical and technology based industries. By outsourcing its core data processing requirements to an affiliated institution, BancShares can offer a complete array of financial services while maintaining its community banking orientation. BancShares’ focus on quality customer service provides it with a stable source of core funding. Members of the Holding family, including Lewis R. Holding have been actively involved in the management of BancShares, and, currently, various members of the family control an aggregate of 46% of BancShares common stock. As a result, BancShares has been managed from a long-term perspective with primary emphasis being placed on balance sheet liquidity, loan quality, and earnings stability. Consistent with its management philosophy, BancShares has emphasized a low-risk loan portfolio derived from its local markets.

Fidelity Bank is focused on serving small businesses, professional groups, as well as consumers. Its objective is to develop franchise value over the long-term. It offers its customers products and technologies comparable to the leading banks in North Carolina. Its basic philosophy is relationship banking with quality customer service. This is consistent with our goal of long term earnings and capital growth because it creates a base of loyal customers who will provide repeat business in the future. Fidelity Bank gives priority to maintaining quality assets and a sound capital position. Profit is always a goal, however, the primary focus is not on earnings, as the stock is very closely held and long-term profitability is more of a focus than immediate returns. The Bank will lag in new markets until a customer base is developed. Associates are also an important factor for all major bank decisions. The goal for the Bank is to be the dominant, high quality, small business bank in our market, recognized for quality of service to business and individuals. We see business loans to be our main loan product within the next five years. We will be very versatile in designing loans to meet each business’ specific needs. Due to this focus on the customer, approximately 70% of our loans are a variable rate, which causes the Bank to be especially asset sensitive. However, credit quality and not quantity will be the focus, therefore we have hired very conservative lenders. Our deposit growth will depend on relationship banking which is our main objective and deposits will be derived from core customers. Deposit products will be designed to meet the needs of businesses and priced on total relationship analysis. The Bank does not have any brokered deposits and this is not part of our plan. Income from TFB Financial Services will grow, as securities become a larger part of the sales activity in each branch.

By expanding the bank’s assets from $583 million in 1997 to $1,139 million in 2003 through de novo branch expansions and branches purchased from other banks, considerable resources have been devoted to human resource development and systems refinement. Income as a result has decreased, which was expected and will eventually increase as new branches reach profitability. Return on Assets is expected to remain below 1%, which was planned by the Board of Directors as a cost of expanding the bank’s assets. It is recognized as an investment for future earning and enhancement of the franchise. We will continue with the strategy of growth and expansion through acquisitions in addition to internal and de-novo growth. We will look for prudent acquisitions that will help us solidify our position in existing markets and allow us to expand into new markets, which can easily be acquiesced into our existing markets. The bank’s policy of keeping greater than fifty percent of its loan portfolio with variable rates has had a negative impact on earnings in the past months, but will position the bank to favorably withstand increases in interest rates and deposit costs in the future.

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One of the challenges faced is to maintain control over credit quality and compliance as we grow and stay decentralized. Another challenge is to maintain profitability with a high overhead resulting from an average branch size of $15 million in assets. A third challenge is to pay business development officers as much as our competitors pay when we have them managing portfolios in the $10 million range while competitors have them managing $20 million portfolios. Lastly, we face a challenge to find sources of fee income as loan margins shrink.

North Carolina is a growing state and presents a favorable environment for community banks. Fidelity Bank is positioned to take advantage of business growth as well as providing services to a growing consumer market. Community banking is still a people business and Fidelity’s challenge is to provide a stable, well trained, caring staff to sell its services. If we can be successful in the implementation of our new message of doing the “right thing for our customers, our associates, and the bank,” we have the opportunity to create an environment where everyone shares a common culture and considers themselves important to our goal of creating long term customer relationships.

Critical Accounting Policies

BancShares’ significant accounting policies are set forth in note 1 of the consolidated financial statements. Of these significant accounting policies, BancShares considers its policy regarding the allowance for loan losses to be a critical accounting policy, because it requires management’s most subjective and complex judgments. In addition, changes in economic conditions can have a significant impact on the allowance for loan losses and therefore the provision for loan losses and results of operations. BancShares has developed appropriate policies and procedures for assessing the adequacy of the allowance for loan losses, recognizing that this process requires a number of assumptions and estimates with respect to its loan portfolio. BancShares’ assessments may be impacted in future periods by changes in economic conditions, the impact of regulatory examinations, and the discovery of information with respect to borrowers which is not known to management at the time of the issuance of the consolidated financial statements. For additional discussion concerning BancShares’ allowance for loan losses and related matters, see ASSET QUALITY.

Acquisitions

On June 20, 2003, BancShares acquired the Ramseur and Thomasville, North Carolina and the Martinsville and Collinsville, Virginia branches of First-Citizens Bank & Trust Company, a related party (see Note 2 to the consolidated financial statements). This acquisition was accounted for as a purchase, and, therefore the results of operations prior to the purchase of the branches are not included in the consolidated financial statements. The combined loans and deposits acquired were $31.4 million and $113.5 million, respectively. The total purchase price was $7.5 million. Of this, $3.1 million was determined to be a core deposit intangible asset and $4.4 million was determined to be goodwill. This acquisition has been accounted for using the purchase method of accounting for business combinations with the assets and liabilities recorded based on estimates of fair values as of June 20, 2003. The following is a condensed balance sheet disclosing the amount assigned to each major asset and liability caption of the four FCB branches as of June 20, 2003, and the related fair value adjustments recorded by BancShares to reflect the acquisition.

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The following shows the calculation of the goodwill recorded in this transaction

Explanation of Fair Value Adjustments

2002 Acquisitions. BancShares made no acquisitions during 2002. There were no de novo branches opened in 2002.

2001 Acquisitions. In February 2001, BancShares acquired the deposits of three North Carolina branches of First Union National Bank. These acquisitions were accounted for as a purchase and, therefore, the results of operations prior to the purchase are not included in BancShares’ consolidated financial statements. These acquisitions were as follows:

(dollars in thousands)

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There were three de novo branch openings in 2001.

Results of Operations

Net Income. For 2003, net income of $7.8 million represented a 4.15% decrease from 2002 net income of $8.2 million. BancShares experienced a decrease in net interest income due to lower interest rates since approximately 70% of BancShares’ loans have a variable rate. Also, an increase in noninterest expense during 2003 affected net income and was due to increased salaries and benefits, with the majority of the increase resulting from pay increases and increases in both health insurance and pension plan expense.

