10-Q 1 nazareth10q.txt UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D. C. 20549 FORM 10-Q ____________________________________ (Mark One) [ x ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2003 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 No. 0-11526 ----------------------------------------------------- FIRST COLONIAL GROUP, INC. -------------------------------------------------------------------------------- (Exact Name of Registrant as Specified in its Charter) PENNSYLVANIA 23-2228154 ------------------------------- ---------------------------------- (State or Other Jurisdiction of (I.R.S. Employer Identification No.) Incorporation or Organization) 76 S. MAIN STREET, NAZARETH, PA 18064 -------------------------------------------------------------------------------- (Address of Principal Executive Office) (Zip Code) Registrant's Telephone Number, Including Area Code: 610-746-7300 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES X NO _____ Indicate by check mark whether the registrant is an accelerated filer as defined in rule 12b-2 of the Exchange Act. YES _ NO __X Indicate the number of shares outstanding of each of the issuer's classes of common stock as of the latest practicable date: 2,266,360 shares of common stock, $5 Par Value, outstanding on July 22, 2003. FIRST COLONIAL GROUP, INC. AND SUBSIDIARIES INDEX

See accompanying notes to interim consolidated financial statements.

See accompanying notes to interim consolidated financial statements.

FIRST COLONIAL GROUP, INC. AND SUBSIDIARIES NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS ------------------------------------------------- (Unaudited) NOTE A - GENERAL The accompanying financial statements, footnotes and discussion should be read in conjunction with the audited financial statements, footnotes, and discussion contained in the Company's Annual Report on Form 10-K for the year ended December 31, 2002. The financial information presented herein is unaudited; however, in the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present fairly the unaudited financial information have been made. The results for the three and six months ended June 30, 2003 are not necessarily indicative of results to be expected for the full year or any other interim period. NOTE B - SUBSIDIARIES First Colonial Group, Inc. (the Company) is a Pennsylvania business corporation, which is registered as a bank holding company under the Bank Holding Company Act of 1956. The Company has three wholly-owned subsidiaries, Nazareth National Bank and Trust Company (the "Bank") founded in 1897, First C. G. Company, Inc. founded in 1986, and First Colonial Statutory Trust I (the "Statutory Trust I") founded on June 3, 2002. NOTE C - CASH AND STOCK DIVIDENDS On May 16, 2003, the Company paid its 2003 second quarter dividend on its common stock of $0.19 per share to shareholders of record on May 2, 2003. On May 17, 2002, the Company paid its 2002 first quarter dividend on its common stock of $0.181 per share (adjusted for the 5% stock dividend of May 2002) to shareholders of record on May 3, 2001. On May 31, 2002, the Company paid a 5% stock dividend to shareholders of record on May 17, 2002. Net income per share and average shares outstanding have been restated to reflect this 5% stock dividend. NOTE D - EARNINGS PER SHARE The Company calculates earning per share as provided by the provisions of Statement of Financial Accounting Standards No. 128, "Earnings Per Share (SFAS 128)". Basic and diluted earnings per share were calculated as follows:

Average common shares outstanding for the three months ended June 30, 2003 and June 30, 2002 do not include 48,943 and 57,413, respectively of average weighted unallocated shares held by the ESOP. Average common shares outstanding for the six months ended June 30, 2003 and June 30, 2002 do not include 48,943 and 57,413, respectively of average weighted unallocated shares held by the ESOP. The exclusion of these unallocated shares held by the ESOP is due to the Company's adoption of SOP 93-6. There were no antidilutive securities stock options at June 30, 2003. At June 30, 2002 there were 31,910 antidilutive securities stock options outstanding. NOTE E - STOCK BASED COMPENSATION Under the Company's Stock Option Plans, options to acquire shares of common stock are granted to certain officers, key employees and directors. In January of 2003, options to purchase 59,950 shares of the Company's stock at an average price of $23.83 per share were granted to certain officers and directors of the Company. There were no options issued during the second quarter of 2003. During the second quarter of 2003, options for 24,204 shares of the Company's common stock issued pursuant to the Plan were exercised at an average price of $20.13 per share. During the first six months of 2003, options for 42,323 shares of the Company's common stock were exercised at an average price of $20.46. The Company's Stock Option Plans are accounted for under SFAS No. 123, "Accounting for Stock-Based Compensation". This standard contains a fair value-based method for valuing stock-based compensation which measures compensation cost at the grant date based on the fair value of the award. Compensation is then recognized over the service period, which is usually the vesting period. Alternatively, the standard permits entities to continue accounting for employee stock options and similar instruments under APB Opinion No. 25. Entities that continue to account for stock options using APB Opinion No. 25 are required to make pro forma disclosures of net income and earnings per share, as if the fair value-based method of accounting defined in SFAS No. 123 had been applied. The Company's stock option plans are accounted for under APB Opinion No. 25. Had compensation cost for the Plans been determined based on the fair value of the options at the grant dates consistent with the method required by SFAS No. 123, "Accounting for Stock-Based Compensation", the Company's net income and earnings per share would have been reduced to the pro forma amounts indicated below.

