## MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 

years or less as well as adjustable rate mortgages. Average commercial and municipal loans offset the decline in 1-4 family mortgage loans and grew $142.9 million, primarily in shorter term and variable rate lending. In addition, 2003 included increases in average installment loans of $41.4 million over 2002 levels. The Corporation has continued to capitalize on lending opportunities with small to mid-sized commercial borrowers, including loans generated through its preferred Small Business Administration (“SBA”) lender status. The Corporation has consistently been one of the top small business lenders in Pennsylvania. 

Interest income on investments declined $16.3 million for 2003 compared to 2002 primarily due to interest rate decreases. Interest rate decreases were also the primary cause of the decline of $10.5 million in interest income on investments in 2002 compared to 2001 levels. Yields on investments for 2003 continued to decline, falling to 4.64% compared to 5.95% for 2002 and 6.45% for 2001. As with the loan category, the increase in average investment security volumes was not enough to offset the reduced interest income caused by declining yields. All categories of interest income on investments were negatively impacted by interest rate changes with the largest decline being registered in the U.S. government agency category, declining $20.4 million due to interest rates declining 162 basis points (1.62%) for 2003 compared to 2002. This decline was partially offset by an increase of $10.4 million in interest income on U.S. government agency securities as a result of average volume increases from 2003 to 2002. Prepayment speeds of mortgage backed securities (“MBS”) continued to accelerate in 2003 as interest rates continued to decline. Interest rate changes have a direct impact on prepayment speeds. As interest rates increase, prepayments tend to decline and average lives of MBS increase. As interest rates decrease, prepayment speeds tend to increase and average lives of MBS decline, which accelerates the amount of premium amortization that is realized, further reducing the yields in current periods. Using computer simulation modeling, the Corporation tests the average life and yield volatility of all MBS under various interest rate scenarios on a continuing basis to insure that volatility falls within acceptable limits. The Corporation holds no “high risk” securities nor does the Corporation own any securities of a single issuer exceeding 10% of shareholders’ equity other than U.S. government and agency securities. 

Interest on deposits dropped $18.5 million for 2003 compared to 2002 primarily as result of decreases due to interest rates of $16.9 million. The Corporation also registered decreases in interest expense of $1.6 million due to declines in average volumes of deposits in 2003 compared to 2002. The rate on savings deposits fell 40 basis points (0.40%) resulting in a decrease to interest expense of $3.2 million for 2003 compared to 2002, while the rate on time deposits for 2003 also declined, down 76 basis points (0.76%), compared to 2002 resulting in a decrease to interest expense of $11.6 

million. The deposit mix changed in 2003 as clients registered a preference for savings products, which jumped $64.8 million or 8.9%, while time deposits dropped $67.6 million or 4.2% due to continued economic uncertainties. Average interest-bearing demand deposit balances for 2003 also advanced, up $41.1 million over 2002 balances. During its management of deposit levels and mix, the Corporation continues to evaluate the cost of time deposits compared to alternative funding sources as it balances its goals of providing clients with the competitive rates they are looking for while also minimizing the Corporation’s cost of funds. 

Interest expense on short-term borrowings rose $726 thousand during 2003 primarily as a result of volume increases of $3.8 million which were partially offset by rate decreases of $3.1 million. Average short-term borrowings rose by $214.2 million for 2003 compared to 2002 while the cost of short-term borrowings fell by 55 basis points (0.55%) compared to the prior year. All categories of short-term borrowing costs declined from year-to-year. The increase in short-term borrowings is due in part to $100 million of long- term debt that matured during the fourth quarter of 2002 and was replaced with short-term borrowings. In addition, the increase in short-term borrowings can be attributed to an ALCO strategy implemented to mitigate the risk of further declines in net interest income resulting from a low or declining interest rate environment. The increase in short- term borrowings funded the purchase of U.S. government agency securities maturing in approximately 3.5 years. 

Interest expense on long-term debt declined $4.7 million for 2003 compared to the 2002 period as decreases due to volume of $4.3 million were further reduced by decreases due to rate of $376 thousand. Average long-term debt for 2003 decreased by $75.9 million compared to 2002. This was due in part to the $100 million of long-term debt that matured during the fourth quarter of 2002 that was replaced by short-term borrowings. Long-term debt includes additional subordinated debentures in the amount of $30.9 million, which were issued during 2003, bearing an adjustable interest rate based upon the three-month LIBOR and maturing in 30 years. The proceeds will be used by the Corporation to partially fund the pending acquisition of GA Financial, Inc. (“GAF”). Refer to NOTE 17 for further discussion of subordinated debentures that are included in long-term debt. 

Net interest margin (net interest income, on a tax-equivalent basis as a percentage of average earning assets) declined to 3.47% for 2003, a decrease of 33 basis points (0.33%) compared to 2002. The year-to-year decrease in the margin was due to asset yields declining more quickly than the cost of funds as interest rates fell to historic lows. Continued pressure on net interest income is anticipated by the Corporation, despite active management of interest rate risk. The Corporation’s use of computer simulation to manage interest rate risk is described in the “Interest Sensitivity” section of this discussion. 

