Item 2 - Management's Discussion and Analysis of Consolidated Results of Operations and Financial Condition

RESULTS OF OPERATIONS

OVERVIEW

Net income for the three months ended June 30, 1999 was $1,628,000, a 17.1% increase over the $1,390,000 reported in the second quarter of 1998. Basic and diluted earnings per share for the second quarter of 1999 increased 17.4% and 17.8% to $0.54 and $0.53, respectively, compared to $0.46 and $0.45, respectively, for the second quarter of 1998.

Net income for the six months ended June 30, 1999 was $3,104,000, a 15.1% increase over the $2,696,000 reported for the first six months of 1998. Basic earnings per share for the six months ended June 30, 1999 increased 15.7% to $1.03 per share compared to $0.89 per share reported for the same six month period in 1998. Earnings per share on a diluted basis amounted to $1.01 per share for the six months ended June 30, 1999, a 16.1% increase over the $0.87 per share for the same six months of 1998.

The increase in net income for the three and six month periods ended June 30, 1999 is primarily due to an increase in net interest income earned by the Company. Net interest income increased 11.3% and 10.3% for the three and six month periods ended June 30, 1999, respectively, when compared to the same three and six month periods of 1998. The increases in net interest income are largely attributable to loan and deposit growth, the effects of which were partially offset by lower net interest margins. The changes in the provisions for loan losses among the periods presented did not have a material impact on net income. The provisions for loans losses amounted to $260,000 and $460,000 for the three and six month periods ended June 30, 1999, respectively, compared to $210,000 and $490,000 for the three and six month periods ended June 30, 1998, respectively.

Noninterest income increased 21.0% and 15.2% for the three and six month periods ended June 30, 1999, respectively, when compared to the same periods of 1998. The increases in noninterest income were a result of increases experienced in most categories of fees and charges as a result of the larger customer base compared to the prior year and a slightly higher fee structure that was implemented in March 1999. Noninterest expenses increased by 10.7% and 9.9% for the three and six month periods ended June 30, 1999, respectively, when compared to the same periods of 1998, due primarily to the increase in the Company's branch network, as well as additional expenses necessary to process, manage, and service the Company's significant increases in its loan and deposit bases.

COMPONENTS OF EARNINGS

Net interest income is the largest component of earnings, representing the difference between interest and fees generated from earning assets and the interest costs of deposits and other funds needed to support those assets. Net interest income for the three and six month periods ended June 30, 1999 amounted to $5,743,000 and $11,189,000, respectively, increases of $585,000 and $1,041,000, or 11.3% and 10.3%, over the amounts of $5,158,000 and $10,148,000 recorded in the same three and six month periods in 1998, respectively. The increases in net interest income have been due to the growth in the Company's loans and deposits, the effects of which were partially offset by a lower net interest margin experienced in 1999. Loans increased from $328.7 million at June 30, 1998 to $387.8 million at June 30, 1999, an increase of 18.0%, while deposits increased from $395.6 million at June 30, 1998 to $451.4 million at June 30, 1999, an increase of 14.1%.

Partially offsetting the positive effects on net interest income associated with the loan and deposit growth was a decrease in the Company's net interest margin. The Company's net interest margin was 5.04% for the second quarter of 1999 compared to 5.30% for the second quarter of 1998, a decrease of 26 basis points. For the six months ended June 30, 1999, the Company's net interest margin was 5.00%, a 42 basis point decrease from

the 5.42% margin realized in the first half of 1998. The Company experienced decreases in both the yield earned on interest earning assets and the rate paid on interest bearing liabilities during the periods presented, primarily due to the 75 basis point decrease in the prime rate that occurred in the fourth quarter of 1998. However, the average decrease in the yield earned on interest earning assets exceeded the decrease in the average rate paid on interest bearing liabilities primarily because the Company aggressively priced its deposits to facilitate the growth necessary to fund the strong demand in loans.