The fair value of each option grant is estimated on the date of grant using the Black-Scholes options-pricing model with the following weighted-average assumptions used for grants in 2003 and 2002, respectively: dividend yield of 1.8% and 3.3%; expected volatility of 53.5% and 43.5%; risk-free interest rates of 4.1% and 4.9%; and expected lives of 7.7 years and 10 years. The stock-based compensation cost for the three months ended March 31, 2003 was affected by the accelerated vesting of all stock options as a result of the execution of the merger agreement with Keystone Savings Bank. NOTE F - MERGER AGREEMENT On March 6, 2003, First Colonial Group, Inc. and Keystone Savings Bank announced that they had signed an Agreement and Plan of Merger to combine into a new bank holding company to be formed, KNBT Bancorp, Inc. In addition, First Colonial's subsidiary bank, Nazareth National Bank and Trust Company and Keystone Savings Bank will combine into a new bank, Keystone Nazareth Bank & Trust Company. The transaction involves the conversion of Keystone Savings Bank from a mutual savings bank to a stock institution and the formation of a holding company, KNBT Bancorp, Inc. Each share of First Colonial Group, Inc. common stock will be valued at $37.00 and exchanged for shares of KNBT Bancorp, Inc. common stock based on the initial public offering ("IPO") price of KNBT Bancorp, Inc.'s common stock. The transaction is subject to certain conditions, including the receipt of various regulatory approvals, the approval of First Colonial Group's shareholders and the approval of Keystone Savings Bank's depositors. NOTE G - NEW ACCOUNTING PRONOUNCEMENTS In November 2002, the Financial Accounting Standards Board issued FASB Interpretation No. 45 ("FIN No. 45"), "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others." The Company adopted the disclosure provisions of FIN No. 45 in the fourth quarter of 2002 and, for guarantees issued or modified after December 31, 2002, adopted the initial recognition and measurement provisions on January 1, 2003. Adoption of the initial recognition and measurement provisions did not materially impact the Company's financial condition or results of operations at or for the three months ended March 31, 2003. While certain guarantees are only subject to the disclosure provisions of this Interpretation, others are subject to both the disclosure and initial recognition and measurement provisions. For guarantees that fall within the scope of the initial recognition and measurement provisions, FIN No. 45 requires a guarantor to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. Under the previous accounting rules, the Company did not record a liability when guaranteeing obligations unless it became probable that the Company would have to perform under the guarantee. The Company issues financial and performance standby letters of credit, both of which are subject to the disclosure and initial recognition and measurement provisions of FIN No. 45. Financial and performance standby letters of credit are conditional commitments issued by the Bank to assure the financial and performance obligations of a customer to a third party. At June 30, 2003, the Company was contingently liable on financial and performance standby letters of credit totaling $47,000 and $2,363,000, respectively, $1,066,000 of which were originated in the second quarter of 2003. The Company's commitments under standby letters of credit expire at various dates through 2005. Amounts due under these letters of credit would be reduced by any proceeds that the Company would be able to obtain in liquidating the collateral for the loans, which varies depending on the customer. The Bank generally holds collateral and/or obtains personal guarantees supporting these commitments. The extent of collateral held for these commitments at June 30, 2003 varied from 0% to 100%, and averaged 96.1%. In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities ("FIN 46"). FIN 46 requires a variable interest entity to be consolidated by a Company if that Company is subject to a majority of the risk of loss from the variable interest entity's activities or entitled to receive a majority of the entity's residual returns, or both. FIN 46 also requires disclosures about variable interest entities that a Company is not required to consolidate, but in which it has a significant variable interest. The consolidation requirements of FIN 46 apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements apply to existing entities in the first fiscal year or interim period beginning after June 15, 2003. Certain of the disclosure requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. The Company has also evaluated the impact of FIN 46 on variable interest entities consolidated by the Company prior to the issuance of FIN 46. Management has determined that First Colonial Statutory Trust I qualifies as a variable interest entity under FIN 46. First Colonial Statutory Trust I issued mandatorily redeemable preferred stock to investors and loaned the proceeds to the Company. First Colonial Statutory Trust I holds, as its sole asset, subordinated debentures issued by the Company in 2002. The timing and amount of payments on the subordinated debentures are the same as the timing and amount of payments by First Colonial Statutory Trust I on the mandatorily redeemable preferred stock. First Colonial Statutory Trust I is currently included in the Company's consolidated balance sheet and statements of income. Management believes that First Colonial Statutory Trust I should continue to be included in the Company's consolidated financial statements after the effective date of FIN 46. However, as additional interpretations related to entities similar to First Colonial Statutory Trust I become available, management will reevaluate its conclusion that First Colonial Statutory Trust I should be included in the consolidated financial statements and its potential impact to its Tier I capital calculation under such interpretations. In April 2003, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 149 "Amendment of Statement 133 on Derivative Instruments and Hedging Activities" ("SFAS No. 149"). SFAS No. 149 is generally effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. All provisions of this Statement shall be applied prospectively. Based on the Corporation's current business operations, management expects that the provisions of SFAS No. 149 will not materially impact the Corporation's financial condition, results of operations, or disclosures. The FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, on May 15, 2003. SFAS No. 150 changes the classification in the statement of financial position to liabilities and requires an issuer of those financial instruments from either equity or mezzanine presentation to liabilities and requires an issuer of those financial statements to recognize changes in fair value or redemption amount, as applicable, in earnings. SFAS No. 150 is effective for public companies for financial instruments entered into or modified after May 31, 2003 and is effective at the beginning of the first interim period beginning after June 15, 2003. Management has not entered into any financial instruments that would qualify under SFAS No. 150. The Company currently classifies its Guaranteed Preferred Beneficial Interest in the Company's Subordinated Debt as a liability. As a result, management does not anticipate the adoption of SFAS No. 150 to have a material impact on the Company's financial position or results of operations. ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations The following financial review and analysis is of the financial condition and earnings performance of the Company and its wholly owned subsidiaries for the three and six month period ended June 30, 2003. The information contained in this Quarterly Report contains forward looking statements (as such term is defined in the Securities Exchange Act of 1934 and the regulations thereunder), including, without limitation, the discussion of the planned merger with Keystone Savings Bank, statements as to future loan and deposit volumes, future expansion plans and new branches, the allowance and provision for possible loan losses, future interest rates and their effect on the Company's financial condition or results of operations, the classification of the Company's investment portfolio, the discussion in "Item 3 - Quantitative and Qualitative Discussion About Market Risk", statements as to litigation and the amount of reserves, statements as to trends, and other statements which are not historical facts or as to the Company's, the Bank's or management's intentions, plans, beliefs, expectations or opinions. Such forward looking statements are subject to risks and uncertainties and may be affected by various factors which may cause actual results to differ materially from those in the forward looking statements, including without limitation, the risk that the transactions contemplated by the Agreement and Plan of Merger