Net income of $8.2 million in 2002 represented a 10.72% increase from 2001 net income of $7.4 million. BancShares experienced an increase in noninterest income during 2002 due to an increased volume of service charges. In addition, there was a decrease in noninterest expense. Noninterest expense decreased due to an impairment loss of $471,000 on the closing of 2 branch offices in 2001 compared to an impairment loss of $143,000 in 2002 from the closing of one branch. Also, in 2001, amortization of goodwill was $1,489,000 compared with $308,000 in 2002 (the reduction thereof was the effect of the adoption of FAS 147 in 2002, as discussed in note 1 to the consolidated financial statements). In addition, noninterest expense was favorably impacted by a decrease in other noninterest expense due to lower consulting, legal and other professional fees in 2002.

Net income per share for 2003 was $280.24 compared to $292.34 for 2002; the $12.10 decrease is attributable to decreased earnings.

Net income per share was $28.63 more in 2002 than the $263.71 recognized for 2001. The increase in net income per share during 2002 was attributable to increased earnings, as well as decreased average shares outstanding due to the repurchase by BancShares of 15 shares of common stock during 2002.

Net Interest Income. The greatest portion of BancShares’ earnings is from net interest income, which is the difference between interest income on earning assets and interest paid on deposits and other interest bearing liabilities. The primary factors affecting net interest income are changes in the volume and yields/rates on earning assets and interest bearing liabilities and the ability to respond to changes in interest rates through asset/liability management. Table I sets forth the average balances on interest earning assets and interest bearing liabilities, as well as the average yields earned and average rates paid for 2003, 2002, and 2001. The average prime rate, as set by the Federal Reserve, was 4.12%, 4.67% and 6.91%, for the years ended December 31, 2003, 2002, and 2001, respectively.

In 2003, net interest income was $36.3 million compared to $36.9 million in 2002, a decrease of $599,000 or 1.62%. 2002 net interest income was $246,000 or 0.67% greater than 2001 net interest income of $36.6 million. In 2003, the decrease in net interest income was due to the lower interest rates in 2003. Because approximately 70% of BancShares’ loans are tied to prime, the decline in prime interest rates noted above has reduced interest income by more than it has reduced interest expense. In 2002, there were approximately 60% of loans that were tied to prime, therefore they did not reprice as quickly. When prime changes, variable rate loans reprice in the first month. Deposits are not tied to prime, however, their rates have also been reduced, but as there are CD’s and IRA’s that have fixed rates, it takes longer for them to reprice, therefore interest expense does not decrease as fast as interest income. Therefore, the rate cuts in 2001 affected loans immediately, but did not affect as many deposits until 2002 due to the slower reaction time. In 2002 the increase in net interest income was attributable to decreased interest expense on deposits and short-term borrowings. In 2001, the Federal Reserve reduced interest rates eleven times. In 2003 interest income declined $5.2 million or 9.26% compared to 2002. During 2002, interest income declined $10.4 million or 15.76% compared to that of 2001. Interest expense decreased $4.6 million or 24.2% in year 2003 compared with a decrease of $10.7 million or 36.2% in 2002. Interest expense was $14.3 million in 2003, $18.8 million in 2002, and $29.5 million in 2001. In 2003 this was a decrease of 24.22% from 2002, which was a decrease of 36.17% compared to 2001. The principal component of BancShares’ interest expense is interest paid on deposits, which totaled $12.1 million in 2003, $16.6 million in 2002, and $26.8 million in 2001. Average interest bearing deposit balances for 2003, 2002, and 2001 were $755.3 million, $698.7 million, and $683.2 million, respectively. This represents an increase of $56.5 million in 2003 and $15.6 million in 2002 or 8.1% in 2003 and 2.3% in 2002, which is due to the acquisition in 2003 as well as growth within the existing branch network for 2003 and 2002. In 2002 the bank experienced higher volumes of interest bearing liabilities, but dramatic decreases in interest rates contributed to the lower

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interest expense. In 2003, there were also higher volumes of interest bearing liabilities, but the rate decreases were not as dramatic. In 2002, the average rate on interest bearing liabilities dropped 150 basis points, while in 2003, the average rate dropped 75 basis points. The average rates paid on interest bearing liabilities were 1.78%, 2.53%, and 4.03% in 2003, 2002, and 2001, respectively. The average balance on the long-term obligations during both 2003 and 2002 was $23 million. The average rate paid on the obligations was 8.50% in 2003 and 2002.

Loans produced the largest component of interest income, amounting to $47.0 million in 2003, $50.8 million in 2002, and $56.1 million in 2001. This represented a decrease of $3.8 million or 7.50% in 2003 and a decrease of $5.3 million or 9.39% in 2002. During 2003 and 2002, average loans outstanding increased $29.8 million or 4.24% and $65.9 million or 10.34% respectively. In 2003, $17.9 million of the increase in average loans was related to the four acquisition branches, while the remainder of the increase for 2003 was due to loan growth within the existing branches. Loan growth for 2002 was due to loan growth within the existing branches and from three de novo branch openings in the second half of 2001. Average yields on loans during 2003, 2002, and 2001 were 6.42%, 7.23%, and 8.81% respectively. The decrease in the 2003 and 2002 average yields was due to a lower average prime rate in both years.

Earnings from investments and overnight funds sold provided the remainder of interest income, contributing $3.6 million in 2003 and $4.9 million in 2002 and $10.1 million in 2001. Average balances and yields on these securities and on interest bearing cash balances are shown in Table I. Yields on investments have decreased due to interest rate changes as well as the reduced average maturity of the securities held. In the past, investments were typically purchased with two year maturities. They have now matured and repriced in the low rate environment. Many of the securities purchased to replace these were bought with a three to six month maturity, hoping that interest rates would begin to rise and not wanting to have a two year maturity on a low interest security.

BancShares’ interest rate spread was 3.37%, 3.65%, and 3.63% on a tax equivalent basis in 2003, 2002, and 2001, respectively. BancShares’ ability to maintain a favorable spread between interest income and interest expense is a major factor in generating earnings. Therefore, it is necessary for BancShares to effectively manage earning assets and interest bearing liabilities. The decrease in the spread is resulting from interest bearing assets repricing faster than interest bearing liabilities.

Provision for Loan Losses. The provision for loan losses is the amount charged to earnings that is necessary to maintain an appropriate allowance for loan losses. A number of factors determine the loan loss accrual from month-to-month, the most significant of which for BancShares include the following, which all attempt to quantify the level of credit risk within our loan portfolio: changes in credit grades within the portfolio, which arise from deterioration or improvement of the borrower’s performance; changes in the amount of outstanding loans; changes in the types of loans; current charge offs and recoveries of loans; and changes in specific loan valuation allowances for impaired loans. Other subjective factors which impact credit quality of the portfolio and estimates for these factors are also included. These factors include concentrations of credit, economic conditions, and operational risk, all of which are measured by a percentage of loans outstanding. The net change in all of these components results in the provision for loan losses.

