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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10–Q

(Mark One)

For the quarterly period ended September 30, 2004

OR

For the transition period from             to             

Commission file number 0–30777

PACIFIC MERCANTILE BANCORP

(Exact name of Registrant as specified in its charter)

(714) 438–2500

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address and former fiscal year, if changed, since last year)

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 Exchange Act).    Yes  ¨    No  x

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

10,082,841 shares of Common Stock as of November 8, 2004

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PACIFIC MERCANTILE BANCORP

QUARTERLY REPORT ON FORM 10Q

FOR

THE QUARTER ENDED September 30, 2004

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PART I. – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in thousands)

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

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Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(Dollars in thousands, except for per share data)

(Unaudited)

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

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Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Dollars in thousands)

(Unaudited)

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

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Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(unaudited)

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

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Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Unaudited)

The consolidated financial statements include the accounts of Pacific Mercantile Bancorp (“PMBC”) and its wholly owned subsidiaries, which are Pacific Mercantile Bank (the “Bank”) and PMB Securities Corp. (which, together with PMBC, shall be referred to as the “Company”). The Bank is chartered by the California Department of Financial Institutions (the “DFI”) and is a member of the Federal Reserve Bank of San Francisco (“FRB”). In addition, deposit accounts of the Bank’s customers are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to the maximum amount allowed by law.

The Bank, which accounts for substantially all of our consolidated operations, provides a full range of banking services to small and medium-size businesses, professionals and the general public in Orange, Los Angeles and San Diego Counties of California and is subject to competition from other financial institutions conducting operations in those same markets.

PMB Securities Corp. commenced operations in June 2002 as an SEC registered securities broker–dealer that is engaged in the retail securities brokerage business and is a member firm of the National Association of Securities Dealers.

During 2002, the Company organized three business trusts, under the names Pacific Mercantile Capital Trust I, PMB Capital Trust I, and PMB Statutory Trust III, respectively, to facilitate sales, in private placements, of an aggregate of $17.5 million of trust preferred securities to institutional investors. In accordance with applicable accounting standards, the financial statements of these trusts are not included in the Company’s consolidated financial statements. See Note 2: “Significant Accounting Policies — Principles of Consolidation” below.

The accompanying unaudited consolidated financial statements have been prepared in accordance with the instructions to Form 10–Q and, therefore, do not include all footnotes as would be necessary for a fair presentation of financial position, results of operations, changes in cash flows and comprehensive income (loss) in accordance with generally accepted accounting standards in the United States of America (“GAAP”). However, these interim financial statements reflect all adjustments (consisting of normal recurring adjustments and accruals) which, in the opinion of the management, are necessary for a fair presentation of the results for the interim periods presented. These unaudited condensed consolidated financial statements have been prepared in accordance with a basis consistent with prior periods, and should be read in conjunction with the Company’s audited financial statements as of and for the year ended December 31, 2003 and the notes thereto included in the Company’s Annual Report on Form 10–K for the fiscal year ended December 31, 2003 filed with the Securities and Exchange Commission under the Securities Exchange Act of 1934.

The Company’s consolidated financial position at September 30, 2004, and the results of its operations for the three month and nine month periods ended September 30, 2004, are not necessarily indicative of the results of operations that may be expected for any other interim period during or for the full year ending December 31, 2004.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Cont.-)

Use of Estimates

The preparation of the financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make certain estimates and assumptions that affect the reported amounts of assets, liabilities, and contingencies at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries Pacific Mercantile Bank and PMB Securities Corp. All significant intercompany accounts and transactions have been eliminated in consolidation. Prior to March 31, 2004, Pacific Mercantile Capital Trust I, PMB Capital Trust I, and PMB Statutory Trust III, (the “Trust Subsidiaries”), were included in our consolidated financial statements. However, in accordance with a revision, adopted by the Financial Accounting Standards Board (the “FASB”) in January 2004, to Financial Interpretation Number (FIN) 46, effective as of March 31, 2004 the Trust Subsidiaries were de-consolidated and are not included in our consolidated financial statements. See “ – Recent Accounting Pronouncements” in this section.

