Capitol Bancorp (CBCRQ) 10-Q 2004 Q3 Quarterly report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

(X) QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2004
OR

(  ) TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT
For the transition period from                                      to                                      

Commission file number001-31708

CAPITOL BANCORP LTD.

(Exact name of registrant as specified in its charter)

Michigan
(State or other jurisdiction
of incorporation or
organization) 38-2761672
(I.R.S. Employer
Identification
Number)

Capitol Bancorp Center
200 Washington Square North, Lansing, Michigan
(Address of principal executive offices)
48933
(Zip Code)
(517) 487-6555
(Registrant’s telephone number)

Not Applicable
(Former name, former address and former fiscal year, if changed since last report)

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

     Indicate by a check mark whether the registrant is an accelerated filer (as defined in Rule 12b of the Act). Yes (X) No (  )

APPLICABLE ONLY TO CORPORATE ISSUERS:

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

     Common stock, No par value: 14,742,591 shares outstanding as of October 20, 2004.

Page 1 of 27

INDEX

PART I. FINANCIAL INFORMATION

Forward-Looking Statements

Certain of the statements contained in this document, including Capitol’s consolidated financial statements, Management’s Discussion and Analysis of Financial Condition and Results of Operations and in documents incorporated into this document by reference that are not historical facts, including, without limitation, statements of future expectations, projections of results of operations and financial condition, statements of future economic performance and other forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, are subject to known and unknown risks, uncertainties and other factors which may cause the actual future results, performance or achievements of Capitol and/or its subsidiaries and other operating units to differ materially from those contemplated in such forward-looking statements. The words “intend”, “expect”, “project”, “estimate”, “predict”, “anticipate”, “should”, “believe”, and similar expressions also are intended to identify forward-looking statements. Important factors which may cause actual results to differ from those contemplated in such forward-looking statements include, but are not limited to: (i) the results of Capitol’s efforts to implement its business strategy, (ii) changes in interest rates, (iii) legislation or regulatory requirements adversely impacting Capitol’s banking business and/or expansion strategy, (iv) adverse changes in business conditions or inflation, (v) general economic conditions, either nationally or regionally, which are less favorable than expected and that result in, among other things, a deterioration in credit quality and/or loan performance and collectability, (vi) competitive pressures among financial institutions, (vii) changes in securities markets, (viii) actions of competitors of Capitol’s banks and Capitol’s ability to respond to such actions, (ix) the cost of capital, which may depend in part on Capitol’s asset quality, prospects and outlook, (x) changes in governmental regulation, tax rates and similar matters, and (xi) other risks detailed in Capitol’s other filings with the Securities and Exchange Commission. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual outcomes may vary materially from those indicated. All subsequent written or oral forward-looking statements attributable to Capitol or persons acting on its behalf are expressly qualified in their entirety by the foregoing factors. Investors and other interested parties are cautioned not to place undue reliance on such statements, which speak as of the date of such statements. Capitol undertakes no obligation to release publicly any revisions to these forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of unanticipated events.

		Page
Item 1.	Financial Statements (unaudited):
	Consolidated balance sheets – September 30, 2004 and December 31, 2003.		3
	Consolidated statements of income – Three months and nine months ended September 30, 2004 and 2003.		4
	Consolidated statements of changes in stockholders’ equity – Nine months ended September 30, 2004 and 2003.		5
	Consolidated statements of cash flows – Nine months ended September 30, 2004 and 2003.		6
	Notes to consolidated financial statements.		7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations.		13
Item 3.	Quantitative and Qualitative Disclosures About Market Risk.		23
Item 4.	Controls and Procedures.		23
PART II.	OTHER INFORMATION
Item 1.	Legal Proceedings.		24
Item 2.	Unregistered Sales of Securities and Use of Proceeds.		24
Item 3.	Defaults Upon Senior Securities.		24
Item 4.	Submission of Matters to a Vote of Security Holders.		24
Item 5.	Other Information.		24
Item 6.	Exhibits and Reports on Form 8-K.		24
SIGNATURES			26
EXHIBIT INDEX			27
Capitol Bancorp Ltd. 2003 Stock Plan
Form of Stock Option Agreement
Certification of Chief Executive Officer Pursuant to Section 302
Certification of Chief Financial Officer Pursuant to Section 302
Certification of Chief Executive Officer Pursuant to Section 906
Certification of Chief Financial Officer Pursuant to Section 906

Page 2 of 27

PART I, ITEM I

CAPITOL BANCORP LTD.

Consolidated Balance Sheets
As of September 30, 2004 and December 31, 2003

	(Unaudited)
	September 30			December 31
	2004			2003
	(in thousands)
ASSETS
Cash and due from banks	$	157,162		$	145,896
Money market and interest-bearing deposits		10,405			13,570
Federal funds sold		120,785			124,157
Cash and cash equivalents		288,352			283,623
Loans held for resale		35,199			43,001
Investment securities:
Available for sale, carried at market value		32,185			83,386
Held for long-term investment, carried at amortized cost which approximates market value		13,537			9,821
Total investment securities		45,722			93,207
Portfolio loans:
Commercial		2,376,624			2,033,097
Real estate mortgage		159,983			143,343
Installment		72,094			71,000
Total portfolio loans		2,608,701			2,247,440
Less allowance for loan losses		(37,027	)		(31,404	)
Net portfolio loans		2,571,674			2,216,036
Premises and equipment		31,838			24,793
Accrued interest income		10,245			9,533
Goodwill and other intangibles		42,082			34,449
Other assets		33,313			32,420
TOTAL ASSETS	$	3,058,425		$	2,737,062
LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits:
Noninterest-bearing	$	494,626		$	435,599
Interest-bearing		2,022,478			1,853,065
Total deposits		2,517,104			2,288,664
Debt obligations:
Notes payable		137,956			92,774
Subordinated debentures		100,822			90,816
Total debt obligations		238,778			183,590
Accrued interest on deposits and other liabilities		16,775			14,965
Total liabilities		2,772,657			2,487,219
MINORITY INTERESTS IN CONSOLIDATED SUBSIDIARIES		39,758			30,946
STOCKHOLDERS’ EQUITY:
Common stock, no par value, 25,000,000 shares authorized; issued and outstanding: 2004 - 14,738,891 shares		195,325			180,957
2003 - 14,027,982 shares
Retained earnings		55,038			43,135
Market value adjustment (net of tax effect) for investment securities available for sale (accumulated other comprehensive income)		51			(200	)
		250,414			223,892
Less unearned compensation regarding restricted stock and other		(4,404	)		(4,995	)
Total stockholders’ equity		246,010			218,897
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	3,058,425		$	2,737,062

Page 3 of 27

CAPITOL BANCORP LIMITED

Consolidated Statements of Income (Unaudited)
For the Three Months and Nine Months Ended September 30, 2004 and 2003
(in thousands, except per share data)

