10-Q 1 form10q2q05.txt FORM 10-Q FILING AS OF JUNE 30, 2005 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ----------------- FORM 10-Q ----------------- [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2005 or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM____ TO ____ Commission File number 1-10518 INTERCHANGE FINANCIAL SERVICES CORPORATION (Exact name of registrant as specified in its charter) New Jersey 22-2553159 ------------------------------------- ---------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) Park 80 West/Plaza Two, Saddle Brook, NJ 07663 -------------------------------------------- ----- (Address of principal executive offices) (Zip Code) (201) 703-2265 ------------------------------------------------------------------------------- (Registrant's telephone number, including area code) None -------------------------------------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report) Indicate by checkmark whether the Registrant (1) has filed all reports required to be filed by Sections 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 report) and (2) has been subject to such filing requirements for the past 90 days. Yes__X__ No____ Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes__X__ No____ The number of outstanding shares of the Registrant's common stock, no par value per share, as of July 29, 2005, was 19,160,765 shares. INTERCHANGE FINANCIAL SERVICES CORPORATION INDEX PART I FINANCIAL INFORMATION Page No. Item 1 Financial Statements Unaudited Condensed Consolidated Balance Sheets as of June 30, 2005 and December 31, 2004..............................1 Unaudited Condensed Consolidated Statements of Income for the three and six-month periods ended June 30, 2005 and 2004.........2 Unaudited Condensed Consolidated Statements of Changes in Stockholders' Equity for the six months ended June 30, 2005 and 2004...........................................3 Unaudited Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2005 and 2004......................4 Notes to Unaudited Condensed Consolidated Financial Statements...5 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations.............................16 Item 3 Quantitative and Qualitative Disclosures About Market Risk......31 Item 4 Controls and Procedures.........................................35 PART II OTHER INFORMATION Item 1 Legal Proceedings...............................................36 Item 2 Unregistered Sales of Equity Securities and Use of Proceeds.....36 Item 3 Defaults upon Senior Securities.................................36 Item 4 Submission of Matters to a Vote of Security Holders.............36 Item 5 Other Information...............................................37 Item 6 Exhibits........................................................37 Signatures....................................................38 PART I - FINANCIAL INFORMATION

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-4- NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND SIX-MONTH PERIODS ENDED JUNE 30, 2005 1. Basis of Presentation The accompanying unaudited condensed consolidated financial statements include the accounts of Interchange Financial Services Corporation and certain of its wholly owned subsidiaries (on a consolidated basis, the "Company") including its principal operating subsidiary, Interchange Bank (the "Bank") and Clover Leaf Mortgage Company, and have been prepared in conformity with accounting principles generally accepted in the United States of America ("GAAP") and in accordance with the rules and regulations of the Securities and Exchange Commission. The Company has two wholly owned trusts which are not consolidated, see Note 12 "Subordinated Debentures" for a more detailed discussion of these subsidiaries. Pursuant to such rules and regulations, certain information or footnotes necessary for a complete presentation of financial condition, results of operations and cash flows in conformity with GAAP have been condensed or omitted. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and schedules thereto included in the annual report on Form 10-K of the Company for the year ended December 31, 2004. The condensed consolidated financial data for the three and six months ended June 30, 2005 and 2004, are unaudited but reflect adjustments consisting of only normal recurring adjustments which are, in the opinion of management, considered necessary for a fair presentation of the financial condition and results of operations for the interim periods. The results of operations for interim periods are not necessarily indicative of results to be expected for any other period or the full year. Use of estimates: The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates. The most significant estimates pertain to the allowance for loan and lease losses, the fair value of financial instruments, goodwill, intangibles, taxes and retirement benefits. New Accounting Pronouncements: In December 2003, the American Institute of Certified Public Accountants issued Statement of Position 03-3, "Accounting for Certain Loans or Debt Securities Acquired in a Transfer" ("SOP 03-3"). SOP 03-3 addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an initial investment in loans or debt securities acquired in a transfer if those differences relate, at least in part, to a deterioration of credit quality. SOP 03-3 prohibits companies from carrying over valuation allowances in the initial accounting for such loans and limits the yield that may be accreted to the excess of undiscounted expected cash flows over the initial investment in the loan. Decreases in expected cash flows are recognized as impairment and increases are -5- recognized prospectively through an adjustment of the loan yield. SOP 03-3 is effective for loans and debt securities acquired on or after January 1, 2005. Our adoption of this guidance did not have a significant effect on our condensed consolidated financial statements. On March 3, 2005, the Financial Accounting Standards ("FASB") Staff issued FASB Staff Position ("FSP") FIN 46(R)-5, "Implicit Variable Interests under FASB Interpretation No. 46" (FIN 46R-- Revised December 2003), "Consolidation of Variable Interest Entities" ("VIE"). This FSP requires a reporting enterprise to consider the impact of implicit variable interests in determining whether the reporting enterprise may absorb variability of the VIE or potential VIE. This staff position was effective in the second quarter of 2005 and its adoption did not have a material impact on our condensed consolidated financial statements. In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error Corrections- a replacement of APB Opinion No. 20 and FASB Statement No. 3". SFAS No. 154 replaces APB Opinion No. 20, "Accounting Changes," and FASB Statement No. 3, "Reporting Accounting Changes in Interim Financial Statements," and changes the accounting and reporting requirements for a change in accounting principle. SFAS No. 154 applies to all voluntary changes in an accounting principle, as well as to changes required by a new accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. SFAS No. 154 is effective for accounting changes and error corrections made in fiscal years beginning after December 15, 2005 and requires retrospective application to prior periods' financial statements for most voluntary changes in an accounting principle, unless it is impracticable to do so. The Company does not anticipate any material impact to its financial condition or results of operations as a result of the adoption of SFAS No. 154. At the June 29, 2005 FASB Board meeting, the Board agreed to issue FSP FAS 115-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" which will replace the guidance previously set forth in EITF 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments". This FSP effectively eliminates the accounting guidance provided in EITF 03-1 in favor of existing impairment recognition guidance under SFAS 115, Staff Accounting Bulletin ("SAB") 59, Accounting Principles Board ("APB") Opinion No. 18, and EITF Topic D-44. The effective date of the FSP is for periods beginning after September 15, 2005, but is not expected to have a material impact on our condensed consolidated financial statements. Stock Based Compensation: The Company accounts for stock option plans under the recognition and measurement principles of "Accounting for Stock Issued to Employees" (APB No. 25) and related interpretations. No stock-based employee compensation costs are reflected in net income, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. In December 2004, the FASB issued Statement of Financial Accounting Standard ("SFAS") No. 123 (revised 2004), "Share-Based Payment," ("SFAS No. 123(R)"). SFAS No. 123(R) addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair -6- value of the enterprise's equity instruments or that may be settled by the issuance of such equity instruments. SFAS No. 123(R) requires an entity to recognize the grant-date fair value of stock options and other equity-based compensation issued to employees within the income statement using a fair-value-based method, eliminating the intrinsic value method of accounting previously permissible under APB No. 25 and related interpretations. On April 15, 2005, the Securities and Exchange Commission ("SEC") issued a ruling amending the date for compliance with SFAS No. 123(R). Registrants will be required to adopt FAS 123(R) beginning with the first interim or annual reporting period of the registrant's first fiscal year beginning on or after June 15, 2005. For the Company, this ruling will require adoption of SFAS No. 123(R) by no later than January 1, 2006. The Company is in the process of evaluating and determining which of the alternative methodologies under SFAS No. 123(R) will be utilized. Prior to the required adoption of SFAS No. 123(R), the Company has elected to account for its stock-based incentive plans and awards under APB No. 25, and has adopted the disclosure requirements of SFAS No. 123, "Accounting for Stock-Based Compensation," as amended by SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure." The following table illustrates the effect on net income and diluted earnings per common share if the Company had applied the fair value recognition provisions of SFAS No. 123, to stock-based compensation for the three and six months ended June 30, 2005 and 2004: (in thousands, except share data) (unaudited)

