First Financial Service (FFKY) 10-Q 2005 Q2 Quarterly report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended June 30, 2005

OR

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

Commission File Number 0-18832

First Financial Service Corporation

(Exact Name of Registrant as specified in its charter)

Kentucky	61-1168311
(State or other jurisdiction of incorporation or organization)	(IRS Employer Identification No.)

2323 Ring Road

Elizabethtown, Kentucky  42701

(Address of principal executive offices)

(Zip Code)

(270) 765-2131

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes    ý     No  o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes    ý     No  o

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

Class	Outstanding as of July 31, 2005
Common Stock	3,626,188 shares

FIRST FINANCIAL SERVICE CORPORATION

TABLE OF CONTENTS

PART I – FINANCIAL INFORMATION
Item 1.	Consolidated Financial Statements and Notes to Consolidated Financial Statements
Item 2.	Management’s Discussion and Analysis of the Consolidated Statements of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures about Market Risk
Item 4.	Controls and Procedures
PART II – OTHER INFORMATION
Item 1.	Legal Proceedings
Item 2.	Changes In Securities, Use of Proceeds and Issuer Purchases of Equity Securities
Item 3.	Defaults upon Senior Securities
Item 4.	Submission of Matters to a Vote of Security Holders
Item 5.	Other Information
Item 6.	Exhibits
	SIGNATURES
	CERTIFICATIONS

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Item 1.

FIRST FINANCIAL SERVICE CORPORATION

Consolidated Statements of Financial Condition

	(Unaudited)
	June 30,			December 31,
(Dollars In thousands, except share data)	2005			2004
ASSETS
Cash and due from banks	$	18,139		$	27,910
Federal funds sold	8,000			8,000
Cash and cash equivalents	26,139			35,910
Securities available-for-sale	42,124			21,928
Securities held-to-maturity, fair value of $33,578 Jun (2005) and $34,557 Dec (2004)	34,102			34,915
Total securities	76,226			56,843
Loans held for sale	763			1,219
Loans receivable, net of unearned fees	608,168			604,698
Allowance for loan losses	(6,714		)	(6,489		)
Net loans receivable	602,217			599,428
Federal Home Loan Bank stock	7,005			6,845
Cash surrender value of life insurance	7,494			7,353
Premises and equipment, net	18,568			17,469
Real estate owned:
Acquired through foreclosure	1,034			681
Held for development	337			389
Other repossessed assets	38			40
Goodwill	8,384			8,384
Accrued interest receivable	2,529			2,487
Other assets	1,878			1,817
TOTAL ASSETS	$	751,849		$	737,646
LIABILITIES AND STOCKHOLDERS’ EQUITY
LIABILITIES:
Deposits:
Non-interest bearing	$	43,239		$	38,441
Interest bearing	555,262			547,945
Total deposits	598,501			586,386
Advances from Federal Home Loan Bank	78,452			78,904
Subordinated debentures	10,000			10,000
Accrued interest payable	378			413
Accounts payable and other liabilities	1,159			637
Deferred income taxes	1,325			1,505
TOTAL LIABILITIES	689,815			677,845
STOCKHOLDERS’ EQUITY:
Serial preferred stock, 5,000,000 shares authorized and unissued	—			—
Common stock, $1 par value per share; authorized 10,000,000 shares; issued and outstanding, 3,626,188 shares Jun (2005), and 3,645,438 shares Dec (2004)	3,626			3,645
Additional paid-in capital	7,730			8,226
Retained earnings	50,272			47,174
Accumulated other comprehensive income, net of tax	406			756
TOTAL STOCKHOLDERS’ EQUITY	62,034			59,801
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	751,849		$	737,646

See notes to the unaudited consolidated financial statements.

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FIRST FINANCIAL SERVICE CORPORATION

Consolidated Statements of Income

(Unaudited)

	Three Months Ended				Six Months Ended
	June 30,				June 30,
(Dollars in thousands, except per share data)	2005		2004		2005		2004
Interest Income:
Interest and fees on loans	$	10,272	$	9,021	$	20,226	$	18,129
Interest and dividends on investments and deposits	755		419		1,431		862
Total interest income	11,027		9,440		21,657		18,991
Interest Expense:
Deposits	3,146		2,528		6,039		5,253
Federal Home Loan Bank advances	951		923		1,895		1,851
Subordinated debentures	175		124		332		248
Total interest expense	4,272		3,575		8,266		7,352
Net interest income	6,755		5,865		13,391		11,639
Provision for loan losses	41		259		316		648
Net interest income after provision for loan losses	6,714		5,606		13,075		10,991
Non-interest Income:
Customer service fees on deposit accounts	1,319		1,268		2,439		2,403
Gain on sale of mortgage loans	168		244		351		462
Brokerage commissions	78		92		157		186
Gain on sale of real estate held for development	143		371		143		376
Gain on sale of investments	—		—		381		—
Other income	268		286		527		605
Total non-interest income	1,976		2,261		3,998		4,032
Non-interest Expense:
Employee compensation and benefits	2,856		2,657		5,634		5,055
Office occupancy expense and equipment	503		482		998		891
Marketing and advertising	195		213		383		352
Outside services and data processing	630		551		1,227		1,065
Bank franchise tax	195		207		398		419
Other expense	897		906		1,781		1,673
Total non-interest expense	5,276		5,016		10,421		9,455
Income before income taxes	3,414		2,851		6,652		5,568
Income taxes	1,120		925		2,172		1,803
Net Income	$	2,294	$	1,926	$	4,480	$	3,765
Shares applicable to basic income per share	3,641,688		3,645,438		3,644,081		3,671,152
Basic income per share	$	0.63	$	0.53	$	1.23	$	1.03
Shares applicable to diluted income per share	3,658,611		3,659,274		3,662,276		3,688,193
Diluted income per share	$	0.63	$	0.53	$	1.22	$	1.02

See notes to the unaudited consolidated financial statements.

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FIRST FINANCIAL SERVICE CORPORATION

Consolidated Statements of Comprehensive Income

(Unaudited)

	Three Months Ended						Six Months Ended
	June 30,						June 30,
(Dollars in thousands)	2005			2004			2005			2004
Net Income	$	2,294		$	1,926		$	4,480		$	3,765
Other comprehensive income (loss):
Change in unrealized gain (loss) on securities	98			(27		)	(149		)	14
Reclassification of realized amount	—			—			(381		)	—
Net unrealized gain (loss) recognized in comprehensive income	98			(27		)	(530		)	14
Tax effect	(33		)	9			180			(5		)
Total other comphrehensive income (loss)	65			(18		)	(350		)	9
Comphrehensive Income	$	2,359		$	1,908		$	4,130		$	3,774

See notes to the unaudited consolidated financial statements.

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FIRST FINANCIAL SERVICE CORPORATION

Consolidated Statements of Changes in Stockholders’ Equity

Six Months Ended June 30, 2005

(Dollars In Thousands, Except Per Share Amounts)

(Unaudited)

						Additional Paid-in Capital			Retained Earnings			Accumulated Other Comprehensive Income, Net of Tax			Total
	Common Stock
	Shares		Amount
Balance, December 31, 2004	3,645		$	3,645		$	8,226		$	47,174		$	756		$	59,801
Net income									4,480						4,480
Exercise of stock options	3		3			54									57
Net change in unrealized gains (losses) on securities available-for-sale, net of tax												(350		)	(350		)
Cash dividends declared ($.38 per share)									(1,382		)				(1,382		)
Stock repurchased	(22	)	(22		)	(550		)	—			—			(572		)
Balance, June 30, 2005	3,626		$	3,626		$	7,730		$	50,272		$	406		$	62,034

See notes to the unaudited consolidated financial statements.

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FIRST FINANCIAL SERVICE CORPORATION

Consolidated Statements of Cash Flows

(Dollars In Thousands)

(Unaudited)

	Six Months Ended
	June 30,
	2005			2004
Operating Activities:
Net income	$	4,480		$	3,765
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses	316			648
Depreciation on premises and equipment	624			524
Federal Home Loan Bank stock dividends	(160		)	(132		)
Net amortization (accretion)	(23		)	20
Gain on sale of investments available-for-sale	(381		)	—
Gain on sale of mortgage loans	(351		)	(462		)
Gain on sale of real estate held for development	(143		)	(376		)
Origination of loans held for sale	(19,644		)	(29,060		)
Proceeds on sale of loans held for sale	20,451			29,312
Changes in:
Cash surrender value of life insurance	(141		)	—
Interest receivable	(42		)	(17		)
Other assets	(61		)	267
Interest payable	(35		)	(26		)
Accounts payable and other liabilities	522			(23		)
Net cash from operating activities	5,412			4,440
Investing Activities:
Sales of securities available-for-sale	1,431			—
Purchases of securities available-for-sale	(27,158		)	—
Maturities of securities available-for-sale	5,435			—
Purchases of securities held-to-maturity	—			(28,100		)
Maturities of securities held-to-maturity	783			17,101
Net change in loans	(3,912		)	(26,089		)
Net purchases of premises and equipment	(1,723		)	(2,027		)
Sales of real estate held for development	195			—
Net cash from investing activities	(24,949		)	(39,115		)
Financing Activities
Net change in deposits	12,115			(2,835		)
Advances from Federal Home Loan Bank	—			57,100
Repayments to Federal Home Loan Bank	(452		)	(39,518		)
Proceeds from stock options exercised	57			—
Dividends paid	(1,382		)	(1,323		)
Common stock repurchased	(572		)	(1,560		)
Net cash from financing activities	9,766			11,864
(Decrease) in cash and cash equivalents	(9,771		)	(22,811		)
Cash and cash equivalents, beginning of period	35,910			48,030
Cash and cash equivalents, end of period	$	26,139		$	25,219

See notes to the unaudited consolidated financial statements.

