First Ottawa Bancshares (FOTB) 10-K 2003 FY Annual report

Exhibit 13.1

SELECTED CONSOLIDATED FINANCIAL INFORMATION

The following table sets forth selected consolidated financial and other data of First Ottawa Bancshares, Inc. and its wholly owned subsidiary, the First National Bank of Ottawa (the “Bank”) and the Bank’s wholly owned subsidiary, First Ottawa Financial Corporation, together referred to as the “Company.” This information should be read in conjunction with the Consolidated Financial Statements and notes thereto included herein.  All dollar amounts are in thousands, except per share information.

	Year ended December 31,
	2003			2002			2001			2000			1999
Statement of Income Data:
Total interest income	$	12,651		$	13,092		$	14,921		$	15,995		$	16,492
Total interest expense	4,384			5,733			7,773			8,525			8,265
Net interest income	8,267			7,359			7,148			7,470			8,227
Provision for loan losses	120			120			300			360			384
Noninterest income	2,592			2,444			2,457			1,749			1,496
Noninterest expenses	7,413			6,718			6,732			6,510			6,736
Income before income taxes	3,326			2,965			2,573			2,349			2,603
Provision for income taxes	867			678			460			257			449
Net income	$	2,459		$	2,287		$	2,113		$	2,092		$	2,154
Per Share Data:
Net income – basic and diluted	$	3.75		$	3.47		$	3.19		$	3.14		$	2.87
Cash dividends declared	3.00			3.00			3.00			3.00			3.00
Book value at end of year (1)	35.54			34.97			34.53			34.62			37.11
Selected Financial Ratios:
Return on average assets (1)	1.00		%	.99		%	.94		%	.91		%	.90		%
Return on average equity (1)	10.50			9.73			9.18			8.89			7.58
Dividend payout ratio	79.79			86.46			94.04			94.96			104.46
Average equity to average assets (1)	9.56			10.20			10.29			10.25			11.87
Net interest margin (tax equivalent)	3.89			3.77			3.74			3.87			4.11
Allowance for loan losses to total loans at the end of period	.80			1.06			1.01			.94			.82
Nonperforming loans to total loans at the end of period (2)	2.04			1.83			1.15			2.26			1.52
Net loans charged off to average total loans	.21			.06			.25			.25			.29
Balance Sheet Data:
Total assets	$	294,490		$	240,662		$	232,565		$	225,007		$	240,490
Total earning assets	276,767			223,324			216,927			210,058			219,427
Average assets (3)	247,961			232,335			224,653			226,787			239,524
Gross loans, including loans held for sale	131,948			111,454			109,508			117,612			129,444
Allowance for loan losses	1,049			1,167			1,109			1,108			1,059
Total deposits	264,921			193,767			165,267			173,453			183,889
Federal funds purchased and securities sold under agreements to repurchase	—			16,322			35,899			24,638			26,265
Shareholders’ equity	24,655			25,183			22,907			22,583			25,983

(1)     Excludes unrealized gain (loss) on securities available-for-sale.

(2)   Includes total nonaccrual loans, impaired loans, and all other loans 90 days past due and still accruing interest.

(3)   Average for the year ended.

1

MANAGEMENT’S DISCUSSION AND ANALYSIS

OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis is intended as a review of significant factors affecting the financial condition and results of operations of the Company for the periods indicated.  The discussion should be read in conjunction with the Consolidated Financial Statements and Notes thereto and the Selected Consolidated Financial Data presented herein.  In addition to historical information, the following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties.  The Company’s actual results could differ significantly from those anticipated in these forward-looking statements as a result of certain factors discussed elsewhere in this report.

Overview

The Company’s principal business is conducted by the Bank and consists of a full range of community-based financial services, including commercial and retail banking.  The profitability of the Company’s operations depends primarily on its net interest income, provision for loan losses, other income, and other expenses.  Net interest income is the difference between the income the Company receives on its loan and securities portfolios and its cost of funds, which consists of interest paid on deposits and borrowings.  The provision for loan losses reflects the cost of credit risk in the Company’s loan portfolio.  Other income consists of service charges on deposit accounts, trust and farm management fee income, securities gains (losses), gains (losses) on sales of loans, and other income.  Other expenses include salaries and employee benefits, as well as occupancy and equipment expenses and other noninterest expenses.

Net interest income is dependent on the amounts and yields of interest-earning assets as compared to the amounts of and rates on interest-bearing liabilities.  Net interest income is sensitive to changes in market rates of interest and the Company’s asset/liability management procedures in coping with such changes.  The provision for loan losses is dependent upon management’s assessment of the collectibility of the loan portfolio under current economic conditions.

Net income was $2.5 million for the year ended December 31, 2003 compared to $2.3 million for the year ended December 31, 2002.  The return on average assets was 1.00% in 2003 compared to .99% in 2002.  The return on average equity increased to 10.50% in 2003 from 9.73% in 2002.  This resulted primarily from the increase in net income and the change in average equity due to stock repurchases in 2003 and 2002.

Net income was $2.3 million for the year ended December 31, 2002 compared to $2.1 million for the year ended December 31, 2001.  The return on average assets was .99% in 2002 compared to .94% in 2001.  The return on average equity increased to 9.73% in 2002 from 9.18% in 2001.  This resulted primarily from the increase in net income and the change in average equity due to stock repurchases in 2002 and 2001.

2

Critical Accounting Policies

The accounting and reporting policies of the Company are in accordance with accounting principles generally accepted in the United States and conform to general practices within the banking industry.  The Company’s significant accounting policies are described in detail in the notes to the Company’s consolidated financial statements for the year ended December 31, 2003. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions. The financial position and results of operations can be affected by these estimates and assumptions and are integral to the understanding of reported results. Critical accounting policies are those policies that management believes are the most important to the portrayal of the Company’s financial condition and results, and they require management to make estimates that are difficult, subjective, or complex.

Allowance for Credit Losses- The allowance for credit losses provides coverage for probable losses inherent in the Company’s loan portfolio. Management evaluates the adequacy of the allowance for credit losses each quarter based on changes, if any, in underwriting activities, the loan portfolio composition (including product mix and geographic, industry or customer-specific concentrations), trends in loan performance, regulatory guidance and economic factors. This evaluation is inherently subjective, as it requires the use of significant management estimates. Many factors can affect management’s estimates of specific and expected losses, including volatility of default probabilities, rating migrations, loss severity and economic and political conditions. The allowance is increased through provisions charged to operating earnings and reduced by net charge-offs.

The Company determines the amount of the allowance based on relative risk characteristics of the loan portfolio. The allowance recorded for commercial loans is based on reviews of individual credit relationships and an analysis of the migration of commercial loans and actual loss experience. The allowance recorded for homogeneous consumer loans is based on an analysis of loan mix, risk characteristics of the portfolio, fraud loss and bankruptcy experiences, and historical losses, adjusted for current trends, for each homogeneous category or group of loans. The allowance for credit losses relating to impaired loans is based on the loan’s observable market price, the collateral for certain collateral-dependent loans, or the discounted cash flows using the loan’s effective interest rate.

Regardless of the extent of the Company’s analysis of customer performance, portfolio trends or risk management processes, certain inherent but undetected losses are probable within the loan portfolio. This is due to several factors including inherent delays in obtaining information regarding a customer’s financial condition or changes in their unique business conditions, the judgmental nature of individual loan evaluations, collateral assessments and the interpretation of economic trends. Volatility of economic or customer-specific conditions affecting the identification and estimation of losses for larger non-homogeneous credits and the sensitivity of assumptions utilized to establish allowances for homogenous groups of loans are among other factors. The Company estimates a range of inherent losses related to the existence of these exposures.  The estimates are based upon the Company’s evaluation of imprecision risk associated with the commercial and consumer allowance levels and the estimated impact of the current economic environment.

3

Mortgage Servicing Rights- Mortgage servicing rights (“MSRs”) associated with loans originated and sold, where servicing is retained, are capitalized and included in other intangible assets in the consolidated balance sheet. The value of the capitalized servicing rights represents the present value of the future servicing fees arising from the right to service loans in the portfolio. Critical accounting policies for MSRs relate to the initial valuation and subsequent impairment tests. The methodology used to determine the valuation of MSRs requires the development and use of a number of estimates, including anticipated principal amortization and prepayments of that principal balance. Events that may significantly affect the estimates used are changes in interest rates, mortgage loan prepayment speeds and the payment performance of the underlying loans. The carrying value of the MSRs is periodically reviewed for impairment based on a determination of fair value. For purposes of measuring impairment, the servicing rights are compared to a valuation prepared based on a discounted cash flow methodology, utilizing current prepayment speeds and discount rates. Impairment, if any, is recognized through a valuation allowance and is recorded as amortization of intangible assets.

Derivatives- As a part of the Company’s funding strategy, derivative financial instruments, all of which are interest rate swap arrangements, are used to reduce exposure to changes in interest rates for certain financial instruments.  These derivatives are accounted for by recognizing the fair value of the contracts on the balance sheet.  The valuation of these derivatives is considered critical because 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 the interest rate swaps and related deposit products are provided by third parties.

Additionally, the Company has purchased certificate of deposits which contain an equity related embedded derivative component.  The initial investment in the certificate of deposit is not at risk but the return on the investment is based on appreciation in the S&P 500 Index.  Accordingly, the fair value of the embedded derivative is recorded at fair value as an adjustment to the certificate of deposit and interest income.

Stock Compensation- Grants under the Company’s stock incentive plan are accounted for under the provisions of Statement of Accounting Standards (SFAS) No. 123, applying the fair value method and the use of an option pricing model to estimate the value of the options granted. The stock options are granted with an exercise price equal to the market price at the date of grant. Resulting compensation expense, under the stock options is measured and recorded based on the estimated value of the options.