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model. The following weighted-average assumptions were used for option grants issued during the six months ended June 30, 2005 and 2004, respectively: dividend yield of 2.00% and 2.01%; expected -7- volatility of 23.07% and 23.05%; risk-free interest rate of 3.87% and 3.86%; and expected lives of approximately 7 years. 2. Earnings Per Common Share Basic earnings per common share represent income available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per common share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Company relate solely to outstanding stock options, and are determined using the treasury stock method. At June 30, 2005 and 2004 the weighted average diluted shares outstanding for the three months were approximately 19.6 million and 19.5 million, respectively. For the each of the six month periods ended June 30, 2005 and 2004 the weighted average diluted shares outstanding were approximately 19.6 million. 3. Commitments and Contingent Liabilities Legal Proceedings The Company is a party to routine litigation involving various aspects of its business, none of which, in the opinion of management, is expected to have a material adverse impact on the condensed consolidated financial condition, results of operations or liquidity of the Company. Commitments to Extend Credit At June 30, 2005, the Company had commitments of approximately $280.5 million to extend credit, of which approximately $2.6 million represents standby letters of credit. 4. Goodwill and Other Intangibles Goodwill is not amortized to expense, but rather is tested for impairment periodically. Goodwill is tested for impairment at least annually in accordance with the provisions of SFAS No. 142. Other intangible assets are amortized to expense using straight-line methods over their respective estimated useful lives. At least annually, management reviews goodwill and other intangible assets and evaluates events or changes in circumstances that may indicate impairment in the carrying amount of such assets. If the sum of the expected undiscounted future cash flows, excluding interest charges, is less than the carrying amount of the asset, an impairment loss is recognized. Impairment, if any, is measured on a discounted future cash flow basis. Net intangible assets are as follows: (in thousands)(unaudited) -8- ---------------- ----------------- June 30, December 31, 2005 2004 ---------------- ----------------- Intangilbe assets $ 4,595 $ 4,595 Accumulated amortization (1,187) (935) ---------------- ----------------- Net intangible assets $ 3,408 $ 3,660 ================ ================= Intangible assets are a result of acquisitions and are primarily related to core deposit intangibles ("CDI") which have an estimated life of 10 years. For each of the three and six month periods ended June 30, 2005 and 2004 the CDI amortized was $107 thousand and $214 thousand, respectively. The CDI will be periodically reviewed for impairment. At June 30, 2005 the scheduled amortization of the intangible assets is as follows (in thousands) (unaudited): 2006 $ 436 2007 430 2008 430 2009 430 2010 430 Thereafter 999 ------------- Total $ 3,155 ============= 5. Segment Reporting SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information" ("SFAS No. 131"), requires disclosures for each reportable operating segment. As a community-oriented financial institution, substantially all of the Company's operations entail the delivery of loan and deposit products and various other financial services to customers in its primary market area, which is Bergen County, New Jersey. The Company's community-banking operation constitutes the Company's only operating segment for financial reporting purposes under SFAS No. 131. 6. Cash Dividend On July 19, 2005, the Company declared a cash dividend of $0.09 per share payable on August 19, 2005, to holders of record as of August 1, 2005. -9- 7. Securities Held-to-Maturity and Securities Available-for-Sale Securities held-to-maturity ("HTM") and securities available-for-sale ("AFS") consist of the following: (in thousands) (unaudited)

At June 30, 2005, the contractual maturities of securities HTM and securities AFS are as follows: (in thousands) (unaudited)

-10- Proceeds from the sale of securities AFS amounted to $77.1 million and $58.2 million for the six months ended June 30, 2005 and 2004, respectively, which resulted in gross realized gains of $670 thousand and $913 thousand for those periods, respectively. Gross realized losses from the sale of securities AFS amounted to $361 thousand and $94 thousand for the six months ended June 30, 2005 and 2004, respectively. Proceeds from the sale of securities HTM amounted to $270 thousand for the six months ended June 30, 2005, which resulted in realized gains of $8 thousand. The securities had significantly paid down to less than 85% of the original purchased balance through normal principal amortization and prepayments. There were no sales of securities HTM for the six months ended June 30, 2004. These amounts are included in net gain on sale of securities in the unaudited condensed consolidated statements of income. On a quarterly basis, the Company makes an assessment to determine whether there have been any events or economic circumstances to indicate that a security on which there is an unrealized loss is impaired on an other-than-temporary basis. The Company considers many factors including the severity and duration of the impairment; the intent and ability of the Company to hold the security for a period of time sufficient for a recovery in value; recent events specific to the issuer or industry; and for debt securities, external credit ratings and recent downgrades. Securities on which there is an unrealized loss that is deemed to be other-than-temporary are written down to fair value with the write-down recorded as a realized loss in securities gains (losses). Based upon the Company's evaluation of the securities portfolios no other than temporary impairment charge was necessary at June 30, 2005 and 2004. The following table summarizes all securities that have an unrealized loss and the duration of the unrealized loss at June 30, 2005: (in thousands) (unaudited)

The following table summarizes all securities that have an unrealized loss and the duration of the unrealized loss at December 31, 2004: (in thousands) -11-

Securities with carrying amounts of $125.8 million and $62.2 million at June 30, 2005 and December 31, 2004, respectively, were pledged for public deposits, Federal Home Loan Bank advances, securities sold under repurchase agreements and other purposes required by law. 8. Loans The composition of the loan portfolio is summarized as follows: (in thousands) ----------- ------------ June 30, December 31, 2005 2004 ----------- ------------ (unaudited) Real estate Residential $ 296,040 $ 292,406 Commercial 418,413 375,985 Construction 73,536 51,162 Commercial Commercial and financial 204,476 186,386 Lease financing 22,877 23,535 Consumer Lease financing 198 680 Installment 4,447 4,027 ---------- -------- 1,019,987 934,181 Allowance for loan and lease (9,945) (9,797) ---------- -------- Net loans and leases $1,010,042 $ 924,384 ========== ========= Loans are net of unearned income and deferred fees of $5.8 million and $5.5 million for the periods ended June 30, 2005 and December 31, 2004, respectively. Nonperforming Loans Nonperforming loans include loans that are accounted for on a nonaccrual basis. Nonperforming loans are as follows: (in thousands) -12- --------- ----------- June 30, December 31, 2005 2004 --------- ----------- (unaudited) Nonaccrual loans Residential real estate $ 700 $ 1,660 Commercial real estate 1,648 2,320 Commercial and financial 2,152 2,981 Commercial lease financing 1,546 1,836 Consumer 230 336 --------- -------- $ 6,276 $ 9,133 ========= ======== 9. Allowance for Loan and Lease Losses The Company's recorded investment in impaired loans is as follows: (in thousands) (unaudited)

Changes in the allowance for loan and lease losses are summarized as follows: (in thousands) (unaudited)

