UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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 ý       No o

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES

Consolidated Statements of Condition (Unaudited)

(Dollars in Thousands)

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INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES

Consolidated Statements of Condition, continued

(Dollars in Thousands)

See accompanying notes to consolidated financial statements.

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INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES

Consolidated Statements of Income (Unaudited)

(Dollars in Thousands, except per share data)

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INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES

Consolidated Statements of Income - continued

(Dollars in Thousands, except per share data)

See accompanying notes to consolidated financial statements.

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INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income (Unaudited)

(Dollars in Thousands)

See accompanying notes to consolidated financial statements.

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INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES

Consolidated Statements of Cash Flows (Unaudited)

(Dollars in Thousands)

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INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES

Consolidated Statements of Cash Flows, continued

(Dollars in Thousands)

See accompanying notes to consolidated financial statements.

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INTERNATIONAL BANCSHARES CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Unaudited)

Note 1 - Basis of Presentation

The accounting and reporting policies of International Bancshares Corporation (“Corporation”) and Subsidiaries (the Corporation and Subsidiaries collectively referred to herein as the “Company”) conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry.  The consolidated financial statements include the accounts of the Corporation and its wholly-owned subsidiaries, International Bank of Commerce, Laredo (“IBC”), Commerce Bank, International Bank of Commerce, Zapata, International Bank of Commerce, Brownsville and the Corporation’s wholly-owned non-bank subsidiaries, IBC Subsidiary Corporation, IBC Life Insurance Company, IBC Trading Company, IBC Capital Corporation, International Bancshares Capital Trusts I, II, III, IV, V, VI and VII, as well as the GulfStar Group in which the Company owns a controlling interest.  All significant inter-company balances and transactions have been eliminated in consolidation.  The consolidated financial statements are unaudited, but include all adjustments, which, in the opinion of management, are necessary for a fair presentation of the results of the periods presented.  All such adjustments were of a normal and recurring nature.  It is suggested that these financial statements be read in conjunction with the financial statements and the notes thereto in the Company’s latest Annual Report on Form 10K.  The consolidated statement of condition at December 31, 2002 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.  Certain reclassifications have been made to make prior periods comparable.

Management of the Company believes that it does not have separate reportable operating segments under the provisions of SFAS No. 131 “Disclosures about Segments of an Enterprise and Related Information.”  The Company’s non-banking operations do not meet the threshold for reporting as separate segments.

All per share data presented has been restated to reflect the stock splits effected through stock dividends.

In April 2003, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (“SFAS”) No. 149 (“SFAS No. 149”), “Amendment of Statement 133 on Derivative Instruments and Hedging Activities,” to amend and clarify financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities.  The amendments (i) reflect decisions of the Derivatives Implementation Group (DIG); (ii) reflect decisions made by the Financial Accounting Standards Board in conjunction with other projects dealing with financial instruments; and (iii) address implementation issues related to the application of the definition of a derivative.  SFAS No. 149 also modifies various other existing pronouncements to conform with the changes made to SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.”  SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003, with all provisions applied prospectively.  Adoption of SFAS No. 149 did not have an impact on the Company’s consolidated financial statements.

In May 2003, the Financial Accounting Standards Board issued SFAS No. 150, (“SFAS No. 150”), “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.”  SFAS No. 150 establishes standards for how an issuer classifies, measures and discloses in its financial statements certain financial instruments with characteristics of both liabilities and equity.  SFAS No. 150 requires that an issuer classify financial instruments that are within its scope as liabilities, in most circumstances.  Such financial instruments include (i) financial instruments that are issued in the form of shares that are mandatorily redeemable; (ii) financial instruments that embody an obligation to repurchase the issuer’s equity shares, or are indexed to such an obligation, and that require the issuer to settle the obligation by transferring assets; (iii) financial instruments that embody an obligation that the issuer may settle by issuing a variable number of its equity shares if, at inception, the monetary value of the obligation is predominantly based on a fixed amount, variations in something other than the fair value of the issuer’s equity shares or variations inversely related to changes in the fair value of the issuer’s equity shares; and (iv) certain freestanding financial instruments.  SFAS No. 150 is effective for contracts entered into or modified after May 31, 2003, and is otherwise effective at the beginning of the first interim period beginning after June 15, 2003.  Adoption of SFAS No.150 did not have an impact on the Company’s consolidated financial statements.

