Arrow Financial - 10-Q quarterly report FY

#

ARROW FINANCIAL CORPORATION

FORM 10-Q

June 30, 2003

INDEX

#

ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Dollars in Thousands)(Unaudited)

See Notes to Unaudited Consolidated Interim Financial Statements.

#

ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(In Thousands, Except Per Share Amounts)(Unaudited)

Share and Per Share amounts have been restated for the November 2002 five percent stock dividend.

See Notes to Unaudited Consolidated Interim Financial Statements.

#

ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(In Thousands, Except Share and Per Share Amounts) (Unaudited)

See Notes to Unaudited Consolidated Interim Financial Statements.

#

ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY, Continued

(In Thousands, Except Share and Per Share Amounts) (Unaudited)

Share and Per Share amounts have been restated for the November 2002 five percent stock dividend.

See Notes to Unaudited Consolidated Interim Financial Statements.

#

ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in Thousands)(Unaudited)

See Notes to Unaudited Consolidated Interim Financial Statements.

#

ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED INTERIM FINANCIAL STATEMENTS

FORM 10-Q

June 30, 2003

1.   Financial Statement Presentation   

In the opinion of the management of Arrow Financial Corporation (the "Company"), the accompanying unaudited consolidated interim financial statements contain all of the adjustments necessary to present fairly the financial position as of June 30, 2003 and December 31, 2002; the results of operations for the three and six month periods ended June 30, 2003 and 2002; the changes in shareholders’ equity for the six month periods ended June 30, 2003 and 2002; and the cash flows for the six month periods ended June 30, 2003 and 2002.  All such adjustments are of a normal recurring nature.  The unaudited consolidated interim financial statements should be read in conjunction with the annual consolidated financial statements of the Company for the year ended December 31, 2002, included in the Company’s 2002 Form 10-K.

2.   Accumulated Other Comprehensive Income (In Thousands)

The following table presents the components, net of tax, of accumulated other comprehensive income as of June 30, 2003 and December 31, 2002:

3.   Earnings Per Common Share (Restated for Stock Dividends) (In Thousands, Except Per Share Amounts)

The following table presents a reconciliation of the numerator and denominator used in the calculation of basic and diluted earnings per common share (EPS) for the three and six-month periods ended June 30, 2003 and 2002:

Share and Per Share amounts have been restated for the November 2002 five percent stock dividend.

#

3.   Earnings Per Common Share (Restated for Stock Dividends) (In Thousands, Except Per Share Amounts), Continued

Share and Per Share amounts have been restated for the November 2002 five percent stock dividend.

4.  Goodwill and Other Intangible Assets (In Thousands)

The Company adopted SFAS No. 147, "Acquisitions of Certain Financial Institutions," during the quarter ended September 30, 2002.  SFAS No. 147 affects the accounting for an unidentifiable intangible asset acquired in the acquisition of a bank or thrift (including acquisitions of branches), where the fair value of the liabilities assumed exceeded the fair value of the assets acquired.  Under SFAS No. 147, if such a transaction met the criteria for a business combination, the carrying amount of the unidentifiable intangible asset is reclassified to goodwill (reclassified goodwill) as of the date SFAS No. 142 was applied in its entirety, which for the Company was January 1, 2002.  The carrying amounts of any recognized intangible assets that meet the recognition criteria of SFAS No. 141 that have been included in the amount reported as an unidentifiable intangible asset, and for which separate accounting records have been maintained, should be account ed for apart from the unidentifiable intangible asset and should not be reclassified to goodwill.  The reclassified goodwill should be accounted for and reported prospectively as goodwill under SFAS No. 142, for which amortization is not required, but which must be evaluated annually for impairment.  Prior to the adoption of SFAS No. 147, effective retroactive to January 1, 2002, the Company's unidentifiable intangible asset was being amortized over 15 years on a straight-line basis.  

Management concluded that the acquisition of branches that gave rise to the unidentifiable intangible asset was a business combination under SFAS No. 147, and therefore ceased amortizing the reclassified goodwill retroactive to January 1, 2002.  The carrying amount of the unidentifiable intangible asset related to the branch acquisitions and reclassified as goodwill was $9,297 as of January 1, 2002.

The carrying amounts of recognized intangible assets that meet the recognition criteria of SFAS No. 141 and for which separate accounting records have been maintained, primarily core deposit intangibles, have been included in the consolidated balance sheet as Other Intangible Assets, Net.  Core deposit intangibles are being amortized on a straight-line basis over a period of 15 years.  

#

4.   Goodwill and Other Intangible Assets (In Thousands), Continued

The following table presents information on the Company’s intangible assets (other than goodwill) as of June 30, 2003 and December 31, 2002:

#

5. Stock-Based Compensation Plans

The Company accounts for its stock-based compensation plans under the recognition and measurement principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations.  No stock-based employee compensation cost has been reflected in net income (other than for certain stock appreciation rights granted in 1992 and earlier, all of which have been exercised as of June 30, 2003), as all options granted under those plans have an exercise price equal to the market value of the underlying common stock on the date of grant.  However, options granted do generally impact diluted earnings per share by increasing the weighted average diluted shares outstanding and thereby decreasing diluted earnings per share as compared to basic earnings per share.