The following table presents average rates earned/paid by the Company for the three and six months ended June 30, 1999 compared to the same periods in 1998:

                                                     For the Three    For the Three         For the Six       For the Six
                                                     Months Ended      Months Ended         Months Ended     Months Ended
                                                     June 30, 1999    June 30, 1998        June 30, 1999     June 30, 1998
                                                     -------------    -------------        -------------     -------------
Yield on loans                                           8.74%            9.35%                8.77%             9.45%
Yield on taxable securities                              5.68%            6.40%                5.63%             6.67%
Yield on tax-exempt securities (tax equivalent)          8.23%            8.71%                8.42%             8.82%
Yield on other interest earning assets,
   primarily overnight funds                             5.21%            5.53%                5.13%             5.62%
Yield on all interest earning assets                     8.25%            8.81%                8.25%             8.92%

Weighted average rate on savings, NOW,
   and money market deposits                             1.94%            2.37%                1.97%             2.37%
Rate on time deposits>$100,000                           5.49%            5.88%                5.56%             5.87%
Rate on other time deposits                              4.98%            5.37%                5.06%             5.37%
Rate on short-term borrowings                            5.12%             n/a                 4.98%              n/a
Rate on all interest bearing liabilities                 3.81%            4.21%                3.86%             4.18%

Interest rate spread                                     4.44%            4.60%                4.40%             4.74%
Net interest margin                                      5.04%            5.30%                5.00%             5.42%
Average prime rate                                       7.75%            8.50%                7.75%             8.50%

See additional discussion regarding interest rate risk below in Item 3 - Quantitative and Qualitative Disclosures About Market Risk.

The provision for loan losses for the second quarter of 1999 was $260,000, $50,000 higher than the $210,000 recorded in the same quarter of 1998. The increase in the provision for loan losses was impacted by strong loan growth and also $52,000 higher net charge-offs in the second quarter of 1999 ($110,000) compared to the same quarter of 1998 ($58,000). The $460,000 provision for loan losses recorded for the six months ended June 30, 1999 was $30,000, or 6.1%, lower than the $490,000 recorded for the same six months of 1998. The decrease in the provision for loan losses in 1999 was impacted by the lower loan growth experienced during the first half of 1999 compared to the first half of 1998, the effects of which were partially offset by slightly weaker asset quality ratios at June 30, 1999 compared to June 30, 1998.

Total noninterest income increased $227,000, or 21.0%, to $1,310,000 in the second quarter of 1999 from the $1,083,000 recorded in the second quarter of 1998. Noninterest income for the first half of 1999 increased $345,000, or 15.2%, to $2,618,000 compared to $2,273,000 for the first half of 1998. The increase in noninterest income for the three and six month periods in 1999 compared to the same periods in 1998 is primarily due to the following factors:
1) increases in service charges earned on deposit accounts caused by the increase in the Company's deposit base, as well as a slightly higher fee schedule that was implemented in March 1999, 2) higher fees from presold mortgages which have been driven by high levels of refinancings as a result of lower mortgage loan rates in 1999, and 3) higher levels of other service charges, commissions, and fees caused primarily by the Company's larger customer base. This category of noninterest income includes items such as safety deposit box rentals, check cashing fees, merchant card income, and ATM surcharges.

The Company has recorded $10,000 of noninterest income in each of the first two quarters in 1999 related to data processing services provided to two de novo banks in the area. The Company's data processing subsidiary, Montgomery Data Services, Inc. (Montgomery Data) makes its excess data processing capabilities available to area financial institutions for a fee. Montgomery Data did not have any nonaffiliated customers from December 1997 to December 1998. In December 1998, a contract was signed to provide data processing for a nearby de novo bank. This customer is expected to contribute approximately $40,000 in fees during 1999. In May 1999, another contract was signed with a de novo bank, which is expected to contribute approximately $12,000 in annual fees. Montgomery Data is not aggressively marketing this service and has no other prospective customers at this time.

Loan and security gains amounted to $17,000 and $22,000 for the three and six months ended June 30, 1999, compared to a loss of $3,000 for the second quarter of 1998 and a net $144,000 gain for the first six months of 1998. In first quarter of 1998 the Company realized a gain of $147,000 from the sale of approximately $3 million in newly originated commercial loans that were sold in order to assist the Company in keeping a proper balance between the amount of loans and deposits that the Company maintains. Similar sales that may also result in gains (or losses) may be made in the future depending on the circumstances.

Noninterest expenses for the second quarter of 1999 amounted to $4,307,000, a 10.7% increase over the $3,892,000 recorded in the second quarter of 1998. Noninterest expenses for the first half of 1999 totaled $8,582,000, a 9.9% increase over the $7,810,000 recorded in the first half of 1998. The 1999 increases are primarily associated with the higher expenses that are necessary to properly process, manage, and service the increases in loans and deposits experienced by the Company. Also contributing to the increase in noninterest expenses was the continued expansion of the Company's branch network and the annual wage increases that are granted to substantially all employees in January of each year. The $33,000 increase in other operating expenses for the six months ended June 30, 1999 compared to 1998 shown in the table below was also due to generally higher operating expenses associated with the Company's growth that were largely offset by approximately $150,000 in fewer non-credit losses experienced by the Company during the first quarter of 1999 compared to the first quarter of 1998. Non-credit losses include miscellaneous operating losses experienced by the Company such as robbery losses. The following table presents the significant components of the Company's noninterest expenses for the three and six month periods ended June 30, 1999 compared to the same periods in 1998.