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Note 2 – Stock Options

At June 30, 2003, the Company had one stock-based employee compensation plan and certain options granted outside the plan.  The Company accounts for all options under the recognition and measurement principles of Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees,” and related interpretations.  No stock-based employee cost is reflected in net income, as all options granted had an exercise price equal to the market value of the underlying common stock on the date of grant.  The following table, as prescribed by Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure, an amendment of FASB Statement No. 123,” illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of Statement of Financial Accounting Standards No. 123, (“SFAS No. 123”), “Accounting for Stock-Based Compensation,” to stock based employee compensation.

Note 3 - Investment Securities

The Company classifies debt and equity securities into one of three categories:  held-to maturity, available-for-sale, or trading.  Such classifications are reassessed for appropriate classification at each reporting date.  Securities classified as “held-to-maturity” are carried at amortized cost for financial statement reporting, while securities classified as “available-for-sale” and “trading” are carried at their fair value.  Unrealized holding gains and losses are included in net income for those securities classified as “trading”, while unrealized holding gains and losses related to those securities classified as “available-for-sale” are excluded from net income and reported net of tax as other comprehensive income and accumulated other comprehensive income until realized.

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A summary of the investment securities held for investment and securities available for sale as reflected on the books of the Company is as follows:

Note 4 - Allowance for Possible Loan Losses

A summary of the transactions in the allowance for possible loan losses is as follows:

The Company classifies as impaired those loans where it is probable that all amounts due according to contractual terms of the loan agreement will not be collected. The Company has identified these loans through its normal loan review procedures.  Impaired loans include 1) all non-accrual loans, 2) loans which are 90 days or over past due unless they are well secured (the collateral value is sufficient to cover principal and accrued interest) and are in the process of collection, and 3) other loans which management believes are impaired.  Substantially all of the Company’s impaired loans are measured based on the fair value of the collateral. In limited cases the Company may use other methods to determine the level of impairment of a loan if such loan is not collateral dependent.  Amounts received on non-accruals are applied, for financial accounting purposes, first to principal and then to interest after all principal has been collected.  Impaired loans at June 30, 2003 were $10,285,000.  The income associated with these loans is not significant.

Management of the Company recognizes the risks associated with these impaired loans.  However, management’s decision to place loans in this category does not necessarily mean that losses will occur.

The subsidiary banks charge off that portion of any loan which management considers representing a loss as well as that portion of any other loan that is classified as a “loss” by bank examiners.  Commercial and industrial or real estate loans are generally considered by management to represent a loss, in whole or part, when an exposure beyond any collateral coverage is apparent and when no further collection of the loss portion is anticipated based on the borrower’s financial condition and general economic conditions in the borrower’s industry.  Generally, unsecured consumer loans are charged-off when 90 days past due.

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While management of the Company considers that it is generally able to identify borrowers with financial problems reasonably early and to monitor credit extended to such borrowers carefully, there is no precise method of predicting loan losses.  The determination that a loan is likely to be uncollectible and that it should be wholly or partially charged-off as a loss is an exercise of judgment.  Similarly, the determination of the adequacy of the allowance for possible loan losses can be made only on a subjective basis.  It is the judgment of the Company’s management that the allowance for possible loan losses at June 30, 2003, was adequate to absorb possible losses from loans in the portfolio at that date.

Note 5 – Common Stock and Cash Dividends

All per share data presented has been restated to reflect the stock splits effected through stock dividends, which became effective May 20, 2002 and May 19, 2003 and were paid on June 14, 2002 and June 15, 2003, respectively.  Such stock dividends resulted in the issuance of 8,331,124 shares of Common Stock in 2002 and 10,509,955 in 2003.  Cash dividends of $.34 per share, adjusted for stock dividends, were paid on April 15, 2003.  On August 7, 2003, a cash dividend of $.50 per share was declared for all holders of common stock, $1.00 par value, of record as of September 30, 2003, said cash dividend to be payable on October 15, 2003.

