Annual Report

U.S. Securities and Exchange Commission

Form 10-K

[X] Annual Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934

For the fiscal year ended December 31, 2003

[  ] Transition Report Under Section 13 or 15(d) of the Securities Exchange
Act of 1934

For the transition period from ____________ to ____________

Commission file number 000-33227

Southern Community Financial Corporation

Registrant’s telephone number, including area code (336) 768-8500

Securities Registered Pursuant to Section 12(b) of the Exchange Act:
None
Securities Registered Pursuant to Section 12(g) of the Exchange Act:
Common Stock, No Par Value

7.25% Cumulative Convertible Trust Preferred Securities
7.25% Convertible Junior Subordinated Debentures
Guarantee with respect to 7.25% Cumulative Convertible Trust Preferred Securities

7.95% Cumulative Trust Preferred Securities
7.95% Junior Subordinated Debentures
Guarantee with respect to 7.95% Cumulative Trust Preferred Securities

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 if disclosure of delinquent filers in response to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [  ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes [  ] No [ X ]

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. $73.4 million.

As of March 12, 2004, (the most recent practicable date), the registrant had outstanding 17,610,132 shares of Common Stock, no par value.

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Form 10-K Table of Contents

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PART I

under the symbols “SCMF”, “SCMFP” and “SCMFO”, respectively. Trading on SCMFP ceased on March 8th, 2004.

Our Market Area

     We consider our primary market area to be the Piedmont Triad area of North Carolina, including Winston-Salem, Clemmons, Kernersville (all in Forsyth County), Yadkinville (Yadkin County) and High Point (Guilford County), North Carolina, and to a lesser extent, adjoining counties.

     The Piedmont Triad is a 12 county region located in the north central Piedmont of North Carolina and is named for the three largest cities in the region, Winston-Salem, Greensboro and High Point. The region has one fifth of the state’s population and one fifth of its labor force. The region’s population grew an estimated 12.3% between 1990 and 2000. It’s estimated population in 2002 was 1.2 million.

     The Piedmont Triad is the largest Metropolitan Statistical Area located entirely in North Carolina. The MSA is also one of the top 50 in the country in both total population and number of households. Winston-Salem is the largest city in Forsyth County and the fourth largest city in North Carolina. Forsyth County had an estimated population of 314,375 in 2003, Yadkin County was estimated at 39,892, and Guilford County had an estimated population of 463,087. The Piedmont Triad is the economic hub of northwest North Carolina. In 2002, the median family income in both Forsyth and Guilford Counties was over $42,000. In Yadkin County, it was over $36,600. The Piedmont Triad has a very balanced and diversified economy. Approximately 99% of the work force is employed in nonagricultural wage and salary positions. The major employment sectors in 2002 were services (29%), manufacturing (23%), trade (22%), finance, communications and utilities (11%), government (11%) and construction (5%). Unemployment has increased in the Piedmont Triad over the last two years and averaged 6.3% in Guilford County, 5.5% in Yadkin County and 5.4% in Forsyth County in 2002.

     The bank serves our market area through eight full service banking offices, including four offices located in Winston-Salem. Our television and radio advertising has extended into this market area for several years, providing the bank name recognition in the Piedmont Triad area. The bank’s customers may access various banking services through twelve ATMs owned by the bank and ATMs owned by others, through debit cards, and through the bank’s automated telephone and Internet electronic banking products. These products allow the bank’s customers to apply for loans, access account information and conduct various transactions from their telephones and computers.

Business Strategy

     We established our bank with the objective of becoming a vital, long-term player in our markets with a reputation for quality customer service provided by a financially sound organization. Our business strategy is to operate as an institution that is well capitalized, strong in asset quality, profitable, independent, customer-oriented and connected to our community.

     A commitment to customer service is at the foundation of our approach. Our commitment is to put our customers first and we believe it differentiates us from our competitors. Making good quality, profitable loans, which result in a long-standing relationship with our borrowers, will continue to be a cornerstone of our strategy. We intend to leverage the core relationships we build by providing a variety of services to our customers. With that focus, we target:

•

Small and medium sized businesses, and the owners and managers of these entities;

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Professional and middle managers of locally based companies;

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Residential real estate developers; and

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Individual consumers.

     We intend to grow our franchise through new and existing relationships developed by our associates, and by expanding to contiguous areas through de novo entry and acquisitions which make strategic and economic sense.

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     We also intend to continue to diversify our revenue in order to generate non-interest income. These efforts have included offering investment brokerage services, our mortgage loan department, our small business investment company manager (which generates management fees) and the creation of our trust department. For the year ended December 31, 2003 our non-interest income represented 19.0% of our total revenue. We believe that the profitability of these added businesses and services, not just the revenue generated, is critical to our success.

     Key aspects of our strategy and mission include:

•

To provide community-oriented banking services by delivering a broad range of financial services to our customers through responsive service and communication;

•

To form a partnership with our customers whereby our decision making and product offerings are geared toward their best long-term interests;

•

To be recognized in our community as a long- term player with employees, stockholders and board members committed to that effort; and

•

To be progressive in our adoption of new technology so that we can provide our customers access to products and services that meet their needs for convenience and efficiency.

     Our belief is that our way of doing business will build a profitable corporation and shareholder value. We want to consistently reward our shareholders for their investment and trust in us.

Subsidiaries

     The bank operates one subsidiary that provides financial services in addition to those offered directly by the bank. The company formed two additional subsidiaries to issue trust preferred securities. Each subsidiary is described below.

     VCS Management, LLC was formed in March 2000 as the managing general partner of Salem Capital Partners, L.P., a small business investment company licensed by the Small Business Administration. Southern Community Bank and Trust has committed $1.7 million for investment in the partnership, which has a total of $9.2 million of committed capital from various private investors including the bank. The partnership can also borrow funds on a non-recourse basis from the Small Business Administration to increase its capital available for investment. The partnership makes investments in the form of subordinated debt and earns revenue through interest received on its investments and potentially through gains realized from warrants that it receives in conjunction with its debt investments. The bank shares in any earnings of the partnership through its investment in the partnership. VCS Management earns management fees for managing the investment activities of the partnership. For the year ended December 31, 2003 VCS Management earned $562,000 of fee income, representing 2.2% of total consolidated revenue.

     In February of 2002, Southern Community Capital Trust I (“Trust I”), a newly formed subsidiary of the company, issued 1,725,000 Cumulative Convertible Trust Preferred Securities (“Trust I Securities”), generating total proceeds of $17.3 million. At December 31, 2003, holders of the Trust I Securities had voluntarily converted $175,000 of the Trust I Securities into 21,187 shares of our common stock at the Conversion Price of $8.26 per share of our common stock. On January 14, 2004, we announced the redemption of all of the Trust I Securities. We redeemed the Trust I Securities under a provision that permitted us to redeem the Trust I Securities in whole at any time prior to March 31, 2007 once the trading price of our common stock had been at least 125% of the Conversion Price for a period of twenty consecutive trading days ending within five days of the date that we gave notice of redemption. The Trust I Securities were redeemed on March 12, 2004 which resulted in the issuance of 2,060,000 shares of our common stock through the conversions and the retirement of $61,000 of the convertible trust preferred securities. The Trust I Securities paid distributions at an annual rate of 7.25%. The Trust I Securities began paying quarterly distributions on March 31, 2002. The company had fully and unconditionally guaranteed the obligations of Trust I. The proceeds from the Trust I Securities were utilized to purchase convertible junior subordinated debentures from us under the same terms and conditions as the Trust I Securities. Subject to certain limitations, the Trust I Securities qualified as Tier 1 capital of the company for regulatory capital purposes. The principal use of the net proceeds from the sale of the convertible debentures was to infuse capital into our bank subsidiary, Southern Community Bank and Trust, to fund its operations and continued expansion, and to maintain the company’s and the bank’s status as “well capitalized” under regulatory guidelines.

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     In November of 2003, Southern Community Capital Trust II (“Trust II”), a newly formed subsidiary of the company, issued 3,450,000 Trust Preferred Securities (“Trust II Securities”), generating total proceeds of $34.5 million. The Trust II Securities pay distributions at an annual rate of 7.95% and mature on December 31, 2033. The Trust II Securities began paying quarterly distributions on December 31, 2003. The company has fully and unconditionally guaranteed the obligations of Trust II. The Trust II Securities are redeemable in whole or in part at any time after December 31, 2008. The proceeds from the Trust II Securities were utilized to purchase convertible junior subordinated debentures from us under the same terms and conditions as the Trust II Securities. We have the right to defer payment of interest on the debentures at any time and from time to time for a period not exceeding five years, provided that no deferral period extend beyond the stated maturities of the debentures. Such deferral of interest payments by the company will result in a deferral of distribution payments on the related Trust II Securities. Should we defer the payment of interest on the debentures, the company will be precluded from the payment of cash dividends to shareholders. The principal use of the net proceeds from the sale of the debentures was to provide cash for the acquisition of The Community Bank, to increase our regulatory capital, and to support the growth and operations of our subsidiary banks. The amount of proceeds we count as Tier 1capital cannot comprise more than 25% of our core capital elements. Amounts in excess of that 25% limitation count as Tier 2 supplementary capital on our books. Prior to the closing of the acquisition of The Community Bank on January 12, 2004, substantially all of the proceeds from the Trust II Securities qualified as Tier 2 supplementary capital. Prior to the redemption of the Trust I Securities, approximately $20 million of the proceeds of the Trust II Securities counted as Tier 1 capital on our books. After the redemption of the Trust I Securities on March 12, 2004, subject to certain limitations, substantially all of the proceeds from the Trust II Securities qualify as Tier 1 capital of the company for regulatory capital purposes.