	Periods Ended September 30
	Three Month Period						Nine Month Period
	2004			2003			2004			2003
Interest income:
Portfolio loans (including fees)	$	44,492		$	39,354		$	126,560		$	116,788
Loans held for resale		504			1,156			1,529			2,818
Taxable investment securities		275			549			1,071			1,593
Federal funds sold		407			306			1,053			997
Other		199			119			547			361
Total interest income		45,877			41,484			130,760			122,557
Interest expense:
Deposits		9,176			9,972			26,891			31,981
Debt obligations and other		2,767			2,093			7,757			6,204
Total interest expense		11,943			12,065			34,648			38,185
Net interest income		33,934			29,419			96,112			84,372
Provision for loan losses		3,553			2,892			9,597			6,608
Net interest income after provision for loan losses		30,381			26,527			86,515			77,764
Noninterest income:
Service charges on deposit accounts		1,091			1,112			3,336			3,228
Trust fee income		796			717			2,535			1,880
Fees from origination of non-portfolio residential mortgage loans		1,314			2,629			4,211			7,456
Realized losses on sale of investment securities available for sale		(191	)		(2	)		(424	)		(2	)
Other		1,531			985			4,777			2,625
Total noninterest income		4,541			5,441			14,435			15,187
Noninterest expense:
Salaries and employee benefits		14,493			13,927			46,082			41,498
Occupancy		2,173			1,983			6,428			5,644
Equipment rent, depreciation and maintenance		1,325			1,172			4,266			3,527
Other		6,191			5,302			16,096			14,824
Total noninterest expense		24,182			22,384			72,872			65,493
Income before federal income taxes and minority interest		10,740			9,584			28,078			27,458
Federal income taxes		3,861			3,405			10,122			9,560
Income before minority interest		6,879			6,179			17,956			17,898
Minority interest in net losses (income) of consolidated subsidiaries		560			(130	)		810			(842	)
NET INCOME	$	7,439		$	6,049		$	18,766		$	17,056
NET INCOME PER SHARE
Basic	$	0.52		$	0.46		$	1.33		$	1.38
Diluted	$	0.50		$	0.44		$	1.27		$	1.33

Page 4 of 27

CAPITOL BANCORP LIMITED

Consolidated Statements of Changes in Stockholders’ Equity (Unaudited)
For the Nine Months Ended September 30, 2004 and 2003
(in thousands except share data)

										Unearned
							Accumulated			Compensation
							Other			Regarding
	Common			Retained			Comprehensive			Restricted Stock
	Stock			Earnings			Income			and Other			Total
Nine Months Ended September 30, 2003
Balances at January 1, 2003	$	135,234		$	26,318		$	191		$	(1,706	)	$	160,037
Issuance of common stock to acquire minority interests in bank subsidiaries		20,002												20,002
Issuance of 183,465 shares of common stock upon exercise of stock options, net of common stock surrendered to facilitate exercise		2,646												2,646
Issuance of 22,512 shares of common stock upon exercise of warrants		259												259
Private placement of 549,000 shares of common stock to institutional investors		10,226												10,226
Surrender and cancellation of 74,179 shares of common stock in repayment of note receivable from exercise of stock options		(1,561	)								1,561			0
Issuance of 255,632 shares of restricted common stock		5,202									(5,202	)		0
Cash dividends paid ($0.36 per share)					(4,510	)								(4,510	)
Components of comprehensive income:
Net income for the period					17,056									17,056
Market value adjustment for investment securities available for sale (net of income tax effect)								(258	)					(258	)
Comprehensive income for the period														16,798
BALANCES AT SEPTEMBER 30, 2003	$	172,008		$	38,864		$	(67	)	$	(5,347	)	$	205,458
Nine Months Ended September 30, 2004
Balances at January 1, 2004	$	180,957		$	43,135		$	(200	)	$	(4,995	)	$	218,897
Issuance of 183,349 shares of common stock in conjunction with acquisition of First Carolina State Bank		4,970												4,970
Issuance of 346,947 shares of common stock to acquire minority interest in subsidiaries		8,665												8,665
Issuance of 167,550 shares of common stock upon exercise of stock options, net of common stock surrendered to facilitate exercise		356												356
Issuance of 13,063 shares of restricted common stock		377									(377	)		0
Recognition of compensation expense relating to restricted common stock											968			968
Cash dividends paid ($0.48 per share)					(6,863	)								(6,863	)
Components of comprehensive income:
Net income for the period					18,766									18,766
Market value adjustment for investment securities available for sale (net of income tax effect)								251						251
Comprehensive income for the period														19,017
BALANCES AT SEPTEMBER 30, 2004	$	195,325		$	55,038		$	51		$	(4,404	)	$	246,010

Page 5 of 27

CAPITOL BANCORP LTD.

Consolidated Statements of Cash Flows (Unaudited)
For the Nine Months Ended September 30, 2004 and 2003

	2004			2003
	(in thousands)
OPERATING ACTIVITIES
Net income	$	18,766		$	17,056
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		9,597			6,608
Depreciation of premises and equipment		3,520			2,959
Amortization of intangibles		410			399
Net amortization of investment security premiums		19			53
Loss (gain) on sale of premises and equipment		1			(68	)
Minority interest in net income (losses) of consolidated subsidiaries		(810	)		842
Compensation expense relating to restricted common stock		968			345
Originations and purchases of loans held for resale		(558,147	)		(1,060,120	)
Proceeds from sales of loans held for resale		565,950			1,078,759
Increase in accrued interest income and other assets		(6,526	)		(1,993	)
Increase in accrued interest expense on deposits and other liabilities		835			2,942
NET CASH PROVIDED BY OPERATING ACTIVITIES		34,583			47,782
INVESTING ACTIVITIES
Cash and cash equivalents of acquired subsidiary		4,202			—
Proceeds from sale of investment securities available for sale		68,302			22,160
Proceeds from calls, prepayments and maturities of investment securities		5,098			14,963
Purchases of investment securities		(18,451	)		(36,309	)
Net increase in portfolio loans		(316,590	)		(150,536	)
Proceeds from sales of premises and equipment		22			1,496
Purchases of premises and equipment		(8,846	)		(7,254	)
NET CASH USED BY INVESTING ACTIVITIES		(266,263	)		(155,480	)
FINANCING ACTIVITIES
Net increase in demand deposits, NOW accounts and savings accounts		172,176			167,525
Net increase in certificates of deposit		2,722			33,241
Net borrowings from (payments on) debt obligations		43,322			(10,200	)
Net proceeds from issuance of subordinated debentures		9,935			9,700
Resources provided by minority interests		14,761			3,537
Net proceeds from issuance of common stock		356			12,786
Cash dividends paid		(6,863	)		(4,510	)
NET CASH PROVIDED BY FINANCING ACTIVITIES		236,409			212,079
INCREASE IN CASH AND CASH EQUIVALENTS		4,729			104,381
Cash and cash equivalents at beginning of period		283,623			251,184
CASH AND CASH EQUIVALENTS AT END OF PERIOD	$	288,352		$	355,565

Page 6 of 27

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
CAPITOL BANCORP LTD.

Note A – Basis of Presentation

     The accompanying unaudited condensed consolidated financial statements of Capitol Bancorp Ltd. (“Capitol”) have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions for Form 10-Q. Accordingly, they do not include all information and footnotes necessary for a fair presentation of consolidated financial position, results of operations and cash flows in conformity with generally accepted accounting principles.

