UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the Fiscal Year Ended December 31, 2003

Commission File No.0-22345

SHORE BANCSHARES, INC.
(Exact name of registrant as specified in its charter)

(410) 822-1400
Registrant’s Telephone Number, Including Area Code

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

        Securities Registered pursuant to Section 12(g) of the Act: Common Stock, par value $.01 per share

        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 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 |_|

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

        The aggregate market value of the Corporation’s voting stock held by non-affiliates of the registrant as of June 30, 2003 was $153,083,156.

        The number of shares outstanding of the registrant’s common stock as of March 1, 2004 was 5,409,967.

Documents Incorporated by Reference

Certain information required by Part III of this annual report is incorporated herein by reference to the definitive Proxy Statement for the 2004 Annual Stockholders’ Meeting to be held on April 28, 2004.

INDEX

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        This Annual Report of Shore Bancshares, Inc. (the “Company”) on Form 10-K may contain forward-looking statements within the meaning of The Private Securities Litigation Reform Act of 1995. Readers of this report should be aware of the speculative nature of “forward-looking statements.” Statements that are not historical in nature, including the words “anticipate,” “estimate,” “should,” “expect,” “believe,” “intend,” and similar expressions, are based on current expectations, estimates and projections about (among other things) the industry and the markets in which the Company operates; they are not guarantees of future performance. Whether actual results will conform to expectations and predictions is subject to known and unknown risks and uncertainties, including risks and uncertainties discussed in this Form 10-K, general economic, market or business conditions; changes in interest rates, deposit flow, the cost of funds, and demand for loan products and financial services; changes in our competitive position or competitive actions by other companies; changes in the quality or composition of loan and investment portfolios; the ability to mange growth; changes in laws or regulations or policies of federal and state regulators and agencies; and other circumstances beyond the Company’s control. Consequently, all of the forward-looking statements made in this document are qualified by these cautionary statements, and there can be no assurance that the actual results anticipated will be realized, or if substantially realized, will have the expected consequences on the Company’s business or operations. Except as required by applicable laws, we do not intend to publish updates or revisions of any forward-looking statements we make to reflect new information, future events or otherwise. For a discussion of risks and uncertainties that could cause actual results to differ materially from those contained in the forward looking statements, see “Risk Factors” in Item 1 of Part I of this report.

PART I

Item 1. Business.

General

        The Company was incorporated under the laws of Maryland on March 15, 1996 and is a bank holding company and a financial holding company registered under the Bank Holding Company Act of 1956, as amended (the “BHC Act”). The Company engages in the business of acting as the parent company to two bank subsidiaries, The Centreville National Bank of Maryland (“Centreville National Bank”) and The Talbot Bank of Easton, Maryland (“Talbot Bank”) (together with Centreville National Bank, the “Banks”), two insurance producers, The Avon-Dixon Agency, LLC and Elliott Wilson Insurance, LLC, one insurance premium finance company, Mubell Finance, LLC (together with The Avon-Dixon Agency, LLC and Elliot Wilson Insurance, LLC, the “Insurance Subsidiaries”), and an investment adviser firm, Wye Financial Services, LLC (“Wye Financial”). The Company also has a non-active subsidiary, Shore Pension Services, LLC.

        On November 12, 2003, the Company announced that it had executed a definitive merger agreement to merge with Midstate Bancorp, Inc., a Delaware bank holding company (“Midstate Bancorp”). If this merger is consummated, the Company will acquire all of the issued and outstanding capital securities of The Felton Bank, a Delaware commercial bank (“Felton Bank”), which will operate in as an independent bank subsidiary. For more information about this transaction, see Item 7 of Part II of this report under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operation—Recent Developments”.

        Talbot Bank owns all of the issued and outstanding securities of Dover Street Realty, Inc., a Maryland corporation that engages in the business of holding and managing real property acquired by Talbot Bank as a result of loan foreclosures. Centreville National Bank owns 29.25% of the issued and outstanding common stock of Delmarva Data. Delmarva Data is a Maryland corporation located in Easton, Maryland, which provides data processing services to banks located in Maryland, Delaware, Virginia and the District of Columbia. Delmarva Data provides these services to Centreville National Bank and Talbot Bank.

Banking Products and Services

        Centreville National Bank is a national banking association that commenced operations in 1876. Talbot Bank is a Maryland commercial bank and commenced operations in 1885. The Banks operate twelve full service branches and sixteen ATM’s, providing a full range of commercial and consumer banking products and services to individuals, businesses, and other organizations in Kent, Queen Anne’s, Caroline, Talbot and Dorchester counties in Maryland. The Banks’ deposits are insured by the Federal Deposit Insurance Corporation (the “FDIC”).

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        The Banks are independent community banks and serve businesses and individuals in their respective market areas. Services offered are essentially the same as those offered by larger regional institutions that compete with the Banks. Services provided to businesses include commercial checking, savings, certificate of deposit and overnight investment sweep accounts. The Banks offer all forms of commercial lending, including secured and unsecured loans, working capital loans, lines of credit, term loans, accounts receivable financing, real estate acquisition development, construction loans and letters of credit. Merchant credit card clearing services are available as well as direct deposit of payroll, internet banking and telephone banking services.

        Services to individuals include checking accounts, various savings programs, mortgage loans, home improvement loans, installment and other personal loans, credit cards, personal lines of credit, automobile and other consumer financing, safe deposit boxes, debit cards, 24 hour telephone banking, PC and internet banking, and 24-hour automatic teller machine services. The Banks also offer nondeposit products, such as mutual funds and annuities, and discount brokerage services to their customers. Additionally, the Banks have Saturday hours and extended hours on certain evenings during the week for added customer convenience.

Lending Activities

        The Company’s lending operations are conducted through the Banks.

        The Company originates secured and unsecured loans for business purposes. It is typical for commercial loans to be secured by real estate, accounts receivable, inventory equipment or other assets of the business. Commercial loans generally involve a greater degree of credit risk than one to four family residential mortgage loans. Repayment is often dependent on the successful operation of the business and may be affected by adverse conditions in the local economy or real estate market. The financial condition and cash flow of commercial borrowers is therefore carefully analyzed during the loan approval process, and continues to be monitored by obtaining business financial statements, personal financial statements and income tax returns. The frequency of this ongoing analysis depends upon the size and complexity of the credit and collateral that secures the loan. It is also the Company’s general policy to obtain personal guarantees from the principals of the commercial loan borrowers.