The Company expanded its formal stock repurchase program on August 6, 2003.  Under the expanded stock repurchase program, the Company is authorized to repurchase up to $175,000,000 of its common stock through December 2003.  Stock repurchases may be made from time to time, on the open market or through private transactions.  Shares repurchased in this program will be held in treasury for reissue for various corporate purposes, including employee stock option plans.  As of August 11, 2003, a total of 3,601,222 shares had been repurchased under this program at a cost of $142,930,000, which shares are now reflected as 5,631,946 shares of treasury stock as adjusted for stock dividends.  Stock repurchases are reviewed quarterly at the Company’s Board of Directors meetings and the Board of Directors has stated that the aggregate investment in treasury stock should not exceed $195,973,000.  In the past, the Board of Directors has increased previous caps on treasury stock once they were met, but there are no assurances that an increase of the $195,973,000 cap will occur in the future.  As of August 11, 2003, the Company has approximately $163,903,000 invested in treasury shares, which amount has been accumulated since the inception of the Company.

Note 6 - Commitments and Contingent Liabilities

The Company is involved in various legal proceedings that are in various stages of litigation.  Some of these actions allege “lender liability” claims on a variety of theories and claim substantial actual and punitive damages.  The Company has determined, based on discussions with its counsel that any material loss in such actions, individually or in the aggregate, is remote or the damages sought, even if fully recovered, would not be considered material to the consolidated financial position or results of operations of the Company.  However, many of these matters are in various stages of proceedings and further developments could cause management to revise its assessment of these matters.

The Company’s lead bank subsidiary has invested in partnerships, which have entered into several lease-financing transactions.  The lease-financing transactions in two of the partnerships have been examined by the Internal Revenue Service (“IRS”).  In both partnerships, the lead bank subsidiary is the owner of a ninety-nine percent (99%) limited partnership interest.  The IRS has issued separate Notice of Final Partnership Administrative Adjustments (“FPAA”) to the partnerships and on September 25, 2001, and January 10, 2003, the Company filed lawsuits contesting the adjustments asserted in the FPAAs.

Prior to filing the lawsuit the Company was required to deposit the estimated tax due of approximately $4,083,000 with respect to the first FPAA, and $7,710,606 with respect to the second FPAA, with the IRS pursuant to the Internal Revenue Code.  If it is determined that the amount of tax due, if any, related to the lease-financing transactions is less than the amount of the deposits, the remaining amount of the deposits would be returned to the Company.

In order to curtail the accrual of additional interest related to the disputed tax benefits and because interest rates are unfavorable, the Company decided to submit to the IRS the interest that would have accrued based on the adjustments proposed in the FPAAs related to both of the lease-financing transactions.  On March 7, 2003, the Company submitted to the IRS a total of $13,640,797 of interest on the proposed adjustments.  If it is determined that the amount of interest due, if any, related to the lease-financing transactions is less than $13,640,797, the remaining amount of the prepaid interest will be refunded to the Company, plus interest thereon.

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No reliable prediction can be made at this time as to the likely outcome of the lawsuits; however, if the lawsuits are decided adversely to the partnerships, all or a portion of the $12 million in tax benefits previously recognized by the Company in connection with the Partnerships’ lease-financing transactions would be in question and penalties and interest could be assessed by the IRS.  Of the approximately $12 million in tax benefits deposited in connection with the lawsuits and $13,640,797 in interest deposited to the IRS, a total of approximately $12 million has been accrued as of June 30, 2003.  Management intends to continue to evaluate the merits of each matter and make appropriate revisions to the accrued amount as deemed necessary.

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

Special Cautionary Notice Regarding Forward Looking Information

Certain matters discussed in this report, excluding historical information, include forward-looking statements.  Although the Company believes such forward-looking statements are based on reasonable assumptions, no assurance can be given that every objective will be reached.  The words “estimate,” “expect,” “intend,” and “project,” as well as other words or expressions of a similar meaning are intended to identify forward-looking statements.  Readers are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date of this report.  Such statements are based on current expectations, are inherently uncertain, are subject to risks and should be viewed with caution.  Actual results and experience may differ materially from the forward-looking statements as a result of many factors.

