SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003

COMMISSION FILE NUMBER 333-90273

FIDELITY D & D BANCORP, INC.

COMMONWEALTH OF PENNSYLVANIA I.R.S. EMPLOYER IDENTIFICATION NO: 23-3017653
BLAKELY AND DRINKER STREETS
DUNMORE, PENNSYLVANIA 18512
TELEPHONE NUMBER (570) 342-8281

SECURITIES REGISTERED UNDER SECTION 12(b) OF THE ACT:
None

SECURITIES REGISTERED UNDER SECTION 12(g) OF THE ACT:
Common Stock, without par value

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.

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 of this Form 10-K [x].

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K in 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 Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2)

Aggregate market value of the voting common stock held by non-affiliates of the registrant equals $49,580,166, as of June 30, 2003, based on a market price of $35.75. The number of shares of common stock outstanding as of March 12, 2004, equals 1,828,266.

DOCUMENTS INCORPORATED BY REFERENCE:

Excerpts from the Registrant’s 2003 Annual Report to Shareholders are incorporated herein by reference in response to Part I. Portions of the Registrant’s definitive Proxy Statement to be used in connection with the 2004 Annual Meeting of Shareholders are incorporated herein by reference in partial response to Part III.

Contents

FIDELITY D & D BANCORP, INC.

PART I

ITEM 1: BUSINESS

Fidelity D&D Bancorp, Inc (the Company) was incorporated in the Commonwealth of Pennsylvania, on August 10, 1999, and is a bank holding company, whose wholly owned state chartered commercial bank is The Fidelity Deposit and Discount Bank (the Bank) (collectively, the Company). The Company is headquartered at Blakely and Drinker Streets in Dunmore, Pennsylvania.

The Bank has offered a full range of traditional banking services since it commenced operations in 1903. In addition, the Bank has a personal and corporate trust department and also provides alternative financial and insurance products with asset management services. A complete list of services provided by the Bank is detailed in the section entitled “Products & Services” contained within the 2003 Annual Report to Shareholders, incorporated by reference. The service area is comprised of the Borough of Dunmore and the surrounding communities within Lackawanna and Luzerne counties.

The Bank is one of two financial institutions headquartered in Dunmore, Pennsylvania. The banking business is highly competitive, and the profitability of the Company depends principally upon the Company’s ability to compete in its market area. The Company competes with, among other sources, the following:

        The Company has been able to compete effectively with other financial institutions by emphasizing technology and customer service, including local branch decision making on loans, establishing long-term customer relationships and building customer loyalty, and providing products and services designed to address the specific needs of its customers. The Gramm-Leach-Bliley Act (see discussion below), which breaks down many barriers between the banking, securities and insurance industries, may significantly affect the competitive environment in which the Company operates.

There are no concentrations of loans that, if lost, would have a materially adverse effect on the continued business of the Bank. The Bank’s loan portfolio does not have a material concentration within a single industry or group of related industries that are vulnerable to the risk of a near-term severe impact. However, the Company’s success is dependent to a significant degree on economic conditions in Northeastern Pennsylvania, especially Lackawanna and Luzerne Counties, which Company defines as its primary market. The banking industry is affected by general economic conditions including the effects of inflation, recession, unemployment, real estate values, trends in the national and global economics, and other factors beyond the Company’s control. An economic recession or a delayed recovery over a prolonged period of time in the Dunmore area could cause an increase in the level of the Bank’s non-performing assets and loan losses, thereby causing operating losses, impairing liquidity and eroding capital. We cannot assure you that further adverse changes in the local economy would not have a material adverse effect on the Company’s consolidated financial condition, results of operations, and cash flows.

The Company had 167 full-time equivalent employees, on December 31, 2003, which includes exempt officers and part-time employees.

Federal and state banking laws contain numerous provisions affecting various aspects of the business and operations of the Company and the Bank. The Company is subject to, among others, the regulations of the Securities and Exchange Commission and the Federal Reserve Board and the Bank is subject to, among others, the regulations of the Pennsylvania Department of Banking and the Federal Deposit Insurance Corporation. Refer to Part II, Item 7 “Supervision and Regulation” for descriptions of and references to applicable statutes and regulations which are not intended to be complete descriptions of these provisions or their effects on the Company or the Bank. They are summaries only and are qualified in their entirety by reference to such statutes and regulations.

Applicable regulations relate to, among other things:

The Bank is examined by the Pennsylvania Department of Banking and the Federal Deposit Insurance Corporation (FDIC). The last examination was conducted by the FDIC as of September 30, 2003.

The Company’s internet address is www.the-fidelity.com. The Company makes available through this website the Annual Report on Form 10-K, quarterly reports or Form 10-Q and current reports or Form 8-K, and amendments to those Reports as soon as reasonably practical after filing with the SEC.

The Company’s accounting policies and procedures are designed to comply with accounting principles, generally accepted in the United States of America (GAAP). Refer to “Critical Accounting Policies,” which are incorporated by reference in Part II, Item 7.

ITEM 2: PROPERTIES

The Company and the Bank are headquartered at the Main Branch on the corner of Blakely and Drinker Streets in Dunmore, Pennsylvania. The main office is a full-service banking center including a walk-up teller window, drive-thru teller windows and two twenty-four hour automated teller machines (ATMs). Administrative, Loan, Trust, Asset Management Services, operational departments and customer service areas are also located in this building. The main office complex is owned and free of any encumbrances.