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Notes To Unaudited Consolidated Financial Statements

1.BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation – The accompanying unaudited consolidated financial statements include the accounts of First Financial Service Corporation and its wholly owned subsidiary, First Federal Savings Bank.  First Federal Savings Bank has three wholly owned subsidiaries, First Service Corporation of Elizabethtown, First Heartland Mortgage Company and First Federal Office Park, LLC.  Unless the text clearly suggests otherwise, references to “us,” “we,” or “our” include First Financial Service Corporation and its wholly-owned subsidiary.  All significant intercompany transactions and balances have been eliminated.

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.  In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.  Operating results for the six month period ending June 30, 2005 are not necessarily indicative of the results that may occur for the year ending December 31, 2005.  For further information, refer to the consolidated financial statements and footnotes thereto included in the Corporation’s annual report on Form 10-K for the period ended December 31, 2004.

Stock Option Plans – Employee compensation expense under stock option plans is reported using the intrinsic value method.  No stock-based compensation cost is reflected in net income, as all options granted had an exercise price equal to the market price of the underlying common stock at date of grant.  The following table illustrates the effect on net income and earnings per share if expense was measured using the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation.

		Three Months Ended						Six Months Ended
		June 30,						June 30,
		2005			2004			2005			2004
		(Dollars In Thousands, Except Per Share Data)
Net income:
As reported		$	2,294		$	1,926		$	4,480		$	3,765
Deduct: Stock-based compensation expense determined under fair value based method		(23		)	(30		)	(56		)	(62		)
Pro-forma		$	2,271		$	1,896		$	4,424		$	3,703
Earnings per share:
Basic	As Reported	$	0.63		$	0.53		$	1.23		$	1.03
	Pro-forma	0.62			0.52			1.21			1.01
Diluted	As Reported	$	0.63		$	0.53		$	1.22		$	1.02
	Pro-forma	0.62			0.52			1.21			1.01

Effect of Newly Issued But Not Yet Effective Accounting Standards – In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 123 (Revised 2004) (“SFAS No. 123R”), “Share-Based Payment.”  SFAS No. 123R is a revision of FASB Statement 123, “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and its related implementation guidance.  SFAS No. 123R requires all public companies to record compensation cost for stock options provided to employees in return for employee service. The cost is measured at the fair value of the options when granted, and this cost is expensed over the employee service period, which is normally the vesting period of the options.  This will apply to awards granted or modified for the year beginning January 1, 2006.Compensation cost will also be recorded for prior option grants that vest after the date of adoption.  The effect on results of operations will depend on the level of future option grants and the calculation of the fair value of the options granted at such future date, as well as the vesting periods provided, and so they cannot currently be predicted. Existing options that will vest after adoption date are expected to result in additional compensation expense of approximately $66,000 in 2006, $60,000 in 2007, $60,000 in 2008 and $45,000 in 2009.  There will be no significant effect on financial position as total equity will not change.

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Reclassifications – Certain amounts have been reclassified in the prior period financial statements to conform to the current period classifications.

2.SECURITIES

The amortized cost basis and fair values of securities are as follows:

			Gross		Gross
	Amortized		Unrealized		Unrealized
(Dollars in thousands)	Cost		Gains		Losses			Fair Value
Securities available-for-sale:
June 30, 2005:
U. S. Treasury and agencies	$	27,463	$	—	$	(73	)	$	27,390
Mortgage-backed	9,966		—		(27		)	9,939
Equity	1,127		690		—			1,817
State and municipal	924		26		—			950
Corporate	2,028		—		—			2,028
Total	$	41,508	$	716	$	(100	)	$	42,124
December 31, 2004:
U. S. Treasury and agencies	$	15,985	$	—	$	(56	)	$	15,929
Mortgage-backed	1,901		—		(22		)	1,879
Equity	1,898		1,181		—			3,079
State and municipal	999		42		—			1,041
Total	$	20,783	$	1,223	$	(78	)	$	21,928
			Gross		Gross
	Amortized		Unrecognized		Unrecognized
	Cost		Gains		Losses			Fair Value
Securities held-to-maturity:
June 30, 2005:
U.S. Treasury and agencies	$	26,095	$	1	$	(382	)	$	25,714
Mortgage-backed	6,007		5		(148		)	5,864
Corporate	2,000		—		—			2,000
Total	$	34,102	$	6	$	(530	)	$	33,578
December 31, 2004:
U.S. Treasury and agencies	$	26,095	$	3	$	(244	)	$	25,854
Mortgage-backed	6,820		7		(124		)	6,703
Corporate	2,000		—		—			2,000
Total	$	34,915	$	10	$	(368	)	$	34,557

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3.LOANS RECEIVABLE

Loans receivable are summarized as follows:

	June 30,			December 31,
(Dollars in thousands)	2005			2004
Commercial	$	34,025		$	32,228
Real estate commercial	314,534			302,567
Real estate construction	11,176			10,850
Residential mortgage	149,787			159,550
Consumer and home equity	68,511			70,143
Indirect consumer	31,353			30,798
Loans held for sale	763			1,219
	610,149			607,355
Less:
Net deferred loan origination fees	(1,218		)	(1,438		)
Allowance for loan losses	(6,714		)	(6,489		)
	(7,932		)	(7,927		)
Loans Receivable	$	602,217		$	599,428

The allowance for losses on loans is summarized as follows:

	As of and For the						As of and For the
	Three Months Ended						Six Months Ended
	June 30,						June 30,
(Dollars in thousands)	2005			2004			2005			2004
Balance, beginning of period	$	6,701		$	5,733		$	6,489		$	5,568
Provision for loan losses	41			259			316			648
Charge-offs	(106		)	(219		)	(246		)	(490		)
Recoveries	78			49			155			96
Balance, end of period	$	6,714		$	5,822		$	6,714		$	5,822

Investment in impaired loans is summarized below.  There were no impaired loans for the periods presented without an allowance allocation.

	As of and For the		As of and For the
	Six Months Ended		Year Ended
	June 30,		December 31,
(Dollars in thousands)	2005		2004
End of period impaired loans	$	4,891	$	5,240
Amount of allowance for loan loss allocated	1,210		928

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We report non-performing loans as impaired.  Our non-performing loans are as follows:

	June 30,		December 31,
(Dollars in thousands)	2005		2004
Restructured	$	3,166	$	3,218
Loans past due over 90 days still on accrual	—		—
Non accrual loans	1,725		2,022
Total	$	4,891	$	5,240

4.EARNINGS PER SHARE

The reconciliation of the numerators and denominators of the basic and diluted EPS is as follows:

	Three Months Ended				Six Months Ended
(Dollars in thousands,	June 30,				June 30,
except per share data)	2005		2004		2005		2004
Net income available to common shareholders	$	2,294	$	1,926	$	4,480	$	3,765
Basic EPS:
Weighted average common shares	3,642		3,645		3,644		3,671
Diluted EPS:
Weighted average common shares	3,642		3,645		3,644		3,671
Dilutive effect of stock options	17		14		18		17
Weighted average common and incremental shares	3,659		3,659		3,662		3,688
Earnings Per Share:
Basic	$	0.63	$	0.53	$	1.23	$	1.03
Diluted	$	0.63	$	0.53	$	1.22	$	1.02

Stock options for 10,000 shares of common stock were not included in the 2005 and 2004 computations of diluted earnings per share because their impact was anti-dilutive.

Item 2.

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

GENERAL

We conduct operations in 14 full-service banking centers in six contiguous counties in Central Kentucky along the Interstate 65 corridor.  Our market presence ranges from the major metropolitan market of Louisville in Jefferson County, Kentucky approximately 40 miles north of our headquarters in Elizabethtown, Kentucky to Hart County, Kentucky, approximately 30 miles south of Elizabethtown.  Our market is supported by a diversified industry base and consists of a regional population of over 1 million.

We serve the needs and cater to the economic strengths of the local communities in which we operate and strive to provide a high level of personal and professional customer service. We offer a variety of financial services to our retail and commercial banking customers. These services include personal and corporate banking services and personal investment financial counseling services.