     The statements do, however, include all adjustments of a normal recurring nature (in accordance with Rule 10-01(b)(8) of Regulation S-X) which Capitol considers necessary for a fair presentation of the interim periods.

     The results of operations for the period ended September 30, 2004 are not necessarily indicative of the results to be expected for the year ending December 31, 2004.

     The consolidated balance sheet as of December 31, 2003 was derived from audited consolidated financial statements as of that date. Certain 2003 amounts have been reclassified to conform to the 2004 presentation.

Note B – Implementation of New Accounting Standard

     FASB Interpretation No. 46,Consolidation of Variable Interest Entities, (as revised December 2003—FIN 46(R)), clarifies when some entities previously not consolidated under prior accounting guidance, should be. In some instances, it also requires certain previously consolidated entities to be deconsolidated. FIN 46(R) is effective for periods ending after December 15, 2003 for special purpose entities and for periods ending after March 15, 2004 for other types of variable interest entities that are not defined as special purpose entities. Implementation of this new guidance required Capitol to deconsolidate (or exclude) its trusts which issued trust-preferred securities effective March 31, 2004 and report the underlying subordinated debentures as debt obligations on Capitol’s consolidated balance sheet at that date and thereafter.

Page 7 of 27

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
CAPITOL BANCORP LTD. - Continued

     Note C – Stock Options

     Statement of Financial Accounting Standards No. 123,Accounting for Stock-Based Compensation, establishes an alternative fair value method of accounting for stock options whereby compensation expense would be recognized based on the computed fair value of the options on the grant date. By not electing this alternative, certain pro forma disclosures of the expense recognition provisions of Statement No. 123 are required, which are as follows:

	Periods Ended September 30
	Three Month Period						Nine Month Period
	2004			2003			2004			2003
Fair value assumptions:
Risk-free interest rate		3.9	%		3.8	%		3.8	%		3.4	%
Dividend yield		2.5	%		1.8	%		2.3	%		2.0	%
Stock price volatility		.22			.44			.26			.47
Expected option life	7 years			7 years			6.5 years			7 years
Aggregate estimated fair value of options granted (in thousands)	$	1,074		$	2,584		$	4,275		$	4,821
Net income (in thousands):
As reported	$	7,439		$	6,049		$	18,766		$	17,056
Less pro forma compensation expense regarding fair value of stock option awards, net of related income tax effect		(698	)		(1,680	)		(2,779	)		(3,134	)
Pro forma	$	6,741		$	4,369		$	15,987		$	13,922
Net income per share:
Basic:
As reported	$	0.52		$	0.46		$	1.33		$	1.38
Pro forma		0.47			0.33			1.14			1.13
Diluted:
As reported		0.50			0.44			1.27			1.33
Pro forma	$	0.45		$	0.32		$	1.08		$	1.08

     Stock option activity for the interim 2004 period is summarized as follows:

						Weighted
	Number of			Exercise		Average
	Stock Options			Price		Exercise
	Outstanding			Range		Price
Outstanding at January 1		2,298,067		$	9.88 to $27.23	$	16.95
Exercised		(390,290	)		9.88 to   25.92		16.33
Granted		562,715			22.43 to   28.75		26.03
Cancelled or expired		(30,950	)
Outstanding at September 30		2,439,542		$	9.88 to $28.75	$	19.67

Page 8 of 27

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
CAPITOL BANCORP LTD. - Continued

Note C – Stock Options – Continued

     As of September 30, 2004, stock options outstanding had a weighted average remaining contractual life of 4.7 years. The following table summarizes stock options outstanding segregated by exercise price range:

			Weighted Average
					Remaining
Exercise Price	Number		Exercise		Contractual
Range	Outstanding		Price		Life
Less than $10.00		11,500	$	9.73	1.0 years
$  10.00 to 14.99		380,693		11.66	6.1 years
$  15.00 to 19.99		842,380		16.57	3.7 years
$  20.00 to 24.99		557,361		21.92	4.5 years
$25.00 or more		647,608	$	26.65	5.5 years
Total outstanding		2,439,542

Note D – Net Income Per Share

     The computations of basic and diluted earnings per share were as follows:

	Periods Ended September 30
	Three Month Period				Nine Month Period
	2004		2003		2004		2003
Numerator—net income for the period	$	7,439,000	$	6,049,000	$	18,766,000	$	17,056,000
Denominator:
Weighted average number of common shares outstanding, excluding unvested shares of restricted common stock (denominator for basic earnings per share)		14,311,842		13,050,227		14,069,446		12,328,380
Weighted average number of unvested shares of restricted common stock outstanding		259,300		241,661		263,869		123,018
Effect of other dilutive securities (stock options)		422,391		515,132		426,651		414,884
Denominator for diluted net income per share—
Weighted average number of common shares and potential dilution		14,993,533		13,807,020		14,759,966		12,866,282
Number of antidilutive stock options excluded from diluted earnings per share computation		—		—		—		205,370

Page 9 of 27

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
CAPITOL BANCORP LTD. - Continued

Note E – Acquisition of Bank

     Effective April 1, 2004, Capitol acquired First Carolina State Bank (First Carolina) located in Rocky Mount, North Carolina, in a purchase transaction with total consideration approximating $10 million. Approximately half of the consideration was paid in cash and the remainder consisted of approximately 183,000 previously unissued shares of Capitol’s common stock. At March 31, 2004, First Carolina’s total assets approximated $61.7 million. Capitol’s acquisition of First Carolina was accounted for under the purchase-method of accounting and its results of operations are included in Capitol’s consolidated financial statements for periods after the effective date of the acquisition. Goodwill of approximately $4 million was recorded in conjunction with this transaction and will not be amortized, but will be reviewed at least annually for impairment. Had this transaction occurred at the beginning of the periods presented, net income would have approximated $18.4 million ($1.23 per diluted share) and $17.3 million ($1.32 per diluted share) for the nine months ended September 30, 2004 and 2003, respectively.

Note F – Share Exchange Transactions

     A share exchange transaction regarding First California Northern Bancorp was completed effective August 31, 2004. A similar share exchange transaction regarding Sunrise Bank of San Diego was completed effective May 31, 2004. In each transaction, the shares acquired from shareholders other than Capitol were exchanged for Capitol’s common stock according to a fixed, but differing, exchange ratio. In total, Capitol issued approximately 347,000 shares of previously unissued common stock resulting from these share exchanges (for aggregate consideration approximating $8.7 million). These transactions have been recorded using the purchase-method of accounting. Had these transactions occurred at the beginning of the periods presented, net income would have approximated $19.0 million ($1.25 per diluted share) and $17.2 million ($1.30 per diluted share) for the nine months ended September 30, 2004 and 2003, respectively.

     Sunrise Bank of San Diego and First California Northern Bancorp were previously included in Capitol’s consolidated financial statements. The carrying value of assets and liabilities of the entities closely approximated the fair value at the date of the share exchanges. Additionally, goodwill of approximately $4 million was recorded in conjunction with the share exchanges and will not be amortized, but will be reviewed at least annually for impairment.