Nonperforming Loans and Other Assets

At September 30, 2004, the Company had $12,000 in nonaccrual and impaired loans and had no restructured loans and no loans that were past due as to principal for 90 days that were still accruing interest.

Income Per Share

Basic income per share for any fiscal period is computed by dividing net income for such period by the weighted average number of common shares outstanding during that period. Fully diluted income per share reflects the potential dilution that could have occurred assuming all outstanding options or warrants to purchase our shares of common stock at exercise prices that were less than the market price of our shares were exercised into common stock, thereby increasing the number of shares outstanding during the period.

Stock-Based Employee Compensation Plans

The Company accounts for stock-based employee compensation as prescribed by APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and has adopted the disclosure provisions of Statements of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock Based Compensation.” SFAS No. 123 requires pro-forma disclosures of the Company’s net income and net income per share as if the fair value based method of accounting for stock based awards had been applied. Under the fair value based method, compensation cost is recorded based on the value of the award at the grant date and is recognized over the employee’s period of service with the Company. In December 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” which amended the disclosure requirements of FASB No. 123 to require certain disclosures about stock-based employee compensation plans in an entity’s accounting policy footnote. The Company has adopted the disclosure provisions of SFAS No. 148 and, in accordance therewith, the disclosures required by SFAS No. 148 are included below in this footnote to our unaudited interim consolidated financial statements included in this Report.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Cont.-)

Effective March 2, 1999, our Board of Directors adopted, and in January 2000 our shareholders approved, the 1999 Stock Option Plan (the “1999 Option Plan”). That Plan authorizes the granting of options to directors, officers and other key employees, that entitle them to purchase shares of common stock of the Company at a price per share equal to or above the fair market value of the Company’s shares on the date the option is granted. Options may vest immediately or over various periods of up to five years, determined by the Company’s Compensation Committee at the time it approves the grant of options under the 1999 Option Plan and expire 10 years after the grant date, or following termination of service, if sooner. A total of 1,248,230 shares were authorized for issuance under the 1999 Option Plan (which number has been adjusted for stock splits effectuated subsequent to the Plan’s adoption).

Effective February 17, 2004, the Board of Directors adopted the Pacific Mercantile Bancorp 2004 Stock Incentive Plan (the “2004 Plan”), which was approved by the Company’s shareholders in May 2004. That Plan authorizes the granting of options and rights to purchase restricted stock to directors, officers and other key employees, that entitle them to purchase shares of common stock of the Company at a price per share equal to or above the fair market value of the Company’s shares on the date the option is granted or the stock purchase rights are awarded. Options and restricted stock purchase rights may vest immediately or over various periods of up to five years, determined by the Company’s Compensation Committee at the time the options are granted or the stock purchase rights are awarded. Options granted under the 2004 Plan will expire 10 years after the grant date, or following termination of service, if sooner. In the case of restricted stock purchase rights, they generally will expire, if not exercised, within 15 days of the date of the award. If exercised, any unvested shares will become subject to repurchase by the Company in the event of a termination of employment or service of the holder of the stock purchase right. A total of 400,000 shares were authorized for issuance under the 2004 Plan.

The Company continues to account for stock-based compensation using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” under which no compensation cost for stock options is recognized in the accompanying financial statements for stock option or stock purchase awards granted at or above fair market value. Had compensation expense for the Company’s 1999 and 2004 Option Plans been determined based upon the fair value at the grant date for awards under those Plans in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation,” the Company’s net income and income per share would have been reduced to the pro forma amounts indicated below:

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Cont.-)

The fair value of the options that were outstanding under the 1999 and 2004 Plans was estimated at the date of grant using the Black-Scholes option-pricing model The following table summarizes the weighted average assumptions used for grants following periods:

Comprehensive Income

Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on securities available for sale, are reported as a separate component of the equity section of the balance sheet net of income taxes, such items, along with net income, are components of comprehensive income.