-13- 10. Other Non-interest Expense Expenses included in other non-interest expense are as follows: (in thousands) (unaudited) ------------------ -------------------- Three months ended Six months ended June 30, June 30, ------------------ -------------------- 2005 2004 2005 2004 ------- -------- -------- ---------- Professional fees $ 232 $ 361 $ 778 $ 677 Legal fees 256 240 441 450 Directors' fees, travel and retirement 205 194 422 410 Data processing 264 283 529 564 All other 1,061 847 1,748 1,675 --------- --------- --------- --------- Total $ 2,018 $ 1,925 $ 3,918 $ 3,776 ========= ========= ========= ========= 11. Long-term Borrowings Long-term borrowings consist of the following FHLB advances: (in thousands) Maturity June 30, December 31, Date Rate 2005 2004 --------------------- ---------- -------------- -------------- (unaudited) January 2006 2.09 % - $ 10,000 January 2007 (a) 4.22 $ 10,000 10,000 January 2007 2.69 10,000 10,000 January 2010 (b) 3.66 15,000 - ---------- -------------- -------------- 3.52 % $ 35,000 $ 30,000 ========== ============== ============== (a) The FHLB has an option to call this advance on a quarterly basis if the 3-month LIBOR resets above 7.50%. (b) The FHLB has an option to call this advance in January 2008. 12. Subordinated Debentures During June 2005, Interchange Statutory Trust I and Interchange Statutory Trust II (together the "Trusts") each issued $10 million of pooled trust preferred securities. In conjunction with the issuance of the trust preferred securities the Company issued subordinated debentures to the Trusts totaling $20.6 million. The rates of interest paid on the securities issued by the Trusts and the Company have been fixed for 5 years, at an average rate of 6.10%, after which time the rates will float at the 3-month LIBOR plus 1.71%. The Company has the right to call the notes after 5 years on any of the interest payment dates. The final maturity date on the pool trust preferred securities and debentures is 2035. The Company does not meet the criteria as primary beneficiary for the Trusts in accordance with Financial Accounting Standards Board (FASB) Interpretation No. 46 (FIN 46) and FIN No. 46(R), "Consolidation of Variable Interest Entities." As a result, these trusts are not consolidated. The Trusts have no independent operations. The obligations of the Trusts are fully and unconditionally guaranteed by the -14- Company. The debentures are unsecured and rank subordinate and junior in right of payment to all indebtedness, liabilities and obligations of the Company. Interest on the debentures is cumulative and payable in arrears. Proceeds from any redemption of debentures would cause a mandatory redemption of pooled trust preferred securities having an aggregate liquidation amount equal to the principal amount of debentures redeemed. 13. Benefit Plans In 1993, the Bank established a non-contributory defined benefit pension plan covering all eligible employees (the "Pension Plan"). In 1994, the Bank established a supplemental plan covering all eligible employees (the "Supplemental Plan") that provides for income that would have been paid out but for the limitation under the qualified Pension Plan. Also in 1994, the Company established a retirement plan for all directors of the Bank who are not employees of Interchange or of any subsidiary or affiliate of Interchange (the "Directors' Plan"). The following table shows the aggregated components of net periodic benefit costs for the periods noted: (in thousands) (unaudited)

During 2005, the Bank anticipates contributing approximately $43 thousand to the Pension Plan of which $9 thousand has already been contributed. -15- Item 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General The following discussion is an analysis of the condensed consolidated financial condition and results of operations of the Company for the three and six month periods ended June 30, 2005 and 2004, and should be read in conjunction with the condensed consolidated financial statements and notes thereto included in Item 1 hereof. In addition, you should read this section in conjunction with Management's Discussion and Analysis and Results of Operations included in the Company's 2004 Annual Report on Form 10-K. Forward Looking Information In addition to discussing historical information, certain statements included in or incorporated into this report relating to the financial condition, results of operations and business of the Company, which are not historical facts may be deemed "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. When used herein, the words "anticipate," "believe," "estimate," "expect" and other similar expressions (including when preceded or followed by the word "not") are generally intended to identify such forward-looking statements. Such statements are intended to be covered by the safe harbor provisions for forward-looking statements contained in such Act, and we are including this statement for purposes of invoking these safe harbor provisions. Such forward-looking statements include, but are not limited to, statements about the operations of the Company, the adequacy of the Company's allowance for losses associated with the loan and lease portfolio, the quality of the loan and lease portfolio, the prospects of continued loan and deposit growth, and improved credit quality. The forward-looking statements in this report involve certain estimates or assumptions, known and unknown risks and uncertainties, many of which are beyond the control of the Company, and reflect what we currently anticipate will happen in each case. What actually happens could differ materially from what we currently anticipate will happen due to a variety of factors, including, among others, (i) increased competitive pressures among financial services companies; (ii) adverse changes in Government-Sponsored Enterprises (the "GSE") status or financial condition impacting the GSE's guarantees or ability to pay or issue debt; (iii) changes in the interest rate yield curve such as flat, inverted or steep yield curves, or interest rate environment which impact interest margins and may impact prepayments on the mortgage-backed securities portfolio; (iv) changes in consumer spending, borrowing and saving habits; (v) technological changes, (vi) deterioration in general economic conditions, internationally, nationally, or in the State of New Jersey; (vii) disruptions caused by terrorism, such as the events of September 11, 2001, or military actions in the Middle East or other areas; (viii) legislation or regulatory requirements or changes adversely affecting the business of the Company; and (ix) other risks detailed in reports filed by the Company with the Securities and Exchange Commission. Readers should not place undue expectations on any forward-looking statements. We are not promising to make any public announcement when we -16- consider forward-looking statements in this document to be no longer accurate, whether as a result of new information, what actually happens in the future or for any other reason. Company The Company is a bank holding company headquartered in Bergen County, New Jersey. The Company's principal operating subsidiary is Interchange Bank, a New Jersey-chartered commercial bank. In addition to the Bank, the Company has three other wholly owned direct subsidiaries: Clover Leaf Mortgage Company, a New Jersey corporation, which is not currently engaged in any business activity; and Interchange Statutory Trust I and Interchange Statutory Trust II, which were formed for the sole purpose of issuing trust preferred securities. The Company does not qualify as the primary beneficiary for our wholly-owned trusts in accordance with Financial Accounting Standards Board (FASB) Interpretation No. 46 (FIN 46) and FIN No. 46(R), "Consolidation of Variable Interest Entities." As a result, these trusts are not consolidated. The Bank has five direct subsidiaries: Clover Leaf Investment Corporation, an investment company operating pursuant to New Jersey law; Clover Leaf Insurance Agency, Inc., a New Jersey corporation engaged in the sale of tax-deferred annuities and insurance; Clover Leaf Management Realty Corporation, a Real Estate Investment Trust ("REIT"), which manages certain real estate assets of the Company; Bridge View Investment Company, an investment company operating pursuant to New Jersey law; and Interchange Capital Company, L.L.C. ("ICC"), a New Jersey limited liability company which engages in equipment lease financing. All of the Bank's subsidiaries are 100% owned by the Bank, except for the REIT, which is 99% owned by the Bank. Bridge View Investment Company has one wholly owned subsidiary, Bridge View Delaware, Inc. ("BVDI"). BVDI is an investment company operating pursuant to Delaware law. Critical Accounting Policies and Judgments The Company's consolidated financial statements are prepared based on the application of certain accounting policies, the most significant of which are described in our 2004 Annual Report on Form 10-K, Note 1 "Nature of Business and Summary of Significant Accounting Policies," to our consolidated financial statements and in Management's Discussion and Analysis of Financial Condition and Results of Operations ("MDA"): "Critical Accounting Policies and Judgments." Certain of these policies require numerous estimates and strategic or economic assumptions that may prove inaccurate or subject to variations and may significantly affect the Company's reported results and financial position for the period or in future periods. The use of estimates, assumptions, and judgments are necessary when financial assets and liabilities are required to be recorded at, or adjusted to reflect, fair value. Assets and liabilities carried at fair value inherently result in more financial statement volatility. Fair values and the information used to record valuation adjustments for certain assets and liabilities are based on either quoted market prices or are provided by other independent third-party sources, when available. When such information is not available, management estimates valuation adjustments primarily by using internal cash flow and other -17- financial modeling techniques. Changes in underlying factors, assumptions, or estimates in any of these areas could have a material impact on the Company's future financial