Note G – New Bank and Bank Development Activities

     Point Loma Community Bank, located in Point Loma (San Diego County), California opened in August 2004. It is majority-owned by First California Southern Bancorp, which is a majority-owned subsidiary of Capitol.

Page 10 of 27

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
CAPITOL BANCORP LTD. - Continued

Note G – New Bank and Bank Development Activities – Continued

     Bank development efforts are currently under consideration at September 30, 2004 in several states including pre-development exploratory discussions, lease and employment negotiations and preparation of preliminary regulatory applications for formation and/or acquisition of community banks. During March 2004, Capitol completed the capitalization of Capitol Development Bancorp Limited II (CDBL II); CDBL II is substantially similar in structure and purpose to CDBL I which was formed in late 2003.

Note H – Impact of New Accounting Standards

     AICPA Statement of Position 03-3,Accounting for Certain Loans or Debt Securities Acquired in a Transfer(SOP 03-3), addresses the accounting for differences between contractual cash flows and cash flows expected to be collected from the initial investment in loans acquired in a transfer if those differences are attributable, at least in part, to credit quality. It includes such loans acquired in purchase business combinations and does not apply to loans originated by the entity. The SOP prohibits carrying over or creation of valuation allowances in the initial accounting for loans acquired in a transfer. It is effective for loans acquired in fiscal years beginning after December 15, 2004. The effects of this new guidance on Capitol’s consolidated financial statements will depend on future loan or debt securities acquisition activity, thus, its impact is not readily determinable.

     On March 31, 2004, the Financial Accounting Standards Board (FASB) issued a proposed statement,Share-Based Payment, that addresses the accounting for share-based payment transactions (for example, stock options and awards of restricted stock) in which an employer receives employee-services in exchange for equity securities of the company or liabilities that are based on the fair value of the company’s equity securities. This proposal, when finalized, would eliminate use of APB Opinion No. 25,Accounting for Stock Issued to Employees, and generally would require such transactions be accounted for using a fair-value-based method and recording compensation expense rather than optional pro forma disclosure of what expense amounts might be. The proposal, when approved, would substantially amend FASB Statement No. 123,Accounting for Stock-Based Compensation. Legislation has been introduced to substantially limit the FASB proposal. Uncertainty continues as to whether the proposal will be finalized and the FASB has recently announced some major proposed revisions to it, including material changes to the fair-value methodology, among other things. Currently, the most recent announcements suggest that this guidance may become effective for periods beginning after June 15, 2005 for public companies. Management has not completed its review of the proposal or assessed its potential impact on Capitol.

Page 11 of 27

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
CAPITOL BANCORP LTD. - Continued

Note H – Impact of New Accounting Standards – Continued

     In 2003, the Emerging Issues Task Force of the FASB (EITF) addressed an issue regarding how companies should account for longer-term declines in value (below cost) of investment securities which are classified as available-for-sale. In the EITF’s consensus, expanded disclosures of declines in market value (below cost) of one year or more are required. Further, this new guidance sought to define “other than temporary declines” in market value, as applied to available-for-sale investment securities, including when such declines should be recognized as if they are realized losses. In October 2004, the effective dates for the definitional guidance (and related loss recognition guidance) were postponed. Based on Capitol’s current investment portfolio, management does not expect this guidance will have a significant effect on Capitol’s financial statements upon implementation.

     A variety of proposed or otherwise potential accounting standards are currently under study by standard-setting organizations and various regulatory agencies. Because of the tentative and preliminary nature of these proposed standards, management has not determined whether implementation of such proposed standards would be material to Capitol’s consolidated financial statements.

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Page 12 of 27

PART I, ITEM 2

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

Financial Condition

     Total assets approximated $3.1 billion at September 30, 2004, an increase of $321 million from the December 31, 2003 level of $2.7 billion. The balance sheet includes Capitol and its consolidated subsidiaries:

	Total Assets
	(in $1,000’s)
	Sept 30			Dec 31
	2004			2003
Great Lakes Region:
Ann Arbor Commerce Bank	$	330,201		$	329,191
Brighton Commerce Bank		101,064			92,184
Capitol National Bank		222,477			221,426
Detroit Commerce Bank		65,862			44,954
Elkhart Community Bank		64,119			53,586
Goshen Community Bank		52,894			46,751
Grand Haven Bank		117,493			122,076
Kent Commerce Bank		87,058			81,437
Macomb Community Bank		95,952			86,001
Muskegon Commerce Bank		93,490			85,908
Oakland Commerce Bank		132,046			120,059
Paragon Bank & Trust		110,588			104,602
Portage Commerce Bank		177,410			161,028
Great Lakes Region Total		1,650,654			1,549,203
First Carolina State Bank(1)		68,516			—
Southwest Region:
Arrowhead Community Bank		71,750			56,192
Bank of Las Vegas		52,439			35,374
Bank of Tucson		157,963			157,717
Black Mountain Community Bank		99,206			83,760
Camelback Community Bank		81,369			81,649
Desert Community Bank		64,870			61,537
East Valley Community Bank		48,980			43,925
Mesa Bank		97,827			70,308
Red Rock Community Bank		106,771			104,944
Southern Arizona Community Bank		84,891			84,374
Sunrise Bank of Albuquerque		71,541			66,359
Sunrise Bank of Arizona		138,302			126,114
Valley First Community Bank		51,501			47,069
Yuma Community Bank		59,187			46,143
Southwest Region Total		1,186,597			1,065,465
California Region:
Bank of Escondido		48,222			26,843
Napa Community Bank		68,833			53,509
Point Loma Community Bank(2)		14,321			—
Sunrise Bank of San Diego		67,529			67,235
California Region Total		198,905			147,587
Other, net		(46,247	)		(25,193	)
Consolidated	$	3,058,425		$	2,737,062

(1)	Acquired effective April 1, 2004.
(2)	Commenced operations in August 2004 and is 51%-owned by First California Southern Bancorp, a majority-owned subsidiary of Capitol.

Page 13 of 27

     Portfolio loans increased during the nine-month 2004 period by approximately $361 million, compared to net loan growth of about $145 million during the corresponding period of 2003. Year-to-date loan growth includes the acquisition of First Carolina State Bank, effective April 1, 2004, which had portfolio loans totaling approximately $50 million at the acquisition date. Loan growth in the first quarter of 2004 approximated $100 million ($60 million in 2003). Second and third quarter 2004 loan growth approximated $114 million and $97 million, respectively, (excluding the second quarter impact of the First Carolina acquisition) compared to $32 million and $53 million in 2003. 2004 loan growth has been significant due to higher loan demand. The majority of portfolio loan growth occurred in commercial loans, consistent with the banks’ emphasis on commercial lending activities.

     The allowance for loan losses at September 30, 2004 approximated $37 million or 1.42% of total portfolio loans, which was slightly higher than the year-end 2003 ratio of 1.40%.