with Keystone Savings Bank may not be completed, the effect of economic conditions and related uncertainties, the effect of interest rates on the Company and the Bank, Federal and state government regulation, competition, changes in accounting standards and policies, and results of litigation. These and other risks, uncertainties and other factors are discussed in this Quarterly Report or in the Company's Annual Report on Form 10-K for the year ended December 31, 2002 a copy of which may be obtained from the Company upon request and without charge (except for the exhibits thereto) as described below. In analyzing whether to make, or to continue, an investment in the Company, investors should consider, among other factors, certain investment considerations more particularly described in the Company's Annual Report on Form 10-K for the year ended December 31, 2002 a copy of which can be obtained from Reid L. Heeren, Vice President, First Colonial Group, Inc., 76 S. Main Street, Nazareth, PA 18064. Merger Agreement On March 6, 2003, First Colonial Group, Inc. and Keystone Savings Bank announced that they had signed an Agreement and Plan of Merger to combine, forming the largest locally controlled bank in the greater Lehigh Valley-Poconos market area. The resulting bank, Keystone Nazareth Bank & Trust Company, and its newly created bank holding company, KNBT Bancorp, Inc., will have combined assets of more than $1.6 billion and 36 branches covering Lehigh, Northampton, Monroe and Carbon counties. Both banks will continue to operate independently until the close of the transaction, which is expected to occur in the fourth quarter of 2003. The transaction involves the conversion of Keystone Savings Bank from a mutual savings bank to a stock institution; the formation of a holding company, KNBT Bancorp, Inc., and the mergers of First Colonial Group into KNBT Bancorp, Inc. and Nazareth National Bank into Keystone Savings Bank. Each share of First Colonial will be valued at $37 and exchanged for shares of KNBT Bancorp, Inc., common stock based on the initial public offering ("IPO") price of KNBT Bancorp's common stock. The transaction is subject to certain conditions, including the receipt of various regulatory approvals, as well as the approval of First Colonial Group's shareholders and Keystone Savings Bank's depositors. Jeffrey P. Feather, chairman of the board of trustees of Keystone Savings Bank, will serve as chairman of the newly created holding company and bank. Six members of the First Colonial Group board will join nine members of the Keystone Savings board to form a new 15-member KNBT Bancorp, Inc. board. Scott V. Fainor, currently president and chief executive officer of Nazareth National Bank and First Colonial Group, will become the president and chief executive officer of Keystone Nazareth Bank & Trust Company and KNBT Bancorp, Inc., effective upon completion of the transaction. All branches from both banks are slated to remain open. Also, within the past six months, both banks have embarked on multi-branch expansion programs that are expected to continue. Together, the banks currently employ 602 people. As part of this transaction, a multi-million dollar charitable foundation will be formed to help fund local projects and programs of civic, charitable and cultural organizations throughout the region. Each of the directors of First Colonial Group has agreed to vote their shares of First Colonial Group in favor of the merger, and each of the trustees of Keystone Savings Bank has agreed to vote their deposits in favor of the conversion. The proposed merger will be submitted to First Colonial Group's shareholders for their consideration. KNBT Bancorp and First Colonial Group will file a registration statement, a proxy statement/prospectus and other relevant documents concerning the proposed transaction with the SEC. Shareholders of First Colonial are urged to read the registration statement and the proxy statement/prospectus when it becomes available and any other relevant documents filed with the SEC, as well as any amendments or supplements to those documents, because they will contain important information, before making any decision regarding the merger. Shareholders of First Colonial will be able to obtain a free copy of the proxy statement/prospectus when it becomes available, as well as other filings containing information about KNBT Bancorp, Keystone Savings and First Colonial Group, at the SEC's Internet site (http://www.sec.gov). Copies of the proxy statement/prospectus can be obtained, without charge, by directing a request to the Secretary of First Colonial, First Colonial Group, Inc., 76 South Main Street, Nazareth, Pennsylvania 18064 (610-861-5721). First Colonial Group and its directors and executive officers may be deemed to be participants in the solicitation of proxies from the shareholders of First Colonial Group in connection with the merger. Information about the directors and executive officers of First Colonial Group and their ownership of First Colonial Group common stock is set forth in First Colonial Group's Annual Report on Form 10-K for the year ended December 31, 2002, as filed with the SEC on March 28, 2003. Additional information about the interests of those participants may be obtained from reading the definitive proxy statement/prospectus regarding the proposed merger when it becomes available. Critical Accounting Policies, Judgments and Estimates The accounting and reporting policies of the Company conform with accounting principles generally accepted in the United States of America and general practices within the financial services industry. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and the assumptions that affect the amounts reported in the financial statements and the accompanying notes. Actual results could differ from those estimates. The Company considers that the determination of the allowance for loan losses involves a higher degree of judgment and complexity than its other significant accounting policies. The allowance for loan losses is calculated with the objective of maintaining a reserve level believed by management to be sufficient to absorb estimated probable credit losses. Management's determination of the adequacy of the allowance is based on periodic evaluations of the loan portfolio and other relevant factors. However, this evaluation is inherently subjective as it requires material estimates, including, among others, expected default probabilities, loss given default, expected commitment usage, the amounts and timing of expected future cash flows on impaired loans, mortgages, and general amounts for historical loss experience. The process also considers economic conditions, uncertainties in estimating losses and inherent risks in the loan portfolio. All of these factors may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provisions for loan losses may be required that would adversely impact earnings in future periods. On January 1, 2002, First Colonial adopted SFAS No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets". At June 30, 2003, and December 31, 2002, First Colonial had goodwill with a carrying value of approximately $127,000 resulting from previous branch acquisitions. In accordance with SFAS No. 142, First Colonial has discontinued the amortization of goodwill resulting from these acquisitions, and subject's goodwill to impairment testing at each defined reporting unit. A fair value is determined for each reporting unit based on at least one of three various market valuation methodologies. If the fair values of the reporting units exceed their book values, no write-down of recorded goodwill is necessary. If the fair value of the reporting unit is less, an expense may be required on First Colonial's books to write-down the related goodwill to the proper carrying value. As of June 30, 2003 and December 31, 2002, First Colonial determined that no impairment write-offs were necessary. The Company recognizes deferred tax assets and liabilities for future tax effects of temporary differences, net operating loss carryforwards and tax credits. Deferred tax assets are subject to management's judgment based upon available evidence that future realization is more likely than not. If management determines that the Company may be unable to realize all or part of net deferred tax assets in the future, a direct charge to income tax expense may be required to reduce the recorded value of the net deferred tax asset to the expected realizable amount. These and other significant accounting policies are described in Note A to the Company's 2002 financial statements contained in the Company's Annual Report on form 10-K for the year ended December 31, 2002. Results of Operations Basic earnings per share for the three months ended June 30, 2003 were $0.47 as compared to $0.45 for the corresponding period in 2002. Diluted earnings per share for the three months ended June 30, 2003 where $0.44 as compared to $0.44 for the same period in 2002. Average basic shares outstanding during this