condition and results of operations. Allowance for Loan and Lease Losses: The allowance for loan and lease losses ("ALLL") is established through periodic charges to income. Loan losses are charged against the ALLL when management believes that the future collection of principal is unlikely. Subsequent recoveries, if any, are credited to the ALLL. If the ALLL is considered inadequate to absorb future loan losses on existing loans, based on, but not limited to, increases in the size of the loan portfolio, increases in charge-offs or changes in the risk characteristics of the loan portfolio, then the provision for loan and lease losses is increased. The Company considers the ALLL of $9.9 million adequate to cover estimated losses inherent in the loan portfolio, loan commitments and standby and other letters of credit that may become uncollectible based on management's evaluations of the size and current risk characteristics of the loan and lease portfolio as of the balance sheet date. The evaluations consider such factors as changes in the composition and volume of the loan portfolio, the impact of changing economic conditions on the credit worthiness of the borrowers, review of specific problem loans and management's assessment of the inherent risk and overall quality of the loan portfolio. For further discussion see the "Loan Quality" and "Allowance for Loan and Lease Losses" sections of the MDA, along with Note 1 "Nature of Business and Summary of Significant Accounting Policies"; Note 6 "Allowance for Loan and Lease Losses"; and Note 12 "Commitments and Contingent Liabilities" to the Consolidated Financial Statements in our 2004 Annual Report on Form 10-K. Business Combinations: Business combinations are accounted for using the purchase method of accounting, which requires that the assets and liabilities of the companies acquired are recorded at their estimated fair value at the date of acquisition and included in the results of operations of the Company from the date of acquisition. The excess of the purchase price over the estimated fair value of the net assets acquired is recognized as goodwill. Goodwill and Other Intangible Assets: Goodwill is not amortized to expense, but rather is tested for impairment periodically. Other intangible assets are amortized to expense using straight-line methods over their respective estimated useful lives. At least annually, and on an interim basis when conditions require, management reviews goodwill and other intangible assets and evaluates events or changes in circumstances that may indicate impairment in the carrying amount of such assets. If the sum of the expected undiscounted future cash flows, excluding interest charges, is less than the carrying amount of the asset, an impairment loss is recognized. An impairment is measured on a discounted future cash flow basis and a charge is recognized in the period that the asset has been deemed to be impaired. Securities Held-to-Maturity and Securities Available-for-Sale: Debt securities purchased with the intent and ability to hold until maturity are classified as securities HTM and are carried at cost, adjusted for -18- the amortization of premiums and accretion of discounts. All other securities, including equity securities, are classified as securities AFS. Securities classified as AFS may be sold prior to maturity in response to, but not limited to, changes in interest rates, changes in prepayment risk or for asset/liability management strategies. These securities are carried at fair value and any unrealized gains and losses are reported, net of taxes, in accumulated other comprehensive income (loss) included in the consolidated statement of stockholders' equity. The estimated fair value for securities are based on quoted market prices, where available. If quoted market prices are not available, estimated fair values are based on quoted market prices of comparable instruments. Gains and losses from the sale of these securities are determined using the specific identification method and are reported in non-interest income. The Company does not acquire securities for the purpose of engaging in trading activities. On a quarterly basis, the Company makes an assessment to determine whether there have been any events or economic circumstances to indicate that a security on which there is an unrealized loss is impaired on an other-than-temporary basis. The Company considers many factors including the severity and duration of the impairment; the intent and ability of the Company to hold the security for a period of time sufficient for a recovery in value; recent events specific to the issuer or industry; and for debt securities, external credit ratings and recent downgrades. Securities on which there is an unrealized loss that is deemed to be other-than-temporary are written down to fair value with the write-down recorded as a realized loss in securities gains (losses). Pension Plan: The Bank maintains a qualified defined benefit pension plan (the "Pension Plan"), which covers all eligible employees and an unfunded supplemental pension plan which provides retirement income to all eligible employees who would have been paid amounts in excess of the amounts provided by the Pension Plan but for limitations under the qualified Pension Plan. In addition, the Company has an unfunded retirement plan for all directors of the Bank who are not employees of the Company or any subsidiary or affiliate. -19- THREE MONTHS ENDED JUNE 30, 2005 AND 2004 RESULTS OF OPERATIONS Summary For the second quarter of 2005, the Company reported earnings per diluted common share of $0.23, as compared to $0.22 for the same period in 2004, an increase of approximately 4.5%. Net income for the three months ended June 30, 2005 was approximately $4.5 million, an increase of $160 thousand, or 3.7%, over the same period last year. The increase in earnings resulted primarily from an increase in our interest earning assets during the quarter of approximately $109 million, offset by a decline in our net interest margin, on a tax-equivalent basis, of 15 basis points. The Company's return on average assets decreased to 1.20% as compared to 1.25% for the three months ended June 30, 2005 and 2004, respectively. In addition, the Company's return on average stockholders' equity decreased to 11.83% for the second quarter 2005 versus 12.08% for the second quarter in 2004. The changes in return on average assets and equity were primarily the result of the decline in the net interest margin. Net Interest Income Net interest income is the most significant source of the Company's operating income. A portion of the Company's total interest income is derived from investments that are exempt from federal taxation. The amount of pretax income realized from those investments, due to the tax exemption, is less than the amount of pretax income realizable from comparable investments subject to federal taxation. For purposes of the following discussion, interest income exempt from federal taxation has been restated to a fully tax-equivalent basis using a corporate federal tax rate of 34% for the quarters ended June 30, 2005 and 2004. This was accomplished by adjusting this income upward to make it equivalent to the level of taxable income required to earn the same amount after taxes. Net interest income on a tax-equivalent basis increased $644 thousand, or 4.9%, to $13.8 million for the quarter ended June 30, 2005 as compared to the same quarter in 2004. The tax equivalent basis adjustments for the quarters ended June 30, 2005 and 2004 were $257 thousand and $162 thousand, respectively. The increase in net interest income was due mostly to an 8.7% growth in interest earning assets. This interest earning asset growth was funded primarily by deposit liabilities, which grew $62.0 million, or 5.3% on average, for the second quarter of 2005 as compared to the same quarter in 2004. The margin for the second quarter of 2005 was 4.05%, a decrease of 15 basis points as compared to the same quarter in 2004. Interest income, on a tax-equivalent basis, totaled $19.1 million for the second quarter of 2005, an increase of $2.9 million, or 8.7%, as compared to the same quarter in 2004. The increase was mostly attributed to the growth in interest earning assets and the shift in asset mix as average loans grew $145.8 million, while investments declined by $24.0 million. -20- Interest expense totaled $5.4 million for the second quarter of 2005, an increase of $2.3 million, as compared to the same period in 2004. The increase in interest expense was a byproduct of the increase in market interest rates, particularly short-term rates, during the second half of 2004 and the first half of 2005. The increase in short-term interest rates increased the average rate paid on deposit liabilities by 67 basis points to 1.84% for the quarter ended June 30, 2005 as compared to the same period in 2004. Interest bearing deposits grew on average $49.6 million, or 5.2%, for the second quarter of 2005 as compared to the same period in 2004. During June 2005 the Company issued $20.6 million of subordinated debentures to unconsolidated trust subsidiaries. The average rate paid on the subordinated debentures is 6.10% and is fixed for 5 years, after which time the rate paid on the subordinated debentures will be the 3-month LIBOR plus 1.71%. The subordinated debentures can be called at any of the interest payment dates following the fifth anniversary of their issuance. The final maturity on the subordinated debentures is June 2035. The issuance of the subordinated debentures did not have a material impact on interest expense during the quarter.