     The allowance for loan losses is maintained at a level believed adequate by management to absorb potential losses inherent in the loan portfolio at the balance sheet date. Management’s determination of the adequacy of the allowance is based on evaluation of the portfolio (including potential impairment of individual loans and concentrations of credit), past loss experience, current economic conditions, volume, amount and composition of the loan portfolio, loan commitments outstanding and other factors. The allowance is increased by provisions charged to operations and reduced by net charge-offs. The table below summarizes portfolio loan balances and activity in the allowance for loan losses for the interim periods (in thousands):

	Periods Ended September 30
	Three Month Period						Nine Month Period
	2004			2003			2004			2003
Allowance for loan losses at beginning of period	$	35,137		$	29,489		$	31,404		$	28,953
Allowance for loan losses of acquired bank subsidiary								724
Loans charged-off:
Commercial		(1,673	)		(1,809	)		(5,142	)		(5,205	)
Real estate mortgage		(17	)		(26	)		(116	)		(47	)
Installment		(108	)		(251	)		(248	)		(492	)
Total charge-offs		(1,798	)		(2,086	)		(5,506	)		(5,744	)
Recoveries:
Commercial		129			198			761			609
Real estate mortgage		—			—			10			—
Installment		6			20			37			87
Total recoveries		135			218			808			696
Net charge-offs		(1,663	)		(1,868	)		(4,698	)		(5,048	)
Additions to allowance charged to expense		3,553			2,892			9,597			6,608
Allowance for loan losses at September 30	$	37,027		$	30,513		$	37,027		$	30,513
Average total portfolio loans for the period	$	2,566,005		$	2,110,423		$	2,437,698		$	2,073,478
Ratio of net charge-offs (annualized) to average portfolio loans outstanding		0.26	%		0.35	%		0.26	%		0.32	%

Page 14 of 27

     Net charge-offs of loans in the nine-month interim 2004 period decreased by approximately $350,000, compared to the corresponding 2003 period. The decrease was mainly due to less installment loan charge-offs and higher recoveries associated with commercial loans.

     The amounts of the allowance for loan losses allocated in the following table (in thousands) are based on management’s estimate of losses inherent in the portfolio at the balance-sheet date, include all loans for which, based on Capitol’s loan rating system, management has concerns, and should not be interpreted as an indication of future charge-offs.

	September 30, 2004					December 31, 2003
			Percentage					Percentage
			of Total					of Total
			Portfolio					Portfolio
	Amount		Loans			Amount		Loans
Commercial	$	34,400		1.32	%	$	29,001		1.29	%
Real estate mortgage		1,596		0.06			1,408		0.06
Installment		1,031		0.04			995		0.05
Total allowance for loan losses	$	37,027		1.42	%	$	31,404		1.40	%
Total portfolio loans outstanding	$	2,608,701				$	2,247,440

     Nonperforming loans (i.e., loans which are 90 days or more past due and loans on nonaccrual status) and other nonperforming assets are summarized below (in thousands):

	Sept 30		Dec 31
	2004		2003
Nonaccrual loans:
Commercial	$	20,258	$	19,852
Real estate		1,291		632
Installment		592		376
Total nonaccrual loans		22,141		20,860
Past due (³90 days) loans:
Commercial		5,291		4,544
Real estate		1,058		1,083
Installment		308		385
Total past due loans		6,657		6,012
Total nonperforming loans	$	28,798	$	26,872
Real estate owned and other repossessed assets		3,618		4,288
Total nonperforming assets	$	32,416	$	31,160

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     Nonperforming loans at September 30, 2004 were 1.10% of total portfolio loans, a significant improvement from the corresponding period in 2003 of 1.48%. Nonperforming loans increased 7.2% or $1.9 million during the nine-month period ended September 30, 2004. Of the nonperforming loans at September 30, 2004, about 67% were real estate secured. Those loans, when originated, had appropriate loan-to-value ratios and, accordingly, have loss exposure which is expected to be minimal; however, underlying real estate values depend upon current economic conditions and liquidation strategies. Most other nonperforming loans were generally secured by other business assets. Nonperforming loans at September 30, 2004 were in various stages of resolution for which management believes such loans are adequately collateralized or otherwise appropriately considered in its determination of the adequacy of the allowance for loan losses.

     In addition to the identification of nonperforming loans involving borrowers with payment performance difficulties (i.e., nonaccrual loans and loans past-due 90 days or more), management utilizes an internal loan review process to identify other potential problem loans which may warrant additional monitoring or other attention. This loan review process is a continuous activity which periodically updates internal loan ratings. At inception, all loans are individually assigned a rating which grades the credits on a risk basis, based on the type and discounted value of collateral, financial strength of the borrower and guarantors and other factors such as nature of the borrower’s business climate, local economic conditions and other subjective factors. The loan rating process is fluid and subjective.

     Potential problem loans include loans which are generally performing as agreed; however, because of internal loan review’s and/or lending staff’s risk assessment, increased monitoring is deemed appropriate. In addition, some loans are assigned a more adverse classification, with specific performance issues or other risk factors requiring close management and development of specific remedial action plans.

     At September 30, 2004, potential problem loans (including the previously mentioned nonperforming loans) approximated $119 million, or about 5% of total consolidated portfolio loans. These potential problem loans do not necessarily have significant loss exposure (nor are they necessarily deemed ‘impaired’), but rather are identified by management in this manner to aid in loan administration and risk management. Management believes such loans to be adequately considered in its evaluation of the adequacy of the allowance for loan losses. Management believes, however, that current general economic conditions may result in higher levels of future loan losses, in comparison to previous years, as evidenced by higher provisions for loan losses in the interim 2004 period.

Page 16 of 27

     The following comparative analysis summarizes each bank’s total portfolio loans, allowance for loan losses, nonperforming loans and ratio of the allowance as a percentage of portfolio loans (dollars in thousands):