There were no options granted in the first six months of 2003.  The weighted-average fair value of options granted during 2002 was $7.61.  The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 2002: dividend yield of 3.24%; expected volatility of 27.5%; risk free interest rate of 3.13%; and expected lives of 7.0 years.  The Company also sponsors an Employee Stock Purchase Plan (ESPP) with a 15% discount on market price.  Under SFAS No. 123, the ESPP is considered compensatory and the entire discount is considered to be compensation expense in the pro forma disclosures.  Under APB 25, a discount of 15% or less is not considered compensatory expense.  The effects of applying SFAS No. 123 on the pro forma net income may not be representative of the effects on pro forma net income for future periods.  

The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123, “Accounting for Stock-Based Compensation,” to stock-based employee compensation plans.

6.   Guarantees

The Company does not issue any guarantees that would require liability-recognition or disclosure, other than its standby letters of credit.  Standby and other letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party.  Those guarantees are primarily issued to support public and private borrowing arrangements, including bond financing and similar transactions.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.  Typically, these instruments have terms of twelve months or less.  Some expire unused, and therefore, the total amounts do not necessarily represent future cash requirements.  Some have automatic renewal provisions.

For letters of credit, the amount of the collateral obtained, if any, is based on management’s credit evaluation of the counter-party.   The Company had approximately $2.9 million of standby letters of credit on June 30, 2003, most of which will expire within one year and many of which were not collateralized.  At that date, all the letters of credit were for private borrowing arrangements.  The fair value of the Company’s standby letters of credit at June 30, 2003 was insignificant.

#

Independent Auditors’ Review Report

The Board of Directors and Shareholders

Arrow Financial Corporation

We have reviewed the accompanying consolidated balance sheet of Arrow Financial Corporation and subsidiaries (the “Company”) as of June 30, 2003, and the related consolidated statements of income for the three-month and six-month periods ended June 30, 2003 and 2002, and consolidated statements of changes in shareholders’ equity and cash flows for the six-month periods ended June 30, 2003 and 2002.  These consolidated financial statements are the responsibility of the Company’s management.

We conducted our review in accordance with standards established by the American Institute of Certified Public Accountants.  A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters.  It is substantially less in scope than an audit conducted in accordance with auditing standards generally accepted in the United States of America, the objective of which is the expression of an opinion regarding the financial statements taken as a whole.  Accordingly, we do not express such an opinion.

Based on our review, we are not aware of any material modifications that should be made to the consolidated financial statements referred to above for them to be in conformity with accounting principles generally accepted in the United States of America.

We have previously audited, in accordance with auditing standards generally accepted in the United States of America, the consolidated balance sheet of Arrow Financial Corporation and subsidiaries as of December 31, 2002, and the related consolidated statements of income, changes in shareholders’ equity and cash flows for the year then ended (not presented herein); and in our report dated January 21, 2003, we expressed an unqualified opinion on those consolidated financial statements.  In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2002, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

/s/ KPMG LLP

Albany, New York

July 18, 2003

#

Item 2.

ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

JUNE 30, 2003

Cautionary Statement under Federal Securities Laws: The information contained in this Quarterly Report on Form 10-Q includes statements that are not historical in nature but rather are based on management’s beliefs, assumptions, expectations, estimates and projections about the future.  These statements are “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and involve a degree of uncertainty and attendant risk.  Words such as “expects,” “believes,” “anticipates,” “should,” “plans,” “will,” “estimates” and variations of such words and similar expressions are intended to identify such forward-looking statements.  Some of these statements are merely presentations of what future performance or changes in future performance would look like based on hypothetical assumptions and on simulation models.  Othe rs are based on management’s general perceptions of market conditions and trends in activity, both locally and nationally, as well as current management strategies for future operations and development.  

Examples of forward-looking statements in this Report are (i) statements in the first paragraph under the caption "Quarterly Taxable Equivalent Yield on Loans" regarding loan yields in upcoming periods and (ii) statements in the fifth paragraph under the caption “Quantitative and Qualitative Disclosures About Market Risk” regarding net interest margin and net interest income.  Forward-looking statements in this Report are not guarantees of future performance and involve certain risks and uncertainties that are difficult to quantify or, in some cases, to identify.  In the case of all forward-looking statements, actual outcomes and results may differ materially from what the statements predict or forecast.  Factors that could cause or contribute to such differences include, but are not limited to, unexpected changes in economic and market conditions, including unanticipated fluctuations in interest rates, new developments in state and feder al regulation, enhanced competition from unforeseen sources, new emerging technologies, sharp fluctuations in capital markets and similar risks inherent in banking operations.  Significant geopolitical developments, whether or not anticipated, also may cause differences between expected future outcomes as expressed in forward-looking statements and actual outcomes.  Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof.  Except as expressly required under applicable laws and regulations, the Company undertakes no obligation to revise or update forward-looking statements contained in this Report to reflect the occurrence of unanticipated events.  This Quarterly Report should be read in conjunction with the Company's Annual Report on Form 10-K for December 31, 2002.