        The Company provides residential real estate construction loans to builders and individuals for single family dwellings. Residential construction loans are usually granted based upon “as completed” appraisals and are secured by the property under construction. Additional collateral may be taken if loan to value ratios exceed 80%. Site inspections are performed to determine pre-specified stages of completion before loan proceeds are disbursed. These loans typically have maturities of six to twelve months and may be fixed or variable rate. Permanent financing for individuals offered by the Company includes fixed and variable rate loans with three-year or five-year balloons, and one, three or five year Adjustable Rate Mortgages.

        The risk of loss associated with real estate construction lending is controlled through conservative underwriting procedures such as loan to value ratios of 80% or less, obtaining additional collateral when prudent, and closely monitoring construction projects to control disbursement of funds on loans.

        The Company originates fixed and variable rate residential mortgage loans. As with any consumer loan, repayment is dependent on the borrower’s continuing financial stability, which can be adversely impacted by job loss, divorce, illness, or personal bankruptcy. Underwriting standards recommend loan to value ratios not to exceed 80% based on appraisals performed by approved appraisers of the Company. Title insurance protecting the Company’s lien priority, as well as fire and casualty insurance, is required.

        The Company also originates and sells long term fixed rate residential mortgage loans on the secondary market. These loans are not typically funded by the Company, however the Company receives a commission upon settlement.

        Commercial real estate loans are primarily those secured by office condominiums, retail buildings, warehouses and general purpose business space. Low loan to value ratio standards, as well as the thorough financial analysis performed and the Company’s knowledge of the local economy in which it lends, can reduce the risk associated with these loans.

        A variety of consumer loans are offered to customers, including home equity loans, credit cards and other secured and unsecured lines of credit and term loans. Careful analysis of an applicant’s creditworthiness is performed before granting credit, and on-going monitoring of loans outstanding is performed in an effort to minimize risk of loss by identifying problem loans early.

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Insurance Activities

        The Insurance Subsidiaries were formed as a result of the Company’s acquisition of the assets of The Avon-Dixon Agency, Inc., Elliott Wilson Insurance, Inc., Avon-Dixon Financial Services, Inc., Joseph M. George & Son, Inc. and 59th Street Finance Company on May 1, 2002. On November 1, 2002, The Avon-Dixon Agency, LLC completed its acquisition of certain assets of W. M. Freestate & Son, Inc., a full-service insurance producer firm owned by Mark M. Freestate, who serves on the Board of Directors of Centreville National Bank. Through these entities, the Company offers a full range of insurance products and services to customers, including insurance premium financing.

Investment Adviser Activities

        Through Wye Financial, which was formed in 2002, the Company offers a variety of financial planning products and services to customers within its market areas.

Seasonality

        Management does not believe that the business activities of the Company are seasonal in nature. Deposits may vary depending on local and national economic conditions, but management believes that any variation will not have a material impact on the Company’s planning or policy-making strategies.

Employees

        At March 1, 2004, the Company and its subsidiaries employed 250 persons, of which 217 were employed on a full-time basis.

COMPETITION

        The banking business, in all of its phases, is highly competitive. Within their market areas, the Company and its subsidiaries compete with commercial banks (including local banks and branches or affiliates of other larger banks), savings and loan associations and credit unions for loans and deposits, with money market and mutual funds and other investment alternatives for deposits, with consumer finance companies for loans, with insurance companies, agents and brokers for insurance products, and with other financial institutions for various types of products and services. There is also competition for commercial and retail banking business from banks and financial institutions located outside our market areas.

        The primary factors in competing for deposits are interest rates, personalized services, the quality and range of financial services, convenience of office locations and office hours. The primary factors in competing for loans are interest rates, loan origination fees, the quality and range of lending services and personalized services.

        To compete with other financial services providers, the Company relies principally upon local promotional activities, including advertisements in local newspapers, trade journals and other publications and on the radio, personal relationships established by officers, directors and employees with customers, and specialized services tailored to meet its customers’ needs. In those instances in which the Company is unable to accommodate a customers’ needs, the Company will arrange for those services to be provided by other financial services providers with which it has a relationship. The Company additional relies on referrals from satisfied customers.

        Current banking laws facilitate interstate branching and merger activity among banks. Since September, 1995, certain bank holding companies are authorized to acquire banks throughout the United States. In addition, on and after June 1, 1997, certain banks are permitted to merge with banks organized under the laws of different states. As a result, interstate banking is now an accepted element of competition in the banking industry and the Company may be brought into competition with institutions with which it does not presently compete.

        The following table sets forth deposit data for Kent, Queen Anne’s, Caroline, Talbot and Dorchester Counties as of June 30, 2003, the most recent date for which comparative information is available.

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Source: FDIC DataBook

Source: FDIC DataBook

Source: FDIC DataBook

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Source: FDIC DataBook

Source: FDIC DataBook

CAPITAL REQUIREMENTS

        The Federal Deposit Insurance Company Improvement Act of 1991 (“FDICIA”) established a system of prompt corrective action to resolve the problems of undercapitalized institutions. Under this system, federal banking regulators are required to rate supervised institutions on the basis of five capital categories: “well -capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized;” and to take certain mandatory actions, and are authorized to take other discretionary actions, with respect to institutions in the three undercapitalized categories. The severity of the actions will depend upon the category in which the institution is placed. A depository institution is “well capitalized” if it has a total risk based capital ratio of 10% or greater, a Tier 1 risk based capital ratio of 6% or greater, and a leverage ratio of 5% or greater and is not subject to any order, regulatory agreement, or written directive to meet and maintain a specific capital level for any capital measure. An “adequately capitalized” institution is defined as one that has a total risk based capital ratio of 8% or greater, a Tier 1 risk based capital ratio of 4% or greater and a leverage ratio of 4% or greater (or 3% or greater in the case of a bank with a composite CAMEL rating of 1).

        FDICIA generally prohibits a depository institution from making any capital distribution, including the payment of cash dividends, or paying a management fee to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to growth limitations and are required to submit capital restoration plans. For a capital restoration plan to be acceptable, the depository institution’s parent holding company must guarantee (subject to certain limitations) that the institution will comply with such capital restoration plan.

        Significantly undercapitalized depository institutions may be subject to a number of other requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized and requirements to reduce total assets and stop accepting deposits from correspondent banks. Critically undercapitalized depository institutions are subject to the appointment of a receiver or conservator, generally within 90 days of the date such institution is determined to be critically undercapitalized.