Consolidated Financial Condition

The Bank purchased and assumed substantially all of the deposit liabilities of two branch offices located in Streator, Illinois from First Midwest Bank on November 14, 2003.  Approximately $69.3 million of deposits and the related cash balances were acquired, along with certain other assets of the branches, including real estate, furniture and fixtures and approximately $11.8 million of loans.  The Bank recorded goodwill of $2.4 million and a core deposit intangible of $2.0 million in connection with this transaction. Many of the employees remained with the branches and became employees of the Bank.

4

As a result of the branch acquisition, total assets at December 31, 2003 were $294.5 million compared to $240.7 million at December 31, 2002, an increase of $53.8 million, or 22.4%.  Cash received in the transaction was used to fund increases in cash and cash equivalents of $2.9 million, federal funds sold of $6.4 million, certificates of deposit held for investment purposes of $205,000, loans of  $20.6 million, investments of $14.5 million, and other assets of $6.2 million. Premises and equipment increased by $3.0 million due to capital expenditures on a new branch facility in Morris, the purchase of land for a new branch in Yorkville, and the acquisition of the Streator branches. Total borrowings decreased $14.9 million as a result of a $14.7 million decrease in federal funds purchased and a $161,000 decrease in borrowed funds, due to the partial repayment of a loan from Bank One. Repurchase agreements decreased by $1.6 million due to a change in products offered by the Bank. Total deposits increased $71.1 million, primarily due to the acquisition of the Streator facilities.

Total equity was $24.7 million at December 31, 2003 compared to $25.2 million at December 31, 2002.  The decrease was primarily the result of a decrease in the unrealized gain on securities available-for-sale, net of tax, of $718,000, dividends declared of $2.0 million and by the repurchase of Company common stock for $315,000. The decrease was partially offset by net income of $2.5 million.

Consolidated Results of Operations

2003 Compared to 2002

Net Interest Income.  Net interest income was $8.3 million in 2003 compared to $7.4 million in 2002, an increase of $900,000, or 12.3%.  Interest income on earning assets decreased $441,000 in 2003 from 2002.  The decrease was primarily due to decreased interest income on investment securities of $638,000, attributable to a decrease in average balances and also average tax-equivalent yields available in the marketplace in 2003. The decrease was partially offset by increases in interest income earned on the loan portfolio of $81,000, and also interest bearing deposits held for investment purposes of $104,000. Increases in income are attributed to growth in average balances in these areas. Interest expense on interest-bearing liabilities decreased $1.3 million as a result of a decrease in the average rate paid on liabilities of 85 basis points, from 3.11% in 2002 to 2.26% in 2003. The net interest margin on a tax equivalent basis increased to 3.89% in 2003 from 3.77% in 2002.  The primary reason for the increase in the net interest margin was the result of rates on interest-bearing liabilities repricing downward and growth in NOW and Money Market products which pay lower interest rates.

Provision for Loan Losses.  The provision for loan losses remained constant at $120,000 in 2003 compared to 2002. As of December 31, 2003, the allowance for loan losses totaled $1.1 million, or .80% of total loans, compared to $1.2 million, or 1.06% of total loans, at December 31, 2002. The reduction in the allowance for loan losses as a percentage of total loans was influenced heavily by the acquisition of  $11.4 million of Streator branch loans in the fourth quarter of 2003.

The amounts of the provision and allowance for loan losses are influenced by current economic conditions, actual loss experience, industry trends and other factors, including real estate values in the Company’s market area and management’s assessment of current collection risks within the loan portfolio. Along with other financial institutions, management shares a concern for the

5

outlook of the economy for 2004. Even though there are indications of emerging strength, it is uncertain if this strength is sustainable. If it is not sustainable, borrowers may experience difficulty, and the level of non-performing loans, charge- offs, and delinquencies could rise and require increases in the provision. The allowance for loan losses represents management’s estimate of probable incurred losses based on information available as of the date of the financial statements.  The allowance for loan losses is based on management’s evaluation of the collectibility of the loan portfolio, including past loan loss experience, known and inherent risks in the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, and economic conditions.

Management has concluded that the allowance for loan losses is adequate at December  31, 2003. However, there can be no assurance that the allowance for loan losses will be adequate to cover all losses.

Noninterest Income.  The Company’s noninterest income increased $148,000, or 6.1% compared to 2002. Noninterest income increased primarily due to increased mortgage refinancing activity in the low rate environment. Gains on loan sales to the secondary market increased $288,000 to $733,000 in 2003 compared to 2002. This increase was partially mitigated by decreases in gains on securities sold of $102, and a decrease in other income from bank owned life insurance of $169,000. Service charges on deposit accounts increased by $98,000, or 12.8%, to $866,000. Trust and farm management fee income increased modestly by $13,000, to $472,000 in 2003 compared to 2002.

The increase in gains on sales of loans was the result of a continued increase in refinancings during the first nine months of 2003.  Due to the rate structure in early 2004 and the large amount of loans that refinanced during 2002 and 2003, current estimates indicate that the gain on sale of loans during 2004 will be significantly less than 2003 or 2002.

Noninterest Expense.  The Company’s non-interest expense was $7.4 million in 2003 and $6.7 million for 2002.  Salaries and benefits, which is the largest component of non-interest expense, increased $168,000, or 4.3%, to $4.1 million.  Increases in occupancy and equipment expense of $76,000, data expense of $67,000, supplies expense of $73,000, advertising expense of $31,000, professional fees of $76,000 and other expenses of $204,000, contributed to the $695,000 increase in non-interest expense for the year. Increased salaries and benefits were primarily a result of additional personnel hired to staff the new Morris facility, which opened in July 2003, and personnel retained in the acquisition of the two branches in Streator in November 2003. The increase in occupancy and equipment expenses was due primarily to increased depreciation on capital expenditures related to the renovation of the main banking facility in Ottawa, the acquisition of the Streator facilities, and the construction of the Morris facility. In addition, the increases in supplies and advertising were primarily attributed to the new facilities in 2003. Increased professional fees were a result of the consulting and legal costs associated with the branch acquisitions. Increased data expenses were a result of a platform conversion which was completed in November 2003.  Increases in other expenses resulted primarily from increased mortgage banking expenses of $85,000, amortization expense related to purchase accounting adjustments made as a result of the acquisition of the Streator branches of $27,000, and other expenses related to index-powered certificates of deposit of $47,000.

6

Income Taxes.  The Company’s tax rate varied from statutory rates principally due to interest income from tax-exempt securities and loans.  The Company’s effective tax rate was 26.1% and 22.9% for 2003 and 2002.

2002 Compared to 2001

Net Interest Income.  Net interest income was $7.4 million in 2002 compared to $7.1 million in 2001, an increase of $300,000, or 2.9%.  Interest income on earning assets decreased $1.8 million in 2002 from 2001.  Decreased interest income on loans was attributable to a decrease in average tax-equivalent loan rates which were 7.65% during 2002, compared to 8.34% in 2001. Interest expense on interest-bearing liabilities decreased $2.1 million as a result of a decrease in the average rate paid on liabilities of 125 basis points, from 4.36% in 2001 to 3.11% in 2002 and a decrease in the average balance of time deposits of $5.7 million.  The net interest margin on a tax equivalent basis increased slightly to 3.77% in 2002 from 3.74% in 2001.

Provision for Loan Losses.  The provision for loan losses decreased $180,000 from $300,000 in 2001 to $120,000 in 2002.  The decrease in the provision was largely due to the decrease in net loans charged off,  $62,000 in 2002 compared to $299,000 in 2001. Although loans considered impaired increased from $1.3 million at December 31, 2001, to $2.0 million one year later, total portfolio delinquencies decreased to 2.5% of outstanding loans as of December 31, 2002, from 4.2% at December 31, 2001. Additionally, allowance for loan loss specific allocations relating to impaired loans increased to $396,000 in 2002, compared to $180,000 in the prior year. As of December 31, 2002, the allowance for loan losses totaled $1.2 million, or 1.06% of total loans, compared to $1.1 million, or 1.01% of total loans, at December 31, 2001.  The amounts of the provision and allowance for loan losses are influenced by current economic conditions, actual loss experience, industry trends, and other factors, including real estate values in the Company’s market area and management’s assessment of current collection risks within its loan portfolio.

Noninterest Income.  The Company’s noninterest income totaled $2.4 million in 2002 compared to $2.5 million in 2001.  The decrease was primarily a result of decreases in service charges on deposit accounts and net gains on sales of securities.  Service charges decreased from $819,000 in 2001, to $768,000 in 2002, as a result of increases in charged off overdrafts and decreased service charges on savings accounts.  Gains on the sale of investments also decreased to $102,000 in 2002 from $539,000 in 2001.  In 2001, management attempted to replace tax-exempt bonds with taxable positions, shorten maturities, improve interest rate risk, and enhance earnings, while in 2002 management had largely implemented this strategy and, as a result, security sales decreased. These decreases were partially offset by changes to other income, which increased from $441,000 in 2001, to $670,000 in 2002, due to a combined $245,000 increase in the cash surrender value of bank owned life insurance along with gains on proceeds from three policies settled in 2002. The $207,000 increase in gains on the sale of mortgage loans in 2002 was primarily a result of the bank retaining servicing rights for loans sold to the secondary market in 2002, which resulted in an increase in servicing assets of $193,000.  This increase in servicing assets as well as the $14,000 increase in gains on loan sales comprised the increase in 2002 income from gains on loan sales.