Recent Accounting Pronouncements

In December 2002, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities”—an interpretation of Accounting Research Bulletin (“ARB”) No. 51. This Interpretation defines a variable interest entity and provides that if a business enterprise has a controlling financial interest in a variable interest entity, the assets, liabilities and results of the activities of the variable interest entity should be included in consolidated financial statements with those of the business enterprise. Furthermore, the FASB indicated that the voting interest approach of ARB No. 51 is not effective in identifying controlling financial interests in entities that are not controllable through voting interests or in which the equity investors do not bear the residual economic risk. This Interpretation became applicable immediately to variable interest entities created or in which an interest was acquired after January 31, 2003, and beginning after June 15, 2003, in the case of variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. The Interpretation applies to public enterprises as of the beginning of the applicable interim or annual periods.

In January 2004, subsequent to the issuance of FIN 46, the FASB issued a revised interpretation, the provisions of which were required to be applied to certain variable interest entities by March 31, 2004. In accordance with the provisions of FIN 46, as revised, effective as of March 31, 2004 the then existing trust subsidiaries organized by the Company to facilitate the sales of trust preferred securities, as described in Note 1 above, were deconsolidated and, for that reason, are not included in the Company’s consolidated financial statements as of September 30, 2004 and December 31, 2003, and for the three and nine month periods ended September 30, 2004 and 2003. However, the adoption of FIN 46 and its revisions did not have a material impact on the Company’s financial statements.

Reclassification

Certain amounts in the accompanying 2003 consolidated financial statements have been reclassified to conform to 2004 presentation.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Cont.-)

Commitments and Contingencies

To meet the financing needs of its customers in the normal course of business, the Company is party to financial instruments with off–balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated financial statements. At September 30, 2004, the Company was committed to fund loans totaling approximately $162 million (inclusive of mortgage loans that, if funded, will be held for sale). The contractual amounts of credit-related financial instruments such as commitments to extend credit, credit-card arrangements, and letters of credit represent the amounts of potential accounting loss should the contract be fully drawn upon, the customer default, and the value of any existing collateral become worthless.

The Company uses the same credit policies in making commitments to extend credit and conditional obligations as it does for on–balance sheet instruments. Commitments generally have fixed expiration dates; however, since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s credit worthiness on a case–by–case basis, using the same credit underwriting standards that are employed in making commercial loans. The amount of collateral obtained, if deemed necessary by the Company upon an extension of credit, is based on management’s credit evaluation of the customer. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, residential real estate and income–producing commercial properties.

In the ordinary course of business, the Company is subject to legal action normally associated with financial institutions. At September 30, 2004, the Company was not a party to any pending legal action that is expected to be material to its consolidated financial condition or results of operations.

In October 2004, the Company issued $10 million principal amount of 30-year floating rate junior subordinated debentures of which $8 million qualify, for regulatory purposes, as Tier 1 capital and the remainder as Tier II capital. The proceeds from the sale of these debentures are to be used to support the growth of the Company’s banking franchise. The debentures were sold to PMB Capital Trust III, a Delaware grantor trust organized by the Company to sell $10 million of trust preferred securities to an institutional investor, the proceeds from which were used to purchase those debentures from the Company.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

Pacific Mercantile Bancorp is a bank holding company that owns all of the stock of Pacific Mercantile Bank (the “Bank”), which is a commercial bank that provides a full range of banking services to small and medium-size businesses and to professionals and the general public in Orange, Los Angeles and San Diego counties, in Southern California. Substantially all of our operations are conducted and substantially all of our assets are owned by the Bank, which accounts for substantially all of our consolidated revenues and operating costs.

The following discussion presents information about our consolidated results of operations for the three and nine month periods ended September 30, 2004 and 2003 and our consolidated financial condition, liquidity and capital resources at September 30, 2004 and should be read in conjunction with our consolidated financial statements and the notes thereto included elsewhere in this Report.

Forward–Looking Information

Statements contained in this Report that are not historical facts or that discuss our expectations or beliefs regarding our future operations or future financial performance, or financial or other trends in our business, constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Often, they include the words “believe,” “expect,” “anticipate,” “intend,” “plan,” “estimate,” “project,” or words of similar meaning, or future or conditional verbs such as “will,” “would,” “should,” “could,” or “may.” The information contained in such forward-looking statements is based on current information and assumptions about future events over which we do not have control and our business is subject to a number of risks and uncertainties that could cause our financial condition or actual operating results in the future to differ significantly from our expected financial condition or operating results that are set forth in those statements. Those risks and uncertainties are described in this Section of this Report, including in the subsection below entitled “Risks and Uncertainties That Could Affect Our Future Financial Performance” and readers of this Report are urged to read this Section in its entirety, including that subsection.