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        As of December 31, 2003, each of the Banks was deemed to be “well capitalized”. For more information regarding the capital condition of the Company, see Note 17 to the Notes to Consolidated Financial Statements contained elsewhere in this Report.

SUPERVISION AND REGULATION

        The following is a summary of the material regulations and policies applicable to the Company and its subsidiaries and is not intended to be a comprehensive discussion. Changes in applicable laws and regulations may have a material effect on the business of the Company.

General

        The Company is a bank holding company and a financial holding company registered with the Board of Governors of the Board of Governors of the Federal Reserve System (the “FRB”) under the BHC Act and, as such, is subject to the supervision, examination and reporting requirements of the BHC Act and the regulations of the FRB.

        Talbot Bank is a Maryland commercial bank subject to the banking laws of Maryland and to regulation by the Commissioner of Financial Regulation of Maryland, who is required by statute to make at least one examination in each calendar year (or at 18-month intervals if the Commissioner determines that an examination is unnecessary in a particular calendar year). Centreville National Bank is a national banking association subject to federal banking laws and regulations enforced and/or promulgated by the Office of the Comptroller of the Currency (the “OCC”), which is required by statute to make at least one examination in each calendar year (or at 18-month intervals if the association has assets of $250 million or less and meets certain other conditions). The deposits of the Banks are insured by the FDIC, and certain laws and regulations administered by the FDIC also govern their operations. The Banks are also subject to numerous state and federal statutes and regulations that affect the business of banking.

         Nonbank affiliates of the Company are subject to examination by the FRB, and, as affiliates of the Banks, are subject to examination by the FDIC, the Commissioner of Financial Regulation of Maryland, and, in certain cases, the OCC. In addition, The Avon-Dixon Agency, LLC, Elliott Wilson Insurance, LLC, and Mubell Finance, LLC are each subject to licensing and regulation by state insurance authorities. Retail sales of insurance products by these insurance affiliates are also subject to the requirements of the Interagency Statement on Retail Sales of Nondeposit Investment Products promulgated in 1994, as amended, by the FDIC, the FRB, the OCC, and the Office of Thrift Supervision. Wye Financial Services, LLC is subject to the registration and examination requirements of federal and state laws governing investment advisers.

Regulation of Financial Holding Companies

        In November 1999, the federal Gramm-Leach-Bliley Act (the “GLBA”) was signed into law. Effective in pertinent part on March 11, 2000, GLBA revises the BHC Act and repeals the affiliation provisions of the Glass-Steagall Act of 1933, which, taken together, limited the securities, insurance and other non-banking activities of any company that controls an FDIC insured financial institution. Under GLBA, a bank holding company can elect, subject to certain qualifications, to become a “financial holding company.” GLBA provides that a financial holding company may engage in a full range of financial activities, including insurance and securities sales and underwriting activities, and real estate development, with new expedited notice procedures. Maryland law generally permits Maryland State chartered banks, including the Bank, to engage in the same activities, directly or through an affiliate, as national banking associations. GLBA permits certain qualified national banking associations to form financial subsidiaries, which have broad authority to engage in all financial activities except insurance underwriting, insurance investments, real estate investment or development, or merchant banking. Thus, GLBA has the effect of broadening the permitted activities of the Bank.

        The Company and its affiliates are subject to the provisions of Section 23A and Section 23B of the Federal Reserve Act. Section 23A limits the amount of loans or extensions of credit to, and investments in, the Company and its nonbank affiliates by the Bank. Section 23B requires that transactions between the Bank and the Company and its nonbank affiliates be on terms and under circumstances that are substantially the same as with non-affiliates.

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        Under FRB policy, the Company is expected to act as a source of strength to its subsidiary banks, and the FRB may charge the Company with engaging in unsafe and unsound practices for failure to commit resources to a subsidiary bank when required. In addition, under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”), depository institutions insured by the FDIC can be held liable for any losses incurred by, or reasonably anticipated to be incurred by, the FDIC in connection with (i) the default of a commonly controlled FDIC-insured depository institution or (ii) any assistance provided by the FDIC to a commonly controlled FDIC-insured depository institution in danger of default. Accordingly, in the event that any insured subsidiary of the Company causes a loss to the FDIC, other insured subsidiaries of the Company could be required to compensate the FDIC by reimbursing it for the estimated amount of such loss. Such cross guaranty liabilities generally are superior in priority to obligations of a financial institution to its stockholders and obligations to other affiliates.

Federal Banking Regulation

        Federal banking regulators, such as the FRB, the FDIC, and the OCC, may prohibit the institutions over which they have supervisory authority from engaging in activities or investments that the agencies believes are unsafe or unsound banking practices. Federal banking regulators have extensive enforcement authority over the institutions they regulate to prohibit or correct activities that violate law, regulation or a regulatory agreement or which are deemed to be unsafe or unsound practices. Enforcement actions may include the appointment of a conservator or receiver, the issuance of a cease and desist order, the termination of deposit insurance, the imposition of civil money penalties on the institution, its directors, officers, employees and institution-affiliated parties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the removal of or restrictions on directors, officers, employees and institution-affiliated parties, and the enforcement of any such mechanisms through restraining orders or other court actions.

        The Banks are subject to certain restrictions on extensions of credit to executive officers, directors, and principal stockholders or any related interest of such persons, which generally require that such credit extensions be made on substantially the same terms as are available to third parties dealing with the Banks and not involve more than the normal risk of repayment. Other laws tie the maximum amount that may be loaned to any one customer and its related interests to capital levels.

        As part of FDICIA, each federal banking regulator adopted non-capital safety and soundness standards for institutions under its authority. These standards include internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, and compensation, fees and benefits. An institution that fails to meet those standards may be required by the agency to develop a plan acceptable to meet the standards. Failure to submit or implement such a plan may subject the institution to regulatory sanctions. The Company, on behalf of the Banks, believes that the Banks meet substantially all standards that have been adopted. FDICIA also imposes new capital standards on insured depository institutions.

        The Community Reinvestment Act (“CRA”) requires that, in connection with the examination of financial institutions within their jurisdictions, the federal banking regulators evaluate the record of the financial institution in meeting the credit needs of their communities including low and moderate income neighborhoods, consistent with the safe and sound operation of those banks. These factors are also considered by all regulatory agencies in evaluating mergers, acquisitions and applications to open a branch or facility. As of the date of its most recent examination report, each of the Banks has a CRA rating of “Satisfactory.”