The Green Ridge Branch, the first Scranton facility, operates from leased space in the Green Ridge Shopping Center in Scranton, Pennsylvania. This branch is a full-service office with a twenty-four hour ATM.

A second Scranton Branch is in a leased facility located at 139 Wyoming Avenue, Scranton, Pennsylvania. This office has a walk-up window and provides full-service banking to the downtown Scranton area.

The Abington Branch is located on the Morgan Highway in Clarks Summit, Pennsylvania. The building from which the branch operates is leased. This office provides full-service financial products, including a twenty-four hour ATM and drive-thru teller windows. This office provides convenience to our customers located throughout the greater Abington area.

There is also a banking facility limited to serve employees and patients of the Clarks Summit State Hospital which is located within the hospital facility in Clarks Summit, Pennsylvania. The office is leased from the hospital under a lease for service provided agreement.

The Keystone Industrial Park Branch (KIP) is located in Dunmore, Pennsylvania. This office provides full-service banking with drive-thru teller windows and a twenty-four hour ATM. KIP is free of encumbrances.

The Pittston Branch is located in Bruno’s Supermarket 403 Kennedy Boulevard, Pittston, Pennsylvania. The space in the supermarket is leased. This office provides full-service banking including a twenty-four hour ATM. This location provides convenient service at extended hours to the Bank’s clientele in Luzerne County, Pennsylvania.

The Financial Center Branch is located at 338 North Washington Avenue in Scranton, Pennsylvania. This office provides full-service banking, including a twenty-four hour ATM. Executive, Finance and Operational offices are located in this building. A portion of the third floor is currently leased to a non-related entity. The Company owns the property free of encumbrance. The Company also owns, free of encumbrance, an adjacent attached building, which is leased to a non-related entity.

The Moosic Branch is located at 4010 Birney Avenue, Moosic, Pennsylvania. The branch operates from leased space. This office provides full-service banking, including a twenty-four hour ATM and drive-thru teller windows. The branch’s location provides the necessary link between the Lackawanna and Luzerne County branch office networks.

The West Pittston Branch is located in the Insalaco Shopping Center at 801 Wyoming Avenue, West Pittston, Pennsylvania. The branch operates from leased space. This office provides full-service, including a twenty-four hour ATM, to the Luzerne County area.

The Peckville Branch is located at 1598 Main Street, Peckville, Pennsylvania. The branch operates from leased space. This office provides full-service banking, including a twenty-four hour ATM and drive-thru teller windows.

The Bank’s branch coverage in Luzerne County includes a leased space known as the Kingston Branch, located at 247 Wyoming Avenue, Kingston, Pennsylvania. This office provides full-service financial products, including a twenty-four hour ATM and drive-thru teller windows.

The Eynon Branch is located on Route 6 Business Eynon, Pennsylvania. The branch operates from leased space. This office provides full-service financial products, including a twenty-four hour ATM and drive-thru teller windows.

In addition to the properties above, the Bank maintains several free-standing twenty-four our ATMs located at the following locations:

The Bank contracted space during 2003 for free-standing twenty-four hour ATMs located in Convenient Food Marts at:

None of the lessors of the properties leased by the Bank are affiliated with the Company or the Bank.

The Bank also owns a commercial facility located at 116 – 118 N. Blakely Street Dunmore, Pennsylvania. The facility is directly across from the Main branch and is currently leased by a non-related entity.

Other real estate owned includes all foreclosed properties listed for sale. Foreclosed properties are recorded on the Company’s balance sheet, upon possession, at the lower of cost or fair value.

ITEM 3: LEGAL PROCEEDINGS

On July 1, 2002, the Bank was served with a civil complaint that was filed in the Court of Common Pleas of Lackawanna County, Pennsylvania, on June 28, 2002. Scaccia Construction Company, the plaintiff, based upon multiple causes of action, demanded approximately $250,000 in connection with certain environmental remediation activities. The activities were purportedly performed prior to the opening of the Bank’s Eynon branch. On July 22, 2002, the Bank filed preliminary objections to the complaint. The preliminary objections were decided on November 26, 2002, and the Bank filed its answer and new matter raising various legal defenses. This lawsuit was settled on October 30, 2003.

The nature of the Company’s business generates some litigation involving matters arising in the ordinary course of business. However, in the opinion of the Company after consulting with legal counsel, no other legal proceedings are pending, which, if determined adversely to the Company or the Bank, would have a material effect on the Company’s undivided profits or financial condition. No other legal proceedings are pending other than ordinary routine litigation incidental to the business of the Company and the Bank. In addition, to management’s knowledge, no governmental authorities have initiated or contemplated any material legal actions against the Company or the Bank.

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

                     None

PART II

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

Shareholders requesting information about the Company’s common stock may contact Salvatore R. DeFrancesco, Jr., Treasurer. Requests may be mailed to:

The common stock of the Company is traded on the over-the-counter bulletin board under the symbol “FDBC.”