Competition

     The activities in which the bank, as our operating subsidiary, engages are highly competitive. Commercial banking in North Carolina is extremely competitive due to state laws, which permit state-wide branching. Consequently, many commercial banks have branches located in several communities. One of the largest regional commercial banks in North Carolina, and one savings institution have their headquarters in Winston-Salem. As of June 2003, there were 97 branches in Forsyth County operated by twelve commercial banks and one savings institution. Approximately $9.5 billion in deposits are located in Forsyth County. Yadkin County had eight banks with ten branches and approximately $378.5 million in deposits. Twenty banks and two savings institutions were operating in Guilford County with 134 branches and approximately $6.7 billion in deposits. Deposits of the bank in June 2003 were $426.4 million in Forsyth County, $69.2 million in Yadkin County, and $10.1 million in Guilford County. Therefore, in its market area, the bank has significant competition for deposits and loans from other depository institutions.

     Other financial institutions such as savings and loan associations, credit unions, consumer finance companies, insurance companies, brokerage companies and other financial institutions with varying degrees of regulatory restrictions compete vigorously for a share of the financial services market. Brokerage companies continue to become more competitive in the financial services arena and pose an ever increasing challenge to banks. Legislative changes also greatly affect the level of competition we face. During 1998 federal legislation allowed credit unions to expand their membership criteria and compete more intensely for traditional bank business. Additionally, the Gramm-Leach-Bliley Financial Services Modernization Act of 1999 expanded the types of activities in which a bank holding company can engage. Currently, we must compete against some institutions located in the Piedmont Triad area that have capital resources and legal loan limits substantially in excess of those available to us and the bank. We expect competition to continue to be significant.

Employees

     Southern Community Financial Corporation has no employees of its own and all employees during 2003 were compensated by the bank. At December 31, 2003, the bank employed 157 full-time equivalent persons (including our executive officers). None of the employees are represented by any unions or similar groups, and we have not experienced any type of strike or labor dispute. We consider our relationship with our employees to be extremely important to our long-term success. The Board and management continually seek ways to enhance their benefits and well being.

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SUPERVISION AND REGULATION

     Southern Community Financial Corporation is registered as a financial holding company with the Federal Reserve. The bank is a North Carolina chartered banking corporation and a member bank of the Federal Reserve System. Banking is a complex, highly regulated industry. The primary goals of bank regulations are to maintain a safe and sound banking system and to facilitate the conduct of sound monetary policy. In furtherance of these goals, Congress has created several largely autonomous regulatory agencies and enacted numerous laws that govern banks, bank holding companies and the banking industry. The descriptions of and references to the statutes and regulations below are brief summaries and do not purport to be complete. The descriptions are qualified in their entirety by reference to the specific statutes and regulations discussed.

Southern Community Financial Corporation

     Southern Community Financial Corporation is a bank holding company that has elected to be treated as a financial holding company. As a bank holding company under the Bank Holding Company Act of 1956, as amended, we are registered with and subject to regulation by the Federal Reserve. We are required to file annual and other reports with, and furnish information to, the Federal Reserve. The Federal Reserve conducts periodic examinations of us and may examine any of our subsidiaries, including the bank.

     The Bank Holding Company Act provides that a bank holding company must obtain the prior approval of the Federal Reserve for the acquisition of more than five percent of the voting stock or substantially all the assets of any bank or bank holding company. In addition, the Bank Holding Company Act restricts the extension of credit to any bank holding company by its subsidiary bank. The Bank Holding Company Act also provides that, with certain exceptions, a bank holding company may not engage in any activities other than those of banking or managing or controlling banks and other authorized subsidiaries or own or control more than five percent of the voting shares of any company that is not a bank. The Federal Reserve has deemed limited activities to be closely related to banking and therefore permissible for a bank holding company.

     However, with the passage of the Gramm-Leach-Bliley Financial Services Modernization Act of 1999, which became effective on March 11, 2000, the types of activities in which a bank holding company may engage were significantly expanded. Subject to various limitations, the Modernization Act generally permits a bank holding company to elect to become a “financial holding company.” A financial holding company may affiliate with securities firms and insurance companies and engage in other activities that are “financial in nature.” Among the activities that are deemed “financial in nature” are, in addition to traditional lending activities, securities underwriting, dealing in or making a market in securities, sponsoring mutual funds and investment companies, insurance underwriting and agency activities, certain merchant banking activities as well as activities that the Federal Reserve considers to be closely related to banking.

     A bank holding company may become a financial holding company under the Modernization Act if each of its subsidiary banks is “well capitalized” under the Federal Deposit Insurance Corporation Improvement Act prompt corrective action provisions, is well managed and has at least a satisfactory rating under the Community Reinvestment Act. In addition, the bank holding company must file a declaration with the Federal Reserve that the bank holding company wishes to become a financial holding company. A bank holding company that falls out of compliance with these requirements may be required to cease engaging in some of its activities. Southern Community Financial Corporation elected, and was authorized by the Federal Reserve, to be a financial holding company.

     Under the Modernization Act, the Federal Reserve serves as the primary “umbrella” regulator of financial holding companies, with supervisory authority over each parent company and limited authority over its subsidiaries. Expanded financial activities of financial holding companies generally will be regulated according to the type of such financial activity: banking activities by banking regulators, securities activities by securities regulators and insurance activities by insurance regulators. The Modernization Act also imposes additional restrictions and heightened disclosure requirements regarding private information collected by financial institutions.

      Enforcement Authority . We will be required to obtain the approval of the Federal Reserve prior to engaging in or, with certain exceptions, acquiring control of more than 5% of the voting shares of a company engaged in, any new activity. Prior to granting such approval, the Federal Reserve must weigh the expected benefits of any such new activity to the public (such as greater convenience, increased competition, or gains in efficiency) against the risk of possible adverse effects of such activity (such as undue concentration of resources, decreased or

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unfair competition, conflicts of interest, or unsound banking practices). The Federal Reserve has cease-and-desist powers over bank holding companies and their nonbanking subsidiaries where their actions would constitute a serious threat to the safety, soundness or stability of a subsidiary bank. The Federal Reserve also has authority to regulate debt obligations (other than commercial paper) issued by bank holding companies. This authority includes the power to impose interest ceilings and reserve requirements on such debt obligations. A bank holding company and its subsidiaries are also prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services.

      Interstate Acquisitions . Federal banking law generally provides that a bank holding company may acquire or establish banks in any state of the United States, subject to certain aging and deposit concentration limits. In addition, North Carolina banking laws permit a bank holding company which owns stock of a bank located outside North Carolina to acquire a bank or bank holding company located in North Carolina. In any event, federal banking law will not permit a bank holding company to own or control banks in North Carolina if the acquisition would exceed 20% of the total deposits of all federally-insured deposits in North Carolina.

      Capital Adequacy . The Federal Reserve has promulgated capital adequacy regulations for all bank holding companies with assets in excess of $150 million. The Federal Reserve’s capital adequacy regulations are based upon a risk based capital determination, whereby a bank holding company’s capital adequacy is determined in light of the risk, both on- and off-balance sheet, contained in the company’s assets. Different categories of assets are assigned risk weightings and are counted at a percentage of their book value.

     The regulations divide capital between Tier 1 capital (core capital) and Tier 2 capital. For a bank holding company, Tier 1 capital consists primarily of common stock, related surplus, noncumulative perpetual preferred stock, minority interests in consolidated subsidiaries and a limited amount of qualifying cumulative preferred securities. Goodwill and certain other intangibles are excluded from Tier 1 capital. Tier 2 capital consists of an amount equal to the allowance for loan and lease losses up to a maximum of 1.25% of risk weighted assets, limited other types of preferred stock not included in Tier 1 capital, hybrid capital instruments and term subordinated debt. Investments in and loans to unconsolidated banking and finance subsidiaries that constitute capital of those subsidiaries are excluded from capital. The sum of Tier 1 and Tier 2 capital constitutes qualifying total capital. The Tier 1 component must comprise at least 50% of qualifying total capital.

     Every bank holding company has to achieve and maintain a minimum Tier 1 capital ratio of at least 4.0% and a minimum total capital ratio of at least 8.0%. In addition, banks and bank holding companies are required to maintain a minimum leverage ratio of Tier 1 capital to average total consolidated assets (leverage capital ratio) of at least 3.0% for the most highly-rated, financially sound banks and bank holding companies and a minimum leverage ratio of at least 4.0% for all other banks. The Federal Deposit Insurance Corporation and the Federal Reserve define Tier 1 capital for banks in the same manner for both the leverage ratio and the risk-based capital ratio. However, the Federal Reserve defines Tier 1 capital for bank holding companies in a slightly different manner. As of December 31, 2003, our Tier 1 leverage capital ratio and total capital were 8.63% and 17.74%, respectively.

     The guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory level, without significant reliance on intangible assets. The guidelines also indicate that the Federal Reserve will continue to consider a “Tangible Tier 1 Leverage Ratio” in evaluating proposals for expansion or new activities. The Tangible Tier 1 Leverage Ratio is the ratio of Tier 1 capital, less intangibles not deducted from Tier 1 capital, to quarterly average total assets. As of December 31, 2003, the Federal Reserve had not advised us of any specific minimum Tangible Tier 1 Leverage Ratio applicable to us.

     In January 2003, the FASB issued FASB Interpretation No. (FIN) 46, Consolidation of Variable Interest Entities . This interpretation addresses the consolidation by business enterprises of variable interest entities as defined in the interpretation. In December 2003, the FASB issued a revision to FIN 46 (FIN 46R) to clarify some of the provisions of FIN 46 and to exempt certain entities from its requirements. The company must apply FIN 46R no later than the end of the first reporting period ending after March 15, 2004. Adoption of FIN 46R will require deconsolidation of the company’s remaining trust preferred subsidiary, Southern Community Capital Trust II (the Trust I Securities were redeemed as of March 12, 2004). Upon deconsolidation, the junior subordinated debentures issued by the company to Trust II will be included in long-term debt (instead of the trust preferred securities) and the company’s equity interest in Trust II will be included in other assets. If Trust I and Trust II were deconsolidated as of December 31, 2003, the effect on the company’s balance sheet would be an increase in other assets of $1.6

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million with a corresponding increase in long-term debt. The deconsolidation of Trust I and Trust II will not materially impact net income.