Provision for the three months ending 12/31/2003 amounted to $420,000 compared to $1,225,000 for three months ending 12/31/2002. The provision for the year ending 12/31/2003 amounted to $1,415,000 compared to $3,250,000. The decrease in the provision was due to generally lower levels of new credit risk being assumed as evidenced by slower loan growth and lower net charge offs than in previous periods.

Net charge offs for the three months ending 12/31/2003 decreased to $140,560 compared to $165,138 for the three months ending 12/31/2002.

Net charge offs for the year ending 12/31/2003 were $434,613 or .06% of average loans compared to $699,308 or .10% for the same period in 2002. The decrease in net charge offs was due to reduced levels of small business charge offs in 2003 and net charge offs for 2003 and 2002 were low due to significant recoveries from prior year periods. Management continues to monitor credit quality, and charge offs are recorded when the financial condition deteriorates and the likelihood of repayment is remote. Management anticipates that net charge offs may increase due to the increase mix of small business and commercial credit compared to previously heavy residential mortgage credit that performed well and has since moved to secondary funding. In addition increases in unsecured credit losses required additional reserves because bankruptcies are increasing. These factors have been taken into consideration by management in arriving at the estimate of the allowance for loan losses.

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During the year ended 12/31/03 BancShares made no changes in its estimated loss percentages for economic factors. BancShares reviews local regional and national economic information and assesses its impact on the allowance. After review it is noted that economic conditions continue to be weak in some areas including textiles, furniture, and lumber, but no incremental provisions for loan losses were necessary in order to adjust for changes in these factors.

BancShares continuously reviews its portfolio for any concentrations for any one borrower or industries in the markets that we serve. This analysis includes preparing various reports showing loans to borrowers by industry, primarily lumber, and residential development and construction loans, as well as reports showing loans to one borrower. At the present time BancShares believes that the only area it has a significant concentration in is the residential construction and development industry. As of 12/31/03 this concentration represents $72,108,467 or 6% of total assets. BancShares also monitors operational risk, which includes front-end underwriting, documentation and closing processes associated with the lending function. The Company believes that due to the recent growth of the bank and the increase in the loan portfolio that it has assumed new risks arising from entering into new markets and using new loan officers. The effects of these new risks are not believed to be reflected in the historical charge-off percentages, so the Company factors this into its estimate.

Noninterest Income. Noninterest income, which consists primarily of service charges, commissions and fees, increased $521,000 in 2003 over 2002 and increased $483,000 in 2002 compared to 2001. Total noninterest income was $11.0 million in 2003, $10.4 million in 2002, and $9.9 million in 2001. The increase was mainly driven by an increase of $300,000 in 2003 of commissions on mortgages. Currently we act as a broker for residential mortgages and earn a commission or brokers fee for introducing these customers to the ultimate lender. Commissions on mortgages were $693,000 in 2002 and $993,000 in 2003. This income is part of other service charges and fees. In addition to increased refinancing resulting from low mortgage rates, during the first four months of 2003, Fidelity Bank sponsored a promotion designed to increase fee income from new mortgage loans. Associate incentives, company-wide contests, and in-branch marketing materials contributed to the success of the promotion, which generated approximately 1,100 new mortgage applications through August 2003 and resulted in a significant increase in mortgage-related fee income. We do not expect to sustain this growth in 2004 as many customers have already refinanced. Service charges on regular checking accounts increased $119,000 in 2003, with the commercial checking accounts providing $172,000 of the increase, and being offset by decreases in service charges on individual checking accounts. The increase in commercial service charges is due to the four acquired branches as well as the decrease in the earnings credit paid on these accounts due to the lower interest rates in 2003. The decrease in service charges on individual accounts is due to more customers switching their accounts to either a free checking product or setting up packaged accounts where there are no service charges, such as key accounts. We expect service charges to increase in 2004 due to having an entire year of service charges on the four acquired branches as well as continued deposit growth.

A loss on marketable equity securities partially offset the increase in noninterest income in 2003, however the loss was less than in 2002. The 2002 increase in noninterest income compared to 2001 is attributable to growth in deposit accounts, a new overdraft checking product which was introduced in 2000, and increased NSF fee income. The increase in 2002 was also partially offset by a loss on marketable equity securities, compared with gains on marketable equity securities in 2001.

Noninterest Expense. Noninterest expense includes expenses attributable to personnel, occupancy, furniture and equipment, data processing, FDIC assessments, printing, supplies, legal and professional fees, postage, amortization of intangibles, and other miscellaneous operating expenses. Noninterest expense was $33.1 million in 2003, $31.1 million in 2002 and $31.9 million in 2001. Control of noninterest expense is an important aspect in managing net income.

The most significant element of BancShares’ noninterest expense is personnel costs. Salaries and employee benefits represented 56.3%, 57.0%, and 52.5%, of total noninterest expense during 2003, 2002, and 2001, respectively. Salaries and benefits increased by $939,000 or 5.30% in 2003 and $986,000 or 5.89% in 2002. The primary causes of the increase in 2003 is pay increases as well as increased numbers of employees from the acquisition of four branches and internal growth. The increase in 2002 from 2001 was due to the acquisition of three branches in 2001, along with three de novo branches opening in the second half of 2001, for which a full year’s effect was felt in 2002. Salaries increased $429,000 or 3.03% in 2003. This was due to normal salary increases as well as the 2003 acquisition branches. Into 2004, salary expense is expected to increase at approximately the same rate as in 2003 due to salary increases as well as increases relating to the 2003 acquisition as these people were only with the Bank for six months of 2003 and will be employed the entire year in 2004. Insurance provided to employees has increased $173,000 in 2003 or 13.9% from 2002. This was due to an increase in

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overall industry cost increases as well as an increased number of employees in 2003. In 2004, we expect the cost of insurance provided to employees to increase, however not to the extent it increased in 2003. We have reevaluated our health insurance plan offerings with costs in mind for 2004. Pension plan expense has also increased $150,000 in 2003 or 32.1%. This is a result of the increased number of employees as well as a decrease in the discount rate and the rate of return on assets which are used to determine pension cost. Pension plan expense is also expected to increase in 2004, however not by as large of an amount due to BancShares making a contribution to the pension plan which will be above the minimum required in 2004 for the 2003 plan year. This will decrease our cost due to the higher amount of assets on which our return will occur. In addition, the assumed rate of return will be calculated on this contribution in determining 2004 plan costs. For 2004, although we increased our expected return on plan assets, we also decreased the discount rate. Actual return on plan assets was higher in 2003, compared to 2002 and 2001, however, some of these gains are spread to future periods, and likewise we are still feeling effects of 2001 and 2002 where the plan had a loss during both years.