The following table lists the quarterly cash dividends paid per share and the range of bid and asked prices for the Company’s common stock. Such over-the-counter prices do not include retail mark-ups, markdowns, or commissions.

The Company expects to continue paying similar dividends in the future. However, future dividends are dependent on earnings, the capital needs of the Company and other factors. Prior to the formation of the Company, the Bank paid dividends on a quarterly basis for over thirty years. Dividends are determined and declared by the Board of Directors. For a further discussion of regulatory capital requirements see Note 14 “Regulatory Matters”, contained within the Notes to Consolidated Financial Statements.

The Company has established a dividend reinvestment plan for its shareholders. The plan is designed to make the Company’s stock more available to our shareholders and to raise additional capital for future needs.

The Company had approximately 1,465 shareholders at March 12, 2004 and approximately 1,463 at December 31, 2003. The number of shareholders is the actual number of individual shareholders of record. Security depositories are considered as individual shareholders for the purpose of determining the approximate number of shareholders.

ITEM 6: SELECTED FINANCIAL DATA

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

Forward Looking Statements

This Annual Report on Form 10-K contains a number of forward-looking statement size=2>Loans are not made by the Company to its Board members, officers, or employees. Loans may be made by our banking subsidiaries and will comply with all federal and state laws, statutes, and regulations.

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

Forward Looking Statements

This Annual Report on Form 10-K contains a number of forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. These statements may be identified by the use of the words “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “outlook,” “plan,” “potential,” “predict,” “project,” “should,” “will,” “would” and similar terms and phrases, including references to assumptions. Forward looking statements include risks and uncertainties.

Forward-looking statements are based on various assumptions and analyses made by us in light of our management’s experience and its perception of historical trends, current conditions and expected future developments, as well as other factors it believes are appropriate under the circumstances. These statements are not guarantees of future performance and are subject to risks, uncertainties and other factors (many of which are beyond our control) that could cause actual results to differ materially from future results expressed or implied by such forward-looking statements. These factors include, without limitation, the following:

• the timing and occurrence or non-occurrence of events may be subject to circumstances beyond our control;
• there may be increases in competitive pressure among financial institutions or from non-financial institutions;
• changes in the interest rate environment may reduce interest margins;
• changes in deposit flows, loan demand or real estate values may adversely affect our business;
• changes in accounting principles, policies or guidelines may cause our financial condition to be perceived differently;
• general economic conditions, either nationally or locally in some or all areas in which we do business, or conditions in the securities markets or the banking industry may be less favorable than we currently anticipate;
• legislative or regulatory changes may adversely affect our business;
• technological changes may be more difficult or expensive than we anticipate;
• success or consummation of new business initiatives may be more difficult or expensive than we anticipate; or
• acts of war or terrorism.

Management cautions readers not to place undue reliance on forward-looking statements, which reflect analyses only as of the date of this report. We have no obligation to update any forward-looking statements to reflect events or circumstances after the date of this document.

Readers should carefully review the risk factors described in other documents that we file, from time to time, with the Securities and Exchange Commission, including Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K.

Critical Accounting Policies

The presentation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect many of the reported amounts and disclosures. Actual results could differ from these estimates.

A material estimate that is particularly susceptible to significant change relates to the determination of the allowance for loan losses. Management believes that the allowance for loan losses at December 31, 2003 is adequate and reasonable. Given the very subjective nature of identifying and valuing loan losses, it is likely that well-informed individuals could make different assumptions, and could, therefore calculate a materially different allowance value. While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in the future. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination.

Another material estimate is the calculation of fair values of the Company’s investment securities. The Company receives estimated fair values of investment securities from an independent valuation service. In developing these fair values, the valuation service uses estimates of cash flows, based on historical performance of similar instruments in similar interest rate environments. Based on experience, management is aware that estimated fair values of investment securities tend to vary among valuation services. Accordingly, when selling investment securities, management typically obtains price quotes from more than one source. As described in Notes 1 and 3 of the consolidated financial statements, the large majority of the Company’s investment securities are classified as available-for-sale. Available-for-sale securities are carried at fair value on the consolidated balance sheet, with unrealized gains and losses, net of income tax, reported separately within shareholders’ equity through accumulated other comprehensive income.

The fair value of residential mortgage loans classified as available-for-sale is obtained from the Federal National Mortgage Association (Fannie Mae). The fair value of SBA loans classified as available-for-sale is obtained from an outside pricing source. The market to which the Bank sells mortgage and other loans is restricted and price quotes from other sources are not typically obtained. Further discussion on the accounting treatment of available-for-sale loans is in the section entitled “Loans-available-for sale”, contained within Management’s Discussion and Analysis.

All significant accounting policies are contained in Note 1 “Nature of Operations and Summary of Significant Accounting Policies”, contained within the Notes to Consolidated Financial Statements, and incorporated by reference in Part II, Item 8.

The following discussion and analysis presents the significant changes in the financial condition and in the results of operations of the Company as of December 31, 2003 and December 31, 2002 and for each of the years then ended. This discussion should be read in conjunction with the consolidated financial statements and notes included in Part II, Item 8 of this report.