Arrow Financial Corporation (the "Company") is a two-bank holding company headquartered in Glens Falls, New York.  Its banking subsidiaries are Glens Falls National Bank and Trust Company (“GFNB”) whose main office is located in Glens Falls, New York, and Saratoga National Bank and Trust Company (“SNB”) whose main office is located in Saratoga Springs, New York.

Peer Group Comparisons: At certain points in the ensuing discussion and analysis, the Company's performance is compared with that of its peer group of financial institutions. Unless otherwise specifically stated, this peer group is the group of 175 domestic bank holding companies with $1 to $3 billion in total consolidated assets identified in the Federal Reserve Board's "Bank Holding Company Performance Report" dated March 31, 2003.  Peer group data presented in this report was obtained from the Federal Reserve's Bank Holding Company Performance Report.

#

Use of Non-GAAP Financial Measures: The Securities and Exchange Commission (SEC) recently adopted Regulation G, which applies to all public disclosures, including earnings releases, made by registered companies after March 28, 2003, that contain “non-GAAP financial measures.”  Under Regulation G, companies making such disclosures must also disclose, along with the non-GAAP financial measures, certain additional information, including a reconciliation of the non-GAAP financial measures to the closest comparable GAAP financial measures and a statement of management's reasons for utilizing the non-GAAP financial measures as part of the Company's financial disclosures.  At the same time that the SEC issued Regulation G, it also made amendments to Item 10 of Regulation S-K, requiring companies to make the same sorts of supplemental disclosures whenever they include non-GAAP financial measures in filings with the SEC.  The SEC has exempted from th e definition of “non-GAAP financial measures” certain specific types of commonly used financial measures that are not based on GAAP such that supplemental information is not required when companies include these exempted measures in their public disclosures or SEC filings.  GAAP is generally accepted accounting principles in the United States of America.  The following measures may be affected by these new rules, however, management is unable to predict whether the SEC will regard these or certain other financial measures used by the Company in its normal presentation of financial information as "non-GAAP financial measures" within the meaning of the SEC's new rules.

Tax-Equivalent Net Interest Income and Net Interest Margin: Net interest income, as a component of the tabular presentation by financial institutions of Selected Financial Information regarding their recently completed operations, typically is presented on a tax-equivalent basis.  That is, to the extent that some component of the issuer's net interest income will be exempt from taxation (e.g., was received by the issuer as a result of its holdings of state or municipal obligations), an amount equal to the tax benefit derived from that component is added back to the net interest income total.  This adjustment is considered helpful in the comparison of one financial institution's net interest income to that of another institution, as each will have a different proportion of tax-exempt items in their portfolios.  Moreover, net interest income is a component of a second financial measure commonly used by financial institutions, net inte rest margin, which is the ratio of net interest income to average earning assets.  For purposes of this measure as well, tax-equivalent net interest income is generally used by institutions, again to provide a better basis of comparison from institution to institution.

The Efficiency Ratio: Financial institutions often use an "efficiency ratio" as a measure of expense control.  The efficiency ratio typically is defined as the ratio of noninterest expense to net interest income and other income.  As in the case of net interest income generally, net interest income as utilized in calculating the efficiency ratio is typically expressed on a tax-equivalent basis.  Moreover, most issuers also adjust both noninterest expense and other income to exclude therefrom certain component elements, such as intangible asset amortization (deducted from noninterest expense) and securities gains or losses (deducted from other income), in calculating the efficiency ratio.

#

OVERVIEW

Selected Quarterly Information:

(Dollars In Thousands, Except Per Share Amounts)

Per share amounts have been restated for the November 2002 5% stock dividend.

#

Selected Quarterly Information, Continued:

¹ See “Use of Non-GAAP Financial Measures” on page 14.

Selected Six Month Period Information:

(Dollars In Thousands, Except Per Share Amounts)

Per share amounts have been restated for the November 2002 5% stock dividend.

#

Selected Six Month Period Information, Continued:

¹ See “Use of Non-GAAP Financial Measures” on page 14.

#

Average Consolidated Balance Sheets and Net Interest Income Analysis - Second Quarter

(see “Use of Non-GAAP Financial Measures”)

(Fully Taxable Basis using a marginal tax rate of 35%)

(Dollars In Thousands)

#

Average Consolidated Balance Sheets and Net Interest Income Analysis - First Six Months

(see “Use of Non-GAAP Financial Measures”)

(Fully Taxable Basis using a marginal tax rate of 35%)

(Dollars In Thousands)

#

OVERVIEW

The Company reported earnings of $4.755 million for the second quarter of 2003, a decrease of $22 thousand, or 0.5%, as compared to $4.777 million for the second quarter of 2002.  Diluted earnings per share were $.59 for the 2003 quarter and $.58 for the 2002 quarter for a period-to-period increase of $.01, or 1.7%.  Average shares outstanding decreased between the two periods due stock repurchases.  On a year-to-date basis, net income was $9.6 million for the first six months of 2003, an increase of $317 thousand, or 3.4%, as compared to earnings of $9.2 million for the 2002 period.  Diluted earnings per share for the six-month periods were $1.18 and $1.13, respectively, a period-to-period increase of $.05, or 4.4%

The returns on average assets were 1.46% and 1.60% for the second quarters of 2003 and 2002, respectively, a decrease of 14 basis points, or 8.8%.  The returns on average equity were 18.37% and 20.16% for the second quarters of 2003 and 2002, respectively, a decrease of 179 basis points, or 8.9%.   On a year-to-date basis, the returns on average assets were 1.48% and 1.59% for the first six months of 2003 and 2002, respectively, a decrease of 11 basis points, or 6.9%.  The returns on average equity were 18.74% and 19.82% for the first six months of 2003 and 2002, respectively, a decrease of 108 basis points, or 5.4%.

