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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2003

Commission file no: 0-22955

BAY BANKS OF VIRGINIA, INC.

(Exact name of registrant as specified in its charter)

100 SOUTH MAIN STREET, KILMARNOCK, VIRGINIA 22482

(Address of principal executive offices) (Zip Code)

Registrants telephone number: 804.435.1171

Securities registered under Section 12(b) of the Exchange Act: None

Securities registered under Section 12(g) of the Exchange Act:

Common Stock ($5.00 Par Value)

(Title of Class)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    YES  x    NO  ¨

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

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 the 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

The aggregate market value of voting stock held by non-affiliates of the registrant based on the closing sale price of the registrant’s common stock on June 30, 2003, was $37,649,446.

The number of shares outstanding of the registrant’s common stock as of March 10, 2004 was 2,325,430

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s definitive Proxy Statement for its Annual Meeting of Shareholders to be held on May 18, 2004 are incorporated by reference into Part III of this Form 10-K.

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BAY BANKS OF VIRGINIA

INDEX

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PART I

ITEM 1: BUSINESS

GENERAL

Bay Banks of Virginia, Inc. (the “Company”) is a bank holding company that conducts substantially all of its operations through its subsidiaries, Bank of Lancaster (the “Bank”) and Bay Trust Company (the “Trust Company”). Bay Banks of Virginia, Inc. was incorporated under the laws of the Commonwealth of Virginia on June 30, 1997, in connection with the holding company reorganization of the Bank of Lancaster.

The Bank is a state-chartered bank and a member of the Federal Reserve System. The Bank serves individual and commercial customers, the majority of which are in the Northern Neck of Virginia, by providing a full range of banking and related financial services, including checking, savings and other depository services, commercial and industrial loans, residential and commercial mortgages, home equity loans, and consumer installment loans.

The Bank has two offices located in Kilmarnock, Virginia, one office in White Stone, Virginia, one office in Warsaw, Virginia, one office in Montross, Virginia, one office in Heathsville, Virginia, and one office in Callao, Virginia. A substantial amount of the Bank’s deposits are interest bearing, and the majority of the Bank’s loan portfolio is secured by real estate. Deposits of the Bank are insured by the Bank Insurance Fund of the Federal Deposit Insurance Corporation (the “FDIC”). The Bank opened for business in 1930 and has partnered with the community to ensure responsible growth and development since that time.

In August of 1999, Bay Banks of Virginia formed Bay Trust Company. This subsidiary of the Company was created to purchase and manage the assets of the trust department of the Bank of Lancaster. The sale and transfer of assets from the Bank to the Trust Company was completed as of the close of business on December 31, 1999. As of January 1, 2000, the Bank of Lancaster no longer owned or managed the trust function, and thereby no longer receives an income stream from the trust department. Income generated by the Trust Company is consolidated with the Bank’s income and the Company’s income for the purposes of the Company’s consolidated financial statements. The Trust Company opened for business on January 1, 2000 in its permanent location on Main Street in Kilmarnock, Virginia.

The Company’s marketplace is situated on the “Northern Neck” peninsula of Virginia’s western shore. The “Northern Neck” includes the counties of Lancaster, Northumberland, Middlesex, Richmond, and Westmoreland. The Company’s primary trading area is dominated by smaller, retired households with relatively high per capita incomes. Growth in households, employment, and retail sales is moderate but the local economic conditions are stable as growth has been positive for several years. Health care, tourism, and related services are the major employment sectors in the “Northern Neck.”

The Company had total assets of $290.7 million, deposits of $257.1 million, and stockholders equity of $25.1 million as of December 31, 2003.

Through the Bank of Lancaster and Bay Trust Company, Bay Banks of Virginia provides a wide range of services to its customers in its market area. These services are summarized below.

Real Estate Lending. The Bank’s real estate loan portfolio is the largest segment of the loan portfolio. The Bank offers fixed and adjustable rate mortgages on one-to-four family residential properties. These mortgages are underwritten and documented within the guidelines of the regulations of the Board of Governors of the Federal Reserve System (the “Federal Reserve”). Construction loans with a twelve-month term are also a significant component of the Bank’s portfolio. Underwritten at 80% loan to value, and to qualified builders and individuals, these loans are disbursed as construction progresses and verified by Bank inspection. The Bank also offers commercial loans that are secured by real estate. These loans are typically underwritten at 80% loan to value and are either variable with the prime rate of interest, or adjustable in one, three, or five year terms.

The Company also offers secondary market loan products. Through the Bank, customers may apply for a home mortgage that will be underwritten in accordance with the guidelines of the Federal Home Loan Mortgage Corporation. These loans are then sold into the secondary market on a loan by loan basis. The Bank earns origination fees through offering this service. Customers, upon approval, receive a fixed or adjustable rate of interest with amortization terms up to 30 years. Since these loans are sold into the secondary market, the Company earns no future interest income, nor does it incur any interest rate or re-pricing risk.