Comparison of Financial Condition as of December 31, 2003 and 2002 and Results of Operations for each of the Years then Ended

Financial Condition

The following table is a comparison of condensed balance sheet accounts and percentage to total assets at December 31, 2003, 2002 and 2001;

A comparison of net changes in certain balance sheet categories as of December 31, are as follows:

        * — Earning assets exclude loans placed on non-accrual status.

Deposits

The following table represents the components of total deposits as of December 31, 2003 and comparative funding changes from December 31, 2002:

Total deposits decreased $12,346,000 or 3% during 2003 to $401,443,000. Total average deposits decreased $12,616,000 or 3% from $424,782,000 at December 31, 2002 to $412,166,000 at December 31, 2003. Non-interest bearing deposits are an important source of funds for the Bank because they lower overall deposit costs. The average balance of these accounts increased $7,482,000 or 14%, during 2003. The interest rates offered on most deposit products were lowered in 2002 and continued through 2003 in response to overall market conditions. Management expects a significant portion of the certificate of deposit portfolio to continue repricing at lower market rates, specifically in the thirty-month time deposit product, as these higher rate certificates reach maturity.

The Bank is largely dependent upon its base of competitively priced core deposits to provide a stable source of funding. The Bank attempts to retain and grow its customer base through a combination of rate, quality of service, convenience and a stable and experienced staff. Core deposits, which excludes time deposits of $100,000 and greater, increased $4,283,000 or 2% during 2003, to $288,585,000. The Bank continued to experience growth in its transactional deposit products, which include non-interest bearing demand deposit accounts (DDAs), NOW, money market deposit, savings and club accounts. Checking accounts increased $11,099,000 or 12%, and savings and club accounts grew $4,355,000 or 11%. Money market accounts grew $11,723,000 or 71%. Thus, the Bank’s deposit mix, although concentrated in time deposits, began to significantly shift toward customer based core deposit and savings accounts.

Time deposits of $100,000 or greater decreased $16,629,000 or 13% from $129,486,000 at December 31, 2002 to $112,857,000 at December 31, 2003. The time deposit reduction occurred from the run-off of high cost non-personal and public fund accounts. The personal time deposit reduction was fully offset by the shift into savings and money market accounts. Total time deposits, at December 31, 2003 were $221,595,000 or 55% of total deposits compared to $256,836,000 or 62% at December 31, 2002. Approximately $145,885,000 or 66% of total time deposits are scheduled to mature in 2004. These maturing time deposits represent 36% of the Bank’s total deposit base and provide a significant opportunity for the Bank to service these customers and retain these deposits at potentially lower rates.

Despite the sluggish economy in 2002 which has not fully recovered in 2003, returns of the domestic equity markets have begun to stabilize and strengthen. As a result, migration of deposits into the equity markets may be a significant factor the Bank faces in its quest to retain and grow its deposit base in 2004. Without strategic planning to replace these funds, the Bank’s asset size may shrink to even lower levels.

The maturity distribution of time deposits of $100,000 or more at December 31, 2003 is as follows:

The over 12 month maturity distribution of time deposits represents 8.50% of total deposits at December 31, 2003. The Bank believes this category provides a stable source of funds for future requirements.

Short-term borrowings

Interest rate reductions and customer liquidity and investment needs caused repurchase agreements (Repos) to decrease from $47,232,000 at December 31, 2002, to $39,363,000 at December 31, 2003. Repos are non-insured interest-bearing liabilities that have a security interest in qualified pledged investment securities of the Bank. Repos offered are either a fixed term or a sweep product of the Bank.

Sweep accounts comprise approximately 70% of Repos. A sweep account is designed to ensure that, on a daily basis, an attached DDA is adequately funded and then excess DDA funds are transferred into an interest-bearing overnight Repo. The sweep will also transfer funds back to the DDA as is necessary, to cover checks presented for payment. The nature of the sweep makes the account more volatile than a fixed-term Repo.

Funding requirements of the Bank, due largely to the reduction in deposits, necessitated $14,920,000 overnight borrowings from the Federal Home Loan Bank of Pittsburgh, (FHLB), at December 31, 2003. FHLB borrowings at December 31, 2002 amounted to $2,850,000.

Repos and overnight borrowings are included with short-term borrowings on the Consolidated Balance Sheet. Refer to Note 7 “Short-term Borrowings”, contained within the Notes to Consolidated Financial Statements in Part II, Item 8.

Long-term debt

Long-term debt consists of borrowings from the FHLB. The weighted-average rate on funds borrowed at December 31, 2003, was 5.31%. The weighted-average rate is 6 basis points below the tax-equivalent yield of 5.39% on average earning assets for the year ended December 31, 2003. Rates on $63,000,000 of convertible select advances are adjustable quarterly, should market rates significantly increase beyond the issue’s three- month strike price. However, year-end rates on similar FHLB advances are 401 basis points below the average rate paid by the Bank. The Bank is deterred from paying off the current borrowings by significant prepayment penalties. FHLB borrowing rates, currently being quoted, will unlikely increase above the stated rates being paid on these borrowings during 2004. Should this occur, however, the Bank has the option, at that time, to repay or renegotiate the converted advance.