7

Noninterest Expense.  The Company’s noninterest expense remained constant at $6.7 million in 2002 and 2001. Slight decreases in data processing expense, supplies, advertising, professional fees, salaries, and employee benefits were offset by increases in occupancy and equipment expense due to increased depreciation of capital expenditures, and increases in other expenses due primarily to expenses associated with a directors deferred compensation plan and a directors retirement plan. Both plans are being funded primarily through the annual increase in cash surrender value of bank owned life insurance policies.

Income Taxes.  The Company’s tax rate varies from statutory rates principally due to interest income from securities, loans and income from cash surrender value of life insurance.  The Company’s effective tax rate was 22.9% and 17.9% for 2002 and 2001.

The components of the changes in net interest income are shown below.  Changes in net interest income are allocated between amounts attributed to changes in rate and changes in volume for the various categories of interest-earning assets and interest-bearing liabilities.

Analysis of Changes in Interest Income and Expense

($000s)

	2003 - 2002 Increase (Decrease)									2002 - 2001 Increase (Decrease)
	Total Change			Change Due to Volume			Change Due to Rate			Total Change			Change Due to Volume			Change Due to Rate
INTEREST INCOME
Loans	$	(155	)	$	518		$	(673	)	$	(1,194	)	$	(408	)	$	(786	)
Investment CDs	104			128			(24		)	181			193			(12		)
Securities	(729		)	(253		)	(476		)	(738		)	272			(1,010		)
Federal funds sold	12			21			(9		)	(92		)	(27		)	(65		)
Total interest income	(768		)	415			(1,183		)	(1,843		)	30			(1,873		)
INTEREST EXPENSE
NOW and money market	125			279			(154		)	(41		)	117			(158		)
Savings	(105		)	27			(132		)	(14		)	29			(43		)
Time deposits	(902		)	43			(945		)	(1,319		)	(263		)	(1,056		)
Repurchase agreements	(465		)	(528		)	63			(650		)	(28		)	(622		)
Borrowings	(101		)	(101		)	—			(26		)	30			(56		)
Federal funds purchased	90			100			(10		)	10			40			(30		)
Total interest expense	(1,358		)	(180		)	(1,178		)	(2,040		)	(75		)	(1,965		)
Net interest earnings	$	590		$	594		$	(4	)	$	197		$	105		$	92

Volume/rate variances are allocated to the volume variance and the rate variance on an absolute basis.  Tax-exempt income is reflected on a fully tax-equivalent basis utilizing a 34% rate for municipal securities and tax-exempt loans.

Interest-Earning Assets and Interest-Bearing Liabilities

The following table sets forth the average balances, net interest income and expense, and average yields and rates for the Company’s interest-earning assets and interest-bearing liabilities for the indicated years on a tax-equivalent basis assuming a 34% tax rate.

8

Analysis of Average Balances, Tax Equivalent Yields and Rates

Years ended December 31, 2003, 2002, and 2001

($000s)

	2003						2002						2001
	Average Balance (4)		Interest		Average Rate		Average Balance (4)		Interest		Average Rate		Average Balance (4)		Interest		Average Rate
ASSETS
Loans (1) (3)	$	115,140	$	8,089	7.03	%	$	107,768	$	8,244	7.65	%	$	113,106	$	9,438	8.34	%
Investment CDs	11,341		357		3.15		7,259		253		3.49		1,728		72		4.17
Securities (2) (5)	93,944		4,596		4.89		99,107		5,325		5.37		94,043		6,063		6.45
Federal funds sold	3,308		32		.97		1,154		20		1.73		2,697		112		4.15
Interest-earning assets	223,733		13,074		5.84		215,288		13,842		6.43		211,574		15,685		7.41
Non-interest-earning assets (6)	24,228						17,047						13,079
Average assets	$	247,961					$	232,335					$	224,653
LIABILITIES AND SHAREHOLDERS’ EQUITY
NOW and money market	$	69,435	$	708	1.02		$	42,056	$	583	1.39		$	33,607	$	624	1.86
Savings	21,158		207		.98		18,388		312		1.70		16,654		326		1.96
Time deposits	92,110		3,292		3.57		90,909		4,194		4.61		96,615		5,513		5.71
Repurchase agreements	475		10		2.11		25,567		475		1.86		27,062		1,125		4.16
Federal funds purchased	10,713		158		1.47		3,902		68		1.74		1,589		58		3.65
Borrowings	—		—		—		3,808		101		2.65		2,685		127		4.73
Interest-bearing liabilities	193,891		4,375		2.26		184,630		5,733		3.11		178,212		7,773		4.36
Net interest income (2)			8,699						8,109						7,912
Net yield on interest- earning assets					3.89						3.77						3.74
Interest-bearing liabilities to earning assets ratio					86.66						85.76						84.23
Non-interest-bearing liabilities	28,644						22,959						22,749
Shareholders’ equity	25,426						24,746						23,692
Average liabilities and shareholders’ equity	$	247,961					$	232,335					$	224,653
Tax equivalent adjustment			432						750						764
Net interest income as reported in the consolidated statements of income			$	8,267					$	7,359					$	7,148

(1)Interest income on loans includes loan origination and other fees of $275 for 2003, $456 for 2002, and $285 for 2001.

(2)Loan and securities income is reflected on a fully tax-equivalent basis utilizing a 34% rate for municipal securities and tax-exempt loans

(3)Non-accrual loans are included in average loans.

(4)Average balances are derived from the average daily balances.

(5)Rate information is calculated based upon average amortized cost.

(6)Average balance information includes an average valuation allowance for securities of $3,375, $1,867, and $1,023, respectively.

9

Impact of Accounting Changes

In May 2003, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.  SFAS 150 establishes standards for classification and measurement in the statement of financial position of certain financial instruments with characteristics of both liabilities and equity.  It requires that an issuer classify a financial instrument that is within its scope as a liability.  The FASB’s Staff Position 150-3 deferred indefinitely the guidance in SFAS No. 150 on certain mandatorily redeemable noncontrolling interests.  The Company has determined that it has no such instruments covered by SFAS No. 150 and Staff Bulletin 150-3.

In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities.  This statement clarifies reporting of contracts as either derivatives or hybrid instruments.  The Company has determined that all derivatives or hybrid instruments covered under this statement have been properly reported under SFAS No. 149.

In January 2003, the FASB issued FASB Interpretation No. 46 Consolidation of Variable Interest Entities.  FIN 46 provides guidance with respect to variable interest entities and when the assets, liabilities, noncontrolling interest, and results of operations of a variable interest entity need to be included in a company’s consolidated financial statements. A variable interest entity exists when either the total equity investment at risk is not sufficient to permit the entity to finance its activities by itself, or the equity investors lack one of three characteristics associated with owning a controlling financial interest. Those characteristics are the direct or indirect ability to make decisions about an entity’s activities through voting rights or similar rights, the obligation to absorb the expected losses of an entity if they occur, and the right to receive the expected residual returns of the entity if they occur.

In December 2003 the FASB deferred certain effective dates for Interpretation No. 46.  For all variable interest entities other than special purpose entities, the revised Interpretation is effective for periods ending after March 15, 2004.  For variable interest entities meeting the definition of special purpose entities under earlier accounting rules, the Interpretation remains effective for periods ending after December 31, 2003.    The Company has determined that it has no such instruments covered by Interpretation No. 46.

In November 2002, FASB Interpretation No. 45 (“FIN 45”), Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others was issued. FIN 45 requires the disclosures to be made by a guarantor in its financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The most significant FIN 45 instruments of the Company are standby letters of credit.  The Company has determined that its standby letters of credit obligations under FIN 45 are not material for disclosure.

10

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company uses overall risk sensitivity to monitor and manage exposure to sudden changes in interest rates.  The Company’s overall interest rate sensitivity is demonstrated by a net interest income analysis.  Net interest income analysis measures the change in net interest income in the event of hypothetical changes in interest rates.  This analysis assesses the risk of change in net interest income in the event of sudden and sustained 1.0% increases and decreases in market interest rates.  The tables below present the Company’s projected changes in net interest income for the various rate shock levels for the periods ended December 31, 2003 and 2002.

	2003 Net Interest Income
	Amount			Change			Change
	(Dollars in Thousands)
+100 bp	$	(3,210	)	$	(64	)	(2.0	)%
Base	3,146			—			—
–100 bp	3,121			(25		)	(0.8	)%

	2002 Net Interest Income
	Amount		Change			Change
	(Dollars in Thousands)
+100 bp	$	2,560	$	(73	)	(2.8	)%
Base	2,633		—			—
–100 bp	2,561		(72		)	(2.7	)%

As shown above, at December 31, 2003, the effect of an immediate 100 basis point increase in interest rates would decrease the Company’s net interest income by 2.0% or approximately $64,000.  The effect of an immediate 100 basis point decrease in rates would decrease the Company’s net interest income by 0.8%, or approximately $25,000, as federal funds overnight rates were under 2.0% as of December 31, 2003, market interest rates decreasing an additional 200 basis points is not achievable.  The Company’s Board of Directors has set a risk tolerance limit of 10% of estimated net interest income for the succeeding 12 months based on an immediate 200 basis point change in market prices.

Interest rate sensitivity reflected modest exposure in an increasing rate environment at the end of 2003.  Overall net interest income sensitivity decreased in 2003 compared to 2002.

Liquidity and Capital Resources

The Company’s primary sources of funds are deposits, repurchase agreements, and proceeds from principal and interest payments on loans and securities.  While maturities and scheduled amortization of loans and securities and calls of securities are predictable sources of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions, and competition.  The Company generally manages the pricing of its deposits to be competitive and to increase core deposit relationships.