	Total				Allowance for				Nonperforming				Allowance as a Percentage
	Portfolio Loans				Loan Losses				Loans				of Total Portfolio Loans
	Sept 30		Dec 31		Sept 30		Dec 31		Sept 30		Dec 31		Sept 30			Dec 31
	2004		2003		2004		2003		2004		2003		2004			2003
Great Lakes Region:
Ann Arbor Commerce Bank	$	298,109	$	287,766	$	3,990	$	3,912	$	3,874	$	2,926		1.34	%		1.36	%
Brighton Commerce Bank		89,566		79,554		896		795		1,000		1,000		1.00			1.00
Capitol National Bank		193,946		177,599		2,526		2,211		1,884		1,440		1.30			1.24
Detroit Commerce Bank		60,835		38,363		776		595		156		633		1.28			1.55
Elkhart Community Bank		59,129		48,388		624		616		—		89		1.06			1.27
Goshen Community Bank		47,223		39,810		533		578		—		101		1.13			1.45
Grand Haven Bank		108,794		101,645		2,606		1,887		7,432		3,178		2.40			1.86
Kent Commerce Bank		82,182		76,093		1,092		829		375		651		1.33			1.09
Macomb Community Bank		92,268		81,776		1,309		1,102		1,668		1,973		1.42			1.35
Muskegon Commerce Bank		87,015		79,223		1,017		1,026		1,710		2,677		1.17			1.30
Oakland Commerce Bank		94,747		93,920		2,020		1,459		2,636		3,022		2.13			1.55
Paragon Bank & Trust		94,881		89,499		1,391		1,365		1,593		1,446		1.47			1.53
Portage Commerce Bank		164,715		150,783		1,911		1,915		2,321		2,746		1.16			1.27
Great Lakes Region Total		1,473,410		1,344,419		20,691		18,290		24,649		21,882
First Carolina State Bank(1)		50,638		—		525		—		23		—		1.04			—
Southwest Region:
Arrowhead Community Bank		59,937		46,135		600		527		—		—		1.00			1.14
Bank of Las Vegas		38,254		27,398		399		337		—		—		1.04			1.23
Bank of Tucson		107,300		102,244		1,125		1,149		811		—		1.05			1.12
Black Mountain Community Bank		79,058		63,184		923		725		218		571		1.17			1.15
Camelback Community Bank		75,107		66,260		1,050		882		—		140		1.40			1.33
Desert Community Bank		56,086		42,543		700		626		—		675		1.25			1.47
East Valley Community Bank		39,818		31,916		486		440		12		10		1.22			1.38
Mesa Bank		76,184		61,714		726		664		—		375		0.95			1.08
Red Rock Community Bank		73,652		71,138		1,796		1,812		965		2,613		2.44			2.55
Southern Arizona Community Bank		74,187		69,965		736		767		222		—		0.99			1.10
Sunrise Bank of Albuquerque		60,624		54,078		845		593		682		14		1.39			1.10
Sunrise Bank of Arizona		121,924		111,148		1,581		1,337		211		59		1.30			1.20
Valley First Community Bank		48,496		34,769		466		491		—		—		0.96			1.41
Yuma Community Bank		41,117		31,409		465		437		100		—		1.13			1.39
Southwest Region Total		951,744		813,901		11,898		10,787		3,221		4,457
California Region:
Bank of Escondido		30,189		9,273		315		120		—		—		1.04			1.29
Napa Community Bank		50,116		35,033		685		492		606		—		1.37			1.40
Point Loma Community Bank(2)		1,530		—		20		—		—		—		1.31			—
Sunrise Bank of San Diego		49,634		43,410		515		577		299		533		1.04			1.33
California Region Total		131,469		87,716		1,535		1,189		905		533		—			—
Other, net		1,440		1,404		2,378		1,138		—		—		—			—
Consolidated	$	2,608,701	$	2,247,440	$	37,027	$	31,404	$	28,798	$	26,872		1.42	%		1.40	%

(1) Acquired effective April 1, 2004.

(2) Commenced operations in August 2004 and is 51%-owned by First California Southern Bancorp, a majority-owned subsidiary of Capitol.

Page 17 of 27

Results of Operations

     Third quarter 2004 earnings were a new record level, $7.4 million, an increase of $1.4 million over the same period in 2003; diluted earnings per share were $0.50 for the 2004 period compared to $0.44 in 2003. Net income for the nine months ended September 30, 2004 was $18.8 million, an increase of $1.7 million or 10% over the same period in 2003. Diluted earnings per share for the nine-month 2004 period were $1.27 compared to $1.33 for the prior year period. The marginal increase in the amount of nine-month earnings was due to lower income in the first quarter of 2004.

     Net interest income for the first nine months of 2004 totaled $96.1 million, a 14% increase compared to $84.4 million in 2003. Net interest income for the third quarter of 2004 totaled $33.9 million, a 15% increase, compared to $29.4 million for the comparable period in 2003. This increase is attributable to the banks’ growth in size and a continued strong net interest margin resulting from a relatively stable interest rate environment.

     Noninterest income for the nine months ended September 30, 2004 was $14.4 million, a decrease of $752,000, or 5%, over the same period in 2003. Noninterest income for the quarter ended September 30, 2004 was $4.5 million, a decrease of $900,000, or 17%, over the same period in 2003. Fees from origination of nonportfolio residential mortgage loans totaled $1.3 million for the third quarter of 2004, and were $4.2 million for the nine-month period, as compared to $2.6 million and $7.5 million for the comparable periods in 2003, respectively, due to lower volume of loan fees derived from residential mortgage loan refinance activity resulting from higher interest rates. Service charges on deposit accounts increased in the nine-month 2004 period by 3%, compared to 2003, due to growth in the size of banks. Trust fee income increased nearly 35% in the 2004 nine-month period, compared to 2003, due to larger account activity. Other noninterest income increased in the interim 2004 periods primarily due to gains on sale of SBA-guaranteed loans.

     The provision for loan losses for the nine-month period in 2004 was $9.6 million, as compared to $6.6 million for the same period in 2003. The provision for loan losses for the three months ended September 30, 2004 was $3.6 million as compared to $2.9 million during the corresponding 2003 period. Provisions for loan losses were higher than in the prior year due to loan growth and, in the first quarter of 2004, a special $1 million loss provision relating to one customer relationship. The provisions for loan losses are based upon management’s analysis of the adequacy of the allowance for loan losses, as previously discussed.

     Noninterest expense totaled $72.9 million for the nine-month period and $24.2 million for the third quarter in 2004, as compared to $65.5 million and $22.4 million, respectively, for the comparable periods in 2003. The increase in noninterest expense is associated with growth in the size of the banks and increases in general operating costs. Increases in both occupancy and salaries and employee benefits relate primarily to the growth in the size of banks within the consolidated group and the addition of a bank in late 2003 and the third quarter of 2004, along with, effective April 1, 2004, the addition of First Carolina State Bank.

Page 18 of 27

     Operating results (dollars in thousands) were as follows:

	Nine months ended September 30
											Return on						Return on
	Total Revenues				Net Income						Average Equity(1)						Average Assets(1)
	2004		2003		2004			2003			2004			2003			2004			2003
Great Lakes Region:
Ann Arbor Commerce Bank	$	16,157	$	17,379	$	3,161		$	3,613			16.32	%		19.66	%		1.31	%		1.52	%
Brighton Commerce Bank		4,576		4,354		794			893			12.93			16.79			1.10			1.42
Capitol National Bank		10,212		9,926		2,605			2,626			20.34			22.70			1.55			1.69
Detroit Commerce Bank		2,760		1,680		66			(377	)		1.78			n/a			.16			n/a
Elkhart Community Bank		2,859		2,379		525			335			9.90			8.29			1.21			.61
Goshen Community Bank		2,372		2,213		373			282			7.83			8.05			1.03			.89
Grand Haven Bank		5,235		7,480		(112	)		1,723			n/a			21.38			n/a			1.76
Kent Commerce Bank		3,957		4,108		408			591			6.65			9.97			.68			1.03
Macomb Community Bank		4,242		4,227		596			(32	)		9.06			n/a			.87			n/a
Muskegon Commerce Bank		4,602		4,798		1,082			1,091			15.68			16.85			1.66			1.71
Oakland Commerce Bank		5,681		6,021		520			1,233			6.96			16.97			.54			1.30
Paragon Bank & Trust		5,208		6,324		790			719			9.47			9.11			.99			.90
Portage Commerce Bank		8,556		7,979		2,045			1,738			20.18			20.50			1.61			1.60
Great Lakes Region Total		76,417		78,868		12,853			14,435
First Carolina State Bank(2)		1,591		—		326			—			4.23			—			.65			—
Southwest Region:
Arrowhead Community Bank		3,748		3,054		505			327			11.63			9.77			1.04			.86
Bank of Las Vegas		2,068		1,452		77			(39	)		1.72			n/a			.18			n/a
Bank of Tucson		7,425		7,061		2,159			2,013			24.39			24.64			1.84			1.92
Black Mountain Community Bank		4,471		3,563		980			643			15.27			14.43			1.41			1.30
Camelback Community Bank		4,083		4,418		286			397			4.39			6.30			.47			.59
Desert Community Bank		3,044		2,881		427			325			7.49			7.58			.97			.77
East Valley Community Bank		2,383		2,154		150			(134	)		4.83			n/a			.46			n/a
Mesa Bank		4,963		4,147		1,098			1,065			20.73			20.72			1.79			2.08
Red Rock Community Bank		4,462		5,310		358			(315	)		3.90			n/a			.44			n/a
Southern Arizona Community Bank		4,106		3,989		976			849			15.81			15.64			1.56			1.34
Sunrise Bank of Albuquerque		3,937		3,236		674			411			14.84			13.31			1.27			.98
Sunrise Bank of Arizona		8,756		7,398		1,847			607			22.22			11.77			1.88			.86
Valley First Community Bank		2,358		2,276		188			211			4.21			4.84			.50			.64
Yuma Community Bank		2,906		2,478		643			340			15.00			11.67			1.69			1.08
Southwest Region Total		58,710		53,417		10,368			6,700
California Region:
Bank of Escondido		1,350		—		(244	)		—			n/a			—			n/a			—
Napa Community Bank		2,884		1,901		327			154			5.20			2.58			.69			.47
Point Loma Community Bank(3)		31		—		(429	)		—			n/a			—			n/a			—
Sunrise Bank of San Diego		4,124		3,217		826			325			11.66			5.60			1.53			.75
California Region Total		8,389		5,118		480			479
Other, net		88		341		(5,261	)		(4,558	)		n/a			n/a			n/a			n/a
Consolidated	$	145,195	$	137,744	$	18,766		$	17,056			10.76	%		12.88	%		.86	%		.89	%

	n/a Not applicable
(1)	Annualized for period presented.
(2)	Acquired effective April 1, 2004.
(3)	Commenced operations in August 2004 and is 51%-owned by First California Southern Bancorp, a majority-owned subsidiary of Capitol.

Liquidity and Capital Resources

     The principal funding source for asset growth and loan origination activities is deposits. Total deposits increased $175 million (exclusive of the April 1, 2004 acquisition of First Carolina State Bank) for the nine months ended September 30, 2004, less than the $201 million increase in the corresponding period of 2003. Growth occurred in most interest-bearing deposit categories, with the majority coming from money-market deposit accounts. The banks generally do not significantly rely on brokered deposits as a key funding source; brokered deposits approximated $187 million as of September 30, 2004, or about 7% of total deposits, an increase of $1.1 million during the interim 2004 period. Brokered deposits, as a funding source, have

Page 19 of 27

increased in recent periods due to competitive environments and to aid in matching repricing of funding sources and assets.

     Noninterest-bearing deposits approximated 20% of total deposits at September 30, 2004 and 19% at December 31, 2003. Levels of noninterest-bearing deposits can, however, fluctuate based on customers’ transaction activity.

     Interim 2004 deposit growth was deployed primarily into commercial loans, consistent with the banks’ emphasis on commercial lending activities.

     Cash and cash equivalents amounted to $288 million or 9% of total assets at September 30, 2004, compared with $284 million or 10% of total assets at December 31, 2003. As liquidity levels vary continuously based on customer activities, amounts of cash and cash equivalents can vary widely at any given point in time. Management believes the banks’ liquidity position at September 30, 2004 is adequate to fund loan demand and meet depositor needs.

     In addition to cash and cash equivalents, a source of long-term liquidity is the banks’ marketable investment securities. Liquidity needs have not historically necessitated the sale of investments in order to meet funding requirements. The banks have not engaged in active trading of their investments. At September 30, 2004, the banks had approximately $32 million of investment securities classified as available for sale which can be utilized to meet various liquidity needs as they arise.

     During the nine months ended September 30, 2004, sales of investment securities available for sale approximated $68 million, an unusually high level. That amount included about $57 million of mutual fund investments which management decided to liquidate, based on its first quarter review of those investments from a risk-management perspective, and for which a loss approximating $500,000 was incurred as of March 31, 2004.

     Several of the banks have secured lines of credit with regional Federal Home Loan Banks. Borrowings thereunder approximated $125 million and additional borrowing capacity approximated $104 million at September 30, 2004. They are used from time to time as a lower-cost funding source versus various rates and maturities of time deposits. Total notes payable borrowings increased $45 million in the interim period of 2004. At September 30, 2004, Capitol had unused lines of credit from an unrelated financial institution aggregating $25 million.

     In March 2004, Capitol participated in a pooled trust-preferred securities offering, structured with a 30-year maturity and a variable interest rate, with net proceeds of approximately $9.9 million. These securities, totaling $100.8 million, augment Capitol’s existing capital base, which totaled $387 million (subordinated debentures—formerly ‘trust-preferred securities’, minority interests in consolidated subsidiaries and stockholders’ equity) or 12.6% of total assets at September 30, 2004.

     Stockholders’ equity, as a percentage of total assets, approximated 8% at September 30, 2004 and at December 31, 2003.

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     Effective April 1, 2004, Capitol acquired First Carolina State Bank (First Carolina) located in Rocky Mount, North Carolina, in a purchase transaction with total consideration approximating $10 million. Approximately half of the consideration was paid in cash and the remainder consisted of approximately 183,000 previously unissued shares of Capitol’s common stock. At March 31, 2004, First Carolina’s total assets approximated $61.7 million. Capitol’s acquisition of First Carolina was accounted for under the purchase-method of accounting and its results of operations are included in Capitol’s consolidated financial statements for periods after the effective date of the acquisition.

     A share exchange transaction regarding First California Northern Bancorp was completed effective August 31, 2004. A similar share exchange transaction regarding Sunrise Bank of San Diego was completed effective May 31, 2004. In each transaction, the shares acquired from shareholders other than Capitol were exchanged for Capitol’s common stock according to a fixed, but differing, exchange ratio. In total, Capitol has issued approximately 347,000 shares of its common stock resulting from these share exchanges (for aggregate consideration approximating $8.7 million). These transactions have been recorded using the purchase-method of accounting. Had these transactions occurred at the beginning of the periods presented, net income would have approximated $19.0 million ($1.25 per diluted share) and $17.2 million ($1.30 per diluted share) for the nine months ended September 30, 2004 and 2003, respectively.