Deposit Insurance

        As FDIC member institutions, the Banks’ deposits are insured to a maximum of $100,000 per depositor through the Bank Insurance Fund (“BIF”), administered by the FDIC, and each institution is required to pay semi-annual deposit insurance premium assessments to the FDIC. The BIF assessment rates have a range of 0 to 27 cents for every $100 in assessable deposits. In addition, as a result of the April 1997 merger of Kent Savings and Loan Association, F.A. into Centreville National Bank, approximately $33.2 million of the Centreville National Bank’s deposits are insured through the Savings Association Insurance Fund (“SAIF”), also administered by the FDIC, which are determined quarterly. The federal Economic Growth and Regulatory Paperwork Reduction Act of 1996 included provisions that, among other things, recapitalized the SAIF through a special assessment on savings association deposits and bank deposits that had been acquired from savings associations.

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USA PATRIOT Act

        Congress adopted the USA PATRIOT Act (the “Patriot Act”) on October 26, 2001 in response to the terrorist attacks that occurred on September 11, 2001. Under the Patriot Act, certain financial institutions, including banks, are required to maintain and prepare additional records and reports that are designed to assist the government’s efforts to combat terrorism. The Patriot Act includes sweeping anti-money laundering and financial transparency laws and required additional regulations, including, among other things, standards for verifying client identification when opening an account 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.

Federal Securities Laws

        The Company’s common stock is registered with the SEC under Section 12(g) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The Company is subject to information reporting, proxy solicitation, insider trading restrictions and other requirements of the Exchange Act. The federal Sarbanes-Oxley Act of 2002 and the new regulations adopted in furtherance thereof made several changes to the Exchange Act and the listing standards of The Nasdaq Stock Market, Inc. to which the Company is subject. These changes impose additional requirements and restrictions on the Company, including, among other things, restrictions on loans to and other transactions with insiders, additional disclosure requirements in the reports and other documents that the Company files with the SEC, new director independence requirements, certain Board of Director committee requirements, and other corporate governance requirements.

Governmental Monetary and Credit Policies and Economic Controls

        The earnings and growth of the banking industry and ultimately of the Bank are affected by the monetary and credit policies of governmental authorities, including the FRB. An important function of the FRB is to regulate the national supply of bank credit in order to control recessionary and inflationary pressures. Among the instruments of monetary policy used by the FRB to implement these objectives are open market operations in U.S. Government securities, changes in the federal funds rate, changes in the discount rate of member bank borrowings, and changes in reserve requirements against member bank deposits. These means are used in varying combinations to influence overall growth of bank loans, investments and deposits and may also affect interest rates charged on loans or paid for deposits. The monetary policies of the FRB authorities have had a significant effect on the operating results of commercial banks in the past and are expected to continue to have such an effect in the future. In view of changing conditions in the national economy and in the money markets, as well as the effect of actions by monetary and fiscal authorities, including the FRB, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand or their effect on the business and earnings of the Company and its subsidiaries.

AVAILABLE INFORMATION

        The Company maintains an Internet site atwww.shbi.net on which it makes available, free of charge, its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to the foregoing as soon as reasonably practicable after these reports are electronically filed with, or furnished to, the SEC. In addition, stockholders may access these reports and documents on the SEC’s web site atwww.sec.gov.

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Item 2. Properties.

        The tables below identify the offices of the Company’s subsidiaries. The Company’s main office is the same as Talbot Bank’s Main Office. The Company owns real property at 28969 Information Lane in Easton, Maryland, which houses the Operations, Information Technology and Finance departments of the Company and its subsidiaries. One half of the facility is leased to an unaffiliated third party.

The Talbot Bank of Easton, Maryland

ATMs

The Centreville National Bank of Maryland

The Avon-Dixon Agency, LLC

        Talbot Bank owns the real property on which all of its offices are located, except that it operates under leases at its Saint Michaels Branch, its Cambridge Branch, and certain administrative offices at 21 East Dover Street, Easton, Maryland 21601. Centreville National Bank owns the real property on which all of its offices are located. The Insurance Subsidiaries do not own any real property, but operate under leases. Wye Financial Services, LLC leases its office space. For information about rent expense for all leased premises, see Note 6 of the Notes to Consolidated Financial Statements appearing elsewhere in this report.

Item 3. Legal Proceedings

        In the normal course of business, the Company may become involved in litigation arising from banking, financial, and other activities of the Company. Management, after consultation with legal counsel, does not anticipate that the future liability, if any, arising out of these matters will have a material effect on the Company’s financial condition, operating results, or liquidity.

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

        None.

PART II

Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters.

        The shares of the Company’s common stock are listed on the Nasdaq Small Cap Market under the symbol “SHBI”. As of March 1, 2004, the Company had approximately 1,436 holders of record. The high and low sales prices as reported on the Nasdaq SmallCap Market for the shares of the Company’s common stock, as well as the cash dividends declared on those shares, for each quarterly period of 2003 and 2002 are set forth in the table below. These prices reflect inter-dealer prices and may not include retail mark-up, mark-down or commissions and they may not represent actual transactions.

        Stockholders received dividends totaling $3,548,409 in 2003 and $3,217,282 in 2002. The ratio of dividends per share to net income per share was 37.29% in 2003 compared to 36.6% in 2002. Cash dividends are typically declared on a quarterly basis and are at the discretion of the Board of Directors, based upon such factors as operating results, financial condition, capital adequacy, regulatory requirements, and stockholder return. The Company’s ability to pay dividends is limited by federal and Maryland law and is generally dependent on the ability of the Company’s subsidiaries to declare dividends to the Company. For more information regarding these limitations, see the discussion above in Part I, Item 1 under the caption “Risk Factors—The Company’s Ability to Pay Dividends is Limited”.

        The transfer agent for the Company’s common stock is:

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Item 6. Selected Financial Data.

        The following table sets forth certain selected financial data for the five years ended December 31, 2003 and is qualified in its entirety by the detailed information and financial statements, including notes thereto, included elsewhere or incorporated by reference in this annual report. This data should be read in conjunction with the consolidated financial statements and related notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, which may be found elsewhere in this report.

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation.

MANAGEMENT’S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

        The following discussion compares the financial condition of the Company at December 31, 2003 to the financial condition at December 31, 2002 and the results of operations for the years ended December 31, 2003, 2002, and 2001. This discussion should be read in conjunction with the Consolidated Financial Statements and the Notes thereto included elsewhere in this report.