Liquidity management is both a daily and long-term responsibility of management.  The Company adjusts its investments in liquid assets based upon management’s assessment of

11

(i) expected loan demand, (ii) expected deposit flows, (iii) yields available on interest-earning deposits and securities, and (iv) the objectives of its asset/liability management program.  Excess liquid assets are invested generally in interest-earning overnight deposits and short- and intermediate-term U.S. government and agency obligations.

The Company’s cash flows are comprised of three primary classifications:  cash flows from operating activities, investing activities, and financing activities.  Cash flows provided by operating activities were $1.9 million, $2.0 million, and $2.4 million for the years ended December 31, 2003, 2002, and 2001.  Net cash from investing activities consisted primarily of principal collections on loans and proceeds from maturation and sales of securities offset by disbursements for loan originations and the purchase of securities.  In 2003, cash flows from investing activities were also affected by the $51.2 million in cash received in connection with the branch acquisition.  Net cash from financing activities consisted primarily of changes in net deposits and short-term borrowings partially offset by dividends paid and the purchase of Company stock.

The Company’s most liquid assets are cash and short-term investments.  The levels of these assets are dependent on the Company’s operating, financing, lending, and investing activities during any given year.  At December 31, 2003, cash and short-term investments totaled $17.9 million.  The Company has other sources of liquidity if a need for additional funds arises, including securities maturing within one year and the repayment of loans.  The Company may also utilize the sale of securities available-for-sale, federal funds lines of credit from correspondent banks, and borrowings from the Federal Home Loan Bank of Chicago and Bank One.

The following table discloses contractual obligations and commercial commitments of the Company as of December 31, 2003:

	Total			Less Than 1 Year		1 – 3 Years		4 – 5 Years		After 5 Years
Note payable	$	490		$	490	—		—		—
Data processing contract payable	1,091			193		$	387	$	511
Lines of credit(1)	15,801			10,527		2,860		1,260		$	1,154
Standby letters of credit(1)	136			136		—		—		—
	$		16,427	$	11,153	$	2,860	$	1,260	$	1,154

(1)  Represents amounts committed to customers.

During 2003 and 2002, the Company repurchased 5,329 and 1,400 shares of common stock for $315,000 and $74,000.

Capital provides the foundation for future growth.  Regulatory agencies have developed minimum guidelines by which the adequacy of a financial institution’s capital may be evaluated.  At December 31, 2003, all of the Company’s ratios exceeded the levels required under regulatory guidelines as shown in Note 15 of the Consolidated Financial Statements.

12

Facilities

The Company has purchased real estate in Yorkville, Illinois and is in the process of establishing a full service branch facility in that community.  Construction of the facility is to begin in late 2004 and the branch is expected to open in early 2005.  The total estimated costs to complete the branch are $700,000 at December 31, 2003.

Impact of Inflation and Changing Prices

The financial statements and related data presented herein have been prepared in accordance with accounting principles generally accepted in the United States of America, which require the measurement of financial position and operating results in terms of historical dollars without considering changes in the relative purchasing power of money over time due to inflation.  The primary impact of inflation on the operations of the Company is reflected in increased operating costs.  Unlike most industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature.  As a result, interest rates generally have a more significant impact on a financial institution’s performance than does inflation.  Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.

Safe Harbor Statement

This document (including information incorporated by reference) contains, and future oral and written statements of the Company and its management may contain, forward-looking statements, within the meaning of such terms in the Private Securities Litigation Reform Act of 1995, with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company.  Forward-looking statements, which may be based upon beliefs, expectations and assumptions of the Company’s management and on information currently available to management, are generally identifiable by the use of words such as “believe,” “expect,” “anticipate” “plan,” “intend,” “estimate,” “may,” “will,” “would,” “could,” or “should” or other similar expressions.  Additionally, all statements in this document, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statements in light of new information or future events.

The Company’s ability to predict results of the actual effect of future plans or strategies is inherently uncertain.  Factors which could have a material adverse effect on the operations and future prospects of the Company and its subsidiaries include, but are not limited to, the following:

•The strength of the United States economy in general and the strength of the local economies in which the Company conducts it operations which may be less favorable than expected and may result in, among other things, a deterioration in the credit quality and value of the Company’s assets

•The economic impact of past and any future terrorist attacks, acts of war or threats thereof and the response of the United States to any such threats and attacks.

•The effects of, and changes in, federal, state, and local laws, regulations and policies affecting banking, securities, insurance and monetary and financial matters.

13

•The effects of changes in interest rates (including the effects of changes in the rate of prepayments of the Company’s assets) and the policies of the Board of Governors of the Federal Reserve System.

•The ability of the Company to compete with other financial institutions as effectively as the Company currently intends due to increases in competitive pressures in the financial services sector.

•The inability of the Company to obtain new customers and to retain existing customers.

•The timely development and acceptance of products and services, including products and services offered through alternative delivery channels such as the Internet.

•Technological changes implemented by the Company and by other parties, including third party vendors, which may be more difficult or more expensive than anticipated or which may have unforeseen consequences to the Company and its customers.

•The ability of the Company to develop and maintain secure and reliable electronic systems.

•The ability of the Company to retain key executives and employees and the difficulty that the Company may experience in replacing key executives and employees in an effective manner.

•Consumer spending and savings habits which may change in a manner that affects the Company’s business adversely.

•Business combinations and the integration of acquired businesses which may be more difficult or expensive that expected.

•The costs, effects and outcomes of existing or future litigation.

•Changes in accounting policies and practices, as may be adopted by state and federal regulatory agencies and the Financial Accounting Standards Board.

•The ability of the Company to manage the risks associated with the foregoing as well as anticipated.

These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Additional information concerning the Company and its business, including other factors that could materially affect the Company’s financial results, is included in the Company’s filings with the Securities and Exchange Commission.

14

INDEPENDENT ACCOUNTANTS’ REPORT

Board of Directors and Shareholders

First Ottawa Bancshares, Inc.

Ottawa, Illinois

We have audited the accompanying consolidated balance sheet of First Ottawa Bancshares, Inc. as of December 31, 2003 and the related consolidated statements of income, shareholders’ equity, and cash flows for the year then ended.  These consolidated financial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these consolidated financial statements based on our audit.  The consolidated financial statements of the Company as of December 31, 2002 and for each of the two years in the period ended December 31, 2002 were audited by other accountants whose report dated January 17, 2003, expressed an unqualified opinion on those statements.

We conducted our audit in accordance with auditing standards generally accepted in the United States of America.  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the 2003 consolidated financial statements referred to above present fairly, in all material respects, the financial position of First Ottawa Bancshares, Inc. as of December 31, 2003 and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.

BKD, LLP

Indianapolis, Indiana

January 23, 2004

15

REPORT OF INDEPENDENT AUDITORS

Board of Directors and Shareholders

First Ottawa Bancshares, Inc.

Ottawa, Illinois

We have audited the accompanying balance sheet of First Ottawa Bancshares, Inc. as of December 31, 2002, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the two years in the period ended December 31, 2002.  These financial statements are the responsibility of the Company's management.  Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America.  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of First Ottawa Bancshares, Inc. at December 31, 2002 and the results of its operations and its cash flows for each of the two years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America.

Crowe Chizek and Company LLC

Oak Brook, Illinois

January 17, 2003

FIRST OTTAWA BANCSHARES, INC.

CONSOLIDATED BALANCE SHEETS

December 31, 2003 and 2002

(In thousands, except share and per share data)

	2003			2002
ASSETS
Cash and due from banks	$	11,477		$	8,606
Federal funds sold	6,400			—
Cash and cash equivalents	17,877			8,606
Certificates of deposit	13,190			12,985
Securities available for sale	113,433			98,885
Loans held for sale	1,644			1,811
Loans, less allowance for loan losses of $1,049 and $1,167	129,255			108,476
Premises and equipment, net	7,537			4,555
Interest receivable and other assets	11,554			5,344
Total assets	$	294,490		$	240,662
LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities
Deposits	$	264,921		$	193,767
Federal funds purchased	—			14,700
Securities sold under agreements to repurchase	—			1,622
Other borrowings	490			652
Interest payable and other liabilities	4,424			4,738
Total liabilities	269,835			215,479
Shareholders’ equity
Preferred stock -  $1 par value, 20,000 shares Authorized; none issued	—			—
Common stock - $1 par value, 1,000,000 shares authorized and 750,000 issued	750			750
Additional paid-in capital	4,008			4,000
Retained earnings	23,988			23,491
Treasury stock, at cost - 98,373 and 93,044 shares	(5,585		)	(5,270		)
Accumulated other comprehensive income	1,494			2,212
Total shareholders’ equity	24,655			25,183
Total liabilities and shareholders’ equity	$	294,490		$	240,662

See accompanying notes to consolidated financial statements.

16

FIRST OTTAWA BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF INCOME

Years ended December 31, 2003, 2002, and 2001

(In thousands, except share and per share data)

	2003		2002		2001
Interest income
Loans	$	8,057	$	7,976	$	9,416
Securities
Taxable	3,457		3,933		3,880
Exempt from federal income tax	748		910		1,441
Federal funds sold	32		20		112
Interest-bearing deposits	357		253		72
Total interest income	12,651		13,092		14,921
Interest expense
Deposits	4,207		5,089		6,463
Repurchase agreements	10		475		1,125
Federal funds purchased	158		68		58
Other borrowings	9		101		127
Total interest expense	4,384		5,733		7,773
Net interest income	8,267		7,359		7,148
Provision for loan losses	120		120		300
Net interest income after provision for loan losses	8,147		7,239		6,848
Noninterest income
Service charges on deposit accounts	866		768		819
Trust and farm management fee income	472		459		420
Gain on sale of loans	733		445		238
Securities gains net	—		102		539
Other income	521		670		441
Total noninterest income	2,592		2,444		2,457
Noninterest expenses
Salaries and employee benefits	4,122		3,954		3,893
Occupancy and equipment expense	943		867		822
Data processing expense	500		433		510
Supplies	190		117		119
Professional fees	419		343		354
Other expenses	1,239		1,004		1,034
Total noninterest expenses	7,413		6,718		6,732
Income before income taxes	3,326		2,965		2,573
Provision for income taxes	867		678		460
Net income	$	2,459	$	2,287	$	2,113
Earnings per share	$	3.75	$	3.47	$	3.19
Average shares outstanding	655,243		658,267		662,249

See accompanying notes to consolidated financial statements.