Throughour personal investment financial counseling services, we offer a wide variety of mutual funds, equity investments, and fixed and variable annuities.

We invest in the wholesale capital markets through the management of our security portfolio and use various forms of wholesale funding. The security portfolio contains a variety of instruments, including callable

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debentures, taxable and non-taxable debentures, fixed and adjustable rate mortgage backed securities, and collateralized mortgage obligations.

Our results of operations depend primarily on net interest income, which is the difference between interest income we earn on loans, investment securities and other interest-earning assets and interest expense we pay on deposits and other interest-bearing liabilities. Our operations are also affected by non-interest income, such as service charges, insurance agency revenue, loan fees, gains and losses from the sale of mortgage loans and gains from the sale of real estate held for development. Our principal operating expenses, aside from interest expense, consist of compensation and employee benefits, occupancy costs, data processing expense and provisions for loan losses.

This discussion and analysis covers material changes in the financial condition since December 31, 2004 and material changes in the results of operations for the three and six-month periods ending, June 30, 2005 as compared to 2004.  It should be read in conjunction with “Management Discussion and Analysis of Financial Condition and Results of Operations” included in the Annual Report on Form 10-K for the period ended December 31, 2004.

Business Risk

We, like other financial companies, are subject to a number of risks, many of which are outside of management’s control, though we strive to manage those risks while optimizing returns.  Among the risks assumed are: (a) credit risk, which is the risk that loan and lease customers or other counter parties will be unable to perform their contractual obligations, (b) market risk, which is the risk that changes in market rates and prices will adversely affect our financial condition or results of operation, (c) liquidity risk, which is the risk that we will have insufficient cash or access to cash to meet our operating needs, and (d) operational risk, which is the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events.

In addition to the other information included or incorporated by reference into this report, readers should consider that the following important factors, among others, could materially impact our business, future results of operations, and future cash flows.

(a)Credit Risk

We extend credit to a variety of customers based on internally set standards and the judgment of management.  We manage the credit risk by maintaining a program of underwriting standards that we update periodically, the review of certain credit decisions, and an on-going process of assessment of the quality of the credit we have already extended.  Despite our credit standards and our on-going process of credit assessment we may incur significant credit losses.

Our loans and deposits are focused in central Kentucky and adverse economic conditions in that state, in particular, could negatively impact results from operations, cash flows, and financial condition.  Adverse economic conditions and other factors, such as political or business development or natural hazards that may affect Kentucky, may reduce demand for credit or fee-based products and could negatively affect real estate and other collateral values, interest rate levels, and the availability of credit to refinance loans at or prior to maturity.

(b)Market Risk

Changes in interest rates could negatively impact our financial condition or results of operations.

Our results of operations depend substantially on net interest income, the difference between interest earned on interest-earning assets (such as investments and loans) and interest paid on interest-bearing liabilities (such as deposits and borrowings).  Interest rates are highly sensitive to many factors, including governmental monetary policies and domestic and international economic and political conditions.  Conditions such as inflation, recession, unemployment, money supply, and other factors beyond our control may also affect interest rates.  If our interest-earning assets mature or reprice more quickly than interest-bearing liabilities in a given period, a decrease in market rates could adversely affect net interest income.  Likewise, if interest-bearing liabilities mature or reprice more quickly than interest-earning assets in a given period, an increase in market rates could adversely affect net interest income.

Fixed-rate loans increase our exposure to interest rate risk in a rising rate environment because interest-bearing liabilities would be subject to repricing before assets become subject to repricing.  Adjustable-rate loans decrease the risk associated with changes in interest rates but involve other risks, such as the inability of borrowers to make higher payments in an increasing interest rate environment.  At the same time, for secured loans, the marketability of the

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underlying collateral may be adversely affected by higher interests rates.  In a declining interest rate environment, there may be an increase in prepayments on loans as the borrowers refinance their loans at lower interest rates.  Under these circumstances, our results of operations could be negatively impacted.

When evaluating short-term interest rate risk exposure, the primary measurement represents scenarios that model a 200 basis point increasing (decreasing) parallel shift in rates over the next twelve-month period.  For the period ended June 30, 2005, that scenario modeled net interest income to be approximately 13.7% lower than the internal forecast of net interest income using the baseline scenario if rates were to decrease 200 basis points in a parallel shift and 10.8% higher than the internal forecast of net interest income using the baseline scenario if rates were to increase 200 basis points in a parallel shift.

Although fluctuations in market interest rates are neither completely predictable nor controllable, our Asset Liability Committee meets periodically to monitor our interest rate sensitivity position and oversee its financial risk management by establishing policies and operating limits.  For further discussion, see the “Asset/Liability Management and Market Risk” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations.

(c)Liquidity Risk

If we are unable to borrow funds through access to the capital markets, we may not be able to meet the cash flow requirements of our depositors and borrowers, or meet the operating cash needs of the Corporation to fund corporate expansion or other activities.

Liquidity policies and limits are established by the board of directors, with operating limits set by the Asset Liability Committee (“ALCO”), based upon analyses of the ratio of loans to deposits, the percentage of assets funded with non-core or wholesale funding.  ALCO regularly monitors the overall liquidity position of the Bank and holding company to ensure that various alternative strategies exist to cover unanticipated events that could affect liquidity.  Liquidity is the ability to meet cash flow needs on a timely basis at a reasonable cost.  The liquidity of the Bank is used to make loans and to repay deposit liabilities as they become due or are demanded by customers.  The ALCO establishes board approved policies and monitors guidelines to diversify our wholesale funding sources to avoid concentrations in any one-market source.  Wholesale funding sources include Federal funds purchased, securities sold under repurchase agreements, non-core brokered deposits, and medium and long-term debt, which includes Federal Home Loan Bank (FHLB) advances that are collateralized with mortgage-related assets.

We maintain a portfolio of securities that can be used as a secondary source of liquidity. There are other sources of liquidity should they be needed.  These include the sale or securitization of loans, the ability to acquire additional non-core brokered deposits, additional collateralized borrowings such as FHLB advances, the issuance of debt securities, and the issuance of preferred or common securities in public or private transactions.

If we were unable to access any of these funding sources when needed, we might be unable to meet the needs of our customers, which could adversely impact our financial condition, our results of operations, cash flows, and our level of regulatory-qualifying capital.  For further discussion, see the “Liquidity” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations.

(d)Operational Risk

We have significant competition in both attracting and retaining deposits and in originating loans.

Competition is intense in most of the markets we serve.  We compete on price and service with other banks and financial companies such as savings and loans, credit unions, finance companies, mortgage banking companies, and brokerage firms.  Competition could intensify in the future as a result of industry consolidation, the increasing availability of products and services from non-banks, greater technological developments in the industry, and banking reform.

Management maintains internal operational controls and we have invested in technology to help us process large volumes of transactions.  However, there can be no assurance that we will be able to continue processing at the same or higher levels of transactions.  If our systems of internal controls should fail to work as expected, if our systems were to be used in an unauthorized manner, or if employees were to subvert the system of internal controls, significant losses could occur.

We process large volumes of transactions on a daily basis and are exposed to numerous types of operation risk.  Operational risk resulting from inadequate or failed internal processes, people, and systems includes the risk of fraud

13

by employees or persons outside of our company, the execution of unauthorized transactions by employees, errors relating to transaction processing and systems, and breaches of the internal control system and compliance requirements.  This risk of loss also includes potential legal actions that could arise as a result of the operational deficiency or as a result of noncompliance with applicable regulatory standards.

We establish and maintain systems of internal operational controls that provide management with timely and accurate information about our level of operational risk.  While not foolproof, these systems have been designed to manage operational risk at appropriate, cost effective levels.  We have also established procedures that are designed to ensure that policies relating to conduct, ethics, and business practices are followed.  From time to time, we experience loss from operational risk, including the effects of operational errors.

While management continually monitors and improves our system of internal controls, data processing systems, and corporate wide processes and procedures, there can be no assurance that we will not suffer such losses in the future.  New, or changes in existing tax, accounting, are regulatory laws, regulations, rules, standards, policies, and interpretations could significantly impact strategic initiatives, results of operations, cash flows, and financial condition.

The financial services industry is extensively regulated.  Federal and state banking regulations are designed primarily to protect deposit insurance funds and consumers, not to benefit a financial company’s shareholders.  These regulations may sometimes impose significant limitations on operations.  The significant federal and state banking regulations that affect us are described in this report under the heading “Regulation”.  These regulations, along with currently existing tax, accounting, and monetary laws, regulations, rules, standards, policies and interpretations control the methods by which financial institutions conduct business, implement strategic initiatives and tax compliance, and govern financial reporting and disclosures.  These laws, regulations, rules, standards, policies, and interpretations are constantly evolving and may change significantly over time.  Events that may not have a direct impact on us, such as the bankruptcy of U.S. companies, have resulted in legislators, regulators, and authoritative bodies, such as the Financial Accounting Standards Board, the Securities and Exchange Commission, the Public Company Accounting Oversight Board, and other various taxing authorities responding by adopting and or proposing substantive revisions to laws, regulations, rules, standards, policies, and interpretations.  The nature, extent, and timing of the adoption of significant new laws and regulations, or changes in or repeal of existing laws and regulations may have a material impact on our business and results of operations.  However, it is impossible to predict at this time, the extent to which any such adoption, change, or repeal would impact us.