Noninterest Expenses                          Three Months Ended June 30,               Six Months Ended June 30,
--------------------                          ---------------------------              ----------------------------
(In thousands)                                 1999                1998                 1999                  1998
                                              -----                ----                 ----                  ----
Salaries                                     $ 1,935               1,720                3,801                 3,445
Employee benefits                                471                 402                  950                   775
                                             -------             -------              -------               -------
     Total personnel expense                   2,406               2,122                4,751                 4,220
Net occupancy expense                            282                 242                  579                   488
Equipment related expenses                       264                 216                  519                   435
Amortization of intangible assets                159                 164                  318                   328
Stationery and supplies                          211                 196                  414                   382
Telephone                                        122                 107                  230                   219
Other operating expenses                         863                 845                1,771                 1,738
                                             -------             -------              -------               -------
          Total                              $ 4,307               3,892                8,582                 7,810
                                             =======             =======              =======               =======
Noncash expenses included above
- consists of amortization of
intangible assets and fixed                  $   383                 347                  754                   691
asset depreciation                           =======             =======              =======               =======

Income taxes recorded for the three months ended June 30, 1999 amounted to $858,000, a 14.6% increase over the $749,000 recorded for the same three months of 1998. Income taxes recorded for the first half of 1999 amounted to $1,661,000, a 16.6% increase over the $1,425,000 recorded in the first half of 1998. The effective tax rate for all periods presented was approximately 35%. During the second quarter of 1999, the Company made certain investments that are expected ultimately to eliminate substantially all state income taxes paid by the Company. The effect on net income from this expected reduction in state income taxes will be largely offset in 1999 by the implementation costs associated with the investments. The Company paid $413,000 in state income taxes in 1998.

FINANCIAL CONDITION

The Company's total assets were $526.3 million at June 30, 1999, an increase of $87.5 million, or 19.9%, from the $438.8 million at June 30, 1998. Interest-earning assets increased by 20.9%, from $407.4 million at June 30, 1998 to $492.3 million at June 30, 1999. Loans, the primary interest-earning asset, grew from $328.7 million at June 30, 1998 to $387.8 million at June 30, 1999, an increase of $59.0 million, or 18.0%. Deposits increased $55.7 million, or 14.1%, supporting the asset growth. The increases in deposits occurred in all significant categories, with noninterest bearing demand deposits increasing by $3.5 million, or 6.3%; savings, NOW and money market accounts increasing by $23.3 million, or 16.9%; time deposits of $100,000 or more increasing by $11.4 million, or 20.7%; and other time deposits increasing by $17.5 million, or 12.0%. The 20.7% increase in time deposits of $100,000 or more was due to the Company more aggressively pricing these deposits to provide funding for the strong loan growth experienced. The Company has not traditionally engaged in obtaining deposits through brokers and had no such deposits in 1999 or 1998. Since December 31, 1998, the Company has experienced annualized increases of 16.4%, 14.0%, and 5.0% in loans, total assets and deposits, respectively.

                                                      June 30,        December 31,         June 30,
($ in thousands)                                        1999              1998               1998
-------------------------------------------------  ----------------  ----------------  -----------------
Nonperforming loans:
   Nonaccrual loans                              $     621              601                346
   Restructured loans                                  254              248                253
                                                 ---------        ---------          ---------
Total nonperforming loans                              875              849                599
Other real estate                                      546              505                581
                                                 ---------        ---------          ---------

Total nonperforming assets                       $   1,421            1,354              1,180
                                                 =========        =========          =========

Nonperforming loans to total loans                   0.23%             0.24%              0.18%
Allowance for loan losses to
   nonperforming loans                             665.37%           648.29%            861.44%
Nonperforming assets as a percentage of
   loans and other real estate                       0.37%             0.38%              0.36%
Nonperforming assets to total assets                 0.27%             0.28%              0.27%
Allowance for loan losses to total loans             1.50%             1.54%              1.57%

Management has reviewed the collateral for the nonperforming assets, including nonaccrual loans, and has included this review among the factors considered in the evaluation of the allowance for loan losses discussed below.