Factors that could cause actual results to differ materially from any results that are projected, forecasted, estimated or budgeted by the Company in forward-looking statements include, among others the following possibilities:  (I) changes in interest rates and market prices, which could reduce the Company’s net interest margins, asset valuations and expense expectations, (II) changes in the capital markets utilized by the Company and its subsidiaries, including changes in the interest rate environment that may reduce margins, (III) changes in state and/or federal laws and regulations to which the Company and its subsidiaries, as well as their customers, competitors and potential competitors, are subject, including, without limitation, banking, tax, securities, insurance and employment laws and regulations, (IV) the loss of senior management or operating personnel, (V) increased competition from both within and outside the banking industry, (VI) changes in local, national and international economic business conditions which adversely affect the Company’s customers and their ability to transact profitable business with the Company, including the ability of its borrowers to repay their loans according to their terms or a change in the value of the related collateral, (VII) the timing, impact and other uncertainties of the Company’s potential future acquisitions including the Company’s ability to identify suitable potential future acquisition candidates, the success or failure in the integration of their operations, and the Company’s ability to maintain its current branch network and to enter new markets successfully and capitalize on growth opportunities, (VIII) changes in the Company’s ability to pay dividends on its Common Stock, (IX) the effects of the litigation and proceedings pending with the Internal Revenue Service regarding the Company’s lease financing transactions, and (X) additions to the Company’s loan loss reserves as the result of changes in local, national or international conditions which adversely affect the Company’s customers.  It is not possible to foresee or identify all such factors.  The Company makes no commitment to update any forward-looking statement, or to disclose any facts, events or circumstances after the date hereof that may affect the accuracy of any forward-looking statement, unless required by law.

Results of Operations

Overview

Net income for the second quarter of 2003 was $28.5 million or $.74 per share - basic ($.72 per share - diluted) compared to $24.9 million or $.62 per share - basic ($.60 per share - diluted) in the corresponding 2002 period. The second quarter earnings represent a 20.0% increase in diluted earnings per share and a 14.5% increase in net income over the corresponding period of 2002.  Net income for the six months ended June 30, 2003 was $59.8 million, or $1.54 per share – basic ($1.52 per share – diluted), compared to $42.3 million, or $1.05 per share – basic ($1.02 per share- diluted) for the same period in 2002.  The increase for the first six months of 2003 compared to the same period of 2002 can be partially attributed to impairment charges taken by the Company during 2002 due to the adoption of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”) and the Company’s share of losses on its investment in the Aircraft Finance Trust (“AFT”).  The adoption of SFAS 142 resulted in an impairment charge of $5.1 million, after tax, on its investment services unit in the first quarter of 2002.  The total losses recorded on its investment in AFT totaled $6.3 million, after tax, for the six months ended June 30, 2002.

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Total assets at June 30, 2003, were $6,771,980,000, which represents a 4.3% increase from total assets of $6,495,635,000 at December 31, 2002.  The increase in total assets was primarily due to an increase in investment securities.  Deposits at June 30, 2003 were $4,282,172,000, which represents an increase of 1.0% over the $4,239,899,000 reported at December 31, 2002.  Total loans at June 30, 2003 of $2,744,179,000 decreased 1.1% from the $2,773,394,000 reported at December 31, 2002.  The aggregate amount of Federal Home Loan Bank (“FHLB”) certificates of indebtedness and trust preferred securities increased to $1,380,528,000 at June 30, 2003, from the $1,185,857,000 at December 31, 2002.  On April 10, 2003, additional long-term debt in the form of trust-preferred securities in the amount of $10,000,000 was issued.  Trust preferred securities, certificates of indebtedness and deposits are used to fund the earning asset base of the Company.

Net Interest Income

As part of its strategy to manage interest rate risk, the Company strives to manage both assets and liabilities so that interest sensitivities match. One method of calculating interest rate sensitivity is through gap analysis.  A gap is the difference between the amount of interest rate sensitive assets and interest rate sensitive liabilities that re-price or mature in a given time period.  Positive gaps occur when interest rate sensitive assets exceed interest rate sensitive liabilities, and negative gaps occur when interest rate sensitive liabilities exceed interest rate sensitive assets.  A positive gap position in a period of rising interest rates should have a positive effect on net interest income as assets will re-price faster than liabilities.  Conversely, net interest income should contract somewhat in a period of falling interest rates.  Management can quickly change the Company’s interest rate position at any given point in time as market conditions dictate.  Additionally, interest rate changes do not affect all categories of assets and liabilities equally or at the same time.  Analytical techniques employed by the Company to supplement gap analysis include simulation analysis to quantify interest rate risk exposure.  The Investment Committee of the Company reviews the gap analysis prepared by management twice a year (see table on page 18 for the June 30, 2003 gap analysis).  Management currently believes that the Company is properly positioned for interest rate changes; however if management determines at any time that the Company is not properly positioned, it will strive to adjust the interest rate sensitive assets and liabilities in order to manage the effect of interest rate changes.  Net interest income for the second quarter of 2003 decreased $4,772,000, or 8.0% over the same period in 2002.  Net interest income for the six months ended June 30, 2003 decreased $3,488,000, or 3.0%, over the same period in 2002.  The decrease in net interest income can be attributed to lower rates earned on interest bearing assets, which was partially offset by lower rates paid on interest bearing liabilities.

