PART I

Certain matters discussed or incorporated by reference in this Annual Report of Form 10-KSB including, but not limited to, those described in “Item 6 - Management’s Discussion and Analysis of Financial Condition and Results of Operations”, are forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements. Such risks and uncertainties include, among others, (1) competitive pressure in the banking industry increasing significantly; (2) changes in the interest rate environment reduces margins; (3) general economic conditions, either nationally or regionally, are less favorable than expected, resulting in, among other things, a deterioration in credit quality; (4) changes in the regulatory environment; (5) changes in business conditions and inflation; and (6) changes in securities markets. Therefore, the information set forth therein should be carefully considered when evaluating the business prospects of the Corporation.

At December 31, 2007 the Bank had total assets, deposits and shareholders’ equity of approximately $252,215,000, $167,818,000 and $20,781,000, respectively.

Northern California Bancorp, Inc. Trust I

On March 27, 2003, Northern California Bancorp, Inc. Trust I, a newly formed Delaware statutory business trust and a wholly owned subsidiary of the Company (Trust I), issued an aggregate of $3.0 million of principal amount of Floating Rate TRUPS â (Capital Trust Pass-through Securities of the Trust) (the Trust Preferred Securities).  Bear Stearns & Co., Inc. acted as placement agent in connection with the offering of the Trust Preferred Securities.  The securities issued by Trust I are fully guaranteed by the Company with respect to distributions and amounts payable upon liquidation, redemption or repayment.  The entire proceeds to Trust I from the sale of the Trust Preferred Securities were used by Trust I in order to purchase $3.0 million in principal amount of the Floating Rate Junior Subordinated Deferrable Interest Debentures due 2033 issued by the Company (the Subordinated Debt Securities).

Pursuant to Financial Accounting Standards Board (FASB) Interpretation No. 46, “Consolidation of Variable Interest Entities (VIE’s) (FIN 46),” this trust is not reflected on a consolidated basis in our financial statements.

The Subordinated Debt Securities bear a variable interest rate equal to the three-month LIBOR plus 3.25%.  The effective rate at December 31, 2007 was 8.49%.  Total broker and legal costs associated with the issuance of $115,000 are being amortized over a 30 year period.

Northern California Bancorp, Inc. Trust II

On November 13, 2003, Northern California Bancorp, Inc. Trust II, a newly formed Delaware statutory business trust and a wholly owned subsidiary of the Company (Trust II), issued an aggregate of $5.0 million of principal amount of Floating Rate TRUPS â (Capital Trust Pass-through Securities of the Trust) (the Trust Preferred Securities).  Citigroup Global Markets, Inc. acted as placement agent in connection with the offering of the Trust Preferred Securities.  The securities issued by Trust II are fully guaranteed by the Company with respect to distributions and amounts payable upon liquidation, redemption or repayment.  The entire proceeds to Trust II from the sale of the Trust Preferred Securities were used by Trust II in order to purchase $5.0 million in principal amount of the Floating Rate Junior Subordinated Deferrable Interest Debentures due 2033 issued by the Company (the Subordinated Debt Securities).

Pursuant to Financial Accounting Standards Board (FASB) Interpretation No. 46, “Consolidation of Variable Interest Entities (VIE’s) (FIN 46),” this trust is not reflected on a consolidated basis in our financial statements.

The Subordinated Debt Securities bear a variable interest rate equal to the three-month LIBOR plus 2.85%.  The effective rate at December 31, 2007 was 7.76%. Total broker and legal costs associated with the issuance of $54,000 are being amortized over a 30 year period.

EMPLOYEES

At December 31, 2007 the Northern California Bancorp, Inc. and its subsidiary Monterey County Bank employed a total of 52 full time equivalent persons.

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COMPETITION

All phases of the Bank’s business have been, since inception, and will continue to be subject to significant competitive forces.  Although the Bank has increasing recognition in its primary service area and Monterey County, it nevertheless has to compete with other independent local banking institutions, including commercial banks and savings and loan associations, as well as branch offices of regional commercial banks, some of which have assets, capital and lending limits substantially larger than the Bank, as well as wider geographic markets, more support services and larger media advertising capabilities.  The Bank will also compete with respect to its lending activities, as well as in attracting demand deposits, with savings banks, savings and loan associations, insurance companies, regulated small loan companies and credit unions, as well as securities brokerage offices which can issue commercial paper and other securities (such as shares in money market funds).

Among the advantages such institutions have over the Bank are their ability to finance wide ranging advertising campaigns and to allocate their investment assets to regions of highest yields and demand.  Many institutions offer certain services, such as trust services and international banking, which the Bank does not currently offer or plan to offer.  By virtue of their greater total capital, such institutions have substantially higher lending limits than the Bank (legal lending limits to an individual customer being limited to a percentage of a bank’s total capital accounts).  These competitors may intensify their advertising and marketing activities to counter any efforts by the Bank to further attract new business as a commercial bank.  In addition, as a result of legislation enacted earlier in the decade, there is increased competition between banks, savings and loan associations and credit unions for the deposit and loan business of individuals.  These activities may hinder the Bank’s ability to capture a significant market share.

To compete with the financial institutions in its primary service area, the Bank intends to use the flexibility, which its independent status will permit.  Its activities in this regard include an ability and intention to respond quickly to changes in the interest rates paid on time and savings deposits and charged on loans, and to charges imposed on depository accounts, so as to remain competitive in the market place.  It also will continue to emphasize specialized services for the small business person and professional and personal contacts by the Bank’s officers, directors and employees.  If there are customers whose loan demands exceed the Bank’s lending limits, the Bank has the ability to arrange for such loans on a participation basis with other financial institutions.  No assurance can be given, however, that the Bank’s efforts to compete with other financial institutions in its primary service area will be successful.

The Bank provides a range of competitive retail and commercial banking services.  The deposit services offered include various types of personal and business checking accounts, savings accounts, money market investment accounts, certificates of deposit, and retirement accounts.  Lending services include consumer loans, various type of mortgage loans for residential and commercial real estate, personal lines of credit, home equity loans, real estate construction, accounts receivable financing, commercial loans to small and medium size businesses and professionals.  The Bank also provides drive-through facilities, at its Monterey and Carmel offices, and night depository facilities for customer convenience.  The Bank offers safe deposit box facilities, cashiers’ checks, travelers’ checks, U.S. Savings Bonds, and wire transfers.  The Bank does not provide trust services.