The net interest margin for the quarter was 4.09%, down 50 basis points or 10.9% from the second quarter 2002 margin and down 20 basis points from the margin for the March 31, 2003 quarter.

Total assets were $1.3 billion at June 30, 2003, which represented an increase of $45.7 million, or 3.6%, from December 31, 2002, and an increase of $123.2 million, or 10.3%, above the level at June 30, 2002.

During the first six months of 2003, shareholders' equity increased $3.3 million to $104.7 million.  The Company's risk-based capital ratios and Tier 1 leverage ratio continued to exceed regulatory minimum requirements at period-end.  Both Company banks qualified as "well-capitalized" under federal bank guidelines.  Efficient utilization of capital remains a high priority of the Company.

CHANGE IN FINANCIAL CONDITION

Summary of Selected Consolidated Balance Sheet Data

(Dollars in Thousands)

(1) Includes Nonaccrual Loans

#

Increases in Sources of Funds:  Increases in internally generated deposit balances (a net increase of $34.5 million, or 3.6%, from December 31, 2002 to June 30, 2003) accounted for most of the increase in the Company's sources of funds, supplemented by a $5.0 million increase in Federal Home Loan Bank advances and $3.3 million in shareholders’ equity.  Municipal deposits, which represented 14.4% of all deposits at June 30, 2003, increased by $12.1 million, or 9.3%, from December 31, 2002 to June 30, 2003.  There was, however, a shift in municipal deposits from NOW accounts, which decreased $13.7 million, to time deposits of $100,000 or more, which increased by $25.8 million.  For consumer non-maturity deposits, the Company experienced growth in all non-maturity deposit product categories from December 31, 2002 to June 30, 2003, a combined increase of $31.2 million, or 5.4%.  Consumer time deposits decreased by $8.8 million, or 3. 5% during the same period.

Deployment of Funds into Earning Assets:  Total loans at June 30, 2003 amounted to $848.8 million, an increase of $37.5 million, or 4.6%, from December 31, 2002, and an increase of $73.3 million, or 9.5%, from June 30, 2002.  The area of the loan portfolio experiencing the greatest increase over the twelve-month period was residential real estate loans, followed by commercial and commercial real estate loans.  Indirect consumer loan balances increased by 6.0% over the period, and continued to represent the largest single category of loans within the portfolio.  From September 30, 2001, to September 30, 2002, indirect loan balances remained essentially unchanged in absolute terms, and declined slightly as a percentage of the overall portfolio, in the face of manufacturers' heavily subsidized vehicle financing programs.  During the last three quarters, however, the Company became more aggressive in pricing these loans and indirect loan balances began to grow again.

It is the intention of the Company that the greatest portion of its earning assets will consist of high quality loans, however much of the earning asset growth occurring in the past twelve months took place in the investment securities portfolio.  As reported in the Consolidated Statement of Cash Flows, the cash flow received from the maturities and calls of securities in the available-for-sale portfolio amounted to $81.1 million for the first six months of 2003.  Most of these cash flows resulted from the monthly amortization of mortgage-backed securities.  Among other needs, this cash flow is available to fund loan growth or for redeployment in the available-for-sale portfolio.

During the second quarter of 2003 the Company partially restructured its securities available-for-sale portfolio with the sale of $41.7 million of securities and the purchase of $89.7 million of securities.  The transaction is further detailed in the quarter-to-date and year-to-date sections on “Other Income” within the “Results of Operations” discussion in this Report.

Deposit Trends

The following two tables provide information on trends in the balance and mix of the Company’s deposit portfolio by presenting, for each of the last five quarters, the quarterly average balances by deposit type and the percentage of total deposits represented by each deposit type.

Quarterly Average Deposit Balances

(Dollars in Thousands)

#

Percentage of Average Quarterly Deposits

For a variety of reasons, the Company typically experiences little net deposit growth in the first quarter of the year, but more significant growth in the second quarter.  In the first quarter of 2003, however, average deposits increased by 1.5%, or $14 million, over average deposits in fourth quarter 2002.  This increase was artificially enhanced by an atypical increase in municipal deposits at period-end, resulting from an automatic deposit of New York State funds into certain municipal accounts (approximately $20 million) on March 31, rather than on April 1, as usual. Average deposits also increased in the second quarter 2003, by $10 million or 1.0%.  Over the last twelve months, the Company experienced growth in all categories of non-maturity deposits.  Based on average quarterly levels, other time deposits remained essentially flat and time deposits of $100,000 or more decreased 9.8%.  The Company experienced modest growth in the average balan ce of demand and NOW accounts, and significant growth in regular and money market savings accounts, which increased $55.9 million, or 25.7%, from the quarterly average for June 30, 2002 to June 30, 2003.  Early in 2002, the Company opened a new branch in Saratoga Springs, New York and in June 2003, the Company opened another branch in Queensbury, New York.  But otherwise, the increase in deposits was achieved through the Company's existing base of branches.