17

FIRST OTTAWA BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

Years ended December 31, 2003, 2002, and 2001

(In thousands, except share and per share data)

	Common Stock		Additional Paid-In Capital		Retained Earnings			Treasury Stock			Accumulated Other Comprehensive Income (Loss)			Total Share- holders’ Equity
Balance at January 1, 2001	$	750	$	4,000	$	23,052		$	(5,000	)	$	(219	)	$	22,583
Net income	—		—		2,113			—			—			2,113
Unrealized net gain on securities available-for-sale, net of reclassi- fication and tax effects	—		—		—			—			394			394
Comprehensive income														2,507
Cash dividends ($3.00 per share)	—		—		(1,987		)	—			—			(1,987		)
Purchase of 3,925 treasury shares	—		—		—			(196		)	—			(196		)
Balance at December 31, 2001	750		4,000		23,178			(5,196		)	175			22,907
Net income	—		—		2,287			—			—			2,287
Unrealized net gain on securities available-for-sale, net of reclassi- fication and tax effects	—		—		—			—			2,254			2,254
Change in minimum pension liability, net of tax	—		—		—			—			(217		)	(217		)
Comprehensive income														4,324
Cash dividends ($3.00 per share)	—		—		(1,974		)	—			—			(1,974		)
Purchase of 1,400 treasury shares	—		—		—			(74		)	—			(74		)
Balance at December 31, 2002	750		4,000		23,491			(5,270		)	2,212			25,183
Net income	—		—		2,459			—			—			2,459
Unrealized net loss on securities available-for-sale, net of reclassi- fication and tax effects	—		—		—			—			(718		)	(718		)
Comprehensive income	—		—		—			—			—			1,741
Cash dividends ($3.00 per share)	—		—		(1,962		)	—			—			(1,962		)
Options vested	—		8		—			—			—			8
Purchase of 5,329 treasury shares	—		—		—			(315		)	—			(315		)
Balance at December 31, 2003	$	750	$	4,008	$	23,988		$	(5,585	)	$	1,494		$	24,655

See accompanying notes to consolidated financial statements.

18

FIRST OTTAWA BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years ended December 31, 2003, 2002, and 2001

(In thousands, except per share data)

	2003			2002			2001
Cash flows from operating activities
Net income	$	2,459		$	2,287		$	2,113
Adjustments to reconcile net income to net cash from operating activities
Provision for loan losses	120			120			300
Depreciation and amortization	335			331			283
Premium amortization on securities, net	189			128			35
Net real estate loans originated for sale	900			109			(544		)
Net gains on loan sales	(733		)	(445		)	(238		)
Net gains on sales of securities	—			(102		)	(539		)
Change in interest receivable and other assets	(1,465		)	474			1,087
Change in interest payable and other liabilities	70			(929		)	(41		)
Net cash from operating activities	1,875			1,973			2,456
Cash flows from investing activities
Proceeds from sales of securities available-for-sale	—			7,831			19,612
Proceeds from maturities and calls of securities	27,879			18,280			46,297
Purchases of securities and available-for-sale	(43,703		)	(16,811		)	(77,159		)
Purchases of certificates of deposit	(8,090		)	(9,885		)	(3,100		)
Proceeds from maturities of certificates of deposit	7,885			—			—
Net change in loans receivable	(9,295		)	(2,003		)	8,372
Premises and equipment expenditures, net	(2,537		)	(2,030		)	(608		)
Cash received in branch acquisition	52,163			—			—
Net cash from investing activities	24,302			(4,618		)	(6,586		)
Cash flows from financing activities
Change in deposits	1,866			28,500			(8,186		)
Change in federal funds purchased	(14,700		)	9,650			5,050
Change in securities sold under agreements to repurchase	(1,622		)	(29,227		)	6,211
Proceeds from borrowings	—			452			4,200
Repayment of borrowings	(162		)	(4,000		)	—
Purchase of treasury stock	(315		)	(74		)	(196		)
Dividends paid	(1,973		)	(1,983		)	(1,987		)
Net cash from financing activities	(16,906		)	3,318			5,092
Change in cash and due from banks	9,271			673			962
Cash and due from banks at beginning of year	8,606			7,933			6,971
Cash and due from banks at end of year	$	17,877		$	8,606		$	7,933
Supplemental disclosures of cash flow information
Cash paid during the year for
Interest	$	4,552		$	6,217		$	8,038
Income taxes, net of refunds	821			563			350
Noncash investing activities
Transfers made from loans to other real estate owned	174			331			215
Due from broker	—			(477		)	477
Assets acquired and liabilities assumed in branch acquisition:
Loans	11,774			—			—
Premises and equipment	780			—			—
Goodwill and core deposit intangibles	4,553			—			—
Other assets, net	18			—			—
Deposits	(69,288		)	—			—

See accompanying notes to consolidated financial statements.

19

FIRST OTTAWA BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2003, 2002, and 2001

(Table dollars in thousands, except per share data)

NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Operations and Principles of Consolidation:  First Ottawa Bancshares, Inc. is a bank holding company whose principal activity is the ownership and management of its wholly-owned subsidiary, First National Bank of Ottawa (Bank).  The Bank is primarily engaged in providing a full range of banking and financial services to individual and corporate customers in LaSalle, Grundy and surrounding counties in Illinois.  The Bank is subject to competition from other financial institutions.  The Bank is subject to the regulation of certain federal and state agencies and undergoes periodic examinations by those regulatory authorities.  The consolidated financial statements include Ottawa Bancshares, Inc. and the Bank, and the Bank’s wholly owned subsidiary, First Ottawa Financial Corporation, together referred to as the Company.  Intercompany transactions and balances are eliminated in consolidation.

Use of Estimates:  To prepare financial statements in conformity with accounting principles generally accepted in the United States of America, management makes estimates and assumptions based on available information.  These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and future results could differ.  The allowance for loan losses, fair values of financial instruments, derivatives, and status of contingencies are particularly subject to change.

Securities:  Securities are classified as available-for-sale when they might be sold before maturity.  Securities available-for-sale are carried at fair value, with unrealized holding gains and losses reported, net of tax, as other comprehensive income.  Equity securities include Federal Home Loan Bank stock and Federal Reserve Bank stock, which are restricted securities that are carried at cost, and a mutual fund investment that is carried at fair value.  Securities are written down to fair value, with a charge to expense, when a decline in fair value is not temporary.

Realized gains and losses on sales are determined using the amortized cost of the specific security sold.  Interest income includes amortization of purchase premiums and discounts.

Derivatives:  All derivative instruments are recorded at their fair values and the change in the fair value of a derivative is included in interest income.  If derivative instruments are designated as hedges of fair values, both the change in the fair value of the hedge and the hedged item are included in current earnings.  Fair value adjustments related to cash flow hedges are recorded in other comprehensive income and reclassified to earnings when the hedged transaction is reflected in earnings.  Ineffective portions of hedges are reflected in earnings as they occur.

20

Loans:  Loans are reported at the principal balance outstanding, net of deferred loan fees and costs and the allowance for loan losses.  Interest income is reported on the interest method and includes amortization of net deferred loan fees and costs over the loan term.  Mortgage loans originated and intended for sale in the secondary market are carried at the lower of cost, net of deferred loan fees, or estimated fair value in the aggregate.  Interest income is not reported when full loan repayment is in doubt, typically when payments are past due over 90 days.  Payments received on such loans are reported as principal reductions.

Allowance for Loan Losses:  The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to income.  Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed.  Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance required based on past loan loss experience, known and inherent risks in the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors.  Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off.

Loan impairment is reported when full payment under the loan terms is not expected.  Impairment is evaluated in total for smaller-balance loans of similar nature, such as residential mortgage and consumer loans, and on an individual loan basis for other loans.  If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the loan’s observable market price or the fair value of collateral if the loan is collateral dependent.  Loans are evaluated for impairment when payments are delayed, typically 90 days or more, or when the internal grading system indicates a doubtful classification.

Premises and Equipment:  Asset cost is reported net of accumulated depreciation. Buildings and related components are depreciated using the straight-line method with useful lives ranging from 7 to 39 years. Furniture, fixtures and equipment are depreciated using the straight-line method with useful lives ranging from 5 to 15 years. These assets are reviewed for impairment when events indicate that the carrying amount may not be recoverable.  Maintenance and repairs are charged to expense and improvements are capitalized.

Other Real Estate:  Real estate owned, other than that used in the normal course of business, is carried at the lower of cost basis (fair value at date of foreclosure) or fair value less estimated costs to sell.  Any reduction to fair value from a related loan at the time of acquisition is accounted for as a loan loss.  Any subsequent reductions in fair value less estimated costs to sell are recorded by charges to expense and a corresponding valuation allowance on the related real estate.