     The Trust Preferred Securities presently qualify as Tier 1 regulatory capital and are reported in Federal Reserve regulatory reports as a minority interest in our consolidated subsidiaries. The junior subordinated debentures do not qualify as Tier 1 regulatory capital. On July 2, 2003, the Board of Governors of the Federal Reserve issued a letter, SR 03-13, stating that notwithstanding FIN 46, trust preferred securities will continue to be included in Tier 1 capital until notice is given to the contrary. There can be no assurance that the Federal Reserve will continue to allow institutions to include trust preferred securities in Tier I capital for regulatory capital purposes. In the event of a disallowance, there would be a reduction in the company’s consolidated capital ratios. However, the company believes that the bank would remain “well capitalized” under Federal Reserve Board guidelines.

      Source of Strength for Subsidiaries. Bank holding companies are required to serve as a source of financial strength for their depository institution subsidiaries, and, if their depository institution subsidiaries become undercapitalized, bank holding companies may be required to guarantee the subsidiaries’ compliance with capital restoration plans filed with their bank regulators, subject to certain limits.

      Dividends . On January 14, 2004, the company announced the declaration of its first annual cash dividend of $0.11 per share of its common stock which was paid on March 15, 2004, to shareholders of record on February 20, 2004. As a bank holding company that does not, as an entity, currently engage in separate business activities of a material nature, our ability to pay cash dividends depends upon the cash dividends we receive from our subsidiary banks (Southern Community Bank and Trust and after January 12, 2004, The Community Bank). Our only source of income is dividends paid by these banks. We must pay all of our operating expenses from funds we receive from these banks. North Carolina banking requires that dividends be paid out of retained earnings and prohibits the payment of cash dividends if payment of the dividend would cause the bank’s surplus to be less than 50% of its paid-in capital. Also, under federal banking law, no cash dividend may be paid if the bank is undercapitalized or insolvent or if payment of the cash dividend would render the bank undercapitalized or insolvent, and no cash dividend may be paid by the bank if it is in default of any deposit insurance assessment due to the FDIC. Therefore, shareholders may receive dividends from us only to the extent that funds are available from our subsidiary banks. In addition, the Federal Reserve generally prohibits bank holding companies from paying dividends except out of operating earnings, and the prospective rate of earnings retention appears consistent with the bank holding company’s capital needs, asset quality and overall financial condition.

      Change of Control. State and federal banking law restrict the amount of voting stock of the company that a person may acquire without the prior approval of banking regulators. The Bank Holding Company Act requires that a bank holding company obtain the approval of the Federal Reserve before it may merge with a bank holding company, acquire a subsidiary bank, acquire substantially all of the assets of any bank, or before it may acquire ownership or control of any voting shares of any bank or bank holding company if, after such acquisition, it would own or control, directly or indirectly, more than 5% of the voting shares of that bank or bank holding company. The overall effect of such laws is to make it more difficult to acquire us by tender offer or similar means than it might be to acquire control of another type of corporation. Consequently, our shareholders may be less likely to benefit from rapid increases in stock prices that often result from tender offers or similar efforts to acquire control of other types of companies.

The Bank

     The bank is subject to various requirements and restrictions under the laws of the United States and the State of North Carolina. As a North Carolina bank, our subsidiary bank is subject to regulation, supervision and regular examination by the North Carolina Banking Commission. As a member of the Federal Reserve, the bank is subject to regulation, supervision and regular examination by the Federal Reserve. The North Carolina Banking Commission and the Federal Reserve have the power to enforce compliance with applicable banking statutes and regulations. These requirements and restrictions include requirements to maintain reserves against deposits, restrictions on the nature and amount of loans that may be made and the interest that may be charged thereon and restrictions relating to investments and other activities of the bank.

      Transactions with Affiliates . The bank may not engage in specified transactions (including, for example, loans) with its affiliates unless the terms and conditions of those transactions are substantially the same or at least as favorable to the bank as those prevailing at the time for comparable transactions with or involving other

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nonaffiliated entities. In the absence of comparable transactions, any transaction between the bank and its affiliates must be on terms and under circumstances, including credit standards, that in good faith would be offered or would apply to nonaffiliated companies. In addition, transactions referred to as “covered transactions” between the bank and its affiliates may not exceed 10% of the bank’s capital and surplus per affiliate and an aggregate of 20% of its capital and surplus for covered transactions with all affiliates. Certain transactions with affiliates, such as loans, also must be secured by collateral of specific types and amounts. The bank also is prohibited from purchasing low quality assets from an affiliate. Every company under common control with the bank, including us and Southern Community Capital Trust I and II, is deemed to be an affiliate of the bank.

      Loans to Insiders . Federal law also constrains the types and amounts of loans that the bank may make to its executive officers, directors and principal shareholders. Among other things, these loans are limited in amount, must be approved by the bank’s board of directors in advance, and must be on terms and conditions as favorable to the bank as those available to an unrelated person.

      Regulation of Lending Activities . Loans made by the bank are also subject to numerous federal and state laws and regulations, including the Truth-In-Lending Act, Federal Consumer Credit Protection Act, the Equal Credit Opportunity Act, the Real Estate Settlement Procedures Act and adjustable rate mortgage disclosure requirements. Remedies to the borrower or consumer and penalties to the bank are provided if the bank fails to comply with these laws and regulations. The scope and requirements of these laws and regulations have expanded significantly in recent years.

      Branch Banking . All banks located in North Carolina are authorized to branch statewide. Accordingly, a bank located anywhere in North Carolina has the ability, subject to regulatory approval, to establish branch facilities near any of our facilities and within our market area. If other banks were to establish branch facilities near our facilities, it is uncertain whether these branch facilities would have a material adverse effect on our business.

     Federal law provides for nationwide interstate banking and branching, subject to certain aging and deposit concentration limits that may be imposed under applicable state laws. Applicable North Carolina statutes permit regulatory authorities to approve de novo branching in North Carolina by institutions located in states that would permit North Carolina institutions to branch on a de novo basis into those states. Federal regulations prohibit an out-of-state bank from using interstate branching authority primarily for the purpose of deposit production. These regulations include guidelines to insure that interstate branches operated by an out-of-state bank in a host state are reasonably helping to meet the credit needs of the host state communities served by the out-of-state bank.

      Reserve Requirements. Pursuant to regulations of the Federal Reserve, the bank must maintain average daily reserves against its transaction accounts. No reserves are required to be maintained on the first $6.6 million of transaction accounts, but reserves equal to 3.0% must be maintained on the aggregate balances of those accounts between $6.6 million and $45.4 million, and reserves equal to 10.0% plus $1.2 million must be maintained on aggregate balances in excess of $45.4 million. These percentages are subject to adjustment by the Federal Reserve. Because required reserves must be maintained in the form of vault cash or in a non-interest-bearing account at a Federal Reserve Bank, the effect of the reserve requirement is to reduce the amount of the institution’s interest-earning assets. As of December 31, 2003, the bank met its reserve requirements.

      Community Reinvestment. Under the Community Reinvestment Act (“CRA”), as implemented by regulations of the federal bank regulatory agencies, an insured bank has a continuing and affirmative obligation, consistent with its safe and sound operation, to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for banks, nor does it limit a bank’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The CRA requires the federal bank regulatory agencies, in connection with their examination of insured banks, to assess the banks’ records of meeting the credit needs of their communities, using the ratings of “outstanding,” “satisfactory,” “needs to improve,” or “substantial noncompliance,” and to take that record into account in its evaluation of certain applications by those banks. All banks are required to make public disclosure of their CRA performance ratings. The bank received a “satisfactory” rating in its most recent CRA examination.

      Governmental Monetary Policies . The commercial banking business is affected not only by general economic conditions but also by the monetary policies of the Federal Reserve. Changes in the discount rate on member bank borrowings, control of borrowings, open market transactions in United States government securities, the imposition of and changes in reserve requirements against member banks and deposits and assets of foreign bank

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branches, and the imposition of and changes in reserve requirements against certain borrowings by banks and their affiliates are some of the monetary policies available to the Federal Reserve. Those monetary policies influence to a significant extent the overall growth of all bank loans, investments and deposits and the interest rates charged on loans or paid on time and savings deposits in order to mitigate recessionary and inflationary pressures. These techniques are used in varying combinations to influence overall growth and distribution of bank loans, investments, and deposits, and their use may also affect interest rates charged on loans or paid for deposits.

     The monetary policies of the Federal Reserve Board have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. In view of changing conditions in the national economy and money markets, as well as the effect of actions by monetary and fiscal authorities, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand or the business and earnings of the bank.

      Dividends . All dividends paid by the bank are paid to us, the sole shareholder of the bank. The general dividend policy of the bank is to pay dividends at levels consistent with maintaining liquidity and preserving our applicable capital ratios and servicing obligations. The dividend policy of the bank is subject to the discretion of the board of directors of the bank and will depend upon such factors as future earnings, growth, financial condition, cash needs, capital adequacy, compliance with applicable statutory and regulatory requirements and general business conditions.

     The ability of the bank to pay dividends is restricted under applicable law and regulations. Under North Carolina banking law, dividends must be paid out of retained earnings and no cash dividends may be paid if the bank’s surplus is less than 50% of its paid-in capital. Also, under federal banking law, no cash dividend may be paid if the bank is undercapitalized or insolvent or if payment of the cash dividend would render the bank undercapitalized or insolvent, and no cash dividend may be paid by the bank if it is in default of any deposit insurance assessment due to the Federal Deposit Insurance Corporation.