Quarterly Average Rate Paid on Deposits

Key Interest Rate Changes 1999 - 2003

#

The Company’s net interest income has traditionally been sensitive to and impacted by changes in prevailing market interest rates.  Generally, there has been a negative correlation between changes in interest rates and net interest income in ensuing periods.  As indicated in the preceding table, prevailing interest rates economy-wide increased in the second half of 1999 and throughout 2000, following a long period of flat or slowly-declining prevailing interest rates.  The 1999 rate hikes had a moderately negative impact on financial results for 1999, as the Company experienced decreases in the average rate earned on earning assets and the average rate paid on earning liabilities in the second half of that year, and more importantly, experienced decreases in net interest spread and net interest margin.  However, the full negative impact of rising rates was felt more sharply in 2000, when the decrease in net interest margin due to rising rates was s ignificant.

In the first quarter of 2001, the Federal Reserve Board reversed direction and began decreasing short-term interest rates rapidly and significantly in response to perceived weakening in the economy.  By December 2001, the total decrease in prevailing short-term interest rates for the year was 475 basis points.  In the first ten months of 2002, there were no further rate changes, but the Federal Reserve Board resumed its rate cutting in November 2002 by decreasing rates another 50 basis points and again more recently by another 25 basis points on June 25, 2003.  Throughout all of 2001 and most of 2002, the Company experienced positive developments in net interest margin and net interest spread, and as a consequence in net interest income.  These positive developments were at least in part a reflection of differing repricing sensitivities of asset and liability portfolios, as interest-bearing liabilities (chiefly, deposits) repriced downward more rapidly than earning assets (primarily loans).  While the cost of deposits decreased in all quarters of 2001 and 2002, the Company did not experience a decrease in the average yield in the loan portfolio until the second quarter of 2001, and such decreases as experienced in successive quarters of 2001 and into 2002 were initially not as significant as the decreases the Company continued to experience in the average cost of deposits.  See the discussion under "Loan Trends" later in this report for a more complete analysis of yield trends in the loan portfolio.

The Federal Reserve Board's decrease in short-term interest rates in November 2002 and June 2003 had a more limited impact on the cost of deposits, because at the time rates on several deposit products, such as savings and NOW accounts, were already priced at such low levels that a matching 75 basis point decrease in rates was not practical or sustainable.  The Company did lower rates to a lesser extent on all major categories of non-maturity deposit products, resulting in a small increase (3 basis points) in the net interest margin from the last quarter of 2002 to the first quarter of 2003, but for the second quarter of 2003 net interest margin continued a downward trend and fell 20 basis points from the first quarter to 4.09%.  See the discussion of net interest income and net interest margin in the section of this report entitled "Use of Non-GAAP Financial Measures," at the beginning of Management’s Discussion and Analysis.

During periods of falling interest rates, the Company typically experiences a pattern where customers reinvest maturing time deposits in non-maturity deposit products, pending a turn around in rates.  At December 31, 2000, before interest rates began their two-year decline, the Company’s time deposits represented approximately 42% of all deposits.  At June 30, 2003, after the steep decline in interest rates, time deposits constituted only 28% of total deposits.

In both rising and falling rate environments, the Company faces significant competitive pricing pressures in its marketplace for both deposits and loans, and thus ultimately both assets and liabilities may be expected to reprice proportionately in response to changes in market rates.

#

Non-Deposit Sources of Funds

The Company has borrowed funds from the Federal Home Loan Bank ("FHLB") under a variety of programs, including fixed and variable rate short-term borrowings and borrowings in the form of "convertible advances."  These convertible advances have maturities of 2 - 10 years and are callable by the FHLB at certain dates beginning no earlier than one year from the issuance date.  If the advances are called, the Company may elect to have the funds replaced by the FHLB at the then prevailing market rate of interest.

Management continues to explore and evaluate new non-deposit sources of funds.  In 1999, the Company established a financing vehicle, Arrow Capital Trust I ("ACT I").  ACT I issued 30 year guaranteed preferred beneficial interests in junior subordinated debentures of the Company ("capital securities") in the aggregate amount of $5.0 million at a fixed rate of 9.5%, and then used the proceeds from the sale of the capital securities to acquire the junior subordinated debentures issued by the Company, bearing the same interest rate (9.5%) and similar amount ($5.0 million).  The debentures and capital securities are redeemable (subject to any required regulatory approval) at the option of the Company beginning December 31, 2004.  The capital securities, with associated expense that is tax deductible, qualify as Tier I capital of the Company under regulatory definitions.  In July 2003, the Company established a second financing vehic le, Arrow Capital Statutory Trust II ("ACST II").  ACST II issued 30 year guaranteed preferred beneficial interests in junior subordinated debentures of the Company ("capital securities") in the aggregate amount of $10.0 million at a fixed rate of 6.53% until September 30, 2008 (afterwards the rate is variable at the three month LIBOR rate plus 3.15%), and then used the proceeds from the sale of the capital securities to acquire the junior subordinated debentures issued by the Company, bearing the same interest rate terms and similar amount.  The capital securities, with associated expense that is tax deductible, also qualify as Tier I capital of the Company under regulatory definitions.  These securities are redeemable (subject to any required regulatory approval) at the option of the Company beginning September 30, 2008

Loan Trends

The following two tables present, for each of the last five quarters, the quarterly average balances by loan type and the percentage of total loans represented by each loan type.