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While the Bank has the authority to engage in a wide range of banking activities, and offers most of the types of banking services of a commercial bank, over the past three years it has derived much of its profitability and differentiated itself from its competitors through (i) commercial and real estate loans guaranteed by the Small Business Administration (“SBA”); and (ii) credit card depository services for merchants.

The Bank entered into an agreement with Genesis Financial Solutions, a purchaser of charged-off consumer credit card balances, to market a MasterCard credit card program.  The Bank issued the cards, but the credit card balances are 100 percent owned by Genesis Financial Solutions.  The program was implemented in the first quarter of 2005 with the initial card solicitations being mailed in February 2005 resulting in 14,741 active cards on file at December 31, 2005.  The Bank’s fee revenue from the program in 2007, 2006 and 2005 were approximately $106,000, $71,000 and $95,000, respectively.  Genesis Financial Solutions maintains deposits with the Bank equal to the sum of the total available credit of the portfolio plus the total of five days average settlement activity for the prior month.  The average deposits maintained during 2007, 2006 and 2005 were $645,000, $648,000 and $276,000, respectively.  It is anticipated the number of accounts in the portfolio will continue to decline as no new accounts are being added.  Program revenues in 2008 will approximate $8,000 per month until the expiration of the agreement in September 2008.

The Bank entered into an agreement in February 2006 with GC Acquisitions, LLC (“GCA”), the owner of a portfolio of consumer credit card contracts and receivables, under which the Bank offered MasterCard® credit cards to qualifying GCA credit card contract holders.  GCA, through its affiliates, agents and vendors, established new credit card accounts with the Bank for certain of its existing credit card contract holders. GCA services the credit card accounts and owns the receivables generated from the accounts.  A total of approximately 252,000 cards were issued during March and April 2006, as a result of GCA’s purchase of a credit card portfolio.  GCA requested and the Bank granted permission for GCA to transfer a total of approximately 87,000 accounts from the portfolio to another card issuer.  In consideration for the Bank granting permission to transfer the accounts GCA paid a one time transfer fee totaling approximately $382,000.  The Bank’s fee revenue from the program in 2007 and 2006 was approximately $473,000 and $1,209,000, respectively.  Included in both 2007 and 2006 revenues were one time transfer fees of $204,000 and $382,000, respectively. GCA maintained average reserve deposits with the Bank of $2,050,000 $7,488,000 at December 31, 2007 and 2006, respectively.  The Bank’s 2008 revenues from the program will be based on monthly minimum fee payments of approximately $10,000.

The Bank has entered into agreements with two additional companies, who are purchasers of charged off debt, to market credit cards to their customer bases.  The Bank anticipates its 2008 revenues from these programs will be derived from the minimum monthly fee payments due under the agreements.

The Bank has implemented a pre-paid debit card program.  The program is marketed by third parties through employer payroll programs and check cashing facilities, through Internet websites for purchasers of the websites’ products and services.  Holders of the pre-paid cards will be able to have additional funds added to the card balance, make point of sale purchases and withdraw cash through automated teller machines.  The Bank will be issuing the pre-paid cards and maintaining the funds held on the cards.  The Bank’s revenues from the program will be in the form of transaction fees and earnings from investing the funds held on the cards.  The fee revenues from the program were $293,000, $75,000 and $14,000 in 2007, 2006 and 2005, respectively.

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The Bank depends largely on rate differentials.  In general, the difference between the interest rate paid by the Bank on its deposits and its other borrowings, and the interest rate received by the Bank on loans extended to its customers and securities held in the Bank’s portfolio, comprise the major portion of the Bank’s earnings.  These rates are highly sensitive to many factors that are beyond the control of the Bank.  Accordingly, the earnings and growth of the Bank are subject to the influence of domestic and foreign economic conditions, including inflation, recession and unemployment.

Monetary and fiscal policies of the federal government and the policies of regulatory agencies, particularly the Federal Reserve Board, also impact the Bank’s business.  The Federal Reserve Board implements national monetary policies (with objectives such as curbing inflation and combating recession) by its open-market operations in U.S. Government securities, by adjusting the required level of reserves for financial intermediaries subject to its reserve requirements and by varying the discount rates applicable to borrowings by depository institutions.  The actions of the Federal Reserve Board in these areas influence the growth of bank loans, investments and deposits and also affect interest rates charged on loans and paid on deposits.  The nature and impact of any future changes in monetary policies cannot be predicted.

SUPERVISION AND REGULATION

The Corporation

Future offers or sales of the stock of the Corporation will be subject to the registration requirements of the Securities Act of 1933, and qualification under the California Corporate Securities Act of 1968, and possibly other state Blue Sky laws, (unless an exemption is available), although the Bank’s common stock is exempt from such requirements.

On December 29, 1995, after receipt of appropriate approvals, and/or passage of notice periods without objection, from the California Superintendent of Banks, the Federal Deposit Insurance Corporation, the Board of Governors of the Federal Reserve System and the shareholders of the Bank, the Corporation acquired the Bank through a reverse triangular merger (the “Merger”).  As a result, by operation of law, each outstanding share of common stock of the Bank prior to the Merger was converted into a share of common stock of the Corporation, while the Corporation became the sole owner of the newly issued shares of common stock of the Bank.

The Bank Holding Company Act of 1956, as amended, places the Corporation under the supervision of the Board of Governors of the Federal Reserve System (the “FRB”). The Corporation must generally obtain the approval of the FRB before acquiring all or substantially all of the assets of any bank, or ownership or control of any voting securities of any bank if, after giving effect to such acquisition, the Corporation would own or control more than 5% of the voting shares of such bank.

A bank holding company is generally prohibited from engaging in, or acquiring direct or indirect control of more than 5% of the voting shares of any company engaged in non-banking activities unless the FRB, by order or regulation, has found such activities to be so closely related to banking, managing or controlling banks as to be a proper incident thereto. In making such determinations, the FRB considers whether the performance of such activities by a bank holding company would offer advantages to the public, which outweigh possible adverse effects.

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The FRB’s Regulation “Y” sets out the non-banking activities that are permissible for bank holding companies under the law, subject to the FRB’s approval in individual cases.  Most of these activities are now permitted for California banks that are well-capitalized.   The Corporation and its subsidiaries will also be subject to certain restrictions with respect to engaging in the underwriting, public sale and distribution of securities.  The Gramm-Leach-Bliley Act (the “Act”) was signed by the President and enacted into law on November 12, 1999.  The Act does three fundamental things: 1) it repeals key provisions of the Glass Steagal Act to permit commercial banks to affiliate with investment banks, 2) it substantially modifies the Bank Holding Company Act of 1956 to permit companies that own commercial banks to engage in any type of financial activity and 3) it allows subsidiaries of banks to engage in a broad range of financial activities that are not permitted by banks.  Management cannot predict what effect these changes will have on the Bank or the Corporation.