     The exact amount of future dividends on the stock of the bank will be a function of the profitability of the bank in general and applicable tax rates in effect from year to year. The bank’s ability to pay dividends in the future will directly depend on future profitability, which cannot be accurately estimated or assured. We expect that, for the foreseeable future, dividends will be paid by the bank to us as needed to pay any separate expenses of Southern Community Financial Corporation and/or to make required payments on our debt obligations, including the debentures which fund the interest payments on the preferred securities issued by our trust subsidiary, and to pay cash dividends to our shareholders.

      Capital Adequacy . The capital adequacy regulations which apply to state banks, such as the bank, are similar to the Federal Reserve requirements promulgated with respect to bank holding companies discussed above.

      Changes in Management . Any depository institution that has been chartered less than two years, is not in compliance with the minimum capital requirements of its primary federal banking regulator, or is otherwise in a troubled condition must notify its primary federal banking regulator of the proposed addition of any person to the board of directors or the employment of any person as a senior executive officer of the institution at least 30 days before such addition or employment becomes effective. During this 30-day period, the applicable federal banking regulatory agency may disapprove of the addition of such director or employment of such officer. The bank is not subject to any such requirements.

      Enforcement Authority . The federal banking laws also contain civil and criminal penalties available for use by the appropriate regulatory agency against certain “institution-affiliated parties” primarily including management, employees and agents of a financial institution, as well as independent contractors such as attorneys and accountants and others who participate in the conduct of the financial institution’s affairs and who caused or are likely to cause more than minimum financial loss to or a significant adverse affect on the institution, who knowingly or recklessly violate a law or regulation, breach a fiduciary duty or engage in unsafe or unsound practices. These practices can include the failure of an institution to timely file required reports or the submission of inaccurate reports. These laws authorize the appropriate banking agency to issue cease and desist orders that may, among other things, require affirmative action to correct any harm resulting from a violation or practice, including restitution, reimbursement, indemnification or guarantees against loss. A financial institution may also be ordered to restrict its growth, dispose of certain assets or take other action as determined by the primary federal banking agency to be appropriate.

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      Prompt Corrective Action . Banks are subject to restrictions on their activities depending on their level of capital. Federal “prompt corrective action” regulations divide banks into five different categories, depending on their level of capital. Under these regulations, a bank is deemed to be “well capitalized” if it has a total risk-based capital ratio of 10% or more, a core capital ratio of six percent or more and a leverage ratio of five percent or more, and if the bank is not subject to an order or capital directive to meet and maintain a certain capital level. Under these regulations, a bank is deemed to be “adequately capitalized” if it has a total risk-based capital ratio of eight percent or more, a core capital ratio of four percent or more and a leverage ratio of four percent or more (unless it receives the highest composite rating at its most recent examination and is not experiencing or anticipating significant growth, in which instance it must maintain a leverage ratio of three percent or more). Under these regulations, a bank is deemed to be “undercapitalized” if it has a total risk-based capital ratio of less than eight percent, a core capital ratio of less than four percent or a leverage ratio of less than three percent. Under these regulations, a bank is deemed to be “significantly undercapitalized” if it has a risk-based capital ratio of less than six percent, a core capital ratio of less than three percent and a leverage ratio of less than three percent. Under such regulations, a bank is deemed to be “critically undercapitalized” if it has a leverage ratio of less than or equal to two percent. In addition, the applicable federal banking agency has the ability to downgrade a bank’s classification (but not to “critically undercapitalized”) based on other considerations even if the bank meets the capital guidelines.

     If a state member bank, such as the bank, is classified as undercapitalized, the bank is required to submit a capital restoration plan to the Federal Reserve. An undercapitalized bank is prohibited from increasing its assets, engaging in a new line of business, acquiring any interest in any company or insured depository institution, or opening or acquiring a new branch office, except under certain circumstances, including the acceptance by the Federal Reserve of a capital restoration plan for the bank.

     If a state member bank were classified as undercapitalized, the Federal Reserve may take certain actions to correct the capital position of the bank. If a state member bank is classified as significantly undercapitalized, the Federal Reserve would be required to take one or more prompt corrective actions. These actions would include, among other things, requiring sales of new securities to bolster capital, changes in management, limits on interest rates paid, prohibitions on transactions with affiliates, termination of certain risky activities and restrictions on compensation paid to executive officers. If a bank is classified as critically undercapitalized, the bank must be placed into conservatorship or receivership within 90 days, unless the Federal Deposit Insurance Corporation determines otherwise.

     The capital classification of a bank affects the frequency of examinations of the bank and impacts the ability of the bank to engage in certain activities and affects the deposit insurance premiums paid by the bank. The Federal Reserve is required to conduct a full-scope, on-site examination of every member bank on a periodic basis.

     Banks also may be restricted in their ability to accept brokered deposits, depending on their capital classification. “Well capitalized” banks are permitted to accept brokered deposits, but all banks that are not well capitalized are not permitted to accept such deposits. The Federal Reserve may, on a case-by-case basis, permit member banks that are adequately capitalized to accept brokered deposits if the Federal Reserve determines that acceptance of such deposits would not constitute an unsafe or unsound banking practice with respect to the bank.

      Deposit Insurance. The bank’s deposits are insured up to $100,000 per insured account by the Bank Insurance Fund of the Federal Deposit Insurance Corporation. The bank’s deposit insurance assessments may increase depending upon the risk category and subcategory to which the bank is assigned. The Federal Deposit Insurance Corporation assesses insurance premiums on a bank’s deposits at a variable rate depending on the probability that the deposit insurance fund will incur a loss with respect to the bank. The Federal Deposit Insurance Corporation determines the deposit insurance assessment rates on the basis of the bank’s capital classification and supervisory evaluations. Each of these categories has three subcategories, resulting in nine assessment risk classifications. The three subcategories with respect to capital are “well capitalized,” “adequately capitalized” and “less than adequately capitalized” (that would include “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized” banks). The three subcategories with respect to supervisory concerns are “healthy,” “supervisory concern” and “substantial supervisory concern.” A bank is deemed “healthy” if it is financially sound with only a few minor weaknesses. A bank is deemed subject to “supervisory concern” if it has weaknesses that, if not corrected, could result in significant deterioration of the bank and increased risk to the Bank Insurance Fund of the Federal Deposit Insurance Corporation. A bank is deemed subject to “substantial supervisory concern” if it poses a substantial probability of loss to the Bank Insurance Fund. Any increase in insurance assessments could have an adverse effect on the bank’s earnings.

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     Our management cannot predict what other legislation might be enacted or what other regulations might be adopted or the effects thereof.

would cause the bank’s surplus to be less than 50% of its paid-in capital. Under federal banking law, no cash dividend may be paid if the bank is undercapitalized or insolvent or if payment of the cash dividend would render the bank undercapitalized or insolvent, or if it is in default of any deposit insurance assessment due to the Federal Deposit Insurance Corporation.

     In the future, any declaration and payment of cash dividends will be subject to the Board of Directors’ evaluation of the company’s operating results, financial condition, future growth plans, general business and economic conditions, and tax and other relevant considerations. There is no assurance that, in the future, the company will have funds available to pay cash dividends, or, even if funds are available, that it will pay dividends in any particular amount or at any particular times, or that it will pay dividends at all.

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Item 6. Selected Financial Data

SELECTED CONSOLIDATED FINANCIAL INFORMATION AND OTHER DATA

     Effective October 1, 2001, the Southern Community Bank and Trust became a wholly owned subsidiary of Southern Community Financial Corporation. Southern Community Financial Corporation has no material assets other than those of the bank. Therefore, the financial statements of the bank prior to October 1, 2001 are the historical consolidated financial statements of Southern Community Financial Corporation. The information set forth below does not purport to be complete and should be read in conjunction with the company’s consolidated financial statements appearing elsewhere in this annual report.

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(1)

Net interest margin is net interest income divided by average interest-earning assets.

(2)

Net interest spread is the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities.

(3)

Efficiency ratio is non-interest expense divided by the sum of net interest income and non-interest income.

(4)

Nonperforming assets consist of non-accrual loans, restructured loans, and real estate owned, where applicable.

(5)

Capital ratios are for the bank.

(6)

Total revenue consists of net interest income and non-interest income.

(7)

All per share data has been restated to reflect the dilutive effect of a stock split effected in the form of a two-for-one stock split in 1999, a stock split effected in the form of a 10% stock dividend in 2000, and 5% stock dividends in 2001 and 2002.

CRITICAL ACCOUNTING POLICY

     The company’s most significant critical accounting policy is the determination of its allowance for loan losses. A critical accounting policy is one that is both very important to the portrayal of the company’s financial condition and results of operations, and requires management’s most difficult, subjective or complex judgments. What makes these judgments difficult, subjective and/or complex is the need to make estimates about the effects of matters that are inherently uncertain. For further discussion, see “Nonperforming Assets” and “Analysis of Allowance for Loan Losses” under “ASSET QUALITY.”

OVERVIEW

     Our founders recognized an opportunity to fulfill the financial service needs of individuals and organizations left underserved by consolidation within the financial services industry. To fill a part of this void, we began in 1995 the process by which Southern Community Financial Corporation was created, finally beginning operations on November 18, 1996. From inception, we have strived to serve the financial needs of small to medium-sized businesses, individuals, residential homebuilders and others in and around Winston-Salem and the Piedmont Triad area of North Carolina. We offer a broad array of banking and other financial products – products similar to those offered by our larger competitors, but with an emphasis on superior customer service. We believe that our emphasis on quality customer service is the single most important factor among many that have fueled our growth to $799 million in total assets in just over seven years of operations.