Occupancy and equipment expenses increased from $5.0 million in 2002 to $5.4 million in 2003. There was virtually no increase in this cost from 2001 to 2002. The increase of $392,000 in 2003 was due to an increase of $124,000 in building repairs and alterations and an increase of $55,000 in furniture and equipment under $1,000 as well as other equipment expenses increasing $88,000. The increase in building repairs and alterations was due to re-wiring expenses paid for many of the branches to prepare them for a new computer installation. The increase in equipment under $1,000 was due to new printer network cards at all of the branches as well as new monitors for many of the branches. In 2003, the Bank upgraded the equipment in the branches. A majority of the hardware such as the computers in the branches were outdated, thus conversion took place late in the year. As a result, all branches needed new workstations and a new server to support new software for the different bank functions. The computers were capitalized as equipment, however the additional costs were expensed such as the monitors, network cards, and wiring as noted above. This was also the reason for the other equipment expense, as the Bank had to pay installation charges of approximately $1,400 per branch to First Citizens Bank. We do not expect this increase to affect 2004 net income. The depreciation should not significantly increase in 2004 as there were six months taken in 2003 as well as the disposal of old computers, some of which had some remaining depreciation in the beginning of 2003.

Data processing costs represent charges by vendors that perform data processing services for the Bank. Data processing fees are primarily based upon per item or per account charges. Data processing costs were $3.5 million, $3.2 million and $3.0 million in 2003, 2002, and 2001, respectively. These increases were due to the addition of acquired and de novo branches as well as growth in the loan and deposit base in the existing branch network, as noted above. As discussed in note 16 to the consolidated financial statements, BancShares’ data processing services are provided by a related party. See RELATED PARTY TRANSACTIONS.

Amortization of intangibles during 2003 increased $224,000 to $532,000 compared to $308,000 for 2002. Amortization of intangibles was $1.5 million in 2001. In 2002, the decrease in amortization of intangibles was related to the adoption of SFAS No. 147 (see Note 1 (o) to the consolidated financial statements, New Accounting Standards) which resulted in BancShares discontinuing amortization of a significant portion of its intangible assets. The increase in amortization during 2003 was a result of the four acquired branches for which a core deposit intangible study was done to determine the amount of amortizable intangible. We expect the amortization expense to increase to $732,000 in 2004 if there are no other acquisitions, due to a full year of amortization being recorded in 2004 for the branches acquired in 2003.

During 2002, BancShares analyzed the results of operations of one branch since its inception in 1999 and determined that the loss experience would not turn around in the near future. The Board of Directors of BancShares approved to close this branch and at June 30, 2002, BancShares accrued disposition costs which included $103,000 for losses on fixed assets, $20,000 for lease cancellation fees, and $20,000 for costs to close the branch. During the third quarter of 2002, BancShares closed the branch with no material adjustments being made to the accrued impairment costs. During 2001, BancShares analyzed the results of operations of two branches through the first three months of 2001 taking into consideration recent economic conditions and the projected performance of these branches. BancShares concluded the carrying value of these branches were impaired and therefore recorded an impairment loss of $470,740 to reduce the carrying value of these branches to fair value. There were no such impairment charges recorded in 2003 and we do not expect to have any in 2004.

Other miscellaneous operating expenses were $5.0 million, $4.8 million, and $5.3 million in 2003, 2002, and 2001, respectively. The increase in 2003 was due to additional expenses relating to the acquisition such as legal fees and costs to provide customer checks, as well as expenses relating to marketing promotions throughout the year such as postage and

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printing for the checking promotion and the mortgage promotion. The decrease in 2002 was mainly the result of decreased consulting fees as well as decreased legal and professional fees in 2002 as there were no acquisitions in 2002. We would expect other miscellaneous expenses to remain fairly stable in 2004 barring any significant nonrecurring transactions such as acquisitions.

Income Taxes. In 2003, 2002, and 2001, BancShares had taxable income for book purposes that resulted in income tax expense of $4.8 million, $4.8 million, and $4.3 million, respectively. The resulting effective income tax rates for the years ended December 31, 2003, 2002, and 2001 were 38.1%, 36.8%, and 36.6%, respectively. The increase in effective rate each year was mainly due to a decrease in the proportion of tax exempt income to overall income reported. We would expect the effective rate to remain consistent in 2004.

Financial Condition

Earning and Noninterest Earning Assets. Earning assets consist of loans, investment securities, and short-term investments that earn interest. Average earning assets during 2003 were $982.6 million, an increase of $80.5 million or 8.92% over 2002’s interest earning assets of $902.2 million. During 2002, average interest earning assets increased $37.6 million or 4.35% over 2001’s interest earning assets of $864.6 million. Increases in 2003 resulted from the four acquired branches as well as growth within the existing branch network. Increases in 2002 were also due to growth within the branch network and de novo branch openings in 2001, which continued to grow in 2002.

Average noninterest earning assets during 2003 were $90.7 million compared to $83.0 million in 2002, an increase of 9.27%. During 2002, a decrease of $1.6 million or 1.88% occurred compared to the 2001 average of $84.6 million. The increase in 2003 occurred primarily due to increases in cash as well as an increase in intangible assets (included in other assets) due to the branch acquisition in 2003. The 2002 decrease was primarily due to decreased intangible assets and decreased accrued interest receivable. The average balances of noninterest earning assets are shown in Table I.

Return on average total assets for 2003 was 0.73% compared to 0.83% and 0.78% in 2002 and 2001, respectively. The decrease in 2003 was a result of decreased earnings in addition to increased average assets. The increase for 2002 was the result of increased earnings which was partially offset by an increase in average assets. Changes in the composition of average balances are shown in Table I and Table II.

Return on average equity for 2003 was 8.07% compared with 9.16% in 2002 and 8.99% in 2001. In 2003, the decrease was due to decreased earnings coupled with increased average equity. In 2002, the increase was due to increased earnings and was offset by increased average equity.

Interest Bearing and Noninterest Bearing Liabilities. Interest bearing liabilities consist of deposits, short-term borrowed funds and long-term borrowed funds. Average interest bearing liabilities during 2003 were $803.6, an increase of 8.10% or $60.2 million from the 2002 average of $743.4 million, which was 1.6% higher than the 2001 average of $731.7 million. BancShares’ principal interest bearing liabilities are interest bearing deposits. Interest bearing deposits represented $755.3 million, $698.7 million, and $683.2 million of average interest bearing liabilities in 2003, 2002, and 2001, respectively. Short-term borrowings and long-term borrowings represent the remaining balances. The cost of total interest bearing liabilities was 1.78%, 2.53%, and 4.03% in 2003, 2002, and 2001, respectively.