PERFORMANCE OVERVIEW

        The Company recorded an 8% increase in net income for 2003 over 2002. Net income for the year ended December 31, 2003 was $9,496,000, compared to $8,790,000 and $7,994,000 for the years ended December 31, 2002 and 2001, respectively. Basic net income per share for 2003 was $1.77, an increase of 7.9% over 2002. Basic net income per share was $1.64 and $1.50 for 2002 and 2001, respectively. Diluted net income per share was $1.74, an increase of 7.4% over 2002. Diluted net income per share was $1.62 and $1.49 for 2002 and 2001, respectively.

        Return on average assets was 1.40% for 2003, compared to 1.42% for 2002 and 2001. Return on stockholders’ equity for 2003 was 11.70% compared to 11.79% for 2002 and 11.70% for 2001. Average assets increased 9.3% totaling $678,647,000, average loans increased 8.0% totaling $457,491,000, average deposits increased 9.2% totaling $565,087,000 and average stockholders’ equity increased 8.9% totaling $81,181,000 for the year ended December 31, 2003, when compared to 2002.

RECENT DEVELOPMENTS

        As previously disclosed in documents filed with the SEC, the Company executed a definitive merger agreement with Midstate Bancorp on November 12, 2003. This merger is subject to regulatory approval, the satisfaction of various conditions set forth in the merger agreement, and the approval of the stockholders of Midstate Bancorp, the meeting for which is scheduled to be held on March 16, 2004. There is no guarantee that the merger will be approved or consummated. If the merger is consummated, the Company will acquire Felton Bank, which will operate as an independent bank subsidiary of the Company. Felton Bank’s integration into the Company, and its future growth and profitability, will likely impact the Company’s growth and profitability.

        The regulations of the FRB require the depository institutions owned by a financial holding company to be and remain, among other things, “well managed”. A financial holding company that fails to meet this requirement is prohibited from engaging in any further financial activities without prior approval and must enter into an agreement with the FRB to address compliance. During this corrective period, the FRB may impose any conditions and restrictions on the business of the financial holding company that it deems appropriate. If the financial holding company is unable to comply with the well managed requirement within 180 days after falling out of compliance, then it may be required to divest its interest in one or more of its depository institutions. As of the date of this report, Felton Bank does not meet this requirement.

        Management is working with the FRB to address Felton Bank’s management deficiencies after the proposed merger. Although management believes that it will correct the deficiencies within 180 days after the effective date of the proposed merger, there can be no guarantee that it will meet this timeline. If the Company is not able to correct the deficiency within 180 days after the proposed merger, then the financial activities of its subsidiaries, including insurance producer activities, may be restricted or prohibited and the Company may be required to either divest itself of Felton Bank, merge Felton Bank into one of its other depository institutions, or otherwise restructure its operations. It is not possible to predict the impact that any of these steps would have on the business, financial performance, or profitability of the Company and its subsidiaries.

CRITICAL ACCOUNTING POLICIES

        The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and follow general practices within the industries in which it operates. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available.

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        The most significant accounting policies followed by the Company are presented in Note 1 of the Notes to Consolidated Financial Statements. These policies, along with the disclosures presented in the other financial statement notes and in this financial review, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified the determination of the allowance for credit losses to be the accounting area that requires the most subjective or complex judgments, and as such could be most subject to revision as new information becomes available.

        The allowance for credit losses represents management’s estimate of probable credit losses inherent in the loan portfolio as of the balance sheet date. Determining the amount of the allowance for credit losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated balance sheets. Note 1 of the Notes to Consolidated Financial Statements describes the methodology used to determine the allowance for credit losses and a discussion of the factors driving changes in the amount of the allowance for credit losses is included in the Credit Risk Management section of this financial review.

RECENT ACCOUNTING PRONOUNCEMENTS AND DEVELOPMENTS

        Note 1 of the Notes to Consolidated Financial Statements discusses new accounting policies adopted by the Company during 2003 and the expected impact of accounting policies recently issued or proposed but not yet required to be adopted. To the extent the adoption of new accounting standards materially affects the Company’s financial condition, results of operations, or liquidity, the impacts are discussed in the applicable section(s) of this financial review and notes to the consolidated financial statements.

RESULTS OF OPERATIONS

Net Interest Income and Net Interest Margin

        Net interest income remains the most significant component of the Company’s earnings. It is the excess of interest and fees earned on loans, federal funds sold, and investment securities, over interest paid on deposits and borrowings. Net interest income for 2003 was $24,596,000, representing a 3% increase over 2002. Net interest income increased 9% in 2002 compared to 2001, resulting in net interest income of $23,868,000. A reduction in interest expense was the reason for the increased net interest income in both 2003 and 2002. The tax equivalent yield on earning assets was 5.44% for 2003, compared to 6.24% and 7.35% for 2002 and 2001, respectively.

        Again in 2003, the Federal Reserve reduced short-term interest rates by 25 basis points. One rate reduction of 50 basis points occurred in 2002, and a record setting eleven reductions totaling 475 basis points were taken in 2001. The federal funds rate was 1.0% at December 31, 2003 and the New York Prime rate was 4.0%.

        The rate paid for interest bearing liabilities declined 72 basis points from 2.60% for the year ended December 31, 2002 to 1.88% for the year ended December 31, 2003. The average balance of earning assets increased during 2003, totaling $638,271,000, compared to $587,100,000 for 2002. On a tax equivalent basis, net interest income for 2003 was $24,987,000, compared to $24,184,000 for 2002 and $22,191,000 for 2001, representing an increase of 3.3% and 9.0% for 2003 and 2002, respectively.

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        The following table sets forth the major components of net interest income, on a tax equivalent basis, as of December 31, 2003, 2002 and 2001.

(1) All amounts are reported on a tax equivalent basis computed using the statutory federal income tax rate of 35% exclusive of the alternative minimum tax rate and nondeductible interest expense. The taxable equivalent adjustment amounts utilized in the above table to compute yields aggregated $392 in 2003, $316 in 2002, and $314 in 2001.

(2) Average loan balances include nonaccrual loans.

(3) Interest income on loans includes amortized loan fees, net of costs, for each category and yields are stated to include all.