     Capitol’s operating strategy continues to be focused on the ongoing growth and maturity of its existing banks, coupled with new bank expansion in selected markets as opportunities arise. Accordingly, Capitol may invest in, acquire or otherwise develop additional banks in future periods, subject to economic conditions and other factors, although the timing of such additional banking units, if any, is uncertain. Such future new banks and/or additions of other operating units could be either wholly-owned, majority-owned or otherwise controlled by Capitol. Most recently, Capitol has recruited several regional bank development executives to pursuede novoand other bank development opportunities in certain regions of the United States where it seeks to expand in future periods.

     Capitol and its banks are subject to complex regulatory capital requirements, which require maintaining certain minimum capital ratios. These ratio measurements, in addition to certain other requirements, are used by regulatory agencies to determine the level of regulatory intervention and enforcement applied to financial institutions. Management believes Capitol and each of its banks are in compliance with regulatory requirements and are expected to maintain such compliance.

Trends Affecting Operations

     One of the most significant trends which can impact the financial condition and results of operations of financial institutions are changes in market rates of interest.

     Changes in interest rates, either up or down, have an impact on net interest income (plus or minus), depending on the direction and timing of such changes. At any point in time, there is a difference between interest rate-sensitive assets and interest rate-sensitive liabilities. This means that when interest rates change, the timing and magnitude of the effect of such interest rate changes can alter the relationship between asset yields and the cost of funds.

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     In the first nine months of 2004, interest rates have remained relatively stable. The Board of Governors of the Federal Reserve, which influences interest rates, has endeavored to maintain a relatively stable, low-rate environment. Home mortgage rates, however, have recently fluctuated, which has adversely impacted fee income from the origination of residential mortgages, particularly from refinancing activities. Additionally, the Open Market Committee of the Federal Reserve increased their key interest rate by 1/4% both during the second and third quarters of 2004 and has indicated the possibility of future interest rate increases. Many of Capitol’s loans are variable-rate and, accordingly, such rate increases should result in higher interest income to Capitol in the near term; however, depositors will similarly expect higher rates of interest on their accounts, potentially offsetting much of the benefit of rising interest rates. The future outlook on interest rates and their impact on Capitol’s interest income, interest expense and net interest income is uncertain.

     Start-up banks generally incur operating losses during their early periods of operations. Recently-formed start-up banks are expected to detract from consolidated earnings performance and start-up banks formed in 2004 and beyond will similarly negatively impact short-term profitability.

     General economic conditions also have a significant impact on both the results of operations and the financial condition of financial institutions.

     Media reports raising questions about the health of the domestic economy have continued in 2004. During the interim period of 2004, the amount of nonperforming loans has increased, however, it is difficult to predict future movements in levels of nonperforming loans and related loan losses may increase as economic conditions, locally and nationally, evolve.

Impact of New Accounting Standards

     There are several new accounting standards either becoming effective or being issued in 2004. They are listed and discussed in Notes B and H of the accompanying condensed consolidated financial statements.

Critical Accounting Policies

     Capitol’s critical accounting policies are described on pages 8 and 9 of the financial section of its 2003 Annual Report. In the circumstances of Capitol, management believes its “critical accounting policies” are those which encompass the use of estimates (because of inherent subjectivity), accounting for goodwill and other intangibles (due to inherent subjectivity in evaluating potential impairment) and classification of trust-preferred securities.

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PART I, ITEM 3

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
MARKET RISK

Information about Capitol’s quantitative and qualitative disclosures about market risk were included in Capitol’s annual report on Form 10-K for the year ended December 31, 2003. Capitol does not believe that there has been a material change in the nature or categories of market risk exposure, except as noted in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section herein (Part I, Item 2), under the caption, “Trends Affecting Operations”.

PART I, ITEM 4

CONTROLS AND PROCEDURES

Capitol maintains disclosure controls and procedures designed to provide reasonable assurance that the information Capitol must disclose in its filings with the Securities and Exchange Commission is recorded, processed, summarized and reported on a timely basis. Capitol’s Chief Executive Officer and Chief Financial Officer have reviewed and evaluated Capitol’s disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as of the end of the period covered by this report (the “Evaluation Date”). Based on such evaluation, such officers have concluded that, as of the Evaluation Date, Capitol’s disclosure controls and procedures, in all material respects, are effective in bringing to their attention on a timely basis material information relating to Capitol required to be included in Capitol’s periodic filings under the Exchange Act.

No change in Capitol’s internal control over financial reporting occurred during Capitol’s most recent fiscal quarter that has materially affected or is reasonably likely to materially affect Capitol’s internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings.

Capitol and its subsidiaries are parties to certain ordinary, routine litigation incidental to their business. In the opinion of management, liabilities arising from such litigation would not have a material effect on Capitol’s consolidated financial position or results of operations.

Item 2. Unregistered Sales of Securities and Use of Proceeds.

(a)	None.
(b)	Not applicable.
(c)	None.

Item 3. Defaults Upon Senior Securities.

None.

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

None.

Item 5. Other Information.

None.

Item 6. Exhibits and Reports on Form 8-K.

(a) Exhibits:

Exhibit No.		Description of Exhibit
	10.1	Capitol Bancorp Ltd. 2003 Stock Plan.
	10.2	Form of Stock Option Agreement for Awards Made Pursuant to the Capitol Bancorp Ltd. 2003 Stock Plan.
	31.1	Certification of Chief Executive Officer, Joseph D. Reid, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
	31.2	Certification of Chief Financial Officer, Lee W. Hendrickson, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
	32.1	Certification of Chief Executive Officer, Joseph D. Reid, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
	32.2	Certification of Chief Financial Officer, Lee W. Hendrickson, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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PART II. OTHER INFORMATION – Continued

(b) Reports on Form 8-K:

On July 23, 2004, a report on Form 8-K was filed, reporting the Registrant’s earnings for the period ended June 30, 2004. On July 28, 2004, a report on Form 8-K was filed, announcing the Registrant’s third quarterly dividend, $0.17 per share, payable September 1, 2004 to shareholders of record as of August 16, 2004. On August 10, 2004, a report on Form 8-K was filed, reporting that the Registrant’s discussions with AEA Bancshares, Inc., a Washington corporation (“AEA”) had concluded and the related agreement announced earlier in 2004, providing for the Registrant’s acquisition of AEA, has been terminated. In that announcement, the Registrant announced its plans to pursuede novobank development opportunities in the Seattle and the greater Northwestern region of the United States.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

CAPITOL BANCORP LTD.

(Registrant)

/s/ Joseph D. Reid

Joseph D. Reid

Chairman and CEO

(duly authorized to sign on behalf of the registrant)

/s/ Lee W. HendricksonLee W. Hendrickson

Chief Financial Officer

Date: October 29, 2004

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INDEX TO EXHIBITS

Exhibit No.	Description of Exhibit
10.1	Capitol Bancorp Ltd. 2003 Stock Plan.
10.2	Form of Stock Option Agreement for Awards Made Pursuant to the Capitol Bancorp Ltd. 2003 Stock Plan.
31.1	Certification of Chief Executive Officer, Joseph D. Reid, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of Chief Financial Officer, Lee W. Hendrickson, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Certification of Chief Executive Officer, Joseph D. Reid, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Certification of Chief Financial Officer, Lee W. Hendrickson, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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