three month period were 2,207,138 in 2003 and 2,152,664 in 2002. Average diluted shares outstanding for the three month period were 2,356,745 in 2003 and 2,195,235 in 2002. Basic earnings per share for the six months ended June 30, 2003 were $0.90 as compared to $0.83 for the corresponding period in 2002. Average diluted earnings per share for the six months ended June 30, 2003 were $0.85 as compared to $0.82 for the same period in 2002. Average basic shares outstanding during this six month period were 2,192,445 in 2003 and 2,149,896 in 2002. Average diluted shares outstanding during the six month period were 2,324,828 in 2003 and 2,188,199 in 2002. Per share earnings and average shares outstanding have been restated to reflect the 5% stock dividend paid on May 17, 2002. (see Note D) The net income for the three months ended June 30, 2003 was $1,049,000 compared to $980,000 for the same period in 2002. This was an increase of $69,000 or 7.0%. The earnings increase was attributable to an increase on the gains on the sale of Available for Sale Securities of $415,000, or 141.2%, a $272,000, or 224.8%, increase in the gains on the sale of mortgage loans, an increase in net interest income of $249,000 or 5.9% (see discussion on Net Interest Income), a $44,000 or 3.9% increase in other income exclusive of gains on the sale of available-for-sale securities and the gains on the sale of mortgage loans held-for-sale. These were offset in part by a $872,000 or 20.9% increase in total other expenses, an increase of $14,000 or 3.9% in the provision for possible loan losses, and an increase of $25,000 or 11.6% in Federal income taxes. Net income for the six months ended June 30, 2003 was $1,981,000 compared to $1,791,000 for the same period in 2002 an increase of $190,000 or 10.6%. The earnings increase was primarily attributable to an increase of $811,000, or 122.3%, in the gains on the sale of available-for-sale securities, an increase of $676,000 or 8.2% in net interest income, an increase in gains on the sale of mortgage loans of $613,000, or 311.2%, an increase of $16,000 or 0.7% in other income exclusive of gains on the sale of available-for-sale securities and the gains on the sale of mortgage loans. These were partially offset by a $2,095,000 or 24.8% increase on total other expenses, a decrease of $186,000 or 24.4% in the provision for possible loan losses and a $17,000 or 4.7% increase in Federal income taxes. Net Interest Income Net interest income amounted to $4,443,000 for the three months ended June 30, 2003 compared to $4,194,000 for the three months ended June 30, 2002, an increase of $249,000 or 5.9%. This increase was primarily the result of decreases in interest paid on deposit and debt exceeding the decreases in the interest earned on loans and investments. The total interest income earned on loans and investments amounted to $7,356,000 for the second quarter of 2003, an increase of $129,000 or 1.8% from the $7,227,000 earned in the same period in 2002. The total interest expense paid on deposits and debt was $2,913,000 and $3,033,000 for the three month period ended June 30, 2003 and 2002, respectively. This was a decrease in second quarter of 2003 from 2002 of $120,000 or 4.0%. The increase in interest income was the result of increased average loans outstanding which was reduced in part by lower interest rates. The reduction of interest expense is attributed to lower interest rates paid on deposits and debt as a result of a general declining interest rate environment. The effect of these lower interest rates were offset in part by an increase in deposit balances. Net interest income for the six months ended June 30, 2003 was $8,945,000 compared to $8,269,000 for the same period in 2002. This was an increase of $676,000 or 8.2%. The interest income earned on loans and investments during the first half of 2003 was $14,935,000, which was $598,000 or 4.2% higher than the 2002 amount of$14,337,000. Total interest expense for the six-month period was $5,990,000 and $6,068,000 in 2003 and 2002, respectively. This was a decrease of $78,000 or 1.3%. The growth in net interest income was primarily the result of lower interest rates in a declining rate environment and higher volumes of deposits, loans and investments. The fully taxable-equivalent net interest income was $9,605,000 for the first six months of 2003, compared to $8,775,000 for the same period in 2002, a 9.5% or $830,000 increase. This increase in taxable-equivalent net interest income was primarily due to a $1,610,000 increase related to volume partially reduced by a $780,000 decrease due to interest rates. First Colonial's provision for possible loan losses was $375,000 for the three months ended June 30, 2003 as compared to $361,000 for the same period in 2002. The provision for possible loan losses was $575,000 for the six months ended June 30, 2003 as compared to $761,000 for the six months ended June 30, 2002. The provision was determined in accordance with SAB No. 102, considering all credit quality risk associated with the loan portfolio (see management's discussion on "Allowance and Provision for Possible Loan Losses") . The "Rate/Volume Analysis" table segregates, in detail, the major factors that contributed to the changes in net interest income, for the six months ended June 30, 2003 as compared to the same period in 2002, into amounts attributable to both rate and volume variances. In calculating the variances, the changes were first segregated into (1) changes in volume (change in volume times the old rate), (2) changes in rate (changes in rate times the old volume) and (3) changes in rate/volume (changes in rate times the change in volume). The changes in rate/volume have been allocated in their entirety to the change in rates. Non accruing loans have been used in the daily average balances to determine changes in interest income due to volume. Loan fees included in the interest income calculation are not material.

Total taxable-equivalent interest income for the six months ended June 30, 2003 increased by $752,000 or 5.1% compared to the same period in 2002. This increase was primarily the result of higher volumes of investments and loans reduced in part by lower interest rates earned on these investments and loans. Interest income on investments on a fully taxable equivalent basis was $1,016,000 or 16.5% higher during the first half of 2003 as compared to the same period in 2002. This increase was comprised of a $3,072,000 increase due to a higher volume of investment securities reduced in part by a decrease of $2,056,000 due to lower interest rates. The interest income earned on loans on a fully taxable equivalent basis decreased by $259,000 or 3.0% for the six months ended June 30, 2003 as compared to the same period in 2002. This decrease was comprised of a $968,000 decrease due to lower interest rates reduced in part by a $709,000 increase due to growth in average loans outstanding. Average year-to-date earning assets increased to $586,960,000 at June 30, 2003 from $458,303,000 at June 30, 2002. This was an increase of $128,657,000 or 28.1% Total interest expense decreased by $78,000 or 1.3% during the first six months of 2003, over the same period in 2002. The decrease was the result of lower interest rates paid on deposits and debt reduced in part by growth in deposits and debt. The interest expense on interest-bearing deposits decreased by $843,000 or 17.1% during the first six months of 2003 as compared to the first six months of 2002. This was comprised of a decrease of $1,776,000 due to lower interest rates offset in part by a $933,000 increase due to deposit growth. Also affecting the decrease in interest expense was a $60,000 decrease in interest paid on securities sold under agreements to repurchase and a decrease of $3,000 on the interest paid on short-term debt. The decrease in interest expense was offset in part by an increase of $478,000 or 47.6% on the interest paid on long-term debt and $350,000 on the interest paid on the $15,000,000 of subordinated debentures issued in June 2002. The increase of the interest paid on long-term debt was comprised of an increase of $930,000 due to higher level of debt partially offset by a decrease of $452,000 due to lower interest rates. The following table "Consolidated Comparative Statement Analysis" sets forth a comparison of average daily balances, interest income and interest expense on a fully taxable equivalent basis and interest rates calculated for each major category of interest-earning assets and interest-bearing liabilities. For the purposes of this analysis, the computations in the "Consolidated Comparative Statement Analysis" were prepared using the Federal statutory rate of 34%; there were no state or local taxes on income applicable to the Company.