OVERVIEW

During the first half of 2005, we completed the redesign of our Mt. Washington facility in Bullitt County.  This follows the redesign of one of our Hardin County facilities and the opening of two new full-service facilities in the growing Louisville market.  We intend to start construction on a new full-service banking center in Elizabethtown during the second half of 2005 with plans of opening in early 2006.  The design of the new and enhanced facilities represents our state of the art prototype branch with a retail focused design, complimenting our commitment to providing superior customer service. We believe these facilities will allow us to more effectively support our lending relationships and to develop a larger presence within these markets.  While we anticipate these facilities will significantly enhance the value of our franchise in the near future, the additional expense in operating these new facilities will continue to place pressure on earnings for a period of time.  We are optimistic that our expansion strategy will minimize this period and the long-term benefits will outweigh the initial investment.

Our emphasis on commercial lending generated a 4% compound annual growth rate in the total loan portfolio and a 35% compound annual growth rate in commercial loans over the past four years.  Commercial loans were $360 million at June 30, 2005, an increase of $50 million from June 30, 2004, and an increase of $13.6 million from December 31, 2004.  The loan growth in the first six months of 2005 has been slower than recent quarters due to scheduled and accelerated payoffs in our portfolio in conjunction with aggressive fixed rate pricing among market participants. While we expect the recent loan growth trends to continue, the commercial loan growth for 2005 is expected to slow from the 27% growth in the commercial portfolio experienced during 2004.

The growth in our commercial loan portfolio, coupled with the rising interest rate environment, has favorably impacted the level of interest income generated.  Net interest margin increased to 3.88% for the six months ended June 30, 2005, compared to 3.67% for the same six months ended a year ago.  This has resulted in an $890,000 increase in net interest income to $6.8 million for the second quarter ended June 30, 2005 and a $1.8 million increase in net interest income to $13.4 million for the six months ended June 30, 2005, compared to the respective periods in 2004.  The increasing interest rate environment positively impacted net interest margin due

14

to the growth in the adjustable rate commercial loans coupled with the decrease in residential fixed rate loans in the loan portfolio.  Net interest margin has increased in each of the last six quarters and is likely to continue to benefit from continued increases in the prime-lending rate.  However, the increase in the cost of deposits will likely slow the increases in net interest margin over future quarters.

Our asset quality remains favorable.  Net charge-offs as a percent of total loans was 0.03% for the six months ended June 30, 2005, compared to 0.06% for the same period year ago.  The allowance for loan losses as a percent of total loans, increased to 1.10% at June 30, 2005 compared to 1.07% at December 31, 2004.  The percentage of non-performing loans to total loans was 0.80% at June 30, 2005, compared to 0.87% at December 31, 2004.

Provision for loan loss expense decreased $218,000 to $41,000 for the quarter ended June 30, 2005, compared to $259,000 for the quarter ended June 30, 2004.  For the six months ended June 30, 2005, provision for loan loss expense decreased $332,000 to $316,000, compared to $648,000 for the same six months ended a year ago.  The decrease in the provision was related to the softer expansion in the commercial loan portfolio for the year, as compared to a year ago, as well as a decrease in net charge offs of $304,000 to $90,000 for the six months ended June 30, 2005 compared to the prior year.

Non-interest income decreased $285,000 to $2.0 million for the quarter ended June 30, 2005.  For the six months ended, non-interest income decreased $34,000 to $4.0 million. Non-interest expense increased $260,000, to $5.3 million for the quarter ended June 30, 2005, and $966,000 to $10.4 million for the six months ended June 30, 2005, compared to the same periods a year ago.  The primary contributing factors to this increase were the additional operating and employee compensation expenses related to the recent expansion efforts.  Twenty-one retail staff positions were added for the expansion into the Louisville metropolitan market, coupled with expanded facilities in Hardin County and Bullitt County, Kentucky.  Additional increases in staff have taken place during 2004 and 2005 to continue the transformation towards a stronger retail sales culture and to provide expanded products and services to our retail and commercial customers.  Non-interest expense levels are often measured using an efficiency ratio (non-interest expense divided by the sum of net interest income and non-interest income).  Our efficiency ratio was 60% for the six months ended June 30, 2005 and 2004, indicating an operationally efficient financial institution.

CRITICAL ACCOUNTING POLICIES

Our accounting and reporting policies comply with accounting principles generally accepted in the United States of America and conform to general practices within the banking industry.  The accounting policy relating to the allowance for loan losses is critical to the understanding of our results of operations since the application of this policy requires significant management assumptions and estimates that could result in materially different amounts to be reported if conditions or underlying circumstances were to change.

Allowance for Loan Losses – We maintain an allowance sufficient to absorb probable incurred credit losses existing in the loan portfolio, and our Executive Loan Committee evaluates the adequacy of the allowance for loan losses on a quarterly basis.  We estimate the allowance required using past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of the underlying collateral, and current economic conditions.  While we estimate the allowance for loan losses, in part, based on historical losses within each loan category, estimates for losses within the commercial real estate portfolio depend more on credit analysis and recent payment performance. Allocations of the allowance may be made for specific loans or loan categories, but the entire allowance is available for any loan that, in management’s judgment, should be charged off.

The allowance consists of specific and general components.  The specific component relates to loans that are individually classified as impaired or loans otherwise classified as substandard or doubtful.  The general component covers non-classified loans and is based on historical loss experience adjusted for current factors. The methodology for allocating the allowance for loan and lease losses takes into account our strategic plan to increase our emphasis on commercial and consumer lending. We increase the amount of the allowance allocated to commercial loans and consumer loans in response to the growth of the commercial and consumer loan portfolios and management’s recognition of the higher risks and loan losses in these lending areas. Allowance estimates are developed in consultation with regulatory authorities and actual loss experience adjusted for current economic conditions.  Allowance estimates are considered a prudent measurement of the risk in the loan portfolio and are applied to individual loans based on loan type.

Based on our calculation, an allowance of $6.7 million or 1.10% of total loans was reserved for potential losses within the loan portfolio as of June 30, 2005.This estimate resulted in a provision for loan losses on the income

15

statement of $316,000 for the 2005 six-month period.If the mix and amount of future charge off percentages differ significantly from those assumptions used by management in making its determination, the allowance for loan losses and provision for loan losses on the income statement could be materially and adversely affected.

RESULTS OF OPERATIONS

Net income for the quarter ended June 30, 2005 was $2.3 million or $0.63 per share diluted compared to $1.9 million or $0.53 per share diluted for the same period in 2004.  Net income for the six-month period ended June 30, 2005 was $4.5 million or $1.22 per share diluted compared to $3.8 million or $1.02 per share diluted for the same period a year ago.  The increase in diluted earnings per share for the three and six-month periods were primarily the result of an increase in net interest income of $890,000 and $1.7 million and a decrease in provision for loan loss expense of $218,000 and $332,000 for the 2005 respective periods compared to 2004.Our book value per common share increased from $15.69 at June 30, 2004 to $17.11 at June 30, 2005.  Annualized net income for 2005 generated a return on average assetsof 1.20% and a return on average equity of 14.58%.  These compare with a return on average assets of 1.10% and a return on average equity of 13.27% for the 2004 period also annualized.

Net Interest Income-On an annualized basis, the net interest margin as a percent of average earning assets increased 15 basis points to 3.86% for the quarter ended June 30, 2005 and 21 basis points to 3.88% for the six months ended June 30, 2005 compared to 3.71% and 3.67% for the respective three-month and six-month periods ended June 30, 2004. The increasing interest rate environment positively impacted net interest margin due to the growth in our adjustable rate commercial loans coupled with the decrease in our residential fixed rated mortgage loans. The yield on earning assets averaged 6.30% and 6.27% for the respective three-month and six-month 2005 periods compared to an average yield on earning assets of 5.97% and 5.99% for the same periods in 2004.The prime-lending rate increased 225 basis points since the Federal Open Market Committee began increasing short-term interest rates in June 2004. Management expects its yield on loans to improve with additional increases in the prime-lending rate.

Our cost of funds averaged 2.65% and 2.59% for the respective three-month and six-month 2005 periods compared to an average cost of funds of 2.42% and 2.49% for the same periods in 2004. The increase in our cost of funds is due to the re-pricing of certificate of deposit maturities rolling off at lower rates into current higher interest rates, as well as our new Priority Rate money market product, which generated $37.5 million for the quarter ended June 30, 2005.  Going forward, our cost of funds is expected to increase as the general market deposit rates have become increasingly competitive with the recent upward trend in interest rates.