A loan is placed on nonaccrual status when, in management's judgment, the collection of interest appears doubtful. The accrual of interest is discontinued on all loans that become 90 days past due with respect to principal or interest. While a loan is on nonaccrual status, the Company's policy is that all cash receipts are applied to principal. Once the recorded principal balance has been reduced to zero, future cash receipts are applied to recoveries of any amounts previously charged off. Further cash receipts are recorded as interest income to the extent that any interest has been foregone. Loans are removed from nonaccrual status when they become current as to both principal and interest and when concern no longer exists as to the collectability of principal or interest. In some cases, where borrowers are experiencing financial difficulties, loans may be restructured to provide terms significantly different from the originally contracted terms.

Nonperforming loans are defined as nonaccrual loans and restructured loans. As of June 30, 1999, December 31, 1998 and June 30, 1998, nonperforming loans were approximately 0.23%, 0.24%, and 0.18%, respectively, of the total loans outstanding at such dates. Although nonaccrual loans at June 30, 1999 were 79% higher than at June 30, 1998, the nonaccrual amount at June 30, 1999 of $621,000 is consistent with the amounts reported at each of the other quarter ends since March 31, 1998 and is considered low when compared to historical levels. The level of restructured loans and other real estate has also not varied by material amounts for the periods presented.

As of June 30, 1999, the borrower with the largest nonaccrual loan owed a balance of $130,000, while the average nonaccrual loan balance was approximately $28,000. If the nonaccrual loans and restructured loans as of June 30, 1999 and 1998 had been current in accordance with their original terms and had been outstanding throughout the six month periods (or since origination or acquisition if held for part of the six month periods), gross interest income in the amounts of approximately $30,000 and $17,000 for nonaccrual loans and $12,000 and $13,000 for restructured loans would have been recorded for the six months ended June 30, 1999 and 1998, respectively. Interest income on such loans that was actually collected and included in net income in the six months ended June 30, 1999 and 1998 amounted to approximately $8,000 and $3,000, respectively, for nonaccrual loans (prior to their being placed on nonaccrual status) and $11,000 and $14,000, respectively, for restructured loans.

A loan is considered to be impaired when, based on current information and events, it is probable the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. The value of impaired loans is measured using either 1) an estimate of the cash flows that the Company expects to receive from the borrower discounted at the loan's effective rate, or
2) in the case of a collateral-dependent loan, the estimated fair value of the collateral. While a loan is considered to be impaired, the Company's policy is that interest accrual is discontinued and all cash receipts are applied to principal. Once the recorded principal balance has been reduced to zero, future cash receipts are applied to recoveries of any amounts previously charged off. Further cash receipts are recorded as interest income to the extent that any interest has been foregone.

At June 30, 1999, December 31, 1998, and June 30, 1998 the recorded investment in loans considered to be impaired was $123,000, zero, and $29,000, respectively, all of which were on nonaccrual status. The related allowance for loan losses for these impaired loans was $18,000, zero, and $4,000, respectively. There were no impaired loans for which there was no related allowance. The average recorded investments in impaired loans during the six month period ended June 30, 1999, the year ended December 31, 1998, and the six months ended June 30, 1998 were approximately $70,000, $110,000, and $174,000, respectively. For the same periods, the Company recognized no interest income on those impaired loans during the period that they were considered to be impaired.

In addition to the nonperforming loan amounts discussed above, management believes that an estimated $1,600,000-$2,000,000 of loans that are currently performing in accordance with their contractual terms may potentially develop problems. These loans were considered in determining the appropriate level of the allowance for loan losses. See "Summary of Loan Loss Experience" below. Loans classified for regulatory purposes as loss, doubtful, substandard, or special mention that have not been disclosed in the problem loan amounts above do not represent or result from trends or uncertainties which management reasonably expects will materially impact future operating results, liquidity, or capital resources, or represent material credits about which management is aware of any information which causes management to have serious doubts as to the ability of such borrowers to comply with the loan repayment terms.

As of June 30, 1999, December 31, 1998 and June 30, 1998, the Company owned other real estate totaling approximately $546,000, $505,000, and $581,000, respectively, which consisted principally of several parcels of foreclosed real estate. The Company's management has reviewed recent appraisals of these properties and believes that their fair values, less estimated costs to sell, exceed their respective carrying values at the dates presented.