Interest and fees on loans decreased $3,194,000, or 6.9%, for the quarter ended June 30, 2003 from the same quarter in 2002 and decreased $4,314,000, or 4.6%, for the six months ended June 30, 2003 compared to the same period in 2002.  Interest income on taxable and tax-exempt investment securities decreased $6,701,000, or 16.1%, for the quarter ended June 30, 2003 from the same quarter in 2002 and decreased $10,630,000, or 13.0%, for the six months ended June 30, 2003 compared to the same period in 2002.  Overall, total interest income from loans, time deposits, federal funds sold, investment securities and other interest income decreased $9,843,000, or 11.1%, for the quarter ended June 30, 2003, from the same quarter in 2002 and decreased $14,863,000, or 8.5%, for the six months ended June 30, 2003 compared to the same period in 2002.  The decrease in total interest income was primarily due to decreased rates on the Company’s loan portfolio and a decrease in investment securities arising from high level of principal repayments, which were used to pay down the Company’s FHLB certificates of indebtedness during the first quarter of 2003.

Interest expense on savings deposits for the second quarter in 2003 decreased $962,000, or 25.6%, compared to the same period in 2002 and decreased $1,632,000, or 22.1%, for the six months ended June 30, 2003 compared to the same period in 2002. Interest expense on time deposits for the second quarter in 2003 decreased $4,187,000, or 28.5%, compared to the same period in 2002 and decreased $9,810,000, or 31.0%, for the six months ended June 30, 2003 compared to the same period in 2002.  Interest expense on federal funds purchased and securities sold under repurchase agreements for the second quarter of 2003 decreased $210,000, or 4.3%, compared to the same period in 2002 and decreased $745,000, or 7.4%, for the six months ended June 30, 2003 compared to the same period in 2002.  Interest expense on other borrowings and long-term debt for the second quarter of 2003 increased $288,000, or 5.3%, compared to the same period in 2002 and increased $812,000, or 8.1%, for the six months ended June 30, 2003 compared to the same period in 2002.  Overall, total interest expense on savings deposits, time deposits, federal funds purchased, securities sold under repurchase agreements, other borrowings and long term debt decreased $5,071,000, or 17.6%, for the second quarter of 2003 from the same quarter in 2002 and decreased $11,375,000, or 19.3%, for the six months ended June 30, 2003, compared to the same period in 2002. The decrease in total interest expense was primarily due to lower interest rates paid on interest bearing liabilities.

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Non-Interest Income

Non-interest income increased $12,908,000, or 69.9%, for the second quarter of 2003 as compared to the same quarter in 2002 and increased $26,841,000, or 79.7%, for the six months ended June 30, 2003 compared to the same period in 2002.  Non-interest income includes income on other investments.  Income on other investments increased by $3,602,000, or 310.8%, for the second quarter of 2003 to $2,443,000, as compared to the same quarter in 2002, and increased $9,155,000, or 193.6%, for the six months ended June 30, 2003 compared to the same period in 2002.  This increase can be attributed to the Company’s share of losses recorded by the Aircraft Finance Trust (“AFT”) recognized by the Company in 2002.  The Company’s share of such losses during the first six months of 2002 totaled $9,772,000.  Investment securities gains of $5,542,000 were recorded in the second quarter of 2003 compared to losses of $146,000 for the same period in 2002.  Investment securities gains of $8,305,000 were recorded for the first six months of 2003, compared to losses of $44,000 for the same period of 2002.  The gains for the first six months of 2003 occurred due to the repositioning of a portion of the Company’s bond portfolio to realize the equity that is eroding in the portfolio due to rapid principal repayments.

Non-Interest Expense

Non-interest expense increased $3,662,000, or 9.5%, for the quarter ended June 30, 2003 when compared to the same period in 2002 and increased $6,528,000, or 8.9%, for the six months ended June 30, 2003 compared to the same period in 2002.  Non-interest expense increased primarily due to increased salaries and commissions paid to employees of the Company’s investment services unit for income produced during the first quarter of 2003.