Critical Accounting Policies

Our consolidated financial statements are prepared in accordance with general accepted accounting principles in the United States, (“GAAP”) and general practices in the banking industry. The accounting policies we follow in determining the sufficiency of our allowance for loan losses and the fair value of derivative financial instruments involve judgments and assumptions which can have a material impact on the carrying value of our loans and those financial instruments, respectively, and, as a result, we consider these accounting policies to be critical accounting policies.

Allowance for Loan Losses. In determining the adequacy of the allowance for loan losses, we use historical loss factors, adjusted for current economic market conditions and other economic indicators, to determine the losses inherent in our loan portfolio. Actual loan losses could be greater than that predicted by those loss factors and our current assessments of current conditions and economic trends if unanticipated changes were to occur in those conditions. In such an event, we would be required to increase the allowance for loan losses by means of a charge to income referred to in our financial statements as the “provision for loan losses.” Such an increase would reduce the carrying value of our loans on our balance sheet, and the additional provision for loan losses taken to increase that allowance would reduce our income, in the period when it is determined that an increase in the allowance for loan losses is necessary. See “—Provision for Loan Losses” and “—Allowance for Loan Losses and Nonperforming Loans” below.

Derivative Financial Instruments. The derivative financial instruments that we enter into consist primarily of interest rate lock commitments that are designed to hedge the change in fair value related to mortgage loans held for sale. At September 30, 2004, approximately $23 million of mortgage loans held for sale were hedged. We estimate the fair value of mortgage loans held

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for sale based on period end market interest rates obtained from various mortgage investors. If the fair values of the mortgage loans held for sale were to decline below those estimated values, we would be required to reduce the carrying values of the mortgage loans held for sale on our statement of financial condition and, correspondingly, reduce our noninterest income. We also enter into non-designated derivative instruments relating to mortgage loan interest rate lock commitments with borrowers and investors in order to reduce our exposure to adverse fluctuations in interest rates. At September 30, 2004 we had $12 million of mortgage loan commitments identified as non-designated derivative instruments. We estimate the fair value of these mortgage loan commitments based on market interest rates at period end. If the fair value of these non-designated derivative instruments were to decline below the expected values, we would be required to recognize a reduction in our noninterest income.

Overview of Operating Results in the Third Quarter and Nine Months ended September 30, 2004

The following table sets forth information regarding the interest income that we generated, the interest expense that we incurred, our net interest income, noninterest income, noninterest expense, and our net income and net income per share for the three and nine months ended September 30, 2004 and 2003.

Key Factors Affecting Operating Results in the Three and Nine Months Ended September 30, 2004

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Set forth below are certain key financial performance ratios and other financial data for the periods indicated:

Results of Operations

Net Interest Income

One of the principal determinants of a bank’s income is net interest income, which is the difference between (i) the interest that a bank earns on loans, investment securities and other interest earning assets, on the one hand, and (ii) its interest expense, which consists primarily of the interest it must pay to attract and retain deposits and the interest that it pays on borrowings and other interest-bearing liabilities, on the other hand. A bank’s interest income and interest expense are, in turn, affected by a number of factors, some of which are outside of its control, including national and local economic conditions and the monetary policies of the Board of Governors of the Federal Reserve (the “Federal Reserve Board” or the “FRB”), which affect interest rates, the demand for loans, and the ability of borrowers to meet their loan payment obligations. Net interest income, when expressed as a percentage of total average interest earning assets, is a banking organization’s “net interest margin.”

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The following table sets forth our interest income, interest expense, net interest income and net interest margin in the three and nine month periods ended September 30, 2004 and September 30, 2003, respectively:

As the table above indicates, the increases in net interest income of $2.7 million, or 81.8% increase in the third quarter of 2004, and $6.2 million, or 61.3%, in the nine months ended September 30, 2004, were attributable to increases in interest income of $3.1 million, or 52.5%, and $6.7 million, or 36.4%, respectively, in those three and nine month periods, respectively. By contrast, our interest expense increased $416,000 or 15.7% and $466,000 or 5.7%, respectively, in the three and nine month periods ended September 30, 2004.