In October 2003, the Bank borrowed $9,000,000 from the FHLB to replenish funds utilized from the investment securities portfolio, to fund deposit run-off. The new borrowings were a $5,000,000 ten year convertible select with a 7.5% strike price costing 3.61% and a five year amortizing $4,000,000 advance fixed at 2.98%. The addition of this debt helped to reduce the overall weighted-average rate of long-term debt outstanding.

At December 31, 2003, the Bank had the ability to borrow an additional $68,800,000 at the FHLB. The FHLB has short-, medium- and long-term funding products available to the Bank.

Accrued expenses and other liabilities

Rate reductions in interest-bearing deposits and short-term borrowings caused accrued interest payable to decrease from $1,707,000 at December 31, 2002, to $ 1,270,080 at December 31, 2003.

A $746,000 pending settlement of investment securities purchased was recorded in other liabilities at December 31, 2002. The Bank did not have any pending investment purchases at December 31, 2003.

Assets:

Investments

Total investments declined $5,143,000, of which $2,240,000 was due to depreciation in the market value of available-for-sale (AFS) investments.

Investment policies dictate permissible investment categories, credit quality, maturity intervals and investment concentrations. Management is responsible for making the specific investment purchases within these standards. The carrying value of investment securities, at December 31, 2003, was $144,730,000 or 25% of total assets. At December 31, 2003 approximately 59% of the investment portfolio was comprised of mortgage-backed securities that amortize and provide monthly cash flow. Agency bonds and municipal bonds comprised 26% and 9% of the investment portfolio, respectively.

Management buys and sells investment securities from time to time depending on market conditions, business trends, liquidity, and capital levels. Investment security purchases provide a way to quickly invest excess liquidity in order to generate additional earnings. The Bank generally earns a positive interest spread by assuming interest rate risk and using deposits and/or borrowings to purchase securities with longer maturities.

Management classifies investment securities at the time of purchase by one of three categories: trading, available for sale (AFS) or, held to maturity (HTM). To date, management has not purchased any securities for trading purposes. Management classifies most securities as AFS even though it has no immediate intent to sell them. The AFS designation affords management the flexibility to sell securities and adjust the balance sheet in response to capital levels, liquidity needs and/or changes in market conditions. Securities AFS are marked to market in the consolidated balance sheet with an adjustment to equity, net of tax that is presented in the caption “Accumulated other comprehensive income (loss)".

With the relative low market interest rate environment, which continued through 2003, higher yielding United States (U.S.) Government Agency bonds along with state and municipal securities of $24,810,000 were called. In 2002, when the composition of the investment portfolio was more susceptible to being called, securities approximating $90,600,000 were called. No losses were incurred, in 2002 or 2003, on any of the called bonds.

The low interest rate environment also caused many borrowers to prepay and/or refinance home mortgages. In terms of investments, this contributed to a major prepayment in the Bank’s portfolio of mortgage-backed securities (MBS), which represents investments in pools of residential mortgages. The majority of MBS owned by the Bank are guaranteed by U.S. governmental sponsored agencies. Prepayments on MBS were $60,127,000 in 2003, compared to $18,229,000 in 2002.

Of the total MBS prepayments received in 2002, $11,682,000 or 64% was received during the fourth quarter, $4,436,000 in December alone. At the prepayment speed experienced during this period, the entire MBS portfolio could have been paid off in just over two years. In addition, amortization of bond premium in the amount of $2,449,000 would have been accelerated into this shorter time period, opposed to over the estimated average life of seven years at the times of purchase. Amortization of bond premium is the periodic charge to earnings for the amount by which the purchase price of a bond exceeds its par value.

A restructuring of the investment portfolio was undertaken in 2003, to protect earnings which were being adversely impacted by bond calls and MBS prepayments. The objective of the restructuring was to effectively manage and predict cash flows from securities within a four year average life range where redeployment of the proceeds could go into higher yielding investments. This control would help reduce interest rate risk and coordinate the Bank’s desired earnings and liquidity needs. To accomplish the restructuring of the MBS portfolio, the Bank participated in a series of strategically planned sales with subsequent buys of similar type securities (swaps). The swaps were designed to maintain cash flow through the sale of the faster prepaying available-for-sale MBS and reinvesting the proceeds into MBS issues with weighted-average coupons that provided the desired structured cash flows. This strategy would help to reduce prepayment risk and take advantage of the steep yield curve. The swaps produced modest gains on the sales and securities were purchased at effective yields above the bonds sold. At December 31, 2003, the estimated weighted-average life of the MBS portfolio extended to approximately four years and the net premiums were reduced to $1,153,000. At December 31, 2003, the MBS portfolio was producing yields that were approximately 56 basis points more than the portfolio was producing at December 31, 2002.

The other aspect of the restructuring strategy was to reinvest the proceeds from called bonds and MBS payments defensively into U.S. Agency and municipal obligations that provided greater protection from future calls. Approximately $27,990,000 of the acquired Agency bonds contained rate steps, whereby the rate automatically increased, if the bond continued past the call date. These defensive structures mitigate extension risks inherent within this low interest rate environment.

A comparison of investments at December 31, for the three previous periods is as follows:

The distribution of debt securities by stated maturity date at December 31, 2003 is as follows:

Debt securities are stated net of unrealized gain or loss on AFS securities. Net unrealized loss on AFS debt securities at December 31, 2003 was $493,000. Debt securities do not include the $279,000 of AFS equity securities or the $4,753,000 of restricted regulatory equity securities owned at December 31, 2003. Net unrealized gain on AFS equity securities was $170,000 at December 31, 2003.