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Consumer Lending. To offer a full range of services, the Bank’s consumer lending products include automobile and boat financing, home improvement loans, and unsecured personal loans. These loans historically entail greater risk than loans secured by real estate, but also offer a higher return.

Commercial Lending. Commercial lending activities include small business loans, asset based loans, and other secured and unsecured loans and lines of credit. Commercial lending may entail greater risk than residential mortgage lending, and is therefore underwritten with strict risk management standards. Among the criteria for determining the borrower’s ability to repay is a cash flow analysis of the business and business collateral.

Business Development. The Bank offers several services to commercial customers. These services include Analysis Checking, Cash Management Deposit Accounts, Wire Services, Direct Deposit Payroll Service, Internet Banking, Telephone Banking, and a full line of Commercial Lending options. The Bank also offers Small Business Administration “Low Document” loan products. This allows commercial customers to apply for favorable rate loans for the development of business opportunities, while providing the Bank with a partial guarantee of the outstanding loan balance.

Bay Services Company, Inc. The Bank has one wholly owned subsidiary, Bay Services Company, Inc., a Virginia corporation organized in 1994 (“Bay Services”). Bay Services owns an interest in Bankers Title of Fredericksburg, a land title insurance agency, and Bankers Investments Group, L.L.C., an investment and insurance services company. Bankers Title of Fredericksburg sells title insurance to mortgage loan customers, including customers of the Bank and the other financial institutions that have an ownership interest in the agency. Operating as Planning Plus, Bankers Investments Group, L.L.C., provides a complete array of investment, estate, and tax planning services.

Planning Plus provides a complete financial services center within the facilities of Bank of Lancaster. Planning Plus supplements the skills of a customer’s attorney, CPA, and insurance advisor to provide a comprehensive plan for investing and estate planning. During 2003, the Bank applied for and was granted status as an insurance agency by the State Corporation Commission. This designation allows for the collection of commissions from insurance sales.

Bay Trust Company. The Trust Company offers a broad range of trust and related fiduciary services. Among these are testamentary trusts, revocable and irrevocable personal, managed agency, and custodial trusts.

COMPETITION

The Company’s marketplace is highly competitive. The Company is subject to competition from a variety of commercial banks and financial service companies, large national and regional financial institutions, large regional credit unions, mortgage companies, consumer finance companies, mutual funds and insurance companies. Competition for loans and deposits is affected by numerous factors, but mainly by interest rates and institutional reputation.

SUPERVISION AND REGULATION

Bank holding companies and banks are regulated under both federal and state law. The Company is subject to regulation by the Federal Reserve. Under the Bank Holding Company Act of 1956, the Federal Reserve exercises supervisory responsibility for any non-bank acquisition, merger or consolidation. In addition, the Bank Holding Company Act limits the activities of a bank holding company and its subsidiaries to that of banking, managing or controlling banks, or any other activity that is closely related to banking. In addition, the Company is registered under the bank holding company laws of Virginia, and as such is subject to regulation and supervision by the State Corporation Commission’s Bureau of Financial Institutions.

The following description summarizes the significant state and Federal laws to which the Company and the Bank are subject. To the extent statutory or regulatory provisions or proposals are set forth the description is qualified in its entirety by reference to the particular statutory or regulatory provisions or proposals.

The Bank is supervised and regularly examined by the Federal Reserve and the Commonwealth of Virginia’s State Corporation Commission’s Bureau of Financial Institutions. These on-site examinations verify compliance with regulations governing corporate practices, capitalization, and safety and soundness. Further, the Bank is subject to the requirements of the Community Reinvestment Act (the “CRA”). The CRA requires financial institutions to meet the credit needs of the local community, including low to moderate-income needs. Compliance with the CRA is monitored through regular examination by the Federal Reserve.

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Federal Reserve regulations permit bank holding companies to engage in non-banking activities closely related to banking or to managing or controlling banks. These activities include the making or servicing of loans, performing certain data processing services, and certain leasing and insurance agency activities.

The Company owns 100% of the stock of the Bank of Lancaster. The Bank is prohibited by the Federal Reserve from holding or purchasing its own shares except in limited circumstances. Further, the Bank is subject to certain requirements as imposed by state banking statutes and regulations. The Bank is limited by the Federal Reserve regarding what dividends it can pay to the Company. Any dividend in excess of the Company’s net profit for that year plus retained earnings from the prior two years must be approved by the proper regulatory agencies. Further, under the Federal Deposit Insurance Corporation Improvement Act of 1991 (the “FDICIA”), insured depository institutions are prohibited from making capital distributions, if, after making such distributions, the institution would become “undercapitalized” as defined by regulation. Based upon the Bank’s current financial position, it is not anticipated that this statute will impact the continued operation of the Bank.