SUMMARY OF LOAN LOSS EXPERIENCE

The allowance for loan losses is created by direct charges to operations. Losses on loans are charged against the allowance in the period in which such loans, in management's opinion, become uncollectible. The recoveries realized during the period are credited to this allowance.

The factors that influence management's judgment in determining the amount charged to operating expense include past loan loss experience, composition of the loan portfolio, probable losses inherent in the portfolio and current economic conditions.

The Company uses a loan analysis and grading program to facilitate its evaluation of probable loan losses and the adequacy of its allowance for loan losses. In this program, risk grades are assigned by management and tested by the Company's internal audit department and an independent third party consulting firm. The testing program includes an evaluation of a sample of new loans, loans that management identifies as having credit weaknesses, loans past due 90 days or more, nonaccrual loans and any other loans identified during previous regulatory and other examinations.

The Company strives to maintain its loan portfolio in accordance with what management believes are conservative loan underwriting policies that result in loans specifically tailored to the needs of the Company's market areas. Every effort is made to identify and minimize the credit risks associated with such lending strategies. The Company has no foreign loans, few agricultural loans and does not engage in significant lease financing or highly leveraged transactions. Commercial loans are diversified among a variety of industries. The majority of Company's real estate loans are primarily various personal and commercial loans where real estate provides additional security for the loan. Collateral for virtually all of these loans is located within the Company's principal market area.

The provision for loan losses for the second quarter of 1999 was $260,000, $50,000 higher than the $210,000 recorded in the same quarter of 1998. The increase in the provision for loan losses was impacted by strong loan growth and also $52,000 higher net charge-offs in the second quarter of 1999 ($110,000) compared to the same quarter of 1998 ($58,000). The $460,000 provision for loan losses recorded for the six months ended June 30, 1999 was $30,000, or 6.1%, lower than the $490,000 recorded for the same six months of 1998. The decrease in the provision for loan losses in 1999 was impacted by the lower loan growth experienced during the first half of 1999 compared to the first half of 1998, the effects of which were partially offset by slightly weaker asset quality ratios at June 30, 1999 compared to June 30, 1998.

At June 30, 1999, the allowance for loan losses amounted to $5,822,000, compared to $5,504,000 at December 31, 1998 and $5,160,000 at June 30, 1998. At June 30, 1999, the allowance for loan losses was approximately 665% of total nonperforming loans, compared to corresponding percentages of 648% at December 31, 1998 and 861% at June 30, 1998. The allowance for loan losses was 1.50%, 1.54% and 1.67% of total loans as of June 30, 1999, December 31, 1998 and June 30, 1998, respectively.

Management believes the Company's reserve levels are adequate to cover probable loan losses on the loans outstanding as of each reporting date. It must be emphasized, however, that the determination of the reserve using the Company's procedures and methods rests upon various judgments and assumptions about economic conditions and other factors affecting loans. No assurance can be given that the Company will not in any particular period sustain loan losses that are sizable in relation to the amounts reserved or that subsequent evaluations of the loan portfolio, in light of conditions and factors then prevailing, will not require significant changes in the allowance for loan losses or future charges to earnings.

In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for loan losses and value of other real estate. Such agencies may require the Company to recognize adjustments to the allowance or the carrying value of other real estate based on their judgments about information available at the time of their examinations.

For the periods indicated, the following table summarizes the Company's balances of loans outstanding, average loans outstanding, changes in the allowance for loan losses arising from charge-offs and recoveries by category, and additions to the allowance for loan losses that have been charged to expense.

                                                                 Six Months            Year            Six Months
                                                                   Ended              Ended              Ended
                                                                  June 30,         December 31,         June 30,
($ in thousands)                                                    1999               1998               1998
                                                                ---------          ---------          ---------

Loans outstanding at end of period                              $ 387,755            358,334            328,743
                                                                =========          =========          =========
Average amount of loans outstanding                             $ 372,466            325,477            306,749
                                                                =========          =========          =========
Allowance for loan losses, at
   beginning of year                                                5,504              4,779              4,779

Loans charged off:
   Commercial, financial and agricultural                             (14)               (92)               (27)
   Real estate - mortgage                                            (101)               (97)               (44)
   Installment loans to individuals                                   (81)              (245)              (117)
                                                                ---------          ---------          ---------
       Total charge-offs                                             (196)              (434)              (188)
                                                                ---------          ---------          ---------
Recoveries of loans previously charged-off
   Commercial, financial and agricultural                               9                 51                 13
   Real estate - mortgage                                               4                 18                  4
   Installment loans to individuals                                    41                100                 62
                                                                ---------          ---------          ---------
       Total recoveries                                                54                169                 79
                                                                ---------          ---------          ---------