The Corporation will be required to file reports with the FRB and provide such additional information as the FRB may require. The FRB will also have the authority to examine the Corporation and each of its subsidiaries with the cost thereof to be borne by the Corporation.  Under California banking law, the Corporation and its subsidiaries are also subject to examination by, and may be required to file reports with, the Superintendent Department of Financial Institutions.

The Corporation and any subsidiari es which it may acquire or organize after the reorganization will be deemed affiliates of the Bank within the meaning of the Federal Reserve Act.  Pursuant thereto, loans by the Bank to affiliates, investments by the Bank in affiliates’ stock, and taking affiliates’ stock by the Bank as collateral for loans to any borrower will be limited to 10% of the Bank’s capital, in the case of any one affiliate, and will be limited to 20% of the Bank’s capital, in the case of all affiliates.  Federal and State law place other limitations on transactions between the Bank and its affiliates designed to ensure that the Bank receives treatment in such transactions comparable to that available from unaffiliated third parties.

The Corporation and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, sale or lease of property or furnishing of services.  For example, with certain exceptions, the Bank may not condition an extension of credit on a customer’s obtaining other services provided by it, the Corporation or any other subsidiary, or on a promise from its customer not to obtain other services from a competitor.

Sarbanes-Oxley Act

The Sarbanes-Oxley Act of 2002 (the Act) was enacted into law on July 30, 2002.  The Act was in response to recent issues in corporate governance and accountability.  Key provisions of the Act provide for:

·                   Expanded oversight of the accounting profession by creating a new independent public company oversight board to be monitored by the SEC.

·                   Revised rules on auditor independence to restrict the nature of non-audit services provided to audit clients and to require such services to be pre-approved by the audit committee.

·                   Improved corporate responsibility through mandatory listing standards relating to audit committees, certifications of periodic reports by the Chief Executive Officer and Chief Financial Officer, and making issuer interference with an audit a crime.

·                   Enhanced financial disclosures, including periodic reviews for the largest issuers and real time disclosure of material company information.

·                   Enhanced criminal penalties for a broad array of white-collar crimes and increases in the statute of limitations for securities fraud lawsuits.

·                   Provides for mandated internal control report and assessment with the annual report and an attestation and a report on such report by the company’s auditor.

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The effect of the Act upon corporations is uncertain; however, it is likely that compliance costs may increase as corporations modify procedures if required to conform to the provisions of the Act.  The Company does not currently anticipate that compliance with the Act will have a material effect upon its financial position or results or its operations or its cash flows.

Subsidiary Bank

Both federal and state laws provide extensive regulation of the banking business.  State and federal statutes and regulations apply to many aspects of the Bank’s operations, including minimum capital requirements, reserves against deposits, interest rates payable on deposits, loans, investments, mergers and acquisitions, borrowings, dividends and locations of branch offices. The California Superintendent of Banks and the FDIC provide primary supervision, periodic examination and regulation of the Bank.

The FDIC, through its Bank Insurance Fund (the “BIF”) insures the Bank’s deposits, currently up to a maximum of $100,000 per depositor, except that individual retirement accounts are insured up to a maximum of $250,000 per depositor.  For this protection, the Bank, like all insured banks, pays a semi-annual statutory assessment and is subject to the rules and regulations of the FDIC.  Although the Bank is not a member of the Federal Reserve System, certain regulations of the Federal Reserve Board also apply to its operations.

California law restricts the amount available for cash dividends by state-chartered banks to the lesser of retained earnings or the bank’s net income for its last three fiscal years (less any distributions to stockholders made during such period).  Cash dividends may also be paid in an amount not exceeding the net income for such bank’s last preceding fiscal year after obtaining the prior approval of the Superintendent.  The FDIC also has authority to prohibit the Bank from engaging in unsafe or unsound practices.  The FDIC can use this power, under certain circumstances, to restrict or prohibit a bank from paying dividends.

Federal law imposes restrictions on banks with regard to transactions with affiliates, including any extensions of credit to, or the issuance of a guarantee or letter of credit on behalf of, its affiliates, as well as the purchase of or investments in stock or other securities thereof, or the taking of such securities as collateral for loans, and the purchase of assets from affiliates.  These restrictions have the effect of preventing affiliates (such as the Corporation) from borrowing from the Bank unless the loans are secured by marketable obligations of designated amounts.  Secured loans and investments by the Bank are limited to 10% of the Bank’s capital and surplus (as defined by federal regulations) in the case of any one affiliate, and 20% thereof in the case of all affiliates.  California law also imposes certain restrictions with respect to transactions involving other controlling persons of the Bank.

From time to tim e, legislation is enacted which has the effect of increasing the cost of doing business, limiting or expanding permissible activities or affecting the competitive balance between banks and other financial intermediaries.  Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies and other financial intermediaries are frequently made in Congress, in the California legislature and before various bank regulatory and other professional agencies. The Bank cannot predict what, if any legislation or regulations will be enacted, or the impact thereof on its business and profitability.

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Capital Adequacy Standards

Government agencies have traditionally regulated bank capital through explicit and implicit guidelines and rules.  State law requires “adequate” capital, without objective definition.  Federal law and regulations require minimum levels of risk-based and so-called “Leverage” capital.

FDIC guidelines implement the risk-based capital requirements. The guidelines establish a systematic analytical framework that makes regulatory capital requirements more sensitive to differences in risk profiles (using the rough measures set forth therein) among banking organizations, take certain off-balance sheet items into account in assessing capital adequacy and minimize disincentives to holding liquid, low-risk assets. Under these guidelines, assets and credit equivalent amounts of off-balance sheet items, such as letters of credit and outstanding loan commitments, are assigned to one of several risk categories, which range from 0% for risk-free assets, such as cash and certain U.S. government securities, to 100% for relatively high-risk assets, such as loans and investments in fixed assets, premises and other real estate owned. The aggregate dollar amount of each category is then multiplied by the risk-weight associated with that category. The resulting weighted values from each of the risk categories are then added together to determine the total risk-weighted assets.

A banking organization’s risk-based capital ratios are obtained by dividing its qualifying capital by its total risk adjusted assets, including dollar equivalents for certain off-balance sheet assets.