Quarterly Average Loan Balances

(Dollars in Thousands)

Percentage of Quarterly Average Loans

#

Indirect Loans: In the several years preceding the third quarter of 2001, the indirect consumer loan portfolio (consisting principally of auto loans financed through local dealerships where the Company acquires the dealer paper) was the fastest growing segment of the Company's loan portfolio, both in terms of absolute dollar amount and as a percentage of the overall portfolio.  In the subsequent five quarters, this segment of the portfolio ceased to grow in absolute terms and decreased as a percentage of the overall portfolio.  This flattening out of indirect loans was largely the result of an aggressive campaign of zero rate and other subsidized financing commenced by the auto manufacturers in the Fall of 2001.  During the fourth quarter of 2002, the indirect portfolio began to grow again as the Company became more rate-competitive.  Indirect loans still represent the largest category of loans (38.2%) in the Company’s loan portfolio, and any developments threatening the indirect loan business generally may impact the Company due to reliance on such loans.  If auto manufacturers continue to offer heavily subsidized financing programs, the indirect loan portfolio is likely to continue to experience rate pressure and limited, if any, overall growth.

Residential Real Estate Loans: Residential real estate loans represented the second largest segment of the Company’s loan portfolio at June 30, 2003, at 31.3% of average loans for the quarter.  Period-end residential real estate loan balances increased only $490 thousand during the second quarter as originations of $28.7 million were offset by normal amortization, refinanced loans, prepayments and the sale of $12.5 million of real estate loans to the secondary market (with the Company retaining servicing rights).  Residential real estate loans represented the fastest growing segment in the Company's loan portfolio for the first quarter of 2003 and the second fastest for the second quarter of 2003.

Commercial and Commercial Real Estate Loans: Commercial and commercial real estate loans represented the second fastest growing segment of the Company's loan portfolio for the first quarter of 2003 and the fastest growing segment for the second quarter of 2003.  These loan balances increased over $19.7 million since year-end 2002.  

Quarterly Taxable Equivalent Yield on Loans

In general, the yield on the Company's loan portfolio and other earning assets has been impacted by changes in prevailing interest rates, as discussed above under the heading "Key Interest Rate Changes 1999 - 2003."  Management expects that such will continue to be the case; that is, that loan yields will continue to rise and fall with changes in prevailing market rates, although the timing and degree of responsiveness will continue to be influenced by a variety of other factors, including the makeup of the loan portfolio, consumer expectations and preferences and the rate at which the portfolio expands.  Many of the loans in the commercial portfolio have variable rates tied to prime, FHLB or U.S. Treasury indices.   Additionally, there is a significant amount of cash flow from normal amortization and prepayments in all loan categories, and this cash flow reprices at current rates as new loans are generated at the lower current yields.  A s noted in the earlier discussion, during the recent period of declining rates (mid-2001 through 2003), the Company experienced a time lag between the impact of declining rates on our deposit portfolio and the impact on the loan portfolio, which positively affected the net interest margin during this period.  Net interest margin expanded during 2001 and into the first quarter of 2002.  As prevailing rates and the Company's deposit rates began to flatten out in mid-2002, however, loan yields began to decline and further declines in loan yields may be expected, reinforced by the Federal Reserve's actions in November 2002 to decrease prevailing rates by 50 basis points and an additional 25 basis points in June 2003.  As a result, the net interest margin began to contract in the second quarter of 2002 and for the following four quarters.  Although net interest margin increased by 3 basis points in the first quarter of 2003 (due primarily to a lagging decrease in the Company’s non-maturit y deposit rates) it fell 20 basis points in the second quarter of 2003.  

#

Asset Quality

The following table presents information related to the Company's allowance and provision for loan losses for the past five quarters.  

Summary of the Allowance and Provision for Loan Losses

(Dollars in Thousands)(Loans Stated Net of Unearned Income)

#

The Company’s nonperforming assets at June 30, 2003 amounted to $2.2 million, a decrease of $567 thousand, or 20.6%, from December 31, 2002, and a decrease of $1.3 million, or 37.4%, from June 30, 2002.  The decrease from June 30, 2002 was primarily attributable to one commercial borrower whose debt was satisfied in full with no charge-off in the fourth quarter of 2002.

At period-end, nonperforming assets represented .17% of total assets, a 5 basis point decrease from .22% at year-end 2002 and a 12 basis point decrease from .29% at June 30, 2002.  At March 31, 2003 this ratio for the Company’s peer group was .65%.