The increase in interest income in the quarter ended September 30, 2004, was primarily attributable to an increase in the volume of interest earning assets, including a $206 million increase in the average volume of outstanding loans (exclusive of mortgages held for sale) over the corresponding period of fiscal 2003, offset by a $19 million reduction in investment securities.

In the nine months ended September 30, 2004, the increase in interest income was primarily attributable to a $177 million increase in our average volume of outstanding loans (exclusive of mortgage loans held for sale) and an increase of $5 million in the average volume of outstanding investment securities. These volume increases in average interest earning assets, were funded primarily by the increase in deposits and in borrowings we obtained from the Federal Home Loan Bank and a shift of funds out of lower yielding federal funds sold.

The increase in interest expense in the third quarter and nine months ended September 30, 2004, as compared to the same respective periods last year, was primarily attributable to increases of $88 million and $78 million in Federal Home Loan Bank borrowings.

Our net interest margin improved to 3.17% in the third quarter of 2004 from 2.19% in the third quarter ended September 30, 2003, and to 2.99% in the nine months ended September 30, 2004 from 2.33% in the same nine months of 2003. In the three months ended September 30, 2004 the yield on interest earning assets improved to 4.78% and the average rate of interest paid on our interest bearing liabilities declined to 2.24%, as compared to a yield on interest earning assets of 3.94% and an average rate of interest paid on interest bearing liabilities of 2.31%, in the same three months of 2003. In the nine months ended September 30, 2004 the yield on interest earning assets improved to 4.58%, and the average rate of interest paid on our interest bearing liabilities declined to 2.19%, as compared to a yield on interest earning assets of 4.21%, and an average rate of interest paid of 2.52%, in the same nine months of 2003.

These improvements were attributable to (i) an increase in the average yield on interest earning assets due primarily to the substantial increase in the volume of core loans on which we generate greater yields than our other interest earning assets, and (ii) a decline in the average rate of interest paid on interest bearing liabilities primarily as result of the change in mix of deposits to a higher proportion of demand and lower cost savings and money market deposits (“core deposits”).

The following table below sets forth changes in interest income, including loan fees, and interest paid in the three and nine month periods ended September 30, 2004, as compared to the same period in 2003, and the extent to which those changes were attributable to changes in the volume of and in the rates of interest earned on interest earning assets and in the volume of and in the rates of interest paid on interest-bearing liabilities.

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The above table indicates that the increases of $2.7 million and $6.2 million in our net interest income in the three and nine months ended September 30, 2004, respectively, as compared to the like periods in 2003 were the result of (i) a $1.9 million increase in the volume variance and by a $844,000 increase in the rate variance for the three months ended September 30, 2004, as compared to the same period in 2003, and (ii) a $4.9 million increase in the volume variance and a $1.3 million increase in the rate variance for the nine months ended September 30, 2004, as compared to the like period in 2003. The increase in the volume variance reflects the increases in average earning assets of $156 million and $148 million, respectively, in the three and nine month periods ended September 30, 2004, as compared to the corresponding periods of 2003.

Provision for Loan Losses

Like virtually all banks and other financial institutions, we follow the practice of maintaining a reserve or allowance (the “Allowance”) for possible losses on loans that occur from time to time as an incidental part of the banking business. When it is determined that the payment in full of a loan has become unlikely, the carrying value of the loan is reduced to what management believes is its realizable value. This reduction, which is referred to as a loan “charge-off,” or “write-down” is charged against that Allowance. The amount of the Allowance for Loan Losses is increased periodically (i) to replenish the Allowance after it has been reduced due to loan charge-offs, (ii) to reflect changes in the volume of outstanding loans, and (iii) to take account of changes in the risk of potential losses due to a deterioration in the condition of borrowers or in the value of property securing non–performing loans or changes in economic conditions. See “—Financial Condition—Allowance for Loan Losses and Nonperforming Loans” below in this Section of this Report. Increases in the Allowance for Loan Losses are made through a charge, recorded as an expense in the statement of income referred to as the “provision for loan losses.” Recoveries of loans previously charged-off are added back to Allowance and, therefore, have the effect of increasing the Allowance for Loan Losses and reducing the amount of the provision that might otherwise be needed to replenish or increase the Allowance.