-21- Provision for Loan and Lease Losses The provision for loan and lease losses represents management's estimate of the amount necessary to bring the ALLL to a level that management considers adequate to reflect the risk of estimated losses inherent in the Company's loan and lease portfolio as of the balance sheet date. A more detailed discussion of the evaluation of the ALLL can be found in the section titled "Critical Accounting Policies and Judgments: Allowance for Loan and Lease Losses" above. In the second quarter of 2005 and 2004, the Company's provision for loan and lease losses was $225 thousand and $300 thousand, respectively. The decline in the provision for loan and lease losses was primarily a result of an improvement in our non-performing assets. Non-interest Income For the quarter ended June 30, 2005, non-interest income totaled $2.5 million, a decrease of $216 thousand, or 8.0%, as compared to the same period in 2004. The change was largely due to a decline in "other" non-interest income, commissions on sale of annuities and mutual funds and net gains on sale of securities of $232 thousand, $108 thousand and $55 thousand, respectively. This was partly offset by growth in gain on sale of loans and leases of $166 thousand. The increase in gain on sale of loans arose out of an increase in sales of Small Business Administration originated loans. Non-interest Expense For the quarter ended June 30, 2005, non-interest expense was $9.2 million, an increase of $382 thousand, or 4.3 %. Contributing to the increase was an increase in salaries and benefits of $290 thousand and "other" non-interest expense of $93 thousand, as compared to the same period in 2004. Income Taxes Income tax expense as a percentage of pre-tax income was 31.1% for the three months ended June 30, 2005 as compared to 33.3% for the same period of 2004. The decline in income tax expense was partly a result of an increase in income from investment securities exempt from federal income taxes. -22- SIX MONTHS ENDED JUNE 30, 2005 AND JUNE 30, 2004 RESULTS OF OPERATIONS Summary Net income for the six months ended June 30, 2005 was approximately $8.9 million, an increase of $594 thousand, or 7.1%, over the same period last year. The increase in earnings resulted from an increase primarily in the average balance of loans outstanding of $143.0 million. The improvement in earnings was partly offset by a 6 basis point decline in the net interest margin. For the first six months of 2005, the Company reported earnings per diluted common share of $0.46 as compared to $0.43 for the same period in 2004. For the six months ended June 30, 2005 and 2004, the Company's Return on Average Assets ("ROA") was 1.20%. Return on Average Equity ("ROE") for the six months ended Juen 30, 2005 was 11.77% an increase from 11.61% when compared to the same period last year. Net Interest Income Net interest income on a tax-equivalent basis increased $1.7 million, or 6.5%, to $27.5 million for the six months ended June 30, 2005 as compared to the same period in 2004. The tax equivalent basis adjustments for the six months ended June 30, 2005 and 2004 were $419 thousand and $322 thousand, respectively. The increase in net interest income was due mostly to an 8.1% growth in interest earning assets. This interest earning asset growth was funded primarily by deposit liabilities, which grew 6.0% on average for the six months of 2005 as compared to the same period in 2004. The aforementioned improvement in net interest income was partly offset by a 6 basis point decline in the net interest margin for the six months ended June 30, 2005 as compared to the same period in 2004. The margin was primarily affected by a 52 basis point increase in the cost of interest bearing deposits and borrowings. Interest income, on a tax-equivalent basis, totaled $37.3 million for the six months ended June 30, 2005, an increase of $5.3 million, or 16.5%, as compared to the same period in 2004. The increase was mostly attributed to a $100.8 million, or 8.1%, growth in interest earning assets. The growth in interest earning assets was the result of increases in average loans of $143.0 million, while investments declined by $34.6 million. Interest expense, which totaled $9.8 million for the six months ended June 30, 2005, increased $3.6 million, or 58.2%, as compared to the same period in 2004. The increase in interest expense was a byproduct of the increase in market interest rates, particularly short-term rates during the second half of 2004 and first half of 2005. The increase in short-term interest rates increased the average rate paid on interest bearing liabilities by 58 basis points to 1.82% for the six months ended June 30, 2005 as compared to the same period in 2004. Interest bearing deposits grew on average $56.6 million, or 6.0%, for the second quarter of 2005 as compared to the same period in 2004. Augmenting our deposit growth and supporting our increase in interest earning assets was an increase of $23.7 million in average borrowings during the first six months of 2005 as compared to the same period in 2004. During June 2005, -23- the Company issued $20.6 million of subordinated debentures to unconsolidated trust subsidiaries. The average rate paid on the subordinated debentures is 6.10% and is fixed for 5 years, after which time the rate will float at 3-month LIBOR plus 1.71%. The subordinated debentures can be called at any of the interest payment dates following the fifth anniversary of their issuance. The final maturity on the subordinated debentures is June 2035. The issuance of the subordinated debentures did not have a material impact on interest expense during the period.