(1) The indicated interest income and average yields are presented on a taxable equivalent basis. The tax equivalent adjustments included above are $660,000 and $506,000 for the six months ended June 30, 2003 and June 30, 2002, respectively. The effective tax rate used for the taxable equivalent adjustment was 34%. (2) Loan fees of ($148,000) and $(127,000) for the six months ended June 30, 2003 and June 30, 2002, respectively, are included in interest income. Average loan balances include non-accruing loans and average loans held-for-sale of $3,709,060 and $4,316,000 for the six months ended June 30, 2003 and June 30, 2002, respectively. (3) Net interest spread is the arithmetic difference between the yield on average interest-earning assets and the rate paid on interest-bearing liabilities. (4) Net interest margin is computed by dividing net interest income by average interest-earning assets. The net interest margin of 3.27% for the six-month period ended June 30, 2003, decreased from the 3.83% net interest margin for the first six months of 2002. The yield on interest earning assets was 5.31% during the first six months of 2003 as compared to 6.48% in 2002. The average interest rate paid on interest bearing deposits and other borrowings was 2.37% for the first six months of 2003 as compared to 3.12% in 2002. Other Income and Other Expenses Other income for the three months ended June 30, 2003, including service charges, trust and wealth management revenues, gains on the sale of mortgage loans, net securities gains and other miscellaneous income was $2,268,000 as compared to $1,537,000 for the same period in 2002. This was an increase of $731,000 or 47.6%. This increase was the result of increased gains on the sale of securities available-for-sale, the higher gains on the sale of mortgage loans, and increases in trust and wealth management revenues and other operating income, reduced in part by a decline in service charges. The net gains on securities available-for-sale for the three-month period ended June 30 were $709,000 in 2003 and $415,000 in 2002. This was an increase of $415,000 or 141.2%. In the three month period ended June 30, 2003, the gains on the sale of mortgage loans amounted to $393,000 as compared to a gain of $121,000 for the same period in 2002, an increase of $272,000 or 224.8%. Mortgage loan sales amounted to $13,803,000 during the three month period ended June 30, 2003 as compared to $11,246,000 during the same period in 2002. Other operating income for the three months ended June 30, 2003 was $230,000, an increase of $40,000 or 21.1% compared to $190,000 for the same period in 2002. The increase in miscellaneous income was primarily the result of an increase in the use of various fee-based services. The trust and wealth management revenues were $325,000 for the three months ended June 30, 2003 as compared to $291,000 for the three months ended June 30, 2002, an increase of $34,000 or 11.7%. The revenues from trust and wealth management operations increased as a result of additional new accounts. Service charges on deposit accounts declined by $30,000 or 4.7% during the three-month period ended June 30, 2003 as compared to the same period in 2002. The service charges for the three months ended June 30 were $611,000 and $641,000 in 2003 and 2002, respectively. The decline in service charge income is due to a lower level of overdraft service charges. Other income for the six months ended June 30, 2003, including service charges, trust and wealth management revenues, gains on the sale of mortgage loans, net securities gains and other miscellaneous income was $4,534,000 as compared to $3,094,000 for the same period in 2002. This was an increase of $1,440,000 or 46.5%. This increase was the result of increased gains on the sale of securities available-for-sale, the higher gains on the sale of mortgage loans, and increases in trust and wealth management revenues, reduced in part by a decline in service charges and a decline in other operating income. The gains on the sale of securities available-for-sale for the six months ended June 30, 2003 were $1,474,000 as compared to $663,000 for the same period in 2002. This was an increase of $811,000 or 122.3%. The gains on the sale of mortgage loans were $810,000 during the first six months of 2003 compared to $197,000 in the first six months of 2002, an increase of $613,000 or 311.2%. Mortgage loan sales amounted to $29,957,000 and $20,918,000 in the first six months of 2003 and 2002, respectively. The increase in the mortgage sales gains was the result of lower interest rates. In the six-month period ended June 30, 2003, service charges were $1,230,000, a $10,000 or 0.8% decrease from the 2002 amount of $1,240,000. The decrease in service charge income is primarily the result of a reduction in the number of overdraft fees collected. The revenues from the trust and wealth management operations were $610,000 for the six months ended June 30, 2003 as compared to $575,000 for the six months ended June 30, 2002, an increase of $35,000 or 6.1%. Other operating income was $410,000 for the first six months of 2003 as compared to $419,000 for the same period in 2002. This was a decrease of $9,000 or 2.1%. Total other expenses for the three-month period ended June 30, 2003 increased by $872,000 or 20.9% to $5,047,000 over total other expenses for the same period in 2002 of $4,175,000. Included in this increase was a $293,000 or 13.9% increase in salary and benefit expenses which were $2,404,000 in 2003 as compared to $2,111,000 in 2002. These increases were primarily due to general salary increases of approximately 4% and the addition of staff for the new branch at 3856 Easton-Nazareth Highway and the other three new branches that will open in the third or fourth quarter of 2003. Occupancy and equipment expenses were $667,000 for the three months ended June 30, 2003 and $642,000 for the three months ended June 30, 2002, an increase of $25,000 or 3.9%. The increase in occupancy expenses were related to rent increase at some branches and general maintenance. During the three months ended June 30, 2003, the expense for the impairment of mortgage servicing rights amounted to $238,000. There was no such expense during the same period of 2002. This impairmentexpense was due to a larger than normal number of customers prepaying their residential mortgage loans as a result of lower interest rates. Other operating expenses for the three month period ended June 30, 2003 were $1,738,000, an increase of $316,000 or 22.2% from the $1,422,000 in other expenses for the same period in 2002. This increase was primarily the result of higher data processing, advertising and professional services expenses. Total other expenses for the six-month period ended June 30, 2003 increased by $2,095,000 or 24.8% to $10,548,000 over total other expenses for the same period in 2002 of $8,453,000. A major factor affecting the increase in total other expenses was the expense of $875,000 for the impairment of mortgage servicing rights during the first half of 2003. There was no mortgage impairment expense during the first half of 2002. This impairment expense is due to a larger than normal number of customers prepaying their residential mortgage loans as a result of lower interest rates. Also included in the increase of other expenses was an $822,000 or 19.8% increase in salary and benefit expenses which were $4,980,000 in 2003 as compared to $4,158,000 in 2002. These increases were primarily due to a charge of $175,000 due to the accelerated vesting and distribution of the deferred stock compensation as a result of the merger agreement with Keystone Savings Bank, general salary increases of approximately 4% and additional staff for the new branches opening in 2003 and staff additions in the third and fourth quarter of 2002, in the commercial lending and trust and wealth management area of the bank. Occupancy and equipment expenses were $1,310,000 for the six months ended June 30, 2003 and $1,308,000 for the six months ended June 30, 2002, an increase of $2,000 or 0.2%. Other operating expenses for the six month period ended June 30, 2003 were $3,383,000, an increase of $396,000 or 13.3% from the $2,987,000 in other expenses for the same period in 2002. This increase was primarily due to higher data processing, advertising and professional services expenses. FINANCIAL CONDITION Assets and Liabilities Total assets at June 30, 2003 were $642,244,000, representing an increase of $30,652,000 or 5.0% over total assets of $611,592,000 at December 31, 2002. Deposits increased by $33,530,000 or 7.1% from $472,798,000 on December 31, 2002 to $506,328,000 on June 30, 2003. Contributing to this increase in total deposits were increases in non-interest bearing checking deposits of $12,997,000, certificates of deposit under $100,000 of $12,828,000, certificates of deposits over $100,000 of $8,359,000, savings and club deposits of $6,556,000, and interest-bearing checking accounts of $4,342,000, partially offset by a decrease in money market accounts of $11,552,000. Loans outstanding at June 30, 2003 were $265,597,000 as compared to $255,844,000 at December 31, 2002. This was an increase of $9,753,000 or 3.8%. The increase in loans was primarily the result of increases in commercial loans of $12,199,000 