Average noninterest bearing liabilities during 2003 were $172.4 million, an increase of $20.0 million or 13.1% over the 2002 average of $152.4 million. During 2002, average noninterest bearing liabilities increased 12.7% or $17.2 million over the 2001 average of $135.2 million. Noninterest bearing demand deposits are the principal noninterest bearing liability. Increases in noninterest bearing demand deposit balances are attributable to acquired branches, de novo branch openings and expansion within the existing branch network. See Table I.

Loans. As of December 31, 2003, loans, net of the allowance for loan losses, totaled $735.5 million compared to $717.3 million and $659.7 million at year-end 2002 and 2001, respectively. The increase was attributable to normal loan growth from the existing branch network and de novo branch openings in 2001 which continued to grow loans in 2002, as well as decreased interest rates in 2002 and 2003 which prompted refinancing activity. Also in 2003, growth was due to acquired loans of $31.4 million from the acquisition of four branches in the second quarter of 2003. The composition of the loan portfolio for each of the years in the five year period ended December 31, 2003 is listed in Table IV. Commercial real estate secured loans have increased from the prior year as well as construction and land development real estate loans. Due

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to the weaker economy, the Bank is seeking sounder collateral such as real estate instead of accounts receivable or equipment which is also leading to the decrease in commercial and industrial non-real estate secured loans. The Bank feels the commercial real estate as collateral reduces overall credit risk. With the furniture and textile manufacturing in a downturn, there has been less equipment financing and more real estate secured loans. In addition, the Bank has refinanced some real estate credit from other institutions and made some non-owner occupied loans such as for hotels as the Bank feels this is safer collateral. The largest risk with construction loans is the potential for market oversaturation. This can have a negative impact on market value. With a traditional real estate loan, individual people own these homes and are not looking to sell in the near future, unlike a construction loan, which will be sold upon completion. In addition, construction loans have inherent risks due to the need to inspect prior to advancing additional funds.

Rate sensitivity and liquidity in the loan portfolio are achieved by making loans with adjustable interest rates and shorter maturities. This allows the Bank to adjust its pricing structure with changes in interest rates. At the end of 2003, 76% of the loan portfolio was due to mature or would be available for interest rate repricing in 2004. See Table IX.

Investments. Management’s asset/liability strategies include maintaining an investment securities portfolio with appropriate maturities to preclude the necessity of selling investment securities for purposes of liquidity. Traditionally, BancShares has maintained a larger investment portfolio (as a percentage of assets) than its peers.

BancShares accounts for investment securities under the provisions of Statement of Financial Accounting Standards No. 115 (Statement 115), “Accounting for Certain Investments in Debt and Equity Securities,” which requires that investments in debt and equity securities be classified in three categories and accounted for as follows: debt securities that BancShares has the positive intent and ability to hold to maturity are classified as held-to-maturity and reported at amortized cost; debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings; and debt and equity securities not classified as either held-to-maturity securities or trading securities are classified as available for sale securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of shareholders’ equity. Securities available for sale consist of securities which may be sold in response to changes in interest rates, prepayment risk, regulatory capital requirements and liquidity needs.

At December 31, 2003, the fair value of available for sale securities exceeded the cost by $10.8 million. Deferred taxes related to these available for sale securities were $4.3 million, and shareholders’ equity included $6.5 million for the net unrealized gain related to these available for sale securities. At December 31, 2002, the fair value of available for sale securities exceeded the carrying value by $8.0 million. Deferred taxes related to these available for sale securities were $3.1 million, and shareholders’ equity included $4.9 million for the net unrealized gain related to these available for sale securities. BancShares does not maintain a trading account.

BancShares routinely reviews its investment securities to identify any declines in market value that are considered other than temporary. This process involves obtaining a current understanding of the overall financial condition of the issuer and the reasons for any deterioration in value, reviewing the length of time the fair value has been below cost, and considering the degree to which fair value is below cost. To the extent management concludes that declines in fair values of investment securities are other than temporary, BancShares records a charge to earnings and reduces the carrying value of the investment security. During 2003 and 2002, BancShares recorded other than temporary losses of $88,000 and $96,000, respectively. There were no such losses recorded in 2001. There can be no assurance that additional other than temporary impairment losses will not occur in future periods.

Commitments, Contingencies and Off-balance sheet risk

BancShares is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, lines of credit and standby letters of credit. These instruments involve elements of credit risk in excess of amounts recognized in the accompanying consolidated financial statements. Substantially all such instruments expire within one to three years.

BancShares’ risk of loss in the event of nonperformance by the other party to the commitment to extend credit, line of credit or standby letter of credit is represented by the contractual amount of these instruments. BancShares uses the same credit policies on the borrower in making commitments under such instruments as it does for on-balance sheet instruments. The amount of collateral obtained, if any, is based on management’s credit evaluation of the borrower. Collateral held varies,

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but may include accounts receivable, inventory, real estate and time deposits with financial institutions. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.

As of December 31, 2003 and 2002, outstanding financial instruments whose contract amounts represent credit risk were as follows:

BancShares does not have any special purpose entities or other similar forms of off-balance sheet financing arrangements.

BancShares’ lending is concentrated primarily in central North Carolina and Virginia and the surrounding communities in which it operates. Credit has been extended to certain of BancShares’ customers through multiple lending transactions; however, there is no concentration to any single customer or industry.

BancShares and the Bank are defendants in certain claims and legal actions arising in the ordinary course of business. In the opinion of management, after consultation with legal counsel, the ultimate disposition of these matters is not expected to have a material adverse effect on the consolidated operations, liquidity or financial position of BancShares or the Bank.

Asset Quality

Provision and Allowance for Loan Losses. Because BancShares’ loan portfolio represents its largest earning asset, BancShares continually monitors the quality of its loan portfolio. The Bank operates in a diversified economic environment and, in the opinion of management, is not unduly exposed to any one particular industry. BancShares’ customers are generally impacted by local and national economic conditions, as increases in unemployment levels, bankruptcy filings, and other key economic factors can directly or indirectly impact their ability to perform in accordance with the loan terms. In 2003, BancShares charged-off loans net of recoveries of $435,000. This represents a decrease of $264,000 from 2002 net charge-offs of $699,000. The 2002 net charge-offs of $699,000 were also a decrease from 2001 net charge-offs of $985,000. The percentage of charge-offs (net of recoveries) to average outstanding loans was 0.06% in 2003, 0.10% in 2002, and 0.15% in 2001. See Table V.

The ratio of total non-performing assets to total loans plus other real estate was 0.08% and 0.13% at December 31, 2003 and 2002, respectively. Assets classified as other real estate were $220,000 and $159,000 at December 31, 2003 and 2002, respectively.