Although we employ economic models that are based on bank regulatory guidelines and industry standards to evaluate and determine the sufficiency of the Allowance for Loan Losses and, thereby, the amount of the provisions required to be made for potential loan losses, those determinations involve judgments about trends in current economic conditions and other events that can

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affect the ability of borrowers to meet their loan obligations. Future economic conditions are subject to a number of uncertainties, some of which are outside of our ability to control. See the discussion below in this Section under the caption “Risks and Uncertainties That Could Affect our Future Financial Performance — we could incur losses on the loans we make.” In the event of unexpected subsequent events or changes in circumstances, it could become necessary in the future to incur additional charges to increase the Allowance, which would have the effect of reducing our income or could cause us to incur losses.

In addition, the Federal Reserve Board and the California Department of Financial Institutions, as an integral part of their examination processes, periodically review the Bank’s Allowance for Loan Losses. These agencies may require the Bank to make additional provisions, over and above that which we have already made, the effect of which would be to reduce our income.

During the three and nine month periods ended September 30, 2004 we were able to reduce the amount of the provisions made for loan losses to $50,000 and $923,000, respectively, down from $518,000 and $1.1 million in the respective corresponding three and nine month periods of 2003. Those reductions were due to a reduction in the volume of non-accrual or impaired loans, which totaled $12,000 or 0.3% of the amount of the Allowance for Loan Losses at September 30, 2004, as compared to $2.5 million or 63.4% of the amount of the Allowance for Loan Losses at December 31, 2003. The reduction in nonaccrual loans during the nine month period ended September 30, 2004 was due to (i) an $822,000 charge-off, in the first quarter of 2004, of a nonaccrual loan for which reserves had been specifically allocated in the Allowance for Loan Losses at December 31, 2003, and (ii) the repayment of or resumption of payments on substantially all of the other loans that were on nonaccrual status at December 31, 2003. See “—Allowance for Loan Losses and Nonperforming Loans” below.

Noninterest Income

Noninterest income consists primarily of mortgage banking income (which includes loan origination and processing fees and service released premiums) and net gains on sales of loans held for sale, which are generated by our mortgage loan division. That division, which we established during fiscal 2001, originates conforming and non-conforming, agency quality, residential first and second lien and home equity mortgage loans.

The volume of residential mortgage refinancings is subject to significant fluctuations in response to changes in prevailing mortgage interest rates. Such interest rate changes can impact the volume of mortgage loan originations which, in turn, affects the loan processing fees and yield spread premiums we are able to realize on the mortgage loans we originate. For example, the decline in mortgage rates which occurred in 2002 and the first six months of 2003 increased demand for mortgage loan refinancings and resulted in increases in our noninterest income during those periods. Conversely, an increasing interest rate environment, or even the prospect of increasing interest rates, which has occurred over the last 12 months, generally causes a decline in mortgage loan refinancings and, therefore, corresponding declines in the volume of mortgage loan originations and in the income that the mortgage banking division is able to generate. We seek to manage the impact of changes in interest rates by seeking to originate mortgages for home purchases which are not as interest rate sensitive as mortgage loan refinancings. Mortgage loans for home purchases accounted for approximately 42% of our mortgage loan fundings in the quarter ended September 30, 2004 as compared to approximately 12% in the quarter ended September 30, 2003.

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The following table identifies the components of and the percentage changes in noninterest income in the three and nine month periods of 2004, as compared to the same period in 2003.

The decreases in noninterest income in the three and nine months ended September 30, 2004, over the like periods in 2003 were primarily attributable to substantial decreases in mortgage loan refinancings prompted by rising market rates of interest and, to a much lesser extent, decreases of $131,000 and $387,000, respectively, in net gains on securities available for sale. The increases in service charges and fees on deposits in the three and nine month periods ended September 30, 2004, as compared to the same periods in 2003, were attributable to the growth in the volume of our deposits subsequent to the second quarter of 2003.

Noninterest Expense

The following table sets forth the principal components of noninterest expense and the amounts thereof, incurred in the three and nine month periods ended September 30, 2004 and 2003, respectively.