and residential real estate loans of $2,592,000. These increases were offset in part by a decrease in consumer loans of $5,038,000. Also affecting loan growth was the sale of $29,957,000 of residential real estate loans during the first six months of 2003. There were $2,803,000 of residential real estate loans identified as held-for-sale at June 30, 2003. There were $1,263,000 residential real estate loans held-for sale at December 31, 2002. The loan to deposit ratio was 52.5% and 54.1% at June 30, 2003 and December 31, 2002, respectively. Allowance and Provision for Possible Loan Losses The provision for possible loan losses is based on management's analysis of the adequacy of the allowance for possible loan losses. In its evaluation, management considers past loan experience, overall characteristics of the loan portfolio, current economic conditions and other relevant factors. Management currently believes that the allowance is adequate to absorb known and inherent losses in the loan portfolio. Ultimately, however, the adequacy of the allowance is largely dependent upon economic conditions that are beyond the scope of management's control. The provision for possible loan losses was $375,000 for the three months ended June 30, 2003. The provision for possible loan losses for the same period in 2002 was $361,000. Net charge-offs were $260,000 and $167,000 for the three month period ended June 30, 2003 and 2002, respectively. The provision for possible loan losses was $575,000 for the first six months of 2003 as compared to $761,000 for the same period in 2002. Net charge offs were $432,000 for the six months ended June 30, 2003 compared with $481,000 for the six months ended June 30, 2002. The ratio of the allowance for loan losses to total loans was 1.22% at June 30, 2003 and 1.21% at December 31, 2002. The allowance for possible loan losses at June 30, 2003 totaled $3,228,000, an increase of $144,000 or 4.7% over the December 31, 2002 amount of $3,084,000. At June 30, 2003, the net loan charge-offs to average loans outstanding for First Colonial increased slightly to .34% from .29% at December 31, 2002. The charge-offs were concentrated in the consumer loan portfolio. Loan portfolio risk increased as the level of commercial loans increased $12,199,000 or 14.7% from $82,742,000 at December 31, 2002 to $94,941,000 at June 30, 2003. Residential real estate loans also increased by $2,592,000 or 2.3% from $114,448,000 at December 31, 2002 to $117,040,000 at June 30, 2003. At the same time, consumer loans totaling $53,616,000 at June 30, 2003 decreased $5,038,000 or 8.6% from the December 31, 2002 amount of $58,654,000. The ratio of the allowance to non-performing loans increased from 138.6% at December 31, 2002 to 161.5% at June 31, 2003. The continued growth in commercial loans and the potential higher risk of these types of loans warranted the $144,000 increase in the allowance for possible loan losses, through a loan loss provision of $575,000 for the first six months of 2003. The provision is determined by applying First Colonial's allowance methodology and is deemed to be adequate. At June 30, 2003, $6,000 of the allowance for possible loans losses was allocated to impaired loans. Transactions in the allowance for loan losses were as follows: 2003 2002 ------------------- ------------------- Balance, January 1, $ 3,084,000 $ 2,264,000 Loans Charged Off (486,000) (583,000) Loans Recovered 55,000 102,000 ------------------- ------------------- Net Loans Charged Off (431,000) (481,000) Provision Charged to Expenses 575,000 761,000 ------------------- ------------------- Balance, June 30, $ 3,228,000 $ 2,544,000 =================== =================== Non-Performing Loans The following discussion relates to the Bank's non-performing loans, which consist of those on a non-accrual basis, and accruing loans which are past due ninety days or more. Accrual of interest is discontinued on a loan when management believes, after considering economic and business conditions and collection effort, that the borrower's financial condition is such that the collection of interest is doubtful. The Company views these loans as non-accrual, but considers the principal substantially collectible because adequate collateral or other resources protect the loans. Interest on these loans is recognized only when received. The following table shows the balance of non-performing loans for each of the periods indicated.

Total non-performing loans (non-accruing loans and loans past due over 90 days) amounted to $1,999,000 at June 30, 2003 as compared to $2,225,000 at December 31, 2002 and $2,674,000 at June 30, 2002. The ratio of non-performing loans to total loans was 0.76%, 0.87% and 1.08% at June 30, 2003, December 31, 2002 and June 30, 2002, respectively. The decrease in this ratio was primarily the result of a decrease in total non-performing loans due to collection efforts. Non-accruing loans at June 30, 2003 of $1,321,000 decreased from the December 31, 2002 amount of $1,351,000 and increased over the June 30, 2002 level of $1,093,000. The amount of decrease from December 31, 2002 to June 30, 2003 was $30,000. This decrease was primarily the result of the charge-off of certain consumer loans. At the present time, management is of the opinion that these non-accruing loans present a minimal amount of exposure to the Bank. Loans past due 90 days or more and still accruing interest are loans that are generally well secured and expected to be restored to a current status in the near future. As of June 30, 2003, loans past due 90 days or more and still accruing interest were $678,000 compared to $874,000 at December 31, 2002 and $1,581,000 at June 30, 2002. The $196,000 decrease in loans past due 90 days from December 31, 2002 to June 30, 2003 was the result of decreases in commercial, mortgage and consumer loans past due 90 days or more. Other Real Estate Owned There was no Other Real Estate Owned at June 30, 2003 and at December 31, 2002. Investment Securities The Company had $255,847,000 in available-for-sale securities at June 30, 2003 with a net unrealized gain of $625,000. At December 31, 2002 available-for-sale securities amounted to $283,481,000 with a net unrealized gain of $1,321,000. During the three-month period ended June 30, 2003, $82,260,000 of securities available-for-sale were sold for a net gain of $709,000 as compared to $28,053,000 of securities available-for-sale sold for a net gain of $294,000 for the same period in 2002. Most of the securities sold were agency mortgage-backed bonds, fixed rate agency bonds and equities. These securities were replaced with shorter term agency mortgage-backed securities, agency bonds with step-up features and other equity securities. The purpose of these sales was to shorten the investment portfolio, reduce interest-rate risk and reposition the equity portfolio. During the six-month period ended June 30, 2003, $133,168,000 of securities available-for-sale were sold for a net gain of $1,474,000 as compared to $48,244,000 of securities available-for-sale sold for a net gain of $663,000 for the same time period in 2002. Most of the securities sold were longer term agency mortgage-backed bonds, fixed rate agency bonds and equity securities. These securities were replaced with shorter-term agency mortgage-backed securities, fixed rate agency bonds, agency bonds with step-up features and equities. The purpose of these sales was to shorten the investment portfolio and reduce the Company's interest rate risk and reposition the equity portfolio. Held-to-maturity securities totaling $68,277,000 at June 30, 2003 are carried at amortized cost. At December 31, 2002, the held-to-maturity securities totaled $30,297,000. The Company has the intent and ability to hold the held-to-maturity securities until maturity. The Company, at June 30, 2003, did not hold any securities identified as derivatives. Capital Resources and Liquidity The Company and the Bank are subject to various regulatory capital requirements administered by the Federal banking agencies. 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 and the Bank must meet specific capital guidelines that involve quantitative measures of the Company's and the Bank's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company's and the Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios of Tier I capital of at least 4% and total capital, Tier I and Tier 2, of 8% of risk-adjusted assets and of Tier 1 capital of at least 4% of average assets (leverage ratio). Tier 1 capital includes common shareholders' equity and qualifying perpetual preferred stock together with related surpluses and retained earnings. The $15 million of trust preferred securities issued by Statutory Trust I are included in Tier 1 capital. Tier 2 capital may be comprised of limited life preferred stock, qualifying debt instruments, and the allowance for possible loan losses. Management believes, that as of June 30, 2003, the Company and the Bank met all capital adequacy requirements to which they were subject.