Accrual of interest is discontinued on a loan when management believes the borrower’s financial condition is such that the collection of principal or interest is doubtful. Loans are returned to accrual status when the factors indicating doubtful collectibility cease to exist.

Management considers a loan to be impaired when, based on current information or events, it is probable that a borrower will be unable to pay all amounts due according to the contractual terms of the loan agreement. Impaired loans are valued using either the discounted expected cash flow method or the value of the collateral.

While a loan (including an impaired loan) is classified as nonaccrual and the future collectibility of the recorded loan balance is doubtful, collections of interest and principal are generally applied as a reduction to the principal outstanding. When the future collectibility of the recorded loan balance is not in doubt, interest income may be recognized on a cash basis. In the case where a nonaccrual loan had been partially charged-off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Receipts in excess of that amount are recorded as recoveries to the allowance for loan losses until prior charge-offs have been fully recovered.

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The Bank had impaired loans, which comprise all of the Bank’s nonaccrual loans, of $407,000 at December 31, 2003, $724,000 at December 31, 2002, and none at December 31, 2001. At December 31, 2003 and 2002, the bank had $1,338,000 and $424,000 accruing loans 90 days or more past due.

BancShares’ allowance for loan losses consists of three components: (1) valuation allowance computed on impaired loans in accordance with SFAS No. 114; (2) valuation allowances determined by applying historical loss rates to those loans not considered impaired; and (3) valuation allowances for factors which management believes are not reflected in the historical loss rates or that otherwise need to be considered when estimating the allowance for loan losses. These three components are estimated by Credit Administration monthly, and comprise Bancshares’ allowance for loan loss model. The resulting estimate is used to determine if the allowance for loan losses recorded by Bancshares is adequate and appropriate for each period.

The first component of the allowance for loan losses, the valuation for impaired loans, is computed based on documented analyses prepared by Credit Administration of individual impaired loans. Credit Administration typically estimates these valuations based upon the difference in the book balance of the loan and the value that BancShares can expect to realize on the underlying collateral for each impaired loan utilizing current appraisals or estimates of value. These estimates are updated periodically as circumstances change. Changes in the dollar amount of impaired loans or in the estimates of the fair value of the underlying collateral can impact the valuation allowance on impaired loans and, therefore, the overall allowance for loan losses.

The second component of the allowance for loan losses, the portion attributed to all other loans not considered impaired, is determined by applying historical loss rates to the outstanding balances of loans. For purposes of computing these estimates, the portfolio is segmented as follows: Commercial and consumer loans based on credit risk grades and other consumer loans consisting of credit cards, unsecured overdraft credit lines, and residential mortgage loans serviced by a third party. Commercial loans and most consumer loans are segmented based on credit grade, so that separate loss factors are applied to each grade level with greater allowance ratios assigned to the higher risk categories. Allowance ratios are determined based on historical loss ratios combined with current trends including: portfolio mix and concentrations of credit, age of credits in the portfolio, underwriting trends, and management’s assessment of economic trends in its trade area including delinquency, bankruptcy, and foreclosure rates. All these factors combine to impact the overall allowance ratio.

The third component of the allowance for loans losses is intended to capture the various risk elements of the loan portfolio that are not sufficiently captured in the historical loss rates. This component currently address operational risk associated with changes in BancShares’ method of tracking insurance coverage on the underlying collateral that secures loans that cannot be mitigated, on a cost effective basis, through blanket insurance coverage. This risk can have long term affects on loan losses that are not adequately reflected by the historical losses. The largest risk with construction loans is the potential for market oversaturation. This can have a negative impact on market value. With a traditional real estate loan, individual people own these homes and are not looking to sell in the near future, unlike a construction loan, which will be sold upon completion. In addition, construction loans have inherent risks due to the need to inspect prior to advancing additional funds. BancShares monitors its portfolio for any concentrations of credits during each period and the related reserve allocation, and if any excessive concentrations are noted for which reserves based on reserve ratios are deemed inadequate, estimates of loss on this group will be made. BancShares has determined that there are not any excessive concentrations for which the reserve ratios are deemed inadequate at December 31, 2003.

All estimates of the loan portfolio risk, including the adequacy of the allowance for loan losses, are subject to general and local economic conditions, among other factors, which are unpredictable and beyond BancShares’ control. Since a significant portion of the loan portfolio is comprised of real estate loans and loans to small owner occupied businesses, BancShares is subject to continued risk that the real estate market and economic conditions could continue to change and could result in future losses and require increases in the provision for loan losses.

Management currently uses several measures to assess and control the loan portfolio risk. For example, all new loans over $20,000 are independently reviewed by Credit Administration to evaluate adherence to the Bank’s underwriting standards and assign the appropriate credit grade. Credit Administration monitors the performance on loans on a monthly basis and automatically downgrades loans as appropriate. Credit Administration conducts periodic independent reviews of credit exposures of $1,000,000 or more. Senior management reviews all new extensions of credit to borrowers with total exposures of $200,000 or more and status reports on problem loans on a monthly basis. These and other measures are taken to ensure that loans are adequately graded, deteriorations in underwriting standards are identified and corrected and that undue risk is avoided or mitigated.

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At December 31, 2003 the allowance for loan losses was $12.8 million or 1.71% of gross loans compared to $11.8 million or 1.62% at December 31, 2002 and $9.3 million or 1.39% at December 2001. The allowance model was influenced throughout 2003 by increased credit risk resulting from loan growth, charge-off behavior, reclassification of loans as a result of adding an additional loan grade and deteriorating asset quality. The principal reason for increased allocation in 2003 is the movement of loans from the company’s average grade to the below average grade and due to an increase in accruing loans greater than 90 days. While these loans are both well-secured and in the process of collection, they have higher inherent risk so more reserve has been allocated to cover potential losses.

Management considers the allowance for loan losses adequate to cover inherent losses in the Bank’s loan portfolio as of the date of the financial statements. Management believes is has established the allowance in consideration of the current economic environment. While management uses the best information available to make evaluations, future additions to the allowance may be necessary based on changes in economic and other conditions. Additionally, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowances for loan losses. Such agencies may require the recognition of adjustments base on their judgments of information available to them at the time of their examinations.

Related Party Transactions

BancShares has entered into various service contracts with another bank holding company, First Citizens BancShares, Inc. (the Corporation) and its subsidiary, First-Citizens Bank & Trust Co. (FCB). The Corporation has two significant shareholders, who are also significant shareholders of BancShares. At December 31, 2003, the first significant shareholder beneficially owned 11,155 shares, or 39.82 percent, of BancShares’ outstanding common stock. At the same date, the second significant shareholder beneficially owned 1,696 shares, or 6.05 percent, of BancShares’ outstanding common stock.