As a bank holding company, Bay Banks of Virginia is required to file with the Federal Reserve an annual report and such additional information as it may require pursuant to the Bank Holding Company Act. The Federal Reserve may also conduct examinations of the Company and any or all of its subsidiaries.

CAPITAL REQUIREMENTS

The Federal Reserve, the Office of the Comptroller of the Currency (the “OCC”) and the FDIC have issued substantially similar risk-based and leverage capital guidelines applicable to banking organizations. In addition, those regulatory agencies may from time to time require that a banking organization maintain capital above the minimum levels because of its financial condition or actual or anticipated growth. Under the risk-based capital requirements of these federal bank regulatory agencies, the Company and the Bank are required to maintain a minimum ratio of total capital to risk-weighted assets of 8%. At least half of the total capital is required to be “Tier 1 capital”, which consists principally of common and certain qualifying preferred shareholders’ equity, less certain intangibles and other adjustments. The remainder (“Tier 2 capital”) consists of a limited amount of subordinated and other qualifying debt (including certain hybrid capital instruments) and a limited amount of the general loan loss allowance. The Tier 1 and total capital to risk-weighted asset ratios of the Company as of December 31, 2003 were 11.1% and 12.1%, respectively.

In addition, each of the federal regulatory agencies has established a minimum leverage capital ratio (Tier 1 capital to adjusted average total assets) (“Tier 1 leverage ratio”). These guidelines provide for a minimum Tier 1 leverage ratio of 4% for banks and bank holding companies that meet certain specified criteria, including that they have the highest regulatory examination rating and are not contemplating significant growth or expansion. The Tier 1 leverage ratio of the Company as of December 31, 2003, was 7.3%, which is well above the minimum requirement. The guidelines also provide that banking organizations that are experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets.

DEPOSIT INSURANCE

Pursuant to FDICIA, the FDIC adopted a risk-based assessment system for insured depository institutions that takes into account the risks attributable to different categories and concentrations of assets and liabilities. The risk-based system assigns an institution to one of three capital categories: (i) well-capitalized, (ii) adequately capitalized, or (iii) undercapitalized. The FDIC also assigns an institution to one of three supervisory subgroups within each capital group. The supervisory subgroup to which an institution is assigned is based on an evaluation provided to the FDIC by the institution’s primary federal regulator and information which the FDIC determines to be relevant to the institution’s financial condition and the risk posed to the deposit insurance funds (which may include, if applicable, information provided by the institution’s state supervisor). An institution’s insurance assessment rate is then determined based on the capital category and supervisory category to which it is assigned.

Under the final risk-based assessment system there are nine assessment risk classifications (i.e., combinations of capital groups and supervisory subgroups) to which different assessment rates are applied. Assessment rates for deposit insurance currently range from zero basis points ($2,000 minimum) to .27%. The capital and supervisory subgroup to which an institution is assigned by the FDIC is confidential and may not be disclosed. A bank’s rate of deposit insurance assessments will depend upon the category and subcategory to which the bank is assigned by the FDIC. Any increase in insurance assessments could have an adverse effect on the earnings of insured institutions, including the Bank.

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SAFETY AND SOUNDNESS REGULATIONS

The FDIC has adopted guidelines that establish standards for safety and soundness of banks. They are designed to identify potential safety and soundness problems and ensure that banks address those concerns before they pose a risk to the deposit insurance fund. If the FDIC determines that an institution fails to meet any of these standards, the agency can require the institution to prepare and submit a plan to come into compliance. If the agency determines that the plan is unacceptable or is not implemented, the agency must, by order, require the institution to correct the deficiency. The federal banking agencies have broad powers under current federal law to take prompt corrective action to resolve problems of insured depository institutions. The extent of these powers depends upon whether the institution in question is considered “well capitalized,” “adequately capitalized,” “under capitalized,” “significantly under capitalized,” or “critically undercapitalized.” All such terms are defined under uniform regulation defining such capital levels issued by each of the federal banking agencies.

The FDIC also has safety and soundness regulations and accompanying guidelines on asset quality and earnings standards. The guidelines provide six standards for establishing and maintaining a system to identify problem assets and prevent those assets from deteriorating. The guidelines also provide standards for evaluating and monitoring earnings and for ensuring that earnings are sufficient to maintain adequate capital and reserves. If an institution fails to comply with a safety and soundness standard, the agency may require the institution to submit and implement an acceptable compliance plan, or face enforcement action.

THE GRAMM-LEACH BLILEY ACT OF 1999

The Gramm-Leach-Bliley Act of 1999 (“GLBA”) was signed into law on November 12, 1999. The main purpose of GLBA is to permit greater affiliations within the financial services industry, primarily banking, securities and insurance. The provisions of GLBA that are believed to be of most significance to the Company are discussed below.