The efficiency ratio, a measure of non-interest expense to net interest income plus non-interest income, was 48.9% for the second quarter of 2003, compared to 49.3% for the same quarter of 2002.  The efficiency ratio for the six months ended June 30, 2003 was 46.3% compared to 49.2% for the same period in 2002.

Financial Condition

Allowance for Possible Loan Losses

The allowance for possible loan losses increased 6.6% to $47,108,000 at June 30, 2003 from $44,213,000 at December 31, 2002.  The provision for possible loan losses charged to expense increased 3.3% to $2,124,000 for the second quarter of 2003 from $2,057,000 for the same quarter in 2002 and decreased $18,000, or .44%, for the six months ended June 30, 2003 compared to the same period of 2002.  The allowance for possible loan losses was 1.7% of total loans, net of unearned income, at June 30, 2003, compared to 1.6% at December 31, 2002.

Investment Securities

Investment securities increased 9.1% to $3,351,143,000 at June 30, 2003, from investment securities of $3,072,771,000 at December 31, 2002.  Total federal funds sold increased 19.2% to $15,500,000 at June 30, 2003 as compared to $13,000,000 at December 31, 2002.  The changes reflected during the six months ended June 30, 2003 were primarily from the results of the purchase of investment securities as part of the bond program currently in place to reposition a portion of the Company’s bond portfolio.

Foreign Operations

On June 30, 2003, the Company had $6,771,980,000 of consolidated assets, of which approximately $223,566,000, or 3.3%, was related to loans outstanding to borrowers domiciled in Mexico, compared to $233,277,000, or 3.6%, at December 31, 2002.  Of the $223,566,000, 77.8% is directly or indirectly secured by U.S. assets, certificates of deposits and real estate; 19.0% is secured by Mexican real estate; .9% is secured by Mexican real estate, related to maquiladora plants, guaranteed under lease obligations primarily by U.S. companies, many of which are on the Fortune 500 list of companies; 1.7% is unsecured; and .6% represents accrued interest receivable on the portfolio.

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Critical Accounting Policies

The Company considers its Allowance for Possible Loan Losses policy as a policy critical to the sound operations of the Banks.  The allowance for possible loan losses consists of the aggregate loan loss allowances of the bank subsidiaries.  The allowances are established through charges to operations in the form of provisions for possible loan losses.  Loan losses or recoveries are charged or credited directly to the allowances.  The allowance for possible loan losses of each bank subsidiary is maintained at a level considered appropriate by management, based on estimated probable losses in the loan portfolio.  The allowance is derived from the following elements:  (i) allowances established on specific loans, and (ii) allowances based on historical loss experience on the Company’s remaining loan portfolio.

The specific loan loss provision is determined using the following methods.  On a weekly basis, loan past due reports are reviewed by the servicing loan officer to determine if the loan has any potential problem and if the loan should be placed on the Company’s internal classified report.  The Company’s credit department reviews the majority of the loans regardless of past due status and determines if the loan should be placed on an internal classified report because of issues related to the analysis of the credit, credit documents, collateral and/or payment history.  As part of its review process, the credit department will discuss the loans with the servicing loan officers to determine any relevant issues that were not discovered in the evaluation.  Also, any analysis on loans that is provided through examinations by regulatory authorities is considered in the review process.

The Company’s internal classified report is segregated into the following categories:  (i) “Pass Credits,” (ii) “Special Review Credits,” or (iii) “Watch List Credits.”  The loans placed in the “Pass Credits” category reflect the Company’s opinion that the loan conforms to the bank’s lending policies, which includes the borrower’s ability to repay, the value of the underlying collateral, if any, as it relates to the outstanding indebtedness of the loan, and the economic environment and industry in which the borrower operates.  The loans placed in the “Special Review Credits” category reflect the Company’s opinion that the loans reflect potential weakness which require monitoring on a more frequent basis; however, the “Special Review Credits” are not considered to need a specific reserve at the time, but are reviewed and discussed on a regular basis with the credit department and the lending staff to determine if a change in category is warranted.  The loans placed in the “Watch List Credits” category reflect the Company’s opinion that the loans contain clearly pronounced credit weaknesses and/or inherent financial weaknesses of the borrower.  Credits classified as “Watch List Credits” are evaluated under Statement of Financial Accounting Standards No. 114, “Accounting by Creditors for Impairment of a Loan,” criteria and, if deemed necessary a specific reserve is allocated to the credit.  The specific reserve allocated under SFAS No. 114, is based on (1) the present value of expected future cash flows discounted at the loan’s effective interest rate; (2) the loan’s observable market price; or (3) the fair value of the collateral if the loan is collateral dependent.