These two significant shareholders are directors and executive officers of the Corporation and at December 31, 2003, beneficially owned 2,525,780 shares, or 28.84%, and 1,378,593 shares, or 15.74%, of the Corporation’s outstanding Class A common stock, and 654,044 shares, or 38.99%, and 203,519 shares, or 12.13%, of the Corporation’s outstanding Class B common stock. The above totals include 467,327 Class A common shares, or 5.34 %, and 104,644 Class B Common shares, or 6.24%, that are considered to be beneficially owned by both of the shareholders and, therefore, are included in each of their totals.

The Bank’s contract with FCB was negotiated at arms-length and was approved by BancShares’ Board of Directors. Based on its comparison in previous years of the terms of the contract with terms available to it from other providers of the services being obtained from FCB, management of the Bank believes the terms of its contract with FCB, including prices, are no less favorable to the Bank than could be obtained from an unrelated provider.

The following are expenses paid by BancShares to the Corporation:

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BancShares also has a correspondent relationship with the Corporation. Correspondent account balances with the Corporation included in cash and due from banks and overnight funds sold totaled $50,013,839, and $38,454,633 at December 31, 2003 and 2002, respectively. The rate paid on overnight funds by the Corporation was 0.71% at December 31, 2003 and 0.99% at December 31, 2002.

BancShares is related through common ownership with Southern Bank and Trust Co. (Southern) in that the aforementioned two significant shareholders of BancShares and certain of their related parties are also significant shareholders of Southern. BancShares has contracted with Southern to service on its behalf $2.8 million of BancShares’ mortgage loans.

Liquidity, Market Risk and Interest Sensitivity

Liquidity. Liquidity refers to the ability of BancShares to generate sufficient funds to meet its financial obligations and commitments at a reasonable cost. Maintaining liquidity ensures that funds will be available for reserve requirements, customer demand for loans, withdrawal of deposit balances and maturities of other deposits and liabilities. Past experience helps management anticipate cyclical demands and amounts of cash required. These obligations can be met by existing cash reserves or funds from maturing loans and investments, but in the normal course of business are met by deposit growth.

In assessing liquidity, many relevant factors are considered, including stability of deposits, quality of assets, economy of the markets served, business concentration, competition and BancShares’ overall financial condition. BancShares’ liquid assets include all investment securities (minus pledged securities), overnight funds sold, and cash and due from banks less the federal reserve requirement. These assets represented 22.24% of deposits at December 31, 2003, an increase from 16.07% at December 31, 2002.

BancShares’ liquidity ratio, which is defined as cash plus short-term and marketable securities (minus pledged securities) less the federal reserve requirement divided by deposits and short-term liabilities, was 23.90% at December 31, 2003, compared to 17.22% at December 31, 2002. In addition, the Bank has a $135 million line of credit with the Federal Home Loan Bank to meet liquidity needs.

BancShares has traditionally maintained high levels of liquidity, characteristic of the high ratio of investment securities to total assets that it maintains. Although loans have increased in each of the recent fiscal periods, BancShares’ ability to manage its liquidity is due to loans being funded by deposits.

Funds received from any maturing investments that are not immediately necessary to sustain BancShares’ liquidity are invested in similar instruments or used to fund any increased loan demand. Investments scheduled to mature within the one-year time frame, without consideration of marketable equity securities, represented 81.63% and 78.64% of the total investment securities portfolio at December 31, 2003 and 2002, respectively.

In addition, BancShares held marketable equity securities with fair values of $14.2 million and $11.5 million at December 31, 2003 and 2002, respectively. These investments are classified as available for sale and could be sold at management’s discretion.

BancShares’ consolidated statements of cash flows disclose the principal sources and uses of cash from operating, investing, and financing activities for 2003, 2002, and 2001. In 2003, BancShares’ operating activities provided cash flows of $11.1 million. Net income of $7.8 million, adjusted for non-cash operating activities, provided the majority of cash generated from operations. Investing activities, including lending, provided $11.8 million of BancShares’ cash flow. Loans originated, net, of principal collected, provided $11.4 million due to a net reduction in the loan portfolio, excluding the impact of loans acquired in the branch acquisition. Securities purchases used $374.4 million, and expenditures for premises and equipment utilized $3.0 million of BancShares’ cash flow. The cash outflows from these investing activities were offset by $304.0 million of cash received from investment maturities and $73.3 million received from branch purchases. Net additional cash outflows of $312,000 resulted from financing activities, principally from deposit outflows of $2.1 million and dividends paid of $896,000 which were offset by increases in short-term borrowings of $2.7 million.

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In 2002, BancShares’ operating activities provided cash flows of $13.1 million. Net income of $8.2 million, adjusted for non-cash operating activities, provided the majority of cash generated from operations. Investing activities, including lending, used $31.0 million of BancShares’ cash flow. Loans originated, net, of principal collected, used $61.2 million. Securities purchases used $211.4 million, and expenditures for premises and equipment utilized $2.1 million of BancShares’ cash flow. The cash outflows from these investing activities were offset by $243.0 million of cash received from investment maturities. Net additional cash inflows of $22.5 million resulted from financing activities, principally from deposit inflows of $27.9 million.

In 2001, BancShares’ operating activities provided cash flows of $14.5 million. Net income of $7.4 million, adjusted for non-cash operating activities, provided the majority of cash generated from operations. Investing activities, including lending, provided $1.1 million of BancShares’ cash flow. Loans originated, net of principal collected, used $51.7 million. Securities purchases used $131.7 million, and expenditures for premises and equipment utilized $3.0 million of BancShares’ cash flow. The cash outflows from these investing activities were offset by $148.0 million of cash received from investment maturities and $38.7 million of cash received in branch acquisitions. Net additional cash inflows of $18.9 million resulted from financing activities, principally from deposit inflows of $19.4 million.

The Bank has no brokered funds. Jumbo certificates of deposit (CD’s) are considered to include all CD’s of $100,000 or more. The Bank does not and has never aggressively bid on these deposits, and it does not seek nor does it accept deposits from outside of its general trade area. Almost all of the Bank’s jumbo CD customers have other relationships with the Bank, including savings, demand and other time deposits and, in some cases, loans. At December 31, 2003 and 2002, jumbo CD’s represented 11.37% and 11.27% of total deposits, respectively.

In the opinion of management, BancShares has the ability to generate sufficient amounts of cash to cover normal funding requirements and any additional needs which may arise, within realistic limitations, during the next twelve months, and management is not aware of any known demands, commitments or uncertainties that will affect liquidity in a material way.

BancShares has obligations under existing contractual obligations that will require payments in future periods. The following table presents aggregated information about such payments to be made in future periods. Transaction deposit accounts with indeterminate maturities have been classified as having payments due in less than one year.