GLBA repealed sections 20 and 32 of the Glass-Steagall Act, which separated commercial banking from investment banking, and substantially amends the Bank Holding Company Act which limited the ability of bank holding companies to engage in the securities and insurance businesses. To achieve this purpose, GLBA created a new type of company, the “financial holding company.” A financial holding company may engage in or acquire companies that engage in a broad range of financial services, including

A bank holding company may elect to become a financial holding company only if all of its depository institution subsidiaries are well-capitalized, well-managed and have at least a satisfactory CRA rating. For various reasons, the Company has not elected to be treated as a financial holding company.

GLBA establishes a system of functional regulation under which the federal banking agencies regulate the banking activities of financial holding companies and banks’ financial subsidiaries, the Securities and Exchange Commission regulate their securities activities and state insurance regulators will regulate their insurance activities.

GLBA and certain regulations issued by federal banking agencies also provide protection against the transfer and use by financial institutions of consumer’s nonpublic personal information. A financial institution must provide to its customers, at the beginning of the customer relationship and annually thereafter, the institution’s policies and procedures regarding the handling of customers’ nonpublic personal financial information. The privacy provisions generally prohibit a financial institution from providing a customer’s personal financial information to unaffiliated third parties unless the institution discloses to the customer that the information may be so provided and the customer is given the opportunity to opt out of such disclosure.

Neither the provisions of GLBA nor the act’s implementing regulations have had a material impact on the Company’s or the Bank’s regulatory capital ratios (as discussed above) or the ability to continue to operate in a safe and sound manner.

USA PATRIOT ACT OF 2001

In October 2001, the USA Patriot Act of 2001 was enacted in response to the terrorist attacks in New York, Pennsylvania and Washington, D.C. which occurred on September 11, 2001. The Patriot Act is intended to strengthen U.S. law enforcements and the intelligence communities abilities to work cohesively to combat terrorism on a variety of fronts. The Patriot Act contains sweeping anti-money laundering and financial transparency laws and

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imposes various regulations, including standards for verifying client 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. Compliance with the Patriot Act by the Company and the Bank has not had a material impact on the Company or the Bank’s results of operations or financial condition.

SARBANES-OXLEY ACT OF 2002

The Sarbanes-Oxley Act of 2002 comprehensively revised the laws affecting corporate governance, accounting obligations and corporate reporting for companies, such as the Company, with equity or debt securities registered under the Securities Exchange Act of 1934. In particular, the Sarbanes-Oxley Act established: (i) new requirements for audit committees, including independence, expertise, and responsibilities; (ii) additional responsibilities regarding financial statements for the Chief Executive Officer and Chief Financial Officer of the reporting company; (iii) new standards for auditors and regulation of audits; (iv) increased disclosure and reporting obligations for the reporting company and their directors and executive officers; and (v) new and increased civil and criminal penalties for violation of the securities laws.

AVAILABLE INFORMATION

The Company files annual, quarterly and current reports, proxy statements and other information with the Securities and Exchange Commission (the “SEC”). The Company’s SEC filings are filed electronically and are available to the public over the Internet at the SEC’s web site at http://www.sec.gov. In addition, any document filed by the Company with the SEC can be read and copied at the SEC’s public reference facilities at 450 Fifth Street, N.W., Washington, D.C. 20549. Copies of documents can be obtained at prescribed rates by writing to the Public Reference Section of the SEC at 450 Fifth Street, N.W. Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The Company’s web site is http://www.baybanks.com and beginning in January 2004, the Company’s SEC filings are available through this Web site as of the day they are filed with the SEC. Copies of documents can also be obtained free of charge by writing to Richard C. Abbott, Treasurer, 100 South Main Street, Post Office Box 1869, Kilmarnock, Virginia 22482 or by calling 804-435-1171.

ITEM 2: PROPERTIES

The Company, through its subsidiaries, owns or leases buildings that are used in the normal course of business. The main office is located at 100 South Main Street, Kilmarnock, Virginia in a building owned by the subsidiary bank. The Company’s subsidiaries own or lease various other offices in the counties or towns in which they operate.

Unless otherwise noted, the properties listed below are owned by the Company and its subsidiaries as of December 31, 2003.

Locations

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ITEM 3: LEGAL PROCEEDINGS

The Company is currently not involved in any material legal proceeding other than the ordinary and routine litigation incidental to its business.

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

There were no matters submitted to a vote of security holders during the fourth quarter of the year ended December 31, 2003.

PART II

ITEM 5: MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Bay Banks of Virginia common stock trades on the OTC Bulletin Board under the symbol “BAYK” and transactions generally involve a small number of shares. There were 2,326,080 shares of the Company’s stock outstanding at the close of business on December 31, 2003 which were held by 765 shareholders of record.

The following table summarizes the high and low closing sales prices and dividends declared for the two years ended December 31, 2003 and 2002.

A discussion of certain restrictions and limitations on the ability of the Bank to pay dividends to the Company and the ability of the Company to pay dividends on its common stock, is set forth in Part I, Business, of this Form 10-K under the heading “Supervision and Regulation.”