At June 30, 2003, the Company had identified only one commercial credit relationship that, although still performing and accruing interest, nevertheless exhibited sufficient weakness to warrant mention as a potential problem loan. The amount of the potential problem loan on that date was $2.2 million.  As of the same date, a related commercial credit to the same borrower was on nonaccrual status.  The amount of the nonaccruing credit was $319 thousand, reduced from $850 thousand on June 30, 2002, reflecting cash payments received from the borrower during the period.

In the first quarter of 2003, a commercial borrower announced plans to discontinue some or all aspects of its business operations.  The borrower was then indebted to the Company in the aggregate amount of $2.3 million through three separate loans.  Subsequent to June 30, 2003, two loans totaling $1.8 million were repaid through liquidation of the underlying collateral.  The third loan with a balance of $477 thousand as of June 30, 2003, is secured by commercial real estate having an estimated market value significantly in excess of the loan balance.  There are no commitments to extend additional credit to the borrower.  We believe that our risk of credit loss to this borrower, at this time, is very limited and the remaining loan remains on accrual status.

The balance of other non-current loans as to which interest income was being accrued (i.e. loans 30-89 days past due as defined in bank regulatory agency guidance) totaled $4.9 million at June 30, 2003 and represented 0.58% of loans outstanding at that date, as compared to approximately $5.7 million, or 0.71% of loans outstanding at December 31, 2002.  These non-current loans were composed of approximately $4.0 million of consumer loans, principally indirect motor vehicle loans, $500 thousand of residential real estate loans and commercial loans of $313 thousand.

The percentage of the Company's performing loans that demonstrate characteristics of potential weakness from time to time, typically a very small percentage, is for the most part dependent on economic conditions in the Company's geographic market area of northeastern New York State.  In general, the economy in this area was relatively strong in the 1997-2000 period.  As the country slid into a mild recession in 2001 and continued throughout 2002, the economic downturn was not as severe in this geographic area.  In the "Capital District" in and around Albany and in the area north of the Capital District, including the Company's principal service areas, unemployment remained below the national average.  The unemployment rate has been at or above the national average in the Company's service areas in Clinton and Essex Counties, near the Canadian border, during 2002 and through the second quarter of 2003.

On an annualized basis, the ratio of the 2003 second quarter net charge-offs to average loans was .13%, 7 basis points higher than the annualized ratio of net charge-offs to average loans of .06% in the comparable 2002 period.  The provision for loan losses was $405 thousand for the second quarter of 2003, compared to a provision of $615 thousand for the second quarter of 2002 and a provision of $405 thousand for the March 31, 2003 quarter.  The provision as a percentage of average loans (annualized) was .19% for the second quarter of 2003, a decrease of 13 basis points from the .32% ratio for the comparable 2002 period.  The decrease in the provision is due primarily to the fact that nonperforming loans, net charge-offs and non-current loans had decreased from the levels at June 30, 2002, even as the Company experienced moderate growth in the loan portfolio.

The allowance for loan losses at June 30, 2003 amounted to $11.5 million. The ratio of the allowance to outstanding loans at June 30, 2003, was 1.36%, 2 basis points lower than the ratio at December 31, 2002 and 1 basis points lower than this ratio at June 30, 2002.   The allowance as a percent of nonperforming loans was 578.50% at June 30, 2003.

#

CAPITAL RESOURCES

Shareholders' equity increased $3.3 million during the first six months of 2003.  During this period, net income was $9.6 million, which was reduced by net unrealized losses on securities available-for-sale (net of tax) of approximately $847 thousand, stock repurchases (net of new stock issuances) of $1.4 million, and cash dividends of $4.0 million ($.51 per share).  Over the twelve-month period, shareholders' equity increased by 8.0%.  Current and prior period changes in shareholders' equity are presented in the Consolidated Statements of Changes in Shareholders' Equity, part of our financial statements set forth elsewhere in this report.

The following discussion of capital focuses on regulatory capital ratios, as defined and mandated for financial institutions by federal bank regulatory authorities.  Regulatory capital, although a financial measure that is not provided for or governed by GAAP, nevertheless has been exempted by the SEC from the definition of "non-GAAP financial measures" in the SEC's newly adopted rules governing disclosure of such non-GAAP financial measures.  Thus, certain information, which is required to be presented in connection with disclosure of non-GAAP financial measures need not be provided, and has not been provided, for the regulatory capital measures discussed below.  The Company and its subsidiaries are currently subject to two sets of regulatory capital measures, a leverage ratio test and risk-based capital guidelines.  The risk-based guidelines assign risk weightings to all assets and certain off-balance sheet items of financial institutions an d establish an 8% minimum ratio of qualified total capital to risk-weighted assets.  At least half of total capital must consist of "Tier 1" capital, which comprises common equity and common equity equivalents, retained earnings and a limited amount of permanent preferred stock and trust preferred securities, less intangible assets.  Up to half of total capital may consist of so-called "Tier 2" capital, comprising a limited amount of subordinated debt, other preferred stock, certain other instruments and a limited amount of the allowance for loan losses.  The second regulatory capital measure, the leverage ratio test, establishes minimum limits on the ratio of Tier 1 capital to total tangible assets, without risk weighting.  For top-rated companies, the minimum leverage ratio is 3%, but lower-rated or rapidly expanding companies may be required to meet substantially higher minimum leverage ratios.  Federal banking law mandates certain actions to be taken by bankin g regulators for financial institutions that are deemed undercapitalized as measured by these ratios.  The law establishes five levels of capitalization for financial institutions ranging from "critically undercapitalized" to "well-capitalized."  The Gramm-Leach-Bliley Financial Modernization Act also ties the ability of banking organizations to engage in certain types of non-banking financial activities to such organizations' continuing to qualify as "well-capitalized" under these standards.  As of June 30, 2003, the Tier 1 leverage and risk-based capital ratios for the Company and its subsidiary banks were as follows:  