The tax equivalent yield on debt securities by stated maturity date at December 31, 2003, is as follows:

Loans

Loans, net of unearned income, increased $13,817,000 or 3.86% from $358,162,000 at December 31, 2002, to $371,979,000 at December 31, 2003. Gross loans represented 64.67% of total assets at December 31, 2003.

In 2003, the Bank originated $37,797,000 of commercial loans, $40,028,000 of mortgage loans and $24,041,000 of consumer loans. In addition for 2003, the Bank committed to maximum lines of credit of $33,158,000 for commercial borrowers, $14,523,000 for real estate construction loans, $15,528,000 in home equity lines and $213,000 for consumer borrowers. Growth in the portfolio was primarily in commercial and commercial real estate.

Loan refinancing to lower interest rates continued in 2003 at a much greater volume than in 2002. Such refinancing occurred in all loan portfolios and had followed a corresponding drop in interest rates which correlated with a national trend. It is anticipated that the volume of prepayments and refinance requests could begin to ease, as rates become stable or increase. Furthermore, new loans are being structured, when possible, to better withstand market fluctuations.

Commercial Loans:

Net of scheduled principal curtailments (“run-off”), loan participation sales, and pre-payment, commercial loans increased $18,302,000 or 9.02% during 2003. This increase in commercial loans was primarily due to increased lending within the small business community.

As indicated, much of the Bank’s loan growth arose from commercial and commercial real estate loans. However, former commercial loan underwriting practices have also presented the Bank with increased non-performing assets. Increased due diligence in the loan underwriting process the past two years has allowed the Bank to pursue credit opportunities that present lower credit risk.

The Bank continues to originate loans using the Small Business Administration (SBA) guaranteed loan program. Under this program, in return for the Bank funding a qualified loan, the SBA guarantees a material portion of the principal balance to the Bank. As of December 31, 2003, the Bank reported $2,510,000 in SBA loans outstanding.

Tax-free industrial development loans, a component of commercial loans, made to or backed by local municipalities increased to $9,020,000 at December 31, 2003. The surge in this sector was due mainly to several large term loans to local municipalities for various infrastructure projects.

Residential Real Estate Loans:

Residential real estate loans increased $5,332,000 or 6.24% to $90,779,000. These loans increased due to strong demand for such loans due to the historic low interest rate environment.

The Bank proudly serves the local market by offering real estate loans. Real estate and construction loan totals of $98,047,000 were 25.02% of gross loans at December 31, 2003. Included with real estate loans are home equity lines of credit. The outstanding balance on the credit lines increased $6,387,000 or 87.31% from $7,315,000 at December 31, 2002, to $13,702,000 at December 31, 2003.

Consumer Loans and Direct Financing Leases:

Consumer loans and direct-financing leases decreased $10,661,000 or 16.77% during 2003. The home equity installment loan portfolio, included within the consumer loans, experienced significant payoffs caused by refinancing into lower rate mortgages. In addition, prepayments could not be successfully replaced due to the tightened credit underwriting standards on indirect auto loans and the decision to no longer originate direct financing leases. A combination of these events brought about this overall decline in consumer loans.

A comparison of loans at December 31, for the five previous periods is as follows (all loans are domestic):

A comparison of gross loans by percent at year-end for the five previous periods is as follows:

There are no concentrations of loans to a number of borrowers engaged in similar activities exceeding 10.00% of total loans that are not otherwise disclosed as a category in tables above.

The following table sets forth the maturity distribution of the loan portfolio at December 31, 2003. Excluded from the table are non-construction real estate loans, consumer loans and direct financing leases (amounts in thousands):

Real estate construction loans are included in the one-year or less category since, by their nature, these loans are converted into commercial and commercial real estate loans within one year from the date the real estate construction loan was consummated. Upon conversion, the commercial and commercial real estate loans would normally mature after five years.

The following table sets forth the sensitivity changes in interest rates for commercial and commercial real estate loans at December 31, 2003 (amounts in thousands):

Non-refundable fees or costs associated with all loan originations are deferred. Using the principal reduction method, the Bank releases the deferral as a charge or credit to loan interest income over the life of the loan.

There are no concentrations of loans that, if lost, would have a material adverse effect on the business of the Bank. The Bank’s loan portfolio does not have a material concentration within a single industry or group of related industries that are vulnerable to the risk of a near-term severe negative business impact.

Loans available-for-sale

Upon origination, residential mortgages, the guaranteed portions of Small Business Administration loans and student loans are generally classified as available-for-sale. Should market rates increase, fixed-rate loans and loans not immediately repricable would no longer produce yields consistent with the current market. In a declining interest rate environment, the Bank would be exposed to prepayment risk and, as rates on adjustable rate loans decrease interest income would be negatively affected. To better manage interest rate risk, loans meeting these conditions may be classified as available-for-sale. Certain consideration is also given to current liquidity needs.

Saleable loans are carried on the balance sheet at the lower of cost or fair value. If the fair value falls below cost, the difference is charged to current earnings. Appreciation in the portfolio is credited to current earnings to the extent of previous write-downs.