Net interest margin has increased in each of the last six quarters and is likely to continue to benefit from continued increases in the prime-lending rate.  However, the flattening of the yield curve will likely slow the increases in net interest margin over future quarters.

The net result of the above factors was an increase in net interest income of $890,000 for the quarter ended and $1.7 million for the six months ended June 30, 2005 compared to the same three and six month periods a year ago.

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AVERAGE BALANCE SHEETS

The following tables set forth information relating to the Bank’s average balance sheet and reflect the average yield on assets and average cost of liabilities for the periods indicated.  Dividing income or expense by the average monthly balance of assets or liabilities, respectively, derives such yields and costs for the periods presented.

	Quarter Ended June 30,
				2005								2004
	Average					Average			Average					Average
(Dollars in thousands)	Balance			Interest		Yield/Cost (5)			Balance			Interest		Yield/Cost (5)
ASSETS
Interest earning assets:
U.S. Treasury and agencies	$	57,509		$	391	2.73	%		$	26,922		$	188	2.81	%
Mortgage-backed securities	8,640			84		3.90			10,087			86		3.43
Equity securities	1,747			18		4.13			2,966			31		4.20
State and political subdivision securities (1)	956			16		6.71			1,071			15		5.63
Corporate bonds	4,031			51		5.08			2,000			15		3.02
Loans receivable (2) (3) (4)	605,217			10,272		6.81			575,987			9,021		6.30
FHLB stock	6,922			84		4.87			6,637			66		4.00
Interest bearing deposits	16,922			116		2.75			11,076			23		0.84
Total interest earning assets	701,944			11,032		6.30			636,746			9,445		5.97
Less: Allowance for loan losses	(6,706		)						(5,724		)
Non-interest earning assets	57,104								55,884
Total assets	$	752,342							$	686,906
LIABILITIES AND STOCKHOLDERS’ EQUITY
Interest bearing liabilities:
Savings accounts	$	88,010		$	350	1.60		%	$	88,223		$	240	1.09	%
NOW and money market accounts	150,649			498		1.33			127,624			160		0.50
Certificates of deposit and other time deposits	318,649			2,298		2.89			287,292			2,128		2.98
FHLB advances	78,692			952		4.85			80,158			923		4.63
Trust preferred securities	10,000			174		6.98			10,000			124		4.99
Total interest bearing liabilities	646,000			4,272		2.65			593,297			3,575		2.42
Non-interest bearing liabilities:
Non-interest bearing deposits	40,792								33,783
Other liabilities	3,550								2,931
Total liabilities	690,342								630,011
Stockholders’ equity	62,000								56,895
Total liabilities and stockholders’ equity	$	752,342							$	686,906
Net interest income				$	6,760							$	5,870
Net interest spread						3.65		%						3.54	%
Net interest margin						3.86		%						3.71	%

(1) Taxable equivalent yields are calculated assuming a 34% federal income tax rate.

(2) Includes loan fees, immaterial in amount, in both interest income and the calculation of yield on loans.

(3) Calculations include non-accruing loans in the average loan amounts outstanding.

(4) Includes loans held for sale.

(5) Annualized

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	Six Months Ended June 30,
				2005							2004
	Average					Average		Average					Average
(Dollars in thousands)	Balance			Interest		Yield/Cost (5)		Balance			Interest		Yield/Cost (5)
ASSETS
Interest earning assets:
U.S. Treasury and agencies	$	53,566		$	715	2.69	%	$	22,045		$	337	3.07	%
Mortgage-backed securities	8,542			164		3.87		9,419			170		3.63
Equity securities	2,210			58		5.29		2,958			64		4.35
State and political subdivision securities (1)	973			31		6.42		1,071			33		6.20
Corporate bonds	3,048			74		4.90		2,000			30		3.02
Loans receivable (2) (3) (4)	603,199			20,226		6.76		569,017			18,129		6.41
FHLB stock	6,884			160		4.69		6,604			131		3.99
Interest bearing deposits	18,666			239		2.58		24,611			108		0.88
Total interest earning assets	697,088			21,667		6.27		637,725			19,002		5.99
Less: Allowance for loan losses	(6,604		)					(5,653		)
Non-interest earning assets	57,405							54,972
Total assets	$	747,889						$	687,044
LIABILITIES AND STOCKHOLDERS’ EQUITY
Interest bearing liabilities:
Savings accounts	$	83,066		$	572	1.39	%	$	89,680		$	428	0.96	%
NOW and money market accounts	153,293			1,010		1.33		124,622			381		0.61
Certificates of deposit and other time deposits	317,571			4,456		2.83		290,881			4,444		3.07
FHLB advances	78,785			1,896		4.85		79,200			1,851		4.70
Trust preferred securities	10,000			332		6.70		10,000			248		4.99
Total interest bearing liabilities	642,715			8,266		2.59		594,383			7,352		2.49
Non-interest bearing liabilities:
Non-interest bearing deposits	40,117							32,851
Other liabilities	3,584							3,065
Total liabilities	686,416							630,299
Stockholders’ equity	61,473							56,745
Total liabilities and stockholders’ equity	$	747,889						$	687,044
Net interest income				$	13,401						$	11,650
Net interest spread						3.67	%						3.50	%
Net interest margin						3.88	%						3.67	%

(1) Taxable equivalent yields are calculated assuming a 34% federal income tax rate.

(2) Includes loan fees, immaterial in amount, in both interest income and the calculation of yield on loans.

(3) Calculations include non-accruing loans in the average loan amounts outstanding.

(4) Includes loans held for sale.

(5) Annualized

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RATE/VOLUME ANALYSIS

The table below sets forth certain information regarding changes in interest income and interest expense of the Bank for the periods indicated.  For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (1) changes in rate (changes in rate multiplied by old volume); (2) changes in volume (change in volume multiplied by old rate); and (3) changes in rate-volume (change in rate multiplied by change in volume).  Changes in rate-volume are proportionately allocated between rate and volume variance.

	Three Months Ended									Six Months Ended
	June 30,									June 30,
	2005 vs. 2004									2005 vs. 2004
	Increase (decrease)									Increase (decrease)
	Due to change in									Due to change in
							Net									Net
(Dollars in thousands)	Rate			Volume			Change			Rate			Volume			Change
Interest income:
U.S. Treasury and agencies	$	(5	)	$	208		$	203		$	(47	)	$	425		$	378
Mortgage-backed securities	11			(13		)	(2		)	10			(16		)	(6		)
Equity securities	(1		)	(12		)	(13		)	12			(18		)	(6		)
State and political subdivision securities	3			(2		)	1			1			(3		)	(2		)
Corporate bonds	36			—			36			44			—			44
Loans	779			472			1,251			980			1,117			2,097
FHLB stock	15			3			18			23			6			29
Interest bearing deposits	76			17			93			163			(32		)	131
Total interest earning assets	914			673			1,587			1,186			1,479			2,665
Interest expense:
Savings accounts	110			—			110			177			(33		)	144
NOW and money market accounts	304			34			338			525			104			629
Certificates of deposit and other time deposits	(57		)	227			170			(377		)	389			12
FHLB advances	46			(17		)	29			55			(10		)	45
Trust Preferred Securities	50			—			50			84			—			84
Total interest bearing liabilities	453			244			697			464			450			914
Net change in net interest income	$	461		$	429		$	890		$	722		$	1,029		$	1,751

Non-Interest Income-Non-interest income decreased $285,000, or 13% for the quarter ended June 30, 2005 to $2.0 million compared to $2.3 million for the same quarter in 2004.  For the six months ended, non-interest income decreased $34,000 to $4.0 million.  The decreased level of non-interest income during 2005 was primarily related to lower recorded gains on the sale of real estate held for development and decreased gains on the sale of mortgage loans. Offsetting these decreases was an increase in gain on the sale of investment securities.

During the second quarter of 2005, we recorded a $143,000 gain from the sale of a lot previously held for development compared to a $371,000 gain on the sale of land and two lots held for development for the same period in 2004, resulting in a $228,000 decrease in non-interest income for the second quarter.  Gain on sale of mortgage loans decreased $76,000 for the quarter and $111,000 for the six months ended June 30, 2005 resulting from lower origination volume.  Offsetting these decreases was a $381,000 increase in gain on the sale of investment securities for the 2005 six-month period.

Non-Interest Expense - Non-interest expense increased $260,000 or 5% during the quarter ended June 30, 2005 and $966,000, or 10% for the six months ended June 30, 2005 compared to the same periods in 2004.

The primary factors impacting non-interest expense include additional operating and employee compensation expenses relating to the recent retail expansion efforts.  Employee compensation and benefits, the largest component of non-interest expense, increased $199,000 and $579,000 for the respective three and six-month periods.  Twenty-one retail staff positions were added for the expansion into the Louisville market, coupled with expanded facilities in Hardin County and Bullitt County, Kentucky.  Additional increases in staff have taken place during 2004 and 2005 as we strengthen our retail sales culture and provide expanded products and services to our retail and commercial customers.