The dividend amount on the Company’s common stock is established by the Board of Directors on a quarterly basis with dividends paid on a quarterly basis. In making its decision on the payment of dividends on the Company’s common stock, the Board considers operating results, financial condition, capital adequacy, regulatory requirements, shareholder return, and other factors.

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ITEM 6: SELECTED FINANCIAL DATA

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

The following discussion provides information about the major components of the results of operations and financial condition, liquidity and capital resources of Bay Banks of Virginia and its subsidiaries. This discussion and analysis should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements presented in Item 8, Financial Statements and Supplementary Data, on this Form 10-K.

CRITICAL ACCOUNTING POLICIES

GENERAL. The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). The financial information contained within our statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change.

ALLOWANCE FOR LOAN LOSSES. The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting: (1) Statement of Financial Accounting Standards (“SFAS”) No. 5, Accounting for Contingencies, which requires that losses be accrued when they are probable of occurring and estimable and (2) SFAS No. 114, Accounting by Creditors for Impairment of a Loan, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. The use of these values is inherently subjective and our actual losses could be greater or less than the estimates.

The allowance for loan losses is increased by charges to income and decreased by charge-offs (net of recoveries). Management’s periodic evaluation of the adequacy of the allowance is based on past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, and current economic conditions.

GOODWILL. In October 2002, the Financial Accounting Standards Board issued Statement No. 147, Acquisitions of Certain Financial Institutions. The Statement amends previous interpretive guidance on the application of the purchase method of accounting to acquisitions of financial institutions, and requires the application of Statement No. 141, Business Combinations, and Statement No. 142, Goodwill and Other Intangible Assets, to branch acquisitions if such transactions meet the definition of a business combination. The provisions of the Statement do not apply to transactions between two or more mutual enterprises. In addition, the Statement amends Statement No. 144, Accounting for the Impairment of Long-Lived Assets, to include in its scope core deposit intangibles of financial institutions. Accordingly, such intangibles are subject to a recoverability test based on undiscounted cash flows, and to the impairment recognition and measurement provisions required for other long-lived assets held and used. The Company adopted this interpretation of Statement 147 for the intangibles associated with branch acquisitions that were executed in 1994, 1997, and 2000. The Company conducted an in-depth study of the issue and has determined that the intangibles associated with these branch acquisitions qualify as a business combination as described in Statement 141 and 142, as well as Emerging Issues Task Force Ruling 98-3. The impact of this reclassification is discussed in detail in the Non-Interest Expense Section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations.

OVERVIEW

2003 Compared to 2002

Bay Banks of Virginia, Inc. recorded earnings for 2003 of $2,013,185 or $.87 per share basic or $.86 per share on a diluted basis as compared to 2002 earnings of $2,301,401 or $1.00 per share basic and $0.99 per share on a diluted basis. This is a decrease in net income of 12.52% as compared to year end 2002. Net interest income for 2003 decreased to $8,562,995, down 2.17% as compared to $8,753,103 for 2002. Non-interest income for 2003, before net securities gains, increased to $2,588,894 as compared to 2002 non-interest income, before net securities gains, of $2,088,624, for an increase of 23.95%. Non-interest expenses increased to $8,536,017, up 18.51% over 2002 non-interest expenses of $7,202,587.

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Performance as measured by the Company’s return on average assets (ROA) was .72% for the year ended December 31, 2003 compared to .91% for 2002. Performance as measured by return on average equity (ROE) was 7.92% for the year ended December 31, 2003, compared to 9.72% for 2002.

2002 Compared to 2001

Earnings for Bay Banks of Virginia, Inc., were $2,301,401 for 2002, up 14.56% as compared to 2001 earnings of $2,008,839. 2002 basic earnings per share were $1.00 and diluted earnings per share were $0.99 as compared to 2001 basic earnings per share of $.87 and diluted earnings per share of $0.86. Net interest income was $8,753,103 for 2002 as compared to $8,121,421 for 2001. This represents an increase of 7.78% over net interest income for 2001. Non-interest income before net securities gains for 2002 was $2,088,624, up 1.23% over 2001 non-interest income before net securities gains of $2,063,146. Non-interest expenses for 2002 were $7,202,587, up 2.27% as compared to 2001 non-interest expenses of $7,042,737.

Performance as measured by the Company’s return on average assets (ROA) was .91% for the year ended December 31, 2002, compared to .88% for 2001. Performance as measured by return on average equity (ROE) was 9.72% for the year ended December 31, 2002, compared to 9.04% for 2001.

Return on Equity & Assets

Years Ended December 31,

RESULTS OF OPERATIONS

Net Interest Income

The principal source of earnings for the Company is net interest income. Net interest income is the amount by which interest income exceeds interest expense. The net interest margin is net interest income expressed as a percentage of interest earning assets. Changes in the volume and mix of interest earning assets and interest bearing liabilities, the associated yields and rates, and the volume of non-performing assets have a significant impact on net interest income, the net interest margin, and net income.