21

Mortgage Servicing Rights:  Servicing rights are recognized as assets for the allocated value of servicing rights retained on loans sold and are classified with interest receivable and other assets in the consolidated balance sheets.  Servicing rights are expensed in proportion to and over the period of estimated net servicing revenues.  Impairment is evaluated based on the fair value of the rights using groupings of the underlying loans as to interest rates and then, secondarily, as to geographic and prepayment characteristics.  Fair value is determined using prices for similar assets with similar characteristics, when available, or based upon discounted cash flows using market-based assumptions.  Any impairment of a grouping is reported as a valuation allowance.  There was no such valuation allowance recorded at December 31, 2003 and 2002, and mortgage servicing rights were not material at either date.

Intangible Assets:  Core deposit intangibles are being amortized on an accelerated basis over 11 years and are periodically evaluated as to the recoverability of their carrying value.

Goodwill:  Goodwill is reviewed for impairment annually with any loss recognized through the income statement.

Stock Options:  The Company has a stock-based compensation plan, which is more fully described in Note 11.  The Company accounts for this plan under the recognition and measurement principles of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation.  The value of options granted under this plan is charged to expense over the vesting period of the grants.

Income Taxes:  Income tax expense is the sum of the current year income tax due or refundable and the change in deferred tax assets and liabilities.  Deferred tax assets and liabilities are the expected future tax consequences of temporary differences between the carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates.  A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.

Earnings Per Share:  Basic earnings per share is calculated based on the weighted average common shares outstanding during the year.  The Company had no dilutive securities during the three years in the period ended December 31, 2003.

Fair Values of Financial Instruments:  Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed separately.  Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items.  Changes in assumptions or in market conditions could significantly affect the

22

estimates.  The fair value estimates of existing on- and off-balance-sheet financial instruments do not include the value of anticipated future business or the values of assets and liabilities not considered financial instruments.

Comprehensive Income:  Comprehensive income includes both net income and other comprehensive income (loss).  Other comprehensive income (loss) includes the changes in unrealized gains and losses on securities available-for-sale, and minimum pension liability, net of deferred income taxes.

Reclassifications:  Some items in the prior years’ financial statements were reclassified to conform to the current presentation.

NOTE 2 - BUSINESS COMBINATION

On November 14, 2003, the Company assumed substantially all of the deposit liabilities and certain loans and other assets of two branch offices located in Streator, Illinois from First Midwest Bank.  As a result of the acquisition, the Company has an opportunity to increase its customer base and continue to increase its market share.

The acquisition was accounted for under the purchase method of accounting.  All assets and liabilities were recorded at their fair values as of November 14, 2003, including goodwill of $2,446,000 which is deductible for tax purposes.  Additionally, core deposit intangibles totaling $2,027,000 were recognized and will be amortized over 11 years using a declining balance method.  The purchase accounting adjustments are being amortized over the life of the respective asset or liability.

The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition.

Loans	$	11,774
Premises and equipment	780
Goodwill and core deposit intangibles	4,553
Other assets, net	18
Deposits	(69,288		)
Net liabilities assumed and cash received	$	(52,163	)

The accumulated amortization of the core deposit intangibles at December 31, 2003 totaled $34,000.  Estimated amortization expense for each of the following five years is $399,000, $319,000, $255,000, $204,000 and $163,000.

23

NOTE 3 - SECURITIES

Securities available for sale as of December 31, 2003 were as follows:

	Fair Value		Gross Unrealized Gains		Gross Unrealized Losses
U.S. treasuries	$	11,689	$	72	$	(2	)
U.S. government agencies	67,858		1,647		(56		)
States and political subdivisions	14,794		796		(43		)
Mortgage-backed securities and collateralized mortgage obligations	13,393		189		(80		)
Corporate bonds	2,323		101		—
Equity securities	3,376		20		(50		)
	$	113,433	$	2,825	$	(231	)

Securities available for sale as of December 31, 2002 were as follows:

	Fair Value		Gross Unrealized Gains		Gross Unrealized Losses
U.S. treasuries	$	3,584	$	81	$	—
U.S. government agencies	65,014		2,641		—
States and political subdivisions	16,962		777		—
Mortgage-backed securities and collateralized mortgage obligations	7,682		233		(21		)
Corporate bonds	2,415		80		(3		)
Equity securities	3,228		3		(111		)
	$	98,885	$	3,815	$	(135	)

As of December 31, 2003 and 2002, the Company had approximately $6,950,000 and $7,730,000 invested in bonds issued by municipalities located within LaSalle County, Illinois.

Securities with an approximate carrying value of $58,428,000 and $79,270,000 were pledged at December 31, 2003 and 2002 to secure trust and public deposits, repurchase agreements, and for other purposes as required or permitted by law.

24

The fair value of contractual maturities of securities available for sale at December 31, 2003 were as follows.  Securities not due at a single maturity date, primarily mortgage-backed and equity securities, are shown separately.

Due in one year or less	$	19,021
Due after one year through five years	59,622
Due after five years through ten years	13,811
Due after ten years	4,210
Mortgage-backed securities and collateralized mortgage obligations	13,393
Equity securities	3,376
	$	113,433

Information regarding realized gains and losses of securities available for sale follows:

	2003		2002			2001
Gross gains	$	—	$	104		$	540
Gross losses	—		(2		)	(1		)

At December 31, 2003, the Company’s securities in a continuous unrealized-loss position for more than a year totaled $600.

NOTE 4 - LOANS

Major classifications of loans as of December 31, 2003 and 2002 are summarized as follows:

	2003			2002
Real estate	$	70,859		$	46,699
Commercial and agricultural	24,197			33,950
Installment, net of unearned income	22,812			19,951
Home equity lines of credit	12,456			9,120
	130,324			109,720
Deferred loan fees	(20		)	(77		)
Allowance for loan losses	(1,049		)	(1,167		)
	$	129,255		$	108,476

25

Certain executive officers, directors, and their related interests are loan customers of the Company.  A summary of such loans made by the Company in the ordinary course of business is as follows:

Balance at January 1, 2003	$	1,745
New loans	3,259
Repayments	(684		)
Balance at December 31, 2003	$	4,320

Information regarding impaired loans at December 31, 2003 and 2002 is as follows:

	2003		2002
Impaired loans with related allowance for loan losses	$	1,943	$	1,447
Impaired loans with no related allowance for loan losses	163		591
Total impaired loans	$	2,106	$	2,038
Allowance for loan losses allocated to impaired loans	$	342	$	396

	2003		2002		2001
Average of impaired loans during the year	$	1,599	$	1,636	$	1,243
Interest income recognized during impairment	157		155		95
Cash-basis interest income recognized	153		112		81

Nonperforming loans were as follows at December 31:

	2003		2002
Loans past due over 90 days still on accrual	$	293	$	757
Nonaccrual loans	137		364

26

NOTE 5 - ALLOWANCE FOR LOAN LOSSES

Activity in the allowance for loan losses is summarized as follows for the years ended December 31:

	2003			2002			2001
Balance at beginning of year	$	1,167		$	1,109		$	1,108
Recoveries on loans previously charged off	181			171			101
Loans charged off	(419		)	(233		)	(400		)
Provision for loan losses	120			120			300
Balance at end of year	$	1,049		$	1,167		$	1,109

NOTE 6 - LOAN SALES AND SERVICING

The Company sells mortgage loans with servicing retained to the Federal Home Loan Mortgage Corporation (FHLMC) and the Illinois Housing Development Authority (IHDA).  The Company realized gross proceeds from the sales of mortgage loans totaling $26,296,000, $15,841,000 and $17,643,000 in 2003, 2002 and 2001.  Mortgage loans serviced for others are not included in the accompanying consolidated balance sheets.  The unpaid principal balances of these loans are summarized as follows:

	December 31,
	2003		2002
FHLMC	$	32,823	$	21,293
IHDA	1,148		1,170
	$	33,971	$	22,463

Following is an analysis of the changes in originated mortgage servicing rights:

	Year Ended December 31,
	2003			2002			2001
Balance at beginning of year	$	301		$	135		$	151
Originated mortgage servicing rights	256			193			—
Amortization	(112		)	(27		)	(16		)
	$	445		$	301		$	135

27

NOTE 7 - PREMISES AND EQUIPMENT

Premises and equipment consisted of the following at December 31:

	2003		2002
Land	$	1,791	$	1,340
Bank premises	6,521		4,408
Furniture and equipment	4,095		3,103
Construction in progress	—		272
Total cost	12,407		9,123
Less accumulated depreciation	4,870		4,568
Net book value	$	7,537	$	4,555

NOTE 8 – DEPOSITS

Deposits consisted of the following at December 31:

	2003		2002
Demand – non-interest-bearing	$	29,933	$	19,475
NOW accounts	64,050		54,537
Money market accounts	28,828		9,186
Savings	27,826		19,513
Time, $100,000 and over	26,425		23,813
Other time	87,859		67,243
Total deposits	$	264,921	$	193,767

At December 31, 2003, the scheduled maturities of certificates of deposit were as follows:

2004	$	71,194
2005	12,059
2006	8,391
2007	9,731
2008	12,430
Thereafter	479
	$	114,284

28

NOTE 9 - BORROWINGS

The Company has a note payable that consists of a $1,000,000 unsecured line of credit with Bank One, NA, maturing on May 15, 2004.  The outstanding balance under the line of credit was $490,000 and $652,000 at December 31, 2003 and 2002.  Interest is payable quarterly at Bank One’s prime rate or LIBOR plus 175 basis points (2.91% and 3.54% at December 31, 2003 and 2002).

NOTE 10 - SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE

Securities sold under agreements to repurchase are financing arrangements.  Physical control is maintained for all securities sold under repurchase agreements.  The average balance and interest rate during 2003 and 2002 was $475,000 and $25,567,000 and 2.11% and 2.04%.  The average interest rate at December 31, 2002 was 1.86% and the maximum month-end balance during 2003 and 2002 was $1,545,000 and $37,594,000.