Provision for Loan and Lease Losses The provision for loan and lease losses represents management's estimate of the amount necessary to bring the allowance for loan and lease losses ("ALLL") to a level that management considers adequate to reflect the risk of estimated losses inherent in the Company's loan portfolio as of the balance sheet date. A more detailed discussion of the evaluation of the ALLL can be found in the section titled "Critical Accounting Policies and Judgments: Allowance for Loan and Lease Losses" above. In the first six months of 2005 and 2004, the Company's provision for loan and lease losses was $400 thousand and $675 thousand, respectively. Non-interest Income Non-interest income totaled $4.7 million for the six months ended June 30, 2005, a decrease of $537 thousand, or 10.3%, as compared to the same period in 2004. The decline in non-interest income -24- was mostly due to decreases in net gains on the sale of securities, "other" non-interest income and commissions on sale of annuities and mutual funds of $502 thousand, $200 thousand and $138 thousand, respectively. The decline in non-interest income was partly offset by an increase in net gain on sale of loans and leases and Bank Owned Life Insurance ("BOLI") income of $246 thousand and $138 thousand, respectively. Non-interest Expense For the six months ended June 30, 2005, non-interest expense was $18.3 million, an increase of $619 thousand, or 3.5%, when compared to the same period in 2004. Contributing to the increase was an increase in salaries and benefits, and occupancy expenses of $397 thousand and $154 thousand, respectively, as compared to the same period in 2004. Income Taxes Income tax expense as a percentage of pre-tax income was 31.2% for the six months ended June 30, 2005 as compared to 32.1% for the same period of 2004. -25- FINANCIAL CONDITION Cash and Cash Equivalents At June 30, 2005, cash and cash equivalents was $35.9 million as compared to $33.1 million at December 31, 2004. Securities Portfolio Under Statement of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"), each security is classified as either trading, AFS, or HTM. The Company has no securities held in a trading account. The securities AFS are recorded at their estimated fair value. The after-tax difference between amortized cost and estimated fair value of securities AFS is recorded as "accumulated other comprehensive income" in the equity section of the balance sheet. The tax impact of such adjustment is recorded as an adjustment to the amount of the deferred tax liability. The securities HTM are carried at cost adjusted for the amortization of premiums and accretion of discounts, which are recognized as an adjustment to income. Under SFAS No. 115, securities HTM, with some exceptions, may only be sold within three months of maturity. The Company's U.S. Government-Sponsored Enterprises securities at June 30, 2005 and 2004 are not guaranteed by the U.S. Government; however, they are credit rated AAA or Aaa by nationally recognized statistical rating organizations. Substantially all obligations of states and political subdivisions are credit rated AAA or Aaa due to insurance, which guarantees the obligations against default, by private insurance companies. At June 30, 2005 and 2004, approximately $26.8 million and $6.4 million, respectively, of issuances are bond or tax anticipation notes from local municipalities, which are not rated. The Company uses its securities portfolio to ensure liquidity for cash flow requirements, to manage interest rate risk, provide a source of income, ensure collateral is available for pledging requirements and manage asset quality diversification. At June 30, 2005, investment securities totaled $361.2 million and represented 23.6% of total assets, as compared to $388.7 million and 26.5%, respectively, at December 31, 2004. Securities AFS comprised 90.4% of the total securities portfolio at June 30, 2005 as compared to 96.3% at December 31, 2004. At June 30, 2005, the Company had a net unrealized loss of $1.8 million as compared to a net unrealized loss of $296 thousand at December 31, 2004. The decrease was attributed to an increase in market interest rates during that period. Proceeds from the sale of securities AFS amounted to $77.1 million and $58.2 million for the six months ended June 30, 2005 and 2004, which resulted in gross realized gains of $670 thousand and $913 thousand for those periods, respectively. Gross realized losses from the sale of securities AFS amounted to $361 thousand and $94 thousand for the six months ended June 30, 2005 and 2004, respectively. Proceeds from the sale of securities HTM amounted to $270 thousand for the six months ended June 30, 2005, which resulted in realized gains of $8 thousand. The securities had significantly paid down to less than 85% of the original purchased balance through normal principal amortization and prepayments. There -26- were no sales of securities HTM for the six months ended June 30, 2004. These amounts are included in net gain on sale of securities in the unaudited condensed consolidated statements of income. Loans Total loans amounted to $1.0 billion at June 30, 2005, an increase of $85.8 million from $934.2 million at December 31, 2004. The growth was attributable to increases in commercial mortgage loans, commercial and financial loans, and construction loans of $42.4 million, $18.1 million, and $22.4 million, respectively. Nonperforming Assets Nonperforming assets are comprised of nonaccrual loans, restructured loans, foreclosed real estate and other repossessed assets. The Company's nonperforming assets at June 30, 2005 amounted to $6.4 million as compared to $9.3 million at December 31, 2004. The ratio of nonperforming assets to total loans and foreclosed real estate and other repossessed assets decreased to 0.63% at June 30, 2005 from 0.99% at December 31, 2004. The following table lists nonaccrual loans and foreclosed real estate and other repossessed assets at June 30, 2005, and December 31, 2004: (in thousands) --------- ------------ June 30, December 31, 2005 2004 --------- ----------- (unaudited) Nonaccrual loans $ 6,276 $ 9,133 Foreclosed assets and other repossessed assets 154 156 --------- --------- Total nonperforming assets $ 6,430 $ 9,289 ========= ========= Allowance for Loan and Lease Losses The ALLL is generally established through periodic charges to income through the provision for loan and lease losses. During the six months ended June 30, 2005, the ALLL increased $148 thousand to $9.9 million. Loan losses are charged against the ALLL when management believes that the probable future collection of principal is unlikely. Subsequent recoveries, if any, are credited to the ALLL. If the ALLL is considered inadequate to absorb future loan losses on existing loans, based on, but not limited to, increases in the size of the loan portfolio, increases in charge-offs or changes in the risk characteristics of the loan portfolio, then the provision for loan and lease losses is increased. The Company considers the ALLL of $9.9 million adequate to cover estimated losses inherent in the loan portfolio that may become uncollectible based on management's periodic evaluations of the loan portfolio and other relevant factors. The evaluations are inherently subjective as they require material estimates including such factors as potential loss factors, changes in trend of non-performing loans, current -27- state of local and national economy, value of collateral changes in the composition and volume of the loan portfolio, review of specific problem loans and management's assessment of the inherent risk and overall quality of the loan portfolio. All of these factors may be susceptible to significant change. Also, the allocation of the allowance for credit losses to specific loan pools is based on historical loss trends and management's judgment concerning those trends. The following table presents the provisions for loan and lease losses, loans charged off and recoveries on loans previously charged off, the amount of the allowance, the average loans outstanding and certain pertinent ratios for the three and six months ended June 30, 2005 and 2004: (dollars in thousands) (unaudited)