Loans available-for-sale at December 31, 2003 was $19,864,000, with a corresponding fair value of $20,500,000. The year-end balance comprised $17,783,000 of residential mortgages, $1,338,000 of SBA loans, and $743,000 in student loans. The Bank decreased loans available-for-sale by $8,852,000 or 30.83% from the December 31, 2002 balance. Available-for-sale loans decreased in part from the overall sale of these types of loans and, in part, from a management decision to temporarily classify fewer residential loans as available-for-sale, in order to take advantage of higher rates offered in this loan category compared to market rates. Also, at December 31, 2002, the AFS portfolio included $2,872,000 of credit card receivables which the Bank sold during the first quarter of 2004. The decision to sell these receivables was based upon lack of an adequate credit card servicing system, lack of consistent growth, high overhead associated with credit card activities and a high loss experience on non-performing credit cards.

As detailed in the “Consolidated Statement of Cash Flows” contained herein, proceeds from the sale of loans in 2003 totaled $28,618,000. The sales were primarily residential mortgages sold to the secondary market. The loans were sold to provide the Bank with the liquidity necessary to meet loan demand and to mitigate interest-rate risk from potential market rate increases.

The Bank retains the servicing rights on loans sold into the secondary market. Servicing rights are retained so that the Bank can continue the personal relationship developed with the borrowers. At December 31, 2003, the servicing portfolio balance of sold residential mortgage loans was $56,021,000.

Allowance for loan losses

Management continually evaluates the credit quality of the Bank’s loan portfolio and performs a formal review of the allowance for loan losses adequacy, on a quarterly basis. The allowance for loan losses reflects management’s best estimate of losses, both known and inherent, in the existing loan portfolio. Management’s judgment is based on the evaluation of individual loans, past experience, the assessment of current economic conditions, and other relevant factors. The provision for loan losses represents the amount necessary to maintain an appropriate allowance. Loan losses are charged directly against the allowance for loan losses when loans are deemed to be uncollectible. Recoveries on previously charged-off loans are added to the allowance when received.

Management applies two primary components during the loan review process to determine proper allowance levels. The two levels are specific loan loss allocation for loans that are deemed impaired and a general loan loss allocation for those loans not specifically allocated. The methodology to analyze the adequacy of the allowance for loan losses is as follows:

• Identification of specific problem loans by loan category by the credit administration;
• Calculation of specific allowances required based on collateral and other persuasive evidence;
• Identification of loans collateralized by cash;
• Determination of remaining homogenous pools by loan category and eliminating loans collateralized by cash and loans with specific allocations;
• Application of historical loss percentages (3 year average) to pools to determine the allowance allocation; and
• Application of qualitative factor adjustment percentages to historical losses for trends or changes in the loan portfolio.

Allocation of the allowance for loan losses for different categories of loans is based on the methodology used by the Bank, as explained above. The changes in the allocations from period to period are based upon reviews of the loan and lease portfolios.

With a continued focus on asset quality throughout 2003, Management identified impaired loan portfolio relationships, whereby borrowers did not have the ability to repay their loans in accordance with the contractual terms. This identification process required Management to determine whether to place these loans on non-accrual status and if so, to determine an appropriate allowance amount. In addition, several long standing customers with significant loan exposures, experienced financial difficulties. Management added over $685,000 to the allowance for loan losses in connection with these loans. Finally, a troubled debt restructuring in 2002 did not meet expectations, and Management added almost $1,300,000 to the allowance for loan losses.

Charge-offs, net of recoveries, for the year ended December 31, 2003, was $2,618,000, compared to $1,506,000 in 2002. Consumer loan net charge-offs increased from $897,000, through December 31, 2002, to $1,019,000, through December 31, 2003. Commercial loan net charge-offs increased $561,000, for the full year 2003, compared to 2002. Mortgage loan net-charge-offs increased $429,000 in 2003. Mortgage loan charge-offs were the result of properties foreclosed on during 2003 with a required write down taken to the fair market value of the real estate prior to transfer to foreclosed assets held for sale. For further discussion on the provision for loan losses, see the “Provision for Loan Losses” located in the Results of Operations section of Management’s Discussion and Analysis contained herein.

For a further discussion of delinquencies and net charge-offs, see the section entitled “Non-performing Assets.” Additional discussion is in Note 1 “Nature of Operations and Summary of Significant Accounting Policies – Allowance for Loan Losses” and Note 4 “Loans and Leases” contained within the Notes to Consolidated Financial Statements, and incorporated herein by reference.

Management believes that the current balance in the allowance for loan losses of $4,997,000 is sufficient to withstand the identified potential credit quality issues that may arise and are inherent to the portfolio. Currently, management is unaware of any potential problem loans that have not been reviewed. Potential problem loans are those where there is known information that leads Management to believe repayment of principal and/or interest is in jeopardy and the loans are currently neither on non-accrual status nor past due 90 days or more. However, there could be certain instances which become identified over the upcoming year that may require additional charge-offs and/or increases to the allowance. The ratio of allowance for loan losses to total loans was 1.28% at December 31, 2003 compared to 1.01% at December 31, 2002.