     We began operations in November 1996 with $11 million in capital, a single branch facility and thirteen employees. Through December 31, 2003, Southern Community Financial Corporation has grown to a total of eight full-service banking offices with $575 million in customer deposit accounts. In support of this growth, we have generated $24 million of additional capital through sales of common stock in 1998, 2000 and 2001. Through our banking subsidiary we offer traditional banking products as well as a full array of financial services. More recently we have created a Trust Department that began operating in the first quarter of 2002. In October of 2001, we formed Southern Community Financial Corporation, a financial holding company, to become the parent company of Southern Community Bank and Trust. In April of 2003 we completed the construction of a new corporate office on property adjacent to our main banking office in Winston-Salem.

     Real estate secured loans, including construction loans and loans secured by existing commercial and residential properties, comprise the majority of our loan portfolio, with the balance of our loans consisting of commercial and industrial loans and loans to individuals. Through associations with various mortgage lending companies, we originate residential mortgages, at both fixed and variable rates, earning fees for loans originated and additional income for loans sold to others. It has been our strategy to recruit skilled banking professionals who are well trained and highly knowledgeable about our market area, enabling us to develop and maintain a loan portfolio of sound credit quality.

     We recognize that our growth may expose us to increased operational and market risk, primarily with respect to managing overhead, funding costs and credit quality. We have developed critical functions such as Training, Audit, and Credit Administration to assist in managing and monitoring these and other risks. We are committed to creating a solid and diversified financial services organization with a focus on customer service. It is our firm belief that this foundation will continue building our loyal customer base while attracting new clients and providing opportunities for future growth. As bank consolidations continue to take place in our marketplace, Southern Community Financial Corporation is positioned to continue to benefit from their effects.

Financial Condition at December 31, 2003 and 2002

     During the year ended December 31, 2003, our total assets increased by $186.3 million, or 30.4%, to $798.5 million. Of this increase in total assets, $176.1 represented growth in interest-earning assets. Continued strong loan demand resulted in an increase of $96.9 million, or 23.3%, in net loans receivable, while investment securities available for sale and held to maturity increased by $71.6 million and $17.5 million, respectively. Much of the growth in the investment portfolio during the first half of the year was primarily due to planned growth combined with pre-investment of projected maturities for the remainder of the year. During the fourth quarter of 2003 we purchased bonds for the investment portfolio to employ funds received from the issuance of Southern Community Capital Trust II in excess of those needed for The Community Bank acquisition, and to leverage that additional capital. The only category of interest-earning assets that decreased was federal funds sold, which ended 2003 at $271,000 as compared with $11.1 million at the end of 2002. Federal funds sold, with an average annual return of 1.21%, is the lowest yielding among interest-earning assets. Premises and equipment increased by $1.4 million, principally as a result of the investment of $610,000 in a new branch facility located in High Point, NC, and the completion of a new corporate office in the first half of 2003. Other assets increased by $3.5 million, which included the capitalization of costs associated with the issuance of Southern Community Capital Trust II and costs associated with the acquisition of The Community Bank.

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     Loan growth in 2003 was concentrated in commercial and real estate lending. Our total loan growth of $97.8 million in 2003 was spread among portfolios secured by residential and commercial mortgages, which increased by $31.7 million and $48.9 million, respectively. Commercial and industrial lending and construction loan outstandings increased by $15.2 and $7.4 million, respectively during the year. Consumer lending declined $5.5 million from 2002 levels as the bank exited the consumer finance business and liquidated Southeastern Acceptance Corporation. During 2003 we continued our active program of originations of residential mortgage loans for sale in the secondary market. At the end of the year loans held for sale totaled $1.1 million.

     Our total liquid assets, defined as cash and due from banks, federal funds sold and investment securities, increased by $84.6 million during the year, to $254.0 million at December 31, 2003 versus $169.4 million at the beginning of the year. Liquid assets represented 31.8% of total assets at December 31, 2003 as compared to 27.7% at the beginning of the year. We have been able to further leverage our capital and generate significant funds for investment both through deposit growth and through borrowings. These available funds have exceeded our lending needs, so we have invested at a positive interest rate spread in securities. In order to optimize our ability to manage interest rate risk, the majority of our increase in liquid assets in 2003 has been in available for sale securities.

     Customer deposits continue to be our primary funding source. While our deposits are primarily generated through our growing branch network, we do utilize some out-of-market and brokered deposits as a funding source. Brokered and out-of-market deposits totaled $159.2 million and $115.7 million at year-end 2003 and 2002, respectively. At December 31, 2003, deposits totaled $575.2 million, an increase of $126.0 million or 28.1% from year-end 2002. As explained above, we have also utilized borrowings to fund growth in 2003. Total borrowings, including $51.7 million in trust preferred securities issued during 2002 and 2003, aggregated $169.5 million at December 31, 2003. Borrowings also included $96.5 million of advances from the Federal Home Loan Bank of Atlanta (FHLB), Federal funds purchased of $11.4 million and securities sold under agreements to repurchase of $10.0 million. We will use FHLB advances and other funding sources as necessary to support balance sheet management and growth. However, we believe that as our branch network grows and matures, the volume of core deposits will become a relatively larger portion of our funding mix, which should contribute to a reduction in our overall funding cost.

     Our capital position remains strong, with all of our regulatory capital ratios at levels that make us “well capitalized” under federal bank regulatory capital guidelines. At December 31, 2003, our stockholders’ equity totaled $50.9 million, an increase of $3.4 million from the December 31, 2002 balance. This increase includes net income of $3.7 million earned during the year and a decrease in other comprehensive income of $1.6 million.

     On July 30, 2003, the company and The Community Bank jointly announced the execution of a definitive agreement in which Southern Community Financial Corporation would acquire The Community Bank of Pilot Mountain, North Carolina in a fixed exchange of cash and stock. The Community Bank, founded in 1987 operates 10 community banking offices throughout Surry, Rockingham, Stokes, Iredell and Yadkin counties of North Carolina. On December 11, 2003, shareholders approved the transaction allowing Southern Community Financial Corporation to acquire The Community Bank. On January 12, 2004, the acquisition was completed. For each share of stock owned, The Community Bank shareholders receive $53.05 in cash, 4.8714 shares of newly issued Southern Community common stock or a combination of both, subject to an overall allocation of approximately 6.4 million shares of common stock and $15.2 million in cash. As a result of the acquisition, consolidated assets for the company reached $1.1 billion, with $120 million of shareholders’ equity, and approximately $48 million of goodwill was created.

     On January 14, 2004, the company announced the redemption of all of its 7.25% Cumulative Convertible Trust Preferred Securities issued through Southern Community Capital Trust I under the provision that the trading price of our common stock had been at least 125% of the Conversion Price for a period of twenty consecutive trading days ending within five days of the notice of redemption. The Securities were redeemed on March 12, 2004 which resulted in the issuance of 2,060,000 shares of common stock through the conversions and the retirement of $61,000 of the convertible trust preferred securities. On January 14, 2004, the company announced the declaration of its first annual cash dividend of $0.11 per share of its common stock which was paid on March 15, 2004, to shareholders of record on February 20, 2004.

Financial Condition at December 31, 2002 and 2001

     During the year ended December 31, 2002, our total assets increased by $131.0 million, or 27.2%, to $612.2 million. Of this increase in total assets, $125.3 represented growth in interest-earning assets. Continued strong loan demand drove an increase of $60.7, or 17.1%, in net loans receivable, while investment securities available for sale and held to maturity increased by $66.3 million and $10.2 million, respectively. The only category of interest-earning assets that decreased was federal funds sold, which

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ended 2002 at $11.1 million as compared with $22.9 million at the end of 2001. Federal funds sold provided the lowest yield among all interest-earning assets, declining from 1.70% at the beginning to 1.16% at year-end. Premises and equipment increased by $3.9 million, principally as a result of the investment of $422,000 in a new branch facility located in Kernersville, NC, and the investment of $3.2 million in a new corporate headquarters that is scheduled for occupancy in the first half of 2003. Other assets increased by $4.1 million, including additional investments in bank-owned life insurance of $557,000. Our total investment in bank-owned life insurance at December 31, 2002 was $2.8 million. This investment is included in other assets in our balance sheet and yielded a tax exempt return of 5.20% during the year 2002.

     Loan growth in 2002 was concentrated in commercial and real estate lending. Our loan growth of $60.7 million in 2002 was spread among our residential and commercial mortgage loans, which increased by $13.2 million and $48.5 million, respectively. Construction loans and loans to individuals increased by $2.9 million and $2.9 million, respectively, while commercial and industrial loans decreased by $5.9 million. During 2002 we continued our active program of originations of residential mortgage loans for sale in the secondary market. At the end of the year loans held for sale totaled $4.9 million.

     Our total liquid assets, defined as cash and due from banks, federal funds sold and investment securities, increased by $62.4 million during the year, to $169.4 million at December 31, 2002 versus $107 million at the beginning of the year. Liquid assets represented 27.7% of total assets at December 31, 2002 as compared to 22.2% at the beginning of the year. We have been able to generate significant funds for investment both through deposit growth and through borrowings. These available funds have exceeded our lending needs, so we have invested at a positive interest rate spread in securities. In order to optimize our ability to manage interest rate risk, substantially all of our increased investment in liquid assets in 2002 has been in investments available for sale.

     Customer deposits continue to be our primary funding source. While our deposits are primarily generated through our growing branch network, we do utilize some out-of-market and brokered deposits to support our funding base. Brokered and out-of-market deposits totaled $115.7 million and $61.0 million at year-end 2002 and 2001, respectively. At December 31, 2002, deposits totaled $449.2 million, an increase of $56.4 million or 14.4% from year-end 2001. As explained above, we have also utilized borrowings to fund growth in 2002. Total borrowings, including $17.3 million in convertible preferred securities issued during 2002, aggregated $113 million at December 31, 2002. Borrowings also included $75.5 million from the Federal Home Loan Bank of Atlanta (FHLB) and securities sold under agreements to repurchase of $20.2 million. We will use FHLB advances and other funding sources as necessary to support balance sheet management and growth. However, we believe that as our branch network grows and matures, the volume of core deposits will become a relatively larger portion of our funding mix, which should contribute to a reduction in our overall funding cost.