            Net charge-offs                                         (142)              (265)              (109)

Additions to the allowance charged to expense                         460                990                490
                                                                ---------          ---------          ---------

Allowance for loan losses, at end of period                     $   5,822              5,504              5,160
                                                                =========          =========          =========
Ratios:
   Net charge-offs (annualized) as a percent of
        average loans                                                0.08%              0.08%              0.07%
   Allowance for loan losses as a
        percent of  loans at end of period                           1.50%              1.54%              1.57%

LIQUIDITY

The Company's liquidity is determined by its ability to convert assets to cash or acquire alternative sources of funds to meet the needs of its customers who are withdrawing or borrowing funds, and to maintain required reserve levels, pay expenses and operate the Company on an ongoing basis. The Company's primary liquidity sources are net income from operations, cash and due from banks, federal funds sold and other short-term investments. The Company's securities portfolio is comprised almost entirely of readily marketable securities which could also be sold to provide cash. In addition, the Bank has the ability, on a short-term basis, to purchase $15 million in federal funds from other financial institutions and has a $50 million line of credit with the Federal Home Loan Bank (the "FHLB") that can provide short or long term financing. The Company has not historically had to rely on these sources of credit as a source of liquidity. The Company has experienced an increase in its loan to deposit ratio over the past two and a half years, from 74.9% at December 31, 1996, to 77.7% at December 31, 1997, to 81.4% at December 31, 1998, to 85.9% at June 30, 1999, as a result of the significant loan growth experienced. This strong loan growth has reduced the Company's liquidity sources. To further enhance available liquidity sources, during 1998 the Company increased its available line of credit with the FHLB from $36 million to $50 million. Since the third quarter of 1998, although the Company has not had any liquidity or funding difficulties, the Company has periodically made draws and repayments on this line of credit on an overnight basis to maintain liquidity ratios at internally targeted levels. At June 30, 1999, the Company had outstanding short-term borrowings totaling $28.0 million, while the average amount outstanding year to date was $4.0 million. The Company's management believes its liquidity sources are at an acceptable level and remain adequate to meet its operating needs.

CAPITAL RESOURCES

The Company is regulated by the Board of Governors of the Federal Reserve Board ("FRB") and is subject to securities registration and public reporting regulations of the Securities and Exchange Commission. The Company's banking subsidiary is regulated by the Federal Deposit Insurance Corporation ("FDIC") and the North Carolina State Banking Commission. The Company is not aware of any recommendations of regulatory authorities or otherwise which, if they were to be implemented, would have a material effect on its liquidity, capital resources, or operations.

The Company must comply with regulatory capital requirements established by the FRB and FDIC. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company must meet specific capital guidelines that involve quantitative measures of the Company's assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Company's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. These capital standards require the Company to maintain minimum ratios of "Tier 1" capital to total risk-weighted assets and total capital to risk-weighted assets of 4.00% and 8.00%, respectively. Tier 1 capital is comprised of total shareholders' equity calculated in accordance with generally accepted accounting principles less intangible assets, and total capital is comprised of Tier 1 capital plus certain adjustments, the largest of which for the Company is the allowance for loan losses. Risk-weighted assets refer to the on- and off-balance sheet exposures of the Company, adjusted for their related risk levels using formulas set forth in FRB and FDIC regulations.

In addition to the risk-based capital requirements described above, the Company is subject to a leverage capital requirement, which calls for a minimum ratio of Tier 1 capital (as defined above) to quarterly average total assets of 3.00% to 5.00%, depending upon the institution's composite ratings as determined by its regulators. The FRB has not advised the Company of any requirement specifically applicable to it.

In addition to the minimum capital requirements described above, the regulatory framework for prompt corrective action also contains specific capital guidelines for classification as "well capitalized," which are presented with the minimum ratios and the Company's ratios at June 30, 1999, December 31, 1998, and June 30, 1998 in the table below.

Although the Company continues to exceed even the regulatory thresholds for "well capitalized" status, the Company's capital ratios have been steadily declining with the strong growth the Company has experienced. The Company's Total Risk-Based Capital to Tier II Risk Adjusted Assets ratio of 10.66% at June 30, 1999, compared to the "well capitalized" threshold of 10.00%, is the only one of the three regulatory ratios that is within 200 basis points of falling below the "well capitalized" threshold. The Company has action plans in place to improve any ratio that falls below the "well capitalized" threshold.