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We anticipate the increased level on non-interest expense to continue during 2005 with continued retail expansion and market share protection efforts.  We intend to start construction on a new full service-banking center in Elizabethtown, KY during 2005 with plans of opening in early 2006.  We are also considering other possible locations within the core market area to protect and grow our 21% market share.

Despite the increase in non-interest expense for 2005, we maintained an efficiency ratio of 60% for the six months ended June 30, 2005 and 2004.

ANALYSIS OF FINANCIAL CONDITION

Total assets at June 30, 2005 increased to $751.8 million compared to $737.6 million at December 31, 2004, an increase of $14.2 million.  The increase was primarily driven by an increase in investment securities of $19.4 million and an increase in net loans receivable of $2.8 million.  The growth in investment securities and loans was principally funded with cash and cash equivalents, which decreased by $9.8 million, and deposits, which increased by $12.1 million.

Loans Receivable

Net loans receivable increased $2.8 million to $602.2 million at June 30, 2005 compared to $599.4 million at December 31, 2004.  Our commercial and commercial real estate portfolios increased $13.6 million to $360 million at June 30, 2005.  For the 2005 period, these loans comprised 59% of the total loan portfolio compared to 57% at December 31, 2004, and 54% at June 30, 2004.  While the loan growth in the first six months of 2005 was slower than recent quarters, we expect the favorable trend, which has generated a 4% compound annual growth rate in the total loan portfolio to continue for 2005.

Offsetting this growth was a $9.8 million, or 6.1% decrease in the residential mortgage loan portfolio to $149.8 million at June 30, 2005, compared to $159.5 million at December 31, 2004.  For 2005, the decline in mortgage loans is expected to slow from the decreases experienced in 2003 and early 2004.  Also, contributing to the decrease was a $1.1 million decline in consumer loans.

Allowance and Provision for Loan Losses

Our financial performance depends on the quality of the loans we originate and management’s ability to assess the degree of risk in existing loans when it determines the allowance for loan losses.  An increase in loan charge-offs or non-performing loans or an inadequate allowance for loan losses could reduce net interest income, net income and capital and limit the range of products and services we can offer.

The Executive Loan Committee evaluates the allowance for loan losses quarterly to maintain a level sufficient to absorb probable incurred credit losses existing in the loan portfolio.  Periodic provisions to the allowance are made as needed.  The allowance is determined based on the application of loss estimates to graded loans by categories.  The amount of the provision for loan losses necessary to maintain an adequate allowance is also based upon an analysis of such factors as changes in lending policies and procedures; underwriting standards; collection; charge-off and recovery history; changes in national and local economic business conditions and developments; changes in the characteristics of the portfolio; ability and depth of lending management and staff; changes in the trend of the volume and severity of past due, non-accrual and classified loans; troubled debt restructuring and other loan modifications; and results of regulatory examinations.

The methodology for allocating the allowance for loan and lease losses takes into account our strategic plan to increase our emphasis on commercial and consumer lending.  We increase the amount of the allowance allocated to commercial loans and consumer loans in response to the growth of the commercial and consumer loan portfolios and management’s recognition of the higher risks and loan losses in these lending areas.  The indirect consumer loan program is comprised of new and used automobile, motorcycle and all terrain vehicle loans originated on our behalf by a select group of auto dealers within our service area.   The indirect loan program involves a greater degree of risk and is evaluated quarterly and monitored by the Board of Directors.  In light of the greater charge-offs from indirect consumer loans compared to direct consumer loans, proportionally more of the allowance for consumer loans is allocated for indirect loans than direct loans.  As the indirect loan program has evolved, dealer analysis and underwriting standards have been refined to improve the loan loss experience of the program.  Estimating the allowance is a continuous process.  In this regard, the Executive Loan Committee continues to monitor the performance of indirect consumer loans as well as our other loan products and updates estimates as the evidence warrants.

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The following table sets forth an analysis of the Bank’s loan loss experience for the periods indicated.

	Three Months Ended				Six Months Ended
	June 30,				June 30,
(Dollars in thousands)	2005		2004		2005			2004
Balance at beginning of period	$	6,701	$	5,733	$	6,489		$	5,568
Loans charged-off:
Real estate mortgage	—		—		4			41
Consumer	106		177		242			407
Commercial	—		42		—			42
Total charge-offs	106		219		246			490
Recoveries:
Real estate mortgage	—		—		1			—
Consumer	78		49		154			96
Commercial	—		—		—			—
Total recoveries	78		49		155			96
Net loans charged-off	28		170		91			394
Provision for loan losses	41		259		316			648
Balance at end of period	$	6,714	$	5,822	$	6,714		$	5,822
Allowance for loan losses to total loans (excluding loans held for sale)					1.10		%	1.00		%
Net charge-offs to average loans outstanding					0.02		%	0.07		%
Allowance for loan losses to total non-performing loans					138		%	134		%

The provision for loan losses decreased $218,000, or 84% to $41,000 for the quarter ended June 30, 2005, and $332,000, or 51% to $316,000 for the six months ended June 30, 2005 compared to the same periods in 2004.  The decrease in the provision was related to slower loan growth in the commercial loan portfolio for 2005 compared to a year ago, as well as, a decrease in net charge-offs for the same periods. The total allowance for loan losses increased $892,000 to $6.7 million from June 30, 2004 to June 30, 2005. The increase in the allowance was related to a $26.6 million increase in net loans receivable at June 30, 2005, compared to June 30, 2004, in conjunction with a $1.4 million increase in classified loans for the 2005 period compared to the 2004 period.Net loan charge-offs decreased $142,000 and $303,000 during the quarter and six-month periods ended June 30, 2005, compared to the 2004 respective periods.The decrease in charge-offs is primarily related to a decrease in charge-offs of indirect consumer loans during the periods.

Federal regulations require insured institutions to classify their own assets on a regular basis.  The regulations provide for three categories of classified loans -- substandard, doubtful and loss.  Assets classified as substandard or doubtful require the institution to establish general allowances for loan losses. If an asset or portion thereof is classified as loss, the insured institution must either establish specified allowances for loan losses in the amount of 100% of the portion of the asset classified loss, or charge off such amount.  At June 30, 2005, on the basis of management’s review of the loan portfolio, we had$6.8 million of assets classified substandard, $948,000 classified as doubtful, and $53,000 of assets classified as loss.At June 30, 2004, on the basis of management’s review of the loan portfolio, we had $5.2 million assets classified substandard, $1.1 million classified as doubtful, and $66,000 of assets classified as loss.

Loans are classified according to estimated loss as follows:  Substandard-2.5% to 35%; Doubtful-5% to 75%; and Loss-100%;. We additionally provide a reserve estimate for probable incurred losses in non-classified loans ranging from .20% to 6.00%.  Although we may allocate a portion of the allowance to specific loans or loan categories, the entire allowance is available for active charge-offs.  Allowance estimates are developed in consultation with regulatory authorities and actual loss experience adjusted for current economic conditions.  Allowance estimates are considered a prudent measurement of the risk in the loan portfolio and are applied to individual loans based on loan type.

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Non-Performing Assets

Non-performing assets consist of certain restructured loans for which interest rate or other terms have been renegotiated, loans on which interest is no longer accrued, real estate acquired through foreclosure and repossessed assets.   We do not have any loans greater than 90 days past due still on accrual.  Loans, including impaired loans under SFAS 114, are placed on non-accrual status when they become past due 90 days or more as to principal or interest, unless they are adequately secured and in the process of collection.  Loans are considered impaired if full principal or interest payments are not anticipated in accordance with the contractual loan terms.  Impaired loans are carried at the present value of expected future cash flows discounted at the loan’s effective interest rate or at the fair value of the collateral if the loan is collateral dependent.

Loans are reviewed on a regular basis and normal collection procedures are implemented when a borrower fails to make a required payment on a loan.  If the delinquency on a mortgage loan exceeds 90 days and is not cured through normal collection procedures or an acceptable arrangement is not worked out with the borrower, we institute measures to remedy the default, including commencing a foreclosure action.  Consumer loans generally are charged off when a loan is deemed uncollectible by management and any available collateral has been disposed of.  Commercial business and real estate loan delinquencies are handled on an individual basis by management with the advice of legal counsel.

Interest income on loans is recognized on the accrual basis except for those loans in a non-accrual of income status. The accrual of interest on impaired loans is discontinued when management believes, after consideration of economic and business conditions and collection efforts that the borrowers’ financial condition is such that collection of interest is doubtful, typically after the loan becomes 90 days delinquent.  When interest accrual is discontinued, existing accrued interest is reversed and interest income is subsequently recognized only to the extent cash payments are received.

Real estate acquired as a result of foreclosure or by deed in lieu of foreclosure is classified as real estate owned until such time as it is sold. New and used automobile, motorcycle and all terrain vehicles acquired as a result of foreclosure are classified as repossessed assets until they are sold. When such property is acquired it is recorded at the lower of the unpaid principal balance of the related loan or its fair market value.  Any write-down of the property at the time of acquisition is charged to the allowance for loan losses.  Subsequent gains and losses are included in non-interest income and non-interest expense.