Net interest income, on a fully tax equivalent basis, which reflects the tax benefits of nontaxable interest income, was $9.0 million in 2003, $9.1 million in 2002 and $8.4 million in 2001. This represents a nominal decrease in net interest income of 1.3% for 2003 as compared to 2002 and an increase of 8.3% for 2002 compared to 2001. The interest rate spread on average earning assets and liabilities was 3.2%, 3.6% and 3.4% for 2003, 2002, and 2001 respectively.

The Company’s net interest margin decreased to 3.53% for 2003 as compared to 3.93% for 2002. The net interest margin was 3.99% for 2001. The yield on earning assets decreased to 5.41% for 2003 as compared to 6.27% and 7.47% for years 2002 and 2001, consecutively. The cost of interest bearing liabilities decreased to 2.17% for 2003 as compared to 2.71% and 4.05% for years 2002 and 2001 consecutively. Average earning assets increased 9.9% to $253.6 million at year end 2003 as compared to $230.7 million at year end 2002. Average earning assets

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were $210.2 million at year end 2001. Average interest bearing liabilities increased 10.4% to $220.0 million at year end 2003 as compared to $199.2 million at year end 2002. Average interest bearing liabilities were $180.6 million at year end 2001.

Average Balances, Income and Expenses, Yields and Rates

Years Ended December 31,

Notes:

(1)-Income and yield is tax-equivalent assuming a federal tax rate of 34%

(2)-Includes Visa credit card program and nonaccrual loans.

During 2003, the Company experienced significant compression in its net interest margin and consequently its net interest income. Conversely, during 2002, there was improvement in net interest income which was due mainly to the falling interest rate environment coupled with the liability sensitive risk position of the Company’s balance sheet. The result was a more rapid decline in deposit rates than in asset rates with deposits re-pricing more rapidly than loans. As the general rate environment reached historic lows during the fourth quarter of 2002 and throughout 2003, the Company experienced heavy volumes of loan prepayments as consumers fled adjustable rate mortgages for conventional 30 year fixed rate loans. These conventional mortgages are not held in the Company’s portfolio, but rather, are sold into the secondary market on an individual loan by loan basis. The sale of these loans creates fee income at the time of sale, but reduces the Company’s expected future cash flow from interest income and principal repayment. Fortunately, while record numbers of loans were being paid off into the secondary market, record numbers of new loans were being generated for the Company’s loan portfolio. However, as the historically low interest rate environment persisted, the new loan volume that was placed in the Company’s loan portfolio was at significantly lower rates than those that were paid off and re-financed into conventional secondary market mortgages.

During this time of heavy prepayment and re-pricing, management decided to not offer a 30 year fixed rate loan product, but rather, to continue offering variable and adjustable rate products. Management believes that by not committing liquidity to a long-term fixed rate product during this period of low interest rates, the potentially negative impact of a rising rate environment will be mitigated. Further, as a result of the success of the one and three year adjustable rate mortgages during 2003, coupled with the success of the 5 year certificate of deposit product that was offered during 2002, the balance sheet mix has become more asset sensitive than the prior period. This realignment of the balance sheet mix may benefit the Company through improved net interest margins, if interest rates begin to increase.

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Another component of the reduction in the net interest margin was the high volume of federal funds sold that the Company maintained throughout 2003. As investors left the equities markets and invested in certificates of deposit and interest bearing transaction accounts, deposit levels increased rapidly throughout the year. Average total deposits increased 9.7% or approximately $19.0 million. This deposit growth, coupled with the heavy volume of loan prepayments, held federal funds sold balances at approximately $27.0 million during 2003. And while these balances provide the necessary liquidity for expected loan growth and investment purchases, they were a very low yielding investment during all of 2003.

Volume & Rate Analysis of Changes in Net Interest Income

Years Ended December 31,

Notes:

The change in interest, due to both rate and volume, has been allocated to change due to volume and change due to rate in proportion to the relationship of the dollar amounts of the change in each.

Interest Sensitivity

Earnings performance and the maintenance of sufficient liquidity depend heavily on efficient management of the interest sensitivity gap. The interest sensitivity gap is the difference between interest sensitive assets and interest sensitive liabilities in a specific time interval. The interest sensitivity gap can be managed by re-pricing assets or liabilities, which are variable rate instruments, by replacing an asset or liability at maturity or by adjusting the interest rate during the life of the asset or liability. By matching the volume of assets and liabilities that mature in the same time interval, the Company can insulate against interest rate risk and minimize the impact of rising or falling rates.

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Interest Rate Sensitivity Analysis

As of December 31, 2003

The Company employs a variety of measurement techniques to identify and manage its exposure to changing interest rates and subsequent changes in liquidity. The Company utilizes a simulation model that estimates interest income volatility and interest rate risk. In addition, the Company utilizes an Asset Liability Committee (the “ALCO”) composed of appointed members from management and the Board of Directors. Through the use of simulation, the ALCO estimates the overall magnitude of interest rate risk and then formulates policy with which to manage asset growth and pricing, funding sources and pricing, and off-balance sheet commitments. These decisions are based on management’s expectations regarding future interest rate movements, economic conditions both locally and nationally, and other business and risk factors.