The guidelines require a minimum ratio of qualifying total capital to risk-weighted assets of 8%, of which at least 4% must consist of Tier I capital.  Higher risk-based ratios are required to be considered “well capitalized” under prompt corrective action provisions.

A banking organization’s qualifying total capital consists of two components: Tier 1 capital (core capital) and Tier 2 capital (supplementary capital).  Tier 1 capital consists primarily of common stock, related surplus and retained earnings, qualifying noncumulative perpetual preferred stock and minority interests in the equity accounts of consolidated subsidiaries. Trust preferred securities qualify as Tier 1 capital up to a maximum of 25% of capital.  Any additional portion will qualify as Tier 2 capital.  Intangibles, such as goodwill, are generally deducted from Tier 1 capital; however, purchased mortgage servicing rights and purchased credit card relationships may be included, subject to certain limitations. At least 50% of the banking organization’s total regulatory capital must consist of Tier 1 capital.

Tier 2 capital may consist of (i) the allowance for loan and lease losses in an amount up to 1.25% of risk-weighted assets; (ii) cumulative perpetual preferred stock and long-term preferred stock and related surplus; (iii) hybrid capital instruments (instruments with characteristics of both debt and equity), perpetual debt and mandatory convertible debt securities; and (iv) eligible term subordinated debt and intermediate-term preferred stock with an original maturity of five years or more, including related surplus, in an amount up to 50% of Tier 1 capital. The inclusion of the foregoing elements of Tier 2 capital is subject to certain requirements and limitations of the federal banking agencies.

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The FDIC imposes a minimum leverage ratio of Tier I capital to average total assets of 3% for the highest rated banks, and 4% for all other banks.  Institutions experiencing or anticipating significant growth or those with other than minimum risk profiles are expected to maintain capital at least 100-200 basis points above the minimum level.

In addition, the Federal Reserve Board and the FDIC have issued or proposed rules to take account of interest rate risk, concentration of credit risk and the risks of nontraditional activities in calculating risk-based capital.

For capital adequacy purposes, deferred tax assets that can be realized from taxes paid in prior carry-back years, and from the future reversal of temporary differences, are generally unlimited.  However, deferred tax assets that can only be realized through future taxable earnings, including the implementation of a tax planning strategy, count toward regulatory capital purposes only up to the lesser of (i) the amount that can be realized within one year of the quarter-end report date or (ii) 10% of Tier I capital.  The amount of deferred taxes in excess of this limit, if any, would be deducted from Tier I capital and total assets in regulatory capital calculations.

Effective January 17, 1995, the federal banking agencies issued a final rule relating to capital standards and the risks arising from the concentration of credit and nontraditional activities.  Institutions which have significant amounts of their assets concentrated in high risk loans or nontraditional banking activities and who fail to adequately manage these risks, will be required to set aside capital in excess of the regulatory minimums.  The federal banking agencies have not imposed any quantitative assessment for determining when these risks are significant, but have identified these issues as important factors they will review in assessing an individual bank’s capital adequacy.  Management of the Company does not believe that the Bank’s assets and activities, as currently structured, would lead the FDIC to require additional capital under this rule.

Future changes in regulations or practices could further reduce the amount of capital recognized for purposes of capital adequacy.  Su ch a change could affect the ability of the Bank to grow and could restrict the amount of profits, if any, available for the payment of dividends.

Prompt Corrective Action and Other Enforcement Mechanisms

Under Section 38 of the FDIA, as added by the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), each federal banking agency is required to implement a system of prompt corrective action for institutions which it regulates.  The federal banking agencies have promulgated substantially similar regulations to implement this system of prompt corrective action.  Under the regulations, an institution shall generally be deemed to be: (i) “well capitalized” if it has a total risk-based capital ratio of 10.0% or more, has a Tier I risk-based capital ratio of 6.0% or more, has a Tier I leverage capital ratio of 5.0% or more and is not subject to specified requirements to meet and maintain a specific capital level for any capital measure; (ii) “adequately capitalized” if it has a total risk-based capital ratio of 8.0% or more, a Tier I risk-based capital ratio of 4.0% or more and a Tier I leverage capital ratio of 4.0% or more (3.0% under certain circumstances) and does not meet the definition of “well capitalized;” (iii) “undercapitalized” if it has a total risk-based capital ratio that is less than 8.0%, a Tier I risk-based capital ratio that is less than 4.0% or a Tier I leverage capital ratio that is less than 4.0% (3.0% under certain circumstances); (iv) “significantly undercapitalized” if it has a total risk-based capital ratio that is less than 6.0%, a Tier I risk-based capital ratio that is less than 3.0% or a Tier I leverage capital ratio that is less than 3.0%; and (v) “critically undercapitalized” if it has a ratio of tangible equity to total assets that is equal to or less than 2.0%.

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Section 38 of the FDIA and the implementing regulations also provide that a federal banking agency may, after notice and an opportunity for a hearing, reclassify a well capitalized institution as adequately capitalized and may require an adequately capitalized institution or an undercapitalized institution to comply with supervisory actions as if it were in the next lower category if the institution is in an unsafe or unsound condition or engaging in an unsafe or unsound practice.  (The FDIC may not, however, reclassify a significantly undercapitalized institution as critically undercapitalized.)

An institution generally must file a written capital restoration plan which meets specified requirements, as well as a performance guaranty by each company that controls the institution, with the appropriate federal banking agency within 45 days of the date that the institution receives notice or is deemed to have notice that it is undercapitalized, significantly undercapitalized or critically undercapitalized.  Immediately upon becoming undercapitalized, an institution shall become subject to the provisions of Section 38 of the FDIA, which sets forth various mandatory and discretionary restrictions on its operations.

At December 31, 2007, the Bank met the te sts to be categorized as “well capitalized” under the prompt corrective action regulations of the FDIC.

Safety and Soundness Standards

Federal law requires the federal banking regulatory agencies to prescribe, by regulation, standards for all insured depository institutions relating to: (i) internal controls, information systems and internal audit systems; (ii) loan documentation; (iii) credit underwriting; (iv) interest rate risk exposure; (v) asset growth; and (vi) compensation, fees and benefits.  The federal banking agencies recently adopted final regulations and Interagency Guidelines Prescribing Standards for Safety and Soundness (“Guidelines”) to implement safety and soundness standards required by the FDIA.  The Guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired.  The agencies also proposed asset quality and earnings standards which, if adopted in final, would be added to the Guidelines.  Under the final regulations, if the FDIC determines that the Bank fails to meet any standard prescribed by the Guidelines, the agency may require the Bank to submit to the agency an acceptable plan to achieve compliance with the standard, as required by the FDIA.  The final regulations establish deadlines for the submission and review of such safety and soundness compliance plans.