As of June 30, 1999, December 31, 1998 and June 30, 1998, the Company was in compliance with all existing regulatory capital requirements, as summarized in the following table:

                                                   June 30,      December 31,      June 30,
          ($ in thousands)                           1999            1998           1998
                                                  ---------       ---------       ---------
Risk-Based and Leverage Capital
Tier I capital:
     Common shareholders' equity                  $  41,728          40,494          38,511
     Intangible assets                               (5,525)         (5,843)         (6,159)
     Unrealized loss (gain) on securities
          available for sale, net of taxes              650             (37)           (142)
                                                  ---------       ---------       ---------
               Total Tier I leverage capital         36,853          34,614          32,210
                                                  ---------       ---------       ---------

Tier II capital:
     Allowable allowance for loan losses              4,825           4,493           3,968
                                                  ---------       ---------       ---------
               Tier II capital additions              4,825           4,493           3,968
                                                  ---------       ---------       ---------
Total risk-based capital                          $  41,678          39,107          36,178
                                                  =========       =========       =========

Risk adjusted assets                              $ 390,884         365,288         323,779
Tier I risk-adjusted assets
   (includes Tier I capital adjustments)            386,009         359,408         317,478
Tier II risk-adjusted assets
   (includes Tiers I and II capital                 390,834         363,901         321,446
    adjustments)
Quarterly average total assets                      500,953         475,698         433,047
Adjusted quarterly average total assets
   (includes Tier I capital adjustments)            496,078         469,818         426,746

Risk-based capital ratios:
   Tier I capital to Tier I risk adjusted              9.55%           9.63%          10.15%
        assets
   Minimum required Tier I capital                     4.00%           4.00%           4.00%
   Threshold for well-capitalized status               6.00%           6.00%           6.00%

   Total risk-based capital to
         Tier II risk-adjusted assets                 10.66%          10.75%          11.25%
   Minimum required total risk-based capital           8.00%           8.00%           8.00%
   Threshold for well-capitalized status              10.00%          10.00%          10.00%

Leverage capital ratios:
   Tier I leverage capital to
       adjusted fourth quarter average assets          7.43%           7.37%           7.55%
   Minimum required Tier I leverage capital            4.00%           4.00%           4.00%
   Threshold for well-capitalized status               5.00%           5.00%           5.00%

UPDATE ON YEAR 2000

The Company recognizes the potentially severe implications of the "Year 2000 Issue." The "Year 2000 Issue" (also known as "Y2K") is a general term used to describe the various problems that may result from the improper processing of dates and date-sensitive calculations as the year 2000 approaches. This issue is caused by the fact that many of the world's existing computer programs use only two digits to identify the year in the date field of a program. These programs were designed and developed without considering the impact of the upcoming change in the century and could experience serious malfunctions when the last two digits of the year change to "00" as a result of identifying a year designated "00" as the year 1900 rather than the year 2000. This misidentification could prevent the Company from being able to engage in normal business operations, including, among other things, miscalculating interest accruals and the inability to process customer transactions. Because of the potentially serious ramifications of the Year 2000 Issue, the Company has devoted significant time and resources to ensure the Company's Year 2000 readiness.

The Company believes that it is currently Year 2000 ready. The Company's systems and processes have been evaluated and tested, and have been determined to be Year 2000 compliant. The following discussion contains additional detail regarding the Company's Year 2000 preparations, as well as disclosures regarding costs incurred to date and projected additional costs related to the Year 2000 Issue.

The Company's Technology Committee, which is comprised of a cross-section of the Company's employees, has led the Company's Year 2000 efforts and involved all employees of the Company in ensuring that the Company is properly prepared for the year 2000. The Company's Board of Directors approved a plan submitted by the Technology Committee that was developed in accordance with guidelines set forth by the Federal Financial Institutions Examination Council. This plan had three primary phases related to internal Year 2000 compliance.

The first phase of the Company's efforts to address the Year 2000 Issue was to inventory all known Company processes that could reasonably be expected to be impacted by the Year 2000 Issue and their related vendors, if applicable. This inventory of processes and vendors included not only typical computer processes such as the Company's transaction applications systems, but all known processes that could be impacted by micro-chip malfunctions. These include but are not limited to the Company's alarm system, phone system, check ordering process, and ATM network. This phase is complete, although it is periodically updated as necessary.