     Our capital position remains strong, with all of our regulatory capital ratios at levels that make us “well capitalized” under federal bank regulatory capital guidelines. At December 31, 2002, our stockholders’ equity totaled $47.5 million, an increase of $5.0 million from the December 31, 2001 balance. This increase includes net income of $3.2 million earned during the year and other comprehensive income of $1.8 million.

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NET INTEREST INCOME

     Like most financial institutions, the primary component of our earnings is net interest income. Net interest income is the difference between interest income, principally from loans and investments, and interest expense, principally on customer deposits and borrowings. Changes in net interest income result from changes in volume and changes in interest rates earned and paid. By volume, we mean the average dollar level of interest-earning assets and interest-bearing liabilities. Spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, and margin refers to net interest income divided by average interest-earning assets. Spread and margin are influenced by the levels and relative mix of interest-earning assets and interest-bearing liabilities, as well as by levels of noninterest-bearing liabilities. During the years ended December 31, 2003, 2002 and 2001, our average interest-earning assets were $655.3 million, $523.3 million, and $397.0 million, respectively. During these same years, our net interest margins were 3.25%, 3.34% and 3.36%, respectively.

      Average Balances and Average Rates Earned and Paid. The following table sets forth, for the years 2001 through 2003, information with regard to average balances of assets and liabilities, as well as the total dollar amounts of interest income from interest-earning assets and interest expense on interest-bearing liabilities, resultant yields or costs, net interest income, net interest spread, net interest margin and ratio of average interest-earning assets to average interest-bearing liabilities. Average loans include nonaccruing loans, the effect of which is to lower the average yield.

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RATE/VOLUME ANALYSIS

     The following table analyzes the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. The table distinguishes between (i) changes attributable to volume (changes in volume multiplied by the prior period’s rate), (ii) changes attributable to rate (changes in rate multiplied by the prior period’s volume), and (iii) net change (the sum of the previous columns). The change attributable to both rate and volume (changes in rate multiplied by changes in volume) has been allocated equally to both the changes attributable to volume and the changes attributable to rate.

from 6.36% to 5.50%. The rates earned on a significant portion of our loans adjust immediately when index rates such as our prime rate changes. Conversely, most of our interest-bearing liabilities, including certificates of deposit and borrowings, have rates fixed until maturity. As a result, interest rate reductions such as the one imposed in June of 2003 generally result in an immediate drop in our interest income on loans, with a more delayed impact on interest expense because reductions in interest costs will only occur upon renewals of certificates of deposit or borrowings. Our average total interest-bearing liabilities increased by $124.1 million, or 26.2%, consistent with our increase in interest-earning assets. With rates sustained at lower levels, our average cost of interest-bearing liabilities decreased by 87 basis points from 3.34% to 2.47%, allowing our interest rate spread to remain relatively unchanged. For the year ended December 31, 2003, our net interest spread was 3.03% and our net interest margin was 3.25%. For the year ended December 31, 2002, our net interest spread was 3.02% and our net interest margin was 3.34%. In November of 2003 the company, through its non-bank subsidiary Southern Community Capital Trust II, issued 3,450,000 Trust Preferred Securities generating total proceeds of $34.5 million. The Securities pay distributions at an annual rate of 7.95% and mature on December 31, 2033. The principal use of the net proceeds from the sale of the debentures was to provide cash for the acquisition of The Community Bank, to increase our regulatory capital, and to support the growth and operations of our subsidiary bank. While this transaction has strengthened the company’s overall financial condition, its fixed rate coupon will initially hamper our margins given the current interest rate environment. The company has entered into a $20.0 million notional amount receive fixed, pay floating interest rate swap to manage the impact of this transaction on the company’s margin and consolidated asset/ liability position.

      Provision for Loan Losses. We recorded a $2.3 million provision for loan losses for the year ended December 31, 2003, representing an increase of $630,000 from the $1.7 million provision we made for the year ended December 31, 2002. Provisions for loan losses are charged to income to bring our allowance for loan losses to a level deemed appropriate by management based on the factors discussed under “Analysis of Allowance for Loan Losses.” We have continued to increase the level of our allowance for loan losses as a result of the continued growth in our loan portfolio. Total loans receivable increased by $97.8 million during 2003, and by $61.7 million during 2002. In addition to loan growth affecting our provision for loan losses, net loan charge-offs, which totaled $1.4 million during 2003, an increase from $713,000 in 2002, also impacted the provision expense. On an annualized basis, our percentage of net loan charge-offs to average loans outstanding was .29% for the year ended December 31, 2003 as compared with .18% for the year ended December 31, 2002. Our consumer finance lending accounted for $774,000 or 57.2% of net charge-offs during 2003, an increase of $368,000 from the prior year. Management decided the consumer finance business was no longer part of the company’s strategic direction, and during the fourth quarter of 2003 we ceased originating new consumer finance loans. It is expected that the residual consumer finance loan portfolio will payoff over a thirty-six month time frame and the company’s level of charge-offs as a percentage of loan outstandings will decline. Nonperforming loans totaled $769,000 or .15% of total loans at December 31, 2003, as compared with $1.8 million or .43% of total loans at December 31, 2002. The allowance for loan losses at December 31, 2003 of $7.3 million represents 1.40% of total loans and 946% of nonperforming loans. The allowance for loan losses at December 31, 2002 of $6.3 million equaled 1.50% of total loans outstanding at that date.

      Non-Interest Income. For the year ended December 31, 2003, non-interest income increased $1.1 million or 26.9% to $5.0 million from $3.9 million for the prior year. This favorable increase resulted from factors that include an increase of $321,000, or 28.6% to $1.4 million, in service charges and fees on deposit accounts due to deposit growth and implementation of a new overdraft protection program during 2003. Income from investment brokerage fees increased by $614,000, or 184.4%, to $947,000. This increase was a result of a new investment product that was offered for a limited time. Fees on the origination of residential mortgage loans sold into the secondary market remained strong and increased slightly to $1.4 million. Fees generated from mortgage originations during 2002 and 2003 were strong as a result of the increased level of home mortgage refinancings due to the low interest rate environment. However, baring another decline in interest rates we anticipate a reduction in fee income from this line of business in the near term.

      Non-Interest Expense . We strive to maintain non-interest expenses at levels that we believe are appropriate given the nature of our operations and the investments in personnel and facilities that have been necessary to support our growth. From 1998 forward, we have consistently maintained our ratio of non-interest expenses to average total assets below 3%. For 2003 our ratio was 2.63%, down slightly from a ratio of 2.66% in 2002. Because of our continued strong growth we have seen increases in every major component of our non-interest expenses. For the year ended December 31, 2003, our non-interest expense increased $3.6 million, or 24.0%. Salary and employee benefits expense increased $1.8 million, or 23.8%, and reflects the addition of personnel associated with branch expansion, additions of personnel to expand and support our lines of business, and normal increases in salaries and employee benefits. Occupancy and equipment expense increased $537,000, or 21.4%, reflecting the expenses associated with our continued branch expansion, new corporate office and investments in technology to support our banking operations. Other non-interest expenses increased $1.2 million, or 25.9%, reflecting the increased volume of business activity, principally increases in lending and growth in deposit accounts. In addition, during the fourth quarter of 2003 the bank ceased operation of its consumer finance subsidiary. Simultaneously, the bank entered into an agreement with the former

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president of that subsidiary to service these loans on the behalf of the bank. The fees paid to service these loans, combined with severance payments to the former employees and costs associated with the transaction, contributed to the increase in non-interest expense.

      Provision for Income Taxes. Our provision for income taxes, as a percentage of income before income taxes, was 35.0 % for the year ending December 31, 2003 and 35.3% for the year ended December 31, 2002.

RESULTS OF OPERATIONS
Years Ended December 31, 2002 and 2001

      Net Income. Our net income for 2002 was $3.2 million, an increase of $1.1 million from net income of $2.1 million earned in 2001. Net income per share was $.37 basic and $.35 diluted for the year ended December 31, 2002, up from $.24 basic and $.23 diluted for 2001. We have continued to experience strong growth, with total assets averaging $555.4 million during the current year as compared to $424.2 million in 2001, an increase of 30.9%. Our percentage growth in net interest income after provision for loan losses of 43.7% exceeded our rate of asset growth, outpacing our 32.4% increase in non-interest expenses, which approximated our rate of asset growth. In absolute terms, our net interest income after provision for loan losses increased by $4.8 million and our non-interest income grew by $525,000, well exceeding the increase of $3.6 million in non-interest expenses. Largely as a result of a lower level of net loan charge-offs in 2002, our provision for loan losses for the year of $1.7 million was $665,000 lower than the provision of $2.3 million made for 2001. Interest rates, which declined dramatically during 2001, were more stable at lower levels during 2002. This interest rate environment, combined with our growth in interest-earning assets, yielded an increase of $4.2 million in net interest income. Our expense growth included a full year of costs for the two new branches opened in 2001 and a partial year’s costs for the new branch opened in 2002, as well as personnel costs associated with expansion of our business. These expenses represent investments in building our franchise, but their initial effect is to dampen earnings.