Premiums for Deposit Insurance

The FDIC adopted regulations implementing a risk-based premium system required by federal law.  Under the regulations which cover the assessment periods commencing on and after January 1, 1994, insured depository institutions are required to pay insurance premiums within a range of $.23 cents per $100 of deposits to $.31 cents per $100 of deposits depending on their risk classification.  The FDIC, effective September 30, 1995, lowered assessments from their rates of $.23 to $.31 per $100 of insured deposits to rates of $.04 to $.31, depending on the health of the bank, as a result of the re-capitalization of the BIF.  The FDIC may alter the existing assessment rate structure for deposit insurance and may change the base assessment rate (currently, 4 to 31 basis points per year) by rulemaking with notice and comment.  Without notice or comment, the FDIC may increase or decrease the current rate schedule uniformly by as much as 5 basis points, as deemed necessary to maintain the target designated reserve ratio 1.25 percent (fund balance to estimated insured deposits).  The insured deposit rates for 2007 were $.05 to $.43 per $100 of deposits.

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On February 8, 2006, the President signed The Federal Deposit Insurance Reform Act of 2005 (the Reform Act) into law. The Federal Deposit Insurance Reform Conforming Amendments Act of 2005, which the President signed into law on February 15, 2006, contains necessary technical and conforming changes to implement deposit insurance reform, as well as a number of study and survey requirements.

The Reform Act provides for the following changes:

·                               Merging the Bank Insurance Fund (BIF) and the Savings Association Insurance Fund (SAIF) into a new fund, the Deposit Insurance Fund (DIF). This change was made effective March 31, 2006.

·                               Increasing the coverage limit for retirement accounts to $250,000 and indexing the coverage limit for retirement accounts to inflation as with the general deposit insurance coverage limit. This change was made effective April 1, 2006.

·                               Establishing a range of 1.15 percent to 1.50 percent within which the FDIC Board of Directors may set the Designated Reserve Ratio (DRR).

·                               Allowing the FDIC to manage the pace at which the reserve ratio varies within this range.

1.                If the reserve ratio falls below 1.15 percent—or is expected to within 6 months—the FDIC must adopt a restoration plan that provides that the DIF will return to 1.15 percent generally within 5 years.

2.                If the reserve ratio exceeds 1.35 percent, the FDIC must generally dividend to DIF members half of the amount above the amount necessary to maintain the DIF at 1.35 percent, unless the FDIC Board, considering statutory factors, suspends the dividends.

3.                If the reserve ratio exceeds 1.5 percent, the FDIC must generally dividend to DIF members all amounts above the amount necessary to maintain the DIF at 1.5 percent.

·                               Eliminating the restrictions on premium rates based on the DRR and granting the FDIC Board the discretion to price deposit insurance according to risk for all insured institutions regardless of the level of the reserve ratio.

·                               Granting a one-time initial assessment credit (of approximately $4.7 billion) to recognize institutions’ past contributions to the fund.

·                               The Federal Deposit Insurance Reform Conforming Amendments Act of 2005 requires the FDIC to conduct studies of three issues: (1) further potential changes to the deposit insurance system, (2) the appropriate deposit base in designating the reserve ratio, and (3) the Corporation’s contingent loss reserving methodology and accounting for losses.

·                               The 2005 act requires the Comptroller General to conduct studies of (1) federal bank regulators’ administration of the prompt corrective action program and recent changes to the FDIC deposit insurance system, and (2) the organizational structure of the FDIC.

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The final rule consolidates the existing nine risk categories into four and names them Risk Categories I, II, III and IV. Risk Category I replaces the 1A risk category.

Within Risk Category I, the final rule combines supervisory ratings with other risk measures to differentiate risk. For most institutions, the final rule combines CAMELS component ratings with financial ratios to determine an institution’s assessment rate. For large institutions that have long-term debt issuer ratings, the final rule differentiates risk by combining CAMELS component ratings with these ratings. For large institutions within Risk Category I, initial assessment rate determinations may be modified within limits upon review of additional relevant information.

The final rule defines a large institution as an institution that has $10 billion or more in assets. With certain exceptions, beginning in 2010, the final rule treats new institutions (those established for less than five years) in Risk Category I the same, regardless of size, and assesses them at the maximum rate applicable to Risk Category I institutions.

The final rule sets actual rates beginning January 1, 2007, as follows:

* Rates for institutions that do not pay the minimum or maximum rate vary between these rates.

These rates are three basis points above the base rate schedule adopted in the final rule:

* Rates for institutions that do not pay the minimum or maximum rate vary between these rates.

The final rule continues to allow the FDIC Board to adjust rates uniformly from one quarter to the next, except that no single adjustment can exceed three basis points. In addition, cumulative adjustments cannot exceed a maximum of three basis points higher or lower than the base rates without further notice-and-comment rulemaking.

The billing for deposit insurance is now quarterly and in the arrears.   Payment for the first quarter 2007 deposit insurance premiums will be collected in June 2007.  The Bank’s portion of the one-time initial assessment credit is estimated to be approximately $49,000, which will be used to offset deposit insurance premiums; the assessment credit cannot be used to offset FICO premiums.

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The Financing Corporation (FICO), established by the Competitive Equality Banking Act of 1987, is a mixed-ownership government corporation whose sole purpose was to function as the financing vehicle for the Federal Savings and Loan Insurance Corporation (FSLIC).  Effective December 12, 1991, as provided by the Resolution Trust Corporation Refinancing, Restructuring and Improvement Act of 1991, the FICO’s ability to issue new debt was terminated.  Outstanding FICO bonds, which are 30-year non-callable bonds with a principal amount of approximately $8.1 billion, mature in 2017 through 2019.

The FICO has assessment authority, separate from the FDIC’s authority to assess risk-based premiums for deposit insurance, to collect funds from FDIC-insured institutions sufficient to pay interest on FICO bonds.  The FDIC acts as collection agent for the FICO.  The Deposit Insurance Funds Act of 1996 (DIFA) authorized the FICO to asses both Bank Insurance Fund (BIF) and Savings Association Insurance Fund (SAIF) insured deposits, and required the BIF rate to equal one-fifth the SAIF rate through the year 1999, or until the insurance funds are merged, whichever occurs first.  Thereafter, BIF and SAIF insured deposits will be assessed at the same rate by FICO.