Earnings Simulation Analysis

The Company employs a simulation model that captures the impact of changing interest rates on the interest income received and interest expense paid on all assets and liabilities reflected on the balance sheet. The method is subject to the accuracy of the assumptions that underlie the process, but it provides a valuable analysis of the sensitivity of earnings to changes in interest rates.

The following table reflects the interest rate sensitivity, at twenty-four months, on net interest income for the Company using different rate scenarios.

Unlike most industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates have a more significant impact on a financial institution’s performance than do general levels of inflation. Interest rates do not necessarily move in the same magnitude as the prices of goods and services. Another impact of inflation is on non-interest expenses, which tend to rise during periods of general inflation. The values of real estate held as collateral by the Company for loans and foreclosed property could be affected by inflation or changing prices due to market conditions.

Management believes the most significant impact on financial results is the Company’s ability to react to changes in interest rates. Management attempts to maintain a favorable position between rate-sensitive assets and rate-sensitive liabilities in order to protect against wide interest rate fluctuations.

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Economic Value of Equity Simulation

Economic value of equity simulation is used to calculate the estimated fair value of assets and liabilities over different interest rate environments. Economic values are calculated based on discounted cash flow analysis with the net economic value of equity being the value of all assets minus the market value of all liabilities. The change in economic value over varying rate environments is an indication of long term interest rate sensitivity of the balance sheet. The following chart reflects the change in the economic value of equity over varying rate environments:

The Company’s duration of equity, or slope of the economic value of equity interest rate risk, is 5%, which reveals that the market value will change 5% for every 100 basis point change in interest rates. At this level, the banks economic value of equity will fall to $0 if rates rise by approximately 2000 basis points.

Non-Interest Income

Total non-interest income increased 41.5% to $3.0 million in 2003 as compared to $2.1 million in 2002. Non-interest income in 2001 was $2.1 million which represents a 0.3% increase for 2002 as compared to year end 2001.

The increase in non-interest income was due primarily to gains on sale of investment securities and gains on sale of other real estate. For 2003, gains on sale of investment securities totaled $371 thousand and gains on sale of other real estate totaled $192 thousand. These gains were significantly greater than 2002 volumes which were $3 thousand for gains on sale of investment securities and a loss of $23 thousand for gains on sale of other real estate. Gains on sale of investment securities resulted from numerous calls within the investment portfolio as well as planned restructuring through the sale of investment securities. Management used 2003 as an opportunity to shorten the duration of the investment portfolio in anticipation of increased yields in coming quarters. This restructuring will result in short term reductions in total investment yield, but will offer management the opportunity to purchase higher yielding bonds without incurring material losses from the sale of investment securities in subsequent quarters. The gain on sale of other real estate was a result of the sale of foreclosed properties during 2003. Management does not expect that non interest income will be impacted to this degree during 2004, but rather the trend will return to modest gains in both investments and the sale of other real estate.

In other non interest income sectors, fiduciary income as provided by the Company’s subsidiary Bay Trust Company declined by 2.1% or $14 thousand during 2003 compared to 2002. Fiduciary income decreased by $176 thousand or 21.6% for 2002 as compared to 2001. Fiduciary income is largely affected by changes in the performance of the stock market, which directly impacts the market value of the accounts upon which fees are earned. This being the case, performance of fiduciary activities can be expected to approximate the performance of the national stock markets. While Bay Trust Company realized a decline in revenues during 2003, their managed accounts consistently outperformed the S&P 500 index. Further, the decline in income for 2003 as compared to 2002 is significantly less than the decline between 2002 and 2001. As general economic conditions have improved, including recent stock market improvements, fiduciary income has also improved. In addition, Bay Trust Company has been successful in acquiring new trust business throughout 2003 and into 2004. This is largely due to increased sales and marketing commitments, and management expects this trend to continue into subsequent quarters.

Service charges on deposits increased by 10.6% to $599 thousand as compared to $541 thousand in 2002. Service charges on deposit accounts were $460 thousand in 2001. Other service charges increased by 4.7% to $663 thousand during 2003 as compared to $633 thousand in 2002. Other service charges were $551 thousand in 2001. Secondary market loan fees increased 39.1% to $363 thousand in 2003 compared to $261 thousand in 2002. Secondary market lending fees were $224 thousand in 2001.

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Non-Interest Expense

During 2003, total non-interest expenses increased 18.5% to $8.5 million from $7.2 million in 2002 and $7.0 million in 2001. This represents an increase of 2.3% for 2002 over 2001. Non-interest expenses are composed of salaries and benefits, occupancy expense, state bank franchise taxes and other operating expenses.