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

BancShares’ market risk arises primarily from interest rate risk inherent in its lending and deposit taking activities. Management seeks to manage this risk through the use of shorter term maturities. The composition and size of the investment portfolio is managed so as to reduce the interest rate risk in the deposit and loan portfolios while at the same time maximizing the yield generated by the portfolio.

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The table below presents in tabular form the contractual balances and the estimated fair value of financial instruments at their expected maturity dates as of December 31, 2003. The expected maturity categories take into consideration historical prepayment experience as well as management’s expectations based on the interest rate environment as of December 31, 2003. For core deposits without contractual maturity (i.e. interest bearing checking, savings and money market accounts), the table presents principal cash flows as maturing in 2004 since they are subject to immediate repricing.

Interest Sensitivity. Short-term, interest earning deposits which are more volatile, have created a need for shorter maturities of interest earning assets. As a result, an increasing percentage of commercial, installment, and mortgage loans are being made with variable rates or shorter maturities to increase liquidity and interest rate sensitivity.

The difference between interest sensitive asset and interest sensitive liability repricing within time periods is referred to as the interest rate sensitivity gap. Gaps are identified as either positive (interest sensitive assets in excess of interest sensitive liabilities) or negative (interest sensitive liabilities in excess of interest sensitive assets), and are set forth in Table IX.

As of December 31, 2003, BancShares had a positive one year cumulative gap position of 31.06% and a positive total cumulative gap position of 18.12%. BancShares has interest earning assets of $806.2 million maturing or repricing within one year and interest bearing liabilities of $485.5 million repricing within one year. BancShares experienced growth in loans and in investments with maturities of one year or less and an increase in deposits and short-term borrowings with maturities of one year or less. A positive gap position implies that interest earning assets (loans and investments) will reprice at a faster rate than interest bearing liabilities (deposits). In a falling rate environment, this position will generally have a negative effect on earnings, while in a rising rate environment this position will generally have a positive effect on earnings.

Inflation. The effect of inflation on financial institutions differs from the impact on other types of businesses. Since assets and liabilities of banks are primarily monetary in nature, they are more affected by changes in interest rates than by the rate of inflation.

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Inflation generates increased credit demands and fluctuations in interest rates. Although credit demand and interest rates are not directly tied to inflation, each can significantly impact net interest income. As in any business and industry, expenses such as salaries, equipment, occupancy, and other operating expenses are also subject to upward pressures created by inflation.

Since the rate of inflation has been relatively stable during the last several years, the impact of inflation of the earnings presented in this report is insignificant.

Capital Resources

Shareholders’ Equity and Capital Adequacy. Sufficient levels of capital are necessary to sustain growth and absorb losses. To this end, the Federal Reserve, which regulates BancShares, and the FDIC, which regulates the Bank, have established risk based capital (RBC) adequacy guidelines.

As of December 31, 2003, BancShares’ Leverage Capital Ratio (as defined herein) was 8.47%, as compared to 9.45% and 8.99% at year-end 2002 and 2001, respectively. Within RBC calculations, BancShares’ assets, including commitments to lend and other off-balance sheet items, are weighted according to Federal regulatory guidelines for the risk considered inherent in the assets. BancShares’ Tier 1 Capital Ratio (as defined herein) as of December 31, 2003 was 12.02% compared to ratios of 12.50% and 12.19% for 2002 and 2001, respectively. The decrease in the Tier 1 capital is due to the increase in goodwill and core deposit intangibles resulting from the June 2003 acquisition as well as increased unrealized gains on available for sale securities. The calculation of Total Capital Ratio (as defined herein) allows, in BancShares’ circumstances, the inclusion of BancShares’ allowance for loan losses in capital, but only to a maximum of 1.25% of risk weighted assets. As of December 31, 2003, BancShares’ Total Capital Ratio was 13.89%. The Total Capital Ratios for 2002 and 2001 were 14.24% and 13.95%, respectively.

As of December 31, 2003, the Bank’s Leverage Capital Ratio (as defined above) was 7.72%, which, along with 8.74% and 8.30% as of December 31, 2002 and 2001, respectively, represents a well-capitalized institution under FDIC standards (one whose ratio exceeds 5%). The Bank’s Tier 1 Capital ratio (as defined above) as of December 31, 2003 was 10.92%, which, along with 11.52% and 11.30% as of December 31, 2002 and 2001, respectively, represents a well-capitalized institution under FDIC standards (one whose ratio exceeds 6%). As of December 31, 2003, the Bank’s Total Capital Ratio (as defined above) was 12.18%. The Total Capital ratios for 2002 and 2001 were 12.78% and 12.55%, respectively. Total Capital Ratio in all three years represented well-capitalized institutions under FDIC standards (the ratio exceeds 10%).

These ratios will improve if BancShares’ capital increases at a rate proportionately faster than liabilities. Management is aware that growth must be controlled. BancShares’ recent expansion plans discussed elsewhere herein may appear to be contrary to this policy but management is also aware that the process of expanding market share by normal business processes can be very difficult and expensive. Management believes that improvement in its overall market share within an existing trade area is valuable in the long run and should be pursued by BancShares, when it can be done prudently.

BancShares’ primary source of new capital is earnings. In 2003, equity capital increased through retention of earnings by $7.0 million, compared to $7.3 and $6.5 million in 2002 and 2001, respectively. At December 31, 2003, shareholders’ equity totaled $100.9 million, compared to $92.3 million in 2002. Shareholders’ equity at December 31, 2003 and 2002 included, as discussed above, $6.5 million and $4.9 million, respectively, of net unrealized securities gains on available for sale securities.

The ratio of average shareholders’ equity to average total assets was 9.07% in 2003, 9.07% in 2002, and 8.67% in 2001.

Retention of sufficient earnings to maintain an adequate capital position that provides BancShares with expansion capabilities is an important factor in determining dividends. During 2003, BancShares paid $896,000 in dividends, versus $896,000 and $898,000 in 2002 and 2001, respectively. As a percentage of net income, dividends were 11.42% in 2003, 10.95% in 2002, and 12.13% in 2001. The increase in dividends paid in 2002 was due to the dividend amount remaining the same with total net income decreasing. The decrease in dividends paid in 2002 compared to 2001 is attributable to a decrease in the number of shares outstanding each year. BancShares expects to pay the same amount of dividends on a per share basis in 2004.

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Accounting and Other Matters

See Note 1(o) of the consolidated financial statements.

Statistical Information

The following tables contain certain additional information regarding BancShares’ business operations.

Table I.

Average Balance Sheet Items and Net Interest Differential

Average Balances and Average Rates Earned and Paid