Deposits Deposits, which include non-interest bearing demand deposits, time deposits and other interest-bearing deposits, are an essential and cost-effective funding source for the Company. Other interest-bearing deposits, which include interest-bearing demand, money market and savings accounts, comprise the largest segment of the Company's total deposits. The Company emphasizes building core customer relationships by offering a variety of products designed to meet the financial needs of its customers based on their identifiable "life stages". At June 30, 2005 total deposits grew $12.0 million, or 2.0% annualized, to $1.26 billion from December 31, 2004 and experienced a favorable shift in deposit mix. The increase was largely in non- -28- interest bearing demand deposits, which increased $32.2 million, or 13.7%, to $267.2 million at June 30, 2005 from December 31, 2004. The aforementioned increase was offset by declines in time deposits and other interest-bearing deposits of $16.9 million and $3.3 million, respectively. At June 30, 2005, non-interest bearing deposits amounted to $267.2 million and improved to 21.2% of total deposits compared to 18.9% of total deposits at December 31, 2004. Other interest-bearing deposits amounted to $670.5 million at June 30, 2005 and slightly declined to 53.3% of total deposits compared to 54.1% of total deposits at December 31, 2004. Time deposits amounted to $320.4 million, or 25.5%, of total deposits at June 30, 2005, as compared to $337.3 million, or 27.1% of total deposits at December 31, 2004. The following table reflects the composition of deposit liabilities: (dollars in thousands) June 30, December 31, 2005 2004 ---------------- ------------ (unaudited) Non-interest bearing demand $ 267,225 $ 235,036 Interest bearing demand 455,729 472,807 Money market 102,273 87,595 Savings 112,504 113,352 Time deposits < $100,000 284,307 286,471 Time deposits > $100,000 36,125 50,877 ---------------- ------------ $ 1,258,163 $ 1,246,138 ================ ============ Subordinated Debentures During June of 2005 Interchange Statutory Trust I and Interchange Statutory Trust II (together the "Trusts") each issued $10 million of pooled trust preferred securities. In conjunction with the issuance of the trust preferred securities, the Company issued subordinated debentures to the Trusts totaling $20.6 million. The rates of interest paid on the securities issued by the Trusts and the Company have been fixed for 5 years, at an average rate of 6.10%, after which time the rates will float at 3-month LIBOR plus 1.71%. The Company has the right to call the notes after 5 years on any of the interest payment dates. The Trusts are wholly owned unconsolidated subsidiaries of the Company and have no independent operations. The obligations of the Trusts are fully and unconditionally guaranteed by the Company. The debentures are unsecured and rank subordinate and junior in right of payment to all indebtedness, liabilities and obligations of the Company. Interest on the debentures is cumulative and payable in arrears. Proceeds from any redemption of debentures would cause a mandatory redemption of pooled trust preferred securities issued by the Trusts having an aggregate liquidation amount equal to the principal amount of debentures redeemed. -29- The trust preferred securities were issued as part of our overall capital management plan and in support of our continued loan growth. The effect of the issuance on net interest income was not material during either the three or six months ending June 30, 2005. -30- Item 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market risk is generally described as the sensitivity of income to adverse changes in interest rates, foreign currency exchange rates, commodity prices, and other relevant market rates or prices. Market rate sensitive instruments include: financial instruments such as investments, loans, mortgage-backed securities, deposits, borrowings and other debt obligations; derivative financial instruments, such as futures, forwards, swaps and options; and derivative commodity instruments, such as commodity futures, forwards, swaps and options that are permitted to be settled in cash or another financial instrument. The Company does not have any material exposure to foreign currency exchange rate risk or commodity price risk. The Company did not enter into any market rate sensitive instruments for trading purposes nor did it engage in any trading or hedging transactions utilizing derivative financial instruments during the first six months of 2005. The Company's real estate loan portfolio, concentrated primarily in northern New Jersey, is subject to risks associated with the local and regional economies. The Company's primary source of market risk exposure arises from changes in market interest rates ("interest rate risk"). Interest Rate Risk Interest rate risk is generally described as the exposure to potentially adverse changes in current and future net interest income resulting from: fluctuations in interest rates; product spreads; and imbalances in the repricing opportunities of interest-rate-sensitive assets and liabilities. Therefore, managing the Company's interest rate sensitivity is a primary objective of the Company's senior management. The Company's Asset/Liability Committee ("ALCO") manages our exposure to changes in market interest rates. ALCO attempts to maintain stable net interest margins by periodically evaluating the relationship between interest-rate-sensitive assets and liabilities. The evaluation, which is performed at least quarterly and presented to the board of directors, attempts to determine the impact on net interest margin from current and prospective changes in market interest rates. The Company manages interest rate risk exposure with the utilization of financial modeling and simulation techniques. These methods assist the Company in determining the effects of market rate changes on net interest income and future economic value of equity. The objective of the Company is to maximize net interest income within acceptable levels of risk established by policy. The techniques utilized for managing exposure to market rate changes involve a variety of interest rate, pricing and volume assumptions. These assumptions include projections on growth, prepayment and withdrawal levels as well as other embedded options inherently found in financial instruments. The Company reviews and validates these assumptions at least annually or more frequently if economic or other conditions change. At June 30, 2005, the Company simulated the effects on net interest income given an instantaneous and parallel shift in the yield curve of up to a 200 basis point rising interest rate environment and a 200 basis point declining interest rate environment. Based on that simulation, it was estimated that net interest income, over a twelve-month horizon, would not decrease by more than 4.4%. At June 30, 2005, the Company was -31- within policy limits established by the board of directors for changes in net interest income and future economic value of equity. The following table illustrates the effects on net interest income given an instantaneous and parallel shift in the yield curve of up to a 200 basis point rising interest rate environment and a 200 basis point declining interest rate environment: (unaudited) ------------------------------------------- Percentage Change in Estimated Net Interest Income over a twelve month horizon ------------------------------------------- June 30 2005 2004 ---------- ---------- +200 basis points -3.3 % -5.6 % +100 basis points -1.4 -1.7 -100 basis points -1.6 -4.8 -200 basis points -4.4 * * Not simulated due to the historically low interest rate environment. The simulation described above does not represent a Company forecast and should not be relied upon as being indicative of expected operating results. These hypothetical estimates are based upon numerous assumptions including: the nature and timing of interest rate levels including yield curve shape; prepayments on loans and securities; deposit decay rates; pricing decisions on loans and deposits; reinvestment/replacement of asset and liability cashflows; and others. While assumptions are developed based upon current economic and local market conditions, the Company cannot make any assurances as to the predictive nature of these assumptions including how customer preferences or competitor influences might change. Further, as market conditions vary from those assumed in the simulation, actual results will also differ due to: prepayment/refinancing levels deviating from those assumed; the varying impact of interest rate changes on caps or floors on adjustable rate assets; the potential effect of changing debt service levels on customers with adjustable rate loans; depositor early withdrawals and product preference changes; and other internal/external variables. Furthermore, the simulation does not reflect actions that ALCO might take in response to anticipated changes in interest rates or competitive conditions in the market place. Capital Adequacy The Company is subject to capital adequacy requirements imposed by the Board of Governors of the Federal Reserve System (the "Federal Reserve"); and the Bank is subject to similar capital adequacy requirements imposed by the Federal Deposit Insurance Corporation (the "FDIC"). The Federal Reserve and the FDIC have adopted risk-based capital requirements for assessing bank holding company and bank capital adequacy. These standards define capital and establish minimum capital requirements in relation to assets and off-balance sheet exposure, adjusted for credit risk. The risk-based capital standards currently -32- in effect are designed to make regulatory capital requirements more sensitive to differences in risk profiles among bank holding companies and banks, to account for off-balance sheet exposure and to minimize disincentives for holding liquid assets. Assets and off-balance sheet items are assigned to broad risk categories, each with appropriate relative risk weights. The resulting capital ratios represent capital as a percentage of total risk-weighted assets and off balance sheet