The Company's second phase in addressing the Year 2000 Issue was to contact all third party vendors, request documentation regarding their Year 2000 compliance efforts, and analyze the responses. This was a significant phase because the Company does not perform in-house programming, and thus is dependent on external vendors to ensure and modify, if necessary, the hardware, software, or service they provide to the Company to be Year 2000 compliant. This phase is complete, although it is updated as necessary. The Company is satisfied that its third party vendors have properly addressed the Year 2000 Issue.

The next phase for the Company under the plan was to complete a comprehensive testing of all known processes. Under the plan, processes were initially tested on a stand-alone basis and then they were tested on an integrated basis with other processes. Testing of the Company's processes on a stand-alone basis, as well as on an integrated basis, has been successfully completed. The most significant phase of testing was the testing of the Company's core software applications. Upgrades of the core software applications currently used by the Company were received from the software vendor in June 1998 and were represented to be Year 2000 compliant by the vendor. These applications were successfully loaded onto the Company's hardware system in July 1998 and Year 2000 testing began in September 1998. The testing of the core applications revealed no Year 2000 problems.

Another part of the Company's Year 2000 plan was to assess the Year 2000 readiness of its significant borrowers and depositors. Through the use of questionnaires and personal contacts, the Company has gathered information regarding the Year 2000 readiness of significant borrowers and depositors of the Company. The assessment of the Company's significant depositors and borrowers is complete. Customers who the Company has Year 2000 concerns about are being counseled on the Year 2000 Issue, urged to take action, and placed on an internal watch list that is updated on a quarterly basis and reviewed and monitored by the Company for any potential effects on the Company. Based on the Company's evaluation, management does not believe that the number or magnitude of customers with potential Year 2000 problems will be significant. Prospective new loan customers are also assessed for Year 2000 compliance as a part of the underwriting process of significant loans.

Management is also working closely with outside consultants and the FDIC on the Company's Year 2000 readiness.

In the Company's 1998 Form 10-K, the Company's projected total costs to address the Year 2000 Issue to be approximately $100,000. Based on ongoing evaluations of the Company's current Year 2000 status, it is management's current belief that total Year 2000 costs will be approximately $140,000, which are being expensed as they occur. The increase in the estimated total expense is attributable to additional projected expenses associated with customer education and certain precautionary measures the Company is planning to take.

A total of $70,000 has been recorded in 1998 and 1999 related to the Year 2000 Issue. In 1998, the Company expensed approximately $32,000 in Year 2000 Issue related costs, none of which was expensed in the first half of 1998. In 1999, the Company has expensed a total of $38,000 in Year 2000 Issue related costs, of which $12,000 was recorded in the second quarter and $26,000 in the first quarter. The remaining expenses are expected to be incurred over the remainder of 1999. The estimated and actual Year 2000 costs include only direct external costs associated with Year 2000 readiness, and do not include any amounts attributable to the significant time that management and the staff of the Company has spent planning, preparing and testing for Year 2000 readiness. Although funding of the Year 2000 project costs will come from normal operating cash flow, the external expenses associated with the Year 2000 Issue are directly reducing otherwise reported net income for the Company.

Management of the Company believes that the potential effects on the Company's internal operations of the Year 2000 Issue have been addressed and that the Company will not experience any significant Year 2000 related problems. However, it is possible that unforeseen circumstances related to the Year 2000 Issue could arise and disrupt normal business operations. The most reasonably likely worst case Year 2000 scenarios foreseeable at this time would include the Company temporarily not being able to process, in some combination, various types of customer transactions. This could affect the ability of the Company to, among other things, originate new loans, post loan payments, accept deposits or allow immediate withdrawals, and, depending on the amount of time such a scenario lasted, could have a material adverse effect on the Company. In the event that unforeseen circumstances do occur, the Company has developed and tested a contingency plan that would allow for limited transactions, including the ability to make certain deposit withdrawals, until the Year 2000 problems are remediated.

The costs of the Year 2000 project are based on management's best estimates, which were derived using numerous assumptions of future events such as the availability of certain resources (including internal and external resources), third party vendor plans and other factors. However, there can be no guarantee that these estimates will be achieved at the cost disclosed, and actual results could differ materially from these plans. The discussion in this section contains Year 2000 readiness disclosures within the meaning of the Year 2000 Information and Readiness Disclosure Act of 1998.