The FICO assessment rate is adjusted quarterly to reflect changes in the assessment basis of the respective funds based on the quarterly Call Report and the Thrift Financial Report submissions.  The FICO quarterly rates for 2007 were 1.22, 1.22, 1.14 and 1.14.  The FICO quarterly rate for the first quarter of 2008 is 1.14.

Interstate Banking and Branching

On September 29, 1994, the President signed into law the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the “Interstate Act”).  Under the Interstate Act, beginning one year after the date of enactment, a bank holding company that is adequately capitalized and managed may obtain regulatory approval to acquire an existing bank located in another state without regard to state law.  A bank holding company would not be permitted to make such an acquisition if, upon consummation, it would control (a) more than 10% of the total amount of deposits of insured depository institutions in the United States or (b) 30% or more of the deposits in the state in which the bank is located.  A state may limit the percentage of total deposits that may be held in that state by any one bank or bank holding company if application of such limitation does not discriminate against out-of-state banks.  An out-of-state bank holding company may not acquire a state bank in existence for less than a minimum length of time that may be prescribed by state law except that a state may not impose more than a five year existence requirement.

The Interstate Act also permitted affective June 1, 1997, mergers of insured banks located in different states and conversion of the branches of the acquired bank into branches of the resulting bank.  Each state may permit such combinations earlier than June 1, 1997, and may adopt legislation to prohibit interstate mergers after that date in that state or in other states by that state’s banks.  The same concentration limits discussed in the preceding paragraph apply.  The Interstate Act also permits a national or state bank to establish branches in a state other than its home state if permitted by the laws of that state, subject to the same requirement and conditions as for a merger transaction.

The Interstate Act is likely to increase competition in the Bank’s market areas especially from larger financial institutions and their holding companies.  It is difficult to asses the impact such likely increased competition will have on the Bank’ operations.

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On October 2, 1995, the “California Interstate Banking and Branching Act of 1995” (the “1995 Act”) became effective.  The 1995 Act generally allows out-of-state banks to enter California by merging with, or purchasing, a California bank or industrial loan company which is at least five years old.  Also, the 1995 Act repeals the California Interstate (National) Banking Act of 1986, which previously regulated the acquisition of California banks by out-of-state bank holding companies.  In addition, the 1995 Act permits California state banks, with the approval of the Superintendent of Banks, to establish agency relationships with FDIC-insured banks and savings associations.  Finally, the 1995 Act provides for regulatory relief, including (i) authorization for the Superintendent to exempt banks from the requirement of obtaining approval before establishing or relocating a branch office or place of business, (ii) repeal of the requirement of directors’ oaths (Financial Code Section 682), and (iii) repeal of the aggregate limit on real estate loans (Financial Code Section 1230).

Community Reinvestment Act and Fair Lending Developments

The Bank is subject to certain fair lending requirements, reporting obligations involving home mortgage lending operations and Community Reinvestment Act (the “CRA”).  The CRA generally requires the federal banking agencies to evaluate the record of financial institutions in meeting the credit needs of their local community, including low and moderate income neighborhoods.  In addition to substantial penalties and corrective measures that may be required for a violation of certain fair lending laws, the federal banking agencies may take compliance with such laws and CRA into account when regulating and supervising other activities.

In May, 1995, the federal banking agencies issued final regulations which change the manner in which they measure a bank’s compliance with its CRA obligations.  The final regulations adopt a performance-based evaluation system which bases CRA ratings on an institution’s actual lending service and investment performance rather than the extent to which the institution conducts needs assessments, documents community outreach or complies with other procedural requirements.  In March 1994, the Federal Interagency Task Force on Fair Lending issued a policy statement on discrimination in lending.  The policy statement describes the three methods that federal agencies will use to prove discrimination: overt evidence of discrimination, evidence of disparate treatment and evidence of disparate impact.  Management of the Bank believes that the Bank is in substantial compliance with all requirements under these provisions.  Following the Bank’s most recent CRA examination, the Bank’s rating was “satisfactory”.

Other Regulations and Policies

The federal regulatory agencies have adopted regulations that implement Section 304 of FDICIA which requires federal banking agencies to adopt uniform regulations prescribing standards for real estate lending.  Each insured depository institution must adopt and maintain a comprehensive written real estate lending policy, developed in conformance with prescribed guidelines, and each agency has specified loan-to-value limits in guidelines concerning various categories of real estate loans.

Section 24 of the Federal Deposit Insurance Act (the “FDIA”), as amended by the FDICIA, generally limits the activities and equity investments of FDIC-insured, state-chartered banks to those that are permissible for national banks.  Under regulations dealing with equity investments, an insured state bank generally may not directly or indirectly acquire or retain any equity investment of a type, or in an amount, that is not permissible for a national bank.  An insured state bank is not prohibited from, among other things, (i) acquiring or retaining a majority interest in a subsidiary, (ii) investing as a limited partner in a partnership the sole purpose of which is direct or indirect investment in the acquisition, rehabilitation or new construction of a qualified housing project, provided that such limited partnership investments may not exceed 2% of the bank’s total assets, (iii) acquiring up to 10% of the voting stock of a company that solely provides or reinsures directors’, trustees’ and officers’ liability insurance coverage or bankers’ blanket bond group insurance coverage for insured depository institutions, and (iv) acquiring or retaining the voting shares of a depository institution if certain requirements are met.

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FDIC regulations implementing Section 24 of the FDIA provide that an insured state-chartered bank may not, directly, or indirectly through a subsidiary, engage as “principal” in any activity that is not permissible for a national bank unless the FDIC has determined that such activities would pose no risk to the insurance fund of which it is a member and the bank is in compliance with applicable regulatory capital requirements.  Any insured state-chartered bank directly or indirectly engaged in any activity that is not permitted for a national bank must cease the impermissible activity.

Financial Modernization Act

Effective March 11, 2000, the Gramm-Leach-Bliley Act eliminated most barriers to affiliations among banks and securities firms, insurance companies, and other financial service providers, and enabled full affiliations to occur between such entities.  This new legislation permits bank holding companies to become “financial holding companies” and thereby acquire securities firms and insurance companies and engage in other activities that are financial in nature.  A bank holding company may become a financial holding company if each of its subsidiary banks is well capitalized under the prompt corrective action provisions discussed above, is well managed, and has at least a satisfactory rating under the Community Reinvestment Act by filing a declaration that the bank holding company wishes to become a financial holding company.  No regulatory approval will be required for a financial holding company to acquire a company, other than a bank or savings association, engaged in activities that are financial in nature or incidental to activities that are financial in nature, as determined by the Federal Reserve Board.  The Bank has no current intention of becoming a financial holding company, but may do so at some point in the future if deemed appropriate in view of opportunities or circumstances at the time.