NOTE 11 - BENEFIT PLANS

The Bank has a noncontributory defined benefit pension plan covering all employees who meet the eligibility requirements.  In 1999, all plan benefits were frozen.  The Bank’s funding policy is to make the minimum annual contribution that is required by applicable regulations, plus such amounts as the Bank may determine to be appropriate from time to time.  The Bank expects to contribute approximately $100,000 to the plan in 2004.  The Bank uses a December 31 measurement date for the plan.

The following tables set forth the Bank’s pension plan’s funded status and amounts actuarially determined for the years indicated:

	2003			2002
Change in benefit obligation
Beginning benefit obligation	$	1,929		$	2,139
Interest cost	114			120
Actuarial loss (gain)	(43		)	48
Benefits paid	(158		)	(378		)
Ending benefit obligation	$	1,842		$	1,929

29

	2003			2002
Change in plan assets
Beginning fair value	$	1,233		$	1,216
Actual return	256			(105		)
Employer contribution	100			500
Benefits paid	(158		)	(378		)
Ending fair value	$	1,431		$	1,233
Funded status	$	(411	)	$	(696	)
Unrecognized net actuarial loss	155			381
Accrued benefit cost	$	(256	)	$	(315	)
Accumulated benefit obligation	$	1,842		$	1,929

	2003		2002		2001
Assumptions used to determine benefit obligations
Discount rate	6.25	%	6.25	%	7.0	%
Expected return on plan assets	7.0		7.0		7.0
Assumptions used to determine benefit costs
Discount rate	6.25	%	7.0	%	7.0	%
Expected return on plan assets	7.0		7.0		7.0

The Company has estimated the long-term rate of return on plan assets based primarily on historical returns on plan assets, adjusted for changes in target portfolio allocations and recent changes in long-term interest rates based on publicly available information.

Components of net periodic benefit cost
Interest cost	$	114		$	120		$	151
Return on plan assets	(82		)	(105		)	(61		)
Amortization	9			20			(152		)
Net expense (income)	$	41		$	35		$	(62	)

30

Plan assets are held by a bank-administered trust fund, which invests the plan assets in accordance with the provisions of the plan agreement.  The permitted investments as established by the plan agreement include, but are not limited to, common and preferred stocks, open-end or closed-end mutual funds, bonds and other evidences of indebtedness or ownership, and real estate or any interest therein.

Asset allocation is primarily based on a strategy to provide stable earnings while attempting to recognize potentially higher returns through limited investments in equity securities.  Plan assets are rebalanced periodically.  At December 31, 2003, and 2002 allocations by percentages were as follows:

	2003		2002
Equity mutual funds	64.3	%	55.6	%
Fixed income mutual funds	26.9		37.9
GNMA pool	1.2		2.1
Money market funds and other	7.6		4.4

At December 31, 2003 and 2002 market values of plan assets were as follows:

	2003		2002
Equity mutual funds	$	920	$	685
Fixed income mutual funds	385		467
GNMA pool	17		25
Money market funds and other	109		55

The Bank has a directors’ retirement plan which provides retirement benefits primarily to former members of the Board of Directors.  The Bank also maintains a supplemental executive retirement plan that provides benefits to certain key executive officers and directors in accordance with the plan document.  The Bank accrued expenses related to these plans totaling  $188,000, $191,000, and $86,000, in 2003, 2002 and 2001.

The Company’s 401(k) profit sharing plan covers eligible employees with more than one year of service, as defined, and who are at least 21 years of age.  The plan allows employee contributions.  The Company may make a matching contribution equal to a percentage of salary deferral and discretionary profit sharing contributions.  The matching percentage is limited to 6% of compensation.  The Company made contributions of $122,000, $85,000 and $90,000 in 2003, 2002, and 2001.

31

NOTE  12 -  STOCK OPTION PLAN

The Company has a fixed option plan under which it may grant options that vest over four years to selected employees for up to 150,000 shares of common stock.  The exercise price of each option is intended to equal the fair value of the Company’s stock on the date of grant.  An option’s maximum term is 10 years.

In 2003, the Company first granted 6,750 shares under the plan at an exercise price of $56, none of which were exercisable at December 31, 2003.  The remaining contractual life of these options at December 31, 2003 was 9.5 years.

The fair value of the 2003 option grant of $9.59 per share was estimated on the grant date using an option-pricing model with the following assumptions – risk-free interest rate of 3.27%, dividend yield of 4.96%, volatility factor of expected market price of 23.55% and a weighted-average expected life of the option of 9.5 years.  Expense recognized under the plan in 2003 totaled $8,000.

NOTE 13 - INCOME TAXES

The balance sheets included the following amounts of deferred tax assets and liabilities at December 31:

	2003			2002
Deferred tax assets
Bad debt deduction	$	219		$	267
Pension plan	118			166
Deferred compensation	219			163
Deferred loan fees	—			8
AMT carryforward	92			92
Additional minimum pension liability	137			137
Other	—			34
	785			867
Deferred tax liabilities
Unrealized gain on securities available-for-sale	(881		)	(1,251		)
Depreciation	(168		)	(202		)
Mortgage servicing rights	(184		)	—
Federal Home Loan Bank stock dividends	(73		)	(51		)
Other	(15		)	(13		)
	(1,321		)	(1,517		)
Net deferred tax liability	$	(536	)	$	(650	)

32

The components of the provision for income taxes for the years ended December 31 are as follows:

	2003			2002		2001
Currently payable tax
Federal	$	619		$	332	$	495
State	(8		)	104		(12		)
Deferred tax expense (benefit)	256			242		(23		)
	$	867		$	678	$	460

The difference between the financial statement provision and the amounts computed by applying the federal income tax rate of 34% to income before income taxes is reconciled as follows:

	2003			2002			2001
Federal income tax expense at statutory rate	$	1,131		$	1,008		$	875
Increase (decrease) in taxes resulting from
Tax-exempt interest	(261		)	(320		)	(452		)
Nondeductible interest expense	21			35			59
State income taxes and other items, net	(24		)	(45		)	(22		)
	$	867		$	678		$	460

NOTE 14 - DERIVATIVES

The Company uses derivatives to fix future cash flows for interest payments on some of its floating rate certificates of deposit.  In this regard, the Company has entered into an interest rate swap with the Federal Home Loan Bank of Chicago to fix the interest rate on a specific certificate of deposit product.  At December 31, 2003, the Company had $2,497,000 of certificates of deposit, which mature in 2007 and 2008, in which it pays the Federal Home Loan Bank a weighted average interest rate of 2.93% and will receive an interest rate from the Federal Home Loan Bank based on the appreciation of the S&P 500 Index.  This interest received from the Federal Home Loan Bank will be paid to the customer.  The assets and liabilities in this transaction are being netted and the expense recorded in interest expense on deposits.

In addition to the above, the Company also purchased $5,900,000 of certificates of deposit which are included in the certificates of deposit caption on the consolidated balance sheet.  These investments mature in 2006, 2007, and 2008.  The investments that individually do not exceed $100,000 are insured by the FDIC.  Investments that individually exceed $100,000 are

33

guaranteed by a standby letter of credit issued by the Federal Home Loan Bank of Pittsburgh with no interest.  The initial investment is not at risk but the return on the investment is based on a calculation of the appreciation in the S&P 500 Index. The fair value of this embedded derivative is recorded in certificates of deposit and the fair value adjustment is included in interest income.  At December 31, 2003, the Bank had allocated $1,067,000 to this asset and recorded a valuation allowance of $350,000, which is classified with the certificates of deposit caption on the consolidated balance sheet.

NOTE 15 - COMMITMENTS, OFF-BALANCE-SHEET RISK, AND CONTINGENCIES

There are various contingent liabilities that are not reflected in the consolidated financial statements, including claims and legal actions arising in the ordinary course of business.  In the opinion of management, after consultation with legal counsel, the ultimate disposition of these claims and legal actions is not expected to have a material effect on financial condition or results of operations.

The Bank is required to maintain reserve funds in cash and/or on deposit with the Federal Reserve Bank.  The reserve required at December 31, 2003 was $5,900,000.

Some financial instruments are used in the normal course of business to meet the financing needs of customers.  These financial instruments include commitments to extend credit, standby letters of credit, and financial guarantees.  These involve, to varying degrees, credit and interest-rate risk in excess of the amounts reported in the financial statements.

Exposure to credit loss if the other party does not perform is represented by the contractual amount for commitments to extend credit, standby letters of credit, and financial guarantees written.  The same credit policies are used for commitments and conditional obligations as are used for loans.  Collateral or other security is normally required to support financial instruments with credit risk.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the commitment.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  Since many of the commitments are expected to expire without being used, the total commitments do not necessarily represent future cash requirements.  Standby letters of credit and financial guarantees written are conditional commitments to guarantee a customer’s performance to a third party.

34

A summary of the notional or contractual amounts of financial instruments with off-balance-sheet risk at year end follows:

	2003		2002
Unused lines of credit	$	15,801	$	12,590
Standby letter of credit	136		361

At December 31, 2003, all of the commitments to extend credit were at variable rates of interest.