The allowance, based on historical loss experience on the Company’s remaining loan portfolio, is determined by segregating the remaining loan portfolio into similar categories such as commercial loans, installment loans, international loans and overdrafts.  Installment loans are then further segregated by number of days past due.  A historical loss percentage, adjusted for management’s evaluation of changes in lending policies and procedures and current economic conditions in the market area served by the Company is applied to each category.

The Company’s management continually reviews the loan loss allowance of the bank subsidiaries using the amounts determined from the allowances established on specific loans, the allowance established based on historical percentages and the loans charged off and recoveries to establish an appropriate amount to maintain in the Company’s loan loss allowance.  If the basis of the Company’s assumptions change, the loan loss allowance would either decrease or increase and the Company would increase or decrease the provision for loan loss charged to operations accordingly.

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Liquidity and Capital Resources

The maintenance of adequate liquidity provides the Company’s bank subsidiaries with the ability to meet potential depositor withdrawals, provide for customer credit needs, maintain adequate statutory reserve levels and take full advantage of high-yield investment opportunities as they arise.  Liquidity is afforded by access to financial markets and by holding appropriate amounts of liquid assets.  The Company’s bank subsidiaries derive their liquidity largely from deposits of individuals and business entities.  Deposits from persons and entities domiciled in Mexico comprise a significant and stable portion of the deposit base of the Company’s bank subsidiaries. Other important funding sources for the Company’s bank subsidiaries during 2003 and 2002 have been borrowings from FHLB, securities sold under repurchase agreements and large certificates of deposit, requiring management to closely monitor its asset/liability mix in terms of both rate sensitivity and maturity distribution.  Primary liquidity of the Company and its subsidiaries has been maintained by means of increased investment in shorter-term securities, certificates of deposit and loans.  As in the past, the Company will continue to monitor the volatility and cost of funds in an attempt to match maturities of rate-sensitive assets and liabilities and respond accordingly to anticipated fluctuations in interest rates over reasonable periods of time.

The Company maintains an adequate level of capital as a margin of safety for its depositors and shareholders.  At June 30, 2003, shareholders’ equity was $568,286,000 compared to $547,264,000 at December 31, 2002, an increase of $21,022,000, or 3.8%.  The change in shareholders’ equity can be attributed to the retention of earnings and the declaration of a $.34 cents per share cash dividend, adjusted for stock dividends, to all shareholders of record as of March 31, 2003, which was paid on April 15, 2003.

The Company had a leverage ratio of 9.07% and 8.71%, risk-weighted Tier 1 capital ratio of 16.13% and 15.95% and risk-weighted total capital ratio of 17.80% and 17.21% at June 30, 2003 and December 31, 2002, respectively.  The identified intangibles and goodwill of $73,973,000 as of June 30, 2003, recorded in connection with the acquisitions of the Company, are deducted from the sum of core capital elements when determining the capital ratios of the Company.

On March 28, 2003, the Company formed International Bancshares Capital Trust VII (“Trust VII”), a statutory business trust formed under the laws of the State of Delaware, for the purpose of issuing trust preferred securities.  On April 10, 2003, Trust VII issued $10,000,000 of Capital Securities.  The Capital Securities accrue interest at a floating rate of 3.25% over the London Interbank Offer Rate (“LIBOR”), and interest is payable quarterly beginning July 24, 2003.  The Capital Securities will mature April 24, 2033; however, the Capital Securities may be redeemed at specified prepayment prices (a) in whole or in part on any interest payment date on or after April 24, 2008, or (b) in whole within 90 days upon the occurrence of any of certain legal, regulatory, or tax events.  The Capital Securities are subordinated and junior in right of payment to all present and future senior indebtedness of the Company.  The Company has fully and unconditionally guaranteed the obligation of Trust VII with respect to the Capital Securities.  The Company has the right, unless an Event of Default has occurred and is continuing, to defer payment of interest on the Capital Securities for up to ten consecutive semi-annual periods.  The redemption prior to maturity of any of the Capital Securities may require the prior approval of the Federal Reserve and/or other regulatory agencies.