items. A banking organization's total qualifying capital includes two components: core capital (Tier 1 capital) and supplementary capital (Tier 2 capital). Core capital, which must comprise at least half of total capital, includes common shareholders' equity, qualifying perpetual preferred stock, trust preferred securities (subject to certain limitations) and minority interests, less goodwill and any unrealized gains or losses. Supplementary capital includes the allowance for loan losses (subject to certain limitations), other perpetual preferred stock, trust preferred securities that exceed Tier 1 limits, certain other capital instruments and term subordinated debt. Total capital is the sum of core and supplementary capital. The Company's $20 million of trust preferred securities is considered Tier 1 capital by the Federal Reserve Board. At June 30, 2005, the minimum risk-based capital requirements to be considered adequately capitalized were 4% for Tier 1 capital and 8% for total capital. Federal banking regulators have also adopted leverage capital guidelines to supplement the risk-based measures. The leverage ratio is determined by dividing Tier 1 capital as defined under the risk-based guidelines by average total assets (non risk-adjusted) for the preceding quarter. At June 30, 2005, the minimum leverage ratio requirement to be considered adequately capitalized was 3%. The capital levels of the Company and the Bank at June 30, 2005, and the two highest capital adequacy levels recognized under the guidelines established by the federal banking agencies are included in the following table. The Company's and the Bank's ratios all exceeded the well-capitalized guidelines shown in the table. -33- The Company's and the Bank's capital amounts and ratios are as follows: (dollars in thousands)

Liquidity Liquidity is the ability to provide sufficient resources to meet all current financial obligations and finance prospective business opportunities. The Company's liquidity position over any given period of time is a product of its operating, financing and investing activities. The extent of such activities is often shaped by such external factors as competition for deposits and demand for loans. The Company's most liquid assets are cash and cash equivalents. At June 30, 2005, the total of such assets amounted to $36.0 million, or 2.4%, of total assets, compared to $33.1 million, or 2.3%, of total assets at December 31, 2004. Financing for the Company's loans and investments is derived primarily from deposits, along with interest and principal payments on loans and investments. At June 30, 2005 and December 31, 2004, total deposits amounted to $1.3 billion and $1.2 billion, respectively. In addition, the Company supplemented the more traditional funding sources with borrowings from the Federal Home Loan Bank of New York ("FHLB") and with securities sold under agreements to repurchase ("REPOS"). At June 30, 2005, short-term borrowings from the FHLB and REPOS amounted to $43.5 million and $4.7 million, respectively, as compared to $24.6 million and $4.4 million, respectively, at December 31, 2004. Another significant liquidity source is the Company's securities portfolio. Total securities at June 30, 2005 amounted to $361.2 million, a decrease of $27.5 million, from $388.7 million at December 31, 2004. At June 30, 2005 securities AFS amounted to $326.5 million, or 90.4%, of total securities compared to $374.2 million, or 96.3%, of total securities at December 31, 2004. In addition to the aforementioned sources of liquidity, the Company has available various other sources of liquidity, including federal funds purchased from other banks and the Federal Reserve discount -34- window. The Bank also has a $100.0 million line of credit available through its membership in the FHLB of which $6.1 million was utilized at June 30, 2005. The Company is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These instruments, which include commitments to extend credit and standby letters of credit, involve, to a varying degree, elements of credit and interest rate risk in excess of the amount recognized in the unaudited Condensed Consolidated Balance Sheets. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates and may require collateral from the borrower if deemed necessary by the Company. Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party up to a stipulated amount and with specified terms and conditions. Commitments to extend credit and standby letters of credit are not recorded on the Company's Condensed Consolidated Balance Sheet until the instrument is exercised. At June 30, 2005 outstanding commitments to fund loans totaled $280.5 million and outstanding standby letters of credit totaled $2.6 million. The Company has historically paid quarterly cash dividends and anticipates continuing paying quarterly dividends in the future. The Company's Board of Directors could, if they deemed it necessary, modify the amount or frequency, of dividends as an additional source of liquidity. There are imposed dividend restrictions on the Bank, which are described in Note 18 "Restrictions of Subsidiary Bank Dividends" in the Notes to Consolidated Financial Statements in the Company's 2004 Annual Report on Form 10-K. Management believes that the Company has sufficient cash flow and borrowing capacity to fund all outstanding commitments and letters of credit and to maintain proper levels of liquidity. Item 4: CONTROLS AND PROCEDURES In accordance with Rule 13a-15(b) of the Securities Exchange Act of 1934 (the "Exchange Act"), as of the end of the quarter ended June 30, 2005, we carried out an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as defined in Rule 13a-15(e) under the Exchange Act. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission, and accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives and in reaching a reasonable level of assurance our -35- management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. The Company maintains internal control over financial reporting. During the quarter ended June 30, 2005, there were no changes in our internal controls over financial reporting that materially affected, or are reasonably likely to materially affect, those controls. -36- PART II - OTHER INFORMATION Item 1. Legal Proceedings Reference is also made to Note 3 of the Company's Consolidated Financial Statements in this Form 10-Q. Item 2. Unregistered Sales of Equity in Securities and Use of Proceeds During June 2005, Interchange Statutory Trust I and Interchange Statutory Trust II (together the "Trusts") each issued $10 million of pooled trust preferred securities. In conjunction with the issuance of the Trust's preferred securities, the Company issued subordinated debentures to the Trusts totaling $20.6 million. The rates of interest paid on the securities issued by the Trusts and the Company have been fixed for 5 years, at an average rate of 6.10%, after which time the rates will float at the 3-month LIBOR plus 1.71%. The Company has the right to call the notes after 5 years on any of the interest payment dates. The issuance of the Trust's preferred securities and the subordinated debentures was made in a private placement in reliance upon the exemption from compliance with the registration requirements of the Securities Act contained in Section 4(2) of the Securities Act and applicable state securities law exemptions. Item 3. Defaults Upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders (a) The company held its Annual Meeting of Shareholders on April 28, 2005. (b) Each of the persons nominated for director was elected; Approval and Adoption of the Company's 2005 Omnibus Stock and Incentive Plan and the selection of Deloitte & Touche LLP as the Company's independent auditors for 2005 was ratified. The following are the voting results on each of these matters: Against or For Withheld Abstentions --- -------- ----------- (1) ELECTION OF DIRECTORS Anthony S. Abbate 16,170,407 286,949 0 Anthony R. Coscia 16,184,527 272,829 0 John J. Eccleston 16,169,323 288,032 0 Eleanore s. Nissley 16,171,058 286,297 0 William P. Schuber 16,070,558 386,798 0 (2) Approval and Adoption of the Company's 2005 Omnibus Stock and Incentive Plan to Increase Shares of Common Stock Reserved for Issuance: For Against Abstain Not Voted --- ------- ------- --------- 9,610,966 1,825,601 57,523 4,963,266 (3) Ratification of the selection of Deloitte & Touche LLP as the Company's independent Auditors for 2005: Against or For Withheld Abstentions --- -------- ----------- 15,916,008 527,905 13,443 -37- Item 5. Other Information None Item 6. Exhibits The following exhibits are furnished herewith: Exhibit ------- 11 Statement re computation of per share earnings 31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32 Certifications pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 -38- SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Interchange Financial Services Corporation By: /s/ Charles T. Field ----------------------------------- Charles T. Field Senior Vice President and CFO (Duly Authorized Officer and Principal Financial and Accounting Officer) Dated: August 9, 2005 -39-

INTERCHANGE FINANCIAL SERVICES CORP /NJ/ 10-Q