Salary and benefit expense is the major component of non-interest expenses. Salary and benefits expense increased 21.8% to $4.4 million in 2003 as compared to $3.6 million in 2002 and $3.6 million in 2001. During the fourth quarter of 2002 and throughout 2003, the Company filled several key relationship and management positions. Of the management positions, several were related to increased regulatory requirements as a result of the enactment of the Sarbanes-Oxley Act and the USA Patriot Act. These legislative acts resulted in the creation of non income earning positions and will continue to impact non interest expenses in subsequent quarters. In addition, commissioned sales staff in the lending area generated salary expense of $162 thousand during 2003. Commissions paid in 2002 were $151 thousand and in 2001, $103 thousand. Increased loan production volume in the secondary market lending program resulted in the increases in commission payments. This trend is subject to continued growth in the local housing market and levels of interest rates. Management does not anticipate adding additional staff during 2004.

For 2002 and 2001 the Company has reclassified salary expense to conform to Financial Accounting Standard Board’s Statement 91, which addresses accounting for loan fees and costs. Salary expense was reduced due to this reclassification by $1,038,533 and $435,070 for 2002 and 2001, respectively. The corresponding entries reduced loan fee income by the same amounts. Salary and benefits expense was $3.6 million in 2002 and $3.6 million in 2001, as adjusted, which represents no increase between 2002 and 2001.

Occupancy expense for 2003 increased 53.7% to $1.4 million as compared to $884 thousand for 2002 and $804 thousand for 2001. This is an increase of 10.0% for 2002 over 2001. Occupancy expense was primarily impacted by the first full year of software maintenance and depreciation expense as related to the installation of a new Companywide network and core processing system. Depreciation and maintenance contract expenses related to the new network and core operating system increased by $204 thousand during 2003 as compared to 2002. Management expects that operating efficiencies will offset this additional expense in future quarters. Occupancy expenses were also impacted by the renovation and rehabilitation of the Montross Branch of the Company’s subsidiary Bank of Lancaster. Renovation of this branch resulted in the addition of $316 thousand to the cost basis of the building which resulted in additional depreciation, repair, and operating expenses. Other expense for 2003 increased 0.3% to $2.0 million over 2002 expenses of $2.0 million. Other operating expenses were impacted primarily by increases in legal, accounting, and consulting expenses that resulted from compliance with the Sarbanes-Oxley Act. These expenses increased by 62% to $230 thousand as compared to $142 thousand in 2002.

As discussed earlier in the Goodwill paragraph of the Critical Accounting Policies section of this document, the Bank adopted Financial Accounting Standards Board Statement No. 147, Acquisitions of Certain Financial Institutions. This statement amended previous interpretive guidance on the application of the purchase method of accounting to acquisitions of financial institutions, and requires the application of Statement No. 141, Business Combinations, and Statement No. 142, Goodwill and Other Intangible Assets. Upon adoption of Statement No. 147, during 2002 the Bank was able to recover the non-cash expense allocated to the amortization of the core deposit intangible that was associated with each of the branch acquisition transactions that were previously executed. The result was a reduction in other expense of $233 thousand in 2002 as compared to 2001.

Income Taxes

Income tax expense in 2003 was $661 thousand, down from $870 thousand in 2002 and $830 thousand in 2001. Income tax expense corresponds to an effective rate of 24.7%, 27.4% and 29.2% for the three years ended December 31, 2003, 2002, and 2001, respectively. Note 11 to the Consolidated Financial Statements provides a reconciliation between the amounts of income tax expense computed using the federal statutory income tax rate and actual income tax expense. Also included in Note 11 to the Consolidated Financial Statements is information regarding deferred taxes for 2003 and 2002.

Loans

Loan production reached record levels during 2003, but net loan growth was hampered by heavy volumes of loan prepayments into 30 year fixed rate secondary market loans. These loans are underwritten by Company staff, but are funded into conventional loan pools outside of the Company balance sheet. The Company earns a fee

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for originating the loan, but no loan volume is placed on the balance sheet and there is no continuing cash flow from interest earned and principal received. During 2003, loans net of unearned income increased by 11.9% to $190.4 million as compared to 2002 balances of $170.1 million. Loans secured by real estate represent the largest category, comprising 80.1% of the loan portfolio at December 31, 2003. Of these balances, 1-4 family residential, not including home equity lines, was 54.7% of total loans down from 56.5% at year end 2002. Commercial loan balances increased 48.1% to $24.8 million from $16.8 million at year end 2002. Commercial loan balances were 13.0% of total loans at year end 2003 as compared to 9.9% at year end 2002. Consumer installment loans increased 5.6% to $10.6 million from $10.0 million at year end 2002.

Types of Loans

Years Ended December 31,

Notes:

Deferred loan costs & fees not included.

Allowance for loan losses not included.

Loan Maturity Schedule of Selected Loans

As of December 31, 2003