The Gramm-Leach-Bliley Act defines “financial in nature” to include securities underwriting, dealing and market making; sponsoring mutual funds and investment companies; insurance underwriting and agencies; merchant banking activities; and activities that the Federal Reserve Board has determined to be closely related to banking.  A national bank (and therefore, a state bank as well) may also engage, subject to limitations on investment, in activities that are financial in nature, other than insurance underwriting, insurance company portfolio investment, real estate development and real estate investment, through a financial subsidiary of the bank, if the bank is well capitalized, well managed and has at least a satisfactory Community Reinvestment Act rating.  Subsidiary banks of a financial holding company or national banks with financial subsidiaries must continue to be well capitalized and well managed in order to continue to engage in activities that are financial in nature without regulatory actions or restrictions, which could include divestiture of the financial in nature subsidiary or subsidiaries.  In addition, a financial holding company or a bank may not acquire a company that is engaged in activities that are financial in nature unless each of the subsidiary banks of the financial holding company or the bank has a Community Reinvestment Act rating of satisfactory or better.

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The Gramm-Leach-Bliley Act also imposes significant new requirements on financial institutions with respect to the privacy of customer information, and modifies other existing laws, including those related to community reinvestment.

USA Patriot Act of 2001

On October 26, 2001, President Bush signed the USA Patriot Act of 2001.  Enacted in response to the terrorist attacks in New York, Pennsylvania and Washington, D.C. on September 11, 2001, the USA Patriot Act is intended to strengthen U.S. law enforcement’s and the intelligence communities’ ability to work cohesively to combat terrorism on a variety of fronts.  The potential impact of the USA Patriot Act on financial institutions of all kinds is significant and wide ranging.  The USA Patriot Act contains sweeping anti-money laundering and financial transparency laws and requires various regulations applicable to financial institutions, including:

·                                           due diligence requirements for financial institutions that administer, maintain, or manage private bank accounts or correspondent accounts for non-U.S. persons;

·                                           standards for verifying customer identification at account opening; and

·                                           rules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering.

The Bank implemented the requirements under the USA Patriot Act during 2001 and 2002.  Compliance with such requirements has all been accomplished with existing staff, so the financial impact on the Bank has been negligible.

Regulatory Enforcement Powers

Commercial banking organizations, such as the Bank, may be subject to enforcement actions by the FDIC and the Superintendent for engaging in unsafe or unsound practices in the conduct of their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency.  Enforcement actions may include the imposition of a conservator or receiver, the issuance of a cease-and-desist order that can be judicially enforced, the termination of insurance of deposits, the imposition of civil money penalties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the issuance of removal and prohibition orders against institution-affiliated parties and the imposition of restrictions and sanctions under the prompt corrective action provisions of the FDICIA.

California and Federal Banking Law

The Federal Change in Bank Control Act of 1978 prohibits a person or group of persons “acting in concert” from acquiring “control” of a bank or holding company unless the appropriate federal regulatory agency has been given 60 days’ prior written notice of such proposed acquisition and, within that time period, has not issued a notice disapproving the proposed acquisition or extending for up to another 30 days the period during which such a disapproval may be issued. An acquisition may be made prior to the expiration of the disapproval period if the agency issues written notice of its intent not to disapprove the action.  The acquisition of more than 10% of a class of voting stock of a bank (or holding company) with a class of securities registered under Section 12 of the Securities Exchange Act of 1934, as amended (such as the Common stock), is generally presumed, subject to rebuttal to constitute the acquisition of control.

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Under the California Financial Code, no person shall, directly or indirectly, acquire control of a California licensed bank or a bank holding company unless the Superintendent has approved such acquisition of control.  A person would be deemed to have acquired control of the Corporation under this state law if such person, directly or indirectly, has the power (i) to vote 25% or more of the voting power of the Corporation or (ii) to direct or cause the direction of the management and policies of the Corporation.  For purposes of this law, a person who directly or indirectly owns or controls 10% or more of the Common stock would be presumed to control the Corporation, subject to rebuttal.

                In addition, any “company” would be required to obtain the approval of the Federal Reserve under the Bank Holding Company Act of 1956, as amended (the “BHC Act”), before acquiring 25% (5% in the case of an acquirer that is, or is deemed to be, a bank holding company) or more of the outstanding Common stock of, or such lesser number of shares as constitute control over, the Bank or the Corporation.

The Community Reinvestment Act of 1977 (“CRA”) and the related Regulations of the Comptroller of the Currency, the Board of Governors of the Federal Reserve and the Federal Deposit Insurance Corporation (“FDIC”) are intended to encourage regulated financial institutions to help meet the credit needs of their local community or communities, including low and moderate income neighborhoods, consistent with the safe and sound operation of such financial institutions.  The CRA and such regulations provide that the appropriate regulatory authority will assess the records of regulated financial institutions in satisfying their continuing and affirmative obligations to help meet the credit needs of their local communities as part of their regulatory examination of the institution.  The results of such examinations are made public and are taken into account upon the filing of any application to establish a domestic branch, to merge or to acquire the assets or assume the liabilities of a bank.  In the case of a bank holding company, the CRA performance record of the subsidiary bank(s) involved in the transaction is reviewed in connection with the filing of an application to acquire ownership or control of shares or assets of a bank or to merge with any other bank holding company.  An unsatisfactory record can substantially delay or block the transaction.

RESEARCH

Neither the Corporation nor the Bank makes any material expenditures for research and development.

DEPENDENCE UPON A SINGLE CUSTOMER

Neither the Corporation nor the Bank is dependent upon a single customer or very few customers.  The Bank’s business is concentrated in, and largely dependent upon the strength of the local economy in, the Monterey Peninsula area of Northern California.  The local economy is affected by both national trends and by local factors.  Tourism and the activities at the former Fort Ord military base are among the major contributors to the local economy.

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The Corporation repurchased 3,795 shares of common stock at $4.00 per share in 2005; no shares were repurchased in 2007 or 2006.

The following table sets forth, according to information known to the Corporation, the price paid per share in, and volume of, transactions in the Corporation’s stock during the quarters ended March 31, 2005 to December 31, 2007.