      Net Interest Income. During 2002, our net interest income increased by $4.2 million or 31.1% to $17.5 million. Our growth in interest income was the result of growth in our overall level of average earning assets. The rates earned on a significant portion of our loans adjust immediately when index rates such as our prime rate change. Conversely, most of our interest-bearing liabilities, including certificates of deposit and borrowings, have rates fixed until maturity. As a result, interest rate reductions will generally result in an immediate drop in our interest income on loans, with a more delayed impact on interest expense because reductions in interest costs will only occur upon renewals of certificates of deposit or borrowings. This affected our net interest income dramatically in 2001. In 2002, however, interest rates were relatively stable at lower levels throughout the year. As a result, the sustained lower rates affected our funding costs more than it did our asset yields, resulting in a 20 basis point increase in our interest rate spread with a decline of only 2 basis points in our net interest margin. Average total interest-earning assets increased $126.3 million, or 31.8%, during 2002 as compared to 2001, while our average yield dropped by 154 basis points from 7.90% to 6.36%. Our average total interest-bearing liabilities increased by $118.8 million, or 33.5%, consistent with our increase in interest-earning assets. With rates sustained at lower levels, our average cost of interest-bearing liabilities decreased by 174 basis points from 5.08% to 3.34%, resulting in the 20 basis point increase in our interest rate spread described above. For the year ended December 31, 2002, our net interest spread was 3.02% and our net interest margin was 3.34%. For the year ended December 31, 2001, our net interest spread was 2.82% and our net interest margin was 3.36%.

      Provision for Loan Losses. We recorded a $1.7 million provision for loan losses for the year ended December 31, 2002, representing a decrease of $665,000 from the $2.3 million provision we made for the year ended December 31, 2001. Provisions for loan losses are charged to income to bring our allowance for loan losses to a level deemed appropriate by management based on the factors discussed under “Analysis of Allowance for Loan Losses.” We have continued to increase the level of our allowance for loan losses principally as a result of the continued growth in our loan portfolio. Total loans receivable increased by $61.7 million during 2002, and by $78.1 million during 2001. Our reduced provision for loan losses for the current year was made largely in response the lower total of loan growth and to a decrease in net loan charge-offs, which totaled $713,000 during 2002, down from $1.2 million 2001. On an annualized basis, our percentage of net loan charge-offs to average loans outstanding was .18% for the year ended December 31, 2002 as compared with .38% for the year ended December 31, 2001. Southeastern Acceptance Corporation, as a stand-alone entity, experienced loan charge-offs of $406,000 in 2002, an increase of $116,000 from $290,000 in 2001 and represented 3.7% and 4.1% of average loans, respectively. Nonperforming loans totaled $1.8 million or .43% of total loans at December 31, 2002, as compared with $894,000 or .25% of total loans at December 31, 2001. The allowance for loan losses at December 31, 2002 of $6.3 million represents 1.50% of total loans and 348% of nonperforming loans. The allowance for loan losses at December 31, 2001 of $5.4 million equaled 1.50% of total loans outstanding at that date.

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      Non-Interest Income. For the year ended December 31, 2002, non-interest income increased $525,000 or 15.4% to $3.9 million from $3.4 million for the prior year. This favorable increase resulted from factors that include an increase of $242,000, or 27.5% to $1.1 million, in service charges and fees on deposit accounts as a result of deposit growth and an increase of $301,000, or 29.8% to $1.3 million, in income from the origination of residential mortgage loans sold into the secondary market. We also generated an increase of $140,000 in investment brokerage fees and gains of $70,000 from sales of investment securities available for sale. In aggregate, the increased level of core non-interest income more than offset the effects of nonrecurring income of $383,000 realized in 2001 from an interest rate floor contract.

      Non-Interest Expense . We strive to maintain non-interest expenses at levels that we believe are appropriate given the nature of our operations and the investments in personnel and facilities that have been necessary to support our growth. From 1998 forward, we have consistently maintained our ratio of non-interest expenses to average total assets below 3%. For 2002 our ratio was 2.66%, up slightly from a ratio of 2.63% in 2001. Because of our continued strong growth we have continued to see increases in every major component of our non-interest expenses. For the year ended December 31, 2002, our non-interest expense increased $3.6 million, or 32.4%. Salary and employee benefit expense increased $2.2 million, or 40.8%, and reflects the addition of personnel associated with branch expansion, additions of personnel to expand our lines of business, and normal increases in salaries and employee benefits. Occupancy and equipment expense increased $441,000, or 21.3%, reflecting the expenses associated with our continued branch expansion and investments in technology to support our banking operations. Other non-interest expenses increased $930,000, or 25.9%, reflecting the increased volume of business activity, principally increases in lending and growth in deposit accounts.

      Provision for Income Taxes. Our provision for income taxes, as a percentage of income before income taxes, was 35.3% for each of the years ended December 31, 2002 and 2001.

LIQUIDITY

     Market and public confidence in our financial strength and in the strength of financial institutions in general will largely determine our access to appropriate levels of liquidity. This confidence is significantly dependent on our ability to maintain sound asset quality and appropriate levels of capital resources.

     The term “liquidity” refers to our ability to generate adequate amounts of cash to meet our needs for funding loan originations, deposit withdrawals, maturities of borrowings and operating expenses. Management measures our liquidity position by giving consideration to both on- and off-balance sheet sources of, and demands for, funds on a daily and weekly basis.

     Sources of liquidity include cash and cash equivalents, net of federal requirements to maintain reserves against deposit liabilities, investment securities eligible for pledging to secure borrowings from correspondent banks pursuant to securities sold under repurchase agreements, investments available for sale, loan repayments, loan sales, deposits, and borrowings from the Federal Home Loan Bank secured with pledged loans and securities, and from correspondent banks under overnight federal funds credit lines. In addition to interest rate-sensitive deposits, the company’s primary demand for liquidity is anticipated fundings under credit commitments to customers.

     Because of our continued growth and the availability of relatively low cost funding sources, we have maintained a high level of liquidity in the form of federal funds sold and investment securities. These aggregated $231.0 million at December 31, 2003, compared to $152.8 million and $88.1 million at December 31, 2002 and 2001, respectively. Supplementing customer deposits as a source of funding, we have available lines of credit from various correspondent banks to purchase federal funds on a short-term basis of approximately $27.0 million. We also have the ability to borrow up to $198.5 million, as of December 31, 2003, from the Federal Home Loan Bank of Atlanta, with $96.5 million outstanding as of that date. At December 31, 2002 we had FHLB borrowings outstanding of $75.5 million. Funding costs have been low during 2003, and we have taken advantage of favorable interest rates offered by the FHLB to provide funding for increased investments. In the second quarter of 2003 the investment portfolio was increased due to planned growth in combination with the pre-investment of projected maturities for the remainder of the year. During the fourth quarter of 2003 we again purchased bonds for the investment portfolio to employ funds received from the issuance of Southern Community Capital Trust II in excess of those needed for The Community Bank acquisition, and to leverage that additional capital. We also had repurchase agreements with a total outstanding balance of $10.0 million at December 31, 2003. Securities sold under agreements to repurchase generally mature within ninety days from the transaction date and are collateralized by U.S. Government Agency obligations. We have repurchase lines of credit aggregating $100 million from various institutions. The repurchases must be adequately collateralized. At December 31, 2003, our outstanding commitments to extend credit consisted of loan commitments of $55.8 million and amounts available under home equity credit lines, other credit lines and standby letters of

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credit of $48.6 million, $42.0 million and $4.7 million, respectively. We believe that our combined aggregate liquidity position from all sources is sufficient to meet the funding requirements of loan demand and deposit maturities and withdrawals in the near term.

     Throughout our seven-year history, our loan demand has exceeded our growth in core deposits. We have therefore relied heavily on certificates of deposits as a source of funds. While the majority of these funds are from our local market area, the bank has utilized brokered and out-of-market certificates of deposits to diversify and supplement our deposit base. Certificates of deposits represented 59.9% of our total deposits at December 31, 2003, reduced from 64.9% at December 31, 2002. Brokered and out-of-market deposits totaled $159.2 million at year-end 2003 and $115.7 million at year-end 2002, which comprised 27.7% and 25.8% of total deposits, respectively. Certificates of deposit of $100,000 or more, inclusive of brokered and out-of-market certificates, represented 31.7% of our total deposits at December 31, 2003 and 29.3% at December 31, 2002. A portion of these deposits are controlled by members of our Board of Directors and Advisory Board members, or otherwise come from customers considered to have long-standing relationships with our management. Based upon the nature of these relationships, management does not believe we are subject to significant liquidity risk related to these deposits. Large certificates of deposits are generally considered rate sensitive. While we will need to pay competitive rates to retain these deposits at their maturities, there are other subjective factors that will determine their continued retention.

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OFF-BALANCE SHEET ARRANGEMENTS

     Information about the company’s off-balance sheet risk exposure is presented in Note 16 to the accompanying consolidated financial statements. As part of its ongoing business, the company does not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as special purpose entities (SPEs), which generally are established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of December 31, 2003, the company is not involved in any unconsolidated SPE transactions.

CAPITAL RESOURCES

     Stockholders’ equity at December 31, 2003 was $50.9 million. At that date, our capital to asset ratio was 6.4%, and all of our capital ratios exceeded the minimums established for a well-capitalized bank holding company by regulatory measures. Our Tier 1 risk-based capital ratio at December 31, 2003 was 10.85%.

     The bank and the company are subject to minimum capital requirements. See “SUPERVISION AND REGULATION.” As the following table indicates, at December 31, 2003, the company exceeded its regulatory capital requirements.

     The trust preferred securities presently qualify as Tier 1 regulatory capital and are reported in Federal Reserve regulatory reports as a minority interest in our consolidated subsidiaries. The junior subordinated debentures do not qualify as Tier 1 regulatory capital. On July 2, 2003, the Board of Governors of the Federal Reserve issued a letter, SR 03-13, stating that notwithstanding FIN 46, trust preferred securities will continue to be included in Tier 1 capital until notice is given to the contrary. There can be no assurance that the Federal Reserve will continue to allow institutions to include trust preferred securities in Tier I capital for regulatory capital purposes. In the event of a disallowance, there would be a reduction in the company’s consolidated capital ratios. However, the company believes that the bank would remain “well capitalized” under Federal Reserve Board guidelines.