The Company is not aware of any trends, events or uncertainties that will have a material adverse effect on the Company's liquidity, capital resources or operations, except for higher interest rates which could cause deposit disintermediation and an increase in interest expense and the possibility of inflationary trends, the results of which cannot be determined at this time. The Company is not under any agreement with the regulatory authorities nor is it aware of any current recommendation by regulatory authorities, which, if they were implemented, would have a material adverse effect on liquidity, capital resources, or the operations of the Company. Liquidity is a measure of the Company's ability to raise funds to support asset growth, meet deposit withdrawal and other borrowing needs, maintain reserve requirements and otherwise operate the Company on an ongoing basis. The Company manages its assets and liabilities to maintain liquidity and earnings stability. Among the sources of liquidity are money market investments, securities available-for-sale, funds received from the repayment of loans, short-term borrowings and borrowings from the Federal Home Loan Bank. At June 30, 2003, cash, due from banks, Federal funds sold and interest bearing deposits with banks totaled $37,850,000, and securities maturing within one year totaled $117,000. At December 31, 2002, cash, due from banks, Federal funds sold and interest bearing deposits with banks, totaled $27,743,000, and securities maturing within one year were $1,033,000. Securities sold under an agreement to repurchase totaled $7,198,000 at June 30, 2003 and $8,801,000 at December 31, 2002. The Bank is a member of the Federal Home Loan Bank of Pittsburgh. The Bank had interest bearing demand deposits at the Federal Home Loan Bank of Pittsburgh in the amount of $12,721,000 at June 30, 2003 and $4,968,000 at December 31, 2002. These deposits are included in due from banks on the Company's financial statements. As a result of this relationship, the Company places most of its short-term funds at the Federal Home Loan Bank of Pittsburgh. There were $2,000,000 in Federal funds sold at June 30, 2003 and at December 31, 2002. The Federal Home Loan Bank of Pittsburgh provided the Bank with a line of credit in the amount of $25,000,000 at June 30, 2003, subject to certain collateral requirements. The Bank had no short-term (overnight) borrowings against this line at June 30, 2003 and December 31, 2002. The Company had long-term debt from the Federal Home Loan Bank of Pittsburgh totaling $66,152,000 at June 30, 2003 and $67,921,000 at December 31, 2002. The loans are secured by the Bank's residential real estate loans and investment securities. These funds were used to fund residential real estate loans, community reinvestment projects and securities in the investment portfolio. The loans outstanding are as follows:

(1) The interest rate on this loan is fixed until October 2003, after which the interest rate may, on any quarter, be converted at the option of the lender to a variable rate of three-month LIBOR plus 15 basis points. If the lender elects to convert to a variable rate, the Bank may pre-pay the loan without a penalty. (2) The interest rate on this loan may, on any quarter, be converted at the option of the lender to a variable rate of three-month LIBOR plus 15 basis points if the three-month LIBOR is 7.5% or higher. If the lender elects to convert to a variable rate, the Bank may pre-pay the loan without a penalty. (3) The interest rate on this loan may, on any quarter, be converted at the option of the lender to a variable rate of three-month LIBOR plus 15 basis points if the three-month LIBOR is 8% or higher. If the lender elects to convert to a variable rate, the Bank may pre-pay the loan without a penalty. (4) The interest rate on this loan is fixed until December, 2002, after which the interest rate may, on any quarter, be converted at the option of the lender to a variable rate of three-month LIBOR plus 15 basis points if the three-month LIBOR is 7.5% or higher. If the lender elects to convert to a variable rate, the Bank may pre-pay the loan without a penalty. (5) The interest rate on this loan is fixed until maturity. This loan amortizes with monthly principal and interest payments. (6) The interest rate on this loan is fixed until December, 2003, after which the interest rate may, on any quarter, be converted at the option of the lender to a variable rate of three-month LIBOR plus 15 basis points if the three-month LIBOR is 7.5% or higher. If the lender elects to convert to a variable rate, the Bank may pre-pay the loan without a penalty. -------------------------------------------------------------------------------- On June 26, 2002, the Company issued $15,000,000 of subordinated debentures to First Colonial Statutory Trust I and the Statutory Trust I issued $15,000,000 in pooled trust preferred securities. The subordinated debentures are the sole asset of the Statutory Trust. The Trust Preferred securities are classified as long-term debt for the financial statements, but are included as Tier I capital for regulatory purposes. The interest rate on this security (4.46% at June 30, 2003 and 4.85% at December 31, 2002) is variable, adjusting quarterly at three-month LIBOR plus 3.45%. The interest is payable quarterly. The trust preferred securities mature in June 2032, and may be redeemed at the option of the Company on or after June 2007, or may be redeemed at any time in the event that the deduction of related interest for federal income tax purposes is prohibited, treatment as Tier I capital is no longer permitted, or certain other contingencies arise. The net proceeds of the trust preferred securities are to be used to support the Company's growth and expansion plans and other general corporate purposes. The Company also has an obligation as a party to the Employee Stock Ownership Plan (ESOP) debt. There were four loans to ESOP as June 30, 2003 and December 31, 2002. The total outstanding on these loans was $1,093,000 at June 30, 2003 and December 31, 2002. The ESOP loans outstanding at June 30, 2003 and December 31, 2002 are as follows:

Cash flows for the six months ended June 30, 2003 consisted of cash provided by financing activities of $30,511,000 and cash provided by operating activities of $10,825,000 offset in part by cash used in investing activities of $39,075,00. The result was a net increase in cash and cash equivalents of $2,261,000. Cash provided by operating activities was the result of net income of $1,981,000, proceeds from the sale of residential real estate loans of $29,957,000, amortization of security premiums of $1,206,000, depreciation and amortization of $714,000, the provision for possible loan losses of $575,000, a decrease in other assets of $538,000, a decrease in accrued interest income of $392,000, and amortization of deferred fees on loans of $272,000. These were offset in part by mortgage loans originated for sale of $21,730,000, net gains on the sale of investment securities of $1,474,000, gains on the sale of residential real estate loans of $810,000, a decrease in other liabilities of $301,000, a decrease in accrued interest payable of $178,000, and deferred taxes of $226,000. Cash provided by financing activities consisted principally of an increase in certificates of deposit of $21,187,000, a net increase in interest and non-interest bearing demand deposits, and savings accounts and money market accounts of $12,343,000, proceeds from the issuance of stock of $964,000, and a decrease in deferred stock compensation of $220,000. These were partially offset by payments on long-term debt of $1,769,000, a decrease in repurchase agreements of $1,603,000, and the payment of cash dividends of $831,000 Cash was used in investing activities for the purchase of securities available-for-sale of $147,348,000, the purchase of securities held-to-maturity of $56,193,000, a net increase in loans of $19,593,000, a net increase in interest-bearing deposits with banks of $7,846,000 and the purchase of premises and equipment of $775,000. These were partially offset by the proceeds from the sale of securities available-for-sale of $133,168,000, proceeds from the maturities of securities available-for-sale of $41,262,000, proceeds from the maturities of securities held-to-maturity of $18,042,000 and proceeds from the sale of other real estate owned of $208,000. In June, 2003, the Bank opened a new full-service branch office in Northampton Crossings Shopping Center, 3856 Easton-Nazareth Highway (Route 248), in Lower Nazareth Township, Northampton County, Pennsylvania. During the second quarter of 2003, the Bank received final approval from the Officer of the Comptroller of the Currency to establish full-service branches at 2510 MacArthur Road, Whitehall Township, Lehigh County, Pennsylvania and 1504 South Fourth Street in the City of