(1)           For the period presented, the information indicated might not include information on shares which may have been traded directly by shareholders or through dealers.

The principal source of cash flow of the Corporation, including cash flow to pay dividends on its stock or principal and interest on debt, is interest and dividends on investments and tax benefit payments and dividends from the Bank.  There are statutory and regulatory limitations on the payment of dividends by the Bank to the Corporation, as well as by the Corporation to its shareholders.

If in the opinion of the applicable federal and/or state regulatory authority, a depository institution or holding company is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the depository institution or holding company, could include the payment of dividends), such authority may require, after notice and hearing (except in the case of an emergency proceeding where there is in no notice or hearing), that such institution or holding company cease and desist from such practice.  Moreover, the Federal Reserve and the FDIC have issued policy statements which provide that bank holding companies and insured depository institutions generally should only pay dividends out of current operating earnings.

Under the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), an FDIC insured depository institution may not pay any dividend once it is undercapitalized or if payment would cause it to become undercapitalized.

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The Bank’s payment of dividends, as a California chartered commercial banking corporation, is regulated by the California Financial Code.  Under the California Financial Code, funds available for cash dividend payments by the Bank are restricted to the lessor of: (i) retained earnings; or (ii) the Bank’s net income for its last three fiscal years (less any distributions to the stockholders made during such period).  As of December 31, 2007 the Bank had $13,050,000 in retained earnings.  The Bank’s net income for the last three fiscal years less distributions to stockholders was $8,160,000.

In December 2007, 2006 and 2005 the Corporation paid cash dividends to shareholders of $0.25, $0.35 and $0.20 per share, respectively.  The Bank paid cash dividends totaling $800,000 and $625,000 to the Corporation during 2007 and 2006, respectively; no dividends were paid in 2005.

The following table provides a summary of the consolidated income statement, balance sheet, and selected ratios for the last five years.  A more detailed analysis of each component of net income is included under the appropriate captions, which follows.

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(1)           Basic earnings per share amounts were computed on the basis of the weighted average number of shares of common stock during the year.  The weighted average number of shares used for this computation was 1,785,812 for 2007, 1,658,675 for 2006, 1,614,196 for 2005, 1,576,589 for 2004 and 1,528,268 for 2003.

(2)           Fully diluted earnings per share amounts were computed on the basis of the weighted average number of shares of common stock and common stock equivalents outstanding during the year.  Common stock equivalents include employee stock options.  The weighted average number of shares used for this computation was 1,881,004, 1,831,892, 1,923,532, 1,919,512 and 1,796,859 in 2007, 2006, 2005, 2004 and 2003, respectively.

(3)   Weighted average common shares.

(4)   Includes loans being held for sale.

(5)           Averages are of daily balances.

Critical Accounting Policies

The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in the Bank’s financial statements and accompanying notes.  Management believes that the judgments, estimates and assumptions used in preparation of the Bank’s financial statements are appropriate given the factual circumstances as of December 31, 2007.

Various elements of the Bank’s accounting policies, by their nature, are inherently subject to estimation techniques, valuation assumptions and other subjective assessments.  Critical accounting policies are those that involve the most complex and subjective decisions and assessments and have the greatest potential impact of the Bank’s results of operation.  In particular, management has identified one accounting policy that, due to judgments, estimates and assumptions inherent in this policy, and the sensitivity of the Bank’s financial statements to those judgments, estimates and assumptions, are critical to an understanding of the Bank’s financial statements.  This policy relates to the methodology that determines the allowance for loan and lease losses.

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Management has discussed the development and selection of this critical accounting policy with the Audit Committee of the Board of Directors.  Although Management believes the level of the allowance at December 31, 2007 is adequate to absorb losses inherent in the loan portfolio, a decline in the regional economy may result in increasing losses that cannot reasonably be predicted at this time.   For further information regarding the allowance for loan losses see “Provision and Allowance for Loan Losses,” and Note 6 to the Bank’s audited financial statements included elsewhere herein.

Recently Issued Accounting Standards

                Refer to Note 1 to the Financial Statements — “Summary of Significant Accounting Policies” for discussion of the recently issued accounting standards.

NET INTEREST INCOME

                Net interest income, the difference between (a) interest and fees earned on interest-earning assets and (b) interest paid on interest-bearing liabilities, is the most significant component of the Bank’s earnings.  Changes in net interest income from period to period result from increases or decreases in the average balances of interest earning assets portfolio, the availability of particular sources of funds and changes in prevailing interest rates.

                The following table summarizes the Corporation’s net interest income.

                Net interest income increased $376,000 or 4.4% from 2006 to 2007.  Average interest bearing assets increased 23.71%, while the average rate earned decreased 8 basis points, resulting in an increase of $3,181,000 in total interest income.  Interest expense increased $2,805,000 the result of a 32.02% increase in average interest bearing liabilities, while the average rate paid increased 68 basis points.

                Net interest income increased $1,544,000 or 22.0% from 2005 to 2006.  Average interest bearing assets increased 11.30%, while the average rate earned increased 120 basis points, resulting in an increase of $3,069,000 in total interest income.  Interest expense increased $1,525,000 the result of a 6.56% increase in average interest bearing liabilities, while the average rate paid increased 100 basis points.

                The following table shows the components of net interest income, setting forth, for each of the three years ended December 31, 2007, 2006 and 2005 (i) average assets, liabilities and investments, (ii) interest income earned on interest-earning assets and interest expense paid on interest-bearing liabilities, (iii) average yields earned on interest-earning assets and average rates paid on interest-bearing liabilities, (iv) the net interest spread (i.e., the average yield earned on interest-earning assets less the average rate paid on interest-bearing liabilities) and (v) the net interest yield on average interest-earning assets (i.e., net interest income divided by average interest-earning assets).  Yields are computed on a tax-equivalent basis, resulting in adjustments to interest earned on non-taxable securities of $330,000, $149,000 and $138,000 in 2007, 2006 and 2005, respectively.  Non-accrual loans and overdrafts are included in average loan balances.  Average loans are presented net of unearned income.

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DISTRIBUTION, RATE AND YIELD ANALYSIS OF NET INTEREST INCOME:

The following table shows the consolidated average balances of earning assets, and interest-bearing liabilities; the amount of interest income and interest expense; the average yield or rate for each category of interest-earning assets and interest-bearing liabilities; and the net interest income and the net interest spread for the periods indicated:

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The following table shows a rate and volume analysis for changes in interest income, interest expense, and net interest income for the periods indicated.