After taking into account the $10,000,000 in Capital Securities issued on April 10, 2003, the Company has a total of $145,000,000 of trust preferred securities issued by statutory business trusts formed by the Company.

As in the past, the Company will continue to monitor the volatility and cost of funds in an attempt to match maturities of rate-sensitive assets and liabilities, and respond accordingly to anticipate fluctuations in interest rates by adjusting the balance between sources and uses of funds as deemed appropriate.  The net-interest rate sensitivity as of June 30, 2003 is illustrated in the table on page 18.  This information reflects the balances of assets and liabilities for which rates are subject to change.  A mix of assets and liabilities that are roughly equal in volume and re-pricing characteristics represents a matched interest rate sensitivity position.  Any excess of assets or liabilities results in an interest rate sensitivity gap.

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The Company undertakes an interest rate sensitivity analysis to monitor the potential risk on future earnings resulting from the impact of possible future changes in interest rates on currently existing net asset or net liability positions.  However, this type of analysis is as of a point-in-time position, when in fact that position can quickly change as market conditions, customer needs, and management strategies change. Thus, interest rate changes do not affect all categories of asset and liabilities equally or at the same time.  As indicated in the table, the Company is liability sensitive during the early time periods and asset sensitive in the longer periods.  The Company’s Asset and Liability Committee semi-annually reviews the consolidated position along with simulation and duration models, and makes adjustments as needed to control the Company’s interest rate risk position.  The Company uses modeling of future events as a primary tool for monitoring interest rate risk.

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INTEREST RATE SENSITIVITY

(Dollars in Thousands)

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Item 3.  Quantitative and Qualitative Disclosure about Market Risk

During the second quarter of 2003, there were no material changes in market risk exposures that affected the quantitative and qualitative disclosures regarding market risk presented in the Company’s Form 10-K for the year ended December 31, 2002.

Item 4.  Controls and Procedures

An evaluation was performed under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of June 30, 2003 pursuant to Exchange Act Rule 13a-14.  Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective, in all material respects, to ensure that information required to be disclosed in the reports the Company files and submits under the Exchange Act is recorded, processed, summarized and reported as and when required.  There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect internal controls subsequent to the date of management’s evaluation.

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PART II - OTHER INFORMATION

Item 4.  Submission of Matters to a Vote of Security Holders

The Annual Meeting of Shareholders of the Company was held May 19, 2003 for the consideration of the following items which were approved by the number of votes set forth:

Item 6.  Exhibits and Reports on Form 8-K

(a)                                  Exhibits

The following exhibits are filed as a part of this Report:

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(b)                                 Reports on Form 8-K

Registrant filed a current report on Form 8-K on April 9, 2003 covering Item 5 – Other Events and Item 7 – Financial Statements and Exhibits in connection with the announcement of a 25% stock dividend to all holders of record as of May 19, 2003,with said dividend payable on June 16, 2003.

Registrant filed a current report on Form 8-K on May 7, 2003 covering Item 5 – Other Events and Item 7 – Financial Statements and Exhibits in connection with the announcement of first quarter 2003 earnings.

Registrant filed a current report on Form 8-K/A on May 8, 2003 covering Item 7 – Financial Statements and Exhibits and Items 9 and 12 – Regulation FD Disclosure and Disclosure of Results of Operations and Financial Condition, amending in its entirety the current report on Form 8-K filed on May 7, 2003.

Registrant filed a current report on Form 8-K on August 6, 2003 covering Item 5 - Other Events and Regulation FD Disclosure in connection with the announcement to expand its stock repurchase program.

Registrant filed a current report on Form 8-K on August 8, 2003 covering Item 9 - Regulation FD Disclosure and Item 12 - Results of Operations and Financial Condition in connection with the announcement of second quarter 2003 earnings.

Registrant filed a current report on Form 8-K on August 12, 2003 covering Item 9 - Regulation FD Disclosure and Item 12 - Results of Operations and Financial Condition in connection with the announcement of the declaration of a fifty cents per share cash dividend for all holders of common stock, $1.00 par value, of record on September 30, 2003 said cash dividend to be payable on October 15, 2003.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

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