        The Company’s tax equivalent yield on loans continued to decline in 2003 as new loans and loans refinanced with the Company were recorded at lower rates than the year before. Increased volume of loans during both 2003 and 2002 was not enough to offset the effects of declining interest rates. The lower overall yield on loans was the primary reason for a $1,892,000 decline in total interest income in 2003. Interest income totaled $34,730,000 for 2003 compared to $36,622,000 for 2002 and $39,252,000 for 2001. Lower yields on taxable investment securities and loans accounted for a decline in interest income of $1,421,000 and $2,785,000, respectively, in 2003 compared to 2002. Increased loan volume generated an additional $2,120,000 of interest income, which was not enough to offset the lower yields.

        Growth in the average balance of earning assets was $51,171,000 or 8.7% for the year ended December 31, 2003. Average loans increased $33,720,000 or 8.0%, totaling $457,491,000, compared to an increase of $37,610,000 or 9.7% during 2002. The average balance of investment securities increased $6,773,000 and federal funds sold and interest-bearing deposits in other banks increased $10,678,000. In 2002, the average balance of earning assets increased $52,876,000 or 9.9%, driven primarily by growth in interest bearing deposits and federal funds sold, with lower overall yields than other earning assets. As a percentage of total average earning assets, loans and investment securities totaled 71.7% and 20.8%, respectively, for 2003, compared to 72.2% and 21.5%, respectively, for 2002.

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        The following Rate/Volume Variance Analysis identifies the portion of the changes in net interest income, which are attributable to changes in volume of average balances or to changes in the yield on earning assets and rates paid on interest bearing liabilities.

The rate and volume variance for each category has been allocated on a consistent basis between rate and volume variances, based on a percentage of rate, or volume, variance to the sum of the absolute two variances.

        The Company’s net interest margin (its tax equivalent net interest income divided by average earning assets) represents the net yield on earning assets. The net interest margin is managed through loan and deposit pricing and assets/liability strategies. The Company’s net interest margin declined 21 basis points for 2003, from 4.12% to 3.91%, compared to a 3 basis point decline for 2002. The Company’s net interest spread, which is the difference between the average yield on earning assets and the rate paid for interest bearing liabilities, declined from 3.64% in 2002 to 3.56% for 2003.

        Interest expense for 2003 decreased $2,695,000 over interest expense for 2002. Lower rates accounted for a $3,122,000 reduction in interest expense, while the increased volume of deposits and other interest bearing liabilities generated additional interest expense of $427,000 for 2003. The average rate paid for certificates of deposit of $100,000 or more decreased 71 basis points, and for all other time deposits the decrease was 97 basis points. Average interest bearing demand deposits increased $9,288,000 during the year, and the rate paid for those deposits decreased 33 basis points to .50%, compared to .83% for 2002 and 1.74% for 2001. The rate paid for short-term borrowings, which consist primarily of securities sold under agreements to repurchase, decreased 39 basis points to .77%, compared to 1.16% in 2002. The rate paid on the Company’s long-term debt was 5.04% for 2003 and 2002 compared to 5.42% for 2001.

Noninterest Income

        Noninterest income increased $3,877,000 or 65.0% in 2003, compared to an increase of $3,322,000 or 125.5% in 2002. The Insurance Subsidiaries, which were acquired in 2002, reported their first full year of operations in 2003, and insurance commission increases represented $3,165,000 and $2,872,000 of the overall increase for 2003 and 2002, respectively. Service charges on deposit accounts increased $14,000 and $38,000 for 2003 and 2002, respectively. The Company recognized $448,000 in gains on sales of securities in 2003, an increase of $422,000 over 2002. These gains were offset by an other-than temporary impairment adjustment of $132,000 in 2003 relating to a U.S. Government bond fund. Other service charges and fees increased $66,000 or 11.3%. Other noninterest income increased $345,000 or 64.7% in 2003 primarily as a result of income generated from the sale of loans on the secondary market totaling $465,000. Mortgage loans that are to be sold in the secondary market are not generally funded by the Company, but the Company receives a commission upon settlement.

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        The following table summarizes noninterest income of the Company as of December 31:

Noninterest Expense

        Total noninterest expense increased $3,384,000 or 21.2% in 2003, compared to an increase of $3,934,000 or 32.7% in 2002. The increase is primarily attributable to the operation of the Insurance Subsidiaries. Expenses related to the operation of the Insurance Subsidiaries in 2003 were: $3,737,000 in salaries and employee benefits; $443,000 in occupancy and equipment expenses; $829,000 in other noninterest expense; compared to the following amounts for the eight months during 2002: $1,949,000 in salaries and employee benefits; $249,000 in occupancy and equipment expense; and $457,000 in other noninterest expense. Amortization of other intangible assets totaling $209,000 and $122,000 for 2003 and 2002, respectively, is attributable to the operation of the Insurance Subsidiaries. A significant portion of the salaries attributable to the Insurance Subsidiaries is based on commissions and fluctuates in accordance with premium revenue fluctuations. See Note 8 of the Notes to Consolidated Financial Statements for further information regarding the impact of goodwill and other intangible assets on the financial statements. The additional amount of increases in each category of noninterest expense are attributable to the operation of a new Centreville National Bank branch that opened in 2003, as well as general increased costs of operations. The Company had 231 full-time equivalent employees at December 31, 2003, compared to 222 and 163 at December 31, 2002 and 2001, respectively.

        The following table summarizes noninterest expense of the Company as of December 31:

Income Taxes

        Income tax expense was $5,266,000 for 2003, compared to $4,730,000 for 2002 and $4,277,000 for 2001. The effective tax rates on earnings were 35.7%, 35.0% and 34.9%, respectively.

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REVIEW OF FINANCIAL CONDITION

        Asset and liability composition, asset quality, capital resources, liquidity, market risk and interest sensitivity are all factors which affect the Company’s financial condition.

Assets

        Total assets increased 7.8% to $705,379,000 at December 31, 2003, compared to an increase of 12.3% for 2002. Average total assets were $678,647,000, an increase of 9.3% in 2003. Average total assets increased 10.5% in 2002, totaling $621,141,000 for the year. The loan portfolio represents 71.7% of average earning assets and is the primary source of income for the Company.

        Funding for loans is provided primarily by core deposits and short-term borrowings. Total deposits increased 8.7% to $592,409,000 at December 31, 2003, compared to an 11.8% increase for 2002.

        The following table sets forth the average balance of the components of average earning assets as a percentage of total average earning assets as of December 31.