Summary of Capital Ratios

All capital ratios for the Company and its subsidiary banks at June 30, 2003 were above minimum capital standards for financial institutions.  Additionally, all Company and subsidiary banks’ capital ratios at that date were above FDICIA's "well-capitalized" standard.

The Company’s common stock is traded on The Nasdaq Stock Market^SM under the symbol AROW.  The high and low prices listed below represent actual sales transactions, as reported by Nasdaq.   

#

On July 23, 2003, the Company announced the 2003 third quarter dividend of $.26 payable on September 15, 2003.

Quarterly Per Share Stock Prices and Dividends

LIQUIDITY

Liquidity is measured by the ability of the Company to raise cash when it needs it at a reasonable cost.  The Company must be capable of meeting expected and unexpected obligations to its customers at any time.   Given the uncertain nature of customer demands as well as the desire to maximize earnings, the Company must have available sources of funds, on- and off-balance sheet, that can be acquired in time of need.  The Company measures and monitors its basic liquidity as a ratio of liquid assets to short-term liabilities, both with and without the availability of borrowing arrangements.

In addition to regular loan repayments, securities available-for-sale represent a primary source of on-balance sheet cash flow.  Certain securities are designated by the Company at purchase as available-for-sale.  Selection of such securities is based on their ready marketability, ability to collateralize borrowed funds, as well as their yield and maturity.

In addition to liquidity arising from balance sheet cash flows, the Company has supplemented liquidity with additional off-balance sheet sources such as credit lines with the Federal Home Loan Bank ("FHLB").  The Company has established overnight and 30 day term lines of credit with the FHLB each in the amount of $57.6 million at June 30, 2003.  If advanced, such lines of credit are collateralized by mortgage-backed securities, loans and FHLB stock.  In addition, the Company has in place borrowing facilities from correspondent banks and the Federal Reserve Bank of New York and also has identified wholesale and retail repurchase agreements and brokered certificates of deposit as appropriate potential sources of funding.

The Company is not aware of any known trends, events or uncertainties that will have or are reasonably likely to have a material effect or make material demands on the Company's liquidity in upcoming periods.  

#

RESULTS OF OPERATIONS:  

Three Months Ended June 30, 2003 Compared With

Three Months Ended June 30, 2002

Summary of Earnings Performance

(Dollars in Thousands, Except Per Share Amounts)

The Company reported earnings of $4.8 million for the second quarter of 2003, a decrease of $22 thousand, or 0.5%, from the second quarter of 2002.   Diluted earnings per share of $.59 for the second quarter of 2003 represented a one cent increase over the second quarter of 2002.  Included in net income for the respective 2003 and 2002 quarters are: (i) net securities gains of $85 thousand and $92 thousand, net of tax, and, (ii) net gains on the sale of loans to the secondary market of $206 thousand and $7 thousand, net of tax.

The following narrative discusses the quarter-to-quarter changes in net interest income, other income, other expense and income taxes.

Net Interest Income

Summary of Net Interest Income

(Taxable Equivalent Basis)

(Dollars in Thousands)

(1) Includes Nonaccrual Loans

The Company’s net interest margin (net interest income on a tax-equivalent basis divided by average earning assets, annualized) decreased significantly, from 4.59% to 4.09%, from the second quarter of 2002 to the second quarter of 2003.  The margin was also down 20 basis points from the first quarter of 2003.  The $112.5 million increase in average earning assets from the second quarter of 2002 to the second quarter of 2003, although significant, was not enough to fully offset the negative impact of the decrease in net interest margin on net interest income.  Net interest income was down $281 thousand, or 2.2%, from the second quarter of 2002.  The decrease in both net interest income and net interest margin between the comparable periods was significantly influenced by changes in prevailing interest rates, and its disproportionate impact on interest-bearing liabilities and assets, as discussed previously in this Report under the sections entitled “Deposit Trends,” “Key Interest Rate Changes 1999-2003" and “Loan Trends.”

The provisions for loan losses were $405 thousand and $615 thousand for the quarters ended June 30, 2003 and 2002, respectively.  The provision for loan losses was discussed previously under the heading "Summary of the Allowance and Provision for Loan Losses."

#

Other Income

Summary of Other Income

(Dollars in Thousands)