The following table sets forth the activity in the allowance for loan losses and certain key ratios for the periods indicated (dollars in thousands):

The allowance for loan losses can generally absorb losses throughout the loan and lease portfolios. However, in some instances an allocation is made for specific loans or groups of loans. Allocation of the allowance for loan losses for different categories of loans is based on the methodology used by the Bank, as previously explained. The changes in the allocations from year to years are based upon year end reviews of the loan and lease portfolios.

Allocation of the allowance among major categories of loans for the past five years is summarized below. This table should not be interpreted as an indication that charge-offs in future periods will occur in these amounts or proportions, or that the allocation indicates future charge-off trends:

        * Prior to 2003, consumer loans included credit cards receivables.

The commercial loan portfolio comprised 73%, or $3,669,000, of the total allowance for loan losses at December 31, 2003. Although the Bank identified 27 commercial loan relationships for which this allowance mostly consisted, the bulk of the allowance fell among only several large non-performing relationships. Collateral values were prudently valued to provide a conservative and realistic value of the collateral supporting these loans. As such, management increased the amount of the allowance required to support them. The allocations to the other categories of loans are adequate compared to the actual three-year historical net charge-offs.

Non-performing assets

The Bank defines non-performing assets as accruing loans past due 90 days or more, non-accrual loans, restructured loans, other real estate owned and repossessed assets. As of December 31, 2003, non-performing assets represented 1.52% of total assets compared to 1.47% at December 31, 2002.

The following table sets forth non-performing assets at December 31 (dollars in thousands):

In the internal review of loans for both delinquency and collateral sufficiency, management concluded that there were an above average number of loans that lacked the ability to repay in accordance with contractual terms. The decision to place loans or leases on a non-accrual status is made on an individual basis after considering factors pertaining to each specific loan.

The majority of non-performing loans and loans past due 90 days or more for the period is attributed to commercial business loans, indirect auto lending and real estate loans in the process of foreclosure. Several of the commercial loans are guaranteed by governmental agencies and the Bank’s loss exposure is reduced accordingly. As a result, the percentage of non-performing loans to net loans has increased from 1.72% at December 31, 2002, to 2.14% at December 31, 2003.

In 2003, Management recognized a number of impaired loans, primarily in the commercial and commercial real estate portfolios. As a result, non-performing loans increased 25% to $8,281,000. The increase was the cumulative result of an ongoing detailed loan review process that began two years ago. Management continues to add experienced staff and has emphasized improved credit quality in all lending decisions going forward. As a result of this review, management increased its allowance for loan losses during 2003. Improved collection efforts combined with solid credit underwriting should curtail serious delinquencies and reduce future non-performing loans.

Repossessed assets consist of previously financed vehicles held for sale. Subsequent to the loan or lease, the borrower or lessee defaulted on their contract and the Company repossessed the unit. Repossessed assets are sold through either a private or public sale and any deficiency balance from the sale of the asset is charged to the allowance for loan losses.

Payments received on non-accrual loans are recognized on a cash basis. Payments are first applied against the outstanding principal balance until the balance is satisfied. Subsequent payments are then recorded as interest income and finally late charges. During 2003, the Bank collected $574,000 of interest income recognized on the cash basis. Interest income that would have been recorded in 2003, if non-accrual loans were current, was $995,000.

Bank premises and equipment, net

Due to the fact that expansion plans were deferred and a major computer system conversion was completed in 2002, additions to premises and equipment were minimal and amounted to $621,000 for 2003.

Foreclosed assets held for sale

Real estate acquired through foreclosure increased $132,000, due to the receipt of five properties foreclosed during the fourth quarter and held for sale at year end. Repossessed vehicles had a net decrease of $102,000, mostly from the increased turn around time on the sales of these vehicles.

Terminated lease assets held for sale

Terminated lease assets are vehicles that were lease financed by the Company with contractual terms fulfilled. As per the lease agreement, the vehicles are returned to the Company and recorded on the books in other assets at the residual value. These vehicles are subsequently sold as soon as practicable. Any difference between sales price and residual value is charged against current earnings with a claim submitted to the Company’s residual insurance carrier for payment. Receipt of any residual insurance proceeds is then credited to current earnings.

Cash surrender value of bank owned life insurance

During February 2003, the Bank purchased $7,000,000 of bank owned life insurance (BOLI) for a chosen group of employees, namely its officers, where the Bank is the owner and beneficiary of the policies. The Bank’s excess liquidity from investment and loan pay downs funded the BOLI. The earnings from the BOLI are recognized as other income. The BOLI is profitable from the appreciation of the cash surrender values of the pool of insurance, and its tax-free advantage to the Bank. This profitability is used to offset a portion of current and future employee benefit costs. The BOLI is an asset that can be liquidated, if necessary, with tax costs associated. However, the Bank intends to hold this pool of insurance, because it provides income that enhances the Bank’s capital position. Therefore, the Bank has not provided for deferred income taxes on the earnings from the increase in cash surrender value.

Results of Operations

Earnings Summary:

Net Interest Income

The following table sets forth a comparison of average balances of assets and liabilities and their related net tax equivalent yields and costs for 2003, 2002 and 2001, in thousands, is as follows (Dollars in thousands):