Interest Bearing Deposits With Other Banks and Federal Funds Sold

        The Company invests excess cash balances in interest bearing accounts and federal funds sold offered by its correspondent banks. These liquid investments are maintained at a level necessary to meet the immediate liquidity needs of the Company. The average balance of interest bearing deposits with other banks and federal funds sold increased $10,678,000 to $47,937,000 during 2003 and $3,635,000 to $37,259,000 during 2002.

Investment Securities

        The investment portfolio is structured to provide liquidity for the Company and also plays an important role in the overall management of interest rate risk. Investment securities in the held to maturity category are stated at cost adjusted for amortization of premiums and accretion of discounts. The Company has the intent and ability to hold such securities until maturity. Investment securities available for sale are stated at estimated fair value based on quoted market prices. They represent securities which may be sold as part of the Company’s asset/liability strategy or which may be sold in response to changing interest rates. Net unrealized holding gains and losses on these securities are reported net of related income taxes as accumulated other comprehensive income, a separate component of stockholders’ equity. During 2003, the Company recognized a loss on a U.S. Government bond fund investment in the amount of $131,394 for declines that were determined to be other than temporary. At December 31, 2003, the Company had classified 90% of the portfolio as available for sale and 10% as held to maturity, compared to 89% and 11%, one year ago. The percentage of securities designated as available for sale reflects the amount needed to support the anticipated growth and liquidity needs of the Company. With the exception of municipal securities, it is the general practice of the Company to classify all newly purchased securities as available for sale.

        At December 31, 2003, investment securities available for sale were $144,368,000, which represents an increase of $33,504,000 or 30.2% compared to $110,864,000 one year ago. The increase was primarily the result of increased investment in U.S. Government Agency bonds totaling $104,264,000 or 72.2% of the total available for sale portfolio. At December 31, 2002, U.S. Government Agency securities totaled $68,087,000 or 61.4% of the available for sale portfolio. Mortgage-backed securities totaled $30,595,000 or 21.2% and $32,237,000 or 29.1% of the available for sale portfolio at December 31, 2003 and 2002, respectively. During 2003, proceeds from matured or called bonds were typically reinvested in U.S. Government Agency bonds with maturities less than 5 years. Earnings on certain U.S. Government Agency Bonds are exempt from state income tax and producing higher effective returns without affecting the overall credit risk and liquidity of the portfolio. Investment securities held to maturity, consisting primarily of tax-exempt municipal bonds, totaled $15,313,000 at December 31, 2003, compared to $13,124,000 one year ago. The Company does not invest in structured notes or other derivative securities.

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        The following table sets forth the maturities and weighted average yields of the investment portfolio based upon the earliest possible repricing date as of December 31, 2003.

(1) Yields adjusted to reflect a tax equivalent basis assuming a federal tax rate of 35%.

Loans

        The Company continued to experience strong growth trends in the real estate lending market. Loans increased 8.1% in 2003, compared to 11.9% in 2002 and 2.7% in 2001. Most of the growth in 2003 was concentrated in loans secured by real estate, which increased $21,844,000 or 6.5%. Commercial, financial and agricultural loans increased $2,457,000 or 4.0%, and real estate construction loans increased $11,286,000 or 44.5%. A healthy local real estate market and low interest rates were the driving force behind the growth. Consumer loans did not grow during 2003, following a consumer loan decline of $2,391,000 or 13.9% in 2002. Many homeowners took advantage of the low interest rate environment during the year and refinanced their residential mortgage loans, paying off consumer debt with equity from their homes. Loans, net of unearned income, totaled $474,955,000 at December 31, 2003, an increase of $35,416,000 when compared to 2002. Loans, net of unearned income, totaled $439,539,000 on December 31, 2002, an increase of $46,833,000 or 2.7% when compared to 2001. During September 2002, the Company began to broker long-term fixed rate residential mortgage loans for sale on the secondary market.

        The table below sets forth trends in the composition of the loan portfolio over the past five years (excluding net deferred loan fees).

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        The table below sets forth the maturities and interest rate sensitivity of the loan portfolio at December 31, 2003.

Deposits

        The Company primarily utilizes core deposits to fund its earning assets. At both December 31, 2003 and 2002, deposits provided funding for approximately 88% of average earning assets. Average deposits increased 9.2% in 2003, compared to a 10.8% increase in 2002. The most significant growth occurred in the average balance of money management accounts, which increased $21,932,000 or 24.1%. Low interest rates kept depositors from utilizing long-term deposit products such as certificates of deposit, whose average balance increased only $2,929,000 or 1.2% during 2003. The average balance of savings accounts increased $4,841,000 or 13.5%, while the average balance of noninterest bearing demand increased $8,843,000 or 13.5% and NOW and SuperNOW accounts increased $9,289,000 or 10.1%.

        Increased deposits in 2002 and 2001 were partly driven by depositors looking for principal protection despite low rates being paid on these accounts. During 2002, the average balance of noninterest bearing demand deposits increased $8,940,000 or 15.9%, NOW and SuperNOW increased $5,838,000 or 6.8%, savings increased $5,505,000 or 18.1%, money management increased $22,184,000 or 32.2% and certificates of deposit $100,000 or more increased $11,181,000 or 14.6% when compared to 2001.

        The Company does not accept brokered deposits, nor does it rely on purchased deposits as a funding source for loans.

        The following table sets forth the average balances of deposits and the percentage of each category to total deposits for the years ended December 31.

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        The following table sets forth the maturity ranges of certificates of deposit with balances of $100,000 or more on December 31, 2003 (in thousands).

Short-Term Borrowings

        Short-term borrowings consist primarily of securities sold under agreement to repurchase. These short-term obligations are issued in conjunction with cash management services for deposit customers. From time to time in order to meet short-term liquidity needs the Company may borrow from a correspondent bank under a federal funds line of credit arrangement.

        The average balance of short-term borrowings increased $2,085,000 or 9.9% in 2003, compared to an increase of $1,671,000 or 8.7% in 2002.

        The following table sets forth the Company’s position with respect to short-term borrowings.

Capital Management

        The Company continues to maintain capital at levels in excess of the risk based capital guidelines adopted by the federal banking agencies. Total stockholders’ equity was $83,527,000 at December 31, 2003, 7.0% higher than the previous year. Stockholders’ equity was $78,028,000 at December 31, 2002, an increase of 9.9% over December 31, 2001. The increase in stockholders’ equity in 2003 is primarily due to earnings of the Company for the year of $9,496,000, reduced by dividends paid on common stock of $3,548,000.