     As of December 31, 2003 the company had formed two subsidiaries for the purpose of issuing trust preferred securities.

     In November of 2003, Southern Community Capital Trust II (“Trust II”), a newly formed subsidiary of the company, issued 3,450,000 Trust Preferred Securities (“Trust II Securities”), generating total proceeds of $34.5 million. The Trust II Securities pay distributions at an annual rate of 7.95% and mature on December 31, 2033. The Trust II Securities began paying quarterly distributions on December 31, 2003. The company has fully and unconditionally guaranteed the obligations of Trust II. The Trust II Securities are redeemable in whole or in part at any time after December 31, 2008. The proceeds from the Trust II Securities were utilized to purchase convertible junior subordinated debentures from us under the same terms and conditions as the Trust II Securities. We have the right to defer payment of interest on the debentures at any time and from time to time for a period not exceeding five years, provided that no deferral period extend beyond the stated maturities of the debentures. Such deferral of interest payments by the company will result in a deferral of distribution payments on the related Trust II Securities. Should we defer the payment of interest on the debentures, the company will be precluded from the payment of cash dividends to shareholders. The principal use of the net proceeds from the sale of the debentures was to provide cash for the acquisition of The Community Bank, to increase our regulatory capital, and to support the growth and operations of our subsidiary banks. The amount of proceeds we count as Tier 1capital cannot comprise more than 25% of our core capital elements. Amounts in excess of that 25% limitation count as Tier 2 supplementary capital on our books. Prior to the closing of the acquisition of The Community Bank on January 12, 2004, substantially all of the proceeds from the Trust II Securities qualified as Tier 2 supplementary capital. Prior to the redemption of the Trust I Securities, approximately $20 million of the proceeds of the Trust II Securities counted as Tier 1 capital on our books. After the redemption of the Trust I Securities on March 12, 2004, subject to certain limitations, substantially all of the proceeds from the Trust II Securities qualify as Tier 1 capital of the company for regulatory capital purposes.

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     In February of 2002, Southern Community Capital Trust I (“Trust I”), a newly formed subsidiary of the company, issued 1,725,000 Cumulative Convertible Trust Preferred Securities (“Trust I Securities”), generating total proceeds of $17.3 million. At December 31, 2003, holders of the Trust I Securities had voluntarily converted $175,000 of the Trust I Securities into 21,187 shares of our common stock at the Conversion Price of $8.26 per share of our common stock. On January 14, 2004, we announced the redemption of all of the Trust I Securities. We redeemed the Trust I Securities under a provision that permitted us to redeem the Trust I Securities in whole at any time prior to March 31, 2007 once the trading price of our common stock had been at least 125% of the Conversion Price for a period of twenty consecutive trading days ending within five days of the date that we gave notice of redemption. The Trust I Securities were redeemed on March 12, 2004 which resulted in the issuance of 2,060,000 shares of our common stock through the conversions and the retirement of $61,000 of the convertible trust preferred securities. The Trust I Securities paid distributions at an annual rate of 7.25%. The Trust I Securities began paying quarterly distributions on March 31, 2002. The company had fully and unconditionally guaranteed the obligations of Trust I. The proceeds from the Trust I Securities were utilized to purchase convertible junior subordinated debentures from us under the same terms and conditions as the Trust I Securities. Subject to certain limitations, the Trust I Securities qualified as Tier 1 capital of the company for regulatory capital purposes. The principal use of the net proceeds from the sale of the convertible debentures was to infuse capital into our bank subsidiary, Southern Community Bank and Trust, to fund its operations and continued expansion, and to maintain the company’s and the bank’s status as “well capitalized” under regulatory guidelines.

     On July 30, 2003, the company and The Community Bank jointly announced the execution of a definitive agreement in which Southern Community Financial Corporation would acquire The Community Bank in a fixed exchange of cash and stock. The Community Bank, founded in 1987 and headquartered in Pilot Mountain, North Carolina operates 10 community banking offices throughout Surry, Rockingham, Stokes, Iredell and Yadkin counties, North Carolina. On December 11, 2003, shareholders approved the transaction allowing Southern Community Financial Corporation to acquire The Community Bank. On January 12, 2004, the acquisition was completed. For each share of stock owned, The Community Bank shareholders received $53.05 in cash, 4.8714 shares of newly issued Southern Community common stock or a combination of both, subject to an overall allocation of approximately 6.4 million shares of common stock and $15.2 million in cash.

ASSET/LIABILITY MANAGEMENT

     Our results of operations depend substantially on net interest income. Like most financial institutions, our interest income and cost of funds are affected by general economic conditions and by competition in the market place. The purpose of asset/liability management is to provide stable net interest income growth by protecting earnings from undue interest rate risk, which arises from volatile interest rates and changes in the balance sheet mix, and by managing the risk/return relationships between liquidity, interest rate risk, market risk and capital adequacy. We adhere to a Board-approved asset/liability management policy that provides guidelines for controlling, monitoring, and reporting exposure to interest rate risk. Our policy is to manage the company’s net interest income exposure by measuring the impact of changing interest rate environments and adjusting the mix of assets and liabilities to provide an acceptable return within established risk limits. Net interest income simulation and gap reports in conjunction with other tools are utilized to measure and monitor interest rate risk.

     When suitable lending opportunities are not sufficient to utilize available funds, we have generally invested such funds in securities, primarily securities issued by governmental agencies and mortgage-backed securities. The securities portfolio contributes to profitability and plays an important part in our overall interest rate risk management. However, management of the securities portfolio alone cannot balance overall interest rate risk. The securities portfolio must be used in combination with other asset/liability techniques to actively manage the balance sheet. The primary objectives in the overall management of the securities portfolio are safety, liquidity, yield, asset/liability management (interest rate risk), and investing in securities that can be pledged for public deposits or for borrowings.

     In reviewing the needs of our bank with regard to proper management of its asset/liability program, we estimate future needs, taking into consideration investment portfolio purchases, calls and maturities in addition to estimated loan and deposit increases (due to increased demand through marketing) and forecasted interest rate changes. We use a number of measures to monitor and manage interest rate risk, including income simulations and gap analyses. An income simulation model is the primary tool used to assess the direction and magnitude of changes in net interest income resulting from changes in interest rates. Key assumptions in the model include prepayment speeds on mortgage-related assets, cash flows and maturities of other investment securities, loan and deposit volumes and pricing. These assumptions are inherently uncertain and, as a result, the model cannot precisely estimate net interest income or precisely predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes and changes in market conditions and management strategies, among other factors. Based on the results of the income simulation model as of October 31, 2003, we would expect an increase in net interest income of $391,000 if interest rates increase from

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current rates by 200 basis points over the next twelve months, and a decrease in net interest income of $872,000 if interest rates decrease from current rates by 100 basis points over the next twelve months.

     The analysis of interest rate gap (the difference between the amount of interest-earning assets and interest-bearing liabilities re-pricing or maturing during a given period of time) is another standard tool we use to measure exposure to interest rate risk. We believe that because interest rate gap analysis does not address all factors that can affect earnings performance, it should be used in conjunction with other methods of evaluating interest rate risk.

     Our balance sheet was asset-sensitive at December 31, 2003 in the three-month horizon and liability-sensitive in the one-year period. An asset-sensitive position means that there are more assets than liabilities subject to repricing in that period as market rates change, and conversely with a liability-sensitive position. As a result, in a falling rate environment, our earnings position could deteriorate initially followed by improvement, with the opposite expectation in a rising rate environment, depending on the correlation of rate changes in these categories.

     The following table presents information about the periods in which the interest-sensitive assets and liabilities at December 31, 2003 will either mature or be subject to repricing in accordance with market rates, and the resulting interest-sensitivity gaps. This table shows the sensitivity of the balance sheet at one point in time and is not necessarily indicative of what the sensitivity will be on other dates. Included in interest-bearing liabilities subject to rate changes within 90 days is 100% of the money market and NOW deposits. These types of deposits historically have not repriced coincidentally with or in the same proportion as general market indicators. As simplifying assumptions concerning repricing behavior, all money market and NOW deposits are assumed to reprice immediately and fixed rate loans and mortgage-backed securities are assumed to reprice at their contractual maturity.

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MARKET RISK

     Market risk reflects the risk of economic loss resulting from adverse changes in market price and interest rates. This risk of loss can be reflected in diminished current market values and/or reduced potential net interest income in future periods. Our market risk arises primarily from interest rate risk inherent in our lending and deposit-taking activities. The structure of our loan and deposit portfolios is such that a significant decline in interest rates may adversely impact net market values and net interest income. We do not maintain a trading account nor are we subject to currency exchange risk or commodity price risk. Interest rate risk is monitored as part of the bank’s asset/liability management function, which is discussed in “Asset/Liability Management” above. The following table presents information about the contractual maturities, average interest rates and estimated fair values of our financial instruments that are considered market risk sensitive at December 31, 2003.

(1)

Tax-exempt securities are reflected at a tax-equivalent basis using a 34% tax rate.

(2)

Callable securities and borrowings with favorable market rates at December 31, 2003 are assumed to mature at their call dates for purposes of this table.

(3)

Includes nonaccrual loans but not the allowance the loan losses.

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QUARTERLY FINANCIAL INFORMATION

The following table sets forth, for the periods indicated, certain of our consolidated quarterly financial information. This information is derived from our unaudited financial statements, which include, in the opinion of management, all normal recurring adjustments which management considers necessary for a fair presentation of the results for such periods. This information should be read in conjunction with our consolidated financial statements included elsewhere in this report. The results for any quarter are not necessarily indicative of results for any future period.