Allentown, Lehigh County, Pennsylvania. It is expected that both of these branches will open during the third quarter of 2003. In addition, the future branch at 29 North Ninth Street in the City of Allentown, Lehigh County, Pennsylvania is expected to open in the third quarter of 2003. The Bank received approval to establish this branch during the first quarter of 2003. The Bank continues to investigate possible locations for additional branches. The Company recognizes the importance of maintaining adequate capital levels to support sound, profitable growth and to encourage depositor and investor confidence. Shareholders' equity at June 30, 2003 was $41,952,000 as compared to $40,314,000 at December 31, 2002, for an increase of $1,638,000 or 4.1%. This increase resulted from net income of $1,981,000, the proceeds from the sale of stock of $964,000, the distribution of the deferred stock compensation of $220,000, reduced in part by a decrease in accumulated other comprehensive income related to a reduction in the unrealized gains in securities available-for-sale of $696,000 and the payment of dividends of $831,000. On May 16, 2003 the Company paid its 2003 second quarter cash dividend on its common stock of $0.19 per share to shareholders of record on May 2, 2003. The Company maintains a Dividend Reinvestment and Stock Purchase Plan. This Plan was suspended as of March 5, 2003 as a result of the merger agreement with Keystone Savings Bank. During the first quarter of 2003, 3,771 shares of common stock were purchased from authorized and unissued shares at an average price of $25.99 per share for proceeds of approximately $98,000. The Company has a Stock Option Plan adopted in 2001, which provides for the granting of options to acquire the Company's common stock for officers, key employees and directors of the Company. In January of 2003, options to purchase 59,950 shares of the Company's common stock at an average price of $23.83 per share were granted to certain officers and Company directors. The Company also has a non-employee director's stock option plan that was adopted in 1994 and a stock option plan that was adopted in 1986 and the 1996 stock option plan that was adopted in 1996. No new options may be issued under these plans. During the three months ended June 30, 2003, options for 24,204 shares of the Company's common stock issued pursuant to the Plan were exercised at an average price of $20.13 per share. During the first six months of 2003, a total of options for 42,323 shares of the Company's common stock issued pursuant to the Plan were exercised at an average price of $20.46 per share for proceeds of approximately $866,000. ITEM 3. Quantitative and Qualitative Discussion About Market Risk As a financial institution, the Company's primary component of market risk is interest rate volatility. Fluctuations in interest will ultimately impact both the level of income and expense recorded on a large portion of the Company's assets and liabilities, and the market value of all interest earning assets, other than those which possess a short term to maturity. Because most of the Company's interest-bearing assets and liabilities are located at the Bank, the majority of the Company's interest rate risk is at the Bank level. As a result, most interest rate risk management procedures are performed at the Bank level. There have been no material changes in the Bank's assessment of its sensitivity to market risk since its presentation in the 2002 annual report to shareholders and its 2002 Form 10-K for the year ended December 31, 2002 filed with the Securities and Exchange Commission. ITEM 4. Controls and Procedures Quarterly evaluation of the Company's Disclosure Controls and Internal Controls. The Company evaluated the effectiveness of the design and operation of its "disclosure controls and procedures" ("Disclosure Controls") as of June 30, 2003. This evaluation ("Controls Evaluation") was done under the supervision and with the participation of management, including Scott V. Fainor, the Chief Executive Officer ("CEO") and Reid L. Heeren, the Chief Financial Officer ("CFO"). Limitations on the Effectiveness of Controls. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. The Company conducts periodic evaluations of its internal controls to enhance, where necessary, its controls and procedures. Conclusions. Based upon the Controls Evaluation, the CEO and CFO have concluded that the Disclosure Controls are effective in reaching a reasonable level of assurance that management is timely alerted to material information relating to the Company during the period when its periodic reports are being prepared. In accordance with SEC requirements, the CEO and CFO conducted an evaluation of internal control over financial reporting ("Internal Controls") to determine whether any changes in Internal Controls occurred during the quarter that have materially affected or which are reasonably likely to materially affect Internal Controls. Based on this evaluation, there has been no such change during the quarter covered by this report. PART II - OTHER INFORMATION ITEM 1. Legal Proceedings From time-to-time, the Company and the Bank are parties to routine litigation incidental to their business. Neither the Company, the Bank nor any of their properties is subject to any other material legal proceedings. ITEM 2. Changes in Securities and Use of Proceeds None ITEM 3. Defaults Upon Senior Securities None ITEM 4. Submission of Matters to a Vote of Security Holders None ITEM 5. Other Information None ITEM 6. Exhibits and Reports on Form 8-K (a) Exhibits 31.1 Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (Chief Executive Officer) 31.2 Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (Chief Financial Officer) 32 Certification pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (b) Reports on Form 8K On April 17, 2003, First Colonial filed a report on Form 8-K, which reported under Item 9 the release of its March 31, 2003 earnings. A copy of the release was filed as an exhibit. On April 18, 2003, First Colonial filed a report on Form 8-K, which reported under Item 9 the announcement of its second quarter 2003 dividend. A copy of this announcement was filed as an exhibit. On June 5, 2003, First Colonial filed a report on Form 8-K, which was reported under Item 9 the announcement of the opening of a new branch office located in the Northampton Crossing Shopping Center in Lower Nazareth Township. A copy of this announcement was filed as an exhibit. On June 11, 2003, First Colonial filed a report on Form 8-K, which was reported under Item 9 and 12 the announcement that First Colonial had mailed its first quarter report to shareholders. A copy of the report was filed as an exhibit. On June 11, 2003, First Colonial filed a report on Form 8-K, which was reported under Item 9 the announcement of the filing of regulatory applications for the proposed merger of Keystone Savings Bank and Nazareth National Bank and the filing of a registration statement by KNBT Bancorp, Inc. with the Securities and Exchange Commission with respect to an offering of common stock in connection with Keystone's previously announced intent to conduct a mutual-to-stock conversion. A copy of this release was filed as an exhibit. On July 18, 2003, First Colonial filed a report on Form 8-K, which reported under Item 9 the release of its June 30, 2003 earnings. A copy of the release was filed as an exhibit. On July 18, 2003, First Colonial filed a report on Form 8-K, which reported under Item 9 the announcement of its third quarter 2003 dividend. A copy of this announcement was filed as an exhibit. On July 21, 2003, First Colonial filed a report on Form 8-K, which reported under Item 9 the disclosure of certain information concerning the financial position and results of operations of First Colonial Group, Inc. at an for the periods ended June 30, 2003, as well as certain comparison periods, in the Pre-Effective Amendment No. 1 to KNBT Bancorp, Inc.'s Registration Statement on Form S-1. A copy of the disclosure was filed as an exhibit. On July 28, 2003, First Colonial filed a report on Form 8-K, which was reported under Item 9 the announcement of plans to open a full-service branch at 1504 S. 4th Street, Allentown in August. A copy of this announcement was filed as an exhibit. On July 29, 2003, First Colonial filed a report on Form 8-K, which was reported under Item 5 reporting the Annual Meeting of Shareholders of the Company will be held on October 1, 2003. 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. FIRST COLONIAL GROUP, INC. DATE: August 14, 2003 BY: /S/ SCOTT V. FAINOR --------------- ------------------------------ SCOTT V. FAINOR PRESIDENT (PRINCIPAL EXECUTIVE OFFICER) DATE: August 14, 2003 BY: /S/ REID L. HEEREN --------------- ------------------------------ REID L. HEEREN VICE PRESIDENT (PRINCIPAL FINANCIAL OFFICER)

FIRST COLONIAL GROUP INC 10-Q