        The Company records unrealized holding gains (losses), net of tax, on investment securities available for sale as accumulated other comprehensive income (loss), a separate component of stockholder’s equity. As of December 31, 2003, the portion of the Banks’ investment portfolio designated as “available for sale” had net unrealized holding gains, net of tax, of $310,000, compared to $1,152,000 at December 31, 2002.

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        The following table compares the Company’s capital ratios as of December 31 to the regulatory requirements.

        Management knows of no trends or demands, commitments, events or uncertainties, which will materially affect capital.

Provision for Credit Losses and Risk Management

        Originating loans involves a degree of risk that credit losses will occur in varying amounts according to, among other factors, the types of loans being made, the credit-worthiness of the borrowers over the term of the loans, the quality of the collateral for the loan, if any, as well as general economic conditions. The Company’s Board of Directors demands accountability of management, keeping the interests of stockholders’ in focus. Through its Asset/Liability and Audit Committees, the Board actively reviews critical risk positions, including market, credit, liquidity and operational risk. The Company’s goal in managing risk is to reduce earnings volatility, control exposure to unnecessary risk, and ensure appropriate returns for risk assumed. Senior members of management actively manage risk at the product level, supplemented with corporate level oversight through the Asset/Liability Committee and internal audit function. The risk management structure is designed to identify risk issues through a systematic process, enabling timely and appropriate action to avoid and mitigate risk.

Credit Risk Management

        The Company’s loan portfolio is subject to varying degrees of credit risk. Credit risk is mitigated through portfolio diversification, limiting exposure to any single industry or customer, collateral protection and standard lending policies and underwriting criteria. The following discussion provides information and statistics on the overall quality of the Company’s loan portfolio. Note 1 of the Notes to Consolidated Financial Statements describes the accounting policies related to nonperforming loans and charge-offs and describes the methodologies used to develop the allowance for credit losses, including both the specific and nonspecific components. Management believes the policies governing nonperforming loans and charge-offs are consistent with regulatory standards. The amount of the allowance for credit losses and the resulting provision are reviewed monthly by senior members of management and approved quarterly by the Board of Directors.

        The allowance is increased by provisions for credit losses charged to expense and recoveries of loans previously charged-off. It is decreased by loans charged-off in the current period. Provisions for credit losses are made to bring the allowance for credit losses within the range of balances that are considered appropriate based upon the allowance methodology and to reflect losses within the loan portfolio as of the balance sheet date.

        The adequacy of the allowance for credit losses is determined based upon management’s estimate of the inherent risks associated with lending activities, estimated fair value of collateral, past experience and present indicators such as loan delinquency trends, nonaccrual loans and current market conditions. Management believes the allowance is adequate; however, future changes in the composition of the loan portfolio and financial condition of borrowers may result in additions to the allowance. Examination of the portfolio and allowance by various regulatory agencies and consultants engaged by the Company may result in the need for additional provisions based upon information available at the time of the examination.

        Each of the Banks maintains a separate allowance for credit losses, which is only available to absorb losses from their respective loan portfolios. Each Banks’ allowance is subject to regulatory examination and determination as to its adequacy.

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        The allowance for credit losses is comprised of two parts: the specific allowance and the formula allowance. The specific allowance is the portion of the allowance that results from management’s evaluation of specific loss allocations for identified problem loans and pooled reserves based on historical loss experience for each loan category. The formula allowance is determined based on management’s assessment of industry trends and economic factors in the markets in which the Company operates. The determination of the formula allowance involves a higher risk of uncertainty and considers current risk factors that may not have yet manifested themselves in the Company’s historical loss factors.

        The specific allowance is based on each Banks’ quarterly analysis of its loan portfolio and is determined based upon the analysis of collateral values, cash flows and guarantor’s financial capacity, whichever are applicable. In addition, allowance factors are applied to internally classified loans for which specific allowances have not been determined and historical loss factors are applied to homogenous pools of unclassified loans. Historical loss factors may be adjusted by management in situations where no historical losses have occurred or where current conditions are not reflective of the specific history of the Company.

        The formula allowance is based upon management’s evaluation of external conditions, the effects of which are not directly measured in the determination of the specific allowance. The conditions evaluated in connection with the formula allowance include: general economic and business conditions affecting the Company’s primary lending area; credit quality trends; collateral values; loan values; loan volumes and concentrations; seasoning of the loan portfolio; specific industry conditions within the portfolio segments; recent loss experience; duration of the current business cycle; bank regulatory examination results; and findings of internal loan review personnel. Management reviews the conditions which impact the formula allowance quarterly and to the extent any of these conditions relate to specifically identifiable loans may reflect the adjustment in the specific allowance. Where any of these conditions is not related to a specific loan or loan category, management’s evaluation of the probable loss related to the condition is reflected in the formula allowance.

        While the local economy does not seem to be showing signs of weakness or the effect of the recent recession exhibited elsewhere in the nation, management is aware that the effects of continued weakness in the national economy could result in future higher loss levels for the Company.

        The ratio of net charge-offs to average loans was .09% in 2003, compared to .10% in 2002. At December 31, 2003, the allowance for credit losses was $4,060,000, or ..89% of average outstanding loans, and 406% of total nonaccrual loans. This compares to an allowance of $4,117,000, or .97% of average outstanding loans and 534% of nonaccrual loans, at December 31, 2002, and an allowance for credit losses of $4,189,000, or 1.08% of outstanding loans and 444% of nonaccrual loans, at December 31, 2001.

        Management’s decision regarding the amount of the provision is influenced in part by growth in commercial and real estate loan balances. In 2003 and 2002, the Company experienced its higher levels of charge-offs than it had experienced in the prior five years. Charge-offs were $530,000 and $538,000 in 2003 and 2002, respectively. Charge-offs were $335,000 and $378,000 in 2001 and 2000, respectively.

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        The following table sets forth a summary of the Company’s loan loss experience for the years ended December 31.

        Total non-accrual loans of the Company increased in 2003, representing .21% of total loans, net of unearned income at December 31, 2003, compared to .18% one year earlier. Specific valuation allowances totaling $349,000 have been established for these nonaccrual loans. Loans 90 days past due increased from $374,000 for 2002 to $1,128,000 for 2003, but $992,000 or 87.9% of those loans were real estate secured and present limited loss exposure to the Company.

        The following table summarizes the past due and non-performing assets of the Company as of December 31.