The following table sets forth information with respect to non-performing assets for the periods indicated.

		June 30,			December 31,
(Dollar in thousands)		2005			2004
Restructured		$	3,166		$	3,218
Past due 90 days still on accrual		—			—
Loans on non-accrual status		1,725			2,022
Total non-performing loans		4,891			5,240
Real estate acquired through foreclosure		1,034			681
Other repossessed assets		38			40
Total non-performing assets		$	5,963		$	5,961
Interest income that would have been earned on non-performing loans		$	331		$	336
Interest income recognized on non-performing loans		212			197
Ratios:	Non-performing loans to total loans (excluding loans held for sale)	0.80		%	0.87		%
	Non-performing assets to total loans (excluding loans held for sale)	0.98		%	0.99		%

Included in non-performing assets for the 2005 period is $3.2 million in restructured commercial and residential mortgage loans.The restructured loans primarily consist of three credit relationships aggregating $2.9 million, including a $2.2 million commercial relationship, a $213,000 commercial relationshipand a $456,000 residential mortgage relationship.  The terms of these loans have been renegotiated to reduce the rate of interest and extend the term thus reducing the amount of cash flow required from the borrower to service the loans.  The terms of the restructured loans are currently being met.

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Investment Securities

Interest on securities provides us our largest source of interest income after interest on loans, constituting 6.6% of the total interest income for the six-months ended June 30, 2005.  The securities portfolio serves as a source of liquidity and earnings and contributes to the management of interest rate risk.  We have the authority to invest in various types of liquid assets, including short-term United States Treasury obligations and securities of various federal agencies, obligations of states and political subdivisions, corporate bonds, certificates of deposit at insured savings and loans and banks, bankers’ acceptances, and federal funds.  We may also invest a portion of our assets in certain commercial paper and corporate debt securities.  We are also authorized to invest in mutual funds and stocks whose assets conform to the investments that we are authorized to make directly. The available-for-sale and held-to-maturity investment portfolios increased by $19.4 million or 34% during the 2005 period due to investments in U.S. agencies, mortgage-backed securities and a corporate bond.  We also sold $1.4 million in securities available-for-sale during the 2005 period due to one of our equity investments de-listing from the NASDAQ National Market System.

Deposits

We rely primarily on customer service and long-standing relationships with customers to attract and retain deposits. Market interest rates and rates on deposit products offered by competing financial institutions can significantly affect our ability to attract and retain deposits. During the period ended June 30, 2005, total deposits increased by $12.1 million compared to December 31, 2004. The increase in retail deposits was primarily in non-interest bearing demand accounts, savings accounts and certificate of deposit balances.  A new money market promotion generated $37.5 million for the June 2005 quarter.  However, we also experienced a shifting of certain deposits from a money market account to a savings account during the quarter, which reduced the balance in money market accounts. We plan to continue our deposit gathering initiatives by utilizing pricing strategies and offering competitive products in our existing markets.

The following table breaks down our deposits.

	June 30,			December 31,
	2005			2004
	(In Thousands)
Non-interest bearing	$		43,239	$	38,441
NOW demand	71,897			73,801
Savings	100,485			78,499
Money market	69,070			85,418
Certificates of deposit	313,810			310,227
	$	598,501		$		586,386

LIQUIDITY

Liquidity risk arises from the possibility we may not be able to satisfy current or future financial commitments, or may become unduly reliant on alternative funding sources. The objective of liquidity risk management is to ensure that the cash flow requirements of depositors and borrowers, as well as our operating cash needs, are met, taking into account all on- and off-balance sheet funding demands. Liquidity risk management also includes ensuring cash flow needs are met at a reasonable cost. We maintain an investment and funds management policy, which identifies the primary sources of liquidity, establishes procedures for monitoring and measuring liquidity, and establishes minimum liquidity requirements in compliance with regulatory guidance. The liquidity position is continually monitored and reviewed by the Asset Liability Committee.

Funds are available from a number of sources, including the sale of securities in the available-for-sale portion of the investment portfolio, principal paydowns on loans and mortgage-backed securities, proceeds realized from loans held for sale, brokered deposits and other wholesale funding. At June 30, 2005, we had brokered deposits totaling $500,000.  We also have secured federal funds borrowing lines from two of our correspondent banks totaling $10 million and $15 million respectively.Our banking centers also provide access to retail deposit markets.If large certificate depositors shift to our competitors or the stock market in response to interest rate changes, we have the ability to replenish those deposits through alternative funding sources.Traditionally, we have also utilized borrowings from the FHLB to supplement our funding requirements.  At June 30, 2005, we had an unused approved line of credit in the amount of $94.1 millionand sufficient collateral available to

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borrow, approximately, an additional$30million in advances from the FHLB.We believe our sources of liquidity are adequate to meet expected cash needs for the foreseeable future.

At the holding company level, the Corporation uses cash to pay dividends to stockholders, repurchase common stock, make selected investments and acquisitions, and service debt. The main sources of funding for the holding company include dividends and returns of investment from the Bank, a revolving credit agreement with an unaffiliated bank, and access to the capital markets.

CAPITAL

Stockholders’ equity increased $2.2 million for the period ended June 30, 2005 compared to December 31, 2004. The increase in capital was primarily attributable to net income during the period.  This increase was offset by a decline in additional paid-in-capital due to the purchase of 22,000 shares of our own common stock and accumulated other comprehensive income, a result of temporary unrealized losses recorded on securities. Average stockholders’ equity to average assets ratio declined to 8.22% for the six-months ended June 30, 2005 compared to 8.26% for 2004.

In March 2002, a trust formed by First Financial Service Corporation completed the private placement of 10,000 shares of cumulative trust preferred securities with a liquidation preference of $1,000 per security.  The proceeds of the offering were loaned to us in exchange for floating rate junior subordinated deferrable interest debentures.  Distributions on the securities are payable quarterly at a rate per annum equal to the 3-month LIBOR plus 3.60%.  We undertook the issuance of these securities to enhance our regulatory capital position, as the securities are considered as Tier I capital under current regulatory guidelines.

Kentucky banking laws limit the amount of dividends that may be paid to First Financial Service Corporation by First Federal Savings Bank without prior approval of the Kentucky Office of Financial Institutions.  Under these laws, the amount of dividends that may be paid in any calendar year is limited to current year’s net income, as defined in the laws, combined with the retained net income of the preceding two years, less any dividends declared during those periods.At June 30, 2005, without prior regulatory approval, we had approximately $9.0 million of retained earnings that could be utilized for payment of dividends if authorized by our board of directors.

Each of the federal bank regulatory agencies has established minimum leverage capital requirements for banking organizations. Banking organizations must maintain a minimum ratio of Tier 1 capital to adjusted average quarterly assets equal to 3% to 5% subject to federal bank regulatory evaluation of an organization’s overall safety and soundness.  We intend to maintain a capital position that meets or exceeds the “well capitalized” requirements as defined by the FDIC.  The following table shows the ratios of Tier 1 capital and total capital to risk-adjusted assets and the leverage ratios for the Corporation and the Bank as of June 30, 2005.

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									To Be Considered
									Well Capitalized
									Under Prompt
					For Capital				Correction
	Actual				Adequacy Purposes				Action Provisions
(Dollars in thousands)	Amount		Ratio		Amount		Ratio		Amount		Ratio
As of June 30, 2005:
Total risk-based capital (to risk- weighted assets)
Consolidated	$	70,206	11.7	%	$	47,935	8.0	%	$	59,919	10.0	%
Bank	68,683		11.5		47,805		8.0		59,756		10.0
Tier I capital (to risk-weighted assets)
Consolidated	63,244		10.6		23,967		4.0		35,951		6.0
Bank	61,721		10.3		23,902		4.0		35,853		6.0
Tier I capital (to average assets)
Consolidated	63,244		8.5		29,765		4.0		37,206		5.0
Bank	61,721		8.3		29,708		4.0		37,135		5.0

									To Be Considered
									Well Capitalized
									Under Prompt
					For Capital				Correction
	Actual				Adequacy Purposes				Action Provisions
(Dollars in thousands)	Amount		Ratio		Amount		Ratio		Amount		Ratio
As of December 31, 2004:
Total risk-based capital (to risk- weighted assets)
Consolidated	$	67,798	11.6	%	$	46,793	8.0	%	$	58,492	10.0	%
Bank	65,087		11.2		46,600		8.0		58,250		10.0
Tier I capital (to risk-weighted assets)
Consolidated	61,029		10.4		23,397		4.0		35,095		6.0
Bank	58,318		10.0		23,300		4.0		34,950		6.0
Tier I capital (to average assets)
Consolidated	61,029		8.5		28,860		4.0		36,075		5.0
Bank	58,318		8.1		28,762		4.0		35,953		5.0

FORWARD-LOOKING STATEMENTS

Statements contained in this report that are not statements of historical fact constitute forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended.  In addition, the Corporation may make forward-looking statements in future filings with the Securities and Exchange Commission, in press releases, and in oral and written statements made by or with the approval of the Corporation.  Forward-looking statements include, but are not limited to: (1) projections of revenues, income or loss, earnings or loss per share, capital structure and other financial items; (2) statements of plans and objectives of the Corporation or its management or Board of Directors; (3) statements regarding future events, actions or economic performance; and (4) statements of assumptions underlying such statements.  Words such as “estimate,” “strategy,” “believes,” “anticipates,” “expects,” “intends,” “plans,” “targeted,” and similar expressions are intended to identify forward-looking statements, but are not the exclusive means of identifying such statements.

Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those indicated by the forward-looking statements.  See “Business Risks” above for an analysis of some of these risks and uncertainties.  Some of the events or circumstances that could cause such differences include the following: changes in general economic conditions and economic conditions in Kentucky and the markets served by the Corporation any of which may affect, among other things, the level of non-performing assets, charge-offs, and provision expense; changes in the interest rate environment which may reduce interest margins and impact funding sources; changes in market rates and prices which may adversely impact the value of financial products including securities, loans and deposit; changes in tax laws, rules and regulations; various monetary and fiscal policies and regulations, including those determined by the Federal Reserve Board, the Federal Deposit Insurance Corporation and the Kentucky Office of Financial Institutions; competition with other local and

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regional commercial banks, savings banks, credit unions and other non-bank financial institutions; ability to grow core businesses; ability to develop and introduce new banking-related products, services and enhancements and gain market acceptance of such products; and management’s ability to manage these and other risks.

Item 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Asset/Liability Management and Market Risk

To minimize the volatility of net interest income and exposure to economic loss that may result from fluctuating interest rates, we manage our exposure to adverse changes in interest rates through asset and liability management activities within guidelines established by our Asset Liability Committee (“ALCO”).  The ALCO, which includes senior management representatives, has the responsibility for approving and ensuring compliance with asset/liability management polices.  Interest rate risk is the exposure to adverse changes in the net interest income as a result of market fluctuations in interest rates.  The ALCO, on an ongoing basis, monitors interest rate and liquidity risk in order to implement appropriate funding and balance sheet strategies.  Management considers interest rate risk to be our most significant market risk.

We utilize an earnings simulation model to analyze net interest income sensitivity.  Potential changes in market interest rates and their subsequent effects on net interest income are then evaluated.  The model projects the effect of instantaneous movements in interest rates of both 100 and 200 basis points.  Assumptions based on the historical behavior of our deposit rates and balances in relation to changes in interest rates are also incorporated into the model.  These assumptions are inherently uncertain and, as a result, the model cannot precisely measure future net interest income or precisely predict the impact of fluctuations in market interest rates on net interest income.  Actual results will differ from the model’s simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and the application and timing of various management strategies.

Our interest sensitivity profile was asset sensitive at both June 30, 2005 and December 31, 2004.  Given a sustained 100 basis point decrease in rates, our base net interest income would decrease by an estimated 6.11% at June 30, 2005 compared to a decrease of 2.38% at December 31, 2004.  Given a 100 basis point increase in interest rates our base net interest income would increase by an estimated 5.54% at June 30, 2005 compared to an increase of 2.19% at December 31, 2004.

Our interest sensitivity at any point in time will be affected by a number of factors.  These factors include the mix of interest sensitive assets and liabilities as well as their relative pricing schedules.  It is also influenced by market interest rates, deposit growth, loan growth, decay rates and prepayment speed assumptions.

As demonstrated by the June 30, 2005 and December 31, 2004 sensitivity tables presented below, we are continuing to transition away from a liability sensitive to an asset sensitive position as compared to prior periods in anticipation of rising interest rates for the next several months. The change in our asset sensitivity is a result of changes in the loan portfolio to a greater extent than changes in the investment portfolio.  While lending practices have shifted to shorter term, variable rate commercial and consumer loans, that impact will be evidenced in smaller degrees over time.

Our sensitivity to interest rate changes is presented based on data as of June 30, 2005 and December 31, 2004 annualized to a one year period.

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	June 30, 2005
	Decrease in Rates								Increase in Rates
	200			100					100			200
(Dollars in thousands)	Basis Points			Basis Points			Base		Basis Points			Basis Points
Projected interest income
Loans	$	39,189		$	41,970		$	44,608	$	47,175		$	49,660
Investments	2,466			3,340			3,955		4,461			4,971
Total interest income	41,655			45,310			48,563		51,636			54,631
Projected interest expense
Deposits	9,973			11,148			12,382		13,616			14,850
Borrowed funds	4,271			4,351			4,431		4,511			4,591
Total interest expense	14,244			15,499			16,813		18,127			19,441
Net interest income	$	27,411		$	29,811		$	31,750	$	33,509		$	35,190
Change from base	$	(4,339	)	$	(1,939	)			$	1,759		$	3,440
% Change from base	(13.67		)%	(6.11		)%			5.54		%	10.83		%

	December 31, 2004
	Decrease in Rates								Increase in Rates
	200			100					100			200
(Dollars in thousands)	Basis Points			Basis Points			Base		Basis Points			Basis Points
Projected interest income
Loans	$	38,503		$	39,834		$	40,943	$	41,960		$	42,995
Investments	1,963			2,332			2,517		2,667			2,820
Total interest income	40,466			42,166			43,460		44,627			45,815
Projected interest expense
Deposits	10,215			10,805			11,395		11,914			12,433
Borrowed funds	4,262			4,307			4,352		4,393			4,434
Total interest expense	14,477			15,112			15,747		16,307			16,867
Net interest income	$	25,989		$	27,054		$	27,713	$	28,320		$	28,948
Change from base	$	(1,724	)	$	(659	)			$	607		$	1,235
% Change from base	(6.22		)%	(2.38		)%			2.19		%	4.46		%

Item 4.  CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures

Our management evaluated, with the participation of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective as of the end of the period covered by this Quarterly Report on Form 10-Q to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

Changes in internal control over financial reporting

There was no change in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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Part II - -  OTHER INFORMATION

Item 1.Legal Proceedings

Although, from time to time, we are involved in various legal proceedings in the normal course of business, there are no material pending legal proceedings to which we are a party, or to which any of our property is subject.

Item 2.Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

(e)  Issuer Purchases of Equity Securities

The following table provides information as of June 30, 2005 with respect to shares of Common Stock repurchased by the Company during the quarter then ended:

				Total number of	Maximum number
				shares purchased	of shares that
	Total number	Average		as part of publicly	may yet be purchased
	of shares	price paid per		announced plans	under the plans or
Period	purchased	share		or programs	programs
04/01/05-04/30/05	—	—		—	193,645
05/01/05-04/31/05	4,000	$	26.15	4,000	189,645
06/01/05-06/30/05	18,000	$	25.95	18,000	171,645
Total	22,000	$	25.99	22,000	171,645

Item 3.Defaults Upon Senior Securities

Not Applicable

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

Our 2005 Annual Meeting of Shareholders was held on May 11, 2005.  At the meeting, the directors listed below were elected as directors of the Corporation for terms expiring at the annual meeting in the year set forth to each of their names.  The voting results for the matters brought before the 2005 Annual Meeting are as follows:

1.  Election of Directors.

Name	Term Expires	Votes For	Abstentions	Broker Non-Votes
Wreno M. Hall	2008	2,414,351	15,605	-
Walter D. Huddleston	2008	2,452,821	15,440	-
J. Stephen Mouser	2008	2,439,165	16,640	-
Michael L. Thomas	2008	2,438,885	15,440	-

In addition, the following directors will continue in office until the annual meeting of the year set forth beside each of their names.

Name	Term Expires
Robert M. Brown	2007
B. Keith Johnson	2006
Diane E. Logsdon	2006
John L. Newcomb, Jr	2006
Donald Scheer	2006
Gail L. Schomp	2007
J. Alton Rider	2007

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Item 5.Other Information

None

Item 6.Exhibits:

31.1  Certification of Chief Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act

31.2  Certification of Chief Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act

32     Certification of Chief Executive Officer and Chief Financial Officer Pursuant to Section 18 U.S.C. Section 1350 (As Adopted Pursuant to Section 906 of the Sarbanes-  Oxley Act of 2002)

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FIRST FINANCIAL SERVICE CORPORATION

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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.

DATE: August 9, 2005	BY: (S)	B. Keith Johnson
		B. Keith Johnson
		President and Chief Executive Officer
DATE: August 9, 2005	BY: (S)	Gregory S. Schreacke
		Gregory S. Schreacke
		Chief Financial Officer
		Principal Accounting Officer

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INDEX TO EXHIBITS

Exhibit No.	Description
31.1	Certification of Chief Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act
31.2	Certification of Chief Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act
32	Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 (As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002)

31