NOTE 16 - FAIR VALUES OF FINANCIAL INSTRUMENTS

The following methods and assumptions were used to estimate fair values for financial instruments.  The carrying amount is considered to estimate fair value for cash and due from banks, demand, NOW, money market and savings deposits, federal funds purchased, securities sold under repurchase agreements, accrued interest receivable and payable, and variable rate loans or deposits.  Securities fair values are based on quoted market prices or, if no quotes are available, on the rate and term of the security and on information about the issuer.  The fair value of loans held for sale and derivatives are based on quoted market prices.  For fixed rate loans or deposits, the fair value is estimated by discounted cash flow analysis using current market rates for the estimated life and credit risk.  Fair values for impaired loans are estimated using discounted cash flow analysis or underlying collateral values, where applicable.  The fair value of off-balance-sheet items is based on the fees or cost that would currently be charged to enter into or terminate such agreements and is not material.

The carrying values and estimated fair values of the Company’s financial instruments as of December 31, 2003 and 2002 were as follows:

	2003				2002
	Carrying Value		Estimated Fair Value		Carrying Value		Estimated Fair Value
Financial assets
Cash and cash equivalents	$	17,877	$	17,877	$	8,606	$	8,606
Certificates of deposit and related derivative	13,190		13,190		12,835		12,835
Securities available-for-sale	113,433		113,433		98,885		98,885
Loans held for sale	1,644		1,644		1,811		1,811
Loans, net	129,255		129,584		108,476		110,296
Interest receivable	2,129		2,129		2,135		2,135

35

	2003		2002
	Carrying Value	Estimated Fair Value	Carrying Value	Estimated Fair Value
Financial liabilities
Deposits with no stated maturities	150,637	139,955	102,711	102,711
Time deposits and securities sold under agreements to repurchase	114,284	116,211	92,678	94,896
Federal funds purchased	—	—	14,700	14,700
Borrowings	490	490	652	655
Interest payable	832	832	999	999

NOTE 17 - REGULATORY AND CAPITAL MATTERS

The Company may pay dividends without restriction under the current Federal Reserve regulations so long as it remains “adequately capitalized” after such payment.  The Bank is subject to statutory dividend restrictions which provide, in general, that the Bank may pay the current year’s earnings and the prior two years’ retained earnings without the prior approval of the Office of the Comptroller of Currency.  At December 31, 2003, the Bank’s stockholder’s equity totaled $24,766,000, of which $24,394,000 was not available for payment of dividends, without prior regulatory approval.

The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies.  Capital adequacy guidelines and prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices.  Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weightings, and other factors, and the regulators can lower classifications in certain cases.  Failure to meet various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements.

The prompt corrective action regulations provide five classifications, including well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition.  If adequately capitalized, regulatory approval is required to accept brokered deposits.  If

36

undercapitalized, capital distributions are limited, as is asset growth and expansion, and plans for capital restoration are required.

The Company’s only activity is ownership of the Bank, and, therefore, its capital, capital ratios, and minimum required levels of capital are materially the same as the Bank’s.   The actual capital levels and minimum required levels for the Bank were:

	Actual				Minimum Required for Capital Adequacy Purposes				Minimum Required to Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio		Amount		Ratio		Amount		Ratio
December 31, 2003
Total capital (to risk-weighted assets)	$	19,661	11.9	%	$	13,201	8.0	%	$	16,501	10.0	%
Tier I capital (to risk-weighted assets)	18,612		11.3		6,600		4.0		9,901		6.0
Tier I capital (to average assets)	18,612		7.2		10,303		4.0		12,878		5.0
December 31, 2002
Total capital (to risk-weighted assets)	$	23,542	17.5	%	$	10,786	8.0	%	$	13,482	10.0	%
Tier I capital (to risk-weighted assets)	22,375		16.6		5,393		4.0		8,089		6.0
Tier I capital (to average assets)	22,375		9.5		9,473		4.0		11,841		5.0

At December 31, 2003, the Company and the Bank were categorized as well capitalized and management is not aware of any conditions or events since the most recent notification that would change the Company’s or Bank’s category.

NOTE 18 - OTHER COMPREHENSIVE INCOME

Other comprehensive income components and related taxes for the years ended are as follows:

	2003			2002			2001
Unrealized holding gains (losses) on securities available for sale	$	(1,086	)	$	3,517		$	1,136
Minimum pension liability	—			(354		)	—
Reclassification adjustments for gains recognized in income	—			(102		)	(539		)
Net unrealized gains	(1,086		)	3,061			597
Tax effect	368			(1,024		)	(203		)
Other comprehensive income (loss)	$	(718	)	$	2,037		$	394

37

NOTE 19 - - PARENT COMPANY FINANCIAL STATEMENTS

The following are the condensed balance sheets and statements of income and cash flows for First Ottawa Bancshares, Inc.

Condensed balance sheets as of December 31 are as follows:

	2003		2002
ASSETS
Cash and due from banks	$	8	$	1,325
Investment in Bank	24,766		25,450
Dividends receivable	1,305		—
Other assets	376		376
Total assets	$	26,455	$	27,151
LIABILITIES AND SHAREHOLDERS’ EQUITY
Other liabilities	$	5	$	—
Loan payable	490		652
Dividends payable	1,305		1,316
Shareholders’ equity	24,655		25,183
Total liabilities and shareholders’ equity	$	26,455	$	27,151

Condensed statements of income for the years ended December 31 are as follows:

	2003			2002			2001
Dividends from Bank	$	2,502		$	2,034		$	1,987
Expenses	(76		)	(86		)	(11		)
Equity in undistributed Bank income	33			339			137
Net income	$	2,459		$	2,287		$	2,113

38

Condensed statements of cash flows for the years ended December 31 are as follows:

	2003			2002			2001
Cash flows from operating activities
Net income	$	2,459		$	2,287		$	2,113
Adjustments to reconcile net income to net cash from operating activities
Change in other assets and liabilities	(1,302		)	976			4
Equity in undistributed Bank income	(33		)	(339		)	(137		)
Net cash from operating activities	1,124			2,924			1,980
Cash flows from financing activities
Loan proceeds	(161		)	452			200
Purchase of treasury stock	(315		)	(74		)	(196		)
Dividends paid	(1,973		)	(1,983		)	(1,987		)
Vested stock options	8			—			—
Net cash from financing activities	(2,441		)	(1,605		)	(1,983		)
Net change in cash and cash equivalents	(1,317		)	1,319			(3		)
Beginning cash and cash equivalents	1,325			6			9
Ending cash and cash equivalents	$	8		$	1,325		$	6

NOTE 20 - QUARTERLY FINANCIAL DATA (UNAUDITED)

	Interest Income		Net Interest Income		Net Income		Earnings Per Share
2003
First quarter	$	3,175	$	1,988	$	614	$	0.94
Second quarter	3,128		2,017		652		0.99
Third quarter	3,094		2,082		627		0.96
Fourth quarter (a)	3,254		2,180		566		0.87
2002
First quarter	$	3,352	$	1,774	$	522	$	0.79
Second quarter	3,358		1,895		483		0.73
Third quarter (b)	3,323		1,937		661		1.00
Fourth quarter (c)	3,059		1,753		621		0.95

39

^(a)Net income and earnings per share in the fourth quarter of 2003 were affected by one time expenses related to the acquisition of Streator branch facilities.

^(b)Net income and earnings per share in the third quarter of 2002 were affected by the gains on sales of securities and gains on proceeds from bank owned life insurance policy benefits paid.

^(c)Net income and earnings per share in the fourth quarter of 2002 were affected by the gains on sales of securities.

40

FIRST OTTAWA BANCSHARES, INC. AND SUBSIDIARY

SHAREHOLDER INFORMATION

ANNUAL MEETING

The Annual Meeting of Shareholders will be held at 3 p.m., local time on May 19, 2004 at the corporate headquarters located at 701 LaSalle Street, Ottawa, Illinois 61350.

PRICE RANGE OF COMMON STOCK

As of February 27, 2004, there were approximately 543 shareholders of record and 651,627 outstanding shares of common stock.

The Company’s common stock is not traded on any national or regional securities exchange and there is no established public trading market for it.  Transactions in the Company’s common stock have been infrequent.  To the knowledge of the Company’s management, during 2002, 2003 and the first two months of 2004, an aggregate of approximately 212,821 shares of the Company’s common stock was transferred in approximately 131 separate transactions, excluding the 1,400 shares purchased by the Company in 2002 at $52 per share and 5,329 shares purchased by the Company at $56 and $60.50 per share.  These transfers represented both transfers for consideration (i.e., sales) and transfers for no consideration (e.g., gifts, estate transfers, etc.).  The Company’s management is unable to differentiate such transfers and has limited knowledge of the sale prices for transfers involving consideration.  The last price known to the Company’s management was a sale of 150 shares on February 27, 2004 at $62.00 per share.

The following dividends per share were paid on the Company’s common stock on the dates indicated:  January 1, 2002 - $2.00; July 1, 2002- $1.00; January 1, 2003 - $2.00; July 1, 2003 - $1.00; January 1, 2004 - $2.00

WEB SITE FOR UNITED STATES SECURITIES AND EXCHANGE COMMISSION FILINGS

All reports filed electronically by the Company with the United States Securities Exchange Commission (the “SEC”), including the annual report on Form 10-K, quarterly reports on Form 10-Q, and current events reports on Form 8-K, as well as any amendments to those reports are accessible at no cost on our internet site at www.firstottawa.com and on the SEC’s web site at www.sec.gov.  We will also provide you with a copy free of charge by contacting Cheryl Gage, Corporate Secretary, First Ottawa Bancshares, Inc., 701 LaSalle Street, Ottawa, Illinois 61350.

CORPORATE GOVERNANCE

The Company’s corporate governance practices are described in the following documents, which are available on the Company’s Web site at www.firstottawa.com or which may be obtained in print form through the investor relations department: Code of Business Conduct and Ethics, Audit Committee Charter, Nominating and Corporate Governance Committee Charter, and Compensation Committee Charter.

41